This study empirically analyzes the determinants of bond market development Pakistan between 2003 and 2009. It considers the stage of development and the size of the domestic bond market, as well as the historical, structural, institutional and macroeconomic factors driving bond market development in Pakistan. In this research the study of macro-economic variables, Banking size, natural openness, Broad money (M2), money in circulation, Interest rates and Inflation rates, to inspect causal impact of each macro-economic indicator on bond market development in Pakistan, six years data gathered on monthly basis from July 2003- June 2009 for macro-economic indicators and bond market capitalization have been collected, the study applied ARIMA model as a statistical tool for data analysis.. Overall, the results show that a convergence of factors matters for the development of domestic bond markets in Pakistan; these include size of the banking sector, and the money in circulation in market. Policy implications include increased efforts to strengthen the investment environment and the need for a regional approach to bond market development.
Introduction The 1997-98 financial crises highlighted the problem of bond market underdevelopment in Asia. The small size and slow growth of regional bond markets, as many observers noted, left corporate borrowers greatly depend on banking finance. Given the short tenor of bank loans, a shock to confidence left Asian economies vulnerable to a disruptive credit crunch. Since banks denominated many of their loans in foreign currency, exchange-rate depreciation could result in serious balance-sheet damage and thrust highly leveraged corporations into bankruptcy. After the Asian crisis significant attention has been paid to the role of bond markets in overall financial sector stability and economic development. Several studies have found that financial market development is correlated with economic development (Levine, 1996) and Montiel, 2003)). Corporate bond markets are important for financial market because it provide long term financing, competition to the banking sector and enhancing stability of financial sector. Whenever companies need finance their project or expansion they have four sources to get money (1) retained earnings (2) bank borrowing (3) corporate bonds, and (4) equity. In emerging market most the financing is done through bank borrowing. For example in 2003 over 80 percent of corporate financing in emerging markets was in the form of bank loans (Luengnaruemitchai and Ong, 2005). Similarly, in Pakistan the majority of external financing of firms is through the banking sector. The bond market is vital to any economy. It raises the capital to build infrastructure, helps promote the economic growth, fuels investment that in turn creates jobs, and enhances market efficiency. Theoretically, bonds lower the cost of borrowing and provide an effective channel for savings. It is believed that the bond market is the one of the main instrument of the capital market and plays important role in mobilizing savings into productive investment that promotes economic growth and development. Pakistani corporate bond market (CB) is only partly developed by international standard.
Statement of Problem This thesis will be taking into account the understanding of the mechanism of the bond market and the strategies required by the government to accelerate and increasing investments in bonds market. This thesis will be also be taking into account in making strategies that will help the issuers of bond in increasing investments in the corporate and to bonds to attract investor's towards the bond market. Some problems that need to address in development of bond market in an emerging economy are macroeconomic conditions and economic policies in practice and the second set of issues are related more with microeconomic development. For this research five independent variables and one dependent variable are taken to identify what are the determinate of development of bond market. The independent variables are 1) Interest Rate, 2) Inflation Rate (CPI), 3) Natural Openness, 4) Money Circulation in market, 5) Banking Size and 6) Board Money (M2) and dependent variable Bond Market Capitalization as a share of GDP
Significance of the Study This thesis will be taking into account the understanding of the mechanism of the bond market and the strategies required by the government to accelerate and increasing investments in bonds market. Significance for the issuers: This thesis will help the issuers of corporate bonds in increasing investments in the bonds market to attract investor's towards the bond market. This research will help in determining your financial goals which is the first step to successful investing. This is a crucial step, for many of the decisions you make later will depend on the goals you set now. Establishing investment goals will help you assess how much money you'll need, when you'll need it, and how much you'll need to invest to reach your goal.
