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BlackRock Investment Institute October 2011 A Rapidly Changing Order The Rising Prominence of Asian Debt Markets
BlackRock Investment InstituteOctober 2011
A Rapidly Changing OrderThe Rising Prominence of Asian Debt Markets
[ 2 ] T h e R i s i n g p R O m i n e n C e O f A s i A n d e b T m A R k e T s — O C T O b e R 2 0 1 1
1 For a detailed discussion on our views of the Emerging Markets space more generally, please see: “Are Emerging Markets The Next Developed Markets?” BlackRock Investment Institute, New York, August 2011.
2 For more on the health of the US consumer, please see: “From Keeping Up with the Joneses to Keeping Above Water: The Status of the US Consumer” BlackRock Investment Institute, New York, September 2011.
The opinions expressed are as of October 2011 and may change as subsequent conditions vary.
emerging markets’ secular Rise and the privileged place of Asia-pacific economiesOver the past few years developed country credit standings have deteriorated as the financial crisis and its aftermath unfolded, and emerging market country relative strength has led to a renewed focus on investment opportunities in that sector.1 Even prior to the crisis, though, the consensus in the investment community was that many emerging market economies would converge toward the positive fundamental picture then seen among developed market economies. Ironically, in the wake of the financial crisis, and the stresses it has placed on developed world economies, the more recent theme is better described as a “divergence” between the trajectory of many developed and emerging economies, with their traditional roles reversed, at least from a credit perspective. The rise of and dynamism displayed in Asia-Pacific-region economies over the past decade has been perhaps the best example of this change in fortunes.
According to International Monetary Fund data, the share of global output (on a purchasing power parity basis) produced by developed world economies declined from 64% in 1992 to 52% in 2010, while at the same time the share of output produced by developing Asia rose from 11% to 24% and most other regions remained fairly static (see Figure 1). Moreover, unlike most developed market countries, many emerging market (EM) countries in Asia hold more favorable demographic trends for sustaining rapid economic growth,
particularly as substantial segments of their populations are migrating from rural to urban areas and as middle class consumers in this region have grown at a substantial rate. In fact, Organization for Economic Cooperation and Development data suggests that the Asia-Pacific region should come to claim the majority of global middle class spending sometime between 2020 and 2030, whereas the North American and European economies do so today.
Neeraj Seth Managing Director, Head of Asian Credit ..........................................neeraj.seth@blackrock.com
Aayush Sonthalia Director, Corporate Credit Group .......................................................aayush.sonthalia@blackrock.com
Sumit Bhandari Vice President, Corporate Credit Group ............................................sumit.bhandari@blackrock.com
Rick Rieder Chief Investment Officer, FI, Fundamental Portfolios [email protected]
Ewen Cameron Watt Chief Investment Strategist, BII .........................................................cameron.watt@blackrock.com
Contents
emerging markets’ secular Rise 2
Asia and the Long Road to “safe haven” status 3
Asia Region economic growth momentum slows 5
Risks to the Asia growth story i: elevated inflation 5
Risks to the Asia growth story ii: A hard Landing in China? 6
Risks to the Asia growth story iii: financial Asset Ownership profiles and Capital flows 7
The evolving state of (and prospects for) Asia debt markets 8
Risks and investment implications 10
About UsThe blackRock investment institute leverages the firm’s expertise across asset classes, client groups and regions. The institute’s goal is to produce information that makes blackRock’s portfolio managers better investors and helps deliver positive investment results for clients.
Executive Director Chief Strategist Lee kempler ewen Cameron Watt
b L A C k R O C k i n v e s T m e n T i n s T i T u T e [ 3 ]
Sources: International Monetary Fund, World Economic Outlook Database, April 2011. Note: Shares based on purchasing power parity.
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This shift in consumer spending potential is a particularly
important dynamic to take note of since, as we have argued
elsewhere, the consumer in the United States will be hampered
by high levels of leverage and a structurally challenged employment
environment for some time to come, which suggests that firms
will increasingly need to engage with Asia-region consumers to
remain competitive.2 In sum, there are profound secular changes
in the structure of the global economy that argue for increasing
attention to be paid to Asia-region economies and companies,
which will be vital for investors to understand in the years ahead.
