While countries in Latin America started their hiking rates earlier in 2021 to help combat inflation, the US Federal Reserve only started its current hiking cycle in March, ratcheted swiftly in the past few months amidst the continuing threat of high inflation, made worse by the Russia-Ukraine conflict.
Since then, it has become almost fashionable for central banks around the world to turn hawkish and play catch up on monetary policy tightening. Amid the rate hikes, the Federal Reserve has also started allowing its maturing bonds to roll off, rather than reinvesting the proceeds in what is termed as Quantitative Tightening (QT).
While the start of QT had been well flagged and expected to be a gradual multi-year process, the exact market implication of the unwinding adds uncertainty in what is already a highly uncertain period for financial markets. While the reasons leading to pullback of funds into developed markets are manifold, this has historically come at the expense of the rest of the world. A weakening local currency results in higher debt servicing cost of foreign currency debt, typically denominated in the US dollar.
As central banks tighten their own monetary policy to defend the value of their currencies, this could result in higher cost of funding in their local currency debt as well. Credit risk of emerging markets would be particularly heightened against this backdrop, as we are seeing in parts of Asia.
However, with reforms made in the past three decades, including the development of local currency bond markets, we are of the view that corporates and banks in Singapore, Thailand, Malaysia and Indonesia are in a more defensive position.
Southeast Asia’s local currency bond markets built from lessons of the Asian Financial Crisis
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In the aftermath of the Asian Financial Crisis of 1997–1998, it became apparent that the impossible trinity of a concurrent free flow of capital, exchange rate targeting and an independent monetary policy that was prevailing prior to the crisis placed the region in an unstable scenario. High debt levels, and currency and tenor mismatches of borrowings further explains how a crisis that started in the currency markets quickly spiralled into the real economy.
In the years prior to the crisis, the region was booming economically, spurring rapid credit growth. It was common then for a local corporate to be borrowing in short-term US-dollar funding to finance a multi-year expansion project in its local market and for banks to be also borrowing in US dollar that was in turn lent to local borrowers who generate income in the local currency.
The bursting of the bubble revealed pre-existing vulnerabilities in the governance and funding models of borrowers while the under-developed financial sector meant that when existing funding sources dried up, there were few shock absorbers in the system. Using data derived from a sample of 5,550 companies presented in a paper by the Asian Development Bank (ADB), around 40% of corporate debt in selected Asian economies comprised of foreign debt in 1996. Much of this was short-term debt.
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Recognising the importance of encouraging regional co-ordination after the crisis and developing an alternative financing market for the regions’ economies, the Association of Southeast Asian Nations (Asean), along with China, Japan and South Korea launched the Asian Bond Markets Initiative (ABMI) in December 2002. The stated aim of the ABMI is to develop efficient and liquid bond markets in Asia, which would enable better utilization of Asian savings for Asian investments. This would also contribute to the mitigation of currency and maturity mismatches in financing.
The Executives’ Meeting of East Asia-Pacific Central Banks (EMEAP), an organisation of eleven central banks and monetary authorities launched the Asian Bond Fund (ABF) in June 2003 to spur the development of the region’s bond market. In the initial phase, the focus was on US-dollar denominated bonds and in the second phase, EMEAP members invested in the local currency sovereign and quasi-sovereign bonds issued by eight EMEAP economies.
Generally, development of a new local bond market starts with the sovereign market, with other segments then building upon the implied credit risk-free curve. While more can still be done in the secondary market and fixed income-related derivative markets, we view Singapore, Thailand, Malaysia and Indonesia as having the most developed local currency bond markets within the Southeast Asian region.
Established funding source
Year to date, the Asia dollar index has fallen 5.7%, though in our view, the economies that have built up their local currency bond markets as a key alternative funding source to their local banking system are in a much better position versus the late 1990s.
