Hong Kong's Bond Market is Looking for Breakthrough (hktdc.com)

As outlined in our previous research, the biggest obstacle hindering Hong Kong's bond market development is the limited scale. Three forces are behind the limitation. Firstly, although the SAR government is facing structural fiscal deficits, there are still vast reserves totaling more than HKD270bn. Strict requirements of maintaining the peg and sovereign rating imply that issuing bonds would only be the last resort. Secondly, in order to strengthen the currency board system, the Exchange Fund only issues more Bill sand Notes when there are capital inflows, limiting its growth by less than 5% per annum in the foreseeable future. Thirdly, bonds issued by private entities are no longer eligible for Repo considerations under the same arrangement, diminishing banks' demand for them and further restricting bond supplies. As a result, HKD bonds may become less able to satisfy investors' hold-to-maturity needs, let alone holdings for secondary trading. Moreover, the rating issue still plagues the corporate bonds sector.

Despite these deficiencies, the HKD bond market soldiered on and its size grew steadily in the past twelve months. The Table below shows that although new issuance declined in 1H03, outstanding amount of HKD bonds rose by 4.43% YoY and its ratio to GDP climbed from 36% in 2000 to 41% in mid 2003. Furthermore, since 1997, Hong Kong's bond market has embarked on a steady expansion track over two interest rate cycles. This demonstrates that the SAR government's efforts to develop the bond market pay off, outweighing the effects of interest rate changes. Therefore, the HKD bond market should be able to continue its expansion even though interest rates may turn upwards in the coming year.

（HKD million）

As at end of	EF Bills & Notes	Change	Other Bonds	Change	Total	Change	HKD Bonds To GDP Ratio
2000	108,602	6.60%	363,496	6.33%	472,098	6.39%	36.64%
2001	113,750	4.74%	380,068	4.56%	493,818	4.60%	38.15%
2002	117,476	3.28%	414,888	9.16%	532,364	7.81%	40.22%
June 2003	119,027	1.32%	433,782	4.55%	552,809	3.84%	40.75%

Aiming to expand the scale and instruments, attract individual investors and stimulate the secondary market, the development of retail bond market has been one of the focuses of the overall bond market strategy. Since the HKMC's initiative in November 2001 of launching retail bonds, this market has seen rapid growth with new issuance amounting to HKD18bn in 2002 or 10% of the new issuance of HKD bonds other than Exchange Fund Bills and Notes. Innovative structures are also added, such as fixed-inverse floating rate notes and notes with extendable options, etc. Judging from the brisk sales of CDs issued by banks this year, sales of retail bonds should continue to outperform. The Exchange Fund joint in and launched a pilot scheme on August 1 this year to sell a portion of each quarterly issue of 2-year and 3-year Notes by non-competitive tender to retail investors. During the tender on August 12, over 900 investors submitted applications through three distributing banks. The HKD120mn allotment was oversubscribed by 1.24 times, reflecting good receptions from investors. If the scheme proceeds well in the future, then an extra HKD1bn will be added to retail bonds issuance in the next twelve months, with more to come progressively. Measures taken to strengthen the market making system and provide real time quotations on the web sites of HKMA and HKCMA further reduce buy/sell spreads and enhance pricing transparency. The three sets of guidelines issued by the SFC to simplify issuing procedures and reduce costs enable retail investors to further take part in the bond market.

One aspect of developing Hong Kong's bond market is to solidify its status as center of Asia's bond market and strengthen its intermediation role. We are pleased to witness some solid progress made in the past twelve months. Hong Kong's top rated financial infrastructure continues to improve. The direct link of the CMU to Euroclear commenced operation in November 2002. The CMU then introduced a new clearing, settlement and custodian service for US Treasuries in December 2002. In January this year, the CMU and Clearstream Banking Luxembourg developed a direct link. Back in July 2002, the Standard Chartered Bank was appointed the settlement institution by the HKMA for Euro clearing. On April 28 this year, its system was linked to the CMU. Thus by now, the clearing system that is capable of dealing with the HKD/USD/EUR has been largely completed. And when systems dealing with the Yen and the RMB are built, Hong Kong will have the most complete and sophisticated clearing and settlement systems for FX, bonds and other securities in Asia. This will undoubtedly enhance its status as center of the regional bond market. In terms of RMB business, besides the joint HKD cheque clearing services between Hong Kong and Guangdong and a HKD RTGS link between Hong Kong and Shenzhen, a major project of the year is to link up the Government Securities Book-entry System of China Government Securities Depository Trust & Clearing Co. Ltd. to CMU. The facility will enable authorized financial institutions in the Mainland to hold, clear and settle HKD or other currencies denominated bonds. Currently, bond transactions conducted by Mainland institutions such as the Big 4 Banks are cleared in Beijing. If the HKMA can assume the responsibilities, these institutions can enjoy cost benefits and Hong Kong can enhance its intermediation role, setting a solid foundation for the RMB business that the bond market has been coveting. Hong Kong's advanced financial infrastructure for the bond market will no doubt help shape our competitiveness in the future.

