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Emerging Asia, led by China, is becoming increasingly important as the growth engine of the global economy, and the Asian financial sector plays a key role in this story. In the interview below, PIMCO credit analyst Koyo Ozeki discusses the issues facing the financial sector in Asia in the wake of the global financial and economic crisis as well as the post-crisis economic outlook.

Q: What is the state of Asian economies and credit markets after the financial and economic crisis that started last fall?
Ozeki: Going into this crisis, Asian economies were generally in a better position compared with 10 years ago after the Asian currency crisis, thanks to the rapid growth in the past few years that improved the fundamentals of the corporate sector. Asian governments also increased their foreign reserves over the same period as they vowed to avoid the devaluations they were forced into 10 years earlier. The banking sector was also stronger financially and has better risk management systems as well as corporate borrowers with improved credit quality (Chart 1). 

However, the market turmoil after the Lehman shock in the fall of 2008 took a serious toll on Asian markets. Since last October, many Asian governments and central banks implemented emergency measures for financial institutions, including liquidity provisions, much like the developed countries in the West. Even so, the global liquidity crunch eventually shifted the market’s focus from individual corporate credit risks to sovereign credit risks due to the belief that government support is constrained by the size of their foreign reserves. For example, South Korea has a relatively large amount of external debt in the banking sector, raising the concern that their ability to repay the debt may be negatively impacted. This sent South Korean credit default swaps sharply higher (Chart 2). In addition to the rise in the volatility of bond prices, the Asian primary markets had effectively shut down and the offshore corporate bond market was not functioning properly.

The situation began to stabilize after Korean government financial institutions successfully issued bonds at the beginning of 2009. Buyers believed the pricing was attractive and global investors returned to the Asian markets, paving the way for a recovery in liquidity. The global markets came under pressure again in February and March, as U.S. and European banks reported widened losses, but the market recovery starting in April helped to lift Asian markets rapidly as well.

Q: What is PIMCO’s secular outlook for the Asian economies and what is your view of the Asian financial sector?
Ozeki: At this year’s Secular Forum in May, PIMCO concluded that one of the major economic themes is that global economic growth will slow down as a whole, but emerging markets, led by China, will likely outperform developed economies. In line with this outlook, we expect the financial sector in emerging Asia to grow in the medium- to long-term as well.

In terms of the valuation of corporate bonds issued in Asia, the market stress since last September has led price levels to adjust to levels that investors find attractive in terms of a risk-return profile. This has made investment in the financial sector more appealing (Chart 3). However, in the short run, we need to remain cautious as there are persistent risk factors to the macroeconomic outlook, and the amount of non-performing loans may potentially increase because of the rapid growth in lending in the past few years.

Q: So you retain a cautiously optimistic view for the region’s economy. What are the risk factors?
Ozeki: For the Asia-Pacific region as a whole there is a risk of another macroeconomic slowdown, so we will watch for a possible decrease in corporate profits stemming from further decreases in external demand. If any central bank moves too prematurely to tighten monetary policy it could also negatively impact the economies in the region. An economic deterioration could push the borrowing costs for companies higher and increase banks’ non-performing loans, causing a further spike in funding costs for borrowers. Even though the Asian economies are now on the path to recovery overall, we will pay close attention to the banks’ fundamentals, as there is a time lag after a downturn in the economy before the actual accumulation of non-performing loans.

On the monetary policy front, policymakers must chart a course to avoid two key risks.  On the one hand, a premature tightening could cause the Asian economy to deteriorate further. On the other hand, there is a risk that an asset bubble could occur due to the prolonged period of low interest rates, which could put the financial system in disarray should it burst.

Even if we can navigate successfully to avoid these stress scenarios, the financial sector remains vulnerable to the risk of lower profit margins due to competition or industry consolidation and through merger and acquisition activity. Furthermore, expansion of international operations, like the Hong Kong banks’ entry into China and the Malaysian banks’ move into Indonesia, means that risks are now diverse and unique to different regions. Investors as well as banks will need an even broader point of view and knowledge base in order to correctly analyze risks in this corner of the world.

