Emerging market bond markets may be heading for serious disruption in coming months even if the US Federal Reserve raises interest rates slowly and gently, bankers warned yesterday.
Banks’ retreat from market-making means past experience will be no guide to how the market behaves this time, they said.
When the Fed begins to hike rates, expected next year, it may reveal what the Institute of International Finance this week called the “illusion of liquidity” in fixed income markets.
Even last year’s turmoil — the so-called taper tantrum — when then-Fed chairman Ben Bernanke first indicated quantitative easing would be tapered might not prove to have been a useful rehearsal for the coming volatility.
“Wall Street is nowhere near the warehouse of risk it used to be,” said Paul Tregidgo, vice-chairman of debt capital markets at Credit Suisse. “The impact of this on market liquidity is a major unknown.”
He said that precedent was “of limited value in helping us predict what will happen if US rates do rise today”.
Macroeconomic conditions, demographics, technology, global connectivity and the size of the EM bond market all represented an entirely new set of conditions in which the world would face a rate rise, Tregidgo said.
In its October Capital Markets Monitor, the IIF highlighted that the dwindling of secondary bond markets since the financial crisis “could make adjustment to the normalisation of monetary policy more difficult, if not disorderly”.
A near-zero interest rate environment had created an “illusion of liquidity”, it said.
The US bond market has grown from $33tr in 2008 to $38tr, but average daily trading volume has fallen from $1tr to $690bn. A widening of bid-ask spreads on EM bonds from 2bp-4bp in 2008 to 6bp-8bp today betrays the poorer liquidity.
As in 2013, therefore, what should be good news — the US economy improving — could shock markets.
“A gradual interest rate increase alongside increased economic activity should be a positive for markets over the long term,” said Tregidgo. “However, the constraint of liquidity coupled with the animal spirits of the market means the risk-averse investor is likely to sit on the side and watch in the early going.”
Debt market participants are thankful, therefore, that the rate hike, when it comes, is likely to be a stepwise process. In fact, this year — when most analysts called a rise in US Treasury yields — the 10 year yield has fallen from 3% to just over 2.3%.
Spencer Lake, global head of capital financing at HSBC, said pricey credit markets suggested spreads were near the bottom, indicating a hike would not be rapid.“If it happens too quickly, it would be more difficult to deal with, but the market’s expectation is that it will be gradual,” Lake told Emerging Markets.
Low growth and interest rates in Europe may also put the brakes on US rate rises.
Lake added that investors’ expected rotation out of fixed income into equities would not be too dramatic, unless the macroeconomic picture became far stronger than it was now.
“People will still put money to work across fixed income, and if the rate rises are done with a conscious and systematic effort you won’t see the major disruption you saw at the beginning of tapering,” said Lake. “These rate rises are somewhat forecast and portfolios are conditioned to think about them. We’ve seen their duration profile has changed.”
It remains to be seen if that is enough. For Stephen Williams, head of capital financing for Asia Pacific at HSBC, “any sell-off will be exacerbated” by the fact that banks can no longer play the buffer role between sellers and buyers.
“Banks don’t have the capacity to hold bonds because of the regulatory changes,” he said. “The amount of capital deployed to support secondary markets across the Street is probably around 25% of what it used to be.”
EM markets may understand what is coming better, having lived through the sell-off of summer 2013, but it will “not necessarily be easier”, believes Williams. “Liquidity and regulatory constraints have not improved,” he said.
BRICS
South Africa rejects brickbats thrown at Brics development bank
The five emerging economies that make up the Brics grouping have come out on the offensive against criticism of their proposed new development bank
By Thierry Ogier
South Africa’s finance minister has hit back at criticisms in Western financial circles of the five Brics countries’ attempt to create a New Development Bank.
Nhlanhla Nene said the NDB, often called Brics bank, was not a “stillborn” institution, as Emerging Markets called it on Thursday.
“We only concluded the establishment of the bank a few months ago. So it would be a bit unfair to say that nothing has happened, because it is actually happening now,” he said.
Emerging Markets had reported concerns among development finance experts that the NDB could struggle, either because its five sponsors would not be able to agree on the details of projects — for example, wanting to favour national contractors — or in the case that one country suffered severe financial difficulties.
