Easy money?

IFR IMF/World Bank 2021
10 min read
Jonathan Rogers

Asia’s economies appear to have weathered the Covid-19 pandemic thanks to decisive fiscal and monetary action, although concerns remain about the sustainability of growth, mounting fiscal deficits and the stability of local currencies

Since the Covid-19 pandemic kicked off in early 2020, the bond markets of Asia (ex-Australia and ex-Japan) have played a key role in addressing the economic and social challenges wrought by the disruption caused as a result of social distancing and lockdowns.

The pandemic has added nuances to the region’s bond markets in the form of massive issuance of social and sustainability bonds, while central banks in India, Indonesia, Malaysia, the Philippines, South Korea and Thailand have engaged in forms of quantitative easing – “QE lite” – in a bid to inject liquidity and control local currency yield curves alongside deep policy rate cuts to historic lows. At the same time, within East Asia, domestic investors – particularly banks – have provided buying support to local bond markets.

According to the Asian Development Bank, outstanding local currency bonds in emerging East Asia rose to US$21.1trn-equivalent at the end of June, with a heady 14.6% growth pace on a quarterly basis, led by government bond issuance, while sustainable bond markets in Asean+3 grew by 54% year-on-year for a total US$345bn market size, equivalent to 19% of the world’s total sustainable bonds outstanding.

Unsurprisingly, fiscal deficits within emerging East Asia have risen as a result of the pandemic thanks to reduced tax revenues and rising expenditure, and local currency treasury bond issuance in Asean almost tripled in 2020 and the first half of 2021 versus pre-pandemic levels as governments sought to fund measures to address the economic fallout from Covid-19.

New challenges emerged this year at the end of the second quarter as the Delta variant swept through swathes of Asean, forcing renewed lockdowns and highlighting what the ADB has described as a “two-track” global recovery between developed and developing nations due to divergent vaccination programmes.

The ADB recently revised its growth forecast for Asean down from 4.4% – projected last April – to 3.1%. And, in a new report, the World Bank downgraded its growth forecast for East Asia and the Pacific to just 2.5%, a cut of two percentage points on its April estimate, citing declining labour force participation, the loss of valuable intangible assets and investment deferment.

A central narrative over the past 18 months has been the seemingly unstoppable rise of debt issued by China as axiomatic to the region, whether in domestic or offshore format. Some 78% of Asia’s domestic bond market is accounted for by China issuance and the country produces 40% of the region’s offshore issuance.

While the domestic bond markets of Asean can often seem as something of an irrelevance in a region still dominated by bank lending, China’s local bond markets have moved to the centre of international investors’ radar screens thanks to a compelling economic backdrop – the ADB estimates growth in the country to hit 8.5% this year – generous yields across the curve, easy execution access and inclusion in the FTSE World Government Bond Index.

And unlike many of Asean+3’s central banks, the People’s Bank of China has not cut policy rates in response to the pandemic nor used QE, preferring instead to provide credit easing through non-bank channels and via reserve ratio requirement cuts, the last being a 50bp cut in July with another cut expected imminently. This means the PBoC has plenty of ammunition left at its disposal should the growth picture cloud over.

“The argument for offshore investors in China’s debt markets has been convincing given the yield and diversification opportunities. Another incentive has been the historically low correlation of China’s debt markets with yield moves in the US and other developed economy bond markets,” said Mushtaq Kapasi Asia-Pacific head of the International Capital Market Association.

For Asia’s offshore bond market, an arena which has surged over the past decade, the backdrop is perhaps troubling: US Treasury yields are rising as inflation gathers pace in the country, while the threat of a messy collapse at China property giant Evergrande highlights the dominance of China debt within the sector – particularly from the real estate industry – and raises questions for investors about participating in that sector, particularly given China’s record for shabby treatment of bondholders during debt workouts

Still, offshore bond markets have provided a much-needed backstop for developing economies in East Asia during the pandemic, as have multilateral development banks.

