IFR Asia Asian Development Bank Roundtable 2017: Part 1
Welcome to this IFR seminar, entitled “Mobilising Asian Investors for Sustainable Development”. One of the central themes of the 2017 ADB meetings in Yokohama is infrastructure. In this session, I wanted to go beyond restating the vast sums of money needed and discuss if and to what extent the infrastructure funding gap can be closed by capital markets, which is a key assumption among policymakers.
We will also talk about the emergence of green finance in Asia and address topics relevant to Asian capital markets. I’d like to kick off with some thoughts about market sentiment today, as it might be constructive as we develop our discussion.
Alexi, could you give us your read of the market, bearing in mind where we are on the monetary side with the Fed, ECB and Bank of Japan, and at a difficult geopolitical juncture. How is event risk impinging on sentiment in broad capital markets?
Alexi Chan, HSBC: I think we have remarkably constructive conditions in international credit markets, given some of the factors you’ve set out. This reflects a number of important features of the market.
First of all, many participants came into the market at the beginning of this year expecting significantly higher global interest rates – in particular US interest rates. The way the Fed has managed its communication with the market, the hikes that have happened and the communication around future plans for its balance sheet have led to a significant degree of stability in long-term dollar rates.
If we look at the 10-year Treasury, for example, we’ve been around the low-mid 2% range for most of the past six months. That level of stability, compared to expectations at the beginning of the year, has really helped underpin sentiment.
The market is feeling more sanguine around political risk right now. We saw a big rally, for example, in French assets after the first round of the presidential elections, which has been further supportive of credit markets.
If we look at the economic growth picture globally, we’re seeing for the first time in recent years signs of sustained and commensurate growth across regions, both developed and emerging markets. That positive global growth backdrop has prompted higher risk appetite; greater comfort for investors to take on risk.
In Asia we’ve seen a record first quarter in the G3 bond market, with over US$75bn equivalent issued, and looking to have a very constructive second quarter as well. So, I think the overall backdrop is very positive.
Keith Mullin, KM Capital Markets: JICA issued in the market recently. How did you find the experience, Satoko?
Satoko Tanaka, JICA: We issued a US$500m 10-year bond at the end of April. We only issue one Global bond a year. Since this year was shaping up to be a year of uncertainty, we tried to issue earlier in the year because there were European elections scheduled and we were not sure how the Trump administration would go, so we targeted the early part of the fiscal year.
We thought the majority of our purchasers would be Japanese, as in the past. But in fact we attracted more global investors from the US and Europe. When we issued in late April and assessed the trend of interest rates, we didn’t think the situation was so good.
But considering relative value compared with competing SSA bonds, there seemed to be merit for investors from Europe and the US to buy our bonds so we encountered a good market environment. We also felt some investors favoured SRI or ESG factors in our bonds, as well as the social mandate of our organisation.
Keith Mullin, KM Capital Markets: Søren, you haven’t issued yet as AIIB but you’re clearly focusing on the market today and you do have some funding intentions going forward. Could you give us your sense of the market today?
Søren Elbech, AIIB: It’s very clear. The Asian Development Bank issued its largest-ever Global dollar benchmark [a US$4bn three-year that priced on April 26], which emphasises that there’s massive demand for high-quality paper. As Alexi said, the stability in the markets and in swap rates is allowing very large sizes to go through.
At some stage, of course, things will change and we’ll have a period where maybe it gets more difficult to issue; these things go in cycles. I’m sure once we get to issue, which will probably be later this year, we will find our space to tap the market as well.
Keith Mullin, KM Capital Markets: Andreas, there are a number of macro policy themes unfolding in global finance. Given your position at the Bundesbank, on the Basel Committee, at the BIS, and bearing in mind Germany has the G20 presidency, what are the key topics on the agenda in policy discussions?
Andreas Dombret, Bundesbank: The German presidency will be an unusual one because there will be elections in Germany on September 24 so the G20 summit will take place earlier than usual. The presidency always runs until the end of November and the summit is usually held around then. But the G20 Hamburg summit will be on July 7-8 so it is far away from the German elections.
In terms of macro topics, one is how to create and maintain sustainable growth. That’s one of the bigger topics of the German G20 presidency. I attended the IMF spring meetings in Washington held on April 21-23. The IMF has increased expectations for global growth to about 3.5% per year. That’s rather good news.
