Facilitating Foreign Exchange Risk Management for Bond Investments in ASEAN+3

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• Publisher: Asian Development Bank
• Year: 2015
• Print ISBN: 9789292570569
• eBook ISBN: 9789292570576
• Topic: Business
• Subtopic: Finance
• Index: Business

The Asian Development Bank (ADB) has been working closely with the Association of Southeast Asian Nations (ASEAN) and the People's Republic of China, Japan, and the Republic of Korea---collectively known as ASEAN+3---to foster the development of local currency bond markets and facilitate regional bond market integration under the Asian Bond Markets Initiative (ABMI). ABMI was launched in 2002 to strengthen the resilience of the region's financial system by developing local currency bond markets as an alternative source to foreign currency denominated short-term bank loans for long-term investment. Bond investors typically have a long position in local currency bond markets. To manage their foreign exchange (FX) risk, they may want to hedge that exposure for a period of time. They also want to be sure they can easily convert the local currency to dollars upon the sale of a bond. This study was undertaken under ABMI and funded by the Government of Japan. It reviews the FX and FX hedging markets in ASEAN+3 as they relate to cross-border investments in local currency bonds, and makes recommendations to facilitate the development of the markets and FX risk management.

Introduction 1

The impediments to local currency foreign exchange (FX) and FX hedging are largely associated with insufficient liquidity resulting from underdeveloped FX and debt capital markets, as well as currency convertibility constraints imposed by authorities in the economy of the issuer. These constraints vary considerably across ASEAN+3, which comprises the 10 members of the Association of Southeast Asian Nations (ASEAN) plus the People’s Republic of China, Japan, and the Republic of Korea.

Hong Kong, China; Japan; and Singapore. These three economies have liquid local currency FX and FX hedging markets, and their currencies are considered convertible. They have limited specific FX regulations. For example, the only notable regulation in Singapore limits the amount of Singapore dollars that certain categories of offshore borrowers can borrow from Singapore resident financial institutions for use offshore. Meanwhile, the Hong Kong dollar is pegged to the US dollar and is a special case.

Brunei Darussalam, Cambodia, the Lao People’s Democratic Republic, Myanmar, and Viet Nam. The overall size and breadth of these economies and their financial markets means that it will be some time before their markets will be liquid. The bond markets and the FX markets of these economies are in their infancy. Recommendations for their development will need to be extensive, detailed, and tailored to their starting point—and are beyond the scope of this study.

The People’s Republic of China. The development of Chinese renminbi hedging markets, both onshore and offshore, is being managed by various government bodies in a very deliberate manner, taking into account the unique characteristics of the domestic economy and its markets. The domestic authorities have a well-defined path. A review of this unique and complex case is also beyond the scope of this study.

The Republic of Korea, Indonesia, Malaysia, the Philippines, and Thailand. These five economies, which are collectively referred to in this report as the KIMPT economies, have partially convertible currencies with regulations that constrain onshore FX and FX hedging transactions. Regulations differ by economy, but all have the common objectives of protecting the domestic currency and economy from abusive currency speculation, and managing unwanted or excessive currency flows. These regulations are designed to restrict certain transactions, resulting in more complicated FX risk management that warrants review.

This report makes recommendations to improve the liquidity of onshore FX markets while taking into account the need to monitor and manage cross-border capital flows. Improved liquidity in onshore FX markets will improve the liquidity of local currency bond markets (and vice versa), and help integrate onshore and offshore markets. Improved liquidity will make these markets better able to withstand shocks and facilitate risk management for all.

As statistical data are not readily available in sufficient detail, the report is based on discussions that took place in June–October 2014 and comprised a broad range of international market participants, representing approximately 30 entities. These include the investment community (e.g., fund managers, international asset managers, and their back offices); their global bankers, both fixed income and FX; local and global custodians; trade associations and the service providers (e.g., law firms) that assist them; and various thought leaders. As local investors do not need FX to buy bonds in their local currency, the report focuses on investors active in cross-border transactions.

