Japan’s banks, like most in the world, will end 2009 in better shape than they entered it. But they do so with considerable headwinds to confront. On the positive side, the biggest banks escaped the financial crisis largely undamaged and in some cases internationally transformed; on the negative, they face a great challenge to flourish in a deflationary country, and must raise billions of dollars in capital to bolster themselves for the future.

The latest round of results do show some promising signs for Japanese banks – or at least an absence of bad news. “We are getting out of the nightmare,” says Hironari Nozaki, bank analyst at Citigroup Global Markets Japan. “Symbolic is the credit cost. Last year it was 80 to 90 basis points, depending on the bank; for the first half of this year, it is coming down to 40 or 50 basis points. It confirms that the worst is over.” And in Japan’s case, “the worst” refers to a double hit: not only the global financial crisis but prior impairments on real estate companies. The bigger players reported modest increase in first half profits, with declines in client-related business being offset by growth in trading revenue.

It’s also true that Japan doesn’t appear to face a wave of distressed debt of the scale that some might have expected. “The Japanese banks have actually got a lot better at managing their credit risk,” says Graeme Knowd, banking analyst at Morgan Stanley. “The average corporate has much less leverage than they had in the past.” Nana Otsuki, banking analyst at UBS notes that the government has been strongly committed to supporting the small to medium enterprise sector, so “it’s in reasonably good shape. Credit costs may creep up in this business environment but we don’t expect a large increase in losses in this area.” And in terms of personal lending, Nozaki at Citi says that while some individual customers are requesting changes in their mortgage arrangements, “so far the deterioration rate is quite low. Japanese mortgages are much healthier than US mortgages.”

But while all that suggests no crisis ahead, that’s a long way from saying that the future is bright. The immediate problem is the health of Japan itself. “Banks don’t grow unless the economy is recovering,” says Knowd. “The general rule is that you’ve got to get nominal GDP growth back in order to get real growth at the banks.” Although Japan’s economy is improving, with 4.8% annualized GDP growth in the third quarter compared to declines of over 10% in the fourth quarter of 2008 and first quarter of 2009, it is still in a period of deflation, and “even the best managed western bank would struggle to make money in a deflationary environment,” Knowd says. “Deflation doesn’t help banks.”

It particularly doesn’t help lending. “It is not easy for Japanese banks to expand their lending domestically in a deflationary environment,” says Otsuki. On first glance, Japanese lenders look to have been very active: hence the fact that the rankings for global loan arrangers in the first quarter of 2009 looked like a throwback to the 1980s, with three Japanese banks in the top five and Mizuho at the top. But in truth that reflected a paucity of lending from European and American names at that time, now largely returned to the fold.

There’s demographics working against them too. Yoshinobu Yamada, banking analyst at Deutsche Securities Inc in Tokyo, adds: “In the long term, if banks are sticking with domestic loans, the prospects are not great because we are expecting a decline in population starting five years from now.”

Consequently, Japanese banks have increasingly been looking overseas for lending growth. It’s hardly been a surge overseas – 99% of Mizuho’s loan proceeds in the second half of 2008 were domestic, and 93% of Sumitomo Mitsui’s – but Mitsubishi UFJ, with 24% of lending directed overseas, is perhaps illustrative of the future. “Japanese banks have to lend or invest overseas, at least to an extent,” says Otsuki. That said, increasing capital requirements may curtail this expansion. “Two years ago Japanese banks were in a great rush to expand their overseas lending,” says Nozaki. “But because of capital constraints they are getting a little bit nervous about expanding overseas businesses.”

In that environment it’s very hard to find an obvious area of growth. Fee-based income, such as sales of funds and other products to retail, have been woeful, but this may yet swing around to provide a driver. Nazaki notes an improvement in the sales of investment products to consumers. “I feel some recovery here,” he says. “The first half clearly showed a bottoming out in sales.” Yamada sees the same thing. “In the medium term, one to two years, the recovery of fee income should sustain some growth in Japanese banks.”Generally, though, he is wary about the fact that recent profit improvements in Japanese banks have been supported by trading; rather than rely on that, he’d like to see Japanese banks expand in retail, not just at home but internationally, where so far only Mitsubishi UFJ (with Union Bank of California) has dared to tread. “The wholesale market all depends on the market, the economy. Japanese banks need stable growth and that comes from the retail market.”

And so all roads seem to lead to international expansion as an engine for growth – and in this respect, Japanese banks’ responses to the financial crisis were fascinating. One can argue that Mitsubishi UFJ’s agreement to take a stake in Morgan Stanley was the turning point of the entire global financial crisis, and it certainly represented a rebalancing of power in global banking. Similarly, Nomura had said before the crisis really took hold that it had built a warchest for acquisition in order to expand in the Asian region; its acquisition of Lehman Brothers’ assets in Asia came swiftly afterwards.

The Mitsubishi UFJ/Morgan Stanley alliance is still taking shape: it was only on November 18 that the structure of the securities joint venture in Japan was announced. “It’s a little too early to say if it was successful or not,” says Otsuki. Clearly it has great potential, but the usual puzzles about cultural integration will have to be sold for it to be a triumph. In the meantime, some analysts are playing equally close attention to the relatively forgotten Union Bank of California acquisition, thinking it could be a springboard to bring in further retail assets in North America. “They may use it as a vehicle to acquire regional banks in the future,” suggests Nozaki.

Particularly outside Japan, there is widespread doubt that Nomura can make its Lehman venture work, but most feel it is too early to make a fair appraisal. “There is scepticism that the cultures can be melded, but a sense of excitement that if it worked it would be the first truly global Japanese financial institution,” says one analyst in Tokyo. “If Nomura can show it can be done, maybe it will make some of the more aggressive banks sit up, take notice, and think: maybe we can do it too.”

There is domestic activity too. The big event of the year was probably Citi’s sale of its Nikko Cordial business to Sumitomo Mitsui, but another transaction may yet prove more significant: the merger between Chuo Mitsui Trust and Sumitomo Trust, announced in November, although the holding company will not be set up until 2011 and the two banks will not come under its wing until the following year. Analysts have been positive about this deal. “Sumitomo Trust is the best managed bank in Japan,” says Knowd. “They see higher capital requirements coming and realise you have to make a return on it; the only micro way of doing that within the control of the bank’s management is a merger that gives you cost synergies.”

“Fundamentally this is a positive move, especially given that they will be able to reduce their costs,” adds Otsuki. “If you look at a past example of mergers between trust companies, Chuo and Mitsui, their cost bases reduced by about 30%.”

So what next? “For the mega-banks we are close to the end,” says Nozaki. “But there may be more opportunity for regional banks to get together. There are 64 large regional banks.” He does see some prospect of the country’s two remaining independent brokers, Nomura and Daiwa, being attractive to the megabanks, in order to help them get closer to vital deposit bases, but it’s a moot point whether that would appeal to the independents themselves.

Overhanging the whole sector is concern about global regulation, and the likelihood that Japanese banks will have to raise vast sums in order to improve their capital adequacy ratios. The capital raisings are already happening: on November 18 Mitsubishi UFJ announced plans to raise up to $11 billion of common stock to improve its capital base. Mizuho and Sumitomo Mitsui UFJ are widely expected to do the same.

In Japan as globally, analysts mainly feel that global regulation is going to impede bank profitability. “With higher capital requirements and more stringent regulation it’s not going to be easy for the banks to achieve the same level of return on equity,” says Otsuki.

But not everyone thinks the capital raisings will be as onerous as the market seems to believe. Knowd argues the earliest one could expect to see capital regulation introduced to Japan is March 2013, which broadly fits in with the Basel timeline (which would require implementation by December 2012). Additionally, capital adequacy can be addressed not just by raising more capital but by reducing assets.

“It’s not that they won’t issue capital, but there’s a difference between being desperate to issue capital and doing so because you want to,” Knowd says. “Doing it because you want to, with consideration given to shareholders, puts a different perspective on how and when you do a deal.”

Nozaki at Citi adds: “Banks have time to think about capital raising. The share prices are very weak right now so it is not the appropriate time for them to think about it.”