We are also focusing on digitisation aspects in finance, which is a broad area but suits Germany well because we are a country where technology – like in Japan– plays an important role. We would like to hand over to the Argentinian presidency issues around how you can have access via digitisation to bank accounts. What can you do if there are no branches in developing countries in order to make sure that there are banking services everywhere?
The third topic of our presidency – a specific topic – is ‘Compact with Africa’ – an initiative to promote private investment and investment in infrastructure – and how we can strengthen the links of the international economies with Africa.
Keith Mullin, KM Capital Markets: From an asset management perspective, Japan has been playing for decades into a global theme in terms of its export of capital. In that respect, it’s decoupled from the rest of Asia, though Asia has played tremendous catch-up. How do Japanese institutional investors view the rest of Asia?
Kunihiro Asai, Nikko Asset Management: We have been committing to Asia and promoting Asia-related products so even though there have been events on the geopolitical side, for example, Japanese institutional investors are still cautiously optimistic about investment opportunities in Asia.
‘Cautiously’ is coming from potential geopolitical risks, which we are closely watching. But we are ‘optimistic’ because we believe in significant growth and demand in Asian countries in terms of retail consumption and demand for new infrastructure, such as roads, airports and ports. Japanese institutional investors have been actively investing in Asia as an asset class and a region.
Keith Mullin, KM Capital Markets: So you would see Asia as an asset class or a segment that you would allocate funds to? What’s the Japanese tolerance for Asian currency exposure?
Kunihiro Asai, Nikko Asset Management: There are several classes of investors. Some have global mandates so see Asia in that context. But other investor classes still have a theme of investing in Asia. Asian high-income products such as high-dividend equities or Asian REITs are among the most popular products, especially among Japanese individual investors.
Keith Mullin, KM Capital Markets: Alexi, you mentioned a record being set this year in G3 bond issuance, but a lot of that was China related. Are non-China/non-Japan borrowers funding more in local currencies in local markets?
Alexi Chan, HSBC: The most eye-catching statistics have been around the G3 market, but there has been strong activity across both G3 and certain Asian currencies. With Chinese offshore supply having been substantial and very well absorbed by the market, this gives a good gauge of how the market is looking at China risk.
We see an increasingly constructive sentiment from the global investor base towards China, and that underpins a lot of the broader positive sentiment in the Asian credit markets.
We’re also seeing broad-based demand from the global investor base for other Asian jurisdictions, met by increasing supply from India and Indonesia. It’s important to highlight that this is not just from sovereign-linked credits or just at the investment-grade end of the spectrum; we’re also seeing the emergence of a real Asian high-yield credit market, involving many of these jurisdictions. This is another positive development.
One other prevalent factor in the first quarter was the strong performance of a number of Asian currencies. This is leading to increased interest in financings in those currencies both from issuers and investors.
Going forward, we anticipate further supply in a number of Asian currency markets, including in renminbi (already the third largest bond market in the world) and other markets such as onshore/offshore Indian rupees, as well as the more established currencies such as Hong Kong dollars, Singapore dollars and Australian dollars.
The overall picture is quite balanced at the moment and we are feeling pretty constructive about how things look going forward.
Keith Mullin, KM Capital Markets: Are investors from Asian country A willing to hold currency exposure from borrowers in Asian country B? I ask because one of the big talking points since the end of the Asian financial crisis has, of course, been recycling Asian savings within Asia. Easy to say, not that easy to do.
Alexi Chan, HSBC: That’s right. I think one needs to disaggregate the investor base to understand some of the different flows. Clearly, we’re already seeing official institutions diversify. For example, with the opening up of the renminbi market, we’ve seen official reserve managers participate in Dim Sum and Panda bond transactions we have led.
There are now also many other types of investors in the Asian bond markets that can play across currencies. Within the private banking/wealth management network, our clients can look at a range of tradable currencies, and frequently participate in bond issues denominated in US dollars, Singapore dollars, Australian dollars and beyond. Clearly, there is work to do in some of the other Asian currency markets to promote cross-border flows, in relation to some of the market mechanics, including custody, clearing and legal systems. There’s a lot of work going on to enhance that connectivity.