In this paper we argue that the considerably improved economic
fundamentals (at both the country and company levels) now
witnessed in Asia have placed some select segments of these
debt markets on a long-term trajectory toward “safe haven” asset
status, which was previously enjoyed solely by high-quality
developed country issuers (such as the United States, Germany,
Switzerland, and Japan), although as witnessed recently that path
will take time. Still, we think this development will take place
despite the cyclical slowdown in growth that is increasingly
evident across the Asia-Pacific region today. Further, despite
global and regional economic slowing, one of the often-cited
systemic risks to the global economy, a hard economic landing
(or severe financial crisis) in China, is not our base case and we
think that economy can handle its potential problems reasonably
well. Moreover, the threat of inflation that has dogged much
of Asia this year has likely peaked and should moderate, albeit
at higher than long-term trend levels, which may continue to
present policy challenges. Thus, in our view, the main systemic
risk to Asia-region economic stability and growth prospects comes
largely from a slowing in global growth rates more generally, and
particularly the broader macroeconomic volatility that may stem
from the European sovereign debt crisis and flight-to-quality
capital flows that negatively impact Asian markets and economies,
and underscore the distance that still needs to be traversed to
attain “safe haven” status. Finally, we will examine developments
in Asian credit markets, which we think will clearly be an expanding
and dynamic segment of the global fixed income marketplace.
Asia and the Long Road to “safe haven” status
Even though Asia-region sovereign debt is not generally considered
to hold “safe haven” status yet (by which we mean an asset that
witnesses dramatic capital inflows during times of market stress),
and recent market movements have confirmed this consensus,
we think these sovereign debt markets do hold that potential
and are broadly following a path toward that end. When
considering the characteristics that help constitute a safe haven
security, it is clear that investors are first concerned with the
very high probability of the return of their capital, and are also
preoccupied with the liquidity and volatility of their holdings.
Moreover, in the case of sovereign debt markets, they may be
seeking a certain duration, or yield curve, exposure, which might
express a view on anticipated local central bank policy moves.
Finally, and importantly, the decision between hard currency
denominated debt (typically in US dollars, euro, or yen) or
local currency debt must be made, which is not a secondary
consideration as currency movements can account for a large
portion of a position’s total return. In fact, according to JPMorgan
research, movements in foreign exchange rates have accounted
for roughly 40% of JPMorgan GBI-EM index total returns in the
past decade or so, although the country-specific contributions
can vary widely. In part, the importance of currencies in overall
returns arises because of the short duration nature of many bond
markets in the emerging world. In addition, currency hedging
can be expensive given rate differentials and therefore an
investor in this asset class is taking a different set of risks from
those encountered in the developed markets. In fact, interestingly,
since Asian country sovereign bonds are not widely used for repo
purposes (as they are comparatively illiquid) these countries’
sovereigns may therefore exhibit less volatility in the event of
credit downgrade, as they are not reliant on repo market technical
support. Some sovereign issuers in Asia may someday provide
debt that displays the desirable factors for investors seeking
a safe haven for their capital, although it is also important to
understand the relative nature of sovereign market risk, and
this is where Asian sovereign issuers have made great strides.
Figure 1: Asia Region Share of Global Output Has Increased
That said, as we have argued elsewhere, the safe haven concept
generally takes a binary form: either the debt is widely perceived
as a secure store of value, or it is seen as trading with a risk
premium, and we expect it will still take some time for Asia
issuers to cross this threshold.
In response to shifts witnessed in sovereign debt markets in
recent years, and specifically to the increased questioning of
sovereign debt representing a genuine “risk-free rate,” BlackRock
has introduced a proprietary index that goes well beyond
commonly used metrics to gauge sovereign vulnerability. The
BlackRock Sovereign Risk Index3 is one of many tools that we
can use to both mitigate risk in global government sector investing,
as well as to discern opportunities. When examining the Index’s
output (see Figure 2), we can see the relative strength of Asian
country sovereign issuers, which are in some cases seen as
stronger bets than many developed nations, a change in fortunes
that might have been hard to imagine just over a decade ago.
The factors that help rank countries like South Korea near
Germany, China near the US, and Thailand and Malaysia well
ahead of any of the peripheral European countries are not only
relatively favorable demographic profiles, lower absolute levels
of debt, manageable term structures, and many other strictly
economic and capital market factors, but also more qualitative
political and institutional characteristics. Over the past decade
many Asian countries have seen improved central bank credibility,
maturing political institutions, and seemingly more sound fiscal
policies. Additionally, bouts of USD and EUR weakness, Asian
central bank rate hikes, and an increasing interest in currency
diversification among institutional investors of various kinds
(including official institutions managing reserve assets) have
also resulted in strong capital flows to the region, a likely
secular trend we do not see reversing, though there will be
periods of retrenchment, as seen recently.
