The Asian Bond Fund initiative

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      Opening markets through
       a bond fund: The Asian
            Bond Fund II

                     Guonan Ma
         Bank for International Settlements
    Representative Office for Asia and the Pacific

                     APEC Seminar
Developing Asian Bond Markets: from Investors‘ perspective
             4-6 November 2005, Shanghai

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           The issues at stake

I.    What is Asian Bond Fund II (ABF2)?
II.   Why was ABF2 launched?
III. How is ABF2 structured?
IV. What are the advantages of ABF2?
V.    How has ABF2 performed so far?




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             I. What is ABF2?

   ABF2 is the second stage of the Asian Bond Fund
    (ABF) initiatives and invests in EMEAP local
    currency bond markets.
   ABF2 investment is initially funded by international
    reserves pooled from the EMEAP central banks.
   It complements other parallel regional initiatives to
    promote bond market development in Asia.


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                     ABF and EMEAP

 First initiatives in which a regional   1.   Reserve Bank of Australia
  organisation has contributed            2.   The People’s Bank of China

  financial resources to setting up       3.   Hong Kong Monetary Authority
                                          4.   Bank Indonesia
  actual bond funds in Asia.
                                          5.   Bank of Japan
 This organisation is a central          6.   The Bank of Korea
  bank forum called EMEAP                 7.   Bank Negara Malaysia
                                          8.   Reserve Bank of New Zealand
  (Executives’ Meeting of East Asia
                                          9.   Bangko Sentral ng Pilipinas
  and Pacific Central Banks) with
                                          10. Monetary Authority of Singapore
  11 members:                             11. Bank of Thailand


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               Two stages of ABF:
                ABF1 and ABF2
 ABF1:
   launched in June 2003;
   US$1 billion pooled from the 11 EMEAP central banks only;
   investing in dollar bonds issued by 8 EMEAP sovereign and quasi
    sovereign borrowers.
 ABF2:
   launched in Spring 2005;
   initial seed money of US$2 billion by the 11 EMEAP central banks;
   investing in local-currency bonds issued by 8 EMEAP sovereign and
    quasi sovereign borrowers.

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        The catalyst role of ABF
 ABF1 allowed EMEAP central banks to work together and
   build trust.
 Importance of the size of the funds – not so big as to influence
   markets but big enough to signal serious intent.
     The combined foreign reserves of the 11 EMEAP central banks
      exceed US$2 trillion
     The aggregate outstanding domestic debt securities of the 8
      EMEAP markets approach US$1.4 trillion
     RBA, BoJ and NZRB pure investors
 Process more important than size: Learning by doing an
   important advantage.
 Aim of ABF2 is to reduce market impediments.
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Initiatives in Asian regional cooperation

   Various regional initiatives to promote Asian domestic
     bond markets under three banners =>
     1. The Asia Pacific Economic Cooperation (APEC)
     2. The Association of South East Asian Nations Plus China,
        Japan and Korea (ASEAN+3)
     3. The Executives’ Meeting of East Asia and Pacific (EMEAP)

   They tend to supplement and complement each other.
   ABF was unique as the only initiative involving actual
     bond funds
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       The role of BIS in ABF

 BIS is a cooperative organisation of central banks.

 BIS has been working closely with the EMEAP group
  as well as other regional central bank fora.
 Upon invitation, the BIS plays an important role in the
  ABF exercises =>
   • Fund manager for ABF1
   • Administrator for ABF2




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                 II. Why ABF2?

   Asian domestic bond markets have advanced but remain
    underdeveloped.
   Learning by doing: impediments are more appreciated in
    the process of actually setting up bond funds.
   Market reform as a public good: ABF2 accelerates bond
    market development.
   Asian local currency bonds are becoming a more
    important asset class in investors’ global portfolio.


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                 Domestic debt market development
 Domestic debt securities outstanding in East Asia1
 In billions of US dollars


                Total                                                                    1,200
                Private
                                                                                         1,000

                                                                                         800

                                                                                         600

                                                                                         400

                                                                                         200

                                                                                         0
1998            1999         2000   2001        2002         2003        2004
 1
  Includes the bond markets of the eight EMEAP members China, Hong Kong SAR, Indonesia, Korea,
 Malaysia, the Philippines, Singapore and Thailand.

