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602 Government Bond Market Development in Asia

13

TAIPEI,CHINALi-Yen Paul Hsueh

Executive Summary

In the aftermath of Asian nancial crisis, bearish equity markets

made it dicult for rms to raise equity funds, tight credit control lim-

ited the availability of business loans, and a depreciated local currency

increased the cost of oshore borrowing.

The domestic bond market thus came increasingly to be seen as an

important alternative source of fund-raising for the private and public

sectors in Taipei,China.

As in other Asian countries, the development of a domestic bond

market in Taipei,China is only a recent phenomenon. or a long time,

the stock market had played a dominant role in the nancial market,

and commercial loans were the main source of funds for businesses be-

sides equity. Direct nancing was rare, and liquidity in the secondary

debt market was low.

The Government of Taipei,China began issuing treasury securities

more than 50 years ago. The bond market never developed in any mean-

ingful way until a decade ago, however, when the Government switched

its scal policy to focus more on infrastructure developments, relying

more on debt issuance as a funding source. The outstanding volume of

government bonds before 1990 was less than New Taiwan (NT) $200

billion, but had reached nearly NT$1.2 trillion (US$38 billion) by the

end of 1999.

As a percentage of gross domestic product (GDP), the amount of

government bonds outstanding in Taipei,China is relatively low, cur-

rently around 14 percent, compared with 60 percent in the US, 110

percent in Japan, 97 percent in Singapore, and 30 percent in Hong Kong,

China. This suggests that the government bond market still has plenty

of room for further development. However, current budgetary laws put a

cap on the maximum size of government borrowing and total amount of

debt outstanding.

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Taipei,China 603

The rapid growth of the local economy, along with a favorable

interest rate environment, has also encouraged rms to aggressively tap thecorporate bond market. Direct nancing has replaced bank loans as the

main source of funds for many businesses. Although small in size when

compared with its government counterpart, the corporate bond market

has also seen tremendous growth in recent years, with the outstanding

volume of corporate bonds surpassing NT$450 billion (US$15 billion)

by 1999.

A third component of the domestic debt market is made up of

foreign bonds, which are currently issued only by supranational organi-

zations such as the Asian Development Bank (ADB) and European Bankfor Reconstruction and Development (EBRD). Their new issue volume

has increased steadily since 1995, with the total outstanding volume

now surpassing NT$80 billion. However, government bonds dominate

the domestic debt market with more than 70 percent of the market share.

Corporate bonds account for a further 25 percent, and foreign bonds the

balance.

The liberalization of the nancial market has played a major role

in overall nancial policy in recent years. Although the Asian nancial

crisis demonstrated the potential risks associated with such liberaliza-tion, especially for the nancial sector, the Governments longstanding

policy of gradual opening has helped lessen the impact of the crisis.

Having applied for World Trade Organization (WTO) accession, the Gov-

ernment is modifying relevant laws and regulations to meet the

requirements. The foreign ownership ceiling of local companies, for ex-

ample, has been raised to 50 percent and will eventually be lifted all

together. Repatriation of foreign investors principal capital and prots

has also been abolished recently. Other limitations on foreign invest-

ment are also scheduled for change in the near future, such as the securitiesand foreign exchange marketsmaking the local market even more at-

tractive to foreign investors.

The development of a deep and liquid domestic bond market has

been a priority for the Government. The issuance of government bonds

in book-entry form was implemented in September 1997 and has now

become the mainstay of the secondary market. The Government is also

studying various ways to modify the bond settlement/clearing system,

and other issues relating to the development of an ecient bond market,

such as lifting transaction tax on corporate and nancial securities, in-troducing bond futures and options, and enhancing the credit ratings

system by means of qualied credit rating agencies.

Since 1992, the issuance of government bonds has been conducted

using multiple-price sealed-bid auctions, a switch from the original xed-

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price allocation. Short- and medium-term government bonds (two- to

seven-year maturities) were issued in the early stages. In order to spreadout bond redemption dates and extend bond duration, longer-term gov-

ernment bonds were gradually included. The rst 10-year government

bond was issued in 1993, followed by a 15-year tenor in 1994 and a 20-

year tenor in 1998.

Only institutions with government security dealer status are al-

lowed to participate in the primary bond auction. Individuals and other

institutional investors who wish to participate in the primary auction

must do so through qualied dealers. Currently there are 71 government

security dealers in this market, more than twice the number of primarydealers in the US, where the Treasury market is almost 100 times larger.

The outstanding government bonds in the market have a well-spaced

maturity range, providing a good basis for establishing a risk-free benchmark

yield curve. However, inactive secondary market transaction (outright

buy and sell), along with other market impediments, have degraded the

benchmarking function of the government bond yield curve in the market.

Annual trading volume for government bonds in Taipei,China

averages NT$50 trillion (with NT$1.2 trillion outstanding). This seemingly

high turnover rate is enabled by an immensely popular repurchaseagreement (repo) market. In fact, outright trading accounts for less than

10 percent of the total market, with a daily trading volume of less than

2 percent of outstanding volume (compared to nearly 16 percent in Hong

Kong, China). This lack of liquidity can be attributed to a number of

factors, including insucient supply of government bonds, the lack of a

benchmark yield curve, and commercial banks preference to hold bonds

for meeting their reserve requirements.

The unique role of repos in the domestic market is mainly due to

the tax arbitrage incentive. A dierential tax treatment exists betweeninstitutional and individual investors. Individual investors are taxed on

a cash basis, and hence tend to hold bonds between coupon payment

dates and sell them back to securities rms who are taxed on an accrual

basis. Consequently, individual investors essentially receive tax-free income

through repo transactions and security rms obtain low cost of fund to

nance the security purchase. Because of this tax arbitrage in the repo

market, the government bond yield curve is depressed to an estimated

75100 basis points (bps).

The book-entry system was implemented in 1998 for governmentbonds, and these scriptless securities are cleared through a centralized

clearing system under the Central Bank of China (CBC). Currently,

payments are transferred through the CBC Inter-Bank unds Transfer

System (CIS), which works electronically and can be on both a real-time

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Taipei,China 605

and designated-time basis, the latter settled on a net basis at the end of

each business day. To reduce settlement risks and establish a systemwhich conforms to international standards, the CBC is restructuring the

CIS to abolish designated-time settlement and make real-time gross

settlement (RTG) the only settlement mode.

Settlement of government bond transactions occurs within three days

(T+3) of the transaction date. Normally, the seller species the exact

date and place where the settlement and physical delivery of scripts are

to occur. Although funds for repo transactions are transferred through

electronic fund transfer, proceeds for outright transactions are normally

through bank-issued checks drawn on the Bank of Taiwan.The Government provides a favorable regulatory framework for the

development of the domestic debt market. The main regulatory authori-

ties include the CBC, the Ministry of inance (MO), and the Securities

and utures Commissions (SC).

The Government has long recognized the importance of a well-

functioning bond market, and serious eorts have been made to improve

eciency. The introduction of the book-entry system has proved an eective

means of doing this. A bill has also been drafted to exempt the transac-

tion tax on corporate and nancial bonds, to smooth the issuance andcirculation of corporate bonds. However, many impediments still exist,

and require rapid attention.

Besides its low liquidity, another troublesome feature of the do-

mestic bond market is the lack of market depth. Since the main purpose

of government bond issuance is to bridge the gap in budgetary shortfall,

the amount of budget decit dictates the issuing volume. This lack of

issuance regularity increases market uncertainly and causes market par-

ticipants to focus unduly on new issues, heightening market yield sensitivity

to bond auction announcements.Under current tax laws, the calculated taxable coupon income is

based on the coupon rate and face value of the bond, regardless of

whether the bond was purchased at a premium or discount. Consequently,

the taxable basis for discount bond investment will be lower, whereas the

basis for premium bonds is higher, resulting in yield distortion in the

market.

Computer-assisted trading systems for government bonds are avail-

able in both the Taiwan Stock Exchange (TSE) and over-the-counter

(OTC), but daily transactions are still done by telephone. With an increasingnumber of bond dealers in the market, this puts a heavy burden on the

communication system and reduces eciency.