Literature Review There has been two phases of development of the corporate bond market in the case of East Asian countries (Das 2005), i.e., before and after the Asian financial crisis. In the pre-crisis period, Korea was the leader in creating corporate bond market which was fuelled by supply of corporate bonds by a large number of chaebols and demand of Investment Trust Companies (ITC). Before crisis, share of corporate bonds in total corporate financing was 32% followed by 31% of private loans and 28% of equity during 1995-1999 (Davis & Stone, 2004). But in post crisis Malaysia become the leader with the volume of bond market of 51 % of GDP in 2001. For bond issuance in Hong Kong, Singapore and South Korea financial institutions plays a very important role, but they are not so active in China and Malaysia. (Ameer, 2007). (Eichengreen and Luengnaruemitchai, 2004) finds that the country size and openness are positively related to bond market development. Distance from the equator, a proxy for endowment theories, similarly enters with its expected positive sign. It is not possible to use colonizer mortality rates in an analysis of Asian bond markets, since relatively few Asian countries were colonized by the European powers, and colonizer mortality estimates (and logic) are based on data for and the experience of one-time colonies. On the other hand, they find that countries with more concentrated banking systems appear to have smaller bond markets, consistent with arguments suggesting that banks with market power may use it to discourage bond flotation. He also looked further at the robustness of the positive association of bank and bond market development, which runs contrary to some popular arguments and is likely to be controversial Asian economies from excessive dependence on bank loans and to foster the development of a more diversified and efficient financial sector, and there is evidence that they are growing (Fernandez and Klassen 2003). But the level of bond market capitalization is low and results from the fact that bond markets are separated by country, with low liquidity, limited investor participation, underdeveloped infrastructure and few intermediaries. In the absence of bond markets in some cases complicated efforts are made to finance large infrastructure projects and enterprises with high minimum efficient scale found it hard to meet their financial needs. The amount that could borrow from a syndicate of banks which could securitize their loans, but security of that amount was too costly and very much difficult in the absence of a bond market. (Eichengreen and Luengnaruemitchai, 2004) Lummer and McConnell, (1989) and Gilson, (1990) point out that bank borrowing enables a firm to efficiently undertake corporate debt restructuring, in contrast to bond issues, where it faces the difficulty of having to communicate with a large number of creditors. To better understanding of the bank-corporate bond market relationship, along with other determinants of bond market development, can drop light on how best to provide appropriate policies to facilitate bond market development. The results (Dickie and Fan, 2005) is also support by the "interest group" theory proposed by (Rajan and Zingales, 2003) that emphasizes s that banks with market power may attempt to strangle the development of corporate bond markets. This is because the development of corporate security markets may compete for good borrowers from banks, through this the quality of bank loans may drop, the task of risk management may become harder as loans become riskier, and they may need to hire more human capital to manage the things. The ability of banks to oppose bond market development is related to the structure of the banking sector. A more concentrated banking sector is the more they will possess bond market development. (Dickie and Fan, 2005) The soundness of the banking system also has important for development of the government securities market and bond market. Domestic and foreign investors are deeply concerns for the soundness of the banking system that has an adversely impact on the ability of the corporate and government to issue new bonds and securities. (Silva, 2008) Adelegan and Radzewicz-Bak (2009 in his research finds that commercial banks are more dominate in SSA countries and, they are comparatively large in size as compared to other segments of the financial sector as well as the roles that play as market makers for primary issues. According to the Eichengreen and Luengnaruemitchai, (2006) coefficients on the ratio of bank loans to total debt finance suggest that the relative importance of bond finance rises with the financial development of the host country, while country (population) size is otherwise insignificant, suggesting minimal economies of scale. Eichengreen and Luengnaruemitchai, (2006) find in his research the interest rate highlight the importance of push factors: investments do not always go to the countries with higher interest rates, but they clearly come from countries where interest rates are low. According to the Adelegan and Radzewicz-Bak (2009) interest rate is also having a negative significant relationship between bond market developments. This suggests that higher interest rates and interest rate volatility are related with a smaller bond market. Silva (2008) In Asian countries banks and non-bank financial institutions plays a very important role in developing bond market as the issuers, mainly raising subordinated debt to meet capital adequacy requirements, and attract investors in this market. According to Silva (2008) there are several unpleasant consequences of high and volatile inflation on the efficient functioning of bond markets. Inflation rate has a very close relationship 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 borrowing from the banking sources also creates additional pressure for monetary management, partly a result of non development of alternative sources of financing or bond market. (Silva, 2008) Maysami, Howe, Hamzah (2004) suggest that an increase in M2 growth would indicate excess liquidity available for buying securities, resulting in higher security prices. Empirically, (Hamburger and Kochin, 1972 and Kraft and Kraft, 1977) found a strong linkage between the two variables, while (Cooper, 1974 and Nozar and Taylor, 1988) found no relation. Adelegan and Radzewicz-Bak (2009) in his study considers the correlation between the share of domestic debt to GDP and M2 to GDP, which is a measure of the domestic financial development base, on the premise that a large banking sector will help the government sell its debt domestically. According to Adelegan and Radzewicz-Bak (2009) as most of the sub-Saharan African (SSA) countries are shallow, and have inadequate access to finance. As a result, domestic resources as an alternative source of financing are becoming increasingly important in SSA, with SSA governments focusing mainly on domestic markets in order to avoid renewed or unsustainable external indebtedness. Weak development of financial sector is meaning that firms borrow from banks instead of issuing bond in stock market. Likewise, smaller value of transaction (turnover ratio, as a percentage of GDP) in stock market shows that public prefers to place deposit in banks more than to issue bond in stock market. This condition also proved by case that broad money growth provided by quasi money growth. (LKhagvajav B., Batnyam D. and Gan-Ochir D. (2008). In his research he consider macroeconomic and bond market stability. Generally macroeconomic stability is very important factor for the development of the bond market. They expect that the higher the volatility of the underlying economic situation the less incentive firms and savers would have to participate in the market.
Theoretical Framework & Hypothesis Construction In this chapter we construct our hypothesis to test the whether interest rate, inflation rate, natural openness, banking size, broad money M2 and money circulation any significant association with bond market capitalization. For this ARIMA technique is applied on the 72 months period data for all the variables.
Banking Size According to Dickie and Xiaoqin Fan (2005) finds that central hypothesis of this research paper is that a highly concentrated banking sector could more effectively protect itself from disintermediation caused by bond market development. These results support the hypothesis that bank concentration is significantly negatively correlated with bond market development. These finding also provides the support for (Rajan and Zingales's, 2003) interest group theory of financial development.
H1: Banking size explains the causes of change in bond market capitalization.
Natural Openness According to the research done by Adelegan and Radzewicz-Bak (2009) find that openness (Exports to GDP) is negatively related to bond market development. This implies that the lower the level of natural openness, measured by exports to GDP, the lower the level of access to external funding and the greater the development of the local bond market. This is opposing to findings in (Rajan and Zingales, (2001) and Eichengreen and Luengnaruemitchai, (2004) on developed and Asian markets
H2: Natural openness explains the causes of change in bond market capitalization.
Inflation Rate According to research done by Ameer (2007) using Granger-causality tests finds that inflation rates have no influence on primary markets activities in South Korea and Malaysia. (Silva 2008) fins as inflation increases, the duration of the government securities declines and investors' preference shifts to short-term government securities.
H3: Inflation rate explains the causes of change in bond market capitalization.
Interest Rate Eichengreen and Luengnaruemitchai (2004) find that volatility of interest rates is not significant bond market development, their level, suggests that higher interest rates are associated with smaller bond markets.
H4: Interest rate explains the causes of change in bond market capitalization.
Broad Money (M2) The research done by Adelegan and Radzewicz-Bak (2009 )considers the correlation between the share of domestic debt to GDP and M2 to GDP, which is a measure of the domestic financial development base, on the premise that a large banking sector will help the government sell its debt domestically.
H5: Broad Money (M2) explains the causes of change in bond market capitalization.
Money in Circulation According to the money market model given by Case and Fair (1999) an enhance in the money supply (Ms) at equilibrium causes a decrease of the interest rate (r), because when ever more money is supplied, than needed, thus households will deposit their over and above money at a bank, trying to take advantage from the high interest rate of interest-bearing bonds. Following this increasing supply of money, force is put upon the interest rate, which drops until new equilibrium will form at a lower interest rate.
H6: Money in circulation explains the causes of change in bond market capitalization.
Data collection Now we turn from broad hypotheses to empirical implications. Data set cover the period 2003 to 2009 at monthly frequency for maximum of 72 observations. The data are for all variables are taken from the annual reports of state bank of Pakistan.
