Asian Debt: Beware of Bubbles

Jakarta
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Jakarta

Gresik is a small industrial town of fewer than 100,000 people, just to the north of Indonesia's second-largest city, Surabaya in East Java. But its position is critical. It sits near the Lombok Strait, the second most important shipping gateway between the Indian Ocean and the South China Sea and the vital trade route for fuel and resources between China and Australia.

That is why AKR Corporindo has picked Gresik for what it hopes will become one of East Java's biggest seaports and the only one tied directly to an industrial estate. The Indonesian logistics group has a 2,500-hectare site and has invested Rp675 billion ($70 million) of a projected Rp7 trillion to Rp8 trillion in the first phase of the development of both facilities.

One of the most notable things about this investment is where AKR got the money: Asia's local currency bond markets. These markets have their roots in the Asian financial crisis of 1997-98 but they have bloomed since the global financial collapse of 2008 unleashed easy money.

However, the hot money flooding out of the west in search of higher returns in growing markets has stoked fears about the biggest credit boom in Asia since the spectacular implosion of the late 1990s.

(Read More: We're Ready for Exit of QE FLows: Indonesia Official)

AKR is just one of hundreds of Asian companies that have never borrowed money from public bond markets before. Bond markets typically give companies longer-term funding than banks and there is no need to put up assets as security. But until just a couple of years ago, many companies such as AKR would have had little or no chance of raising money in this way.

Since the start of 2012, a fifth of Asian local currency bonds have been issued in debut deals, according to Dealogic. In the U.S. and Europe, this proportion is typically less than 3 per cent.

Some debut borrowers have been able to raise large amounts of money. For example, Maxis, a Malaysian telecoms company, raised Ringgit2.45 billion ($810 million) in its first outing. Deals such as this have seen Asian markets almost double in size since the end of 2008 to $6.5 trillion worth of bonds outstanding. Companies now make up more than a third of that much bigger market compared with about a quarter at the end of 2008.

So many new – and often higher- risk – companies are borrowing funds at increasingly low rates that there are growing fears about a bubble in Asia and the role of foreign money spilling out of the U.S. and Europe. What happens when interest rates eventually start to rise, particularly in the U.S.? How much of that money will turn around and flee?

Thiam Hee Ng, a senior economist at the Asian Development Bank, says governments need to be wary of the recent surge in foreign capital inflows. They need to be "prepared for a possible reversal when the economies of the U.S. and Europe pick up again".

Each new round of ultra-loose monetary policy from western central banks, known as quantitative easing, has prompted growing flows of money into bond funds that invest in Asia but not Japan. More than $5.6 billion in retail money alone has flooded into such funds since February 2012, according to Citigroup estimates.

The money is coming for obvious reasons. The low interest rates and poor growth levels in the west make Asia a much more attractive place to invest. Consequently, foreigners own much more of Asia's debt. A third of Indonesian rupiah government bonds, for example, are owned by foreigners, up from less than a sixth at the end of 2008, the ADB estimates. Others reckon that share is as high as 50 per cent for Indonesia and about 40 per cent for Malaysia and the Philippines.

But if interest rates in the west do begin to rise again, how much of a risk will that pose to the stability of Asian economies?

One big fear is that while the money flowing in is significant for Asian markets, it is much less significant for the investors that have sent it here. In other words, a small decision on moving money back to the west could have a very big impact in Asia.

However, large investors in the region reckon that the money coming to Asia is part of a longer-term strategic allocation. Asset managers such as Pimco and BlackRock, which run hundreds of billions of dollars invested in debt around the world, have been increasing staff numbers and capabilities in centres such as Singapore.

Ramin Toloui, global co-head of emerging markets at Pimco, who moved to Singapore to build a deeper Asian business in 2011, says emerging markets have been transformed from the financial basket cases they were a decade ago. "They have gone from being the world's debtors to the world's creditors," he says.

Because of this shift, some of the world's biggest bond investors have begun looking at markets differently. Norway's sovereign wealth fund said last year that it would stop making global investment decisions using bond market indices that are based on how much debt exists in each country and start looking instead at each country's contribution to global gross domestic product. This means that instead of investing in bonds from the most indebted developed countries, it will invest in those from faster-growing emerging markets. Other large sovereign wealth and pension funds are expected to follow this move.

"There is a big strategic dimension to the money that is coming to Asia. It is not just a short-term reach for yield driven by central bank action in developed markets," Mr. Toloui says. "Global investors are still so under-allocated to emerging markets bonds that any small extra allocation across the industry means massive new inflows."

Low Guan Yi, who runs bond funds for Eastspring, the Asian asset management arm of the UK's Prudential, an insurer, says that QE has simply forced western institutions to act more quickly. However, she adds that local money is becoming more important in bond markets as societies become both older and the middle classes grow.

