“Frontier” capital has come into sharp focus within Asia-Pacific since the advent of the Covid-19 pandemic. Debate about the proper role of government and multilateral institutions in the face of severe economic contraction heralds heightened awareness that the relationship between the developed and developing world is being recast.
The capital markets’ collective consciousness on the subject of Asia-Pacific frontier capital was roused into fascination last year by two deals – one which happened, for Mongolia, and one which didn’t, for the Lao People’s Democratic Republic.
Apart from summoning into the minds of DCM bankers the prospect of the fees and kudos to be derived from arranging frontier market transactions, the deals opened up the old topic of whether lower-tier emerging nations should seek to raise capital in offshore public markets, running the attendant risk of the “double mismatch” of currency and tenor which lay at the root of the Asian Financial Crisis of the late 1990s.
The argument in response to this risk is that these countries should instead seek to fund via local currency debt markets, and that the proper role of their governments should be to develop the depth and sophistication of these markets – to avoid double mismatch – with the support of multilateral institutions such as the development banks and export credit agencies.
At the same time, new topics also emerged in APAC: how best could the countries of the developed world assist those of the poorest in the region in the face of the devastating economic fallout from the pandemic? And precisely what role is being played by China in the long-term dynamic of funding APAC’s emerging and frontier economies?
“You could argue that frontier debt capital is not a distinct asset class as such but simply a subsection of emerging markets,” said Florian Schmidt, founder of Frontier Strategies, the Singapore-based boutique solutions provider for frontier market sovereigns and private sector entities.
“Whatever that argument, ‘frontier capital’ has risen in the minds of market players over the past year thanks to the dynamic of the pandemic, which has focused attention on the economies and debt management of the poorer DSSI-eligible countries, particularly in Africa and Asia-Pacific.”
The Debt Service Suspension Initiative was initiated by the World Bank and the International Monetary Fund and took effect in May 2020 with the aim of aiding poorer countries affected by the economic fallout from the pandemic to concentrate their resources on fighting Covid-19 and the lives and livelihoods of vulnerable populations. Some 40 eligible countries have benefited from the scheme, which has delivered US$5bn of debt service relief.
“There has been a lot of talk about the G20 framework to relieve the debt burden of the poorer countries, something that used to apply to frontier economies under the purview of the Paris Club,” said Schmidt.
“But there is a new reality within the international framework – China is now the largest creditor nation of emerging economies in Africa and APAC as a the result of both concessional and commercial direct lending. China Eximbank’s commercial loans, for example, feature margins of only 0.5%–4.5% over Libor, which looks attractive given such loans often go into destinations where others are wary to lend.”
This is to state the reality that on the subject of frontier markets: China sits at the core of the fundraising action. And those markets also are also a central theme of one of the most significant transformational dynamics which is unfurling at rapid pace – the internationalisation of the renminbi.
That dynamic has been gathering pace since the inclusion in 2016 of the Chinese currency in the IMF’s Special Drawing Rights Basket of currencies, and as China seeks to challenge the hegemony of the US dollar not only with the “traditional” renminbi but also with its digital version, the frontier markets – particularly those of APAC – are in the crosshairs.
Armenia, Cambodia, Kazakhstan, Laos, Mongolia, Nepal, Pakistan and Uzbekistan enjoy renminbi swap deals with China, which effectively represent lines of credit and which push further the growing internationalisation of the Chinese unit. That sits alongside the direct lending which China has been conducting with these countries – principally to fund infrastructure projects – and which segues into the activities of the Asian Infrastructure Investment Bank.
If there were to be any single institution which has the potential to transform APAC’s frontier markets in terms of international debt capital, it is the AIIB.
The lender, established in 2015 and now the second largest MDB after the World Bank, is likely to continue its activities with the frontier economies via funding for “Belt & Road” infrastructure projects, Premier Xi Jinping’s mammoth undertaking which seeks to recreate the ancient Silk Road that once linked trade between China and the West.
In APAC, according to the Asian Development Bank, the infrastructure need requires US$1.7trn of funding between now and 2030 to maintain growth momentum, poverty reduction and climate change mitigation, so the AIIB’s place at the forefront of the B&R initiative is on the money and Asia’s frontier economies are on that road.
But how will the AIIB go about dispersing funds and will debt market development be involved?
At its annual meeting last July, the bank revealed it was assembling a US$500m fund to test its in-house investment framework which aligns with the Paris climate accord – the Asia Climate Bond Portfolio, which will be managed by Paris-based Amundi. The ACBP is part of the bank’s Sustainable Capital Markets Initiative which aims to “crowd-in” private capital to sustainable initiatives.
The modus operandi to facilitate this is not fully explained. But of course it is one thing to compile a portfolio of sustainable bonds and another to actively develop local bond markets, particularly as far as frontier economies are concerned.
Proponents of debt capital market development will not be best pleased if the modus operandi involves just more of the same – direct lending, perhaps at concessional rates, with non-disclosure clauses attached.
Their argument would be that, much as the ADB has done, the proper role of the AIIB is to develop local frontier capital markets by issuing in local currency for benchmarking purposes, or to take large strategic block positions in issuance from frontier countries or other MDBs issuing to support them. In the latter case, the ACBP may of course go on to invest along those lines, but the former strategy has not yet been embraced.
What's in a name?
That strategy has been adopted by the ADB, which eschews the use of the term “frontier markets” but rather classifies countries as A,B and C, according to their income levels, with group A representing the poorest members.
“The ADB takes a holistic approach to its support for developing member countries, through the provision of loans, guarantees, investments – equity and debt – grants and technical assistance,” said Jonathan Grosvenor, head of treasury client solutions at the ADB’s treasury in Manila.
“From ADB Treasury we also frequently contribute from a transactional perspective by mobilising finance in local currencies through a diversified toolbox of funding instruments and supporting the development and use of financial sector infrastructure.”
The bank has pushed the development of frontier markets, by opening local currency issuance to offshore players - via offshore local currency bond issues in Armenia, Mongolia and Pakistan and a domestically sold local currency bond for Georgia, between 2018 and 2020 – usually in fixed-rate format due to lack of available hedging instruments (although it has issued in FRN format in Georgia and Kazakhstan).
On the point of frontier countries borrowing in offshore currencies, the question is whether the “original sin” (of mismatch and tenor) should be committed at all, and that it is the job of the MDBs to work to encourage the development of local bond markets in a bid to avoid that sin.
A case in point is the ADB’s inaugural “nomad” bond, issued in five-year Mongolian tugrik last June at the height of the pandemic, which was sold to a single European investor.
But however laudable that bond issue, not least from its ESG focus – it funded a gender inclusive dairy farm – the reality remains that the most effective venue for achieving size, tenor and absolute term funding cost are the international debt capital markets denominated in hard currencies.
Mongolia demonstrated that reality last September with a US$600m 5.5-year which funded a tender offer to retire high-coupon paper, with the extension easing refinancing fears on the due 2021s and 2022s the new paper took out. Frontier Strategies advised on the deal, which reduced the sovereign’s blended funding cost down to 3.5%, a far cry from the 11% of just four years ago.
That sweetened the sourness left by the somewhat farcical proceedings involving a planned US$300m five-year for the Lao People’s Democratic Republic, which was pulled from the market on three separate occasions by sole global coordinator and books Oppenheimer and Co, most recently in March.
Initial non-disclosure of breached negative pledge covenants on external loans was cited as the reason, which perhaps goes to show that one of the biggest pitfalls in developing the frontier bond markets lies in direct or syndicated loans, and their often onerous covenants, which lurk in the shadows, often under the cover of non disclosure.
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