Developing the domestic government bond market country experiences and suggestions for vietnam

MINISTRY OF EDUCATION AND TRAINING
UNIVERSITY OF ECONOMICS, HO CHI MINH CITY
FULBRIGHT ECONOMICS TEACHING PROGRAM

--------------------------------------VO CHAU THUY TRIEU

DEVELOPING THE DOMESTIC GOVERNMENT BOND
MARKET: COUNTRY EXPERIENCES AND SUGGESTIONS
FOR VIETNAM

Major: Public Policy
Code: 60340402

MASTER OF PUBLIC POLICY THESIS

SUPERVISOR

Dr. Jonathan R. Pincus

Ho Chi Minh City – 2013


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CERTIFICATION
I hereby certify that
- I wrote the thesis by myself.
- the study has not been submitted for any other degrees.
- any help I received as well as all sources used have been acknowledged in this thesis with
the best of my knowledge.
- the study does not necessarily reflect the views of the Ho Chi Minh City Economics

University or Fulbright Economics Teaching Program.

Author
Vo Chau Thuy Trieu


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Table of Contents
CERTIFICATION ..............................................................................................................................1
ABBREVIATIONS ............................................................................................................................4
LIST OF GRAPHS .............................................................................................................................5
ABSTRACT ........................................................................................................................................6
Chapter 1 INTRODUCTION ..............................................................................................................7
1.1 Background ...............................................................................................................................7
1.2 Policy questions ......................................................................................................................10
Chapter 2 LITERATURE REVIEW .................................................................................................11
2.1 Financial repression is ineffective for the economy................................................................11
2.2 Benefits of a developed domestic government bond market ..................................................13
Chapter 3 COUNTRY EXPERIENCES ...........................................................................................16
3.1 How did Malaysia develop their domestic bond markets? .....................................................16
3.1.1 Situation and motivation for reform .................................................................................16
3.1.2 Key policies......................................................................................................................18
3.1.3 Achievements ...................................................................................................................21
3.2 How did Thailand develop its bond market? ..........................................................................23
3.2.1 Situation and motivation for reform .................................................................................23
3.2.2 Key policies......................................................................................................................25
3.2.3 Achievements ...................................................................................................................29
Chapter 4 VIETNAM........................................................................................................................31
4.1 Developing the bond market is important for Vietnam...........................................................31

4.2Vietnam government debt market overview ............................................................................32
4.3 Types of government debt securities.......................................................................................36
4.3.1 Government bonds ...........................................................................................................36
4.3.2 Government-guaranteed bonds ........................................................................................37
4.3.3 Municipal bonds ...............................................................................................................37
4.4 Investors base ..........................................................................................................................37
4.5 Factors hinder Vietnam’s domestic government bond market ................................................38
4.5.1 Interest rate cap ................................................................................................................41
4.5.2 Statutory liquidity ratios of banks ....................................................................................43
4.5.3 Primary dealers.................................................................................................................43
4.6 Suggestions for Vietnam’s bond market .................................................................................44


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Chapter 5 CONCLUSION ................................................................................................................46
REFERENCES..................................................................................................................................48


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ABBREVIATIONS
BTH: Thailand Bath
HNX: Hanoi Stock Exchange
HSX: Ho Chi Minh City Stock Exchange
MOF: Ministry of Finance
OMO: open market operations
SBV: State Bank of Vietnam
USD: U.S. dollar
VND: Vietnam dong

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LIST OF GRAPHS
Graph 3.1: Bond outstanding value of Malaysia ............................................................... Page 22
Graph 3.2: Domestic financing profile of Malaysia ...................................................................23
Graph 3.3: Size of Thailand financial market .............................................................................24
Graph 3.4: Financing profile of Thailand (% GDP) ...................................................................29
Graph 3.5: Regional Government bond turnover ratio ..............................................................30
Graph 4.1: Bank credit to GDP of regional countries.................................................................31
Graph 4.2: Vietnam bond outstanding value ..............................................................................34
Graph 4.3: Vietnam domestic bond issuances ............................................................................35
Graph 4.4: Vietnam GDP growth and inflation rate ...................................................................39
Graph 4.5: Regional bond market size in % GDP ......................................................................40
Graph 4.6: Regional countries’ government bond bid-ask spreads ............................................41
Graph 4.7: Vietnam government bond auctions over years........................................................42


