Increasing Risks to Emerging East Asia’s Local Currency Bonds: “tough times certainly lie ahead” – ADB

Asia Bond MonitorEmerging East Asia’s local currency bond markets are still expanding but risks to the outlook are rising given the prospects of tighter US monetary policy, slower economic growth in Asia, and persistent capital outflows, according to the latest quarterly Asia Bond Monitor from the Asian Development Bank (ADB). “Asia’s bond markets, and its borrowers, are better placed to stand up to this latest round of global volatility than they were in 1997-1998 but tough times certainly lie ahead,” said Iwan J. Azis, Head of ADB’s Office of Regional Economic Integration. “The challenge will be to ensure the region can cope with higher borrowing costs and falling asset prices, which could hurt corporate balance sheets and dampen economic growth.” Emerging East Asia has witnessed an outflow of funds since the May 22 remarks of US Federal Reserve Chairman Ben Bernanke that US monetary policy could soon be tightened. A slower growth outlook for the region has also contributed to capital flowing out, with the withdrawal of funds leading to rising bond yields and depreciating currencies. The turmoil in global financial markets has made it harder and more expensive for companies to issue foreign currency bonds. However, the issuance of local currency bonds has been less affected. The capital outflows highlight the need to promote more stable sources of funding. Promoting greater intra-Asian holdings of financial assets can help shield the region’s financial markets from global financial volatility.

Bond markets in the region are more resilient now than during the 1997/98 Asian financial crisis as the growing use of LCY bonds has reduced currency mismatches. Risks to the region’s bond markets are intensifying. Specifically, (i) the region’s interest rates could rise further when the Federal Reserve starts to tighten policy; (ii) weakening growth momentum in the region could accelerate the pace of capital outflows; and (iii) continued outflows could result in vulnerable economies raising interest rates to prop up their currencies, thereby further dampening growth.

The report also warns that most governments in the region have missed the opportunity to raise cheap funds to finance critical infrastructure spending. That will be a further constraint on growth and poverty reduction going forward. ADB estimates that Asia needs to spend at least $8 trillion on infrastructure between 2010 and 2020 to sustain economic growth. Compared with 1997-1998 when Asia suffered a financial crisis, governments and companies now hold more of their debt in local rather than foreign currency and the debt is now longer-dated than it was, meaning they are less vulnerable to currency depreciation and sudden shifts in borrowing costs and investor appetite. To build resilience and support growth, the region needs to continue to develop more stable sources of funding, including more foreign direct investment (FDI), which tends to be more stable than capital market investment (CMI), and to encourage a wider range of bond investors, including pension funds. Insurance and pension fund investments, guarantees, and greater use of subordinated debt, alongside better project data, could also help channel more funds into transport, energy, telecommunications, and other infrastructure. Special chapter: bond financing for infrastructure Infrastructure financing needs in Asia are significant. The region cannot afford to skimp on infrastructure as maximizing the benefits of investment spending often depends on having an adequate level of infrastructure. Tighter global liquidity conditions and stronger prudential regulations under Basel III are constraining lending from banks, which have traditionally provided the bulk of infrastructure project financing. At the same time, there is growing demand for financial assets with long-term maturities among institutional investors such as pension funds. This makes it natural to promote the development of infrastructure bonds that can help bridge the financing gap. A key hurdle to overcome is the shortage of quality infrastructure projects that can be bundled and offered to institutional investors who are usually mandated to invest in investment grade bonds. Guarantees and the creation of subordinated debt tranches can help improve the ratings of infrastructure bonds, while greater data transparency and a database of costs and past performance can help close the information gap for investors. Read more …