It is a queasy sort of a day when Asiamoney meets Zeti Akhtar Aziz, Governor of Bank Negara Malaysia, at Washington DC’s Four Seasons Hotel in September, and not just because of the jetlag and the changeable weather. We meet during a period of miserable uncertainty in world markets: the eurozone in crisis, the US staring at a double-dip recession, and markets looking hopefully to the IMF/World Bank annual meeting to provide some direction, which they utterly fail to do.

For Zeti, the mood is not as bad as it is for some others: Malaysia is basically doing fine, and while it will clearly slow as a result of global problems, it would be a surprise if its growth rates dipped below 4% at any point in the next 12 months. But what’s striking about this meeting is that the normally reticent and softly-spoken Zeti has some unusually strong opinions about problems in the west – and how to fix them.

That’s because, having worked through the Asian financial crisis – she was rising through the Bank Negara ranks at the time and became governor in its aftermath, in May 2000 – she believes there are clear lessons about the process of recovery that the west has not yet shown much sign of taking on board.

“While we need to deal with the financial sector and bring about regulatory reform, it has to be accompanied by pro-growth policies,” Zeti says. “That is what we did in the Asian crisis. We had to do the financial and debt restructuring, but for a chance for those policies to be successful we needed to have growth.” She’s quite specific about what she means – which also stands out, in a week dominated by broad and grand statements and an absolute minimum of practical detail: she  highlights policies to support SMEs, households, access to finance, credit enhancements, infrastructure development and private sector incentives. “We had a V shaped recovery,” she says. “Many parts of the developed world, and the IMF, said we would have a lost decade. We didn’t.”

The west, she says, just hasn’t been doing what it needs to. “Only now are we seeing some of these measures being implemented in the US,” she says. “They needed to have been implemented three years ago.” She also calls for policy that is “more anticipatory rather than reactive. When we were managing the crisis in Asia we looked at what was the worst yet to come and what did we need to do to deal with it, rather than just implementing policies to prevent a collapse and thinking that was it.”

Malaysia is not a member of the innumerable groupings and federations in world finance – the G7, the G20, the G24 – instead making its presence felt more in Asean and in Islamic finance initiatives around the world. Lacking a voice on the world stage, it is perhaps not surprising that she is not a fan of the IMF, nor of representation of emerging economies within it. “The IMF has to become neutral,” she says. “This neutrality and credibility would be enhanced if there was greater representation of emerging markets in the role of the IMF and in its governance process. Crises don’t just happen in emerging markets; this is something the IMF didn’t highlight to the world until quite late.” She says while the IMF has sought to increase that representation, it has done so “in a very incremental manner.”

She goes further and doubts the leadership the IMF has shown; Asiamoney’s interview takes place directly before the formal start of the meetings, but it’s unlikely her opinion was changed by any of the statements of the following days. “The IMF doesn’t seem to have a significant role in this,” she says. “We have looked for the IMF to have a greater role in recognizing what the issues are in their surveillance, and we look for it to provide solutions to many of these problems. Their solutions have not been forthcoming.”

So how does all this affect Malaysia and Asean? “In emerging markets we are doing better [than in the west] but we are going to see moderation in our growth as well, because we are very much part of the global economy and most of us are highly open. But we are still going to see growth, and are still on a growth path.”

Across Asia, central bank governors are having to deal with shifting priorities. For much of the last year, most of them have had to fight off inflation, and have correspondingly been rising interest rates through the year. There are markets where inflation remains a challenge – Vietnam, India, China – but across most of Southeast Asia it’s all but stopped being an issue.

Take the Bank of Thailand, which has raised rates on seven separate occasions since December, reaching 3.5%. “I think we were on the right direction so far, but if you ask the question from now on, we do think the slowdown in the world economy will mollify somewhat the inflation pressure,” says Prasarn Traitvorakul, Governor. “The job is to take a proper balance, but the balance lately has tilted towards the risk of growth becoming more apparent than inflation pressure.” When the bank next meets to discuss rates, on October 19, it would now be a major surprise to see another hike.

In places like Thailand, where domestic consumption is strong and the outlook good, the global problems have arguably been helpful. “We hope that some slowdown in the world economy will lower the pressure from the supply side,” says Prasarn. (A wild card, though, is a new government policy offering to buy local rice at heavily subsidized rates; HSBC has warned that, with Thailand being the world’s biggest rice producer, this could put inflation back on the agenda in rice-importing countries.) Like many Asian nations, Thailand has sought to boost intra-regional trade’s proportion of the overall national trade balance sheet, reducing reliance on the west, and this should prove helpful. “The feeling is not too pessimistic or optimistic,” he says. “There are threats from what’s happening in the euro zone and the US, but there are also encouraging factors like regional integration in trade and financial flows.”

Zeti, in Malaysia, has been viewing the world with similar interest. From late 2010 Bank Negara raised rates four times in seven months, from 2% to 3%, and then stopped in July, “given the increased uncertainties and the significantly heightened risks to growth,” says Zeti. From her perspective, in a country with palm oil and rubber at the heart of the national economy, commodities were the most important thing to watch. “As commodity prices stabilized, which was a major factor from the supply side producing higher inflation, demand has slowed globally,” she says. “This will limit inflation, so most central banks have paused their increases in interest rates.” Official estimates of full-year growth in Malaysia are 5-6%, but it dropped to just 4% year on year in the second quarter of 2011.

Zeti says that for central bank governors in Asia, “the biggest challenge is to have price stability in an environment of sustainable growth. You have rising prices, and at the same time you also have risks to growth, and those risks have become higher because of what is happening around the world.”

One area Asia cannot escape is capital flows. In recent years foreign money has flooded into Asia, particularly Asian bonds, in search of yield backed by strong fiscal stories. But as always, when markets get really bad, capital instead is withdrawn from these supposedly riskier asset classes, despite the fact that the risks appear far bigger in the developed world. In some cases, this isn’t a judgment on risk at all, but a need to liquidate capital in order to pay down other exposures.

Indonesia is the market that has most to lose in this respect; by the end of August foreign ownership of rupiah-denominated government bonds stood at over 35%. That money has been chasing the Indonesia story: a transformed fiscal position over the course of the last decade, a growth model predicated on commodities and domestic consumption, and an apparently successful and stable democracy. But for some time, investors both local and foreign have worried: what if it all leaves again?

Rahmat Waluyanto, in the debt management office of the Ministry of Finance, says that a modest reversal has started to happen. In the space of a week in September, foreign ownership dropped from 35.4% to 33.6%. But he is at pains to point out that foreign ownership in the government bond market is still heavily net positive, at around US$5.5 billion year to date. The withdrawal, he says, “has nothing to do with domestic economic fundamentals but FX movements due to jitters caused by the worsening euro debt crisis.” Not all fixed income is fully hedged in terms of FX exposure, hence the withdrawal, he says, although in fact non-deliverable forwards on the rupiah have been moving up, not down. “There’s no reversal yet; the real money accounts still stay,” Waluyanto says. “Indonesia has the capacity to withstand,” he adds, citing relatively large foreign exchange reserves (which crossed US$100 billion for the first time earlier this year), a widening domestic investor base (including retail investors, pension funds and insurers), and a bond stabilization framework.