This brings us to the issue of cross-shareholdings, rife in Japanese banks and corporate life generally. Analysts don’t like these cross-shareholdings at the best of times, but Knowd argues that selling them in the next few years would be particularly sensible since, by reducing assets, it would also help improve capital adequacy ratios. By his calculations, both Sumitomo Mitsui Financial Group and Chuo Mitsui Trust (in its pre-merger form) could move their core tier one ratios over 7% purely by selling cross-shareholdings; indeed, only Mizuho would need to make substantial further reductions in assets beyond selling cross-shareholdings in order to hit the 7% mark.

It’s already beginning to happen: Mizuho started selling down shares in the first half. “If Japanese banks accelerate their cross-holding sales,” says Yamada, “it should be bad in the short term for the equity market but good in the long term for Japanese banks.”

When you buy a credit default swap, you know what you’re getting: a derivative where you get paid if the underlying instrument defaults. Fine. But one of the curious spillovers of the global financial crisis is a controversy about who decides whether something has defaulted or not, and how they decide it.

This came to the fore in Japan in October over the fate of the Japanese consumer finance house Aiful. In September, Aiful said it would suspend loan payments and apply for alternative dispute resolution, and that it was in negotiations with creditors. This was enough for Standard & Poor’s to declare a selective default on Aiful, which naturally caught the attention of the many hedge funds and other holders who had credit default swaps with Aiful debt underpinning them.

On October 2, one of Aiful’s creditors, Aozora Bank, wrote to the determinations committee of the International Swaps and Derivatives Association. The determinations committee was set up to make binding decisions on issues such as whether or not a credit event (such as a default) has happened, and what obligations are deliverable. Aozora wanted the committee to decide whether a bankruptcy credit event had happened at Aiful, and also whether a restructuring credit event had taken place. (These events have different consequences for various different derivatives.)

ISDA’s Japan determinations committee came together on October 5, and dismissed both questions: the first because there wasn’t enough publicly available information to consider it, and the second because not enough committee voting members had agreed to deliberate the question. “This,” says one hedge fund manager, “is like saying that the committee decided not to answer it on the grounds that the committee decided not to answer it.”

Not deterred, another request came in to ISDA on October 15, again believed to be from Aozora, although this has not been confirmed.  This time, the request asked whether another type of default, called a failure to pay credit event, had occurred; the request was backed it up with supporting evidence suggesting that it had.

At this point, things started to get a little odd. Members following the ISDA web site saw two pages of Japanese text appear on the site, only for them to disappear shortly afterwards. The text, seen by Euromoney, gives details of repayments by Aiful, and appears to support the contention that it had failed to pay due debts.

So why was it taken down? Euromoney understands that ISDA put the documents on its site in good faith, only to receive a complaint from Aiful saying that the information was confidential and should not be published. ISDA duly took it down. But the real twist in the tale was that because that information had been declared confidential, ISDA’s determination committee refused to accept it. Consequently it rejected the question about whether Aiful was in default, despite the fact that it had already inadvertently published information appearing to suggest clearly that it was.

Those on the other end of the derivatives are furious – and there’s a lot of money at stake. According to data from the Depository Trust & Clearing Corp, contracts protecting $1.36 billion of Aiful’s debt were outstanding as of November 6, with as much as $238 million more protected through credit swaps based on indices that feature Aiful as a member, according to Bloomberg. Hedge funds and others who will get paid in the event of a formal default are furious. They want to know why it is that ISDA’s committee, having not only had evidence of a failure to pay waved in front of them but having published it online themselves, can then refuse to consider that information or even deliberate a question relating to it. They also wonder how ISDA can argue there is insufficient public information when Aiful itself put out a press release on September 18 – in English – saying it wanted to change the principal repayment schedules to its creditors.

At stake, hedge funds argue, is the credibility of the whole CDS industry, particularly in Japan. And that’s big business: Bank of Japan data shows that at the end of June, the notional outstanding of credit default swaps was US$887.3 billion.

Asian real estate has followed up an epic plunge with an equally dramatic rebound. Extraordinarily, deep in a global financial slowdown, there is even talk of a bubble in the residential property markets of China, Hong Kong and Singapore.

It’s quite a difference compared to the mess of 2008 and early 2009. According to CB Richard Ellis, the real estate services group, Asian property investment sales fell 83% to US$3.1 billion in the first quarter of 2009 compared to the same period a year earlier, with Japan, Singapore and Hong Kong suffering the biggest falls; investment turnover for industrial and office property fell 95% and 89% respectively. Many listed property stocks halved in value last year: indeed, the average real estate investment trust (REIT) in Singapore fell 54% in 2008.

While few property stocks have recovered all their losses, they have bounced impressively from their lows, to the point that analysts are already starting to wonder if there is any value left. “Asia Pacific listed property is relatively expensive,” says Matt Nacard at Macquarie Research, who says the sector is now at just a 3% discount to net asset value (NAV), compared to 8% outside Asia, and is now trading at 19 times 2009 earnings. The MSCI Asia Real Estate Index rose 47% in the second quarter alone.

So how has this happened? It depends on the market, but there are some common themes. “This revival in property prices has been mainly driven by the abundance of liquidity in countries such as China and Hong Kong,” says Keith Chan, an analyst at HSBC Global Research. China is probably the clearest example. As our special report on banking in China on page xx explains, the RMB4 trillion government stimulus package there has triggered a vast increase in lending by Chinese banks, with most of the bigger banks showing year on year loan growth of around 30%. Lending like this naturally helps the property market, as well as generating earnings revisions. Says Nacard: “In the absence of cooling measures from the authorities, this leads to a powerful positive combination.”

China also has some unique characteristics. “In China investment alternatives are very limited: it’s either the residential property market or the listed market,” says Kenneth Tsang, head of Asia Pacific research and strategy at LaSalle Investment Management. “And the underlying fundamentals: demand has always been very strong in China because of the growth in income, GDP and productivity. They are long term drivers for the China market.”

Consequently, just months after a period in which the real estate market seemed to be dragging down China’s economy, it is booming again, at least on the residential side. According to data from the National Bureau of Statistics of China, national residential sales were up 54% in volume and 82% in value in June year on year. Eastern seaboard cities, particularly Beijing, led the growth. According to Morgan Stanley, listed property developers in China have achieved an average of 63% of their full year sales targets in the first half of the year, “setting the stage for a potential upward revision of their target during the interim result announcements”. Also, despite the bounce back, Morgan Stanley believes affordability in China “remains at a healthy level, with property prices at six to eight times annual income, or monthly mortgage payments at 40-50% of monthly household income.” This suggests support for further growth. Correspondingly, developers are now actively bidding for new land in China, trying to get prime sites cheaply before the market recovers.

Similarly, in Hong Kong too, liquidity is driving residential prices up, despite the fact that rents are falling. Partly it has to do with government stimulus in Hong Kong itself, but also China is having a big influence. “We are seeing increased inflows from China into Hong Kong,” says Chan. “In the past, buyers from mainland China accounted for less than 5% of the property purchases in Hong Kong. Nowadays 20 to 30% is the norm.” So, when China receives a huge boost to liquidity, it is felt in Hong Kong property too. “I won’t be surprised to see property prices continue on this up trend in Hong Kong,” Chan adds.

Singapore, too, is suddenly filled with talk of price bubbles, which seems remarkable in a recession-hit country that expects its economy to shrink by between four and six per cent this year. Residential rents have halved, and yet the purchase price of the properties themselves is soaring to the point that the government is openly discussing overheating. National Development Minister Mah Bow Tan was quoted in state media in July as saying: “I wouldn’t say there’s excessive speculation at the moment, but there is some element of speculation involved. I think some of the practices that you saw in the last property boom are starting to come back. So I think we’ll have to be careful.” He also said: “I would say that there is more than sufficient supply over the next couple of years and it’s a bit too early to say whether there is a speculative bubble or property bubble building up.”

But analysts seem less enthused about the prospects in Singapore’s real estate markets than Greater China’s. Macquarie expects a 20% fall in residential prices this year.  Morgan Stanley analyst Melissa Bon calls the valuations of Singapore’s listed property developers “fundamentally unjustifiable” and has an underweight recommendation on big developers like CapitaLand, Keppel Land and City Developments.