 Source: BIS.                                                                          Graph 1


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 Asian bond markets advance …
 Local currency bond markets in Asia has expanded
  considerably since 1998:
    Total domestic debt securities of the 8 EMEAP markets have
     almost tripled.
    Domestic private debts outstanding also more than doubled.
 Economic consequences of the Asian crisis
  themselves added impetus to market development:
    It brought home the lessons of currency mismatch due to a weak
     domestic debt market.
    Budget deficits widened amid economic contractions.
    Large-scale bank recapitalisation added to public financing needs.


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                   Domestic debt securities
                                       (% of GDP, 2004)
                                                                    100.0%
                                                                    90.0%
                                                                    80.0%
                                                                    70.0%
                                                                    60.0%
                                                                    50.0%
                                                                    40.0%
                                                                    30.0%
                                                                    20.0%
                                                                    10.0%
                                                                    0.0%
ID    HK          PH          CN          TH     SG       KR   MY
     Sources: national authorities and BIS.




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   … but remain underdeveloped
 Despite expansion, Asian local currency bond markets
  are still well below their potential to intermediate.
 Capital flows show that much of financial intermediation
  is being carried out abroad =>
    Asians investing in low-yielding foreign assets and foreigners in
     higher-yielding Asian assets.
 To bring such intermediation home, Asian policymakers
  perceive a need for deeper and more liquid local bond
  markets.



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     Share of non-intermediated debt
                         (% of total domestic debt, 2004)

                                                                                   50.0%


                                                                                   40.0%


                                                                                   30.0%


                                                                                   20.0%


                                                                                   10.0%


                                                                                   0.0%
CN         HK           TH       ID        PH        MY         SG         KR

Note: Domestic debt is the sum of domestic debt securities and domestic credit. Non-intermediated
    debt is domestic debt securities.
Sources: BIS and IMF.




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Impediments to market development

  Cross-border impediments:
     Capital controls and FX regulations
     Excessive regulatory hurdles to non-resident issuers/investors
     Cross-border delivery and settlements
  Local market impediments:
     Taxes
     Regulatory fragmentations and inconsistency
     Insufficient market development
     Inadequate market infrastructure

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     ABF2: Learning by doing

 Learning: impediments encountered and better
  understood by policymakers in setting up of actual
  bond funds.
   • Direct participation as an investor offers fresh perspectives.
 Doing: overcoming these impediments directly by
  policymakers benefits broader market development.
   • Reducing regulatory impediments can be seen as providing
     public services.
   • Private-sector approach via circumventing or lobbying may not
     be the most efficient.

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    Asian bonds as an asset class

 From USD, yen and euro investors’ perspectives, low
  correlations between an EMEAP basket and their home
  currency bond returns make a strong case for
  diversification.
    Even among components within the Asian basket, there is a
     good case for diversification via capital flows across the region.
 For a dollar or yen investors’ perspective, the ABF2
  basket offers higher risk-adjusted returns.
    Moreover, the Asian index has higher risk-adjusted returns than
     most of its individual components.


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               Annualised 3M USD returns of 5Y bonds
                                     over the past five years




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Source: Martin Hohensee, “An Introduction to ABF2”, June 2005. The EMEAP basket includes HK, MY, PH, KR & TH.
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                 Annualised 3M USD returns of 5Y bonds
                                       over the past five years




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Source: Martin Hohensee, “An Introduction to ABF2”, June 2005. The EMEAP basket includes HK, MY, PH, KR & TH.
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        III. How is ABF2 structured?

   ABF2 has nine funds in two phases:
       Phase One: 11 EMEAP central banks invest $2bn in 8 EMEAP
        markets via 9 separate private bond funds.
       Phase Two: these 9 bond funds will be open up to all investors
        via listing in exchanges.

   All nine funds are index funds tracking benchmarks
    provided by International Index Company (IIC).
   One of these nine bonds funds directly covers the eight
    EMEAP markets.

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Nine bond index funds under ABF2

  ABF2 comprises nine separate bond funds:
    • 1 Pan-Asia Index Bond Fund (PAIF);
    • 8 single-market bond index funds.
  All 9 ABF2 funds are bond index funds:
    • Passively managed against (tracking) benchmark indices;
    • International Index Company is the third-party benchmark
      index provider.
  So far, the PAIF, Hong Kong Fund and Malaysia
   Fund have already been listed.

