In the Monty Python sketch “Vocational Guidance Counsellor,” a chartered accountant passionately makes his case to become a lion tamer. The counselor is unimpressed, describing the man as “irrepressibly drab and awful” and mocking his ability to tame a “huge savage beast.” It turns out that, in Monty Python’s world, the accountant was unaware of the realities of his ambition, and his lack of courage to go through with it. Well, Asia’s accountants are going to have to be a lot braver and, if so, they may get their chance to tame lions. They are a part of the region’s push to develop capital markets; to provide a resource for middle class savers; and to build trust around financial reporting and corporate governance, in order to attract international investors. That is why the number of accountants in places like China and India is growing so quickly. So what reforms are Asia attempting to make to assist in this process?
Administrations across Asia seem to be prioritizing financial sector reform. Perhaps they believe that Asia’s capital markets are still an Achilles' heel for the region. Overreliance on the U.S. dollar always seems to leave the economies vulnerable to speculative attacks despite sound long-term economic growth prospects. Nearly 20 years ago, the Asian Financial Crisis (AFC) exposed flaws in Asia’s capital markets. Fixed exchange rates, underdeveloped bond markets, inefficient banking systems lending to state-backed industry and a lack of long-term domestic equity capital forced the most vibrant enterprises to borrow in U.S. dollars. When over-inflated asset prices started to fall, the economic reckoning took the form of a downward spiral. Falling demand and depreciating currencies raised the burden of foreign debts, causing companies to cut labor and capital expenditures, further worsening demand.
The Needs of the Middle Class
Asia today looks very different. Growth is no longer a consequence of globalization but instead is being sparked from within. Domestic demand is the catalyst as populations are approaching middle class status and driving change in very different ways from in the past. In fact, research suggests that Asia will account for two-thirds of the world's middle class citizens by 2030.
Median ages in Asia have risen over the last 30 years and now range from the mid-20s in the Association of Southeast Asian Nations (ASEAN) and India to between 35 and the early 40s in prosperous North Asia. So, as these wealthy Asians reach their peak earnings years, they have a greater need for trustworthy, efficient capital markets to help them save for retirement. To serve these needs, insurance companies and pension funds require a healthy return with a measure of security to cover their long-term liabilities.
But so far, financial innovation and retail investment have taken time to gather pace. Even in markets considered quite sophisticated, certain financial products are new. South Korea essentially did not offer open-end mutual funds until banks started to distribute them in the early 2000s. In Japan, where retirement savings vehicles are widely established, variable annuities have been available to investors for barely more than a decade.
Financial product advancement generates additional investment and increases demand among the suppliers of capital (investors). This requires broad and deep capital markets; so it is essential that small- and medium-sized enterprises (SMEs) have wider access to capital, not through bank loans, but via the capital markets. This creates the beginning of a virtuous cycle as increased access allows SMEs to invest more toward future growth, enhancing economic growth and encouraging further investment in the capital markets.
The Old Banking Model Faces Competition
In Asia, tradition still co-exists alongside transformation and the world of finance is no exception. But growth is increasingly being driven by SMEs, instead of by conglomerates closely tied to the state. Privately run family businesses still wield tremendous power but they are often considered laggards in efficiency, innovation and corporate governance. Ironically, as such business models are being rendered obsolete, state-run banks still tend to favor them.
So, how are the markets deepening to provide greater access to capital for the SMEs—the region’s most dynamic companies? How does broader access for the seekers of capital institutions create opportunities for investors, the providers of capital? The combination of increased wealth, more sophisticated investment ability and deepening markets creates a groundswell, not only generating interest among domestic and regional investors, but creating greater assurance among foreign investors.
Influx of Private Equity
Private equity has been one option for new sources of financing for some firms. The market in China has been particularly strong where funds now account for 15% of the US$2 trillion global private equity funds market (as of December 2013). More deals are generated domestically and the investor base is growing from within. Insurance companies can now invest as much as 10% of their portfolios in private equity. With over a million millionaires in China today, high net-worth individuals are looking for avenues in which to invest their wealth.
Historically, shallow equity markets meant many international institutions sought their China exposure through this asset class. But today’s strong demand raises the possibility that there may be too many funds chasing few compelling deals.
In today’s expanding equity markets, investors may benefit just as much by taking public equity market exposure without being subject to the illiquidity and higher fees associated with private equity.
Equities, IPOs are an Indication of Deepening Markets
Because equities can be bought and sold at any time, and valuations are readily available, they are a highly liquid diversification* opportunity for investors. Unlike most private equity funds that charge a 20% performance fee on top of a 2% annual management, equities can be bought and sold at a relatively low cost. Equity markets in Asia Pacific compose approximately 32% of the world’s free-floating market-capitalization, up from less than 20% 15 years ago. In total market cap, that comes to US$20 trillion. Some of this growth has been due to privatizations but much of it has been due to private company initial public offerings (IPOs). Over the past decade, approximately 45% of China and Hong Kong’s market-cap growth has been due to IPOs. This is notably higher than the 15% contribution of IPOs to market-cap growth in the U.S.
