BOND MARKET DEVELOPMENT: MONETARY AND FINANCIAL

SYSTEM STABILITY ISSUES

2008

Ananda Silva∗

∗
Ananda Silva, Director of Bank Supervision Department, Central Bank of Sri Lanka.

1
 CONTENTS

I. Introduction

II. Bond Markets and Macroeconomic Stability

A. High and Volatile Inflation

B. Continuing large Fiscal deficits and Rising Public Debt
C. Continuing Current Account Deficits Leading to Depreciating Currency
D. Other Impediments in market and Institutional Infrastructure

III. Importance of Bond Market Development on Monetary and Financial System

Stability

A. Bond Market Development and Monetary Stability

B. Bond Market Development and Financial System Stability
C. Importance of Derivative markets in Bond markets, New Risks and Their Impact on
D. Monetary and Financial Stability
E. Monetary and Financial Sector Policies in Sri Lanka Promoting Bond Market
F. Policy Measures to Promote Bond Market

IV. Conclusion

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I. INTRODUCTION

A stable macroeconomic environment particularly a credible monetary policy along

with supporting fiscal management and financial system stability have found to be the
prerequisites for the development of the bond market. Similarly, the bond market
development contributes to enhance the efficiency of monetary management and
financial system stability. A developed bond market also plays an important role in
improving the efficiency of overall economic management through expanding the range
of opportunities of available to financing large scale projects, contributing to better
allocation of capital, providing a non-inflationary source of finance for government and
facilitating public debt management, and contributing to promote sustainable economic
growth. Therefore, it is important that concerted efforts are taken to develop a deep and
liquid bond market.

Section I of the paper discusses the interaction between bond development and
macroeconomic stability focusing on the sources of instabilities affecting the bond
market. Section II presents the contribution of the bond market in improving the
efficiency of monetary management and financial stability. Section III provides an
overview of risks associated in new developments in bond markets and Section IV
discusses the policies taken by the Sri Lankan authorities in the areas of monetary
management and financial stability that contribute to bond market development.

II. BOND MARKETS AND MACROECONOMIC STABILITY

Bond markets consist mainly of the bonds issued by governments and large
corporations.1 In many developing countries, including Sri Lanka, corporate financing
mainly comes from the banking sector while debt markets are dominated by the
government sector. Banks and non-bank financial institutions are another major category

1
In developed markets – Europe and the United States., a sub-set of corporate bond market includes
however “High Yield Bonds” which are a source of funds for new or small enterprises that have
outperformed companies in terms of employment growth, productivity and capital investment.

3
.that play an important role in developing corporate bond market as the issuers, mainly
raising subordinated debt to meet capital adequacy requirements, and investors in this
market. In advanced economies, where bond markets are developed, there are derivative
financial products such as collateralized debt obligations (CDOs), and structured credit
products, which expand the depth and liquidity of bond markets.

It is estimated that the outstanding securities issued by government, financial

institutions and corporates accounted for 66 per cent, 57 per cent and 16 per cent of GDP
as at end 2004 in mature markets.2 These figures were 25 per cent, 8 per cent and 5 per
cent of GDP in emerging economies. In Sri Lanka, the outstanding government debt to
GDP as at end 2006 was 93 per cent of GDP yet bonds issued by financial institutions
and corporate sector were small accounting only 0.5 per cent of GDP.

Figure 1. Depth of bond market in Asia

(Market capitalization at stock and bond markets to GDP)

Depth of Bond Market

(Market Capitalisation/GDP)
300

Malaysia Singapore
Market Capitalization as a % of GDP

250

200 Thailand
Korea
150

100
India

50
Sri Lanka
0
0 5000 10000 15000 20000 25000 30000
Per Capita Income

The contribution of overall macroeconomic stability to bond market development is

clearly seen from the expansion of bond markets in emerging markets in the recent past.3
The crisis in many emerging market economies in the late 1990s was caused mainly by

2
IMF (2005).
3
The corporate bond markets are among the largest in Malaysia, the Republic of Korea and Thailand.
Bond markets in terms of GDP, 38 per cent, 21 per cent and 12 per cent respectively as at end 2004. Size
of bank bond market in the United States is 22 per cent.

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macroeconomic imbalances, especially misalignment in exchange rates and weak
governance in financial markets and balance sheet weaknesses as a result of currency
mismatches. With the improvement in macro economy, as reflected by the reduction in
inflation and volatility of inflation, stronger fiscal performance, strong current account
performance, output growth and accumulation of foreign reserves, further reforms and
efforts have been made by these countries to strengthen the bond markets. 4 These
included market infrastructures such as secondary markets, create benchmark issues and
remove structural impediments in the markets such as address high costs of debt issuance,
expand the set of institutional investors, improve corporate governance and transparency
to promote the bond markets.

