Asia has been in the headlines a lot for all the wrong reasons: the ongoing and violent pro and anti-Thaksin split in Thailand paralysing the political process; and China’s perceived expansionary activities, characterised by increasingly fractious manoeuvrings of its ships with those of Japan and Vietnam, ongoing disputes with the Philippines, Taiwan, Malaysia and Brunei in the South China Sea and, most recently, tensions with pro-democracy activists in Hong Kong.
But do the news headlines give a misleading impression? There are plenty of positives, too, in the shape of reform-oriented progress after the elections of Narendra Modi in India, and Joko Widodo in Indonesia, not to mention the steady economic progress in many countries across the region. For bond investors, the really important question is not necessarily about the reality of political risk in the region but, rather, the trade-off between perceived political risk and the current level of sovereign yields.
“What is surprising is that yields – and asset prices generally – are at levels where it almost seems as though nothing really matters in terms of political risks, with a few exceptions in cases like Ukraine or Argentina,” argues Maurice Meijers, head of emerging market debt at Robeco. “We are in a low-volatility environment and in such an environment political factors are not something that investors pay much attention to. You don’t take political risk into consideration to make money but to protect yourself from downside risks.”
Thailand is the perfect example. Its debt markets refuse to exhibit the same kind of volatility as its political situation. Meijers says that his team has been cautious about Thailand for some time, adding ruefully: “But we have not made any money as a result.” But he points to a number of uncertainties – particularly around the health of King Bhumibol – to make the case that the country is close to an inflexion point that could potentially cause a rapid change in sentiment. “With five-year Thai government bond yields around 3% against the average yield in EMD at 6.5%, foreign fund managers are not seeing much upside,” he adds.
“There is growing investor indifference to political developments in Thailand,” counters Yerlan Syzdykov, head of emerging market debt at Pioneer Investments. “It has seen a lot of coups and they have not proved to be a good indicator of a time to sell.”
Similarly, while she acknowledges that the coup can only be a “negative underlying theme”, Alia Yousuf, a senior portfolio manager at ING, cites technical factors when she warns about being over-cautious on Thailand. The bond market is both deep and liquid and less than 20% foreign-owned.
“When the government does not function, there is no implementation of the budget, so the local institutional investors were quite cash rich when the political instability arose,” she explains. “That meant that they invested large amounts into government bonds – which, for them, is the risk-free instrument. So the Thai bond market did well throughout the political crisis.”
Separating purely economic from political factors in emerging market local currency debt spreads is subjective. As Jerome Booth, Ashmore Group’s ex-head of research and an influential commentator on emerging markets, argues in his recent book, Emerging Markets in an Upside Down World, that political risk exists everywhere, including in developed economies. That risk is often not priced correctly, so any judgement as to whether emerging-market bonds price emerging-economy political risk correctly has to be based on assumptions about how that risk is being is priced in developed markets.
Booth sees three layers to the market pricing of sovereign risk. The first is quantitative, based on macroeconomic ratios such as debt-to-GDP and fiscal deficits. The second is a policy layer, reflecting the ability of policy makers to implement sound economic policies, including spreading a market economy and enabling intelligent and timely responses to events – which effectively means the development of a robust institutional framework incorporating independent central banks, savings intermediaries such as pension funds and insurance companies, and a regulatory framework that seeks to enforce a level playing field through the rule of law. The third layer consists of simple perceptions of risk – which Booth pointedly describes as the “prejudice layer”.
On the first layer, by and large, Asian countries have high savings ratios and have been net creditors to the rest of the world, facts that underpin their credit fundamentals. On the other hand, exceptions like India and Indonesia are clearly significant. Moreover, Joep Huntjens, head of Asian debt at ING Investment Management, points out that while the debt-to-GDP ratio for emerging markets, especially in Asia, looks quite good, the direction of travel over the past couple of years is less encouraging for some – particularly China. “[This is] not so much [evident] in sovereign debt, but if you include all local denominated credit there has been a significant deterioration,” he observes.
Is that a risk? Few can now be unaware of the noise around the potential for China’s credit ‘bubble’ to burst disastrously. But China sits on $4trn of reserves, has a savings rate of 30%, and a state-owned banking sector. “If you replace the term ‘bank loan’ by ‘social welfare fund’ and expect no return, it reflects the reality and also the fact that the government is easily capable of recapitalising the state banks,” argues Booth. This need not be a financial risk, in other words. But it is not clear whether these facts introduce more or less political risk.
When we look at the most fundamental of Booth’s three layers of sovereign risk – the second one of policy development – coup-plagued Thailand seems like more and more of an outlier against an Asia that increasingly accepts democratic frameworks and the importance of market pricing. This includes China.
“The biggest underlying risk in Thailand is that democracy is not working and developments are going the wrong way, but it is an exception in Asia,” says Yousuf, at ING. “Countries like Indonesia and India are undertaking huge elections and are moving in a much more positive direction.”
The most significant development across emerging markets, as a whole, has been the phenomenal institutionalisation of their economies dramatically improving the ability of policy makers to implement policies.
At a glance
• Headline political risk in Asia seems to be on the rise – from the coup in Thailand to tensions in Hong Kong, and a number of big elections in between.
• But as the Thailand case illustrates, even political turmoil does not necessarily translate into bond market volatility.
• Moreover, situations like Thailand’s may grab the headlines, but they are the exception rather than the rule.
