Local currencies — more important than ever

After a strong start to the year, global emerging market local currency debt issuance has taken a beating amid the volatility sparked by fears of a reduction in US quantitative easing. Local currency markets are more important than ever — but for stability to be achieved, the institutional investor base must broaden. Philip Moore reports.

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Is the emerging market currency party over? It may certainly feel that way if you’re an Indian or Brazilian entrepreneur with unhedged US dollar debt, which is much more expensive now than it was before May 22. That was when US Federal Reserve chairman Ben Bernanke appeared to call time on the era of very accommodating monetary policy that had unleashed unprecedented flows of cross-border liquidity.

So far he is still to follow up with concrete action, having decided against a reduction in the country’s asset purchase programme at the most recent Federal Open Market Committee meetings in mid-September. His next opportunity will be in December, but whatever the timing, markets know that it is on the way.

After a buoyant period in the primary market between January and mid-May, the Bernanke announcement prompted a sharp deceleration in the issuance of globally distributed bonds in emerging market currencies. By the middle of August, according to data published by CMDPortal, international bond issuance denominated in the top 10 emerging market currencies reached just under $57bn. 

That is a marked increase on the $35bn in the same period of the previous year, but the headline numbers mask the slide in issuance following the Bernanke comments. In the three months after May 22, issuance amounted to $11.34bn, compared with $13.4bn in the same period in 2012, which represents a 15% year-on-year decline.

It was not just the Bernanke bombshell that cast a cloud over emerging market debt. Throw one or two local difficulties into the mix — including worries over the shadow banking sector in China and unrest in countries such as Turkey and Brazil — and the immediate outlook for global local currency issuance certainly looks less rose-tinted today than it did at the start of the year.

The obvious question raised by this slowdown is whether it will curtail the rise in issuance of local currency debt sold simultaneously to domestic as well as overseas investors, which has been a striking feature of the international capital market in recent years. According to Chris Jones, managing director and head of local currency syndicate at HSBC in London, over the last five to six years the share of non-G4 currencies has risen from 7% to about 23% of total global fixed income issuance.

“Today we may be at a crossroads post the QE tapering announcement,” says Jones. “Are we going to see a continued rise in the issuance of global local currency debt, or are we now going to see the increase in non-G4 volumes go into reverse?” 

Some argue that investors’ recent jitters about the impact of tapering on emerging markets simply underscores even more forcefully the importance of developing local currency bond markets. 

“The recent volatility in a number of emerging markets should reinforce our commitment to our capital market development agenda,” says Monish Mahurkar, director of treasury client solutions at the International Finance Corporation (IFC), which has issued recently in markets ranging from Zambia to the Dominican Republic. “The recent crisis has been a reminder that borrowers without US dollar revenues should not be encouraged to take on US dollar debt,” he says.

Mix and mismatch

This particular lesson was learned the hard way across a number of central and eastern European markets a number of years ago. “Because there was a general expectation that a number of CEE countries would join the single European currency, with many of those countries’ debt redenominated in euros, currency mismatches were not given sufficient attention,” says Isabelle Laurent, deputy treasurer at the European Bank for Reconstruction and Development (EBRD). 

“During the crisis, there was a realisation that having an income in local currencies and outflows in hard currencies can be very problematic,” she says. “It meant that a number of countries in the Baltics and central Europe had limited room for manoeuvre in terms of preventing overheating. If central banks raised interest rates in response to inflationary concerns it simply created a greater differential between local and hard currency rates. That in turn encouraged borrowers to issue more hard currency debt, aggravating the problem of currency mismatches.”

This, says Laurent, has made it doubly important for emerging countries in central and eastern Europe to continue to build their local currency markets, as well as to encourage the evolution of more durable domestic institutional investor bases capable of protecting local markets from intense volatility when external sentiment turns sour.

This historical precedent supports the opinion of those who are persuaded by the long term case for global local currency debt. “My own view,” says Jones at HSBC, “is that this is a short term retracement in a much longer term growth story. We believe these markets will continue to develop, given that emerging markets now account for more than 50% of global GDP.” Rising issuance in local currencies, he says, has been a natural by-product of this rising share of the global economy, although this can only explain part of the breathless expansion in non-core currency issuance, or of investor demand for the asset class.

