Visitors to the triple-A rated Asian Development Bank might once have been invited for a leisurely game of doubles before discussing how far through Libor its bonds should trade. How times have changed. The ADB’s tennis courts were converted into car parking space in March, an omen of busier and more troubled times ahead.
International investors clearly take seriously the possibility that one or both of the major rating agencies might downgrade the ADB – and soon. The bank’s benchmark dollar issue, which at launch in June 1997 traded 2 basis points wider than World Bank and 2bp through the Inter-American Development Bank, has been tremendously volatile. At one point in March the ADB 2007 traded 13bp wider than World Bank and 5bp wider than the Latin bank. Its 10-year Deutschmark deal has traded 20bp wider than the EIB.
More significantly, the ADB’s most recent deal had to be scaled down dramatically. Originally slated as a $3 billion to $4 billion benchmark, the deal was slashed to $2 billion as a combination of Molotov cocktails, looting and tanks in Jakarta persuaded some investors that a bank which has nearly a quarter of its loans in Indonesia might not be such a stable credit story after all.
After the eventual launch in mid-May, the spread was widened by the lead managers to 27bp over treasuries from 24bp – leaving it 6bp wide of the World Bank, an institution whose issue spread it has always tried to match. ADB funding head Peter Balon – whose borrowing target has surged to $9.5 billion this year – describes the deal as a “market friendly transaction” and comments: “Amidst all that is happening in Asia we have a lot of work ahead of us, but we are proud and confident of our credit credentials.”
Others are not so confident. They point out that the ADB has a high concentration of risk in a number of the most troubled Asian countries. Its biggest exposures are to Korea (12%), Thailand (8%), India (17%), Pakistan (9%) and Indonesia (23%). Should a scheduled $1.5 billion loan to Indonesia be approved, its exposure to the most troubled of Asia’s borrowers will rise to 25%.
The general collapse in credit quality in Asia has shaken the bank’s portfolio. Now some 67% of its loans are to non-investment-grade countries. Before the crisis that percentage was just 28%. One banker asks: “What’s the creditworthiness of these loans? Is the portfolio going to deteriorate?”
Indonesia in trouble
President BJ Habibie’s new Indonesian government certainly faces acute problems. One foreign diplomat has been told by “knowledgeable insiders” that the rupiah and the foreign-currency reserves have dropped to levels that make essential imports impossible to come by and put the country “one week from insolvency”. Most forecasts reckon the Indonesian economy will contract by well over 10% this year.
According to ADB’s annual report the bank has disbursed $8.2 billion to Indonesia. Cumulative net effective loans stand at $12 billion. This disbursal number will rise further should a new $1.5 billion loan be approved. (This approval was meant to take place at the bank’s May 15 board meeting – but was “deferred”.)
In theory the bank could lend 100% of its loan book to Indonesia. Unlike the World Bank it doesn’t have a single-party lending limit (in the World Bank’s case it is 10%). Loans to Indonesia have at times touched 30%, although if the $1.5 billion is approved the percentage will rise to 25%.
“We reckon 25% is about the limit to any one borrower,” says Bong Suh Lee, one of the bank’s three vice-presidents.
Normally the bank would lend $1.1 billion to Indonesia a year. The bigger $1.5 billion awaiting approval was hit upon in view of the crisis. “This seemed to us to be about right,” says Paul Dickie, the director responsible for infrastructure, energy and financial sectors (east), who has spent a lot of time in Jakarta recently.
“I’m not having sleepless nights worrying over repayments,” says Dickie, who notes that 25% of the bank’s Indonesian loans are to the power sector, which is “the greatest worry”. He says the situation is particularly serious in Java: “They’ve particularly overbuilt capacity in Java and the loans are typically in dollars. They are not able to service current loans at current [power] tariffs.”
The state-owned power company PLN is the recipient of many of the loans. “PLN was adequately servicing debt when the rupiah was at Rp2,450 [to the dollar],” he notes, adding that because of devaluation it has faced problems. He says it has continued to service the debt but with “ad hoc arrangements”.