The office market in Singapore has been particularly badly hit: CB Richard Ellis said it hosted the worst office rental contraction in Asia in the first quarter, down 34% on the previous year, and Macquarie expects a 38% fall in office rents in total this year. Indeed, across the region the office market has not enjoyed anything like the ardor that residential has. “Office is a different picture,” says Chan. “In top tier cities in China office values have dropped 15 to 20% from the peak of last year.” In Hong Kong the office market suffered in the first quarter – the 25% drop in office rents compared to the previous quarter was the worst Macquarie had seen since it started keeping records in the 1980s – but Chan says the limited supply in places like Central (Hong Kong’s CBD) help to maintain stability.

Tsang agrees. “Supply for commercial real estate in Hong Kong is not an issue: not much is coming and we are not anticipating very high vacancies.” This is in contrast to Singapore where a lot more supply is still due to come on to the market, “which may delay the recovery process.”

Nevertheless, things have clearly improved, but analysts and fund managers are mindful of how quickly things can change. Morgan Stanley’s Derek Kwong, in a recent report on Hong Kong, notes: “While we are upbeat about the benefit of escalating asset prices on the back of ample liquidity, there is always the risk of its exit.” He adds: “We are certainly mindful that the bull case is not dissimilar to a bubble situation.” In China, where momentum and mood have such an impact, there are a number of things that could reverse sentiment: the authorities may seek to rein in lending or implement a round of tightening by raising rates and reducing the attraction of debt; or a round of corporate earnings downgrades could also reduce confidence.

The global financial crisis put a serious dent in the REIT market, which had otherwise been flourishing up to 2007. Asian REITs suffered their deepest ever fall in the second half of 2008, with their market capitalization falling by almost one third to US$48 billion, according to CB Richard Ellis. Only one new REIT has been launched in Asia in the last 12 months – Centra Hotels & Resorts Leasehold Property Fund, in Thailand in October – and many existing ones struggled to raise funds to meet short term debt obligations. New City Residence, listed in Tokyo, was the first to be wiped out, filing for bankruptcy in October 2008 (see Japan box). In other cases REITs were offloaded in order to help shareholders improve their own positions: Allco Finance Group sold its stake in AllcoCommercial REIT to Frasers Centrepoint; Malaysia’s YTL bought a 26% stake in Macquarie Prime REIT from Macquarie, and renamed it Starhill Global REIT.

At its worst, there was real concern about the very viability of the REIT model, although that moment appears to have passed. “The model was under a lot of pressure when yields were 8, 9, 10%,” says Arjun Khullar, managing director and head of equity capital markets for south and southeast Asia at JP Morgan. “It’s difficult to make an accretive acquisition then. Now some are at 5, 6%, it is much easier to do.” Many of the bigger REITs that needed to recapitalize were able to do so, notably Ascendas REIT, Singapore’s biggest industrial property trust, which raised S$300 million in January in the first successful recapitalization, and CapitaMall Trust, part of the CapitaLand family, which managed to raise S$1.23 billion in a rights issue in February. “S-REITs have not disappointed in terms of refinancing their debt,” says Bon. “Indeed, they recapitalized ahead of our expectations.”

Singapore is ex-Japan Asia’s biggest market for REITs, with 21; Hong Kong, which started trying to attract REITs later, has only seven. Other, smaller markets exist in South Korea, Taiwan, Thailand and Malaysia. The Philippines and China have both spoken about launching REIT markets, with legislation already underway in Manila. Since the Philippines boasts three of the region’s blue chip developers in Ayala Land, SM Prime and Megaworld, it is a natural home for REIT structures.

While it’s clearly going to be some time before any new REITs are launched, existing ones may return to the markets. “We’re likely to see more REITs raising money again,” says Khullar. “A-REIT and CMT [Ascendas and CapitaMall], earlier this year, were defensive plays: they were raising money so that if the world did end, they would still be able to stay standing. Now valuations have come down, I think REITs will look to raise money for more aggressive reasons: for acquisition.”

BOX: Japan

Japan’s property markets have slumped with the rest of that economy. According to Mizuho Trust and Banking, real estate transactions more than halved in value and volume in 2008, particularly because J-REITs, Japanese real estate investment trusts, have not been buying. “The J-REIT market is still stagnant in terms of property acquisitions, given that most of the J-REITs’ balance sheets are geared up to their respective self-imposed maximum levels, and concerns about financing and potential bankruptcies had brought down most JREIT share prices substantially below their book values, essentially closing the door for equity raising,” says Macquarie in a recent report.

Japan was where REITs first started to come unstuck, with New City Residence being the first in the region to go under in October 2008. Things have picked up in the second quarter, though. The government has brought in measures to try to temper concerns about bankruptcies, including the provision of loans through the Development Bank of Japan, and eased tax transparency requirements around M&A (making it easier for one J-REIT to acquire another at a discount to its NAV). Also, new sponsors are being found for those J-REITs whose existing sponsors have already applied for bankruptcy. Most recently Daiwa Securities announced in June it would become the new sponsor of DA Office; other JREITs including Nippon Residential, Nippon Commercial and Joint REIT, were expected to appoint new sponsors at the time of writing.

Despite the trials of the markets, Tokyo is not officially the most expensive place in the world for office space, according to CB Richard Ellis: US$183.62 per square foot per annum, edging out London’s West End and Moscow. Despite that, vacancy rates have continued to rise in Tokyo; Macquarie expects a 9% peak within the next two to three quarters.

BOX: Asia’s blue chips

Asia’s blue chip companies are emerging from financial crisis, sometimes scarred but generally intact, and ready to take on opportunities as they arise.

The Dow Jones Country Titans indices, which measure the performance of the biggest and best known companies in each country, tell the story. Its China 88 index is up 92.5% year to date, while Singapore’s is up 48.4%, Hong Kong’s 43.7% and South Korea’s 41.1%. Compare this to the world’s old guard: the UK’s blue chips have gained just 5.4%, Germany’s 6.4% and France’s 8%.

Partly, this is because Asian markets fell irrationally far in the first place, particularly given that their banking systems were largely immune from the problems that blighted those in the US and Europe. The fall was a consequence of capital behavior: as times turned difficult for US and European fund managers, they tended to bring money home in the belief that it was safer to do so. This exit of foreign institutional capital more than anything else hit Asian markets so hard.

Now, though, some common sense is returning. Economically Asia has the best prospects, given the scale of its population steadily growing in wealth, bringing with it demand for goods and services that can’t be matched elsewhere in the world. As it is, GDP numbers in many Asian markets remain highly impressive despite their decline – China may well log 8% GDP growth this year. Generally, Asia’s populations are characterized by high savings, and those in weaker Anglo countries by higher debt. On top of that, Asian banks and companies, have learned lessons the hard way from the Asian financial crisis in 1997-8, have tended not to be highly leveraged; the banks in particular have been run with greater conservatism than many US houses in particular, and it could also be argued they were protected by a lack of sophistication from owning things like collateralized debt obligations which caused such trouble elsewhere.

Those fundamentals are coming back into focus for analysts and investors. “Expect Asian markets to outperform in the next five to 10 years,” says Shane Oliver, chief economist and head of investment strategy at AMP Capital Investors. And the biggest companies, since they have the easiest access to capital when bond and stock markets regain their liquidity, are also in the best position to acquire other businesses.

From the investor perspective, much of the easy gains may already have passed: Oliver, speaking to Institutional Investor in July, points out that most Asian markets are already trading around their long-term price/earnings ratio averages despite the fact that most of the world is still technically in recession. Nevertheless, he thinks that five to 10 year projected equity returns are higher in ex-Japan Asia (11.6% per year, 3.6% of it coming in dividend yields) than anywhere else in the world – he projects just 6.4% for Europe, for example. Besides, very few stocks have recovered so far as to be higher today than they were 12 months ago: while a handful have done so, such as China Life, Posco, CNOOC and Sun Hung Kai Properties [NOTE to EDITOR: this is based on August 6 closing prices], even some of the most resilient portfolio stalwarts are still under water over the last 12 months, among them PetroChina, Hutchison Whampoa, Taiwan Semiconductor Manufacturing, Industrial & Commercial Bank of China, China Mobile and Shinhan Financial. This suggests there is still value available.