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ABSTRACT
While other countries use open market operations (OMO) as an indirect instrument to
manage the liquidity in the economy to steer market interest rates, Vietnam has to use
direct instruments of interest rate control which have been proved inefficient for the
economy. After reviewing papers on using OMO to implement monetary policies of
countries in the world, the thesis finds that Vietnam is lacking a vibrant domestic
government bond market to facilitate the conduct of OMO.
Vietnam’s conventional secondary government bond market is just seven years old and the
country’s government debt market is just beginning to develop. By looking at the

experiences of countries in the region which have similar features to Vietnam’s domestic
bond market, this thesis aims to derive lessons to help improve and boost the development
of the domestic government bond market.
This paper goes through the development of government bond markets in Malaysia and
Thailand when they were at the first stage of developing their bond markets twenty years
ago in order to discover key policies to promote the bond market. From that result, the
dissertation considers whether these measures can apply to Vietnam. The main
recommendation is for the government of Vietnam to set up a primary dealer system
facilitating bond auctions and trading as well as supporting the conduct of open market
operations, to build a market-based benchmark yield curve and provide tax exemption to
government bond investors.


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Chapter 1 INTRODUCTION
1.1 Background
Transition to indirect instruments: global trends
Inflation control is among the top priorities of every government. Controlling inflation
requires careful management of the money supply by the central bank. Central banks
possess three main indirect instruments of reserve requirements, discounting eligible bank
assets, and open market operations (OMO). However, Mishkin (1995, 540) argues that
OMO has more advantages than the other two in implementing monetary policy. Thus,
using this instrument has become a common trend in the developed countries.
Country experiences show that indirect instruments especially market-based operations
have brought greater benefits for economies than direct tools whether in developing or
developed countries. The benefits are mentioned by William et al (1996), in which the
authors state that “They [indirect instruments] permit the authorities to have greater
flexibility in policy implementations. Small, frequent changes in instrument settings
become feasible, enabling the authorities to respond rapidly to shocks and to correct policy

errors quickly.” Meanwhile, direct instruments including interest rate controls, credit
ceilings, and directed lending often lose effectiveness because economic agents find means
to go around them, according to the paper.
Research on implementing monetary policies has shown that there has been a clear trend of
switching to using indirect instruments and then a greater reliance on market-based
operations since the 1970s given the advantages of market-based instruments. Buzeneca
and Maino (2007) find that direct instruments of monetary policy are no longer used in the
majority of countries and there is a trend towards reliance on indirect instruments
especially on open market operations. In the 2004 survey of IMF of 45 central banks
around the world, there is no developed country using direct instruments while a few
developing countries still use them. Meanwhile, the ratio of emerging market economies
and developing economies using market-based instruments has increased compared to
results in the 1998 survey.


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Vietnam: delaying the trend
Thus the transition to greater reliance on market-based operations, particularly open market
operations, in implementing monetary policy is a global trend which is relevant to
Vietnam. The country liberalized interest rates in 2002 and since 2000 has introduced open
market operations in conducting monetary policies. However, Vietnam’s transition has
been delayed.
Since 2008 the State Bank of Vietnam (SBV) has reintroduced direct or administrative
instruments to implement monetary policy.
The year 2007 saw a boom on the stock market that was mainly caused by a massive
inflow of foreign capital, equal to about 18 percent of GDP. SBV was unable to sterilize
these inflows, with the result that money supply increased sharply. According to World
Bank data, net foreign portfolio investment strongly increased from USD1.31 billion in
2006 to USD6.24 billion in 2007. Stock market capitalization increased from three percent