If PLN stopped paying, he says, the obligation would transfer to the central government. He also notes that the bank is proactively cancelling loans that it now feels inappropriate and is channeling the money elsewhere. “At one extreme,” he says, “we put in place port expansion projects in eastern Indonesia. We were looking at traffic forecast growth of 10% per year out to 2005. Now those growth rates are not there.” The loan has not yet been disbursed. “We approved the expansion in good faith, but we can beneficially cancel the loan.”
When asked how much Indonesia’s debt repayments are per month, Dickie replies he’s never been asked that question before, but gets out a calculator and starts to work it out. He figures it’s about $55 million.
Korea – to which the ADB lent $4 billion last year – may have successfully negotiated the first stage of its rehabilitation but has many problems still to solve. The possibility of labour unrest, a heavily contracting economy, and further chaebol bankruptcies over the summer loom heavy. According to some calculations the Korean economy needs $100 billion in fresh equity capital if it is to meet the goal of reducing the chaebol’s debt to equity ratio from 500% to 200%. Moreover the Korean banking sector is riddled with dud loans – quite how many no one knows.
If more than one-third of the ADB’s portfolio is exposed to two crisis-ridden countries, what of the rest? The Indian subcontinent has also gone radioactive – literally. India’s decision to test nuclear weapons has thrown up another problem for the ADB just when it didn’t need it. According to the United State’s 1994 anti-nuclear proliferation law, the US will veto any fresh lending by the World Bank, and by extension the ADB, to India. According to one former ADB staffer, the US’s 16.05% shareholding – which equals Japan’s – gives it the power to veto any new loan.
India’s nationalist government has already shown its contempt for international opinion. If the nationalists equate the development banks with their main sponsor – the US – will India keep up repayments on ADB and World Bank loans? Perhaps it will take a tit-for-tat approach. Until new loans are approved in the normal fashion, old loans won’t be serviced.
If Pakistan tests a nuclear device, then it too would be cut off and might take the same line. This combination would send 26% of the ADB’s loan book into default.
No credit culture
The bank’s lending policy has not, up till now, paid much attention to credit quality. As well as the lack of formal lending limits, the bank has not priced credit into its loans – instead lending to all its borrowers at the same rate – a flat 40bp over cost of funds. This may be changing.
When Korea asked for a $4 billion emergency loan at the end of last year it wanted floating-rate money. Usually the ADB lends fixed. So the loan was made at Libor plus 40bp, which means the bank is making more than its usual 40bp spread. That’s because it can borrow at Libor less 15bp or thereabouts. This is currently the bank’s most profitable loan and will boost net income, which last year stood at $467.9 million. That said, it is not clear whether the extra 15bp was deliberately extracted as a risk premium or whether the team simply adds 40bp to whatever benchmark index is chosen.
As the credit quality of its key clients has plunged, the bank’s lending to them has ballooned. Disbursals increased 106% in 1997 to $5.3 billion. As a result of this its own borrowing programme has also been revised up. In an average year the ADB will borrow around $3 billion. This year it plans to borrow $9.5 billion.
All this means Peter Balon has to work harder than ever to keep investors happy. In March he went on an international roadshow. It was probably long overdue. “Normally Balon would talk about how his credit was better than the World Bank and I and everyone else would fall asleep,” recalls one banker. “This time people were considerably more interested.” The most frequently asked question was: “Do you expect to ever have a loan default,” to which Balon answered no.
In a conversation with Euromoney Balon goes through the flip-book he prepared for this roadshow. He doesn’t mince his words: “I don’t see any justification at all, or potential, for a downgrade. If we got to a situation of sustained non-accruals or were continually making a loss, then maybe.”
In fact, he points out, the ADB is a fundamentally misunderstood credit. For one thing, it has never had a public-sector default in the whole of its 32-year history and public-sector loans comprise 98% of the loan book.
Balon is keen to correct the market’s perception that the ADB has a lot of exposure to Indonesian corporates. It does have private-sector loans – and it is here where non-accruals crop up – but at 2% of the portfolio it is a tiny exposure.
