Asia’s economic outlook is a story of cautious optimism. All the signs are good, but the process of withdrawing stimulus, avoiding asset bubbles without derailing the recovery, will be delicate.

It’s hard to start a look at Asia’s outlook anywhere other than China. “I’m in the ‘China saves the world’ camp,” says Tin Condon, chief economist for Asia at ING. “In late 2008 China’s policies, particularly the fiscal stimulus early on, saw domestic demand and investment almost immediately accelerate.” That started to suck in imports, visible in the stabilizing of Asian export markets early in 2009, and one by one other economies are recovering in line with their exposure to Chinese demand. “It’s just a question of where they are in the cycle,” he says. “The North Asian economies are ahead of the Southeast Asians, and they are ahead of the US; the winners in terms of growth are going to be the ones most exposed to China.”

China’s influence, and that of emerging markets generally, has become a widespread view; HSBC’s group chief economist Stephen King and global head of emerging markets research Phil Poole wrote in January that “we have reached a tipping point in global economic affairs….2009 will surely go down as the year when we both uncovered the scale of the crisis in the developed world and celebrated the resilience of much of the emerging world in the face of what appeared to be a perfect economic storm.” They, too, pinned this on China, now “able to stand on its own two feet, capable of delivering rapid economic growth even while its export engine was badly misfiring.”

But the scale of China’s influence has been clear in a less welcome way recently, with its efforts to withdraw stimulus having a pronounced negative effect on world markets. “It’s been an awful two weeks and a lot of that is China bubble angst, and worries about the removal of stimulus,” says Condon.

Certainly, getting this process right is – for China and all world economies – going to be tricky, and hugely important. “It’s all about fine tuning,” says Mike Rees, CEO for wholesale banking at Standard Chartered. “It’s a very delicate balance. The differences between overreacting and under-reacting are quite profound. Many local banks are flush with liquidity and trying to use that liquidity. The problem is how you withdraw it in a certain way so you don’t go cold turkey.”

It’s already happening: India has raised its statutory reserve requirements for banks by 75 basis points, to 5.75%, and is expected to increase policy interest rates at the next opportunity. China has introduced curbs on bank lending. “It’s about pulling gently on each of the levers to find the right balance,” says Rees. “The real question is whether they accept a lower level of growth to reduce the risk. And I don’t think that debate has started yet.”

Economists vary on their opinions of where China goes next in withdrawing stimulus, but Jun Ma, the chief economist at Deutsche Bank, has a representative view: a desired level of new lending at RMB7.5 trillion for the year, compared to RMB9.6 trillion in 2009; a rise in reserve requirement ratios in the first few months of 2010 [this has since happened]; raised interest rates from the People’s Bank of China from the second quarter; and gradual appreciation in the RMB. Regulators have already said they want an increase in capital adequacy ratios at the big banks to 11% in 2010.

Ma says China will also undertake significant structural reforms, to remedy over-reliance of growth on investments and exports; the external imbalance, illustrated by a large trade surplus and the rise in FX reserves; overcapacity in low-end energy intensive manufacturing sectors; and the environmental impact of the current growth model. He suggests stimulating consumption, promoting urbanization in second and third tier cities, accelerating health care reform and promoting new (greener) energies as possible policy shifts.

China’s cooling measures are not proving especially popular with markets so far, but most economists are pleased to see them happen. “In China’s case it’s difficult to bet against the track record of the authorities in soft landing their economies,” says Condon. “Eventually investors will get comfortable that these measures in China are positive, and will sustain growth not derail it, and this bubble angst will fade.” But it’s going to take a while. “This removal from stimulus question will be a serious overhang for risk assets in the first quarter of the year and it’s already proving to be.”

Nobody is expecting Chinese growth to go backwards as the stimulus comes out though, and projections on its numbers still look dramatically different to anywhere in the developed world. Qu Hongbin, HSBC’s chief economist for China, is calling GDP growth to accelerate to 9.5% in 2010 from 8.7% last year, with an infrastructure-led recovery sustained well into 2010.

India has similar prospects and equally robust challenges, just without quite the same global scrutiny that China attracts. India’s own official GDP target for 2010 is now 7.5%, revised upwards from 6%, and once again the question has turned from how to recover to how to keep things calm. Barclays Capital economist Prakriti Sofat calculates that India’s recent cash reserve ratio hike will withdraw Rs360 billion from the system, but that “even after a full pass-through of the hike, we think there is roughly Rs350 billion of excess liquidity in the system.” Sofat adds: “The RBI has clearly indicated that liquidity management and controlling inflation were its key policy goals ahead of its next meeting in April.”

Elsewhere in Asia, the picture varies from place to place. Some countries look far removed from the Indian and Chinese success stories: Philippines GDP growth in 2009 was just 0.9%, and government forecasts for 2010 are a modest 2.6 to 3.6%, hostage to food prices and El Nino conditions. In Malaysia, where prime minister Najib Razak has predicted 3.5% growth, there is the potential impact of political change and social unrest, something Malaysia has not had to think about for 40 years. In Thailand, the timetable for stimulus withdrawal looks positively American: Barclays Capital doesn’t expect a rate rise until the third quarter of 2010 and expects interest rates to reach 1.75% by year end. Generally speaking, it’s the bigger economies that engender optimism, with Indonesia another standout, buoyed by the political stability that came from last year’s presidential re-election.

Generally, few economists are predicting unbridled joy for emerging market economies, with most expecting some kind of scare or distraction in the course of the year without necessarily reaching consensus on what it will be. Bank of America Merrill Lynch analyst Daniel Tenengauzer has been describing this as “Thanksgiving before Halloween”, with a market feast in the first six months of 2010 followed by some kinds of market scare. This premise calls for strong performance in emerging markets assets in the first part of the year, driven by appetite and a rebound in inflows, with some volatility. Merrill points to forecasts from the Institute of International Finance, which recently revised up its projection for net private capital flows into emerging markets for 2010 to US$722 billion, from US$672 billion. This would be a 65% increase on 2009, and would also be up on 2008.

The second part of this scenario (the scare bit) could be prompted by further tightening of monetary policy – including the European Central Bank, which Merrill expects to see raise rates in September – and a correction in foreign investor positioning if they have overstretched their emerging markets exposure in the first half of the year.  

For years, economists have been debating the strength of intra-Asian trade and its resilience when export markets are down; the crisis has provided some illustration of how much Asia has grown in that regard. Asia may not have been strong enough to miss out on the world’s stock market collapses, but economically, it does look reasonably well differentiated. “Internal Asian trade is one of the main drivers of export recovery,” notes Qu at HSBC. “With demand elsewhere in the world stabilising following earlier declines, exports should continue to underpin Asia’s rebound over the next several quarters.” But he is keen to note it’s not all about exports, and Asia’s recovery is not entirely dependent on them. “To date, domestic demand has provided the main lift to Asian growth, a theme that will continue over the coming years.” He says surveys show hiring intentions near record highs in most markets, with car sales soaring across the region, particularly in China, Vietnam, Taiwan and India.

And so the big questions all come back to central bank policy. “We expect central banks in all Asian markets, with the exception of Japan, to raise interest rates, even before their peers in the west have embarked on a tightening course,” Ho says. “In essence, the trajectory of monetary policy between the East and the West will have to diverge, putting ever growing pressure on the region’s exchange rates to appreciate.”

But none of this is easy, and Rees has a cautionary, practical reminder. “Not everyone is going to get this right,” he says. “The chances of every country getting it right first time are virtually nil.”

Few parts of the world financial markets were harder hit than securitization in the global financial crisis. Across the world, deals dried up: the practice of pooling of securities into single instruments received a lot of the blame for starting and exacerbating the crisis, and even as investors returned to debt instruments, they tended to steer clear of anything complicated.

But there are signs of revival in the securitization markets in the Asia Pacific region. This is so far chiefly an Australian story rather than a regional one, but practitioners are hopeful that as Australia demonstrates a way back to liquidity, issuance and reasonable pricing, other nations in the region will follow.

In Australia, the revival of the markets has been underpinned by the Australian Office of Financial Management, a specialist agency of the federal government with responsibility for Australian government debt. In September 2008, as the crisis bit, the AOFM announced plans to invest up to A$8 billion in Australia’s residential mortgage-backed securities (RMBS) markets by purchasing issues in order to support competition and provide liquidity. By December 2009 it had invested A$7.753 billion of that in 20 RMBS issues, with other investors, encouraged by the government’s involvement as a cornerstone investor, putting in another A$3.611 billion in the same deals. According to the government, that program financed mortgages over more than 62,000 Australian residential properties in Australia with an aggregate value of about A$17 billion. That first package was, as Tim Galt, director for asset backed securities at UBS, says: “a welcome lifeline for the market.”

The big question, once that funding was used up, was whether the government would come back. The answer came in October 2009, when the Treasurer, Wayne Sawn, pledged another A$8 billion to purchase RMBS, this time with a focus on supporting lending to small businesses and “lenders who have been largely or wholly reliant on securitisation markets to fund mortgage lending.” They had a January 15 deadline to lodge proposals, and six were received; after evaluating them the AOFM has agreed to invest in five of them, from AMP Bank, Firstmac, Liberty Financial, Members Equity Bank and Resimac, with an aggregate investment of up to A$3.4 billion. In other words, it’s the non-banks – those that were not covered by the government guarantee during the financial crisis.

While the government was considering its second program, the markets improved so much that several RMBS deals were successfully completed without needing AOFM funding. The most notable was SMHL Securitisation Fund 2009-2, backed by Members Equity Bank, a A$1.25 billion landmark (upsized from A$500 million) launched in September 2009. Only the second RMBS deal done without a cornerstone contribution from AOFM, it attracted 20 investors, some of them foreign fund managers. With Macquarie Bank as sole arranger and Commonwealth Bank of Australia and Deutsche Bank as joint lead arrangers, the deal stood out for its size and the demonstration of confidence in the market.

That confidence has been demonstrated again with a still bigger deal for Westpac, which raised A$2 billion in an RMBS deal in December, again without AOFM involvement. Entitled Series 2009-1 WST Trust, it was self-led and, at 130 basis points over one-month BBSW for a triple A-rated tranche with a weighted average life of 2.6 years, it brought the cost of funds into line with that payable on Australian government-guaranteed offshore bonds for the big four banks.

Kevin Lee, division director at Macquarie Bank, calls deals like Members Equity “a real watershed, giving the market confidence that things are recovering and getting to a self-sustaining footing.” Galt at UBS adds: “The best examples of how the market is starting to revive itself are the new issues that have been executed without AOFM sponsorship. It is a very positive sign to be able to launch and price a meaningful RMBS transaction without small to no government sponsorship.”

More than that, the new deals demonstrated a strong third party investor bid for RMBS. “What suggests that the market is emerging is that primary markets are pricing flat or competitively to secondary markets for Australian dollar denominated RMBS,” says Galt. “How we’re reading that is that investors can’t get bite sizes in the secondary market as large as they need and so they have to come to primary issues to get that volume.”

