DEPARTMENT OF MANAGEMENT RESEARCH PAPERS VOLATILITY TRANSMISSION IN ASIAN BOND MARKETS: TESTS OF PORTFOLIO DIVERSIFICATION

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1 DEPARTMENT OF MANAGEMENT RESEARCH PAPERS VOLATILITY TRANSMISSION IN ASIAN BOND MARKETS: TESTS OF PORTFOLIO DIVERSIFICATION Nitawan Charoenwongse and Jenifer Piesse Research Paper 39 Subject area: International Business To request a paper please contact Andrea Sudbury at the following address: Department of Management King s Colege London Franklin-Wilkins Building 150 Stamford St London SE1 9HN Tel/Fax: 44(0) andrea.sudbury@kcl.ac.uk Corresponding Author: Jenifer Piesse Department of Management King s Colege London Franklin-Wilkins Building 150 Stamford St London SE1 9HN Tel/Fax: 44(0) jenifer.piesse@kcl.ac.uk 1

2 VOLATILITY TRANSMISSION IN ASIAN BOND MARKETS: TESTS OF PORTFOLIO DIVERSIFICATION 1 Nitawan Charoenwongse Deloitte Touche Tohmatsu, Bangkok, Thailand Jenifer Piesse King s Colege London, UK and University of Stelenbosch, RSA Abstract The 1997 Asian financial crisis illustrated the need to develop local bond markets to reduce vulnerabilities to future mismatches in currency and maturity. The paper focuses on regional initiatives, such as the Pan-Asian Bond Index Fund, and tests the implications for portfolio diversification. Intra- and inter-regional transmission of bond market volatilities between Hong Kong, Singapore and South Korea and from the US and Japan is investigated. Results show that while Hong Kong and Singapore are highly integrated into global capital markets, the prospects of diversification of investment become undermined. The study provides evidence to assist policymakers in designing bond-index funds as a strategy for portfolio diversification to promote the regional bond markets. JEL classifications: G15, O16 Keywords: International financial markets, Integration, East Asia 1 The views expressed in this paper are those of the authors and do not necessarily reflect those of Deloitte Touche Tohmatsu. The authors thank Dr Chaiwat Vibulsawasdi, the former Governor of Bank of Thailand and advisor to the Finance Minister, for valuable input on the development of the regional bond markets in Asia. 2

3 Volatility Transmission in Asian Bond Markets: Tests of Portfolio Diversification Introduction In the 1990s, emerging economies experienced recurring financial crises associated with sudden reversals of capital flows and liquidity shortages as countries relied excessively on short-term foreign borrowing (Broner et al, 2004; Jang, 2003). Consequently, lessons learned from the Asian financial crisis in 1997 have indicated the urgent need to develop localcurrency bond markets as the source of longer-term financing, and thus reduce the vulnerabilities to future double mismatches in maturity and currency in these economies (IMF, 2002). In addition, in the absence of a well-functioning bond market, it is clear that the damage caused to the real economy from the financial crisis is much greater than originally thought and the necessary restructuring more protracted (Dalle, 2003; Reserve Bank of Australia, 2003). Nonetheless, evidence suggests that fears of future currency crises are no longer an issue for policymakers in Asia, given recent stockpiles of foreign reserves that are close to two-thirds of the world reserves (Chaipravat, 2004; Preiss, 2004). Rather, many authors point out that a more important problem is the inefficiency and the instability of these official reserves, which are mostly held in US$ by these economies. In particular, the inefficient financial intermediation in the region is the result of Asians investing heavily in low-yielding foreign assets while foreigners are investing in high-yielding assets in the Asian domestic markets. That is, Asian savings are being sent abroad only to return in the form of foreign investments. Therefore, it is critical that Asian policymakers develop more liquid local bond markets to create domestic intermediation and reduce the increasing inefficiency and instability that results from an excessive reliance on US$ reserves (Ma and Remolona, 2005; Hamada et al, 2004). Investigating movements in bond markets is significant to the development of economic and financial systems because bond markets are not only instruments for facilitating monetary policies, but also suppliers of information for macroeconomic analysis as well as pricing strategies in financial markets. In particular, studies of yield volatility provide a number of useful implications with respect to bond markets including the prediction for market returns or bond yields. In addition, it is noted that some particular maturities of bond yields, particularly ten-years, are more liquid than others in the international markets, and thus more appropriate for benchmark bond analyses. For example, ten-year government bonds are 3