"People's ideas are changing because of the demographic changes," Ms. Low says. "Previously it was all equity but now people are much more interested in income products."

Other traders and investors are less sanguine. They estimate that half of the money coming from abroad could prove flighty when the west begins to recover. But they still point to the growth in pension funds, life insurers and bond-focused mutual funds locally in Asia as an important backstop.

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Still, the most important factor for financial stability is that Asian companies increasingly borrow in local currencies rather than U.S. dollars. The more mature market of South Korea aside, emerging Asian economies have five times the amount of bonds outstanding in local currencies as they do in U.S. dollars, according to Deutsche Bank.

During the Asian financial crisis, companies and governments held the vast majority of their debt in U.S. dollars. When western money pulled out of Asia, it put downward pressure on their local currencies, making U.S. dollar debt more expensive for the borrowers. This caused difficulties for companies and governments and concerns about bankruptcy. In a vicious circle, the flight of western money heaped further pressure on local currencies.

The collapse of the Thai baht from 25 to the dollar to 56 to the dollar at its worst set off a wave of currency collapses around the region.

If western money flees the local currency markets now, it will still depress those currencies. But critically, it will not increase the burden of debt upon local companies and governments in the way that it did in the late 1990s.

Thomas Meow, head of Credit Markets at CIMB in Kuala Lumpur, says: "If there is an outflow I think the impact could be felt in prices and yields, which have dropped by at least 1 percentage point over the past couple of years. But local demand will remain strong and borrowers won't be affected."

(Read More: Where Do the World's Happiest Consumers Live?)

It is equally crucial that overall corporate borrowing levels have been significantly higher in the past. The IMF describes them as moderate. Analysts at Forensic Asia point to a marked north-south divide in borrowing. Gillem Tulloch at the independent research house reckons the credit growth cycle for companies has years still to run in southeast Asia. By contrast, many companies in China and South Korea are overindebted already, he reckons, and suffering cash flow problems as a result.

But there is still a lot of credit being created in emerging Asian markets. The ratio of bank credit to GDP has hit levels higher than those reached just before the Asian financial crisis, according to Citigroup. However, Johanna Chua, an Asian economist at Citi, says this has been driven by Hong Kong, China and Vietnam, which is already going through a banking crisis. Indonesia, the Philippines, Thailand and Malaysia still have lower ratios than in 1997, she says.

There is growing concern that credit is being created much more rapidly in the consumer sector than in the corporate sector. A senior official at a regional sovereign wealth fund says: "Emerging market countries have to try and keep their currencies relatively weak to remain competitive in the global economy but this means importing the ultra-loose credit standards of the west. This is driving consumer credit growth in Malaysia, Thailand and the Philippines – that will be a big concern if this situation carries on too long."

The most reassuring factor for southeast Asia is that its economies are more self-sustaining and mutually supportive than 15 years ago. Thailand, Malaysia, the Philippines, Indonesia and Singapore have formed a crucial trade block among themselves. Indeed the IMF estimates that regional trade is more valuable to each country than trade with any other outside partner. Ports such as the one planned for Gresik will be far more important for regional trade than as a global staging post.

But as consumerism grows, southeast Asian countries will need to ensure that they do not follow the west's more reckless lead in the accumulation of debt.

Consumer Debt Threatens Stability

Car dealers in Thailand are having the time of their lives. They sold a record 1.4 million new models last year, have had their best first quarter and in March clocked up the highest monthly sales figures on record at almost 156,000.

The story is similar in Malaysia. It too reached new highs in 2012 with sales of 552,000, and had another excellent first quarter this year.

(Read More: Flood of Easy Money Putting This Region at Risk)

In Thailand, part of the reason for the buying frenzy was a tax break for first-time buyers – dealers are fretting that sales will drop now the program has ended. But perhaps more crucial was the huge growth in consumer credit that has taken place in both countries over recent years.

Some economists are concerned that growing consumer credit is threatening to become a source of financial instability – especially if regional growth continues to slow. Thailand already reported slower economic growth this week. In Malaysia, some worry that in the past year each ringgit of economic growth has been almost matched by an extra ringgit of consumer debt.

The big question, then, is how far can credit keep growing – and how healthy is its current level?

For Thailand the answer is positive. Consumer credit has grown from 16.5 per cent of gross domestic product in 2007 to 25.3 per cent now, leaving plenty of room for a further rise, according to Johanna Chua, an economist at Citigroup.

For Malaysia, however, where consumer debt has reached 76.6 per cent of GDP from 65.9 per cent in 2007, the answer is more tricky. It has the highest household debt ratio in the region and Ms. Chua believes this makes the Malaysian economy vulnerable, especially as lower-income households have a greater share of the overall debt.

However, Daniel Martin at Capital Economics says that among all the emerging market economies, it is Asia that still has most room for fresh consumer lending to keep growth going.