Emerging East Asia's Local Currency Bonds Resilient But Face Risks

Asian Development Bank’s. 29 November 2011. MANILA, PHILIPPINES. Emerging East Asia’s local currency bonds are still in demand from domestic and offshore investors, but the region’s markets face increasing challenges, according to the latest Asia Bond Monitor released today.

Emerging East Asia’s local currency markets continue to expand, but at a slower rate than previously. At the end of September, the region had $5.5 trillion in outstanding bonds, 5.5% more than a year earlier in local currency terms.  That compared with a year-on-year growth rate of 7.6% at the end of the second quarter of 2011.

The expansion in the third quarter was largely due to strong growth in the region’s corporate bond market, which expanded by 15.4%, while the government bond market grew by a smaller 1.3%.

“Asia’s low debt levels, strong economic fundamentals and the yield pick-up compared with bonds of developed markets contribute to the attractiveness of local bonds,” said Iwan J. Azis, Head of the Asian Development Bank’s (ADB) Office of Regional Economic Integration.

Still, risks to the outlook include growing uncertainty surrounding the European economies, which is generating volatility in global and regional markets and a flight to safe-haven investments. Furthermore, the slowdown in Asia’s economic growth and the potential for abrupt capital outflows are also challenges.

The report assesses the bond markets of the People’s Republic of China (PRC); Hong Kong, China; Indonesia; the Republic of Korea; Malaysia; the Philippines; Singapore; Thailand; and Viet Nam.

Bonds issued by local governments could become an interesting new asset class in the local markets.  The Thai government now permits issuance by local governments and the companies they own. Meanwhile, the PRC recently approved  issuance of bonds by the  municipal government of Shanghai and the province of Guangdong for CNY7.1 billion and CNY6.9 billion, respectively.

Yield curves in most markets have flattened and in some cases shifted downwards as markets and policymakers focus on supporting growth rather than stemming inflation. Declining yields, particularly for longer-dated bonds, offer governments in the region an opportunity to raise cost-effective debt should they need to finance additional borrowing.

Viet Nam was the fastest-growing local currency bond market in the third quarter, expanding 22.2% on year to $17 billion. The corporate bond market grew by a strong 34.7% with the government bond market increasing 21.1%.

The PRC has the largest local currency bond market in emerging East Asia with $3.2 trillion in bonds outstanding at the end of September. That was 3.5% more than a year earlier and 0.5% more than at the end of June. The 20.0% year-on-year growth in the corporate bond market contrasted with the 0.7% contraction in the government bond market.

Bond issuance in the region totaled $829 billion in the third quarter, up 7.6% versus the second quarter but down 19.9% year-on-year as central banks reduced sales to offset foreign exchange inflows. Corporate issuance was also down 24.4% on a year-on-year basis. This decline, however, was from extraordinarily high levels in 2010.

Asian BondsOnline’s latest liquidity survey of over 100 investors shows that bid-ask spreads have widened compared with last year but turnover ratios have improved. The survey results show that market participants want governments to issue more bonds to improve market liquidity.

As of the end of October, borrowers in emerging East Asia had raised $63 billion in so-called G3 bonds – or bonds denominated in US dollars, euros or yen -- suggesting the region may, after all, fall short of the record $87 billion in issuance witnessed in 2010.v

IMF Executive Board Discusses Criteria for Broadening the SDR Currency Basket

On October 28, 2011, the Executive Board of the International Monetary Fund (IMF) discussed a staff paper on Criteria for Broadening the SDR Currency Basket.

Background

The SDR (Special Drawing Right) is a global reserve asset created by the IMF to address long-term global liquidity needs. Since the 2000 decision on the SDR valuation basket, the weighted basket consists of the four currencies that are (i) issued by Fund members (or monetary unions of Fund members) which are the largest exporters; and (ii) have been determined by the Fund to be a “freely usable” currency—a currency that is widely used for international payments and is widely traded. These currencies are currently the U.S. dollar, the euro, pound Sterling and the Japanese yen. The freely usable currency concept has been at the core of the IMF’s operations since the Second Amendment of the Articles in 1978. Considerations relating to this concept have been taken into account for SDR valuation since that time, but a formal requirement that currencies in the SDR basket be freely usable was adopted only in 2000.