Empirical Model/ Statically Tool Bond market capitalization = f (Natural Openness, Banking Size, CPI, Interest Rate, Broad Money (M2), Money in circulation) Bond market capitalization = f (NO, BS, CPI, I, M2, M) Following model is used to find the relationship between macroeconomic variables and bond market capitalization. And to test the hypothesis that "Macro economic variables has significant association with bond market capitalization.
Empirical Result The Parameter Estimate table 1 shows that estimate of model parameters and associated significance values; including AR and MA orders as well as any predictors the parameter representing. Non- seasonal moving-average component (labeled AR1) is significant. The variable representing the natural openness, broad money (M2), interest rate and inflation rate are not significant i.e. 0.497, 0.842, 0.947 and 0.112 respectively which means they don't have any relationship with the Bond Market Capitalization. Only two variables that predict significant are Banking Size and Money Circulation i.e. 0.001 both at 5% significance value; it means that this predictor has a relationship with the Bond Market Capitalization. The change in natural openness, broad money (M2), interest rate and inflation rate does not affect the Bond Market Capitalization, but the change in Banking Size and Money Circulation does affect the change in Bond Market Capitalization. The correlation coefficient table 2 is a measure of linear association between two variables. The values of the correlation coefficient range from -1 to 1. The sign of the correlation coefficient indicates the direction of the relationship (positive or negative). The absolute value of the correlation coefficient indicates the strength, with larger absolute values indicating stronger relationships. The correlation coefficients on the main diagonal are always 1.0, because each variable has a perfect positive linear relationship with itself. Correlations above the main diagonal are a mirror image of those below.The correlations table displays Pearson correlation coefficients, significance values, and the number of cases with non-missing values.Pearson correlation coefficients assume the data are normally distributed.The Pearson correlation coefficient is a measure of linear association between two variables. The values of the correlation coefficient range from -1 to 1. Non seasonal lags values are the previous values of the present natural openness, broad money (M2), banking size, money circulation, interest rate and inflation rate. When natural openness is 0 then the bond Market capitalization will be -0.858, similarly when banking size, inflation rate, interest rate, board money, and money circulation is 0 then the bond Market capitalization will be 0.749, 0.505, -0.538, 0.426 and -0.525 respectively. Alpha is not in percent it is a magnitude, when natural openness, broad money (M2), banking size, money circulation, interest rate and inflation rate are zero then bond Market capitalization will be equal to intercept. The sign of the correlation coefficient indicates the direction of the relationship (positive or negative). The absolute value of the correlation coefficient indicates the strength, with larger absolute values indicating stronger relationships. The correlation coefficients on the main diagonal are always 1.0, because each variable has a perfect positive linear relationship with itself. The correlation coefficient for the natural openness and banking size is -0.623 thus, these both are 62.3% negatively correlated. The correlation coefficient for the banking size and inflation rate is 0.196 thus, these both are 19.6% positively correlated. The correlation coefficient for the inflation rate and interest rate is -0.483 thus, these both are 48.3% negatively correlated. The correlation coefficient for the interest rate and broad money (M2) is -0.281 thus, these both are 28.1% negatively correlated. The correlation coefficient for the broad money (M2) and money circulation is -0.401 thus, these both are 40.1% negatively correlated. The correlation coefficient for the money circulation and natural openness is 0.4 thus, these both are 40% positively correlated.
Summary Assessment of Hypothesis
Regression Coefficient ÃŽÂ²
H1 Banking size explains the causes of change in bond market capitalization. -4.141 0.001 -3.695 Accepted
H2 Natural openness explains the causes of change in bond market capitalization 0.682 0.497 0.688 Rejected
H3 Inflation rate explains the causes of change in bond market capitalization. -0.202 0.112 1.64 Rejected
H4 Interest rate explains the causes of change in bond market capitalization -0.043 0.974 -0.064 Rejected
H5 Broad Money (M2) explains the causes of change in bond market capitalization. -3.40E-007 0.842 -0.201 Rejected
H6 Money in circulation explains the causes of change in bond market capitalization. 4.85E-005 0.001 3.933 Accepted
Results/Findings As discussed in the earlier chapters different variables have been taken based on the secondary data of 6 years comprised on monthly basis year 2003-2008, collected from the source "SBP". Each variable explains the impact of each macro-economic variable on bond market capitalization in Pakistan, for each scenario a hypothesis was constructed. The independent variables taken in the study were (Inflation rates, Interest rates, Banking Size, Natural Openness, Broad Money (M2), Money Circulation) the dependent variable is Bond Market Capitalization. The results and their findings are as follows.
