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Growth remained strong in the region in 2012, with regional GDP rates increasing in most countries (excluding Nigeria and South Africa). Projections point to a moderate, broad-based acceleration in growth to around 5½ percent in 2013¬14, reflecting a gradually strengthening global economy and robust domestic demand. Investment in export-oriented sectors remains an important economic driver, and an agriculture rebound in drought-affected areas will also help growth. Uncertainties in the global economy are the main risk to the region's outlook, but plausible adverse shocks would likely not have a large effect on the region's overall performance.

While many studies have looked into the determinants of yields on externally issued sovereign bonds of emerging economies, analysis of domestically issued bonds has hitherto been limited, despite their growing relevance. This paper finds that the extent to which fiscal variables affect domestic bond yields in emerging economies depends on the level of global risk aversion. During tranquil times in global markets, fiscal variables do not seem to be a significant determinant of domestic bond yields in emerging economies. However, when market participants are on edge, they pay greater attention to country-specific fiscal fundamentals, revealing greater alertness about default risk.

We use data on the extent to which residents of one country hold the bonds of issuers resident in another as a measure of financial integration or interrelatedness, asking how Asia compares with Europe and Latin America and with the base case in which the purchaser and issuer of the bonds reside in different regions. Not surprisingly, we find that Europe is more financially integrated than other regions. Asia, more interestingly, already seems to have made more progress on this front than Latin America and other parts of the world. The contrast with Latin America is largely explained by stronger creditor and investor rights, better contract enforcement, and greater transparency, all of which are conducive to foreign participation in local markets and to intraregional cross holdings of Asian bonds generally. Further results based on a limited sample suggest that one factor holding back investment in foreign bonds in East Asia may be limited geographical diversification by mutual funds, in turn reflecting a dearth of appropriate assets. Asian Bond Fund 2, by creating a passively managed portfolio of local currency bonds potentially attractive to mutual fund managers and investors, may help to relax this constraint.

Large fiscal financing needs, both in advanced and emerging market economies, have often been met by borrowing heavily from domestic banks. As public debt approached sustainability limits in a number of countries, however, high bank exposure to sovereign risk created a fragile inter-dependence between fiscal and bank solvency. This paper presents a simple model of twin (sovereign and banking) crisis that stresses how this interdependence creates conditions conducive to a self-fulfilling crisis.

A two-tiered approach to financial market development aimed at both bank and bond market reform would also be complementary to longer term economic development, provided services could be delivered through efficient financial and legal institutions (Chakraborty and Ray 2006) and there was strong protection for investors and sound fiscal and monetary policy management by government (Burger and Warnock 2006b). Historically, local issuers tend to issue in the major currencies (U.S. dollars, yen, and euro), and then either swap the proceeds into local currency (interest rate parity theory suggests this should deliver funds equivalent in yield to what is available in the domestic market) or, more often, sell the foreign currency proceeds in spot foreign exchange markets, leaving the repayment cash flows unhedged. Chakraborty and Ray (2006) recently established that although stronger bank monitoring helps to resolve information asymmetries and agency concerns, it is the efficiency of financial and legal institutions that influences growth outcomes, whether there is a bank- or a market-based financial system. Among them are the need for enabling regulation, including reform of withholding and other foreign investor taxes (Lejot, Arner, and Liu 2006); continuing reform of corporate governance, which includes better creditor rights, bankruptcy procedures, and contract enforcement (Beck, Levine, and Loayza 2000; Burger and Warnock 2006); and strong financial infrastructure for better information disclosure, the establishment of reliable credit ratings (Kisselev and Packer 2006) and robust benchmark yield curves The securities market is largely self-regulated through organizations such as the Korea Securities Dealers Association, the Korea Exchange, and the Korea Securities Depository, and four local agencies assign credit ratings: Korea Investor Service (a Moody's affiliate), Korea Ratings (a Fitch affiliate), National Information & Credit Evaluation, and Seoul Credit Rating & Information. This process began in 2004 with the introduction of the Korea Interbank Offered Rate (KORIBOR), which should become the benchmark interest rate for short-term financing for banks and may become a reference rate for bond or swap transactions. The first phase of the Foreign Exchange Liberalization Plan (2002 2005) increased won funding limits for nonresidents and raised the ceiling on the amount of residents' foreign borrowings requiring notification. The 2005 merger of the Korea Stock Exchange, the Korean Securities Dealers Automated Quotation stock market, and the Korea Futures Exchange into the Korea Exchange is expected to upgrade the competitiveness of the nation's trading system for a variety of financial products, including stocks, bonds, options, and other derivatives. There appears to be a natural ordering to the tasks involved: first, establish benchmark bonds and indices; second, develop a diverse derivatives market; third, systematically lengthen the bond market's maturity profile; and fourth, build and develop over-the-counter capability and price structures for derivatives and other complex financial instruments. In developed countries, as banks have become increasingly cautious about extending credit, a gradual process of disintermediation has been occurring in historically bank-oriented financial regimes, fed by considerable regulatory efforts directed at market liberalization.