While we do not want to discount the importance of other key
players in Asia’s recent economic success (such as India, South
Korea, and Singapore, for instance) there’s little question that
the dramatic rise of China over the past two decades—to become
the dominant economy in the region—will be of paramount
significance for eventually attaining safe haven status. China
has been the leading contributor to global growth over the past
decade, and it has capably managed its way through the global
financial crisis, which we believe lends stability and support to
the region overall. In fact, that nation’s real GDP grew at a 10.3%
rate in 2010, compared to the developed market average rate
of roughly 2.6%. Moreover, with more than $3 trillion in foreign
currency reserves held by the government, a dynamic corporate
sector generating massive levels of cash, and a tremendous
household savings rate, there is room for the country to maneuver
in the event of a significant slowing in global growth. This is not
to suggest that China does not face its share of challenges, but
we believe that the strength of its economy, and economic ties
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[ 4 ] T h e R i s i n g p R O m i n e n C e O f A s i A n d e b T m A R k e T s — O C T O b e R 2 0 1 1
3 Detailed in “The BlackRock Sovereign Risk Index: A Performance Assessment and Update,” BlackRock Investment Institute, New York, October 2011.
Figure 2: BlackRock Sovereign Risk Index Score
to its neighbors, should go some distance toward the eventual
transformation of Asia-region sovereign issues (once the depth
and liquidity of these markets improve) into safe haven alternatives
to recently troubled developed country debt markets.
Asia Region economic growth momentum slows
The slowdown in economic growth momentum impacting the
eurozone and the US has not spared Asia, where slowing growth
has been evident in China, India, , and Australia. Indeed, many
of Asia’s export-led economies, in particular, have struggled to
maintain growth rates, as they are highly sensitive to changes to
global growth dynamics. That said, the composition of GDP
growth has varied in the past from country to country, and where
China’s GDP growth has recently been driven by fixed asset
investment (FAI), the rest of the region displays broader based
growth characteristics. In fact, government spending (and other
types of FAI) are somewhat lacking in India, Indonesia, Malaysia,
and the Philippines, underscoring the diversity of the regions’
economies. In our view, the Asia ex-Japan region will see a
deceleration in growth from roughly an above 8% level over the
past year, to the 7% region in the coming year. We think both
China and India will be key contributors to slowing real GDP
growth, with China’s torrid pace of double digit growth (more
than 10% last year) moderating to a bit less than 8% in 2012,
and India slowing to just under 7% from 8.5%. This loss in global
growth momentum is illustrated clearly in Composite Purchasing
Managers Index (PMI) data (see Figure 3), which turned down
after a robust recovery in the wake of the global recession.
After seeing a cyclical peak in the first quarter of 2010, GDP
growth in the Asia ex-Japan region has steadily decelerated
(and should continue to do so in the year ahead), despite still
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being meaningfully stronger than growth in most other regions.
The slowing can be seen in both regional domestic demand, as
well as in external demand data, and with inflation still running
higher than most central banks are comfortable with, there are
headwinds to monetary policy action that could arrest the
slowdown. Still, while we think heightened levels of inflation
across the Asia region have been concerning (and clearly have
resulted in recent central bank tightening intended to slow growth),
we think we are close to an inflation peak. Indeed, where feasible
governments are likely in the months ahead to move slowly from
fighting inflation as a primary concern towards supporting
growth, as Indonesia’s central bank recently illustrated via
a surprise 25 basis point rate cut to 6.5%.
Risks to the Asia growth story i: elevated inflation
As Asia-region economic growth rebounded strongly from the
depths of late-2008/early-2009, and capital flows poured in,
elevated inflation rates across the region have been registered.
In fact, recent CPI data places China’s inflation rate at 6.2%,
India’s at 9.78% for the month of August, and apart from the
perennial disinflationary case of Japan, the entire region has
experienced significant inflationary pressure (see Figure 4).
Selective Asian country central banks have been more assertive
in normalizing interest rates than in the rest of the emerging
markets, but of course the region has witnessed some of the
strongest growth and inflation too, apart from some commodity-
led countries in Africa. That said, we think that many of these
central banks were “behind the curve” in their policy rate hiking,
as they appeared to focus on growth and believe that inflation
would remain more moderate than it has. Recently, some central
banks may have regained credibility (Malaysia, India, and China,
for example) by continued policy tightening to tame inflation,
b L A C k R O C k i n v e s T m e n T i n s T i T u T e [ 5 ]
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Figure 3: Global Recovery Losing MomentumComposite pmi Output: diffusion index
Figure 4: Selected Asia Region CPI Data
even in the face of a slowing in global growth. Ultimately, the
question of whether inflation can remain contained, or can be
reduced, is partly a factor of capital flows into the region, which
is explored further below.
