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

1. Corporate bond markets in developing countries: A BSC based approach to solving the problem of information asymmetry Saidiev Ulugbek KAIST ITTP ulugbek@kaist.ac.kr

2. �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

3. 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

4. Introduction Korea, China, Japan and the 10 members of ASEAN have agreed to create a US$700 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

5. 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

6. 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.

7. Major exporters of capital in 2009 Source: IMF, World Economic Outlook database as of March 10, 2010

8. Major importers of capital in 2009 Source: IMF, World Economic Outlook database as of March 10, 2010

9. 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

10. 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

11. 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

12. 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 principal�s 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

13. 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

14. 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

15. 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

16. 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

17. How network formation features show up in evolving of financial markets

18. 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

19. The management system: Linking strategy to operations (Source: Kaplan and Anderson, Execution Premium, 2008)

20. An approximate structure of operational excellence strategic theme for corporate bond market development project

21. 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

22. References Akerlof, G. (1970). The Market for Lemons: Quality Uncertainly and the Market Mechanism, Quarterly Journal of Economics, vol. 84, no. 3, 488�500. Bala, V., and Goyal, S. (2000). A non-cooperative model of network formation. Econometrica, 68(5), 1181�1229 Cagno D.D., and Sciubba E., (2008). The Determinants of Individual Behavior in Network Formation: some Experimental Evidence, In M. Abdellaoui, J.D. Hey (eds.) Advances in Decision Making Under Risk and Uncertainty. Springer-Verlag Berlin Heidelberg , 219-241. Eichengreen, B., Borensztein, E., Panizza, U. (2006). A Tale of Two Markets: Bond Market Development in East Asia and Latin America, Hong Kong Institute for Monetary Research. Ely, B. (1999). Regulatory Moral Hazard, Independent Review, volume4, no. 2, 241�255. Frankel, J. A. and Schmukler, S. L. (1997). Country Funds and Asymmetric Information, Centre for International and Development Economic Research, Working Paper no. C97-087, California: University of California at Berkeley. Genesove, D. (1993), Adverse Selection in the Wholesale Used Car Market, Journal of Political Economy, vol. 101, no. 4, 644�665. Jackson, M. O., & Wolinsky, A. (1996). A strategic model of social and economic networks. Journal of Economic Theory, 71(1), 44�74. Jensen M.C. (1986). Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers. The American Economic Review, Vol. 76, No. 2, 323-329 Kaplan, R.S., Anderson,S.R. (2008). Execution Premium, Harvard Business School Press. Kool ,C.J.M., The Global Market for Capital: Friend and Foe. (2003). In P.de Gijsel and H. Schenk (eds.), Multidisciplinary Economics, 405-424. Stiglitz J. E. , Jaramillo-Vallejo, J. and Park Y.-C . (1993). The Role of the State in Financial Markets, World Bank Research Observer, Annual Conference on Development Economics Supplement ,19-61.