Late September was a miserable time in global capital markets. Stock markets were falling; all news from the eurozone seemed to be bad; and the IMF annual meeting was punctuated by disappointment at a lack of clear leadership, and a generally toxic mood. Yet in its slipstream, Development Bank of Japan opted to launch a bold US$1 billion five-year bond issue.

The result was positive: a coupon of 1.625% and a yield of just 45 basis points over mid-swaps. Both borrower and bookrunners – HSBC, JP Morgan and Nomura – were delighted, and Japanese agencies had once again proven that the world sees them as safe havens, a welcome diversification away from the challenges of Europe and the USA.

It is perhaps surprising that this should be the case. Japan’s debt to GDP, at over 200%, is among the highest in the world, and is clearly going to become a challenge even if the vast levels of Japanese savings prevent it being a problem today. Japan is still working out a path to recovery from the terrible Great East Japan Earthquake in March, and has not yet passed the multi-trillion yen budget it is expected to need. It has been downgraded twice this year, and until recently had to wrestle with political uncertainty as well, until Prime Minister Noda brought some welcome direction to government. It seems an unlikely safe haven. But it’s not Europe, and it’s not America, and those are two vital commodities at the moment. “It’s a geographical thing,” says Gyo Sato, in the treasury department at DBJ. “It’s not Europe. It’s not the USA.”

Partly this may also have to do with scarcity. “There is a lot of media use of the term safe haven,” says Alexandre Sautour at BNP Paribas. “When you look at the reality of things, Japan remains the country with the highest debt to GDP ratio, yet the yen continues to be perceived as a safe haven in the international community. I think it’s fair to say there is a shortage of Japanese name issuance in the international market, and the rarity means investors are attracted as a diversification play. Rarity of issuance is really the key here.” Correspondingly he expects more of the same. “We’ve seen these deals print regularly inside guidance, and with a reasonable amount of interest from investors.”

And it is, after all, a select handful who can access this liquidity in these markets. “Issuers like DBJ, JBIC and JFM are the most sophisticated investors in Japan,” says Minoru Shinohara, senior managing director, investment banking at Nomura. Shinohara had been at the Washington IMF meeting and had a clear sense of just how bad the mood was. “But we talked with DBJ; it is sophisticated enough that once it sees the small window, it can go through it, as the quality is there.” DBJ was alongside KfW and UK Gilts in raising capital that week. “They are leaders in the market: professional enough to go out when it’s very stormy and to see some bright sky in the storm.”

Sato says the DBJ deal attracted just over US$1.1 billion of demand, which does not appear well covered, but bookrunners say this was a function of closing the book almost as soon as capacity was reached in order to avoid allocation problems. In any event, the DBJ issue, along with the two US$2 billion JBIC jumbos (see box), and JFM’s US$1 billion deal in January (see muni section), clearly show the continuing appetite towards Japanese agency paper.

JBIC still has budget for a further US$3.2 billion of issuance this financial year; for DBJ’s part, Sato says the agency has budget for Y150 billion of international government-guaranteed issuance, which would imply room for another deal of a similar size to the one just completed, “but we haven’t yet decided on any additional issue. We are going to consider that depending on our asset demand and the market situation.”Much will presumably depend on demand for DBJ’s services. “We are now conducting the crisis response business for the clients damaged by the earthquake, as well as our ordinary business. So depending on the development of those businesses, we will decide our bond issuances for the rest of this fiscal year.”

He adds: “We are always looking at the international capital markets, both government-guaranteed and non-guaranteed bonds, in every currency, but under the current market situation, mainly in US dollars.”

Outside the agencies, the banks have also found a favourable response when they have attempted to issue internationally. SMBC has been the standout in 2011, raising US$2 billion  in July in a three-tranche fixed and floating rate bond issue, following a US$1.5 billion issue in January. One of the most significant elements of the July fund-raising was that it incorporated a floating-rate element for the first time.

Other banks have been less active: Bank of Tokyo-Mitsubishi UFJ has raised twice, for US$1 billion in February and US$544 million in January, while Nomura has also raised funds through its holding company and a European vehicle, but Mizuho has been curiously absent. “Banks have been fairly quiet recently, but we expect they will come to the market,” Sautour says. Increased expectations of bank liquidity should be a prompt for further issuance, but changing bank regulation may instead have a bigger impact on corporate issuance. “Basel 3 regulations mean that banks will probably have to downsize their balance sheet and reduce lending, and as a natural consequence corporate borrowers will have to turn to the capital markets to meet their funding requirements,” Sautour says.

The corporate issuers are a tricky sector to read. Much has been made of the strong yen prompting Japanese corporations to look overseas for acquisition targets, particularly since asset values are subdued in Europe and the USA; so far it has been more theory than substance, but if it starts to happen in earnest, that could boost international issuance from the corporate sector. Auto funding vehicles Toyota Motor Credit and American Honda Finance are perennially active, but the only standout example of pure corporate financing in the international debt markets lately is Mitsubishi Corps $500 million raising in early September.

“We saw Mitsubishi Corp in September. However, since Japanese domestic markets have been very stable with new issue spreads trending at historical tight levels, there are no strong incentives for Japanese corporate issuers to tap international markets unless they need to use the money in the international arena,” says Reiko Hayashi, head of Japan DCM at Bank of America Merrill Lynch. “There are many discussions about how cross-border M&A should be happening because of the highly appreciating yen. However, issuers would normally fund in yen and conduct foreign exchange. Japanese banks are very happy to provide highly competitive yen loans.”

Theodore Lo at RBS takes a similar view. “The hard pill to swallow is the actual cost,” he says. “The management at companies [potential issuers] will be trying to justify that. Mitsubishi Corporation got over that hurdle; others are waiting for a better window.” But he describes the combination of a strong yen, depressed international asset prices and cashed-up Japanese corporations as “a once in 10 years situation” that ought to drive M&A.

For the future, though, Japan’s macro conditions are not going to go away, and it is an open question how long it takes before it becomes a potential difficulty. “Japan is a long term problem, and people are not thinking it will be a problem in the next few years,” says Shinohara at Nomura. “But it won’t disappear, and the government has to tackle it – and Prime Minister Noda is already showing some leadership in the right direction.”

Others take a darker view. “Net net, Japan is still cash rich, because the savings of the households and corporate sector exceeds the total borrowing of the public sector,” says Seiichiro Miyaoka, head of debt capital markets at UBS. “According to some researchers, this surplus may last for about two years. After that, if the deficit exceeds the savings, and the Japanese investor cannot sustain the supply of JGBs, the supply and demand for JCBs may change.” And that, unarguably, would be bad news for Japan.

BOX: JBIC

Japan Bank for International Cooperation (JBIC) is the heavyweight of Japanese agency borrowers. Above all others, it is the name whose international bonds investors flock to when they want to play Japan as a safe haven.

“JBIC has clearly come out as the benchmark for Japan in the last five years,” says Theodore Lo at RBS. “It has emerged as the dollar representative for Japan.”

Twice this year, JBIC has proven its strength as a borrower in jumbo issues in increasingly difficult market conditions – and it is likely to need to do so once more in still more trying circumstances.

In May, it raised $2 billion in a five-year global through Bank of America Merrill Lynch, Barclays Capital, Citi and HSBC, with a 2.5% coupon, and pricing of 45 basis points over mid-swaps. The deal came not long after the devastating March earthquake, and the subsequent rating downgrade on Japan, yet received over $5 billion of demand, allowing price guidance to tighten. The deal was seen not only as a statement of support for JBIC, but for post-earthquake Japan itself, and therefore had a far broader importance than just JBIC’s own fundraising. This deal was dominated by Asia, which accounted for 60% of the book; and – by investor type – by central banks and official institutions, also accounting for 60%.

In July it raised a further US$2 billion in a global five-year deal with a 2.25% coupon, pricing at 34 basis points over mid-swaps, and led by Bank of America Merrill Lynch, BNP Paribas, Daiwa and JP Morgan. Bookrunners said the deal attracted more than $3.4 billion of orders from over 100 institutions. Bookrunners also put distribution at 38% Europe, 36% Asia, 15% Middle East/Africa and 11% North America, with central banks accounting for 44% and banks 39%.

It all clearly demonstrates the continued attraction Japan holds for international investors despite its own problems. “We were worried about how investors would see the credit of Japan and JBIC, especially with regard to our first issue,” says Takeshi Sakamoto, division chief for the capital markets and funding division at JBIC. “Soon after the earthquake, we were not sure how investors would see us. But when we went to the market in May, it was a very successful issue, attracting large demand. I thought it was due to investors seeing Japan’s credit as no problem, as a safe haven, and because it offered geographical diversification.”

Is he surprised Japan retains that safe haven status despite its own debt position? “Of course Japan has a huge fiscal deficit, but at the same time it has a large current account surplus, and most of the buyers of Japanese government bonds are domestic Japanese,” he says. “The market thinks it will be no problem. They want to diversify their portfolio away from Europe and America to Japan.”

JBIC is little affected by the soaring yen, since about 80% of its loans are denominated in US dollars anyway. And its remaining borrowing for the year is likely to stay in that currency. JBIC has a total budget of around US$7.2 billion for government guaranteed bonds in the international market in this financial year, so still has $3.2 billion to go, depending on its funding needs. “Considering the current basis swap rate, it is difficult to issue in euros, and considering the size, it is also difficult for us to issue in other currencies,” he says. “So probably it will be US dollars if we go to the markets in the coming months.”

The last four deals from JBIC have been five years, and Sakamoto says he “would like to diversify that tenor. But at the same time, considering current investor demand, the yield on shorter term bonds is too low. If possible, we may seek longer maturity than five years, but in volatile markets, it depends on the timing of the situation.”

Japan’s municipalities and prefectures are, in many cases, in considerably better financial shape than the sovereign itself. Sophisticated and communicative borrowers, albeit mainly domestically, they are able to borrow within a few basis points of Japanese government bonds.

Leaving aside JFM (see box), the only one of Japan’s various prefectures and city issuers with a track record in international markets is Tokyo Metropolitan Government, or Met Tokyo, as it is widely known. Met Tokyo could hold its own as a sovereign issuer in its own right: little surprise, considering it represents a population of 13.16 million and a nominal GDP of $917 billion, bigger than many countries. Its general account budget alone is worth Y6.24 trillion and it initially targeted Y750 billion of fundraising for 2011, and potentially more to fund earthquake countermeasures.

The vast majority of that will be domestic, but Y50 billion of it is earmarked for international markets; Met Tokyo first launched a government-backed bond in 1964 and issued five without guarantees between 2004 and 2008 before it stopped being cost-efficient to continue. “In the last three years, cost-wise international funding was not competitive enough,” says Yoshiko Aida, director of the bond section in the Bureau of Finance within Tokyo’s metropolitan government. “But we believe international bond issuance is one way to diversify our investor base, and to reduce the risk of unstable funding. We believe it is very important.”In August, she said that a single dollar five-year deal looked the most likely. At the time of writing, Met Tokyo was about to depart on a non-deal roadshow across Asia, “in order to have international investors understand Met Tokyo’s credit as well as to have better ideas of investor appetite,” according to Reiko Hayashi at Bank of America Merrill Lynch, one of the banks leading the roadshow.

That apart, Met Tokyo and the rest of the prefectures (there are 32 prefectures and 19 cities, making 51 municipal issuers in total) tend to do almost all of their funding domestically, but in the main they do so with sophistication and a commitment to communication. There is a clear second tier of prefecture issuers covering much of Honshu and including, among others, Yokohama, Aichi, Shizuoka, Kanagawa, Osaka, Kobe and Kyoto.

Those in this field tend to make clear well in advance not only how much they will borrow through the course of the coming year, but in what maturities. For example, any investor in Kobe’s paper will know that the prefecture intends to raise Y20 billion apiece of five, 10 and 20-year paper in financial 2011, along with Y10 billion in 30-year, Y30 billion in jointly issued local government bonds, and a further Y10 billion in whatever maturity makes sense at the time. Investors in Kyoto knew to expect five-year bonds of Y10 billion each in July 2011, September 2011, January 2011 and March 2011, and 10-year deals of the same among in August and December 2011. Doing so ensures the market is not surprised. “We announce our plan at the beginning of every fiscal year, on our home page and in other ways too,” says Akihiko Onodera, director at Aichi prefecture’s budget management division. “We think it is quite important to let investors know they have stable funding, and we hope this will help international investors’ understanding of Aichi prefecture bonds.”

There are several patterns evident in Japanese municipal issuance. One is the increasing use of joint muni issuance, through which 35 prefectures and cities have joined forces to issue collectively, sharing proceeds and costs. Kyoto is one of the most prolific users of this approach: it will raise more in 10-year funding this way in financial 2011 than it will in its own name. “The market treats these joint muni bonds as a benchmark, as representing all local governments,” says Yoshitaka Kamitana, director of the budget section at Kyoto municipality. “We think there is some merit to participating in this programme.”

Another pattern is a growing interest in longer-term funding. Shizuoka, for example, has issued 30-year bonds every year since 2007. “There is a receptive audience for 30 year funding, with strong demand,” says Tsukamoto. “Also, investors in this area are different from those in 10 and 20 years.” 30-year bonds attract life insurance companies, 20-year bonds are bought by big funds often representing local regional banks and associations, and 10-year bonds appeal to regional investor bases.

A third pattern is exceptionally tight pricing, reflecting the superiority of some credits to Japan itself. Shizuoka is not the biggest issuer in Japan by any means, yet launched a 10-year issue in July at just 3.5 basis points over JGBs – a far from unusual rate for a municipality. While this low yield is perhaps off-putting for foreign buyers (and removes any sense in issuing offshore), it does make for remarkably efficient cost of funding for the prefectures themselves. This, in turn, is part of the reason that more and more of them have highly impressive financial standing. Aichi, for example – which was rated at AA until Japan’s sovereign was downgraded, dragging it down with the sovereign ceiling – has undergone about 20 years of administrative and fiscal reforms, carving huge chunks out of overall headcount, retiring outstanding debt, and building the sinking fund, whose reserves stood at Y393.9 billion by 2010. A comparison between the financial position of Met Tokyo and the sovereign is particularly stark: Met Tokyo’s total bonds outstanding are 1.6 times general account tax revenue, compared to 16 times for the national government. Met Tokyo’s dependency on bonds is 7.9%, whereas the national government is close to 50%. And debt in the general account compared to metropolitan Tokyo’s GDP comes to just 7.6%, compared to almost 200% for Japan itself.

Several prefectures have at least local ratings, and some have international ones too: Aichi has three in total, including Standard & Poor’s. Local ratings (from R&I and JCR) tend to be higher, since they do not feel a prefecture has to be capped by a sovereign ceiling; disputes over methodology are one reason that Met Tokyo, for example, no longer has a rating from Moody’s (though it has one from S&P, which has also been dragged down by sovereign downgrades).

There is also growing use of flexible-term bonds: Kyoto introduced these in 2010, for example, and Aichi moved from Y5 billion in this style in 2009 to Y40 billion just a year later. “Flexible-term bonds are in order to respond to investor needs in every maturity,” Onodera at Aichi says. “For example, in June, when we did bonds in 20 years, originally the issue size was expected to be Y10 billion. But because of strong demand from investors, we used our flexible-term bond budget to increase it to Y20 billion.” Flexible tranches can reflect reverse inquiry, or be used to increase a benchmark bond.

Prefectures have generally had to launch additional budgets since the March 11 earthquake, but outside of the affected areas, they have not been badly impacted in financial terms.

BOX: JFM

Japan Finance Organization for Municipalities was reorganized considerably between 2008 and 2009, moving from a national-funded model to one instead sourced from Japanese local governments, and with a broadened responsibility to provide funding to municipal general accounts across Japan.

This year JFM has launched its first international bonds since that shift took place, but the lack of national backing appears to have made almost no difference from an international investor perspective: they admire the credit just as much as they already did. “In January we issued our first bond in the international markets since the 2009 reorganization,” says Hiroshi Kiyota, referring to a US$1 billion 10-year bond launched on January 13, with a 4% coupon. “The attitude of investors had not changed: our creditworthiness was accepted as the same as before.”

Perhaps this should not be a surprise. JFM’s credit quality is arguably better than the sovereign – it would be higher rated, were it not for the sovereign ceiling – and in any case the markets see it as implicitly state-backed anyway. When it launched 10-year funding domestically in two issues earlier this year, one with a guarantee and one without, there was only a 1.1 basis point difference between the two.

JFM, like Met Tokyo, had been a frequent issuer in international markets (64 issues raising more than Y2 trillion since 1984) but largely pulled out of the market for cost efficiency reasons in 2008. January was therefore a landmark bond, particularly since it was accomplished by the establishment of a new EMTN program. “Our funding requirements are very big, so in order to make our funding stable, we like to diversify our investor base, not only in the domestic market but in the international markets,” says Kiyota. The January bond was bought by a range of European, US and Asian investors, from central banks to asset managers and banks. It priced at 60bps over mid-swaps. Kiyota says the MTN program will help to respond to reverse inquiry.

In domestic funding, JFM looks a lot like many of the munis themselves; its sweet spot is 10 year funding, which will account for Y1.17 trillion of funding in the 2011 financial year. It will also issue in 20, six and five-year maturities, some guaranteed and some not; will issue private placement 10-year bonds; and will use a program called FLIP, or flexible issuance program, a form of domestic MTN introduced in 2009 to allow issuers to be opportunistic, and increasingly popular among prefectures.

JFM is rated by Standard & Poor’s at the sovereign ceiling and makes efforts to attract international investors, even if the yields on its paper are unattractive to many buyers.

Samurais and uridashi

Yen issuance is offering attractive and robust funding for foreign issuers, but local investors are likely to be picky about the names they invest in.

The samurai market has proven resilient this year. By September 16, according to Dealogic, 25 samurai deals had raised $17.46 billion equivalent in 2011 to date. And the pipeline appears to be healthy. “Samurai is the market that stands out as being very strong this year,” says Alexandre Sautour at BNP Paribas. “It is to some extent a consequence of the fact that after March, domestic issuers have stopped issuing, and investors are keen to put their money to work. Samurai issuers have taken advantage of the lack of domestic issuance.” This is partly a consequence of the fact that domestic utilities, normally a considerable part of the market, have not issued since the earthquake, while it becomes clear what policy will be around nuclear power.

A look at the top 10 deals year to date (see chart) shows a number of US and European banks among the top 10: HSBC and JP Morgan have accounted for the biggest deals this year, while Rabobank Nederland (twice) and Sweden’s SBAB have also been active. But all of those deals came since May, and since then toxic sentiment towards western markets has prompted some US and European issuers to rethink, such as Bank of America, which pulled a samurai in June, one week after Societe Generale had done the same. Instead, attention has focused upon two pockets of issuers: Korea, and Australian banks.

“There’s been a fall-off in issuance from the US and European bank sector which normally dominates the issuance league table,” says Theodore Lo at RBS. “Now that’s gone, there is extra cash that can be put elsewhere, and that opens an opportunity for other issuers. The Koreans and Australians have been the beneficiaries.”

In September Korea Finance Corp raised Y30 billion ($391.6 million) in a three-tranche samurai including a Y15.5 billion two-year bond, Y7.5 billion three year and Y7 billion five year. All priced at the tight end of guidance, and the five year note was added on the back of investor demand.

The deal was representative of continuing appetite for Korean names. The biggest so far this year was from Kexim, which raised the equivalent of $994 million in June. Others have included Hana Bank, which raised 30 billion in a dual-tranche Samurai in August, while Posco and KDB have announced transactions for October and IBK is also expected to issue.

Australians, too, have enjoyed diversification and cost-effective funding in yen this year. Both Westpac and Commonwealth Bank of Australia have launched Y100 billion deals this year, in August and June respectively, while ANZ and National Australia Bank have also launched in decent size.  All four banks are believed to have hit their yen funding targets for the year but could be tempted to come back to a welcoming investor base; on Westpac’s most recent deal, for example, a Y74.4 billion five-year fixed rate note had its guidance revised inwards, and then came at the tight end of that amended range.

At the heart of this flurry of Korean and Australian paper is a coincidence of interests. “The samurai market continues to provide attractive opportunities to Japanese investors,” says Reiko Hayashi at BAML. “For international issuers, the market provides investor diversification, and the cost can be competitive against other markets.”

Seiichiro Miyaoka, head of debt capital markets at UBS, adds: “The spread on samurai  bonds  is much wider than  those of domestic corporate bonds. That is very attractive for Japanese investors.” For issuers, “the Japanese market is still stable and resilient   vis-à-vis other funding markets like the US, which is one reason  samurai  borrowers are still looking at the samurai as a funding market.”

Still, the market is not completely shut to others. Bank of America Merrill Lynch recently announced a mandate from Scandinavia’s Nordea Bank to launch an inaugural samurai bond. “However, given recent concerns towards the European situation and global economic slowdown, Japanese investors are becoming more selective,” says Hayashi.

Sautour agrees. “At the moment I think there is less appetite for European issuers, and many will not be able to come to the market under the current environment. There is always a price at which people are able to issue, but I don’t think they would want to pay the spread that would be needed for printing.” Many investors say they are not allowed to invest in European names because their volatility is so high. Still, bankers say that Japanese investors do differentiate between different European states; Scandinavia and the Netherlands, for example, are still considered largely remote from eurozone problems.

There is a separate class of samurai issuance: those carrying a guarantee from JBIC, who are mainly emerging market sovereigns. Turkey launched a Y180 billion 10-year guaranteed note in March; in recent years most other issuers have been Latin American or Southeast Asian, among them Indonesia, the Philippines, Mexico and Brazil. A JBIC guarantee could perhaps provide a way in for European names; in the meantime Colombia is expected to be the next guaranteed sovereign issuer.

Uridashi tranches tap into the same opportunity that samurai issues do. “Japanese investors need to buy something attractive. The domestic issuance is very boring because of the tight spreads,” says Hayashi. “So a good international name can be acceptable to retail investors.” Masayoshi Tezuka, director and  head of Japan debt syndicate at RBS, says “the uridashi market is the hottest market in Japan right now: many issuers manage to price bonds at the tightest level compared to other markets.”

But uridashi issuance has declined in recent months as interest rates have come down in some higher yielding currencies, and because of volatility. According to Dealogic, the 10 biggest uridashi deals of the year – led by deals from Nomura Europe Finance and RBS – all came by June 15, with all but two of them by April 8.

“But on the private placement side we see a relatively healthy stream of business,” says Sautour. “In euroyen in particular, there is still demand for credit, though it’s obviously very selective.”

It will be interesting to see the impact when utilities do return to the domestic market and suck up some of the demand that is now going to foreign names. “We don’t really see anything coming anytime soon,” says Sautour. “There’s still a debate about energy policy which is putting a lid on the ability of issuers to come to the market; the CDS market remains fairly wide and investors are really not willing to return to that segment just yet.”

One market participant, though, expects a utility to come to market “next month [October], or November – before the end of the year. They’ve got to refinance.” Despite the high CDS levels, he thinks it would tighten very sharply and that the right issuer could probably launching at JGBs plus just 40 or 50 basis points at the moment.

It’s certainly true that utilities can’t stay out of the market forever, and when they return, their volumes and their reception will have knock-on effects throughout the yen markets.

BOX: How developed world heavyweight issuers view Japan

For top-drawer international issuers, Japan represents a vital part of their investment constituency – if not always in yen.

“Our conversation on yen-denominated issuance is going to be very short: we haven’t done any this year,” says S Dhawan at European Investment Bank in Luxembourg. “The yen basis swap has grinded out to levels that would make pricing on new issue unattractive for yen investors. For us to issue at competitive levels to our issuance in euros or dollars, we would come out in yen at sub-JGB levels, so clearly domestic investor interest would be somewhat limited.” In previous years, EIB has generally found a window for yen issuance, through a global yen, euroyen or samurai issue, but this year has provided no such opportunities.

That’s not to say, though, that Japanese investors aren’t enormously important for EIB and similar institutions. “We access Japanese investors across a range of currencies, structures and formats, be they global bond issues, EMTN, samurai or uridashi. We offer a recognisable, triple A supranational name and they account for a substantial proportion of our investor base.”

As Dhawan says, “there is no investor base you can reach in more ways and through more different approaches” than in Japan. Different products give access to different parts of the investor base. Larger, liquid global bond issues go to large banks and money managers; issues in higher yielding currencies like Brazilian real, Turkish lira and Australian dollars go to yield-hungry retail mutual funds and insurance companies. Uridashi issues go to high net worth individuals and retail investors of Japanese banks, and samurais tend to go to domestic institutional investors.

KfW has been more active in yen, and has been particularly busy in uridashi issues, although that is across a range of currencies. “That has been a very strong market for KfW this year,” says Alexander Liebethal, head of new issues, structured notes and private placements. “Investors are looking for yield enhancement in a very volatile market. We have done almost 30 uridashis this year, and are approaching an amount of Eu2 billion equivalent.” In previous years, the total has usually been closer to Eu1 billion. KfW has also conducted 45 private placements in yen this year, “typically a reverse inquiry-driven market,” says Liebethal.

EIB says it has tended to issue more plain vanilla style uridashis than structured ones, but notes that since recent changes in Brazilian regulations, a large part of the market, in popular BRL, has now fallen away.

While Japan’s safe haven status is generally more relevant to investors than issuers, it does have the effect of making Japan’s investor base stable. “Over the past 12 months Japanese investors have continued to be active in the dollar and euro market,” says Horst Seissinger, head of capital markets at KfW. “We would expect to continue to see solid placement of our euro and dollar bonds, as well as Australian dollar bonds.”

“My impression is that Japanese investors are very reliable, at least if it comes to our name,” says Liebethal. “They seem to be in favour of a German credit offering a bundle of different products with opportunities for yield enhancement. Even after the earthquake there was not a pause in our issuance activities.”

Euroweek: Japan occupies a curious position in terms of the way world investors see it. It has faced a year of great challenges: the terrible earthquake, political uncertainty, sovereign downgrades, and very high debt. Yet the strength of the yen shows the world sees it as a safe haven. Where do you see Japan in world markets today?

Sumi-san: In Japan, we have gone through adjustments in the real estate market about a decade earlier than what is currently going on in Europe and America. Japan as a market is considered already to have been beaten; the remaining downside risk seems to be minimal, whereas for Europe and North America, people are still hoping that the real estate market doesn’t fall as badly as it did in Japan’s case. In Japan we had a full adjustment with the price of land going back to pre-bubble levels entirely. The US and UK don’t want to go down as far as Japan did, but investors fear the risk of further decline.

I would like to say that people are crazy about Japanese prospects and are therefore investing in Japan. But unfortunately, many would agree that investors see Japan has already taken the hit, has limited further downside risk compared to other economies, and hence is seen as a safe haven.

EW: Given that environment, what is the effect on Japan’s bond markets, and in particular JGBs?

In terms of the ownership of Japan’s JGBs, only 5% are held by foreigners. That said, the foreigners tend to trade more actively compared to Japanese institutional investors; they account for about 20% of the trading volume. If you consider Goldman Sachs Japan or Merrill Lynch Japan, they are very active participants and qualify as Japanese.

The JGB market is reasonably linked to the entire global market, but it is a yen denominated market, and its characteristics are very different from the dollar or euro denominated world. Nominally speaking we have very low yield, although in the rest of the world the yield curve has come down quite a lot too; with the American and German 10-years closing to 2%, and Japan now at 1%, the nominal difference between the Japanese and other interest rate environments has somewhat closed down.

Japan is a nation of net savings, and will continue to be so for a while at least. Nobody knows for sure how this ageing population impact will play out, and intuitively it should mean we will have lower net savings down the road, but for the moment we have plenty of savings – both household and corporate sector savings.

EW: You mention the 5% ownership level today. Would you like that 5% level to be higher, and is this the sort of environment in which it’s likely to happen?

I would like to have a very diversified investor base for Japanese government bonds. 45% of JGBs are in the hands of Japanese commercial banks, all of whom have similar business models. As a result of this similar way of thinking, they tend to act similarly to certain news; hence there is a chance of herding, with money moving together in one direction and then the next. So we would like to welcome more foreign ownership of JGBs, but at the same time we do not have a target number per se.

Sometimes people argue that Japan is different to Greece, in that in Japan 95% of JGBs are held by domestic investors. If you look at the Japanese net savings position, we could of course go to 100%. We have no difficulty in funding our own debt with our own savings. So 95% doesn’t mean much in itself, as long as we keep our net saver position and continue to be a creditor to the rest of the world. By the same token, if foreigners take on 10% of JGBs but the Japanese have a whole bunch of other foreign assets, that’s fine with us.

There are arguments that foreigners make the markets more unstable, which I personally don’t buy. Look at the last few disturbances of the JGB market. In 1998 the Trust Fund Bureau of the Japanese Ministry of Finance announced it wouldn’t be buying as much JGBs as it used to. The way we conveyed the news was not sophisticated enough; we inadvertently surprised the market, in a bad way. That was purely domestic, but we did have a shock. Then there was the VAR shock, which happens when banks are equipped with similar value at risk, risk hedges or risk management software. Therefore a certain movement of the JGB market triggered a sell order to most of the commercial banks. That effect fed into another program, and it escalated.

There is of course a chance that some news that may not surprise the Japanese may surprise foreigners, but we would rather have small tremors than calm and then boom. That’s my personal view, but I think it’s shared by many of my colleagues: we do welcome people who think and act differently from Japanese commercial bankers, including foreigners, households, pension funds, and foreign reserve banks. Some people may not want hedge funds to be active in the market, but I personally think somewhat differently. The arbitrage is important in demonstrating our yield curve is well managed, and that the integrity of our yield curve is strong. We don’t want to exclude any type of investors. But we don’t want malicious kinds of people; we understand Europeans may have different views on the shorting of government securities.

EW: Can you outline your plans for JGB issuance?

We formulate our issuance plan every Christmas time for the next fiscal year which starts in April. Our policy is to make it as predictable and transparent as possible. Our issuance plan goes from bills for two, three and six months, to 40 years, as well as inflation linked and floating or constant maturity types. We consult with the investor community and broker-dealers before coming up with these final numbers, and usually when they are finalized and published, they come as no surprise to the market.

One characteristic is that we have more issuance in the long end, 30 to 40 years, responding to the market’s need, especially the insurance industry: its regulator is increasingly aware of the need to match the duration of their assets and liabilities. Long-dated securities are in high demand.

On these longer-dated securities, the government has a comparative advantage over private issuers; it is a very long period of time for a corporation. But people are tending to live very long these days, and therefore need some certainty, some longer-term commitment on a nominal fixed term basis. So in these areas, and on the other very short term side, at either end of the yield curve the need for the government is stronger. And we are willing to respond to this increased demand. That translates to lower costs to tax payers who pay the interest rates.

EW: I notice a lot of municipalities in Japan have started to do more flexible term issuance, in order to issue opportunistically. Is that something you can do with JGBs?

If you are issuing 145 trillion yen of JGBs, there’s very limited room for being opportunistic. You can take an opportunistic position and may gain one time, but you have to go back to the market every year for large scale issuance. Instead of being seen as taking advantage of situations, we believe that being seen as predictable and transparent will pay off more in the longer run. We issue to finance government operations, and of course government funding needs may change; a good example is disaster relief, and in such cases we may need to change in mid-year, and we do. But in such cases when people know about disaster relief, they can think in terms of what the government, or our office, would be likely to think. We try to float the idea, and once it’s finalized it usually comes as very little surprise. Investors are not a homogenous bunch: some like this way, others like that way, and we can’t fulfill everybody’s requests at the same time.  But usually we are within expectations. Our aim is to try to convey bad news as early as possible, to keep the surprise element to a minimum. If anything, the surprise element should be a good one.

EW: Japanese domestic investors are tremendously loyal to JGBs: as you said, you could cover them 100% domestically. But will that remain the case in the long term? Are there circumstances in which domestic investors could look elsewhere for greater yield?

Theoretically we could go to 100% – my point was that Japan has national savings sufficient to cover the entire issuance of the government at the moment. Would it stay that way indefinitely? I’m not sure. We will be facing the ageing of the population; the baby boomers will become 65 this year and next year, the people born in 1946 and 1947. They will start collecting their pensions. And the retirement age is 60 for many Japanese firms, so of course as people retire they live out of their savings and therefore the savings ratio, intuitively, will be declining. That is exactly why we have a fiscal consolidation plan of shrinking the primary deficit with the national and local government, to try to achieve a primary balance by 2020. We may have net declining savings but at the same time are trying to shrink government dissaving. That’s our plan.

EW: I know you don’t want to talk about currency direction, but does the current strength of the yen have an impact on your borrowing program?

It is reflected only on the very short end. We see demand pretty much across the entire spectrum of the yield curve. Perhaps you should ask foreign investors how much of their decisions are currency motivated. In my experience, many investors distinguish between the currency play and the rates play. There may be some investors who think in terms of their own currency, but among most major players there is a division: currency people are currency people and rates people are pretty much rates people.

EW: When you communicate with foreign investors, do you coordinate your marketing with JBIC and DBJ

We have a somewhat coordinated appearance. Today [at a Euromoney conference in Singapore] I had a keynote speech, Shizuoka Prefecture was presenting, and so was the Japan Housing Finance Agency. This sort of opportunity is beneficial for ourselves and issuers, so it is natural we congregate.

EW: What impression do you have from international investors today about how they see sovereign debt?

I have had a four year interval [at the FSA] so this is my return to this scene. I would like to observe the market a bit longer; my knowledge is four years old. In the FSA I have been in touch with the other regulators, and we have been observing the market from that perspective; but the world from the eyes of a regulator is a bit different from the eyes of an issuer or investor.

EW: Having returned to the Ministry of Finance, what experience will you bring from the FSA to your new role?

When you perform duties, you do so with your entire personality; it is very difficult to say this part is relevant and this part is not. To me, it was good to be able to look at interest rate swap regulations worldwide. Interest rate swaps are a parallel world: for example for the Japanese yen yield curve, there is a risk free yield curve – the JGB yield curve – and a swap yield curve. And these fortify each other. If you have a 20 year JGB as a backstop, you can enter into a 20 year swap market knowing you are not too exposed. They are a reality check with each other, and in that sense fortify the integrity of each yield curve. Having a chance to look at this, and knowing the interest rate swap people and the other regulators around the world, is beneficial and allows you to look at JGBs from a different perspective.

EW: There is a Ministry of Finance man in charge of the country now. Is it good for Japan to have someone in charge who has gone through this financial discipline?

I wouldn’t describe Prime Minister Noda as a Ministry of Finance person, but you are right that he has been deputy minister of finance, then minister, and now prime minister. Let me refrain from making any comments on the parliamentary choice. But the parliament has nominated Mr Noda as Prime Minister and in his inaugural press conference speech he made it very clear that regaining fiscal health is something you cannot delay. So we have a very strong mandate from the Prime Minister and we – not only in the Ministry of Finance but the entire government – are trying to work with his new direction.

EW: Can you share a view on what you would like him to do in terms of improving Japan’s fiscal position?

Last year in June the cabinet launched the medium term fiscal framework, and more recently we have tax and social security reform. We have had a temporary departure from this approach after the Lehman crisis: we used to have a goal of achieving primary balance by the mid 2010s, that was decided under the LDP government a few years ago, but in 2008 we had to stimulate the economy so departed from it. Then in June 2010 there was a cabinet decision to put back this primary balance target again. Pretty much every year, except for the big shock in 2008, we have been on target, and that has been the basis of investor confidence in JGBs. We would like to keep that basis. Fiscal health is the basis for debt management.

I like to liken it to a building which is reasonably tolerant to earthquakes, but if the earth itself shudders underneath it… so fiscal health is the base. Under this policy target for the primary balance, we can have a solid basis to debt management policy. For our part, we would like to continue to talk with the market, and come up with no surprises. It may not be too sexy, but it will be no-surprise debt management.

EW: You sound positive. Are the right things being done in Japan?

I certainly believe that.

EW: When the third supplementary budget is passed, is there likely to be a knock on effect in your funding process from that?

We haven’t decided on the magnitude of the third supplementary budget, but the finance minister has said recently that his current thinking is around the 10 trillion yen. That, I think, comes as no surprise to many investors. They are foreseeing a rather large amount of the JGB issuance. But we have some room for maneuver: we have some reserves we have built up by issuing bonds a little earlier than they actually mature. Adjustments can be made – not in the magnitude of tens of billions, but at the margin, we have some room.

EW: Are there any tax issues coming that investors should be aware of?

I think we now have a reasonably broad and easy to follow withholding tax exemption. To me, that should solve many of the issues, but once again that kind of issue is easier to see from the side of the investor. If you have any issue please bring it to our attention. Our recent experience with the tax bureau on this issue has been quite positive. We have been expanding exemptions and lowering procedural barriers.

EW: Do you have any concluding message to international investors?

The JGB is a very liquid instrument and comes in various forms that are easy to fit investors’ needs. We are willing to make it even more investor friendly. For those investors who may want to seek some diversification, the JGB comes in very handy. We welcome the new entrants to the market.

SRI LANKA

The Democratic Socialist Republic of Sri Lanka has issued its fourth dollar benchmark in the global bond markets since 2007, reflecting renewed appetite for the country in the wake of the conclusion of its long civil war. On July 20 it raised US$1 billion in a 10-year global bond, paying a fixed rate yield of 6.25%.

That price is equivalent to 332.2 basis points over 10-year Treasuries, and represented a tightening from initial guidance of 6.5%. The pricing was a more than 40 basis point improvement over Sri Lanka’s previous 10-year bond offering, in September 2010, which launched at 373.1 basis points over treasuries. Moreover, the conditions within which this deal came are arguably more volatile than those that existed in September 2010.

“I was pleased and, I have to say, pleasantly surprised by the market,” says someone close to the deal. “We thought we had a window to issue before some big event risk, and results were better than we expected. Sri Lanka has paid no new issue premium and is marginally through where fair value is, even on the most aggressive stance. It’s a great result for the central bank.”

It’s not a bad result for existing investors, either, since earlier bond deals improved in its wake. The 2020 bond was trading at around 101 before the terms of the new deal were announced, and at the time of writing was at 102 and seven eighths. The new bonded traded well in the aftermarket too, and was at 101 and three eights yesterday afternoon.

The deal, led by joint bookrunners Bank of America Merrill Lynch, Barclays Capital, HSBC and the Royal Bank of Scotland with Bank of Ceylon as co-manager, was helped considerably by a credit rating upgrade by Fitch to BB- that came in the middle of a roadshow. Moody’s and Standard & Poor’s have also moved Sri Lanka to a positive outlook. Correspondingly, $7.5 billion of orders came in from 315 accounts. The roadshow had taken in Singapore, Hong Kong, several US cities and London.

Partly, the deal’s success reflects appetite towards emerging market sovereigns in general, which have obviously become more appealing compared to several developed country peers. Funds are continuing to flow into emerging market bond funds, and the idea of getting paper in a newly-upgraded sovereign with some scarcity value – on average, it has issued once a year since rejoining international markets in 2007 – was attractive.

The deal’s distribution was well diversified geographically. The USA was the largest component, at 43%, followed by Europe at 30% and Asia at 27%. Fund managers accounted for 86% of distribution, with banks and private banks 8%, corporates 3% and insurance companies 3%. Those close to the deal say the fund managers were largely real money. “The quality of the book was among the highest I have seen for quite a long time,” says one.

SMBC

Sumitomo Mitsui Banking Corporation has raised US$2 billion in a three tranche fixed and floating rate bond issue.

The deal, which priced on July 18, was made up of US$1.1 billion of 2.9% senior bonds, due 2016; US$400 million in three-year senior bonds, paying 1.9%; and US$500 million of senior floating rate bonds, due 2014. The floating rate bonds will pay three-month dollar Libor plus 0.95%, payable quarterly.

Although SMBC has launched a number of fixed rate yankee bonds in recent years, with similar three- and five-year fixed rate bonds last July and then again in January, this latest issue marks the first time the issuer has added a floating rate instrument. This broadened the investor base. “With a five year bond you’re talking about asset managers, banks, insurance companies and so on, but with floating rate bonds there is a different investor base,” says someone close to the deal. “Specifically, money market funds and bank treasuries. Those are the core buyers for three-year floating rate. There is minimal contamination between the investor bases.”

Despite volatile conditions, the deal attracted $5.8 billion in total demand, according to someone close to the deal. The deal featured six joint bookrunners: Goldman Sachs, Citigroup, Barclays, Deutsche, SMBC Nikko Capital Markets, and Credit Suisse. On Friday New York time, with the European debt situation worsening, they opted to monitor headlines over the weekend to assess whether further volatility was likely, then decided on Monday morning Tokyo time to launch. Pricing appears impressive compared to established international financial credits active in the yankee markets; while JP Morgan increased a five-year senior deal by $500 million and paid 160 basis points over treasuries, Sumitomo paid 150 over for the same tenor.

CHINA SHANSHUI

China Shanshui Cement completed a RMB1.5 billion CNH bond issue last Friday in a rare example of good news from the Chinese credit space. The deal was completed in a week during which three other dim sum deals were pulled.

The cement group, rated BB/BB- by Standard & Poor’s and Fitch, raised its funds in three-year bonds and paid 6.5% to do so, at the wide end of a 6.25-6.5% marketing range. Bank of China International, Credit Suisse, Deutsche Bank and UBS were joint bookrunners on the deal.

Shanshui Cement may have been helped by the fact that it is a very recent borrower in dollars, having raised $400 million in a five-year deal in May. While some raised eyebrows at it returning to the markets so swiftly, it does appear to have helped the issuer. “The fact that it issued the dollar bond was positive for the credit,” says someone close to the deal. “That bond, vis a vis the rest of the Chinese industrial space, was trading well, and above par; that was a good indicator for credit investors.” During a roadshow in Hong Kong and Singapore, which saw 35 accounts in one-on-ones or groups, few issues were raised about the credit, but rather concerns about market volatility.

Bookrunners said that although the deal could have been completed at a lower size at the 6.25% end of the range, in these markets it made more sense to take funds while they were available.”It was obviously a deal that could have happened at a tighter spread, but in this market the issuer was encouraged to get as much funding done as possible,” says someone close to the deal. “In my view, if you look at the next few weeks, the macro noise doesn’t die down. If there’s a market window, all issuers should go with it.”

The deal went almost entirely to Asia – 99%. Funds accounted for 50% of the deal, private banks 24% and banks 16%. It was approximately twice covered with a book around the RMB3 billion level.

Shanshui Cement was a rare example of braving the markets last week. China Eastern Airlines, China ITS Holdings and Hangzhou ZhongCe Rubber (through its Hai Chao Trading subsidiary) had all planned dim sum bonds, only to postpone or outright axe them. Hangzhou ZhongCe did so despite having a guarantee from China Eximbank, the first such credit enhancement for a dim sum bond.

The dim sum pipeline is modest, with Qingdao Haier Holdings a rare exception, with an expected RMB2 billion bond through HSBC and UBS. For others, there is little appeal in such choppy markets. “The better borrowers are still looking to the dollar market,” says one banker. “If you’re BB or BB-, that market makes more sense; you’re not going to get pricing like in January, but it will be executable. Issuers who don’t have ratings may migrate to the CNH market. But as there are more CNH deals to choose from, investors are going to become more discerning.”

THAILAND

Thai Union Frozen Products Public Co completed a Bt6.75 billion multi-tranche local currency bond in Thai baht this week. The deal, led by HSBC, Siam Commercial Bank and Kasikornbank as joint bookrunners,

The deal reflected continuing enthusiasm for Thai baht bonds, and was notable for including a Bt1.5 billion 10-year tranche alongside a Bt1.95 billion five-year and a Bt3.3 billion three-year. This was the longest tenor the issuer has so far achieved.

The deal priced at a coupon of 5.02%, 4.7% and 4.51% respectively across the three tranches, and was well covered by institutional investors, according to someone close to the deal.

HDB

Singapore’s Housing Development Board upsized a 10-year deal to S$600 million this week, reflecting a taste for emerging market debt provided the credit and territory is strong enough.

The deal, originally planned as a S$400 million print, priced at just 2.815% for 10-year paper, which is 32.5 basis points cheaper than a S$500 million 10-year deal from the same issuer in March. ANZ, CIMB, Citigroup, HSBC, OCBC, Standard Chartered and UOB were lead managers on the deal – a seven-bank lead group for a single-tranche deal equivalent to just under US$500 million.

The bonds went to around 40 accounts and were understood to have included some big orders from foreign accounts based in Singapore. The success appears to reflect growing optimism about local Asian currencies in the face of continuing concern about dollars and euros.

In January, headlines began to appear about Asian sovereigns saving the eurozone. They were caused by public comments from officials in China and Japan indicating that the two sovereigns would, in different ways, support debt issues from struggling European Union nations. This convenient mirroring of a shortage of funds in one continent and a surplus in another seemed a tidy way of remedying a potentially crippling problem. As one of those headlines said, reflecting the sense of happy symmetry: “Sovereign crisis, sovereign solution?”

Asia’s involvement in EU debt raises a number of questions, starting with how much commitment of funds actually happened. There are also issues about how much tolerance these sovereigns, and others in Asia, will have for eurozone exposure, and precisely how they are likely to engage.

First, it’s useful to pin down exactly what happened in January. In that regard, it’s much easier to answer the question with respect to Japan, which came in as the lynchpin for the inaugural bond from the European Financial Stability Facility. (The EFSF is a Luxembourg-incorporated entity set up to preserve financial stability in the EU by providing temporary financial assistance to troubled member states, and its bond issues are backed by guarantees from member states of up to Eu440 billion).

The bond, placed on January 25, raised Eu5 billion as part of the EU/IMF financial support package for Ireland. Japan had pledged to be a big part of the deal, and the EFSF has confirmed that it purchased more than 20% of the issue. EFSF also said that “very strong demand came from Asia,” though it has not been more specific on how and where that was represented; one bookrunner said 38% of the deal went to Asian accounts.

Pinning down what China did is trickier to do. When Klaus Regling, who heads EFSF, was asked if China had come in to his bond, he appeared to confirm it indirectly by saying: “None of the major players were missing.” Certainly, media and analyst coverage has spoken widely of China’s pledges to support the eurozone’s debt markets, but it is hard to be certain about any tangible investment. The certainty of China’s involvement all stems from comments made by Li Keqiang, who is China’s Vice-Premier (China actually has several of these, but he is understood to rank highest) and deputy party secretary of the State Council; he’s considered a likely successor to Premier Wen Jiabao, so what he says matters. In January, he wrote a guest article in El Pais, the Spanish national newspaper, that “China is a responsible, long-term investor in the European and particularly Spanish financial markets, and we have confidence in Spain’s financial market” and “It [China] has purchased Spanish Treasury bonds and will buy still more.” The figure Eu6 billion has been mentioned, but not confirmed, in relation to purchases of Spanish Treasuries.

In other remarks on visits around the region that month, he appeared to suggest China would support the debt of the eurozone’s more troubled countries, and it is understood – but again not confirmed by China – that it has bought Greek debt too. Finally, when the European Financial Stability Mechanism, a rescue fund representing the EU and a separate vehicle from EFSF, raised Eu5 billion earlier in the month, China – through the State Administration of Foreign Exchange – is believed to have bought 6% of the bond (we do know, from bankers close to the deal, that Asian investors made up one quarter of demand, and those close to the deal say that SAFE, the Bank of Korea, Bank Negara Malaysia and Hong Kong Monetary Authority all received full orders rather than being scaled back in the four times over-subscribed deal).

Whether or not China did come into these deals, in some sense it hardly matters; the market took enormous comfort from the sense that there was a flood of sovereign wealth waiting and potentially able to solve Europe’s problems. Partly for these reasons, Portugal’s closely-watched bond sale in January – actually earlier than the EFSF, but after China had made positive noises about support and Japanese finance minister Yoshihiko Noda had said it would be sensible for Japan to take 20% of the EFSF deal – sold very well, comfortably oversubscribed in both its five and 10 year tranches. Spain and Italy completely fairly long-term debt the same week, and Belgium, which had also been drifting into scrutiny, completed an FRN issue.

The improvement in sentiment has happened despite the fact that, in Japan’s case at least, there has actually been no new flow of euros involved. Noda said of the ESFS investment that “we’d like to do this within the realm of euro liquidity in the foreign currency reserves,” which is understood to mean that the investment comes from holdings Japan already had in euros, rather than from, say, a sale of US treasuries to convert those funds into the European currency. This news did have an impact on the euro itself – it rallied first, then fell back again when it became clear the investment would come from existing euros – but doesn’t seem to have impacted sentiment about the debt markets themselves.

But what’s in it for these Asian investors? Why does any entity – the state itself, or its designated investment vehicle – invest in troubled EU debt? These aren’t just acts of charity, of course. The spread on the EFSF deal was fixed at mid-swaps plus 6 basis points, implying a borrowing cost of 2.89% for the facility, and that proved remarkably attractive: 500 investors came into a book of Eu44.5 billion. While not a huge payer, the suite of guaranteeing nations makes this unquestionably AAA-rated paper, yielding modestly more than German bunds; the earlier EFSM deal was 12 points over mid-swaps.

But there’s more to it than that, and clearly a political dimension. When Li Keqiang went to Spain, he didn’t just bolster the country’s debt markets with his comments, but sign Eu 6 billion or more of trade agreements that, among other things, give Chinese companies greater access into Spain. It’s not unreasonable to think there might be a quid pro quo in supporting a country’s debt position. Similarly, when Japan’s Noda made his pledge on the EFSF bonds, he couched it not in investment terms but prudence and responsibility. “The euro zone is planning to issue a large amount of bonds in a cooperative manner late this month to raise funds to assist Ireland, and it is appropriate for Japan, as a major economy, to buy some of the EFSF bonds to bolster confidence.”

Economists and strategists see plenty of this latter sentiment in the behaviour of the Asian buyers. “The euro zone is of incredible importance to both China and Japan as trading partners,” says James Woods, chief Asia strategist for Citi Private Bank. “There’s a sense of a need to support these countries, both for what you might call global prudential purposes, but also to underpin some of the demand among trading partners.”

This political element might also explain why almost nobody in Asian banking wants to speak publicly about the trend: seven different economists and strategists declined to be interviewed on the subject.

Diversification is also key. China in particular is felt to be particularly heavily exposed to dollars and sees the need to do something about it. “The diversification aspect is particularly apparent with regards to China’s concentration risk in Treasuries,” Woods says. “Japan has its own challenges at the moment, and investing in the eurozone is not going to be top of its list of priorities. [Woods was speaking shortly after the earthquake in Japan.] But China will be doing much more to diversify its FX holdings, and I suspect this underpinning of support to countries like Greece is having quite a positive effect.”

Does he expect them to continue to invest? “Yes, I absolutely believe that will be the case. I can’t see any reason why not.”

Also, Asian sovereigns do already have exposure in euros, and it is not in their interests to watch the currency decline or even fail. Rachel Ziemba, analyst at Roubini Global Economics, estimates that 25-30% of China’s reserves are in euro denominated assets. If that’s true, it equates to almost US$800 billion-worth of euro-denominated securities. “Recent Chinese rhetoric has oscillated between providing pledges of support for eurozone assets, and calling on European leaders to prove that they can get the debt issues under control, lest the bloc’s woes continue to destabilize the global economy and financial markets,” says Ziemba in a recent study. “The mixture seems designed to protect China’s existing portfolio, stabilize the global economy and perhaps if necessary secure for China some seat at a restructuring table.” The first of those – the portfolio – is clearly of pressing importance if her estimates on the proportion of holdings in euros is correct; she believes that China has invested in both sovereign debt and agency issuance of European countries, and chiefly European bonds in order to ensure liquidity. “The search for yield may have made some of the debt of periphery countries attractive, but such debt may not make up a large part of the portfolio,” she adds.

