The Prime Minister of Kazakhstan led a delegation to HK and paid a visit to the HK Exchange.

In the photo, I was explaining how we used to place orders on the old trading system.

The Prime Minister was accompanied by the Governor of the National Bank of Kazakhstan (the central bank) Mr. Marchanko, as well as the Head of the Kazakhstan Stock Exchange and the CEO of Samruk-Kazyna the sovereign wealth fund.

Yuan Settlement – What is it, Who will benefit, and What is the End Objective?

Background

On 29 June 2009, Zhou Xiao Chun, Governor of the People’s Bank of China (the Chinese central bank) and Joseph Yam, Chief executive of the Hong Kong Monetary Authority (the de facto central bank and bank regulator in Hong Kong) signed a Memorandum of Understanding (“MOU”) putting into place a pilot scheme to allow the settlement of trade between HK and Mainland Chinese enterprises in Yuan (the Chinese currency also known as Renminbi or “RMB” i.e. “people’s currency”). The international currency symbol of the Yuan is “CNY”.

The MOU was quickly supplemented by detailed directives issued 2nd and 3rd July 2009 which laid out the conditions for the Yuan settlement.

What is it?

Under the Yuan settlement scheme, enterprises in China and Hong Kong trading with each other will be allowed to settle those trades in Yuan. The scheme will now allow enterprises whose costs are mainly in Yuan to reduce their foreign exchange exposure by using Yuan as the currency of trade. Previously, trades have been settled in foreign currencies, mainly US dollars which had weakened against the Yuan over the past 3 years.

Under the pilot scheme just announced, qualified enterprises in certain cities in the Yangtze (Shanghai) and Pearl River (Guangzhou, Zhuhai, Shenzhen and Dongguan) deltas will be allowed to participate. The list of eligible enterprises has yet to be announced but it is expected that no more than 500 enterprises will be eligible in the initial phase.

It is expected that all companies in Hong Kong and Macau trading with mainland enterprises will be allowed to participate.

In addition to companies Hong Kong and Macau, companies in the 10 Association of South East Asian Nations (“ASEAN”) will also be allowed to participate in using Yuan as the currency of trade and settlement with the to be designated Chinese enterprises.

In order to encourage the Chinese enterprises to use Yuan for trade and settlement, the Chinese Government will provide certain tax incentives.

What is the impact?

Since 2004, Hong Kong banks have been allowed to conducted limited Yuan business. This has been limited primarily to accepting deposits of Yuan from companies and individuals in Hong Kong. Most of these deposits are generated by retailers in Hong Kong from the spending of Mainland Chinese tourists travelling under the “independent travellers” scheme.

As of the end of March 2009, the Yuan deposits held by Hong Kong banks amounted to CNY 53 billion (USD 7.7 billion). While this may appear to be fairly substantial, it pales in significance when viewed against the USD 200 billion bi-lateral trade between Hong Kong and China.

Mainland banks will also allowed to lend Yuan to Hong Kong banks as part of trade finance settlement. However, under the detailed rules issued on 3 July 2009, the trade finance lending can only be for up to 1 month and is capped at 1% of the Mainland banks Yuan deposits as of the end of 2008. Foreign banks borrowing Yuan on the Chinese Mainland interbank market is capped at 8% of the its Yuan deposits at the end of 2008. Chinese banks will be required to provide the PBOC with detailed breakdowns of Yuan lending to foreign banks.

The limited amount of Yuan deposits in Hong Kong can be supplemented by a CNY 200 billion currency swap facility between the HKMA and the PBOC. Hong Kong banks requiring Yuan funds may borrow from the HKMA which will drawdown on the swap.

Under a separate arrangement, Hong Kong banks will also be allowed to issue Yuan denominated bonds on the Mainland and in Hong Kong to fund their Yuan business.

The stringent controls are put in place to discourage the flow of “hot” money into the Chinese economy if foreign banks were to be allowed to borrow unlimited amounts of Yuan.

What is the End Game?

China has been running massive trade surpluses with the US and has nearly USD 2 trillion in reserves. In march 2009, Premier Wen Jiao Bao of The People’s Republic of China indicated concerns about the huge amount of the country’s reserves held in US dollars and Zhou Xiao Chun the PBOC Governor has been talking about the need for a new world reserve currency.

The introduction of a limited pilot scheme to settle trade in Yuan is the first step towards the ultimate goal of internationalising the Yuan as an international currency of trade and settlement.
The inclusion of the ASEAN countries is an attempt at creating a Yuan currency block in South East Asia with smaller trading partner nations. For example, China is trying to create an ASEAN free trade zone based in Nanning, Guangxi.

In the meantime, as more Yuan circulate in the Hong Kong economy, it is conceivable that the Yuan will one day replace the US dollar as the base currency in the Hong Kong dollar peg.

Corporate Governance CITIC Pacific

On 20 October 2008, Citic Pacific disclosed that it had incurred losses of HK$15.5 billion from using currency accumulators to hedge against a rise in the Australian dollar. Citic Pacific directors and management are being heavily criticized for not disclosing the losses earlier when they had known of the problem at least 6 weeks before the public announcement.

Company shares fell 42 percent between Sept 7, when the board learned of the company's exposure to risk, and Oct 20. Hong Kong's benchmark Hang Seng Index dropped 23 percent over the same period.

The red-chip group purchased equipment and supplies in Australian dollars and euros. To help fund the mining endeavor, group finance director Leslie Chang signed derivative contracts that stood to profit the company, as long as the US dollar grew weaker against the Australian currency.

When the financial crisis exerted a downward pressure on commodities prices last summer the Australian dollar fell sharply against the US dollar. The resulting loss may be the biggest derivatives loss ever reported by a Chinese company.
As a result of the losses, Citic Group had to step in to save the company from going under. Shareholders of Citic Pacific have now approved the issue to the parent Citic Group of US$1.5 billion in convertible bonds which on conversion will give the parent company majority control with 57.6% (up from 29.4%) diluting management shareholder Larry Yung.