In our view, inflation in the Asia ex-Japan region should peak in
the second half of 2011, and it should then begin to moderate
across the region, albeit at levels that are still above most central
bank target ranges. We think that given the structural nature
of inflation in the region, changes in CPI data series will likely
settle down at modestly elevated levels, such as between 4%
to 5% in China and 6% to 7% in India in the mid-term. Inflation
rates will remain sticky, in part, due to the continued shift of
wealth from the corporate sector to the household sector over
the coming years in the form of rapidly increased wage rates.
Of course, there is the possibility of upside risks to this outlook,
particularly in the form of any external supply shocks to commodity
prices (such as weather or political instability), but the more
dramatic slowing of developed market economies argues for
a moderation of inflation in Asia as well.
In China, recent CPI data moderated somewhat from what we
think was its July cyclical peak of 6.5%, and PPI has also witnessed
a downward move in August. Despite what may be the beginning
of a modest down trend in inflation, we do not believe that China’s
central bank will take the opportunity to relax monetary policy
at this time, since it will likely continue to have concerns over
inflationary pressures, and the global economic environment
will likely need to worsen significantly before it is prodded into
action. We think central bank policymakers will attempt to avoid
the policy calibration missteps from the last crisis period, when
policy was made too tight and then too loose, with slower and
more deliberate moves.
Risks to the Asia growth story ii: A hard Landing in China?
In preview, as we have argued more extensively elsewhere,4 there
are undoubtedly some significant risks to growth brewing in China’s
economy, such as with: local government funding vehicle debt
levels, a credit growth slowdown, the possibility of a property
price bubble, and the negative impacts on exports from developed
world troubles, but a hard economic landing (or severe financial
crisis) in China is not our base case. China’s strong fiscal situation
(including its tremendous reserve assets), and implicit government
support for the banking system, provide comfort to us in arguing
that there is a very low likelihood of economic hard landing in at
least the next 6 to 12 months. As we mentioned previously, we
believe that inflation (while perhaps understated by official
statistics) has likely peaked in China, and should trend down
to more manageable levels. Additionally, since the Chinese
government is going to soon be undertaking a transition in
leadership, there is an enormous incentive to ensure economic
stability and avoid stresses. To that end, we also do not expect
to see dramatic shifts in central banking policy, but rather
anticipate some indirect easing and targeted fiscal incentives
focusing on credit availability for the small- and medium-size
enterprises sector to provide support for the economy and
encourage job growth. Finally, based on our estimates, the local
government funding vehicle debt levels should be manageable,
even if banks are forced to write down significant amounts of
non-performing loans, and of course the banking sector would
likely be supported materially by central government resources.
There has been a tremendous amount of discussion surrounding
the red hot real estate markets in segments of China, and the
possibility that a property bubble could destabilize the banking
system and the economy overall. While we acknowledge that
there are material risks embedded in segments of the real estate
markets, and in the lending that supports it, we also think some
of the rhetoric on this issue has been overdone. There does appear
to be a property bubble in China’s Tier 1 cities (such as Shanghai
and Beijing), but this must be understood in the broader context
that many other regions of the country are not experiencing
analogous bubble-like conditions (see Figure 5).5 The oft repeated
stories of empty apartment buildings (and whole cities) have
been exaggerated and there is little evidence of exceptionally
high vacancy rates. Moreover, in the residential real estate
market, households are considerably less encumbered by
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[ 6 ] T h e R i s i n g p R O m i n e n C e O f A s i A n d e b T m A R k e T s — O C T O b e R 2 0 1 1
4 Please see: “Can China’s Savers Save the World?” BlackRock Investment Institute, New York, July 2011.
5 Lu, Ting. “China at a Crossroads,” Bank of America Merrill Lynch Research, July 2011.
Figure 5: Regional Differentiation in Property Prices in China
mortgage debt (mortgage loans represent roughly 20% of
total household bank deposits) than their developed market
counterparts are. Added to this is the fact that seemingly
meaningful regulations have been introduced in China since
2009 to avoid a real estate meltdown. For instance, first-time
buyers are now required to make a minimum down payment
of 30%, while purchase of a second unit requires a 50% cash
deposit. Also, nascent property taxes are being introduced
to discourage rapid transfer of property and speculation.