On top of that, a weak euro creates competitive pressures for exporters in Asia – none bigger than China and Japan. Toyota, for example, most certainly doesn’t benefit from a weak euro as it seeks to sell Japanese cars into Europe.

There is, after all, a track record of Asian and Middle Eastern sovereign entities – and in particular sovereign wealth funds – intervening in support of the western financial system, believing that doing so creates a long-term investment opportunity while also stabilising the global economy to everyone’s benefit. They did so by buying into flagging US and European banks during the Asian financial crisis. It’s well worth remembering that this yielded heavily mixed results, and caused a lot of pain for all of them at least for a while. On the positive side: both the Government of Singapore Investment Corporation and Kuwait Investment Corporation bought stakes in Citi and, after suffering for a while, sold out (at least in part) at a profit. The Qatari state made a fortune with a swift purchase and sale of a stake in Barclays. But Abu Dhabi Investment Authority, the biggest of them all, is suing Citi for money it lost on its investment in the US house, and Temasek in Singapore lost unspecified amounts – but likely billions – by selling out of stakes in Bank of America Merrill Lynch and Barclays Capital at what turned out to be the bottom of the market. Korea Investment Corporation is still sitting on a heavily underwater position in Bank of America Merrill Lynch. They are not all going to pile in blindly again in support of a turnaround story.

Global sovereign wealth is truly vast: common estimates are around the US$4 trillion mark for sovereign wealth funds alone. And that’s not counting overall foreign exchange reserves: Japan’s foreign currency holdings were worth US$1.096 trillion at the end of 2010, second only to China, where they were last logged at $2.85 trillion.

That scale is especially helpful since the existing EU/IMF support package is already too small to bail out Ireland, Portugal and Spain in aggregate, much less Italy or anyone else. Sovereign entities are a good fit with any macro-related debt instrument that is going to require years to come good, since in the main they don’t have to justify quarterly or even annual performance.

For groups like this, a designated facility like the EFSF (or its sister agency, the European Financial Stabilisation Mechanism) make a lot of sense. Though most sovereign entities in Asia and the Middle East don’t really have to justify their decisions to anybody, it is nevertheless an easier sell politically to invest in a broad multilateral European agency than, say, directly into Greece. Additionally, EFSF creates conditionality on fund recipients that an individual sovereign would find it difficult, politically or practically, to impose itself. “I think it makes more sense to go in to support the facility, because essentially it means that the checks and balances and terms of conditions for the facility are protecting their money as well,” Woods says. “It encourages a greater amount of cooperation from the recipient country to the donors than going in with direct bilateral lending. Much better to support the conditionalities which are being imposed by the donors, rather than to circumvent those conditionalities by going directly.”

They will have plenty of further opportunity: according to the EFSF itself, it plans to raise up to Eu16.5 billion this year, and up to Eu10 billion in 2012, while the EU through the EFSM will raise up to Eu17.6 billion this year and Eu4.9 billion in 2012. That’s on top of the sovereign debt issuance from member states themselves.

Will other Asian entities seek to invest in European sovereign debt? “I think that’s largely a call on two factors,” says Woods.” Firstly, the euro itself: whether it will perform well in the coming year or so. Secondly, what the eventual resolution of the peripheral story is – whether it’s a bailout, a restructuring or just more of the same. Once there is clarity as it relates to those two drivers, we will see support as a consequence.” Additionally, he points to an anomaly in European economics at the moment. “One factor I would highlight is the likelihood of higher interest rates in the eurozone, alongside the liquidity support.” That creates an unusual situation: rising interest rates clearly impact bond yields, but liquidity support underpins support for those bonds. “It’s a conundrum Asian sovereign wealth funds will want to understand first before having comfort to start investing.”

The likely outcome is that some Asian money will come, and this will certainly help; but expecting Asia to prop up the eurozone is unrealistic and probably dangerous. And, moreover, Asia can’t fix the eurozone, just apply the band-aids that get sovereigns through to the next redemption deadline. Beyond that, it’s all up to Europe itself.

Asiamoney.com

Private wealth managers across Asia breathed a sigh of relief late last week when the G7 nations followed Japan’s finance ministry and central bank in intervening to drive down the value of the yen.

Let’s be charitable and imagine that some of this relief stemmed from the real matter at hand: the fact that selling the yen, after its appreciation to a record of 76.25 against the US dollar, would help Japan in its recovery from the terrible events it had endured in the previous week. A soaring yen was going to wreck exports at exactly the worst time for the country; right now it needs everything it has going for it, not more hurdles. The actions of the G7 nations – and there are expected to be more – were primarily an expression of solidarity with Japan when it needs it, as well as a natural desire to maintain stability in world financial markets.

But there’s another reason the private bankers were cheered. They had spent much of the week taking calls from clients deeply troubled by the climbing yen.

Remember the yen carry trade? Before the financial crisis it was all the rage, for its peerless simplicity. Borrow in yen, with a next-to-zero interest rate; invest the proceeds elsewhere to earn a greater return. If you want to keep it relatively risk averse, just put it in Australian dollar government bonds or an Aussie bank account; a 6% risk-free differential, even prior to the financial crisis. New Zealand and, for a time, South Africa were other recipients of this trade. It works a treat – provided the currencies stay stable, or more specifically, provided the yen doesn’t start climbing dramatically and wipe out the gains.

Several years ago there was widespread concern as the yen did start moving and the high-yield currencies like the Australian dollar went into decline. The carry trade started to unwind and there was a great deal of concern about the impact this would have on global financial stability. The world didn’t end; currencies like the Aussie dollar, underpinned by emerging market demand for local commodities, swiftly went most of the way back to where they started from. People stopped talking about the yen carry trade. But it’s back. In fact, it’s been back for a couple of years now.

Hence the alarm when, post the earthquake and tsunami, the yen counter-intuitively leapt to record strengths – based on the theory that Japanese businesses would repatriate overseas capital home where it was needed. Suddenly a lot of clients found their trade unraveling. Getting six percentage points of yield differential from Japan to Australia is all well and good, but not if the yen is going to appreciate by 10 per cent and make it a losing trade.

In truth, the yen carry trade has evolved somewhat over the years, because these days it applies to so many other currencies beyond the yen. You can borrow in US dollars for almost nothing and invest the proceeds elsewhere. You can borrow in sterling, in euros. The gap between major currencies and second-tier commodity currencies, in terms of the interest rates you can earn in these currencies, is bigger than ever. So really, the important cross-rate for private banking clients is not so much the yen versus the dollar – there’s no point borrowing in yen to invest in dollar assets – but the yen against whatever currency you put your assets in, which is a slightly different story.

But the whole experience has underlined the fact that, for all the probity and caution that came with the financial crisis, people do continue to expose themselves to trades that are vulnerable to sharp movement. Asiamoney spoke to three client-facing staff at three different private banks – two multinational, one Swiss private – and they all spoke of the drama of the week and the fear that clients had for a sharp climb in the yen. Which begs the question: has anything really changed in the way the wealthy invest, and are advised to invest?

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.