Developing Bond Markets a Comprehensive View

7/29/2019 Developing Bond Markets a Comprehensive View

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Developing Bond Markets: A Comprehensive View by Clemente del Valle1

1.- Introduction

Bond markets provide the means to fulfill mid- and long-term funding needs.When developed, they contribute to reduce the financial risks of the overall economy, provide the government with a non-inflationary source of finance, create a well-balancedfinancial environment and promote economic growth. Due to the importance of thesemarkets to the entire economy, it is necessary that governments lead the process of developing bond markets by creating a domestic government securities market and providing an adequate framework to develop corporate bond markets. In that sense,evidence has proven that domestic government bond markets are the fundamental stone

upon which the domestic bond markets are built. In an inter-American bond market perspective, the stage for the market’s development differs substantially, and countriescan be categorized in three groups: the first one is the developed group that includesUnited States and Canada; both countries have a well developed capital market and a bond market in particular, where the government obtains all its funding needs via theissuance of fixed rate and local denominated currency bonds. The second group is thedeveloping one and includes Mexico, Brazil, Chile, Colombia and Argentina; all of themhave achieved substantial progress in developing bond markets, especially governmentsecurities markets, but the process is far from being completed. The third one, the pre-developing group, includes the rest of Latin American countries and is characterized, inmost cases, by small economies where the size of their financial system does not

necessarily support the infrastructure required to develop a bond market or countries thathave not started the developing process yet. Table 1 shows the relative size of thegovernment securities market with respect to the domestic and international bond marketsin selected developed and emerging countries.

1 Senior Financial Sector Specialist, World Bank The author gratefully acknowledges the contribution of

Rodrigo Trelles Zabala who provided helpful comments and suggestions to this article but also contributedwith a major part of the editing and the research on the regional cases. Any errors or omissions are solelythe responsibility of the author.



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Table 1 – Size of the Government Securities Market(outstanding debt securities, September 2001)

Domestic Markets International Markets

CountryTotal Debt

(US$ billions)% Government

SecuritiesTotal Debt

(US$ billions)% Government

Securities

Argentina 30 90.4 87 85.1

Brazil 269 85.0 63 51.7Canada 563 69.9 206 49.6

Chile 31 60.3 5 9.3

Colombia 13 83.6

France 1,091 60.7 375 7.3

Germany 1,656 43.3 1,003 1.9

Italy 1,314 75.3 261 27.6

Japan 6,343 75.3 277 6.1

Mexico 81 83.3 65 46.3

Peru 4 45.9 0

Spain 365 75.9 174 21.2

United Kingdom 939 45.2 599 1.1United States 15,057 55.7 2,126 29.4

Uruguay 3 89.3

Venezuela 12 56.3

Source: BIS

As noted, it appears clear that government bond markets are the bases of theentire bond market. Another interesting fact that Table 1 shows is that most of thedeveloped countries fund their financial needs in their domestic markets, while LatinAmerican countries require an important access to international sources (e.g., multilateral banks and international capital markets) to finance their needs. In that sense, the first

challenge that Latin American countries face in the capital markets framework is todevelop sound domestic government securities markets and respond at the same time totheir growing financing needs. Nevertheless, to achieve that goal, important challengesat more micro level must be tackled first. The main challenges are the following: developsound money markets, increase competition among market participants, provide liquidityand transparency to secondary markets, expand investors’ base, establish a regular andtransparent primary market system and strengthen government debt management capacity(e.g., human resources and information technology). To meet these challenges, theregion has been building some capabilities during the last years that include a certainlevel of macroeconomic and financial stability, some development of their financialsystem, a more stable legal and institutional framework, some of the basic infrastructure

required and finally, the development of institutional investors which some countries are promoting. The challenges and the initial achievements are clear. What seems to belacking in many of these countries is the level of awareness within the governments, that by having a more systematic and comprehensive vision of the requirements to develop bond markets, they could be more successful and expedient in achieving this veryimportant goal.



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In fact, like any other major project that involves many institutions and policies,developing vibrant capital markets, and bond markets in particular, requires a soundframework, the right inputs and a proper management. Therefore, due to the importancethat bond markets have to build a sound capital market, governments should lead the process supported by a comprehensive and well-thought framework. Moreover, bond

markets are one of the principal means to achieve a developed and sound domestic capitalmarket. Thus, governments, through their Ministry of Finance, have the duty of leadingthe process of development not only because of their role of developers, but also becauseas issuers, they are the most important player of capital markets and bond markets in particular. In that sense, policymakers face important questions at developing bondmarkets: what is the right sequence of development?; what are the essential initiativesthat have to be addressed to encourage the bond market development? what is the role of the government? This paper provides general policy guidelines and recommendations onthese and other thoughtful questions for market development.

The main goal of this paper is to convey a very simple, but important message

that it is essential for policymakers to think about the bond market development as acomprehensive and dynamic process. In that sense, it is clear that the government,through the Ministry of Finance, or in some cases the Central Bank, must lead thedevelopment process not only because they will benefit as issuers, but also because adeveloped bond market diversifies the risks of the entire economy and leads to a morecompetitive economic and financial environment. More competitive economicenvironments are especially important in Latin America, because their lack of competitiveness has historically hampered economic growth in the region. Thus, itappears clear that bond market development and, more generally, the capital marketdevelopment will lead the region to a more sustainable economic growth. Additionally,the paper provides a succinct description of what Latin American countries have doneand which seem to be the biggest challenges ahead. Thus, this paper is mainly directed toLatin American policymakers because on them relies the duty of building a more soundfinancial and capital markets framework toward their countries’ development. Finally,from a broader point of view, this paper is directed to every institution and individualcommitted with the development of the capital markets.

The paper relies heavily on (i) the book recently published by the World Bank andthe IMF: Government Bond Markets: A Handbook, (ii) the survey that was conducted in2000 by the World Bank with several of the Latin American countries and which resultswere presented in the Regional Workshop that the World Bank and the IMF jointlyorganized in Rio de Janeiro in July 2001, and (iii) the experience of the authors as Bondand Capital Markets developers and debt managers. Thus, the experience gained in “thefield of battle” constitutes an immeasurable asset that helped to write this paper.

The paper is structured as follows: the first part of the paper emphasizes theimportance of two main steps toward the development: a comprehensive view and themain prerequisites to begin the process. Both are necessary but not sufficient conditionsfor market development. Some countries started their bond market development withouta plan and reached certain level of development, but sooner or later the lack of a strategic



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view emerges. As for the prerequisites, they are unavoidable ingredients that no countrycould begin the bond market development process with success without first meetingcertain conditions. All of this is followed by the sequence of development, whichestablishes a tentative sequence of steps to be followed in order to achieve a successfulmarket development. The following parts of the paper address the importance of the

government securities market, the characteristics of the private bond market and the links between them. Government securities market is the main component of bond marketsand the private market helps to diversify the financial risk allocation of the entireeconomy. In that sense, it is important to mention that strong links exist between bondmarket development and risk diversification so that virtuous or vicious circles can becreated. Further, the paper touches upon the role of the taxation policy and its impact onmarket development. Finally, the conclusion states some policy recommendations andmentions what are the challenges to Latin America.

2. - A Comprehensive View

Governments pursue economic growth and development by their policies andactions. One of the means to promote economic development is the capital market anddue to the vast benefits that it spreads over the entire economy, well-developed domesticcapital markets are deemed essential tool for growth. A sound domestic capital marketreduces risks and interest rates, leads to lower volatility and higher diversification, andestablishes a long-term horizon for investments. Money market is usually the first step inthe development of a sound domestic bond market, then the government securitiesmarket, followed by the corporate bond market and finally the derivatives market. Thislogic sequence has not always been followed, because some factors, such as, the level of competition, the grade of macroeconomic stability or the investors’ base can modify thesequence. Despite the mentioned sequence, these four markets have a close relationshipas one helps to build or improve the other one: money market helps to provide liquiditytowards the development of the government bond market; additionally, it supports theshort-term yield curve building process and allows reducing the costs warehousegovernment securities. On the other hand, the government bond market provides short-term bonds and standardized issues to the money market, ensuring the supply of instruments to maintain a proper level of liquidity. Both money and government bondmarkets help to build the private sector bond market, as they provide the infrastructure,the tools for price discovery, and hedging mechanisms. The corporate bond marketexpands investors’ options and leads to a more balanced domestic financial architecture,reinforcing the development of the entire bond market. Finally, the derivative marketarise as a consequence that participants have to hedge their risks and its creation leads tolow interest rates and better financial management practices. The benefits of that marketspill over the other three markets and reinforce their development. The links amongmarkets show not only the crucial role of capital markets as a tool for economicdevelopment, but also the importance that governments do take into account the linkswhen designing economic policies. Graph 1 shows the correlation between developmentand deepening of capital markets, while the size of the bubble shows the relativesignificance of the markets.