The success of these deals begs the question: was there any need for further government involvement in the market? One banker says: “I’ve got to say, when it first came out, it looked like it was a bit pre-emptive and not really required. I would have preferred to see the market shoulder more by itself.” But a closer examination of the difference between the two programs means that most bankers are glad it’s there as a spur to diversify the range of issuers. As Lee puts it: “Although we are starting to see standalone deals, it doesn’t mean every issuer can do a standalone transaction. It’s important for market confidence that they know the government is there and supporting in this transitional phase.”

“It sends a very positive signal to the market,” argues John Claudianos, managing director in the global asset securitization group at Deutsche Bank. “It says we are going to see continuing government support for the issuers and originators outside of the major banks, who look after the sector of the community that has needs for business-related mortgages.” It was part of the bidding process that applicants had to demonstrate they weren’t only going to support residential mortgages but also those with an emphasis on small business lending. “It allows those originators to know that funding will be forthcoming,” Claudianos adds. “Previously they didn’t have the confidence to go in with a campaign to originate mortgages because it was unknown to them whether there would be support when they got to financing.”

“The measure here is not to alleviate a legacy mortgage problem,” says Claudianos adds. “It’s the forward outlook of originating new mortgages and making sure the originators know they’ve got funding.”

For its part, the AOFM explained its decision in a January announcement. “Investor sentiment has improved in Australian RMBS markets since the inception of the program, especially in recent months,” he says. “Some RMBS issuance has been possible without AOFM support. However RMBS markets continue to be affected by the fallout from the global financial crisis and will need to improve further to support affordable new issuance from a broad range of lenders.”

The AOFM did make some changes to its methodology between the two programs, shifting to two platforms: a reverse enquiry approach, and the ‘pipeline’ mandates outlined above. “Any securitization issuer in the Australian market can now apply for a specific deal to see if the AOGM is keen to support it under the reverse inquiry platform,” Lee says. “For those five issuers announced to have mandates under the pipeline platform, it tells them they have AOFM support through 2010 and we can expect a range of deals from them.”

Structurally, unsurprisingly, there’s little that’s new here: straightforward RMBS deals are the way to go. So far deals have been in Australian dollars only rather than the dual-currency deals commonplace three years ago, but they are likely to return in time. Bankers also report that the investor base is very similar now to what it was pre-crisis, although some new professional accounts have arrived. “We didn’t have the SIVs,” says Claudianos. “The Australian dollar tranches were always real money investors, fund managers that did not have a SIV type funding problem and so didn’t disappear. 80% of the investor base that used to be there is still there.”

Australia is all about RMBS: the quality of collateral is famously high, reflecting both the strength of regulation and the strong cultural link between Australians and physical property. “I don’t think that dynamic has changed,” says Galt. “The collateral we’ve seen come to the market since late last year has been very strong. People are well aware of the necessity to bring very well seasoned pools with high quality borrowers.” Claudianos agrees. “The quality is superb,” he says. “The seasoning of these pools has been on average 30 months.” Defaults on prime mortgage pools in Australia, which in the good times are normally 1% or a little lower, peaked at 2% in January 2009 and currently stand at around 1.4%.

The next question is when the market diversifies into other sources of collateral. It could be a while. “The core funding facility that an Australian family has is centred around the home loan,” says Claudianos. “In the US you grow with auto companies offering so much competition they give a great package and so need to get funding from the securitisation markets – that doesn’t happen here. And there’s no specialist credit card lenders to do those deals. I think it’s going to be 95% mortgages here.”

Consequently it’s likely to be a while before deals extend into other underlying classes. “CMBS has been quieter,” says Lee. “The cloud that has been hanging over the head of that asset class has been the refinancing risk in some of those structures. But sentiment in that sector has been improving as well as we have seen some CMBS deals refinance recently and we could see more activity this year.”

Outside Australia, deals are rarer; a recent deal from India’s IFMR Capital, backed by 42,000 micro-loans from microfinance lenders, was a good sign but it was worth just Rs308 million, or US$6.68 million. At the time of writing, all eyes were on the Philippines, where a planned Ps40 billion deal from Power Sector Assets and Liabilities Management (Psalm, the power utility) was halved and delayed in December; it’s not yet clear how, when or where joint leads Standard Chartered and Development Bank of Philippines will place the deal. If it does, it will be a shot in the arm for the markets, a real sign that asset-backed deals are alive and well in Asia.

Australian Financial Review, February 2 2010

When Anwar Ibrahim walks into the Kuala Lumpur High Court today, he will at least know what to expect.

Anwar, Malaysia’s one-time deputy prime minister and now the de facto leader of the first credible opposition in Malaysia’s independent history, is facing the third incarceration of his life. The first was a 22-month detention when a student leader in the 1970s; the second a six-year stint in 1998 for sodomy (overturned in 2004) and corruption, during the administration of his one-time mentor, Mahathir Mohamed. Now, he faces another sodomy charge, and the potential of 20 years in jail. Locally the press are calling it Sodomy II, like a sequel. “They use the same script,” he tells the AFR in an interview in his Kuala Lumpur offices. “I’ll leave it to the lawyers. I don’t have any trust in the system.”

That’s no surprise. Anwar’s trial represents an enormously significant moment for Malaysia, because it could make or break the opposition movement at a time of intense racial tension on a scale the country hasn’t seen since the race riots of the 1960s. Malaysia, though a sometimes uneasy patchwork of a Muslim Malay majority and significant Chinese and Indian minorities, has for decades been amongst the most moderate and peaceful of Muslim nations. Yet in recent months it has become a place where churches are firebombed over the right for Christians to use the word Allah, and where cows’ heads are kicked around outside Hindu temples.

Some feel these forces have been inflamed by the country’s UMNO party, the leader of the ruling Barisan Nasional coalition, seeking to secure its hold on the Malay vote; Anwar calls it “desperate measures to frustrate this peaceful transition.” But at the same time Anwar’s own rise, with his multi-racial coalition securing one third of the votes and five out of 13 states in landmark elections in 2008, has become something of a catalyst for this expression of tension. “Yes, of course that is true,” he says. “You can see the press, controlled by UMNO, blaming me for causing this, for giving courage to non-Malays to express themselves. But I think the contrary: we are giving that right of expression to all. There is a new generation of Malays who are asserting themselves with greater confidence.”

Another jail term for Anwar could do one of two things. It could wreck his coalition, which despite its outstanding 2008 performance has widely been viewed as fragile: it unites a party formed by Anwar’s wife, Wan Azizah Ismail (who is still officially its president), during Anwar’s 1998 jail term, with a sometimes hard-line Islamic party and another whose key constituency is overseas Chinese. Lacking a charismatic leader to glue it together, the alliance could fail well before the next elections, due in 2013, although Anwar insists detailed contingency plans are in place among the three parties. “There is already an agreement what to do in the event – the unlikely event – I am convicted, yet again. The coalition will stay with or without Anwar.”

Alternatively, another conviction could unite opposition behind a cause and give it renewed momentum. It is also not likely to go down well overseas, where doubts over Anwar’s earlier conviction are already widespread; public figures who have already voiced their concern for him range from Al Gore to US Supreme Court Justice Sandra Day O’Connor and, right up to his death, former Indonesian president Abdurrahman Wahid.

The uncertainty is not helping Malaysia, where foreign direct investment numbers are flagging even after accounting for recession: from M$62.8 billion in 2008 to M$12.6 billion in the first nine months of 2009. “Foreign investors are asking me about Anwar and the firebombings all the time,” says one foreign banker in Kuala Lumpur who deals with major foreign investors. “If Anwar ends up back in the slammer it’s going to have major negative consequences on Malaysia. Whether or not it will mean riots on the streets I don’t know, but it will certainly harm the government.”

Anwar is an appropriate figurehead for his country’s painful change. It’s easy to forget it now, but he was once the chosen one to succeed Mahathir: he was deputy leader and finance minister through the Asian financial crisis and was trusted so implicitly he was made acting prime minister for two months in 1997 when Mahathir took a holiday. But he wanted reform in governance and institutions, and when he started linking Mahathir with improper contracts and bailouts for family members and cronies, his time in the sun came quickly and brutally to an end. His 1998 trial raised concerns worldwide; Amnesty International considered him a prisoner of conscience, and the injuries incurred in jail cause him back pain to this day.

Because Anwar’s corruption conviction was never overturned, he was banned from politics until April 2008, and took to teaching in the US. Malaysia’s then prime minister, Abdullah Badawi, timed the 2008 elections to be just one month before Anwar’s ban expired, fearing his popular voice, but it didn’t work: Anwar simply canvassed for his wife’s party, and when his ban expired she surrendered her seat and he won it in a by-election. For a time his momentum seemed unstoppable: by September 2008 he was claiming to have secured 30 parliamentary defections that would give his coalition a majority. He demanded a vote of no confidence.

But then things stalled. First, he couldn’t force that vote, and he says he couldn’t expect his converts to declare openly until the moment of truth on the parliament floor – consequently, there’s no proof that he ever had the numbers at all. “In any democratic country we would have taken over by now, because we had the numbers, but there’s no way to go about it,” he says. “In this climate of fear and repression you can’t expect people to declare openly now except for the critical moment when the motion is tabled.” By this he is referring to the string of opposition figures, including a number of state leaders, who have been comprehensively investigated by federal institutions since the election.

Momentum was further derailed when in June 2008 a new sodomy charge, from a young aide called Saiful Bukhari Azlan, appeared with a convenience of timing that many have found deeply troubling: the taint of sodomy, illegal in this Muslim country, is considered a death knell to an aspiring politician. Whether people believe the charge or not, defending it has been time-consuming and helped to take the wind out of the challenge’s sails. And many events in the build-up to the case – the team of commandos sent to arrest him when he was on his way to the police station to make a statement, the dispute over whether the prosecution should have to let the defence see evidence prior to the trial, confirmation that Saiful visited current prime minister Najib Razak’s residence days before filing his police report – seem to bode badly for him.

But while Anwar is under pressure in the court, it’s the incumbent government, and in particular the UMNO party at its heart, that is struggling, and not just with those election results. Even in a country with a largely compliant mainstream press (but a vibrant alternative media), the government and the country’s other key institutions have found themselves mired in scandal: the death of opposition political aide Teo Beng Hock, who fell from a 14^th floor window during questioning by the Malaysian Anti-Corruption Commission (MACC). There’s the murder of the Mongolian model Altantuya Shaariibuu, the mistress of Najib’s foreign policy advisor, who prosecutors claim was killed by government commandos in 2006 and whose body was destroyed by C4 explosives. There have been scandals over contracts for French submarines, jet engines that have gone missing, and a dispute over the legitimacy of a state government in Perak.

And most recently, a court case regarding the use of word Allah by non-Muslims has flared up. In December the High Court, in dealing with a long-standing dispute between the government and the Catholic Herald newspaper, ruled that the government had no power to prohibit the use of the word Allah or to make it the exclusive preserve of Muslims. Numerous acts of arson on Christian churches have followed the ruling, while the original debate has become a somewhat farcical exercise in semantics, with the government – which, incidentally, is in the middle of a major public relations tilt called One Malaysia aimed at promoting racial and religious unity – ruling that Christians in East Malaysia can use the word Allah when speaking Malay, but that those in West Malaysia cannot.