Macroeconomic instability is also found to be the main determinant affecting the

development of bond markets in many empirical studies. As argued in “Financial
Stability and Local Currency Bond Markets” by the Committee on the Global Financial
System, bonds issued in domestic currency decrease with the rise in the volatility of
inflation, and the rise in public debt-to-GDP, and increase with the depth of the financial
system and the improvements in the quality of institutions. The importance of the
soundness of macroeconomic policies is also emphasized quoting the elasticity estimates
found by Mehl and Reynaud (2005) on the ability of governments to raise long-term debt
considering the effects of different macroeconomic aggregates. It is found that high level
of debt burden makes more difficult to raise long-term bonds than the inflation.

In Sri Lanka, although there have been several improvements in different areas of
macroeconomic management, a significant improvement is yet to be achieved in
containing debt burden, the fiscal deficit, current account deficit in balance of payments
and addressing structural weaknesses in labour and input markets and capacity
constraints, to contain the volatility in inflation. The discussion in this paper is mainly
focused on the need to improving overall macroeconomic stability as well as the need to
address the other structural factors to develop the bond markets.

4
The main purpose of promoting bond markets in these countries is that it is an alternative source of debt
financing for corporations that reduces vulnerabilities of the corporate sector by reducing currency
mismatches and lengthening the duration of debt.

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 A. High and volatile inflation

There are several adverse consequences of high and volatile inflation on the efficient
functioning of bond markets. The rise in inflation requires central banks to adopt a tight
monetary policy stance with a contraction of market liquidity. Money market liquidity,
especially the liquidity in the inter-bank market, facilitates smooth functioning of other
segments in the money market such as secondary market of Treasury bills and private
sector money market instruments such as commercial paper. The reduction in inter-bank
liquidity will therefore negatively affect the liquidity in bonds and raise the volatility of
market rates leading to a reduction in activities of the secondary markets, which provides
price discovery.

Another consequence of the volatility in inflation is the building of inflationary

expectations. These expectations discourage investors from allocating resources to
financial assets, in particular long-term bonds. This affects corporate bonds as well as
government bonds and overall financial savings of the country. The Government then
requires borrowing from inflationary sources, further building up inflationary pressures.

High inflationary expectations and volatility of short-term rates also cause the market
participants to have problems in deciding on future path of long-term interest rates.
Uncertainty of future rates causes higher preference in investing in short term paper
shortening the yield curve. From a macroeconomic perspective, inflation affects foreign
currency inflows and country’s competitiveness adversely. If domestic inflation is higher
than those of other countries, a country’s exports will be less competitive and hence in
less demand in international markets. There will also be less foreign currency inflows
through foreign direct inflows and portfolio flows. These again negatively impact on the
overall bond market.

During the last few decades, inflation in Sri Lanka has been relatively high and
volatile (Figure 2). The low increases in prices that prevailed in the early sixties, began

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accelerating and peaked at 26 per cent in 1980. Since 1980 inflation has been declining,
albeit with high volatility. The average inflation during the last three decades was around
10-11 per cent.

Figure 2. Changes in inflation in Sri Lanka and Asia, 1969-2006

Annual Average Inflation

35.0

30.0

25.0

20.0

15.0

10.0

5.0

0.0
1969 1973 1977 1981 1985 1989 1993 1997 2001 2005

Sri Lanka Asia

Figure 3 shows the behaviour of inflation and related macroeconomic factors.

Inflation shows a very close association with expansion in money supply, budget deficits
and currency depreciation. High inflation is largely a result of higher growth of money
and fiscal deficits financed by banking sources, especially by central bank which
increases reserve money and fuels the overall monetary growth, thereby leading to
inflation. The private sector has also been borrowing from the banking sources creating
additional pressure for monetary management, partly a result of non development of
alternative sources of financing.

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 Figure 3. The behaviour of inflation and related macroeconomic variables

I n f l a t i o n a nd M o ne y S u pp l y Gr owt h I nf l a t i on a n d B u dg e t D e f i c i t

30.0
40. 0

25.0
30. 0
20.0

20. 0 15.0

10. 0
10.0

5.0
0. 0

0.0
-10. 0
-5.0

Inflation M2 Growth
Inflation Budget Deficit (%of GDP)

Inflation and Rupee Depreciation

45.0

35.0

25.0

15.0

5.0

-5.0

Inflation Ex.Rate Depreciation

Figure 4 clearly shows the impact of rising inflation and building up of inflationary
expectations on the bond market. As inflation increases, the duration of the government
securities declines and investors’ preference shifts to short-term government securities.

