IFR Asia IMF/World Bank 2018 Roundtable: Part 1

IFR ASIA: Welcome everyone to our discussion on how the debt capital markets can support long-term development in South and South-East Asia. Neeraj, how far have we come, and how attractive are these markets to a global investor?

NEERAJ SETH, BLACKROCK: We obviously have seen a significant growth in the capital markets in the region from where we were, let’s say, 10 or 20 years ago. But the fact is, the capital markets are still very far from where they need to be. From a longer term perspective, you would see a very strong correlation between deep, functioning capital markets and economic growth.

Now, at this juncture, everybody is worrying about what’s happening in terms of market volatility – the move in the Indonesian rupiah, Indian rupee, or any other currency in a broader EM complex. It does get pauses from a lot of international investors. It also has changed the course on the policy side, with five hikes from Bank Indonesia over the last six months, up 150bp, and some outflows from the region.

I would argue, from a longer term perspective, the fundamentals of the region and a lot of these countries are still actually very strong. It does still warrant, if anything, more of a focus from global investors. But there’s still a lot to be done – and I’m sure we’ll discuss as we go through the panel – from the government, from the regulators, to help develop these markets.

I don’t think there are major concerns. Yes, we are going through some noise because of the macro factors, which we can talk about, and obviously changes in the US policy, trade tensions and oil price are causing some concerns. But fundamentally, I would remain positive on a lot of these economies, and I do think there’s a case for longer-term growth of these markets.

IFR ASIA: Christian, when you look at governments in this part of the world, where have we come since, say, the Asian crisis 20 years ago? How much more resilient are we today?

CHRISTIAN DE GUZMAN, MOODY’S: There are certain ways we can look at Asian ratings today versus 20 years ago. There has been a sort of divergence as a few of the countries in the region haven’t actually recovered to their pre-Asian financial crisis rating levels, in particular Thailand and Malaysia. But then there are those who have actually surpassed their pre-crisis rating levels, including the Philippines and Korea.

By and large, over the past 10 years, what we have seen amongst all these, with the exception of Thailand and Malaysia, is a general increase in their actual sovereign ratings. That reflects a number of things, as Neeraj was mentioning. The fundamentals have improved, whether that means moving to an economic growth model with more value-added activities; whether it’s in terms of access to funding, or a lower reliance on external financing.

The institutions are also very important. We’ve acknowledged that with regards to Indonesia and India, more recently. Last December we upgraded India, and earlier this year, we upgraded Indonesia. We knew that a lot of the pressures we are seeing in these two countries today were there – they didn’t just pop up this year. But Moody’s had expressed greater confidence that the institutions have been set up to withstand a lot of these pressures when they do come, and certainly that firefighting that Neeraj mentioned has made a big difference in the case of Indonesia.

Perhaps in 2013, we saw the institutions here in Indonesia as a little more growth-oriented, but in the current context, we saw a pre-empting of some of these pressures with Bank Indonesia hiking in advance, and acknowledging that the global environment was shifting.

This is a bit of a sea change that is reflected in our view of the fundamentals in the region.

IFR ASIA: What does all that mean for corporate credit, and access to capital? Augusto, I’m going to come to you on that.

AUGUSTO KING, MUFG: I think one critical change in the region is really the growth of the domestic market. One could argue that the domestic market is deep enough now to allow the vast majority of credits to be sold domestically, so as a result, you can see in the region that corporates do have the choice – at least the better ones have the choice – of either looking internationally, or looking domestically.

Of course, the challenge for the lesser-known corporate credits is that maybe the domestic market is not ready for them yet, but for the better credits – some state-owned enterprises, for example, or in the case of India, some of the PSU – do have access to both the international market and the domestic market. That is one significant change we have seen over the last 15, 20 years in Asia. People have a much greater choice.

Of course, one would want to investigate to see how we can actually deepen the respective domestic markets. Again, for some of the very good credits, they do have an option to look internationally or domestically.

IFR ASIA: Soufat, specifically on Indonesia, how confident are you, as a fund manager here, about some of these risks and tensions that the market is facing?

SOUFAT HARTAWAN, SCHRODERS: In Indonesia the rupiah bond market has become one of the most active local markets in the world, ever since the Indonesian banks were recapitalised nearly 20 years ago. Along the way, the search for higher yield has revealed that Indonesia is improving fundamentally, and is on the right path of reform.

As a local emerging market, we have some weaknesses. A lot of foreign involvement makes this market more vulnerable to capital inflow or outflow. Currently we have nearly 40% of foreign concentration in the rupiah market. That is roughly US$50bn. Now, if you compare that with our reserves at slightly above US$100bn, this can create a potential instability should there be a major outflow from foreign investors.