Indonesia has mentioned this framework before, but it’s not always been clear what’s involved. Waluyanto says there are four strategies to negate a negative impact of a sudden reversal: the debt management office will use funds from the annual budget to buy back government securities; state-owned companies will buy in; so will be Treasury Unit and Government Investment Unit of the finance ministry; and if necessary, parliament can approve the use of accumulated cash surpluses to buy government securities.

Zeti, too, notes a change in the threat of capital flows. “We are seeing very significant surges in capital outflows and reversals,” she says. “Previously it destabilized us quite significantly. But in the current environment we are seeing these flows are better intermediated by emerging economies.” In 2009, she says, Malaysia’s reserves declined by $25 to $30 billion, with a major depreciation in the currency. “But we could take it in our stride.” She says that, in contrast to the Asian financial crisis, Malaysia has more resilient financial institutions, more developed financial markets, higher reserve levels, a more flexible exchange rate, and more instruments to sterilize inflows than before. Today, around 20% of Malaysian government bonds are foreign-held.

Whatever else happens, southeast Asia is surely the only part of the world where you can still find people barracking for sovereign upgrades at a time when the rest of the world is falling apart. In the Philippines and Indonesia, expectations are high of improved ratings from international rating agencies. Both countries can provide long lists of improvements, from budget deficits to domestic market depth and government responsibility. With Turkey having been upgraded in early September, its Asean peers are not about to stop waving the flag now. Indonesia, Waluyanto points out, has credit default swaps trading considerably tighter than Turkey’s; proof, he says, that if the story is bright there, then it’s brighter still in Indonesia. “So Indonesia should now be in the investment grade category,” he says. It’s good that somewhere in an uncertain world, there are people looking up and not down.

Smart Money was in Washington DC last week for the IMF/World Bank annual meetings. We could describe the mood as toxic, miserable, scared, grim and hopeless. But that would be putting too positive a spin on it.

If the world had been hoping for leadership, and a clear sense of direction out of crisis, then they didn’t get it. There is no shortage of gatherings, groups and institutions in the world today – the G7, the G20, the World Bank, the IMF, the various European bodies, plus of course all of the national sovereigns – but none of them gives any impression of being in charge. Markets, lacking any roadmap they can rely upon to fix the world economy’s many problems, are panicking and falling.

One moment encapsulated the meeting. With the mood at its worst, late on Friday night the G20 – led by France – hosted a press conference. It was packed, as the world’s media waited to hear a message of reassurance and the concrete steps the group would set out for recovery. France’s finance minister and development minister took to the stage and started talking. They talked about a new financial transactions tax; about infrastructure development in the emerging world; about transparency. After half an hour they stopped; they hadn’t mentioned the growing financial crisis once, and became visibly irritated when anybody asked about it. It was like watching an ostrich bury its head in the sand. If the sand was on the Titanic. And the Titanic was on a different planet.

It summed up the sense that the world economy is a car going downhill on a steep mountain road with no driver.

But what does all of this mean for investments? Several themes came out of the meeting, and of market behavior around them:

1. Not only could Greece default, the euro really could collapse. It probably won’t, but the possibility can no longer be ignored. The precise consequences of this are unclear, but anybody thinking of buying into European equities because they look good long-term value might want to wait a little longer for some certainty – and maybe a lot longer.
2. Just because emerging markets have better economic fundamentals than the developed world, it doesn’t mean their markets are invulnerable to global shocks. This perverse logic applied in the 2008 financial crisis and it is happening again: the Singapore dollar, for example, having fallen 8% against the US dollar in about a week having previously soared; and the Indonesian stock market plunging despite the fact that Indonesia has one of the world’s most vibrant economies, built almost entirely on domestic consumption. The US dollar, for all its troubles, remains a safe haven asset and money is returning there during difficult times.
3. Traditional safe havens are not behaving like they used to. Gold fell with all other asset classes, presumably because people have had to liquidate their holdings just to get cash.
4. On its own, the US economy probably wouldn’t go into recession; there’s nothing happening there to suggest the economy would shrink, just grow sluggishly. But the crisis in the eurozone on top of America’s other problems – unemployment, fiscal deficit – may be enough to create the so-called double dip, with the US returning to recession barely two years after coming out of the last one.
5. Remember what happened to the Aussie dollar in 2008? As the world economy floundered, demand for commodities suffered, and assets moved to US dollars for safety, causing the Australian dollar to decline. It’s already starting to do so again, dropping below parity last week, and if we do go back into global recession there will likely be further to go. That said, this time around Australia is a higher rated sovereign credit than the United States, and the case for it as a safe haven is better than ever. If the world investment community does decide the Australian dollar is a safe haven, that should push the currency up, not down.
6. In the medium term, fund managers tend to see good prospects for Asian bonds. Some say Asian equities too, but there’s also a fear that things are going to get worse before they get better.
7. In the meantime, cash is looking rather attractive.
8. And how about Australian equities? Investors will have fresh memories of the market halving over 2007 and 2008. Just like last time, the crisis has very little to do with Australia – arguably even less so. The last crisis was about the banking system, and Australia did have some problems in that area. But the current crisis is about sovereign debt, and Australia has no problem at all in that respect: it is one of the most robust economies in the world. But as we learned last time, when a global stock rout takes place, pretty much everyone suffers, fairly or otherwise. Analysts are already pointing to the good long term value in the Aussie market: Aussie shares now carry a grossed up dividend yield of 7.3%, which looks attractive. But the mood is very much buyer beware.

Qantas The Australian Way, October 2011

Two South Korean soldiers stand facing north, fists bunched, in a taekwando stance, staring straight ahead. A few metres away a North Korean soldier looks straight back at them. More South Korean soldiers join their colleagues and glare with them, their intended sense of menace enhanced by sunglasses that leave only the rictus clench of their jaws from which to guess their expression. Time seems to stand still. But the moment passes; an everyday standoff.

And the 20 watching tourists file away.

Welcome to Panmunjom, also known as the Joint Security Area (JSA) – the border of North and South Korea. Bill Clinton once called this “the scariest place on earth,” and he was on to something: the tension is everywhere in this extraordinary location, the only place where you can see what’s left of the Cold War up close and personal. It’s a stark illustration of one of the most dangerous potential flashpoints on earth, a mental and sometimes physical conflict that has held fast for more than half a century. But it is also, improbably, the heart of a burgeoning tourist itinerary.

To see the article as it ran in the magazine, with photography, click here: qa1011_Korea indd

Three Seoul tourist operators – only three have been licensed – specialize in tours to both Panmunjom and the broader demilitarized zone (DMZ), a 4 kilometre wide, 241-kilometre long coast-to-coast no-man’s-land along the border that was the basis of the 1953 armistice at the end of the Korean war. And if it seems an absurd thing to do with a free day in Seoul, think again; it’s hard to think of a tour that could teach you more about the threat and tension that Koreans face every day.

A typical tour takes one of two approaches, or combines them into a single long day. DMZ tours focus on one of the four North Korean tunnels that have been discovered in the South’s territory since the 1970s, each one bigger and more sophisticated than the last. The third of them – the biggest and the closest to Seoul, having reached just 44 kilometres from the city – has been opened to tourists as an attraction, and a popular one too.