On most counts the ADB looks better than the World Bank. Take, for example, those non-accruals. In fiscal year 1997, the ADB’s non-accruals totaled a mere $41 million. This is considerably less than the World Bank’s $2.3 billion of non-accrued loans – and comprises only 0.22% of the loan portfolio.
It is also less geared than the World Bank. I’s ratio of disbursed loans to paid-in capital and reserves is 202%, where the World Bank’s is 403%.
It’s interest coverage ratio is also superior. As of December 31 it was 1.55 which means its net income is over one and a half times as big as the financial expenses on its borrowings. In the World Bank’s case it is 1.2.
Probably the most important number is the risk asset coverage ratio. This is a multilateral bank’s equivalent to a commercial bank’s capital adequacy ratio. It measures the ability of the institution’s capital to support its sub-investment grade assets. Before the crisis the bank’s ratio was a comfortable 203%. With the region’s slip down the credit scale this number is 75%. However, this is still better than the World Bank, which has a risk asset coverage ratio of 35%.
Two-thirds of the ADB’s income generation is from the loan portfolio. A quarter of that is Indonesia. So if Indonesia defaulted, net income would fall by 18%. According to Balon, interest coverage would still be above one. “Our interest coverage ratio will be kept at 1.31 as a policy objective. We can do that by adjusting our lending spread.”
The bank deems a public-sector loan impaired if its principal and interest have not been paid for one year. Only then would it need to provision for it.
Fortunately the bank’s long record of profitability and prudent management mean the reserves are well funded. The bank has about $6.6 billion of reserves – which as one banker put it, “is the front line of defence”. That means that even if Indonesia defaulted on all its outstanding loans, the bank could absorb a major portion of the loss through the reserves. The rest would eventually hit the bank’s equity.
But the likelihood is that if Indonesia is going to pay anyone, the ADB is high, if not highest on the list.
Says Goldman Sachs economist Donald Hanna, “The IADB and the World Bank were always paid in Latin America in the 1980s. Why? Because the failure to repay a few hundreds of millions [in interest] would jeopardize billions more in fresh disbursements.”
Additionally, he points out, it is a somewhat trite argument to say just because the proportion of non-investment-grade loans in the portfolio has increased it therefore puts pressure on the triple-A rating. The whole idea of development banks is to lend to countries that are less developed and by definition less likely to be investment grade. Institutions such as the ADB were designed to transfer credit risk from poorly rated borrowers to their highly rated developed world shareholders.
It was a breach of this fundamental mechanism that led to Standard & Poor’s decision to downgrade the African Development Bank from AAA to AA+ in 1995. Although this proved to the markets that development banks are not immune from downgrade, it does not necessarily mean that the ADB is next. In the ADB’s case, its OECD shareholders comprise 65% of the bank’s $46 billion capital base. This compares favourably with the AfDB which is two-thirds owned by African states.
That is not the only difference between the ADB and AfDB. According to S&P there are problems with the quality of the AfDB’s assets. Gross non-performing loans as a percentage of the total loan book have ranged between 8% and 14% in recent years. “AfDB’s weak asset quality,” says S&P in its latest report, “reflects the economic and political difficulties in Africa.”
Those who question the ADB’s triple-A say a key issue is how the shareholders would react to a capital call. If there was a sharp increase in defaults, it would eventually hit the equity. Should it be severe, the bank would – for the first time – have to draw on its callable capital. The paid-in capital is only $3.3 billion. The remainder of the capital base is callable.
There are only two shareholders of any consequence in the bank: Japan and the US. Between them they control a third of the bank’s capital. If they were asked to produce their share of the callable capital it would amount to about $15 billion.
There is good reason to presume that neither country would be particularly happy about this. In Japan’s case, recent calculations are showing that its government debt is spiralling to politically unacceptable levels. One estimate is that Japan’s public debt is 250% of GDP, if outstanding zaito loans to government-funded entities such as airports and railways are included. Considering the public apathy to state-backed bail-outs of the country’s own banking sector, presumably bailing out the ADB would not be particularly popular either.