We’ve also seen the growth of some offshore Asian currency markets in recent years, whether that’s Masala or Dim Sum, where the main class of investors is international or offshore, rather than domestic. This has been a helpful recent milestone in the development of the Asian bond markets.
Keith Mullin, KM Capital Markets: I wanted to touch on the regulatory wave that’s been washing over the banking and asset management sectors and indeed over the capital markets since the end of the global financial crisis. Regulatory developments have been a clear focus in the US and Europe but to what extent has that been the case with regard to Asian jurisdictions? Eriko, how do you see the regulatory situation play out?
Eriko Sakata, Linklaters: There are so many regulatory burdens now on the banks. Both banks and asset managers have had a lot of restrictions imposed on them and don’t have a lot of freedom on the capital markets side. [As a result], there’s been a slight shift in capital markets players from regulated institutions – banks and asset managers – to trading companies, shadow banking entities and corporations.
Trading companies previously made their own investments but have been setting up funds using fund techniques and utilising third-party investment money with leverage. They’ve tried to create wider freedom in this area. As the players in the markets undergo this slight change, in accordance with such changes the structure of the investment changes from pure equity or bond investments to structured finance or investment fund structures.
I’m not suggesting this is avoidance of regulation but I do think it means the market has diversified from retail investors to more sophisticated institutional investors. It’s a very interesting trend.
Keith Mullin, KM Capital Markets: On that point of non-banks playing a quasi-banking or quasi-investor role, how is that development viewed by regulators?
Eriko Sakata, Linklaters: Good question. Actually, it’s a chicken-and-egg situation. Regulators, of course, want to impose meaningful regulation on the shadow banking sector but of course shadow banks want to keep their freedom, avoid needing licences and have regulation imposed on them.
As a lawyer, I’m assisting non-regulated clients create these kinds of structures within the limits of applicable regulatory compliance. On the other hand, because of increased regulatory pressure, regulated clients such as asset managers and financial institutions are losing their freedom in the market. It’s a very difficult moment for asset managers and financial institutions bound by regulation to survive the current situation and for regulators to find a right balance of regulations applicable to regulated players and non-regulated players.
Andreas Dombret, Bundesbank: With regard to shadow banking, you need to bear two things in mind. First, whenever there is a banking service carried out you will find liquidity as well as maturity transformation. Whether you call it a shadow bank or not, and regardless of the structure you use, we will regulate it because if you act like a bank but call yourself something else, we will catch that entity and regulate it in order to create a level playing field.
If you are not providing a banking service but are in “true” shadow banking, there’s nothing wrong with that at all. Not everything needs to be in the banking sector but, if it is of systemic relevance – that’s the important phrase: of systemic relevance – there may well be regulation. Otherwise, there should be no regulation of “pure” shadow banking activities.
With regard to this grey area of shadow banking, we need to look at whether banking services are part of it or not. If yes, to have a level playing field it should be regulated. If no, the question is: is it systemically relevant or not? We are not trying to restrict services outside of the banking sector because these are valuable services and we are not trying to prevent this at all.
Kunihiro Asai, Nikko Asset Management: Regulation is an opportunity for asset managers. In Japan, all investors are seeking yield. Because of regulation in the US and Europe, many banks can no longer conduct long-term lending or engage in equity-type investments. So Japanese retail and institutional investors are investing in senior bank loans or in business development companies listed on the New York Stock Exchange in place of the banks.
But it’s not shadow banking in my opinion. Banks have been acting like investors but actually they are not so regulation is necessary for financial system stability. The role of investors is just going back to the role of real investors, be they institutional investors like pension funds or individual investors. The role of asset managers is to work with law firms to structure funds for investors who can take risk and who want yield.
Keith Mullin, KM Capital Markets: Terry, if banks are constrained – for all sorts of reasons – from many of the things they used to do, this begs the question: is the infrastructure funding gap going to be filled by institutional investors or by retail through pooled schemes?
We’ve all seen the numbers. Rather than going over them again, let’s instead focus on that. Moody’s put out a report on this very subject, so perhaps you could start off by summarising that report.
Terry Fanous, Moody’s Investors Service: Moody’s published a report on May 4 that picks up on the US$1.7trn the ADB told us is needed over the next 15 years to support infrastructure development in Asia. If you use that figure and compare it to how much infrastructure is being raised every year, I would suggest that over the last 10 years the average infrastructure debt-raising per year has been around US$210bn.