Donning a hard hat and heading down a slope 73 metres into the ground, visitors reach a dark tunnel that runs 1.6 kilometres, of which they can walk a few hundred yards. It is an extraordinary sight. Officially it’s two metres by two, although it never really feels that high; apparently that’s big enough to get a full infantry battalion through in an hour. At the end of the section that’s open is one of three concrete blockades, each protected by coiled razor wire. It is chilling to think what’s beyond them and what these tunnels were intended to do.

It also demonstrates the way that these tours combine the terrifying with the somewhat surreal. When South Korea discovered this tunnel by boring in 1978, the retreating northerners set about coating the walls in coal dust, so that they could claim they had been looking for coal; to this day, all you have to do is rub your finger against the wall and find your finger coated black but a solid block of coal-less granite behind. In fact, the whole idea is somehow preposterous: this instrument of invasion has been turned into a lucrative money-spinner for the South Korean state, which is nothing if not making the best of things. Guides say that the north has since, in all seriousness, asked for a share of the proceeds, since it put the effort into digging the tunnel in the first place.

The DMZ tours usually take in the Dora Observatory too, where there is a viewing platform with binoculars allowing a clear view into the North. From a distance, it looks surprisingly beautiful: a range of pleasing peaks, often covered in snow. From here one can clearly see two of the tallest flagpoles in the world, one on each side of the border, a game of one-upmanship eventually won by the North Koreans whose flag files some 160 metres high.

It’s no surprise that visits into places like these come with some eccentricities. Most nationalities (but not South Koreans, who must undergo a separate approval process) can do the tour, though you will have to sign a disclaimer warning of the “possibility of injury or death as a direct result of enemy action”. Photography is complicated too. At Dora, there is a painted yellow line some distance back from the viewing platform; you can’t take pictures any further forward, thus rendering any useful picture of the north impossible. (It may be, though, that this is to stop cameras being mistaken for weapons by alert snipers. “We had to close this observatory recently because you are a target for North Korean soldiers,” says our guide. “But I think it should be OK this week.”) Elsewhere, you can’t take a camera into the tunnel, but can buy a jigsaw of a photo of the tunnel in the gift shop, right next to the DMZ baseball caps and the officially endorsed DMZ barbed wire gift sets; and you can’t take a lens any bigger than 100mm into Panmunjom.

Still, the Panmunjom visit – the alternative to the DMZ tour – does illustrate clearly why tour guides take precautions. When one is facing North Korean soldiers with binoculars barely 50 metres away, it is best not to give them any reason to think you are armed. Photo-opportunities here are strictly moderated, and the trip is preceded by a detailed briefing at nearby Camp Bonifas – named, if a reminder of the gravity of the place was needed, after one of two US soldiers hacked to death with axes after attempting to cut down a poplar tree that was interfering with the view between two checkpoints.

There is, though, plenty to see here – far more than one might expect. The border is straddled by a series of blue UN buildings in which official meetings are still often held, and you can enter one. Since the border bisects the main table (upon which three microphones record every word that is spoken), this is the one place where one can wander unrestricted into North Korea, or at least a few metres of it. Next to the building, you can see a small concrete line that marks the border. Also in the JSA, you can see the so-called Bridge of No Return, one of two locations (the other being the Freedom Bridge at the south of the DMZ, covered on both tours) where prisoner exchanges have taken place over the years.

The whole area is full of surprises. There is a town practically on the border on the South Korean side, called Daesong-dong, and apart from the constant threat of imminent invasion it’s not such a bad place to live: there are no taxes, no national service, and the land is free, while farmers raise ginseng, rice and beans. Also, since nobody in their right mind (Daesong-dong apart) has built within the DMZ for more than 50 years, it has evolved into a wildlife reserve, with flocks of birdlife, and wild deer skipping within sight of the tour buses.

There is a hope that, when reunification comes, this will remain an environmental haven. But the truth is reunification is much further away now than it was eight or nine years ago. And for all the perplexing novelty of a border tour, it’s also a sober reminder of the brutality of the Korean War. They call it a fratricidal war: that is to say, brother against brother. A glimpse of the border in action provides both a reason for hope that it will never be repeated, and an illustration of the fear that it might.

BOX: You went where? Five destinations to brag about

1. North Korea. It’s actually not that hard to visit North Korea for real. The established experts are Koryo Tours, a westerner-staffed outfit in Beijing; in particular they specialize in getting people in to the stunning Mass Games, among the most remarkable things you will ever see. It’s safe, too – apart from the flight in.
2. Darvaza. In the 1950s, Soviet gas explorers accidently collapsed the roof of a cavern in the desert. Within, they smelled methane, so decided to burn it off before continuing exploration. They thought it would take a day or two; it’s still going after half a century. Now in Turkmenistan, camping next to this vast, flaming crater is like the gates of hell – which occurred to the locals too, since Darvaza means Gateway.
3. Chernobyl. Remarkably, Chernobyl is now a tourist attraction run by the Ukrainian government. The 30-mile exclusion zone is now open, although some areas are still considered too dangerous to visit.
4. Anthrax Island. Gruinard Island, off the magical Scottish highlands, has a sinister past as a hope for biological warfare testing  in 1942. But after decontamination – including the entire island being drenched with formaldehyde – it was declared clean in 1990 and is now openly promoted to tourists, as well as harbouring plenty of healthy sheep.
5. Everywhere else. When you think about it, the world is full of macabre attractions predicated on suffering of some form or another, from Alcatraz to the Tower of London, Changi prisoner of war camp to Mandela’s cell on Ryker Island. And if you think Australia’s different, just pop over to Sydney’s Pinchgut Island.

Asian central bank governors are shifting their focus from inflation to growth in the wake of problems in the world economy.

The Bank of Thailand has raised rates on seven consecutive occasions since December, to 3.5%, in an attempt to combat inflation pressures, but that process appears to be over for the time being. “I think we were on the right direction so far, but if you ask the question from now on, we do think the slowdown in the world economy will mollify somewhat the inflation pressure,” Prasarn Trairatvorakul, Governor, told Emerging Markets. “The job is to take a proper balance, but the balance lately has tilted towards the risk of growth becoming more apparent than inflation pressure.” Bank of Thailand’s next meeting on interest rates takes place on October 19.

In some respects, the global slowdown makes life easier for Asian central bank governors, who in many cases – most notably India and Vietnam – have wrestled with limited success with inflation this year. “We hope that some slowdown in the world economy will lower the pressure from the supply side,” Prasarn said. He added that domestic consumption in Thailand remained very strong.

Zeti Akhtar Aziz, Governor of Bank Negara Malaysia, agreed that inflation had largely ceased to be a pressing issue for Asian central banks. “As commodity prices stabilized, which was a major factor from the supply side producing higher inflation, demand has slowed globally,” she said. “This will limit inflation, so most central banks have paused their increases in interest rates.” Bank Negara hiked rates in four steps from 2% to 3% from late 2010, “to normalize interest rates and adjust the degree of monetary accommodation,” but ceased in July “given the increased uncertainties and the significantly heightened risks to growth.”

