News first reported by the Wall Street Journal last week appears to show a massive shift in the currency composition of China’s reserves. The numbers appear to show that the proportion of China’s $3.2 trillion that is invested in dollar assets had fallen from 65% to 54% from June 2010 to June 2011.
While these figures cannot be confirmed, they are nevertheless an indication that a serious macroeconomic rebalancing is underway. And this will have large implications for companies in Asia in how and where they finance themselves.
“It is to be expected that China, aware like many other central banks of the dangers of holding too large a proportion of its reserves in Western currencies and the dollar in particular, should wish to diversify into other surplus currencies,” said Jerome Booth, head of research at Ashmore Investment Management.
The massive deleveraging of the West is being made worse by emerging market reserve managers repatriating their money. These managers have upwards of $9 trillion of liquid reserves and when they decide to move it out of the West and bring it back home it will have two very clear consequences: the problems in the West will get appreciably worse, while domestic bond markets in emerging markets will get measurably bigger.
According to research published by Ashmore, these markets are already $12 trillion in size, which is roughly the same as the US Treasury market. And yet they are seen as something of an ugly duckling among the competing pools of global capital. Ashmore says this will change. “There is a huge desire by emerging market policymakers to develop their local currency bond markets,” according to Booth. “In particular, they are very aware that banks — local and international — are highly levered institutions that are at the centre of every financial crisis. By their very nature, banks are in theory insolvent whereas bonds need not be levered at all.”
Booth admits that a lot more still needs to be done in working out some of the technicalities, such as establishing reliable sovereign curves or improving trading systems, before these markets can truly take off. But he points to the underlying change in pension systems, which create a captive investor base, as the crucial first step to helping these markets take off. Most countries in Asia have created pension regimes that are fuelling demand for long-term assets.
As a result, Booth predicts that corporate bond issuance will become the most important part of most local bond markets in the developing world. Corporate issuance in local currencies made up just 33% of total emerging market fixed income issuance in 2004, but now it accounts for 46%. This rate of increase will continue.
Companies in Asia will benefit greatly from this shift. The development of local markets will become even more important as the regions’ governments start to reduce their exposure to dollars and look for a place to park the juggernaut of cash they hold. Booth points to the following calculation to back up his view. Emerging markets as a whole have a quarter of their GDP in reserves, two-thirds of which are invested in dollar assets in most countries. Moreover, the rest of their reserves are in other Western currencies. This means that a 30%-weighted move down in the value of developed market currencies could shave 7.5% off those countries’ GDP, purely due to “what appears to be a highly imprudent reserve policy”, he says.
So while there will definitely be problems caused by the structural rebalancing of reserves out of the West and back into emerging markets, Asian companies could benefit from the trend. With their local bond markets deepening, they will be able to raise longer, cheaper and less skittish capital by moving from bank to bond financing. The clearest expression of this trend is the development of the dim sum bond market. While it has been a success, the market is opening up slowly.
“The Chinese authorities are understandably cautious about the internationalisation of the RMB,” says Booth. “They are trying to build a reputation for stability.”
Stability, of course, is the most important quality for a reserve currency. If the renminbi is considered a stable store of value, it will be able to attract the reserves of other emerging markets. And that in turn will open huge new avenues of liquidity to corporate issuers.
