Contagion could plague E Asia’s bond markets

The region’s debt capital markets could be vulnerable to contagion effects due to shift in global risk sentiment, says the Asian Development Bank.

Emerging East Asian bond markets could be hit by contagion from economies more vulnerable to the current emerging market turmoil if the situation in financial markets worsens, according to the Asian Development Bank.

The region has remained relatively stable in spite of the turmoil impacting other emerging markets globally because of its robust economic fundamentals, combined with a reliance on mainly local currency financing, the ADB said in a recent report.

Additionally, investors have been distinguishing between stronger and weaker markets based on country-specific economic vulnerabilities and have not been treating all emerging economies as a homogeneous group, notes ADB.

However, East Asia could be vulnerable to a shift in global risk sentiment against all emerging markets if there were a severe crisis in one or two vulnerable economies. Countries with large current account deficits and low levels of foreign exchange reserves are seen as being particularly at risk, highlights the organisation.

“If there is an event that has a big enough impact on investor sentiment – be it within or outside Asia – that could cause them to throw caution to the wind and flee the emerging markets in one shot,” Thaim Hee Ng, senior economist at ADB, told FinanceAsia. “That is when the region’s economies could be affected despite their best efforts in making their economy much more resilient.”

As a result, further reforms may be needed in some of the region’s economies to improve their resilience in the face of possible contagion effects, adds the organisation.

Examples of reforms could include taming bureaucracy, boosting domestic investment and improving infrastructure quality, says Ng. “Countries have to really focus on improving their productivity,” he said. “These factors can help a country generate more growth so that they become less dependent on foreign capital.”

Higher yields

In addition to possible contagion effects, tighter liquidity conditions and rising inflation are also risks that emerging markets need to address. This could in return result in higher bond yields, making it more costly for both sovereigns and corporates to raise funding.

Inflationary pressures have started to pick up in several countries in the region, notes ADB. Some of the increases have been driven by removal of subsidies, such as in Malaysia, or supply shocks, as in the Philippines and Indonesia.

At the same time, generally higher global liquidity conditions will also push up interest rates. This is already happening as the Federal Reserve seeks to continue reducing its monthly purchasing programme by $10 billion per month.

By the end of January 2014, yields for most tenors in most markets in emerging East Asia had risen in response to the Fed tapering. Yields rose strongly for most tenors in Indonesia and the Philippines, with the 10-year yield rising 58 bps and 52 bps in each country respectively, estimates the organisation.

“In Indonesia, negative sentiment continued to prevail amid persistently high inflation. Bank Indonesia stated that inflation is expected to remain elevated given the recent supply shocks due to flooding,” said Ng. “In the Philippines, yields reacted on expectations of a power rate hike and concerns over the peso’s further depreciation.”

Furthermore, ADB adds that if some emerging market currencies were to come under selling pressure, they might be forced to raise interest rates to stave off an attack.

Currency depreciation

Economies with high levels of foreign currency-denominated debt are vulnerable to currency depreciation, highlights ADB.

“If the region’s exchange rates were to fall, many corporates would face higher debt servicing costs at a time when domestic economic conditions would also likely be weakening,” said Ng.

While the region’s sovereigns have mostly focused on issuing local currency bonds in recent years, corporates in some markets have taken advantage of the plentiful liquidity in the US dollar market to issue more foreign currency bonds.

In 2013, for example, real estate companies in the People’s Republic of China were major issuers of foreign currency bonds, partly because it is becoming more difficult for them to borrow from banks domestically due to tightening regulatory restrictions.

“We have to reduce our reliance on the domestic loan market to a certain extent and also other types of loans including trust loans,” said a Hong Kong-based chief financial officer of a Chinese real estate company with sizable operations in Tier 2 and 3 cities on the mainland. “We have to increase reliance on self-raised funds, either through the bond or equity markets overseas.”

Overall, the region’s G3 currency bond issuance in 2013 reached US$141.5 billion, of which US$128.4 billion originated in the corporate sector, estimates ADB. Furthermore, G3 currency bond issuance by corporates represented 14.4% of total corporate bond issuance in emerging East Asia in 2013.

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