of GDP in December 2005 to 43 percent of GDP by March 2007, according to World Bank
(2009, 90).
In addition to the price bubble on stock and property markets, the rapid increase in money
supply contributed to price inflation which peaked at 28 percent per annum in 2008. High
inflation led to rising nominal lending rates which hindered enterprises’ access to bank
loans. In 2008, SBV tried to use indirect instruments of raising policy rates and reserve
requirements, aiming to rein in the inflation. However, it did not have much effectiveness
since banks had considerable excess stocks of reserves (Riedel and Pham 2012).The
central bank therefore had to use the direct instrument of the ceiling rates again and also
forced banks to buy central bank bills totaling VND20.3 trillion in March 2008.
The central bank wanted to restrain inflation at that time but also wanted to decrease
nominal interest rates as instructed by the government, so they officially came back to
direct monetary instruments by asking banks to set lending rates within the band of 150
percent of the prime rate set by SBV. By May 16, 2008 the central bank issued directive
16/2008/QD-NHNN on the prime rate managing mechanism, ending the period of six


9

years of interest rate liberalization. However, as large amounts of money were withdrawn
via central bank bills, many banks experienced a liquidity shortage and had to raise deposit
rates which in turn pushed nominal lending rates higher. Banks competed with each other
to attract deposits, which also put upward pressure on lending rates for enterprises. Stricter
administrative instruments from the central bank to punish banks breaking the rule were
applied. The central bank even set up a hot line to receive information about banks giving
loans at rates higher than the ceiling level.
Inflation has become the biggest threat to the Vietnamese economy since 2008, except in
2009 during the global recession. Given the lower inflation rate in 2009, SBV let banks
negotiate lending rates in 2010. However, when high inflation rose again in 2010 and 2011
prompting a rise in interest rates, the central bank came back to administrative controls

again in 2011 aimed at decreasing market lending rates. These measures have continued
until the end of 2012 as banks have to give loans at rates no higher than the ceiling given
by the central bank.
SBV in fact used two indirect instruments of required reserve ratios and lending facilities
to rein in inflation - but they didn’t help much. The reason is that Vietnam has maintained
a pegged foreign exchange rate regime and does not have an independent monetary policy,
according to Riedel and Pham (2012). Theoretically, there are three things that cannot
happen at the same time, namely free capital inflows, pegged exchange rate, and
independent monetary policy. Vietnam received massive foreign capital inflows in 2007
and still wanted to peg its foreign exchange rate to support exports, so its monetary policies
cannot have effectiveness as the central bank’s purposes. For example, large foreign capital
entering Vietnam has made local currency stronger. To keep the foreign exchange rate
stable, the central bank had to buy foreign capital and supply money to the economy which
put pressure on prices. Meanwhile, Vietnam could not rely much on open market
operations to manage the money supply, or in this case sterilize the unexpected increase in
money supply, like other countries with developed financial markets. Because Vietnam’s
domestic bond market was too small relative to the capital inflow and liquidity in the
secondary market was low, the government could not sterilize its foreign exchange
operations.


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But even if it could, this probably would not have solved the problem. Rising domestic
interest rates would attract even more capital given the pegged exchange rate, making the
problem even worse. For small economies with large capital inflows there may be no
“equilibrium” set of exchange rates and interest rates (Ocampo, Rada and Taylor 2009).
Research on implementing monetary policies has pointed out many reasons for limited
effectiveness of open market operations. However, one prerequisite mentioned by most
papers is an active secondary government bond market. Vietnam also has a secondary

government bond market but it cannot support the conduct of money market operations for
monetary policy implementation. Finding out suggestions to improve Vietnam domestic
government bond market is the target of this thesis.

1.2 Policy questions
Therefore, the thesis will find answers to two questions:
-

What are problems of Vietnam domestic bond market?

-

How can Vietnam develop a government bond market?