Many of Kuala Lumpur’s business community are increasingly alarmed. “You see Najib on one hand talking about One Malaysia and a multi-racial tolerant country, and on the other you see the complete opposite of that driven by the establishment,” says a banker, who like all commercial figures in this article wished not to be named for fear of damaging relationships with government. “This may sound over the top but I would describe Malaysia as almost anarchy at the moment, because all the institutions of government believe that their job in life is to restore BN back to its previous power. The judiciary believes its job is to prosecute the opposition. The police: that their mission is to prosecute the opposition. MACC, the same. The guys in power are stoking racial unrest because they believe it’s one way of supporting the Malay vote.”

Anwar – who took some strident positions on Islam himself in his youth – has sought to preach a less radical middle ground. “I have asked the world’s most renowned authorities on Islam and nobody, not one, disputes the fact that Allah can be used by anyone,” he says. “It’s been a non-issue for 1,400 years among the Muslims.” Even PAS, the Islamic party in Anwar’s coalition, normally known as the voice of those with a more traditional and inflexible view of Islam, has publicly said they have no problem with Christians using the word: the fact that the purely Islamic party is now on more moderate ground than the government has cemented a feeling that the government has been playing the race card to try to win back disgruntled Malay voters.

The government has not been blind to change and has taken some reformist measures itself. The most significant concern the New Economic Policy, the measures enacted in the 1960s – by Najib’s father – in support of the local Bumiputra (“sons of the soil”, or Malay) population. It guaranteed them, among other things, a certain proportion of civil service jobs, and a minimum share of any stock market float. While understandable in the context of its time, many, Malays included, have come to see it as a crutch that has become a hindrance, damaging competitiveness and breeding complacency. Late last year Najib began some modest repeals.

So does Anwar believe change can be effected peacefully in Malaysia? “Well for the first phase, the five states [in the March 2008 elections], it did,” Anwar says. And despite doubts about his coalition’s durability, he argues its very cross-faith existence is enormously positive. “It means that in Malaysia, if political leaders don’t continue to incite hatred and use the race card in politics, we can survive,” he says. “The problem is UMNO: they have become an obsolete party of the past.”

But Anwar is not a Mandela and will never quite be embraced in that way. For a start, there is the fact that, having started out a somewhat radical student and youth leader, he switched allegiances to Mahathir in the 1980s and made his name soaring through the ranks of the party he now dismisses as “the last refuge of scoundrels”. He argues that when he joined Mahathir in 1981 he did so because the leader was talking about reform, and that through much of the 1980s they were effective; it was when a more authoritarian style came into effect that he objected, at great personal cost. “But can I absolve myself from the entire policy, decisions, excesses? No I cannot. I have made that very clear to the people.” Did he ever engage in the money politics commonplace in UMNO at that time? “When I announced my candidature (as deputy leader) 80% of the UMNO cabinet members, all chief ministers, were with me. So I didn’t need to go beyond that. The culture on the ground, you have big fees, but nothing compared with this cash being paid [in UMNO now].”

Additionally, some accuse him of opportunism in his career, and of inconsistency: a chameleon quality (he uses the word himself), saying what the audience of the moment want to hear, which raises questions about how he would fare in office when there can be only one decision for all audiences. Some say he is disorganised too, and unable to give his closest staff a clear mandate. “He is a great politician inasmuch as his oratory skills are fantastic, and he can definitely speak to a crowd,” says one observer. “But he can’t administer and he can’t organise.” Another stresses that “what happened in the election was a vote against government, not a vote in favour of the opposition.” On top of that mainstream media is unlikely to take his side, though the advent of Twitter, Facebook and blogs have helped dramatically, and it is noticeable how much stronger his support in well-connected and tech-savvy urban areas is than in rural Malaysia.

Listening to him in English, fluent but understated and sometimes a little unclear, one wonders how the chameleon projects to the heartland.

The answer comes later that night at a rally in a community hall in the Kuala Lumpur suburb of Cheras. Here, in the local Malay language of Bahasa, the delivery is utterly different, voice playing the ranges from aggression to a whisper, arms expressively aloft, the audience by turns brought to laughter, indignation and applause.

For sure, this is a home team crowd, but it’s largely a Malay Muslim crowd, supposedly the very core of UMNO’s appeal, and they are packed 50 deep outside the hall exits, arms folded, listening intently. Some have brought their children, drooping flopped on shoulders; it is 11.45pm on a Thursday night.

He will do the same on alternate nights leading up the trial, campaigning steadily when an election could still be years away. Over noodles with his chief ministers and supporters, well past midnight, he tells the AFR about the forthcoming weekend rallies where he expects crowds far greater than the 1,000 or so who turned up tonight.

It’s no surprise he looks tired. Earlier the AFR had thanked him for his time, remarking how busy he must be. “Not busy,” he says. “Under siege.”

 Click below for a PDF of the story as it ran

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The global financial crisis tested banks and corporates alike. In Asia, the vast majority of both camps survived. But as treasurers and their forex bankers emerge from the other side of crisis, how has their relationship changed?

For many, the answer is not so much about product but relationship: the rigour with which banks and companies seek to understand each others’ creditworthiness, a growing need for documentation and a shared focus on risk management. Some paint this as a deeper relationship than before; others, a more hard-headed one in which credit is tighter and far less is taken on trust.

Talking to treasurers, one would think nothing has changed. There are plenty of stories in Asia about companies that came unstuck because of unwise attitudes to forex: the worst was Citic Pacific, which announced in October 2008 that it faced HK$14.7 billion (US$1.9 billion) in losses after currency market positions it had taken on the Australian dollar and the euro went wrong. But mercifully the Citic Pacific story is unusual. The best-run companies in Asia were not involved in speculative derivative transactions to start with and are very keen to make that clear. So a common response on the product side is that business is the same today as it was two years ago.

“We have always hedged all exposures transactionally using mainly plain vanilla spot and forward contracts,” says Jayant Parande, senior vice president and group treasurer at Olam International, the Singapore-based soft commodity group. “Therefore there has not been any change or additional requirements post-crisis.”

At Taiwan Semiconductor Manufacturing Corp, treasurer Wendell Huang takes a similar view. “In terms of foreign exchange derivatives, we only do hedging. We do not do speculation or trading: for us our primary mission under any circumstances is to hedge our positions.”

And in Manila, San Miguel’s treasurer, Sergio Edeza, says he has seen little change. “Companies in the Philippines are not as sophisticated in their requirements for FX and derivatives as they are elsewhere, especially because the central bank is very restrictive on what local banks can offer corporations here,” he says. “As a result, there were probably very minimal changes in terms of transactional needs from companies here. What we have here are sufficient for corporate requirements: forward spot and forward foreign exchange dealing, including non deliverable forwards, swaps and to some extent currency options.”

But senior forex figures at the banks who deal with treasurers talk about the last two years in an altogether different tone, detailing significant shifts in corporate treasury behaviour and bank relationships. “A lot of things have changed,” says Ray Franzi, head of FX structuring for Asia at Deutsche Bank. “Business is being conducted in a much more conservative manner than it was three years ago.”

More than anything, what comes through is a toughness from banks towards their clients. One senior foreign exchange figure at an international bank speaks to Asiamoney on condition of anonymity in exchange for “telling you what’s really happening.” “We’re asking for information from corporate customers now that we never would have done in the past,” he says. “We insist on a client telling us categorically if they could be over-hedged across the full range of their counterparties; whether they have thought through the worst case scenarios and are prepared to absorb them if they happen.”

This bank, like many, is now insisting on many counterparties collateralising – putting money or assets on the line to underpin whatever credit is extended to them. “In the past, they could expect to be given a clean credit line from the majority of the banks, but we are more discriminating now. Most are moved into a collateralized arrangement or struck off our counterparty list.

“That’s a shock to the system if the corporate treasurer is used to ample credit lines,” he adds. “Under this new regime it’s easy to think the bank doesn’t value the client. It’s actually nothing to do with that: it’s to do with the fact that capital is more scarce.”

And in exchange for that capital, banks expect more business. “Rolling over loans is not as easy as before,” says the banker. “Corporates are increasingly expected to give their ancillary business to the lending banks as well, such as commodities, FX, interest rate derivatives. It’s a more two-sided relationship now: it’s not like when there was too much liquidity and we were all bending over backwards to serve treasurers.”

Others are less blunt in their assessment, but there is clear evidence of a change in stance.

“If we are looking at vanilla products, like plain forwards, before we were only looking at the market prices, with less scrutiny of the credit of our clients,” says Franzi. Now, he says, pricing reflects the credit standing of the other party. While that might not sound good news for the customer, Franzi argues it is to everyone’s benefit. “It shows a maturing of our business. The fact that we are applying this to as many of our customers as possible makes us a much more valuable and credible partner for the corporate.”

This is where bankers and corporates find common ground in their views on the impact of the crisis. “Before we go into dealings both they and we are very interested in pricing in all the risk that they have, and going much deeper with the clients to understand what those risks are,” Franzi says. “Before, we had an easy conversation:  we have revenues that are x, we want to hedge them. Now we do checks and take the dialogue to the balance sheet level.”

Still, if banks are getting tougher, it’s a two way street. One foreign exchange banker recalls, now with some amusement, that in the depths of the crisis “half our customers thought we were going down and we thought half our customers were going down.” Franzi puts it like this: “We are more demanding with our customer but they are more demanding with us.”

And corporates can give as good as they get. Treasurers who were previously willing to countenance working with all manner of banks with little differentiation between them have got smarter. One, asking not to be named, notes that two years ago it would have bracketed Lehman Brothers, Citi, Barclays and JP Morgan as being roughly the same sort of counterparty. No more.

“We require an even higher credit standing from the banks,” says Huang. “To give you an example, we may have dealt with some local Taiwanese banks which may not have had an A- rating or higher. But during the crisis we started to exit from these banks, in terms of placing deposits. Now, our banks are pretty much at least A- rated.”

This is a comment echoed elsewhere. “We have been very selective in the banks we deal with because of their own financial position,” says Edeza at San Miguel. “We try to deal with more stable banks.” In the short term, this has helped domestic banks, who have the advantage of familiarity with local companies, although Edeza says: “I think foreign banks have a lot to offer in terms of their network and the ease of doing business.”

In practical terms, this shift in trust can be seen in changed attitudes to documentation. The two key documents that typically underpin foreign exchange derivatives are the International Swaps and Derivatives Association (ISDA) master agreement template, and the credit support annex (CSA) which regulates collateral support for derivatives transactions and is generally combined with an ISDA document. “They enable the netting of products, and decrease exposure for most of our clients,” Franzi says. The CSA has typically been seen as optional but in this new environment is becoming essential.

