Volatility on the rise, risks loom in Asian bond markets, ADB report says

By Angela McDaniels

Tacoma, Wash., April 23 - The most immediate and visible fallout for Asian borrowers from the global credit market turmoil has been an increase in volatility in emerging East Asian bond markets, according to a report issued by the Asian Development Bank.

ADB said that while credit tightening in emerging East Asian economies has not been severe in the wake of the U.S. subprime mortgage turmoil, corporate bond yields have edged up as investors seek bigger risk premiums. Also, some borrowers have delayed bond issues, relying on short-term bank financing rather than longer-term debt issuance.

At the initial stages of the recent credit tightening, emerging East Asian local-currency bond markets benefited as investors chased attractive returns outside U.S. markets, ADB noted. But as risk aversion in global markets spiked, foreign investors began retreating from Asian markets, causing a rise in volatility in domestic capital markets.

The pace of government and corporate issuance has slowed but not to the same extent as the decline in global bond issuance, the bank said, adding that the region's offshore bond issuance market has slowed markedly and securitization markets have largely dried up.

Continued market growth expected

ADB said the outlook for emerging East Asian bond markets is of continued growth but at a slower pace. It highlighted that domestic credit, supported by ample local savings, continues to provide resources for investment even as portfolio equity and bond flows taper off.

"Governments in the region carried out key reforms in the secondary market in 2007. They need to continue to improve bond market liquidity and strengthen risk management," Jong-Wha Lee, head of ADB's Office of Regional Economic Integration, said in a bank news release.

Asia Bond Monitor, an ADB publication that reviews the development of East Asian local-currency bond markets, conducted a survey to identify key determinants of bond market liquidity. The survey found that amid growing risk aversion, illiquidity of the region's local-currency bond markets is a limiting factor in their development.

Increasing investor diversity, improving availability of hedging tools, consistent secondary market pricing and a more investor-friendly tax structure in corporate bond markets are measures that can help promote more liquid regional bond markets, in the bank's view.

Asia Bond Monitor said emerging East Asia's local-currency bonds outstanding expanded at an annual rate of 21% in the second half of 2007 from 10% in the first half of last year. Government bond markets grew 21%, which ADB attributed largely to central bank sterilization and fiscal stimulus, and corporate bond markets grew by 20%.

Heightened inflation risks, the slowdown in global growth and fears of external shocks led to increased volatility in local-currency yield curves in 2007. ADB said that despite the global market turbulence, the ABF Pan Asian index gained 8% in 2007 in dollar terms, partly lifted by stronger regional currencies. The index gained 13.6% in 2006.

Asia Bond Monitor cited three main risks to regional bond market outlook: a deep or protracted U.S. economic contraction, continued global capital market volatility placing pressure on investors to cover rapidly shifting positions and rising inflation in the region constraining policy options as growth slows.

It urged policymakers to focus on five key challenges to make local-currency markets more vibrant.

These are boosting investor confidence by strengthening legal protection and corporate governance, reducing barriers to market entry and encouraging investor diversity, developing derivative markets and increasing liquidity, improving data compilation and tightening regulatory oversight.

India

The April edition of Asia Bond Monitor said India's government bond market has grown steadily in size, largely due to the need to finance its fiscal deficit and is comparable to many government bond markets in emerging East Asia.

However, the ADB said, the domestic corporate bond market remains less developed, with private placements dominating. At 3% of GDP, corporate bonds are comparable to levels in the Philippines and Indonesia, where corporate finance is less well developed, and with China, where state-ownership remains dominant.

ADB said the public issue process in India is reportedly slow, taking several months, and the disclosure requirements are viewed by many as excessive. Prospectuses for bond issuers are reported to be several hundred pages long, and there is no provision for shelf registration.

In addition, the bank said corporate demand is limited for genuine bond finance - as opposed to loans disguised as bonds - and bank credit continues to dominate corporate funding.

Like many emerging economies, the investor base in India remains narrow in both government and corporate bond markets, with limited foreign participation, according to the bank. Asia Bond Monitor urged regulatory supervision in local bond markets to be streamlined to create a more level playing field for investors.

China

Local-currency government bonds outstanding in China grew by 33% in 2007, according to the bank, and the local-currency corporate bond market grew by 39%, a slower pace than in the previous two years.

Bond market turnover in China was mixed in the midst of turbulent market conditions, ADB said, which included a 4.85% increase in inflation and a more than 1% increase in interest rates. Market turnover was 1.46 times the average value of bonds outstanding for government bonds and 2.29 times for corporate bonds.

The bank reported that the yield curve, as indicated by the two-year to 10-year yield curve spread, steepened by almost 40 basis points in China as continuously rising inflation became a major concern of the central bank, which employed increasing tightening measures.

South Korea

South Korea's local-currency government bond market growth slowed to 3% as the government continued to try to reduce its public debt stock below 50% of GDP, according to ADB. In contrast, the local-currency corporate bond market grew by 22%, led by financial institutions.

The bank said Korean bond market turnover in 2007 continued its declining trend. Government bond turnover fell to 1.49 times the average value of outstanding bonds, and the corporate sector fell to 0.43 times.

Korean bond yields rose slightly across the yield curve during the year, ADB said, as the central bank's efforts to restrain excess liquidity led to an increase in interbank rates of 21 bps over the first half of 2007.

Indonesia

Issuance of local-currency government bonds increased by 18% in Indonesia, and the local-currency corporate bond market increased by 29%, which ADB said is four times the growth rate of 2006. Reforms to the secondary market - making its pricing more transparent - combined with tax incentives for listed companies led to a significant increase the number of new corporate issues, the bank said.

Indonesia also continued its strong increase in bond market liquidity, the bank reported, and saw government bond turnover rise to 1.44 times the average value of outstanding bonds and corporate bond turnover improve to 0.49 times.

The monetary easing beginning in 2006 continued in Indonesia through most of 2007, as the central bank reduced its policy rate by a total of 150 bps in six increments of 25 bps, ADB said.

Asia Bond Monitor is based in Mumbai, India, and examines local-currency bond developments in emerging East Asia, which is defined as the Association of Southeast Asian Nations member countries, plus China, Hong Kong and South Korea.

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