By Nachum Kaplan and Umesh Desai
Singapore (Reuters) - The panic that rippled through Asia's markets in May and June might just be a prelude to a more serious capital flight when the U.S. Federal Reserve starts winding down its stimulus measures for real.
How quickly the U.S. Federal Reserve reduces its $85 billion a month of bond purchases, which keep interest rates low, will determine how quickly money is pulled out of Asia.
Countries with large current account deficits where foreign investors hold a significant portion of stocks and government bonds, such as Indonesia, Thailand and Malaysia, look vulnerable, analysts say. Fleeing capital would drive bond yields higher and local currencies lower.
Asian companies that borrowed in dollars but have local currency revenue streams, not uncommon in the property, telecoms and fertiliser sectors, are also vulnerable as are those that have borrowed in the U.S. dollar high-yield bond market.
"Emerging markets have received a quantitative easing boost and when the money gets pulled out, the risks of an accident are high given the very poor secondary market liquidity," said Kaushik Rudra, a strategist with Standard Chartered Bank in Singapore.
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Indonesia's rupiah, the Thai baht and Malaysia's ringgit all fell during the May/June rout and have been under pressure since, suggesting further capital flight would do more damage.
Foreigners own 34.7 percent of Indonesian government bonds, 31.7 percent of Malaysian ones and 18.9 percent of Thai government bonds, BNP Paribas estimates.
These countries have higher foreign exchange reserves than ever but they may not be the central banks' main weapon to support their currencies given the reserves offer limited import cover.
Indonesia has reserves to cover just seven months of imports, Korea eight months and Malaysia nine months, central bank data shows. By contrast, Hong Kong reserves cover 27 months of imports, China 20 months and Singapore 17 months.
"The most aggressive selling in emerging markets has been in those rate markets that offered very attractive yields and fundamentals were not as strong," said Endre Pedersen, fund manager with Manulife Asset Management, in Hong Kong.
"Now fundamentals are playing out. What people are watching are twin deficits (current account and fiscal) so markets like Indonesia and India are vulnerable to any reversal of monetary easing in the U.S.."
Forward currency markets are already pricing in further falls. The Singapore non-deliverable forward (NDF) market puts the rates one year out for the rupiah, ringgit and baht at down 11 percent, 5 percent and 4 percent respectively.
So far, Indonesia's central bank has propped up the rupiah by spending some of its $100 billion in foreign reserves. But it raised its key interest rate on June 13 as the rupiah came under pressure, suggesting it is reluctant to rely too heavily on reserves to defend the currency.
A weak currency also leaves Indonesia's state-owned companies, who owe $20.5 billion and are banned from hedging their foreign debt, exposed to a firmer dollar.
India faces less risk from foreign investors, who own just 6.4 percent of its government bonds. But a record current account deficit of 4.8 percent of GDP in the fiscal year that ended in March suggests the economy's reliance on overseas funding will keep the rupee under pressure. The rupee, which hit a record low of 61.21 on July 8, is trading at 63.80 in a year in the NDF market.
India also has the weakest foreign exchange position among major emerging markets in Asia with reserves covering just six months of imports.
CORPORATE WEAKNESS
The tightening of dollar liquidity in Asia will shut out many companies from capital markets.
Local currency bond markets are liquid but investors are risk averse. Top quality companies can secure funding but firms with low or no credit ratings have to borrow in dollars, often by offering high yields to attract capital.
"A challenge that policy makers and market participants must now address is the need for lower-rated issuers to have access to local currency bond markets," said Surinder Kathpalia, managing director for ASEAN at rating agency Standard & Poor's in Singapore.
"At present, issuers in local currency bond markets, including Malaysia and Thailand, have almost entirely been those rated at the upper end of the credit spectrum," Kathpalia said.
South Korean shipper Hyundai Merchant Marine failed to attract investors in May when it tried to issue a high-yield dollar bond.
Korean media said in June that the country's Financial Supervisory Service, a financial regulator, might ask policy banks to buy bonds from local companies that are unable to borrow or refinance.
Reflecting the global shipping downturn and a weak property market in South Korea, sub-investment grade companies in the shipping, ship building and construction sectors are likely to struggle the most to refinance maturing debts, analysts said.
Indonesia has its share of high-yield borrowers in challenging positions.
Bakrie Telecom, which posted a 97 billion rupiah loss in the first quarter, owes $380 million in high-yield bonds and defied bondholder expectations of a default in May when it made a $21.9 million coupon payment on the bond.
PT Bakrieland Development narrowly avoided default in March on a 280 billion rupiah bond and still has an outstanding $155 million convertible bond.
The convertible bonds are languishing in the mid 60s in the secondary market and the company's share price is 50 rupiah, way below the 255 rupiah price at which the bonds convert to equity.
Shipping firm Berlian Laju Tanker Tbk PT is undergoing a corporate restructuring.
"Among the weaker credits, it will be worth keeping an eye on Bakrie Telecom, which is yet to sort out its cash flow problems," said CreditSights analyst Sandra Chow in Singapore.
Bond performances are weighing on stock returns.
"Equity markets became hostage to a lot of carry trades that were going on in the background," said Sean Darby, chief global equities strategist at Jefferies in Hong Kong, adding that currency weakness was hurting returns on equity investments as much as falling stocks.
In the year to date, all non-Japan Asian equity markets have had net equity outflows with the exception of India and the Philippines. Little surprise that the MSCI Asia ex-Japan index is down almost 8 percent for the year.
"We haven't had people selling good quality stocks. The bottom... is when investors start selling the best of companies, we are nowhere near that. The pain trade hasn't got anywhere near that in emerging markets," said Darby. (Editing by Neil Fullick)