Rough Sailing Ahead for the East Asian Credit Market

Debt servicing of dollar-denominated bonds in Asia could become onerous.

After years of smooth sailing through calm market conditions, bond markets in East Asia are navigating through stormier weather.

Data from the supplement to the 2015 Asian Development Outlook released this week shows that weaker growth in the United States and the People’s Republic of China (PRC) has weighed down overall regional growth.

The yet unresolved Greece debt crisis and the stress in the PRC financial markets have so far had a relatively minor impact on bond markets in East Asia. However, risks remain that deterioration in either situation could spark further volatility in bond markets.

Over the long term, the actions of the US Federal Reserve may affect Asian markets more than recent market volatility. The Fed is poised to raise rates for the first time in over 9 years. While the rise is widely anticipated, the exact timing is yet uncertain. Recent positive economic news from the US has raised the possibility of a rate hike as early as this September.

Higher interest rates make US bonds more attractive to investors, which could lead to investors pulling their money away from emerging markets, including those in East Asia. While the region’s bond markets can handle a gradual adjustment, there is a possibility of a sharp rise in bond yields similar to what happened during the “taper tantrum” in 2013.

Moreover, higher US interest rates would likely further strengthen the US dollar, putting additional pressure on businesses and governments that have raised money in dollar-denominated bonds. While the pace of foreign currency issuance has slowed since last year, the emerging East Asian economies have accumulated $858 billion in dollar-denominated debt. Of this total, corporates—that is, non-government issued debt—account for $712 billion. Companies that have issued US dollar-denominated debt will find their debt servicing costs in local currency terms increasing with the stronger dollar – especially if they are unhedged.

The lack of liquidity in East Asia’s bond markets could magnify the volatility effect

The lack of liquidity in the region’s bond markets could magnify the volatility effect. If a large number of investors were to exit the market suddenly, it could be disruptive if there is not enough liquidity in the bond market. Tighter regulations after the 2008-09 global financial crisis have led to banks reducing the size of their trading books, making them less active participants in the bond markets.

Exchange-Traded Funds (ETFs) have also been gaining popularity. Although bond ETFs offer a liquid investment vehicle, the underlying assets in the ETFs are much less liquid than the ETF itself. If a large number of investors were to sell the ETFs, it could lead to large price swings if the underlying bonds trade in illiquid markets.

As the region’s bond markets face more volatile external factors, strong economic fundamentals could help the region weather the stormy weather ahead. The continued development of local currency markets—for both sovereign and corporate issuers of debt—will help to stabilize the region in times of stress. While issuance of debt declined slightly, overall local currency bonds continued to grow in the first quarter of 2015, reaching $8.3 trillion.

To further insulate the region’s markets from external shocks, authorities could undertake reforms to improve efficiency and transparency of financial markets to help strengthen the economies’ resilience against external shocks. Macro-prudential regulations can also be a useful tool in policymakers’ arsenal to manage volatile capital flows.

East Asian bond markets entering choppy waters is republished with permission from Asia Pathways

See also: Taking a Higher Level View on Foreign Holdings of US Treasuries