Southeast Asian countries with weak or disconnected foreign exchange and derivatives markets need to make investing easier for foreigners if they are to deepen their local currency bond markets, according to a study of 13 East and Southeast Asian countries by ADB.

The report on cross-border investors' ability to use foreign exchange derivatives such as forwards, swaps and cross-currency swaps—used to manage exposure to foreign exchange risks—is part of the ADB's efforts to support cross-border investments in local currency bonds under the ASEAN+3 Asian Bond Market Initiative.

The study looked at the 10-country Association of Southeast Asian Nations (ASEAN) plus the People's Republic of China, Japan and the Republic of Korea. It focused on five economies: Korea, Indonesia, Malaysia, the Philippines and Thailand, all of which have active onshore foreign exchange markets but disconnected or nonexistent derivatives markets, and rely for hedging on offshore nondeliverable foreign exchange forward markets, known as NDFs. 

The other ASEAN+3 economies have well-developed foreign exchange markets (Japan and Singapore) or markets that remain embryonic, such as Brunei, Cambodia, Laos, Myanmar, and Viet Nam. The PRC market was considered to require a separate study of its own.

The study found that investors in the five countries' local currency bonds who chose to hedge currency risk were commonly using NDFs, which were developed as a result of limited access to or unavailability of onshore foreign exchange derivatives.

Normally, NDF markets for the five countries' currencies are liquid and flexible, so investors can hedge a local currency bond portfolio at low cost. But NDF markets are typically dominated by a small number of global banks that tend to share similar risk appetite. This means that their liquidity cannot be relied upon in times of stress. 

As a result, investment in local currency bonds by cross-border investors may be limited to those who are prepared to live with the limited reliability of NDFs in hedging foreign exchange risks. It follows from this that improving access for derivative instruments could significantly increase the willingness of foreign investors to buy local currency bonds.

To improve the diversity and liquidity of the foreign exchange derivatives market, the study recommends integrating onshore and offshore markets. In particular, it suggests relaxing limits on foreign portfolio investors' cash balances and borrowings; easing rules on foreign investors using onshore markets to hedge foreign exchange risks; and liberalizing domestic banks' participation in offshore foreign exchange and NDF markets. 

The study says the five countries should also look at making sure sufficient US dollars are available for bond investors when they exit the market; allowing delivery of offshore foreign exchange contracts onshore; and enhancing the transparency and fairness of the exchange rate fixing process.

From a market perspective, such an integration of onshore and offshore foreign exchange and derivatives markets would broaden and deepen the credit markets, enhance their liquidity and reduce funding costs for issuers. Malaysia has already moved a long way in this direction.

However, the case for such reforms has to be set against governments' concerns about volatile capital flows and macroprudential stability. Managing capital flows requires identifying investors and their investment motives and/or the types of assets being bought and their liquidity. But when cross-border investments are made through global custodians, the identities of beneficiary investors are disguised.

On the other hand, assets purchased onshore can be identified through local custodians because they are within the jurisdiction of the authorities. So regulatory measures tend to focus on either the latter or on limiting the exposure of domestic financial institutions to offshore market risks.

In addition, local cash balances of foreign portfolio investors are part of the noncore liabilities of local banks—including branches of foreign banks—which tend to rise and fall with financial booms and busts. These risks associated with wholesale deposits are now well recognized by Basel III, the global framework of prudential rules imposed on banks after the 2008 financial crisis.

Limiting the availability of foreign exchange in local markets and fixing the official exchange rates at which local banks are allowed to sell foreign exchange have been effective measures to combat capital outflows. This means that the recommended reforms and liberalization moves would need to be balanced with macroprudential measures to give the authorities continued ability to take effective action on capital flows when needed.

Should such reforms be adopted, it would be necessary to distinguish bona fide structural investors from cyclical or speculative ones, and to target the reforms on the former group only. The ADB study examined different types of investors in emerging Asian bond markets, their investment behavior and risk management needs. Cyclical investors generate more volatile capital flows even if they are simply conducting passive portfolio reallocation. Needless to say, aggressive funds with active portfolio reallocation strategies need to be controlled the most.

Clearly, more work is needed on macroprudential policy to ensure the stability of the system. Meanwhile, fundamental legal issues and capacity weaknesses in financial information technology infrastructure need to be addressed to enhance the transparency of cross-border investments.

Those include measures to enhance the bankruptcy regime for derivatives and repos: ensuring the feasibility of closed out netting; improving the information and communications technology infrastructure of central securities depositories and custodians to allow cross-border investors to settle across subaccounts offshore; and developing a legal entity identifier to pinpoint beneficiary investors.

The ASEAN+3 countries have come a long way in developing their bond markets in size, but they have a way to go if they are to keep the markets and financial systems flexible, sound and safe.

This blog was first published in the Nikkei Asian Review.