Bond market development indicators

Financial Sector Indicators Note: 6 Part of a series illustrating how the (FSDI) project enhances the assessment of financial sectors by expanding the measurement dimensions beyond size to cover access, efficiency and stability. Data on these dimensions, as well as other information relevant for financial sector assessment, will become available online during Summer 2006. Bond market development indicators Introducing the bond market indicators under the multidimensional indicator system Using multidimensional system to diagnose dimensions of bond markets in countries Information incommensurate with growth Bond financing, both international and domestic, has become an integral and significant part of countries and firms financing, especially for emerging market economies. The size of the global bond market has grown from $25 trillion in 1990 to $57 trillion in 2004, while that of emerging markets has increased from $1 trillion to $4 trillion. International bond financing due to its market oriented nature, being susceptible to short-run developments that affect prices, can be volatile. Domestic bond markets are still less developed in many countries. Therefore, information on this form of financing is particularly important, especially for countries that are relatively new participants. Presently, information on emerging market economies international bonds is more comprehensively captured and documented than that on their domestic bond markets. This is partly because the development of domestic bond markets in general lags that of international markets, yet there is a greater interest in monitoring on part of international investors. Overall, efforts on measuring bond market development for a large cross-section of countries other than high income ones, remain limited. The FSDI project, as part of its objective to assess comprehensively financial systems, introduces indicators for monitoring bond markets as per the four dimensions of the financial system size, access, efficiency and stability (refer to FSDI dossier for information on the concept and framework utilized). Information organized per these dimensions helps Bond market indicators in FSDI Size Ratio of private sector bonds to GDP Ratio of public sector bonds to GDP Ratio of international bonds to GDP Dummy variable: Existence of bond market Dummy variable: Existence of corporate bond market Access Government bond yields (3 months and 10 years) Ratio of domestic to total debt securities Ratio of private to total debt securities (domestic) Ratio of new corporate bond issues to GDP New corporate bond issued ($ billion) Efficiency Quoted bid-ask spreads (10-yr government bond yield) Turnover of private sector bond on securities exchange Turnover of public sector bond on securities exchange Settlement Efficiency Index Stability Volatility of sovereign bond index Skewness of sovereign bond index Ratio of short-term to total bonds (domestic) Ratio of short-term bond to total bonds (international) Correlation with German bond returns Correlation with US bond returns page 1

understand better the relative development of bond markets around the world, as well as the strengths and weaknesses of each dimension. Size The size dimension comprises the most commonly used measures of bond markets, notwithstanding that the other three dimensions can be equally important. Ideally, FSDI would like to record comprehensively the size of bond markets globally. However, given the limited amount and reliability of data from many developing countries, this goal cannot be met. Nonetheless, as a first step, utilizing documents, statistical handbooks, websites and correspondence with individual securities exchanges around the world, a map (below) depicting the trading of bonds (public and corporate) has been put together. For the measure of size, public, private and international bonds are included. This section discusses first the indicators of the size of bond markets and then briefly comments on the determinants. More than 130 countries have some bond securities traded on exchanges. These countries cover nearly 77% of the world s gross domestic product (measured at purchasing power parity term) and 91% of world s population. Public sector bond markets Based on the World Bank s Financial Structure Database, FSDI utilizes the basic measure of public bond market size, namely, the ratio of public sector bonds to GDP. This measure is available for most countries since 1990. The public sector bond market size varies across regions and income groups. In terms of both absolute and relative (to GDP) terms, North America leads the rest of the world, with the largest bond market, followed by Europe, where in some individual countries public bond markets are more developed than in the U.S. Asia outperforms Latin America, for which the relative measure (as a ratio of GDP) is the smallest among all developing regions (left graph, next page). High income OECD countries have substantially larger bond markets, while the relative size of bond markets in middle Documenting the existence of bond markets worldwide page 2