Euromoney, June 2009

One contender leaves, and another enters. The revolving door of foreign participation in Japanese domestic brokerage has taken a few more turns this year, with Citi selling its Nikko Cordial retail brokerage to Sumitomo Mitsui Banking Corporation, and Morgan Stanley striking a joint venture deal with Mitsubishi UFJ Financial Group.

Forming a judgement on Citigroup’s enterprise is tricky. It is tempting to add it to the file marked “failed foreign attempts to penetrate Japanese retail”, alongside Merrill Lynch’s venture with Yamaichi. But the truth is we’ll never know whether Citi really could have made it work as it was still a work in progress after just two years, and the imperative to sell it was driven by problems at head office, not in Japan.

But as Citi departs retail, another foreign house moves in. In March Mitsubishi UFJ followed up its $9 billion investment in Morgan Stanley last October – which, with hindsight, one could argue was one of the true turning points of the financial crisis – with a joint venture combining Mitsubishi UFJ Securities with Morgan Stanley Japan Securities. This creates a single venture including Mitsubishi’s domestic retail brokerage network, the full range of institutional businesses offered in Japan by both sides, and the international reach for Japanese clients offered by Morgan Stanley.

So why should this do any better than previous contenders? Unlike Nikko Cordial, which had remained a separate business to the institutional arms of the Nikko Citi venture, this starts out as a single business. Morgan Stanley’s position, privately, is believed to be that a structure that combines retail and institutional capabilities in a single company from day one has a better foundation. On top of that, there is a belief that the links with the broader MUFG organisation, now locked in with the stakeholding and MUFG’s representation on the Morgan Stanley board globally, provide an additional layer of support for the JV.

Those who doubt the ability of the two sides to make this work tend to start out with the cultural differences. Combining a Wall Street heavyweight investment bank known for its innovation with any Japanese megabank is challenging enough. But Mitsubishi UFJ, or more specifically the Mitsubishi legacy within it, is known for conservatism even by Japanese standards. “These guys are so bureaucratic they would barely admit the name of the bank is Mitsubishi,” says Stephen Church, research partner at Japaninvest, an independent research house in Tokyo. In fact, the other article in this section shows that in syndicated lending, MUFG is actually the more daring of the three megabanks, with a far greater exposure to overseas markets. But it’s still a tough fit. “The idea of how Morgan Stanley is going to fit with Mitsubishi is just a mystery. It’s difficult enough for Mizuho and its IBJ [Industrial Bank of Japan, one of Mizuho’s legacy banks] content to operate, but for Mitsubishi, it just doesn’t make sense.”

Morgan Stanley declined to comment on cultural differences, or on internal morale. After all, do bankers who signed up for a Wall Street dynamo feel unhappy about working instead for a Japanese megabank – who, with a 60% stake, will control the venture in ownership terms? It is understood that Morgan Stanley clearly recognises that finding common ground on risk tolerance and employee expectation is among the biggest challenges that it will face, but considers it a chance worth taking in order to reach a retail base that is otherwise off-limits. It’s a choice between having 40% of someone else’s business that might have a chance of penetrating a market no other foreigners have successfully reached; and owning all of a profitable and successful, but smaller and entirely institutional, other business.

]]> http://www.chriswrightmedia.com/securities-japan-for-euromoney/feed/ 0 http://www.chriswrightmedia.com/loans-japan-for-euromoney/ http://www.chriswrightmedia.com/loans-japan-for-euromoney/#comments Mon, 01 Jun 2009 04:06:02 +0000 Chris Wright http://www.chriswrightmedia.com/?p=64 Euromoney June 2008

League tables haven’t looked like this since the 1980s. Rankings for global loan arrangers in the first quarter of 2009, compiled by Dealogic, show three Japanese banks in the top five worldwide – with Mizuho at the top. The trinity of Mizuho, Sumitomo Mitsui Banking Corp and Mitsubishi UFJ Financial Group between them led almost exactly half of the 1,453 loans Dealogic tracked worldwide in that three-month period.

This is partly because of an absence of activity at American and European banks rather than an increase at the Japanese. But it’s still very notable that volumes for the Japanese banks have held up so well. In fact, in some cases they’ve done better than hold up: during the October to December quarter, in arguably the worst climate for global finance in history, Japanese deal volumes went up more than 50% compared to the same quarter in 2007. In the first quarter of 2009, they were down year-on-year for the industry as a whole, but at two of the three megabanks – which account for 90% of the market in Japan – their volumes actually went up.

It’s tempting to think that this shows Japanese banks stepping into the void internationally left by western lenders, but the truth is this is predominantly a story about Japanese borrowing. According to data from ThomsonReuters, 93% of Sumitomo Mitsui Financial Group’s loan proceeds in the second half of the 2008 financial year were in Japan, and 99% of Mizuho’s.

Partly, the strength of domestic activity is a consequence of the closing of Japan’s bond markets to lower rated credits. “Single A companies have seen their bond issuance reduced,” says Mayuko Suzuki in the syndication department of Sumitomo Mitsui. “Therefore they want to arrange more syndicated loans.”
At the same time, the domestic Japanese institutions who typically participate in syndicated loans were not badly hit by sub-prime and their lending appetite did not drop anything like as drastically as elsewhere. “Japanese regional banks, who are the main buyers for the loans, were not significantly damaged and are relatively strong in their capacity to lend,” explains Sadahiro Sato, general manager of the syndicated finance division at Bank of Tokyo-Mitsubishi UFJ, part of Mitsubishi UFJ Financial Group. “Also, Japanese individuals have shifted from investment trusts and stocks to deposits. That means regional banks’ total deposits have increased and they have been looking for a way to invest that.”

They’re still happy enough to take part in lower rated credits. “Of course there are many terms and conditions,” says Takashi Tadokoro, senior vice president in Sumitomo Mitsui’s syndication department. “But we do not have any difficulty in placing or selling loans to investors.”

Asia’s bond markets enter 2009 at a crossroads. Last year many of them demonstrated that they were credible alternatives to credit-clogged G3-currency markets, at least for local borrowers. But  what happens next? The coming 12 months will demonstrate whether Asian markets have shown sufficient depth and maturity to hold their ground as a key funding source or will once again be only an afterthought to the major global currencies.

“Local currency markets are a lot more important than people give them credit for,” says Sean Henderson, head of debt syndicate for Asia Pacific at HSBC. Dealogic, the data provider, says bonds in the 10 main Asia ex-Japan currencies combined amounted to the equivalent of US$231.8 billion in 2008, compared to US$28.3 billion for Asian issuers in dollars, yen and euros combined. “Both in terms of scale and the trajectory of the markets, local currency became a lot more important in 2008,” Henderson says. In particular, Asia proved itself a rare location in which borrowers could raise bank capital: Maybank, UOB, DBS and OCBC all raised tier one capital locally in 2008, and several Philippine lenders raised tier two funding.

Different markets responded to the opportunity – if one can call a global credit crunch an opportunity – in different ways. The standout, by a considerable distance, was China. The 10 largest local-currency bonds out of Asia last year were all in Chinese renminbi, and the smallest of those 10 was worth Y19.5 billion (US$2.85 billion). Consider China Ministry of Railways: in September, as Lehman Brothers plunged towards bankruptcy, it raised Y20 billion; a month later, as world stock markets hit some of the worst volatility for nearly a century, it raised another Y20 billion; and in November, amidst all that global uncertainty, it trumped them both by raising another Y30 billion in the largest bond of the year. China National Petroleum Corp, China Merchants Bank, China Development Bank and the sovereign itself have all raised billions of dollars worth of local money in 2008.

“China’s bond markets are starting to play a more meaningful role in the overall economy and we expect to see this welcome development continue,” says Mark Leahy, head of global risk syndicate for Asia at Deutsche Bank. “The regulatory framework around the bond market, and in particular the corporate bond market, continues to be strengthened and will allow more participants to play a more active role. This is the area we believe will have the most rapid growth in the coming years.”

