Commentary

Turmoil in global credit markets is taking its toll on Asia’s emerging domestic bond markets, according to the results of the most recent Greenwich Associates Asian Fixed Income Research Study. Asian domestic bond markets grew at a furious pace in the years leading up to the current global financial crisis. Trading volumes in the domestic currency bond markets of countries like China, Indonesia, Malaysia, India, Thailand and Australia/New Zealand increased more than 135 percent from 2006 to 2007 alone. As a result of this expansion, local currency products grew to make up over 50 percent of overall fixed-income trading volume across Asia in 2006 to 2007, up from just 30 percent the year before.The onset of the global credit crisis stopped this growth in its tracks over the past year as local currency bond markets in many major Asian countries experienced severe retrenchment. Domestic currency fixed-income trading volume fell some 47 percent in India and contracted by about one third in China and Australia/New Zealand. These declines shrunk local-currency business to less than a third of total Asian fixed-income trading volume from 2007 to 2008.“The development of these markets represented a profound shift for Asian financial markets,” says Greenwich Associates consultant Tim Sangston. “In the past, large Asian companies that earned most of their revenues in local currency had to obtain most of their long-term financing in dollars or European currencies—which history has proven is a dangerous position to be in. The emergence of thriving local-currency debt markets has been seen as an important new source of stability, but the severity of the current financial crisis leaves the near-term fate of these markets in real doubt.”Surge in G-7 bonds boosts total trading volumeDespite the contraction in domestic markets—or perhaps because of it to some extent— overall Asian fixed-income trading volume (including derivatives) among investors interviewed by Greenwich Associates increased 35 percent to $2.3 trillion in 2007 to 2008. Trading volume in cash bonds was up 15 percent.Much of that growth came about as a result of a surge of activity among institutions in Asian bonds denominated in the currencies of G-3 and G-7 countries, in which trading volumes doubled from 2007 to 2008. “This is a classic flight to quality on an historic scale,” says Tim Sangston. “Institutions are shifting en masse from local-currency bonds to Asian credit products denominated in G-3 and G-7 currencies.”Asian institutional trading volumes in G-3 denominated Asian bonds soared 90 percent to $214 billion in 2007 to 2008. Fueling that growth was a dramatic spike in activity in G-3 denominated investment-grade sovereign/corporate issues, in which trading volume increased nearly four-fold, and in G-3 high-yield bonds, in which trading volumes more than tripled.Overall trading volume in investment-grade credit products issued by companies in G-7 countries increased to $163 billion amongst Asian institutions in 2007 to 2008, up 55 percent from the prior year. Much of that growth occurred in G-7 credit default swaps and index products, in which trading volume tripled year-over-year. Trading volumes in interestrate derivatives also skyrocketed among Asian institutions, more than doubling to $722 billion. “Investors were actively looking to lock in hedges on the back of other investments,” says Tim Sangston.Flight to quality shakes up dealer rankingsRetrenchment in domestic Asian bond markets is having a significant impact on the fortunes of the major broker-dealers competing for the fixed-income trading business of Asian institutions. In short: Dealers that have invested heavily to build a presence in local currency bond markets are feeling some real pain.As part of its 2008 Asian Fixed-Income Investors Study, Greenwich asked nearly 770 institutional investors to name the dealers they use for their fixed-income trading business, to specify how much of their total trading business they allocate to each dealer in specific products and to rate the quality of service each dealer delivers. Based on the results of this research, Greenwich Associates compiles its Dealer Market Share Rankings, and identifies the Greenwich Quality Leaders for Asian Fixed-Income. HSBC rose to the top of Greenwich Associates’ Asian Fixed Income Dealer Rankings in 2007 to 2008 with a 12.1-percent market share in overall trading. Citigroup ranked second in this year’s rankings with 9.6-percent market share in Asian fixed-income trading, followed by Deutsche Bank at a 9.3- percent share.“It is interesting to note that among all the major dealers competing in Asia, HSBC has built the biggest trading franchise in local-currency products,” says Tim Sangston. “But the banks’ strength in other areas and its market-leading scores for overall franchise quality over the course of the credit crisis have enabled it to weather the storm in Asia to this point.”