Recommended directions for the establishment of a more ecient

domestic debt market could include (i) the introduction of a regular,

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predictable schedule for oering government bonds; (ii) bond reopening

to increase liquidity; (iii) changing of the bond auction technique to amore ecient single-price auction; (iv) the introduction of forward trad-

ing and bond lending, which could eectively broaden the scope of

delayed-settlement trading, and facilitate risk hedging; (v) trading of

bond futures, which should contribute signicantly to the establishment

of a benchmark yield curve; and (vi) a netting clearing and settlement

system, which could reduce settlement costs, traders reliance on credit

lines, and prevent settlement loop situations.

In addition, removal of dierential treatment of coupon taxation

between individual and institutional investors would eliminate the taxarbitrage in the repo market.

The Government is proposing a new taxation bill to eliminate this

incentive. Care, however, must be taken to reduce the possible negative

impact of new taxation rules on government bonds already outstanding.

It is suggested that the new law is nonretroactive and applicable only to

newly issued bonds to maintain the existing equilibrium in the market.

To eliminate the bias towards premium bonds in the market, since

the calculation of taxable coupon is based on the bond coupon rate,

coupon income can be calculated on a yield basis, i.e., based on thepurchased yield to maturity.

The Government should consider revising the related security trad-

ing laws to encourage when-issued (WI) trading of government bonds,

which provides a price discovery function and valuable risk hedging

functions to government bond dealers entering the auction. Potential

problems associated with WI trading, such as short squeeze, can easily

be prevented through the introduction of careful rules and regulations.

I .iscal Policy and Management

MO enforces national scal policies. It is charged with maintain-

ing a balanced budget, raising funds to meeting the needs of national

economic development, regulating public Treasury systems and super-

vising Treasury administration at all levels of government, adjusting

revenues and expenditures, and securing economic stability through

government debt policy. Its major areas of responsibility include the

National Treasury, customs, insurance, taxation, banking, securities and

futures administration, and management of national property.The Governments guidelines for the formulation and management

of its scal policies include (i) ecient allocation of nancial resources

to support major construction programs; (ii) strict enforcement of bud-

geting and operation of government bonds to establish sound nancial

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Taipei,China 607

status; (iii) improvement of tax structure to promote economic develop-

ment; (iv) improvement of customs and taxation administration to enhanceeciency of collection and provide more convenient services to taxpay-

ers; (v) improvement of nancial and insurance systems to promote

modernization and internationalization; and (vi) strengthening the func-

tion of the capital and money markets to promote economic development.

In the area of Treasury management, emphasis is on coordination

of scal policies to support economic development and strengthening of

public debt management to raise funds for national construction. In the

area of monetary administration, focus is on promoting nancial liberal-

ization and internationalization, as well fullling nancial systematizationand modernization. Appendix 1 details the guidelines for formulation

and management of scal policies.

A Government Revenue

The main source of government income in Taipei,China is taxes

and monopolies, accounting for slightly over 65 percent of total revenue

for all levels of government. In recent years, revenues from government

bonds and loans have increased gradually. The governments emphasison the development of infrastructure and social sectors since 1990 has

increased reliance on proceeds from the issuance of government bonds,

making the development of a deep and liquid domestic bond market a

government priority.

Other sources of income are revenues from the earnings of public

enterprises and loans for economic construction. Table 1 shows the revenue

structure for all levels of government in Taipei,China between scal years

1987 and 1996.

TABLE 1

Share of Government Revenue by Source, 1987 and 1996

(percent)

Source 1987 1996

Taxes and Monopolies 65.2 64.4Earnings of Public Enterprises 14.5 8.1Receipts from Loans for Economic Construction 1.2 4.9Proceeds from Issues of Government Bonds 6.8 8.5

Surplus of Previous iscal Years 0.1 4.2Others 12.2 9.9Total Revenue (in NT$ billion) 6500 1,5650

Source: MO reports.

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B Government Expenditure

At all levels of government, expenditure for national defense, edu-

cation, science, culture, social security and economic development has

accounted for the largest part of total expenditure. The National Six-

Year Infrastructure Plan, which started in the early 1990s, has persistently

pushed forward economic growth in the region. The island-wide high-

speed railway system construction plan, which has a budget of nearly

NT$5 trillion, is expected to help keep economic momentum going for

years to come. In terms of growth trends, expenditure for obligations

and social security have increased enormously in recent years, whileexpenditure for economic development and national defense have declined.

Table 2 compares the expenditure structure for all levels of government

in scal years 1987 and 1996.

TABLE 2

Share of Government Expenditure Structure by Sector, 1987 and 1996

(percent)

Expenditure 1987 1996

Economic Development 25.9 13.2

National Defense 22.5 13.0

Education, Science and Culture 20.2 21.7

Social Security 15.6 25.7

General Administration 10.9 13.0

Obligations 4.1 12.0

Miscellaneous 0.8 1.6Total Expenditure (in NT$ billion) 6621 1,8974

Source: MO reports.

Since 1989, the decit increased due to expenditure on reserve

land for local government public facilities, as well as the promotion of

major public construction projects, but the gap narrowed in recent years,

with a balanced budget attained in 1998.

C .inancing of .iscal Decits

The Government has switched from its traditional goal of main-taining a scal surplus to focus more on infrastructure development.

Consequently, there is a decit scal policy, which entails a signicant

increase in the issuance of government bonds in order to fund a series of

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Taipei,China 609

.IGURE 1

Governments Revenue and Expenditureas a Percentage of GDP, 1999

17

16

15

14

13

12

11

1091 92 93 94 95 96 97 98 99

18

Percent

Year

Revenue/GDP Expenditure/GDP

Source: Statistical Releases, MO.

.IGURE 2

Government Borrowings as a Percentage of

Total Expenditure, 1999

30

25

20

15

10

5

0

91 92 93 94 95 96 97 98 99

35

Percent

Year

Source: Statistical Releases, MO.

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expansionary scal policies, such as the National Development Plan

initiated in early 1990s.The CBC acts as the scal agent for the Government, and is re-

sponsible for conducting the issuance of government bonds. Since the

main purpose of government bond issuance is to obtain necessary fund-

ing for national development, this is mainly done on a need basis.

Consequently, the issuing authorities do not observe a regular calendar

of bond issuance, as is done in the US. The abolition of the provincial

government (to streamline governmental structure) in 1999, however, sig-

nicantly increased the Governments funding needs for the following

year, providing room for more regular debt issuance. However, currentbudgetary laws place a limit on government borrowing and total amount

of debt outstanding.

Meanwhile, to promote economic development through productive

facilities and techniques from abroad, the Government has established

nancing arrangements with foreign governments, nancing institutions,

and suppliers. The major components of this outstanding external public

debt include electric power development (30 percent) and communica-

tion and transportation facilities (51 percent), while items such as water

supply and general economic development projects account for the bal-ance. Over the past years, however, the amount of external public debt

has decreased steadily, from more than US$1.8 billion in 1987 to less

than US$60 million in 1999. Table 3 shows the amount of external

public debt over time and the debt-service ratio, which is the percentage

of external debt over total export of goods and services in the same

year.

TABLE 3

External Public Debt and DebtService Ratio(US$ million)

1991 1992 1993 1994 1995 1996 1997 1998 1999

Amount 713 455 395 360 305 165 106 55 5 9Debt-Service ratio (%) 0.3 0.3 0.1 0.1 0.1 0 .11 0.04 0.04 0.01

Source: Central Bank of China reports.

D Special Issues

Tax Relief To promote economic development and encourage exports, the

Government has reduced part of the tax revenue by granting tax exemp-

tions and rebates (Table 4).

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Taipei,China 611

TABLE 4

Tax Relief as a Percentage of Tax Revenue

Tax Reduction/Exemption Tax Rebate for Export Total Tax Relief

1990 5 . 6 0 . 7 6 . 31991 5 . 2 0 . 6 5 . 81992 4 . 2 0 . 4 4 . 61993 3 . 4 0 . 4 3 . 81994 2 . 1 0 . 3 2 . 41995 1 . 5 0 . 3 1 . 81996 1 . 4 0 . 4 1 . 81997 2 . 4 0 . 4 2 . 8

1998 3 . 0 0 . 3 3 . 3

Source: MO reports.

