Asia in Transition

The year 2007 marked a major turning point in the financial world order. The market capitalization of the Americas (USD22.5 trillion), Europe Middle East and Africa (USD20.3 trillion) and Asia Pacific (USD19.7 trillion) were roughly equal. Over the next decade, the Asian markets are expected to continue their phenomenal growth with the expansion of the economies of China and the Indian sub continent as the new engines of growth.

During 2007, the New York Stock Exchange and the London Stock Exchange each grew at a paltry rate of 1.5%. Over the next several years, the US and European markets will be pre-occupied with dealing with the aftermath of the subprime debacle. New regulations expected to be put in place to prevent similar problems will handcuff the principal US and European markets in the same way that Sarbanes-Oxley inhibited US market growth in the wake of WorldCom and Enron.

Asia had always played catch up with the US and European spheres of influence. For a while, Japan rose to financial super power status on the back of the cheap capital that it was able to export. However, the financial deregulation that proved to be its’ undoing, and Japan was brought back down to earth experiencing a “lost decade” where its’ economy stagnated.

We are now seeing a resurgence of Asian strength. This time, the growth is internal. Except for Japan which had negative growth in 2007, the other Asian markets Korea, China, Chinese Taiwan, Hong Kong, Thailand, Malaysia, Philippines, Indonesia, Singapore, Australia, India, and Vietnam all experienced substantial double digit growth.

Of the top 5 growth markets in 2007, the top 4 were in the 2 most populous countries China and India. Shanghai and Shenzhen grew at 303% and 244%, and Bombay and National Stock Exchange of India grew at 122% and 115%.
Of the top 10 markets by capitalization, four were from Asia (Japan, Shanghai, HK, and India). In aggregate, these four markets had capitalization of US$12.5 trillion vs. US$10.1 trillion for EMEA, and US$21.7 trillion for the Americas.

The Asians are Coming, the Asians are Coming!
The largest market, of course, is the US where the NYSE and NASDAQ together account for US$19.6 trillion. However, every day we hear of more fallout from the subprime debacle with US investment and commercial banks losing tens of billions of US$ due to write downs

Morgan Stanley announced a 4th quarter loss of US$3.59 billion, the first in its history, and an injection of US$5 billion. But this time, unlike Citigroup (US$7 billion) and UBS (US$10 billion), it is not the Middle-East cavalry that is coming to the rescue. It is the China Investment Corp ("CIC") the Chinese sovereign-wealth investment fund set up to funnel some of the excess trade surplus dollars back into the world market.

The CIC had previously made a US$3 billion investment as a cornerstone investor in the Blackstone Group's IPO. So far, only a minor portion of the earmarked US$200 billion has been used. The sub-prime crisis has single-handedly changed the landscape of international funds flow and ownership. This is a 180 degree turnaround from just a few short months ago, when the US objected to Dubai buying up US Ports, and to China investing in Unocal. Before that, the US also objected to Hutchison a HK listed company investing the Panama Canal on the dubious allegation that it is a de facto proxy of the Chinese Government. Now, Middle East and Chinese money is welcomed with open arms. Money is green and it doesn't matter if the owner is brown or yellow.

Chinese companies have also invested in Standard Bank (ICBC US$5.6 billion), Barclays Bank (China Development Bank US$2.98 billion), and Fortis (Ping An Insurance (US$2.7 billion). Chinese M&A deal flow has been mostly outwards with the top 5 accounting for close to US$20 billion while the top 5 inflows were a measly US$3.8 billion.
Just as the Middle East is recycling petrol dollars, the Chinese are recycling trade dollars.

Lessons From Asia

The Bush Administration is proposing to freeze the resets on subprime loans in order for borrowers to be able to continue to pay their mortgages. This of course is politically expedient. But is it good economics, some ask. Many have condemned the proposal as going against the original spirit of the contract and therefore will undermine the competitiveness of the US dollar as a store of value, and the attractiveness of the US economy as the storehouse of wealth. Recently, the SEC had given notice that it would strictly enforce “short selling” regulations to ensure that “short sellers” have actually borrowed stock that they are selling.

During the Asian Financial Crisis, the HK government was castigated by many "free market" thinkers for intervening in the stock market to stop speculators using it as a proxy for shorting the HK dollar. Similarly, the Malaysian government was pilloried for imposing exchange controls. In both cases, the governments saw the need to protect the local economy from excessive outside intervention and took the appropriate steps. The current strength of the economies belies the dire predictions of the "learned" community.