Of course, our fundamentals speak for themselves. We’ve seen three major events in the last five years. The first one was probably during the Asian taper tantrum back in 2013. The second one in 2015 during the China devaluation, and probably the recent one is this year, the EM market rout. But, I think we’ve learned a lot from those crises. The government policy has been quickly addressed to stabilise the market, and the policy that has been made is always to avoid the worst market expectation.

For example, this year, we know that the currency will have to depreciate to be in line with other EM currency. Now, we are almost in line with India, and probably other emerging market currencies. So, if that’s the level that the market wants, then we have to follow that in order to maintain the confidence.

The crisis that we’re seeing this year – probably a mini-crisis – is slightly different from 2013 and 2015, because this is where the global central banks are starting to normalise interest rates. The market has its own mechanism to adjust by itself. The Indonesian bond yield has been rising by more than 200bp. That is probably what the market expects where the tightening should be.

If you look from the foreign perspective, the real rate differential in holding the Indonesian government bond is one of the most attractive in the world; currently, about 500bp. It’s very difficult to find such a real differential anywhere in the world! Even with the recent opening up of the China local bond market, we think the impact will be marginal, because we are still carrying one of the highest-yielding currencies that is the most attractive for carry trade.

But, of course, the key is the FX volatility. With the recent volatility, it is hard for a global investor, such as Neeraj, to see the entry point on when we should invest in the Indonesian bond market. My observation reveals that as long as the hedging costs, the FX swap premium, are either in line or below the bond yield, that’s the time when markets start to see positive intervention.

What we need to see going forward is whether the FX market stabilises a bit further, and that’s when we will see the real positive relationship in the eye of the investors.

IFR ASIA: Yes. I’m interested in what the rest of the panellists think about Indonesia at the moment. Christian, with 37.6% of Indonesian government bonds owned by foreign investors, is that a weakness from a rating agency point of view?

CHRISTIAN DE GUZMAN, MOODY’S: I would say that is one of the key weaknesses for Indonesia.

I think the 37.6% maybe understates the risk. I believe that’s the proportion of local currency government bonds that are owned by foreigners, but then let’s not forget that 40% of the government’s debt stock is also denominated in foreign currency. You can pretty much assume, given shallow capital markets onshore, that most of that – if not all of it – is non-resident debt. We understand that some of that are indeed concessional exposures, to the World Bank, the ADB, but by and large, a lot of that is just market debt.

For example, Indonesia is a key pillar in the Islamic financing market, where they are the largest US dollar sukuk issuer in the world, and I think many Islamic investors do look to that steady supply every year from the Indonesian government.

There’s a strength there in terms of the diversification of funding sources, but mirroring that is the weakness, in terms of the continued reliance on overseas debt.

Going forward – perhaps piggybacking on what Augusto was mentioning – what we need in Indonesia to address this weakness is further development of the local capital markets.

It’s been present in other markets in Asia, but not necessarily in Indonesia. We don’t have a captive form of savings, like we do in the case of Malaysia, or Singapore, with large provident funds. We do have BPJS here in Indonesia, but it’s simply not big enough to help fund the government. Further development of local captive sources of savings – that could include the insurance sector, for example – could go a long way in terms of addressing these key vulnerabilities related to the reliance on external financing.

IFR ASIA: Neeraj, it’s one of these topics that comes up a lot. Foreign investors want an open market to invest in, but that’s going to create vulnerabilities when it comes to an emerging market sell-off. How do you see that playing out here?

NEERAJ SETH, BLACKROCK: When you think about any capital market, and the way capital flows around the world, it’s very much intermingled. To some extent, having your capital markets integrated in a global capital market through open channels, I do think it’s positive.

Now, yes, it comes with some risk. If you have close to 40% government bonds owned by foreigners, and you’re going through the Fed’s normalisation for the first time since the crisis, you are seeing some noise factors around it. At the same time, I don’t think those noise factors are reasons enough to not keep the markets open.

From a foreign investor’s perspective, you can take different horizons. If you’re looking with a one or three-month horizon, you would be cautious today. But if you are someone who’s looking at a three to five-year horizon – going back to all the points you heard about in Indonesia in terms of fundamentals, valuations, where they are in real rates, nominal rates – I don’t see any reason why foreign investors should not be looking into these markets.

It’s not an easy answer, and there obviously has been a lot of debate. You have on one hand Indonesia, the government bond markets are open. I would argue in fact more needs to be done to open the corporate markets and equalise taxes, similar to government bond markets, and create more incentives for foreign investors to come in.