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Graph 1: Depth of Domestic Capital Markets and per capita GDP – December 2000

0%

50%

100%

150%

200%

250%

300%

350%

1,000 10,000 100,000

GDP per capita (logaritmic scale)

S t o c k s + B o n d s / G D P

US

Canada

Argentina

Chile

Brazil

Venezuela

Colombia

Peru

Mexico

Source: IDB based on FIBV, OECD and BIS

Viewing capital markets as a means for the country’s development, thegovernment needs to take a capital markets developer’s role, and the first step of that long process is to create and promote a government securities market. In that sense, thedeveloper’s role has two dimensions: the first, as bond government issuer, and thesecond, as a regulator and developer for private market participants. Therefore, it appearsclear that the government, through the Ministry of Finance (issuer and market developer)has to lead the development process. In some countries, this leadership could be passedon to the securities regulator, particularly, in those stages in which the development ismoving away from the government bond market into the other markets. It is important tonote that, particularly in small economies, Central Banks play a key role since they havesome financial and market knowledge and capacity and need efficient money markets to

support their monetary policy operation. If the Government does not issue or is notcapable of issuing bonds, they have to assume the developer role (e.g., Chile), so that, insome cases, Central Banks are the only issuers of short-term instruments in the moneymarkets. In any case, the success lies on building a very close partnership between theFinance Ministry, the regulators and the Central Bank. The partnership is extremelyimportant, since at the beginning of the process they have to design a comprehensive andstrategic plan for capital markets development in general and for the bond market in particular. In fact, the Ministry of Finance has to coordinate with different government



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agencies and bodies to ensure that the development process and the government policiesare consistent over time. That is especially important because in some stages of the process conflicts could arise, for example, between the tax authority wanting to raisemore revenues from the financial system and the monetary and economic authoritiesaiming at bond market development process. Therefore, it is important that the Ministry

of Finance ensures the proper sequencing and makes a better use of the differentsynergies, coordinates separated agencies and bodies. Institutional weakness arise as aconsequence of lack of coordination, therefore, since early stages of the process, it isessential to establish the proper management in order to achieve a comprehensivedevelopment process. Additionally, the Ministry of Finance as a leader of the process hasto build a dialogue with markets participants to get feedback from its actions and policies.In that sense, the developer and coordinator must have the comprehensive perspective of the complex network of market components and their interactions in order to design policies and initiatives. In fact, it is fundamental that network of investors, infrastructure,regulation, supply, government agencies, intermediaries and other market players sharesome form of a strategic market development plan.

3. - Prerequisites for Market Development

The development of the government bond market is a long-term and dynamic process. Building and establishing a credible market for government securities must beviewed as a key component of the country’s development strategy. It should be notedthat not all the mature economies have a similar strategy, either because the governmenthas not run budget deficits requiring funding or because the country is not large enoughto support the necessary infrastructure. There are two main prerequisites to develop themedium and longer term government securities markets: (i) certain level of macroeconomic stability and (ii) a liberalized and stable financial system supported bycompetition. Additionally, in order to develop the corporate bond market it is essential to pass a bankruptcy law that clearly delimits rights and obligations. Therefore, at firstefforts must be aimed at achieving these basic prerequisites, which will be thencomplemented by others, such a credible and stable government, and a sound legal andregulatory framework.

The Macroeconomic Framework

A sound and credible macroeconomic framework includes a sustainable fiscal policy, stable monetary conditions and a credible and transparent exchange rate regime.

Fiscal policy: In the context of government securities market developmentframework, the Government must be able to communicate to the market that fiscal policyis on a sustainable path and under control. Therefore, it is important that investors perceive the ability of the government not only to manage expenditures and debts, butalso to collect taxes, otherwise a higher risk of default will be perceived and the cost of the government debt will rise. A credible budget and control system of expenditures



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plays a key role in the fiscal policy. High real interest rate are one of the common effectsof an economy with a government incapable of implementing discipline in the fiscal side,and constitutes a major impediment for extending the yield curve and developing a liquidnominal bond market.

Monetary conditions: Stable monetary conditions are closely related to the fiscal policy because fiscal deficits financed by the Central Bank thorough monetary issuesgenerate inflation. Inflationary expectations discourage investors to allocate resources ongovernment bonds, increase the cost of funds and shorten the maturity of the issues.Therefore, a credible commitment to contain inflation is an essential step to develop asecurities market. An independent and well-managed Central Bank is necessary tocomplement, or counterbalance the fiscal policy, because it is almost impossible for themonetary authority to contain inflation, if not complemented by a sound fiscal policy.

Exchange rate regime: Exchange rate and capital account policies impact directly ongovernment bond yields, reflecting exchange rate and default premiums. Inadequate

policies increase both volatility and interest rates. Volatility has a negative impact notonly in developing long-term government bonds, but also on the secondary marketliquidity, especially where no complementary markets exist to hedge the risk of pricemovements. Capital account deregulation needs to be carefully considered, becauseunrestricted capital movements could expose the economy to risks of contagion fromexternal crises, but sound monetary and fiscal policies combined with a goodmanagement of debt and reserves can lessen these risks. An unstable macroeconomicframework not only constitutes an impediment to capital market development, but alsodestroys efforts and achievements in that direction.

Financial Sector Reform and Stability

Investors’ concerns about the banking system adversely affect the governmentefforts to develop the market. Moreover, the lack of financially healthy intermediarieswill cause secondary market liquidity to fall. Therefore, with a banking system in crises,it is not possible to develop a government securities market, because markets, such as, therepo and interbank markets, are closely related to both the government securities and thefinancial market, and cannot function properly with an unsound banking system. Thus,the steps to consolidate a sound financial system reform are liberalization andstabilization. In that sense, the reform process must address (i) informationinfrastructure, (ii) sound supervision and regulation, (iii) interest rate liberalization, and(iv) competition.

Information infrastructure: Information disclosure plays a key role in buildingmarket credibility, not only because investors are reluctant to deal without properlydisclosed information, but also because it leads to transparence and best practices. Well-established and transparent accounting and auditing methods help the monetary authorityand the market in supervising the financial system. Moreover, it is important that the



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monetary authority collects and processes all information in order to ensure the proper disclosure of the information that the market needs.

Supervision and regulation: Banking regulation must be designed according tointernational standards. Prudential regulations including lending standards, capital

adequacy, and asset diversification must be addressed to gradually reach BIS standards.In addition, monetary authority must gain enforcement power; otherwise, control isdowngraded to a monitoring function without intervention. In that sense, a soundfinancial system reinforces investor confidence and facilitates the development of new products, such as, mutual funds. Finally, in order to prevent systemic risks, it is desirableto have the existence of a safety net to support banks that are experimenting temporaryliquidity, but not solvency problems.

Interest rates liberalization: Removing interest rates and portfolio limits from the banking system and the financial sector as a whole is necessary to build a sound financialsystem. This form of liberalization leads to a better pricing and allocation of assets and

liabilities. In order to develop the government securities market, liberalization must becomplemented by regulations and reforms not only to improve loan foreclosure andcorporate bankruptcy but also to reach international standards of prudential regulation.In addition, reserve requirements and taxation policies must be reviewed to attain theobjective of developing the government bond market.

Competition: A more competitive environment spreads benefits over the entiremarket and helps the development of the process. The entry of international financialservice providers is an interesting way towards banking and financial sector reform, but ithas to be carefully analyzed, especially during the first stages, in order to avoid damageto local players.

In various parts of the world, the banking system is the center of the financialsystem, and in an environment of limited competition and weak supervision, banks may be less interested to support the disintermediation implied with developing bond markets.In addition, if the system operates under a flexible regime where banks dominate also theasset management industry (e.g., mutual funds, pension funds) and the brokerage firms,this lack of interest could become a major impediment to develop the domestic debtmarkets.

Developing a government bond market requires a focused and dedicated view onthe essential steps to achieve that goal. In that sense, stable macroeconomic and financialenvironments are unavoidable requirements.

The Situation in Latin America

Currently, in Latin America there is an uneven situation of development of the bond markets and this is the result of the structural as well as economic difference in thelevel of development of the countries, in the region. For these reasons, in the level of



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achievements on the key pre-requisites referred above, the differences, could beexplained in a big degree by the big diversity in the size of their economies that makes iteasier for the bigger economies in the region to support such a development of their debtmarkets. For example, the identified second group of countries (i.e., Argentina, Brazil,Colombia, Chile and Mexico) achieved an important level of macroeconomic stability

during the first half of the 1990s

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. On the financial sector, the 1990s were alsocharacterized by important reforms, such as, the liberalization of the markets and theimportant inflow of foreign direct investment in the financial system. The latter was prompted in some countries by the Mexican crisis that exposed important deficiencies inthe governance of the companies and weaknesses in the regulatory framework of thefinancial system. The second half of the last decade was characterized by the importantdevelopments in the bond markets favored by the lower levels of inflation, sounder financial systems and relatively more stable macroeconomic environment. In fact, lowinflation allowed these governments to extend bond maturities and issue fixed rateinstruments. It is important to set aside the case of Chile that implemented its reformslong before any other Latin American country which explains why in certain areas of

capital markets development, they are more advanced. However, in the case of the bondmarkets, it is important to note that most of fixed income securities (e.g., Central Bank and corporate sector) are inflation indexed which has represented a major impediment for a more active and deep markets. Both countries, Brazil and Mexico, have been exposedto currency and macroeconomic crises during the last decade. However, in the case of Mexico after the crisis of 1995 and their joining of the NAFTA agreement, the countryhas been consolidating some of the key reforms in the macro and the financial sector areas. For example, after the 1994-95 crisis, the government has encouragedinternational banks to participate in the domestic financial market, leading to a privatization and consolidation of the banking system. Due to better macroeconomic andfinancial practices, Mexico was upgraded to investment grade. This positiveenvironment combined with a more proactive debt management strategy to develop thelocal debt markets has proved to be quite effective. The Mexican authorities have beenable to extend the average maturity of the debt portfolio, increase its duration with theintroduction of the 5 and 10 year nominal fixed rate bonds and improving liquidity due tothe fungibility, reopening and the introduction of market makers in 2000. Since itsdevaluation in 1999, Brazil experimented high levels of volatility in the key financialvariables and although they have achieved important results in terms of consolidating asounder macroeconomic framework, the volatility continues to be high and real interestrates are among the highest in the world. This environment still represents a major constraint for further development of the local debt markets, which has forced thegovernment to offer indexed instruments (to the foreign exchange and to the overnightinterest rate) in order to extend the maturities and keep the refinancing risk and the costof debt under control in the short term. Therefore, the reduction of very high real interestrates and the realization of further stability in the financial variables should be key priorities for the government going forward. Colombia implemented important reformsin the macro and financial sector areas during the first-half of the 1990s, that combined

2 Chile gained macroeconomic stability much earlier due to the reforms implemented during the ‘80s.Additionally the recent currency devaluation of Argentina has introduced a high degree of macroeconomicinstability in that country.



