The size of Asia’s local-currency bond market expanded nearly 9 percent in the first half of the year, but the Asian Development Bank (ADB) warns that increased capital flows from the West as central banks embark on easing measures, could lead to a surge in volatility and create asset bubbles.
“Near-zero policy rates in mature markets and continuing hints from the U.S. Federal Reserve over the possibility of more stimulus should conditions warrant have sparked fears in emerging markets of a surge in capital inflows,” the Manila-based ADB said in its latest report on the bond market released Monday.
“These inflows can cause large exchange rate fluctuations, affect trade, and ratchet credit growth – leading to asset price bubbles,” the bank said, adding that policymakers in the region should brace for the possibility that the money could pull out of the region as quickly as it entered.
If that was to happen, bond yields would spike, as they did during the 2008/09 financial crisis, the ADB warned. During the crisis, for example, government bond yields in Indonesia rose as much as 9 percentage points, while in South Korea, Malaysia, and Thailand, the increase was 2 percentage points, the report said.
It added that there are already signs of weakness in the market, with bond yields in China, Indonesia, and Vietnam edging up in July and August.
The warning from ADB comes at the time when investors are expecting central banks globally to implement fresh measures to stimulate their economies. Last week, U.S. jobs growth data came in weaker than expected, which could prompt the Federal Reserve, which meets Wednesday and Thursday, to embark on an easing program. The European Central Bank also announced last week a bond-purchase program aimed at lowering borrowing rates for cash-strapped countries and experts say they could follow up soon with a full stimulus package aimed at boosting growth in the Euro zone.
Weakness in developed economies and the lure of higher returns has seen investors put money into Asian bonds this year. In the first half of the year there were $5.9 trillion in outstanding corporate and sovereign paper, a rise of 8.6 percent year-on-year, the ADB said.
It added that local governments in Asia have to boost demand from domestic investors so that they can reduce its dependency on foreign inflows.
"As far as challenges in the bond market are concerned, they need to take steps to improve liquidity through developing a stronger domestic investor base to make local markets more resilient," the bank said.
—By CNBC’s Jean Chua.