4 used most frequently for benchmark analyses in Asian countries, such as India, Malaysia, Singapore and Thailand (McCauley and Jiang, 2004; Mohanty, 2001). Similarly, Alonso et al (2004) suggest that ten-year government bonds are the most liquid class of Spanish government securities given liquidity measures such as number of trades, trading volume and turnover ratio and McCauley and Jiang (2004) argue that the benchmark bond analyses in Japan, the Euro area and Australia are based on ten-year government bonds. This paper investigates the developing bond markets in South East Asia since the 1997 crisis, including the instruments and institutional arrangements in three Asian markets and tests of volatility in those markets. Section 1 discusses the characteristics of these local markets and the initiatives introduced to establish a functioning secondary market for domestically sourced financial intermediation. Section 2 reviews the literature on empirical tests of volatility in bond markets and the next section describes the econometric approaches to modelling volatility. The data and estimation is described in Section 4, followed by the analysis, results. Section 6 provides some discussion and policy implications and the final section concludes. 1 The development of Bond markets in South East Asia There is considerable evidence of a substantial demand for local-currency bond markets in East Asia. Jiang and McCauley (2004) argue that because of the diversity in withholding tax, regulatory and legal factors, and a different degree of infrastructure development, the localcurrency bond markets in East Asia are segmented, both from each other and global fixedincome markets and thus investment and be diversified in these markets following only moderate movements with US returns. In addition, arbitrage opportunities for issuers between foreign- and local-currency debt markets exist where lower costs of borrowing can be exploited and a local-currency yield curve would allow market participants to hedge foreign exchange exposures, either with forwards or cross-currency interest rate swaps (Reserve Bank of Australia, 2003; Ghon Rhee, 2000). Similarly, Hirose et al (2004) suggest that the growth of local-currency bond markets in East Asia provides opportunities for foreign companies to diversify funding sources and fund managers greater opportunity for portfolio diversification. In the public sector, government securities can reduce the risk of excessive reliance on central bank funding and enhance more transparent governance and credibility, while high levels of government borrowing to fund fiscal deficits can be met efficiently in the nonintermediated debt market as well as providing a benchmark for other fixed-income securities 4

5 (Reserve Bank of Australia, 2003). In addition, McCauley (2003) argues that transforming central bank debt into government securities increases liquidity in the secondary market from consolidating public debts, and attracts more investors. Even governments that have built up large net asset positions, such as Hong Kong and Singapore, continue to issue fixed-income securities in the interests of developing a well-functioning bond market with reliable pricing benchmarks and effective management of financial risks (Amyx, 2004; Hirose et al, 2004). Finally, Ma and Remolona (2005) argue that the development of local bond markets is beneficial for establishing the market for local information which is both important in the functioning of these markets and also helps to reduce substantial borrowing costs in the economy. This is supported by Broner et al (2004) who suggest that due to risk aversion to emerging markets, international capital markets charge relatively high risk premia for longer maturity securities, which forces the emerging economies to borrow short-term. This is particularly critical during crises where there is a tendency to issue shorter maturity instruments despite increasing exposure to liquidity crises. Therefore, establishing localcurrency yield curves could greatly contribute to the stability of the financial system, reducing overall risk and spreading remaining risk across many risk-diverse participants more familiar to the markets. However, despite these positive features, and the growth of the markets since the financial crisis of 1997, the local-currency bond markets in East Asia remain small in terms of trading volume than those in industrialised countries (IMF, 2002). In an attempt to establish benchmark yield curves, South East Asian governments repeatedly issue large amounts of securities in the bond markets with the expectation that this would encourage increased market activity, but so far, this has been largely unsuccessful. One reason is that the main investors in the region, such as government pension funds and banks, adopt buy-and-hold investment strategies (Hirose et al, 2004). Another is that well functioning hedging markets are an important determinant of market liquidity and in East Asia, active and developed swap markets exist only in Singapore and Hong Kong, while the rest of the region is characterised by regulatory restrictions and the lack of any reliable reference rates (Jiang and McCauley, 2004, Mohanty, 2001). Thus so far, investors in the region remain reliant on foreign-currency bond markets, with the US$ dominating local-currency borrowing. This reflects the close link between a number of Asian currencies and the US$, and the fact that the US$ bond markets are still more liquid, especially for securities of longer maturities than the local-currency Asian bonds (Reserve Bank of Australia, 2003). Equally important, evidence suggests that the local- 5