And while products have broadly shifted to the simpler end of the spectrum, banks argue it’s more about the way that products are used than the products themselves. “One lesson that has been learned is the need for rigour in the way companies approach risk management,” says one forex banker. “It used to be like this: I have exposure to the Japanese yen and would like to enter into a hedge; I have a view of the markets and if my view is correct the hedge will be better than a vanilla forward, and if I’m wrong, it will be worse.

“Now, people take a step back. You might still end up asking for a product that outperforms a vanilla forward, but first you will have asked: what are our exposures? Can we quantify the variables that will affect that exposure? Should we mandate treasury so that at least 50% of the exposure requires a hedge, 20% is unhedged and in between you can do an option structure? So the range of products isn’t necessarily more limited, it’s the way they are contextualised.”

The move to simplicity doesn’t particularly entice bankers. “There has been a preference for more vanilla products, but a lot of that is driven by a lack of understanding of derivatives at the highest level of companies,” says Adam Gilmour, managing director and co-head of corporate sales and structuring for Asia at Citigroup. “An unfortunate consequence of that is that if a hedge loses money, the guys at the top tend to blame the guy who put the deal on, when it might well have been the correct thing to do at the time.”

In Gilmour’s view, treasurers ought to be given a bit more slack. “We always talk to companies about core hedging and tactical hedging,” he says, referring to the difference between hedging a set percentage of your known exposure with a simple product, and taking a view on where currencies are going to go. “I say to treasurers: you are paid to have a view. Most people agree there is a degree of view-based hedging that is allowable.” Consequently, in his view, “the push back into more vanilla products is temporary.”

Be that as it may, it’s certainly there. San Miguel’s Edeza is uniquely placed to judge both sides of the debate: entering the financial crisis he was a banker, at Rizal Commercial Banking, before joining San Miguel in late 2008 (he is also the former national treasurer). “I was working for a bank during the time the crisis was happening, and the management decided to be more focused on the simple and straightforward products,” he says. “It’s true for many institutions, including local banks and it’s true in the corporate world as well.”

One view that does receive unanimous agreement is that the corporate treasurer’s job has got harder in the last two years. “The principle change is the need to be more focused on risk management,” says Edeza. “You need to be more probing in the financial products you would like to engage in, and weight very well the risks you are taking.” Or as Huang puts it: “Life has become more and more difficult.”

BOX: When it really goes sour

In some cases, relationships between treasurers and forex or derivative bankers have turned really nasty. Korea, China and Sri Lanka all have their examples, but Indonesia is arguably the focal point of these increasingly acrimonious disputes.

Five cases involving local parties and foreign banks stand out. HSBC found itself in the South Jakarta District Court twice last year, each with seafood exporters: PT Toba Surimi Industries and PT Fresh On Time Sea Food. JP Morgan was in the same court against the pharmaceutical group PT Kalbe Farma, and Citibank came up against palm oil group PT Permata Hijau Sawit. Standard Chartered crossed swords in the Central Jakarta court with PT Nubika Jaya, which manufactures olechemicals. One other thing binds these cases together: in all five cases, the foreign party lost. Every time one of these cases has reached a local court, the original contract has been declared null and void.

There are various reasons for the decisions: most of these contracts are callable rather than vanilla forwards, and have been interpreted as speculative by the courts, rendering them in breach of a Bank Indonesia circular (albeit one that came out after the contracts were signed). Other reasons include a claim that the transactions were not explained in Bahasa, breached the company’s master agreement with the bank, involved inadequate disclosure of risk or were signed by the wrong person.

The cases that have gathered the most publicity are those involving JP Morgan and Citi, and in neither instance is the dispute over. Each intends to appeal to higher courts. The JP Morgan one stands out because the derivative contract was structured under English law and was first heard in court in London, where JP Morgan was given a US$19.2 million award. The problem came when JP Morgan sought to get it enforced in Jakarta, only to see it overturned.

It remains to be seen who comes out on top when the disputes reach Indonesia’s more senior courts, in front of judges likely to be more familiar with the complexity of derivatives contracts. But in the meantime, foreign banks have all but axed their derivative sales in Indonesia, fearing that anything bar the most straightforward contracts will later be rendered unlawful, or that contracts won’t be respected. It’s not a good outcome for anyone.

When Credit magazine started out 10 years ago, Asia was still fighting its way back from the financial crisis that had rocked the region through 1997 and 1998. A decade later, its reaction to another crisis –this time global – would illustrate just how much Asia’s debt markets had grown in maturity in the meantime.

A first glance at the volume numbers might suggest that the big story of the last 10 years has been the development of the G3 markets for Asian issuers. Volumes have more than trebled during that period, from US$19.2 billion in 2000 to US$65.7 billion in 2009, according to Dealogic. But really, that’s a story of the first half of the decade: most of the increase had come by 2005, when volumes topped $50 billion, and declined thereafter until the huge refinancing needs that came through last year. “Most of the growth happened in the first five years, since when we’ve been running at a pretty steady pace,” says Fergus Edwards, head of syndicate at UBS, based in Hong Kong. He also downplays the significance of that growth, pointing out that compared to the US$1 trillion dollar market for US borrowers, it’s “barely out of the blocks: there’s so much capacity for market growth.”

Instead, the more significant shifts during that period are about international investor attitudes to Asia, the wider range of credits and in particular the growth of local currency bond markets – most recently China’s.

In the last 10 years, the role of Asian debt in the global portfolio has been transformed. “The pool of people who buy emerging markets is significantly deeper,” says Sean Henderson, head of debt syndicate, Asia Pacific, at HSBC. “Back in 2000 the market was more niche in the fund management community: there was a specialist investor base who covered Asia with relatively small amounts of capital, or else it was a small part of the global portfolios used just for yield enhancement.” That has changed. “Now, the view is that Asia is a significant driver of the global economy and you absolutely must have exposure as part of your long term strategy.

“These days when you’re doing a high quality offshore deal from Asia it’s very rare that you don’t get all the major global fund managers taking down a good portion of it,” says Henderson; the week before the interview, HSBC had been a bookrunner on a US$1.5 billion bond for the Republic of the Philippines that raised a US$10 billion book. “In fact, the most common complaint is wanting to see larger, more liquid benchmarks.”

Here again, though, Edwards believes much more can be achieved. “You could make the argument that the problems of the past year would have been mitigated if international investors had bought more Asian debt,” he says. “Investors were all holding the same risks, especially in US housing markets, just cut and recut and pretending that each transaction was a unique and uncorrelated risk. If investors had bought more Asian debt within the same investment portfolios then they would have seen proper diversification across differentiated assets.”

Another major shift in the Asian debt markets in the last 10 years has been the range of issuers who can access the capital markets. At the heart of this is the development of high yield. In truth, a high yield market has existed in Asia for some time – some sub-investment grade Indonesian issuers were accessing dollars as far back as 1993 – and one could argue that some deals done before the Asian financial crisis could still not be repeated today. But it is only in recent years that the high yield market has started to regain momentum and to broaden, in terms of range of issuers, availability of volume and range of tenor. “Investors had a very long memory about some of the defaults during the Asian financial crisis, and it did take a while for the market to come back,” says Sykes. “But it has come back, and we are doing things we would not have been able to do back then. We would never have seen Chinese real estate deals back then, or the size we’ve seen from single assets or single companies.”

Paul Au at Citigroup Global Markets considers high yield one of the key developments of the last 10 years. “We see more corporate issuance from more diversified sectors across the region,” he says. “You see Singaporean, Indonesian, Hong Kong, Korean issues tapping high yield. You see coal, property, a lot more types of issuers. That trend is going to continue to grow.”

Additionally, although high yield did exist in 2000, one could argue that the gap between it and the top issuers has since been filled in. “It feels like there was a bifurcated market back then,” says Henderson. “There were the investors who bought only top quality Asia, such as the sovereigns and the very big blue chip companies like Hutchison Whampoa; and then you had real high yield specialists. Today we are more likely to see the full range of credits coming to the market from AAA through to B ratings, and investor demand exists for almost any deal across that range. It is much easier now for the mid-tier corporate to issue than it was back then.”

But probably the most important change to have taken place in the last decade in Asia is the emergence of domestic bond markets – and this is where the bookending of the decade with two financial crises provides such telling evidence of change. The Asian financial crisis was, if not caused, then certainly exacerbated by the lack of local currency funding options for Asian companies and banks. Many had sought to raise capital through the dollar markets, but then found themselves in trouble when their currencies declined dramatically against the dollar in 1997 and 1998. Indonesian corporates, for example, found that the cost of repaying that debt multiplied eight times over in a matter of weeks. That currency mismatch was at the heart of the crisis, and if local companies had had the option of raising their funds in their own currency, the problems would have been nothing like as acute.

This time, when the global financial crisis shut down the G3 markets, many Asian companies that needed funding were able to simply go local – to Malaysian ringgit, Korean won, Thai baht. Data from Dealogic shows that total raised in Asian local currencies, ex-Japan, hit a record US$397.55 billion in 2009, an almost eightfold increase from the US$50.6 billion figure in 2000. Six times more was raised in Asian local currencies than by Asian issuers in G3 currencies in 2009.

Consider, for example, the week that Lehman Brothers defaulted and Merrill Lynch was taken over by Bank of America. That same week, Maybank raised M$1.1 billion of tier one debt in Malaysia’s domestic markets, through Deutsche, Aseambankers and HSBC. A bank borrower being able to raise tier one funds in the same week Wall Street seemed to be collapsing says everything about the newfound resilience of Asian domestic debt.

Partly, this is a function of an emerging Asian investor base that really wasn’t there a decade ago. No Asian country has a pension fund market on the scale of Australia’s superannuation industry, but gradually they are getting there: Malaysia’s Employees Provident Fund, Hong Kong’s Mandatory Provident Fund, Singapore’s Central Provident Fund, China’s National Social Security Fund. Alongside the pension funds are emerging insurers, and developing mutual fund industries. In combination they are creating a strong domestic bid for local paper, and one that doesn’t really care what is happening to American banks from one day to the next. “Ten years back, the investor base for Asian paper was predominantly out of the US, with investors there taking leadership in shaping transactions,” says Au. “It was the driving force of Asian paper. But with the growth of the regional economy, the wealth created, and with a better understanding of fixed income product, we have seen increased appetite for Asian credits from Asian investors.”

“Asian investors now define most of the trades we do,” he says.

The result is a powerful, and new, local currency bloc. “Asia’s individual domestic capital markets in many cases exist in a way that they absolutely did not 10 years ago,” says Rod Sykes, head of debt capital markets, Asia Pacific at HSBC.

For him, the deal that underlines this transformation is another that took place during the global financial crisis – the P38.8 billion (US$800 million) raising for San Miguel Brewery in Philippine pesos in March 2009. This was by any measure a staggering achievement: San Miguel Brewery, having been spun off from San Miguel Corp, was a first time issuer in any debt market, and was approaching investors in the middle of the worst global financial crisis in memory. Yet it quadrupled the previous record for a Philippine peso bond issue. In ordinary circumstances SMB would probably have gone overseas for its money, but in early 2009 couldn’t do so; consequently it learned that there had been no need to try as all that they wanted could be found at home. The local currency peso market barely even existed in 2000; the almost P150 billion raised there in 2009, while only a quarter of what was raised in Malaysia that year, represents an exponential increase and even a near doubling from 2008.