According to a statement to the Stock Exchange, Citic Pacific revealed that its entire board of directors was being investigated by the SFC over the incident. Those under the investigation included Citic Pacific Chairman Larry Yung, Citic
Pacific Managing Director Henry Fan and 15 other directors of the
company, while Yung’s daughter, Frances Yung, former group finance
director Leslie Chang and former financial controller Chau Chi-yin were
not on the investigation list, papers reported.

Citic Pacific’s disclosure that all its directors were subject to the SFC’s investigation was made to comply with amendments to the Listing Rules that went into effect on 1 January. The amendments require continuous and timely disclosure by listed companies of information concerning directors who are subject to any investigation, hearing or proceeding by any securities regulatory
authority, or any judicial proceeding in which a violation of any securities
law or regulation is alleged. Many listed companies made similar announcements on Friday to comply with the amended rules since some of their board members were also Citic Pacific directors.

Investor Sentiment and Forecast for 2009

The J.P. Morgan announced that the J.P. Morgan Investor Confidence Index in HK moved up slightly from the previous quarter when sentiment was at its weakest.

The Index is designed to measure the outlook of retail investors in the local market over the next six months. The index rose to 98 in December from 95 in September, when it fell below its neutral level of 100 for the first time since July 2006. The December index shows that overall investor confidence in Hong Kong has stabilized although investors are still wary of the risk of a deeper economic recession in the next six months.

Hong Kong investors anticipate that the employment market may deteriorate further over the next six months, according to the survey. 44% of those surveyed expect an increase in the Hang Seng Index over the next 6 months from the current level. 39% expect the Hang Seng Index to exceed 16,000 at the end of June 2009.

The index covers six areas: Hong Kong stock market performance, the local economic environment, the local investment environment, the global economic environment, personal asset valuations, and amount of investments. Each of those index components registered an increase in the latest survey, with the exception of plans to increase investments.

Both aggressive and conservative investors continue to shift their attention from overseas to the Hong Kong market. Portfolio strategists will tell you that the high concentration of equity investments in the local market may limit the potential scope for returns when the global economy begins to recover, and also increases the risk of portfolio volatility from over-dependence on a single market. However, all portfolio management theories have been thrown out the window this time around. So much for diversification (geographic, industry, asset class, currency). Everything got clobbered.

Of course, retail investors are always the worst predictors of the market.

I don't see any real improvements until after the April final results reporting season. HK has the longest reporting period of any of the developed markets. Final results have to be reported with 3 months.

Institutional investors are sitting on their hands right now and waiting for results announcements. No one wants to buy now and finish with egg on their faces when the results come out and the company announces huge "hedging losses".

So things will be very volatile between now and then. Morgan Stanley just downgraded Hsbc with a target of 52 (was 75 now 66). The market went up 1,200 points on the first 2 days of trading to 15,500 and now has given up more than 2,000 points!

"Blackout Period"

Recently front-page advertisements have been taken out in the local papers protesting against a change in HK’s Stock Exchange rules which came into effect on 1 January 2009. Over 200 listed companies have signed a letter protesting this rule change that in their opinion will undermine the viability of Hong Kong’s market making it easier for unwarranted hostile takeovers, corporate exits, reduction in stock market liquidity and exodus of management talent.

Under the old rules directors and managers of listed companies were allowed to trade shares in their companies until a month before results are announced. The problem is that listed companies are allowed three months after the end of the period to report half-year results, and four months for the year-end. This meant that they were able to trade on information that was not publicly available between the end of the reporting period and the start of the “black out period” i.e. for two months before the interim results were reported, and three months for the final results.

In theory, the Listing Rules also require companies to announce meaningful events as soon as practicable, and the SFC does have the power to investigate insider dealing. But such disclosure is still problematic and after the fact. For example, recently Citic Pacific only disclosed news of a $2 billion currency loss six weeks after the fact was known to the directors.

Under the new rules which were originally promulgated in January 2008, directors and managers are not allowed to trade shares in their companies until after the results are announced. Therefore, if the companies continue to make full use of the 3 month interim reporting period and the four months final reporting period, directors and managers are barred from trading for a total of seven months.

In the US, financial results are reported quarterly and must be disclosed within 40 days of a quarter-end and 60 days of a year-end. Thus, if a listed company in HK can announce interim results within 40 days and final results within 60 days (using the US as rule as an example), the total “black out” period is only 100 days and not 7 months.

The problem, of course, is that auditors have to co-operate and the auditors would like to have as much time as possible after the year end before giving the company a clean bill of health because of their own scheduling. Also, companies may sometimes need more time after the year end to work with the auditors on the results.

On December 30th, the Stock Exchange announced that it would delay introduction of the new regime until April 1st. Opponents to the proposals hope the delay will become permanent.

Corporate governance advocates would like to introduce more frequent reporting to increase transparency, and to ban insider trading until important information has been publicly announced to level the playing field.

2009 Emerging Markets

The MSCI Emerging Markets Index fell from 54% during 2008. Many have laughed at those who suggested that the emerging markets will perform better than the established markets. Sure, "de-coupling" did not occur. The problems in the US and Europe split over into all other markets. But by the same token, none of the popular investment concepts worked either. Diversification did not work, all markets and all industries got clobbered. The destruction of wealth occured in every market be it equities, commodities, currencies, you name it. If there was a theme for 2008, it was disintegration.

The housing slump in the US will take a couple of years (optimistic) to work itself out. This is not helped by the US governement pumping money into the system to prop up ailing banks. The urgency and market discipline will be lacking and the market will take a while to find the bottom and make the proper adjustments.

Unlike developed developed economies which have multiple drivers, most emerging markets have a central theme. They are energy based, commodities based or like China, simply a huge market that has only started moving. As the world starts to recover, the demand for these products will rise again leading the emerging markets out of the current difficulties.

These markets have fallen more than the developed markets simply because of the lack of liquidity. By the same token, there is more upside.

The MSCI China Index fell 60% in 2008 having risen some 370% from 1 November 2004 through 31 October 2007. Much of this was due to indiscriminate selling by hedge fund (to meet margin calls) and traditional funds (in anticipation of redemptions). Slowing demand for Chinese goods from the US and Europe will slow growth but the Chinese government will be spending over US$586 billion over the next 2 years to stimulate the economy with most going into infrastructure projects which will major consumers of energy and commodity products. Chinese stocks now trade at 12 times earnings compared to 53 times in October 2007.