Zeti said she expected emerging markets to continue to grow, but at a slower rate due to the global economy. “In emerging markets we are doing better [than the west] but we are going to see moderation in our growth,” she said. Malaysia’s economic growth was just 4% year on year in the second quarter of 2011, though Zeti has said she expects full year growth of at least 5%.

For central bank governors in Asia, “the biggest challenge is to have price stability in an environment of sustainable growth,” Zeti said. “You have rising prices, and at the same time you also have risks to growth, and those risks have become higher because of what is happening around the world.”

Prasarn noted that Thailand’s international trade had been shifting towards an intra-regional focus, and less from the USA and the eurozone, so from his perspective “the feeling is not too pessimistic or optimistic. There are threats from what’s happening in the euro zone and the US, but there are also encouraging factors like regional integration in trade and financial flows.”

Prasarn said that international investors appeared to have responded well to Thailand’s new government. “On the positive side, the winning is quite clear, rather than a political system which is split,” he said, noting the stock market had risen after the election. “Longer term it very much depends on the results: the outcome of the work produced by the government.” He did, however, appear cautious about a controversial new rice policy that pledges to buy rice at inflated rates and has pushed rice prices up globally. “That’s also our concern,” he said. “We hope that whatever the plan, it will be executed efficiently.”

Former Federal Reserve Chairman Alan Greenspan has called upon the US to prioritize reducing debt over stimulus, calling the debt position “the most extraordinarily difficult fiscal problem the US has ever had.”

“There has never been a question about the quality of American sovereign debt since we started in 1791,” he said. “If we had the luxury of waiting, I would say we could probably find a theoretical construction in which we would stimulate today and pay off the debt later.” But he said waiting was not an option.

“My view is, when confronted with an issue like this, you have to ask yourself in a policy sense what are the consequences if you are wrong?” If the US were to pay down debt and to find it wasn’t necessary, he said, “that is relatively easy to readjust. If, however, we assume we have time to counter this problem and we are wrong, then it is very dangerous.”

“I don’t think we can take the risk of not coming to grips with our debt problem fairly quickly,” he said.

Dr Greenspan said that if the US were to return to recession, it would be a consequence of problems in Europe. “If it weren’t for the existence of the euro problem, I would say it would be very unlikely. Though the American economy is confronted with a high degree of uncertainty, it isn’t the type of uncertainty that creates economic declines: it just suppresses growth.”

He described Europe as “the major problem” in the world economy, and appeared to question whether the euro’s existence had been sensible. “It turns out that 1999 [when the euro was formed] was one of those very rare periods in a boom when everything is working, including the euro,” he said. “I recall when the euro was about to go into play, I said: I don’t believe it, they made it work.” But it was predicated, he said, “on the conventional wisdom that Italians would henceforth behave like Germans. And here, I think, was a gross underestimation.”

“What we’re seeing now is a pulling apart of northern and southern Europe,” he said. “Northern Europe is essentially lending to southern Europe, and the question is, either there is fiscal consolidation – which implies political consolidation – or something breaks.

“Markets are telling us they are fearful that something will break, and Greece is weeks away from default unless there is a new tranche of funding.”

In light of problems with the euro, Dr Greenspan said there were lessons for emerging economies. “I would say it’s essential that they maintain flexible exchange rates,” he says. “If your exchange rate is weakening because investment policy is not good, then adjust that, but don’t try to artificially lock yourself into a stronger currency in expectation that the benefits of the stronger currency will flow to you without cost.”

In other remarks, Dr Greenspan criticized Obama administration policies based around job creation. “I have a problem defining a goal of government policy as jobs in the private sector,” he said.  “Corporations try to keep their workforces as slim as they know how. They work very hard not to create jobs, but to destroy them.” Government should instead create economic conditions in which businesses have to hire people to meet demand.

Asked about the internationalization of the renminbi, he said “I think it’s many years in the future… At this stage I don’t see the Chinese will perceive it to their advantage to do what is required for the RMB to become an international currency.”

Note: this was a sponsored report and not editorially independent, but is included here as a resource

SECTION 1 – interview with Alisher Ali, Chairman, Eurasia Capital

EM: Set the scene: what is the opportunity in Mongolia today?

AA: Mongolia has so many things going for it. It is physically located next to China, which has become the de facto engine of growth in the global economy. It has been blessed with natural resources. And you have the government and political system: the country is a true democracy, so as a result there is a good chance of the country being able to manage effectively not only its mineral wealth but the economic growth that will come with the development of those mineral resources.

So we have been early believers in Mongolia. We opened our office in 2008 in the same week as the Lehman disaster, and even though the timing may not have been perfect, we are still proud of the fact that we saw the opportunity for Mongolia’s growth potential and investment opportunities much earlier than many others. We built the infrastructure, we focused on building relationships with government entities, and with the corporate sector and international investors. Now we have the largest investment bank in the country, well positioned to capitalize on opportunities. The mission for Eurasia Capital is to provide a bridge between Mongolia and the international markets: to give international investors access to Mongolia growth, and to facilitate the entrance of Mongolian companies and banks to raise capital internationally.

EM: What shifts have you seen in the business climate since 2008?

I’ve appeared at least 20 times in studios for interviews with Bloomberg, CNBC, Al Jazeera and others to talk about Mongolia. And I always get the question: why haven’t we heard about Mongolia before, with its massive resources? The reason was that for years, the Mongolian government, parliament and public in general have had intense debates about how to develop those resources. It took a long time and was frustrating for foreign investors trying to bring big mining projects into production. The big example was Ivanhoe Mines, which discovered the Oyu Tolgoi deposit a decade ago yet only signed the landmark agreement allowing it to develop it in October 2009. But when we set up here there was no doubt in our mind that the government would decide to develop its strategic projects and large mines. The question was when.

The 2008 crisis hit Mongolia very hard: by the first quarter of 2009 the government was running out of money, foreign exchange reserves were depleted and investors were fleeing. It led to a bailout with support from the IMF and a number of bilateral agreements. But that crisis, in my view, had a silver lining, because it helped the government and public to focus on the key need to develop mineral resources. It became clear they had no luxury to wait and debate further. So we were all relieved when, on October 6 2009, they finally came to agreement with Ivanhoe and Rio Tinto. That was a turning point. It was a big sign: this country is ready for business. It was a crucial milestone and the catalyst for a change in investment sentiment towards Mongolia. The country has never looked back since then.

EM: Where are the opportunities in investment? Everyone knows about the mining, but how about the knock-on effects in the economy?

One of the main reasons for us spotting the opportunity in Mongolia early on was our early experience in Central Asia, especially Kazakhstan. Our time in frontier markets and Eurasian countries allowed me to see the parallels: that once you have momentum, and the development of world class resources, you are going to see knock-on effects. Yes, mining is going to be the largest and most important sector for Mongolia, but there will be other sectors and the opportunity is not going to be confined only to mining.

