Market overview

The Asian financial crisis taught us that a robust bond market could mitigate the problems of capital mismatch and increase the efficiency of financial intermediation. The SAR government has been working hard to promote Hong Kong as Asia's regional bond center. Statistics showed that newly issued Hong Kong dollar debt securities reached HKD385.8bn in 2001, and outstanding debt securities reached HKD530.8bn by June this year. Hong Kong's state of the art financial infrastructure is most advanced in Asia. The Central Moneymarkets Unit (CMU) is linked up with the USD debt clearing and RTGS payment system, with Euroclear and Clearstream, with Central Securities Depositories in Australia, New Zealand and Korea. The Yen clearing system is currently under development. Moreover, the retail bond market has come to life and issuance of retail bonds in 1H 02 alone reached HKD13.2bn.

Constraints and potential from supply side

Hong Kong's bond market is the second largest in Asia behind Japan. But when compared with market leaders such as the US, Japan and Britain, it still has a long way to go. Take the ratio of outstanding debt securities to GDP for example, the three countries have ratios of 146%, 136% and 64% respectively, while Hong Kong's was only 35% at the end of 2001. The underdevelopment caters for tremendous growth potential. Even with a conservative plan for a debt to GDP ratio of 70%, Hong Kong's bond market can still be further expanded to HKD350bn. However, such simple calculations can be misleading because the unique structure of Hong Kong's financial market limits the supply of bonds and therefore hinders the development scope of the bond market.

The product line in a mature bond market generally includes treasury and statutory bonds, corporate bonds and asset backed securities (ABS). Bond markets in the US, Japan, Britain and Germany all have these three product tiers, albeit in different proportions. According to the HKMA, Hong Kong's bond issuing bodies include the Exchange Fund, statutory organizations, MDBs, non-MDB overseas banks, AIs and local corporations. They are all subject to certain restrictions in their bond issuing needs.

The Hong Kong government has long been taking a prudent approach in its fiscal policies. Historical fiscal surplus in the past removes the need for issuing treasury bonds. Even with the structural fiscal deficit that emerged from the current economic transformation, the SAR government can still tap a fiscal reserve of HKD300bn. Moreover, the goal has been set to achieve budget balance before the current reserves run out. Thus in the foreseeable future, it is unlikely that the government will issue large amount of bonds to finance the fiscal deficit. Hong Kong's currency board regime demands strict fiscal discipline. If the government has to resort to borrowing by issuing bonds, the negative impacts on financial stability would far outstrip the benefits of developing a bond market.

The Exchange Fund bills and notes issued have been regarded as quasi government papers and a ten-year yield curve has been established as the benchmark for Hong Kong's bond market. But its size cannot be expanded indefinitely. The HKMA's seven measures to strengthen the currency board arrangements stipulate that new Exchange Fund papers can only be issued when there is an inflow of funds. In other words, Hong Kong's foreign currency reserves will have to grow before new bonds can be issued. Currently outstanding Exchange Fund papers are at HKD115.7bn or 20%+ of the total bond market. Since its size and supply will not go up dramatically, its market share will decrease accordingly.

Local suppliers of Hong Kong dollar bonds include statutory organizations such as the Mass Transit Railways (MTRC), Kowloon-Canton Railways (KCRC), and Airport Authority (AA), asset backed securities such as mortgage backed securities (MBS) issued by the Hong Kong Mortgage Corporation (HKMC), and other private corporations. The government-owned corporations have to weigh their operational needs when considering bond issuance. Thus bond supply can only grow steadily. Current mortgage portfolios owned by HKMC are only worth HKD20bn. Although it is a very small sum compared with the banking sector's huge mortgage loan portfolios, there is ample room for expansion. The weakest link lies in corporate papers. Currently, some historical obstacles have been removed with the introduction of Exchange Fund paper yield curve and the strengthening of the market making system. Measures to simplify bond issuing procedure and lower issuing costs are also under study. But the credit rating issue will plague corporate supplies for a long time to come. According to the S&P, the number of local blue chip companies with ratings B or higher is only 17. Less than 10 have ratings with A or higher. Most local corporations do not seek credit ratings enthusiastically because of the strict financial disclosure requirements and high costs associated with hiring lawyers and auditors. Once related costs exceed those of bank loans, or become out of proportion to the company's borrowing needs, they lose interest. Moreover, many family-owned corporations are not willing to disclose detailed financial information to the public. As a result, outstanding corporate papers at the end of 2001 were only HKD38.88bn and its development faces uphill battles. Nevertheless, given the huge asset base of some local corporations, a fully developed ABS market can certainly extract the latent supplies. As for authorized institutions, they issue bonds to meet their funding needs or reduce their asset and liability mismatch.

Last year, the outstanding HKD bonds of the MDBs and non-MDB overseas borrowers accounted for $ 153.78bn. or 31.2% of the total market. Whether they will tap Hong Kong's bond market depends on their financing needs and our competitiveness.

In general, Hong Kong's bond market development faces certain constraints from the supply side. But there are many potential borrowers in the region. The key issue is whether Hong Kong can be competitive enough to attract their businesses.

Constraints from demand side

Demands for bonds generally come from retail and institutional investors.