Yes, China's growth will slow from over 11% in 2007 to an estimated 7.5% in 2009. The Chinese government is targetting growth of 8% which looks achievable given the stimulus package. We like Chinese stocks in the following sectors - energy, construction materials, banks, and retail products with strong franchiese.

Turning Crisis Into Opportunities

Where do we stand?
During the second half of 2008, economic growth slowed noticeably. In Q3 2008, the GDP grew at 1.7% down from 4.2% in Q2. The GDP growth for 2008 is now estimated at 3.0 to 3.5% (officially announced on 14 November 2008) and it is unlikely that the original forecast of 2009 GDP growth of 4.5% made at the time of the Budget Speech for 2008/09 will be achievable.

No systemic damage but not immune

HK has been through many financial crises in the past. In recent times, HK survived the 1967 riots, the 1987 Black Monday, and the 1997 Asian Financial Crises. Since 1997, we have also faced down the SARS epidemic in 2005. Each crisis had its own origin but the end result is a “crisis of confidence”. After each crisis, new measures were put in place to ensure the integrity of our financial system. Thus, HK is better prepared than most to weather the current storm.

The current Financial Tsunami is both deeper and wider in its impact on the local economy. With the exception of Black Monday in 1987, the crises we faced in the past were localized in scope. Even the 1997 Asian Financial Crisis was restricted to the Asian region and the Asian economies were still able to export their way out of recession because the US and European economies continued to remain strong and their consumers provided the demand for Asian goods.

This time it is different. The most optimistic forecasts for the US and European economy for 2009 is for no more than 1.5% growth and many are forecasting negative growth. With the US and European consumers expecting to cut back on their spending due to unemployment and tighter credit, the Asian economies need to look beyond the traditional export led recovery scenario.

During the Asian Financial Crisis and the SARS Outbreak, both the stock and property markets suffered major setbacks. However, manufacturers and exporters were not affected as the orders continued flowing from the US and Europe. During the current crisis, manufacturers and exporters are as severely affected as those in financial services with their order books being down by 50% or more. It is now obvious that a purely monetarist approach of loosening credit and lowering interest rates will not have the same effect as in previous other financial crises.

What are we doing about it?

The current meltdown calls for a Keynesian (i.e. fiscal) approach to stimulate the economy.

On 15 October 2008, the Chief Executive of the HK Government, Mr. Donald Tsang, announced a number of measures in his Policy Address aimed at maintaining and expanding HK’s position as an international financial centre. The cornerstone of the measures to combat the slowdown in the economy ranges from minor tweaks which can be implemented almost immediately to major public works programs.

Longer term, the HK government will start implementing 10 major infrastructure projects which will require total investments of HK$250 billion (US$32 billion). Some of these projects are aimed at integrating Hong Kong with nearby provinces on the Chinese mainland e.g. HK/Macau/Zhuhai Bridge (HK$37 billion) and Guangzhou/Shenzhen/HK Express Rail Link (HK$40 billion). While others are aimed at further development of the transport links within HK itself e.g. Shatin/Central Rail Link (HK$38 billion), Tuen Mun Western Bypass and Tuen Mun/Chep Lap Kok Link (HK$20 billion). Urban development has not been forgotten as the West Kowloon Cultural District project (HK$22 billion) will finally be started. All of these projects are in the final planning stages and implementation works will begin in two years time.

Altogether, 180 minor capital works programs will be started within the next 2 years involving some HK$60 billion (US$7.7 billion). These interim programs are meant to help the local economy absorb the return flow of construction works from neighboring Macau where the construction boom in hotels and casinos is grinding to a halt.

The Chinese have a saying, “Water from far away cannot put out the fire next door”. Clearly, something needs to be done within the next two years. The Chief Executive will chair a Task Force to monitor and assess the impact of the financial crisis and to recommend actions which can be taken to help alleviate the effects. HK government departments have been asked to assess their needs and come up with a list of projects which may be outsourced to the private sectors in an effort to sustain employment in the non construction area.

Most important of all, these are not “make work” projects. In other words, they are projects which are economically justified and are needed to allow the economy to continue to grow and integrate with the Chinese mainland. “Make work” projects which are not economically justifiable are a waste of taxpayers’ money, and are no more than “handouts”.

Crisis? What crisis?

The Chinese word for “crisis” (危機) is made up of two characters, danger (危) and opportunity (機). Since 1967, we have seen no fewer than 4 major and countless minor financial crises. Yet, we have weathered the turbulence and came out stronger with better regulatory regime and more vibrant business environment. And the current storm will also pass.

Kazakhstan: Development of the Financial Sector

The following article was written by the author and published in the November 2008 edition of "Exclusive" a Kazakhstan magazine.

The Government of the Republic of Kazakhstan has already taken a number of steps in creating the infrastructure needed for Kazakhstan to position itself as the financial hub for the Central Asian Region. These steps included creating a state holding company “Samruk” to hold the shares in the large State Owned Enterprises (SOE’s) and a development fund “Kazyna” to encourage sustainable development, and establishing the Regional Financial Centre in Almaty “RFCA”.

In a review of the progress of the SOE’s, it became apparent that State’s assets in key sectors such as oil and gas, metallurgy, petro-chemistry, infrastructure should be combined to create a state corporation of the global rank, which is capable of implementing large scale projects.

Thus, in a package of measures announced on 13 October 2008, President Nursultan Nazarbayev signed a Decree on the merger of the two major state holdings “Kazyna” and “Samruk” into the National Well-being Fund “SamrukKazyna”. SamrukKazyna will manage the state owned shares of “Kazatomptom”, “Eurasian Corporation of Natural Resources”, “Kazakhmis”, “Kazakh Mortgage Company”, “Kazakhstan Fund of Guarantees of Mortgage Loans”, “Housing Construction Bank”, as well as of seven Social-Entrepreneurial Corporations.

SamrukKazyna will operate along the lines of successful national holding companies such as “Temasek” in Singapore, and “Khazanakh” in Malaysia, and be engine driving regional industrial breakthrough.


Where Are We In The Development Of The Financial Sector?