Within Southeast Asia, Singapore, Thailand and Malaysia have the three largest local currency bond markets by amount outstanding at US$467.4 billion ($645.30 billion), US$464.8 billion and US$461 billion respectively per Bloomberg data. This is followed by Indonesia at US$438.9 billion. While each of the markets are at a different stage of development, corporate credit (including banks and government-linked companies) makes up a fourth of the total local currency bonds outstanding in these markets, on average.
In the more established primary corporate credit markets of Singapore, Thailand and Malaysia, corporates (including banks) are able to issue in long dated tenors including perpetuals. Despite its smaller size, we consider the Singapore corporate credit market to be the most internationalised of the three, in view of the freer flow of capital which encourages foreign investor participation and a sizeable presence of foreign issuers.
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As domestic use is typically limited for foreign issuers, such issuers are required to swap the Singdollar proceeds into other currencies. They tend to be attracted by funding cost differentials and diversification of funding sources. As a point of comparison, these four countries collectively only have US$291.2 billion of US-dollar denominated bonds outstanding, mainly comprising of corporate credit.
“Diamond hands” – for real?
The existence of foreign investors in local currency bond markets adds to demand and hence may lead to lower cost of funding for issuers and aid more efficient price discovery. This is particularly useful if the domestic pool of capital is not deep.
However, as foreign investors invest across borders, the existence of such investors who can pull away capital at any time may also lead to higher bouts of volatility. We would expect the existence of levered investors and those with shorter investment timeframes, for example, certain hedge funds, to also add to market volatility.
As such, for a more sustainable development of a local currency bond market, we view it to be critical that a market consist of sticky money, which in our view is correlated to investors investing in their home currencies. Generally, locally domiciled banks are major participants of local currency bond markets, both as a market maker as well as for their own investments.
The existence of local institutional investors is important in our view to channel savings into the bond market and to encourage more effective pricing of credit risk, something that has aided the relatively more developed local currency bond markets in Singapore, Thailand and Malaysia. All three are economies that have set up pension and/or retirement schemes and a thriving asset management industry. Indonesia’s pension fund to GDP is still small at less than 3%, while the asset management industry was negatively affected by recent scandals.
However, the long-term growth in the industry, underpinned by projected rising wealth may reduce Indonesia’s reliance to offshore markets. Bond markets including local currency bond markets have historically been an institutional market. In the Singdollar market, wholesale bonds generally have a minimum size of $250,000. The development of a robust asset management industry can form a strong base of domestic investors where capital from dispersed sources are pooled together for investments. This is especially so as the retail bond market continues to be underdeveloped despite investor penchant for yielding products.
The establishment of Singapore as a private wealth hub provides a sizeable pool of capital including from offshore investors who see Singapore as a safe haven and the Singdollar as a store of value. According to MAS data, 21.6% of investors in Singdollar issues in 2020 consist of private banking investors. For longer dated bonds, insurers are sizeable sources of capital where such instruments would better match their liability needs. Barring the largest deals in the market, we observe that it is uncommon for Singdollar issues to require active distribution to investors located inside the US and Europe.
Why do companies still issue in the offshore markets?
Despite the existence of sizeable local currency bond markets in the region and currency mismatches, issuers still raise funding in currencies other than their home currencies. Whilst offshore currency markets beyond the US dollar exist, the Asiadollar (excluding Japan) market is by far the largest offshore market in the region, with corporate bonds outstanding of US$1.8 trillion per Bloomberg data.
Gleaning studies from the Bank of International Settlement and based on our observations, we find issuers still issuing outside their local currencies for the following key reasons (1) Cost savings after factoring in the cost to swap funds into their home currency (2) Large deal sizes and need for constant funding from wholesale markets (3) More complete offshore markets where the investor pool is more diverse and able to invest across the risk spectrum. The third reason is especially relevant in our view for high yield issuers who may not find sufficient demand in their local currency bond markets or where their local currency bond market is underdeveloped.
Ezien Hoo, Andrew Wong and Wong Hong Wei are credit research analysts with OCBC Bank’s global treasury research & strategy