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with a relatively well organized strategy proved to be very effective in building themarket, i.e., Colombia is one of the very few countries in the region that has been able toestablish a liquid 10-year benchmark with nominal bonds. Since 1997/98, thedeterioration in its fiscal situation is leading the country to a more complicated debtoverhang that is seriously endangering the process of development; however, the

important drop on the real interest rates has contributed to offset partially the problem of the accelerated growth of the stock of government debt. Argentina had built a stablemacroeconomic framework during the 1990s that contributed to an importantdevelopment of the local debt markets. However, the unsustainable fiscal deficit carriedover during the last years lead the country to default and devaluation, creating an unstablemacroeconomic environment aggravated by a broken financial system.

The situation in the third group of countries differs substantially: Uruguay, CostaRica and Venezuela are in some way the more advanced markets within this group givena more proactive role of their governments to support bond market development, which isstill in its early stages. The cases of Peru and Panama are rather special. In the former

case, its relatively small net financing needs and its explicit decision, until very recently,of not engaging in an active financing in the local soles market, explains why there has been such a limited development of the local debt markets in Peru and a strong reliance by the real sector on dollar denominated loans. In the case of Panama, the fact that theeconomy is fully dollarized and for a long time it has been a financial center, has alsocreated very special conditions for the government to rely primarily from internationalsources (e. g., capital markets and international organizations) and to a lesser degree fromlocal sources.

4. - Sequence of Development

The sequence of development of the government bond market could be dividedinto three main stages: prerequisites (addressed in the prior section), expansion andmature stage. It is crucial to note that the strength of the financial sector, the size of theeconomy, or the investors base exert a substantial impact on developing the market andcould modify the dynamics of these stages. Moreover, these stages are not watertightcompartments and the developing process must be regarded as a flexible framework,where the dynamics of the market make different stages to coexist at different points intime. Policymakers have to keep in mind that, in general, the corporate marketdevelopment will tend to follow the government securities process, and the first one is built upon the other. Therefore, a comprehensive view is essential since the beginning, because the initiatives designed for the government securities market will impact on thecorporate bond market and ultimately on capital market.



Graph 2 – Sequence of Development

The Expansion of the Development Process

During the second stage, governments have to deal with different challenges, andundertake four essential initiatives: to build the money markets development (i.e., repomarkets); to design and implement a market oriented funding strategy; to establish a basicand safe market infrastructure and regulatory framework; and to promote and improvecompetition. The Ministry of Finance and the monetary authority must coordinate effortsto develop money markets and liquid repo markets in particular; the former will provideinstruments, such as, Treasury bills and the latter will conduct a monetary policycontributing to this development. The Ministry of Finance must design its debt strategy,which includes better auction procedures, transparent government securities operations,standardization of the instruments and development of a short term yield curve. However,the most important initiative is that government moves away from captive sources of funding and implements a market oriented funding strategy. At this stage, banks andmoney market funds are the essential players to support the achievements of the first two

Macroeconomic

Stability

Financial

Stability

Bankruptcy

Law

Competition

Debt Policy - Debt strategy- Market oriented funding

strategy- Auction procedures- Transparency

- Gov. Bond Standardization

- Short-term yield curve

Money markets

(repo markets)

Infrastructure

and regulation

Secondary Gov. BondMarket Liquidity

Debt policy - Strength Government DebtTeams- Use of primary dealers

- Risk management- Extend bond’s maturities

Secondary

intermediaries

Credit Rating

System

Disclosure

system

Expand Investors

base

Infrastructure and

Regulation up grade

Time



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initiatives. The legal framework has to be adapted to meet market-oriented legalrequirements. It is important to note that no complex infrastructure is needed at this time, but it must provide a safe environment. Finally, one of the actions that has to beimplemented at this stage and whose results would be seen in the future, is to encourageand promote competition among the different participants of the market, establishing the

pillars of a more diversified base of investors. That is especially challenging in thoseeconomies where the banking industry is vertically and horizontally integrated. In thatsense, some Latin American countries have allowed international banks to entry to their domestic markets, bringing know-how in treasury management and competition. In fact,some long-term initiatives to diversify investors’ base and market participants, such as,the pension funds reform, which takes years to be implemented, could be initiated inearly stages and the same occurs with mutual funds. In any case, it is imperative tounderstand that the results of such initiatives are going to be seen in the mid and long-term.

The Maturity of the Development Process

The last stage of the development process presents different challenges.Lengthening the maturity of government securities, by issuing fixed interest rates or indexed bonds, is one of these challenges. In that sense, government debt managers arevital at this stage and the government has to ensure that the “debt team” counts with theneeded resources to implement a debt management strategy with special focus inmanaging risks properly. The key step of the third stage is to ensure and promoteliquidity in secondary government securities markets. To that end, market infrastructureand regulation are essential. In fact, secondary market liquidity is the most complex goalto address, because it is extremely sensitive to a wide combination of factors, such as, theexistence of standardize and fungible instruments, diversified investors, safe an efficientinfrastructure, conducive regulation, a well balanced tax regime, and sound monetary andfiscal policies among others. Moreover, settlement and depository systems have to be upgraded, and government bonds need to be fully dematerialized, in order to help theachievement of Delivery Versus Payment (DVP) standards. Additionally, credit ratingand disclosure systems have to be designed and put in place to satisfy specific corporate bond markets necessities. At this stage, the government needs to carefully analyze theuse of primary dealers as market makers and the role of intermediaries in the secondarymarket. Another major challenge during this stage is to develop and expand theinvestors’ base, promoting long-term investors such institutional investors like pensionand insurance funds.



Box 1. Peru: A Market in its Nascent Stage

Due to the recent macroeconomic stability and lowinflation Peru has began the process to develop itslocal government bond market. Nowadays, thecountry is in the middle of the prerequisites and theexpansion stage. The money market isunderdeveloped and most of the transactions take place in the interbank overnight market, which ischaracterized by a strong size and creditsegmentation. Large banks are reluctant to lend tosmall banks, or they do but adding a significant premium. Credit segmentation is relative to thenumber of credit lines available, because each bank trades with a limited number of players. The BancoCentral de la Reserva del Perú (BCRP) is the onlysovereign player in the market that issuesinstruments with maturities less than a year. CDs areused to trade in the repo market, but thesetransactions rarely exceed one week and are nottraded among banks, but only with the BCRP.The government is preparing a one-year Treasury bill program, in order to provide a regular supply of instruments that would address the structure of thedemand and at the same time support thedevelopment of the money markets and facilitate themonetary policy operations of the BCRP.Additionally, the industry is preparing a standardizedrepo contract, which is important to promote trading

in that market. To that end, other initiatives couldencourage banks to adjust their liquidity amongthemselves while the BCRP adjust the liquidity of the whole system. It is clear that authorities have towork in the development of the short-term yieldcurve to have a positive impact on money marketsand monetary policy and help the Ministry of Finance to manage its short term funding needs better. In this regard, it is important to highlight thatthe Banco Nacion, which added to its banking business lead to a non-transparent operation,executes a major part of the treasury operation of the

Ministry of Finance. In fact this rare system lacks of proper incentives to improve the cash flows forecastsand leads to a very unpredictable liquiditymanagement at the Banco Nacion.

From the debt policy point of view, due to theauction procedures that the government has recentlyintroduced (January 2002), it seems that authoritiesare committed to a market oriented funding strategy.

Nevertheless, a lot of work has to be done due to thecharacteristics that Peru’s public debt presents: (i)strong concentration of funding sources (i.e., morethan the 70% of the funding came from multilaterallenders and the Paris Club); and (ii) high foreigncurrency risk (namely, more than the 85% of the public debt is denominated in foreign currencies).Because of the lack of confidence and hyperinflationmemories, the authorities are facing the challenge toextend the maturity of soles denominated securities.In contrast, the market is heavily demanding one-year or less local currency government bonds. The“debt team” requires not only improving its know-how and practices, but also its technologicalresources. In fact, better risk management systemsand IT infrastructure are required.

Additionally, there is a need of strong coordinationamong the regulator and supervisors to ensure that a playing field exists for all the participants and avoid potential regulatory arbitrages and an unfair competition that could hamper the developing

process. A clear example of that need is that there isa different “mark to market” valuation approach for banks, mutual funds, insurance companies, pensionfunds and brokerage houses.The main settlement system of the country isCAVALI and its infrastructure is sufficiently well built to support the development of the bond marketat this stage. In fact, the link between CAVALI andthe Bolsa de Valores de Lima could, in theory, reachDVP for their direct participants.

Finally, the Ministry of Finance has to exercise

strong leadership and coordination not only withrespect to private market participants, but also todifferent government agencies and bodies.



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5.- The Government Bond Market

Bond markets are the link between issuers and investors with medium and long-term financing and investment needs. The government bond market is the backbone of most fixed income securities markets,3 not only in developed countries, but also in

developing ones. The benefits of such markets are wide and can be viewed from bothmacro and micro-economic perspectives.

Benefits of Developing a Government Bond Market

From a macro-economic point of view, the government securities market providesa benchmark yield curve, which helps not only to determine the price of the differentassets of the economy and improve the transmission conduit of monetary policy, but alsoto make comparisons among countries. This market is the suitable channel for thefunding of domestic fiscal deficits avoiding the use of the Central Bank, and as a

consequence, reducing the potential damage to the monetary policy. Moreover, the behavior of the cost of funding constitutes a market test for the Government policies.Taking into account the close relationship between monetary policy and securitiesmarkets, the government bond market strengthens the transmission of the monetary policy through the use of indirect monetary policy instruments in order to achieve, for example, inflation targets. Another important advantage is that it reduces foreigncurrency issues and the dependence on international bond markets. In fact, if combinedwith a sound debt management policy, domestic bond market allows the reduction of theexposure to financial risks. Moreover, a market-oriented funding policy based on a liquidgovernment securities market will reduce debt-service costs over the medium to long-term. It is only by having a less risky portfolio and lower real costs that governments canachieve a more sustainable growth of the debt portfolio.

From a micro-economic and market architecture perspective, the governmentsecurities market leads to the development of financial infrastructure, products andservices, creating a competitive environment that helps to build long-term financialsustainability. If properly developed, the securities market could change the financialarchitecture of a country, from a bank-oriented system to a bipolar system with asignificant capital market component, aiming at a more harmonious financialdevelopment. In addition, the government bond market leads to the development of alegal, information and institutional infrastructure that benefits the entire financial system.Finally, some financial products, such as, derivatives, repos, and money marketinstruments, which help to manage risks for the overall economy and improve financialstability, can only be introduced after the government securities market is either developed or being developed.