But China is something of a special case. “It is the most cloistered of the domestic bond markets,” says Fergus Edwards at UBS in Hong Kong. “Local investors have a relatively limited number of markets to consider, and at present those with cash are less likely to invest in equities or in property than they were a year ago. That makes the bond market a very attractive third option.” Also, Edwards says, the Chinese are a relatively protected investor base, unaffected by declines in global markets, forex wobbles or the oil price. “Chinese companies continue to grow strongly, driven by continued, if weaker, domestic demand. The renminbi market allows them to domestically fund the investment that generates this growth.” Edwards, who was on the October Ministry of Railways deal, says the ructions in world markets at the time were “not a problem. Chinese accounts focused on the strength of their home market rather than the weakness of others.”

Elsewhere in Asia, though, few places were quite that resilient. Most markets showed healthy issuance until the October crash, and then locked up just like everywhere else. Malaysia, for example, hosted deals in ringgit worth $500 million or more from Cekap Mentari, Syarikat Prasrana, Cagamas (twice) and Khazanah, but there’s been nothing of any size since September. Barring an encouraging $554million-equivalent deal for Woori Finance in December, the same is broadly true of the Korean won. Philippine pesos and Indonesian rupiah have been active in low quantities (though Indonesia effectively shut down in August), but traditional stalwarts, especially the Hong Kong dollar, have been all but dormant: there hasn’t been a deal worth US$100 million in Hong Kong dollars for almost a year now.

It’s been a while since the world has expected anything positive from Japanese banks, but in the darkest months of 2008 they emerged as unlikely heroes for their counterparts in the west. The cash-rich but inefficient megabanks of Japan, stuffed with deposits that wobbly Wall Street financiers would have killed for as the credit crunch took hold, have clearly been opportunistic and perhaps picked up some bargains. But can we say their role in world finance has changed?

Two transactions have caused the world to look afresh at the positioning of Japanese banks on the global stage. On September 22, Mitsubishi UFJ Financial Group announced it planned to acquire up to 20% of Morgan Stanley’s common stock. By the time the deal was closed on October 13, the terms had changed a touch (to be benefit of MUFG), bringing it 21% of the US bank on a fully diluted basis, but the expenditure remained vast: It will spend $7.8 billion to acquire convertible preferred shares, and $1.2 billion on nonconvertible preferred shares.

The other came when Nomura jumped in to take over Lehman Brothers’ Asian operations in September, following up with a deal for Lehman’s European and Middle East equities and investment banking businesses the following day. Between the two, these franchises employed about 5500 people, and come at a considerably lower cost to Nomura than the Morgan Stanley deal does to MUFG: no formal price has been announced but the Asia franchise is believed to have cost around $225 million.

They are two very different deals from two very different institutions, and they tell us different things about Japanese financial ambition. The MUFG deal is, first and foremost, a smart investment: it takes advantage of a formidable institution having been dragged into extraordinary circumstances, and gives it a big stake in an institution that, logically, should bounce back well in brighter markets.

It was telling that the very first line of Morgan Stanley’s press release on the deal mentioned MUFG’s “$1.1 trillion in bank deposits.” In fact, that got mentioned even before Morgan Stanley’s name. In America today, stable and boring deposits are what it’s all about – witness the plunge in Citigroup’s rejuvenated share price after it got gazumped by Wells Fargo on the acquisition of deposit-rich Wachovia – and if Japanese commercial banks do one thing well, it’s stable and boring deposits.

Shinichi Ina, bank analyst at Credit Suisse, explains the marriage of convenience like this. “The market has been losing faith in the investment bank business model, which does not have the means to tap into bank deposits as a stable fundraising source,” he says. “Investment banks urgently need to convey to the market that they have solid fundraising capabilities. Meanwhile, MUFG and the other Japanese megabanks have huge deposits, but demand for capital is weak in Japan, and they must turn to overseas sources for generating growth. We believe the agreement is mutually beneficial for both sides.”

A look at how the deal changed during its negotiation also says a lot about the balance of power in the deal. Nobuo Kuroyanagi, MUFG’s president and CEO, said the two parties “have revised the terms of our investment in the best interests of both companies”. Rubbish: the revisions, which reflected a falling Morgan Stanley share price by axing a pledge to spend the bulk of the acquisition cost on convertible shares with a conversion price of $31.25 (as opposed to $25.25, where the bulk of the shares will now convert), is entirely in MUFG’s benefit, giving it more protection to share price declines and better dividend benefits (both the convertible and non-convertible preferred shares will yield 10%). Morgan Stanley simply needed the money and, perhaps more importantly, the vote of confidence.

How MUFG behaves now will be interesting. It gets a seat on the board, and a steering committee is being established to work out the best ways to benefit from the alliance. But will that mean MUFG seeks to be a powerful global investment banking brand in its own right, or be happy to sit back and reap the benefits of a shrewd investment?

Ina sees trouble ahead. “The challenges will be formidable,” he says. “MUFG plans to ease Morgan Stanley’s fundraising difficulties and increase earnings contributions to the group through its investment, but it will need to avoid an exodus of talented personnel from Morgan Stanley.” He believes it would be a mistake to push the MUFG brand through Morgan Stanley. “However, MUFG’s corporate culture, which is conservative even by Japanese banking standards, clearly clashes with the aggressive profit-driven business culture of US investment banks. Putting these two distinctive business cultures together in the same group may generate synergies, but it also harbours considerable risks of inefficiencies and a failure to live up to expectations.”

Nomura’s position is rather different, partly because it has picked off assets of a failed business rather than undertaking a merger, and partly because it has been much more brazen in its global ambitions.

The author interviewed Nomura chief executive Kenichi Watanabe for another publication in July, and started by asking him about a rumour going around at the time that the bank had a Y300 billion war-chest ready to spend on global acquisitions. Watanabe quickly set the record straight: it was actually Y500 billion, he said. “I am very interested in looking at these assets [troubled financial institutions],” he said, two months before Lehman went bankrupt. “We look at it from two angles. One is trying to capture capabilities we currently do not have, and the other is trying to capture a talented human resource pool.” He was very clear Asia was the priority, and said he would like 30% of Nomura’s earnings to come from outside Japan in due course (at the time of the interview, strictly speaking the rest of the world made a negative contribution to Nomura’s earnings, since it had taken significant write-downs on its US businesses in that financial year).

The Lehman deal clearly gives Nomura the additional skilled headcount that it wants, and appears to leave plenty of the war-chest left over. The scale of the personnel makes it a more obviously transformational deal than the MUFG transaction, which looks more strategic, though naturally it raises more questions too. Chief among them: can Nomura keep the staff it has acquired? Can it integrate them into its own systems and teams?

“A deal like this enables the acquirer to get intangible assets like human resources at cheap prices,” says Nana Otsuki, head of financials research at UBS in Tokyo. “But what is not sure is the second or third year after the acquisition. Even if they guarantee first year’s remuneration or something like that, I don’t know if there is any motivation for employees after that.”

In the Lehman franchise, Nomura has gained a business with strength in M&A, derivatives and prime brokerage, among other things. But there’s another question, too: is there anything in Nomura’s track record, in which for many years its executives have sought to translate its domestic strength into a profitable and powerful international presence, that suggests it should be any good at managing its expanded Asian and European team anyway? Nomura’s most recent adventures in America don’t give a lot of cause for optimism. It has exited completely from its RMBS business there, reducing its residential mortgage exposure from Y266 billion in June 2007 to almost nothing today. It booked Y140 billion of losses in the first half of the 2007-8 year alone. In early 2008 it pledged overall cuts of 400 people, net, in its North American businesses.

The Nomura deal perhaps illustrates a change of focus in Japan, though: less on the US, and more on Asia. And that makes sense, given local expertise. Besides, many fund managers are pleased to see Japanese banks trying to do something constructive with their capital other than sit on it. “The whole Japanese market is a dream world for unlocking value and its companies are beginning to use their cashed-up balance sheets to pick through the wreckage of Western markets,” says Kerr Neilson, founder of Platinum Asset Management, a fund manager in Sydney. Mitsubishi UFJ is one of the top three holdings in an international fund he manages.

Going global, though, comes at a cost for Japanese banks. The planned Y990 billion capital expansion by MUFG was so badly received by the market it was partly responsible for pushing the Nikkei 225 to its lowest level for more than two decades. And the other banks that have dabbled globally are also under pressure. Sumitomo Mitsui Financial Group, which has invested about GBP500 million in Barclays Capital, cut its full-year net profit forecast by 63% in late October because of bad loans and a drop in the value of its shareholdings in other companies (Barclays among them). Mizuho Financial, which has taken a $1.2 billion stake in Merrill Lynch, lost 67.8% of its share price in the 12 months to October 29.