“Capital flows into emerging markets show an upward trend both in US dollar terms and as a percentage of EM GDP in the past three decades,” notes a recent HSBC report. “Given the growing share of EM in world GDP, this would suggest a growing share of DM [developed market] GDP is now invested in EM.”

However, the same HSBC analysis adds that since 2008, these capital flows have been driven largely by so-called “push” factors, such as ultra-low rates in the US, rather than “pull” factors, which would include improving credit quality. “We believe it has been the ‘ugliness’ of DM over the ‘prettiness’ of EM that has been the major driver of inflows post-crisis.”

That may be. But there appear to be a number of reasons for believing that from the standpoint of investor demand, there is still plenty of gas in the local currency issuance tank.

One of these is that investor demand for geographical diversification remains a conspicuous long-term trend. This has been most evident in the shifting allocation of central bank holdings in recent years, which have progressively challenged the status of the US dollar as the world’s number one reserve currency. That is a status the US currency still holds, and will continue to hold for a number of years to come. But it is diluting demand for dollars and increasing holdings of currencies such as Australian and Canadian dollars. 

There has also been a discernible rise in central bank demand for a handful of emerging market currencies – most notably for Chinese renminbi. Symptomatic of this trend was the announcement in April by the Reserve Bank of Australia (RBA) of its plans to invest up to 5% of its total foreign currency assets in Chinese sovereign bonds. 

A similar pattern is unfolding throughout the world. “We were making a presentation a couple of months ago to an African central bank which told us it would be making a significant allocation of RMB to its reserve base,” says Jones at HSBC.


It is not just central banks that have been signalling an increasing commitment to diversification in recent years. Other institutional investors across a range of developed and emerging markets have also been expanding their horizons – driven by a combination of regulatory change, rising assets and a change in investment strategies. 

Assets under management at Latin American pension funds, for example, are growing at a breathless rate, with those in Chile, Colombia and Peru combined having seen their assets grow from a little over $100bn in 2008 to more than $270bn at the end of 2011. Assets at Mexico’s pension funds (Afores) have doubled over the last four years and are projected to more than double again by 2019. That will increase pressure on the local regulator to increase the limit of their assets they can invest overseas, which is now set at 20%. 

In Asia, meanwhile, one reason why the Malaysian fixed income market has shown such explosive growth in recent years, for example, has been the surge in assets under management among heavyweight institutional investors. According to the Malaysian credit ratings agency (MARC), the local Employees Provident Fund (EPF) and KWAP fund combined recorded a compound annual growth rate (CAGR) in the total investable size of their funds of 7.4% from 2007 to 2011. Over the same period, takaful and conventional insurance funds posted CAGRs of 20.3% and 9.4% respectively.

The result is that local institutions are outgrowing even the Malaysian debt and equity markets. The EPF, for example, increased its exposure to global real estate, bonds and equities by $1.3bn in the first quarter of 2013, which it said was part of its longer term diversification strategy. Announcing its first quarter results, EPF’s CEO explained that “the fund’s investment assets now exceed half a trillion ringgit and continue to grow at an average of 8%-9% yearly. The constraints in the domestic market makes it imperative for us to find suitable investments globally that fit our long term diversification programme. This will enable the fund to build a more balanced portfolio in accordance with our risk appetite.”

EPF still has plenty of room to add to its international exposure. At the end of the first quarter of 2013, overseas assets accounted for 17.55% of its assets under management (AUM), well below its permitted maximum of 23%.

More broadly, there has also been a notable increase in demand for fixed income exposure among institutional investors across the emerging market universe. Again, Asia provides the clearest example. In its most recent analysis of trends in fixed income trading in Asia, published in January, Greenwich Associates reports that in the year ending July 2012, trading volumes in Asian fixed income increased by 13%. Over the same period, fixed income assets under management among institutions in Asia (excluding Japan) grew by 33%. 