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 Figure 4. Duration of government securities and inflation

Duration of Government Securities

and Inflation

20.0
3 16.0
Duration

Percent
2 12.0
8.0
1
4.0
0 02 0.0

03

04

05

06

06/
20

20

20

20

20

07
20
T bill T Bond Inflation

B. Continuing large fiscal deficits and rising public debt

Continuing high budget deficits requiring borrowings from banking and non-banking
sources create impediments to developing an efficient bond market. Fiscal deficits are, in
general, financed through domestic and foreign borrowings, and foreign grants. The
relative importance of foreign grants in deficit financing has been declining as the overall
foreign grants received by the country is declining, despite the recent increase due to
tsunami related inflows. As foreign loans are typically tied with projects, the level of
foreign borrowings through loans depends on the progress of the public investment
programme. Therefore, if the deficit is maintained over and above the revenue generated
by the government, additional financing from domestic sources including borrowings
from banking sources will be required, creating inflationary pressures since the available
resources in the non-bank sector is limited.

The imposition of taxes on the financial sector constrains the efficient functioning of
the financial market. First, the relatively high effective tax rate may tend to reduce
effective interest rate paid to depositors and increase effective lending rates thereby
increasing the interest rate spread. Second, the high tax incidence increases

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administrative costs of financial institutions, again requiring banks to maintain high
margins. Third, it could indirectly favour the unregulated financial sector institutions
while distorting the interest rate structure thereby retarding the development of the
development of the bond market.

Continued higher borrowings, particularly with more maturities at the shorter end,
create difficulties in rolling over maturing debt on a sustainable manner. The resultant
bunching of maturities creates undue pressures on the interest rate structure of the market
as well as on the liquidity position of the debt market. It also creates difficulties in the
debt management process of the government.

High borrowings by government from non-bank sector also crowd out borrowings by
the private sector. At present, a major share of domestic borrowings is made through
market based domestic debt instruments such as Treasury bills/Treasury bonds as
opposed to non-marketable instruments, contributing to debt market development.
However, government borrowings pre-empt the resources available to the private sector.

C. Continuing current account deficits leading to depreciating currency

Exchange rate stability is another factor that has an impact on the bond market. The
most direct effect of exchange rate changes is through domestic inflation. The changes in
exchange rate affect the price of imported goods, which in turn, are important
determinants of the firms' costs and the retail prices of many goods and services.

The volatility in exchange rates also leads to an uncertainty in the foreign exchange
market. This adds to risk premium to the forward market transactions and these
uncertainties adversely affect the foreign participation in domestic bond markets and

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affect the development of benchmark yield curve. If there are no markets to hedge the
price risks foreign investments may be declined.

Another consequence of high volatility in exchange rate is that it contributes to reduce

other foreign currency inflows to country and foreign participation in equity markets
affecting the liquidity in the rupee and foreign exchange markets. Although foreigners
invest in government securities markets in many emerging economies, the foreign
investors in general do not invest in corporate sector bonds. One of the reasons for the
lack of interest of foreign investors in corporate bond markets in emerging markets is the
general unfamiliarity of the market conditions. Therefore, the participation of equity
markets and other inflows too contribute help improve the secondary market and the
bond market development.

D. Other impediments in market and institutional infrastructure

In addition to macroeconomic stability, several policy initiatives and targeted reforms are
found to be needed to strengthen the institutional infrastructure and remove impediments
which will foster efficient functioning and sustained growth in the bond market
particularly the corporate bond market. With regard to institutional infrastructure,
establishing rating agencies, trading platforms, clearing and settlement systems,
regulatory environment are some of the major requirements. Policies to develop a
diversified institutional investor base will create ensure sustainable demand for bonds. In
particular, pension funds, mutual funds, not only create demand for fixed income
securities but also contribute to increase financial innovation, corporate governance, and
enhance competition in bond market. Strengthening the disclosure standards and
establishing credit rights and investor protection too help remove the impediments to
smooth functioning of bond markets.

III. IMPORTANCE OF BOND MARKET DEVELOPMENT ON

MONETARY AND FINANCIAL SYSTEM STABILITY

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 A. Bond market development and monetary stability

The developments in bond markets improve the efficiency of monetary management.

Banks, which are the main counter parties in the implementation of monetary policy, take
into account their borrowings and lending decision based on market determined yield
curve. Accordingly, changes in the monetary policy stance are reflected in the markets
and improve the transmission of monetary policy.

A developed bond market reduces the need for governments to finance its budget
deficits from inflationary banking financing. Therefore, bond market is an alternative
channel for mobilizing funding which enhances the flexibility of monetary management.

A well-established yield curve allows inferring expectations of inflation and interest

rates. A distorted yield curve on the other hand, restricts the information that can be
obtained and restricts the ability to affect long-term rates. Moreover, a market determined
yield curve facilitates investors and savers to price their borrowings and lending more
competitively. Thus, the yield curve promotes economic growth prospects through its
impact on promoting savings, expanding investment thus reducing bank borrowing
leading to reduced monetary expansion.

