China bracing itself for winds of change

Q Bearing in mind the loosening of regulations regarding derivatives in China and other Asian countries, are capital markets now sufficiently developed for foreign and pan-Asian fund houses and private banks to thrive and be able to offer diversified strategies to their clients?

A The curse of success has finally afflicted China. It is caught in a tug of war between domestic policy makers and foreign market players. On regulatory liberalisation, one wants a softly, softly approach; the other a big bang. As a result, China is compressing a 50-year evolution into a single decade. The winds of change are palpable.

First, via QDII and QFII, China is opening up as a source of new funds for asset managers from the West as well as a destination of funds from the West. Second, China is providing foreign investors large-scale access to its quoted companies by allowing their listing in Hong Kong, which remains a highly liquid and transparent market.

Third, by issuing Renminbi denominated bonds to foreign buyers, China is kick-starting a nascent market in fixed income products with untold potential in the years to come. Doubtless, as a capital market, Shanghai will be on par with New York and London by the end of this decade.

However, the success of these initiatives is predicated on two pre-conditions being met. The first concerns currency. Renminbi is over-valued on any objective measure. Its peg against the US dollar is unrealistic and undesirable. The peg was essential during China’s last wave of break-neck industrialisation. The resulting economic maturity now requires a more market-driven approach to currency valuation as much as to trade flows. The modest revaluation in the past 12 months is no more than a baby-step. It reflects the desire to maintain the country’s high economic growth essential for social stability. But the economy has arguably reached the level of maturity and momentum that justify further revaluations. China is now a major player in the world economy: its mercantalist approach is at odds with its new status as an economic superpower.

The second pre-condition concerns corporate governance. Most of China’s quoted companies are government-owned. Transparency in business conduct and financial performance required by institutional investors in the West are conspicuous by their absence.

Many companies trade at stratospheric p/e ratios; as did their counterparts in Japan some 40 years ago, when Japan was expected to overtake the US by the 1990s – only to crash and burn when the Nikkei spectacularly lost its bloom in 1989.

Will we see the repeat of history? China’s recent successes are amazing. But we live in a world where the past is an imperfect guide to the future. History rarely travels in a straight line. Anyone hoping to make a quick buck is living in a fool’s paradise. Investors in the China story fall into two buckets: opportunistic and buy-and-hold. Those good at market timing are attracted by the former: those prepared to ride out regular volatility by the latter. At present, the weight of the money is in the first bucket. Knowing the investment graveyard is full of people who have tried to time the markets in the past, the omens are not good.

China’s policy stance is overtly crafted toward nurturing its own fund managers. Beyond that, transparency and governance have yet to reach levels conducive for deep liquid markets in China. China will have its share of financial scandals and social upheavals. Governance may prove its Achilles heel. Its economy will have periodic down drafts, out of which will emerge a more mature wealth management industry. But it will happen later rather than sooner.

Q Is there still an over-bearing suspicion in some Asian markets regarding devices and products such as ETFs and hedge funds, particularly since the Lehman mini-bonds collapse?

A Investors in Asia Pacific are deeply suspicious of anything that looks funky. For example, outside Japan, hedge funds have yet to score with Asian investors. Even in a sophisticated market like Australia, equities and bonds predominate. Elsewhere, tools like derivatives, leverage and shorting are either banned or shunned. Asset classes are judged on their intrinsic values, not as clever overlays created by financial engineering.

Overall, Asia Pacific significantly trails behind the US and Europe in three major areas: diversification into alternatives, adoption of new asset allocation tools, and deployment of returns-enhancing techniques. Local pension plans have yet to adopt the mark-to-market rules which have forced their peers in the West to be more innovative. In places like China, South Korea and Taiwan, asset allocation decisions of pension plans are governed more by local regulations than market opportunities.

Q Are you seeing any changes to the fast-turnover portfolios to which many Chinese-born inhabitants of a new finance industry seem addicted?

A It is essential to distinguish between institutional and retail investors. The former take a long-term view and aim to hold their largely bond-denominated portfolios to maturity. Even those who have ventured into global equities are not intrepid traders. In contrast, retail and high net worth investors remain hugely momentum driven: for example, the average holding period for mutual funds in Taiwan is reportedly four months.

There and elsewhere, investing retains a gambling undertone that is self-defeating. Excessive opportunism on the part of investors forces fund sellers to adopt high charges to cover their costs. In turn, this forces investors to demand high returns and high redemptions, when they are not forthcoming. At the first whiff of a market downturn, investors head for the hills.

High portfolio churn is common in countries as diverse as China, Japan, Malaysia and Singapore. Broadly speaking, the reasons are two-fold. First, behavioural biases have ensured retail clients tend to buy high and sell low, thereby burning their portfolios unwittingly. Second, Asians have a strong savings culture which, via bank deposits, has delivered capital protection and a small income upside. They expect investments in mutual funds to deliver more than that in a short period. When that does not happen, they throw in the towel and head for the exit door.

Q In your latest research, you mentioned that while Asia is a big priority for most Western fund houses, few expect it to be one of their leading growth engines over the next five years. Do you feel, after your most recent pan-Asian tour, this viewpoint could change?

A Those asset managers in the West who have Asian footprints have largely relied on distribution alliances. These have rendered them ‘price takers’: local partners have tended to keep a larger share of the wallet. In contrast, those who have created physical presence on the ground by venturing into manufacturing via joint ventures have done marginally better. Some have even been ‘price makers’.

In future, a large share of new money at the global level will have Asia as both its origin and its destination. Asset managers from the West who have manufacturing capacity on the ground are likely to fare better.

CV

Amin Rajan

Current Post: CEO of CREATE-Research, a think tank specialising in future trends in global fund management

Vistiting Professorships: Cass Business School; London Metropolitan University; Centre for Leadership Studies at Exeter University

Key clients have included: Aviva, Allianz, Axa, BlackRock, Citigroup, Credit Suisse, Deutsche, Morgan Stanley, Principal Global Investors, UBS

Previous role: Senior Economist at UK Treasury

Recent Asian tour included: Australia, China, Hong Kong, Japan, Malaysia, and Singapore to carry out his latest research on Asian finance trends. He conducted 30 interviews and four public presentations. The one-to-one meetings focused on how Asia will become a major originator as well as the destination of new funds. The public meetings focused on the future trends in global asset and wealth management

Amin Rajan: "Anyone hoping to make a quick buck from China is living in a fool's paradise"