To accelerate industrial development and better accommodate

domestic supply and demand, the Government adjusts tari rates on

daily necessities and industrial raw materials. These measures have con-

tributed to domestic price stability, economic development, and industrial

competitiveness. or implementation of policy on economic internation-

alization and trade liberalization, the Government sets the target of the

average eective rate to be comparable to that in industrialized coun-tries. The average rate and the average eective rate of tari fell from

9.65 percent and 5.4 percent in 1990 to 8.25 percent and 3.13 percent

in 1998, respectively, after tari reduction programs were enforced.

Development .und To upgrade the industrial structure of the nation,

the Executive Yuan (executive branch of the government) established a

so-called Development und in 1973. The purposes of this fund include

(i) investing in, or providing loans to, important enterprises or plans

relating to industrial structure upgrading; (ii) providing loans in linewith government industrial policy for assisting the sound development

of industries; (iii) providing necessary assistance to the development of

small and/or medium enterprises by setting aside an appropriate percent-

age of the Development und as support; and (iv) taking coordinated

action for the furtherance of plans initiated by competent authorities

concerned with the provision of advanced training to personnel, pollu-

tion control, acceleration of improvement of industrial structure and/or

improvement of economic development.

Since the introduction of the fund, various investments and loanshave been made to dierent industries, including information, semiconductor,

and biotechnical, to name a few. Total funding provided up to 1998 in-

cluded NT$29.47 billion for investment and NT$57.78 billion for loans.

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E Liberalization and World Trade Organization Accession

The liberalization of the nancial market has also been a major

part of overall nancial policy. The Asian nancial crisis showed that

liberalization involves potential risks for the nancial sector. The

Governments longstanding policy of gradual opening, however, has helped

to lessen the impact of the crisis on Taipei,China. In applying for WTO

accession, the Government is modifying all relevant laws and regula-

tions to meet requirements. or example, the foreign ownership ceiling

of local companies has been raised to 50 percent and will eventually be

lifted, and repatriation of foreign investors principal capital and protshave been abolished recently. Other limits on foreign investment are

also scheduled for change in the near future, for example in the securi-

ties and forex markets, making the local market even more attractive to

foreign investors.

II Monetary Policy and Management

The CBC is the highest monetary authority in Taipei,China and

has completely independent control over monetary policies. It has longbeen committed to maintaining economic and nancial stability in the

region to create a conducive environment for continued economic growth,

and Taipei,China has enjoyed sustained economic growth and low ina-

tion over recent decades. The annual growth rate of GDP has long been

kept in double digits, and fell to around 8 percent only in recent years.

The growth rate of consumer prices, on the other hand, has been kept

below 4 percent (igure 3).

Major operations of the CBC include regulating the nations nan-

cial conditions, implementing foreign exchange regulations and operations,examining nancial institutions, issuing currency, providing check clearing

and check credit information services, performing scal agency func-

tions for the Government, and representing the Government in international

nancial cooperation.

A Monetary Policy Tools

The CBCs main policy instruments include open market opera-

tions (OMOs), rediscounts and temporary accommodation facilities, reserverequirements, nancial institution redeposits, and selective credit con-

trols. As in many countries, OMOs are the most important and exible

monetary policy tools. The CBCs OMO Division is responsible for the

day-to-day ow of funds in the money market. It issues negotiable

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Taipei,China 613

certicates of deposits (NCDs) to adjust liquidity in the market and pro-

vide liquidity through repo transactions, in which government bonds are

the main instruments.

The CBC implements its discount policy mainly through accom-

modation against secured loans to banks. The interest rate on these

accommodations with collateral was at 4.88 percent in 1999, relative to

4.77 percent in the call loan market. The CBC discount window divi-

sion establishes the rediscount rate and serves as a source of funds by

buying commercial paper from the market. The current rediscount rate isat 4.5 percent. Liquidity in the market may also be regulated by the

CBC, through the acceptance or release of redeposits from banks and

the postal savings system (PSS). The PSS accepts deposits from the gen-

eral public but cannot make loans. It therefore places its deposits with

the CBC and other banks, or invests in highly liquid nancial assets.

Since nancial institutions redeposits accounted for nearly 70 percent

of the reserve money in 1999 (85 percent in 1998), the redeposit policy

has been a powerful monetary tool for the CBC.

The reserve requirements for various deposit accounts have beenadjusted downward in the past, and more frequently in recent years,

having been lowered on ten occasions since 1996. The weighted-aver-

age required reserve ratio has decreased from 16.2 percent in 1989 to

less then 8 percent at present. Lower interest rates have reduced the cost

.IGURE 3

Annual Growth Rate of GDP and Consumer Prices

6

7

8

5

4

3

2

1

0919089 92 93 94 95 96 97 98

9

Percent

Year

GDP Consumer Price

Source: Central Bank of China .inancial Statistics Monthly.

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of capital for domestic rms and improved the competitiveness of do-

mestic banks.The CBC adopts an intermediate targeting strategy and uses the

monetary aggregate M2 for its target variable. To ensure transparency

and conform to its commitment to price stability, the CBC announces at

the beginning of each year a target range for the growth rate of M2 The

range of 1015 percent was set between 1990 and 1995, 914 percent for

1996 and 1997, and 612 percent in 1998. or the scal year 19992000,

the target was set between 611 percent. The average growth rate of M2

has usually been kept within the range (igure 4).

.IGURE 4

Annual Growth Rate of M2 and Key Interest Rates

12

14

16

10

8

6

4

2

093 94 95 96 97 98 99

18

Percent

Year

M2 Rediscount Prime Interbank

Source: Central Bank of China .inancial Statistics Monthly.

B .oreign Exchange Rate Policy

Taipei,China has adopted a oating exchange rate regime since

1979. The New Taiwan (NT) dollar oats freely against all other curren-cies, and exchange rates are determined by the market. CBC intervenes

only to smooth out seasonal and irregular factors. Aiming to promote

Taipei,China as a regional nancial center, CBC has adopted a series of

measures to gradually remove controls over the exchange rate. Increased

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Taipei,China 615

capital movements and the move toward more exible exchange rate

arrangements have increased the volatility of the exchange rate. Sincethe NT$ exchange rate is mostly determined by balance of payments,

monetary policy has a relatively limited inuence here.

C Impact of Liberalization on Bond Market Development

Measures to speed up the pace of nancial liberalization in the dom-

estic market have stemmed from the signicant increase in economic

activities over the past decades. These measures, such as the liberaliza-

tion of interest rates, relaxation of foreign exchange controls and capitalmovements, and reforms in nancial markets, have encouraged issuance

of market instruments by domestic enterprises, which have traditionally

relied more on bank loans as their main source of nancing.

III Overview of the Bond Market

The government bond market in Taipei,China rst appeared in 1949,

when the central government issued the so-called patriot bond to -

nance defense expenditure. Secondary market trading for governmentbonds was nearly nonexistent in the early days. In 1962, with the estab-

lishment of the Taiwan Stock Exchange (TSE), government bonds began

to be exchange-traded, but their liquidity was very low. By 1971, the

Government Bond Dealers Association ushered in OTC trading for gov-

ernment bonds and established the so-called two-tier (exchange and OTC)

trading system. With only a short period of interruption, this two-tier

trading system is still the one used in the market today.

Taipei,China is a good example of how a government bond market

can be made to develop in a short time. In order to maintain a healthyscal position, investments in infrastructure and the social sectors were

limited until the late 1980s. When the central Government embarked on

the National Six-Year Infrastructure Plan in early 1990s, it changed its

scal policy to focus more on the issuance of government bonds as an

alternative funding source, and consequently stimulated the growth of

the government bond market (igure 5).

The outstanding volume of government bonds in 1987 was only

NT$131 billion, remaining around NT$200 billion until 1991, but by

1999 had swollen almost 10 times, surpassing NT$1.2 trillion (US$38billion) (igure 6). This upward trend of borrowing is expected to con-

tinue for at least the near future, since more than NT$400 billion in

bond issuance is already slated for the coming year. Additional borrowing

is also required to cover funding needs due to the damage done by

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recent major earthquakes that hit the center and south of the island. As

a percentage of GDP, the amount of government bonds outstanding iscurrently at 14 percent (igure 7), compared to nearly 60 percent in the

US, 110 percent in Japan, 97 percent in Singapore, and 30 percent in

Hong Kong, China. This indicates that the government bond market in

Taipei,China still has plenty of room for further development. However,

current budgetary laws put a cap on the maximum size of government

borrowing and total amount of debt outstanding.

