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The changing landscape of international debt flows: rising bond issuance amid declining bank lending

Dilek Aykut's picture

We have just launched our first Financial Market Outlook publication. The publication analyzes global financial market trends and provides a forecast of capital flows to developing countries.

One of the issues we have discussed in this edition of Financial Market Outlook is the changing composition of international debt flows to developing countries. As widely discussed in our bi-annual publication Global Economic Prospects over the last few years, the financial crisis has had a significant impact on developing countries’ access to international debt markets (international bond issuance and bank lending).

As risk-aversion escalated in late 2008, like any other crises before, global investors searched for safer and more liquid assets, which meant a selloff of emerging-market debt that was perceived to be high risk. This led to sharp contractions in bond flows in 2008 and in bank lending in 2009 and increased volatility in most flows thereafter. But the 2008/09 crisis has also had a much more significant impact on developing countries’ access to international debt: developing countries increasingly rely on bonds flows.

This is quite different from what we observed before the crisis. Historically, developing countries have relied more on bank credit rather than bond financing for external financing needs, as cross-border bank lending tended to be cheaper and high-risk developing countries had limited access to bond markets. There are several reasons for that. First, because banks have closer customer relationships with borrowers than bond issuers do with bondholders, banks have an advantage in monitoring creditworthiness and assessing revenue streams, which has traditionally resulted in lower costs and better access for bank loans. Second, countries need to fulfill certain costly institutional and legal benchmarks to issue an international bond—perhaps most notably in the form of a minimum sovereign credit rating. As a result, high-risk borrowers, including sub-investment grade sovereigns and companies and most low-income countries, have tended to have access only to bank financing.

Developing countries’ access to international bank loans has been limited in recent years. While many factors were at play, deleveraging pressures as well as tighter regulations contributed to the weakness in international bank-lending to developing countries. Banking-sector losses associated with undue risk-taking during the boom period have forced banks in the high-income world to strengthen their balance sheet including by reducing their loan portfolios. This deleveraging (reducing loans values relative to underlying capital) has been particularly acute among high-income European banks, because their capital positions were further weakened as the market value of sovereign debt declined and regulatory requirements implemented in late 2011. As a result, international bank lending to developing countries declined—most notably those countries and regions with close ties to European banks.

On the other hand, conditions for international bond financing have been more favorable since the 2008/09 financial crisis as a result of the injection of liquidity into global financial markets, quantitative easing efforts of high-income central banks, and continued improvement in developing-country credit quality (both in absolute and relative terms).

These factors translated into decline in cost of international bond issuance (proxied by 10-year U.S. Treasury bond yield plus the EMBIG cash bond spread). Though the cost of bond financing remains higher than financing via syndicated loans, the gap between the two (with the cost of syndicated lending determined by the underlying benchmark, usually the six-month Libor rate, plus the average spread) has narrowed. The comparable costs have encouraged large developing-country companies to rely on bond financing as a substitute for bank lending.
As a result, developing countries have issued increasing quantities of international bonds. Bond issuance by developing countries in 2012 was the highest yearly volume, while the issuance in January 2013 was the highest monthly issuance ever. As a result, international bond issuance now accounts for more than half of the international debt flows to developing countries since 2009, compared to less than one-third between 2005 and 2008.

Unprecedented investor demand in fixed income markets—supported by G3 monetary easing and increased search for yield—has enabled frontier-market and infrequent issuers to tap the international bond market in recent years, especially since September 2012. For example, several countries have issued their first ever international bonds: Angola and Zambia; Bolivia (the first in 90 years) in 2012 and Belarus, Georgia, Honduras, Mongolia, Montenegro, Nigeria, Tanzania, and Zambia in 2013. Other governments such Papua New Guinea, Rwanda, and Bangladesh are planning to launch their first international bonds soon. 

Will this trend continue? Probably yes in the short-term. Favorable conditions for the bond market are likely to continue in the coming months. There are signs that global investors are going back to equity markets especially in the US and Japan, but flows to EM fixed income funds during the first quarter still remain higher than the same period in 2012.

Bank lending might also increase as there are some indications that the deleveraging by banks has slowed down since June 2012 (increased syndicated loans and improved funding conditions in recent months). That said, the rebound in bank lending this year might be limited given the regulatory changes ahead (Basel III in particular).

In the medium-term, however, the cost of borrowing for both bond and bank financing will increase as developed countries start monetary tightening as low benchmark rates have kept the costs down especially after the crisis. We have discussed some of the policy actions for developing countries in Global Economic Prospects 2010.

Please check out our first Financial Market Outlook publication. Let us know what you think.

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