The development of government securities market also facilitates implementing

indirect instruments of monetary policy. Most countries are moving away from the use
of direct instruments to indirect instruments such as repos and direct open market
operations. Typically, Treasury bills and Treasury bonds are the main instruments used in
conducting repo transactions. Central banks in general, absorb and inject liquidity
through the purchase and sale of Treasury bills/Treasury bonds. An important component
in the management of liquidity is crucially dependent on development of money market
and Treasury bill and Treasury bond markets in particular. The development of Treasury

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bill and Treasury bond markets therefore contribute for the Central Bank to conduct
monetary policy more effectively.

B. Bond market development and financial system stability

Bond market development has a significant impact on strengthening financial system

stability. Well-functioning government and corporate bond markets expand the array of
financial assets that are available to institutional investors. Long-term investors such as
pension funds and life insurance companies require long-term investments that mach
their long-term liabilities. Market determined investments reduce mismatches and
facilitate their portfolio management. In this context, bond markets help strengthen the
balance sheets of these institutions and reduce their exposures to interest rates and roll
over risks of investments.

Another important advantage is that it reduces instabilities arising from foreign

currency mismatches and the dependence on international bond markets by corporations.
In fact, combined with a sound debt management policy, domestic bond market allows a
reduction of the exposure to other financial risks since bond market provides an
alternative and cost efficient source of medium and long-term capital for corporations.
Moreover, a market-oriented funding policy based on a liquid government securities
market will reduce debt-service costs over the medium to long-term.

A liquid corporate bond market may prevent development of asset price bubbles.
Bond markets expand the array of financial instruments available to diverse investors.
Yield curve allows investors to infer more information about market expectations
regarding interest rates and other economic developments. With the expansion of market
players in the market, the herd behaviour will also be restricted.

Development of bond markets facilitates and expands the opportunities to financial

institutions to raise debt capital. Specially, this is important since banks are required to
build capital with the implementation of new Basel capital accord. The development of

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other ancillary intermediaries such as rating agencies can support the overall credit risk
management of financial intermediaries.

Another important advantage is that it helps governments to structure the debt

management. In fact, several United States dollar-denominated debt instruments have
been introduced by the government of Sri Lanka in recent years in view of the issues in
raising borrowings from the market. Sri Lanka Development Bonds (SLDBs), The Sri
Lanka Nation Building Bond (SLNBB), a new sovereign debt instrument, foreign
commercial borrowing through a syndicated loan and an international bond issue are the
different instruments through which foreign borrowings were raised to complement
domestic borrowings. These bonds mitigated pressures on the domestic debt securities
market and to stabilize the interest rate structure. Yet, these increased debt management
vulnerabilities to exchange rate movements.

In general, investment programmes undertaken by government to a large extent are the

infrastructure developments which have long gestation periods. The continuation of the
government’s investment programmes mainly concentrating on infrastructure
development projects, which have long-term gestation periods, creates the necessity of
raising long-term funds for government. Developed bond markets expand not only the
range of opportunities available for government but also the assets available for
institutional investors.

C. Importance of derivative markets in bond markets, new risks and their impact
on monetary and financial stability

Derivative markets play an important role in the development of bond markets.

Investing in bond markets exposes investors to market, liquidity and credit risks.
However, derivative markets in currencies and interest rate swaps and various derivative
products such as credit derivatives allow for allocation/transfer of risks such as credit
risk, interest rate risk between market participants according to their preferences,
expectation and risk aversion and make market liquidity throughout the system.

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 For instance, the securitization which originates as an issue of bonds or securities by
the pooling receivables of capital and interest on loans, are sold to investors so that banks
can raise liquidity without waiting for repayments of the original loans. These
securitization subsequently have become more complex with the involvement of
investment banks, mortgage lending institutions, equity firms, mutual/hedge funds and
credit rating agencies leading to the introduction of innovative financial products
generally known as ‘complex structured finance products’, e.g., asset or mortgage-backed
securities (MBSs) and collateralized-debt obligations (CDOs).

One purpose of these exotic products is to create new securities that could be sold to a
broader group of investors such as pension funds and insurance companies whose
investment horizon better suited depending on their liability structures. These instruments
therefore enabled the transfer of credit risk to a diversified group of investors in the
market. Therefore, these innovative products were generally encouraged, even by
regulators, as a risk management tool. Markets evolved to trade these securities to suit
investors with different risk appetites. Interestingly, during last two years, financial
regulators have been raising concerns over the credit derivative markets boom because
the risks taken by the investors outside the regulatory purview.

Although the derivative markets and hedging instruments facilitate the expansion of
the bond market, the evolution of derivative products has brought in two distinctive
features to the financial market: an increasing complexity of instruments, which combine
an extensive use of derivatives with customization to individual investors’ needs and the
fragility of off-balance sheet structures and vehicles, which was rediscovered during the
recent sub-prime turmoil.