Brazil, Russia, India and China are the other four large emerging market countries backing the NDB.
“Countries now have to ratify the capital of the bank,” said Nene. “We have agreed on the entire logistical arrangement, it just has to be ratified in the respective country capitals. The Brics bank was first proposed in 2013 in South Africa, and we have already sealed on the contingency reserve arrangement and on the creation of the NDB. We have made great progress.”
INNOVATIVE HELPLINE
The contingency reserve arrangement, or CRA, is one of the most innovative aspects of the Brics’ initiative. It is a $100bn pool of reserves countries may be able to draw on, and required an operational agreement between banks of member countries.
The CRA could be useful for states, like South Africa, with large current account deficits. South Africa’s jumped from 4.5% of GDP in the first quarter to 6.2% in the second.
South Africa is already a potential candidate for the CRA. “We have our options and it is important to have more than one option,” Nene said.
South Africa also enjoys some advantages among the emerging market group. “Even though South Africa is the smallest economy among the five Brics, the CRA gives us a better advantage because we can draw twice the amount of capital [that we have to contribute]. We put $5bn in the capital of the bank, and we can call on $10bn [as part of the CRA],” Nene said.
Officials from another Brics country acknowledged that the ratification process might be slow and that an interim board of directors would have to start discussing the initial strategy to be implemented in the next five years.
Nene sees specific advantages for his own region. “There is an estimated backlog of investment in infrastructure in Africa of some $9bn per year,” he said. “If we have an additional institution to complement existing investment, the Brics bank will have an important role to play.”
The NDB is opening a South Africa office.
ALTERNATIVE TO WASHINGTON
As activists were leafletting delegates outside the International Monetary Fund building yesterday and calling for the US to join the Brics’ initiative, some analysts praised the new emerging giants’ effort.
“Both the IMF and the World Bank are controlled by Washington. It is bad for the world, it is like dictatorship,” said Mark Weisbrot, co-director of the Center for Economic and Policy Research in Washington.
Europe’s banks wait for AQR: release from jail or fresh torments?
Standfirst: In a fortnight’s time the ECB will publish its asset quality review (AQR) of the eurozone banking sector. Analysts are nervously waiting to see if it will be a day on celebration or woe.
By Jon Hay
For over a year, the European Central Bank’s Asset Quality Review has loomed over the eurozone banking sector. Now the results are just two weeks away — but analysts still don’t know whether they will bring celebration or woe.
High hopes are riding on the Comprehensive Assessment, which also includes stress tests by the European Banking Authority. Optimists believe that once the ordeal is past, banks that have been straining every nerve to polish their balance sheets will feel a wave of relief — and start lending with new vigour.
“These stress tests are important for the credibility of the European banking system,” said George Osborne, UK finance minister, yesterday. The weakness of the European banking system had been one of the big drags on economic growth, Osborne said, contrasting it with “the strength of the UK banking system,” which he attributed in part to the UK’s own stress tests.
But while some believe banks largely know what to expect and have raised the capital they need, others insist the results on Sunday October 26 will hold surprises.
“The banking sector has met the challenge of solvency — we are now facing the challenge of profitability,” said a cheerful Frédéric Oudéa, CEO of Société Générale. He called the AQR and stress tests “a fantastic benchmarking exercise at a scale never done before” and said the eurozone’s introduction of a single bank regulator would help harmonise bank risk models.
But Nicolas Véron, senior fellow at thinktank Bruegel, warned: “It’s going to be more murky, complicated and confusing than many people expect.”
The headline numbers on which banks needed to raise capital would not be the whole story, he said. “The ECB is going to add a number of Pillar 2 provisions, using its discretion as a supervisor. And the definition of capital differs by country — they might need more for fully loaded Basel III compliance.” Banks might, he said, need to raise more capital than what the ECB initially requested.
UNCLOGGING LENDING
Sorting out the banks really matters. As Alberto Gallo, credit strategist at RBS, pointed out, Germany’s €6bn fiscal injection for childcare and the European Investment Bank’s extra €60bn of lending in 2013-15 pale beside the post-crisis shrinking of corporate loans — €600bn in peripheral Europe alone.