Meanwhile, CBC and MO have introduced a series of fundamen-

tal reforms that have signicantly opened up the market and improved its

liquidity. or example, the government bond issuance procedure has beenchanged from the previous xed-price allocation system to an auction-

based system. Up to November 1999, the new issue volume of government

bonds for scal year 2000 (July 1999December 2000) had reached more

than NT$140 billion.

Overall, government bonds dominate the domestic debt market with

more than 70 percent of the market share, while corporate bonds ac-

count for a quarter of the market, with foreign bonds and nancial

debentures making up the remainder.

However, the corporate bond market has gained rapid momentum

.IGURE 5

New Issue Volume of Domestic Market Debts

(NT$ billion)

300

250

200

150

100

50

09291 93 94 95 96 97 98 99

Year

NT$

billion

Government Corporate Foreign

Source: Bond Market Database, Grand Cathay Securities Corporation.

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Taipei,China 617

.IGURE 6

Outstanding Volume of Government Bonds(NT$ billion)

1,600

1,400

1,200

1,000

800

600

200

400

09291908988 93 94 95 96 97 98 99 00

Year

NT

$

billion

Source: Bond Market Database, Grand Cathay Securities Company.

.IGURE 7

Government Bonds Outstanding as a Percentage of GDP

20

18

16

14

12

10

9291 93 94 95 96 97 98 99

Year

Percen

t

Source: Statistical Release from the Central Bank of China.

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over the past decade, becoming an important funding source for corporations.

While both government and corporations are seeking low cost fundsin the nancial market, the potential crowding-out eect becomes trouble-

some. urthermore, some regulations, such as the imposition of transaction

tax on corporate bonds, have put private debt issues at a disadvantage

when competing with government bonds. Although the size of the govern-

ment bond market in Taipei,China overshadows its corporate counterpart,

the balanced development of both deserves serious attention.

or the most part, public and private bond markets can function

complementarily. A well-functioning government bond market can be of

great value to the healthy development of the corporate bond market.The creation of a risk-free benchmark yield curve, for example, should

facilitate the pricing and valuation of corporate bonds. Unfortunately,

such a benchmark yield curve is not yet well-established in the domes-

tic market.

Since 1998, all new issues of government bonds in Taipei,China

have been switched to the book-entry system, which greatly improves

the markets operational eciency. Still, many obstacles, such as ine-

ciency in clearing and settlement, need to be overcome. Recent proposals

to alter the longstanding tax treatment on coupon income have raisedconcerns and increased uncertainty in the market. The primary dealer

system, which is of critical importance to a well-functioning government

bond market, also deserves close scrutiny.

A Secondary Market for Government Bonds

On the surface, the secondary market trading of government bonds

appears well-established, with annual trading volume at around NT$50

trillion (or slightly more than NT$1 trillion per outstanding volume).However, this high turnover rate is enabled by an immensely popular

repo market. Outright trading (i.e., buy and sell) of government bonds

accounts for less than 15 percent of total transactions, with daily trading

volumes less than 2 percent of outstanding volume (compared to nearly

6 percent in Hong Kong, China and 3 percent in Singapore for example).

Consequently, liquidity (as measured by the outright transaction) of govern-

ment bonds in the domestic market is rather limited.

Lack of liquidity can be attributed to insucient supply of gov-

ernment bonds, the lack of a benchmark yield curve, and the fact thatmajor investors (e.g., banks) tend to hold government bonds to meet

reserve requirements.

The main purpose of government bond issuance in Taipei,China is

to bridge the gap in the budgetary shortfall. The amount of budget

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Taipei,China 619

decit, therefore, dictates the issuing volume. While additional capital

expenditure for infrastructure development in the early 1990s resulted inan annual issuance volume of over NT$200 billion, the call for a bal-

anced budget and statutory limits on government bond issuance kept

the annual issuance amount to less than NT$150 billion, except in 1997.

To most investors in Taipei,China, such uncertain supply of government

bonds signals scarcity, and fosters a tendency to hold onto them.

urthermore, holders of government bonds can easily obtain short-

term liquidity from the well-developed repo market, which further

exacerbates the situation of inadequate trading in the market.

B Corporate Market and .inancing Behavior

The rst issue of corporate bonds was in 1958, when TaTung Steel

Corp. oated a NT$15 million straight debt. Strict issuing requirements,

along with other impediments in the market, however, discouraged pri-

vate enterprises from tapping this funding source. Instead, they relied

more on bank loans as a source of funds. This situation started to change

in the early 1990s, following a series of eorts by the Government to

liberalize the nancial market. The rapid growth of the economy, a fa-vorable interest rate environment, and strong investor demand, have resulted

in rms aggressively tapping the corporate bond market. Although small

when compared with its government counterpart, the corporate bond market

in Taipei,China has seen tremendous growth in recent years. The amount

of new issue corporate bonds took a major step forward in 1994, and

even surpassed the issue volume of government bonds in 1998, with the

outstanding volume more than NT$450 billion (US$15 billion) by the

end of 1999.

With an increasing number of borrowers and more complex bonddesigns, an issuers credit risk becomes dicult to measure, however, seriously

aecting the eciency of both the primary and secondary bond markets.

A crucial requirement in the development of corporate bond mar-

ket in Taipei,China, therefore, is the establishment of credit rating system.

C Types of Securities

Government Securities Government bonds can be grouped into four

major categories: (i) infrastructure, (ii) reconstruction, (iii) highwayconstruction, and (iv) provincial construction. The rst two categories

accounted for more than 95 percent of the total issue outstanding in

July 1999.

The majority of government bonds are coupon securities, which pay

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interest either annually or semi-annually. Two issues of discount (zero-coupon)

bonds of three-year tenor each were marketed in 1995, but with lacklustermarket acceptance. No future issue of zero-coupon bonds is planned at the

moment.

Table 5 shows the maturity breakdown of new issue government

bonds since 1991. Short- and medium-term government bonds (two- to

seven-years) were issued in the early 1990s, and in an eort to spread

out bond redemption dates and extend bond duration, longer-term gov-

ernment bonds were gradually included, with the rst 10-year government

bond introduced in 1993, followed by the 15-year tenor in 1994. To

extend the Treasury yield curve even further, 20-year government bondsbegan to appear in the market in 1998. It should be noted that the

Government does not nance across the yield curve on a regular basis

and the market lacks on-the-run issues for key tenor segments.

TABLE 5

Breakdown by Tenor of New Issue Government Bonds

(NT$ billion)

Year 2-Year 4-Year 5-Year 7-Year 10-Year 15-Year 20-Year Total

1991 20 40 64.5 8 0 204.51992 20 95.0 1 2 0 235.01993 8 3 60.0 143.01994 5 5 45.0 2 0 120.01995 3 0 25.0 4 5 100.01996 3 5 110.0 1 0 0 245.01997 30.0 3 0 30.0 6 0 150.01998 30.0 92.9 122.91999 30.0 30.9 8 0 140.9Total 20 60 219.5 433 330.9 305 92.9 1,491.0


igure 8 displays the maturity breakdown of outstanding govern-

ment bonds in the market. The well-spaced maturity range provides a

good basis for establishing a risk-free benchmark yield curve. However,

lack of liquidity in the market, along with other factors, makes pros-

pects for a benchmark yield curve unhopeful.

or short-term funding needs, MO also issues Treasury bills through

the CBC. These securities have tenors of less than one year and are sold

on a discount basis. Maturities of three months, six months and 270days are auctioned.

.oreign Bonds and .inancial Debentures The market for foreign bonds

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Taipei,China 621

is just taking shape, its total volume reaching over NT$80 billion (US$2.5billion) in 1999.

Several supranational borrowers have tapped the domestic bond

market in recent years and spearheaded the capitalization of funding

opportunities. ADB has been the leader in foreign bond issuance in

Taipei,China with a series of Dragon Bond (denominated in US$ and

Japanese yen) in the early 1990s. Since 1995, ADB and other supra-

nationals, including the Central American Bank for Economic Integration

(CABEI), EBRD, Nordic Investment Bank (NIB), Inter-American

Development Bank (IADB) and Council of Europe (COE), have all issuedNT$ bonds in the local market. New issue volume of these foreign bonds

has increased steadily since 1995 and surpassed NT$30 billion in 1998.

So far, there has been no issuance of NT$ bonds in the domestic market

by foreign corporations.

inancial debentures are issued by special-purpose banks to meet

short- to medium-term funding needs. With a limited number of eligible

issuers, these securities have never played any major role in the local

debt market. The nancial debenture has maintained a stable outstand-

ing amount below NT$100 billion over the years.igure 9 shows how the size of the government bond market has

expanded signicantly from 1992. The outstanding volume of government

bonds in 1987 was only NT$131, but had swollen almost 10 times to

NT$1.2 trillion (US$38 billion) by 1999. The outstanding volume of

.IGURE 8

Breakdown by Tenor of Outstanding Government Bonds, 1999(percent of total volume outstanding)

< 1 year

10%

< 15 years

8%

< 13 years

17%

35 years12%

57 years19%

710 years

12%

1015 years

22%


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corporate bonds in Taipei,China had surpassed NT$450 billion (US$15

billion) in the same period. The market for foreign bonds was only just

starting to take shape, however, with total volume reaching more than

NT$80 billion (US$2.5 billion). The nancial debenture has maintained

a stable outstanding amount below NT$100 billion over the years. Over-

all, government bonds dominate the domestic debt market, with over 70

percent of the market share, while corporate bonds account for a quarter

of the market and the other two types the remainder.

D Investor Base

Commercial banks such as the Bank of Taiwan, Taiwan Coopera-

tive Bank, irst Commercial Bank, Hua-Nan Commercial Bank, and Chang

Haw Commercial Bank are traditionally the major investors in govern-

ment bonds in the domestic market, holding more than half of all

outstanding issues. Other big investors are insurance rms and postal

services. These savings institutions hold government bonds mainly tomeet reserve requirements, and therefore have little incentive to trade in

the secondary market. In the secondary market, securities rms and bill

nance companies are the major players, but their trading is limited to a

few on-the-run issues, while a high liquidity premium is often imposed

.IGURE 9

Outstanding Volume of Domestic Market Debt(NT$ billion)

1,600

1,400

1,200

1,000

800

600

400

200

091 92 93 94 95 96 97 98 99 00

Year

NT$

billion

Government Foreign Financial Corporate


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Taipei,China 623

on o-the-run issues. This lack of liquidity hinders the price formation

process for government bonds in Taipei,China.This means, if commercial banks win a larger portion in a newly

auctioned issue, that particular issue is unlikely to have an active sec-

ond market. On the other hand, benchmark issues in the market are

usually the ones where security rms and bill nance companies have

won most of the bids in the auction.

Individual investors gure largely in the repo market, or through

the Postal Savings System, but rarely participate in outright purchase or

sale activities. Institutional investors such as government pension funds,

retirement funds, and insurance companies do not play an active role inthe government bond market. This can be attributed to the relatively

low yield provided by government bonds, which are essentially quasi

tax-free instruments in the domestic market. Since these institutional

investors are tax-exempt entities, they can obtain better returns simply

by putting their investment dollars in time deposits.

Bond funds are becoming a major player in the capital market, ac-

counting for well over NT$1.5 trillion in capital. However, unlike their

counterparts in other countries, most bond funds put a large share of their

investment dollars into time deposits and repos. Consequently, the per-centage of outright government bond investment is very low. Contributing

to this investment behavior is the fact that, to facilitate the required daily

calculation of their net asset value (NAV), bond funds must mark to mar-

ket their investment assets. Inactive trading on most o-the-run government

bonds, however, fails to provide readily available benchmark prices, thus

making daily marking-to-market operations questionable. This results in

bond funds not being willing to play a serious investment role, further

reducing the liquidity of government bonds.

IV Bond Market Infrastructure

A Primary Dealer System

Only institutions with government security dealer or primary dealer

(PD) status, awarded by the Treasury Department of the CBC, are al-

lowed to participate in the primary bond auction. To become a government

securities dealer, institutions (banks, bill nance companies, or integrated

security rms) must rst be qualied by meeting the minimum capital ornet worth level and other requirements. These dealers are expected to

actively participate in every government bond auction, and to provide

two-way quotations to ensure liquidity in the secondary market.

Dealers who do not abide by the rules, or who make bid/ask quotations

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that are obviously out of line with the market, can have their dealer

status revoked by CBC. Since the inception of the government bonddealers system in 1980, however, no dealership status has been revoked.

In fact, the number of dealers has increased from less than 20 to 71 in

1999, more than twice the number of PDs in the US, where the Treasury

market is of much greater size.

Individuals and other institutional investors who wish to par-

ticipate in the primary auction must do so through qualied dealers.

Each dealer can submit 10 competitive bids and one noncompetitive

bid. To ensure reasonable distribution of auctioned bonds in the market;

the total amount of new issue awarded to each government securitydealer cannot exceed a preset level, usually at 30 percent of the auction

amount.

B Issuance Methods and Procedures

In 1991, the issuance procedure for government bonds was switched

from the previous xed-price allocation system to the auction system.

The new issue auction size of government bonds ranges from NT$10

billion to NT$50 billion, with NT$30 billion as the norm.Competitive bids are submitted on a price basis, while noncom-

petitive tenders are based on quantity rather than price. Unlike in the

US, where all noncompetitive bids are satised before allocating the rest

to competitive bids, the amount of competitive and noncompetitive al-

location is determined before the auction. A 70/30 allocation is usually

observed for competitive and noncompetitive bids, respectively.

The competitive bidding system used in the auction is the so-

called multiple-price auction system, in which the highest price bidders

are awarded securities at their bid price rst, then lower price bidders aresuccessively awarded securities at their bid price, until the total amount

of competitive allocation is awarded. A single-price auction system (or

the Dutch auction) was used briey in 1995, when the Government is-

sued zero-coupon bonds. The temporary switch to the Dutch auction

method was to ensure that all zeros were awarded at the same price to

facilitate capital gains calculation at the time of bond redemption.

With the implementation of the book-entry system for government

bonds in 1998, competitive bids are now submitted on a yield basis,

and bids are specied to three decimal places.Because the issuance of government bonds in Taipei,China is still

done on a need basis, and there is no preset schedule for the bond

issuance, Treasury securities are not oered at regular cycles, although

eorts have been made to ensure bond oerings at xed intervals. The

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Taipei,China 625

maturity and size of each oer is usually determined and announced two

weeks prior to the auction.This lack of issuance regularity increases market uncertainty and

causes market participants to pay undue attention to new issues, height-

ening market yield sensitivity to bond auction announcements.

C Size, Coupon and Interest Payments

The average size of each government bond auction is around NT$30

billion, regardless of bond maturity. Smaller auction sizes in the past

have resulted in bond issues suering from liquidity problems in thesecondary market.

Until recently, the coupon rate on new issue government bonds

was determined prior to the auction. This was necessary because bond

certicates need to be prepared ahead of time so that delivery can be

made soon after the auction. Since coupon rates were set slightly higher

than the going market rates, government bonds were normally issued at

a premium. With the adoption of the book-entry system in 1998, bond

certicates were no longer required. The bond coupon rate is now deter-

mined at the time of auction, based on average auction rates. Specically,fractions of a percentage point are quoted in eighths, and the bond

coupon is set at the closest (but not over) rate fraction level. or example,

if the average auction rate is 6.34 percent, then the coupon rate will be

set at 6.25 percent, not 6.38 percent. With this coupon-setting convention,

new issue government bonds since 1998 are all sold with a slight discount.

Coupon payments on most government bonds are made twice a

year, but the current trend has been to cut down the payment frequency

to once a year, while maintaining the semi-annual compounding prac-

tice. In fact, all new bond issues since 1996 have adopted the annualinterest payment schedule. Appendix 2 provides the government bond

auction results from the second half of 1995 to the end of 1999. As can

be seen, the weighted average yields on the new bond issue were lower

than the bond coupon for issues before September 1997, indicating that

government bonds were all sold at a premium. With the introduction of

the book-entry system after September 1997, bond auctions were con-

ducted on a yield basis and coupon rates were set based on the winning

bid yields. Hence, the coupon rates were in line with market interest rate

levels. Appendix 3, on the other hand, shows the auction results of T-billsfrom December 1995 to December 1999. These bill issues have various

maturities, from as short as 56 days to almost seven months, and issue

sizes range from NT$5 billion to NT$30 billion.