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Chapter 2 LITERATURE REVIEW
2.1 Financial repression is ineffective for the economy
Financial repression will hinder financial system’s development while interest rate control
is considered the main measure of financial repression (Kitchen 1995).
Interest rate controls are a policy tool that results in financial repression, but which
nonetheless is preferred by some developing countries which do not have or cannot use
indirect instruments given shallow financial markets. Most of governments control interest
rates due to uncertainties on the market but this action also leads to distorted interest rates
and dampens the development of the financial markets, thus exerting a negative effect on
economic growth (Kitchen 1995). The author explains this conclusion via the model
below:
Savings and investments under situation of interest rate controls

Source: Kitchen (1995), Chapter 3, Figure 3.1


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Under normal conditions, investments (I) and savings (S) in an economy meet at point e
with real rate of interest at re (assuming that the lending rate is equal to the deposit rate).
When a ceiling rate on deposits (rc) is set, investment demand increases to Id1, but the
savings level is only at Sc which cannot meet investment demand in the economy.
Therefore, total real investment in the economy is only at Sc and is lower than the
potential. Meanwhile, financial intermediaries will enjoy the difference between lending
rates and the deposit ceiling rate of (ri– rc). Similarly, if there is a ceiling on lending rate
(rl) which is lower than the equilibrium rate, investment demand in the market is increased
to Id2 but savings cannot meet this level. Thus total real investment of the economy is at Il,
lower than the potential level at Ie.
In developing countries where the private sector is the engine of economic growth, funding
sources for private investment mainly come from the banking system. When total
investment is lower than its potential, it will impact economic growth.
Kitchen (1995) also says that given lending rate caps, banks must decide credit lines for
many kinds of borrowers by tools other than interest rates. Thus they will prefer low risk
borrowers and prestige projects that have access to their own capital, modern technology or
foreign management. Safe projects that usually have low rates of return are preferred by
financial intermediaries, high-risk and high-return projects which are usually new or in
new industries will face a capital shortage. This can also reduce the economic growth rate.
In addition, the combination of interest rate controls and inflation can lead to negative real
interest rates, which will prompt savers to withdraw money from banks and seek other
investment channels like gold or foreign currencies. Savings in the banking system will
decline.
The theory has proven correct in Vietnam. Since 2008, the central bank has reintroduced
the interest rate control mechanism via deposit and lending rate ceilings, either on their

own or in tandem. However, the actual deposit rates that depositors receive and real
lending rates borrowers have to pay are not under the range regulated by the central bank.
Banks have to go around the regulations by paying interest through promotion programs as
well as charging borrowers more via hundreds of other fees. The market has been distorted


13

while reports from banks to the central bank on the rates are distorted also. As banks have
to find ways to go around regulations, their operational costs have been increased which is
reflected in higher lending rates for borrowers, mainly private enterprises. In addition, in
years like 2008, 2010, 2011 given high inflation rates and interest rate caps, real rates were
negative and in fact, savings found their way to other channels like US dollars and gold,
which contributed to speculation in these assets during those years.1
Therefore, it can be said that interest rate controls are not an effective way to stabilize the
financial markets and support economic growth in general as well as specifically in
Vietnam.

2.2 Benefits of a developed domestic government bond market
There are many papers mentioning prerequisites as well as difficulties that economies have
to face in the transition from direct controls of interest rates to rely on open market
operations to implement monetary policies. Alexander et al. (1996) gives seven
recommendations to facilitate a smooth transition to indirect instruments: monetary policy
must be insulated from the government’s capital needs, the development of money and
interbank markets, the development of a healthy banking system, enhancing the
supervisory and regulatory framework, strengthening technical capacity and careful
consideration of the speed, methods, and timing of introducing indirect instruments.
In a paper entitled “Monetary Policy Implementation at Different Stages of Market
Development,” IMF (2004) gives its views on the difficulties and some missing market
infrastructure conditions which can hinder countries’ transition to market-based

frameworks to implement monetary policies. These include fiscal dominance, which means
monetary policies have to serve fiscal purposes, limited independence of the central bank,
a shallow interbank market, and lacking an active secondary market for government or
central bank securities.
However, the critical prerequisite for a country to conduct open market operations must be
a well-developed debt securities market. As open market operations involve operations on
1