Following the sub-prime issue, a number of central banks in developed economies

acted to stabilize markets and forestall a potential financial crisis. The European Central
Bank, The US Fed injected significant amounts and in order to encourage banks to come
to it for liquidity, the Fed reduced the discount rate the charge it makes for emergency
lending to banks. The central banks of Canada, Japan, UK and Australia also intervened
to provide liquidity to the market. This recent episode also highlights that regulators are

15
required to play a major role indirectly in finance product innovation, in view of the
systemic and economic risks. Regulators are required to ensure that systemically
important banks and financial institutions are not exposed to concentration risks in
specific products or markets. Banks and financial institutions are also required to follow
fair market practices without unduly affecting public confidence.

D. Monetary and financial sector policies in Sri Lanka promoting bond market

1. Conduct of monetary policy

The conduct of monetary policy is one of the prime responsibilities of the Central
Bank, since monetary policy is the means by which Central Bank attempts to attain its
one of the core objectives, i.e., the economic and price stability. Monetary Law Act
provided a wide range of instruments that could be used by the Central Bank for
monetary management.

At present, the monetary policy framework places greater reliance on market based
policy instruments and the use of market forces to achieve the desired objectives as they
help achieve a better allocation of resources, reduce associated transaction costs, and
improve the efficiency in monetary management. As a further step in making toward for
more market oriented monetary management system, the Central Bank moved to more
market based active open market operations with effect from 3 March 2003.

Steps were also taken to enhance the transparency, predictability and credibility of
monetary policy. After each decision on required change in monetary policy stance, or
otherwise, a public statement, i.e., a press release, explaining the monetary and economic
conditions that led to the particular decision on the policy change (or otherwise), is issued
to the public. In addition, the monetary policy framework, and monetary projections,
along with the explanatory notes are regularly posted on the Central Bank website.

The independently floating exchange rate regime, which was implemented from
January 2001 served well in reducing the excess volatility in the exchange rate and

16
maintaining the country’s competitiveness vis-à-vis the rest of the world, while allowing
greater freedom in the conduct of monetary policy.

2. Polices to promote financial system stability

A comprehensive approach is adopted in preserving financial stability, which is one of

the core objectives of the Central Bank. This encompassed surveillance at systemically
important financial institutions; regulations to ensure prudent practices by banking
institutions and healthy developments in financial markets; and supervisory activities.
This is work is being initiated towards developing additional tools to enhance ongoing
surveillance and analyses of financial system resilience which includes developing
forward-looking indicators both at the system and institution levels to identify, measure,
assess and predict emerging vulnerabilities and adopt stress test methodology to ensure
its effectiveness and relevance.

Given the diverse risks associated with financial conglomerates, it has become
increasingly important to ensure that the activities of financial conglomerates do not pose
risks to the stability of the financial system. In this regard, the Central Bank has
introduced a number of policy initiatives to address the potential systemic risk posed by
financial conglomerates to monitor systemic risks of financial conglomerates and
promote consolidated supervision.

a. Banking sector

The stability of the banking sector, which is the major sub-sector within the financial
sector is crucial for bond market since it provides payment facilities and a major buyer
and issuer of securities and facilitates secondary market activity. In fact, banks are one of
the major investors in government securities market to meet statutory liquidity
requirements and as collateral for repo transactions in managing short-term liquidity.
Accordingly, number of measures continued to be taken promote a competitive, sound
and robust banking sector.

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 There has been a significant improvement in capacity and capability of the banking
system and this is supported by improved earnings, increase in capital funds and
improvements in risk management amidst enhanced regulatory and supervisory
framework. This was further underpinned by the gradual decline in non-performing loans
(NPLs), reflecting general improvements in credit quality and enhanced risk management
standards and practices over the years. The strong financial position has enabled the
banking sector to expand the access to finance.

With a view to further strengthening the efficiency and greater competition among
financial institutions, a number of legal reforms relating to the financial sector were
brought in and regulatory oversight were enhanced to be in line with international best
practices.

b. Money market

The Central Bank has implemented several measures to broaden and deepen the
money market. In order to help pricing money market products, the Central Bank started
providing Sri Lanka Interbank Offered Rate from 1999. The Central Bank also engages in
Repurchase and Reverse Repurchase transactions in order to inject and absorb liquidity
from the market. Further, it disseminates information on market transactions on a daily
basis. Measures have also been taken to further promote and upgrade the payments
system to take effect large value money market transactions through the Real Time Gross
Settlement System and the Scripless Securities System, which will expand and promote
the efficiency of money market transactions.

c. Foreign exchange market

Another noteworthy development in the foreign exchange market was that the
independent floating of Sri Lanka rupee in 2001. The main players in the foreign
exchange market are the commercial banks. Dealings in the foreign exchange market are

18
mainly in spot and forward transactions. These operations are largely generated by trade
related activities, capital flows, and trading activities of commercial banks.