Ratio of public sector bond to GDP, by region Percent 55% North America Ratio of public sector bond to GDP, by income Percent 50% High Income:OECD 45% Europe & Central Asia 40% Low Income 35% South Asia Sub Saharan Africa 30% 20% Upper Middle Income 25% East Asia & Pacific Latin America & Caribbean 10% Lower Middle Income High Income: Other 15% 2000 2001 2002 2003 0% 93 95 97 99 01 03 income countries is generally indistinguishable from the one in low income countries, even though the difference may be significant in absolute terms. Private sector bond markets FSDI documents global trading of corporate bonds, which is also depicted in the world map. A total of 104 countries, covering 75% of world GDP and 85% of world population, have corporate bonds traded on securities exchanges. As a measure of private sector bond issues, the ratio of private sector bond to GDP is available since 1990. The graph below shows the relative distribution of private sector bonds to GDP for different income groups. The change in the ranking of income groups compared with public sector bonds is noticeable. International bond issues International bonds in part reflect a country s ability to raise capital globally, and in FSDI this is measured by the ratio of international bonds to GDP. Developing countries, because of limitations in the management of their fiscal and exchange rate policies, have difficulty utilizing international markets, although there has been significant progress in their cross-border bond issuance since the mid- 1990s. Almost 96% of the international debt secu- Ratio of private sector bond to GDP, by income Percent 50% 40% 30% 20% High Income: Other High Income:OECD Upper Middle Income Ranking by ratio of Int'l. bonds to GDP (%) High Low Lebanon Saudi Arabia Liberia Pakistan Iceland India Netherlands China Ireland Iran 10% 0% Lower Middle Income Low Income 2000 2001 2002 2003 page 3

rities outstanding are accounted for by high-income countries. Most developing countries, e.g., Pakistan, Iran etc., have low international bond to GDP ratios. However, some developing countries, like Lebanon and Liberia, have a high international bond to GDP ratio (table, previous page). Determinants of bond market size The size of a country plays an important role in determining whether it operates a securities exchange (Clayton, Jorgensen, and Kavajecz, 2006). A literature survey suggests that this is also applicable to bond markets. Countries with less developed or non-existent domestic bond markets are in general small countries. And countries with small financial markets tend to have small bond markets. The correlation coefficient between the ratios of international bond to GDP and private credit to GDP has a value of 35%. However, small countries can overcome the size constraint and develop bond markets by issuing bonds in foreign countries and foreign currencies, or by developing common securities exchanges and spreading the infrastructure costs among members. The size of the bond market, measured by private sector bond to GDP ratio is positively correlated with the size of the banking sector (left graph, below). Academic literature, such as Claessens, Klingebiel, and Schmukler (2003) and Burger and Warnock (2005), show that the main determinant of the size of the bond market is the protection of creditor rights in a country. Creditors are willing to purchase arm s length securities products such as corporate bonds, only when they are convinced that their claims will be repaid without too much difficulty. The graph (below, right) illustrates the positive correlation between countries institutional framework, which incorporates creditor rights, and the ratio of private sector bonds to GDP. Access Access, especially with regard to domestic market is useful and effective only when the cost of capital is low and the process of obtaining capital for the domestic private sector is relatively easy. Cost of capital: As a proxy measure of the cost of capital, data on 3-month and 10-year government bond yields are collected utilizing information from the World Federation of Exchanges (WFE). Ease of access: To measure access, two indicators are created based on data from the Bank for International Settlements: Banking sector and bond market development Ratio of private sector bonds to GDP (%) 120% 100% Creditor protection and bond market development Ratio of private sector bonds to GDP (%) 120% 100% Denmark 80% 60% Italy Netherlands 80% 60% France 40% 40% Australia 20% Argentina Switzerland 20% Peru 0% 5 105 205 Ratio of private credit to GDP (%) 0% 1 3 5 7 9 Creditor Rights Index page 4

(i) Ratio of domestic bonds to total bonds outstanding. This reflects the capacity of local markets to provide capital for issuers. It is assumed that in order to reduce currency mismatch, an issuer would prefer raising capital domestically than internationally, unless the domestic market is underdeveloped. Value of new corporate bonds to GDP, 2004 Percent 22 17 12 (ii) Ratio of private sector bonds to total domestic bonds outstanding. This indicator helps measure the convenience of obtaining capital for the domestic private sector. The composition of a country s outstanding debt securities also reflects the ease of access to capital for private borrowers. This information is important from the perspective of borrowers, and the private sector in particular, as it makes apparent the degree of accessibility and thus affects financing decisions. 7 2 High income: OECD High income: Other Low income Lower middle income Upper middle income Using Thomson Financial as a source, data on the local corporate bond market s absolute capacity to raise new capital are collected. This offers a flow measure of access to bond markets. Both the number and value of new corporate bond issues in domestic markets are available in FSDI annually for 2001-2005 for an exhaustive list of countries around the world. The data show that corporations in high-income OECD countries account for nearly 90% of the corporate bond issues globally. Corporate bond issues in developing countries are still small by global standards, as well as incommensurate with their rising share of production in the world economy. Private sector information Information on private sector participants in bond markets is important from the following perspective: For the bond market to play an effective role in the growth of business, it has to be able to facilitate financing for both the corporate sector and the government. It reflects systematic progress in creditor protection, legal infrastructure etc., in a country, as the development of corporate bond markets requires more systematic progress than does the development of government bond markets (Claessens et al, 2005). It reflects facilitation of private credit. Heavy issuance of bonds by the government, coupled with regulations forcing banks to purchase and hold such securities, can result in financial repressions and crowding out of the private sector. Value of new corporate bonds issues, 2004 4% 2% 3% 2% 89% High income: OECD High income: Other Upper middle income Lower middle income Low income page 5

