Emerging East Asia remains vulnerable to a shift in investor sentiment when the US eventually scales back its asset purchase program and as it tackles still-unresolved questions over its government debt ceiling, the report warns. Volatile capital flows make it tougher for policymakers to manage the economies while looming tighter liquidity could push down asset prices, particularly in the property sector, undermining the health of financial firms with large holdings.

Despite the market uncertainty, emerging East Asia’s local currency bond markets expanded 2.4 percent quarter-on-quarter with USD $7.1 trillion in bonds outstanding at the end of September. The growth was led by Indonesia, up 3.9 percent, the Philippines, up 3.6 percent, and the People’s Republic of China (PRC), up 3.0 percent. The emerging East Asian bond market was 12.5 percent bigger than a year earlier.

The region’s government bond markets grew 2.1 percent on quarter to USD $4.4 trillion, up from the quarterly growth of 1.1 percent in the April through June quarter. The corporate market increased 2.9 percent to USD $2.7 trillion, slower than the 8.0 percent expansion in the previous three months.

At the end of September, the outstanding stock of Thai baht-denominated bonds stood at THB8.9 trillion, or USD $285 billion, 0.2 percent more than at the end of June and 8.8 percent more than at the end of September 2012. Gross issuance fell to USD $63 billion in the third quarter from USD $79 billion in the second quarter.

Market returns have improved somewhat in recent months. Year-to-date returns on the Pan-Asian Index for local currency bonds were still down 1.6 percent on a US dollar unhedged total return basis as of 18 October, but that was an improvement on the 3.5 percent loss as of 31 July.

The report’s annual liquidity survey showed concerns about when the USA would start to shrink its asset purchase program was the main factor affecting local currency bond market liquidity.

Respondents continue to point to limited investor diversity as the key factor holding back market liquidity. Although government bond trading desks remain the key drivers of trading in the region, the report noted that institutional investors such as pension funds, insurers, private banks, and asset management firms are becoming increasingly important. Other factors include limited hedging mechanisms, transaction funding, foreign exchange regulations and transparency, settlement and custody, and tax treatment.

Emerging East Asia comprises the PRC; Hong Kong, China; Indonesia; the Republic of Korea; Malaysia; the Philippines; Singapore; Thailand; and Viet Nam.

This article was first published by the Asian Development Bank