6 currency markets in East Asia have so far failed to achieve their potential in terms of actual diversification of investment. Following the sell-offs in the US market in mid 2003, there were periods of market volatility in East Asian markets and the 10-year bond yields in China, Singapore, Taiwan and Thailand all under-performed compared to US treasury notes. Ma and Remolona (2005) characterise the East Asian bond markets as failing when needed most. During the 1997 crisis, these economies contracted and governments rejected foreign borrowing in favour of domestic funding but found that local secondary markets were not sufficiently liquid to function efficiently. But encouraging, most bond markets in East Asia are now growing with government bonds playing a central role, although these markets still face major bottlenecks in terms of tradability, especially with a narrow investor base and lack of active dealers such as hedge funds. Given the liquidity problems, a broader investor base is needed to improve bond market liquidity, not only because of size effects, but also as more diversity of risk profiles from a larger number of investors would enable smooth dissipation of market shocks. To attempt to reverse this situation, policymakers in each country have developed several multilateral initiatives to improve the dynamics of the local-currency bond markets and attract investments to increase efficient financial intermediation (Chaipravat, 2004; Hamada et al 2004; Hirose et al, 2004). The remainder of this section briefly describes these initiatives. i The emergence of regional initiatives and Asian Bond Funds (ABFs) It is well documented that individual markets in East Asia have the benefit of more security and stability from regional level of cooperation than efforts at the country-level (Hamada et al 2004; Dalle, 2003; McCauley, 2003). In particular, establishing regional supervisory and guarantee agencies, mobilising more resources and harmonising market regulations to expand bond issuance and investments internationally, will result in faster and more efficient development of local bond markets. Finally, the case for regional co-operation is made by Mohanty (2001), noting the problem of low liquidity and underdevelopment in emerging market economies and emphasising the benefits in terms of efficiency and spillovers that results from coordinating infrastructure and shared resource costs in building bond markets on a regional level. Currently, there are three major government-sponsored international organisations in East Asia actively involved in the development of a well-functioning regional bond market. First is the Asia-Pacific Economic Cooperation (APEC), which facilitates the development of securitisation and credit guarantee markets. Second is the Asian Bond Market Initiative (ABMI), under the framework of the Association of South East Asian Nations plus South 6

7 Korea, Japan and China (ASEAN+3). This focuses on the establishment of regional market infrastructure, including the role of credit ratings agencies and settlement procedures, with a primary responsibility of developing liquid bond markets. Finally, the Executive Meeting of East Asian and Pacific (EMEAP) 2 has been established to create the instruments (ABFs) on which the market is based. ABFs represent the first regional pooling of international reserves in Asia as member central banks attempt to stimulate investment activities in their local bond markets. In June 2003, the EMEAP central banks launched their first project, the Asian Bond Fund 1 (ABF1), pooling $1 billion in international reserves from 11 member countries invested in a basket of US$ denominated government bonds. The fact that the ABF1 only limited itself to dollar denominated bonds, which are mostly traded in more developed international markets, led to the second project being more directly involved in promoting local-currency bond markets. The $2 billion Asian Bond Fund 2 (ABF2) was announced in December 2004 in two phases. The first limited the funds to the pool of international reserves of the member central banks. The next will allow funds to be open to institutional and retail investors, both domestically and internationally (EMEAP, 2005). Figure 1 The ABF2 consists of nine separate funds including the Pan-Asian Bond Index Fund (PAIF) and eight single market-funds, shown in Figure 1. The ABF2 is expected to provide an incentive mechanism to reduce impediments in local markets. It is planned to be a new asset class in Asia, and is expected to support the development of regional markets. In particular, the structure of the ABF2 should help clarify the legal framework, regulations and taxation in each country, and improve the infrastructure of the bond markets by eliminating several related structural barriers such as capital controls in Malaysia. In addition, the benefits of the ABF2 are expected to enhance the development of corporate bond markets by establishing more credible benchmarks. ii The Pan-Asia Bond Index Fund (PAIF) Within the structure of the ABF2 is a single-index bond fund, the Pan-Asia Bond Index Fund (PAIF), which is aimed at diversified investment in government bonds. The PAIF is issued by the EMEAP member countries, and quoted in US$ on an unhedged basis. Initially, it will be based in Singapore and listed on the Hong Kong Stock Exchange while additional listings on other EMEAP stock exchanges will be considered at a later stage. Both the ABF2 and the 2 These are the central banks and monetary authorities in Australia, China, Hong Kong, Indonesia, Japan, Malaysia, New Zealand, the Philippines, Singapore, South Korea and Thailand. 7

8 PAIF are expected to broaden and deepen the domestic and regional bond markets, and contribute to more efficient financial intermediation in Asia (EMEAP, 2005). Figure 2 To determine the portfolio allocation of the PAIF, the market weight is calculated using four factors; local market size, turnover ratio, sovereign credit rating, and market openness factors, such as the availability of hedging instruments and the standard of clearing and settlement systems (International Index Company, 2005). South Korea, Singapore and Hong Kong currently earn the top market weights in the PAIF portfolio while the Philippines and Indonesia have the least weight. This is shown in Figure 2. The potential benefits of portfolio diversification are derived from all three instruments and represent the core element in promoting the local bond markets and regional cooperation. However, their impact is highly dependent on the degree of volatility transmission in these markets. Understanding the relationship of returns including the correlation and the volatility of returns is relevant from the perspective of a fund manager (McCauley and Jiang, 2004), and the PAIF is important for foreign portfolio investment and the main objective of these regional initiatives. This paper investigates the patterns of volatility transmission in the three major PAIF bond markets, Hong Kong, Singapore and South Korea, to determine the potential for portfolio diversification. The paper adopts the argument of McCauley and Jiang (2004) that if Asian bond risk is measured by the volatility of returns, then including these instruments a portfolio will offer a favourable risk-return trade-off relative to US Treasury bonds. The only other study of bond markets in East Asia during the post-crisis period is Batten et al (2004), which examines the co-movements of government bond yields by issuers in China, South Korea, Malaysia, Philippines and Thailand in international markets. Thus, this paper contributes to the literature by investigating the scope of diversification resulting from the Pan-Asia Bond Index Fund and the dynamics of portfolio investment in these emerging financial markets. 2 Empirical tests of volatility in bond markets Standard investment theory states the risk premium on a corporate bond depends on maturity and the default risk. Cai et al (2004) investigate the time trend of bond volatility in the US using a CAPM approach on a sample of daily market returns, time-to-maturity and credit ratings from 1996 and 2000 from Lehman Brothers Corporate Index database. Results show that the volatility of bond market returns is a significant predictor of bond yields, especially when forecasting one- and three-month ahead returns, suggesting that while bond and equity 8