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                             Structure of ABF2
                                                                      USD 1 billion
                       USD 1 billion
                                               EMEAP’s investment in             Pan-Asian Bond Index
                                                     ABF21                           Fund (PAIF)

     Eight single-market funds
                                                                                      Local currency
                                                                                      bond markets


          Hong     Indo-                  Malay-   Philip-   Singa-     Thai-
China                        Korea
          Kong     nesia                    sia    pines      pore      land
fund                          fund
          fund      fund                   fund     fund      fund      fund



          Hong                             Kuala             Singa-     Bang-
 China             Jakarta       Seoul             Manila
          Kong                            Lumpur              pore       kok
markets            market        market            market
          market                          market             market     market

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           Two phases of ABF2

 Phase 1: investments of some $2 billion in the nine
  ABF2 funds are confined to EMEAP central banks
  (already fully operational).
 Phase 2: the nine ABF2 funds are to be gradually
  opened up to other institutional and retail investors, both
  within and outside the EMEAP region (so far, four funds
  have been listed on exchanges).
 A staged approach: each fund could proceed at its own
  pace and timing to accommodate differences.

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                   More on the PAIF
 A single-index fund covering all eight EMEAP markets.
 Domiciled in Singapore and initially listed in the Hong Kong
   Stock Exchange.
 Quoted in USD on an unhedged basis and tracking the total
   returns of the Pan-Asia Index.
 Starting with an initial equal weight, the market weights of the
   “iBoxx Pan Asia Index” are determined by four factors:
    1.   Bond market size (20%)
    2.   Turnover (20%)
    3.   Sovereign rating (20%)
    4.   Market openness (40%)

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                    Market weights for the PAIF
                                                                                       China

                                                                          Korea
                        China                                                             Hong Kong
       Korea
                                                                                            (HK)



                                                                                         Singapore
                                                                           Others
                            HK                                                              (SG)
               Others
                          SG




   Based on market
   capitalisation alone                                         Based on four factors


Note: Others comprise the remaining four EMEAP markets of Indonesia, Malaysia, the Philippines and Thailand.
Sources: International Index Company (2005b, right-hand panel); BIS calculations (left-hand panel).              25
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A new family of indices by IIC (iBoxx)

 A family of Asian bond indices, known as iBoxx ABF, serve
   as the benchmarks for the ABF2 funds.
 These indices include sovereign and quasi-sovereign local
   currency debts, with the latter subject to credit rating criteria.
 Bond prices for index constituents are provided daily by
   leading international investment banks and local institutions.
 A useful addition to market infrastructure.




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            Two ways to trade the PAIF

                                Investors

     Buying and selling                     Buying and selling




        Participating dealers                  Stock exchange



 Subscription
and redemption                                             Liquidity


                                Arbitrage
           PAIF trustee                           Market-makers



        Primary market                        Secondary market



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IV. What are the advantages of ABF2?


    Market impediments were encountered in the setting up of
     ABF2 …
    … but peer encouragement “fast-tracks” market reforms
    and promotes central bank cooperation and public-private
     sector cooperation.
    Mechanisms have been built to offer incentives to further
     reduce impediments.
    More product innovations and broader investor base.


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 Peer encouragement to fast-track
         market reforms

 Working as a group, EMEAP central banks
  benefited from peer encouragement =>
   Better appreciating more their divergent regulatory
    frameworks.
   Seeing that neighbouring countries have already instituted
    market reforms helps in “fast-tracking” your own initiatives.
   Central bank officials worked with their counterparts at the
    MoF or securities regulator to deal with impediments.
   Building confidence and rapport for central bank cooperation.

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Some impediments are already removed….

  Relaxing capital controls:
     Malaysia announced significant measures to liberalise FX
      controls on the eve of launching ABF2.
     ABF2 is the first foreign institutional investor gaining direct access
      into China’s inter-bank bond market.


  Withholding taxes and other taxes:
     Thailand and Malaysia have already granted non-resident
      investors withholding tax exemption;
     So far, five of the eight EMEAP member markets have offered
      some sort of exemptions;
     In the Philippines, the documentary stamp duty will be removed.

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An example of public-private cooperation

  Seed money: EMEAP central banks.

  Initial mandates: EMEAP central banks.

  PAIF fund manager and custodian: SSgA and HSBC.

  Single market funds: prominent local fund managers.

  Index provider: IIC.

  Investors: ABF2 will eventually be open to retail or
    institutional investors, both within and outside the EMEAP.
  Administrator of EMEAP investments: BIS.