In January 2010 we produced a report called Mongolia Outlook 2010 – a historical document in the development of our firm. It was positive and optimistic about Mongolia at a time when the turnaround wasn’t obvious, but we said that Mongolia was going to go through a multi-year bull market: that there would be growth in GDP and in FDI. Beyond that macro vision, we made two important calls which were – this is important – executable investment recommendations for international investors. The first was that the Mongolian tugrik was going to appreciate and influence FDI. There is no derivative or spot market, so investors had to initiate bank deposits with Mongolian banks, which at that time were offering 16% in tugrik local currency deposits. Those investors who followed our advice made over 25% return after subtracting all costs, a combination of high deposit rates and the appreciation of the currency.

The second important call was that we recommended investors start investing in local equities. In January 2010, this was considered an optimistic call: the local market collapsed in 2008 and was also negative in 2009 in dollar terms. But we were confident the worst was behind us and estimated the market would gain 70% that year. In fact, it went up almost double that amount. In 2010 the tugrik was the second best performing currency globally, and the stock market was the best in the world.

From the beginning I have trained our research team to think in a way so as to come up with actionable recommendations. We look at opportunities in the currency markets, in fixed income, in public equities – domestic and international – in private equity, infrastructure and property, then tailor recommendations around them. We have built indices allowing investors to track performance of Mongolia-related companies listed in countries around the world.

EM: What funds and businesses have you built to do this?

Eurasia Capital Management is a Central Asian investment and fund management business. Silk Road Management, which started in 2008 as a wealth management advisory firm, is now being transformed into a Mongolia-focused investment management firm. We aim to build the largest such institution in the country. Our first product was the first ever venture capital and private equity fund focused on Mongolia, the Mongolia Human Capital Fund, which raised US$30 million from investors. The idea of this fund is to focus on non-resource sectors where human capital is going to be crucial in the success of the business: areas such as media, healthcare, education, professional services industries and information technology. These are industries in their infancy stage that are going to benefit from strong economic growth.

We have plans to launch funds across different asset classes. We intend to launch a publicly-listed Mongolia-dedicated fund. And we have teamed up with a Korean group, Goran Capital Partners, to launch a Mongolia-Korea resources fund and to tap the interest of Korean institutional investors looking for investments in Mongolia. We tailor investment products around the interests of investors.

Eurasia Capital itself has been recognized by several international publications; this year it was named the best investment bank in Mongolia by Euromoney magazine.

SECTION 2 – interview with Ganhuyang Chuluun Hutagt, Vice Minister of Finance, Mongolia

Euromoney: At a time when the rest of the world is struggling, economic projections for Mongolia are extremely positive. Is the outlook realistic?

Minister: The outlook will be as good as the demand for what we are producing. In recent years what we possess in terms of minerals has attracted a lot of investor interest, based on global demand for these commodities: copper, uranium, gold, coal, iron. There will be demand for our products despite what happens with Chinese inflation, the American budget and debt ceiling, and European defaults.

EM: What is a realistic expectation for GDP growth?

Minister: It will depend on what’s going to happen in the US and how it will affect production in China, and what appetite China will have for Mongolian commodities. I don’t think the Mongolian government can become too arrogant: I advocate we watch out for negative trends, and manage risks. Consecutive crises have shown that they do have an impact on the Mongolian economy.

Despite that, the outlook that is being projected by the international community, our development partners and ourselves is pretty positive. We will have tremendous growth in our economy based on mining and the building of physical infrastructure to make our products more available to international markets: border ports, railways, roads, airports. We are going to need to build new cities in the new mining areas, currently mostly in the Gobi. Most of the business will happen around the mines and in the value chain. We need new power plants, new houses, and even here [Ulaanbaatar] with growing incomes we have a minimum of 200,000 people who will need houses and apartments. You don’t need too much imagination to think of the investments behind these numbers in terms of water, sewage, energy, roads, schools and hospitals. It entails huge business opportunities, but mining can support it only through steady and growing cashflows.

What will be the role of the state in all this investment?

The role of the state is going to not diminish in the near future. At this stage of development the government needs to take a leading role, creating not only the environment and good opportunities for foreign investors, but also intervening in managing the economy, supporting our traditional industries such as agriculture, as we did today [in an issue of bonds to support agricultural producers and SMEs]. We need to help our industries in this tough environment with foreign competitors coming in and cheap imports, aggravated by the impact of the strong tugrik. We will need to continue direct involvement such as the development bank, to build public services. This year we budgeted MNT627 billion for capital investments, and the number will go above 1 trillion this year. Altogether in the past 20 years put together, the capital expenditures were only MNT1.6 trillion; in two years we are doing what was done in 20.

What will be the role of the private sector in this?

The private sector has plenty on its plate already. Almost all of the banking sector is in private hands: out of 70,000 registered companies, only 100 are state-owned, although they include the champions.

How do you rate ease of doing business in Mongolia?

We have fared pretty well. Mongolia is one of the friendlier environments in which to do business. Because we are latecomers we can implement some systems immediately: for example we rank one of the top countries in terms of extractive industries transparency. If you compare us with some Eastern European countries, we are pretty similar; if you compare us to former Soviet Republics, we are way better.

And what still needs to be done?

Last year the government announced the year of Business Environmental Enabling Reform, or BEER. The results of it are yet to be fully reflected, but the government made an important decision to continue with reform here in 2011.

Can you explain the mandate of the new Development Bank? For example will it fund small business as well as long-term infrastructure?

It’s not for small business, it is to support large national projects and to help the government invest in energy, infrastructure and to help us utilize our mines more efficiently. It is specifically stated in the law what sort of projects will be funded, and they will include housing. The bank is operational – it has not yet funded projects, but we have given them the guarantee to issue MNT800 billion of bonds. They are working hard to issue those bonds, get the funding and start financing projects.

Are you considering a sovereign wealth fund?

We have set up a stabilization fund, which by the end of the year will have MNT180 billion. When it hits 5% of GDP we will start investing it actively; in the meantime it’s in cash. I will do my utmost to make sure the government makes the right decisions and does not have incentives to spend it all right now. It is a big responsibility for our future.

What are its sources of funding?

Any income that is in excess of certain fixed prices for coal and copper. We also have the Human Development Fund; we put revenues from the mines in that fund and will start investing this money outside of the country to protect our economy and insulate it from foreign currencies, as well as preserving wealth to share with future generations.

You said Mongolia is dependent on demand for commodities. What is being done to diversify the economy away from such reliance on mining?

Traditionally Mongolia has been an agrarian economy: livestock and anything related to it like meat, pelt, felt, wool and cashmere. They are all industries of high potential. Food security is a big concern for us; Mongolia has become self-sufficient in terms of wheat, which is a success. We could focus on and develop other industries: our increasingly educated workforce will be able to drive industries such as tourism and financial services to become major contributors to the economy.

The financial services industry had a rough time in 2009. How is its health today?

Over 95% of the financial industry is commercial banks. The system is doing well: it is growing, NPLs are decreasing on the back of the economic boom, and the stock market has consistently outperformed most others. But we start from a low base and there is a need for reforms. We need to approve the draft law on securities – hopefully this year – and reform in the pensions system will need to happen. We need to overhaul our insurance sector. And with this we will create local institutional investors who will help us create robust, dynamically growing local stock markets.

The world is watching the forthcoming Erdenes Tavan Tolgoi IPO. How transformative will it be for Mongolian markets?