3 See World Bank - IMF Developing Government Bond Markets: A Handbook Chapter 1, page 3, Table 1.1



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Box 2. Small Economies & Bond Markets

Some countries did not developed a domestic bond market because they do not carry fiscaldeficits, or the size of their economies is not bigenough to support the infrastructure required todevelop a bond market. This is very relevant inLatin America where many countries have smalland non-developed economies. In these cases,governments must carefully analyze the necessityof developing a bond market. Additionally,authorities have to explore what other mechanismsof funding exist, because other alternatives could prove more efficient. Some alternative fundingchannels are private placements, access tointernational markets or regional solutions.Other schemes could include syndicated lending,multilateral organizations lending, bilateral loans

or combinations of these alternatives. It is clear that Latin American economies rely on externalsources to finance their needs. In fact, except for Brazil, Costa Rica, Chile and Jamaica, the externaldebt is greater than the domestic one in everyLatin American country. However this couldincrease the government exposure to the foreignexchange risk that could become unsustainable inthe medium term.

These circumstances show that in many casesthe activities undertaken are more theconsequence of an improvised fundingmechanism than a strategic funding policy. A particularly interesting possible solution for countries with small financial systems is aregional market. Merging different smallmarkets in a bigger regional one would createscale economies that can support the requiredinfrastructure and resources that marketsrequire. However, this type of initiativesrequires macroeconomic and financialharmonization among participants, which isespecially difficult to accomplish amongdeveloping countries. In that sense, the lack of compatibility among different financial and

macroeconomic country schemes constitutes amajor barrier towards markets integration.

External Debt as % of GDP at December 2000

A

r g e n t i n a

B r a

z i l

C

h i l e

C o

l o m b i a

M e x i c

o

P

e r u

U r u g u a y

V e n e z u e l a

B

o l i v i a

C o s t a

R i c a

E c u a d o r

E l S a l v a d o r

G u a t e m a l a

H a i t i

H o n d u r a s

J a m a i c a

P a r a

g u a y

D o m i n

i c a n R e p u b l i c

P a n a m a

N i c a r a g u a

0

50

100

150

200

250

300

E x t e r n a l D e b t a s % o

f G D P

Source: ECLAC



16

Money Markets and Monetary Policy

Governments cash transactions and movements have a significant impact onmoney supply, not only because governments are the largest participants of the banking

system in most economies, but also because they deposit their cash in the Central Bank inorder to avoid credit counter party risks. Since uncertain government cash movementsare an unpredictable source of liquidity for Central Banks and could force the monetaryauthority to tighten conditions for banks, sound cash management practices becomeessential. Additionally, proper cash management practices support the efforts of theCentral Bank to stabilize inflation and develop money markets.

Banking systems need to manage liquidity and risks, and both can be addressedthrough government securities, because these securities bear “zero risk” and the mostliquid instruments in almost every market. After the short-term interest rateliberalization, the development of short-term government securities and that of money

markets can grow simultaneously and reinforce each other. A sound money market is anecessary condition for government bond market as it provides liquidity for thosesecurities. Additionally, this market not only makes government securities cheaper andless risky to warehouse, but also allows to fund trading portfolios of securities, which isessential for the effective involvement of market intermediaries in developing secondarymarkets (e.g., market makers). In recent years, monetary operations have beenimplemented more and more through indirect monetary instruments, such as, openmarket operations. Indirect instruments improve the efficiency of monetary policies byhaving financial resources allocated on a market basis. In order to develop a moneymarket, the Central Bank role is essential, thus encouraging participants to manage risksactively and trade in that market. The monetary authority can do this by lengthening thereserve compliance period, excluding interbank transactions from the reserverequirements, adopting a costly accommodation policy, and maintaining the daily level or excess reserves very close to that desired by the banks4.

When markets are thin, the Ministry of Finance and the monetary authority canuse the same short-term instruments, the former to fund short-term cash flows needs andthe latter to implement indirect monetary policy. In these cases, information becomesvery important and it must be assured that funds raised by the monetary authority will not be used to provide funding to the Treasury. In other circumstances, when the Treasury bill market is developed, bills issued by the Central Bank might fragment the market.

Once again, the discussion above shows that the coordination between theMinistry of Finance and the Central Bank is both essential and unavoidable. The former has to inform its intentions to raise funds and to provide a daily forecast of its revenuesand expenditures and the latter must provide information about the money marketconditions and the best time for tapping the market with issues.

4 World Bank – IMF Developing Government Bond Markets chapter 2, page 67.



17

Government Securities Issuance Strategy and the Primary Markets

The government bond issuance process impacts directly on government securitiesmarket development. That process is an essential component of the debt managementstrategy and both must be viewed as means to achieve a major end: the securities market

development. A sound debt management strategy sets some of the bases upon which thecredibility of the market is built. Commitment with market practices and transparencycombined with a market funding policy implies a long-term view of market development.Additionally, it is important to ensure an adequate regulatory framework in order tosupport market development.

A market oriented strategy shows commitment with market practices, reinforcedduring the first stages when, in the short-term, the cost of funding may increase comparedto other sources of funding. In that sense, it is essential that governments move awayfrom captive sources of funding. In the medium term, the government can concentrate in building a sovereign yield curve, issuing simple and standardized government securities,

avoiding market fragmentation and providing enough liquidity for each issue. In earlystages, authorities may need to issue inflation linked or floating rate securities to obtainlonger maturities, particularly in countries that have experienced recent histories of badmacroeconomic management (e.g., high inflation, debt restructuring, unsustainabledeficits, etc.) and due to the size of their debt could face a significant refinancing risk.The most common type of government bond benchmarks in developed markets are thoseissued at fixed interest rate and the benchmark maturities usually are 2-3, 5 and 10 years.Treasury bills issued as zero-coupon instruments dominate the short-term portion of theyield curve. Some Latin American countries have reached an interesting level of development in benchmark issues. As mentioned earlier, after several years of efforts,Colombian authorities have established a 10-year fixed interest rate bond benchmark,extending the average life of the debt portfolio. Other interesting case is Chile, who hasachieved a very extended range of maturities, even reaching the 30-year maturity.However, given that the instruments are indexed to the inflation rate and the issues arenot very liquid, the market is not active and therefore the yield does not necessarilyconstitute a true benchmark. The limited liquidity of the market could lead to higher interest rates as a result of liquidity premiums. Brazil has been issuing indexed bonds(e.g., to overnight rate, to inflation or to US dollar) to reach longer maturities, but thisstrategy, that diminishes the country’s rollover risk, is bringing other risks, such as, theinterest rate and currency risks. In fact, the government carries all the risks and still is paying very high real interest rates, while the bondholder is basically only assuming thesovereign credit risk. That practice has not been very conducive to a sustainable marketdevelopment.

Another very important component of a sound debt issuance strategy is the accessto primary markets. The main objectives for implementing an effective securities salemethod are to increase competition in the primary market and to efficiently deliver securities to investors. It is important that the legal framework supports governmentactions and reinforces market development. The most common sale procedure in maturemarkets is auction, but early stage syndication is also useful because it ensures the



18

allocation of the issue and minimizes placement risks. Primary dealers could play a keyrole in government’s funding strategy because their principal goals are to promoteinvestment in government securities and ensure activity in the government bond market.In this case, some rules of the game must be established in order to regulate rights, limitsand obligations. Benefits of using primary dealers are: (i) they provide liquidity, (ii) the

government can reach different types of investors, and (iii) they can facilitate the shift toa market-based funding environment. On the other hand, the disadvantages of primarydealers system are (i) collusion in countries with small financial sectors,5, (ii) limitedcompetition, particularly in small markets, (iii) limited development in situation of scarceliquidity due to lack of repos and other hedging instruments. Authorities have to ensurethat the required conditions that primary dealers need to operate as market makers in thesecondary market were fulfilled. On the other hand, the government needs to haveenough capacity to properly monitor the performance of the PDs and avoid marketmanipulations, or artificial activity to comply with the obligations impose to such asystem. In any case, the government must carefully analyze the benefits and risksassociated with the primary dealer system in order to determine its use or not.

Transparency and information disclosure are also very important components of a sounddebt management strategy. This includes providing information about funding needs andcosts, debt structure and strategies, issues calendar, expenditures and revenues amongothers. Finally, it is important that the government develops a dynamic interaction with private and public market participants to obtain feedback from its actions and buildinternal capacity to better read and follow the market.

The following table shows the different types of auctions that selected LatinAmerican governments are implementing as well as the countries that work with primarydealers.

Table 2 – Access to the Market – Types of AuctionsCalendar of issues

ParticipationUniform Price

Argentina Yes Financial intermediaries

Chile YesFinancial intermediaries and

Institutional investors

Colombia Yes Primary Dealers

Peru Yes Stock BrokersMultiple Price

Costa Rica Yes Stock Brokers

Honduras No Everyone

Jamaica Yes Everyone

Panama Annual Stock Brokers

Uruguay No Financial intermediaries

Venezuela Yes Financial intermediariesBoth Methods

Brazil Yes Financial intermediaries

Mexico Quarterly Financial intermediaries

Source: World Bank Survey (2001)5 World Bank – IMF “Developing Government Bond Markets” chapter 1, page 16.



19

Box 3. The Colombian Government Debt Strategy – Most Recent Experience

Since 2000, the Colombian Debt Office has been focused on two main goals: (i) thedevelopment of the domestic governmentsecurities market; and (ii) the extension of thesovereign yield curve.In 2001, the government implemented its first

domestic debt swap, which was conducivewith the two main goals mentioned above.Colombia exchanged 52 issues due in 2001,2002 and 2003 for 3 issues due in 2001, 2004and 2006. The swap was very successful notonly because it diminished marketfragmentation, but also because it extendedthe average life of the domestic debt portfoliofrom 3.4 years to 4.5 years. Additionally, theamount exchanged was almost 3 times higher than that previously estimated. In fact, because the swap diminished the cost of

funding and provided more liquidinstruments, international analysts rated thetransaction very highly. One of the major achievements of the last two years is that thegovernment has developed a 10-year fixedrate bond benchmark, moving away fromindexed inflation bonds. Moreover, thisstrategy is helping to create a long-terminvestment culture, which is needed to extendthe investment horizon of the entire economy.