• The longer-term sustainability of Asia’s financial position will depend on the deepening institutionalisation of its economies and markets – and here it, arguably, lags other emerging regions.
• But the direction it is heading is encouraging, indicated by China’s November reforms and the success of pro-market candidates in important elections in India and Indonesia.
• Is this enough to eradicate the prejudice premium in emerging market spreads generally, and Asia’s in particular?
“In the 1997 Asian crisis, it was locals who fled the markets first, selling local assets and the currency to shift to safer havens,” says Booth. “There is central bank independence now, a growth of domestic pension funds and institutional investors who are mandated to invest in domestic assets.”
Michael Gomez, head of emerging market debt at PIMCO, develops the theme – but draws some regional distinctions that do not flatter Asia. The three key developments required to emulate the institutional framework of the developed markets are: creating a central bank with at least operational autonomy (a single or dual mandate is less important than defining and communicating that mandate clearly); establishing a financial framework with rules that are well understood by the markets; and removing barriers to entry and exit around those markets.
“Mexico now has a completely open capital market,” he says. “Price discovery is set automatically and we don’t have worries about over-valuation of the currency. They have removed barriers to buying local bonds, so it is as easy to buy them as US Treasuries. In contrast, Indonesia, one of the three major Asian local currency debt markets for foreign investors alongside Malaysia and Thailand, has a tendency to get very opaque during times of volatility, such as in 2013 – the liquidity in local bonds and therefore the ability to transact and get price discovery in the FX market dries up. In the long run, that adds to the risk premium. In India and China, the process is going in the right direction but it is slow.”
As Gomez points out, Italy, with its debt-to-GDP ratio of more than 120%, is still able to issue 10-year debt at a 3% yield. He argues that there is more to this than mere prejudice.
“The reason is that the euro-zone debt markets are underpinned by the ECB,” he says. “Italy has support from one of the strongest institutions in the world.”
Meijers concurs: “Some local currency bond markets have yields at levels very close to Spanish and Italian debt, but the liquidity in the euro-peripheral countries like these is still massive compared to local currency EMD, and the ECB is backing them.” Moreover, widening bid-offer spreads indicate that liquidity has been in decline in emerging markets over the past few years.
Fragile institutional frameworks explain how, despite enviable debt levels and balance sheet flexibility in Asia, cautious investors are able to argue that the risk that countries might set out on a cycle of decisions that put debt sustainability into question is real.
The Renmimbi Rises – Myths, Hypes and Realities of RMB Internationalisation and Reforms in the Post-Crisis World, is a book recently published by Chi Lo, China economist for BNP Paribas Investment Partners, that makes a similar point.
The ultimate goal of financial liberalisation is to have market-driven interest rates to allow efficient capital allocation in the economic system. But, as Lo points out, in China, this means that Beijing will have to uproot its closed-system economic management model. The result of this dissonance has been a set of confusing and inconsistent reform moves in recent years which Lo sees as a reflection of the lack of a coherent reform vision from the Chinese leadership.
“China’s structural reforms have shown a confusing stop-go pattern since the late 1990s,” he writes.
The good news is that the Asian institutional framework is evolving and getting better – indeed, the real significance of the Third Plenary Session of the 18th Central Committee of the Chinese Communist Party in November 2013 might be the decision to create a central leading team for comprehensively deepening reform. This process of institutional reform in the region may be slow and has occurred in fits and starts, but the trend is unmistakeable, and the move towards more robust, professional and independent institutions is also reflected in the changing political environment.
Populist politicians who have been winning power for decades through a mixture of crude nationalism and expensive market-distorting subsidies designed to buy votes from the masses rather than create the environment in which they can improve their lot, seem to be going out of fashion. India is the prime example.
“The reason why people are getting so excited about India, for example, is that now it has an effective government coming in and starting reforms that can enhance productivity,” says Gomez.
He still prefers Latin America and Eastern Europe to Asia, given the low level of real rates and the history of central banks being accommodative of inflation, but it is notable that he holds up Mexico as the poster child for what could happen in India and other reform-minded countries across the region.
“Mexico is undertaking a very aggressive structural reform agenda that, unusually, has not arisen as the result of a crisis,” he observes. “We see their reforms [potentially] increasing GDP by 1.0-1.5% per annum and at the same time, reducing inflationary pressures by 0.5%.”
In summary, economic fundamentals are generally good, and most of Asia is on a path to the more robust institutional framework that should maintain those fundamentals long-term. What remains up for debate is Booth’s third layer to emerging market debt pricing – prejudice.
Global investors educated in financial economics heavily influenced by US academics for whom the risk of investing outside the US demanded higher returns still instinctively regard US Treasuries as the risk-free asset. But for European investors, for example, which makes more sense – investing in US Treasury bonds or Chinese RMB-denominated government bonds? As Booth points out, the risk of default in either is close to zero, although the US has closed down twice in the past few years and threatened technical default as a result of political budget stand-offs between Congress and the White House.
“Investors can get robbed in different ways – they can be robbed gradually through inflation and currency devaluation [as well as quickly via default],” he says. “The RMB will appreciate relative to the dollar, so China should definitely offer lower yields than the US, as it is safer to invest in RMB government debt.”
Investors will be used to hearing this argument from Booth. For what it is worth, plenty of other emerging market practitioners, like Syzdykov at Pioneer, would concur. But, as he adds: “The paradigm shift is not there yet.”