The Asian bond market is less sophisticated when compared to their Western counterparts but the status quo may change
Rohit Chawdhry

The performance of Asian equity markets has been so robust over the last few years that investors have simply forgotten about another asset class – the Asian bond market. They have another reason to forget it besides the relative underperformance of Asian bonds. That reason is that, compared to their western counterparts, Asian bonds are less sophisticated.

Further, the turnover ratio of bonds to stocks, usually 7:1 in the western markets, is the other way round in Asia. The level of diversity in Asian bond markets varies as much as the diversity in their economies. From Japan's huge and highly advanced but largely domestic-focused market to Thailand's small but rapidly developing market, it varies.

But the status quo of having lacklustre Asian debt markets might not last too long. Why? First the structural reason. According to the International Monetary Fund (IMF), emerging economies account for 48 per cent of global GDP (in purchasing power parity (PPP) terms), and these economies are growing at an average rate of seven per cent versus three per cent for the developed economies. Thus, their share of the global pie is large and growing.

But at present these countries are significantly under-represented in relation to their economic importance. A look at the IMF estimates for share of global GDP compared with those countries' representation in the Lehman Global Aggregate index (as a proxy for fixed income investors' exposure), reveals that an amazing 96 per cent of investments are concentrated in countries that make up only 52 per cent of world GDP. Merely 4.2 per cent of investments are for countries that make up 48 per cent of world GDP or emerging markets. The share of non-Japan Asian bond markets in the global bond markets is just three per cent. Needless to say, it's a no brainer that this situation won't last too long. Especially if Asia wants to grow at six per cent on a sustainable basis.

Bonds fulfil an important function in the economy. They provide stable, long-term financing for companies and states alike and offer investors an important alternative to stocks. Bonds may be less flamboyant and more boring than stocks, but they are less volatile as well, and offer a more predictable flow of income.

It is rather ironical that Asia requires around US$1tn just to meet the infrastructure backlog in the continent in the next five years, to say nothing about the funds needed for education, health and the capital requirements of domestic industries. Yet a bigger amount, about US$1.1tn, still gets shipped out of Asia and gets invested in US Treasury securities – that is, it has been lent to a rich western country despite the huge requirements to finance development and poverty reduction in Asia. It almost reminds us of the Asian crisis 97.

The failure to establish a strong and robust Asian bond market is foremost among the reasons that led to the crisis of 1997. The crisis reflected the region's funding mismatch with an over-reliance on short-term funds.

The borrowing was predominantly done in the short-term and in US dollars while the lending was done on a long-term basis and in domestic currencies. Once the crisis arrived and the local currencies tumbled, the structure became untenable. Asia has come a long way from the dark days of the 1997-1998 crisis. While it is a work in progress, banking systems are being strengthened and foreign-currency debt reduced. Currency reserves have been amassed to protect foreign exchange rates and governments are working to reduce corruption. But more importantly, Asians have tried to develop a vibrant domestic bond market. There have been notable advances, though far from enough.

The Asian Bond Market Initiative is one such effort to encourage local financial intermediation and invest Asian savings directly at home rather than 'round tripping' the capital via western security markets with an estima-ted opportunity cost of two per cent. Members are the ASEAN Plus Three Countries (Japan, South Korea and China) with India being associated via the Asian Cooperation Dialogue.

In the Asian Bond Funds (ABF) I and II, the countries are investing part of their reserves in domestic bonds denominated in local curr-ency or the US dollar. The targeted size of ABF I is up to US$32bn which appears to be small compared to the huge currency reserves of Asian countries of more than US$1.7tn.

ABF II will invest US$2bn in domestic currency bonds issued by sovereign and quasi-sovereign issuers in the eight Asian markets: China, Hong Kong, Indonesia, South Korea, Malaysia, the Philippines, Singapore and Thailand. Half of that is being invested in country sub-funds, while the other half has been allocated to the ABF Pan Asia Bond Index Fund (PAIF), an open-ended, listed bond fund investing across the region.

The outstanding amount of Asian local currency-denominated bonds outside of Japan (ie, issued by emerging and developing Asian countries) has increased by 167 percent since 1996. This amount as a percentage of the GDP has almost doubled, from 24 per cent to 44 per cent during the same period.

These figures mean that an increasing amount of Asian surplus funds is now being used for Asian financing needs. Consider the following. Between 1998 and 2004, the Singapore government bonds and outstan-ding bills increased by 152 per cent. The yield curve was also extended from seven to 15 years. Or consider India's new initiative. The latest Capital Account Convertibility Committee has proposed increasing the upper bound for FII investments in bonds from US$2bn to around US$10bn.

Multilateral organisations such as World Bank and ADB are also doing their bit in helping to develop this essential market. In Thailand, ADB issued Thai bhat-denominated bonds in May 2005. It issued ringitt-denominated Islamic Bonds in Malaysia in May 2005. In October 2005, IFC and ADB issued renmibi-denomina-ted bonds, the so called ‘Panda Bonds’ in China. ADB also issued Peso-denominated bonds in the Philippines.

Absence of a long-term yield curve has also been another reason for lack of interest, both from the issuers as well as investors. Some of the largest private sector borrowers in these countries issue bonds outside of their home markets because there is lack of a long-term yield curve, a semi-state credit culture/ appetite for the volume of funding sought. For eg, Reliance Industries, a leading Indian cong-lomerate, has been issuing 50-year Samurai bonds since 1996, precisely for a lack of a long-term yield curve. However, things are changing in Asia. Increasing amount of Asian government debt is being issued for longer-term tenure ie, 15-30 years, in a bid to establish the longer end of the curve.

A good, healthy bond market should have a sophisticated offshore market. A recent study by Standard & Poors suggested that a key need (for development of Asian bond market) is to address the policies that have led to the development of two distinct markets: a local currency market and an offshore market that's denominated in US dollars and euros. This is also progressing at a decent pace.

Overall, it seems that the time for an integrated Asian bond market has come. A well developed Asian bond market is likely to reduce the cost of capital – so essential for Asia's development. The next phase of Asian investment opportunities will also include two key areas, namely corporate and local market debt investments. And both investors and issuers are likely to have enormous opportunities as they look to participate in Asia's glory.

The author is portfolio manager, Oxus investments, new delhi, india
Tel: +091 9899048845 Email: rchawdhry@gmail.com