Q: What are the country-specific points when looking at risk factors for the financial sector?
Ozeki: Among the Asian nations, Korean and Indian banks are actively raising funds in foreign currencies, such as the U.S. dollar. In Korea, the loan-to-deposit ratio is above 100%, making Korean banks highly dependent on access to capital markets (Chart 4). In India, to meet the demand from Indian companies that operate abroad, banks have frequently issued bonds denominated in foreign currencies.

In terms of factors that can affect the financial sector, in Korea we are focusing on the activities of small- to medium-sized companies. Real estate development projects in the rural areas have already turned into a source of bad loans for roughly the past two years. More recently, the manufacturing and service industries have also suffered ill effects from the economic downturn, resulting in an increase in bankruptcies in those sectors. Lending through the government programs has mitigated the shock to some extent, but in the long run could actually slow the healthy turnover of companies and lead to eventual declines in asset quality.

As for India, we will be watchful not only of corporate activity but consumer lending, which expanded rapidly as a result of the remarkable economic growth over the past few years. The modern banking system has a relatively young history in India, and therefore hasn’t weathered many economic cycles. While it is difficult to predict how the level of bad loans will develop across the economy, it will likely be the first test for the financial institutions’ enhanced risk management measures.

In China, there is no overseas bond issuance by banks, but their lending stance has an indirect but significant impact on the ability of companies in other sectors, such as real estate developers, to raise funds in foreign currencies. Four government-sponsored financial institutions make up more than half of the market for loans in China, and lending has increased dramatically since the beginning of the year due to the government programs (Chart 5). This increases the potential risk for overheated asset prices due to the rapid expansion of money supply, and if the banks continue to lend to companies where profitability has decreased, it could lead to an increase in bad loans in the future.

Q: Can you tell us about PIMCO’s process of investing in Asian financial bonds?
Ozeki: Sure. As you are aware, PIMCO focuses on both the top-down investment strategies based on our secular and cyclical economic outlook and the bottom-up research involved in the selection of individual securities. In our bottom-up research, we value both qualitative valuation as well as quantitative analysis, involving practices such as frequent meetings with bond issuers, for example.

In analyzing the financial sector, fundamental analysis and thorough understanding of the regulatory and systemic support frameworks for each country are imperative. We also consider factors such as the historical background, political environment and direction of regulatory changes in order to evaluate the current situation and formulate our views on possible future scenarios. We also meet with policymakers in each country to try to share investors’ opinions and advice regarding administrative issues. 

Factors such as the relationship of foreign reserves and widening sovereign risk premiums in Asia make it important to incorporate a macroeconomic viewpoint when analyzing the financial sector. Moves in foreign exchange rates can impact the risks that banks and their borrowers face. On the other hand, an excessive widening of sovereign risk premiums sometimes presents a great opportunity to invest in private sector bonds. When we analyze sovereign risks and the financial institutions’ credit risks, it is important to evaluate the balance between risks and opportunities. In order to make the best possible investment recommendations, we work closely with the sovereign analytics team to share ideas and exchange opinions. 

It is also necessary to do an analysis of the supply and demand balance. In particular, investors need to pay attention to increases in bond supply as it can put pressure on the spreads, causing them to widen. At PIMCO, we look at refinancing and new financing needs at both the overall market and individual issuer levels.

Q: How have you been investing in Asia and what is PIMCO’s investment strategy for the Asian financial institutions going forward?
Ozeki: From 2005 to 2007, Asian financial institutions have actively issued not only senior unsecured bonds but also subordinated bonds and preferred securities. These securities attracted strong investor demand amid the global credit boom and therefore were issued at very tight spreads. PIMCO approached these bonds with extreme caution. From September 2008 to March of this year, the financial crisis forced the credit risk premium to correct, and now the spreads look attractive over a mid- to long-term horizon. During the first half of this year PIMCO has invested actively in bonds and securities of issuers whose credit qualities remained high and stable in our opinion, even as the sovereign risk premium widened. 

Going forward, we believe that the credit risk premium in Asia will not be determined only by factors limited to the region but will continue to be heavily influenced by global market moves. The credit spreads of Asian financial institutions have tightened since April as the market recovered, but on the other hand, the room for U.S. and European credit tightening is limited and the risk is for spreads to potentially widen from their current levels; depending on the economic activities, we should consider the possibilities of the Asian market moves reversing. In this environment it is more important than ever to make rigorous and prudent bond selection. 

Q: Thank you.