"The Satyam fraud case illustrates that where there is little separation of ownership and control, minority shareholders need to voice their opinion or run the risk of having their rights significantly compromised," said Lee Kha Loon, CFA, Asia Pacific head of the CFA Institute Centre for Financial Market Integrity, with the release of its study titled "Related-Party Transactions: Cautionary Tales for Investors in Asia".

Western Asset Management, the leading global fixed income manager wholly owned by Legg Mason, Inc., said it is difficult to forecast when the current process of deleveraging will end or when liquidity will return to the marketplace, but policymakers in most countries seem determined to avoid erring on the side of doing too little.

The government announced the FY2009 budget on the evening of January 22, bringing it forward from the usual February timetable in light of the severity of the macro downturn. Overall, the budget is constructive and expansionary in our view. The government expects a fiscal deficit of -3.5 percent of GDP for FY2009 (versus -0.8 percent of GDP for FY2008). For basic balance (which excludes top-ups to endowment and trust funds and net investment income/returns revenue), it expects -6.0 percent of GDP (versus -1.0 percent of GDP in FY2008). Specifically, government revenue is expected to fall from 15.1 percent of GDP in FY2008 to 13.4 percent in FY2009. Total expenditure (including special transfers) is expected to increase from 17.2 percent of GDP to 20 percent of GDP in FY2009. In terms of size, the budget announced is in line with our overall expectation of 3-percent fiscal stimulus (i.e. increase in expenditure), dated January 13, 2009). We maintain our view of -3.5-percent YoY GDP growth for 2009 and +3.0 percent YoY for 2010.

Downgrading 2009 real GDP forecast to -3.8%:Amidst severe headwinds from the rest of the world, we now see a deeper recession for the Hong Kong economy this year, with real GDP contracting by 3.8 percent (revised down from -1.2 percent), with negative growth sustaining for five quarters in both YoY and QoQ terms, in line with our latest downgrade on China. The latest cuts are driven primarily by further weakening in external demand, which is expected to slash merchandise trade flows by more than 10 percent and take Hong Kong’s service exports, a key growth pillar, into negative growth for the first time since 1998. The recovery in 2010 is expected to be tepid at best; we forecast 2.5-percent growth.

The current financial turbulence and threat of a global recession will result in an increase in white collar crime as well as significant changes in how fraudsters operate, according to the newly released Kroll Global Fraud Report. Kroll expects to see an increase in full-scale fraud investigations involving legal disputes, regulatory action and prosecution in 2009 as whistleblowing also becomes more common.

Policy traction over the past year has more resembled the pain and trauma of the medical treatment called traction, rather than the traction of a car’s wheels getting a grip on an icy road! In Asia in 2009, a key differentiator will be successful policy traction. We believe that we are in the midst of the most aggressive policy stimulus in Asia on record. The success of this stimulus, however, will depend on the traction it achieves in a context of record global headwinds. Why Has Policy So Far Failed in Asia? Asia Only Started to Ease 4 Months Ago Whilst the Fed began to ease policy in Sep-07, the first material easing of policy in Asia was a year later! This reflected the inflation threat posed by the record commodity boom, which only peaked in July-08. In addition, until the collapse of Lehman Brothers in mid-September, the economic impact of the US slowdown on Asia had appeared limited.

Barack Obama's rhetoric during the transition period since his election has made it clear that his new administration will take an active approach to address the many current economic issues.

China – 4Q08 GDP (Jan 22): China will release 4Q08 GDP report coupled with a batch of macro indicators. The significant deceleration observed across almost all economic indicators probably slashed overall headline growth in 4Q to around 6.3 percent (vs. +9 percent in 3Q), the lowest since late 1990s. This implies 9 percent growth for full year 2008, down from the recently revised 13 percent in 2007 and below 10 percent for the first time in six years. On the nflation front, we believe that disinflation continued in December across both upstream and downstream. Whilst industrial output growth will likely decline further on destocking ahead of global slump and shipment contraction; retail sales and fixed investment growth probably remained relatively resilient.

As the credit crunch impacts markets globally and the US and Europe experience economic slowdown, Baring Asset Management (Barings) argues there is room for positive surprises in global markets in 2009. At a press conference held on January 14 in the Landmark, Central, Khiem Do, Head of Asian Multi-Asset and Henry Chan, Head of Asian Equities at Barings, highlighted that investors should look to cheap and under owned growth assets for returns in 2009.

Moody's Investors Service says that the outlook for Australia's general insurance industry is stable, but 2009 is likely to prove a challenging year, given the state of the global and local economies.

