The excessive risk-taking of international investors, in their desperate hunt for yield, has undoubtedly fueled an Asian bond bubble. US dollar-denominated bond sales in Asia reached an all time high in Q3, as local issuers took advantage of the historically low USD interest rates to lock in favorable financing terms. This situation has created a potential systemic risk for the global economy which could witness a massive wave of Asian defaults (EPP) if a new monetary tightening cycle in the US begins. Should that occur, the greenback will strengthen way beyond the 100 level of the US Dollar index, making coupon payments and bond redemptions in USD too expensive for the Asian issuers to service. More companies and banks around the world will be competing for the global reserve currency, which in turn will exhaust the limited availability of US dollars, making it even harder for Asian issuers to procure the currency for their bond obligations. So, how close are we to a new Asian crisis with cataclysmic effects on the global economy?
U.S.-Dollar-Denominated Asian Bonds Flood the World
USD bond issuance in Asia Pacific soared by 66% in Q3 on a YoY basis, reaching a record amount of $152 billion, according to Bloomberg estimates. The average yield on these bonds dropped to the lowest level since 2007 giving Asian issuers a rare opportunity to lock in low borrowing rates. However, their over-reliance on debt brought the net debt-to-EBIDTA ratio of listed Asia Pacific companies to 3.1, from the 1.9 it was five years ago. This shows that the return on borrowed money is shrinking. More and more leverage is needed to produce the same amount of profits.
How Fragile is the Asian Economy?
While there is plenty of evidence out there that shows just how over-leveraged the Asian corporate world really is, there are is an equal amount of evidence to indicate that the macro landscape is very different, this time around, than what it was during the last Asian crisis of 97-98. In the mid 90s Asian economies began overheating due to the excessive use of cheap yen financing (a process known as the big Asian yen carry trade), building huge current account deficits along the way. These deficits were expanding as more and more counterproductive domestic spending was financed by foreign cheap capital. These economies were spending much more than they could afford. This process eventually made them extremely vulnerable to the downturn of the business cycle, and produced an unprecedented Asian FX crisis, which forced them to tighten their monetary policies in a big way. The shock and the magnitude of the Asian financial crisis led these economies to overhaul their long-term growth models and begin a rebalancing process of historic proportions towards an export-oriented structure. Apart from the domestic shocks to the Asian economies, global commodity markets plummeted from their lofty levels, which were fueled by an artificially strong Asian demand, causing multiple reverberations across the world.
Today, Asian economies are positioned differently. Even though the cheap USD financing cycle is reminiscent of the cheap yen financing of the 90s, there are no signs of overheating. This time around a sizable pile of trade and current account surpluses has transformed some of these nations into creditor players. As a result a big chunk of the global foreign exchange reserves ended up in Asian pockets. Asian currencies have been correcting for years and for this reason have managed to reign in the imbalances of their economies. Currently, the Bloomberg JP Morgan Asia Dollar Index hovers around the lowest level of the last six years. On a more global scale, commodity markets do not seem to be in a bubble territory, and there is much less room for them to drop even if an Asian demand shock occurred.
The current macroeconomic landscape might be different for the Asian economy this time around. Nevertheless there are systemic risks of a different nature lying beneath the surface, the biggest one being an uncontrolled devaluation of the yuan. This could happen if corporations and individuals lost their faith in the integrity of the Chinese economic system. As unlikely as that may seem, there are some indicators that point to the fact that China continues to burn its foreign exchange reserves at a steady pace, while its money supply expands equally fast. Since more and more money accumulates in China, there is more and more capital available to flee the country, if a credibility crisis occurs. It is worrisome that the FX reserves to M2 money supply ratio, which consists of cash and deposits, has dropped to 14% from almost 20% that it was only two years ago. This means that in case of a credibility crisis there aren't enough reserves to defend the yuan against a massive capital outflow or the economy in the future.
The only force which could at least halt such a disconcerting trend is a reversal in the Chinese business cycle, allowing the PBOC to activate a tightening policy. In fact, China, as well as the Asia region, apart from Japan, seems poised for a rebound, after a prolonged soft landing cycle. Such a turnaround is supported from a series of positive PMIs. If this shift in the economic cycle materializes into a solid growth phase, then it will certainly benefit its neighboring Asian trading partners, as they will witness resurgence in Chinese demand for their exports. South Korea, Hong Kong, Singapore, Malaysia, Vietnam, India, and Indonesia are first in line to reap the benefits of a stronger Chinese economy. This means that the entire Asian region will experience a revival and that is the only cushion against the risk of a bond bubble bursting.
Unless the Asian business cycle resumes its growth path and permits local issuers of USD denominated bonds to increase their profitability and improve their balance sheets, the Asian debt overhang could quickly prove to be a real nightmare for the regional as well as the global economy. In the next few months over-leveraged Asian players will be heavily challenged with the rest of the world waiting to see if they're going to make it.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The views expressed in this article are solely those of the author, provided solely for informative purposes and in no case constitute investment advice.