Asean+3 bond market handbook 3: investment

EMERGING MARKETS Asean +3 bond markets handbook

Chapter 3: Investment

Cross-border investment within the region faces a number of challenges, ranging from varying regulation to a lack of standardisation of credit rating standards, weakness in swap markets and uneven supply.

There is a particular lack of supply in corporate debt. Although the Asian Development Bank says local currency corporate bonds outstanding totalled $1.6 trillion as of the end of 2010, having grown 20.3% in the previous year, it tends to be the case that six to eight issuers completely dominate the market, issuing in large size, while a further 30 to 50 issuers offer much smaller amounts. “In some Asean countries, there is a common problem in that one entity that issues bonds is close to half, or even higher, of the market,” says Khun Thirachai at the Thai SEC. “That would mean that mutual funds that invest in paper of those companies come up against a single company limit quite quickly.”

A related problem is liquidity. This is one of the main things ADB initiatives work towards. “The government market typically has moderately good liquidity, but in the corporate market it is still very constrained,” says Sabyasachi Mitra at the ADB. “It is very important: if there is no liquidity it hampers the ability of any market participant to price assets. And if you don’t have a liquid and efficient yield curve, it is very hard to conduct monetary policy.”

The ADB interviews around 100 heads of trading desks, fund managers and others in the industry each year to look at what is happening in liquidity development. The feedback is always the same: lack of diversity of investors. “That is the one of the big challenge we face in the market,” Mitra says.

Shu-Pui Li at the HKMA is part of the Asian Bond Market Initiatives team working on greater integration of regional markets, with a focus on post-trade systems; he senses progress but “the pace is relatively slow,” he says. “We face a lot of challenges. The bond markets in the region have different standards, processes and practices. The tax regime also varies in different economies: some with withholding tax and some without. Harmonization and standardization of processes among different economies is not easy to achieve, but it is crucial to the further development of the bond market in the Asia Pacific region.”

Lee at CIMB agrees. “Right now, regional cross-border investing in domestic currency debt markets is very much greenfield: one has to address what rating agency to use, whether existing investment and credit policies allow the usage of cross-border domestic rating agencies, FX restrictions, withholding tax, avenues for hedging local interest rates, transactable credit spreads for the cash bond and derivative markets, ability to repatriate FX from coupons and capital gains, and so forth.”

There is, too, some concern about what can be lost with integration, and if it is entirely necessary. “Integration must be carefully designed,” says Nurhaida, chairwoman of Indonesia’s Bapepam regulator. She says she can, right now, through her Reuters dealing system or Bloomberg Chat, contact an intermediary in another Asean market to ask for a firm price on their local currency bonds, execute the trade, and have settlement handled by the respective depository agents. “So let me ask you, is the market integrated or completely fragmented?”

She has her doubts about some of the initiatives being put forward at the Asean level “to try to ‘improve’ on this eco-system”. She argues that a linkage among central depositaries would kill domestic custodian institutions, and that when considering trading linkages it should be remembered that bonds are naturally over the counter. She does, though, think that standardized offer documents, like an ASEAN bond prospectus, would help on disclosure, “but investors are still exposed to a complex legal risk in the event of default.”

Still, despite her cynicism, she sees the necessity for progress. “The desirability of greater integration is a given as we position ourselves in the global flow of liquidity,” she says. “Currently country risk, currency controls and current account convertibility may be a barrier, but moving ahead I foresee these barriers will be reduced gradually to accommodate greater intra-regional investment flows.”

Tetangco, too, stresses that greater integration is not a one-way-street with only positive outcomes. “Financial integration has its own problems, such as increasing the likelihood of contagion,” Tetangco says. “But, having said that, all these efforts are worthwhile, because they show regional cooperation is being pursued in Asean. During a crisis, they are most beneficial to all participants: that’s why you have regional cooperative efforts like the Chiang Mai initiative.”

There is a great deal of talk of linkages and recognition. Dato Zarinah at Malaysia’s Securities Commission, for example, says she is “proactively working with our regional counterparts to deepen regional bond markets by enhancing market linkages, market access and market liquidity.” This includes proposals to promote a mutual recognition framework for documents on cross-border transactions.

But underneath these good intentions is a sense that it is somewhat untrodden territory. “Developing a local currency bond market is very difficult, in my personal experience,” says Thirachai. “You are trying to piece together a jigsaw without a clear idea of what the final picture should look like.”

The withholding tax debate

There are practical things that need to be addressed, starting with frictional issues like withholding tax and stamp tax. “These are areas where, sometimes understandably, there is a desire for revenue on the part of the authorities,” says Sykes at HSBC. “But if they are set to levels where they discourage the development of domestic capital markets, then frankly there’s likely to be a negative economic impact overall.” That is an obvious barrier to integration, since regulatory regimes differ on this point.

