28 Sep 2012, Standard Chartered , Asia Risk
The acceleration of depth and liquidity in Asian capital markets is being driven by two factors: the onshore growth in formal savings in non-bank financial institutions (NBFIs) across Asia; and the secular rotation of foreign investors into Asia.
The importance of local demand
As per-capita gross domestic product (GDP) increases, household savings rise as a percentage of household income. This increase in per-capita GDP creates a positive feedback mechanism for market development as it leads to a more rapid increase in the size of NBFI assets, including mutual funds, pension funds and insurance companies.
“For most countries in Asia, we are still on a steeply positive curve. The counterpart to this is that, as household incomes rise, the proportion allocated to bank deposits and money market mutual funds decreases, as the preference switches away from solely liquidity to longer-term investment. This development drives critical demand for assets across the term structure,” says Will Oswald, Global Head of Fixed Income, Currency and Commodities (FICC) Research at Standard Chartered Bank.
A secular trend increase in international demand
Asia’s markets are now at a stage where foreign participation can provide this missing liquidity link. The global demand for Asian assets continues to rise noticeably. It is well documented that Asia represents a high proportion of global GDP, yet, in global portfolios, it represents just a small fraction of investments. In April 2009, foreign investors held just over 9% of the domestic debt stock outstanding in emerging markets. This has risen to 21%, but is still far below that of developed markets. “Even adjusting for fixed rate debt only – as inflation-linked bonds and floaters have a strong domestic bias – allocations have gone from just under 15% in April 2009 to 30% in 2012. This has doubled but still has much further to go,” says Oswald.
Central banks, for example, allocate just 5.2% of their reserves in currencies other than USD, GBP, JPY, CHF and EUR. While these have grown, they remain significantly below what might be expected from prudent allocation relative to trade partners. According to International Monetary Fund data, the number of countries holding more than 5% of reserves in ‘non-traditional’ currencies has increased from 19% in 2001 to 45% in 2011. Recent benchmark dim sum bond offerings by the People’s Republic of China and Chinese policy banks have witnessed strong participation by central banks in Asia, Africa and Europe. In some cases, central banks accounted for up to one-quarter of total demand. “We expect this trend to continue, resulting in further impetus for the development of the local currency bond markets in Asia,” says Carsten Stoehr, Global Head of Capital Markets at Standard Chartered Bank.
European and US funds also remain under-invested in emerging market fixed income. In Mercer’s annual European asset allocation survey, only 13% of Europe (excluding the UK) pension funds had any allocation at all to emerging market debt and, for those that did, the typical allocation was just 4.8%.
Meanwhile, Oswald says that, for US pension funds faced with a 4% discount rate and funding gaps in their portfolios, Asia may be the place to seek greater returns. “This problem is especially acute under negative real returns due to financial repression costs in the West.”
Oswald believes the confluence of international participation and structural demand from NBFIs onshore will provide the impetus for deeper, more liquid capital markets in Asia. “With many global investors previously wary of participating because of liquidity concerns, the combination of both onshore and offshore drivers is likely to reinforce liquidity growth and shift Asian domestic capital markets more strongly into global portfolios.”
As Asia becomes more self sufficient and reverts from being export-driven to more domestically focused, there is a growing natural demand created for Asian assets that has been relatively muted until now. There are also other demand drivers, such as regulation and the search for yield, which are drawing investors to Asia.
Two important trends are unfolding in the Asian debt markets as a result. First, a significant shift in the debt mix towards bonds and second, a substantial broadening of the local currency markets in the region. Asian issuance activity now comprises 77% bonds versus loans, up from 61% in 2011. With a year-to-date volume of US$423billion equivalent, the share of local currency bond issuance continues to increase, and it currently represents 78% of total Asian bond volumes. “North Asia has always been the dominant component, but we are witnessing significant double-digit growth in local currency issuance from Southeast Asia, resulting in an important diversification of the local currency asset class in Asia,” says Stoehr. Southeast Asian local currency issuance has increased 58% in the year to date, with Singapore already 45% ahead of full-year 2011 volumes, followed by significant issuance volume increases in Malaysia, Thailand and the Philippines this year.
Global regulation such as Basel III will make banking-driven credit growth more expensive than in the past, especially with developments such as the credit valuation adjustment capital charge and the move to clearing of over-the-counter derivatives through a central counterparty (CCP). The effects are already taking hold, with some Western and European banks pulling out of specific areas of financing in Asia.
“Historically, to raise $1 billion in Asia, you would do a dollar-denominated five-year or 10-year issue and then swap it back to local currency; now, the swap will get caught in a CCP, so it makes sense to raise it domestically,” says Nitin Gulabani, Global Head of Foreign Exchange, Rates and Credit at Standard Chartered Bank.
With demand for local currency paper from NBFIs both domestically and abroad, Gulabani believes companies in Asia will increasingly turn to capital markets for their local funding needs. “The business availability now makes sense. Asian institutions will increasingly finance themselves in local currency, which means less of a currency mismatch on the balance sheet and less money going outside of Asia,” he says.
Virtuous circle of growth
Gulabani adds that the new buyer base in the West may stick to higher-quality assets, whereas domestic investors will be more willing to invest in the higher-yielding corporate sector, which then creates a virtuous circle of capital markets growth in Asia. “This means all sectors of the bond markets will develop, which in turn increases liquidity in Asia’s capital markets,” he says.
An example of this trend is the Indonesian domestic high-yield sector, which is now a buoyant market among domestic investors. Where the domestic oil company Medco Energi had previously accessed the USD markets for funding, in June this year, it chose to raise IDR1,500 billion through a five-year domestic bond issue.
There are still potential bumps in the road. “The most fundamental risk is an Asian hard landing, as foreign money may have second thoughts. And, while it may not be a perfect ride, the trend is here to stay,” says Gulabani.
There is also the risk of credit growing too rapidly, leading to an inefficient allocation of resources but, as the global savings glut drifts towards Asia, the demand dynamics are well placed to meet any surplus in supply.
Some may also point to currency volatility as a concern but, in reality, emerging market foreign exchange is now less volatile than in developed markets and has been for a long time, but investor memories may be stuck in the Asian financial crisis, according to Oswald. While the past 10 years has seen Asia as a centre of trade, if Asia takes advantage of this watershed moment, the next 10 years could see it become a true centre of capital markets.