Text books on economics are written after the fact. Different people will extract and interpret facts in different ways. In time, some of these lessons will be "Economics 101". People tend to forget the market is made up of individuals who are prone to the emotions of fear and greed.

That's "Market economics 101". Sometimes, it is necessary to take some action that the "pure" economists abhor. The alternative is that we will be faced with a bigger problem of a collapse as borrowers renege, banks start writing off bad debts, and the credit crunch becomes a black hole.

How Will Sub Prime Impact Asia

The subprime crisis will take some time to work its’ way through. There is a real problem in that the underlying assets may not be as good as it should be because mortgage originators have been cutting corners and lending to unqualified borrowers. However, the extent of the problems in the financial market is magnified by the fact that there is no market for the CDO’s securitized by mortgages regardless of the quality of the underlying assets.

So far, we have seen financial institutions writing off tens of billions of US$. There have been delinquencies in mortgage payments but not to the extent suggested by the financial markets which have over reacted as usual. Just because Merrill Lynch (US$15 billion) and Citigroup (US$18 billion) have had to write off tens of billions of US$, the market is expecting every bank to have to do the same.
JP Morgan has just announced write-offs of less than US$1.3 billion much less than Merrill or Citigroup.

The US government has been mulling measures to stave off a recession and a collapse of the housing market.

Tightening in China

The Chinese has a different problem. Instead of trying to stimulate the economy, the Chinese Government is trying to hold back inflation. The Chinese government announced that the banks reserve ratio will be further tighten to 15% in an attempt to rein in inflation. In a mature economy where the deposit base is stable, increasing the reserve ratio will mean less money can be lent out. But in China where the deposit base is growing at double digits, increasing the reserve ratio will very little impact on banks’ ability to lend.

Some people are concerned that exports to the US will fall because the US economy may go into a recession. In looking at exports, we must remember that only a small component of that is value added in China. The rest are raw material and energy costs. Therefore, we cannot compare the entire value of exports to GDP (which measures value added) as some have done.

Using only value added in China, exports are not a large component of GDP. In fact with the Chinese economy expanding at double digits, any shortfall in exports may be made up for by increased domestic consumption.

Analysts have bemoaned the slowdown in profits growth at Chinese companies which fell from 42% for the 1st 6 months of 2007 to 20% in 2008. Anywhere else, a 20% profit growth would have been trumpeted as outstanding. When you have been used to exceptional high growth, it is a big come down to just high growth.


Last year’s profits growth have been boosted by returns from investments in the Mainland stock market. This year, not only have the stock market not grown but in fact had fallen by some almost 60% from the peak. Under fair value accounting, this would have hit the bottom line of companies which are still holding onto the stocks they bought last year. On top of this, there is the surge in oil price to add to costs of operations, and the effects of the blizzards in January and February which greatly affected sales. Not to mention interest rates hikes and a clamp down in bank lending.

+20% growth profits growth with all the bad news is nothing to sneeze at!!!
In the first half of 2008, the shares in Chinese banks have fallen 43% in Shanghai, and 13% in HK wiping out US#300 billion of market value. However, JP Morgan believes that the current sell-off in the Chinese banks is irrational due to misplaced fears over margins, bad debts, etc. according to a recent report.
There remains a lingering economic racism. Asian companies with foreign partners are overvalued vis-a-vis their peers because of the "halo" effect. However, the foreign partners do not have control (either from management or operationally) and can only provide "technical" assistance for new products. The thinking is that with foreign partners on board, the banks are unlikely to make bad loans. Well, the HSBC subsidiary in the US made big bad decisions on subprime too. When banks made bad decisions it doesn't matter who is on board. Without a steady partner, the Asian companies can "cherry pick" and choose the "best of breed" partner for each new product.

Many in the western world point to the “fact” that Asian economies will not be able to avoid tripping into a recession because “when the US sneezes, Asia catches a cold”. In particular, they like to point out that Asian central banks have not done a good job in steering their economies. “Just look at the Asian Financial Crisis”, they say. Well, somehow they seem to have forgotten that the US Federal Reserve Bank and the European Central Bank stood by while the subprime bubble inflated. Apparently, the Asian central banks do not have a monopoly for making mistakes.