Efficiency Efficiency of bond markets is as important as their size. More than 130 countries operate some form of organized bond market, but only about 50 have become substantial in size, and an even smaller number are efficient by international standards. To measure the efficiency of bond markets, FSDI focuses on the liquidity of markets as reflected by the tightness of the quoted bid-ask spread and the turnover ratio. Substantial and adequate liquidity enables markets to fulfill their roles in diversifying risks, monitoring issuers, and allocating resources for more productive purposes. Quoted bid-ask spreads on government bond yields (as of March 2006) are obtained for a large cross-section of countries from major marketmakers of sovereign bonds in developed and emerging markets. The following patterns are revealed: In European countries that have adopted the Euro as their currency, bid-ask spreads on bond yields are lower than one basis point, while in other countries with similar fundamentals, e.g., Sweden, traders have to pay substantially higher spreads. The bid-ask spreads on government securities of Asian emerging economies in general are between 6-10 basis points and much below those for Latin American countries. Ranking of Countries by Bid-Ask Spreads Tight Spread Wide Spread USA Vietnam Austria Peru Germany Qatar Belgium Dominican Republic France Pakistan Quoted bid-ask spread worldwide (10-yr government bond yield; basis points) page 6

The data on turnover ratio (from WFE) for both private and public sector bonds traded on secondary markets is another efficiency indicator. However, these numbers do not include the many trades that settle outside the stock exchanges between, for example, financial institutions and over the counter markets. Stability Lack of stability in bond markets can contribute to a higher cost of capital and discourage investors from entering the markets. For example, high volatility in the price of benchmark government bonds hampers the development of yield curves and the adequate pricing of corporate bonds. Due to paucity of high frequency data on corporate bonds, FSDI primarily focuses on government bonds. Daily return index of sovereign bonds are collected from both Datastream (for developed economies) and Citibank (for mainly emerging markets). Based on the daily return indices, volatility (annualized standard deviation), skewness, maturity structure and correlation between bond returns are analyzed. Volatility: This is the commonly used measure of stability. Analysis highlights that volatility in select developing countries is below that in developed markets. This maybe the outcome of (i) trading of bonds being less active in developing countries, and in many instances prices remain unchanged for several weeks; and (ii) interest rate regulation in some markets sometimes distorts the true cost of capital. As such, underestimation of instability in developing countries remains a distinct possibility. Skewness: This indicator gauges the probability of large negative losses associated with countries sovereign bonds. Losses concern investors more than large surges of bond prices. As shown in the map (below), bond returns in developed markets in general exhibit less negative skewness, i.e., they are less likely to deliver large negative returns than those in developing countries. Skewness of government bond returns page 7

Short-term bond to total bond ratio (%) Argentina 5.4 Australia 45.0 France 31.4 Germany 31.3 India 7.7 Indonesia 13.7 United Kingdom 40.7 United States 21.7 Correlation with US and Euro Bond Returns US Euro Canada 0.85 0.09 Chile 0.91 0.09 China 0.82 0.11 Mexico 0.64 0.18 Netherlands 0.58 0.43 United Kingdom 0.58 0.42 Maturity: A large share of short-term securities in total securities debt is an important sign for instability and risk, as it heightens vulnerability to sudden outflows of capital, or surges of short-term interest rate that can increase the burden of debt service. Correlation: This refers to the correlation of a country s bond returns with returns on U.S. or German (Euro) bonds. Lower correlation indicates higher diversification and therefore less crossborder synchronicity. The table above (right) shows that geographic proximity with the U.S. (and vice-versa Germany) results in higher correlation. Composite Indicators FSDI provides composite indicators for the dimensions of the bond market (size, access, efficiency and stability), as well as for their overall development. These composite indicators have been constructed using the standardized methodology utilized in the FSDI framework. Dimensions complimentary Overall, the four dimensions of bond market development are positively correlated. Larger bond markets are more efficient and provide easier access to lower cost domestic capital. This reinforces previous findings, such as those in McCauley and Remolona (2000), which suggest that a critical size of around $100-$200 billion is required to support a liquid market. Further, countries that do well in size are also more stable. Smaller markets are more volatile and closely correlated with major developed markets, and in addition the maturity structure of their debt is shorter. The table on page 10 presents the composite bond Composite Bond Market Indicators Size USA Brazil Creating composite indicators The composite indicator for each of the various four dimension of capital markets is comprised of subindicators. These sub-indicators are standardized by subtracting the median of the distribution and scaled by the standard deviation of the distribution. These standardized scores are then averaged to create the composite indicator for each dimension. Stability India Efficiency Access page 8

