Beware of I’s India and Indonesia bonds continue to face headwinds HSBC

Beware of I’s
India and Indonesia bonds continue to face headwinds
Heightened FX volatility and wider current account deficit
make India and Indonesia bonds most vulnerable in Asia
Indian bond markets remain vulnerable to tight liquidity
conditions despite latest steps to stabilize long-term yields
Heavy bond supply and rising inflation are key risks for
Indonesia bonds

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The beginning of the withdrawal of excess global liquidity has varying ramifications for
Asian bond markets. India and Indonesia are the most exposed as they rely on foreign
investments to finance wider current account deficit. This is already reflected in the
significant currency weakness, surge in local government bond yields and outflows from
the bond and equity markets. Uncertainty over domestic policy responses for these two
key countries is set to linger while market expectations of a tapering in the Fed’s bond
purchase programme, set to intensify ahead of the FOMC meeting on 17-18 September,
will weigh further. Policy responses in India and Indonesia so far have been to tighten
liquidity or encourage foreign inflows. More tightening measures are likely, which would
place further upward pressure on government bond yields (Figure 1). Yet, with economic
growth still fragile, it is hard to envisage a sustained tough monetary policy stance.
Between the two countries, Indonesia has a far better balance of economic growth and a
greater chance of revival in the event that the valve of FX weakness and further policy
tightening is allowed to run its full course to tackle the current account deficit. Despite the
more generous valuations, it is far too early to favour either Indonesian Government
bonds (IndoGBs) or Indian Government securities (Gsecs). We retain a marketweight and
underweight recommendation respectively (Asia-Pac rates: The risk of higher US Rates).
There is a risk that the volatility in these two markets could spill over to the rest of Asia
and other EM rates markets if capital controls to limit outflows are implemented. Our
base-case scenario is that strict capital controls are unlikely, nor is a rerun of the Asian
financial crisis 1997/98, as Asia is in significantly better shape.

Further measures to encourage inflows both in the bond market and other capital are more prudent than
attempts to curb outflows. Unfortunately, they are no replacement for allowing currency weakness to
gradually address the current account deficits. In the unlikely event that capital controls on outflows are
imposed (see Table 1 for historical precedents), significant alarm bells would be raised across the region
and beyond. From an elevated international bond holding perspective and extent of recent currency
weakness (page 2, Figure 2) the Malaysia Government Securities market may be vulnerable to contagion
and higher US Treasury yields despite sound domestic fundamentals. Korea, Thailand, and the Philippines
(local currency government bonds rather global peso notes) are more resilient to the withdrawal of US
liquidity and EM volatility and are likely to trail the broad rise in yields. These markets are less sensitive
to outflows from offshore bond investors and, in the case of Korea, could continue to be a recipient of
safe-harbour flows.
Indonesia: Where fair values no longer matter
Indonesia’s current account deficit widened to a record wide of USD9.8bn in Q2, nearly 70% larger than
that of Q1 (USD5.8bn). This deficit is equivalent to 4.4% of GDP, bringing the severity of its current
account deficit close to that of India’s which stood at 4.8% of GDP in FY12/13. The good news is that the
worst of the current account deficit may be behind us as the deficit for the second half of the year should
be smaller following the fuel price hike in June. In addition, the ongoing controlled depreciation of the
rupiah could also reduce non-oil import demand and in turn, reduce the current account deficit. However,
the coast is not yet clear as there are other factors like bond supply, foreign reserves and inflation to be
concerned about. HSBC FI Research retains a neutral stance on IndoGBs, awaiting potentially better
entry levels towards the end of September.
The last time Indonesia held a conventional bond auction was on 30 July and the next auction is due on
27 August. The auction on 30 July received IDR27trn worth of incoming bids, the largest demand since
14 February 2013. Due to the Idul Fitri holidays, there was a scheduled three-week pause in conventional
bond supply and this is the key reason why the auction was well received. The temporary positive supply
dynamics is however, coming to an end as the auction schedules resumes next week. The government has
an uphill task in terms of funding as it has only reached 55% of its full-year funding target, making this
the primary reason for our call to wait until at least the end of Q3, to further judge the issuance progress,

before re-entering the market. Investors should also note that as the rupiah depreciates, the government’s
oil subsidy bill could increase, resulting in a wider-than-expected fiscal deficit and hence, even more
bond supply.
There will be mild positive support for the bond market when IDR4.4trn of FR49 (originally a 5-year
bond) matures on 15 September. Yet, this amount is tiny compared with the current weekly auction size
of close to IDR10trn. Bank Indonesia could also support the market via its purchases. However, such
buying is difficult to pre-empt, and data as of 16 August suggests that the central bank has not been
buying aggressively.
Foreign investors are highly unlikely to meaningfully add to Indonesian bonds at this juncture as inflation
concerns persist. Assuming that inflation rises 1.3%mom in August, the year-on-year print could reach
8.99% (July: 8.6%yoy). The schedule release of August CPI is on 2 September (Page 5, Figure 5). The
drop in foreign exchange reserves from USD98.1bn in August to USD92.7bn as of July is also worrying
(Figure 3), particularly given the fact that the country’s dollar bond issuance and the central bank’s FX
swap auctions in July should have boosted the reserves. It is for these reasons that foreign investors have
reduced their holdings of government bonds from a peak of IDR306.6trn on 16 May to IDR285.7trn as of
16 August. Correspondingly, their market share has also slipped from 34.6% to 31.2%. Data over the past
two weeks suggests that foreign holdings have been stable but this may not be an accurate reflection of
investor sentiment as it has been relatively more difficult to obtain dollars during the liquidation of
Indonesian bonds than in other markets due to the stronger dollar demand in the market. Foreign demand
for domestic bonds is expected to remain weak as investors move out of markets like Indonesia and India
(Page 5) in favour of more stable markets such as Korea (Page 5, Figure 4). Going forward, the release of
FX reserve data in early September (Page 5, Figure 5) will be closely watched.
India: Tighter liquidity conditions likely to prevail
Government of Indian Securities (Gsec) yields were rather resilient from May and mid-July, despite the
rise in US Treasury yields (Page 1, Figure 1). It was the introduction of liquidity tightening measures by
the Reserve Bank of India (RBI) on 15 and 23 July that led to a sharp rise in bond yields. 10-year Gsec
yields have surged higher from around 7.5% in mid-July to over 9%. Until there are signs that the recent
tightening measures will be rolled back, there is unlikely to be a reversal of this trend.