One of the key initiatives in developing Almaty as the main financial centre in Central Asian Region is focused on creating favourable conditions for domestic and foreign financial institutions to act as the main providers of credit, insurance and financial services, and to facilitate the implementation of big regional projects.
The Kazakhstan Stock Exchange (KASE) was originally established as a currency exchange on 15 November 1993, 2 days after the launch of the national currency, the Kazakhstan Tenge. In December 2006, the KASE was designated as the Special Trading Floor of the RFCA, and began trading as such on 27 February 2007. Today, currency transactions account for approximately 25% of the trading turnover. The KASE is also the primary trading platform for debt securities including short-term repos, and government and corporate bonds. Besides currency and debt trading, corporate equities are also traded on the KASE. However, equities account for less than 2% of the trading turnover.

Despite numerous concessions and incentives, Kazakhstan has only achieved limited success as a financial centre. The credit crisis which hit Kazakhstan in 2006 was a re-play of the financial crisis which hit Thailand ten years earlier in 1996, and which subsequently became the Asian Financial Crisis. To recap, local banks expanded rapidly in financing local development, and because they did not have the domestic deposit base to support this expansion, borrowed heavily from foreign financial institutions. When the global financial crisis hit and foreign banks began calling in lines, the local banks were left high and dry.

Much of the plans to attract foreign financial institutions fell by the wayside as the economy adjusted to the contraction in credit. With the entire world now embroiled in the Financial Tsunami, it is an appropriate time to re-examine the approach so that Kazakhstan is positioned to take advantage of the turnaround when it comes.

What Does It Take To Become A Financial Centre?

To be sure, a number of incentives have been provided to attract more corporate equity listings and foreign participation in order to boost the development of the securities market. These include:

1. The RFCA is a tax free zone for brokers and investors. Income from executing client trades, market marking, underwriting, nominee services, etc. are free of tax for broker dealers. Dividends, and capital gains and interest income on securities bought on the KASE are also exempted from tax.

2. Where companies seeking a listing on the KASE have to undergo an audit (where none were previously required) the initial audit fees are reimbursed by the Agency of RFCA.

3. To facilitate communications with international partners, the RFCA will operate in three languages – Kazakh, Russian and English.

4. An International Advisory Board, with well known financial experts, has been set up to ensure that RFCA adopts the best practices from the international community in developing the financial infrastructure. An example of this is the establishment of special financial courts to arbitrate financial disputes.

5. Participants such as broker dealers are required to be registered with the Agency of the RFCA and licensed by the Financial Supervisory Agency (FSA). All dealings must be on the special trading floor (i.e. KASE), and foreign participants must have a permanent office in Almaty.

6. Debt securities can be listed as long as they have credit ratings at or above the level recognized by the FSA as investment grade.

7. Companies seeking a listing must either comply with the requirements of the Listing Rules as defined by the FSA, or be already listed on one of the recognized exchanges. Exchanges which are accredited by the Agency includes NYSE, NASDAQ, and Toronto in the North America; London Stock Exchange, Euronext, Deutsche Borse, BME Spanish Exchanges, Borsa Italiana, Swiss Exchange, and MICEX in Europe; and Tokyo, HK, Shanghai, Singapore, and Taiwan in Asia.

But is it enough to provide easy access and incentives? According to TIME magazine, the world will revolve around 3 international financial centres – NY covering the Americas, London covering Europe, Middle East and Africa, and Hong Kong the Asia Pacific Region. What distinguish these 3 from the many which aspire to be financial centres?

Lesson Number One: Location, Location, Location

Historically, financial centres grew out of the need to service the local economy. In the case of London in the 1600’s, the trade in commodities with the far flung colonies and later commonwealth countries created the beginnings of joint stock companies to fund larger enterprises, and insurance to distribute the risks. The well renowned merchant banks came out of the integration of trade and finance. NY became powerful providing financial services the vast American hinterlands.

The financial services sector in Hong Kong grew out of the need to finance the trading activities of the Hongs (British trading companies). As its’ share of world trade grew, many foreign banks established offices in HK which engaged in foreign exchange and money market transactions to fund the trade finance needs of their customers back home, making HK an international banking centre.

With the accumulation of financial expertise in Hong Kong, currently there are 285 banks operating in HK of which 200 are foreign registered, it was a short step to help their client companies seeking longer term capital to raise funds through IPO’s. Finally, with the return of sovereignty to the China, HK re-invented itself as the preferred listing destination of Chinese enterprises.

In the 1980’s Singapore had for a time challenged the supremacy of HK as a financial centre by offering many incentives to financial institutions re-locating their headquarters to that city including tax holidays, seed capital for fund management companies, etc. However, at the end of the day HK’s position on the doorstep to China, and its’ location and ease of transportation, won out and HK became the choice of fund management companies investing in the Asia Pacific region.

A financial centre is a bridge between investors and issuers. HK has been playing the role of financial intermediary to China over the past decade. Since the first Chinese company was listed on the HK Exchange in 1993, Chinese enterprises have raised over US$250 billion from the equity market in HK. China recently announced that it has foreign currency reserves of US$1.9 trillion which means that the equity market in HK provided more than 12% of China’s foreign currency holdings.

Kazakhstan has vast energy and mineral resources available and is situated at the cross roads between the East and the West. Natural resource companies need to raise capital and loans to develop the resources, to refine the raw materials, and to distribute the end products. Meanwhile, banks, telecommunications, media and transportation companies will also need to raise funds in order to provide the infrastructure necessary for the economy to grow in tandem.

Lesson Number Two: The Foundations

Before international investors will flock to invest in equities in Kazak enterprises, they must feel comfortable with the clarity of the regulatory regime, the efficiency of the dealing and settlement platform, and application of the rule of law in dispute resolution.

The opportunities are boundless. However, with a population of only 16 million, Kazakhstan will need to bring in additional expertise to develop its resources and infrastructure. Financial services professionals will come from around the world and not just CIS countries (Russia has only just started on its’ own road to financial development). Therefore, the use of a common language in international finance will be essential in order to allow participants to easily communicate with each other across the globe. More than likely, this will be English.

Tokyo was an international banking centre the 1980’s when HK was just starting out. With its’ huge financial institutions funded by strong deposit base, Japan was a financial juggernaut. However, many financial institutions decided to locate their regional head offices in HK because of easy access to financial services professionals, and ease of communications in English.

