Asia cenbanks turn to bond playbook to buttress FX reserves

Policymakers in Asia's emerging markets are turning to unconventional tools to protect their currencies as well as foreign exchange reserves amid capital outflows spurred by fears over higher-for-longer US interest rates and rising global tensions.

Central banks have spent this year defending their currencies against a strong US dollar, paring foreign exchange reserves to multi-month lows in the process. Although foreign exchange reserves are still sufficiently high to cover imports in many emerging markets a consistently strengthening dollar due to a widening Middle East war could soon change the dynamics.

As such, deploying forex reserves have struggled to soothe market nerves and contain capital outflows warranting a change in tactics, for example by selling central bank bonds, to reassure global investors.

Analysts at JP Morgan estimated Asian central banks, excluding China, have sold more than $30 billion of reserves in the past two months to stabilise currencies.

But that intervention has done little to calm investors worried about diminishing returns in emerging markets as dollar yields rise and currencies weaken.

Asian currencies are especially exposed to outflows as benchmark rates in the region are generally lower than their emerging peers, resulting in a wider differential with the US. 

Official data showed a net outflow of $2.7 billion from Asian local currency bonds in August as bond markets in Malaysia, Indonesia, South Korea, India and Thailand clocked their biggest net sales since October 2022.

With the central banks holding off on interest rate increases and corporate bond sales surging, policymakers are intervening by issuing their own bonds. The Reserve Bank of India said this month it's looking to sell more bonds to soak up cash, which should bolster the rupee. Their Indonesian peers in September issued a new line of debt to attract inflows. China is selling a record amount of local-currency sovereign debt offshore to raise yuan demand.

Indonesia and India are issuing more of their higher-yielding bonds to encourage inflows, which "is a new way where they can still support the currencies without having to use foreign-exchange reserves," said Eddie Cheung, a senior emerging markets strategist at Credit Agricole CIB in Hong Kong. "That's playing it quite smart."

Resorting to market operations and debt sales is one way out of the dilemma of having to choose between allowing a currency to weaken, burning through reserves, or raising rates and crimping economic growth.

Foreign exchange reserves have dwindled across the region. South Korea's reserves stood at $414.12 billion at September-end – the smallest amount since October 2022, while Indonesia's reserves fell to $134.9 billion last month, the lowest since November.

India's foreign exchange reserves stood at $584.74 billion as of 6 October, the lowest in more than five months.

Not all of the change can be attributed to intervention, though, as the dollar's rise has also eroded the value of other currencies held by central banks.

But gyrating currencies and the challenge of fighting an unstoppable and forceful dollar rally have also hamstrung any hope of monetary policy easing in most of Asia this year.

Aninda Mitra, head of Asia macro and investment strategy at BNY Mellon Investment Management, said it was not a surprise that rate cuts in Asia are off the radar this year and seem to be getting pushed into 2024.

"The reality is FX intervention will tighten liquidity... That completely works against what you are trying to accomplish via a rate cut. So why even bother?"

And yet, while reserves have fallen, they are above levels seen in October last year and still leave central banks with ample ammunition.

Bloomberg's dollar index has surged more than 6% from its July low as traders have boosted bets on higher Fed rates amid sticky inflation and robust US economic data. At the same time, the war in Ukraine and the Israel-Hamas conflict are pushing up oil prices, driving haven demand for the greenback.

The outlook for Asia currencies is a big deal for global emerging-market indexes. The yuan, rupee and rupiah have a collective weighting of 45% in the MSCI EM Currency Index. The government bonds of China and India make up a combined 22.2% of the JPMorgan Government Bond Index-Emerging Markets, according to a representative from the US bank.

Depleting stockpiles

India's falling foreign-currency reserves suggest the central bank has been dipping into its stockpiles this year to bolster its currency. Policymakers took another step at their Oct. 6 meeting by announcing a potential bond-sale plan to mop up extra cash and support the rupee by pushing up yields.

The measures employed by India so far have largely succeeded as the rupee has been virtually unchanged this year even as most of its emerging peers have weakened.

Indonesia's central bank began selling so-called Bank Indonesia Rupiah Securities in mid-September with the goal of luring in more inflows. The bills, known as SRBI, allow global investors to take short-term currency risk exposure. They were introduced as the nation saw outflows of $1.1 billion from Indonesian bonds last month, the most in almost a year.

'Creative complements'

The measures from India and Indonesia "make for very creative complements to currency support that also take into consideration judicious use of FX reserves," said Vishnu Varathan, head of economics and strategy at Mizuho Bank Ltd in Singapore. "Especially given that reserve drawdown can be a double-edged sword that suddenly accentuates a selloff if it presents worries about a possible cash-burn."

China is employing a range of measures to buttress its currency. The government this week announced a 26-billion-yuan ($3.6 billion) issue of yuan-denominated sovereign bonds for this quarter, boosting its 2023 total to a record 55 billion yuan. Investors see the main goal of the issuance is to support the yuan by raising demand for the currency.

The People's Bank of China last month intervened in the offshore yuan market, increasing the cost for banks to borrow the currency from each other in Hong Kong to make it less attractive to bet against it.