Analysts at Morgan Stanley predict that the AQR will be “a critical enabler of unclogging the lending channel”.
“Most banks are quite a long way above their [capital] targets,” said Bernard De Longevialle, managing director in financial services ratings at Standard & Poor’s.
But there are pessimistic views too. If the AQR censures many banks, it could sideline them from lending until they have raised capital, and even depress sentiment about the sector in general.
“The large banks are healthy, but a lot of mid-tier banks are still weak,” said Gallo. “Especially in Italy and Spain, the big two banks can’t take up all the slack.”
And banks might be fit to pass the stress tests, but still not be “fit for purpose”, Gallo warned. Deferred tax assets, for example, count as capital, but are questionable.
The other gloomy take on the AQR lies in between: it may not hamper banks, but will not unleash any new lending drive, either. “The simple answer is that the AQR is a necessary but not sufficient condition [for a recovery in lending],” said Andrew Milligan, global head of strategy at Standard Life. “In theory the TLTRO and Comprehensive Assessment might lead to a release of lending power, but there are a lot of hurdles to jump and there are questions about demand for loans.”
Eurozone lenders rush to Russia’s bond market as sanctions bite
Standfirst: Banks in the eurozone are piling into the Russian rouble bond market sources as much financing as possible locally to limit cross-border exposures in the face of western sanctions
By Elliot Wilson
European lenders are desperately seeking to tap Russia’s rouble bond market in order to ringfence their local operations financially as Western sanctions against Moscow begin to bite.
A slew of sizeable rouble-denominated bond issuances this year has highlighted the desire on the part of eurozone lenders to limit their exposure to the world’s eighth largest economy.
Rouble bond issuance by European banks in the first nine months of the year hit $3.8bn, according to data from Dealogic, including sizeable debt sales by the likes of UniCredit, Rabobank and Rosbank, the local unit of France’s Société Générale.
Gunter Deuber, head of CEE currency and bond research at Raiffeisen Bank, another leading recent foreign seller of rouble bonds, says the rush to market has only just begun. “The market, for now, is deep and willing, and for the next six to nine months foreign banks will sell as much debt as possible — it’s a general trend among foreigners and Western banks,” he said.
“We are all thinking along those lines, whether you are talking about us or SocGen or UniCredit; we are all keen to source as much financing as possible locally, to limit cross-border exposures.”
But the long-term prognosis for a country that once provided a solid chunk of eurozone lenders’ earnings remains worryingly clouded. In September, Raiffeisen’s chief executive Karl Sevelda warned the bank would post a €500m ($630m) loss this year, as a direct result of the Russia-led conflict in Ukraine. In May, SocGen booked a $730m loss on the value of its stake in Rosbank, at the height of the crisis.
CRISIS OF CONFIDENCE
Deuber warned that while the rouble market could support the needs of most local and foreign lenders for the time being, he was “cautious about whether the market could viably meet [the bank’s] long-term” funding needs. The biggest concern, he said, was a rising crisis of confidence about the Kremlin’s current mindset.
“You have the feeling that Russian policymakers aren’t taking the state of their economy into account at the moment,” he said. “They aren’t thinking rationally. For a long time, Russia was integrating relatively well into international financial structures.
“But then you see it [regressing] like this, in such a short period of time. Definitely, no one operating there expected such a swift deterioration in business conditions. It has damaged a lot of trust that Russia had built up among foreign corporates over recent years.”
Nor was the reversion to an expensive rouble bond market an ideal outcome for foreign lenders, he added. “Yield levels are far more expensive in Russia, and they will only continue to rise as the economic pain worsens. And this is another reason why the current situation needs to be resolved. In the short-term, the banking sector can manage but not for too much longer.”
At some point, experts say, foreign banks may have to make a calculated decision about their operations in a country battered by sanctions, slowing growth, capital flight, rising inflation and an increasingly hostile business environment.
“For now, there are still corners of profit in the Russian market,” said Neil Shearing, chief emerging market economist at Capital Economics. “But the question is how long they can remain profitable in the face of a stagnating economy, or whether they should beat a retreat. If Russian growth levels continue to stagnate, the second option remains far more likely.”