9 volatilities are important for explaining contemporaneous bond returns, only bond volatility has the capacity to predict bond returns. Moreover, analysis of volatility in bond markets is also important in exploring integration between financial markets. Bodart and Reding (1999) examine volatility of asset returns in Germany, France, Belgium, Italy, the UK and Sweden, from January 1989 to December 1994 and finds significant transmission of volatility in bond and currency markets, although not in equity markets. Uncertainty surrounding the conduct of domestic monetary policy was also found to be a major determinant of the volatility of bond prices. In a further study, Fleming et al (2001) find that market volatility also plays a central role in derivative pricing, optimal portfolio selection and risk management in financial markets, using daily returns on S&P 500 stock index futures, US Treasury bond futures and gold futures from 1983 to Prediction based on volatility modelling is also found to be statistically significant. A number of papers investigate links between bond markets with analyses of volatility and bond yields. Sutton (2000) examined the historical trends of ten-year government bond yields in the US, Japan, Germany, the United Kingdom and Canada, from 1960s to 1992, using regression to test the co-movements of bond yields between countries, based on term structure expectations theory. These results show that bond yields in these markets have excess volatility and co-movements relative to the base model with a positive correlation across the markets. In a similar paper, Yang (2005a) examines links among six government bonds markets in Belgium, France, Germany, Italy, Netherlands and the UK based on monthly government bond indices from the J P Morgan total return government bond index from January 1988 and December Granger-causality tests and contemporaneous correlation indicate that European bond markets are interdependent with moderate integration in the short run, with no distinctive leadership evident. Bernoth et al (2003) examine bond yield differentials among Eurobonds issued in 15 EU countries between 1991 and 2002 to estimate yield spreads of Eurobonds between countries, using four main groups of variables: fiscal variables, corporate bond spreads, maturity and liquidity. Findings show that default probabilities, liquidity of bond markets and investors aversion to credit risk significantly determine bond yield differentials in these markets, and the financial markets do not treat European Monetary Union (EMU) member states systematically differently from nonmember states. That is, there is no evidence that bond markets in the EMU are more integrated than those in non-member countries. 9

10 Several authors examining international bond market linkages focus on determining the weights of domestic and international influences on the co-movements of markets. In a study of the integration of government bond markets by Christiansen (2003), volatility spillover effects from the US and aggregate European bond markets to individual European markets are investigated using weekly data from January 1988 and November Results fall into two groups. For Denmark and the EMU countries, European effects (regional effects) are the most important in explaining the volatility in each market, followed by country effects (local effects), while the US volatility spillover effects (global) are not statistically significant. However, in non-emu countries (Sweden and the UK), local effects and global effects tend to be more significant while regional volatility has a smaller effect in these markets. This suggests that the introduction of the euro is an important factor in determining whether European and US spillovers of volatility strengthened or dampened and also accounts for substantial differences between the nature of the volatility of bond markets in EMU and non- EMU member states. In a study of crisis periods, Clare and Lekkos (2001) examine the relationship between bond markets using the government bond yield curve in the US, Germany and the UK, by estimating the term structure of weekly one- and ten-year interest rates of zero-coupon government bonds from 1990 to 1999 to determine the separate effects of domestic and international factors on yields. Results show that during financial crises, such as the sterling exchange rate crisis in 1992, the Asian financial crisis in 1997 and the Russian debt crisis in 1998, the slopes of the yield curves responded mainly to international factors in terms of portfolio reallocation by international investors, while the covariance between the US, German and UK bond market indices during these crises suggest strong contagion effects. Finally, a study of excess volatility of interest rates in international bond markets indicates the presence of an international component in terms of levels of uncertainty about the commitment of monetary authorities to fighting drastic changes of inflation in a number of countries (Sutton, 2000). 3 Approaches to modelling volatility in international bond markets Three aspects to establishing linkages between fixed-income markets are common in the literature. First is the relationship between current volatility and past patterns of volatility. This is based on a vector autoregression (VAR) framework for cointegration tests, and estimates a vector of bond yield series for five government bond markets with yields lagged one period (Yang, 2005b). This method is also used to investigate volatility transmission 10

11 between financial markets, where equity indices are used to examine the significance of market volatilities at national and regional levels (Cifarelli and Paladino, 2005; Piesse and Hearn, 2005) The second relationship evident in the estimation of volatility in bond markets highlights the role of currency markets, in particular, a link between the appreciation of local currency against the US$ and a sudden cessation of capital flows, as well as a rise in bond yields (Battern et al, 2004; Jahjah and Yue, 2004; Bernoth et al, 2003; Hoontrakul, 2002; Bodart and Reding, 1999). Many studies include the value of domestic currency against the US$ in estimating bond volatility to explain credit spreads of Asian sovereign bonds that have implications for macroeconomic uncertainty in these countries. Thirdly, many studies include capital market movements, such as the effect of equity markets, to estimate the volatilities of bond markets. In a study of spillover effects in European bond markets, Christiansen (2004) investigates the relationship of volatilities in bond and equity markets, with a sample from 1988 to 2003, using generalized autoregressive conditionally heteroskedastic (GARCH) methods to estimate unexpected bond market returns. The variance between US bonds and equities, European bonds and equities, and own country bond market variance are found to be statistically significant, suggesting that all levels of effects, local, regional and global, are important for European bond volatility. As noted above, recent empirical studies of international bond markets focus on industrialised countries, although there is now some literature on emerging markets. Min (1998) investigates the determinants of dollar-denominated bond spreads in eleven emerging markets including East Asia and Latin America from 1991 to 1995, using a regression approach. This suggests that external shocks, such as international interest rates, are not significant but there is a relationship between other macroeconomic variables and a constant that represents the risk-free world interest rate (US Treasury bill). Battern et al (2004) investigate yield spreads between benchmark US Treasury bonds and sovereign bonds issued in international markets by major Asia Pacific issuers in China, Malaysia, the Philippines, South Korea and Thailand between December 1999 and November This estimated the daily volatility structure of credit spread returns with interest rates and also the stock market index, as a proxy for an asset parameter. Results show that credit spreads of Asian sovereign bonds are negatively related to changes in US interest rates, and asset and exchange rate variables are more important in the Philippines than the other countries. Finally, Hoontrakul (2002) estimated credit spreads with interest rates and a stock index with a sample of yields of Thai government bonds issued in the domestic foreigncurrency market and of US Treasury bonds for different maturities. The study suggests 11

12 limitations to the market approach for pricing and managing risks of Thai bonds using US Treasury bonds with equivalent maturity. That is, while credit spreads of Thai government bonds are negatively related to changes in indices of the Stock Exchange of Thailand (SET Index), changes in US Treasury bond yields affect these spreads positively for long maturity bonds. This study explores volatility transmission of local-currency bond markets in East Asia during the post-crisis period using two econometric techniques. Firstly, correlation analysis investigates co-movements of volatilities between countries. Secondly, regression models are used to estimate the volatilities of the three markets with the effects of movements in foreign exchange rates, equity markets, and volatilities of bond markets in more advanced countries. The results are valuable in providing new evidence of intra- or inter-regional volatility transmission and the diversity of major bond markets in East Asia. 4 Data and Model i Data This study uses data from Hong Kong, Singapore and South Korea, plus Japan and the US, for January 2003 to 2 June Unfortunately, incomplete data from further countries in the region limits the analysis to these countries. However, since are characterised by relatively high trading volumes and advanced trading and settlement systems, yield benchmarks ensure efficiency and therefore economic and pricing information is more accurate than the less active markets in the region. In addition, the inflation rates (macroeconomic factor) in these three markets are more stable than those in other countries in the group of Asian Bond Fund during the sample period, especially the Philippines and Indonesia (Asian Development Bank, 2005). As can be seen in Table 1, for the whole region, sovereign debt markets are very important, particularly in both Hong Kong and Singapore, where these comprise the total bond market. Furthermore, South Korea accounts for nearly 50% of the total government debt for the region. Credit ratings for these markets show high categories from both Standard & Poor s and Moody s, with Singapore the highest rated but Hong Kong and South Korea also in the top band (See Table 2). Tables 1 and 2 In the analysis, the data is daily, and was obtained from three main sources. Yield volatility of local-currency benchmark ten-year government bonds was collected from the 12

13 Asian Development Bank, a coordinator of Asian Bond Market Initiative (ABMI) 3 and is the standard deviation of the change in daily yields of ten-year government bonds. The changes of daily yields are derived from the previous closing bid yields of local currency benchmark ten-year government bonds, computed by Reuters. The explanation from the Asian Development Bank for highlighting analyses of yield volatility is that it allows for the interpretation of interest rate risk. That is, high volatility increases the uncertainty of daily movements in bond yields. Equity indices from Hong Kong (Hang Seng), Singapore (Straits Times), and South Korea (KOSPI) are from Datastream, and converted into daily rates of change. One hypothesis of the estimating model is that movements of national equity indices should explain volatility in bond yields. Finally, US$ exchange rates are from Thomson One Banker, with the domestic currency expressed in US$ and again, expressed as daily rates of change. These transformations are to test the hypothesis that relationships exist between the financial markets and also to provide a common unit of measurement across countries. Table 3 Table 3 reports summary statistics and correlations between the data in all three markets. The Singapore bond market has the lowest mean volatility (0.0522) and South Korean the highest (0.0633). However, there are more differences in the dispersion measure, with South Korea the highest (0.0293) and Hong Kong the lowest (0.0164). These data reflect previous observations on patterns of volatility in bond markets in the region. Jiang and McCualey (2004) note that transactions in a more liquid market can be carried out more cheaply and rapidly without affecting price or leading to high volatility. As a result, the lower volatility in Singapore and Hong Kong should imply higher market liquidity and more efficiency than that in South Korea. Similarly, taxes on transfers of financial instruments impose an explicit transaction cost and therefore their removal can improve trading and liquidity in bond markets (Mohanty, 2001), while Dalle (2003) argues that Singapore and Hong Kong have the most generous tax regime for investing, issuing and intermediation in the bond markets, but South Korea lags in market development. High volatility in a bond market can be a result of high volatility in the overnight rate and insufficient development of the money market. Furthermore, a well developed money market reduces liquidity risks for bondholders by providing access to the immediate cash market, and also facilitates the development of sovereign long-term yield curves. In

14 particular, the 3% reserve requirement in South Korea, compared with 0% in Hong Kong, reduces the depth of the money market, and makes investors face heightened liquidity risks that limit their ability to undertake maturity transformation (Mohanty, 2001). Two issues should be noted in Table 3. Firstly, mean past volatilities of the advanced markets, especially Japan (0.0349), are lower than those of the three emerging markets. Bond markets in Japan and the US have higher liquidity and more efficient transactions than two of the emerging markets, despite their dominant roles in the region. Singapore appears to be an exception, with a mean past volatility (0.0523) slightly lower than that of the US (0.0573). Secondly, equity indices in all three countries have a higher standard deviation than do their currency markets. This implies that domestic currencies in these Asian markets are on average more stable than their national stock exchanges. Hong Kong in particular, has the greatest variation between these two indices, with the currency market dispersion (0.0004) lower than the Hang Seng index (0.0099). This currency index is also the least volatile of the countries in the study. ii Model The estimating equations in this paper considers current volatility to be a function of historical patterns, and the significant relationship between bond yields, asset parameters where stock index is a proxy, and foreign exchange rate effects. The model for each country firstly takes account of volatility from the developed country markets and then adds that of the other countries in the region to examine the transmission or spillover effects within and across the region. Following the literature, the specifications are: V = + V + EQX + Forex + VJapan + VUS + (1) i,t 0 1 i,t-1 2 i 3 i 4 t-1 5 t-1 i and V = + V + EQX + Forex + VJapan + VUS + V + (2) i,t 0 1 i,t-1 2 i 3 i 4 t-1 5 t-1 1 j,t-1 i where in (1) V it is bond volatility in country i, at time t, and V i,t-1 is lagged one period. EQX is the change in the equity index and Forex is the change in the domestic exchange rate with respect to the US$. The last two terms represent bond volatility in Japan and the US, following by an error term. In (2), the trading markets in the other sample countries are also included to determine the volatility transmission between these markets and identify possible spillover effects within the region. It should be noted these are wholly or near time-synchronous, with Hong Kong and Singapore in a common time zone and South Korea (plus Japan) one hour ahead. 14

15 5 Results i Correlation Analysis Two sets of correlations are computed on these three markets, as shown in Table 4. Firstly, correlations of bond volatilities indicate significant and positive links between these markets at the 1% significance level. Second, Box-Ljung autocorrelation tests do not detect any significant time trends of volatilities in the three markets. This suggests that any links identified are not simply the result of spurious relationship caused by strong time trends. Table 4 As shown in the Table, the correlation between Hong Kong and Singapore is the highest (0.608) while South Korea has relatively low correlations with both Hong Kong (0.194) and Singapore (0.372). These low correlation could reflect strong influences of domestic factors such as the credit standing of government issuers. South Korea appears to have lower credit rating than both Hong Kong and Singapore, which hold a similarly higher ratings class. Country ratings reflect the risks associated with the ability of governments to service debt obligations, and particularly, in relatively low and medium rated economies, country-specific factors like political events weigh heavily on bond markets (McCauley and Jiang, 2004). As a result, there is the potential for investment diversification in South Korea from these two markets, given low correlations. The high correlation between Hong Kong and Singapore can be explained by the development of derivatives markets, which also explains the relatively low volatilities in the two markets. Mohanty (2001) argues that securities lending and short-selling promote liquidity by preventing settlement failure, and increasing arbitrage opportunities. However, these hedging strategies are not available in every emerging market and only a few, such as Hong Kong and Singapore, allow these operations, due to required risk management practices and heightened risks to the financial systems. In summary, the correlations are all less than 0.608, suggesting there may be other relevant factors determining volatility in each country and these will be investigated in the next section. ii Econometric analysis These results are divided into two main parts; country level factors and the effects of volatility transmission at intra- and inter-regional levels, reported in Table 5. Table 5 a) Hong Kong In the top part of the Table, positive coefficients indicate that past patterns of domestic volatility and that in the US are both important in explaining current volatility in Hong Kong, 15