Since the commencement of independent floating in 2001, a greater stability in foreign

exchange market has been seen, with an increase in market activity. Foreign exchange
market activities have also been expanded significantly.

d. Development of government securities market

A number of positive developments have also taken place in the government securities
market supporting bond market development. In an effort to upgrade the market
infrastructure, the Scripless Securities Settlement System (SSSS) was introduced in 2004
to replace the paper-based instrument system with the dematerialized settlement system.
Meanwhile, the Central Depository System (CDS) for GS was introduced to record
trading information for scripless securities. As a result, the settlement and clearing of
government securities has achieved Delivery Versus Payment (DVP), whereby security
delivery and payment will be simultaneous.

A conscious effort has been taken to increase issues of marketable government

securities. Accordingly, Treasury bonds were issued in place of rupee securities. As a
result, the share of T-bonds increased from 28 per cent in 2001 to 60 per cent in 2006,
and the share of Rupee loans decreased from 35.8 per cent to 8 per cent.

With a view to further opening the capital account transactions and to develop the
capital markets by broadening the investor base and increasing competition in the bond
market, foreign investors have been permitted to purchase up to five per cent of rupee
denominated Treasury bonds since November 2006.

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e. Financial system infrastructure

An efficient and reliable payment and settlement system contributes to the soundness
and the development of the financial system and the smooth functioning of bond markets.
Therefore, the Central Bank moved towards introducing a more advanced payment and
settlement system in 2003. For high value and time critical payments on real time, the
Central Bank implemented the Real Time Gross Settlement System (RTGS) in 2003,
which significantly reduced the settlement risks and improved efficiency.

To further modernize the payment system, measures were also taken by the Central
Bank and Lanka Clear (Pvt.) Ltd to introduce Cheque Imaging and Truncation (CIT) to
the country’s cheque clearing system with the long-term objective of moving towards
electronic cheque transactions.

f. Legal enactments

A number of laws relating to the financial sector have been enacted strengthening the
legal framework for the efficient functioning of bond market. These included the
Payments and Settlement Systems Act, Electronic Transactions Act, Payment Devices
Frauds Act and legislation pertaining to Anti-Money Laundering, Terrorist Financing and
Financial Transactions Reporting.

E. Policy measures to promote bond market

A prudent monetary policy supported by fiscal policy while allowing appropriate

adjustment in exchange rate is important to achieve macro economic stability and contain
inflationary pressures and promote stability in the foreign exchange market which are
fundamental to bond market development.

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 1. Monetary policy

• Maintenance of a medium-term macroeconomic framework and following a

credible monetary policy to attain monetary growth targets and reduce high
inflationary pressures in the economy: Achieving macroeconomic stability, that is
to maintain the inflation rate, contain high monetary expansion and the fiscal deficit
at sustainable levels are the key prerequisites for the development of the bond
market., thereby ensuring price stability, is crucial in further developing bond market.
Therefore, preparation of a medium term macroeconomic framework supported by
fiscal policy is the most essential to bring the inflation to a sustainable level.

• Further improving the efficiency of money market operations: Measures could be

taken to improve the management of money market liquidity addressing weaknesses
in the inter-bank call money market, improving the cash management framework of
the government will facilitate the Central Bank to manage short-term liquidity
appropriately.

• A greater co-ordination by monetary and fiscal authorities: Inflation targeting per

se can improve the co-ordination between monetary policy and other macroeconomic
policies (depending on the way the target is set and whether the target is consistent
with other policy objectives). The announcement of inflation targets clarifies the
central bank’s intentions and reduces uncertainty about the future course of monetary
policy. Inflation targets make policy transparent.

• Monetary policy communication: A good communication policy helps to achieve

the objectives of the Central Bank. It is essential that market participants and the
public at large know and understand the objectives of the Central Bank and the
monetary policy actions taken by the bank. Any change in monetary policy stance
should therefore explicitly explain to the public.

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• Managing expectations: Inflation expectation surveys and constructing leading
indicators are two other areas where work could be developed. Change in
inflationary expectations, which are an indicator of credibility of monetary policy and
inflation inertia, are also variables used in inflation forecasting models.

• Inflation Targeting: In recent years, there has been an increasing focus on inflation
targeting as a framework for implementing monetary policy. The rationale behind
inflation targeting is that inflation targets may help provide a clear path for the
medium term inflation outlook, reducing the size of inflationary shocks and their
associated costs. Since long-term interest rates fluctuate with movements in inflation
expectations, targeting a low rate of inflation would lead to a more stable and lower
long-term rates of interest.