Interest is rising in these markets from both foreign investors, as well as from foreign institutions that seek to list on Asia’s regional exchanges. Larger trading volumes, higher liquidity and ongoing market liberalization have prompted both regional and foreign firms to seek funding in Asia.
Fixed Income, Shifting the Blend from Sovereigns to Corporates
The growth of Asia’s local currency (LCY) bond markets is one of the region’s most important capital market developments over the last decade. Asia now represents over 31.7% of all new global bond issues (YE 2013). This is quite a contrast from 1997 when it accounted for about 11% of total issues. In Emerging East Asia local currency bond markets have more than doubled since the Global Financial Crisis (GFC), to US$7.9 trillion (as of June 2014). While some express concerns over a rapid rise in leverage, Asia is coming off a low base, and holds a relative fraction of the similar pool of debt carried by the U.S., the U.K. or the Euro-Zone.
We are aware that relatively low sovereign debt levels are positive and provide local governments with some flexibility in managing fiscal balance sheets. But on the private side, higher levels of debt may be considered positive, especially when the debt is held in relatively low-cost fixed income securities. A bond market’s stage of maturity can be measured in terms of its size relative to GDP. Based on this measure, South Korea (130%), Malaysia (102%), Singapore (81%) and Thailand (76%) rank among the region’s more developed local bond markets. In terms of absolute size, however, China dominates the region, accounting for about 62% or approximately US$4.9 trillion of local currency bonds (including sovereigns and corporates). But China still maintains a relatively low ratio of LCY bond market to GDP at 51%, indicating there is still ample room for growth.
Because of disparities in liquidity and transparency between public and private sector bonds, foreign investors continue to place a majority of their holdings in government bonds in Asia. Most locally denominated government bonds are more liquid than corporates, which, due to the lack of secondary markets, tend to be more buy-and-hold. We expect transparency improvements and increased financial market integration, particularly out of ASEAN, to promote secondary market activity. This would further build momentum for corporate issues, which currently make up about 40% of LCY issuances.
The Start of a Virtuous Cycle
In order to create a virtuous cycle within these markets, both institutions seeking capital as well as investors need confidence in the market’s liquidity. Asia’s stock markets have been small and vulnerable to shocks. The lack of bond markets has exacerbated the problem. Typically, when stocks fall into decline, bond markets provide an alternative source of liquidity for investors and companies—but in Asia both markets have been shallow. Formalization, improved practices and regional market integration are helping—as is the internationalization of China’s currency.
The GFC set off a tide of speculation over the need for an additional international reserve currency and it has not taken long for the renminbi (RMB) to become the world’s second-most frequently used currency for trade finance. Asia has had its own share of problems since the GFC. And yet, Asia’s financial sector, has been much more resilient than it was in 1997. Post-AFC reforms were essentially forced upon the region from the outside. The intention was to rectify policy missteps and to clean up major faults in the financial system. But the hangover in Asia, after the GFC, was relatively painless because it was indirect. Clearly, the root cause of the 2008 Financial Crisis was the West. The recent reforms in Asian financial markets were not made in response to crisis. These were more capitalistic reforms, driven by the domestic markets to improve efficiencies and to create more self-sustaining markets.
Although broader local participation has provided a floor of capital, uncertainty over global monetary policy has meant continued volatility in Asia’s capital markets. The weaker sentiment has led foreign investors to question Asia’s growth story. However, as the growing middle class demands more sophisticated savings options and a groundswell is taking place, the importance of stability in capital markets cannot be overlooked. It is one key reason why investors should believe a full-scale re-run of currency-related events of 1997 is becoming increasingly unlikely. With broader and more consistent local demand from both the seekers and the providers of capital, volatility tends to subside. In such a scenario, foreign investors may become less fickle.
“Drab” Results of Deeper/Less Volatile Markets
Whereas much of Asia is motivated by the need to meet domestic demand for savings products, China has this imperative, plus the desire to raise the international profile of the RMB—and thus capture the consistent participation of foreign investors. No one can sustain an international currency without seeing demand for both goods and assets. To the extent that China wants the RMB to compete with the U.S. dollar and the Euro, it needs to support such demand. According to the International Monetary Fund, a measly US$135 billion of Chinese equities were held by U.S. residents at the end of 2013—just 2.1% of total holdings by U.S. residents of foreign equities. And although the Chinese can point to a rising trend, the absolute amount is still minute.
And after the nation state was built by Mao and the capitalist revolution has flourished under Deng Xiaoping and Jack Ma, it is the accountants, the bankers, and such who will lead the next wave of China’s revolution. And in China, local accounting firms are already challenging the Big Four as the industry grows at a rapid pace. China has at least the right foot soldiers for the coming challenges.
Monty Python, it always seemed to me, enjoyed poking fun at some of England’s “middle-classness.” Financial reform may sound “irrepressibly drab” compared to the romance of national revolutions and the development of entrepreneurial economies. But the era of the accountant—if it is truly beginning in Asia—marks an exciting step in the evolution of capital markets, from volatile and speculative casinos to trustworthy institutions capable of supporting the investment needs of Asia’s middle class. And that, to me at least, is exciting.
Robert J. Horrocks, PhD
Chief Investment Officer and Portfolio Manager