Retail investors' share used to be insignificant. Most bonds were not issued for them. And they had so many other investment vehicles to choose from. During investment bubbles, they tended to ignore the risk diversification feature of bond investments and showed little interest. But as the stock market went down for three consecutive years, property bubble bursting, risk of trading currency, bullion and other derivatives rising, the market turned friendly towards low risk vehicles such as retail bonds, principal protection funds, CDs, etc. The SAR government's efforts to facilitate the development of the retail bond market prove correct in extracting latent retail demands. But retail investors themselves have limited knowledge on bond investments and treat them as substitutes of time deposits. They want primarily shorter-term bonds and hold them until maturity. Therefore, large demands in the primary market cannot be translated into an active secondary market, thus hindering bond market development.

In theory, institutional investors including banks, insurance companies, retirement funds and bond funds should play a more active role in the secondary market. But the options they can have also restrict their demands. Banks are the most active holders and traders of the Exchange Fund papers because they can use them as collaterals to acquire liquidity through repos with the HKMA. Institutional investors, however, do not have currency restrictions in their investment decisions and they do not have to invest in Hong Kong dollar debt securities. Instead, they prefer to invest in US papers that are much more liquid and of higher ratings. For example, the US bonds are strong competitors to the Hong Kong dollar counterparts, foreign exchange risk does not exist under the currency board regime, and interest rates move in synchrony on both sides. Nonetheless, considering the cash rich situation and proper asset composition, institutional investors' demands will increase once bond supplies improved.

Positioning Hong Kong's bond market developments

In recent years, the SAR government has taken many initiatives in developing Hong Kong's bond market. They include building advanced financial infrastructure, strengthening the market making system, facilitating development of the retail bond market, studying internet and ATM bond trading, lowering bond listing costs, simplifying bond issuing procedure, and relaxing marketing regulations, etc. But it is worth pointing out that any strategy adopted has to be medium to long term because measures currently taken may start to bear fruits only years later.

Development efforts should be focused on three fronts: (a) continue to develop local Hong Kong dollar bond market; (b) to expand the mainland bond market; (c) to compete for regional bond businesses. Equal efforts should be put into expanding the market size as well as enhancing intermediation.

The keys to developing local Hong Kong dollar bond market include increasing supplies, improving secondary market and stimulating demands. HKMC can purchase more high quality mortgage assets to increase its size of issuance. In the corporate arena, the developments of both the high yield and high-grade sectors should be left to the market for now. The government's focus should be on those corporations with financing needs but lower credit ratings. Initiatives can be taken to bundle their assets for securitization or provide credit guarantees to enhance their credit ratings to levels acceptable to institutional investors. Moreover, the share of longer-term bonds should be increased to lengthen the overall maturity of the bond spectrum, providing long-term investors such as insurance companies with sufficient supplies. Until then, MPF and PPF schemes can be required to invest a certain percentage of their money into Hong Kong dollar bonds.

A natural step to take in developing Hong Kong's bond market is to expand China related market. Laying the foundation in this area will take time and efforts. But once China completely opens its financial market and the RMB becomes a super regional currency, then the full potential of China's bond market can be mobilized. In current stage when the RMB is still not freely convertible, Hong Kong has yet to find a way to participate in the RMB bond market. In the area of infrastructure, for example, Hong Kong can leverage its advanced knowledge and help build the infrastructure in the Mainland, seeking to link up the two systems during the process. Once the RMB bond market opens up, Hong Kong should position itself as the offshore center for the RMB bond issuing, trading, clearing and settlement. And more businesses can be gained on debt derivatives designing, trading, clearing and settlement. Also, Hong Kong should shoulder the responsibility of launching foreign currency bond programs for the Mainland government and corporations. Hong Kong's CMU will soon be capable of handling the US dollar, the Euro and Yen bonds, making Hong Kong the ideal place to help raise foreign debts for the Chinese government and corporations. Hong Kong's extra edge of a free FX market enables currency hedge when issuing bonds on behalf of Chinese government and corporations under China's current capital account controls. For example, China Southern Airline's interim earnings were down 39% on the back of RMB159m FX loss from its 30bn Yen loans. Since the Hong Kong dollar and the RMB are both de facto dollar bloc currencies, a proxy hedge of Hong Kong dollar against the Yen could have been performed to remove most of the currency risk. In order to win over China's businesses, large amounts of efforts will need to be put into. Most importantly, we have to increase Hong Kong's competitiveness.

The most difficult task is to pave the way for Hong Kong to become Asia's bond center. Fierce competition inside and outside the region resulted in little traffic of the CMU linkages. So far there is no other payment system in the region to accept the linkage invitation. In the future, initiatives should be taken on both reaching regional cooperation agreements between governments and bringing issuers and investors to Hong Kong. Corporations in the region and overseas entering the China market should be targeted for their bond issuing businesses. With Hong Kong's state of the art infrastructure, perseverance will see our efforts through.

In the short term, the SAR government's campaign to develop the retail bond market has made some progress. The new placement mechanism provides convenience to retail investors, successfully changing their investment habits, expands the investor base, and further stimulates the secondary market. Banks take most of the credits because of their active involvement in selling bonds to the public. As part of the off balance sheet strategy, banks offer retail bonds agency service to harness non-interest incomes and strengthen their wealth management businesses and customer relationships. They will further cooperate with the government to establish Hong Kong as Asia's primary retail bond market, which is just unfolding.

New Hong Kong Dollar Debt Securities Issued (HKD billion)*

Hong Kong Dollar Debt Securities Outstanding (HKD billion)*