“If you look back to the development of the Eurobond market, and why it grew and developed so quickly in the latter part of the 20^th century, one reason was the lack of regulation, from a fiscal perspective,” Sykes continues. “One of the ways you can foster these things and make them grow is to remove some of those fiscal restraints.”

In theory, agreement with Sykes is almost unanimous on this, but it’s not quite so easy in practice. For example, one country that still has withholding tax for foreigners holding bonds is the Philippines. BSP Governor Tetangco recognizes this is an impediment to investment flows. “One can say that you can price that into the bond, but an investor would compare the yields across different countries, and it complicates the whole picture. It makes it more difficult.” Removing the tax, though, is a tricky political position in a country without a lot of money. “The national government is aware of this, and it is something that they are considering, but at the same time they would also want to see an improvement in the fiscal position first. There are competing objectives.”

Still, says Clifford Lee at DBS, “withholding tax is likely to be the first thing to go.” It certainly seems to work. Zarinah at Malaysia’s Securities Commission says Malaysia is “one of the few bond markets that has taken early steps to attract foreign participation from foreign investors,” removing withholding tax on foreign investors and building an easier approval framework while peeling back FX restrictions (FX is covered in more detail in Chapter 4). Correspondingly at the end of December 2010, foreign investments in local currency bonds came to RM121 billion – up from just RM4 billion when the market was first liberalized in early 2004. “As a result, we are increasingly recognized as an important hub for cross-border investments and issuances in the region,” she says.

Singapore’s MAS points to improved price transparency as a key need. “This will allow investors to be better informed in their investment decisions and encourage bond issuances and trading activities,” a spokesperson says. “This may be done through establishing a common listing and trading infrastructure for local bonds in the region. With a common price discovery and execution platform, it can facilitate increased liquidity in the market and a transparent and orderly manner.” It would help issuers, too, the MAS says.

And for CIMB’s Lee, the biggest issue is not the small stuff – tax, settlement – but the big picture. “They are not big ticket items. The big one is the platform, to enable domestic funds in each Asean +3 country to be able to invest cross-border. Then let the private sector decide.” Creating this platform is at heart a regulatory issue. “To enable that, you need to be able to have the local regulator provide the latitude to domestic funds, from banks to pension funds and unit trusts.”

The rating agency challenge

Perhaps the thorniest issue around cross-border investment is the role of rating agencies in the region – and differences between them. The biggest Asean+3 nations all have their own home-grown rating agencies now – Tris in Thailand, Rating Agency Malaysia (RAM) and Malaysian Rating Corporation (MARC) in Malaysia, Pefindo in Indonesia, PhilRatings in the Philippines, and so on – but there is generally no recognition of one another’s ratings in cross-border transactions.

There is an institution, the Association of Credit Rating Agencies in Asia (ACRAA), which brings together local credit rating agencies; launched in September 2001 by 15 agencies within the ADB’s headquarters, it now includes 28 members in 15 countries. Its mandate is to develop and maintain cooperative efforts to promote interaction and exchange of ideas, as well as promoting best practices and common standards; it publishes a code of ethics it wants its members to uphold and, in that regard, does help credit rating agencies move to a common set of standards. But that is not, yet, the same as mutual recognition.

“Asean countries have local rating agencies but it is not easy to compare,” says Governor Tetangco at BSP. “There is no conversion table to see ratings between domestic and foreign rating agencies. Methodologies may differ, rating definitions may differ, benchmarks and the overall rating process may differ from one credit rating agency to another.”

“The purpose of these rating agencies is to provide guidance to domestic investors,” adds Tetangco. “But if you are going to expand the market in the region then there’s got to be guidance for investors to look at in terms of the credit standing of different issuers in the region.”

Consequently, one idea that gets talked about is a single credit rating agency covering all regional markets, but it tends to garner a mixed reception from industry. Nurhaida at Bapepam says talk of a regional rating initiative is “something which I find amusing”, and takes a different view on the way forward. “We believe that what should be promoted is more market driven M&A between foreign and local rating agencies instead of mutually recognizing them.” Further north in Thailand, Khun Thirachai is also doubtful about a regional house. “I’m not sure how practical that is. Instead what we are trying to do, among securities regulators in the Asean region, is to try to get each country to accept the ratings done by the agencies approved by other countries in the region. That takes some negotiation. But it is on the list of things to do.”

Lee, who firmly believes mutual recognition between rating agencies should take place, accepts that “this requires some trust between regulators in the region.” But it would reduce reliance on international rating agencies. Besides, local agencies and local ratings have a lot to recommend for them, he says. “If you go back through 15 years of credit rating time series, despite very low ratings of sovereigns internationally, the default and the credit rating transition matrix of regional domestic ratings look quite good relative to the AAA and AA ratings of international credit rating agencies, as the AAA and AA structured finance/CDOs/SIV ratings turned out to be not what they seemed.”

