Finance Papers

Document Type

Working Paper

Date of this Version

7-2000

Publication Source

ADB Institute Working Paper Series

Start Page

11

Abstract

Although the growing literature on the importance of finance in economic growth contrasts bank-based financial systems with market-based financial systems, little attention has been paid to the role of the bond market. Correspondingly the role of the bond market has been very small relative to that of the banking system or equity markets in most Asian emerging economies. We argue that the underdevelopment of Asian bond markets has undermined the efficiency of these economies and made them significantly more vulnerable to financial crises. We begin by describing the role of financial markets and institutions in economic development. We show that the underdevelopment of capital markets limits risk-pooling and risk-sharing opportunities for both households and firms. The weak financial infrastructures that characterize many Asian economies are shown to inhibit the development of bond markets relative to equity markets. The consequences of operating a financial system with a banking sector and equity market, but without a well-functioning bond market are profound and far ranging. Without a market-determined interest rate, firms will lack a true measure of the opportunity cost of capital and will invest inefficiently. Opportunities for hedging financial risks will be constrained. Savers will have less attractive portfolio investment choices and, consequently, fewer savings may be mobilized by the financial system to fund investment. Firms may face a higher effective cost of funds and their investment policies may be biased in favor of short-term assets and away from entrepreneurial ventures. Firms may take excessive foreign exchange risks in an attempt to compensate for the lack of domestic bond markets by borrowing abroad. In addition, the banking sector will be larger than it would otherwise be. Since banks are highly leveraged, this may render the economy more vulnerable to crisis. Certainly, in the event that a banking crisis occurs, the damage to the real economy will be much greater than if investors had access to a well-functioning bond market, and the financial restructuring process will be more difficult. What can be done to nurture a well-functioning bond market? We review the key policy measures for developing a broad, deep, resilient bond market and conclude with an analysis of recent developments in Thailand, which is broadly representative of the wide range of countries that have highly-developed equity markets and large banking sectors, but only rudimentary bond markets. The case of Thailand illustrates the dangers of growth without a well-functioning bond market, and it also demonstrates how policies can be implemented to rebuild the financial system with an expanded role for the bond market

Copyright/Permission Statement

This work is licensed under a Creative Commons Attribution 3.0 IGO license.

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Date Posted: 27 November 2017