Clouds of uncertainty in Asia bond markets may presage storm
Although emerging-market local bonds, up 8% according to JPMorgan’s index, were just behind equities and outperformed external counterparts in the first quarter, the Asian Development Bank’s March update warned of “clouds” from policy uncertainties and investor swings. Yield trends diverged between advanced-economy and East Asian markets from December to February, as they rose in the former and fell in the latter with the exception of China.
Credit default swaps (CDS) spreads also improved and currencies appreciated for almost all of the nine countries tracked by the ADB. Total size reached US$10 trillion but growth moderated and foreign holdings dipped with capital outflows in half of regional destinations through the end of 2016.
The global economic outlook is brighter, but higher interest rates in the US, Europe and Japan, depreciation of China’s yuan, and uneven domestic fundamental and structural trends may upset the asset-class streak and scope, which remains stuck in an average of around 70% of gross domestic product, according to ADB data.
This year emerging East Asian growth and inflation have both increased along with investor confidence that may dampen potential portfolio-outflow pressures. Yields on benchmark two-year and 10-year local instruments are down outside China, which has tightened monetary policy to contain asset and credit price risks.
Indonesia’s 50-basis-point slide through mid-February led the pack with an accompanying sovereign ratings upgrade and higher international reserves. The move came despite a nearly 2-percentage-point cut in foreign ownership of domestic bonds to 37.5% in the final quarter of 2016.
Malaysia’s overseas share dropped 3 percentage points to 32% for the period, as South Korea extended a lengthier exit pattern from mid- 2016. It is the only market in the group where CDS spreads jumped in recent months, mainly because of the presidential-impeachment process, while real external bond values as measured by JPMorgan’s EMBI gauge have otherwise rebounded.
Currencies have likewise bounced, with only the Hong Kong dollar and Philippine peso weaker against the greenback, despite the US Federal Reserve’s interest-rate increases and US trade-retaliation threats.
Over the last 12 months the yuan depreciated against both developed-economy and Asian currencies, with only the Philippine peso and Malaysian ringgit slightly losing ground. South Korea’s won is up 13% against the unit, and at the other extreme Vietnam’s dong rose 3%. The fallout is mixed for Asian exporters, since their assembly and supply chain benefits from China’s cost edge, while they are at a disadvantage in direct competition toward third countries, the ADB believes.
Reduced Chinese tourism will result for the region, and expectations for yuan devaluation could translate into negative sentiment elsewhere, but Chinese authorities for now may have pre-empted fears of a sharp correction through stricter individual and corporate cross-border transfer controls.
Local-bond growth moderated to 2.5% in the last quarter of 2016 and to 16.5% on an annual basis, with the pace slackening in six out of nine markets, although issuance in Indonesia and mainland China jumped by more than 20%. China’s US$7 trillion size dominates, followed by South Korea’s US$1.7 trillion, and Thailand, Malaysia, Hong Kong and Singapore range from US$200 billion to US$300 billion. More than half of Malaysia’s is Islamic-style sukuk, and East Asia’s government-corporate bond split is 65-35.
As a portion of GDP, South Korea is the largest at 120% and Indonesia and Vietnam the smallest at 20%. Foreign-investor control is at the bottom in Korea and Thailand at 10% and 14% respectively. External bond placement in G-3 currencies also stumbled toward year-end for a 10% gain overall to US$215 billion, again led by China and Korea. A handful of corporates and sovereigns issued cross-border in local currencies, with Laos tapping the Thai market for a fifth time.
Central banks have been on hold but the spread between two-year and 10-year government bond yields has climbed on higher growth and inflation prospects, with interest-rate steepening joining currency mismatch as a corporate danger in particular.
The ADB also notes complacency on policy and regulatory reforms, with only Vietnam set to prepare a 2017-20 local-bond roadmap, including derivatives and floating-rate launch in a first phase. Its neighbors are focused on more routine market oversight and liquidity steps, which suggest fair weather can persist despite the repeated gray forecast.