On 20 August, the RBI announced the buy-back of INR80bn of long-dated Gsecs in order to stabilise the
long-dated bond yields. It also indicated that it may scale down the issuance of Cash Management Bills as
required in order to keep the overnight rate at around Marginal Standing Facility (MSF) rate at 10.25%.
Additionally, banks were allowed to keep bond investment holdings of 24.5% of Net Demand and Time
Liabilities in held-to-maturity (HTM) segment to avoid booking large mark-to-market loss. Banks are
allowed to transfer excess bond holdings in Available for Sale and Trading categories to HTM segment
and given an option to value these holdings as on 15 July 2013. Earlier regulation required banks to
reduce the holdings in HTM category from 25% of NDTL to 23% of NDTL in a phased manner. It will,
however, be premature to consider these moves as a roll-back of previous measures as RBI’s objective is
still to maintain higher short term rate and tighter liquidity conditions.
Even though these steps may provide some temporary relief to bond markets, this may not be enough to
discourage banks from paring bonds holdings. The overnight call rate has been hovering around 10.4%
and banks are borrowing more than INR400bn from the RBI’s Marginal Standing Facility at 10.25%. To
avoid borrowing funds at this penal rate, banks could move to liquidate their Gsec holdings which are in
excess of the mandatory Statutory Liquidity Ratio (SLR). This is estimated to be around INR5trn.
In the near-term, Gsec yields will remain strongly coupled with the USD/INR level. The liquidity
tightening measures were implemented to check rupee depreciation. However, despite this, rupee
weakness has intensified, increasing the possibility that these measures could remain in force for longer.
The Indian rupee has depreciated by around 12.5% against the US dollar since early May and USD/INR
has reached a record low of above 63.00.
The current inflation situation is also not helping. WPI increased by 5.8%yoy in July, up from 4.86%yoy
in June, led by higher food and fuel prices. Even though the rise in food prices was the result of crop
damage and is likely to subside on the back of a good monsoon, higher fuel price and imported inflation
are possible with the rupee weakness. According to the RBI’s estimates, a 10% depreciation in currency
could lead to a 1% increase in WPI. Rising inflation risks will further reduce the possibility of looser
monetary conditions in the near future. The incoming RBI governor Dr. Raghuram Rajan could signal
such stance at his first MPC meeting on 18 September (Page 5, Figure 5).
Expectations of the Fed’s tapering of its QE program have intensified concerns over the financing of the
current account deficit in India. According to the Ministry of Finance’s estimates, India will need around
USD70bn of funds in FY13/14 versus USD88bn in FY12/13 to finance the current account deficit (CAD).
Even though recent curbs on import items such as oil, gold, and non-essential imports may help to lower
the CAD, it will still be difficult to finance USD70bn without foreign portfolio/direct investments. Yet,
such investments may be difficult to attract given the current weaker demand for EM assets and the lack
of clarity on India’s reform process following the general election which is due by May 2014 (Page 5,
Table 2). As such, the rupee may continue to weaken on the back of these concerns which would prove
detrimental to the bond market. There is also a limit to the degree of central bank intervention in the
currency market as total FX reserves (USD254bn) amount to only six months of imports. The political
timetable is also not conducive for immediate reforms with elections looming for India and Indonesia and
greater temptation for short-term populist measures. Fortunately, elections have already either been held
as in the case of Malaysia in May or remain some time away for others, providing more leeway for
structural policy changes if required (Page 5, Table 2).
Even though India has finished around 78% of its planned issuance programme (INR2.4trn) between
April and September, there are still five bond auctions totalling INR780bn before the end of September.
There will be little demand at these auctions given the acute liquidity shortage in the banking system.
Weak investor appetite was evident at the Gsecs auction last week where INR14bn out of INR160bn
supply was devolved onto primary dealers. As such, some of the planned borrowings could be deferred to
the second half of the fiscal year as it will be difficult to raise the required amount without significant
devolvement. The borrowing programme for the next half of the fiscal year (i.e. October 2013 – March
2014) will be announced in late September. Though the issuance programme is likely to keep the total 2H
FY13/14 bond issuance at INR2.5trn versus INR3.5trn in March-September period, it is more likely to
concentrate issuance during the later part of the year.
Some market participants are also speculating that the RBI may introduce capital control measures for nonresident Indians after it announced several measures to restrict outflows from resident Indians on 14 August.
Such restrictions cannot be completely ruled out considering that foreign investors hold outsized investments
of around USD139bn in Indian equity markets. However, there is a very low possibility of any such moves
in the bond market, as foreign flows are moderating following the massive outflow of USD11.4bn since
21 May. In addition, the government had previously tackled similar situations by introducing measures
aimed at increasing foreign inflows into the bond markets rather than restricting outflows.