The genuine challenge to China’s economy in the years ahead,
which has not been as discussed by many market commentators
fixated on shorter-term asset price bubbles, revolves around
increasingly less favorable demographic trends than the country
has experienced in its recent past, resulting in headwinds to
future growth. Specifically, China’s economy added more than
100 million people to its working population over the past decade,
but it will add less than 20 million over the next ten years. Indeed,
the trajectory of labor force growth in China appears to be moving
in a less favorable direction for the next few decades (see Figure 6).
In fact, according to Deutsche Bank research, over the next 50
years the working population in China should actually decline
by nearly 200 million people from today’s levels, a significant
headwind to economic growth, and one of the reasons we think
longer-term growth in China must come down to more sustainable
levels.6 This shifting dynamic presents a significant longer-term
challenge for China, and an eventual decline in the working-age
population will keep pressure on wage inflation in the short- to
mid-term, despite some attempts by industry to relocate plants
inward toward western parts of the country to take advantage
of regional income variations in lower cost areas. Over a longer
time horizon, we believe it is absolutely critical for China to
move up the value chain in terms of higher value added job
creation, rather than merely attempting to be the low cost
manufacturing center for the world.
Another important concern is expected to be that savings growth
rates may slow over the next few years and that deposit growth
may be much more pedestrian than over the last decade. The
recent consolidation of data on funding growth under the banner of
Total Social Financing (TSF) presents a clearer picture of the
efficiency of deposit mobilization in funding growth. Even allowing
for shortcomings in methodology, the incremental growth per
unit of financing—Financial Incremental Capital Output Ratio,
or FICOR, as we term it—has deteriorated over the last decade.
Despite the many challenges presented to China’s economic
growth engine, from elevated inflation, and shorter-term
property price bubbles, to the meaningful headwind of long-
term demographic change, one of the more significant short-
term risks to growth is external in nature. China’s export
machine and financial markets could be negatively impacted by
an intensification of the eurozone’s sovereign debt crisis plus a
secondary recession in that region and in the US. This type of
broad-based economic slowdown would certainly have an
impact on China’s growth, and indeed that of the Asia Pacific
region, which is highly sensitive to global growth and trade
dynamics. That said, September’s manufacturing PMI data in
China came in slightly ahead of consensus, and at 51.2,
represented an improvement from August numbers. Thus, we
remain vigilant of shifting trends in the data and continue to
think that the key risks to China’s growth stem from Europe’s
troubles, and can likely be dealt with through assertive policy
moves, if required.
Risks to the Asia growth story iii: financial Asset Ownership profiles and Capital flows
The old saw in economics that generalized price inflation
occurs due to “too much money chasing too few goods,” not
only underscores the chief importance capital flows play in the
creation of inflationary phenomena, but also serves as a good
analogy for the technical asset price inflation seen in the emerging
markets arena in recent years. Of course, the opposite case
also holds that capital flight from a region or asset class can
serve as a technical headwind to asset prices, and can indeed
fuel steep price declines. It matters, therefore, that investors
understand, to the extent that they can, the ownership profiles
of their financial assets. And in preview, it matters to many regions
of the Asian fixed income markets that foreign ownership levels
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Source: Deutsche Bank.
b L A C k R O C k i n v e s T m e n T i n s T i T u T e [ 7 ]
6 Slok, Torsten. “Demographic Trends that Matter for Investors,” Deutsche Bank Research, September 2011.
Figure 6: China’s Labor Force to Shrink in Coming Decades
can be high in some countries, domestic demand sources
can be scant, and as argued previously, despite fundamental
improvements to sovereign credit profiles, the region has
not yet attained “safe haven” status.
In the context of Asia region fixed income markets, greatly
increased foreign ownership of sovereign debt stocks, as well
as limited domestic demand due to underdeveloped pension
fund systems and smaller institutional investor bases, places
certain countries at risk of unanticipated outflows, asset price
declines, and subsequent yield spikes. For instance, the cases
of Korea and Indonesia are instructive on this issue: according
to JPMorgan Asia Markets Research, 18% of Korea’s locally
denominated sovereign debt is held by foreign owners, and
Indonesia represents an even more extreme example with 33%
of its local market debt owned by foreign market participants.