SGlobal growth environment continues to deteriorate

Singapore, January 07, 2009 -- Moody's Investors Service has assigned a foreign currency rating of B1 with a positive outlook to the government of the Philippines' forthcoming global bond issuance.

People in Hong Kong buy life insurance primarily for wealth accumulation, althoughthere is renewed interest in basic protection, according to a survey on Hong Kong’sinsurance market conducted by HSBC.Twenty-seven percent of respondents bought investment-linked policies, up from 21percent in 2007. Nearly half of new life policies (44 percent) sold in the previous 12months were investment-linked products, up from 42 percent in 2007.Penetration into pure and term life insurance increased to 16 percent in 2008 from 12percent. At the same time, the number of new pure and term life policies in the lastyear climbed to 18 percent, from only seven percent in 2007.Bruno Lee, Head of Liabilities Business and Wealth Management for PersonalFinancial Services in Hong Kong, said: “We believe that Hong Kong people willcontinue to look to insurance for long-term savings and wealth growth despite currentmarket conditions. However, low interest rates, market volatility and slowingeconomic growth are likely to result in a potential gap in family protection as networth declines and a need for more basic and affordable protection plans.”When asked for the reasons why they bought insurance, eight in 10 respondents (79 percent)said they bought life insurance to accumulate wealth—as part of a long-term savings,retirement or investment plan. Seven in 10 said they bought life insurance to provideprotection for the family.Mr. Lee added: “People need not abandon their wealth management goals as they waitfor economic conditions to normalise especially for those with a 10- to 30-yearinvestment horizon. Those looking to accumulate wealth long-term may findattractive investment opportunities when the market recovers especially for thoseunder a monthly investment plan. Investment-linked products will continue to beconsidered for long-term wealth accumulation while annuities, also designed toaddress long-term savings objectives are suitable for people who want the dualcushion of future income and protection.Awareness of annuities remains low among Hong Kong people: only 36 percent (vs 38 percent in2007) of respondents saying they knew about them. Only 5 percent of respondents(vs 5 percent in 2007) have taken up annuities in 2008. Potential take-up of annuities in thenext 12 months doubled to 5 percent, from 2 percent in 2008, according to thesurvey.Self-purchased medical insurance holds steadyHSBC’s 2008 Insurance Monitor showed over half (53 percent) of respondents are coveredby self-purchased medical insurance while only one-third (33 percent) are covered bycompany-purchased medical coverage.Lee says: “The steady penetration in self-purchased medical insurance is a positivetrend especially in the current environment. The threat of losing medical coveragedue to job displacement and increasing mobility underscores the importance oftopping up existing company coverage or securing separate medical coverage.”HSBC’s survey shows that over half of the respondents (54 percent) do not have a budgetfor medical expenses in old age. This is especially true among the most vulnerablesegments – singles aged 18-29 years old (61 percent) and those aged 50-64 years old (54 percent).Among those with a budget in mind, over 50 percent believe that medical expenses inold age will cost over HK$1 million.Six in 10 say they will use their savings to cover for medical expenses in old age,while over half (52 percent) say they will rely on insurance protection. Forty-five percentsay they will use public hospitals and one-third (34 percent) will use their investments.One-quarter will use part of the money saved from their MPF (24 percent) or seek helpfrom their family or children (22 percent).However, less than a third (23 percent) of respondents feel that their current level ofmedical protection will be sufficient to cover over 70 percent of their future medicalexpenses, indicating that many perceive a gap in the adequacy of their medicalcoverage in old age. On average, half of the respondents are willing to set aside belowHK$1,000 a month to save for medical expenses in the future.