The staff paper responds to calls by the International Monetary and Financial Committee and the Ministers from the Group of Twenty Countries to develop a criteria-based path to broaden the composition of the SDR basket. The paper is also part of the follow-up work program on the SDR agreed at the conclusion of the 2010 Review of SDR Valuation (see Public Information Notice No. 10/149) and of the IMF’s work on reform of the international monetary system and the role of the SDR (see Public Information Notice No. 11/22 and the accompanying paper).

The paper reviews the criteria for the valuation of the SDR basket, guided by long-standing principles underlying SDR valuation. It also reflects considerations related to changes in the global economy and to the role of the SDR in promoting the stable evolution of the international monetary system. The paper discusses two options for the freely usable currency criterion in that context.

The first option is to maintain it as a criterion for the SDR basket valuation, but to update and clarify the related indicators. The suggested indicators include the currency composition of foreign exchange reserves, international debt securities and international bank liabilities, and foreign exchange spot market turnover.

The second option is to replace the freely usable currency criterion with a tailored new criterion, and to identify suitable indicators, that preserve the status of the SDR as reserve currency. The paper also reviews issues related to the exports criterion and to the number of currencies in the SDR basket.

Finally, the paper identifies key data gaps that affect indicator selection and assessment under either reform option, as well as under the exports criterion.

Executive Board Assessment

Executive Directors welcomed the opportunity to discuss criteria for broadening the SDR currency basket, a key element of the work program on SDR valuation and the reform of the international monetary system. They noted that a criteria-based path to broaden the composition of the SDR basket aims to strengthen the role of the SDR in the international monetary system and facilitate the system’s stable evolution. Directors agreed that the long-standing principles, which have ensured the stability and representativeness of the SDR, should continue to guide future SDR valuation decisions, with the aim of enhancing the attractiveness of the SDR as a reserve asset.

Directors welcomed the clarifications of the existing criteria in the staff paper, with most being of the view that the current criteria for SDR basket selection remain appropriate. A number of Directors were open to exploring alternatives to the “freely usable” criterion, along the lines of the “reserve asset” criterion presented in the staff paper. Directors stressed that the bar for SDR basket inclusion should not be lowered.

In this ongoing work, Directors welcomed as a useful step the indicators put forward by staff for the freely usable criterion in the context of the regular review of SDR basket valuation. They broadly concurred that the currency composition of official reserve holdings, the currency denomination of international banking liabilities, the currency denomination of international debt securities, and the volume of transactions in foreign exchange markets should be important factors in the assessment of free usability. A few Directors suggested that indicators should also capture progress toward capital account liberalization.

Directors emphasized that the indicators should not be used mechanistically and that ultimately, the determination of free usability would need to rely importantly on judgment, framed by the definition of freely usable currency set out in the Articles of Agreement. In this connection, a number of Directors saw scope for using some of the indicators proposed for the reserve asset criterion as a complement to those proposed for clarifying the freely usable criterion. A number of Directors also stressed the importance of allowing changes in the basket to keep pace with developments in the international monetary system. In this regard, a few suggested exploring indicator options, if any, that would be less subject to the strong inertia suggested by the staff’s analysis and illustrative scenarios. Some Directors also noted that the approach to assessing free usability should promote the pursuit of reforms that facilitate currency internationalization, while a few others cautioned against unrealistic expectations for policy incentives.

Most Directors agreed that there continues to be an important role for a size-related criterion for SDR basket selection. While agreeing that augmenting the current exports criterion with financial inflows would, in principle, be desirable, most Directors preferred to maintain exports as the sole size criterion for the time being, pending further improvements in financial accounts data. A few Directors, however, noted that exports are a weak indicator of currency use and should not play a role in SDR basket selection.

Directors noted the significant data limitations that constrain the assessment of the role of currencies in international monetary and financial transactions, and called on the Fund, its members, and other providers to intensify efforts toward alleviating these limitations.

Directors agreed that the number of currencies in the SDR basket should not be prejudged. They generally considered that, as the SDR basket evolves in due course, its size should remain relatively small to avoid adding undue costs and complexity for SDR users. While a few Directors saw merit in considering shadow baskets to capture the implications of potential SDR basket enlargement, some others noted that such an approach could be technically challenging and may confuse SDR users.

Public Information Notice (PIN) No. 11/137. November 11, 2011
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm