Even as the subprime crisis turns debt into a four-letter word in the West, Asia shows a certain resilience. So far, growth in the region continues unabated.
Bond issuance in Asia was up 28% in 2007 despite re-rating of debt in the developing world. The lion’s share of growth came from local currency bonds, which shot up 38% to raise US$148 billion while G3 issuance grew 5% to touch US$48 billion.
Total local currency bonds outstanding in emerging East Asia grew 10% in the first half of 2007, expanding faster than gross domestic product (GDP) in most markets, according to Asian Development Bank (ADB) statistics.
The situation today has much to thank 1997 for. Then, the over-concentration of risk in the banking
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system, forced regulators to address alternatives. Initiatives to develop local bond markets have been a direct response – be it the Asian Bond Fund that directly invests in domestic paper or Asian Bond Market Initiatives that focusses on market infrastructure.
In addition, the drive towards improving fiscal prudence and strengthening financial systems seems to have paid off as Asia displays some degree of insulation from the credit crunch. Today, economic growth prospects are strong, external balances large and financial systems a far cry from the crisis days.
Certainly, there has been an impact on Asia from the subprime debacle, even if it has been limited so far. Should the situation in the US worsen, there are downside risks for the region’s markets. Credit spreads have widened significantly and even well-respected names have taken a strong beating – Temasek Holdings’ five-year credit spreads sprinted from about 15bp in mid-year 2007 to nearly 90bp by end of the year according to Bloomberg.
But Asia continues to look attractive in the bigger picture especially as currencies are appreciating against the US dollar. “Our view is that widening spreads today are not warranted to their current extent,” says Shriram Ramanathan, investment manager at ING Investment Management and several panellists concur. “The current market situation is creating an opportunity,” agrees Phoon Chiong Tuck, chief investment officer for Asia ex-Japan at Deutsche Asset Management.
Several of the region’s economies received rating upgrades in 2007. Moody’s raised Korea’s sovereign foreign exchange rating to A2 at the end of July. It also moved up the Chinese government’s long-term foreign currency bond rating to A1 and upgraded Hong Kong’s foreign and domestic currency bond ratings to Aa2. A month later, it placed Indonesia’s sovereign bond’s foreign exchange rating under review for possible upgrade.
Part of the impetus for currency upgrades comes from the reform and liberalization undertaken by the countries, asserts the ADB. Hong Kong, for instance, forged closer integration with the mainland China markets as renminbi issues were allowed for the first time in the territory. The inaugural issue came from China Development Bank in a 5 billion renminbi (US$658 million) bond deal in early July. The book was covered nearly thrice over, attracting 14 billion renminbi in orders.
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In another major development in China, corporate issuers no longer need a mandatory bank guarantee to issue bonds. The approval process they must go through has also been streamlined – only the China Securities Regulatory Commission (CSRC) will determine their financial and legal worthiness; a nod from National Development and Reform Commission (NDRC) is no longer necessary. This opens up avenues for Chinese corporates to raise money in China – while helping mop up escalating liquidity in the country.
At the same time, the future may see Hong Kong emerge as a base for Chinese corporates requiring long-term finance, such as for infrastructure projects. The Hong Kong Monetary Authority introduced a 15-year exchange fund note in August, unveiling it as a semi-annual feature of its operations.
Extending the yield curve is a long-standing need of the region’s markets. Indonesia, too, moved to address the problem and issued a new 30-year government bond in March. Similarly, Singapore issued a new 20-year government bond in May.
Despite all the effort, Asia lags far behind Europe and US in market development. While outstanding bonds in the US and Japan amount to more than 150% of GDP, emerging East Asia’s scrambled over the 50%-mark only in 2005. Within this region, only South Korea’s bond market exceeds its GDP.
Moreover, bonds available are heavily skewed in favour of sovereign and quasi-sovereign paper; corporate debt is far behind in size and liquidity in almost all markets. “Asian investors are very good at identifying risks but very bad at pricing them. AAA and AA rated paper is snapped up fast but below that you have difficulty getting the right price. As you go down the credit curve, liquidity evaporates quickly,” contends Clifford Lee, managing director and head of fixed income for global financial markets at DBS Bank.
Issues of size and liquidity are the biggest constraining factors in attracting investors to the market. Further, illiquidity is also a problem in the synthetic markets that are critical for the management of cash market risk. This thwarts efforts of foreign investors (who need to manage their currency exposures) as well as local companies. Singha Nikornpun, deputy secretary-general of the Government Pension Fund in Thailand points to the problem he faces. “We don’t mind holding long-dated fixed rate securities, but we just cannot bear the risk. The interest rate swap market, which would help us manage the fixed rate risk is inadequate,” he says.
Indeed, criticisms of Asia’s developing bond markets abound. But then, that is to be expected, the region is still in the developing stage. More significant are the improvements that have been made. “The Asian markets today are a lot further developed than was the case in Europe was in the 1980s,” Joseph Taylor, emerging markets bond strategist at Loomis Sayles, points out.
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Turnover ratios
The growing depth of the Asian debt markets is evident in the indices that cover them. For instance, the CDS index iTraxx Asia ex-Japan has expanded from 50 to 70 names. Simultaneously, trading in paper is improving. According to ADB statistics, turnover ratios, a measure of market liquidity, rose appreciably in government bond markets in Indonesia, China and Thailand. Corporate bond turnover increased substantially in Hong Kong and China. There is nevertheless still ample room for improvement. “The interest in the local markets is greater than the paper available,” affirms Taylor. His firm is one of the largest US-based investors in emerging markets.
On a purchasing power parity basis, developing Asia contributes more than a fourth of the world’s GDP, estimates the International Monetary Fund (IMF). India and China alone account for 16% and 7%, respectively. That itself makes a strong case for foreign investors to allocate more to the Asian markets.
Obstacle course
However, for foreign investors who are convinced of the investment case, the opportunity is not easy to tap. Firstly, the markets are still too small to fill their appetites. “It is a big fish in small pond issue,” comments Donald Amstad, head of fixed income for Asia-Pacific at Aberdeen Asset Management. The size of the markets makes it difficult to enter or exit quickly.
Secondly, foreign currency regulations and withholding taxes muddle efforts. “Capital control restrictions exist in many countries, often as a reaction to the 1997 crisis when currencies were attacked. That is the main impediment to growing the market more rapidly,” says Lee.