The current capitalization of the local stock exchange is $2 billion; we are talking about $10 billion in an IPO of one company. That’s the magnitude, and if we decide to float some percentage locally it will have a huge impact. Right now 10% is owned by the Mongolian people and another 10% will be sold to Mongolia-based companies. This will provide a strong incentive for international investors to come in early and take part in the trading of those securities.

What is the idea behind giving shares in it to every Mongolian citizen?

It gives people a feeling that they are benefiting from the big national treasure directly. It’s a good lesson to all Mongolian citizens in terms of managing capital, really understanding what a stock market is and how it works, and what being a shareholder entails. It brings accountability to the person, whereas if the state was to manage the wealth for our own citizens, it is more indirect. Tavan Tolgoi will be a better governed organization because it is owned by individuals, not just the faceless state.

With the US and Europe in turmoil, what is your resilience to external shocks?

I don’t think we have been particularly resilient at any time in history. We depend on our buyers; we have one rail line. Economically we are dependent on two neighbours: we import all of our gas from Russia, we export most of our coal to China.

What message do you want to give to foreign investors about Mongolia?

It makes sense to get exposed to Mongolia. It is the top opportunity globally in terms of our mineral resources. We possess almost all the elements in the periodic table. We are tripling coal exports this year. The ambition with our partnership with the London Stock Exchange is that one day Asian investors can trade on the Mongolian exchange with their stocks listed in London, on the same platform, the same systems.

Cashflows are exploding, the budget is in surplus and we have record high cash levels in our treasury. We will one day make a decision on sovereign bonds: we are issuing local currency and giving a very good return to our investors. Debt to GDP is just 17%, so we can borrow, and I think we want to borrow to make investments and increase the capacity of the economy.

SECTION 3: ECONOMY

Economy

Mongolia has experienced rapid economic growth since the global financial crisis. Eurasia Capital, an Ulaanbaatar-headquartered investment bank, estimates that Mongolia became the world’s second fastest growing economy in 2010 in terms of US$ GDP growth rate at current prices, with a 44% year-on-year increase, driven by the 12.9% appreciation of the Mongolian tugrik (MNT), the national currency, against the dollar over that period. This means that Mongolia outperformed the BRIC emerging economies as well as all other leading frontier and high-growth economies globally. Fueled by investment in the mining sector and a significant increase in exports, real GDP growth reached 6.1% last year, according to official data, versus 2.7% in developed and 7.1% in emerging and developing economies. And it is getting better still: in the first half 2011 it was up 14.3%, or in nominal terms 29.1%. The second quarter, with 17.3% year on year growth, was the fastest expansion since 2005.

Significant investments and demand from China, the major market for Mongolian products, have allowed Mongolia to double coal output to more than 25Mt in 2010, up from 13Mt a year earlier. Coal exports increased 2.9 times in 2010, overtaking copper for the first time, and in 1H2011 Mongolia overtook flood-hit Australia as the largest coal exporter to China. Crude oil production rose 17% to 2.2MMbbl, and iron ore output more than doubled to over 3.2Mt. Major manufacturing industries, such as food and beverages, grew 24% in 2010.

Mongolian foreign trade surpassed its historical high in 2010. Trade turnover surged 53.5% year-on-year to US$6.2bn. 2010 was a record year for exports, reaching US$2.9 billion, with a 53.8% annual expansion driven primarily by Chinese demand (it bought 85% of Mongolia’s exports), commodity price increases and volume expansion. Record level exports have been the primary driver of Mongolia’s impressive economic growth. And they are getting better still: Mineral exports jumped 72% year-on-year in the first half of 2011, with coal up 135% and iron ore exports 122%.

Increases in international prices for Mongolia’s major export commodities boosted already substantial export earnings. The price of coal, the largest 2010 export earner for Mongolia, rose more than 14% over 2010, with copper, gold, iron ore and crude oil gaining 28%, 26%, 52% and 8%, respectively.

Eurasia Capital expects Mongolian foreign trade to grow at an even faster rate in 2011. A positive outlook on commodity prices, increased output from existing operations, the launching of new mines, and strong growth prospects in major trading partner markets – particularly resource-hungry China – should fuel increased exports from Mongolia. Eurasia now believes that Mongolian economic growth should beat its original projection of 10% GDP growth for 2011.

Foreign direct investment (FDI), which was considered frozen until as recently as 2008, hit a record high of US$1.6bn in 2010, according to official data, further underpinning the economy. The mining sector was the major destination for FDI.

China was for many years the only major FDI player into Mongolia, accounting for US$2.5 billion between 1990 and 2010. That is changing. Canadian FDI, the second biggest in Mongolia, increased more than 140 times in 2010 to US$147.8 million. Investment from Hong Kong is also climbing.

By sector, geology and mining have attracted US$3.15bn in FDI – 65.3% of the total – since 1990. The majority of this investment has come since 2008, when the mining industry began to entice resources giants around the world. Hong Kong and Canada’s FDI focus is mainly on mining and related activities, while South Korean and Japanese investments have targeted trade and service, engineering construction, and financial sectors. The biggest investor, China, has followed varied targets covering almost every sector. Infrastructure is likely to attract more FDI in coming years, with 1100km of Mongolian railways planned, for example.

Remarkably, Mongolia is thriving with limited inflation. Prices rose around 13% last year, and there were concerns from the World Bank that an expenditure plan – including major increases in salaries – could push inflation over the 25% mark. Yet according to N Zoljargal, deputy governor of Bank of Mongolia, the central bank, inflation has instead declined to around 6.5% year on year in June. In any case, he says, Mongolia is an exceptional case when it comes to considering inflation. “Mongolia has for so long been under-invested,” he says. “So when you see a flow of new cash wealth, how much of it do you sterilize and how much do you let trickle into the economy? That is the challenge we faced in 2010, we are facing it now and we will probably live like this for the next few decades.” Last year the bank sterilized around 30% of net inflows in foreign exchange, feeling that it was short-term and speculative; this year, it has sterilized far less.  “Yes inflation is a worry, with banks over-extending credit in the good days; people argue the economy is getting too hot,” he says. “I say we are nowhere near to that: we are just warming up. Everybody has their own temperature.”

Indeed, some argue inflation should actually be higher, and monetary policy looser. “Economists say that if there is inflation, just take out money from the economy,” says Sambuu Demberel, Chairman and CEO of the Mongolian National Chamber of Commerce & Industry, and a key economic advisor to Mongolia’s president and prime minister. “It’s nonsense. We need money in circulation: the more money the better. People in real sectors want money to create business and profit, but the majority of SMEs don’t have access to lending. We need decisive action to change our monetary environment to drive the economy.”

Rich mineral resources

Mongolia hosts world-class mining deposits, including estimated coal resources of over 160Bt, ranking fourth in the world after the USA, Russia and China. Erdenes Tavan Tolgoi, one of the world’s largest untapped coking coal mines, is a vivid example of a world class resource: it is estimated to contain 6.4Bt of thermal and coking coal worth approximately US$390bn. The Government of Mongolia is in the process of finalizing the deal with international bidders.