Additionally, efforts have also been made toestablish a liquid yield curve composed by 1, 2,3, 5, 7, 8 and 10 years bonds. The graph belowclearly shows not only that the debt team hasextended the average life of the debt portfoliodiminishing its roll over risk, but also that it has

lowered the cost of access to the market. Theuse of primary dealers has helped inimplementing the mentioned strategy.Moreover, in the past (1998 and 1999) thecountry had to afford higher interest rates toextend the average life of the debt, while in2000, 2001 and 2002 Colombia attained both,extending its portfolio average life anddiminishing interest rates. However, a big partof the explanation lies on the very seriousslowdown of the economy (one of the worst inmany decades) and the very negative

expectations of the market participants on thefuture recovery. The pro-active debtmanagement strategy has not withstandingtaken advantage of the situation to improve thestructure and cost of the debt portfolio. Muchhas been done and much remains to beaccomplished and one of the main challengesfor the future is to define a clear commitment toa market oriented funding strategy away fromcaptive sources of funding6.

Source: Colombian Ministry of Finance

9,6%

6,6%7,0%

12,1%12,8%

6,2%5,6%

5,8%

0

1

2

3

4

5

6

1995 1996 1997 1998 1999 2000 2001 2002

P o r t f o l i o ' s A v e r a g e L i f e

0%

2%

4%

6%

8%

10%

12%

14%

C o s t o f F u n d i n g

c



20

Another important fact in the case of Latin America is that countries exposed tohigher level of development of their markets are using primary dealers, introduced after some level of development had been achieved. Argentina and Colombia were the firstcountries that introduced primary dealers in 1997, followed by Mexico in 2000 andseveral of them based their dealers’ scheme in the experience of Spain in the late 1980s.

That country successfully used primary dealers to promote its government securities,increase competition among participants and lead the banking sector to thedesintermediation process.

Investor Base for Government Securities

A diversified investor base is essential to create and develop a governmentsecurities market. Both developed and developing countries have historically relied inthe early stages of development on their coercion and regulation power to raise funds; for example, by establishing that banks must meet their reserve requirements by holding

government securities. The consequence of these practices is that market participantscannot reach an optimal portfolio, producing a cost of opportunity for their investors’assets and inducing some moral hazard within the government. While most developedcountries have implemented reforms toward eliminating those distortions, few developingones are introducing reforms to change the before mentioned situation. The commitmentwith market oriented funding strategies is especially threatened when government facesdeteriorated fiscal conditions that could prompt the return to the use of captive sources of funding.

Commercial banks are one of the major investors in government securities, particularly at the early stages of development of the market. They allocate resources ingovernment bonds not only to meet reserve and liquidity requirements, but also tomanage short-term liquidity, provide collateral for repo transactions, obtain stable interestincome and hedge interest rate positions. However a more permanent strong presence inthe government market securities could indicate that those banks are weak in doing their job, which is lending7. When banks are the dominant player of the market and limitedcompetition- exists, some resistance could arise against developing the government bondmarkets, because it leads to a desintermediation process that threaten the banks’traditional business. In that sense, the action of the government becomes essential inthose markets where banks are the owners of related financial business, such as,insurance, brokerage and mutual funds. The government, as the developer of the market,is the only one in position to offset the stated resistance by setting the rules to encouragedesintermediation from bank deposits to capital market instruments and promotingcompetition among participants. One way to do it is by presenting a large enough business perspective to the new players and by a strong moral suasion that only publicsector authorities can exercise. In Latin American countries the banking industrydominates the financial system and that is especially difficult to change in smalleconomies. In Costa Rica, for example, the system is dominated by one or two lead banks, and a more competitive environment is difficult to establish due to the lack of economies of scale and the political resistance to reform the public sector banks.



21

Mutual funds represent a significant source of demand for short and mid-termsegments of the government securities markets. These funds are created with specialinvestment purposes, which explain why they do not necessarily have diversified portfolios. In order to develop the mutual fund industry, it is important to increase

competition, removing barriers to entry to the financial sector and allowing internationalinstitutions to enter the domestic markets. Additionally, a sound regulatory framework must be built to develop mutual funds, which should include investor protection, marketintegrity, high standards of disclosure of information, and a clear separation betweenmanagers and depositary institutions. It is imperative to avoid any regulatory arbitrage particularly between the regulatory framework for banks and for mutual funds. On theother hand, mutual funds constitute an excellent means to reach out to retail investors.However, they require the network of commercial banks to distribute their products andthat may lead to conflicts of interest between both market participants that governmenthas to address by creating a more competitive environment. Brazil constitutes ashowcase, where the mutual fund industry has experimented a major increase in the

savings channeled by these institutions. This growth can be partially explained by the tax benefit that the funds receive with respect to the tax applied to financial transactions; i.e.,investments made by mutual funds do not pay the transaction tax. Therefore, economicagents including other institutional investors (e.g., banks, pension funds and insurance)directed an important part of their investments thorough mutual funds. Nowadays thatthe industry has reached a certain grade of development, interesting problem have arisenfrom the tax distortion; i.e., the concentration of the investor base has seriously affectedthe liquidity of the market as fewer participants of the same characteristics are nowmanaging a greater part of the resources.

Pension funds and insurance companies provide a strong demand for fixedincome securities. Institutional investors benefit capital markets developmentintroducing financial innovation, transparency, corporate governance, competition,efficient financial practices and market integrity8. Government securities can fulfill their needs for long-term, fixed interest and low credit risk instruments. In countries whereequity markets are well developed, institutional investors usually allocate a substantial portion of their portfolios in those markets, but where those markets have not developed, pension funds and insurance, companies invest heavily in bonds. In addition, where the bond market is well-developed institutional investors prefer non-government fixedincome securities, while in non-developed bond markets, pension funds and insurancecompanies invest heavily in government bonds. Finally, it is important to note thatinstitutional investors and securities markets do complement each other, and improve oneanother, thus generating a virtuous circle. Chile was the first Latin American country thatimplemented the pension reform. Other countries that implemented a similar scheme areArgentina, Colombia, Mexico, Peru and Uruguay. Due to their professionalism, thesenew market participants have introduced to Latin American countries better risk management and better market practices. The main challenge going forward is to avoidhigh level of concentration in their industry as a result of the high concentration in thefinancial system as a whole related to the necessity of economies of scale, or to barriersto entry.



22

Retail investors constitute a non-volatile source of funding, but the problem of reaching out to this “clientele” has to do with its high processing and distribution costs.Hopefully, the use of new technologies, such as, the Internet, may open newopportunities to sell government securities directly to retail investors efficiently and at

low cost.

Non-financial corporations do not largely invest in government securities.Although they use these securities to manage liquidity and hedge risks, they are not long-term investors. Despite this circumstance, they can contribute to the development of money markets by investing directly in treasury bills and short-term government bonds,or indirectly via money market funds.

Foreign investors have an important participation in emerging markets and could be heavy investors in domestic government bonds. They not only could add liquidity tothe market but also help to extend government securities yield curve. Additionally, they

demand high quality and cheap financial services, and a credible and safe infrastructure.On the other hand, because they are especially sensitive to market movements and their portfolios are actively managed, they can add volatility to the market. That behavior could aggravate a delicate financial situation and because emerging markets are perceived as one asset class, foreign investors can spread a contagion effect on countrieswith sound economic fundamentals. However, economies with a more stable and soundmacro conditions will be better equipped to make the participation of foreign investors inthe local markets a win-win situation.

A broad investor base implies several benefits for developing a governmentsecurities market, including but not limited to market stability, financial innovation, moreliquidity, and lower costs of funding. The government must lead the process of expanding its investor base through developing an environment that attracts a greatdiversity of investors. Additionally, special attention deserves the bankingdesintermediation process, because banks do not have great incentives to expand theinvestors' base and desintermediate their activities, therefore, regulation and competition become essential tools to achieve that goal.

Graph 3 shows the investors’ base in selected Latin American countries.



23

The graph shows that countries like Colombia, Costa Rica, Honduras, Jamaicaand Panama heavily rely on public sector investments that constitute a captive sources of funding. For example, in Colombia financial surpluses from state companies andagencies must be invested in government securities, including the public sector socialsecurity fund, and this captive investors represent around 50% of the whole demand for government bonds. Additionally, directly or indirectly the majority of the LatinAmerican countries still require that banking reserves be met exclusively by governmentsecurities.

Secondary Markets and Infrastructure

A liquid secondary market for government securities requires the involvement andcommitment of several market participants. Developing a liquid secondary marketrequires not only sound infrastructure, but also an adequate regulatory framework. Soundinfrastructure involves trading systems and procedures, market intermediaries, relatedmarkets and settlement and depository systems.

0

25

50

75

100

B r a s i l

C h i l e

C o l o m b i a

C o s t a R i c a

H o n d u r a s

J a m a i c a

M e x i c o

P a n a m a

P e r u

Banks and Financial institutions Public Sector Institutional investors Companies and Families Others

0

25

50

75

100

0

25

50

75

100

B r a s i l

C h i l e

C o l o m b i a

C o s t a R i c a

H o n d u r a s

J a m a i c a

M e x i c o

P a n a m a

P e r u

B r a s i l

C h i l e

C o l o m b i a

C o s t a R i c a

H o n d u r a s

J a m a i c a

M e x i c o

P a n a m a

P e r u

Banks and Financial institutions Public Sector Institutional investors Companies and Families OthersBanks and Financial institutions Public Sector Institutional investors Companies and Families Others

Source: World Bank survey 2001

Graph 3- Investor Base in selected Latin America Countries – December 2000



24

Spot trade is the main form of transaction in secondary markets and governmentsmust ensure that those trades can be executed and settled safely. It is important thatgovernment securities be perceived as very liquid instruments, in order to achieve that perception these securities have to accomplish the following requisites: (i) lowtransaction costs, (ii) widely available and continuous pricing, (iii) wide access to trading

systems and intermediaries that provide immediate execution, (iv) safe and rapidsettlement of transactions, and (v) efficient custodial and safekeeping services9.

