Malaysian Debt Conference
3 April 2000 |   By : Dato' Ainum Mohd Saaid, Deputy Chief Executive, Securities Commission
Towards a Market-Oriented Financial System: The Role of Corporate Bond Markets

Dato' Ainum Mohd Saaid
Deputy Chief Executive, Securities Commission

at the Malaysian Debt Conference
3 April 2000
Mandarin Oriental, Kuala Lumpur

Good afternoon, ladies and gentlemen. Allow me first to thank the organisers of the Malaysian Debt Conference for inviting me to speak to all of you today. The issue of bond market development is, as I'm sure you are aware, a critical one for Malaysia at this stage of its economic development and indeed one that is being accorded considerable priority by other developing economies as well. In terms of the comparative development of financial systems, it is the private debt market component of developing economies that lag the furthest behind the industrialised economies. Relative to GDP, these amount to only about 12% of the size of more developed debt markets. Although Malaysia recently appears to have been among the top emerging markets in terms of the issuance of private long-term debt in relation to GDP, the development of our domestic debt market still has some way to go, especially compared to the equities market.

Ladies and gentlemen, I wish to share with you today some of my thoughts on what I see as the some of key issues concerning the development of the domestic corporate bond market as we move towards further enhancing the role of capital markets in financing economic growth-in other words, the development of a more market-oriented financial system in Malaysia. In this respect, I view the need to establish a well-diversified financial base for the economy as crucial.

For one, the banking sector on its own cannot support the future financing needs of the economy. As Malaysia has embarked on the road to industrialisation, banks have been able to adequately finance the needs of its rapidly growing economy. However, the experience of the recent past as well as our own growth projections clearly indicates that capital markets will have to play a more prominent role in our financing needs. Indeed, Malaysia's long-term economic objectives, which is soon to be articulated in the country's Third Outline Perspective Plan for 2001-10, and which will encompass the forthcoming Eighth Malaysia Plan for 2001-5, will require substantial financing.

As countries mature and evolve towards a more service-oriented economy, capital markets tend to provide an increasingly important source of external finance. In the case of technology-related firms, for instance, such firms typically lack traditional forms of collateral-they are heavily dependent on human capital and hence lack the tangible assets often required for collateral by banks. This is even more crucial for start-ups which typically do not have much internal funds.

That said, it is important to realise that the banking system and capital markets have complementary roles in the effective channelling of resources within the economy. But it is also important we recognise that where the financial system is narrowly-based, funds tend not to be allocated as efficiently or as robustly compared to one in which all the various components of the system-market for equity, bonds and their derivatives as well as the banking system-have developed to the extent that they can play a substantial and complementary role to each other.

A more diversified financial system is also necessary to provide firms with a better opportunity to adopt value-maximising capital structures. There is of course no simple answer to exactly what kind of debt-equity profile a company ought to have; this is something that is clearly subject to all sorts of considerations. But it is necessary for our companies-especially those involved in infrastructure projects and ventures that exhibit long gestation periods-to have the appropriate instruments that would allow them to better match their asset and liability maturity profiles. The problems of not being able to achieve this, as you know, include an exposure to substantial roll-over risk in trying to extend short-term credit. But it should be remembered that from a broader perspective, adopting a less than optimal capital structure means that companies are not serving the best interests of their shareholders.

For institutional investors, in particular pension funds and insurance companies, a more diversified financial system affords products that would allow for a better match between the duration of their assets and liabilities, as well as a better opportunity for their portfolios to attain an optimal risk-return profile. As a result of an inadequate supply of certain securities, there may be instances where portfolio allocations are not optimised. Correspondingly, demand-side constraints, such as investment restrictions, can have a detrimental effect on the mobilisation and intermediation of savings, and ultimately an adverse impact on financing and the cost of capital.

Lastly, by facilitating the secondary trading of assets, a market-oriented financial system reduces macroeconomic vulnerability to shocks and systemic risk. For instance, the liquidity needs of institutional investors and changes to the required risk and maturity profiles of their investment portfolios are met by liquidating assets in the secondary market. In a well-functioning, deep and liquid market, the impact of such actions will be absorbed by prices. For the issuers of security, this ensures a more continuous form of financing, while for the economy as a whole, shocks can be mitigated by the price mechanism.

Ladies and gentlemen, our efforts in developing the corporate bond market in Malaysia form a key thrust of this shift towards a more market-oriented financial system. Work currently being carried out by the National Bond Market Committee, for instance, is focusing on legal and regulatory reform, product and institutional development and the improvement of market infrastructure and operations. Among other things, the committee is in the process of formulating plans to establish a liquid benchmark securities market, to reduce the costs associated with regulatory approval and to enhance the disclosure and transparency of corporate debt issuance.