But how much scope for further growth is there? Markets like Malaysia have arguably already got towards the natural limits of domestic fundraising requirements; the imperative now is to attract foreign issuers into that market, which is limited by the slender swap market to take proceeds back out of ringgit again. The same problem applies in other markets, creating an apparent ceiling to development.

“There’s a certain pool of assets held within Korea, and a certain pool of borrowers who would like to raise won for their liability profile – and that’s clearly capped,” says Edwards. More broadly, he points to the lack of a common and universally understood legal system across Asia as an inhibitor of further cross-border development – and the lack of a common currency, “and that development isn’t exactly imminent.” More pragmatically, Asian bond markets would probably have grown more if it were not for the fact that the loan market in many Asian nations is so strong. Asian banks by and large remain highly liquid and reduce the need for capital market funding.

There is, though, an exception – and this will be the most exciting story in Asian capital markets over the next 10 years. This is the Chinese renminbi market. There were no deals whatsoever in this market in 2000; one, worth $604 million, came in 2001, according to Dealogic. In 2009, that total hit US$222 billion from 428 issues: more than half the volume of all Asian local currency markets that year. “The growth in that market is just phenomenal,” says Henderson. And perhaps the most striking thing is that this market has only just begun. “Back in 2000 it barely existed, and it’s difficult to argue that you’re going to see growth at that kind of pace. But there has to be some element of growth just by virtue of the underlying economy.”

Edwards says there is “huge potential for that space to grow”. Partly, that’s because of continued demand by Chinese issuers for capital, “but also because of the amount of companies from outside of China who wish to enter that market and fund growth in their Chinese operations,” he says. “Somebody like a Wal-Mart wants to grow their Chinese domestic business, and who comes from a market extremely familiar with using local bonds to fund local growth.”

Using the funds for local growth removes any need for swap markets, which limit the growth of other local currency markets; all that’s stopping it from happening is the regulatory environment, with only the IFC and Asian Development Bank permitted to issue in RMB so far. That said, several banks have issued in RMB in Hong Kong, another highly significant development, and one covered in the most recent edition of Credit.

If China does open up its domestic bond markets to foreign issuers or investors, it will be the most significant step of the next decade.

And even if the scale of new issuance doesn’t continue at the same exponential pace, the market will grow in sophistication. “I expect most of the development will be in the broadening of the investor base, the developing of more complex products, and in the syndication strategies,” says Henderson. “Rather than a relatively few key investors, you will start to see a more developed insurance, pensions and fund management community and an increase in the range of products to suit their needs. That’s going to be the major story of the next five years.”

 BOX: The deals of the decade

Asked for their views on the key deals of the decade, most people point to recent deals: those that demonstrated Asian resilience to a global financial crisis, thus proving how far things have moved in the last 10 years. For Sykes, that’s the San Miguel deal; for Henderson, the tier one deals for Maybank and UOB in local currency mid-crisis. For Edwards, it’s “the point at the start of last year when the world was really in trouble, and emerging market sovereigns were trading in double digits – but Indonesia still managed to raise $3 billion of financing. That’s the point at which we saw that Asia had moved well beyond the issues of 97.” He also highlights the first bond deals for the Chinese sovereign and the long dated funding raised through 30-years deals from issuers such as Thai energy company PTT in 2005. Au points to the $5 billion raising for Hutchison Whampoa in 2003, a “market defining trade in terms of its scale.”

The year is 2030 and the renminbi is one of the world’s major reserve currencies. Since becoming fully convertible it has been embraced by central banks the world over and is now on track to rival the dollar as the reserve of choice, reflecting the fact that China’s economy is now approaching the size of the USA’s.

It seems a very distant prospect given that the renminbi is not even convertible today. But as the currency does become more international – and every trend of the last five years suggests it will continue to do so – it is almost inevitable that its use by world investors, institutions and central banks will increase dramatically once they have the chance.

“If you talk about the very long term, most people see an international currency as a natural outcome for China,” says Wensheng Peng, head of China research at Barclays Capital and a former China specialist at the Hong Kong Monetary Authority. “A small economy, no matter how hard you try or what policy support you give, will never have an international currency. But if you are one of the largest economies in the world – and this year China is likely to become the second largest – it is natural that your currency will become international. It’s a fundamental driving force and although you can restrict it for some time with policy I don’t think you can prevent it forever.” China already has a relatively open stance on trade, and its currency controls seem increasingly odd in that context. “That disparity will face increasing international pressure as China’s economy grows.”

Others agree. “The goal is definitely a convertible currency,” says Callum Henderson, head of global FX research at Standard Chartered. “It’s part and parcel of the liberalization of the economy. When we get it is a tougher call.” He says most reasonable estimates put it at 10 to 15 years away. “Certainly not immediately, but it’s undoubtedly the goal. Eventually it will be a reserve asset for banks around the world.”

That’s the long-term picture. But getting there is going to take time – few see full convertibility in anything less than a decade – and in the meantime, the debate is preoccupied with the currency’s value and the degree to which China should allow it to shift. Over the years (see box) the currency has drifted through various pegs and managed exchange mechanisms, but since mid-2008 has effectively been pegged to the US dollar with limited scope for gradual variation. Since the dollar itself has gone through dramatic periods of strength and decline in that period, the effect has been that the RMB has moved quite dramatically back and forth against European and Asian currencies through the financial crisis. The question most people have is when the latest dollar peg will be abandoned, and what the path to appreciation will be.

China-watchers got particularly excited about the People’s Bank of China’s third quarter monetary policy statement in November, which in its section on the RMB exchange rate included the words: “With reference to international capital flows and trends in major currencies.” Just as important was what it didn’t say: the usual sentence, about “maintaining the broad stability of the RMB exchange rate at a reasonable equilibrium level,” was gone.

Many took this as an indication that a new exchange framework, and a period of appreciation, were on their way. “We think the central bank did make it clear – as clear as a central bank can be – that in light of the weakening US dollar and increased capital inflows, the RMB is facing increasing appreciation pressure and may need to break the de facto US dollar peg and be more flexible,” says Tao Wang, economist at UBS. He doesn’t expect a change until there’s evidence of exports recovering, but nevertheless he expects the RMB to appreciate to 6.4 or 6.5 against the dollar by the end of 2010, compared to 6.83 at the time of writing. (Tao notes, though, that what really matters is not so much the dollar rate – which has appreciated over 20% in the last few years – but the effective exchange rate against a trade weighted basket of currencies.)

Most other economists and strategists broadly agree, with the only major differences being the degree of change. Peng at Barclays expects a break away from the tight range against the dollar and appreciation against it of “up to 5%” over 2010. Shen Minggao, economist for China at Citigroup Global Markets, is predicting a 3% appreciation in 2010. Henderson is calling a modest decline to 6.7 in 2010 (a 2% appreciation from today’s rates), with a shift away from the de facto peg in the second and third quarter. “Our view is that China continues to approach economic reform in a gradual and very focused way,” he says. “We see the next move as being an expansion of flexibility.”

In any event, while international pressure is clearly there, nobody is really expecting China to do anything other than on its own terms. “China is still showing all the signs of conducting FX policy on the basis of its domestic needs, rather than necessarily what other countries might view as more desirable for them,” says Richard Yetsenga, managing director, Asian FX strategy at HSBC. “That is likely to mean a gradual pace of reform to China’s capital control regime and its openness to global capital. It’s also likely to mean that China moves the RMB in a way which is consistent with its domestic policy settings rather than some global objectives.”

“A stronger RMB is likely to be desirable whether the dollar is weakening particularly sharply at that time or not,” he adds.

But why is that? We all know why the rest of the world wants a stronger yuan – for trade and export reasons, particularly when unemployment is high in developed countries – but why is it China’s interests? One key reason is inflation, which is back on an upward track. “Renminbi appreciation will likely create more winners than losers over time,” Shen says. Larger firms can shift the burden of a stronger yuan to their customers, he says; importing firms get cheaper imported goods and expanded domestic markets; H share companies become relatively more profitable in dollar terms; and capital inflows support property prices. “However, as a stronger yuan will boost imports, overcapacity problems could worsen in sectors that don’t have comparative cost advantages,” he says.

There’s also the issues of China’s vast reserves to consider. Opinion varies on what the effect of the falling value of China’s dollar-denominated holdings – whether cash or treasury reserves or physical assets held through the China Investment Corporation sovereign fund – will have on policy. “The dollar has a major impact,” says Henderson. “If you have roughly $2 trillion of FX reserves and the majority is in dollars there is obviously a valuation effect on your reserves, which theoretically has a P&L impact. It doesn’t in reality until you realise it, but it definitely has resulted in an increased focus on diversification.”

Peng sees it differently. “If you are a government or a central bank, you manage your wealth not for the next three to five years but for the next generation, so you need to take a very long term investment horizon,” he says. “In that investment horizon it is difficult to forecast exchange rates. So diversification is not about the currency, per se; it’s more about the assets. As a side effect that may give rise to a reduction in the share of US dollar denominated assets, but it’s not one of the motivations.”

If appreciation is eventually to lead to full convertibility and a totally open exchange rate, a number of structural changes need to take place, and some are expected in the near future. Ditching the peg for a wider trading band and a link to a basket of currencies would be a start. Others would like to see the development of better yuan asset markets.

 “A lot of the basic infrastructure is already in place,” says Yetsenga. “There is already a mature spot market and something of a forward market, some cogniscence about currency volatility and how to manage it. But many of the systems and institutions which surround those issues have not been exposed to significant currency volatility, and third markets don’t necessarily support some of the derivative markets which in other developed economies appear necessary for hedging forex risk.”

Another element to China’s forex debate is the liberalization of its capital account. FDI is clearly still strong and brings money in to China, but a trend of recent years has been for China to acquire more resources and companies overseas. As Chinese companies (and the State) become more comfortable about investing abroad – as its resource companies and the CIC demonstrate – then those outflows should help to offset the FDI inflows. China’s recent approvals for QDII (qualified domestic institutional investor) licences and mandates also creates a source of outflows, while the QFII program (qualified foreign institutional investors), under quota, allows foreign money to participate in Chinese domestic securities.

“Significant process has been made in the last decade,” says Peng. “Basically all the direct investment, inward and outward, has been liberalized. China attracts a lot of FDI, and in recent years we have seen significant Chinese investment abroad: Chinese companies investing in Australia, Africa, Latin America, Russia, as well as domestic markets.”

Peng envisages that these ventures may also become testing grounds for a greater use of renminbi outside China, because at the moment, restrictions on the currency are a natural barrier to practical trade settlement. “If a Chinese exporter pays RMB to its exporters, those exporters have no place to invest their assets. And if a Chinese exporter says it wants to receive RMB from foreign importers, where will that foreign importer get the RMB from? The only source is from China.” So, for that to start to happen, he predicts some ad hoc arrangements could be made for, say, an oil company to pay in RMB to offshore exporters, and allow that exporter to invest in RMB assets. Going further, he believes foreign central banks would like to set up QFII-style arrangements with the PBOC in order to buy RMB bonds in China as part of their reserves.

