For Asia-Pacific Sovereigns, Capital Outflows Are Likely To Be Disruptive But Not Destructive

Primary Credit Analyst: KimEng Tan, Singapore (65) 6239-6350; kimeng.tan@standardandpoors.com Secondary Contact: Agost Benard, Singapore (65) 6239-6347; agost.benard@standardandpoors.com

Table Of Contents
Capital Inflows Have Lifted External Liabilities Australian, Korean, And New Zealand Banks Have Reduced External Borrowings But Foreign Capital Continues To Help Keep Their Funding Costs Low Indonesia And India Struggle To Maintain High Investment Rates As Foreign Inflows Slow Disruptive Policy Responses Are A Risk Modest To Moderately Higher Financing Costs Likely In Most Cases Related Criteria And Research

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For Asia-Pacific Sovereigns, Capital Outflows Are Likely To Be Disruptive But Not Destructive
The greatest fear is fear itself. That may be a way to sum up the risks facing Asia-Pacific sovereigns with the normalization of global monetary policy. Governments that had warily allowed foreign capital into their economies not so long ago now worry about a sharp reversal of these flows. Standard & Poor's Ratings Services expects most sovereigns to weather this without a sharp slowdown in economic growth or prolonged financial volatility. But negative policy surprises from anxious governments could hurt investor confidence and worsen credit conditions much more than we expect in some economies. Sovereign credit fundamentals, including growth prospects and financial soundness, may also weaken more than we anticipate now. Overview Capital flows into Asia-Pacific have lifted external liabilities or have kept them elevated in recent years. In some economies, it has helped to sustain relatively high investment rates. Slower capital inflows or outright outflows, in response to improved conditions in the eurozone and the U.S., may increase financing costs from current levels. Most sovereigns are likely to see economic growth weighed down somewhat by modest-to-moderate increases in funding costs. Although not our base case, unexpected policy changes that reduce investor interest in Asia-Pacific may undermine sovereign creditworthiness.

Capital Inflows Have Lifted External Liabilities

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For Asia-Pacific Sovereigns, Capital Outflows Are Likely To Be Disruptive But Not Destructive

Chart 1

Capital flows into Asia-Pacific have lifted external liabilities or have kept them elevated in recent years (see chart 1). Corporate borrowers in the region have benefited. An indication is the sharp increase in foreign currency bonds that non-government entities have issued (see chart 2).

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For Asia-Pacific Sovereigns, Capital Outflows Are Likely To Be Disruptive But Not Destructive

Chart 2

The rise in corporate bond issuance may also have increased refinancing risks. For 2015, Standard & Poor's projects that US$40.6 billion in corporate bonds will be maturing, up from less than US$20 billion this year. If capital inflows slow much more than we expect, the cost of refinancing these debt may unpleasantly surprise borrowers. The continued interest of foreign investors in this region has become more important. Yet, the chances of a slowdown or reversal of capital flows have increased recently. Stronger U.S. economic prospects and greater stability in the eurozone (Economic and Monetary Union) have much to do with it. But the fact that capital outflows indicate improved circumstances in the developed world may be a weak mitigating factor. After all, the earlier inflows had occurred partly because of the relatively stronger economic performance in the receiving economies, an attraction that could now weaken. As the financial market volatility in May-June 2013 showed, the impact of such reversals could be disruptive.

Australian, Korean, And New Zealand Banks Have Reduced External Borrowings
Investors' concerns naturally focus on banks. Banks that borrowed internationally were among the hardest hit when

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For Asia-Pacific Sovereigns, Capital Outflows Are Likely To Be Disruptive But Not Destructive

liquidity in the global financial market dried up in 2008-2009. Several governments had to step in to guarantee domestic banks' borrowings at that time, including those of Australia, Korea, Hong Kong, New Zealand, and Singapore.
Chart 3

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For Asia-Pacific Sovereigns, Capital Outflows Are Likely To Be Disruptive But Not Destructive

Chart 4

Banks that borrow internationally to fund domestic lending are of particular concern to investors. The largest of these banks seem to have improved their resilience. Net external debt at banks in Australia, Korea, and New Zealand has declined relative to foreign earnings of their respective economies (see chart 3). Average maturities of the remaining foreign borrowings have also increased (see chart 4). As the importance of foreign funds decline, these banks raised sufficient domestic financing to maintain lending growth (see chart 5).

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For Asia-Pacific Sovereigns, Capital Outflows Are Likely To Be Disruptive But Not Destructive

Chart 5

But Foreign Capital Continues To Help Keep Their Funding Costs Low
Even if banks have reduced international borrowings, some--especially those in Australia and New Zealand--continue to shoulder sizable foreign debt. Non-resident funding is still more than 27% of the total in New Zealand and remains more than 34% of total banking liabilities in Australia (see chart 6).

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For Asia-Pacific Sovereigns, Capital Outflows Are Likely To Be Disruptive But Not Destructive

Chart 6

The banks also benefit indirectly from foreign capital inflows to other sectors. Significant new inflows to domestic currency government bond markets (see chart 7) have helped to keep domestic financing costs low. This has facilitated the banks' switch to local funding without a steep increase in funding costs (see chart 8). Corporate and household borrowers have benefited as a result. And, in the case of Australia, net external liabilities and net external debt have changed little--relative to current account receipts--in the past few years.

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For Asia-Pacific Sovereigns, Capital Outflows Are Likely To Be Disruptive But Not Destructive

Chart 7

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For Asia-Pacific Sovereigns, Capital Outflows Are Likely To Be Disruptive But Not Destructive

Chart 8

A substantial drop in external demand for Australian and New Zealand assets could noticeably slow their economies. As foreign funds become scarcer, current account deficits may shrink to adjust. This means either higher saving rates (accompanied by lower consumer spending) or a slowdown in business investment demand, triggered by higher lending rates. Free-floating exchange rates should mitigate some of this economic impact. In part, it's because large local banks do much of their external borrowing in their home currencies or hedge their foreign exchange exposures. Consequently, large foreign exchange fluctuations are unlikely to cause significant losses at banks. Still, higher interest rates accompanying large capital outflows could prolong the period of sub-par growth for the Australian and New Zealand economies in recent years.