People rushed to buy gold in 2011 when inflation rate was over 18 percent while deposit rate is cap at 14
percent: />

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the secondary markets where the central bank trades financial assets with financial
institutions, instruments or goods traded on the market are very important. Most of the
instruments are government debt securities or repurchase agreements (repo) with collateral
of government securities. Axilrod (1997) says that with the ability to raise taxes,
government securities can be considered a risk-free instrument, and thus the best medium
for OMO.
Government debt securities are created from the primary market where government
securities are auctioned for capital. Thus, to have diversified government debt securities,
the government’s primary bond market must be active. Nevertheless, to ensure success for
government debt securities auctions, the secondary market for them must be liquid,
meaning that they have a lot of participants as well as good infrastructure. That means a
broad and deep secondary bond market. As Axilrod (1997, 12) concludes, without an
active secondary market in securities, central banks are in practice limited in their open
market operations. Discussing how the U.S. Federal Reserve conducts OMO, Akhtar
(1997, 35) says the breadth and depth of the treasury securities market are essential for the
effectiveness of open market operations.
BIS (2002, 199) in a section on the development of Thailand’s bond market, says that the

development of bond markets has allowed the Bank of Thailand to move away from direct
instruments towards a greater use of market-based instruments, namely through open
market operations.
Therefore, it can be said that the critical condition for a country’s transition to rely on
OMO must be a well-developed bond market.
In addition, WB and IMF (2001, 4) points out developing the domestic government bond
market can provide an avenue for domestic funding of budget deficit other than that
provided by the central bank. In addition, a developed market for government securities
can help to reduce debt service costs over the medium and long term. Given developed
bond market, a country’s financial system can change from a primarily bank-oriented to a
multilayered system, and banks have to develop new products to intermediate credit more
competitively, boosting the development of the financial system. The paper also said the


15

development of securities and credit markets and a related benchmark yield curve enables
the introduction of new financial products, money market instruments, structured finance,
and derivatives, which can improve risk management and financial stability.
The rest of the thesis will find out how the market for government debt securities works,
and review experiences from countries like Thailand and Malaysia where bond markets
have developed well, and then give recommendations for Vietnam to improve and set up
conditions for a well-functioning government bond market.


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Chapter 3 COUNTRY EXPERIENCES
This section will discuss how Malaysia and Thailand developed their bond markets. The
countries have been chosen due to the rapid and consistent development of their bond

markets since the financial crisis late of the 1990s. In addition, the two countries also have
similar economic features with Vietnam which has just gone through a financial crisis
leading to slow economic growth, high non-performing loans of banks and a government
plans to restructure the whole economy including the banking system. Like Malaysia and
Thailand in the late 1980s, Vietnam is just at the very first step of developing its debt
securities market.

3.1 How did Malaysia develop their domestic bond markets?
3.1.1 Situation and motivation for reform

Remarkably, Malaysia has currently one of strongest and consistently growing bond
markets among Asian countries, according to ADB (2012). This development goes back to
the period when the Malaysian government discovered that the bond market could be an
effective funding source to meet the changing needs of the economy. They recognized that
bonds can be a great financing source for the private sector besides bank loans and the
equity market. This realization enabled the country’s astonishing transformation from an
agricultural-based country to an industrial country over the next twenty years. Thus it is
generally accepted that bond issuance aimed to finance economic development met with
considerable success.
However, the transformation was anything but smooth as the early 1980s would prove.
Like many other export-based nations, Malaysia was hit by the global recession during that
period that turned out to be a factor pushing issuance of government bonds. The Malaysian
government recognized that bonds would be a great financing source for both the public
and private sectors. Initially, attempts focused on issuance of government and Cagamas
bonds.2 Many measures were also taken in the late 1980s to develop bond markets like
introducing the principal dealer system and the auction system to develop a secondary
2