Using HK and Singapore as models, the Dubai International Financial Centre went so far as to re-write the laws using English common law as base and to invite British judges to sit on cases that come to court. Equities are traded and settled in US dollars on the Dubai International Financial Exchange, and there are no restrictions on the free flow of capital. As far as familiarity with the system is concerned, Dubai’s approach is hard to beat.

However, both Dubai and Singapore lacks the natural advantage that both HK and NY have i.e. a vast hinterland in China and America respectively. Additionally, Dubai has competitors as a regional financial centre in Egypt, Bahrain, and Qatar, while Singapore is competing with Jakarta and Kuala Lumpur. HK has a formidable competitor in Shanghai as a domestic financial centre. But for the time being, Shanghai is hampered by China’s rules and regulations and the lack of convertibility of the Chinese currency.

And let us not forget about logistics and transportation. As a regional financial centre, Kazakhstan has to be a hub in the physical sense with frequent direct connections with major cities and financial centres, and ease of travel for financial services professionals.

Kazakhstan has the benefit of starting from scratch in building a financial services infrastructure, and has the benefit of access to the best practices available because of its enormous wealth potential. The structures that have been put in place, such as “Samruk”, “Kazyna”, and RFCA shows the willingness to streamline existing institutions, and to put the weight of the government behind the push for modernization in financial practices. More importantly, it has the wealth to put its plans into practice, and the strength of will to overcome whatever obstacles may be in the way.

Lesson Number Three: Play To Your Strength

In 2006, trading turnover on the KASE amounted to US$169 billion, a huge increase over the volume of US$10 billion in 2001. During this period, GDP rose from US$18 billion to US$57 billion, international currency reserves increased from US$2 billion to US$ 26 billion, and Foreign Direct Investments doubled from US$2.7 billion to US$5.4 billion.

The KASE Index rose from 216 on the 1 January 2005 to over 2,048 by the end of 2006
. Market capitalization increased 14 times to US$64 billion.
So far notable IPO’s include KazMunayGas Exploration and Production, and the secondary listing of KAZAKHHMYS which was listed in London. Kazakhstan has enormous resource potential with many in the early stages of exploration and production. Within a few short years, we will see major local resource companies being listed on the KASE.

In addition to resource companies, a number of SOE’s under the control of “SamrukKazyna” will be privatized and spun off in accordance with the charter of the development agency which is to facilitate development but to return control to the private sector when the enterprises are self-sustaining.
In the near term, Kazakh enterprises will need to look to an offshore exchange for primary listing for reasons of funding and liquidity, and to give international investors comfort in the quality of the listing. For example, early listings of Chinese enterprises were wholly listed on the HK Exchange which has rules and regulations that international investors are familiar with. As domestic liquidity builds up, China began to maintain dual listings with the domestic portion on the home exchange for domestic investors. The ultimate aim is to repatriate the listing to the domestic exchange as the liquidity and confidence builds up, and the domestic currency is freely convertible.

Lesson Four: Build strategic Alliances

Due to the previous Soviet influence, Kazakhstan has looked to Russia and London (because foreign financial institutions in Russia are run out of London). Many Kazakh enterprises have listed on the AIM, the junior market in London. However, they have found that the subsequent trading is subdue, and opportunities for secondary fund raising virtually nonexistent.

China has 140 million domestic investors and foreign currency reserves of over US$1.9 billion. Chinese investors will be a powerful force in international finance. Although Chinese investors are currently barred from investing abroad, China allows Qualified Domestic Institutional Investors (QDII funds) to invest abroad on their behalf. The HK market as part of China will be the first beneficiary of funds going overseas.

Kazakhstan shares a common 1400 km long border with China’s Xinjiang Region, and is only 250 kilometres from Urumchi. There are daily flights to Almaty from Beijing and Urumchi, or one can choose to transit in Bangkok or Seoul. From Hong Kong, there is the additional choice of travelling to Shenzhen and taking an internal flight to Urumchi. Almaty, and the capital Astana, are only 2 time zones away from HK and Beijing, but 6 time zones away from London and Europe.

A pipeline is being built from the Caspian to Xinjiang in China which will be a major end buyer of Kazakh energy and mineral exports. Kazakhstan and Xinjiang is separated only by the Tian Shan mountain range. Therefore, it makes sense for Kazakhstan, in positioning itself as the Central Asian Financial Centre, to more closely align with Hong Kong and China than with Europe. Kazakhs are Central Asian in outlook and attitudes which are more Asian than European. We look very much alike and think alike.

Have We Seen The Bottom? Redux

Investors are very pessimistic. Globally, stocks are trading at 10x earnings (i.e. 2007 earnings). Chinese shares are trading at 9x, Indian shares are 10x. The prize goes to Russian shares which are now trading at 4.4x earnings. This tells us that investors are expecxting earnings next year to fall 50% at least.

Bears now outnumber bulls. Which in itself is a good sign. Fund managers are sitting on over 60% cash waiting for investors to redeem, not necessarily because they are pessimistic.

The Chinese market looks to be the only game in town with the Chinese government announcing a USD586 billion stimulus package for the next 2 years. Also, the Chinese banking sector has only minimal exposure to Lehman, and the toxic CDO's which have dragged down their Western counterparts. look for value in Chinese banks which have been sold off on concerns about their level of exposure to toxic assets, infrastructure, natural resources, and consumer shares. Stay away from export based companies as the markets in the US and Europe will contract. Ditto trtansportation shares.

Happy hunting!

The October Effect

With the exception of October 2007, october can right lay claim to being the worst month for stock markets.

October 2007 proved to be different for HK at least because China had announced the "thru train" allowing Chinese retail investors to buy stocks in HK. With over 150 million registered investors in China each being able to exchange USD50,000 per year this announcement gave further life to a flagging market.

However, the arrangements were made by the China Banking Regulatory Commission (CBRC) to allow banks to conduct this business, and the scheme ran into bureaucratic infighting with the China Securities Regulatory Commission (CSRC) warning of dire consequences for the Chinese stock market (which was over valued) if Chinese investors were allowed to invest their money elsewhere ie HK. Finally, the scheme was suspended awaiting 'further clarification".

