The emerging East Asia’s local currency bond market (LCY) expanded at a slower pace in the fourth quarter of 2022 due to a deceleration in the issuance of government bonds. According to the latest issue of Asia Bond Monitor published by the Asian Development Bank (ADB) on March 28, the slowdown was driven by a decline in issuance as most of the jurisdictions had fulfilled their borrowing requirements earlier in the year.

At the same time, issuance of corporate bonds contracted amid the elevated borrowing costs due to a tightening of monetary policy by most of the central banks in the region and concerns of bond defaults in China and Vietnam, particularly in the property sector in both economies.

Overall, the region’s LCY bond market totalled US$23.2 trillion at the end of December. The issuance volume in the fourth quarter reached US$2.2 trillion, with growth easing to 1.2% from 2.3% in the previous quarter. Government bonds outstanding totalled US$14.8 trillion at the end of 2022, while corporate bonds reached US$8.4 trillion.

The LCY bond market of China continued to be the largest in the region, amounting to US$18.5 trillion at the end of December for a market share of 79.7%. The Chinese government continued to issue sovereign debt to finance stimulus measures and to roll over existing debt in the fourth quarter, albeit at a slower pace compared to prior quarters following the completion of local government bond quotas. The growth in government bonds in the fourth quarter of 2022 stemmed from the expansion in Treasury bonds and other government bonds, policy bank bonds and local government bonds. On the other hand, the corporate bond market contracted 0.3% quarter-on-quarter amid the worsening property market debt distress.

Weakened conditions

As ADB points out, financial conditions improved modestly in emerging East Asia between late November 2022 and early March 2023 amid eased recession risks and inflationary pressure. However, conditions weakened at the end of the period due to uncertainty about the US monetary policy and recent turmoil in the US and European banking sectors.

Between December 2022 and January 2023, easing economic headwinds and the re-opening of China drove up equity markets, narrowed risk premiums, strengthened currencies and propelled portfolio inflows into the region. Regional financial conditions weakened between February and early March.

“The recent turmoil in the US and European banking sectors underscores the importance of sufficient liquidity buffers amid tightening financial conditions,” says ADB chief economist Albert Park. “Corporate balance sheets weaken as asset values fall due to rising interest rates. Liquidity stress can occur when companies can’t refinance to meet their financial obligations in a timely way.”

ADB notes the emerging East Asia bond markets recorded aggregate net foreign portfolio inflows of US$1.7 billion in December 2022 and January 2023. Most regional bond markets posted inflows, with the exceptions of South Korea and Malaysia. South Korea posted net outflows of US$8.6 billion from its bond market as a sizable volume of bonds matured and investors anticipated that the Bank of Korea was nearing the end of its tightening cycle.

In Malaysia, there were small net capital outflows of US$100 million during December 2022 and January 2023. Among the remaining regional bond markets, Indonesia recorded the largest net inflows at US$5 billion due to its attractive yields. China recorded the region’s second-largest net foreign capital inflows of US$2.6 billion. Meanwhile, the Thai bond market received US$2.5 billion of foreign capital inflows over optimism that China’s reopening would boost the country’s tourism receipts.

Key risk factors

Meanwhile, the outlook for emerging East Asia’s financial conditions remains benign, according to ADB, as recession fears and inflation have eased and some regional central banks are expected to end their tightening cycles. Investors see many opportunities in global bond markets in 2023.

The outlook, though, is far from certain and remains largely driven by a few key risk factors.

First is the uncertain pace of monetary tightening in advanced economies. The US Federal Reserve in its March projections indicated that it will take a pause after one more rate hike in 2023. However, uncertainty in inflation and development of the current banking sector turmoil would affect the path of monetary policy, casting uncertainty over financial conditions in the region.

Second, a US dollar strengthened by the Fed’s monetary tightening can challenge financial stability and debt sustainability in emerging market economies. The third risk is the longer-than-expected persistence of elevated inflation. Although inflation in major advanced economies and many regional economies has eased, it remains at a higher level. There is uncertainty over how long the elevated inflation will last; if longer than expected, it would reduce purchasing power and weaken asset values.

The fourth risk is the uncertainty in the economic outlook in the region. Although fears of recession in major advanced economies have abated, ADB argues the external demand in many regional economies remains weak. There is also uncertainty over how much the China re-opening will benefit other economies in the region.

Last but not least, the higher interest rate levels may cause liquidity stress as the balance sheets of financial institutions and corporates weaken. “Higher interest rate will lead to value losses in financial and real assets, while tightened financial conditions make refinancing difficult, putting pressure on high-leverage firms such as small banks and real estate companies,” says ADB.

For example, during the review period, stress was observed in Vietnam’s corporate bond market, as many real estate firms found it hard to refinance their debt. This led to concerns over other firms’ ability to repay debt obligations as liquidity in the market dries up. Similarly, the liquidity positions of banks with less diversified portfolios and large maturity mismatches on their balance sheets must also be closely monitored to avoid the liquidity stress that led to bank failures such as Silicon Valley Bank.