However, we must ensure that our bond market initiatives are not being pursued in a vacuum or simply based on what is perceived to exist in other jurisdictions. What is important is that our efforts are relevant within the Malaysian context and, more importantly, within the broader philosophy that underpins a well-functioning market-oriented financial system. Allow me to elaborate a little on this point by referring to some key issues concerning benchmark securities, market liquidity, the trading infrastructure and investor breadth.

As you are aware, it has been announced that there will be a programme to establish the Malaysian government securities (MGS) as a benchmark security. For this initiative to be effective, however, a competitive environment must exist to support active trading. It must also allow for yields that are free to reflect market expectations and opportunity costs. Hence, spreads between yields on assets and the costs of funds to financial institutions must reflect true costs and risks, as well as a competitive rate of return; yields of corporate debt securities and risk-free securities must reflect their true credit risk (or lack thereof); and the nominal yield on default risk-free securities must sufficiently reflect the appropriate term to maturity, as well the appropriate premiums on liquidity and inflation.

In relation to market liquidity, it is recognised that liquidity does not pervade across the entire breadth of debt instruments as it does for, say, the equity market; instead, it is far more likely to concentrate on selected issues. However, it is essential that the market provides sufficient liquidity to ensure that there is efficient market-based price discovery for all bonds. Therefore, there must be the right incentives in place to ensure that continuous markets are available to match the prevailing demand and supply for bonds. What this implies, among other things, is that secondary bond markets must be supported by liquid ancillary markets, such as those for repos, swaps and other derivatives, to facilitate risk management by market participants.

Concerning the trading infrastructure for bonds, as you well know, Malaysia has both over-the-counter markets as well as exchange-traded bonds. While the relative merits of each system is, I believe, subject to further debate (and which is likely, in my opinion, to be determined by where liquidity concentrates), I would like to highlight the point that without greater access by market participants to the trading structure in general, it is highly unlikely that we will succeed in promoting an active and liquid bond market.

Finally, in relation to investors, it is not sufficient simply to allow for a greater breadth of participants if they are not going to make full use of the investment opportunities open to them. Institutional investors, including pension funds and unit trusts must therefore be competitive and provide the best risk-return profile. This requires the pursuit of optimal asset allocation strategies across a broader range of instruments than is being done at present. An important corollary to this is that institutional portfolios must accurately reflect their current market risks. This would entail the consideration of reporting and disclosure by institutions based on market values.

The point to all this, ladies and gentlemen, is that, for bond market development to truly succeed, our efforts must include injecting a greater dose of competition among domestic participants in order to achieve a more efficient and effective financial system. Among the key issues that I believe need to be considered is the mindset of the market's stakeholders. The need for change and of the requisite steps needed to effect change must be understood and accepted by all parties involved. Moreover, once the idea is accepted, there must be unwavering commitment by all involved. This includes commitment by the authorities, whose policies and strategic approach will be a key factor in removing uncertainty among market participants. This in turn should encourage greater support for the development efforts initiated by the authorities. More importantly, however, this should also serve to facilitate innovation on the part of the financial industry itself.

At the SC, we are conscious of the need for appropriate deregulation, where relevant and necessary, in developing the capital market, for instance in relation to transaction costs. As I am sure you are aware, the SC is examining the possibility of deregulated commission rates for brokers. I am also sure you know that we have embarked on the phased introduction of a disclosure-based regulatory framework (DBR), in which the SC is deregulating the requirements on securities pricing, asset valuation and the use of proceeds. The SC's guidelines now allow, among other things, for the market-based pricing of securities for all types of corporate proposals, not just initial public offerings. With this, the SC aims to bring about the more efficient pricing of securities issuance and, more importantly, a lower cost of capital for issuers.

However, appropriate safeguards must also be in place so that the market remains competitive and efficient. In the case of DBR for instance, while the SC has worked on the deregulation of the primary market, it has also introduced measures to enhance disclosure and accountability in order to ensure that investor protection is not compromised. These have included a strengthening of rules on related-party and interested-party transactions, an improvement to the regulation of takeovers and mergers.

In this respect, enforcement is crucial in ensuring that standards are maintained. By enforcement, I refer not only to that carried by the authorities but also self-enforcement by market participants. For unless participants themselves take responsibility for ensuring strong compliance and for maintaining high standards in their conduct of business, it will be impossible to realise an efficient, market-driven system. The highest standards of self-regulation, due diligence, integrity in the conduct of business and risk management will be expected of market participants. These must form the cornerstones of any market-based system.

Ladies and gentlemen, the issues I have just described are clearly not the only ones which we must deal with in our efforts to drive the Malaysian financial system in general, and the corporate bond market in particular, forward in order to meet the economic challenges ahead. If we are to make effective headway in our efforts, they must therefore be recognised as such by all parties concerned. I believe that the Malaysian Debt Conference will make a significant contribution in promoting that awareness within the industry and will serve to complement the efforts of the government through the National Bond Market Committee. I look forward to hearing the results of your discussions and deliberations.

Thank you for your attention.
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