II. Financial Developments in Emerging Asia
- Published Date:
- October 2006
Prospects for capital flows to emerging Asia remain good, despite the May-June financial turbulence. International investor sentiment toward the region continues to be positive as regional asset prices have corrected and the region has demonstrated its resilience to a volatile global financial environment. Portfolio flows are expected to moderate, however, as the global monetary tightening continues and the world economy slows gradually from the rapid pace of the last few years.4
Despite the correction of May-June this year, prospects for capital flows to emerging Asia remain good. Overall, net private capital flows to the region are expected to increase to $88 billion this year, up from $60 billion last year. Despite the impact of the May-June correction, emerging Asia is poised for another year of solid capital inflows thanks largely to its strong fundamentals and improved resilience. However, given signs that global economic growth may be moderating and that the spread of regional policy rates over the U.S. Fed Fund rate may remain near zero, capital inflows are projected to moderate in 2007.
Net Private Capital Flows to Emerging Asia
Source: IMF, World Economic Outlook.
1Data for 2003 include $45 billion in capital flows to China that were subsequently used to recapitalize two state-owned banks.
Assessment of the Recent Correction
As in other emerging markets, the region underwent a correction in May-June this year. The correction occurred as central banks in advanced economies tightened monetary policies amid rising inflationary pressures. This triggered an adjustment in international investors’ risk assessment and some sell-off in positions on risky assets in general and emerging markets in particular.5 To some extent, this correction mirrored the gains in regional capital markets earlier this year. All classes of assets were affected, and countries which had seen the sharpest gains corrected the most.
Until the correction, Asia had recorded a surge in portfolio inflows. Anticipating an early end to the monetary tightening in the United States, international investors increased their exposure to risky assets and emerging markets. Gross inflows from U.S. mutual funds into Asian emerging markets reached $11 billion in the first quarter of the year, compared with $16 billion for 2005 as a whole. The inflows fueled a rally in regional equity markets and compressed yields in local currency bond markets, putting strong upward pressure on regional currencies. The rally unraveled in May and June.
Emerging Asia: Exchange Market Pressure Index1
Source: IMF staff calculations.
1 The exchange market pressure (EMP) index is the sum of the growth of the nominal exchange rate and the change in international reserves as a fraction of the monetary base.
Emerging Asia: Equity Market Performance
The May-June financial turbulence contributed to an equity market correction that was not unexpected. From January 2005 to April this year, regional equity markets rose by 45 percent on average, driving price-earnings (PE) ratios up to around 15. By historical standards, these PE ratios were not very high—they remained below the post-2000 average of 16—but as valuations increased, markets became vulnerable to a sudden shift in investor sentiment. (See Chapter IV for a more detailed discussion of the role of stock markets, and an analysis of equity price valuations in Asia.) Markets that suffered the sharpest declines were those that had risen the most during the rally. The Indian market, which was seen by many as overvalued, stood out in the region: the equity index gave back about one-third of the gains since early 2005.
Emerging Asia Equity Performance
Source: Bloomberg LP.
The correction was driven to a large extent by foreign investors. Net foreign equity sales reached $14 billion in May-June hitting Korea, India and Taiwan Province of China especially hard. Hedge funds, which only recently became active in regional equity markets, liquidated most of their positions, shifting into less risky cash positions (Box 2.1). There was also some selling from global funds which recently had moved into emerging markets. At the same time, pension funds and other Asia-dedicated long-term investors did not lower significantly their exposure to Asian equities.
Box 2.1.Hedge Funds—Recent Developments in Asia1
Asian-focused hedge funds (AHFs) have experienced rapid growth in recent years, both in terms of number of funds and assets under management. Based on industry estimates, the total number of these funds has more than quadrupled since 2002 to approximately 750, with two-thirds based in the region.2 More than half of the Asian-focused funds have been launched the past two years. Total assets under management (AUM) are reported to be around $120 billion, up tenfold since 2002. Some 15-20 funds manage assets in excess of $1 billion, although few yet approach in size the large global players (typically with AUM of $5-10 billion). AHFs are generally viewed as providing support for market stability. While they did appear to play a major role in the May 2006 sell-off of regional equities, trading activity was generally viewed as orderly and losses self-contained by the industry watchers.
While a majority of AHFs are operated through advisory services located outside Asia, the fastest growth in the past two years has been in funds establishing operations in Hong Kong SAR and Singapore.3 Industry experts expect this trend to continue, given ongoing efforts to improve the environment in emerging Asia for operating funds and the region’s attractiveness as an investment destination. Japan has also experienced rapid growth in hedge fund activity, starting in 2003. Hedge funds have also set up operations in China, Korea, Malaysia, and Thailand, although their numbers remain small.
