As 2015 business gets fully under way, bond investors face a major divergence in world central bank policies: the US Federal Reserve is moving closer to monetary tightening, while the European Central Bank (ECB) has just launched an aggressive asset purchase program with an open-ended commitment and the Bank of Japan (BoJ) continues to gobble up large chunks of Japanese government bonds.

A few months ago, the potential windfall for Asia from the global quantitative easing (QE) race appeared confined to some spillover portfolio flows from Japan. But the ECB’s aggressive easing has raised the prospect for a greater positive impact, given the dominance of European investors in many Asian bond markets. Moreover, Asia would also benefit from inflows through the bank credit channel, given European banks have been a key external funding provider in the region.

EU Bond Investors’ Presence Grows

Even prior to the ECB’s latest easing, European investors were expanding purchases of foreign debt securities, which accelerated in early 2014 (Display 1). In fact, the EU has surpassed the US as the largest bond investor in the region over the past few quarters. Overseas portfolio investments by US investors, which have mirrored the Fed’s balance sheet expansion over the past several years, have moderated after the Fed began tapering its QE3 program. while Japanese investors’ foreign-asset buying has remained modest despite the BoJ’s aggressive QE.

So far, portfolio outflows from Europe have been driven primarily by interest-rate differentials, especially after the ECB pushed its deposit rate into negative territory in June 2014. The euro area’s monetary base has remained largely flat over the past two years, but now the ECB’s balance-sheet expansion is likely to provide an additional impetus for portfolio outflows.

EU investors have always been among the largest players in Asia, even though the ECB has lagged well behind the Fed and the BoJ in recent years in terms of the scale of its quantitative easing (Display 2). Even after excluding a significant portion of the flows from Luxembourg—the country is a global hub for investment funds, and the ultimate holder of debt securities would be hard to track—the EU’s investment position in the Asian bond market was still larger than that of US investors and more than double that of the Japanese as of end of 2013. Accelerated foreign bond purchases by European investors over the past few months may have further widened their lead.

Potential Winners

Within Asia, bond markets that are likely to benefit the most from the policy divergence would be those with less reliance on US investors (and thus less exposed to a Fed tightening) and those in which European and Japanese investors have a greater presence.

Traditionally, European investors have had a large presence in Indonesia. Even after excluding Luxembourg, the EU accounts for one-third of foreign holdings in Indonesia’s bond market (Display 3). Bond markets in Thailand and Malaysia also enjoy a greater presence of European investors, although foreign participation in Thailand’s bond market is smaller than in Malaysia or Indonesia.

By contrast, the Philippines and South Korea have a greater exposure to US investors, while India has less exposure to investors from all these major economies.

While many factors may affect European investors’ asset allocations to individual markets, the pattern of current holdings at least indicates those investors’ traditional preference and should help to identify the markets with better prospects of receiving increased inflows. Markets with a greater participation of European and Japanese investors are also likely to face less rollover risk for maturing debt.

Benefits from Banks Credit Channel

Flows from Europe are not limited to portfolio investments. European banks have had the greatest share of external lending in Asia over the past few years (Display 4). Their total exposure has been little changed since the European sovereign-debt crisis, but now with the ECB expanding the monetary base more aggressively, more external leakage is likely. Japanese banks’ Asian loan books expanded significantly after the BoJ stepped up its monetary easing. The fresh European flows would help offset an otherwise decelerating credit cycle in the region.

Thailand and Malaysia may be the main beneficiaries of the current global monetary policy backdrop, given that these economies rely more on credit provided by European and Japanese banks and less on that from US banks (Display 5). Taiwan and South Korea are mixed cases, as they are also reliant on US lending and may be vulnerable to a Fed tightening.

Hong Kong and Singapore, Asia’s main financial centers, have seen a noticeable increase in European banks’ credit over the past two years. That may be reflecting European lenders’ preference for larger corporations that have regional headquarters in those cities or are more actively involved in capital-market transactions.

Bottom Line

All in all, given the strong presence of European investors in Asian bond markets, the impact of increased ECB liquidity is worth paying attention to in the coming months. Along with other positive factors— such as lower inflation expectations and increasing odds of more accommodative central bank policies in the region—it may provide additional impetus for local bond market performance. Because of a greater exposure to EU and Japanese investors and less reliance on US money, ASEAN markets—particularly Indonesia, Thailand and Malaysia—may be better positioned than their other regional counterparts, in our view.

By Vincent Tsui, Economist—Global Economic Research and Anthony Chan, Asian Sovereign Strategist—Global Economic Research, AllianceBernstein

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