16 although the domestic influence is much greater (0.907 versus ). However, past volatility from Japan has a negative impact in Hong Kong, although this estimate is not significantly different from zero. The lower half of the table shows results of the specification that includes the intra-regional effects. Here, past domestic volatility is the most important positive effect, followed by a slightly increased influence from the US, but a negative and significant transmission of volatility from Singapore. As before, transmission from Japan is negative but insignificant and no impact enters from South Korea. From this it is reasonable to conclude that because of the negative relationship between Singapore and Hong Kong, the potential benefits of diversification and reduced risks of volatility transmission can be achieved by investing in the two markets. In neither equations are other markets, such as equity or foreign exchange, a determinant of domestic volatility in Hong Kong. b) Singapore Results for Singapore are similar to those of Hong Kong. There is a significant and positive relationship between current return volatility and that of past returns in Singapore and the US. Thus, when there is high volatility in US bond markets, there is transmission to the Singaporean market. Firstly, the transmission of volatility from Hong Kong to Singapore is unidirectional, as there is no evidence of the reverse effect. However, volatility from South Korea is apparent in the Singaporean bond market. In addition, the foreign exchange market is also as a determinant of volatility of domestic bond markets, with a positive and significant estimated coefficient in both parts of Table 5. Thus, there is evidence of a transmission of volatility from the United States to Singapore and also risks from investment in the Singaporean bond market will be higher as the Singapore dollar strengthens against the US$. This supports the findings of Jahjah and Yue (2004), who note that exchange rate appreciation is not always beneficial. A stronger local currency makes external financing cheaper and debt-service costs in local currency lower, but increased likelihood of default presents higher risk to the economy. In this case, although Singapore is one of the more advanced and stable economies in Asia, risk can arise from the domestic bond market, particularly given the domination of these markets by sovereign debt, as noted in Table 1. c) South Korea Finally, the results for South Korea are shown in the right hand columns of Table 5 and clearly reflect a different pattern of volatility transmission from that in the Hong Kong and Singapore bond markets. Past domestic volatility alone determines current volatility, as while the estimated coefficients on the US and Japan have opposite signs, in common with the other markets, neither is significantly different from zero. In both specifications, volatility is 16

17 influenced by the foreign exchange markets, similar to Singapore, but uniquely in this sample the domestic equity market enters as a positive and significant effect in South Korea. Thus, this market is subject to different patterns of volatility transmission than the other two. Therefore, given the pattern in equity and currency markets, the interdependence of domestic financial systems in South Korea appears to be higher than those in the other two countries. In particular, the transmission of volatility between bond and currency markets indicates a cumulative effect, that is, investors tendency to hedge aggressively during periods of increased exchange rate volatility leads to further instability, as recognised by Hirose et al (2004). Finally, it is interesting to note that despite synchronous trading hours for Japan and South Korea and only a one hour difference between Japan, Hong Kong and Singapore, there is not evidence of volatility transmission in these domestic bond markets. The dominance of the Japanese bond market in the region fails to provide any explanations for bond volatility in these sample countries. 6 Discussion and policy implications i Intra-Regional Volatility The study of intra-regional volatility in this paper focuses on investigating linkages between daily volatilities in Hong Kong and Singapore. Specifically, the two markets have synchronicity of trading data, and share the similar characteristics of advanced financial markets in the region (Dalle, 2003). The results above indicate that volatility in Singapore is a determinant of volatility in Hong Kong, but the reverse is not the case. This is not entirely unexpected as Singapore has been a dominant player in the region, leading the South East Asian economies, despite the common view that Hong Kong represents a regional financial centre due to the relationship with China (Ma and Remolona, 2005; Chaipravat, 2004; Preiss, 2004; Reserve Bank of Australia, 2003). As discussed in Section 2, Singapore and Hong Kong were selected for initial implementation of the index Asian bond fund or the PAIF, before listings on other countries in the region are considered (EMEAP, 2005). Equally important is the negative relationship between Hong Kong and Singapore since high bond yield volatility in Singapore tends to be linked to lower volatility in Hong Kong. Hence, the potential benefits of portfolio diversification by investing in Singapore can be obtained with additional investment in the bond market in Hong Kong as volatility transmission can be beneficial in terms of improved liquidity obtained from dominant markets (Piesse and Hearn, 2005; Mohanty, 2001). Furthermore, market volatility in Hong Kong has 17