The Asia Era

The huge internal markets in Asian countries mean that internal consumption will be able to take over as the engines of growth when the US economy falters. Already, growth in Asian markets exceeds growth in more traditional US and European markets. In time, intra Asian trade will replace trade with US and Europe, in the same way that trade within the European Union is exceeding trade with the US.
The challenge for Asian economies is to reduce the gap between rich and poor and build a solid middle class which will be the foundation for the Asian Era.

Have We Seen The Bottom?

It is very hard to predict the top and bottom of a market. Chartists use a combination of many indicators, volume, price volatility, etc. to measure change in investor sentiments.

Very often, the top and especially the bottom occur when there has been a in investors' sentiments. At the top, you don't suddenly see people rushing for the exits, rather, the opposite as ever more people join the line at the "ATM machine" where there is "free" money.

Bottoms are even harder to predict. How much further can the market drop? Just like at the top commentators keep changing the target. However, changes in sentiment at the bottom is very subtle. It is often a final surrender when everyone decides that the market has nowhere to go but down.

So, have we seen the bottom? In terms of sentiment, I still cannot detect the sense of abject surrender. However, I have seen the interest of retail clients decline to levels that are 20% of the peak or less. HK retail investors have been through many cycles, and many are using only spare cash for the stock market so there is less need to meet margin calls. Also, 60% of the market is dominated by institutions and although they will trim their portfolios, they also know that when the market turns around, it is very difficult to buy back in, so they will always hang on to the core holdings.

But every market turning point needs a trigger. And the trigger this time is the takeover of Fannie Mae and Freddie Mac by the US Government.

Many will remember that HK Government was castigated by the world for "interfering in the free market" by intervening in the currency market to protect the HK dollar's peg to the US dollar at a time when all Asian currencies were being sold off by hedge funds. When the hedge funds found they could not borrow enough HK dollars for shorting they decided to short the HK stock market as a proxy. The market fell from around 18,000 to around 6,000 before the HK Government stepped in to buy blue chips in the open market. That marked the turning point. The shares bought were subsequently injected into a new vehicle called the Tracker Fund (#2800) and HK residents were allowed to buy into this at around the 12,000 level, But that is another story.

The US Government had decided to "rescue" the 2 mortgage companies and put the credibility of the US Government behind the papers they issued. The minority shareholders are out of luck, but that is unavoidable. However, financial institutions around the world breathed a sigh of relief because if they failed, banks around the world will have to go through another round of write downs.

The financial markets are all about credibility, sentiment, and liquidity. In the past few months, the US Fed had injected liquidity into the system and will continue to do so. By taking engineering the takeover of Bear Sterns, and now taking over Fannie and Freddie, it is now putting some much needed credibility into the market. There is nothing that can be done about sentiment. Investors will either decide it is time to buy or time to sell.

A very interesting thing happened on the HK market. Cocal Cola announced that it is buying out the shareholders of Huiyuan Juice (#1886) at HK$12.20 which is the highest price achieved after the stock was listed at around HK$6. The stock was trading at about HK$4 at the time of the announcement. The interesting thing is that Coca Cola had decided to buy into the China market with 1.4 billion consumers rather than to try and build their franchise and distribution network. Huiyuan owned close to 50% of the pure juice market in China. At HK$4, it was valued at HK$6billion. Even at HK$12 it is only HK$18 billion (or 18 times P/E).

Buy or sell Huiyuan? Coke will privatise the company if it gets enough acceptance to the offer. If it doesn't, then it will have to maintain the listing. Will Huiyuan become "Coke China"? That is the question. I suspect that Coke will want to list its' own shares someday in China (as and when it is allowed) rather than a subsidiary. Some are hoping for a better offer from Coke to sweeten the deal. Or, maybe a competing bid?

However, there are still regulatory hurdles and the deal is by no means assured, although I cannot believe that Coke would go this far without some indications that it will be approved. There is 20%-25% upside if the deal goes through.

My advise to clients who already hold this is to decide whether the upside is attractive enough or to look for the next value stock to be taken over now that Coke had started the ball rolling. For the HK and China markets, this may be the trigger that changes sentiments.

Note: Clients and entities affiliated with the author holds some positions in this stock.