Corporate bond markets in developing countries: A BSC based

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Corporate bond markets in developing countries
A BSC based approach to solving the problem of
information asymmetry

• Saidiev Ulugbek
• KAIST ITTP
• ulugbek_at_kaist.ac.kr

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• Financial markets essentially involve the
  allocation of resources. They can be thought of
  as the "brain" of the entire economic system, the
  central locus of decisionmaking if they fail,
  not only will the sector's profits be lower than
  they would otherwise have been, but the
  performance of the entire economic
• system may be impaired
• J. E. Stiglitz, J. Jaramillo-Vallejo, and Y-C
  Park, 1993

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Outline

• Introduction
• Importance of corporate bond market for
  developing countries
• Major problems and challenges in developing the
  corporate bond market
• How BSC based approach can help in developing
  the strategy on bond market development

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Introduction

• Korea, China, Japan and the 10 members of ASEAN
  have agreed to create a US700 million facility
  in 2011 to back up bonds issued by Asian firms
• ADB will contribute 130 million to the facility
  and Japan 200 million.
• The new organization will guarantee local
  currency bonds issued by Asian companies and
  receive premiums, with the main focus on debt to
  finance infrastructure projects.
• The aim is to create an environment that supports
  corporate debt issuance in Asia, because profits
  made by exporters in the region end up being
  invested in the U.S. and Europe
• The launch of the facility would enable lesser
  known Asian companies to raise long-term capital
  in emerging Asian markets
• Source Nihon Keizai Shimbun, May 19, 2010

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Introduction (cont.)

• Given that the process of formation a national
  corporate bond market is very complex, predicted
  outcomes are not typically unique that extremely
  important constraint for policy and decision
  makers
• Even for those cases where structure for bond
  market is assumed as unique, the coordination
  problem between agents involved at the different
  stages of the market roll-out still remains
• In general corporate bond market development in
  developing countries requires balanced set of
  measures and targets for managing all relevant
  major strategic themes
• Literature on bond market is presented
  considerably poorer than on stock, bank credit
  and insurance markets
• Characteristics of bonds OTC based trading,
  relatively lower liquidity, specific determinants
  of price setting

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Introduction (cont.)

• This presentation discusses corporate bond market
  in developing countries. More particularly, it
  investigates how adverse selection and moral
  hazard, two main problems caused by information
  asymmetry, harm to potentially beneficial
  coordination within economic agents and limit the
  corporate bond market development
• We also consider what can be learned from social
  networks formation for understanding and
  designing bond market structure
• We introduce a balanced scorecard (BSC) based
  management system linking a country level
  strategy and operations plan for bond market
  development.
• The recommendations are mainly addressed to
  financial policy makers.

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Major exporters of capital in 2009 Source IMF,
World Economic Outlook database as of March 10,
2010
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Major importers of capital in 2009 Source IMF,
World Economic Outlook database as of March 10,
2010
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Why local bond market is so important for
developing countries?

• Crises in Mexico and Argentina in 1995 and 2002
  and East Asian countries and Russia 1997-1998
  demonstrated the vulnerability of dominance of
  bank loan based financing. Access to bond markets
  came to be seen as an essential spare tire
  (Eichengreen et al, 2006)
• Crisis of 2008 showed that financial resources
  run away from developing markets toward developed
  ones
• Although globalization made investment more
  accessible for developing markets (Frankel and
  Schmukler, 1997) most part of the developing
  world still needs in funds for basic
  infrastructure and social development projects
• Bond market is less volatile comparing to stock
  or derivatives markets
• Modern information and communication
  infrastructure create new opportunity for
  building an on-line network for global bond
  trading

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Why local bond market in developing countries is
important for capital-rich countries?

• Kool (2005) argues that although in theory
  capital is expected to move from mature economies
  with excessive savings toward economies with
  productive capacity growth potential, in practice
  countries with developed capital markets obtain
  major share of the world excess savings
• Excessive cash flow can lead to inefficiency of
  firms investments (Jensen, 1986)
• This together with growing instability of
  financial markets may lead to dissaving in
  countries with mature economies and aging
  population
• Good timing now, after the global financial
  crises of 2008, governments, international
  finance institutions, and major traders seek for
  new and more sustainable ways of building the
  global financial architecture

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Asymmetric Information

• Asymmetric information refers to a situation
  where one side of the market has a better
  information than the other
• This may show up in different ways
• One group of potential investors may have better
  (or less costly access) to information than
  other. For instance, domestic investors vs.
  foreign ones, or a commercial bank vs. investment
  fund
• Firm managers due to different reasons and
  conditions can be better informed regarding bank
  loan or stock issuance than debt funding
• Some investor can be better informed in certain
  regional or industrial segments than others
• Perception of business risk which a firm may
  accept can be different for managers and
  shareholders

