The appeal of Asian debt
Over the decade since Asia’s 1997-98 financial crisis, emerging Asian economies have become stronger, as is evidenced by recent trends in growth, inflation and fiscal and external balances. GDP growth in emerging Asia has averaged 7.5% a year over the past five years, significantly outpacing the OECD average of 2.5% a year. This economic and financial resilience has been underpinned by strengthening socio-political checks and balances. Policy management has become flexible, prudent and proactive, and macroeconomic discipline has been the lynchpin of development programmes.
Given these vast economic improvements, it’s no surprise that Asian countries have established a reputation for credibly autonomous central banks and a time-tested respect for fiscal responsibility.
At the same time, they have benefited from the market-signalling effects of more liberalised currency and interest rate regimes, and from progressive globalisation of onshore financial markets. The resulting increase in transparency, far from being destabilising as was initially feared, has served Asian countries well by helping them avoid the slippages and pitfalls that precipitated previous market meltdowns.
Improvements in credit standings for Asian countries have been nothing short of spectacular. The increase in credit quality has in large part been the result of a massive accumulation of foreign reserves, which provide an effective buffer against the vagaries of global demand.
Other fundamental economic measures have advanced considerably, highlighted in Figure 1. This radar chart is based on four widely used sovereign indicators - foreign reserves, current account balance, external debt leverage and short-term debt. The larger the radar reading, the stronger the fundamentals.
The dramatic improvement is mirrored by a steady stream of credit ratings upgrades in Asia, as shown in Figure 2.
On average, upgrades outpaced downgrades by a ratio of five to one over the past five years. Remarkably, the return of South Korea to an investment-grade single-A rating, from a low of single B at the worst of the Asian crisis, resulted in its exit from the JPMorgan EMBI Global in mid-2004.
Nonetheless, most countries have yet to attain their pre-crisis ratings.
Current ratings are at least two notches below mid-1990s levels.
With at least five countries in Asia on positive outlooks (China, Hong Kong, Indonesia, Pakistan and South Korea), there is still further upside for credit ratings. Admittedly, the positive momentum will likely slow from its pace in recent years.
At the same time, the health of corporations and banks has staged a marked improvement. Asian corporations’ balance sheets are in a much better shape, with debt-to-equity ratios down from above 150% in 1999 to under 100%.
This reflects a combination of large-scale government-led debt restructuring (as in Korea and Thailand), as well as the initiative of companies themselves. In addition, non-performing loan ratios of the region’s banks have corrected to healthy levels.
Against this constructive economic backdrop, the performance of Asian debt has been breathtaking. On a total return basis, measured by the JPMorgan Asia Credit Index (JACI), Asian US dollar-denominated debt returned an average 10% a year between 1998 and 2006. Over the same period, the average spread narrowed to just over 100 basis points from almost 500bps. Indeed, this sustained tightening of credit spreads has prompted increased interest in local currency denominated fixed income as well. As a case in point, offshore investors now account for roughly 13% of Indonesia’s local bond market.
One key technical factor behind the resilience of Asian debt has been a broadening investor base. Over the past decade, an Asian debt market once dominated by short-term traders has transformed into one with stable, buy-and-hold investors with reduced leverage.
Additionally, the improvement in credit quality has attracted a more diversified range of participants with different constraints and considerations.
Notably, local investors are now among the dominant players. International high-grade fund managers are being forced to follow Asian debt as more issuers move up the credit ladder. India presents a case in point: with S&P’s one-notch upgrade in late January to BBB-, India is now rated investment grade by all major credit rating agencies.
In addition, the number of issuers has risen sharply, bolstered in part by new high-yield corporate
entrants. The JACI is comprised of 300 bond issues falling within a broad rating spectrum of AAA through B-. The heterogeneous nature has led to a growing recognition that what is valid at the level of the asset class may not be applicable to every issuer. In addition to the benefit of diversity, this large differentiation between countries and credits provides significant scope for active portfolio management.
Going forward, the key risk to the constructive outlook for Asian debt would be a disorderly shock to the global economy, large enough to overwhelm the self-insurance that Asian countries have in the form of foreign reserves, improved external balances and low financing requirements. Another concern would be an increase in domestic headline noise in the run-up to scheduled political elections over the next 12 months, including Hong Kong, Pakistan, Philippines, South Korea, Taiwan and Thailand.
Still, any contagion impact of these events on the rest of Asia would likely be limited. For example, volatility in Thai markets since the military coup in September has not widely impacted other Asian markets.
Overall, economic and financial fundamentals will likely continue to improve for the foreseeable future. Notwithstanding potential market volatility arising from a still-fluid external environment, a pullback in risk appetite, and domestic political developments,
Asian debt should continue to look attractive in both relative and absolute terms. Asian bonds, therefore, remain a compelling candidate for global asset diversification.
Chia-Liang Lian is a portfolio manager with global bond specialist Pimco