Indonesia And India Struggle To Maintain High Investment Rates As Foreign Inflows Slow
The banking sectors of Indonesia and India are less exposed to the slowdown in foreign inflows, but these economies are still feeling the chill of weaker capital inflows most keenly. Net external liabilities in the two economies have

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For Asia-Pacific Sovereigns, Capital Outflows Are Likely To Be Disruptive But Not Destructive

climbed markedly in recent years due to capital inflows. In these countries, foreign investments have contributed to keep corporate financing costs stable even as investment rates stayed high at near or above 30% of GDP recently (see chart 9).
Chart 9

Financing conditions have weakened in recent months as capital inflows slow. The Indonesian government, for instance, had to pay almost 200 basis points more to issue a 10-year global bond in June 2013 than in April 2013 (although this partly reflected higher U.S. long-term interest rates). This contrasted with the low and stable funding costs that Australian and New Zealand banks faced even during the international financial volatilities of May and June 2013. Policy changes in Indonesia and India that increased uncertainties for foreign investors, coupled with the better prospects of developed economies, have contributed to the slowdown in capital inflows. Most forecasters have revised their growth projections for the India and Indonesia partly as a result. This slowdown may have an economic impact over the next two to three years, at least. Infrastructure bottlenecks in both countries have been important economic growth constraints. Slower near-term growth, likely to be a result of declining investment rates, could weigh on medium-term economic potential.

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For Asia-Pacific Sovereigns, Capital Outflows Are Likely To Be Disruptive But Not Destructive

Disruptive Policy Responses Are A Risk

Sovereigns have responded to the slowdown in capital inflows with policy changes. The Indian and Indonesian governments have reduced fuel subsidies in a bid to reduce their current account deficits (and external financing needs). Both governments have also tightened domestic monetary conditions, partly to make holding their currencies more attractive. In addition, the Indian government has announced measures to attract foreign direct investments and offshore lending. Less consumer- and investor-friendly measures have also emerged. The Indian government has tried to reduce gold imports with higher import taxes and restrictions on credit used to finance gold imports. It has also restricted banks' activities in currency derivatives. Mid-August this year, the government introduced new controls on outward remittances and direct investments abroad. In Indonesia, the government has tried to reduce currency trading unrelated to economic activities since 2011. It also asked exporters to repatriate foreign exchange earnings. An important risk for India and Indonesia is a marked increase in reliance on more market-disruptive measures to slow capital outflows. Outright controls on foreign capital outflows are one such example. The likelihood of such moves may grow if slowing capital inflows weigh increasingly on economic growth. Looming elections in 2014 for both countries may increase the strain on politicians in this scenario. The result could be much more serious than the economic slowdown if the capital outflows were tolerated. At best, these measures buy time for policymakers to address structural issues that weaken investor confidence or widen external imbalances. If investors and savers perceive that no structural reform efforts accompany their impositions, then investor confidence and business financing conditions could deteriorate sharply.

Modest To Moderately Higher Financing Costs Likely In Most Cases

Unexpected policy changes that hurt investor interest may prove even more damaging elsewhere. This is certainly true for Australia and New Zealand, which continue to depend the most on foreign financing in the region. International financial centers Hong Kong and Singapore could also be severely affected if such measures were introduced. This is even though the two high-saving economies are net capital exporters. Capital flows in and out of these Asian financial hubs are larger, compared with their economies, than elsewhere in the Asia-Pacific. Open capital accounts and a predictable policy environment underpin Hong Kong and Singapore's status as international financial centers. If the policy environment takes a sharp turn for the unexpected, strong capital outflows could result. Such changes could also threaten Hong Kong and Singapore's continued success as international financial centers, with negative implications for their economic growth. We see no reason to believe that the advanced Asia-Pacific economies would make confidence-damaging changes. Any changes are unlikely to be a result of the modestly to moderately higher financing costs that we expect to derive from the monetary policy normalization of developed economies. Governments in the advanced Asia-Pacific economies also have had long histories of coping well with international capital flows through their financial systems.

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We also expect the impact on financing costs to be limited because of the high savings rates and structurally strong domestic liquidity in Hong Kong, Singapore, and other East Asian economies--including China, Japan, Malaysia, Korea, Taiwan, and Thailand. This is reflected in their consistent current account surpluses. We anticipate that associated economic or financial volatility (if any) will be temporary in the absence of policy over-reactions. Elsewhere, the higher financing costs and possible exchange rate volatility associated with capital withdrawals could put more pressure on policymakers. The strain is likely to be greater in economies that run sizable current account deficits or have inflexible exchange rates. Responses or political developments that negatively surprise investors could spread the impact beyond an economic slowdown. Sri Lanka is among these more vulnerable sovereigns, given the importance of foreign financing in supporting its high investment rate. Without timely official funding support, sovereign credit fundamentals could materially deteriorate. In this unlikely event, even if economic fundamentals are sound otherwise, the resulting liquidity squeeze could cause healthy businesses to face financing difficulties or even the prospect of default. An increase in nonperforming loans at banks in this scenario may spread the damage to other parts of the economy.

Related Criteria And Research

Credit Conditions: Increased China Downside Risk Dampens Asia's Growth, July 30, 2013 Asia-Pacific's Growth Continues To Slow Along With China But Japan Looks Ready To Blossom, Aug. 5, 2013

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