Cagamas bonds are issued by CagamasBerhad, the National Mortgage Corporation established in 1986 to
support homeownership in Malaysia

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market for these bonds. However, other factors like statutory requirements on holding
government and Cagamas bonds, as well as lacking of a benchmark curve, hindered the
bond market’s development at that time.
The period 1988-1997 saw a decline in Malaysian Government Securities (MGS) issuance
again as the government’s fiscal balance was in surplus. In this period, the country gained
funds from the privatization program as well as a fiscal surplus from strong economic
performance. Furthermore, the country’s positive outlook made it a promising destination
for foreign capital, which partly contributed to the country’s asset bubble built up as the
decade progressed. Stock market capitalization in Malaysia hit 318 percent of GDP in 1996
and then plummeted to 133 percent in 1997 when the financial crisis ultimately took hold
of the economy (SEACEN 2005).
Looking at the 1997 financial crisis in greater depth, it can be noted that bank loans by this
year accounted for 150 percent of the country’s GDP, leading to the conclusion that most
of the funding resources in Malaysia were from the banking system. Meanwhile, equity
capitalization was 133 percent of GDP and the bond market was only 47.7 percent
(SEACEN 2005, 181). These factors together formed a system that was overly-dependent
on bank financing while lacking an alternative source to obtain funds given the
underdeveloped bond market. Thus, the risk of maturity mismatch was inevitable and
consequently made the country vulnerable to sudden capital outflows. The shallow
financial system and bubble prices pushed the country into the financial crisis of 1997.
In the aftermath of the financial crisis, the Malaysian government realized the importance
of a well-functioning bond market where both private and public sectors can find longterm capital without foreign exchange risk. Prior to the crisis, the private sector could
easily find funds which were readily available at commercial banks or by floating shares
on the booming equity market. Foreign capital for both private and public sectors was easy
to access during this period of time. However, when the financial crisis happened, these
channels shut down as banks restricted loans to focus on their non-performing loans. At the

same time it was no longer easy to issue shares on the collapsed equity market. Bonds
become a channel which was considered by both government and the private sector. In
addition, a developed bond market also put pressure on issuers to be more transparent and


18

focus on corporate governance. Developing the bond market also helped the central bank
of Malaysia use market-based policy instruments like open market operations (SEACEN
2005, 172).
With a majority Muslim population, Malaysia has created and supported the development
of Islamic bond markets based on Islamic principles. The measure has helped to widen the
investor base for the debt securities market as Islamic investors were encouraged to join
the bond markets. However, the coming section will not discuss developing this market as
there is no similarity in the kind of population between Vietnam and Malaysia.
3.1.2 Key policies

To confirm the effort of developing a well-functioning bond market, The Malaysian
government established a National Bond Market Committee (NBMC) in 1999 which was
expected to provide overall policy direction for the development of the bond market as
well as to recommend appropriate implementation strategies. The NBMC is chaired by the
Secretary General of Treasury and comprises senior officials from Bank Negara Malaysia
(the central bank), Registrar of Companies (presently known as the Companies
Commission of Malaysia), Foreign Investment Committee, Ministry of Finance, Kuala
Lumpur Stock Exchange (presently known as Bursa Malaysia) and the Securities
Commission.
Malaysia’s Ministry of Finance in a press statement on the initiatives for the development
of the ringgit corporate bond market said, “The National Economic Recovery Plan has
identified that the over-dependence on the banking sector for much of the long-term
funding needs for corporate growth and expansion has been a contributory factor to the

1997 crisis. Therefore, it becomes crucial that the ringgit corporate bond market be
developed in order to be able to cater to the financing needs of the private sector.”3 NBMC
has authorized the Securities Commission to be the single regulatory body to regulate and
promote the development of the corporate bond market.