So, if China were to become a reserve currency, how powerful would it be? The Hong Kong Institute for Monetary Research put out a detailed study in May – jointly authored by Peng in his HKMA days – about just what the renminbi’s potential as a reserve currency could be. Using different models they came up with figures of 10% and 3%, but that’s based on the size of China’s economy today rather than at the point when convertibility is possible, by which time it will presumably be much larger. “These results suggest that at present the renminbi’s potential as a reserve currency would be comparable to that of the Japanese yen and British pound,” the report says.

The report makes another telling conclusion too: “Whether the renminbi realises its potential as an international currency that is line with the size of the Chinese economy will be a market choice.” And it will, more than anything, be China’s choice, done at China’s pace. “Deng Xiaoping said so many years ago that he was crossing the river while feeling the stones with his feet,” says Henderson. “It’s a very well-worn cliché but it’s very appropriate in terms of what’s happening in monetary reform.”

BOX: The RMB bond market in Hong Kong

Over the years China has undertaken a few experiments involving the use of the currency outside its borders. These have included increased use of the yuan in Hong Kong and Macau, bilateral agreements with countries including Brazil and Malaysia.

The Hong Kong RMB bond market is, in many people’s eyes, the most significant of those experiments. At RMB38 billion outstanding it’s not a huge market – the RMB6 billion sale of government bonds to Hong Kong retail investors in September was the largest ever deal in this market, and only the 13^th in total since the China Development Bank kicked off the market in July 2007 – but it’s really not about the size.

“I think it’s very significant,” says Simon Jin, head of fixed income for China at UBS in Beijing. “If you look at the trends and discussions that are going on around the internationalization of the RMB, it’s clearly an interesting strategy to develop an RMB market that’s not just functional in the domestic market but potentially other markets.”

The market works because retail investors and local merchants have been accumulating RMB deposits and need to be able to do something with them other than putting them in hopelessly low-yielding deposit accounts. Today, potential investors are strictly limited, but if other buyers were allowed in the appetite would likely be insatiable, and this may well be the long term plan. “Hong Kong is the perfect candidate,” Jin adds. “It’s so interlinked with mainland China, people understand China well and are very bullish on the economy, and there is a need for the currency.”

The experience helps China to get to grips with RMB outside the mainland.  “It seems China’s intention, at least partly, is to build up a pool of RMB offshore that can be gradually used to settle outside the country,” says Yetsenga. “The perception seems to be this will take some pressure off China’s balance of payments.”

It’s also seen as a significant step towards convertibility. Says Jin: “If you look at the big picture in terms of RMB internationalization, this is an integral part of that process.”

BOX: Yuan reform

Back in the 1950s and 60s, China frequently changed its foreign exchange rates in order to encourage exports and restrict imports, first pegging to the dollar, then to the pound. After the Bretton Woods system – the post-war monetary agreement signed by the world’s industrial states in 1944  – broke down in 1971, China moved instead to a broad basket.

Next came a multiple FX rate structure with a controlled float in the 1980s, followed by a more market-determined FX rate in the 90s as China sought admission to the General Agreement on Tariffs and Trade (GATT). By 1994 the official rate had become the prevailing swap rate, where the yuan’s external value would be managed against an undisclosed basket of currencies. This lasted just 16 months: after a period of volatility in global currency markets in April and May of 1995, China moved back to a straight peg, at RMB8.28 to the dollar. Current account convertibility came in 1996; capital account liberalisation was interrupted by the Asian financial crisis, although China was applauded at the time for shoring up the peg and avoiding further regional devaluations.

In July 2005, the peg was abandoned for a managed float against a reference basket, which was calculated using elements including the composition of China’s trade, inward direct investment and foreign debt. Since then spot dollar/yuan cross rates have been cautiously adjusted as economic conditions change. In 2005 the daily fluctuation range was set at plus or minus 0.3%, and was widened to 0.5% in May 2007. The ranges have been much wider for non-dollar currencies: originally plus or minus 1.5%, but since 2005, 3%. As the global financial crisis kicked in in September 2008, China informally moved back to a peg to the dollar, and now the debate is when it will relinquish it.

Part of this material is abridged from Deutsche Bank research

In December, world markets reacted strongly to the news that an expected default on a US$3.52 billion sukuk issue from Dubai’s Nakheel Developments would not now take place, following a US$10 billion bailout by the Abu Dhabi government. For creditors in the Nakheel sukuk – the Islamic equivalent of a bond – the news was clearly good: only weeks earlier they had been told that Dubai World, the state-owned holding company that includes Nakheel, was entering a debt standstill and that they would have to wait indefinitely to get any of their money back. But one can also argue that Nakheel’s step back from the brink is a lost opportunity.

How so? Well, the Nakheel/Dubai World standstill represented something that has to happen at some stage, but hasn’t yet: a default in an international sukuk. Without it, uncertainty hangs over the whole sector and impedes its maturity. That, in turn, hinders its development as an asset class for fund managers.

The sukuk industry is youthful and most of its activity has taken place in the last decade. Zawya, a research group in the United Arab Emirates, calculates US$106.6 billion was raised through 747 sukuk issues between December 1996 and September 30 2009, the majority of it since 2002, and that more than 90% of that total is still outstanding, with only US$12.6 billion having matured so far. At a local level, defaults have happened and been worked out in Malaysia’s sophisticated ringgit sukuk industry, but in the more complicated global, cross-border deals, they remain an unknown quantity. Two have happened in the last 18 months – Kuwait’s Investment Dar, and the US-based oil firm East Cameron Partners, which is under Chapter 11 bankruptcy protection in the US and has a sukuk outstanding that will be impacted by that filing. But neither has yet made it to court so not much can be learned from either.

A Nakheel default – on the biggest sukuk ever launched – might have answered a lot of questions about how the sukuk market works when, as must inevitably happen from time to time, things go wrong. That would have helped to create a path for the future which, in turn, would give investors a clearer idea about the level of risk they are entering into when they buy a sukuk.

A sukuk behaves broadly like a conventional bond, in that it pays out a predictable and regular amount over a pre-agreed period of time. Its key difference from conventional finance stems from the fact that in Islam, riba, or interest, is prohibited. So sukuk use the cashflows of an underlying asset, usually a property, to pay out a regular income stream. While this may sound like just semantics, the point is that money isn’t just turning into more money without doing something else – which is what happens with interest on a bond – but is instead a sharing of the profits being created by a tangible asset. In Nakheel’s case, this was a 50-year leasehold on two plots of land in the Dubai waterfront.

So the first question many people have is: if things go wrong, what are the rights of the creditor to the underlying asset? Some investors believe that, had Nakheel defaulted, they ought to have had rights to those underlying plots of land (or at least the leasehold on them). Others believe that, unless it’s specifically stated in the documentation, the creditor’s rights are instead to the obligor’s balance sheet – and that the underlying asset is only there to make the whole thing Shariah-compliant, not to serve as collateral. This latter is the norm in Malaysia, where these issues have been successfully tested by the courts. We don’t now know what the answer would have been for Nakheel.

Things are much more complicated in an international than a domestic deal. A Moody’s analyst, studying the sukuk, says that in the case of Nakheel, different parts of the structure fall under different legal codes. The declaration of trust, the transaction administration deed, agency agreement, certificates, co-obligor guarantee and the Dubai World guarantee are governed by English law. The purchase agreement, lease, mortgages and share pledge, amongst other things, are under UAE laws – which are Islamic. That would have a big bearing on the enforcement of rights in a default. And, even those areas that are governed by familiar and commercially-savvy English law are not clear cut, because any English judgment would need to be enforced locally.

And for that, consider the position of the creditor, going after Nakheel assets – owned, ultimately, by Sheikh Mohammed bin Rashid Al Maktoum, Dubai’s emir. Who’s going to go into a court (in which there is a symbol of the ruler behind the judge) and say: “Give me that land. It’s mine”?

In practice, for this reason and the general reluctance of creditors to head to the courts in the Gulf, Nakheel would almost certainly never have made it to court but instead been hammered out in a behind-the-scenes restructuring – but this, too, would have been instructive. A Nakheel default would have told potential buyers in any global sukuk just what they should expect – what they really own, where they would rank in bankruptcy restructurings, what their recourse is to assets in different jurisdictions and under different laws.

One good thing that does appear to have come out of the confusion is the promise of a new bankruptcy law. One of the things creditors, and market-watchers generally, had been so concerned about as Nakheel approached default was the lack of clarity about bankruptcy and the whole process of pursuing a debt. This, too, is an area of difference with Malaysia, where the bankruptcy legislation is clear and tested. When Dubai announced the Abu Dhabi bailout in December (in a statement from the chairman of Dubai’s Supreme Fiscal Committee), it announced a new bankruptcy law in the same release, saying: “The law will be available should Dubai World and its subsidiaries be unable to achieve an acceptable restructuring of its remaining obligations.”

That, at least, does represent some of the dispute resolution maturity that the industry needs to grow further. And this matters considerably to portfolio managers in the region. So far, sukuk-only funds are reasonably rare: examples are from Dubai’s Algebra Capital, in which Franklin Templeton owns a stake, and some newer Saudi Arabian asset managers such as Jadwa Investment Co. But, although it’s difficult to track, sukuk are much more widely held than that, and not just in the Middle East. In recent years the yield pick-up offered by sukuk over some conventional bonds, coupled with the supposed security of being underpinned by real assets, have seen sukuk move into portfolios run by conventional asset managers worldwide too. Prominent holders of the Nakheel sukuk are understood to include BlackRock, Ashmore and the New York hedge fund QVT Financial.

The sukuk market faces other challenges too. One is that, again notwithstanding Malaysia’s domestic market, they just don’t trade: there is hopelessly thin secondary market liquidity because supply is still exceeded by demand and people who buy them don’t want to sell. Also, there are a number of different structures used for sukuk, and the most commonplace was recently denounced by one of the world’s leading Shariah scholars, Pakistan’s Sheikh Taqi Usmani, in a speech that appeared to suggest that 85% of non-ijarah sukuks were not Shariah compliant at all (ijarah is a type of structure that is increasingly commonly used for sukuk in the Middle East, but less so in Asia). This raises another issue: standards on Shariah compliance vary between the Middle East and southeast Asia, and even within Gulf jurisdictions, which impedes cross-border sales and trading of sukuk.

Nevertheless, the fact that this youthful market faces challenges does not suggest it lacks a vibrant future; these are necessary teething troubles from which the sector has the potential to emerge stronger. More sukuk mutual funds are bound to follow in due course, while the presence of individual sukuk in global conventional debt portfolios is here to stay. It’s just that, for true acceptance globally, there has to be clarity on what happens when things go wrong – because sooner or later, they always do.