The growth in AHFs reflects both global and local developments:
- As elsewhere, AHFs have benefited from demand in recent years for alternative investments, in particular by institutional investors seeking higher risk-adjusted returns. In this context, AHFs have become a popular investment vehicle for those seeking exposure in emerging market equities, which has attracted the largest concentration of hedge fund money in East and South Asia. The strong performance of Asian equities since 2003 has been aided by AHFs and in turn has encouraged their growth, with funds seeking to be closely sourced to local knowledge. Finally, the strong medium-term growth outlook for the region is a positive factor, especially as a number of AHFs run large net-long positions (similar to mutual funds) or pursue investment strategies akin to private equity funds.
- While the tax and regulatory regimes facing hedge funds differ across the region, rules are generally perceived as becoming more industry friendly. Recent reforms have focused on more favorable tax treatment of locally sourced income, streamlining of registration procedures, and improvements to trading platforms. Some regional financial centers, most notably Singapore, are actively courting the global wealth management business, including hedge funds.
- AHF growth has led to, and been partly fueled by, the development of a wider range of derivative markets and structured products, and allowance of new investment strategies in the region. The area most affected has been equity derivatives: stock futures and index options are now available in major Asian economies, with market liquidity increasing substantially in recent years. Securities markets have also proliferated in the region, although short selling is considered more easily done in Japan, Hong Kong SAR, and Singapore than elsewhere. Credit default swaps are also currently available, but these markets remain shallow in much of Asia.
The investment strategies of AHFs are reportedly concentrated in long-short and market neutral securities. Other strategies employed are convertible bond arbitrage and fixed-income arbitrage, as well as commodity trading and real estate. The interest of AHFs in local currency bonds appears limited by relatively illiquid markets and the lack of bond derivative products, often necessitating imperfect hedges. Fund managers also tend to take positions in local currency bonds only when exchange rate risk can be properly hedged. As a result, AHFs typically have not run pure foreign exchange trades, where inflows and outflows are usually most volatile.
Even with recent growth, AHFs still hold a small share of the global hedge fund business. Among the world’s 100 largest funds, only one is focused on Asia (Japan). The share of AHFs’ AUM in total global hedge funds business—less than 10 percent—remains well below that of Asian market capitalization in the global equity market, pointing to the potential for hedge fund growth. Currently, AHFs appeal primarily to family offices, private banks, and institutional investors (pensions, insurance, endowments), as well as to select government agencies and central banks. In addition, as these funds grow, they are attracting more interest from funds of funds. For family offices and high net worth individuals, the bulk of funds comes from Europe and the Middle East, and to a lesser extent the United States.4 For this class of investor, the local base has remained small, mainly because Asian family offices have traditionally employed their own investment managers and/or diversified their investments outside the region. However, this is seen as changing, with AHFs being more aggressively marketed and developing new trading strategies. Among institutional investors, the United States and Europe are the principal funding sources. However, their Asian counterparts—led by Japanese pension funds and insurance companies, with some significant action by Singapore and Hong Kong SAR investors as well—are slowly taking larger stakes in alternative investments, including AHFs, partly driven by deregulation.
The Asian equity sell-off in May-June 2006, in which AHFs were seen as key drivers, was generally viewed as orderly, although a number of funds suffered large losses. Most market watchers suggest fund managers sold regional equities in their portfolios in order to move to less risky cash positions rather than in response to redemption pressures. Real money investors—particularly pension funds and endowments—were thought to have largely maintained their exposure to Asian equities, in line with their longer term, more structural, view. The May sell-off also suggests AHFs were running sizable net-long positions, as fund managers experienced their worst month, on average, since late 2002. Although as a group they continued to outperform regional indices, they still fell well short of returns promised to hedge fund investors, with those AHFs targeting long-short securities declining by 3 percent. In fact, average returns of hedge fund indices were significantly negative in May, even outside those long-short equities, but still maintain positive year-to-date returns on average.
Asian Hedge Funds: Long-Short Equities, January 2002-June 2006
Asian Hedge Funds: All Strategies, January 2002-June 2006
Japan Equities: Long-Short Hedge Funds vs. MSCI1
Sources: Eurekahedge; and Bloomberg LP.
1 Based on local currency returns.
Asia Ex-Japan Equities: Long-Short Hedge Funds vs. MSCI1
Sources: Eurekahedge; and Bloomberg LP.
1 Based on local currency returns.
Going forward, market concerns remain about AHFs if global liquidity conditions were to tighten further significantly. While the May sell-off did not appear to pose any systemic risk, concerns remain that further market turbulence could lead prime brokers to suddenly pull back funding. In addition, the recent sell-off revealed some less-than-perfect hedges in select markets (India being most widely cited). Related to this, certain trades are reported to have yet to be fully unwound owing to illiquid markets, with AHFs possibly sitting on unrealized losses. However, these funds are not generally viewed as excessively leveraged, and long/short AHFs have also not been seen as very active in the yen carry trade.1 The main author of this box is David Cowen.2 The term “Asian-focused hedge funds” refers to those funds with investment strategies primarily focused on Asia (including Japan). It excludes hedge funds that are operated from the Asia region but with principal investments elsewhere.3 A recent report by GFIA, a Singapore-based hedge fund consultancy, indicated that as of late 2005, the advisory services for 52 percent of AHFs was done in the United Kingdom, United States, or Australia. Another 19 percent were advised from Hong Kong SAR and China (mainly the former), 11 percent each from Japan and Singapore, and 3 percent from elsewhere in the region (with the remaining 4 percent from other jurisdictions).4 Some hedge funds have reduced their marketing to potential American clients, owing to additional compliance costs associated with these investors.
Emerging Asia: Equity Inflows
Source: Bloomberg LP.
The adjustment in risk assessment also impacted government bond yields. In the first few months of the year, government bond yields in a number of countries in the region fell, driven by foreign inflows. This decline was especially rapid for the Philippines and Indonesia, where yields dropped by almost 200 to 300 basis points. In these countries, anticipation of fading inflationary pressures fueled the compression in government bond yields.6 As global financial conditions changed, foreign investors exited and yields reverted.
Emerging Asia: Changes in Government Bond Yields
Source: CEIC Data Company; and Bloomberg LP.
The yen carry trade does not appear to have been a major factor in this episode.7 Unlike in October 1998, when an unwinding of the yen carry trade triggered a massive yen appreciation, the yen did not appreciate during the recent correction. To some extent, this was not unexpected as underlying conditions for the yen carry trade did not change materially following either the end of quantitative easing in March or the end to the zero interest rate policy in July: the rise in short-term yen rates has remained contained, and long-term JGB yields have been stable, leaving spreads with U.S rates broadly unchanged. But this is also because the yen carry trade may not have been sizable enough—some estimates of outward yen lending by Japanese banks point to a figure around $70 billion8 in 2005—to influence global markets at a time of massive retrenchment of dollar-based investors from emerging markets. Nevertheless, small mature markets which had seen heavy inflows from yen-funded investors, such as New Zealand, were affected.
Japan and United States: Interest Rates Yield Spread
Sources: CEIC Data Company Ltd; and Bloomberg LP.
Outlook for Capital Flows to Emerging Asia
Despite the recent reassessment of risks by international investors, capital flows to the region should remain sizable because sentiment toward Asia remains positive (“pull factors”) and despite a more difficult international environment (“push factors”). Given its strong fundamentals, reduced vulnerabilities and fairer valuations, emerging Asia will likely continue to attract sizable capital inflows, especially in the form of FDI.
Reflecting strong fundamentals, net FDI flows to emerging Asia are expected to remain buoyant. They are projected to reach $85 billion in 2006, down from $93 billion in 2005. Gross inflows are forecast to drop modestly with China continuing to attract the bulk of FDI, albeit at a more moderate pace. At the same time, FDI flows to India are projected to double this year, from low levels, as inflows into the service sector continue and foreign investment into IT and steel picks up. Meanwhile, the recovery in FDI flows to ASEAN economies is also gathering momentum. FDI abroad by emerging Asia is also expected to continue its rising trend reflecting, in part, continued capital account liberalization (India) and efforts to acquire oil assets and other commodities abroad (China).
Emerging Asia: Net FDI Flows
Source: IMF, World Economic Outlook.
Investor sentiment has also received a boost from demonstrated resilience by the region during the correction. While emerging markets in Latin America and Eastern Europe suffered sharp declines in equity markets and currencies, as well as a steep rise in external spreads, movements in the region were more limited. Emerging Asia’s resilience was further demonstrated, as despite the correction, credit ratings for the sovereign external debt of China, Hong Kong SAR, India and Indonesia were upgraded by Standard and Poor’s during late July-early August. (China was also upgraded by Moody’s in July.) At the same time, the Philippines successfully raised $750 million in international markets at a spread of around 250 basis points above US treasuries. Also, external debt issuance by the private sector has remained very active, with total issuance reaching a historical high in the second quarter.
Emerging Markets: Financial Markets Performance Indicators
Sources: JP Morgan; MSCI; and Bloomberg LP.
