- Higher global interest rates and depreciating currencies push up borrowing costs and debt servicing obligations for Asian governments and corporates.
- Foreign currency borrowing is still perceived as a risk to Asia’s economic and financial stability.
- Capital inflows linked to easy global monetary settings have lifted foreign ownership rates in Asia's local currency bond markets.
- Strong growth in local currency bond markets helps to reduce liquidity concerns, exchange rate risk, and the threat of financial turmoil.
Global monetary easing since 2008 has driven an inflow of capital into Asia, helping to fund investment while pushing down borrowing costs for governments and corporates. However, an end to these easy monetary settings is near, with higher U.S. interest rates on the horizon. We've already had a sneak peak of how this shift may play out; a selloff in financial assets from mid-June through August lifted bond yields in the U.S. and Asia and caused Asian currencies to depreciate.
Higher interest rates and depreciating currencies push up borrowing costs and debt servicing obligations for Asian governments and corporates. Indian and Indonesian central bankers are pushing up local policy rates to try to shore up currencies, though this action risks choking economic growth. Current account imbalances and a relatively high exposure to external debt leave India and Indonesia the most susceptible to the whims of investors.
The next step is to examine how much of Asia's debt is denominated in foreign currency as well as the rate of foreign ownership in local currency bonds to help assess which governments and corporates are vulnerable to exchange rate risk and a repatriation of funds as global monetary conditions tighten.
Foreign currency debt
Excessive foreign currency borrowing was a key contributor to the 1997-1998 Asian financial crisis, and is still perceived as a risk to Asia’s economic and financial stability. As was the case in 1997, foreign currency borrowing brings trouble when local currencies lose value because repaying foreign debt becomes more costly. The value of Asia’s foreign currency bond market (excluding Japan) has doubled from US$380 billion in December 2008 to just over US$750 billion in June. Since then Asian corporates, in particular, have taken advantage of low interest rates in the U.S. and taken out foreign loans rather than issue bonds at higher local rates. Strong overseas demand for higher-yielding Asian securities and underdeveloped local currency bond markets has also driven this trend towards foreign currency borrowing.
Japan's government issues only a very small share of its massive debt load in foreign currency, which helps to insulate it somewhat from bond vigilantes. And even though South Korea, Singapore and Malaysia have outstanding bonds exceeding 100% of GDP, less than 15% of this debt is denominated in foreign currencies. Hong Kong's high rate of debt denominated in foreign currency reflects its standing as a global financial hub.
The notable exceptions and possible sources of current risk are Indonesia, the Philippines, and to a lesser extent Vietnam, which have a relatively higher share of foreign currency denominated debt. The Philippines, however, has managed to largely avoid financial market turmoil and has worked to lower its foreign currency debt ratio from a high of 43% of all bonds in 2005 to 32% now. The downward trend has also helped allay investors' concerns about Malaysia and Thailand.
Government debt across Asia remains under control, notwithstanding the ever-present risk of a fiscal crisis in Japan. Despite pockets of weakness in the Philippines, Indonesia and Vietnam, foreign currency denominated government debt appears manageable. These three economies also hold a relatively higher share of foreign currency corporate debt, though it reflects a small proportion of GDP. Most worrisome is the sharp jump in Vietnam's foreign currency corporate debt ratio from 7% in 2012 to more than 52% now. This reflects tight credit at home as Vietnamese banks are reluctant to lend to each other because of a raft of bad loans on their books, which has prompted firms to seek overseas funding.
Indonesia, however, now fares poorly on these debt metrics, which makes it one of the most susceptible to higher interest rates and a weakening currency. Indonesia's share of foreign currency denominated debt has jumped from about 5% of all bonds in 2005 to more than 33% now, as offshore bond issuance from both the government and corporates has surged in recent years.
Flaky foreign bondholders?
Another emerging problem is the rate of foreign investment in Indonesian local currency bonds, which has surged to more than 30% from 15% in 2008. Because foreign investors tend to be the most sensitive to sudden shifts in global sentiment, a high proportion of foreign-owned local currency bonds can exacerbate pressure on bond yields and currencies. Reflecting this, the yield on Indonesia’s 10-year bond surged from 6% in June to a peak near 9% in early September. Investors also perceive Indonesian assets as a risky investment because of persistent high inflation, a wide current account deficit, and structural deficiencies. Bond yields in Singapore and Hong Kong also increased sharply as investors pulled money from these financial hubs.
Foreign ownership of Malaysian local currency bonds is relatively high, yet Malaysian bonds performed relatively well amid the recent financial market turbulence, partly because investors perceive it as less risky than other parts of Asia. Total foreign currency borrowing has fallen from 20% of all bonds in 2005 to about 8% now. The Malaysian government is also committed to boosting fixed investment, the central bank is transparent, the economy is growing solidly, and inflation is contained. Similar characteristics in Thailand also helped it to avoid the wrath of foreign investors recently, despite a substantial share of local bonds being owned by foreigners.
Foreign ownership of local currency bonds in Japan and Korea are around 10% of total issuance, insulating them somewhat from financial pressures. But in a global financial system, this is still no guarantee of market stability. Indian bond yields, for example, surged in recent months, even though tight foreign investment regulations mean less than 2% of Indian government bonds are held by foreigners.
Despite pockets of weakness in bond markets, Asian governments and corporates are in much better shape now than in 1997. Most are not overburdened with foreign currency debt and have been reducing their reliance on this type of funding in recent years. For Asia as a whole, about 90% of all borrowing occurs in local currencies, which mitigates exchange rate risk. There has also been a conscious effort to lengthen the maturities on debt. An increasing proportion of bonds have maturities of more than 10 years, which provides a more stable source of funding and helps to reduce exposure to sudden shifts in borrowing costs and investor risk appetites.
Matthew Circosta is an Economist at Moody's Analytics.
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