Some feel they don’t have a choice, given the lack of obvious opportunity at home. “Japanese banks can make profit by using their very cheap and stable funding base, but if they want reasonably high profit base – ROE of 10% plus – then that’s a different story,” says Otsuki. “Because banks have too much deposits on their balance sheet, they have to do something, and in terms of lending activity it makes sense to go overseas.”

And can Japanese banks go overseas successfully this time? “They used to be overseas and were forced to stop those activities,” says Otsuki. “Now they are coming back to those markets. We can say it’s a new stage. But it could also be just a repetition of their past track record.”

The banker is smiling but there’s an undercurrent of venom in his voice. “You won’t believe me, but our business has done exceptionally well recently,” he says. “Our revenue from Asia is well up year-on-year.” He lists four different areas of his bank’s franchise which have grown, not flagged, in the last 12 months. And then comes the inevitable postscript. “Of course, not that any of us are going to get paid for it…”

Every conversation with a banker in Asia these days seems to have that undertone. The subtext: we’ve done what we were supposed to do. We’ve worked hard. We’ve brought in business. But because of decisions somebody else made – and generally someone half a world away in New York or London – we’ll get no bonus this year, and we’ll very likely lose our jobs. Worse, we might lose our jobs in order to save the jobs of some of the fools in New York or London who put us in this mess in the first place.

Bankers are disappointed, worn down – and angry. And it just keeps getting worse, often on the whims of people who wouldn’t know an investment bank if it bit them (which, in a manner of speaking, it probably has). Asia-based employees of American banks looked on in horror as the House of Representatives voted down the first bailout package in September, precipitating a market plunge and a further erosion of bankers’ already hopelessly out-of-the-money options. They have swallowed hard as US congressmen have lobbied for banks to be made an example of, something that would lead to redundancies for bankers with families to support not just in New York or Connecticut but in Hong Kong, Singapore, Seoul, Mumbai. And they have shaken their heads as Hank Paulson has redrafted the bailout that did eventually get through the House, going back on the promise to purchase toxic assets – assets mainly bought in the first place by people in Europe and the States, not Asia. Employees here, powerless to do anything about it, and without any kind of voice or leverage over American politics, can only watch.

There’s even the injustice of the markets’ behaviour. As of November 21, Asian markets, at 61% off last year’s highs, have done notably worse than those in the US at 52%, despite the US being at the root of the problems. What happened to decoupling? Remember that magical idea that intra-Asian trade would be sufficiently strong to protect Asia from falls in other markets? And as Asian markets have been hit by the repatriation of foreign capital back to Europe and the US in a supposed flight to quality – is the UK or US growing at 8% a year like China? – the cycle has been getting depressingly worse. Grown men can be found swearing at their screens at the irrationality of credit default swap pricing, or the stubborn refusal of emerging market stocks to bounce.

The reshaping of the world financial services industry is also creating some friction, and perhaps the most potent example of this can be found at Nomura following the acquisition of the Lehman Brothers franchise in Asia.

This was fabulous news for Lehman employees and at the time people were genuinely pleased to hear that the 5,500 European and Asian employees affected would no longer be out of work. One minute they were not only out of a job but not at all sure if they’d even be paid for their last month’s work; the next, they were back in their original positions, on their existing deals.

And there’s the rub. The problem is, being an American investment bank, those existing deals were in many cases considerably better than those the existing Nomura staff were on. Nomura says it’s been shifting its remuneration policy to better represent the meritocratic eat-what-you-kill approaches of the Americans, but it’s a work in progress and, as one banker puts it, “there are plenty of people at Nomura who’ve been bringing in millions of dollars of business and are taking home US$100,000 a year.” The arrival of the Lehman people, earning more than they are, was always going to create friction.

Conditions are turning tough in Japanese listed real estate. The TOPIX Real Estate index dropped 23% from mid-May (its peak so far this year) to the end of August, and the TSE REIT index is down 32.2% year to date.

In global terms, that’s actually not that bad, but the pressure appears to be towards continuing decline. Office vacancy rates are rising in Tokyo and have been doing so for six months now, surprising some analysts. “The recent pace of the rise in the Tokyo office vacancy rate has been faster than we initially expected and while we believe the current pace is likely to slow down towards the beginning of 2009, it may rise towards mid 4%, getting closer to 5% in 2010,” notes Macquarie analyst Hiroshi Okubo.

On top of that, a number of real estate and housing companies – including six listed ones – have filed for bankruptcy this year after failing to either get refinancing or buyers. While not bankrupted, some big names, such as Urban Corporation and Ardepro, have been hit by concerns about their ability to access credit. Smaller J-REITs have been downgrading earnings. And residential property doesn’t look great either. “The condo sector is stuck between a rock and a hard place, where some developers have been faced with the rise in land prices as well as construction costs on the one hand, but not being able to pass on to the buyers, whose affordability has already declined due to rising prices and flat growth in wages,” Okubo says. He believes a price decline of 10 to 20% would be needed before any pick-up in demand should be expected.

As everywhere, the challenge is knowing when to hide and when to buy. Some see value: Merrill Lynch recently noted that around half of all J-REITs are now trading below book value. They also pay what is, by Japanese standards, an exceptionally high yield of over 5%. “Companies appear to be getting increasingly cautious in the face of low visibility on the future of the economy, but we get a sense that supply/demand conditions are tight,” says Yoshizumi Kimura, an analyst at Citi, speaking on the office market in a recent report. “Coupled with limited supply volumes, this makes for a firm outlook on the rental market, in our view.”

Analysts tend to recommend exposure to listed developers with the strength in the balance sheet to ride out the credit crunch, at which point they will be well positioned to pick off distressed assets or competitors. Macquarie has kept an outperform recommendation on Nippon Building Fund, Japan Real Estate and Nomura Office Fund, although it has downgraded its target price on each of them; “They are our preferred exposure in the JREIT space as they are well-capitalised with strong balance sheets with both internal and external growth opportunities,” the broker notes.

Big transactions have taken place this year, in particular the acquisition of the Resona Bank headquarters in Otemachi, with Mitsubishi Estate acquiring a 73% sectional ownership of the building for Y162 billion. Other deals have included GIC Real Estate, the property investment arm of the Government of Singapore Investment Corporation, purchasing the Westin Tokyo from a Morgan Stanley real estate fund for Y77 billion; Morgan Stanley Real Estate Investment acquiring the Citigroup Centre in Shinagawa-ku from Citibank for Y48 billion; and another Morgan Stanley acquisition, of the Shinsei Bank Building in Chiyoda-ku, for Y118 billion. REITs, too, have been acquisitive this year, with examples including Industrial and Infrastructure Fund acquiring IIF Haneda Airport Maintenance Center for Y42.2 billion, and Japan Retail Fund acquiring Aeon Sapporo Hassam Shopping Center in Sapporo for Y18.4 billion.

That said, all of these were in the first half of the year, and transactions have slowed considerably since. Like everywhere else, it’s all about confidence.

Asian stock markets are suffering – even more than the US markets whose banks precipitated the credit crunch. While the S&P 500 index was down 12.2% in the year to August 18, Hong Kong’s Hang Seng index is down 24.7%, Singapore’s STI 19.9%, India’s Sensex 27.8% and China’s CBN600 an eye-watering 55.5%.

While the experience has been painful for investors, many feel that the decline represents a rare buying opportunity in Asia. There might be worse to come, but almost universally analysts and fund managers feel that investors with a long term view will be rewarded. The question is: where to pick?

The consuming issue of the moment is just what is happening to China. China’s economy is slowing, but all things are relative: it has slowed from 11.9% year on year GDP growth in 2007 to 10.1% in the second quarter of 2008, which by the standards of any other market is still breakneck speed. Even bears like Kenneth Rogoff, a Harvard economics professor and former International Monetary Fund economist, speak only of a “significant growth recession in China” to “at least one year of sub-6 per cent growth,” still dramatically higher than is routine in the developed world. The threat, though, is chiefly inflation, which hit 8.5% in April; on top of that, a US and European recession would clearly hit exports.