More likely to baulk at the cash call is the US. The current mood in congress is best described as belligerent, especially in regard to the IMF, where it is blocking an $18 billion capital increase.
This call for fresh capital is one thing. More worrying is fact that the US does not always pay up even when it owes international organizations money. Take, for example, its persistent arrears with the United Nations which involves a sum of just under $1 billion. Just because the US has made a commitment to pay an international institution it doesn’t necessarily mean that Uncle Sam will cough up.
In his closing press conference at the annual meeting, ADB president Mitsuo Sato commented that the next capital increase might have to be brought forward. It was scheduled for 2003, but he suggested it might take place in 2001 instead.
Nevertheless, there are many who think the chance of a downgrade is slim. “I think ADB is a buy to be honest. I think the triple-A will stay,” says Salomon Smith Barney’s rating expert, Stephen Taran – who used to work for both the ADB and Moody’s. Philippe Delhaise, who runs rating agency Thomson Bankwatch in Hong Kong agrees.
“It would raise reputational contagion for other supranationals,” says one Hong Kong based banker, who adds the agencies would have to think long and hard before they took such a politically-sensitive step.
Senior figures in the ADB give the idea short-shrift. US board director Linda Tsao Yang thinks it “absolute nonsense”. She continues: “If anything I think the bank’s rating should be triple A plus.” She adds: “I don’t see any chance of even thinking about a call on the callable capital. It’s as far-fetched as you can think.”
The dean of the Tokyo-based ADB Institute, Jesus Estanislao is equally convinced the possibility is out of left field. “I used to be Philippines minister of finance during the worst period of our debt crisis. Even then we never for a second considered missing a debt repayment to the ADB,” he says.
Moody’s published its latest report on the bank in April and noted: “The bank’s balance sheet will maintain its ability to withstand additional negative shocks because of the strength of its proven record of sound management, its conservative income and reserve policies, and its solid capital position – which is the strongest in its peer group.”
Moody ratings
But the agencies are nervous on Asia. If Moody’s can put Japan on creditwatch with a negative outlook, why not the ADB? Many derided the market-moving announcement in April, and asked how it was possible to reconcile this verdict with Japan’s status as the world’s biggest creditor nation. At the ADB’s annual meeting in Geneva – also in April – former Thai finance minister, Narongchai Akransenee, summed it up when he told an audience “When Moody’s are moody you’re really in trouble.”
Worried about the hammering their reputation has taken in recent months, the agencies are prone to act quickly these days. Pre-emptive strikes are the order of the day. S&P in particular has taken a newly aggressive line on Asia.
The agency’s decision to downgrade Singapore-based Asian Securitization and Infrastructure Assurance (ASIA) in January is particularly telling. ASIA is a financial-guarantee company that offers credit enhancement for securitization transactions and infrastructure debt in Asia. It used its AA rating with S&P to enhance credits as low as BB and give investors comfort. Not anymore. S&P now reckons the firm is only worth a BB itself thanks to its Asian exposure. According to a former S&P employee, who works for one of ASIA’s key shareholders, this is the first time a credit enhancer has ever been downgraded below investment grade. The third-biggest shareholder in ASIA is the ADB, with 13.5%.
If either of the major agencies downgraded the ADB, it would have an immediate impact on its spreads. One estimate given by a top trader in Hong Kong is that a downgrade would lead to an immediate 15bp widening. “It snowballs,” says the trader. “Even if I think it’s silly I may still join in the selling because our stops are triggered and my selling will trigger others.”
Whether it is downgraded or not these are worrying times for an institution used to effortless success. The Geneva ADB meeting must have been the first in history where the number of people from Myanmar exceeded those from Malaysia, according to the official guest list. Attendance at the 1997 meeting in Fukuoka had touched 3,000. Only 1,781 turned up in Geneva – of whom 1,124 were ‘guests’.
At least one person won’t miss the tennis courts. With his borrowing levels trebled to $9.5 billion, funding head Peter Balon won’t have much time for leisure.