There is a big gap between the US$1.7trn and the US$210bn that is being raised on an annual basis. Clearly, the gap is partly going to be filled by governments themselves, and by equity. Even so, there is a significant gap that needs to be filled.
As a result of that, a fair amount of work needs to be done. Greater funding diversity is what is going to help bridge that gap. If you look at the spectrum of how infrastructure debt is being raised in Asia, about two-thirds is raised by infrastructure corporates, the state-owned enterprises that dominate our rated universe in Asia, and one-third is project finance loans and a minuscule amount in project finance bonds.
Our report suggests that at the macro level this asset class is really attractive to institutional investors. Let me just highlight them. One is it provides a good match between long-term assets and long-term liabilities. Our research over the years has concluded that, on average, infrastructure debt actually has a better credit performance than typical non-financial corporates.
In addition, project finance debt has a very high recovery rate. Let me just throw one ratio at you: on average, project finance loans have a recovery rate of 80%. That’s very high. In nearly two-thirds of all the defaults that we have experienced in the last 30 years, lenders were able to recover 100% of every dollar that they had lent.
The paradox is that infrastructure debt is attractive. But the report says there are some serious credit challenges: currency mismatch risk, political risk, regulatory risk and off-taker risk being four of them.
There are a number of initiatives we could see to support development of infrastructure finance. The multilateral development banks play a key role in bridging that gap. A number of really exciting credit-enhanced structures have popped up in emerging markets that can be replicated in other emerging-market regions, including Asia.
Keith Mullin, KM Capital Markets: Could you just give one example of a structure that you’ve looked at?
Terry Fanous, Moody’s Investors Service: Sure. Credit enhancements really became very popular with the European Investment Bank when they ran a pilot in 2012-13 to credit enhance projects in Europe to make them more attractive for institutional investors. We saw 10 transactions under what is called ‘Europe 2020 Project Bond Initiative’.
On average, the EIB put in 10%-20% of the value of the bonds as an unfunded credit enhancement through a contingent guarantee. That allowed the structure to be uplifted by between one or two notches. Fast forward to five months ago, when we saw, I think, the first of a credit enhancement structure in an emerging market.
Turkey, which is rated one notch lower than investment grade at Ba1 (with a negative outlook), is building a hospital campus in the town of Elazig through a PPP structure: design, finance, build, and maintain. In doing so, Moody’s was asked to assign a rating to the transaction.
It’s not policy but our practice is that a local project generally cannot be rated higher than the sovereign. There are a number of very logical reasons why that is the case. It’s because the project is subject to all the political risk, regulatory risk, operating risk, labour risk, all sorts of risks that are within that sovereign.
The €288m Elazig Hospital project bond, for a PPP transaction in a non-investment grade jurisdiction, benefited from credit enhancement from two multilaterals. MIGA provided political risk insurance, and the EBRD provided a subordinated liquidity facility. That happened in an emerging market. The reason why I’m saying ‘emerging market’ quite often is because institutional investors tell us that in EM there are a number of challenges.
The first is currency risk – not only currency mismatch risk but currency convertibility and currency transferability risk. The second is expropriation risk. The third is breach of contract; the fourth is they really don’t have a lot of appetite for investments in high-yield non-investment grade.
These credit enhancements – MIGA basically providing cover for breach of contract, transferability risk, expropriation and currency convertibility risk – mitigated a lot of the country risk issues to the extent that this cover, supported by the liquidity facility from the EBRD, allowed that project to be rated two notches above the sovereign.
The project is rated Baa2, so you’ve gone from a non-investment grade rating profile to an investment-grade rating profile. As a result, institutional investors felt very comfortable with this structure as it took away risks that they were concerned about.
That’s one transaction but I think it probably signifies that these types of structures, with the assistance of the multilaterals, can help – maybe not to bridge the gap between the US$220bn and the US$1.7trn, but it can help. It will, I think, create a virtuous cycle insofar as it will start attracting other institutional investors, who will gain familiarity with the asset class.
Keith Mullin, KM Capital Markets: Søren, the AIIB is front and centre of this subject. What can you do to make the difference?