One way to provide liquidity to the secondary market is using intermediaries inthe government bond market. Market makers need to hedge risks, otherwise the cost of carrying an inventory of government bonds increases, and thus derivatives markets helpand complement the government securities market development. In addition, theexistence of Inter-Dealer Brokers (IDBs) can improve the market liquidity by helpingmarket makers to execute transactions and the price discovery process.

Government bonds have historically been traded in Over The Counter (OTC)

markets, where dealers, large investors or IDBs close the trades by telephone and confirmthe deal by fax. The following table shows the different markets in which governmentsecurities are traded and it clearly shows that most government bonds are traded in OTCmarkets and that is particularly true in those countries that have reached certain level of development.

Table 3 – Secondary Markets Bond Government Trading by type of Market (%)

Stock Exchanges OTC Markets

Argentina 15 85

Brazil 20 80

Colombia 16 84Costa Rica10 100

Honduras 100

Mexico Most of them

Panama 2 98

Peru11 100

Venezuela Most of them

Source: World Bank Survey 2001

To provide liquidity in the early stages of the market, authorities can require thatspecific market participants trade government securities in specific places. Trading andinformation systems that facilitate an efficient completion of transactions are essential for an effective secondary market infrastructure. In its early stages, markets are thin andilliquid, but liquidity can be gained by implementing short trading sessions (i.e., periodicmarkets) and when more liquid, those markets can move to continuous trading. For moredeveloped stages of the markets where volumes and activity are growing, electronictrading systems may provide the lowest cost for trades and the possibility to sell anddistribute government securities to final investors. Therefore, government has to remove



25

any entry barriers to the market to corporations that own those trading systems. Brazilhas developed one of the first transactional electronic system to trade governmentsecurities in the region using part of the infrastructure of the Rio Stock Exchange, butcreating a new organization with a different governance structure where banks are themajor players. In Colombia, the Central Bank introduced, in 1998, an electronic trading

platform for the dealer community and more recently the Colombia Stock Exchange hasintroduced another electronic trading platform aimed at providing a platform for thedealers to trade with their institutional clients (i.e., the second tier).

The settlement system is one of the key aspects in developing a securities market.Dematerialized bonds not only help the settlement process because they can be processedquickly and cheaply, but also provide protection to investors because they cannot bedestroyed or lost. Therefore, one of the first steps in improving settlement proceduresmust be to change paper government securities for dematerialized ones. Moreover, a keydecision in settlement design is to determine the gap between trade execution andsettlement. That gap is related to the infrastructure of the settlement system and the

shorter the gap between execution and settlement, the lower the risks. Nevertheless, inorder to reinforce the view that government instruments are very liquid, somegovernment securities, such as, Treasury Bills, can be settled in shorter periods that isT+1, than other government bonds.

To reach delivery versus payment transactions (DVP), it is necessary to provide asettlement system that supports large-value trades. In that sense, it is preferable thatmembers of the depositary system have accounts at the Central Bank, which can becredited and debited, in order to ensure settlement of both the securities and the paymentsides of the trade. In order to provide transparency and security, a separate clearing andsettlement agency or corporation is required. In OTC markets, those functions work bilaterally, and each participant assumes the credit risk of his counterpart. In early stagesof development, the collection of settlement orders can be implemented by non-sophisticated methods, such as, the telephone or fax, but always ensuring validation,encryption and authentication.

The custody of government securities can be carried out through the CentralBank; other options are private companies, partly private companies and/or a separatedgovernment agency. In any case, due to the fact that the depository activity is acentralized business, authorities must ensure non-monopoly practices, transparency,competition and wide access to the custody agent. The following table shows that thereis not a clear trend in depositary arrangements among the selected group of LatinAmerican countries.



26

Table 4 – Depositary Services and Dematerialized Securities

Dematerialized (%) Depositary

Argentina 100 Independent company

Brazil 100 Central Bank

Chile 99 Independent companyColombia 100 Central Bank

Costa Rica 0 Stock Exchange

Ecuador 0 Independent company

Honduras 90 Central Bank

Mexico 100 Independent company

Panama 28 Stock Exchange

Peru 100 Stock Exchange

Uruguay 44 Central Bank


Additionally, the table shows that those countries that reached a certain grade of development, only operate with dematerialized securities. Argentina, Brazil, Chile,Colombia and Mexico began the dematerialization of securities relatively early. Other countries, like Costa Rica, are currently in the process of introducing the electronic book entry system.

International investors prefer to deal with just one custody agent, which assure better liquidity management practices. At a later stage, efforts must be oriented towardslinking domestic custody systems with cross-border depositary houses, such as,Clearstream or EUROCLEAR, especially in those markets where foreign investors have alarge presence.

The design of infrastructure plays a key role in developing a secondarygovernment security markets. Therefore, it is important that policymakers view thedesign in perspective, analyzing its impact in three market dimensions: (i) the capitalmarkets as a whole, (ii) the government securities market, and (iii) the secondary marketsfor government bonds.

Regulatory Framework and Information

A sound legal and regulatory framework is a requisite for market development.Therefore, a legal reform must be addressed during the first stage of development. Thegovernment securities market and the corporate bond market have in common most of therules of the secondary market, except those related to information requirements since thegovernment does not have to meet disclosure standards. Most of the countries regulateand supervise the market through the national securities agency, though that body is notthe only one that controls and regulates the market. Other government agencies and



27

bodies, such as, the Central Bank and the Ministry of Finance, are involved in the processand need to coordinate their activities. In any case, the legal framework has to achievethree main goals: (i) ensure transparent and efficient markets, (ii) reduce systemic risks,and (iii) provide protection for investors.

During the early stages, the government acts as a regulator based on legislation,setting the bases the market is going to be built on. The Congress has to pass bills thatinclude but are not limited to a securities law, a public offering framework, a bankruptcylaw, the role of the Central Bank and the role of the national securities agency amongothers. The principal objective of these laws is to establish the principal rules for themarket including enforcement power to the Central Bank and the national securitiesagency, basic practices for disclosure of material information, legal resources againstmarket participants, and liabilities for organizations that manage third party investmentaccounts.

The legal framework has to be consistent with a market oriented funding strategy.

The Ministry of Finance, or the Government body or agency that borrows funds, has to be empowered with clear borrowing powers. In general, Legislatures establishes annual borrowing limits, but this practice needs to be reconsidered, as it could act as a limit to a proactive debt management scheme12. In that sense, it is preferable that Congressestablishes net borrowing limits rather than gross ones.

The regulatory framework of the market has to ensure a transparent and efficientone, discouraging and sanctioning improper trading practices including insider trading,use of clients’ trading information, frauds and market manipulation. Since t-bonds aregenerally traded in OTC markets, the authority should have access to trading records inorder to investigate the compliance with rules.

Another important goal of market regulation is to minimize systemic risks, whichcan be addressed by introducing capital requirements and control risk systems to market participants. Capital adequacy has to be carefully considered, because non-uniformity of capital requirements within the same class of securities market actors could increasesystemic and credit risks, but different capital requirements across different classes of market participants could create incentives for self-regulation. Additionally, capitaladequacy has to address liquidity, price and credit risk not only for the assets of theintermediaries but also for third parties’ assets. Margin requirement surveillance is alsoimportant to manage these stated risks. In order to minimize systemic risks, the CentralBank is essential, as it is the one that generally determines and supervises marginrequirements, capital adequacy, risk control systems and settlement operations of thedealers, engage in the government market. Therefore, as it occurs with the nationalsecurities agency, the Central Bank needs to be entitled to enforce regulation compliance.But clear definition of responsibility will need to be established with the supervisors of the different type of dealers (banks and brokerage firms) in order to avoid conflicts,excessive controls or gray zones.



28

In ruling and supervising the secondary market, the national securities agency isnot on its own: the Central Bank is a relevant participant. Additionally, the Self Regulatory Organizations (SROs) help the authorities not only in supervising andimplementing rules, but also in creating, faster than governments, new regulations as aresponse to new financial products.

Finally, it is important to note that regulation must be consistent among differentfinancial industries in order to avoid regulatory arbitrages. Two interesting LatinAmerican examples are Mexico in mid 1990s and Peru in the late 1990s. In the mid-nineties, the regulation of banks and mutual funds, in Mexico, was under theresponsibility of different agencies and the process of reform and improvement came atdifferent speed. The consequence was that the banks, which were more rigorouslyregulated and supervised, but had ownership control on the management of the mutualfunds, allocated their funds to their clients through those vehicles in order to avoid therestrictions in their banking segment. During the Mexican and Asian crises, many of thefunds were exposed to big losses that came as big surprise to the investors due to the

limited transparency and the weak supervision. Since then, regulation and supervisionhas been strengthened, but the credibility of mutual funds suffered enormously and hasmade the new development of this institutional investor very difficult. A similar storyoccurred in Peru where the local SEC had two formal roles: as supervisor and as marketdeveloper. In this case, under the flag of being a market developer they allowed a laxregulation in terms of establishing clear “Chinese Walls” on the management of the fundsthat has affected the financial industry’s credibility during the recent international crisis.

6.- Private Sector

The development of corporate bond markets will come, in general, after thedevelopment of government securities markets, and it requires three specific elements todevelop: (i) a credit rating system, (ii) a disclosure system, and (iii) bankruptcy laws.With the exception of the U.S, secondary markets of corporate bonds are not very liquidso the main activity of the private sector bond market is focused in the primary market.The size of the corporate bond market is noticeably different among developed anddeveloping countries: in the latter the private sector bond market rarely exceeds 10% of GDP, while in the former most of them exceed that figure, reaching the highest in U.S(70.2% of GDP).13. There are two main classes of corporate bond issuers: (i) major issuers, which are financially strong, issue low risk and uniform bonds, their issues arelarge and stable, they regularly access to the market in a non-opportunistic manner, andare well known by the investors’community; (ii) minor issuers are those that access themarket irregularly and at opportunistic times, their bonds are heterogeneous and notfrequently traded in secondary markets, and they usually reach certain types of investorswith specific investment needs.