Back to October. This past October 2008, recorded the worst performance inall markets with HK down 22%, Japan down 24%, Korea down 23% and US down 17%. Market capitalisation fared even worst down 50% for the year as some companies disappeared completely.

USD586 Billion Stimulus Package

China approved a RMB4 trillin (USD586 billion) stimulus package for the next 2 years, 2009 and 2010 to boost the Chinese internal growth rate.

This will be invested in 10 areas: budget housing, rural and key infrastructure, medical system improvements, environmental protection, industrial innovation, and raising people's income.

In addition, the value-added tax reforms will reduce RMB120 billion in tax payments by companies. The central bank will also lossen loan quotas.

It's good to have some spare cash lying around. China's foreign currency reserves amounted to USD1.9 trillion and this represents only about 25% of the reserves.

Investing Paradox

It is paradoxical! Just when the market is right for buying in, most investors are scared out of their wits and are selling indiscriminately. And it is usually the better stocks that are being sold because nobody wants to buy the "rubbish" anyway. Thus, just when the market may have bottomed, you will find investors selling all their solid stocks (because there is still some value left) and holding onto the rubbish.

The question really is, "Have we bottomed?". From the peak of 32,000 to the low last Monday, the market had fallen over 60%. It has recovered somewhat in the last few days but there are no shortage of people telling us that there is a long way to go before the we can see light at the end of the tunnel.

I do not disagree with them, especially if we are talking about the US or Europe. In China, the government still has sufficient surpluses to stimulate the economy without going into debt, and have been making moves recently to encourage more investments and lending by the banks.

On the short 3.5 year cycle, the last peak was in October 2007. Usually, we look for the market to fall for 1.5 years before finally turning around. Then we will have a 2 year run up to the next peak. So far, we are 1 year into the 1.5 year downturn. During the next 6 months, there will be opportunities to buy into the market.

Do we buy now? It depends on the stock. Now is the time to stock pick. Look fro stocks which have a great franchise but are sold down because of market sentiments. A good example is #2319 Mengniu Dairy (accounts which I manage own some). It was sold down because of the milk scare in China. I can remember the Tylenol tampering in the US. Eventually, they introduced tamper proof packs and consumers went back to buying them.

I also like #941 China Mobile. People are not going to stop using their mobile phones.

Happy hunting!

CITIC Pacific May Lose Up To HK$15.5 Billion

CITIC (#267) announced last night that a currency hedge transaction went wrong and the company may lose up to HK$15.5 billion.

This is a trading opportunity for those with "intestinal fortitude" i.e. guts. Based on the 2007 financials net equity was HK$59.8 billion. According to the most recent financials NAV is HK$66.73 billion (including net income in 1st 6 months of HK$4.38 billion). The no. of shares in issue is 2.193 billion; therefore NAV per share is HK$30.42 before any write-offs related to the "hedge".

Assuming the company loses all HK$15.5 billion, net NAV is HK$51.23 billion based on most recent figures, or HK$23.36 per share. If we assume that the company will earn another HK$4.38 billion in the 2nd half, the NAV would be HK$55.61 or HK$25.35 per share

At current market price of HK$8 per share, market value is HK$17.54 billion. The shares are trading at between 31% and 34% of projected and current NAV assuming total write-off.

The share price was down 41% from 7 Sept 2008 (when the problem was discovered) through 16 October 2008 (last Friday's price because trading was suspended on Monday 20 October 2008). During that time, the HSI was down only 23%.

China Update

In the first half of 2008, GDP growth slowed from 11.9% (2007) to 10.4% mainly due to slowing exports. During the first 6 months, exports grew at the rate of 21.9% (down 5.7% from last year) to US$666.6 billion.

During the same period, reatil sales more than made for the slowing export growth raising 21.4% to RMB5.1 trillion. Fixed assest investments increased 26.3% to RMB6.84 trillion.

After 5 years of double digit growth, it is expected that GDP will only grow 9% this year (the smallest growth rate since 2002).

The Chinese government will be aggressively cutting lending interest rates (by at least 0.81% to up to 1.35%), deposit rates (by 0.27% up to 0.81%), and reserve requirements (by 3.5% up to 5.5%) over the next 12 months. See previous article.

The cut in interest rates is important but there is no lack of borrowers even at the present rates. More important, the cut in resewrve requirments will mean that banks are at last being allowed to re-start their lending which had been put on hold since 2006.

China is the one bright spot in the global economy where is growth albeit slower than before.

NOTE: I have been asked if I got my numbers wrong. Why 0.27% and not 0.25% (which is a quarter point) for those more familiar with the Western system. The answer is that China use numbers divisible by 9 in calculating interest rates (360 days basis). It actually makes sense when you start working the numbers.

Perspective on China

Many economists predict that China will not be able to escape the contagion. It is significant that they all come from the US or Europe and are projecting their own despondency into their forecasts. It is difficult to be optimistic when the world as you know it is collapsing around you and your own job may not be there tomorrow.

China is the fastest growing of the so-called BRIC (Brazil, Russia, India and China) countries. All four countries have massive land masses and that is where the similarities end. Brazil, Russia and China have natural resources, and India and China are the two most populous countries in the world. But only China has it all - land mass, large population, natural resources, and most important of infrastructure.

The interior of China still lacks investment and infrastructure but the government is addressing this weakness ith major planned investments. Many predicted that China's economy will suffer the "post Olympics blues", and to some extent the stock market seemed to bear this out as it has retreated 60% from the October 2007 peak. However, this is due more to the sentiment and cpncerns about the subprime crisis in the US.

Many countries do suffer slowdowns in their economies after hosting the Olympics because so much has been spent on the required facilites. China spent US$42 billion over the past 6 years on Olympics related projects. However, this represents only 0.5% of the RMB51 trillion spent on fixed assets investments over the same period of time. Travel up and down the coastal region and you can see the results of this investment in infrastrucutre. Over the next 2 years, China has budgeted over RMB400 billion per year (ie the equivalent of the total spending on Olympics each year) for infrastrucure developments with much of the it aimed at the interior.