Søren Elbech, AIIB: Filling the gap is the elephant in the room. How do you do that? Obviously, AIIB cannot do it alone and neither can any of the other multilaterals. Private sector participation is super key to this. And as Terry said, so is the ability to provide innovative credit enhancement structures to absorb or transfer some of the risk.
Of course, multilaterals are taxpayer-owned. The countries that have come in and provided capital that allows us to take risk doesn’t necessarily mean that the risk has been taken. But what we’ve seen with the structure that Terry just mentioned is that that is actually starting to seriously happen.
Providing subordinated liquidity facilities is, of course, something that we have taken note of. The AIIB is just 15 months old so we’re not yet fully set up. Give us some more time to learn from some of these innovative structures and we’ll get there. We have US$9bn of paid-in capital; as we mature we will benefit from learning from some of these tremendously innovative structures.
It’s not only a question of credit enhancement; local currency financing also needs to be taken into account. I don’t think you can talk about filling the infrastructure financing gap in Asia if you’re not also willing to talk about local currency financing. There the multilaterals also must play a significant role with their risk-bearing capacity in coming years.
The investor side also needs to be reassessing construction risk. Once you have operating assets and long-term cashflows matching long-term assets or long-term liabilities, that is very nice. But before we get to that long-term asset there’s construction risk.
That has to be mitigated; it has to be assessed, understood and priced. Of course, the ability for the multilaterals to come together and standardise some of the risk would also be a tremendously helpful factor in bridging the gap.
Eriko Sakata, Linklaters: On subordinated credit enhancements, Japanese financial institutions typically have equity departments and bond departments but they don’t work together. They have different credit analysis systems, different consolidated rules etc.
In terms of subordinated credit enhancements, I think it’s difficult for them to create meaningful structures because the credit enhancement is provided by the guarantee, which is generally provided by the debt department, but the fund is typically arranged by the equity group and they generally don’t work together.
Creating a bridge between internal groups, systems, and of course internal regulation will be one of the keys to create a meaningful system for credit enhancement.
Keith Mullin, KM Capital Markets: Banks are comfortable taking construction risk; they’ve been doing it for a long time. Will asset managers ever get over the notion of construction risk?
Kunihiro Asai, Nikko Asset Management: Infrastructure is among the most attractive asset classes for Japanese investors. Japan has lost any semblance of yield even in the 10-year JGB [which was quoted at a yield of 0.021% on the day of the seminar, having been negative between February and November 2016].
We don’t have a base asset class for long-term investment so infrastructure is definitely one of the best candidates. But we have two challenges, both for institutional and retail investors. For institutional investors the challenge is credit risk and country risk. In this regard, the credit enhancement scheme that Terry described is really powerful and effective.
For retail investors, the challenge is liquidity. We have about 6,000 publicly offered funds sold in Japan but almost all offer daily liquidity. One solution is listing. We have infrastructure funds listed on the Tokyo Stock Exchange but only three, with AUM of about US$100m.
The more promising prospect is the new long-term investment programme we will have from next January, a cumulative type of NISA (Nippon Individual Savings Account). It’s very sticky.
If this channel becomes active and popular – some analysts are anticipating that US$4bn-$5bn per year will flow into the investment trust market – this channel is ideal to invest in infrastructure-type products. Asset managers won’t have to worry about redemption risk, about liquidity risk. I’m very positive and optimistic about future investment by Japanese investors into infrastructure projects.
Keith Mullin, KM Capital Markets: There’s an acceptance, Andreas, an assumption, at the policy level that infrastructure will get financed. In the darkened back rooms of policy-making, is that optimism mirrored by the optimism we see in public?
Andreas Dombret, Bundesbank: At the G20 level, not really, because the assumption is that markets are efficient, that there is enough competition and, especially in liquid markets like those we have today, that there is enough interest to finance attractive investments.
What we are thinking about is how we can sustain competitive markets. How can we make sure that there is growth in the market, that the market creates attractive offerings, and that there is regulation and supervision, which provides benchmarks for investors to orientate themselves.
Whether or not this will be picked up is up to the markets. I am a big believer in the markets, and the markets will make sure that they prioritise the more attractive versus the less attractive investments. It’s not for central bankers to invent instruments; our role is to make sure that regulation is strong and transparent so that the markets can find equilibrium and invest.
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