The Asian Development Bank warns that the region’s local currency bond markets remain at risk of heightened volatility and reduced returns as a result of the eurozone crisis.

Iwan Azis, head of ADB’s office of regional economic integration, urges regional central bankers not to be complacent in thinking their markets offer a safe haven to local investors. He says governments must improve local currency debt market liquidity, both at the country and regional level.

Asia’s local currency bond market has expanded by 8.6% this year, or nearly $6 billion by end-June, finds the ADB’s Asia Bond Monitor report. But it has been impacted by problems in Western developed markets in two ways: via shocks, such as the 2008 bankruptcy of Lehman Brothers, and through continuing volatility.

This raises the cost of borrowing for governments and companies, while uncertainty is undermining monetary policy because investor behaviour has become less predictable.

“We have analysis to show that the shock and volatility from the Lehman and eurozone crisis is real in the [Asian] local markets,” says Azis. “In the Lehman crisis, the shock and spillover was higher. In the eurozone crisis, they are less, but the eurozone crisis is still unfolding, so we don’t know [what will happen].”

Last week, Mario Draghi, the European Central Bank president, announced plans to buy struggling eurozone countries’ bond, which immediately calmed the market. However, investors should pay attention to the conditionality of ECB proposals, says Azis.

“What kind of conditionality is the troika going to put?” asks Azis, referring to the ECB, the IMF and the European Commission’s coordinated response to euro woes. He believes the conditionality effect is more likely to be felt in the medium term rather than immediately, with the risk the troika’s demands will force austerity and low growth on potential borrowers such as Spain and Italy.

Europe’s economic slowdown is already having a contagion effect on China’s bond market. Europe is the largest trading partner for China, and during August Chinese bond yields rose 40 basis points – a move partially due to shrinking exports, says the September 2012 Asia Bond Monitor report.

It says Thailand and Indonesia have also seen yields rise because of Europe. The damage appears modest compared with the spikes suffered in the wake of Lehman’s collapse: China, Thailand, Malaysia, Korea and the Philippines all suffered volatile bond markets in the wake of Lehman’s downfall.

In contrast, this year local currency bond markets appear resilient, with issuance continuing, the value of bonds outstanding up, and in many cases yields down year-on-year.

Moreover, the ADB believes the expansion of local debt markets reduces the risk of Asia falling into a crisis as in 1997, when many local companies and banks splurged on borrowing from abroad, creating mismatches in both currency and maturity – to the region’s detriment when local currencies suddenly plummeted.

Azis also points to increasing diversification of funding resources into the bond markets among issuers, reducing their over-reliance on banks, as well as the use of bond issuance among governments to fund their stimulus packages, most significantly in the 2008 Lehman aftermath.

On the demand side, growth in the local currency market is expected to grow further from intra-regional demand, as Asian investment positions in developed markets become untenable, according to Hon Cheung, managing director at State Street Global Advisors.

“There’s about $6 trillion of Asian debt out there, backed by $3 trillion of asset-backed securities [made up by the region’s monetary sterilisation programme],” Cheung says. This makes Asia’s debt especially attractive when compared with the “relative pay-as-you-go fiscally challenged developed markets”.

The worry, he says, is that Asian reserves held in US dollars or euro are at risk of suffering losses. There are $6.4 trillion worth of Asian central bank reserves. On average they invest 85% of these in developed-market debt. Cheung worries that such reserves will suffer up to $1.5 trillion of losses over the next five years, or a 4-6% loss per annum, assuming regional currencies appreciate against the greenback and euro. That argues for greater diversification into Asian fixed income.

The ADB is trying to improve liquidity in Asian bond markets by launching a credit guarantee and investment facility. It will provide guarantees on local currency-denominated bonds issued by the region’s corporations. This facility is slated to launch with $700 million, a modest size to test the waters.

“The question is how to go from there, and then we have to understand the demand, the role it can play in the context of market development,” says Noritaka Akamatsu, deputy head of the office of regional economic integration at the ADB.