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ABF2 broadens both investment
   menu and investor base
 ABF2 brings new investment vehicles to local bond markets.
    Five of the eight single-market funds are expected to be exchange-
     listed, and another may join their ranks soon.
 PAIF is relatively low-cost, low-denomination and
  transparent, appealing to a broad spectrum of retail and
  institutional investors.
    PAIF is passively managed – leaving open the possibility of active
     management for other asset managers.
    PAIF allows for diversification both into and across Asia in a simple
     and cost-efficient manner.



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Dynamic incentives for further reforms

   Market weights determining ABF portfolio allocations will be
     reviewed annually.
   Market openness is the single most important adjustment
     factor in market weights.
   Portfolio allocation for a particular market may adjust upward
     upon further deregulation.
   Incentives to continue reforms are thus built into the
     mechanism of ABF2 annual portfolio weighting reviews.




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V. How has ABF2 performed so far?

   ABF2 was first launched in March 2005.

   So far, four of the nine-fund family have been listed.

   Sizable investment from outside the EMEAP.
   Liquidity varies across markets and over time.




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       The launch of ABF2

 ABF2 was fully launched by June 2005:
   • EMEAP seed money was invested in the nine funds.
 Four of the ABF2 family have been listed as ETF:
   • The Hong Kong Index Fund (Hong Kong, 21 June)
   • The Pan Asia Index Fund (Hong Kong, 7 July, LoF)
   • The Malaysia Index Fund (Kuala Lumpur, 18 July)
   • The Singapore Index Fund (Singapore, 31 August)
 Work under way to list two other funds as ETF.


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 Outside investment into ABF2

 The four listed funds are open to non-EMEAP investors.

 Interest shown by both institutional and retail investors.

 All four listed funds registered growth (as of Sept 2005):
   • The PAIF: 13%
   • The HK Index Fund: 44%
   • The MY Index Fund: 26%
   • The SG Index Fund: 36%



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                ABF2 trading

 Liquidity in the secondary markets for the four listed
  funds was good initially …
 … but trading decline somewhat lately.
 Trading activities vary across markets.
 One way to measure market liquidity is the tightness of
  bid-ask spreads.
 The PAIF and HK Index Funds appear to be deeper
  and more liquid by this score.


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     Bid-ask spread of listed ABF2 funds
                                (% of bid-ask average)

                                                                           3.0%
           HK Fund
           PAIF
                                                                           2.5%
           MY Fund
           SG Fund
                                                                           2.0%


                                                                           1.5%


                                                                           1.0%


                                                                           0.5%


                                                                           0.0%
21.06.05             21.07.05         21.08.05       21.09.05   21.10.05
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            Source: Bloomberg
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            Progress in ABF2

 Net asset value declined by 2% since launch …
 … mostly due to changing interest rate and currency
  cycles:
   • Higher local interest rates (ID, HK, KR and TH)
   • Weaker regional currencies (ID, KR, PH and TH)
   • The July renminbi move was initially a boost to the PAIF
   • US interest rate cycle and dollar strength




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               PAIF Closing NAV/unit (US$)
                                                                                         101




                                                                                         100




                                                                                         99




                                                                                         98




                                                                                         97




                                                                                         96
06.07.05   20.07.05   03.08.05   17.08.05   31.08.05   14.09.05   28.09.05   12.10.05

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           Source: State Street Global Asset Management.
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             PAIF weighted average yield vs.
            yield on comparable US Treasury
                                                                                              5.0%

           Weighted Average Yield

           Yield, Similar Duration US Treasury



                                                                                              4.5%




                                                                                              4.0%




                                                                                              3.5%
07.07.05    21.07.05     04.08.05    18.08.05    01.09.05   15.09.05   29.09.05   13.10.05


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             Sources: Bloomberg; SSgA.
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                       Summary
 ABF2 is a learning-by-doing exercise by EMEAP central
   banks through actually setting up bond funds investing in
   local-currency bond markets.
 ABF2 initially invests $2bn international reserves pooled from
   11 EMEAP central banks in 8 EMEAP markets and eventually
   will be open to all other investors.
 ABF2 has helped already reduce market impediments and
   built a mechanism for further market reforms.
 The four listed funds of the ABF2 family so far have grown in
   size, with liquidity varying across markets.


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If later you have questions or
comments, please email
guonan.ma@bis.org

Thank you!




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