29

Benefits of the Corporate Bond Market

From a macroeconomic point of view, the corporate bond market does not only benefit the private sector but also the entire economy as well. Corporate financemanagers have to decide how to finance their companies, and they know that an adequate

mix of debt and equity is essential for sustainable growth. Additionally, they have tochoose between loans and bonds. Though both vehicles have advantages, bonds aremostly cost-effective for long-term, large scale and opportunistic financing. From a broad perspective, corporate bond markets (i) provide long-term investment products for long-term savings, (ii) improve the supply of long-term funds for long-term investmentneeds, (iii) lead to financial innovation in order to meet the specific needs of investorsand borrowers, (iv) provide lower funding costs by capturing a liquidity premium, (v)relocate capital more efficiently, and (vi) diffuse stresses on the banking sector bydiversifying credit risks across the economy. Private sector fixed income securities notonly contribute to the disintermediation process mitigating financial risks, but also reduceinterest rates, foreign exchange and refunding risks by issuing long-term fixed rate local

currency bonds.

The consequences of an underdeveloped and dysfunctional corporate bond marketcan be widespread and produce an impact not only on the corporate sector but on thewhole economic system as well. The absence of private sector fixed income securitiescomplicate assets’ diversification, leading to inefficient portfolio investments. Other negative effects are that companies may be forced to build an imbalanced structure of funding, financing their needs through international corporate bond markets and exposingthe economy and themselves to foreign exchange risks.

Current Trends

There are two main trends that are supporting the development of the corporate bond market: the first one is desintermediation, and the second is deregulation and privatization. The latter is related in most cases to the increasing incapacity of governments to finance major infrastructure projects, utilities and housing. In addition,due to the pursuit of economic efficiency, government companies and infrastructureactivities have shifted from the public sector to the private one. These changes have beenimplemented by privatization and deregulation processes. Given the large sizes and longdevelopment periods of infrastructure projects, the corporate bond market is the proper place to finance those projects, though many of them are financed by syndicated loans

from commercial banks, particularly in the early stages of the projects. From 1990 to1997, it is estimated that in developing countries 10 to 20 percent of infrastructure projects were financed by debt securities14. On the other hand, in many developingcountries, privatized companies are becoming the most outstanding issuers of privatesector bonds. Given that housing is for governments, one of the major socioeconomic priorities, efforts have to be aimed at developing a mortgage market. In that sense,desintermediation through securitization is the right procedure to promote and developthe above mentioned market, not only because it leads banks towards a higher lending



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capacity, but also because housing is an engine of economic growth. The size of residential mortgage markets varies throughout the developed countries, but thesemarkets are clearly underdeveloped in emerging economies and in many cases due to avery limited standardization of the mortgage loan market. In any case, due to thementioned trends, governments have to assess, design and implement the development of

an efficient corporate bond market.

Box 4. Structured ProductsStructured products are collateralized securitiesthat in general adopt the form of bonds.During the last years the industry of structured products has growth significantly as aconsequence of risk desintermediation throughsecuritization. The most prominent sector inthe structured products industry is the mortgage bond sector, and that is particularly true in U.S.where at the end of 2001 the mortgage

securities market reached US$ 3.6 billion of debt outstanding. Mortgage bonds aresecurities backed by a pool of mortgages andU.S. has the greatest mortgage securitiesmarket in the world, which is explained by theuse of GSE (Government SponsoredEnterprises) that promote and back mortgagesecurities, with an implicit or explicit guaranteeof the Federal Government (e.g., Fannie andGinnie Mae). As consequence of collateral’sguarantees and great diversification, thesesecurities are high rated and their spreads over

Treasury bonds are very low. Moreover, a properly developed mortgage securities marketcan be an engine of desintermediation,stimulating the securitization process, leadingto a better management of risks, improving theuse of capital and reducing interest rates.Additionally, in those countries that do notcarry fiscal deficits and they do not have toissue government bonds, mortgage bonds can be an imperfect, but valid substitute of Treasury bonds by creating a benchmark yieldcurve based on mortgage bonds. Latin

America has a great potential to developmortgage markets given that themacroeconomic framework is becoming morestable and there is a huge housing deficit. Theregion has not achieved significant advances inreal estate finance, except for Chile, where pension funds purchased mortgage productsrepresent 17% of GDP in 2000 and funds 66%

of the mortgage needs. Recently, Colombiaintroduced a mortgage securitization scheme based in the long established mortgage loanindustry in the country. Other interestingstructured products are those that throughcredit enhancements allow corporations andSub-national governments to be rated better than the sovereign does, and this is especiallyimportant in emerging markets. There are

many forms of credit enhancements, e.g.,over-collateralization, insurance policiesagainst political and exchange risks, special purpose vehicles, sinking funds, assetcollateralization, multilateral organizationsguarantees, offshore trusts. During the lastdecade many Latin American issuers adoptedthis kind of product in order to be ratedhigher than its sovereign is. An interestingexample is the Province of Salta inArgentina, which sold its oil revenues to anoffshore trust that issued a 15-year fixed rate

bullet bond. The oil revenues that theProvince sold to the trust backed these bonds.Despite the fact that bond was over-collateralized, the structure also has aninsurance policy against exchange risks thatcovered 31 months of debt service and a 6-month interest reserve fund. S&P assignedan investment grade to that structured product, while the Argentine Governmentwas internationally rated as a non-investmentgrade country. It is important to note thatafter the Argentine default, the Salta

Hydrocarbon Royalty Trust honored its debtservice in time and form.



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Particular Issues in Developing Corporate Bond Markets

The development of the government bond market constitutes a sort of prerequisiteto develop a private sector fixed income securities market. The existence of a stocksmarket is another main requisite to develop the corporate bond market. The following

are three aspects that do not stem from the existence of a government bond market andare particularly important to develop the corporate bond market: (i) disclosure systems,(ii) credit rating systems, and (iii) bankruptcy laws. Every bond issuer has to discloseobjective, relevant and timely information not only about itself but also about itssecurities. It is important to establish sound standards of information aiming at reachingthe international ones, which include international accounting and auditing standards. Inaddition, an improvement in corporate governance promotes transparency and helpsdisclosure standards. The credit rating system represents an important complement of thedisclosure system. Credit rating agencies encourage transparency, increase informationflows and improve accounting and auditing practices. These companies provide anindependent and objective view about instruments and their issuers. A low credit rating

implies that the issuer might not afford debt services properly, therefore, these ratingshave a direct impact on corporate bonds interest rates because the lower the rating thehigher the interest rate. That aspect constitutes an incentive for companies to improve both their financial structures and operations. The government can promote credit ratingagencies establishing that certain investors, such as, pension funds, can only buy ratedinstruments. It is important to note that competition among credit agencies is essential.Finally, a bankruptcy law is vital to develop the corporate bond market, because it definesthe boundary of the investor’s legal ability to force a bankrupt issuer to serviceobligations and procedures to reach that limit. In addition, it is important to have anefficient mechanism for the bond issuer to recover investments and to determine the priority or subordination of an investor’s right to that of other creditors.

Regulatory Framework and Information

One important goal of the legal framework is to ensure a transparent and efficientmarket, discouraging and sanctioning improper trading practices. Information disclosurerequirements are especially important for corporate bonds, not only in primary markets but also in secondary ones. The regulation has to enforce that corporations releaserelevant information expeditiously, reaching all market participants at the same time toavoid inside information practices. In order to build sound information disclosure procedures, it is desirable that countries adopt international standards of information not

only in prospects for primary markets, but also in periodically informative disclosures.Credit rating agencies are especially important for the corporate bond market becausethey have a direct relationship with companies and provide an independent view thatensures investors a good credit risk assessment.

Other main objective of market regulation is the investor protection and it could be achieved by means of a sound legal framework and transparent information disclosure.A sound investor protection framework includes (i) a bankruptcy law, which is especially



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important for corporate bonds in order to determine rights and obligations of market participants; (ii) best execution of trades; (iii) separate treatment and management of intermediaries and clients assets; (iv) acquisition of licenses for brokers and advisors tooperate, but not introduction of barriers to new participants because competitionreinforces professionalism among brokers and advisors; and (v) legal resources against

market participants and efficient conflict resolution, which means that investors caninitiate legal actions against brokers, dealers, corporate issuers, clearing houses and eventhe government itself to exert their bond holder rights.

7.- Linkages Between Markets

Government securities markets and corporate bond markets have strong linkagesnot only between them but with other markets as well. Therefore, a comprehensiveapproach must be taken in order to design and implement different initiatives. In this process the government has two roles: the first one as regulator and developer, and the

second one as bond issuer. In that sense, it is important that authorities keep in mind theglobal perspective as they have to reconcile their funding needs with their developer’srole. Essential linkages between these two markets take place via many differentchannels: the government benchmark issues, intermediaries’ experience, investors’ base,infrastructure, disclosure practices, regulatory framework, and authorities' experience.Additionally, fixed income markets are closely related to other markets, such as, thederivatives and money markets. Government bonds are the principal source of pricediscovery in other markets and the short-term yield curve is especially important toensure money market efficiency. In that sense, the government bond market is soimportant for corporate bond market that some countries, like Hong Kong or Singapore,have taken the initiative of issuing government bonds even when they do not carry fiscaldeficits. Of course, the latter is an expensive proposition that not many countries canafford to implement.