Two years ago international fund managers were excited at the possibilities arising in the Middle East. Soaring oil prices were driving exceptional economic growth; stock markets had proven themselves uncorrelated to those in the rest of the world; the region’s vast sovereign wealth funds – including by far the biggest in the world, the Abu Dhabi Investment Authority – were showing an increasing willingness to give their portfolios out to external managers to run; and the biggest market of them all, Saudi Arabia, was starting to open up to the world.

In the time since, much has gone wrong. The Middle East’s stock markets did stay uncorrelated for the opening months of the financial crisis – but then fell just as far as everywhere else, only faster. “What world markets had experienced in six months, we experienced in six weeks,” says one local fund manager ruefully. The oil price plunged from US$140 a barrel to US$37 before recovering (to US$82 at the time of writing), and not all economies have followed the rest of the world in emerging from the global crisis. Dubai, in particular, is still in the thick of debt restructuring problems, while Saudi, the main prize in the region, has been mired in high-profile defaults.

The fundamental problem for foreign fund managers, in a nutshell, is this: the foreign money that was coming into the Middle East has to a large extent left, and, worse, it hasn’t come back. International capital fled all emerging markets as the global financial crisis kicked in, but many of them – especially in Asia – have enjoyed a surge of returning capital as institutions have regained risk appetite. But the money doesn’t seem to have returned to the Middle East.

At the heart of this problem is the fact that the Gulf Cooperation Council (GCC) nations don’t appear in the major international indices that global capital usually track. A year ago the expectation was that Kuwait and the United Arab Emirates would be added to the MSCI Emerging Markets index, which would have prompted a huge increase in the volume of funds that would have sought allocation in the region in order to match their benchmarks. But that no longer appears to be on the cards, at least in the short term. The region’s biggest market, Saudi Arabia, won’t be added to an index until it becomes easier for foreigners to own shares in the country: at the moment, a proxy security called a P-note is used to create synthetic exposure to Saudi stocks, rather than foreigners being able to own the securities themselves. (Even that’s an improvement: until recently foreigners could only get Saudi exposure by buying a Saudi Arabian mutual fund.)

And if international capital isn’t going there, the local money isn’t proving as easy to get as many had hoped. Few foreigners want to go after retail money, which can only really be reached by the widespread local bank distribution networks. The sovereign funds of Abu Dhabi, Kuwait, Qatar and (through its central bank) Saudi Arabia are still among the most powerful institutional investors in the world, but were burned badly in the crisis, with several having bought into US banks far too early; nursing their wounds, they have started to focus more on investing in their own region than the west, which doesn’t help international asset managers pitching for their business. Additionally, they have raised the bar on the strength they require in their counterparties, which has the effect that investment managers either need a very strong parent or a long-standing and happy existing relationship with the fund in question. The barriers to entry, high already, have got higher. For many fund managers, the real target is the large family offices that exist in places like Saudi Arabia, Kuwait and the UAE, though the suspicion remains that the real money there goes straight through the private banks of Geneva, Zurich and London rather than being captured and serviced on the ground in Riyadh, Abu Dhabi or Kuwait City.

That said, there is still a decent investment case for the Middle East, and until Dubai’s near-default on its Nakheel sukuk in December (see separate article), there was a growing sense that the region offered some of the most tempting valuations in world emerging markets. The fundamentals, although interrupted, are still impressive: Middle East GDP doubled between 2002 and 2007, according to Morgan Stanley; national income in the GCC nations averaged 19% growth in the four years to 2007, with per capita GDP averaging 15% growth through that period; and population demographics are in a sweet spot with a total labour force of 185 million expected by 2020 and a declining age dependency ratio, according to the International Labour Organization. Despite oil’s fluctuations, those pre-crisis trends should continue as the region emerges from crisis – and although the falls in oil prices didn’t help Gulf economies, the truth is most of them break even (in terms of balancing the budget) at between US$25 to US$45 per barrel, meaning there is still plenty of revenue to support infrastructure development.

So how should fund managers play the region? The trend pre-crisis was for more and more fund managers to set up in the region – typically an office in Bahrain or the Dubai International Financial Centre – and staff it at first with a sales presence. These groups would typically then target institutions rather than retail, or would supply local banks with product (sometimes white labelled, sometimes co-branded) to distribute through those local branch networks. Only a handful ever put manufacturing on the ground here: examples are Schroders, which runs a Middle East fund that is sold both internationally and regionally; Credit Suisse; ING; and Deutsche, which has pulled back from asset management globally and has reduced its manufacturing presence in Dubai. Another approach was taken by Franklin Templeton, which bought a 25% stake in the Dubai-based boutique, Algebra Capital, and uses that for its product manufacturing needs. Several other groups offer Middle East expertise to those who need it – private clients, for example – or use London-based teams for whatever Middle East stock exposure they need in global or regional portfolios. For the moment, there’s little reason to advocate international managers pushing further into the region than they already have.

The argument as to which centre foreign fund managers should use has died down as economic activity has faded. Bahrain remains the place with by far the most registered foreign funds; Dubai has probably attracted the most foreign names, albeit often with a skeleton presence; and Qatar, despite successes in other areas of its financial centre, has only really attracted one big name on the asset management side – Axa.

Saudi Arabia is a separate case. Saudi is the market that matters most in the Middle East: the largest economy, the largest domestic mutual fund industry, the most oil, the richest people. Foreigners have historically been limited in their involvement in this country, but several have stakes in local partnerships: HSBC (in SABB), Goldman Sachs (in NCB Capital, the investment banking arm of National Commercial Bank), RBS (in Saudi Hollandi, through the old ABN Amro business), Credit Agricole (in CAAM Saudi Fransi, a JV with Banque Saudi Fransi), and BNP Paribas (in The Saudi Investment Bank). Each of these therefore have a stake in highly active local funds management businesses, with the HSBC/SABB and Goldman/NCB Capital (through its Al Ahli range) among the most powerful in the country, although they don’t have overall control either of the revenues or the direction of the businesses.

On top of that, the arrival of a new regulator, the Capital Market Authority (CMA), in 2003 led to major changes in the financial services industry in Saudi Arabia, and has included the issuance of dozens of new licences in recent years. Many of these have involved foreign partners, among them Credit Suisse, Morgan Stanley, JP Morgan and Merrill Lynch (now part of Bank of America). In practice, many of these licences are being used more for brokerage than for asset management, but they do have the right licences to grow businesses in this area and one of the key developments of the next few years will be the methods they use to do so.

In sum, the Middle East still has the same potential it always did, but global fund managers will see little reason to build a substantial presence on the ground without evidence of two things: foreign money wanting to be deployed in Middle East markets, and Gulf sovereign wealth funds wanting their investment managers to be based in the region.

There’s nothing like a stock market collapse to remind people how useful bonds can be. Investors with a decent allocation to defensive investments such as bond funds enjoyed a buffer from the financial crisis, and while it may have seemed a drag during the market rebound of the last nine months, that’s more than compensated for by the insulation it provided on the way down.

Terms like ‘income’ or ‘defensive’ cover a multitude of different products, styles and ideas. They go from tedious plodding cash and bond funds through mortgage funds to high-risk, high-reward credit products and even into high yielding stocks. The boxes on this page talk about the different types of products available and how to tell them apart.

As a rule of thumb, though, this type of investment has become a lot simpler since the global financial crisis, as the things that looked clever and lucrative a few years ago were often the ones that came unstuck. “The last two years have seen an incredible turnaround in the types of investment people have been considering for the income component of their portfolio,” says Peter Dorrian, head of Australian retail at Pimco, one of the world’s leading fixed income managers.

“If you think back to 2006, bond funds struggled to gain a lot of traction because the income investment class was dominated by things like mortgage funds, highly geared property funds, and even hedge fund of funds.” But all those areas ran into trouble for one reason or another and the trend today is towards the straightforward. “The little old bond market, long forgotten by investors, has suddenly got increased interest.”

Adam Coughlan, general manager for retail at Australian Unity Investments, agrees. “Where investors got themselves into trouble in the financial crisis was with some of the very high yielding types of products available,” he says. “I would say this: if it seems too good to be true, it is. Now we’re starting to see people using bond funds more for their traditional defensive purposes.”

Data from fund researcher Morningstar shows that of the 116 new income funds launched in 2009, 82 were at the straightforward end of things: Australian cash, Aussie bonds, global bonds or a combination of the two. Just three mortgage funds appeared.

So what should investors think about when looking for income products? “There are two related but different roles a defensive asset can play in your portfolio,” says Dorrian. “Firstly as a buffer against the volatility of the equity markets and global asset markets, and secondly as a provider of income to a portfolio on a very dependable and reliable basis.”

“When you go into any bond fund there are two risks you need to think about,” he adds. “One is the risk of not getting income, the other is the risk of not getting 100 cents in the dollar back when it matures.” That risk varies depending on who issued the bond. A government, for example, can raise taxes to ensure it repays its debts; a company can’t do that and has to rely on its own balance sheet. 

So just as with stocks, an important decision to make is just what level of risk you want to take. Government bonds won’t generate much money but they’re unlikely to fall over. Corporate bonds pay out more, for more risk. Globally, professional investors have spent much of the last year trying to work out how best to take advantage of opportunities in what is called credit: higher yielding, riskier bonds from companies. “One trend I’ve noticed in the last 12 months is an interest in credit funds, born out of an incredible spike in the yields and returns available,” says Dorrian; two Pimco funds sold in Australia have some credit exposure and he says “both have had good inflows from investors in the last 12 months.”

But in an area like this it is essential to have professional management involved. It can be difficult for investors to access, and tricky to understand. “We think it is very important for people to understand the systemic risk in any part of the market they invest in,” says Kathy Cave a portfolio manager at Russell Investments. “When you buy equity there is a list of shares – the ASX 300, for example – but in fixed income that’s not the case.”

Another decision to make is whether you want international exposure. “When you’re buying an offshore bond, you are taking on a whole different level and style of risk,” says Coughlan. “The first one investors need to be conscious of is the exchange rate: the Australian dollar is at historically high levels but if it continues to go up then income will naturally go down in Australian dollar terms. That’s probably the biggest risk those investors will face.”

The risk Coughlan refers to – that gains on your overseas investments will be wiped out by a rising Aussie dollar – can be mitigated: many products offer a hedged and an unhedged version, giving you a choice about whether you want to be exposed to movements in currencies.

A separate point, though, is where the best prospects are. Australia is a high-interest country: the Reserve Bank of Australia has for many years set interest rates higher than is common in other major economies like the US or Japan, and the gap is getting wider now as the bank raises rates while other countries are still keeping them low as they emerge from the financial crisis.

“We’re a big believer in diversifying your portfolio so you need to have exposure outside Australia,” says Dorrian. “But the other side of the argument is that Australia has traditionally been a higher interest rate country than many around the world: the US cash rate is virtually zero and it doesn’t look like changing until early 2011. Australia has come through in better shape and investment returns from the bond markets look pretty promising in the next 12 to 18 months.”