18 relatively low risk, measured by the standard deviation, thus the developmentthis market s depth and liquidity ensures that changes in yields are not excessively volatile (Jiang and McCauley, 2004). ii Inter-Regional Volatility In this paper, the transmission of volatility from Japan and the United States is used to examine the pattern of inter-regional volatility in the Asian bond markets. With respect to the former, there is no significant effect of volatility from the Japanese bond market to any of the sample countries. However, volatility from the US is present in both Hong Kong and Singapore, resulting in the transmission of risk between these markets. This outcome is already established in the literature, for example, McCauley and Jiang (2004) using Granger causality tests found that movement of yields in the US market appears to precede changes in Asian bond yields, but not the reverse. The links between bond markets in Hong Kong and Singapore with those of the US is not surprising since these are regional financial centres in East Asia with high levels of market internationalization. Countries that have high credit ratings, globalised domestic markets and considerable foreign investment have relatively high correlations with yield volatility in the US. This result weakens the likelihood of portfolio diversification in these local markets. In addition, research from the Reserve Bank of Australia (2003) argues that derivatives contracts in Hong Kong and Singapore can lead to closer links with the US market because of access to US$ bonds, which can be swapped into local currencies in the Asian markets. Despite limited opportunity for diversification Mohanty (2001) argues that the spillover effects can be beneficial in terms of higher trading volumes, and the range of bid-ask spreads in both Hong Kong and Singapore move to levels similar to those in more mature bond markets. In contrast, volatility in South Korea exhibits no significant relationship with the US market, with little spillover of inter-regional volatility. This can be explained by the lower level of integration into global capital markets, the still segmented character of some markets and the relatively small scale of foreign investment in South Korea (McCauley and Jiang, 2004). The results in this paper indicate that South Korea is substantially different from those countries with greater levels of globalisation. Most evident is that the development of the South Korean bond market has been driven by asset-backed securities in the corporate sector rather than the high levels of government bonds that are issued in Singapore and Hong Kong. The South Korean bond market is largely dominated by domestic banks and financial institutions following the securitisation of non-performing loans caused by the crisis in

19 (Dalle, 2003). Accordingly, the share of foreign market makers in the South Korean bond market is less than 10% while, in the regional financial centres such as Hong Kong and Singapore, it is more than 90% and around 33%, respectively (McCauley and Jiang, 2004). This small number of foreign players and the paucity of international flows in the South Korean bond market help explain the lack of any significant spillover of inter-regional volatility in that country. Conclusion Following the Asian crisis in 1997, several multilateral initiatives have been established to facilitate the development of local-currency bond markets in East Asia. The main objective of regional cooperation is to attract more investment and improve liquidity of the bond markets in order to enhance the efficiency of financial intermediation in the regional financial systems. The paper focuses on one aspect of this policy initiative, which is the creation of the PAIF under the operation of ABF2. The potential benefits of portfolio diversification in PAIF are first explored with the correlation analysis of volatilities in Hong Kong, Singapore and South Korea, which represents the markets with the highest weights in the PAIF. The correlation tests show that volatilities across the three markets are positively related. However, these values are not particularly high and so regression models are used to investigate the determinants of volatilities in the three markets, and the effects of intra- and inter-volatility transmission. The analysis of inter-regional volatility between Hong Kong and Singapore indicates that high volatility in Singapore tends to lower volatility in Hong Kong. Therefore, the risk associated with investing in Singapore can be diversified with a bond market in Hong Kong, but not the reverse. There is evidence of inter-regional spillovers in East Asia as both regressions of Hong Kong and Singapore exhibit the significant transmission of volatility from the United States. High volatility in the US market leads to higher risks of bond volatilities in the two Asian markets. In contrast, the South Korea market does not indicate any similar transmission. However, the South Korean market has relatively high volatility, and appreciation of the South Korean won against US$ increases the volatility of the bond market. In summary, deeper economic and financial integration with more globalised domestic bond markets such as Hong Kong and Singapore can lead to higher correlations with each other and with the US markets, and undermine the prospects of diversification for investors. Therefore, it is important that policymakers, using a strategy of portfolio diversification in 19

20 promoting the regional bond markets, are aware of the diversity in allocating weights in bondindex funds. Nonetheless, putting more weight on less internationalised bond markets is also risky as the markets generally tend to have a high degree of volatility due to a lack of liquidity and market depth. Recommendations for future research are two-fold. One is a study of volatility transmission for various bond durations because different maturities are more liquid in different national markets. Particularly in less-advanced, low-rated markets, traders and other market participants are more actively involved in bonds that have shorter maturities than in ten-year instruments. Secondly, it would be useful to include other Asian countries, especially China, for a study of East Asian bond markets in order to examine the extent of portfolio diversification in the region in more detail. 20

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