Impediments for Development

Governments can hinder the corporate bond market instead of promote it bycrowding out the market and setting statutory restrictions. Given that governmentsecurities are zero risk free, they are the preferred choice of many investors. Recurrentdeficits combined with market oriented funding policies could lead to crowding out thecorporate bond market. In that scenario, private bond issuers won’t find investors for their bonds, or they will, but issuing bonds with high interest rates. Other crowding out practices are the use of captive sources of funds and the issue of government bonds withspecial benefits, such as, tax exemptions. Additionally, statutory restrictions usually areimposed on products and/or market participants. These restrictions always have apparentsustainable objectives, but they usually hide their real purposes and negative impacts, for instance, restrictions include the protection of certain market participants’ interests (e.g., pension funds), the preservation of the existence tax base, and the existence of inefficient bureaucracies. At some point, banks will be threatened by the development of the fixed



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income market because they will lose a share of their intermediation business, so theycould use their political influence to establish certain types of statutory restrictions. Fromthe government perspective, statutory restrictions could be introduced or not removed because of its lack of capacity to collect taxes or as a result of its own inefficient bureaucratic system.

A Virtuous Circle

In a virtuous scheme, the government as both issuer and developer establishes the bases for the corporate bond market development by implementing its comprehensivestrategy of market development. The virtuous circle begins with a sound sovereign issuer and regulator committed to the overall market development that sets the bases for thecorporate bond by issuing benchmark bonds, improving infrastructure, building a soundlegal framework, and sharing more developed intermediaries and investors. Additionally,new hedging and collateral options arise with the government bond market. The

development process of the private sector fixed income securities market leads to better priced and more liquid corporate bonds, technological and financial innovation, and possibly private benchmarks that release at some point the government role in thisrespect. The benefits of the corporate bond market, namely, sustainable and balancedcorporate debt structures, a more diversified financial system, less systemic risks, better shock absorbability, and a more efficient capital allocation, reinforce governmentfinances, corporate governance and economic efficiency in general, closing the circle andstrengthening the entire economy.

A Vicious Circle

In a negative scenario, the government can hinder the market by runningunsustainable deficits, or by its lack of proactive action and that is how the vicious circlestarts. The government hinders the process by crowding out the market, carryingrecurrent deficits and using captive sources of funding or in some other cases by itsinactive action, i.e., no funding needs or recourse to external financing. In the case of thecrowding out, the interest rates may rise, the investor base is limited, the legal and taxframeworks are inadequate. Pressured by the need of substantial funding, the governmentcan act in a rather selfish manner and not willing to share the infrastructure developed or the investor base. Moreover, captive sources of funds draw away demand from the private sector leading to additional market distortions. Therefore, the corporate bondmarket is seriously affected, forcing the private sector to rely exclusively on the bankingsystem or international bond markets to finance its needs, and conducting to non-optimaldebt structures, high interest rates and assets’ concentration. This situation perpetuates anunsound and inefficient financial system decreasing private sector’s investment. Finally,the unstable financial system, the unsustainable fiscal deficits, and the negative effects oncorporate governance and economic efficiency slow economic growth and holds back further development.



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Primary and Secondary Markets

At the early stage of government bond market development, primary markets areessential. At a later stage, the only way to consolidate a regular an efficient primarymarket is by developing an active the secondary government securities market. The

secondary market, not only serve as a basis upon which corporate bonds and further government securities will be priced, but they provide hedging tools for market participants and help to develop the required infrastructure.

As a regulator the government has to provide the legal framework for primary andsecondary markets. While the secondary market regulation should be aim to be the samefor both corporate and government securities and it is designed and controlled by thesame government body, in general the national securities agency, the scheme in the primary market is very different. The government is a self-regulated issuer, not only because regulation is its inherent duty, but also because primary market governmentsecurities are in general not regulated by the national securities agency, thus the Ministry

of Finance is the regulator and the issuer of the primary government bond market.Therefore, the Ministry of Finance is the key actor, and it has to coordinate not only theissues but also make sure that there is proper disclosure of information on the governmentfinances and on the debt policy. As issuer, the Ministry of Finance has to ensure that thecongress has passed the required authorizations to borrow funds and the rights to act asmarket regulator. Moreover, the congress has to delegate to the Ministry of Finance the power to borrow money.

The government and the private sector should preferably share the infrastructureand regulatory framework of the secondary market, but there are two importantconsiderations to consider: the first one is that, except for U.S. where corporate bonds areliquid instruments, corporate bond markets enjoy very limited activity in their secondarymarkets; the other consideration is that governments are generally exempted of disclosurerequirements Nevertheless they have to provide transparent and timely information to themarket in order to build confidence on their debt strategy. Legally and constitutionally inmost cases, the government has an obligation with the society to be transparent anddisclose all necessary information on important activities that the government carries out.Moreover, the business infrastructure built to support secondary markets of governmentsecurities is an essential component to facilitate the development of primary corporate bond markets, otherwise the costs involved in supporting a corporate bond marketstructure are higher than their profits. A clear example of that is the intermediaries’ business, where illiquid corporate bond markets cannot be supported without an activesecondary government bond market because the profits of government bonds tradingactivities and the hedging tools that it provide compensate the costs and risks of non-liquid private sector bond market. Additionally, investors benefit from the corporate bond market because it leads them to more diversified portfolios with a better risk-returnrelationship due to the higher yields of the private sector bonds.



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8.- Taxation Policy

Taxation policies have a major impact on securities and financial marketsdevelopment. As tax systems are more rigid than other systems, it is important for regulators to implement a coordinated approach between financial and tax policymakersin order to design the tax system for financial and capital markets.

In developing countries, tax authorities usually intend to take advantage of thefinancial system structure to collect revenues easily by imposing taxes on that sector,even though these tax policies are at odds with the objective of developing the capitalmarket. In that sense, viewing the bond market development as a national objective, tax policies and regulations must be suitable to achieve that goal, without damaging efficienttax practices. In addition to the lack of capacity of some governments to collect taxes, particularly in developing countries, poorly and improvised tax policies hamper thedevelopment of certain financial instruments and markets.

Tax incentives have been used in developed and developing countries either to promote the use of some financial instruments, or to encourage the development of asector or market. Some governments have provided tax exemptions to bonds in order to

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extend maturities. In any case, regulators have to keep in mind that tax policies affect notonly financial instruments and their development, but also consumption behavior, as wellas savings and investment decisions. As a first step, authorities must pursue taxneutrality by avoiding tax fragmentation, tax loopholes and tax avoidance opportunities.15

Therefore, an efficient taxation system should be based upon tax neutrality, simplicity

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9.- Conclusion

Domestic capital markets are one of the most important means for development,and the bond market, especially the government bond market, is the backbone of capitalmarkets. In fact, the government securities market is a key foundation of domesticcapital markets, and its expansion has to be addressed in a comprehensive way.Moreover, policymakers have to keep in mind that it is a long-term process and require avision and a strategic plan. Government agencies and bodies have to be independent, butcoordinated. In that sense, the Ministry of Finance is usually the one who has to lead,

implement and coordinate the process of developing domestic government bond markets.Except for Canada and U.S, where markets are well developed, Latin America and theCaribbean are facing substantial development challenges. Some countries haveaddressed significant advances in developing their markets, but the process is far from being completed. Other countries did not initiate the process, and due to their economicsize, they must evaluate the convenience of such effort. The challenges, although atdifferent phases are common and range from design a comprehensive plan to develop themarket, set higher information standards, implement more transparent practices, increasesecondary markets’ liquidity, expand the investors base, strength government debtmanagement, promote competition among market participants and implement a monetary policy conductive with the money markets development.

Nowadays the region’s bond markets are seriously threatened. Argentina hasdefaulted its debt producing the highest default in the history of the world. Brazilgovernment bonds are facing higher spreads over U.S. Treasury bonds and most of itsdebt is indexed to the dollar, or to the overnight rate, showing a great market risk thatinvestors perceive. Colombia achieved great goals in recent years, but its constants fiscaldeficits could complicate debt management and provoke a permanent damage to the progresses achieved. Chile has a relative sound position, but the turbulence in SouthAmerica is affecting the country and its capital market. Mexico is not touched by theregional crises yet, but as emerging markets are perceived as one asset class, the countryhas to reinforce its commitment to sound market practices and to the consolidation of themarket development process. The rest of the countries are facing similar or morecomplicated problems that those mentioned above, but it is clear that they have to exploredifferent alternatives for market development, including regional solutions.

In any case, the process requires a long-term view and a firm commitment tomarket practices, especially during the first stages where governments are usuallytempted to return to old behavior. Policy makers have to be fully convinced that the benefits of those efforts are much higher than the costs and they will spread a positiveimpact over the entire economy.



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BIS (Bank for International Settlements). Statistical Tables on Securities. Available at

www.bis.orgECLAC (Economic Commission for Latin America and the Caribbean). 2001, Statistical

Yearbook for Latin America and the Caribbean. Available at www.cepal.orgFIABV (Iberoamerican Federation of Stock Exchanges). 2000, Statistical Summary.

Available at www.fiabv.orgFIBV (International Federation of Stock Exchanges). 2000 Statistics. Available at

www.world-exchanges.orgOECD (Organization)Rodriguez, Gerardo. 2001, Development of the Domestic Debt Market in Mexico. June,

Presentation.Sardenbergs, Rubens. 2002, VI Seminar of Risk Management . May, Brazil.

Sharpe, William F., Alexander, Gordon J., and Bailey, Jeffery V. 1995. Investments.Prentice Hall.Standard & Poor’s. 2002, Local and Regional Government .Standard & Poor’s. 1999, Public Finance Criteria.Standard & Poor’s. 2000, Global Credit Rating Criteria.Vittas, Dimitri. 1998, Institutional Investors and Securities Markets: Which Comes

First? In J. Burki and G. Perry, eds., Banks and Capital Markets. Annual WorldBank Conference on Development in Latin America and the Caribbean.

Vittas, Dimitri. 2000, Pension Reform and Capital Markets Development: Development

Research Group, World Bank, Washington, D.C. Processed.Vives, Antonio. 2002, Financial and Capital Markets Development in Latin America

and Caribbean. May, Presentation.World Bank and IMF. 2001, Developing Government Bond Markets A Handbook .World Bank. 2001. Regional Snapshot , Rio de Janeiro, June 11 2001.

Documents

Developing Bond Markets a Comprehensive View