On the other hand, you have markets like India where there is still a quota – a maximum cap on holdings of government bonds. That’s surprising, because a lot of it is very much predicated on the perception that foreign investors bring volatility. Well, the fact is, it does, but more importantly, the key for a deep capital market is to have a broad base of institutional investors and retail investors, leverage the capital markets as channels for local savings, and have a proper allocation of capital for long-term growth. I think that’s the key objective.

If that’s what you’re trying to achieve, I think opening up of the markets is inevitable in today’s environment.

IFR ASIA: From my research, assets under management in insurance and pension funds total about 125% of GDP in Singapore. In Malaysia it’s about 80% of GDP. India about 22%. If you go to Indonesia, it’s about 6%. There’s certainly quite a bit of room for growth there.

On these local sources of demand, Augusto, what’s your experience been in connecting Asian issuers and Asian investors?

AUGUSTO KING, MUFG: Both Indonesia and India have been actively promoting offshore financings in their own currencies, what they call Komodo bonds here, and Masala bonds in India. We’re lucky enough to be involved in a number of those transactions. If you look at Indonesia there have been two Komodo bonds; one from Jasa Marga, and one from WIKA, and we were involved in WIKA.

It’s an interesting situation. When we’re trying to promote and sell these to international investors, there is always the question as to whether this is a rates product, a credit product, or a combo. I don’t think there’s a lack of interest but, again, there is certainly a lack of understanding in terms of how to make it work.

So when we talk about this particular topic, I think the key is really what we can do to actually enhance and develop the local capital markets. If you look at India and Indonesia per se, the lack of non-bank FIs is one critical hindrance for further development. Again, if you look at ASEAN as a whole – at least from a capital markets perspective – each of the markets is still relatively small. Any initiative in terms of creating some kind of common identity, or common platform within ASEAN, would certainly help as well. It’s been talked about for a long time. Again, I don’t think that has actually taken a lot of steps forward.

IFR ASIA: Soufat, I know you’ve looked at Komodo bonds as well. How big can that market get? Is it something that people in Indonesia should be quite excited about?

SOUFAT HARTAWAN, SCHRODERS: Certainly, this Komodo bond has been a major breakthrough for the Indonesian capital market. We have always had an issue around how we can access as many investors as possible. But we also have not many insurers in the Indonesian market that can manage the FX mismatch. Komodo bonds can be the solution for that; whereby Indonesian companies can issue in local currency to the offshore market, where the investor base is far greater.

As you mentioned, the Indonesian pension fund business is only 6% of GDP. That’s very small. So, if you want to gather more interest from the government market, the capacity is just not there. We need to explore other opportunities.

The Komodo bond market is still in the early stages of development. Firstly, not many issuers understand the mechanism, and secondly, there’s some outstanding issue regarding transaction settlement, and so on. Once we settle all these issues, we probably are going to see the Komodo be a bit more attractive for investors who want a greater yield over government risk, but want to have the local currency exposure as well. I think this is going to be another asset class in the future.

IFR ASIA: Neeraj, do you think creating offshore pools in the rupee or rupiah is part of the solution to bring long-term money into this part of the world?

NEERAJ SETH, BLACKROCK: I think it’s certainly a part of the solution, but if I look back in the last few years at the Masala bond out of India, and the Komodo out of Indonesia, I would argue the success is very mixed. The simple reason for that is what you touched on: for a lot of investors, it’s still not very clearly positioned. Are you taking a rates view, or a credit view? And from that standpoint, a lot more education is required. The countries, the regulators, the governments have to do more to actually educate global investors in terms of what the instrument is, what risk you are taking, and how it works.

Typically, the way you would do it is to start with the top end of the quality curve, and establish that curve in an offshore market. A quasi-sovereign, or even the sovereign should start that process, and then you make your way down to the corporate sector, and then from investment grade to high yield. You have to have more of an established instrument and curve, and then you can take it from there and use it for the corporate sector. So, it certainly is a part of the toolkit.

I would argue that the development of the domestic capital market remains the primary part of the solution. Other ways of diversifying the funding sources can add on top, but they will not be able to substitute for a big part of the missing capital markets in these countries.

IFR ASIA: Market liquidity often comes up as another obstacle for investors. Augusto, when you look around Asian markets, how has that evolved?

AUGUSTO KING, MUFG: Broadly speaking, over the last maybe seven, 10 years, if you look at any international bond issue, the Asian bid is very significant. I’ve been in this business for more than 20 years, and in my early days of my career, we always had to look into the US market for US dollar liquidity, but now the liquidity pool within Asia can support very large US dollar transactions, and even euro transactions for that matter. We are seeing these pockets of money not just from Singapore, or Hong Kong; we are seeing that from Korean, Chinese investors. Also recently, a lot more Japanese investors are looking beyond their normal zone and into South-East Asia for US dollar products. Asian liquidity in that sense has grown significantly.