• Further work in moving inflation targeting: More empirical work is needed to

understand the monetary policy transmission mechanism better. In particular, the
degree of pass through from money market rates to retail rates, lags associated with
monetary policy shocks and channels though which these shocks are propagated need
to be examined A good forecast of the inflation rate can provide valuable inputs in
the formulation of macroeconomic policies, in particular, monetary policy. Inflation
forecasting is central to any monetary framework. Monetary policy affects output and
inflation with lags and a forward-looking approach is essential in the monetary policy
decision making process.

2. Fiscal policy

• Government’s commitment to maintain fiscal targets: Government’s Medium

Term Macro Framework (MTMF) enunciated in the Fiscal Management Reports, and
the overall deficit announced in these reports should be maintained. Government

22
 should take necessary adjustments in the areas of enhancing revenue through
additional measures and improved tax administration, rationalization of current
expenditure and improvements in the government debt management to meet this
target since large deviations of government borrowings affect the smooth
implementation of the borrowing programme. It is also important that the medium-
term fiscal targets announced in the FMRA are achieved effectively so that there
would be less pressure in the conduct of monetary policy as well.

• Reduction in High Budget Deficits: Persistently high budget deficits due to a

combined outcome of declining revenue as well as increasing government
expenditure are the major problem in the country’s public finances at present.
Consequent to the higher deficits and resultant borrowings from both domestic and
foreign sources, the outstanding stock of government debt has also risen to a high
level. Past experience reveals that the level of public investment has gradually
declined mainly to compensate the high budget deficits that are causing from higher
recurrent expenditures. As such, increasing public investment has become important
to facilitate the private sector participation in economic activities. Accordingly,
measures are being introduced particularly to enhance the tax revenue collection and
reduce the expenditure almost entirely through further rationalization of current
expenditure are urgent needs.

• Reduction in High Level of Debt: The government debt as a percentage of GDP

continued to remain high, suggesting that there is an urgent need for fiscal
consolidation. Without a reduction of the budget deficit, there would be an increase
in the extra yield expected of for investments affecting the bond market development.

• Taxation of financial instruments: High deficits force the government to impose

additional taxes on financial instruments or financial institutions constraining the
efficient functioning of financial market. At present, in Sri Lanka, the financial sector
is subjected to six types of taxes; two on financial institutions and four on services.

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 The VAT and corporate tax are payable by institutions. Withholding taxes on interest
income, debit taxes on withdrawals, stamp duties and VATs on fee-based activities
are paid by customers.

• Improvements to debt management through the creation of benchmark issues:

Government can reduce its debt servicing costs by concentrating the bond issuance to
a limited number of large benchmark securities instead of current multiplicity of
issues. Larger and concentrated issues tend to be liquid and beneficial in developing
a yield curve which in turn help in pricing range of other financial instruments.
Accordingly, the issues could be limited to pre-determined maturities and coupons. A
range of debt instruments allows the debt to be issued to address the preferences of
range of investors with different risk appetites. However, too many issues could
fragment the market. Hence, the outstanding instruments could either be buy
back/exchange for benchmark issues.

• Work on establishing an independent Debt office: As in many central banks,

public debt management is a responsibility of the Central Bank of Sri Lanka.
Separation of roles and responsibilities will allow greater clarity in setting objectives
and maximizing the transparency of monetary policy. There is also a need for
cooperation to share information to properly estimate the liquidity forecasts by central
banks so that monetary management be undertaken with a greater precision.

• Cooperation of other stakeholders is needed: In developing countries, like Sri

Lanka, there are structural issues (i.e., inefficiencies in product, labour and capital
markets) that also need to be addressed in order to create an environment of low and
stable inflation. Monetary policy alone is not sufficient to maintain price stability
since monetary policy cannot be carried out in isolation of other polices and the
impact from external sources. Therefore, the co-operation of other stakeholders is
needed to reduce inflation on a sustainable basis. Measures are necessary to increase

24
 supply condition along with the improvements to productivity, removing bottlenecks
in infrastructure and inputs markets.

3. Promoting financial system stability

• A series of measures will need to be implemented to further enhance the efficiency

and strengthen the financial sector, which will contribute to financial system stability
and the developments of bond markets. These encompass regulatory and supervisory
measures to strengthen major financial institutions; forward looking surveillance
indicators and tools to predict emerging vulnerabilities; measures to improve
efficiency of financial markets including access to finance; initiatives to enhance the
safety of payment systems; and introduction of necessary changes to legal enactments
governing the wider financial system.

• Further reforms to broaden and improve efficiency of the financial sector: As an

integral part of the economic liberalization policy package initiated about three
decades ago, several financial sector reform measures have been undertaken to create
an efficient and resilient financial sector. With these changes, the financial services
sector has shown a significant expansion during the last three decades. Further
reform measures would help deepen the money and capital markets and improve their
efficiency leading to higher savings and positive effect on growth. .