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D When-Issued Trading

In most countries, WI trading of government bonds constitutes an

integral, and sometimes indispensable, part of the bond auction process,

as it can lessen the uncertainty surrounding Treasury auctions. Under

current security transaction regulations in Taipei,China, however, WI trading

is not technically permitted in the domestic market, meaning the market

cannot benet from these trading activities.

WI trading of government bonds did appear among government

bond dealers in 1993, however, despite being strictly speaking at odds

with the existing security trading laws. Allowing bond dealers to takeviews on the upcoming auction, it provides risk hedging and price dis-

covery functions (bond futures are not yet available in Taipei,China).

WI trading starts soon after a new issue of bond auction is announced

and lasts until the auction day. A WI bond is quoted on yield basis

between new issue announcement and bond auction, since traders do

not know the coupon rate. So far, only major government bond dealers

participate in the WI market, and the trading volume is relatively low,

averaging less than 5 percent of the auction amount.

E Secondary Trading Systems

Government bonds are cross-listed on the TSE and OTC market,

although almost all trading activity occurs OTC. igure 10 shows the

annual turnover of government bonds.

Trading hours are Monday to riday, from 0900 to 1500 hours, but

most trading occurs in the morning session. Two-way quotations are

provided by active traders and can be found on the Reuters screen.

Quotations, made on a yield basis, are for a single transaction with anominal principal value of NT$50 million. Trading amounts other than

NT$50 million require price negotiation. The bid/oer spread for gov-

ernment bonds is typically in the range of 510 bps.

Computer-assisted trading systems for government bonds are avail-

able in both the TSE and OTC, but neither has successfully fullled the

purposes they were designed for. Daily transactions are still done by

telephone. With an increasing number of bond dealers in the market,

this puts a heavy burden on the communication system and reduces

trading eciency, especially when dealers need to cut or build a largeposition. Another disadvantage of negotiated trading practices is that

price quotations and details of a matched deal cannot be revealed in

good time, thus reducing price transparency in the market (several major

bond dealers now do post bid/ask quotations on the Reuters system).

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Taipei,China 627

. Repo Market

Government bonds are used predominantly in the repo market for

at least two reasons. irst, they account for well over 70 percent of the

outstanding volume of the straight bond market and second, corporate

bond trading incurs a 0.1 percent transaction tax, which discourages

trading. Supranational foreign bonds although, like government bonds,

exempt from transaction tax, are held mostly by long-term investors and

seldom traded in the market. Insucient supply of government bondshas been blamed for the lack of outright trading activities. Investors in

government bonds tend not to sell the bond outright since the repo

market can provide sucient short-term liquidity in case of need.

Meanwhile, the dierential tax treatment between institutions and

individuals means individual investors, who are taxed on a cash basis,

can hold bonds between coupon payment dates and sell them back to

securities rms, who are charged on an accrual basis, and thus hold the

bonds on the coupon payment date. Consequently, individual investors

essentially receive tax-free income through repo transactions, while securityrms obtain low cost of funds to nance the security purchase. This

depresses the government bond yield curve to an estimated 75100 bps.

.IGURE 10

Annual Turnover of Government Bonds(NT$ billion)

70,000

60,000

50,000

40,000

30,000

20,000

10,000

089 90 91 92 93 94 95 96 97 98 99

NT$

billion

Year


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Market Participants Major participants in the repo market are securities

rms, accounting for about 60 percent of transactions. Bill nancecompanies are a distant second, taking up about 23 percent of the market

share, and banks and other institutions account for the rest. There are

about 20 active traders in the market and approximately 80 percent of

the total trading volume is handled by the top ve market makers, Grand

Cathay Securities Corp., President Securities Corp., China Bills inance

Corp., Chinatrust Commercial Banks, and Capital Securities Corp.

G Other Aspects

1 Benchmark Yield Curve

The outstanding amount of government bonds in the domestic market

has reached more than NT$1.2 trillion, with tenors spread evenly across the

maturity spectrum. With active trading of the outstanding volume, a bench-

mark yield curve could easily be established. However, the quality of govern-

ment bond yield curve in the domestic market leaves a lot to be desired.

The new issue auction size of government bonds ranges from NT$10

billion to NT$50 billion, with NT$30 billion as the norm. However,when commercial banks win the majority of a new issue in an auction,

they tend to hold the bonds for reserve requirements, and the remaining

outstanding volume becomes too small to support a liquid market. With

a small outstanding volume, price manipulation becomes more likely

and market yields lose their benchmarking role.

Another problem is the excess yield spread between on- and o-

the-run issues. This can sometimes be quite signicant; 25 bps or even

higher is not uncommon, whereas 1015 bps is normally observed in

other markets. Since building a complete benchmark yield curve requiresyield information on both on- and o-the-run issues, large yield spreads

make constructing a smooth curve more dicult, consequently reducing

its benchmarking function in the market.

2 Tax Treatment

Trading of government bonds in the secondary market is exempt

from taxation, whereas corporate bonds and other nancial debentures

are subject to a transaction tax of 0.1 percent, whether outright buyingor selling, or a repo transaction. This dierential tax treatment puts cor-

porate bonds at a disadvantage, since the transaction tax deters secondary

market activities. Supranational foreign bonds are largely free of transaction

tax, but this privilege is granted on a case-by-case basis.

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Taipei,China 629

Tax inequality breeds arbitrage activities, which in turn create price

distortions in the market. However, MO has drafted a bill to exemptcorporate and nancial bonds from transaction tax, in order to smooth

the issuance and circulation of corporate bonds, as well as to stimulate

medium to long-term funding for the private sector.

urther distortion is created in yield through current tax laws, which

require the calculation of the amount of taxable coupon income from

bond investment to be based on the coupon rate and the face value of

the bond, regardless of whether the bond was purchased at a premium or

discount. Consequently, the taxable basis for discount bonds investment

is higher, whereas the basis for premium bonds is lower.Coupon income for individual investors is taxed on a cash basis,

i.e., taxable in the year when coupon payments are actually received.

or institutional investors, on the other hand, it is based on an accrual

basis, i.e., based on the coupon income earned during the holding pe-

riod in a taxable year. This creates an incentive for tax arbitrage, in

which individuals sell bonds to institutional investors such as brokerage

houses right before the coupon day and repurchase them right after. In

this way, individuals incur no coupon income, and institutional inves-

tors pay taxes only on the coupon earned during the interim holdingperiod. This explains the uniquely high volume of repo transactions in

the domestic bond market, and also results in depressed yields in gov-

ernment bonds, since they are practically tax-free for individual investors.

3 Credit Ranking

Until recently, investors in the domestic market have largely based

their bond investment decisions on subjective criteria, such as a borrowers

name and reputation. With an increasing number of borrowers and morecomplex bond designs, an issuers credit risk becomes dicult to mea-

sure. Practitioners have long raised concerns about credit spread in the

domestic market being distorted, which seriously aects the eciency

of both the primary and secondary bond markets.

A major step forward in the development of the corporate bond

market is thus the establishment of credit rating system. Taiwan Rating

Corporation (TRC) was established in 1997 and is the islands rst credit

rating service. The company is a joint venture between Standard & Poors

and a number of domestic institutions led by TSE. The rating agencyprovides credit ratings to the domestic market so that investors, lenders,

and other interested parties can gain clear benchmarks to judge credit

strength. Currently, all issuers of nonguaranteed bonds must obtain

credit ratings before issuance. inancial guarantors such as banks must

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also obtain credit ratings before providing such a service. Bond funds

are required to invest in nancial institutions with a minimum level ofcredit ratings.

4 Clearing and Settlement

Settlement of government bond transactions occurs within three

days after the transaction date. Normally, the seller species the exact

date and place where the settlement and physical delivery of scripts are

to occur. Although funds for repo transactions are transferred through

electronic funds transfer, proceeds for outright transactions are normallythrough bank-issued checks drawn on the Bank of Taiwan. In fact, the

Bank of Taiwan has become a de facto standard as a settlement interme-

diary due to its popular use by market participants in the domestic market.