Another world class mine is Oyu Tolgoi, which is one of the world’s largest undeveloped copper-gold deposits, rivaling Escondida and Grasberg. Oyu Tolgoi contains approximately 37Mt of copper and 1,300 tonnes of gold, with a project cost of US$5.9bn. Based on conservative calculations, the monetary value of the Oyu Tolgoi project is approximately US$252bn. It may become as much as US$424bn if measured, indicated and inferred resources are taken into account.

Balanced Political Environment

Mongolia is to hold parliamentary elections in the summer of 2012. The newly elected parliament will oversee the implementation of major mining, infrastructure and industrialization projects, which will define Mongolian politics, economy and society for years to come.

The parliamentary election in 2008 saw a brief period of turmoil, but the formation of a coalition government between the two main political parties, the Mongolia People’s Party (MPP) and the Democratic Party (DP), has resulted in a stable functioning government. Domestically, the coalition government has focused on expanding investments in Mongolia’s vast natural resource wealth, diversifying the economy, job creation and improving living standards. Internationally, the government has maintained good relations with Mongolia’s traditional partners, Russia and China, as well as expanding relations with countries beyond its traditional partners.

In June 2011, Mongolia and China agreed to upgrade bilateral ties to a strategic partnership level and to bolster economic ties. The agreement is expected to bring more Chinese investments and financial support into resource and non-resource sectors and infrastructure development. Mongolia also enjoys strategic partnership status with Russia. In terms of “third neighbor” relations, Mongolia has held high-level meetings with Japan, the USA, Korea and India, among others: it expects to sign an Economic Partnership Agreement, roughly equal to a free trade agreement, with Japan in 2012. During the visit of Mongolian President Tsakhia Elbegdorj to the USA in June 2011, the Obama Administration stated that it was committed to developing a broader, deeper and more strategic relationship with Mongolia, including expanded commercial, political and cultural ties. India is actively pursuing cooperation with Mongolia in nuclear energy and mining.

With upcoming elections, the coalition government is eager to start the Tavan Tolgoi coking coal project in partnership with major international mining players. Large mining deals, infrastructure development and poverty reduction will remain recurring themes of parliamentary elections in 2012. There is a wide political consensus among major political parties about the development needs of Mongolia. Therefore, regardless of the election results, the country should be expected to stay on its current course of resource-driven growth.

SECTION 4: CAPITAL MARKETS

Public equities: Best Performing Market Globally

Despite its relative tiny size in global market terms, the Mongolian Stock Exchange (MSE) is increasingly gaining importance for local and international investors intending to gain exposure to the Mongolian market. Naturally, most of the market is resource-related.

Mongolia has so far this year maintained its title as the world’s best performing equity market. Having gained 138.4% (173.7% in US$ terms) last year, the MSE Top-20 Index has continued its global outperformance in 2011 at +43.8% at the time of writing. By comparison, the MSCI Frontier index gained 16.6% in 2010 and is down 11.6% so far in 2011; the MSCI EM Asia index gained 12.9% in 2010 and is down 0.7% year to date; and the Shanghai Composite Index fell 14.3% and 5% respectively.

After the Mongolian Stock Exchange benchmark surged 123.3% within the first two months of the year, hitting 32,954.97 on February 25, it went through a significant correction, losing 43.8% by the end of May. This volatility is a function of speculation, low liquidity, a small free float in listed companies, and unrealistic and uninformed investor expectations. Improved investor sentiment driven by the expected launch of Tavan Tolgoi coal mining operations and proposed IPO, the strategic partnership agreement between the MSE and the London Stock Exchange (see box), and a strong outlook for commodities, contributed to the surge and underpin further growth.

The MSE market capitalization grew 2.5 times in 2010, passing the landmark US$1bn in November 2010  and reaching US$1.7 billion by July 2011. The top five stocks (Coal groups Baganuur, Tavan Tolgoi, Shivee Ovoo and Sharyn Gol, and beverage group APU) contributed 82.1% of this growth. The combination of expected double-digit economic growth, and the experience of other commodity-linked emerging markets, suggests that the momentum has just begun: Kazakhstan Stock Exchange’s market capitalization grew 100-fold to US$100 billion between 2000 and 2008, while the Qatar Stock Exchange grew 31 times from 1997 to 2007 to US$95 billion. Stock market penetration – total market cap representing just 20% of GDP – is relatively low compared to other emerging and even frontier markets, underlining the growth potential.

The MSE, with its huge gains, is still challenged by companies with small free floats and low trading volume. Average daily trading volumes were US$234,000 from January to February 25, and US$33,000 from then to May 30. It is likely that the lack of liquidity will remain a concern in the short term.

The Mongolian government has approved a list of state-owned enterprises that are slated for privatization starting from 2011. These SOEs are in mining, mineral processing, construction materials, power distribution and generation, telecommunications and airline industries. Many will pursue a listing locally on the MSE to serve as a vehicle for privatization and then seek additional listings in regional or international markets to raise capital for expansion and modernization.

The leader among these expected privatizations is the highly anticipated IPO of Erdenes Tavan Tolgoi, expected early next year, and potentially worth over US$10 billion. This government-owned company holds the licence for Tavan Tolgoi, the world’s largest undeveloped coking coal mine. The government has distributed 10% of the company’s shares to Mongolian citizens, with a lock-up period that has not yet been decided, and plans to sell another 10% to Mongolian companies and offer 30% on a combination of domestic and international markets. It should substantially boost MSE market capitalization and liquidity while also enfranchising citizens in the capital markets. “The entire population of Mongolia will become shareholders,” says Munkhtushig Dul, Deputy Director and head of finance and logistics at the MSE. “When that happens, new brokerages will have to develop, as will the capital markets themselves.”

“There are several separate pipelines of new listings,” he adds. “First there are the big strategic mineral deposits, which by law should have no less than 10% listed on the MSE. Then there are many companies with huge assets in Mongolia who are not listed here: we are hoping to repatriate them to create more involvement in the Mongolian markets. And then there are local privately held companies: cell phone companies, food companies, very strong businesses that will need more money.”

There have been no new IPOs on the MSE in the last two years, but it is expected this will change dramatically in the coming years as a number of leading domestic private companies are expected to launch IPOs first internationally and later on MSE. Mongolian private business groups that are expected to launch IPOs at a group or subsidiary level include MCS Holding, Petrovis Corp, Bodi Group, Newcom Group and Monnis Group. New IPOs, whether from state or private sources, should ease liquidity concerns and therefore volatility.

Many Mongolian companies – now over 20 – have listed overseas, often instead of domestically, in locations including Toronto, London, Hong Kong and Australia. But Mongolian authorities do not see this as capital fleeing the country. “I don’t see it as a bad sign,” says Bayarsaikhan D, chairman of the Financial Regulatory Commission of Mongolia. “Companies are using the opportunity to raise funding in large amounts.” The hope is that companies that have listed overseas will come to list more of their stock domestically as the Mongolian market gains in scale and sophistication.

Eurasia Capital believes the outlook for Mongolian equities in the short to long term is very positive. This year, it expects the MSE to retain its title among the top three equity markets, if not the best.

BOX: The LSE partnership

Mongolia took a historically important step to develop its capital markets when MSE and London Stock Exchange (LSE) signed the landmark Master Service Agreement to manage the MSE on April 7 2011.

