Reliance on External Borrowing

Asia’s frontier-market economies such as Mongolia, Pakistan and Sri Lanka have been frequent issuers in the international bond market. They rely primarily on external borrowings to finance their current account deficits and replenish their foreign reserves (Display 1). Nonetheless, in the current risk-averse market environment and unfavorable funding conditions, these frontier economies are now exposed to refinancing risks.

Of those Asian frontier issuers, we think Mongolia will be the most vulnerable in the coming months. Given that the adverse market conditions may linger for some time, we believe that central banks should lay their hands off their currencies and tolerate market adjustments so as to prevent a further depletion of their limited reserves.

Fundamentals Remain Intact

Purely on fundamental grounds, macroeconomic stability risks for these frontier markets are not too concerning in the near term. In Mongolia, previous tightening efforts are now bearing fruit, while the expanded export capacity thanks to foreign investment-driven mining projects has helped to improve the non-oil trade balance (Display 2). In Pakistan an International Monetary Fund (IMF) program for an Extended Fund Facility (EFF) arrangement remains on track—with budget consolidation, monetary tightening and a foreign reserves rebuild all making progress—even though a decline in exports has kept the non-oil trade deficit elevated.

In contrast, a procyclical policy mix in Sri Lanka deserves attention. A strong rebound in private sector credit growth, together with a populist budget, has buoyed domestic demand and kept the trade deficit wide. Still, despite the rising risks of overheating, subdued oil prices are providing a cushion for Sri Lanka’s external account.

Upcoming Refinancing Stress Points

For now, refinancing external liabilities in these tough market conditions will be a daunting task for these Asian frontier economies.

The good news is that the three countries issued sovereign bonds and acquired foreign currency liquidity to strengthen their reserves in late 2014 and early 2015—before market sentiment turned sour. The import coverage ratios of their foreign reserves remain comfortably above the critical threshold of three months (Display 3).

However, maturing foreign currency debt in the coming quarters will be sizable. The funding requirement is particularly worrying in Mongolia—equivalent to 28% of total foreign reserves in the second half of 2015 and another 13% in the first half of 2016 (Display 4).

Pakistan’s refinancing needs in the coming 12 months are more manageable, at 5% of foreign reserves. Although Sri Lanka’s refinancing needs amount to 17% of foreign reserves in the first half of 2016, the administration can still wait till the end of the year to see if there is any improvement in market conditions.

Mongolia Vulnerable

So, of the three frontier markets, Mongolia faces the greatest urgency to secure foreign currency funding by the end of September. Unfortunately, timing is less than ideal, both in terms of the global market and the economic cycle. A commodity exporter, the country not only suffers from collapsing commodity prices but also from a slowdown in the Chinese market—a dominant export destination. And political uncertainty ahead of a June 2016 election will also keep investors wary in any upcoming sovereign bond issues.

There are limited policy options: the government can approach the IMF as the central bank’s tightening efforts have already met most of the criteria for the IMF program. However, that would be politically tricky ahead of the election, as it implies a failure of economic policies. A more likely outcome would be for Mongolia to tap the market, even at relatively high costs, when the market stabilizes.

Monitoring Sovereign Risks

So, how should investors monitor sovereign risks ahead of likely bond issuances by the frontier-market countries?

For Mongolia, which enters an election cycle, investors should focus on the commitment to prudent policies: Will there be a supplementary budget to cut fiscal expenditure in response to a revenue shortfall when the parliamentary session starts? Will the 2016 budget reflect prudent revenue projections? Will the central bank steer clear of any premature monetary easing?

For Sri Lanka, the central bank’s decision in early September to cease quoting the reference rate and effectively float the currency was a welcome move. A marketdriven exchange rate would act as an automatic stabilizer for import demand. Investors should monitor whether this is a one-off adjustment, and how actively the central bank intervenes in the foreign exchange market going forward.

Meanwhile, with parliamentary elections just finished, the market should focus on whether fiscal consolidation will be back on the agenda. Also, will the administration be friendlier to foreign investors? Will the central bank tighten monetary policy to curb credit growth?

For Pakistan, steady progress in macroeconomic adjustments required by the IMF program will be key. Bond investors should also monitor the execution of a Sino-Pakistani foreign direct investment pact signed in April totaling 20% of Pakistan’s gross domestic product. This holds the key to strengthening the country’s external account, pulling the economy out of prolonged lethargy, and lowering the cost of bond issuance.

Currency as Shock Absorber

For now, central banks should refrain from foreign exchange intervention. Attempts to stabilize exchange rates have already sharply drained reserves over the past several months (Display 5). Given the uncertainty over how long the risk-off market conditions will persist, the central banks should preserve their ammunition and wait for the window of opportunity for a bond issuance to reopen, in our view.

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

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