Can China afford it? You bet! the Chinese foreign currency reserves have just hit US$1.906 billion as of the end of September 2008 rising from US$1.809 trillion in August 2008. China has had fiscal surpluses since the 1985, and expect the surplus this year to to be RMB600 billion (US$87 billion). It is growing at the rate of 30% in the first 8 months of 2008.

China has room to stimulate growth. While the US was gorging on easy credit, China had raised lending interest rates 8 times since April 2006, raised deposit interest rates 6 times since August 2006, and raised banks' reserve requirements 18 times since July 2006 17.5% of deposits. In September 2008, China announced limited cuts to the lending rate of 0.27% to 7.2%, deposit rate cut to 4.14%, and cut reserve requirements to 16.5% for smaller banks to encourage them to lend to SME's (small, medium enterprises). On 8 October 2008, China announced across the board cuts to reduce lending rates to 6.93%, deposit rates to 3.87%, and reserve ratios to 17%.

Over the next 12 months, we can expect to see further cuts to the interest rates and reserve ratios as China stimulates the domestic economy to make up for any shortfalls from reduced exports to US and Europe.

China will celebrate its' 60th Anniversary on 1 October 2009, and we can expect it to put on a big birthday party!

Just How Much Is US$700 Billion?

Actually, not a lot as it represents only about 5% of GDP. By way of compariosn, Germany's rescus package of US$400-536 billion is 12-16% of GDP, and the UK's package of US$835 billion is 30%. Russia's package is 10% of its' GDP.

Can the US afford to add to the national debt? We were all treated to the news media's hysteria about there being not enough digits to show the new national debt. To put this in perspective, the total debt (including the package) is 62% of GDP, while the corresponding figures for the Eurozone is 75%, and Japan a whopping 180% of GDP.

More worrying is whether the US consumer can make it through the coming economic slowdown. In 1986, US household debt anounted to 80% of disposable income, growing to 100% by 2000, and 140% in 2007. US households do not have any savings to speak of, with many treating the built up equity in their homes as their savings which they have tapped regularly as housing prices moved up. Now that housing prices have fallen, many will be faced with diminhed savings and even calls from their banks to repay home equity lines. With money already spent or invested in additional real estate, the prospects are not good.

Bankers are now worried that the next crisis will be in consumer credit such as uncollectible credit card debts.

Black Wednesday --- Interest Rate Cuts

Stock markets around the world fell as the credit crisis reduced confidence in the banking system leading to questions about the economic prospects with many economists forecasting recession and some even likening the current to the 1929 depression.

For the record, there are a number of similarities in how the crisis came about. No, they did not have sub prime and Alt A mortgages, and they did not have CDO's back then. But what they did have was a period of easy credit. The major difference between then and now is that our central bankers have learned their lessons and have intervened massively. Back then, the US government believed that government should not intervene in the market and kept this up until 1933.

Some may argue that the intervention came too late. Would it have been better to start intervening in 2007 when it became apparent that sub prime mortgages are being defaulted on? I guess we will never know. Still, better late than never.

The Hang Seng Index fell 8% to below 16,000 for the first time in 3 years. The HKMA cut interbank interest rate by 1.5% to 2%. The discount rate is 2.5% which is below the Hibor. In effect the HKMA and other central banks are acting a intermediaries to the banking system Banks with surplus funds are reluctant to lend to other banks and prefer to place the funds with the HKMA which then re-lends to banks needing short term funding.

Yesterday, the China announced that from today interest rates will be cut by 0.27% with lending rate at 6.93% and deposit rate at 3.87% (that's a spread of 3.06%, not bad if you can get it). At the same time, all banks will have their reserves requirements cut by 0.5% to 17% meaning that they will be able to lend more.

Some analysts on the mainland are negative on bank stocks because they believe that by cutting the lending rate this will cut into the banks profitability. Wrong! For banks, the most important drivers of profitability are the spread (i.e. the difference between the deposit rate it pays to depositors and the rate at which it lends to the borrowers) and the reserve requirement (i.e. how much they can lend out). As long as they maintain their spread, they will make more profits by lending more.

In fact, during periods of high interest rates, banks are actually less profitable because borrowers shy away from paying the high rates unless they are desperate (and therefore may be bad credit risks). Bad debts tend to rise when interest rates are high. So, low interest rates are good for the banks. Borrowers are more willing to borrow, investments make more sense because of the lower costs, and failure to repay is less.

By the way, China Construction Bank announced that 98% of their busines is in China and therefore their direct exposure to the credit crisis is limited.

Another One Bites The Dust!

How appropriate! The Queens hit really hits the nail on the head. Over the past 2 weeks, we saw the demise of the "investment banking" business model.

Bear Stearns was acquired by JP Morgan, Lehman Brothers filed for bankruptcy protection under Chapter 11, Merrill Lynch was driven into the arms of Bank of America in a "shot gun" marriage, and Goldman Sachs and Morgan Stanley sought the protection of the Fed by applying for and being granted status as a "commercial bank".

Let's get something straight. These were never banks in the common useage of the word. They were merely securities dealers who grew too big and decided that that they needed a more exalted name. Banks usually take deposits from consumers and make loans. The so-called "investment banks" took no deposits, instead borrowing from banks and big investors through various vehicles such as bonds and "repo" agreements.

What does the change in status mean?

First of a;ll they will now come under the supervision of the banking regulators and will be able to access the Fed's discount window. Most important of all, as a bank they will be able to designate certain securities as "long term" holdings and therefore can value them at cost (less impairment) and not mark-to-market (and take the hit in their income statements).

What's the downside?

As securities dealers, they were not covered by the FDIC, nor were they regulated or supervised by the banking regulators. They will now be required to file financial returns to the banking regulators and maintain commercial bank reserves. Lehman Brothers was infamously geared at 35 times capital ie their borrowing are 35 times their paid up capital. Lehman owed US$613 billion as of 31 May 2008.

Commercial banks are required to maintain capital reserves of at least 8%. In China the China Banking Regulatory Commission (CBRC) requires commercial banks to have 16.5% reserves. HK securities dealers are required to have $40 of capital for every $100 they lend to clients for margin purchases.