“While the surge in institutional assets under management obviously reflects market-driven valuation increases within institutional fixed income portfolios, it also provides a clear demonstration of the market’s long term momentum,” says Greenwich, which gives three specific reasons underpinning this trend. These are a 55% increase in G7 government bond trading, the continued growth in trading volumes generated by Asian banks, and — perhaps most significantly — a 29% increase in turnover in the domestic currency Asian bond market. As Greenwich observes, “local currency bonds are emerging as a viable source of funding for issuers and as a critical component of the Asian fixed income market.”

A rising preference for fixed income has not been confined to Asian institutional investors, with retail investors also acquiring a taste for bonds. Even among famously speculative Chinese retail investors, for example, there is evidence of a growing demand for fixed income over their beloved equities. According to a recent Boston Consulting Group (BCG) analysis, bonds accounted for 7% of HNWIs’ assets at the end of 2012, compared with just 3% in 2011. Over the same period, the share of equities dipped from 30% to 21%, while holdings of cash and deposits fell from 18% to 16%.

There are a number of sound, fundamental reasons warranting this longer term migration into a wider range of currencies and into a more diversified cluster of asset classes — chiefly but not exclusively fixed income. As Schroders argues in a recent white paper on Asian bonds, their intrinsic strengths include a demonstrably superior currency-hedged risk-return profile versus developed market bonds, allied with relatively low correlations to other risk assets. “We are… not concerned about the high levels of foreign ownership of Asian local currency bonds as past experience has shown that Asian bond markets have been able to absorb sharp foreign selling pressures and FX weakness,” adds Schroders.

Asian currencies have similarly compelling properties. As currency specialist Merk notes in a recent white paper on Asian currencies, “Within the emerging market currencies, Asian currencies have demonstrated favourable risk-return profiles for US-based investors with what we believe are comparably attractive risk-adjusted returns, low volatility, and low correlation with US equities. 

“Despite recent risk aversion, we believe Asian currencies may weather increased volatility triggered by speculation surrounding Fed policy better than other EM currencies. Furthermore, over the longer term, we believe Asian currencies may outperform other emerging market currencies as a result of Asian countries’ transition to a higher value added and more consumption-oriented growth model.”

 Promoting local currency bond markets
The wheels of supply of local currency debt have been greased by a growing number of governments in recent years, albeit with varying degrees of fervour. 

“Asia’s local currency bond markets fall into two broad categories,” says Alexi Chan, managing director of debt capital markets for Asia Pacific at HSBC. “The first are those that can easily be tapped using EMTN programmes without additional documentation or approvals, and are therefore readily accessible to global borrowers, such as the Hong Kong and Singapore dollar markets.”

“The other local markets tend to have their own specificities around approvals, governing laws and regulations,” Chan adds. “International issuers require an extra degree of navigation to access these markets successfully.”

On balance, Chan says that governments in Asia have been highly supportive of local currency bond markets for a number of very compelling reasons. “I think there is a huge commitment to the development of bond markets in Asia, which is very positive,” says Chan. “One of the lessons that was learned from the Asia crisis back in 1997 was the importance of encouraging the development of a well-functioning local currency bond market, which led to a number of initiatives on a regional basis as well as by individual governments and regulators.”

An early milestone in the evolution of local currency bond markets in Asia came in November 2002, with the establishment of the Asian Bond Market Initiative (ABMI) by the Association of South East Asian Nations (ASEAN), together with China, Japan and Korea, collectively known as ASEAN+3. Under this initiative, the Asian Development Bank (ADB) launched its $10bn Asia Currency Note Programme in 2006, allowing it to issue local currency bonds in Singapore, Hong Kong, Malaysia and Thailand using the same documentation governed by British law. 

A more recent initiative was the establishment in 2010 of the Credit Guarantee and Investment Facility, which provides guarantees for local currency corporate bonds issued in the region. 2010 also saw the launch of the ASEAN+3 Bond Market Forum (ABMF), which brings together depository and exchange institutions, market associations and local and overseas market participants from the public and private sector in order to “foster standardisation of market practices and regulations in the local currency bond markets.”

Another key landmark in the development of Asia’s bond markets, says HSBC’s Chan, has been the emergence of the offshore RMB — dim sum — bond market. “We expect the offshore RMB market to go from strength to strength, as the RMB continues its path of internationalisation,” he says.