Then we take a step back and look beyond the G3 currencies. What about liquidity in the local markets? It’s really a matter of whether those countries have put in any initiatives to direct liquidity into the capital markets. In Singapore and Malaysia, for example, vis-à-vis what we are seeing in India and Indonesia, there is a difference in terms of non-bank, non-FI liquidity. Is there enough to support a domestic currency trade? Again, that is the interesting part of capital markets development in the region. From the cross-border perspective, we see a lot more liquidity, but when you go into each country, it seems that it is not deep enough.

Certainly, there are a lot of structural constraints, and it varies from country to country. How can we actually have more sustainable capital markets in the region? It’s really about being able to develop domestic market access for issuers in their own countries, and maybe one day allow cross-border, or cross-regional issuance as well.

NEERAJ SETH, BLACKROCK: If I may add, just to put some numbers in perspective. If I look at our credit business in Asia ex-Japan, leaving aside local currency government bonds and the macro business, we manage about US$12bn in credit. About 90% of that is in US dollar credit, and it’s been 90%-plus at any given point over the last 10 years. That number hasn’t moved a lot since I joined the firm in 2009.

If you look at the dollar credit markets in Asia, they have grown from about US$200bn in 2009 to about US$900bn today. You do have liquidity in that market. You can issue with proper size anywhere between three and 30 years, and you do get liquidity across the curve.

When it comes to the local markets, and specifically the moment you go beyond government bonds and into the corporate segment, in any South-East Asian country, there are very few places where you will find liquidity. Malaysia and Singapore have some, yes. But in India it’s low. Indonesia, very low. That, obviously, is where the solution has to start from. It comes back to the point about creating a more institutional framework, with more, larger insurance, pension, other investors, getting more of the global asset managers to come onshore.

The last point I would make is in relation to creating the right infrastructure and the right institutional framework, with transparency and the rule of law. The creditor protection framework has to be fixed. When you get into corporate credit, the question is always “What happened in the last 5, 10, 20 years? What’s the history?” And if there are question marks anywhere in that history, foreign investors will hesitate to go beyond the government bond markets.

IFR ASIA: When you think about the 10% that you do allocate into local currencies, what’s really holding that back? Is it price? Is it credit risk? Is it liquidity?

NEERAJ SETH, BLACKROCK: It’s a combination of factors. It’s valuation, and it’s liquidity.

Now, in terms of valuation, if you think of your underlying base currency in dollars, which is the case for a lot of these pools of capital for us, you have to think of your returns in dollar terms. That means that if the hedging cost is too high, or if you are looking at it unhedged and the currency volatility is high, it affects the net dollar return you are going to make. Obviously, that’s more valid for the government bonds, but as you go down the corporate curve and you look at corporate credit, the underlying fundamentals and the creditor protection framework play a role.

Some of that does get reflected in the ratings, but even ratings will not be able to capture all of the risk, and that’s where it becomes an idiosyncratic risk that you are trying to underwrite. In a lot of these cases, you will have to have a very strong view. So, yes, that liquidity waterfall goes from government bonds to SOEs, or quasi-sovereigns, and to some good quality corporate, and it sort of stops there.

IFR ASIA: Christian, you mentioned this divergence between sovereign credits since the Asian financial crisis. How much of that is down to frameworks and policies, rather than economic growth?

CHRISTIAN DE GUZMAN, MOODY’S: One of the reasons we think why this time is a bit different from 20 years ago is indeed the institutional framework.

We’ve changed from the nearly universal presence of fixed exchange rate regimes, which led to the currency mismatches that led to crisis conditions all around the region, to more flexible exchange rate policies, and increased reserve buffers. Some countries that were literally counting reserves in days’ worth of import payments are now looking at months and months – hundreds of billions of dollars in some cases.

I think what’s underappreciated, other than these mitigants on the external side, are the domestic policy frameworks. In the wake of the Asian financial crisis, a lot of countries in the region implemented, or started to implement, inflation-targeting frameworks. Now, some of those countries were more successful than others in actually anchoring inflation, but I think that these frameworks have promoted macroeconomic stability, which is fundamental to creating the conditions for developing local bond markets. In particular, when you see how inflation has behaved in Thailand – which was the key source of contagion 20 years ago – their success in anchoring macro conditions has arguably been a source of comparative strength this time around.