The Future of Asian Government Bonds

Where to after the pandemic?

While the coronavirus pandemic is likely far from over, countries are learning to adapt to its presence. With this in mind, it may be time to look beyond pandemic crisis management mode into Asia's recovery beyond.

If the leads from the UK and US are any guide, a rebound in economic activity will eventually be supported by the easing of movement restrictions, associated resumption of travel and a rebound in tourism and entertainment. Although the World Bank forecasts a deceleration in global growth from 5.5 per cent in 2021 to 4.1 per cent in 2022,¹ the second year of the pandemic had a far more favourable base of comparison after a sizeable contraction in 2020.

A continuation of growth would be good news for the expected returns on Asian assets. Stable economic prospects strengthen government balance sheets, improving the quality of bond assets, while monetary policy normalisation improves the yield for investors looking to make a new allocation. Markets like South Korea and Singapore have all tightened their monetary belts in moves that often surprised investors. Yet, others, like Malaysia, the Philippines, and Thailand, have opted to put any increases on hold for the time being. China, on the other hand, is loosening monetary policy as it seeks to rebalance growth to fulfil its "common prosperity" policy.

Asian currencies, mostly weak during 2021 with the exception of the renminbi and New Taiwan dollar, have the potential to rebound later in 2022, says State Street Global Advisors, which manages the ABF Pan Asia Bond Index Fund (PAIF).

“Higher foreign reserves, improved current account balances, and undervalued currencies have better equipped Asian economies to withstand exogenous shocks. Structural trade surpluses and growth differentials between Asian economies and developed markets should be supportive of Asian currencies over the medium to long term”, says Kheng Siang Ng, Asia Pacific head of fixed income and head of Singapore at State Street Global Advisors.

Near-term uncertainties mount

Of course, there are many uncertainties. The pandemic has precipitated the creation of unprecedented levels of debt around the world, and Asia has been no exception. Fitch Ratings notes that several Asian nations are on its watchlist for possible debt rating downgrades given government bond issuance trajectories that might strain their balance sheets.

Satoru Yamadera, advisor for the Asian Development Bank’s Economic Research and Regional Cooperation Department, points out that the fiscal response across Asia has been far healthier than in previous crises.

“During the Covid-19 period the government bond market really functioned to support various policy measures,” he says. “This is quite important because local currency finance and issuance is much quicker than foreign currency funding, and because of that they can provide a lot of government policy measures against Covid quickly.” Yamadera also notes that debt-to-GDP levels are still modest by European benchmark standards.

Inflation is another source of risk. High levels of inflation are already expected to lead to rate rises in the US — which could attract capital causing the US dollar to further strengthen against other currencies, including Asian currencies, or worse, causing capital flight that is disruptive to the local economies. Meanwhile higher energy and commodity prices present further upside inflationary risks to Asian economies, especially to the net consumers — any significant upside surprise to the ADB's inflation forecast of 2.7 per cent for the region in 2022 could force Asian economies to raise rates before they have fully recovered from the effects of the pandemic.

"Endogenous pressure of inflation is relatively low compared to the US, but imported inflation pressure could be higher,” especially for nations that rely on external sources of food or fuel, says Yamadera.

So far, though, inflation in Asia has been relatively subdued, allowing for a measured response. Central banks that have raised rates, such as those of Singapore and South Korea, have done so against a relatively robust economic backdrop.

Solid foundations

With their prudent response to the pandemic, Asian nations have laid solid foundations for the future of Asian fixed income in the region. Indicating the market's approval of the shift to reliance on local currency debt, for instance, Yamadera observes that "even during the pandemic period you don't see interest rate rises in Asean markets — they could finance these debts without causing big market turbulence".

The measured growth of local currency debt markets in Asia presents an attractive opportunity for investors seeking diversification into higher-yielding fixed income. Through funds such as the PAIF, which tracks the Markit iBoxx ABF Pan-Asia Index, investors get a spread of exposure across eight markets in Asia, all of which are in different stages of the cycle.

Going Green

Asia's governments are tabling more debt issuance in categories where investor interest is growing, too, notably green bonds. In fact, the region's supply of green bonds is exceeded by demand, sometimes resulting in a premium on such exposures. Indonesia is an active issuer of sovereign green bonds, targeting state-owned green infrastructure projects such as renewable energy, low carbon transportation and sustainable waste management.
To meet its 2030 emissions target, the government also woos private investment through incentives including tax allowances and renewable tariff regulation.

Over in the Philippines, a market leader with ASEAN's first Climate Bonds Certified green bond launch in early 2016, the private sector has led green bond efforts. In November 2021, the government announced its intention to issue sovereign green bonds for the first time. Meanwhile, China's 13th Five-Year Plan also has a heavy focus on green financing.

Given the growing interest in green bonds, Markit iBoxx ABF Pan-Asia Index has changed its methodology to allow their inclusion at a lower issuance size cutoff than for grey bonds. While the near-term impact may be limited, it is likely to encourage further investment in the category, offering more high quality exposure to a region full of potential.

Ng emphasises, “Asia’s rapid growth in the ESG bond space is in line with global trends that have been developing for some time. With the region's diversification and yield advantages, international investors can target both investment and sustainability related goals.”