"Investment banking" will never be the same again. The Glass Steagal Act forced banks to spin off their securities dealing arms in 1933, and regulation fell to the SEC which must shoulder a good part of the blame for not properly supervising the "investment banks" and their toxic products. Admittedly, it is difficult for supervisors earning US$80,000 a year to debate complex products with "investment bankers" earning tens of millions of dollars in bonuses.

The current agruments about "naked short selling" is a case in point. In HK, only certain stocks with sufficient market capitalisation are eligible for short selling. And, you can only "short sell" if you have already borrowed the stock before hand. If settlement is not effected on T+2 ie 2 days after the trade day, the seller is subject to "buy-in" at the then market and will be penalised. Borrowers will also be required to post and maintain a margin with the lender (usually around 105% of the market price).

In the US, sellers do not need to have borrowed the stock before the sale and therefore they do not need to post any margin unless the price goes up, and then only for any price difference. Thus, the number of shares that are sold short may be many times the number of shares available.

In HK, we learnt our lesson during the Asian Financial Crisis and have tightened the rules to ensure settlement on T+2 so that it is not possible to maintain open "naked short" positions for more than 2 days. Also, "short selling" must be disclosed.

I can remember Christopher Cox saying that the US is the "gold standard" in regulations and supervision when he took office as SEC chairman. I wonder if anyone still believes him. The performance of the Bernanke, Paulson ands Cox before the House says a lot. Bernanke was studious as a professor (which he was), Paulson was selling the package like the "investment banker" that he still is. Cox was totally out of his depth. I would not be surprised if he is replaced soon by someone who actually knows how the market works.

And While We Wait ....

Don't You Just Love The US Political System?

The US Senate has passed the bailout plan with a few changes, and this will go back to the House of Representatives for a vote on Friday night US Time. While we sit and wait for the US political system to decide whether to turn the life support system on or off, let's consider what happened.

The Dow fell 777 points (or about 8%) on 29 September 2008 after the House rejected the original bailout plan. This wiped out US$1 trillion of market capitalisation or wealth. This of course does not include the subsequent (consequent?) falls in the rest of the world and the wealth that was destroyed as a result of that decision.

But I Use A Professional Fund Manager!

Fund managers are just starting to realise that their much vaunted "asset allocation" models just do not work. Actually, they only ever worked in their own minds, and never did in reality. The world markets are so interlinked that they all fell (and sometimes rose, albeit not too frequently in the past few months) at the same time. Geographic allocations did not work, industry diversification did not work. Portfolio theory did not work. Why are we paying the fund managers to manage our money with their fancy theories and strategies if they cannot stay out of trouble any better than you or me?

The Chinese have a saying which goes, "When the tide rises, so does the ship". Conversely, when the tide falls, so does the ship. In other words it is easy to be a star when all markets are going up.

So What Is This De-leveraging?

Between 1980 and 2007, US household debt rose from 50% of GDP to 100%. At the same time, US financial sector debt rose from 21% to 116%. Everyone now knows that Lehman was leveraged at 35 to 1 i.e. it uses 1 dollar of capital and borrowed 35. Securities companies in HKG have to have $40 capital for every $100 lent out i.e. 1.5times leverage.

So Who's Minding The Store?

Well, it is obvious that Christopher Cox and the SEC were not. Because if they were, you would not have have Enron and WorldCom, and now Bear Stearns and Lehman. I can remembers when Christopher Cox became Chairman of the SEC, he was asked why Chinese companies chose HKG for their listing instead of NYSE. He answer was classic Western arrogance ... because the US is the GOLD STANDARD of regulations and companies that choose not to list in the US are engaging in regulatory arbitrage. That is a barely polite way of saying that HK not not properly regulated.

HK has remained relatively untouched by the sub prime mess. This is because we lived through the Asian Financial Crisis, the Dotcom Bubble, the Bird Flu Crisis, and the SARS Crisis. It seems that we went from one crisis to another after the handover of HKG by the British back to the Chinese in 1997. Maybe the fortune tellers were right after all, the handover did bring many crisis although they were unrelated to the change in sovereignty.

Anyway, we learnt from each and put in place appropriate measures to make sure that the problems doe not recur. An appropriate example, is the handling of short selling. Only certain stocks which are deemed to have sufficient liquidity are eligible for short selling, and short sellers have to have already borrowed the stock before they actually short sell. Sellers who are unable to deliver the stock they sold on settlement date (in HKG it is T+2) while be subject to buy-in by a broker nominated by the clearing house. At the very least, the short seller will be hit with additional brokerage and other charges, plus a penalty. If the market has moved up since the short sell, the seller will also incur a loss on the difference.

"Naked short selling" and delayed settlement means that short sellers do not incur the costs of borrowing the stock (with margins of 105% of the price and the need to post margin if the stock moves up. Of course, they object to the banning of "naked short selling".

China and HKG

The Shanghai index has fallen by over 60% from over 6,000 to as low as 1,800. Meanwhile, HK's Hang Seng Index has faller from 31,000 to as low as 16,000 intra day before reversing course to close flat. The "spike down" to 16,000 occurred twice and this appears to be the support level.

Separately, many shares which were listed over the past 2 years are trading at or near their IPO prices. This creates a problem for the Chinese authorities, as the major banks, insurance companies, and social security fund invested heavily in the IPO's of SOE's (state owned enterprises). Below this level, they will have take write downs and begin the downward spiral that we are now seeing in the US.

The Chinese government appears to understand this and has started making moves to limit the effect of the US slowdown. It had just cut interest rates after raising them since 2006 and also reduced banks reserve requirements to stimulate the economy. It is rumoured that an amount equivalent to the Olympics related spending of US$42 billion (which was spread over the 6 years of preparations) will be spent in the coming 2 years on infrastructure which will give the economy a boost after the clampdown over the past 12 months.

The Chinese has learnt that intervention must be quick and must early before the problem becomes intractable. It is easy to take the high moral ground when you are not feeling the pain. Asian governments were lectured on the evils of government intervention during the Asian Financial Crisis, and HK was pilloried for daring to intervene in the stock market to see off the hedge fund speculators who were using it as proxy for shorting the HK dollar. Now that the shoe's on the other foot, "how does it feel?"

I am waiting with bated breathe for the vote. Let's hope that US politicians can stop their posturing and selfish views for long enough to do the right thing!

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.