In the short term, some are still bearish about China. Stephane Mauppin-Higashino heads a product specialist team at Credit Agricole Asset Management, which offers a global emerging markets fund. His fund is overweighting Russia and Brazil at the expense of China and India. But looking further ahead, he has little doubt about the country’s prospects. “We believe the growth is here to stay,” he says. “Whether it’s nine or 10 or 11 or six, China will grow. It will average seven to eight per cent annualised growth through the cycle and we don’t have much of an issue with it falling below the trend, even to five per cent, if it were to happen.

“The issue we have had with China is the price: valuation, and inflation. It’s been a fantastic story but too expensive.” 

Some investors are also troubled by transparency in Chinese listed companies. Hugh Young is the managing director of Aberdeen Asset Management Asia in Singapore; he actively avoids most Chinese stocks. “At the company level, we really don’t have a clear view of earnings because of the lack of transparency,” he says. “Aside from that, so much depends on policy action: the level of stamp duty, the pipeline of IPOs, the release of non-tradable shares, and so on.”

That said, most foreign investors in China don’t go anywhere near the so-called A-share markets, which are domestic Chinese stocks listed in Shanghai and Shenzhen. Generally, they can’t, except through tightly controlled occasional institutional allocations from the Chinese state. Instead, they are more likely to invest in H-shares (Chinese companies listed in Hong Kong), red chips (Hong Kong listed and incorporated companies with substantially mainland operations and management), or Greater China plays – and in this regard Taiwan is looking increasingly interesting.

Taiwan has been a perennial underperformer over the years. “Over the last eight years the market has consistently disappointed, primarily due to policies that have encouraged capital flight,” says Adrian Mowat, chief Asian and emerging equity strategist at JP Morgan in Hong Kong. But when a new government was voted in on March 22, there was great hope of a change in fortune. President Ma Ying-jeou was elected on a platform that included a much more friendly relationship with mainland China than his predecessor, Chen Shui-bian. Ma will not push for independent statehood for Taiwan as Chen did, but will instead look for a better economic future for Taiwan predicated on greater freedom of trade, investment and general cooperation with the world’s most populous and vibrant nation.

An initial euphoria that prompted a 20% climb in the stock market in the run-up to and through the election has since unwound, partly because of the behaviour of world stock markets, partly because of the outlook for electronics stocks that dominate Taiwan’s economy, but also with a sense of reality about just what can be achieved in pro-China relations. Still, as CY Huang, the president for Greater China investment banking at the Taipei financial institution Polaris, points out: “Nobody can make magic in two months.”

And change is taking place. The iconic moment came with the announcement of direct flights between Taiwan and mainland China, albeit only on weekends. But there are more substantial shifts happening in investment and financial services. A long-standing limit on Taiwanese companies obliging them to invest only 40% of their net worth in China is being raised to 60%, and is likely to rise further. In June, limits were relaxed on the amount Taiwanese funds can invest in Chinese stocks. Additionally, an equally long-standing ban on Chinese investment in Taiwan’s stock and futures exchanges has been lifted: qualified domestic institutional investors, or QDIIs, which are Chinese institutions with approval from Beijing to invest overseas, will be permitted to buy in. Foreign mutual funds backed by Chinese capital can also now come in to Taiwan. “The government wants to attract PRC money to come into Taiwan,” says Huang. “Previously, you needed a declaration: if HSBC wanted to bring money in it would have to declare none of it came from China.”

Measures like this have two effects: they mean that Taiwanese companies are more likely to use Taiwanese banks and other service providers to handle their business, rather than moving the whole lot offshore to avoid restrictions; and they mean there is a greater chance of capital flooding into Taiwan instead of constantly leaving it. It’s this sort of momentum that has attracted Mowat at JP Morgan to make Taiwan one of his four major overweights in emerging markets today (the others being China, Mexico and Turkey). “Our argument is that during the DPP administration [under Chen] you saw capital flight and the government appeared to have no economic policy. The KMT government has come to power, liberalised investment restrictions for Taiwanese going into China, and has improved relations with the mainland.” Taiwan has three prongs for accelerating growth in the next year, Mowat says: tax cuts, infrastructure development and deregulation.

Elsewhere, prospects vary from market to market. (India is a whole other subject, beyond the scope of this article.) In southeast Asia, markets are struggling, whether through basic economics (Singapore, which being fundamentally a country of service industries suffers more than most when the US and other major trading partners run into trouble) or unusual specifics (the increasingly fractious political environment in Malaysia).

But the turmoil has created some unlikely opportunities. Global fund managers searching for a combination of low stock market valuations and high earnings potential might want to take a second look at Thai equities. The Stock Exchange of Thailand (SET) not only trades on a 2008 PE of 9 compared with 12.6 in Malaysia and 11.6 in the Philippines, but it offers a dividend yield of 4.9%. Better still, after years of dismal returns, analysts are forecasting that corporate earnings will increase by 21.3% this year and by 6.6% next year.

In its latest strategy report on the Asia-Pacific, Merrill Lynch rates Thailand as one of the cheapest markets in the region and suggests that investors overweight it. Merrill is not the only one with a buy on the market. Andrew Stotz, head of research at CLSA also believes that Thai stocks look attractive. “With the Thai market down almost 20% this year and with valuations looking the lowest in Asia, we believe that investors should be aggressively buying the market,” he says.

As is so often the case in Thailand, however, there is one major problem. And that’s the political situation. Few analysts believe that the coalition government led by Prime Minister Samak Sundaravej will survive the next 12 months let alone its full term in office. Furthermore, despite the recent decision by deposed former Premier Thaksin Shinawatra to seek political asylum overseas, the threat of mass street protests and a possible violent confrontation has not gone away.

Concerns over the fragile political situation together with fears of rising inflation, which reached 9.2% in July, have already dampened expectations for the second half of the year. The Securities Analysts Association recently downgraded its forecast for the SET Index to a range of 628 to 828. That compares with a current level of 702.

Still with the SET index having fallen by 20% since the beginning of the year and by more than 60% since its all time high in January 1994, canny fund managers will certainly find bargains. Asia Plus Securities suggests that investors look at property company Land & Houses, coal miner Banpu and energy giant PTT. These companies are expected to show impressive second quarter earnings as well as solid long term growth potential. Meanwhile Kim Eng Securities recommends select blue chips like Bangkok Bank, PTT Exploration and Production (PTTEP) as well as Total Access Communication.

So after the recent sharp correction in equity prices, has the stock market finally bottomed out?  Poramet Tongbua, head of research at Tisco Securities in Bangkok, certainly thinks that it has. “We believe that the market already reflects more than 80% of the worse-case scenario for political developments, rising inflation and higher NPLs. Consequently we are convinced that Thai stocks now offer an attractive risk to reward ratio for longer term investment,” he says.

Perhaps the best news for investors is the fact that for the first time since 2005, managers of listed companies in Thailand have become significant buyers of their own stock, suggesting that they believe that their businesses are undervalued. According to Phatra Securities, so far this year management of 47 of the SET100 companies have been net buyers of their own shares on a cumulative basis. That compares to only 28 companies where management have been net sellers.

To date, foreign investors have shown considerably less confidence in the market. Since January, they have sold off Bt86 billion (US$2.6 billion) of stock, representing most of what they had accumulated since the beginning of 2006. As a result, large capitalized companies like Advanced Info Services, PTTEP and K-Bank are at their lowest level of foreign ownership for at least three years. If and when foreign investors decide to return, Ian Gisbourne, strategist at Phatra Securities believes that these stocks could be amongst the star performers.

But whilst Thailand does offer some compelling reasons to buy, fund managers would do well to remember that this has been one of the worst performing markets in the region over the past decade. And whilst by most measures Thai stocks look cheap, investors will want to know that this time round, the market really will go up. Stotz for his part remains upbeat. “In Thailand, analysts are at the tail end of four long years of earnings downgrades. To us, earnings look much more vulnerable in China, Singapore, India and Hong Kong.”

In terms of sectors, three have been particularly badly hit in Asia. One is financial services, although banks in Asia generally had very limited subprime exposure. The others are real estate and gaming.