Discussions with investors and their advisors revealed that many investors in Asian bonds do not hedge their FX risk. Their objective is often to get exposure to both the domestic interest rate and the FX rate. Those that do hedge FX risk can do so easily in offshore markets, except in times of stress. For example, some implied interest rates in the Indonesian rupiah non-deliverable forward (NDF) market were negative in 2013 as a result of an imbalance between supply and demand. Bond investors typically hedge the value of their investment (not the future cash flow) using offshore FX forwards. FX forwards are more liquid and flexible, and suit their needs better than swaps.

While hedging offshore is easy, hedging onshore is more complicated in the KIMPT economies because of the “real demand principle” regulations put in place by local authorities to control capital flows. These regulations, which generally prohibit onshore hedges that are not tied to an underlying qualifying transaction, are targeted at speculators but affect all investors. The impact of these regulations on bona fide investors is detailed in Section 4.1. Because of their perceived complexity, the rules reduce significantly the demand from smaller bona fide investors that could potentially bring stability and diversity, and reduce the borrowing cost for issuers. The regulations also separate the onshore market from the offshore market.

While the existence of offshore markets is not undesirable per se, two silos of liquidity are much less liquid than one consolidated market. Therefore, integrating the onshore and offshore FX markets would generally be beneficial. To do this, the real demand principle rules may need to be updated to reflect the growth of these markets and, if possible, streamlined. Also, the development of the legal framework for an onshore derivatives market may need to be accelerated to make onshore markets more attractive to all investors and to have the widest possible range of investors. As a result, speculative and opportunistic investors will represent a smaller minority and hopefully be less disruptive. The markets, by being more liquid, will be more resilient.

The rest of the report is structured as follows. In Section 2, we discuss the different investor types and their hedging behavior. In Section 3, we review the hedging instruments and markets used by investors. In Section 4.1, we describe the impediments to onshore hedging and FX markets, and make recommendations on how rules could be made more market-friendly and transactions less costly. In Section 4.2, we present recommendations for increasing domestic FX market liquidity, which would lead to the improvement and integration of onshore and NDF/offshore FX markets. In Section 4.3, we present recommendations for improving domestic government bond market liquidity. In Section 5, we conclude by summarizing the recommendations.

2 Bond Market Investors and Their Behavior

It is useful to categorize various bond market investors in order to analyze their investment and hedging behavior. However, it is not possible to obtain volume or pricing statistics with sufficient granularity across Asia, nor even for the five focus economies, that would permit a detailed analysis of cross-border investments, offshore FX, and FX hedging by investor category. Some central banks have such information on their markets but generally do not release this publicly. The comments below are based on conversations with important market participants.

Individuals. Globally, individuals hold less than 3% of bonds directly. Individuals will generally invest in bonds indirectly via the institutional savings sector. While we have no statistics for cross-border investment by individuals into the KIMPT economies, the amounts are assumed to be small and will not be a focus area for this report. Also, retail investors who invest directly themselves typically do not hedge their FX exposure.

Asian institutional savings sector. This sector includes pension funds; insurance companies; mutual funds; dedicated bond funds, including exchange-traded funds; and hedge funds. The domestic institutional savings sector based in one ASEAN+3 economy makes relatively limited cross-border investments in bonds issued by other ASEAN+3 economies. With a few exceptions, the Asian institutional savings sector is still in its infancy and remains domestically focused. In the case of Japan, the Republic of Korea, Malaysia, and Singapore, where this sector is more established, conversations with the global banks suggest that the portion of overseas investment is still very modest, with the main destination for overseas bond investments being the deep and liquid markets in...

Table of contents

• Front Cover
• Title Page
• Copyright Page
• Contents
• Tables
• Foreword
• Abbreviations
• Executive Summary
• 1. Introduction
• 2. Bond Market Investors and Their Behavior
• 3. General Comments on Foreign Exchange and Foreign Exchange Hedging
• 4. Review of Measures to Facilitate Foreign Exchange Risk Management for Bond Investments
• 5. Conclusions
• Footnote
• Back Cover