3

/>

19

Then the Capital Market Masterplan (CMP) unveiled in 2001 divided into three phases
during the 2001-2010 period with an aim to build a competitive capital market to meet the
country’s capital and investment needs. The CMP has 152 capital market
recommendations, of which 17 recommendations were for the bond market (ADB 2012).
There were five key elements defined in order to support the development of Malaysia
bond market, including government and private bond markets. They are:
-

Establish a reliable and efficient benchmark yield curve

-

Introducing an efficient and facilitative issuance process

-

Widen issuers and investor base

-

Improving liquidity in the secondary market

-

Facilitating the introduction of risk management instruments

Among these, there were three priority actions at that time, namely enhancing the use of
Malaysian Government Securities as a benchmark; increasing liquidity on the secondary
market; and giving tax incentives to support bond market growth. It was argued that when
the three elements were met, investors and issuers would be interested in this market.
Creating a benchmark yield curve:
To create a benchmark yield curve, the Malaysian authorities took a series of measures
which spanned a few years. The country introduced the Auction Calendar in 2000 to
provide transparent information about the issuance schedule of government securities. The
government regularly issued government securities of various maturities of 3, 5, and 10
years. The maturities also lengthened to 15 and 20 years in 2005 (SEACEN 2005, 173).
Since 1989, Malaysia has introduced the Primary Dealers system to enhance liquidity of
the secondary bond market as well as to support the creation of a benchmark yield curve.
Those dealers, who are reviewed annually, are appointed by Bank Negara to bid for
primary issues of specified securities and become market makers for those securities by
providing reasonable continuous two-way price quotations for selected securities to
individuals, institutional clients, and the central bank. The benchmark yield curve is
considered an important element to develop the bond market. The government since 1997


20

issued Khazanah bonds with the purpose of creating a benchmark yield curve as they were
not eligible securities required to be held by financial institutions.4 In fact, at that time,

commercial banks, finance companies, merchant banks, and even Employees Provident
Fund (EPF) were subject to statutory requirements that they had to hold assets in eligible
securities, mostly government and Cagamas bonds (Shimomoto 1999, 96). The
government also asked the EPF to hold a percentage of up to 70 percent of their funds in
government bonds. Therefore, government securities were usually in shortage and their
yields did not reflect market yields exactly. The issuance of Khazanah bonds which were
not eligible papers was hoped to set up a yield curve which was close to the market yield.
Since 2006, Khazanah and Cagamas bonds have been classified as corporate and not quasigovernment bonds.
Increasing liquidity of the secondary market
Provident and pension funds (mainly EPF), insurance companies and banks were required
to invest a proportion of their funds in government securities which were not always
abundant so they tend to hold securities until maturity. Thus the liquidity regulations
hindered the development of an active secondary bond market. Several measures were
taken to widen the bond investor base like relaxation of minimum investment requirements
imposed on EPF from 70 to 50 percent, from 25 to 20 percent for an insurer’s margin of
solvency in 1996 and to 10 percent in 2002. In 1998, the liquid asset ratio for banks was
also relaxed (SEACEN 2005, 174).
The central bank also introduced the Institutional Custodian Program under which banks
could borrow securities, mainly Malaysian Government Securities, from major institutional
investors like pension funds and insurance companies and use them in repo operations.
With this measure, institutions were exempted from the securities holding situation and the
secondary market’s liquidity was enhanced. Meanwhile, principal dealers had an incentive
to do short-selling of securities regulated by the central bank. In addition, the principal
dealers could enjoy a securities lending facility from the central bank that could help them
to be more flexible in trading as well as provide more competitive prices. The source for
4

Khazanah bonds are issued by Khazanah National Berhad and guaranteed by the Government. These zerocoupon bonds are based on Islamic principles