A criterion for judging the market intermediation role is the profile of overseas issuers. The 2002 statistics show that HKD bonds newly issued by overseas issuers increased by HKD13.9bn. The outstanding amount increased by HKD26bn, with its proportion in the HKD bond market making a new high at 33.81%, nearly doubling the 1997's level of just 10.20%. This serves as an international affirmation of our bond market development. Another gauge is our role in the development of the regional bond market. In June this year, an agreement was reached to launch the Asian Bond Fund by the EMEAP Group of 11 members. The initial investment size is about USD1bn, investing in a basket of US dollar denominated bonds issued by major Asian economies. The HKMA is the leading organizer and investor in the Fund. Some may argue that its small size, the USD choice and investment vehicles of government or statutory body issues are of little help to the development of the Asian bond market and the channeling of official reserves back to Asia. But we believe the opposite is true. Just as Hong Kong's bond market cannot be built overnight, the development of Asia's bond market that involves greater conflicts of interests has to be gradual. Hong Kong has assumed the leadership role in its early stage of development. As long as plans are followed to expand its scale, include bonds denominated in other Asian currencies, and include corporate, ABSs and securitized issues, then the Asian Bond Fund will achieve its goal and become a heavyweight in regional bond market investment. During this process, as long as Hong Kong continues to play a leading role, it will help solidify our status as center of the regional bond market.

Recently, discussions have begun to heat up regarding the possibility of the SAR government issuing bonds. In order to achieve multiple goals such as stimulating the economy, balancing the budget, protecting the peg/sovereign rating and developing the bond market, some principles should be considered in any possible bond issuance. Firstly, bond issuance should not be mentioned as means to eliminate the deficits and balance the budget, although it can have the same effects in accounting terms. The structural deficits Hong Kong is facing originated from the mismatch between recurring revenues and expenditures. If the government's bond issuance is perceived as merely making up for the shortfall in recurrent revenues, then the market may fear for the insolvency and the peg and Hong Kong's sovereign rating will come under severe pressure. Secondly, if bonds are issued to finance infrastructure projects that promote economic development and integration, then they should be treated as commercial investment decisions. Detailed estimates of financing needs and investment returns and timetables should be carefully outlined. This could attract more investors, convey a message of accountability and relieve the market's concerns on such bond issuance. Infrastructure expenditures by the government are capital expenditures. Issuing bonds to finance them should not negatively affect the goal of balancing the recurrent accounts. If within the next five years, most of the HKD100bn infrastructure projects can be financed by bonds, it will bring breakthroughs to Hong Kong's bond market in terms of both quantity and quality. Thirdly, if bonds are issued as means to cash in in advance as part of the government's share offering plan for assets worth HKD120bn, then each asset must be independently evaluated for different type of bonds issuance in order to maximize its value. The government's medium term privatization plan may involve MTRC, KTRC, the Airport Authority and the Housing Authority's shopping and parking centers. The amount to raise may well exceed HKD50bn within a 12-18 months timeframe. If the market reception turns out to be modest, then value maximization may not be achieved. Therefore, it is a sound financing maneuver using the assets as collaterals and issuing bonds to cash in in advance, buying time for maximum valuation. Since each asset is in distinct operational stage and has different development prospects, independent study should be carried out to determine the type of bonds to issue (ABSs or convertibles) and the type of investors (institutional or individual) to target.

Will Hong Kong's sovereign rating be compromised when the SAR government issues bonds under the circumstances mentioned above? Currently, S&P sticks a "Negative" outlook to Hong Kong's rating while Moody's maintaining "Stable" assessment. The latter feels more confident with the SAR government's still large fiscal reserves, far better than many other countries where ratings are the same but government finances are mostly in the red. S&P is more concerned about the plan to tackle the deficit problem. Thus, the SAR government's bond issuance should not lead to the conclusion of worsening finances. And the fiscal reserves can be maintained at a comfortable level covering 6 to 10 months of expenditures or HKD120-200bn. Consequently, Hong Kong's credit rating should not be compromised. Nevertheless, the SAR government must take great precautions to consult and lobby the rating agencies before any bond issuance to ensure that our rating will remain intact in any circumstances.

China could provide another breakthrough to Hong Kong's bond market. It becomes clear that the RMB will continue to come under revaluation pressure until the US presidential election next year. As long as stability is the main concern, ways to mitigate the pressure need to be found. The bond market provides viable options. Mainland institutions can issue foreign currency bonds in China, taking advantage of the low financing cost and absorbing the extra liquidities from the market. Another option is to allow Chinese enterprises to invest in foreign bonds abroad, encouraging controlled outflows. As for the latter, Hong Kong can try to win over the trading and clearing businesses. HKD bonds can also be recommended as eligible vehicles. And if Hong Kong can attract more foreign bond issuers to come to our market, then we can also satisfy China's needs in these areas. Besides, we must heighten our efforts to win over FX bond businesses from the Chinese government, public entities and private enterprises, striving to become the offshore bond-financing center for them. Their refinancing needs also provide a new line of business. The biggest breakthrough in the future would certainly lie in the RMB bond business. Hong Kong should strive to become the first choice when Mainland issuers are allowed to issue RMB bonds overseas. We can even ponder an arrangement with the Treasury Department about allotting a fixed portion of RMB bonds in Hong Kong in their regular auctions. To sum up, we are still in the very early stage of competing for China's bond businesses and thus the potential is tremendous.

Hong Kong's bond market development still has many obstacles to overcome. The corporate bonds sector remains sluggish with a proportion of less than 8% in 2002. Problems in rating, cost and secondary market still plague the sector. The Exchange Fund Notes are trading in the HKEx but turnovers are very thin, reflecting tight supplies and high trading costs. The bond derivatives market has made little headway. And although REIT is categorized as mutual fund instead of bond, Cheung Kong's decision to launch its first REIT in Singapore caused heated debates about approval efficiency of new investment vehicles in Hong Kong. In view of these, although Hong Kong's bond market is poised for takeoff, there is still a long way to go.