With the book-entry system implemented in 1998 by the Taiwan

Securities Central Depository (TSCD), a centralized system under CBC,

scriptless securities are now cleared through more than 10 clearing banks

as part of the clearing framework. Currently, payments are transferred

through the CIS which works electronically, and can be on either a

real-time or designated-time basis, the latter settled on a net basis at theend of each business day. To reduce settlement risks and establish sys-

tems that meet international standards, CBC is restructuring the CIS to

abolish designated-time settlement and make RTGS the only settlement

mode. In the near future, RTGS will also provide the framework for

merging the Book-Entry Central Government Bonds System (BECGBS)

with the delivery versus payment system (DvP).

V Regulatory Structure

The Government provides a favorable regulatory framework for the

development of the domestic debt market. The main regulatory authori-

ties include CBC, MO, and SC, which oversee market participants

who trade in government bonds.

The issuance of public debt, including government bonds and bills,

is governed by the Codes of Public Debt. The total amount of public

debt for all levels of government cannot exceed 48 percent of average

nominal GNP of the previous three years. This puts an upper limit on

the amount of government bonds that can be issued in any given year.To provide adjustment for treasury ow of funds, the Government can

issue T-bills with a maturity of less than 364 days. The amount of out-

standing bills, however, cannot exceed 50 percent of the central

Government annual budget for the scal year.

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Taipei,China 631

CBC imposes reserve requirements on deposits and other liabilities

of commercial banks that are regulated by the Banking Law of the Re-public of China. There are maximum limits for the reserve ratio for various

deposit accounts, within which CBC can make necessary adjustments.

CBC can also keep reserves for indemnity deposited by investment and

trust companies. Since government bonds are generally used to meet

liquid reserve requirements, they are in high demand by these institu-

tions, and commercial banks are the major (and long-term) holders of

government bonds in the domestic market. Appendix 4 shows the trend

of required reserve ratios set by CBC for various accounts.

Participants of primary auctions of government bonds are restrictedto PDs, who must apply and be awarded such status by the Treasury

Department of CBC. Government bond dealers must participate in every

government bond auction, make reasonable bids in the auction based on

the then market conditions, and provide two-way quotations in the sec-

ondary market. Dealers who do not abide by the rules, or who make bid/

ask quotations that are obviously out of line with the market, can have

their dealer status revoked by CBC. Since the inception of the govern-

ment bond dealers system in 1980, however, no dealership status has

been revoked, and the number of dealers has increased from less than 20to 71 in 1999.

VI Major Policy Issues and Recommendations

The Government has long recognized the importance of a well-

functioning bond market, and serious eorts have been made to improve

eciency.

The regulatory environment for government bonds is generally sup-

portive, and market development is consistent with government scaland monetary policies, although certain rules and regulations are be-

coming somewhat obsolete and unsuitable for future developments. In

order to give government decision makers a solid base for formulating

policies to develop the bond market, the following means of overcom-

ing these impediments are proposed:

A Regular, Predictable Schedule for Oering Government Bonds

Although eorts have been made by government authorities to make

auction announcements to market participants as far in advance as ispractical, irregularity of bond oering is still a major source of uncer-

tainty, and has a signicant inuence on market yield. The Government

should release updated estimates of its borrowing requirements periodi-

cally to allow market participants to estimate more accurately the sizes

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of Treasury oerings. A regular, predictable oering schedule should

help reduce the Governments borrowing costs, as has happened in manycountries, such as the US.

One foreseeable problem of a regular oering schedule is that, under

current budgetary laws, the total amount of government borrowing is

capped by the annual budget. urthermore, since the issuance of govern-

ment bonds is mainly for decit funding, the amount of issuance may

actually decrease in future with budget surpluses. It is therefore neces-

sary for the Government to rethink the role of government bonds in the

development of the domestic debt market. or example, although Hong

Kong, China and Singapore have traditionally enjoyed budget surpluses,both have a regular government bond issuance program, which aims to

establish a benchmark yield curve in the market.

Bond Reopening Participants in the domestic bond market trade only

on-the-run issues of government bonds. When these bonds are held mainly

by commercial banks or insurance rms for reserve purposes, only a

small portion of the outstanding volume is available for secondary trad-

ing. Limited supply results in undesirable trading practices and distortion

of market prices. Bond reopening increases the outstanding volume ofan existing bond issue in the market, enhancing its market liquidity and

reducing the chance of cornering and price manipulation. This can also

extend the shelf life of on-the-run issues in the market and provide

better benchmark yield information.

Some technical issues need to be ironed out before a bond reopen-

ing program can be implemented, however. or example, a reopened

issue must have the same maturity date and coupon rate as the existing

bond issue. Under the current multiple-price sealed-bid auction system,

those conditions may not be met.

Bond Auction Technique When the Government changed its bond is-

suance method from xed-price allocation to public auction in 1991,

the sealed-bid multiple-price system was adopted for all new issues of

government bonds. The single-price or Dutch auction system was used

only in the cases of two zero-coupon bonds issued in late 1984. Under

the single-price auction, all awards are at the highest yield of accepted

tenders, hence the single price. The use of the Dutch auction system in

those two situations was to ensure that only a single winning yieldexisted for the bond issue, allowing calculation of coupon income for

the zero coupon bonds to be done without confusion.

Various studies have examined the merits of dierent auction systems,

and it is argued that a good bond auction system can achieve many

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Taipei,China 633

desirable goals such as funding cost reduction. The US Treasury experi-

mented with single-price auctions for the monthly sales of two- andve-year notes in September 1992 (multiple-price auctions were the pre-

vailing method used in the US at that time). Based on the US study

released in 1995, and a follow-up study in 1998, there are several ad-

vantages to single-price auctions. They result in a broader distribution

of auction awards, and bring consistency to auction procedures and tech-

niques. Single-price auction participants also tend to bid more aggressively.

Consequently, the US Treasury has applied the use of single-price auc-

tions to the sale of all marketable Treasury securities since November

1998.The Government should therefore reexamine its existing auction

system. A more ecient system can help to improve operational e-

ciency in the primary market and spillover into the overall bond market.

.orward Trading and Bond Lending To broaden the size and depth

of the government bond market, a proper hedging mechanism must be in

place, or traders will be forced to act more defensively and conserva-

tively, and market development will suer. Unfortunately, interest rate

forward and bond futures, used for hedging purposes, are not yet avail-able in the domestic market, partly due to the lack of a benchmark yield

curve. More specically, traders can act on their bull market view by

margin trading, but cannot eectively react when expecting a bear mar-

ket, because short-selling is prohibited. Consequently, bond dealers are

actually exposed to high interest rate risk with no eective hedging

instruments.

As an alternative, a delayed-settlement trading system can be es-

tablished to provide the needed function before bond derivatives are

available. This oers the risk-hedging function needed by market par-ticipants, and allows traders to conduct futures-like transactions. This

would require only minimal changes in current rules and regulations.

Market makers need only provide quotations for various distant settle-

ment dates. Since this is only one step from cash market trading, some

additional risks arise. or example, the extended settlement period increases

the chance of default on both parties. This risk, however, can be minimized

by margin requirements. Another type of risk is the lack of availability

of bonds at times of settlement. This is where a bond lending mechanism

is needed. A well-functioning bond lending system can eectively broadenthe scope of delayed-settlement trading as mentioned above, and thus

facilitate risk hedging. Bond lending aords traders with no, or insucient,

holdings to participate without fear of potential settlement diculties.

Since banks, postal services, and insurance companies own the majority

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of government bonds in the market, they are natural candidates for the

role of bond lenders, allowing bond dealers to borrow bonds throughreverse repos.

In short, forward-trading can stimulate secondary market activities,

aord bond dealers more exibility in hedging interest rate risks, and

reduce the chance of price distortion in the market. More importantly, it

can strengthen the market-making function of major bond dealers, al-

lowing them to provide more competitive bid-ask quotations, and thus

attracting more investors into the market and further facilitating the price

formation process.