Michael Mauboussin, Chief Investment Strategist at Legg Mason Capital Management interviews Doug Erwin, a highly respected paleobiologist at the Smithsonian and a member of the Santa Fe Institute’s resident faculty on the parallels between the biological world and the current market.The extraordinary recent market activity and associated discussion prompted me to pose the same questions many are now asking: – What is the role of free markets? – Can overseers structure regulation so as to encourage progress while discouraging poor behavior? – How can we achieve greater stability, provided that is a worthy goal? Like others, I have opinions on these issues. But as these questions rolled in my mind, it occurred to me that we have a similar system — nature — that has been coping with the very same issues for roughly 3 billion years. That is probably sufficient time to allow for some insights.One of the great aspects of an affiliation with the Santa Fe Institute (SFI) is the opportunity to exchange ideas with world class scientists who are self-selected to be curious about the world. Doug Erwin, a highly respected paleobiologist at the Smithsonian and a member of SFI’s resident faculty, is a great example. (Doug’s full biography is at the end of this interview.) While an expert in his field, Doug reads and thinks broadly and can intelligently discuss just about any topic you can think of.So rather than share my views, I thought it would be useful to interview Doug. Note that I lured him into this discussion precisely because he is not a finance expert. That said, the parallels between the biological world he describes and the markets are vivid and provocative. I begin with a summary of our dialogue, then follow with the complete interview.Summary of ideas: – Parallels between reproductive and investment strategies. Doug mentions three reproductive strategies. The first two, the r-selected and the K-selected, are well known. The r-strategy — have lots of offspring and hope for the best — is similar to diversification. The K-strategy opts for fewer offspring but invests much more in each, comparable to constructing a concentrated portfolio. The third strategy, anti-z, was new to me. That strategy seeks to build reserves in good times to allow for better performance in bad times. This is akin to insurance or, in the extreme, strategies that take advantage of fat-tail events (e.g., deep out of the money put and call buying). But, as he mentions, since crises happen infrequently, most species are unable to adapt to the challenging conditions. – Exogenous and endogenous shocks. Some extinctions are the result of exogenous shocks, like an asteroid hitting the earth. Markets have similar events like terrorist attacks or sharp changes in political regimes. But many extinction events arise from the inner workings of the system: pinpointing a specific cause is a challenge. Likewise, in markets most crises are endogenous, not exogenous. The lethal combination of human nature and leverage assure that excesses — both on the upside and downside — occur periodically. Managing the market requires taming human nature. It is unclear any organizational structure has fully succeeded in that task. – You cannot manage a complex adaptive system. By definition, a complex adaptive system has many interconnections. While financiers and politicians seek to help the system, chances are extremely high that any move will have unintended consequences. Biologists have consistently failed to manage systems like national parks and wetlands where the network structure is, if anything, simpler than that of markets. – Surviving the crisis is different than thriving post-crisis. Because ecosystems are rebuilt after a crisis, those species that survive the crisis may not do well after it. Likewise, following a financial and economic crisis the strategies that worked in a prior time may no longer be in favor. Crises close down old opportunities while creating new ones. Participants who can identify and exploit new niches stand to benefit.

Western Asset Management, the leading global fixed income manager wholly-owned by Legg Mason, Inc., said the worst period of risk aversion is over, and that Asian corporate bonds now offer some of the highest current liquidity premiums with the best macroeconomic fundamentals.“All sectors of Asian local bonds look attractive at current levels. Government bonds have rallied but monetary policy will likely remain loose and inflation should be dampened by lower commodity prices and weaker growth. Sovereign and corporate bonds will likely benefit as positions are reallocated between investors. Default rates in Asia remain low whereas the current prices of Asian corporate bonds imply an unprecedented surge in failures over the next few years. This large valuation gap appears to favor investors,” said Rajeev De Mello, Head of Asian Investment at Western Asset.The global fixed income manager points out that Asia is in a much healthier financial position now than it was during the 1997-98 crisis. Countries have substantial foreign reserves and boast strong fiscal positions, companies have more robust balance sheets and banks are far sounder. Monetary policy-makers also have room to reduce interest rates. This gives the region a better position from which to address the global slowdown. Asia will also be a beneficiary of lower food and commodity prices.“Our short-term outlook for currencies is more mixed as certain countries will likely allow their currencies to fall in order to soften the adverse impact on their export markets. However, massive monetary expansion in G3 countries should have an impact on their currencies relative to Asian currencies. Western Asset believes that the expected decline in risk aversion in the next few months will also benefit those Asian currencies specifically hit in the recent months. Over the medium term, Asia is likely to rotate its growth away from the export sector towards domestic sectors. As that happens, the attractiveness of weaker currencies to stimulate growth will diminish. “Therefore we remain positive on Asian currencies in the medium term. We have increased our exposure to corporate bonds and will continue to scale in issues and sectors where we see extraordinary value. With the recent sell-off, Asian corporate bonds currently offer significant opportunities in a range of subsectors and countries,” De Mello concluded.