Results With the help of ARIMA model, investigation of secondary data it is found that banking size and money circulation are the primary source among macro-economic indicators that are able to cause a change in the performance of bond market capitalization compared to other four macro-economic indicators i.e. Inflation rates, Interest rates, Natural Openness, Broad Money (M2), it is also found that inflation rates are the second source of causing a change in bond market capitalization. While other variables are i.e. interest rates, natural openness and broad boney (M2) are able to cause a very small change in bond market capitalization. The reason this is that whenever there is excess money is supplied in market people will move out cash and checkable deposits by buying bonds, In Pakistan most of the corporate sector heavily depend on banking sector instead of issuing their own TFCs; the reason for not issuing TFCs by corporate sector is that they have to go through a long process before issuing TFCs and they have to follow certain rule and regulation for issuing TFCs. The statistical interpretations given above show the level of importance of each macro-economic indicator, the acceptance and rejection of result depends upon the significance level i.e. p > 0.50 is not acceptable where as p < 0.05 is acceptable. Interest rates, inflation rates, broad money (M2), natural openness result point out that they are not able to cause a change in the bond market capitalization due to the reason of no relation among their independent and dependent variables. Where banking size and money in circulation, they cause a change in bond market capitalization (positive/negative impact on bond market capitalization).
Conclusion & Discussion This paper has argued that the Pakistani bond market has not taken-off and there are many challenges that need to be addressed before it can be put into top gear. Indeed the development of bond market requires hectic efforts which include, corporate sector and banking reforms, the strengthening of legal environment, restore investors confidence, improvement in infrastructure, the extensive process of approving draft, issue costs, competition from other private and public savings schemes, poor understanding and lack of information about the bond market on the part of retail investors and last but not least low volume and limited supply of bond by corporate and government. This paper also finds that the slow development of local bond markets is a phenomenon with multiple proportions. To some extent the problem is one of minimum efficient scale: Pakistan have better capitalized bond markets when capitalization is measured relative to GDP as compared to some other countries. The other problem Pakistani bond market is facing to follow the internationally recognized accounting standards has slowed the development of bond markets. Corruption, uncertain poetical conduction, law and order and low bureaucratic quality, which are signs of unreliable securities market regulation, work in the same direction. Countries with competitive, well-capitalized banking systems, on the other hand, have larger bond markets but this is not case in Pakistan. Due to the heavily dependence on banking system and lack of money supply plays a main obstacle for the development bond market in Pakistan. Fortunately, there is little evidence that the small size of public debt markets is an insurmountable obstacle to corporate bond market development. LKhagvajav B., Batnyam D. and Gan-Ochir D. (2008) using the Auto Regression also find that macroeconomic stability (measured by the CPI) and financial intermediary development are important predicators of bond market capitalization determination in Mongolia. StanisÃ…â€šaw Kluza, Andrzej SÃ…â€šawiÃ…â€žski, (2002) Using two set of data to predict the relation between NBP (National Bank of Poland) and bond market capitalization; one on daily bases and other on monthly bases, find in both cases that bond yield is a second order autoregressive process. However, both models significantly predict the role of interest rate for bond market capitalization.
Implications Availability of data largely affected the statistical analysis and determination of the relationships among variables affecting the bond market in Pakistan. With the passage of time, it is expected that the data will be available through reliable sources and can be used to improve upon the quality of this study. This limitation is mitigated through the use of published works and qualitative analysis in the study. This research has also certain delimitations. It is expected that after globalization there might be more significant and different policies for the Investment in corporate bonds and Individual investors will also be able to participate in the bond Market. Inaccurate and incomplete information of company's financial position to investors are also one of the main problems. It is also not possible to find data of variables of 50 years and X no of variables.
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