For the past several years the flow of capital into local Asian
debt markets has provided meaningful support to these markets
and facilitated the maintenance of lower bond yields. Now,
however, the threat of significant outflows has reversed this
favorable dynamic. For instance, EM bond funds have seen
outflows for the past few weeks, including more than $5 billion
in the three weeks from September 14 to October 5, 2011. Indeed,
in some cases the concentration of foreign ownership can be
extreme, which again adds to the risk of capital flight. According
to a Deutsche Bank report7, investors domiciled in the United
States and Luxemburg accounted for approximately 38% of foreign
holdings of Korea Treasury Bonds. Interestingly, according to
the report, “flows from [these] two countries seem to be driven
by a single large institution… [and] this single player is estimated to
take account of over 50% of Korean paper holdings by [the] US
and Luxembourg. While it can be difficult to quantify the impact on
domestic rates markets of foreign capital, according to JPMorgan
models the impact can be meaningful: Korean Treasury yields
“typically decline by 5 bps [basis points] for every percentage
of foreign ownership.”8
In Indonesia’s case the country’s sovereign debt markets were
seen as particularly vulnerable due to the very high percentage
of foreign ownership, and indeed foreign buyers pulled back in
August and September as risk appetites waned for all types of
risk assets. Consequentially, the Indonesian rupiah (IDR) has
declined nearly 5% since the beginning of September, the
country’s sovereign CDS spreads have widened, and current
foreign currency reserves have declined somewhat. Still, we
have seen bond yields remain fairly stable in the face of this
mounting pressure, which can partly be explained by effective
government intervention in the markets. Beyond the recent rate
cut, the Indonesian Treasury and the Bank of Indonesia have
labored to maintain relative stability in the markets for the
country’s sovereign debt, and thus far their efforts appear
successful as witnessed in yield levels. The episode, however,
underscores the critical variable of currency volatility, as most
foreign investors do not hedge their currency risk when engaging
these markets. Recently, currency movements have had a
disproportionately negative effect on local debt total returns.
This fact is best illustrated by the Barclays Asia Local Currency
Diversified Bond Index return breakdown by currency, price, and
coupon: in September 2011 the Index performance was -5.75%,
of which -6.04% was due to currency movements, 0.40% due to
coupon, and -0.10% the result of price declines. As mentioned
previously, currency dynamics have a tremendously important
impact on returns in these markets and need to be considered
carefully as both a source of added risk as well as of potential
return. Interestingly, throughout the recent period of volatility,
Asian market currency fluctuations have been much more unstable
than country interest rates, which can partly be explained by
the fact that currencies are also impacted by equity market
outflows (which have been substantial) and other trade
related hedging activity.
The evolving state of (and prospects for) Asia debt markets
We think global debt markets are in the process of undergoing
a tremendous secular change that will make fixed income
investing over the next five-to-ten years look very different from
what it has looked like over the past twenty. Specifically, lower
economic growth rates in the developed world, and very high
current levels of aggregate system-wide leverage there, should
place limits on the total amount of debt issuance from those
countries. Moreover, as we have argued extensively elsewhere,
not only will developed market fixed income supply be less than
it has been in the past (providing a technical tailwind to those
markets), but demand for yielding assets from both developed
market and emerging market institutions will continue to rise
sharply at the same time, in part due to widespread demographic
changes. This factor, as well as the relatively improved economic
fundamentals amongst Asia-region issuers, and the higher
rates of growth those countries enjoy, should meaningfully
begin to shift fixed income supply from the developed markets
to emerging markets (particularly in local currency denominated
issues), with Asia region issuance being key to this change.
[ 8 ] T h e R i s i n g p R O m i n e n C e O f A s i A n d e b T m A R k e T s — O C T O b e R 2 0 1 1
7 Seong, Kiyong. Korea Rates Strategy: Foreign Flows: Hot Asia versus Cold Europe, Deutsche Bank, Hong Kong, October 6, 2011.
8 Gochet, Bert. Macro Strategy View: “Quantifying the Impact of Foreign Selling of Asian Government Bonds,” J.P. Morgan Asia Markets Research, October 3, 2011.
We think economic growth is the most important factor to consider
when looking at regional changes in debt issuance (at both the
sovereign and corporate levels), and Asia-region credit growth,
excluding Japan, may advance at a compounded annual growth
rate of around 10% to 15% in the years to come. Moreover, this
shift will appear particularly dramatic when regional differences in
historical corporate capital structures are taken into account.