This resilience is likely the result of improvements in reducing fiscal, financial and external vulnerabilities over several years. External debt levels in the region have declined and foreign reserves are ample. Current account positions, albeit on the decline in most countries outside of China, remain in most cases positive, and exchange rates have become more flexible. Corporate sectors in the region are stronger, their profitability higher and their leverage ratios reduced. Despite persistent problems in a few countries, banking systems have been strengthened, as capital adequacy ratios have risen and vulnerabilities have decreased. In Indonesia and the Philippines, which were seen as the most vulnerable to a change in investor sentiment, external public debt levels have been brought down and fiscal positions have improved following the recent implementation of a series of fiscal measures.
Emerging Markets: Indicators of External Vulnerability, 2005
Source: IMF, WEO database.
With regional asset prices now appearing more fairly valued, equity inflows have recently picked up again and regional equity markets have rebounded. Since the trough of mid-June, markets have risen by 12 percent. This occurred as world equity markets rose on increasing expectations of an end to the tightening cycle in the United States and healthy corporate profits. Following the correction, equity markets valuations in the region have returned to moderate levels (see Chapter IV). The average price earnings ratio for emerging Asia now stands at around 14, slightly below the average recorded since 2000. Other indicators also point to generally fair valuation.
Price-Earnings Ratio on Equities
Despite Asia’s strong position, portfolio and other short-term flows to the region are expected to moderate next year as the global tightening continues and industrial country growth slows. While the region could see inflows and upward pressure on regional currencies related to persistent expectations of appreciation of the renminbi, the situation looks very different from that of a year ago where such expectations led to massive capital inflows into the region. In particular, the spread of policy rates in the region over the U.S. Fed Funds rate has vanished, and industrial country growth is slowing down, affecting prospects for regional equity markets and net equity inflows.
Continued renminbi appreciation expectations could put some upward pressure on regional currencies. The renminbi is continuing its incremental appreciation since its one-off 2.1 percent revaluation on July 21, 2005. Fueled by an increase in China’s trade and current account surpluses, the Non Deliverable Forward (NDF) market continues to point to a further gradual appreciation of the renminbi over the next twelve months. Consistent with these expectations and given the strong trade linkages with China, other regional currencies are seen by market participants as following the appreciation of the renminbi. Any upward movement, however, is not expected to match in intensity that of late 2004, as many regional currencies have already recorded sizable appreciation.
Emerging Asia: Exchange Rates1
Sources: IMF, APDCORE database and Consensus Forecasts.
1 Simple average; excluding China and Hong Kong SAR. An increase indicates depreciation.
With the spread of regional rates over U.S rates expected to remain near zero, portfolio flows are likely to slow. Since the beginning of the tightening cycle in the United States in May 2004, the average spread between Asian policy rates and the U.S. Fed Fund rate has declined by 240 basis points to almost zero now. This decline occurred as strong balance of payments positions and limited inflationary pressures in the region enabled central banks to delink from the pace of Fed tightening. With inflationary pressures expected to remain under wraps, especially in the ASEAN economies, investors are expecting a quick end to monetary tightening in the region. Accordingly, the spread is expected to remain near zero well into 2007.
Spread of Regional Policy Interest Rates over U.S. Fed Funds
Sources: CEIC Data Company Ltd; Bloomberg LP; and IMF staff calculations.
Moreover, the expected deceleration in industrial country growth could affect regional stock markets and prospects for foreign equity inflows. Because of emerging Asia’s intensive trade and financial linkages to the global economy, regional equity markets have been strongly correlated with the global economic cycle and equity markets in advanced economies (see Chapter 4). As the world economy gradually slows from the rapid pace of the past few years, prospects for stock markets in the region could be affected, limiting foreign investors’ interest. Moreover, should the current strong momentum in the technology cycle unravel, given the importance of the technology sector in regional equity markets, prospects could be significantly affected.
Emerging Asia: Equity Performance and OECD Leading Indicators
Sources: OECD; and Bloomberg LP.
Should the global monetary tightening be more pronounced, and the slowdown in the world economy sharper than projected, capital flows to emerging Asia could fall well short of expectations. Our central scenario is a relatively benign one. In this scenario, emerging Asia would be expected to fare well, and could again show its resilience as it did in May-June this year if there were other bouts of volatility. However, should central banks in advanced economies tighten monetary policy more aggressively, the world economy could slow down more rapidly, and a rise in risk aversion could be triggered, impacting Asia significantly. In such a case, emerging Asia would face the challenge of dealing with a sharply reduced external demand and lower capital inflows (or even net outflows), putting downward pressure on regional exchange rates.