Bernanke and the Asian debt sell-off

Who's afraid of Ben Bernanke? Hints of Fed tapering sparked a sell-off in emerging market bonds, but most of the outflow came from mutual funds.
US Federal Reserve chairman Ben Bernanke hinted that the Fed would reduce its vast purchases of US Treasuries, signalling an end to an era of ultra-low interest rates.
US Federal Reserve chairman Ben Bernanke hinted that the Fed would reduce its vast purchases of US Treasuries, signalling an end to an era of ultra-low interest rates.

The sell-off in Asian emerging market debt started early on May 23, when most people in the region were still asleep. On the other side of the planet, US Federal Reserve chairman Ben Bernanke hinted that the Fed would reduce its vast purchases of US Treasuries, signalling an end to an era of ultra-low interest rates.

During the aftermath of the Lehman bankruptcy and the global financial crisis of 2008, the Fed kept rates low to stave off deflation. As a result, investors have been allocating money to emerging markets in search of higher growth and richer returns.

But Bernanke’s comments raised the possibility of a shift to tighter policy and caught the market on the wrong foot, prompting an exodus of money from emerging markets. From Brazil to South Africa to India, countries felt a sudden shock as investors pulled money out.

The outflows from emerging markets exposed fundamental weaknesses in some of Asia’s biggest economies. India and Indonesia, both plagued by current account deficits, looked wobbly and bore the brunt of the capital outflows, while China also went through a liquidity crunch. In addition, other countries such as Malaysia and Thailand also saw foreign investors pulling out funds.

According to data from Deutsche Bank, foreign investors pulled out about $19 billion from the region’s local currency bond markets from July to September. This was a sharp reversal from the $45 billion worth of inflows seen when the Fed started its third round of Treasury purchases in September 2012 to May 2013, and $203 billion of inflows from the start of 2009 to May 2013.

The dramatic slide in some of Asia’s currencies brought back memories of the Asian financial crisis, which started off with the rapid depreciation of the Thai baht. However, economists say that the recent sell-off differs from the dark days of 1997.

For one, most Asian countries no longer peg to the US dollar, and are not squandering their reserves to defend arbitrary currency levels. They have also developed local currency bond markets that offer access to domestic funding. So, while Asian currencies have depreciated, it has not brought companies to their knees the way it did back in 1997.

“In 1997, companies were borrowing in foreign currency while their revenues were in local currency, so that was a big problem when the currencies depreciated,” said Thiam Hee Ng, senior economist from the Asian Development Bank. “Now, more companies have issued in the local bond markets, so they no longer have this problem when their currency depreciates.”

Also, while the headline numbers suggest huge outflows, asset managers say that mutual funds are responsible for most of the reported outflows. They argue that the inflows from institutional investors such as central banks and sovereign wealth funds are under-represented.

“Much of the attention has focused on the outflows in the mutual fund space,” said Owi Ruivivar, portfolio manager for Goldman Sachs Asset Management. “But mutual funds are only a small subset of the investor base, and do not reflect the inflows we are seeing from institutional investors.”

While mutual funds are pulling out money to meet redemptions by retail investors, institutional investors are gradually increasing their exposure.

“The institutional flows are a slow burn, and we are seeing them increase allocations to Asian emerging market fixed income,” said Dominic Pegler, managing director and head of Asia-Pacific fixed-income product strategy at BlackRock. “The hot money, which is mainly the retail and mutual funds, is less sticky.”

Losing liquidity
Although asset managers say fund outflows have been largely from mutual funds, they have had an effect on prices. This is particularly true as liquidity has drained from Asia’s bond markets recently.

Under the new Basel III regime, banks have to set aside more capital to warehouse bonds, and as a result traders have less ability to keep a bond inventory. This has resulted in wilder swings in the market.

The region’s bond markets vary vastly in terms of liquidity. The Malaysian ringgit and Korean won bond market for example are much deeper and more liquid. But others are far less liquid, and bid-offer spreads — an indication of liquidity — have widened sharply during the past few months.

“We have not seen a great deal of flow in Indonesian corporate bonds, while India also suffers from a lack of liquidity, with bid-offer spreads for corporate bonds widening from 5bp to 25bp,” said Vishal Goenka, head of local currency credit trading at Deutsche Bank in Singapore.

The lack of liquidity is not idiosyncratic of local currency bonds, but true of credit markets. But thin levels of trading mean that the market is vulnerable to exaggerated swings in prices, and this has come at the cost of investors.

See FinanceAsia's upcoming fixed-income supplement for the full version of this story.

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