It is often said that an orderly retreat from battle is in many ways harder to orchestrate than an advance. As sovereigns in Asia consider exit strategies from their economic stimulus programmes, Standard & Poor's Ratings Services anticipates that they will seek to strike a balance to prevent a derailing of the still-nascent recovery. In our view, governments will need to retreat from economic stimulus in a measured fashion, while keeping administrative controls in place to avoid potential asset price bubbles and inflation. This in mind, the potential onset of a second broad global economic slowdown could constrain available policy options at a time when renewed support measures would become necessary.
Fiscal deficits may soon peak
In S&P's view, the strong economic rebound in Asia compared with other regions should eventually prove to be a boon for sovereign fiscal trends. Nevertheless, we expect that sovereign commercial issuance in Asia during 2010 will likely outpace 2009 levels by 5%. According to S&P's survey of borrowing and debt, sovereign requirements for 2010 are likely to bring commercial issuance in the region to $2.2 trillion.
This follows a jump in the overall average deficit for the region in 2009, which we estimate to be about 5% for the year, up from nearly 3% in 2008, as fiscal improvement lags the nascent economic recovery and policy support remains necessary. This recovery faces risks though. Among them, a reversal in perceptions of emerging market risk because of events outside the region and potential fiscal demands above forecast.
Excluding the outsize contribution of Japan to the total, we expect commercial issuance from the rest of Asia to be about $471 billion. This will raise the overall total of outstanding short-term and long-term commercial debt held by Asia-Pacific governments to an estimated $7.1 trillion. We believe that the test for sovereigns in the coming year will be managing macroeconomic crosscurrents while stimulus-based policies are still in place, despite worries over asset and consumer price trends. Longer term, the prospect of lingering deficits, combined with the significant downside risks of a second slowdown in global growth, raises questions about debt sustainability for a number of sovereigns in the region and the implications of borrowing plans on ratings.
The sovereign borrowing story in Asia has always varied depending on whether one includes or excludes Japan from the calculations. We expect Japan's debt issuance to account for about 80% of the regional total for 2009 and 2010. Some might point to structural similarities in the industrial economies of the sovereigns that have been active issuers during the past year, such as Korea and China. However, the respective fiscal trajectories of these countries do not, thus far, presage a Japan-style outcome. Excluding Japan, we expect issuers in the 'A' 'to 'AAA' rating category to account for 62% of medium- and long-term sovereign commercial issuance during 2010.
We expect 'A' rated sovereigns to issue a majority of regional debt during 2010 and estimate China and Korea to account for 39% and 17% of the total market, respectively. However, 'BBB' rated sovereigns should make up a larger portion of debt issuance, with projected gross commercial borrowing increasing by 39% compared with 2009 levels. We expect that the debt issuance by 'BBB' rated sovereigns will account for 26% of the overall market, excluding Japan, by the end of 2010. As a result, future rating outcomes in this category will have an impact on the overall size of Asia's investment-grade market.
S&P believes that ultra-loose monetary policies from major central banks around the world have helped fuel high domestic liquidity. We expect this trend to continue at least through the middle of 2010, and renewed appetite for emerging market risk has amplified the effect of these policies. This has helped to lower sovereign spreads over US Treasuries, as well as the spreads for corporate issuers perceived to have strong ties to government. Higher levels of inflation or risks to the nascent recovery could reverse these trends, however, and make funding in 2010 more costly than during 2009.
A key question for the region is whether the effect of borrowing trends for 2009 and 2010 will shift perceptions of sovereign risk, should the global economic recovery falter. Another important dimension is the path of the US dollar, which has generally weakened as a function of improving sentiment in Asia and elsewhere and has helped to fuel the search for yield in the region.
In search of the right policy mix
The apparent contradiction between the words and actions of regulators in the region reflects unique global monetary circumstances. In our opinion, the recovery remains fragile, and steps are still necessary to prevent inflation, asset price bubbles, and unproductive investment.
Thus far, regulators in the region have favoured administrative measures over interest rate increases in order to target inflation and asset prices, while maintaining a policy stance that supports real economies. This is perhaps most apparent in India, where the Reserve Bank of India (RBI) has increased the proportion of deposits that commercial banks must put into holdings of government securities, as well as the provisioning requirements for loans issued to real estate companies. It has also suspended several special refinance facilities. China's recent implementation of increased provisioning requirements for commercial banks, sector-specific lending controls, and other administrative measures to direct the flow of credit, despite the stated need for sustained policy support for the coming year, reflects similar concerns.
Given that sovereign debt issuance is likely to remain active during the coming year, if not managed properly, the prudential policy mix could run the risk of crowding domestic intermediaries into government debt, and in the process partially crowd out private issuers and borrowers whose investment has helped to drive the recovery thus far. The level of liquidity on financial institutions' balance sheets has been one area of focus for reforms to prudential regulation (regulation that aims to ensure the safety of depositors' funds and keep the stability of the financial system). Proposals that would require banks, and potentially other financial institutions, to maintain minimum levels of liquid assets have already surfaced. Under general zero risk weighting formulas, sovereign or quasi-sovereign debt would probably be an easy means to meet such a requirement.
However, one unintended consequence of such regulations might be that under a reasonable stress scenario -- a combination of economic recession and rising sovereign deficits -- price volatility for concentrations of "risk-free" assets on the balance sheets of domestic financial institutions could cancel out the intended benefits of this aspect of tighter scrutiny. Additionally, the potential for moral hazard resulting from regulatory-induced demand for sovereign debt cannot be ignored.
A tricky 2010
For many sovereigns in the Asia-Pacific region, 2010 will bring the difficult task of controlling inflation and asset price appreciation at at time when economic support measures and borrowing needs remain significant. To date, the reliance of some governments on directed lending and government-supported corporate borrowing in place of more direct fiscal stimulus measures has helped to stabilise growth.
However, one potential economic scenario for the coming year involves strong support for asset prices as a function of loose monetary policy amid a weakening recovery. Such an outcome could test the fiscal and monetary flexibility of numerous regional sovereigns as funding costs rise and tension between the policy demands of supporting the real and financial economies increases.
Although the borrowing increase we expect during 2010 is below that expected for year-end 2009, we believe that sovereigns in the region are not yet ready to retreat from capital markets either for their own funding purposes or for general economic support programmes. However, as history has shown, an orderly and selective retreat from market support measures and accommodative policy --especially during times of increasing economic uncertainty -- takes far greater skill than the initial advance. For sovereigns in Asia during 2010, this could mean remaining active issuers in markets that they may otherwise like to tame. The result of this balancing act will be important for medium-term fiscal trends.
William Hess is an associate director of sovereign & international public finance ratings at Standard & Poor's.