Bond .utures Trading of bond futures should contribute signicantly

to the establishment of a benchmark yield curve. The existence of a

derivatives market ensures that cash market prices stay within the no-

arbitrage range, preventing price distortions, and making cash prices

more ecient. Physical delivery of bond futures contracts, along with

the cheapest-to-delivery (CTD) conventions, should eectively wake-

up many o-the-run government bonds which are no longer actively

traded in the domestic market. This is because the CTD design allows

sellers of bond futures to select a wide range of bonds for delivery,henceall other things being equalbonds with high yields (low price)

will be in demand and thus encourage trading. This will bring the mar-

ket prices of on- and o-the-run issues more in line with each other,

enabling the reduction of the wide liquidity spread currently observed

in the domestic bond market and facilitating the establishment of a bench-

mark yield curve.

Electronic Trading System There is no doubt that an electronic or

computer-based system improves trading eciency, because it allowson-line risk management and real-time dissemination of trading informa-

tion, which is vital in order to establish a benchmark yield curve. While

both the TSE and OTC have electronic bond trading systems in place,

they are not embraced eagerly by traders in the market. The OTC has

recently overhauled its existing computerized trading system to make it

more accommodating of market trading conventions. This was expected

to provide a much-needed boost to trading eciency in the market when

it was put into use in Spring 2000.

Clearing and Settlement Currently, trading on all book-entry govern-

ment bonds is cleared and settled through a RTGS system to prevent

settlement risk. The current system, however, still has room for improve-

ment. Many market participants have voiced support for a netting system

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Taipei,China 635

to better facilitate secondary market transaction. Netting can be bene-

cial for the following reasons:irst, it can reduce settlement cost. Under gross settlement, each

transaction must be settled separately. or example, a bond dealer with

15 transactions in a trading day with another dealer requires the same

number of settlement actions under the gross settlement system, while

only a single action is needed under netting, signicantly reducing costs

and improving settlement eciency.

Second, netting can reduce traders reliance on credit lines. or

small bond dealers, gross settlement puts a heavy burden on their ability

to obtain sucient credit to support transactions, making it more di-cult for them to increase their trading volume. Under the netting system,

however, a dealers total trading volume can be made more exible, as

long as the netting amount is within the credit limit.

Third, it can prevent settlement loop situations. In any normal trading

day, a settlement loop can easily occur. In a settlement loop, Trader A

sells a bond to Trader B, who resells it to Trader C. Later, Trader C sells

the bond to Trader A and nally Trader A sells it to Trader D. In the

gross settlement process, the same bond is needed in two separate trans-

actions, thus creating a looping problem. With netting this can be avoided.

Coupon Taxation Dierential treatment of coupon taxation between

individual and institutional investors encourages tax arbitrage in the

repo market and results in a depressed repo rate and government bond

yields. Although this reduces the Governments fund costs, it is oset by

reduced tax revenue. urthermore, subsidized government funding cost

creates an uneven playing eld for other borrowers and exacerbates the

crowding-out eect. Meanwhile, major institutional investors such as

pension funds, insurance companies, and bond funds are discouraged bythe distorted low yields, and become inactive in the domestic bond

market, contributing to low bond market liquidity. The Government is

fully aware of the situation and is proposing legislation to eliminate the

incentive for tax arbitrage.

According to one estimate, with the outstanding amount of bonds

in the market standing at around NT$1.6 trillion (over NT$1 trillion in

government bonds), and an average duration around ve years, a 100-bp

increase in yield would cause a value reduction of more than NT$80

billion. On the other hand, tax revenue increase would be much lower atabout NT$50 billion. Care must also be taken, however, to reduce the

possible negative impact of the new taxation rule on government bonds

already outstanding. Separate taxation can eectively curtail the tax

arbitrage activities which currently prevail in the repo market, and alleviate

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the price distortion problem in the government bond market. However, it

is suggested that the new rule be nonretroactive, that is, applicable onlyto newly issued government bonds, so that the existing equilibrium in

the market can be maintained.

On the issue of the taxable basis of coupon income, current regulations

are biased toward premium bonds in the market, since the calculation of

taxable coupon is based on the bond coupon rate. To eliminate this

potential bias, coupon income can be calculated on a yield basis, that

is, based on the purchased yield to maturity.

When-Issued Trading The Government should consider revising therelated security trading laws to allow or even encourage WI trading of

government bonds. Not only does WI trading provide an important price

discovery function, it also provides valuable risk hedging functions to

government bond dealers entering the auction. Potential problems asso-

ciated with WI trading, such as short squeeze, can be easily prevented

with careful rules and regulations.

Book Entry System Issuing government bonds and bills in book-en-

try form not only eliminates the printing of physical certicates, butstreamlines issuance procedures and lowers government funding costs. It

improves the trading eciency of government bonds because the deliv-

ery of bond scripts can be done through electronic transfer, with no fear

of loss, theft, or forgery. Since the introduction of the book-entry system

in 1998, scriptless securities have dominated outright trading in the

market with more than 80 percent of market share. The Government has

taken measures to encourage conversion of script bonds into book-entry

form to further improve bond market eciency and enhance secondary

marker liquidity.A number of problems need to be addressed before the market can

fully embrace the scriptless environment, however. or example, the cur-

rent information system supporting the book-entry system can accommodate

only one repo transaction per day, which discourages the use of book-

entry securities in the repo market. urthermore, the clearing procedure

may have diculty handling same-day buy/sell transactions.

Another concern of most investors is that the identity of bondhold-

ers will be recorded, which will have tax consequences that do not exist

when using physical certicates. Consequently, investors demand a pre-mium on book-entry government bonds, and the conversion of existing

bonds to scriptless form has met with resistance. inally, the Govern-

ment can encourage conversion by giving book-entry government securities

high priority in OMO in meeting the liquid reserve requirements.

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Appendix 1

Guidelines for .ormulation and Management of .iscal Policies

Guidelines for Treasury Management

1. Coordination of scal policies to support economic developments;

2. Strengthening of public debt management to raise funds for national construction;

3. Utilization of revenue and expenditure information to eectively manage national

treasury funds;

4. Establishment of a users charge system to promote the fairness of the national

taxation burden; and5. Improvement of treasury administration to eectively manage national treasury

funds.

Guidelines for Tax Administration

A Improvement of the Tax System

1. To improve the income tax system by proposing a tax system that aims to

eliminate double taxation, and by combining the prot-seeking enterprise income

tax with the individual consolidated income tax; and2. To continuously review tax laws and regulations so as to improve the equity

of the tax burden.

B Strengthening of the Tax Administration

1. To continuously adopt measures to curb tax evasion so as to increase tax

compliance;

2. To continuously implement tax administration automation systems to upgrade

eciency; and

3. To reinforce the systems of tax auditing and supervision for the prevention ofillegal cases.

Guidelines for Customs Service

1. Revise the Customs Laws and Regulations to improve customs clearance

procedure;

2. Continuously review tari rates and optimize their structure;

3. Improve duty collection and antismuggling measures;

4. Streamline customs organization and make its personnel system more sound;

5. Gradually abolish the refund system and improve the administration of bonded goods;

6. Strengthen the enforcement of the countervailing duty and antidumping duty

system; and

7. Enhance the internationalization of customs administration and take part in

international activities.

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Guidelines for Monetary Administration

1. Promote nancial liberalization and internationalization;

2. ulll nancial systematization and modernization;

3. Promote the development of nancial institutions other than commercial banks,

to expand their business scope and diversify their services; and

4. Strengthen banking examination and supervision to maintain nancial discipline.

Guidelines for Insurance Administration

1. Review all insurance laws and regulations so that the functions of insurance

can be strengthened and market order maintained;2. Oversee insurance companies in developing new insurance products;

3. Review insurance rates and insurance policy clauses to promote liberalization; and

4. Enforce the functions of insurance inspection and ensure the well-rounded

development of insurance enterprises for the protection of the insured public.

Guidelines for Securities Administration

1. To enlarge the scale of the securities market;

2. To publicize nancial information of publicly listed companies;

3. To update the laws and regulations of securities administration;4. To strengthen the supervision of CPA;

5. To strengthen the surveillance and inspection of illegal transactions;

6. To strengthen the supervision and administration of securities-related services;

7. To continue promoting securities market liberalization and internationalization;

8. To strengthen the education of investors and the cultivation of professionals;

9. To establish a sound foreign futures trading

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