April 20 (Bloomberg) -- The usually taciturn Asian central bankers are waxing eloquent.

About bonds.

Last week, a group of 11 central banks announced an initial structure for the second Asian Bond Fund.

The move follows the first Asian Bond Fund, which was launched in June 2003 with $1 billion pooled by the region's central banks. The new fund will buy local-currency Asian debt, while last year's kitty has been invested in U.S. dollar bonds issued by the region's governments.

``The question probably occurs to you: What's such a big deal about bond markets?'' Glenn Stevens, deputy governor of the Reserve Bank of Australia, said at a forum of Asia-Pacific business executives in Sydney last week. ``Why is that important?

``A system which relies entirely on bank financing,'' Stevens went on to answer, ``concentrates funding risks in a way which is dangerous''

Asian economies hardly need a reminder of how grave those risks could be. The continent is booming now, but it still bears the scars of the financial crisis of 1997-98, when skittish bank managers called in their loans and caused bankruptcies across the region -- from South Korea and Hong Kong to Thailand, Indonesia and Malaysia.

Bank Loans

Since then, many commentators have blamed the region's over- dependence on bank loans as the reason for much of the anguish.

``Bank loans are primarily illiquid, fixed-price assets in the sense that the interest rate does not vary much on the basis of changing market circumstances,'' explains Ramkishen Rajan, an economics professor at the University of Adelaide in Australia. ``Almost all the adjustment has to take place via rise and fall in the quantity of bank lending, which in turn leads to sharp booms and busts in bank flows.''

Now it seems Asian central bankers have discovered a weapon to fight future shocks: bonds. Unlike loans, if creditors feel jittery about holding a bond, they sell it to someone else who can stomach the additional risk -- at a discounted price. The company doesn't necessarily die for lack of funds.

Is Asian Bond Fund really the crisis-fighter that it's cracked up to be? Or, is it more likely to be a gun that explodes in the hand that holds it?

`Asian Miracle' Collapses

After Thailand devalued the baht on July 2, 1997, foreign banks very quickly lost confidence in the ``Asian miracle'' that they had nurtured, and profited from.

The region's banks cut credit lines to local borrowers to repay overseas lenders.

Borrowers -- even good ones -- started going bankrupt. The International Monetary Fund made the situation worse by asking the crisis-affected countries to raise interest rates so overseas lenders would not withdraw their funds.

Higher interest rates wrecked the local industry. South Korea, Indonesia, Malaysia and Thailand went into recession. Six years after the crisis, per capita income in Indonesia in U.S. dollar terms is 13 percent lower then it was in 1997.

Boom-and-Bust

Asian economies are still too dependent on boom-and-bust bank financing, which renders them vulnerable to future shocks. In Thailand, bank loans equal 86 percent of the nation's $143 billion gross domestic product, while government and corporate bonds together make up only 26 percent of the economy.

In comparison, the U.S. bond market is twice the size of the world's biggest economy.

Still, with all its apparent benefits, the Asian bond fund may be ineffective at its best, and dangerous at its worst.

For one, at $1 billion, the first Asian Bond Fund is too small to make an impact. Newport Beach, California-based Pacific Investment Management Co.'s Total Return Fund, the world's biggest bond fund, has $74 billion under its management.

The size of the second bond fund is not yet known, though contributing countries ``will be careful to limit the size of the total investment, so that it will not have any crowding out effect on private sector investors,'' the group of Asian central bankers said in a press statement last week.

No Cure-all

The second shortcoming is more fundamental. A fund that invests only in dollar-denominated bonds can't prevent another crisis. If confidence in Asian economies and currencies evaporates, the cost of servicing dollar debt would go up for borrowers, causing them to shut factories to pay bondholders.

The second bond fund, which will invest in local-currency debt, will solve that problem.

But it'll pose some challenges of its own.

The outstanding value of Asia's local-currency bonds is $1.1 trillion. Still, the market is fragmented. Issuers raise money on the strength of ratings assigned by local companies. Unlike a Standard & Poor's or a Moody's Investors Service rating, local credit evaluations can't be compared across national boundaries.

An Asian credit rating organization will take time to build.

Moreover, capital controls in Malaysia, India and China prevent their local savings from flowing to, say, Thailand or Indonesia.

Capital Controls

Will Asian countries allow free capital flows into and out of their national boundaries for the sake of building a regional bond market?

And should they even try to do it before they've done away with their fixed-currency regimes?

Imagine the Chinese or the Malaysian central bank trying to defend their currencies' fixed levels to the U.S. dollar in the face of unrestricted capital flows. They'll be sitting ducks for speculators.

Beijing and Kuala Lumpur may have to float their currencies before they can hope to benefit from the Asian bond fund. Otherwise, it could be 1997 all over again.

To contact the writer of this column: Andy Mukherjee in Singapore amukherjee@bloomberg.net

Last Updated: April 19, 2004 16:50 EDT