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Asymmetric Information two main problems

• Adverse selection (hidden information) problem
  arise from the asymmetry of information regarding
  riskiness of the project before occurrence of
  the transaction
• Moral hazard (hidden action problem) refers to
  the situation which may occur after the
  transaction when the agent pursues self- interest
  conflicting to the principals interest. More
  particularly, moral hazard is actions by economic
  agents which maximize their own utility without
  bearing the full consequences of their actions
  and detriment others position

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Adverse selection

• Akerlov in 1970 in his seminal lemon paper
  showed how information asymmetry may cause to
  complete break down of a market
• Genesove (1993) considers a theoretical model
  with buyer in search of good apple and two
  distinct types of sellers one who has large
  orchard and hates apples and a second who has
  small orchard and loves apples
• Genesove shows that while only the seller is able
  to discern true quality of apples, the buyer
  prefers to purchase from the first seller because
  in this case by incorporating the information on
  seller type the buyer can improve on the estimate
  of the average apple
• These theoretical findings have extremely
  important implication for understanding how
  financial markets work and should be designed.
  Particularly, they explain role of mediating
  institutions

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Moral hazard

• In the financial world moral hazard usually
  occurs because borrowers has incentives to invest
  in in projects with risks unacceptable for
  lenders. This problem leads to lending and
  investment at sub-optimal levels
• Ely (1999) states argues that moral hazard leads
  to financial crisis in three situations
• Bad management
• Economic contagion
• Government restrictions on asset and geographical
  risk dispersion
• Solutions
• Better corporate governance
• Diversification of risks
• Better information sharing

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What can studies on social network formation tell
us?

• The theoretical literature on network formation
  follow a game-theoretical approach implying that
  players earn benefits from being mutually
  connected both directly and indirectly and bear
  costs for maintaining direct links (see Jackson
  and Wolinsky, 1996 Bala and Goyal, 2000)
• To explore network formation behavior Cagno and
  Sciubba (2008) run a computerized experiment in
  which players simultaneously submit link
  proposals and connection is made only when both
  players involved agreed
• For the first treatment with low cost of
  maintaining direct links, the authors show that
  any minimally connected network is both pair wise
  stable and efficient
• In the second treatment with high cost, the
  theoretical prediction for a stable architecture
  is unique but inefficient

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What can studies on social network formation tell
us? (cont.)

• For the low cost treatment convergence to a
  stable network architecture is problematic due to
  coordination problem and multiplicity of
  equilibrium
• Interestingly, the authors find lack of
  convergence into a stable network also for the
  treatment with high cost, despite to the fact
  that equilibrium here is unique and does not
  require much coordination.
• Despite to the lack of convergence, Cagno and
  Sciubba report stronger tendency to inclusion in
  the low cost treatment
• The most commonly observed deviation from stable
  network formations are 1)over-connectedness
  (redundancy of links) and 2) minimally connected
  graph reached earlier on in the session are
  later departed from
• Main drivers of network formation best response
  behavior, attempt to coordinate on efficient
  architecture

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How network formation features show up in
evolving of financial markets
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What should to do?

• Accept that natural self-evolution of corporate
  bond markets in capital-poor countries may take a
  very long time while this has extremely important
  implication for sustainable economic conditions
  both for developed and developing countries
• International financial organizations should lead
  the process in order to exploit fully the effect
  of positive externalities for provision of price
  setting and liquidity of corporate bonds, to
  synergize private businesses, states and
  international initiatives toward developing
  global bond market
• Introduce a common standardized non-banking
  mechanism, protocols and open platform linking
  lenders, borrowers and guarantors worldwide

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The management system Linking strategy to
operations (Source Kaplan and Anderson,
Execution Premium, 2008)
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An approximate structure of operational
excellence strategic theme for corporate bond
market development project
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Roles of project implementation units

• Role as architect
• Role as a process owner
• Developing the strategy
• Planning the strategy
• Aligning the organization
• Reviewing the strategy
• Adapting the strategy
• Role as integrator
• Linking the strategy to financial resource
  planning and budgeting
• Aligning plans and recourses to important
  supporting groups
• Communicating the strategy
• Managing strategic initiatives
• Linking strategy to key operating processes
• Sharing best practices
• Adapted from Kaplan and Anderson, Execution
  Premium, 2008

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References

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