market indicators for the multidimensional system and the correlation between the four dimensions. As an example of benchmarking all four dimensions, a comparison of Brazil, India and the U.S. is presented in the radar chart (previous page). The U.S. has the most developed bond market among the three countries, while India s bond market is more stable than Brazil s even though the latter has a larger bond market compared with the former. Correlation matrix for composite indicators Size Access Efficiency Stability Size 1.00 Access 0.40* 1.00 Efficiency 0.46* 0.40* 1.00 Stability 0.05 0.09-0.02 1.00 * indicates significance at the 5% level The four-dimension analytical capacity provided by FSDI serves as a powerful mechanism for identifying strengths and weaknesses in bond markets and can be utilized effectively for the purposes of policy formulation and reforms. Select References Burger, John D., and Francis E. Warnock, 2005, Foreign participation in local-currency bond markets, Working Paper. Clayton, Matthew J., Bjorn N. Jorgensen and Kenneth A. Kavajecz, 2005, On the presence and market-structure of exchanges around the world, Journal of Financial Markets, Vol.9(1): 27-48. Claessens, Stijn, Daniel A. Klingebiel, Sergio L. Schmukler, 2005, Government Bonds in Domestic and Foreign Currency: The Role of Institutional Factors, Review of International Economics. McCauley, Robert and Eli Remolona, Size and Liquidity of Government Bond Markets, BIS Quarterly Review, November 2000. Data Sources Bloomberg Bank of International Settlements (BIS) Datastream Financial Structure Database, The World Bank Thomson Financial World Federation of Exchanges (WFE) page 9

Bond Market Composite Indicators and Ranking Country Size Efficiency Access Stabilty Overall DNK 7.92 8.33 6.46 3.96 6.67 JPN 8.76 5.99 5.98 5.04 6.44 USA 7.54 6.06 6.43 5.26 6.32 ISL 9.92 5.00 5.00 5.00 6.23 SWE 6.07 9.30 5.52 3.65 6.13 NLD 8.08 6.13 4.84 4.38 5.86 ITA 7.49 6.10 5.39 4.34 5.83 AUT 6.06 6.00 4.94 6.12 5.78 BEL 7.59 6.13 5.33 3.93 5.75 FRA 6.54 6.13 5.33 4.59 5.65 DEU 6.13 6.16 5.12 5.07 5.62 GRC 6.89 6.04 4.43 5.00 5.59 ESP 5.87 6.01 5.44 4.76 5.52 KOR 5.29 5.33 6.15 5.00 5.44 PRT 6.02 6.10 5.28 4.05 5.36 CHE 5.19 5.15 6.58 4.42 5.34 CAN 5.87 6.06 5.00 4.38 5.33 COL 4.36 7.41 4.03 4.70 5.12 POL 4.49 5.87 3.76 6.09 5.05 SGP 5.32 5.40 5.10 4.22 5.01 SVK 4.32 5.70 5.00 5.00 5.01 FIN 5.57 6.10 4.75 3.60 5.00 GBR 5.37 7.24 3.82 3.55 5.00 IRL 6.40 6.31 4.36 2.91 4.99 MYS 5.86 4.13 5.70 4.28 4.99 NOR 4.71 5.88 5.20 4.07 4.96 AUS 5.10 5.92 5.09 3.66 4.94 CZE 5.18 4.51 5.00 5.00 4.92 THA 4.45 4.51 5.53 5.00 4.87 HKG 4.33 4.71 5.19 5.00 4.81 CHL 4.68 4.08 5.55 4.82 4.78 ZAF 4.67 3.77 4.22 5.53 4.55 IND 4.35 4.53 4.26 5.00 4.54 ARG 4.35 4.99 3.54 5.00 4.47 RUS 3.48 4.69 5.00 4.55 4.43 NZL 4.30 5.00 5.00 3.15 4.36 HUN 5.01 3.12 3.52 5.38 4.26 IDN 4.10 3.47 4.61 4.26 4.11 MEX 4.17 4.14 3.09 4.47 3.97 TUR 5.09 4.16 3.20 3.35 3.95 PAK 4.39 1.94 5.00 4.07 3.85 BRA 5.16 3.12 3.10 2.83 3.55 PHL 4.57 2.79 2.18 4.57 3.53 PER 3.66 2.55 4.49 3.27 3.49 page 10