To Lee, the main problem is the methodology employed by the international rating agencies to rate Asean+3 sovereigns which set the credit rating cap for their corporates and banks. “A lot of countries in Asean + 3, the sovereign rating is quite low despite their credit fundamentals: borderline investment grade,” he says. “Because of the sovereign ceiling cap, most private sector banks and corporates are rated borderline junk and that kills the  premise of Asean+3 investing in the region, as reliance on international ratings is quite institutionalized.”

The methodology employed by international rating agencies, Lee says, “needs to be urgently addressed as it does not seem to bear much semblance to the probability of default of Asean+3 nations. The methodology of how sovereigns are rated today is quite subjective. The right to assembly, democracy, media freedom… these have nothing to do with the probability of default of the sovereign which is presumably what the rating is trying to reflect. Ratings should focus on probability of default and/or expected loss and take out the subjective factors.” He raises the example of Thailand, which has US$150 billion of foreign exchange reserves and minimal foreign currency debt, a savings rate of more than 30% of GDP annually, more demand for government bonds than can be met, and healthy trade and current accounts. “How likely then is that country going to default on such a small foreign currency obligation when it has amassed so much more reserves? Yet when you compare the relative ratings with others in the west, it borders on the preposterous.”

If integration is to happen among agencies, then regulators and private sector alike agree there is a need for the highest possible standards. “On local rating agencies, the actual market impediment is transparency of ratings methodology,” argues a spokesperson for the Monetary Authority of Singapore. “Any effort to create regional credit rating agencies or standards must not take an insular approach. Instead, we should emphasize an empirical, objective and transparent ratings methodology and this work should be undertaken in consultation with IOSCO and securities regulators.” Elsewhere, Hong Kong’s Securities and Futures Commission has proposed a regulatory framework for oversight of credit rating agencies, following on from suggested codes of conduct issued by IOSCO in 2008 and the G20 in 2009.

But Clifford Lee at DBS takes a step back. “Realistically, if you think about it, when markets open up they are not going to open to the weaker credits first,” he says. “You’re not going to have a mid-tier company in Singapore getting a good reception in Thailand immediately, and vice versa. It’s going to open to stronger rated names who are rated by S&P and Moody’s and are more universally accepted across the region.”

And what of the agencies themselves? Indonesia’s Pefindo was among the founders of ACRAA and is a regular participant in its efforts. But asked about synchronicity, Ronald Andi Kasim, President Director, notes: “We are not there yet. It will be a very challenging and will involve sensitive issues for most of us.” He adds: “We could do a synchronised methodology; we could agree on minimum criteria that all rating agencies should look upon when they analyse banks, or pulp or paper companies. We could at least agree on a methodology and model and so on. But the rating itself will be a very tough exercise.” Pefindo is domestically powerful and closely followed – by the end of March, Rp11 trillion of debt issuance had come to it for ratings so far in 2011 – but Kasim notes that Fitch, as the most locally entrenched international competitor, does have some reputational advantages. “Fitch has been able to position itself as adopting international standards. It has started to affect Pefindo negatively by not having direct ownership by an international rating agency. It’s very hard now to sell the idea of being a local credit rating agency.”

Box: The investor’s view

The Employee Provident Fund is Malaysia’s most powerful institutional investor. What would greater regional integration mean for it?

“Obviously, reductions in barriers to investment, greater flexibility in the flows of funds, and liberalization in state-owned companies will help create a more conducive investment environment among Asean + 3 members,” says Wan Kamaruzaman bin Wan Ahmad, general manager of the treasury department at the EPF. Greater volumes and depth could then make funding cheaper for domestic issuers. “With many new investors, such as the EPF, diversifying their asset classes and seeking exposure into the regional bond markets, demand for local currency bonds would enhance liquidity, add depth and lower funding costs to the mutual benefit of all parties.”

As a key institution, the EPF was at the most recent Asean+3 Bond Market Forum meeting, in February in Kuala Lumpur, when the idea of a regional credit rating agency was raised. “We welcome this initiative as the development of regional bond markets would benefit the EPF,” Wan says. “However, realistically, there are many constraints to this option, such as ensuring the credit rating agency independence and objectivity, uncertainty over the revenue model, and it would require a long period to build confidence among investors and markets.” Wan, instead, calls for gradual mutual recognition of existing credit rating agencies in the region in order to extent their current domestic roles. “The recent global crisis has highlighted the shortcomings of being over-dependent on the global rating agencies whose coverage of the region is limited, involves double standards, and lacks local knowledge.”

Wan notes that recent global financial turmoil has led to increased capital controls, to the detriment of integration. “Thailand, South Korea, Taiwan and Indonesia have imposed forms of capital controls, which affect genuine investors like us and impede greater integration between Asean+3 bond markets,” Wan says. “The issue of liquidity in the local currency bond markets remains a concern, together with benchmark restrictions and political risk associated with those markets.”