• Supervision and regulation: The increasingly complex and dynamic financial

activities demand continuous enhancement to the regulatory and supervisory
framework. Accordingly, several initiatives have been taken by the CBSL, SEC and
IBSL which regulates and supervises major financial institutions. The
implementation of Basel II capital adequacy framework, the introduction of
mandatory corporate governance rules, the adoption of International Accounting
Standards viz., IAS 32, 39 & IFRS 7, and the implementation of an integrated risk
management framework are expected to provide a significant boost to the capacity

25
 and capability of the banking institutions, promote overall risk management and
reinforce the resilience of the banking sector

• Financial system infrastructure: With a view to developing a safe and efficient

payment instruments, a nation-wide non-cash retail payment system is to be
introduced as proposed by the National Payments Council.

• Expanding investor base: A broad investor base has several advantages for
developing the bond market through enhanced market stability, promoting financial
innovation and contributing to expanding liquidity. Accordingly, measures need to be
taken for the development of a group of private institutional investors especially
developing pension funds, mutual funds. An initial boost could be given for bond
market development by participating in bond issues by relaxing the restrictions on the
investment policies of the EPF, the ETF, and the NSB as regards their ability to invest
in private securities and allowing foreign investors to invest in fixed-income
securities.

• Procedures for corporate insolvency and rehabilitation: It is necessary that there

are procedures and laws to provide for corporate insolvency and rehabilitation.

• Promoting investment banking: The investment banks could function as a catalyst to the
development of vibrant and efficient bond market. These banks facilitate the issuing of
corporate bonds in several ways such as advising on the timing and terms of the
issuers. In addition, underwriting of bond issues are some of the services that could
be provided.

• Expanding markets: The securitization market has expanded considerably in recent

years, driven mainly by mortgage-backed securities in many countries. In Sri Lanka,
draft bill has been prepared and it is necessary that process of securitization be
expedited.

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• Disclosure of information to build market credibility: Information disclosure plays
a key role in building market credibility. Developing proper disclosure standards
based on consolidated accounts and well established auditing and accounting
standards will help market and supervisors. In this regard, the adoption of IAS
standards and move to consolidate listed companies, through strict enforcement of
free float requirements, will also have a positive impact on information disclosure.

• Improve the financial literacy and awareness among investors about the
characteristics of new capital products. Enhanced understanding of the capital
markets by issuers, investors (both institutional and retail), will allow them to make
educated decisions would contribute enormously to the long-term development of the
capital markets.

• Protecting investors from bond defaults: Necessary safeguards needs to be in

place to protect investors from bond defaults since there are possibilities that some
companies which are not creditworthy could issue junk bonds. In fact, it is reported
that Chinese government has adopted a merit based selection system for issuing
corporate bonds, ceilings on corporate bond interest rates and mandatory credit to
protect investors following number of corporate bond defaults in 1990s.5

III. CONCLUSION

Macroeconomic policies, fiscal and monetary policies in particular need to be

harmonized to achieve a stable macroeconomic environment which is a pre-requisite and
provide a conducive environment for the development of the domestic debt market.
However, it needs to be reiterated that the success of many of the above critically
dependent on achieving a durable peace. The continuous civil unrest had a huge cost on
economic activity with significant direct and indirect impacts. In addition to
macroeconomic stability, several policy initiatives and targeted reforms are found to be
5
IMF (2005), Box. 4.4.

27
needed to strengthen institutional infrastructure and remove impediments which will
foster efficient functioning and sustained growth in the bond market particularly the
corporate bond market. With regard to institutional infrastructure, establishing rating
agencies, trading platforms, clearing and settlement systems, regulatory environment are
some of the major requirements. Policies to develop a diversified institutional investor
base will create ensure sustainable demand for bonds. In particular, pension funds,
mutual funds, not only create demand for fixed income securities but also contribute to
increase financial innovation, corporate governance, and enhance competition in the bond
market.

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 REFERENCE

Bank Negara Malaysia, The Corporate Bond Market in Malaysia, Muhammad bin
Ibrahim and Adrian Wong.

Bank for International Settlements (2007). CGFC Papers No.28 Financial Stability and
Local Currency Bond Markets, June.

Del Valle, C., A Comprehensive View: Developing Bond Markets,

http://www.iadb.org/sds/doc/IFM-ClementeBond-E.pdf.

IMF (2000). International Capital Markets: Developments, Prospects, and Key Policy
Issues, World Economic and Financial Surveys, September (Washington D.C.).

_____ (2001), International Capital Markets: Developments, Prospects, and Key Policy
Issues, World Economic and Financial Surveys, August (Washington D.C.).

_____ (2004), Global Financial Stability Report, World Economic and Financial Surveys,
April (Washington D.C.).

_____ (2005), Global Financial Stability Report, World Economic and Financial Surveys,
April (Washington D.C.).

The World Bank and IMF (2001). Developing Government Bond Markets, A Handbook,
(Washington D.C.).

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