Dialogue dividends

“Faced with multiple sovereign downgrades, investor appetite for emerging market hard currency debt quickly dried up as a consequence of the risk-off environment, with Indonesia, Philippines, and the People’s Republic of China among the few developing countries able to borrow offshore in the middle two quarters of 2020. This paid testament to their regular dialogue with investors and established track record in the international bond markets,” said Jonathan Grosvenor, assistant treasurer and head of treasury client solutions at the ADB.

Indonesia managed to issue a multi-tranche US$4.3bn social bond last April – billed as Asia’s first “pandemic bond” – printing Asia’s longest tenor of 50 years on one piece, while the Philippines priced a US$2.35bn 10 and 25-year the same month.

The question remains just how resilient Asia’s offshore bond market will be should US Treasury yields continue to rise – the 10-year hit a 1.54% month high towards the end of September, while 100-day and 200-day moving averages crossed, indicating higher yields to come – and challenges emerge in the macroeconomic backdrop.

“The offshore bond market in Asia has grown so rapidly in such a relatively short space of time, from around US$200bn a decade ago to around US$1.2trn now, that there are a host of attendant anomalies,” said Owen Gallimore, head of Asian credit trading strategy at ANZ in Singapore.

“These range from a pragmatic but backward-looking quantitative approach to credit analysis, versus the more forward-looking but resource demanding qualitative approach, index-driven passive investment in new issuance, and high-risk concentration to the dominant China property sector. Plus, there is a high-yield market which is covenant-lite and where Single B issuers are often able to price as Double Bs.”

Yield pick-up

Meanwhile, Asia’s local bond markets continue to offer a solid diversification and alpha-generaton play despite the fact that foreign participation has been relatively low in the Asean arena.

“About one-quarter of the global bond market has a yield below zero and many are close to zero, including corporate bonds, but the Asian local currency bond market still offers an attractive yield pick-up of around 2.4% versus global sovereigns,” said David Cheng, fixed income investment director at Schroders in Singapore.*

“Additionally, Asian sovereign debt to GDP ratios are lower than many developed market countries and reliance on external debt is also low, unlike other emerging market regions. Asian economies have been resilient throughout the Covid-19 pandemic and are expected to continue leading the world in GDP growth in the coming years.”

As far as Asia’s economies are concerned the immediate outlook is grim as a result of the pandemic. According to the Asian Development Bank US$260bn of output has been lost thanks to Covid, and those living in extreme poverty in the region rose by 5.4 million last year.

“The economic recovery of developing East Asia and Pacific faces a reversal of fortune,” said World Bank vice-president for East Asia and Pacific, Manuela Ferro. “Whereas in 2020 the region contained Covid-19 while other regions of the world struggled, the rise in Covid-19 cases in 2021 has decreased growth prospects for 2021.”

At the same time, a worry for the region and its central bank monetary policy is the build-up of inflationary pressure in the form of supply chain bottlenecks – due to decreased labour market participation and mobility – rising fuel and precious metal prices and cost surges within shipping and transportation. Thailand, the Philippines and Vietnam are vulnerable to a higher oil price and the ADB has estimated that without fuel subsidies, inflation in Malaysia would have hit 7% last year.

Another concern is the potential for widespread monetisation of fiscal deficits and the creeping loss of central bank independence as government leans on these institutions to help fund the hole created by massive fiscal stimulus.

This phenomenon has been most starkly illustrated in the Philippines, where the central bank has helped finance the fiscal deficit via three-month short-term advances, as well as in Indonesia, where the central bank has agreed to “burden sharing” with the government.

And as the Federal Reserve prepares to unwind its quantitative easing programme, there remain questions about the resilience of Asian currencies and bond markets in countries where fiscal deficits are rising, should a risk-off mentality return with a vengeance.

The big fear for the region’s local currency markets is downside currency volatility, a consequent importation of inflation, rising stress in servicing external debt, low growth as base rate effects drop out and the spectre of stagflation.

* This sentence was changed to correct David Cheng's location.

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