Asia credit: winners and losers of a rising USD

Asian credit vulnerability could mount due to a stronger US dollar, prompting investors to look at alternative forms of investment including local currency debt.

A strengthening US dollar and potential interest rate hike in the country are causing uneasiness among many investors who fear Asian corporates have become vulnerable to higher foreign exchange-denominated debt.

Corporates in Asia ex-Japan have trebled their FX borrowings from $700 billion in 2008 to $2.1 trillion in 2014, according to a Morgan Stanley report released on February 24. The region’s economies have also grown during that period, although not as fast, resulting in a foreign debt-to-GDP growth of 12.3% for these companies.

Although most Asian corporates that seek foreign funding are naturally hedged, one jurisdiction where investors should exercise caution is China, which houses the largest and most leveraged corporates in the region, the bank added.

This is because Chinese large-cap companies earn less foreign income, despite being the ones that rely less on external funding compared to the regional average (29% for China versus 38% for the region). Merely 10% of Chinese earnings are FX-linked, suggesting a bigger asset-liability mismatch.

“There are vulnerabilities and they are related to companies and industries that meet the double-leveraged criteria — in other words, they’re leveraged overall but have weak balance sheets and are relying heavily on US dollar funding,” Viktor Hjort, credit analyst at Morgan Stanley, told FinanceAsia. "This is prominent in China."

China real estate stands out as being both among the most leveraged industry in the region as well as having the most reliance on foreign funding, credit analysts said. 

Chinese developers accounted for 61% of all high-yield bonds issued by Asian companies, excluding Japan and Australia, in the US dollar market in 2014, according to Thomson Reuters data.

Domestic banks in China have been constrained in how much exposure they could have to the sector. This has prompted developers to turn to the bond markets, which has allowed them to extend their debt maturities and enhance product mix.

However, almost all their incomes are renminbi-denominated and hedging practices are not common among Chinese borrowers, suggesting that developers could face a hard time refinancing their outstanding debt.

“Speculative-grade issuers will face tighter financing conditions as investors and financiers become more cautious,” said Christopher Yip, credit analyst at Standard & Poor’s. “Developers with already-weak liquidity and high refinancing needs in the next 12 months may face a funding crisis as financing sources could be steered toward more stable players.”

China materials — which include the steelmakers and cement companies — along with Greater China and India utility companies were also flagged as being vulnerable to the rise in US dollars, Morgan Stanley highlighted. Capacity utilisation has been low and the lack of pricing power has eroded earnings of these corporates, putting significant pressure on their balance sheets.

The dollar was the best performer among 10 developed-nation peers in the past 12 months, gaining 16.5% against the basket of currencies, according to Bloomberg data.

Opportunities

As the market moves towards the Fed’s rate hike sometime in mid-2014, and as Asian central banks continue to cut rates to spur growth, the region will see a convergence between the cost of funding in local currency versus the US dollar.

Asian borrowers' future funding plans will, as a result, gradually shift towards the local currency space - an attractive asset class that could see an uptick in foreign investor participation over the next few years, credit analysts said.

Asia's challenging growth environment and deteriorating external conditions, along with subdued inflation - given the fall in energy prices - will likely encourage the region's central banks to maintain a easing monetary policy stance. 

In this context, local bonds in Asia are an interesting proposition, said Singapore-based Krishna Goradia, economist at Barclays. “Cyclical headwinds are likely to keep central banks in check even as US yields start turning higher,” he said. “From an asset allocation point of view, this difference [in yield between emerging markets and developed markets] is hard to ignore.

Additionally, the universe of positive real yields is becoming scarcer as central banks in the developed world continue to hold policy rates close to zero, with some even venturing into negative policy rates.

As a consequence, long-term government bond yields have collapsed with all western economies seeing bond yields dip below 2% this year, according to data provider Markit.

This contrasts with policy rates in emerging markets, where real policy rates are close to 3%, the highest since 2007.

“One area investors seeking yield might consider is emerging markets, and in particular sovereign bonds,” said Neil Mehta, analyst at Markit. “Within this grouping, Southeast Asia has been a standout performer, in particular the Asean-5, [which include] Thailand, Malaysia, Indonesia, Philippines and Vietnam.”

Ten-year local currency bonds saw yields hold steady in the region in the two years leading up to the last quarter of 2014.

Yields have since tightened across the board with Thailand in particular seeing its ten-year yield drop around by more than a third to 2.77%, most likely driven by the region’s strong growth and depressed global yields, according to Markit data. Indonesia has been the exception as it yields more than 7%; a figure largely attributed to its high target interest rate.

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