For example, the typical corporation in the Asia-ex Japan region
has historically held a capital structure with a considerably greater
weight in equity, with less debt than US or European counterparts
(see Figure 7). In fact, bank loans have historically been the
Asian issuers’ primary source of debt financing, representing
approximately 10% of the typical corporation’s capital structure,
versus half of that level for the average US firm. Overall, total debt
(both bonds and loans) represents nearly a quarter of US corporate
capital structures, and around a third of the capital structure
of a European company, yet despite trends toward increased
issuance, it still only represents about 17% of Asia company
capital structures. The upshot is that not only has issuance
increased recently, which aids in improving market depth and
liquidity, but we believe this also represents the early stages of
a transition to greater global emphasis on Asia debt markets.
According to Morgan Stanley research, fixed income issuance in
2011 may still come close to hitting record levels for the third
straight year (see Figure 8), although recent market volatility
presents a headwind.9 Placed in context, though, these issuance
trends (which account for both sovereign and corporate debt)
are off a relatively low base compared to most developed country
and company debt loads. This has partly to do with the fact that
since Asia’s financial crisis in 1997 corporations have been involved
in a very significant deleveraging cycle. For instance, since that
time, Asia-region corporate leverage (as measured by debt/EBITDA)
has come down from 4.6x to about 2x currently, and at the same
time cash levels as a percentage of debt have risen from about
20% to near 60%. Corporations in Asia appeared to learn early
on lessons US firms would learn a decade later, namely that
in the wake of financial crisis uncertainty a firm may need to
maintain higher levels of cash and lower amounts of leverage to
insure itself somewhat from left-tail economic risks. Of course,
typically speaking, maintaining high corporate cash balances
presents a drag to return on equity, but that has generally not
occurred with the corporate sector in Asia, partly due to the decline
in total interest costs (from near 8% to 9% in 1998, to a bit over
3% today) and improved operating margins. Still, both the low
relative leverage of the corporate sector in Asia, and the broad-
based debt dynamics presented above, do point to the possibility
that the deleveraging cycle for the region may be over.
100%
80
60
40
20
1/84 1/88 1/92 1/96 1/00 1/04 1/08 7/11
0
1/94 1/98 1/02 1/06 1/11
100%
80
60
40
20
0
Fixed Income Liquid Assets Equities
Developed Markets, 1984–2011
Asia, 1994–2011
% O
F TO
TAL
CAP
STR
UCT
UR
E%
OF
TOTA
L CA
P ST
RU
CTU
RE
Sources: Cross Border Capital; IMF, Datastream, IBV.
b L A C k R O C k i n v e s T m e n T i n s T i T u T e [ 9 ]
9 Hjort, Viktor. “The Old Normal,” Asia Credit Strategy, Morgan Stanley Research, updated September 2011.
80,000
60,000
40,000
20,000
0
Jan Mar May Jul Sep Dec20082007
20112010
2006
2009
2005
CUM
ULA
TIVE
YTD
SU
PPLY
(U
S$
MIL
LIO
NS)
Source: Morgan Stanley.
Figure 7: Comparing Capital Structures— More Debt in Developed Markets
Figure 8: Asia FI Supply
Finally, we think it is important to emphasize that there are broader
social and demographic reasons that would argue for deeper
and more robust debt markets in Asia. As mentioned previously,
demographic workforce trends in the region and modestly aging
populations present a natural demand base for yielding assets.
This development is partly the result of evolving social safety
net programs, and is particularly important since relying on
short duration debt and deposits to fund long duration liabilities
and projects can only work for as long as the deposit base grows
faster than investment spending, which may not be the case
going forward. Developing deeper and more robust debt markets
can allow for lower-risk debt rollover and can aid in avoiding
asset/liability mismatches over time. As this debt market evolves,
it should present opportunities for investors well beyond the
region, even as it serves a key functional role within the region.
Risks and investment implications
We think that the temptation for corporations in Asia to add
leverage is certainly present, not least because of a corporate cost
of equity of roughly 11% to 12% and a median pre-tax cost of debt
of roughly 3.2%10 argues for added leverage for share repurchasing
or mergers and acquisitions (see Figure 9). This can be seen as
particularly critical for boosting performance in an environment
of slowing global growth. We already are seeing signs of this trend
in the first quarter of 2011, where EBITDA for corporations in the
region grew 16% year-over-year and leverage at nearly a 40% rate.