Not everyone agrees where the opportunities are. “We actually think international might be more attractive than domestic bonds at this point,” says Cave at Russell, which recently changed the strategic asset allocation in its multimanager products to increase the allocation towards international bonds. Greg Michel says ING Investment Management, where he is director of fixed income, has a bias for interest rate exposure in Australia versus the UK, US and Japan. In any case, as he points out: “The fixed income market is already a global market when you consider the range of issuers in Australian dollars – a multitude of foreign financial institutions and supranationals whose businesses are operated in the main well outside Australia. At the same time, most of the larger iconic Australian companies are active borrowers in foreign capital markets.”

A third question is when it is time to return to unloved assets – and in particular, mortgage funds. Many of these ran into serious liquidity problems during the global financial crisis and investors have not been quick to forgive them, but Coughlan at Australian Unity argues that many were perhaps misusing them in the first place.

“The typical mortgage fund was used by two types of investor,” he says. “The first type was using it as, in effect, a high returning bank account. The other type was a pension style client who saw a rate of interest better than the banks.

“When the financial crisis hit, the first group were the ones that didn’t want to be trapped in there – they were really using them not in the way they had been designed.” Their attempts to exit swiftly led to problems such as redemption freezes. But, Coughlan says, “the lesson has been learned, removing these investors from the funds and leaving in place the pension style client who the product is best suited for. Most mortgage fund providers by the end of this quarter will be through that process and we’ll see a really good level of stability from those funds. Things are definitely looking up for the mortgage fund sector in 2010.”

All providers agree that the push towards income products is driven by a broader change in Australian society. “We are seeing a demographic shift,” says Craig Hobart, head of retail at Tyndall Investment Management. “More baby boomers are approaching retirement, and demand for quality income streams is something we have identified as a gap.” And Cave at Russell speaks of “a focus on people who are in the post-accumulation, decumulation phase of their lives,” says Russell. “They are no longer accumulating super but are starting to use it.”

Michel says people wanting a fund for income should consider the following key considerations in choosing a fund: the stability of the income stream; the creditworthiness of what that fund holds; any use of derivatives by the fund; entry and exit charges; the fund’s size; and the experience of the fund’s managers.

Australians today have a greater range of choice in this field than ever before, but for the moment, it seems they’re exercising that choice with greater caution than was the case before the financial crisis. And that’s no bad thing. “It would be very disappointing if we didn’t learn from our mistakes,” says Coughlan.

BOX: What’s an income fund?

You get a sense of the diversity of this style of investment by looking at fund research Morningstar’s classification of income products. The researcher considers them to fall in to 10 different camps, roughly along these lines:

• Australian cash: invest mainly in very liquid market securities like bank deposits and bank bills. They usually mature in less than 12 months.
• Australian cash enhanced: similar to Australian cash, but can also have exposure to bonds, corporate debt and asset-backed securities, and may use derivatives. Usually have about a 12 month duration.
• Mortgage funds: mainly invest in registered first mortgages secured over Australian property, but sometimes in fixed interest, money market securities or cash.
• Mortgage funds – aggressive: Like mortgage funds, but may invest 20% or more in mezzanine debt, development and construction loans, pre-developed land, or specialty loans such as to hotels and retirement villages.
• Australian bonds: invest in traditional Australian fixed interest securities such as government or Australian corporate bonds with a maturity of more than one year.
• Global bonds: invest in foreign government and corporate debt with a maturity of more than one year.
• Global/Australian bonds: Combine global and Australian bonds, with at least 25% of the total in Australian.
• Diversified credit funds: Invest in credit securities in Australia and/or worldwide. This involves active selection to try to get better returns than government bonds; usually they invest in securities rated BBB or above (the definition of investment grade), but not always.
• High yield: Invest in credit securities where the average credit quality is below BBB, or sub-investment grade (sometimes called junk). Typically invest heavily in emerging market debt, junk bonds, structured credit and unrated issues.
• Multi-strategy income: Combine different sectors to improve yield, which might include domestic and international government bonds, corporate debt, private debt and hybrid securities.

Even this impressive list does not include several other styles investors might consider as sources of income, such as high-yielding equity funds, or listed property funds.

Note: fixed income or fixed interest? Bankers and investors in most of the world use the term fixed income (even sometimes for bond products where the income isn’t actually fixed). In Australia, the term fixed interest tends to be used instead. They mean the same thing.

BOX: Income products and the financial crisis

Although income products are usually painted as defensive investments that protect you in the bad times, it’s worth recalling that it was bond-related products that kicked off sub-prime, which in turn led to the global financial crisis.

Five years ago, it had become common for investors to put money into products like collateralised debt obligations (CDOs), which packaged together dozens of debt instruments in order to make a return, usually combining leverage to boost that return. “But the leverage was not always appropriate and because you were investing in assets that were similar, it didn’t provide you with diversification benefits,” says Cave. “They could go badly wrong, and that’s what happened.”

Usually, if something goes wrong in an asset, it doesn’t affect the rest of the market. “The recent experience was dramatically different,” says Michel. “The freezing of markets for these assets was not a specific credit event but rather a market wide liquidity event, with many traditional income based assets being impacted.”As investors tried to pull out of funds that were never intended to face sudden redemptions from so many people simultaneously, the problem spiralled; it was in this environment that managers like Basis Capital had to suspend redemptions from funds and in some cases eventually shut them down at considerable cost to investors.

It wasn’t just CDOs. Peter Dorrian at Pimco recalls how investors had moved their income allocation out of safe bonds and into things like mortgage funds, property trusts and fund of hedge funds. In each case, something went wrong in these asset classes. “In the case of mortgage funds it was for structural reasons, where there was a mismatch between the ability to provide liquidity and the underlying assets they invested in,” he says. In hedge funds it was a similar problem: the liquidity of what the funds were invested in, versus the weight of redemptions seeking to get out. “And while most property trusts survived the crisis, they are engrossed in massive capital raisings which do nothing positive for investors other than reduce gearing levels.”

The financial crisis also gave guaranteed funds a bad name, for two reasons: in the worst cases, the bank that had provided the guarantee (such as Lehman Brothers) went under, rendering it useless; and in others, while investors didn’t lose their money, they found themselves locked into an unproductive fund for up to seven years.

While there’s still plenty of life in guaranteed products provided you trust the guarantor, there is still a sense of suspicion about them. “We have seen a few products launched that have some kind of guarantee attached to them,” says Cave. “It’s a different profile – some of them are fixed terms and are not necessarily simple investments. You are giving up the flexibility to get out of products for a guarantee over a period of time.”

Nevertheless Coughlan argues that “there are still good products out there that do what they’re meant to do but have a fixed rate of return.” Australian Unity offers a fixed term product – called an income note – secured on income from retirement villages. “Retirement income is very stable,” he says. “Something underpinned by real property is a safer way of getting income.” The notes are fixed at three, five and seven years, with interest ranging from 8 to 8.5% according to the term. “That’s a pretty attractive return for retirees.”

BOX: Yield stocks and income funds

While most investors think of bond funds when they talk about income product, the Australian share market supports a different kind of income product: the dividends on shares.

Australia has one of the world’s highest-yielding major stock markets. Better still, it’s the solid blue chips like Telstra and the Commonwealth Bank of Australia that tend to exhibit consistently high dividend yields.

High yielding stocks have a lot to recommend them. For a start, they provide the income from the dividend, which in many blue chip stocks is around 5 or 6% a year. Secondly, they may be fully-franked: this means the company has already paid the tax on them so you don’t have to pay tax on it yourself. And third, like any other share, you have a very good chance that the value of the share itself will go up over time.

Yields go up and down not only according to how much a company pays out, but how its share price is moving. If the share price goes up, that’s good because you get capital growth, but your yield expressed as a percentage will go down – because $1 a share when the share price is $30, is a lower percentage yield than $1 a share if the stock goes up to $60. Correspondingly, we have seen big movements in yields over the course of the last year as stocks have rebounded, from a peak of around 7.25% for the ASX 200 to about 3.7% today (or about 5.6% on a grossed-up basis taking into account the tax benefit).

While one can build a portfolio of yield stocks just by buying them through a broker, there are a number of funds that are designed to invest in shares from an income perspective. For example, Tyndall Investment Management launched one in late 2008 with a mandate to generate an income stream of 2% higher than the grossed up yield of the ASX 200 Accumulation Index (which, at the moment, means about 7.6%). It considers the capital growth of the stocks a secondary investment objective, and it tailors its investment technique to focus on after-tax returns.

“We’re trying to take a conservative approach to high yielding stocks: utilities, telcos, consumer staples and financials,” says Craig Hobart, head of retail at Tyndall. Big positions include Spark Infrastructure, Telstra, Westpac, Woolworths, Duet, Commonwealth Bank of Australia, AMP and Axa. Property trusts, notably, represent only a little exposure – through Lend Lease, which the index does not consider a property trust anyway.

So where does such a fund fit into a portfolio? “The traditional way of doing asset allocation is to have defensive and growth investments, with defensive being cash and fixed income, and growth being equities,” says Hobart. “With this product, rather than focusing the question around defensive and growth, it works when people say: what’s my income requirement?” Advisors talk to clients about what they need this year, next year and so on, and build a portfolio based on those income needs; a share income fund can be part of that approach.

There is some cause to hope for dividend payouts to increase in the year ahead. “One of the consequences of all the capital raising is that debt has really fallen and balance sheets in Australia are quite lazy now,” says Hobart. “Gearing ratios have fallen across the industry. The consequences of that are, as the economy recovers, corporates are going to be left with strong balance sheets.” That gives them options to do three things: share buybacks, which usually help the share price; increase dividends, which helps people who want income; or buy other businesses, which can be good or bad for a company. Hobart, naturally, is hoping they take the dividend option. “There was a time when companies did cut dividends – February 2009 was the worst we’ve seen in recent history in terms of dividend revision – but we’re through the eye of the storm and we’re going to see a far more normal dividend profile.”

“In some ways, a bank is just like a company that sells banana smoothies.”

Behold the most talked-about sentence in Australian banking. It comes from a three-minute animation sent to retail customers by Westpac in December in which the bank sought to explain rising interest rates on its mortgages by comparing it to the increase in Australian banana smoothie prices after Typhoon Larry.

Westpac is on the defensive after raising its mortgage interest rates by 45 basis points on the back of a Reserve Bank of Australia raise of barely half that, 25 basis points. But many customers have felt patronised by the animation, whose opening line is “once upon a time there were big lush fields of banana crops”, delivered in a voiceover one Australian commentator describes as “the manner of a Hi-5 presenter on Mogadon.”

It’s a rare challenge to CEO Gail Kelly, who has built her career on the power of banking brands and the ability to relate to the individual customer. The antagonism has spread right the way up to prime minister Kevin Rudd, who said he thought Westpac should take “a long, hard look at itself.”

The public reaction was not helped by coming out shortly after Westpac’s annual report revealed she earned A$8.48 million in the 2009 financial year including equity-based awards that vested during the year, rather more than one imagines Sydney’s banana smoothie vendors take home.