The Asian Bond Fund's currency conundrum

Asian central banks'' attempt to improve regional bond markets is hampered by fixed exchange rate regimes, says S&P.

While the initiative by Asian central banks to improve the regional bond markets via pooling reserves to invest in local markets has merit, it may not work as long as the region maintains fixed currency regimes, warns a recent report by Standard & Poor's.

John Chambers, a credit analyst at S&P in New York, says the 11 central banks and monetary organizations in the Asia-Pacific region that set up the $1 billion Asian Bond Fund from their foreign reserves have the right idea: that they can improve their sovereign creditworthiness by deepening their domestic capital markets.

Governments, banks and companies in Asia (or elsewhere) borrow abroad because foreign lenders offer better terms or maturities, but this creates risk, as foreign lenders are more likely to suddenly turn off the taps than domestic ones. Improving the depth and breadth of domestic capital markets reduces these risks. It also gives country more independence in monetary policy, as central banks can manage short-term interest rates by adjusting the flow of government securities, rather than make direct loans, Chambers says.

To this end, the regional central banks established the Asian Bond Fund, which passively invests in dollar-denominated sovereign and quasi-sovereign paper by the Bank of International Settlements. Because it is in dollars, it doesn't provide any local-currency funding, and because its management is passive, it doesn't add liquidity, but the ABF is only the beginning. The 11 central banks are now working on ABF II, a series of country funds investing in local currency bonds, as well as a fund of funds, all open to local and global investors.

Chambers says that by attracting portfolio flows, these initiatives are meant to catalyze reforms that will harmonize markets and build market infrastructure, measures more important than the fact of the funds themselves. These measures should bring withholding taxes into line, make government securities more fungible, improve regulation, and encourage things such as a repo market, better settlement systems and liberalizing forward and futures forex markets.

Moreover, these funds are intended to attract investment from regional institutions such as pension funds, life insurance companies and wealthy individuals, to create a long-term and stable investor base.

This is all to the good, says Chambers, but the snag is that this is taking place in fixed currency regimes. He highlights an argument put forth by economists at groups like the Asian Development Bank and the International Monetary Fund that says the ABF inflows will ultimately end up being invested in US Treasuries.

In fixed-exchange forex regimes, Asian interest rates correlate to US dollar rates. While Asian investors (or investors in Asian paper) may want the yield pickup from credit risk, or may be punting on the soft pegs being broken, they aren't looking for interest rate diversification. Central bank stockpiles of dollars will grow, but the cost of carry between Asian and US rates is negative. This means Asia must sterilize the inflow at a fiscal loss, or risk higher rates of inflation as the money supply expands.

In other words, if ABF is too successful, it could dampen economic growth, so long as the currency regimes remain fixed to the greenback. This suggests that if Asian governments want the benefits of developed bond markets, they need to free their currency regimes. And to do that will require extensive capital market and banking reform, lest some members such as China face instability reminiscent of 1997.