This dynamic, as we argue above, can potentially mean added
debt supply to meet ever increasing demand requirements, as
well as improved liquidity in the region’s debt markets, but it
can also carry some significant risks for investors. Specifically,
these dynamics suggest that event risk is high, and investors
need to be cognizant of a corporation’s strategy with respect to
M&A, share buybacks, dividend hikes, and any other cash/liquidity
depleting actions that may be perceived as bondholder unfriendly.
Moreover, in an environment where there is re-leveraging,
credits that display organic deleveraging should likely trade
at a premium. In markets such as this, carry becomes a more
important factor in generating strong total returns, and one
cannot count on spread tightening to do the heavy lifting.
It is also important to understand that while liquidity has improved
in Asia’s debt markets, it is still considerably less liquid than
developed country bond markets, as seen in recent market
stresses, and there are significant variations by market segment.
Thus, for example, the total corporate credit market (excluding
Japan, and financial sector firms) stands roughly at $1 trillion, 58%
of which is in the form of bank loans, 27% in bonds denominated in
local currencies, and 16% in bonds denominated in G3 nation
currencies. Yet, from a liquidity perspective, these G3 denominated
issues are the most liquid, followed by locally denominated bonds,
with liquidity being lowest in the largest segment, bank loans.
And while liquidity has been improving in local currency market
issues, it is still far inferior to that found in G3 bond markets,
and the most liquid bonds tend to be sovereign paper, rather
than corporate bonds. This liquidity risk premium is one of the
reasons we see Asia high-grade issues trading 40 to 50 basis
points wider than comparable US investment-grade bonds, and
Asia high-yield trading at 100 to 125 basis points wider from US
high yield. Good apple-to-apple comparisons can be difficult to
make between these markets, however, we believe the sovereign
debt ceiling (the view arguing that corporations should not be
able to borrow at preferential terms to the sovereigns in which
they operate) constrains some firms that do indeed appear to
be sounder credits than their country of domicile.
9%
7
6
8
0
5
3
2
4
1
’95 ’97 ’99 ’01 ’03 ’05 ’09’07 ’11
INTE
RES
T EX
PEN
SE/
TOTA
L D
EBT
(%)
Source: Morgan Stanley Research, October 2011.
[ 10 ] T h e R i s i n g p R O m i n e n C e O f A s i A n d e b T m A R k e T s — O C T O b e R 2 0 1 1
10 Morgan Stanley Research, October 2011.
Figure 9: Asian Corporations Enjoy Declining Cost of Debt
The legal, regulatory, and governance protections that bondholders
enjoy in Asia debt markets can also be seen as generally weaker
than those of the developed world. In China, for instance, offshore
creditors are almost always subordinate to onshore lenders.
Also, upon a default, recovery rates have historically tended to
be substantially less than that found in developed markets. For
the high yield sector, for instance, recovery rates have typically
hovered around 20% on average, compared to recoveries of
35% to 40% in developed market high yield issues. That said,
bond covenants can be fairly strong in Asia, relative to the
weakening covenants seen amongst US and European issuers,
but lax regulatory frameworks and some poor financial reporting
practices make the overall situation mixed at best. Still, as these
markets continue their process of maturation, we believe many
of these issues will likely improve markedly in the years to come.
3,500,000
3,000,000
2,500,000
2,000,000
1,500,000
1,000,000
500,000
0
1/00 1/01 1/02 1/03 1/04 1/05 1/06 1/07 1/08 1/09 1/10 1/11 7/11
Republic of Korea Hong Kong Singapore Thailand
IndiaRepublic of China (Taiwan)JapanChina
OFF
ICIA
L R
ESER
VE A
SSET
S(U
S$
MIL
LIO
NS)
Sources: Bloomberg, IMF.
Finally, while we have described a dynamic by which Asia region
countries and companies will increasingly come to define the global
debt markets, the fundamentally solid situation of these actors
today from the standpoint of credit risk must be underscored.
Asian countries continue to fund the overleveraged developed
world and add to their already sizeable stock of reserve assets
(see Figure 10), and may continue to do so for some time.
Moreover, as debt issuance in Asia increases, institutions from
around the globe will increasingly see these investments as a
new benchmark for value. Indeed, there may one day come a
time when the region’s debt markets are not only seen as an
attractive place to invest for carry and currency rationale, but
also as a budding safe haven for capital, perhaps beginning to
supplant the fiscally strained and indebted developed world.
b L A C k R O C k i n v e s T m e n T i n s T i T u T e [ 11 ]
Figure 10: Foreign Currency Reserve Growth in Asia
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Lit. No. ASIA-DEBT-WP-VI-0212 AC6040-0212