Here, too, there is ammunition for the bold contrarian. “People are going to make an awful lot of money out of real estate in the next couple of years,” says Mowat. “But at the moment it’s incredibly out of favour, particularly Chinese real estate. We think it’s oversold.”

Nobody has escaped. Take Capitaland, the Singaporean blue chip often considered the best run company in the country, the unquestioned leader in Asia’s fledgling real estate investment trust sector, and a true real estate blue chip. By August 19 it had almost halved in value in the space of a year. Ascott REIT, one of its trusts based around serviced apartments, looks even worse: well over $2 a share a year ago, 99 cents in August.

The fall in stocks like these reflects a number of dynamics. A slowing economic outlook reduces demand for high-end residential property and commercial property. Stocks that have used a lot of gearing – this applies to many REITs – have been particularly badly hit. But generally property related share prices have fallen by much more than the prices of the underlying assets, which causes some fund managers to see a buying opportunity – if it can only be timed right.

The pain has hit the region’s other developed markets too, notably Australia, which has the most entrenched REIT market in the region. “It’s been incredible, really,” says Andrew Saunders, CEO of Real Estate Capital Partners, a Sydney-based real estate fund manager. “The A-REIT sector was worth about A$145 billion in June 2007. Now it stands at A$70 to A$75 billion.” Saunders says some REITs are trading at as much as a 45% discount to net tangible assets, despite being underpinned in some cases by world class assets – such as Australian bank Westpac’s head office on Sydney’s Kent Street.

Arguably the chief attraction of this sector is the extraordinary yield. Australia is a high-dividend market at the best of times – CommSec chief equities economist Craig James says the Australian stock market today is paying its highest yield for 17 years, with blue chips paying as much as 6 or 7%, particularly in the banking sector – but the REIT sector is more generous still.

Fund manager Stephen Hiscock of SG Hiscock & Co in Melbourne says the sector has a forecast yield of over 9% for 2009, and 11% if one big and distorting stock, Westfield, is excluded. One fund manager calls it “potentially the buying opportunity of a decade. But the problem is, you know it could still all halve again tomorrow.”

The other big listed property market in the Asia Pacific region is Japan, which at the start of this year had a higher market cap in its REIT sector than the rest of ex-Australia Asia put together, at US$46.035 billion, though it has fallen since. There are 42 REITs listed in Japan.

Japan’s property sector generally has been hit by a credit crunch despite the fact that Japan had little exposure to subprime. 43 real estate developers filed for bankruptcy in July alone, mainly because they could not access funds. This, rather than the underlying properties themselves, has been the problem: at a time when Jones Lang LaSalle puts Tokyo CBD office vacancies at only 3%, relatively big names such as Urban Corporation and Ardepro have been badly hit by concerns about their ability to access credit.

Once again, there’s a question of whether falls create opportunities for investors. A recent report by Merrill Lynch said around half of all J-REITs are now trading below book value. They also pay what is, by Japanese standards, an exceptionally high yield of over 5%. And among listed real estate developers generally, those with the strength of balance sheet to ride out the credit crunch are likely to be well positioned and modestly valued by the end of it, and even in a position to acquire from troubled peers.

Already, several landmark transactions have taken place this year: CBRE Research highlights the acquisition of the Resona Bank headquarters in Otemachi, with Mitsubishi Estate acquiring a 73% sectional ownership of the building for Y162 billion. Others include GIC Real Estate, the property investment arm of the Government of Singapore Investment Corporation, purchasing the Westin Tokyo from a Morgan Stanley real estate fund for Y77 billion; Morgan Stanley Real Estate Investment acquiring the Citigroup Centre in Shinagawa-ku from Citibank for Y48 billion; and another Morgan Stanley acquisition, of the Shinsei Bank Building in Chiyoda-ku, for Y118 billion. REITs, too, have been acquisitive this year, with examples including Industrial and Infrastructure Fund acquiaring IIF Haneda Airport Maintenance Center for Y42.2 billion, and Japan Retail Fund acquiring Aeon Sapporo Hassam Shopping Center in Sapporo for Y18.4 billion.

Yuto Ohigashi, an analyst at Jones Lang LaSalle, sees opportunity. “While the type of real estate buyers has changed from high-leveraged investors to low-leveraged ones, the Japanese market remains attractive due to the sheer size of its investment grade property market compared with that of other Asian markets,” he wrote in a recent report. “Among Japanese real estate, Y490 trillion is held by corporations, about Y68 trillion of which is considered as revenue-generating properties. Part of the remaining real estate, which is valued at about Y420 trillion or more than six times revenue-generating real estate, is likely to be simply dormant, suggesting the enormous size of the potential market.”

The other sector to have been horribly hit is the gaming industry. Two years ago there was great fanfare and optimism in Macau. The state had opened up the gaming industry once dominated by Stanley Ho and awarded three concessions and a further three sub-concessions, bringing competition and money into a previously seedy sector. Groups like Las Vegas Sands, Wynn Resorts, Melco and Galaxy Entertainment had all committed considerable sums to casino development in the years ahead, and in terms of gaming revenue (as opposed to retail and entertainment in the same area), Macau has now overtaken Las Vegas as the world’s gaming centre. Many of the new ventures are very much in the Vegas style, combining world class entertainment and retail facilities with the traditional casinos, plus top-of-the-line hotels.

But if the share price performance in real estate looks bad, that’s nothing compared to gaming stocks. Consider Dore Holdings, which specialises in the VIP junket game, providing high-roller players to casinos. It has gone from HK$3.60 per share to HK$0.21 in a year – that’s a 94% fall. While not all stocks have suffered quite so dramatically, the situation has not been kind to anyone: when Sociedade de Jogos, the casino business owned by the ultimate gaming tycoon Stanley Ho, sought a Hong Kong listing, it took three years, more than 30 court cases, an application for judicial review on the eve of the float which caused half of the retail investors to back out of the offering, and a halving of the targeted amount to get away. And when it did, it promptly started sinking.

Part of the reason for the problems in Macau’s gaming industry are related to an apparent rethink on China’s part about just what it wants Macau to be. Over the course of this year it has introduced a number of measures designed to cool the growth of Macau’s gaming industry, to reduce the maximum length of time Chinese nationals can spend there, and to cut the frequency of their visits. Since the development of Macau is to a large extent based on the promise of China’s population, this has hit the industry hard. Increased competition is another concern.

But some consultants feel the future is much brighter than these headwinds would suggest, which again raises the possibility of buying opportunities. The Las Vegas based consultancy Globalysis estimates that Macau will experience 28.8% growth in gross gaming revenue (GGR) in 2008 year on year, to reach a total of US$13.5 billion. “It now looks like Macau will bypass not only the Las Vegas strip once again in terms of gaming revenue in 2008, but for the first time, also that of the entire metropolitan area of Las Vegas,” said Jonathan Galaviz, partner at Globalysis, in May when he launched his most recent report on Macau. “Macau’s continued growth in GGR is a reflection of the generally strong macro-economic environment that Macau finds itself within Asia.” If he’s right, then the sector is clearly oversold and presents opportunities.

A big question for the Asia Pacific region is what happens to commodity prices, which will have differing impacts in different locations. Of major markets, Australia is probably the one that has benefited most from the commodities boom: it is home (or a joint home) to world mining leaders like BHP Billiton and Rio Tinto, and its role as a quarry and breadbasket for ardent importers like China has led it to a stunningly protracted period of economic strength. Consequently Australia has not had a year of less than 2.5% GDP growth since the early 1990s, remarkable in a developed economy.

Australia’s market has been hit as hard as any this year though, and was down 21.4% year to date by August 18, partly as a result of market contagion spreading to the commodity sector. Those who believe the commodities boom has further to run tend to be more bullish on Australia than on other markets, although the short term is likely to be less favourable. “Given the relative important of resources in the Australian share market, Australian shares may underperform global share markets for a while yet as the commodity correction runs its course,” says Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors in Sydney. “Asian shares are likely to be key beneficiaries of the correction in commodity prices given Asia’s high reliance on commodity imports.”

Asia, then, as ever presents a wide range of differing stories. Putting money into such volatile markets requires some tough nerves and a willingness to ride out some likely losses along the way. But, as one fund manager says: “Contrarianism is where the real money is made.”