21

the lending facility to principal dealers was from the Institutional Custodian Program
above. Once a sufficient supply of Malaysian Government Securities for successful
securities lending and repo operations is present, the central bank will purchase
government securities from primary and secondary market at market prices. The amount of
purchased securities on the primary and secondary markets cannot exceed 10 percent of the
issued amount (SEACEN 2005, 176).
In 2005, the central bank of Malaysia announced the use of repos as a monetary policy
instrument with the aim of encouraging market participants to strengthen the usage of
repos as an alternative funding instrument. That also helped to encourage banks to move
towards collateralized interbank transactions.
Tax incentives to support bond market growth
Tax incentives were given to both investors and issuers. Tax exemption of interest income
earned was given to individuals, unit trusts investors, and listed closed-end funds. Tax
exemptions were also given to interest income earned by non-resident companies from
Ringgit-denominated bonds approved by the Securities Commission. These measures
attracted more foreign investors and widened the investor base for the bond market.
To develop an Islamic financial market and the asset securitization market, the government
applied tax deductions for expenses incurred on issuance of Islamic Private Debt Securities
and all Asset Backed Securities for five years starting from 2003 and 2004 respectively
(SEACEN 2005, 179).
3.1.3 Achievements

It is not easy to separate out the effectiveness of each measure, since the country has a
wide range of measures in place to support the bond market’s development. However, the
performance of the Malaysian bond market over past years is clear proof that the measures
have achieved their overall objective. In fact, the bond market size in Malaysia for the last
12 years has strongly developed and consolidated its role in financing capital needs of
public and private sectors of the country.

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Graph 3.1: Bond outstanding value of Malaysia

Bond outstanding value (in USD billions)
300
250
200
150
100
50
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Govt

Corp

Total

Source: Asianbondsonline
The size of the bond market compared to the country’s GDP has also grown considerably
in recent years from the low level of less than 50% in 1997.
The outstanding value of the Malaysian bond market has also rapidly increased, making it
an important funding channel in the economy besides equity market and bank credit.


23

Graph 3.2: Domestic financing profile of Malaysia

Domestic financing profile of Malaysia
(in USD billions)
500
400
300
200
100
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Credit

Bonds

Equity

Source: Asianbondsonline

3.2 How did Thailand develop its bond market?
3.2.1 Situation and motivation for reform

As in Malaysia, easy access to capital from economic growth and foreign inflows before
the Asian financial crisis made the bond market less important as a funding source in
Thailand. At that time, the government and State-owned enterprises were the main issuers
on the debt markets as private enterprises were restricted from issuing bonds. This
regulation was removed after 1992 paving the way for bond issuance by domestic
companies (Shirai 2001, 114).
Meanwhile, the Thai government before 1992 had no need to issue bonds as the country
was in fiscal surplus. As a result, from 1987 to 1997 the government did not issue any

government bonds. In addition, other infrastructure like an organized secondary market,
credit rating agencies did not develop to support a well-functioning bond market at that
time.


24

The lack of a risk-free benchmark from government debt securities hindered development
of a private debt securities market in Thailand. Bank loans were the major financing source
for the private sector. Once again, like Malaysia, the banking system of Thailand was
exposed to risks as they had to raise short-term deposits to satisfy long-term investments.
These risks in the presence of an asset bubble and huge foreign capital inflows contributed
to the country’s financial crisis in 1997. Domestic banks and companies had increasingly
looked off-shore for financing, which, given a fixed exchange rate, built up huge currency
mismatches in addition to the tenor mismatch described above.
After the crisis, the private sector which was the engine for economic growth faced a
severe problem of lacking capital from the traditional channel of bank loans. Commercial
banks had to restrict lending operations given their high non-performing loans and also
needed time to rebuild their financial capabilities.
Graph 3.3: Size of Thailand financial market

Size of Thai financial market
(THB billions)
7,000.0
6,000.0
5,000.0
4,000.0
3,000.0
2,000.0
1,000.0

0.0
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Bank Loans

Equities (mkt. cap)

Domestic Bond (at par)

Source: Thai Bond Market Association
Meanwhile, to finance the budget deficit and meet the needs of financial sector
restructuring, the Thai government increased debt securities issuance to finance its budget
deficit. This increased the total outstanding value of domestic bonds three fold from