Through this agreement the MSE will be modernized with the LSE’s support over the next three years. LSE will introduce an integrated securities trading system, create an effective legal and regulatory environment, and will bring infrastructure, technology and human resources capability in line with international standards. LSE has appointed a management team at the MSE to oversee its development and privatization, and has brought in Millennium IT, the leading global exchange technology provider, to assist with trading, surveillance and post-trading infrastructure.

The partnership should bring modern market rules, procedures and operations, as well as broadening tradable asset classes to derivatives and ETFs. The ultimate aim is for MSE to become a regional resources hub for international investors. In future it may even attract resources listings from neighbouring countries.

“The main purpose of the agreement is to bring the stock exchange to international standards,” says Bayarsaikhan. “A lot of work has been done so far on the legal framework, on IT, and in corporate governance and transparency. The future is bright and all the professional players in the market are working hard.”

In Eurasia Capital’s view, this partnership should accelerate the process of MSE becoming a viable source of capital for Mongolian companies and an efficient channel for wealth distribution from mineral resources among the Mongolian population.

Private equity

Flurry of M&A Activity

In recent years Mongolia has seen a flurry of M&A activity, particularly in the resources sector. M&A volumes doubled from 2009 to 2010 to a record level of over US$1bn, most of it in mining, and chiefly coal; international interest has grown dramatically since the investment agreement on the Oyu Tolgoi (OT) mine was signed in late 2009. The origins of acquiring companies were diverse but Hong Kong and Australia led the charge: Hong Kong was involved in US$473mn worth of M&A deals through injections of resource assets into existing publicly listed companies.  Australian companies have not only bought assets but held IPOs.

This year M&A activity is more vibrant still. Total deal value for the first half of 2011 increased 45% year on year to US$636mn, and had reached US$690mn by July 27; Eurasia Capital expects another record year. Close to 50% of the announced deals were reached in participation with Australian companies, suggesting Mongolia will continue to be on the radar of cash-rich mining companies that have strengthened their cash positions through improved operational efficiencies and high commodity prices. The Erdenes Tavan Tolgoi deal will impact this year’s numbers: some bankers estimate the overall worth of the asset at US$15-20bn.

Fixed income: Bond Market Kicking off

Until very recently, not many people knew of the existence of the bond market in Mongolia. But it is becoming more active. The market has been waiting for the right time and conditions while building knowledge, experience, and infrastructure. News about bond issues is not on-and-off anymore; the market is underway.

The Mongolian Government is being cautious in approving new issues, knowing the damage any default would cause to the reputation and credit rating of the market. Government issues have focused on national benefit: for example, in September 2010 it issued a MNT60bn bond, half of which was offered to the public, to fund the “4000 Apartments for Public Servants” project. So far, offers worth MNT69.6bn out of a planned MNT72bn have been launched for project funding.

Backed by confidence in Mongolia’s expected growth, the government is planning another offering to support the cashmere and wool sectors, and small-to-medium enterprises.

Through the Development Bank, established in 2010, big industrial, infrastructure and mining projects will be funded and the government will issue MNT800bn bonds for necessary funding as new projects come up. The Bank also supports those projects by providing guarantees to the loans. Both domestic and international investors can participate.

Corporate bonds will become an interesting area for investors. For most of the companies who intend to tap the debt markets, it is a testing period: they need models to follow, but there have been only 12 issues since 2001. But by waiting, they risk losing out to competitors. Just Agro has made the first move this year to attract bond investors with a MNT30bn bond offering. If successful, other companies may follow.

Trade and Development Bank (TDB) is the only bank in Mongolia to tap the international bond markets so far, with a US$75mn deal in 2009 (successfully repaid), and two new bonds in 2010. Other banks, Khan Bank and XacBank, have followed suit and announced smaller debt issues. But bank deposits, offering more than 11% returns in MNT, remain favoured by many local investors.

BOX: Currency

After an impressive 12.9% appreciation in 2010, the Mongolia tugrik (MNT) has been relatively volatile this year, appreciating 1.6% year to date by August 4. Eurasia Capital believes it will remain a strong currency to hold. This confidence comes from expected capital flows to the large projects in the mining industry and infrastructure: FDI was US$1.5bn in 2010. The revenues from the two mega-projects of Tavan Tolgoi (coal) and Oyu Tolgoi (copper and gold), both under development, will consolidate the MNT for many years to come. Mongolia’s exports of mineral resources will dramatically increase when the necessary infrastructure, including the rail lines, become ready.

The currency is comparable to other resource driven currencies, such as the Australian dollar or Brazilian Real, which have experienced large appreciation. The MNT has emerged as a new resource currency and is increasingly correlated to the export commodities. It represents an excellent carry trade opportunity.

SECTION 5: PROPERTY, INFRASTRUCTURE AND FINANCIAL SERVICES

Property

As mining has brought wealth to Mongolia, the property market has experienced speculation and rapid expansion. After the highest ever price for a luxury residential apartment was registered at US$8000/sqm in the new Blue Sky Tower, an April Fool’s joke by a local broker about Donald Trump’s plans to build 120-storey “Trump Tower” for US$1bn in the center of Ulaanbaatar was picked up and distributed by some respected online sources.

Although Mr. Trump is not planning to build a tower in the capital city of Mongolia, the property market is poised to benefit from the country’s mining-led economic growth. Already, the residential, office, retail and hospitality property segments have consistently grown over the last few years, with supply struggling to meet demand. The market in Ulaanbaatar stabilized in 2010 following the turmoil of 2008-2009, and has benefited from increased inflows of foreign capital. Industry experts expect a period of accelerated growth.

Residential property prices in Ulaanbaatar have nearly quadrupled since 2002, although the global financial crisis corrected the steep market growth up to 3Q2008. The past year’s strong economic growth, national currency appreciation and speculative inflows of foreign capital for Mongolia have driven residential property prices up nearly 20% in the capital; the average residential property prices in 2010 was around US$900 per square meter, although much of that can be attributed to the 12.9% MNT appreciation.

Although foreign investors have an impact, the growing number of wealthy Mongolians is also significant, boosted by successful capital raising by mining companies. Fundamental demand for housing in Ulaanbaatar and nationwide will be a key driver of near-term growth. Since 2005, the population of Ulaanbaatar has increased 22% to 1.16 million, which represents over 40% of the total Mongolian population. More than half of Ulaanbaatar’s inhabitants live in traditional “ger” settlements, whilst the others live in old buildings that are deteriorating fast. Facing the need to accommodate its population, the Mongolian Government has initiated several measures that stipulate construction of mid-budget accommodation through government support. These initiatives include programmes such as the “100,000 Apartments Project” which aims to alleviate the strains on infrastructure services, social services and pollution.

Despite the newfound wealth, more than one third of the Mongolian population lives below the poverty line. Increasing prices might deter low income earners from buying property. However, 2010 was marked by a revival in the mortgage market as major Mongolian banks have started providing loans to the population, albeit at high rates – currently from 11% to 28.8%, with required downpayments as high as 50% (but more commonly 30% and sometimes 10% if the construction company takes on some of the risk).

Ulaanbaatar is again crowded with construction cranes, just as before the 2008 crisis. Maybe Mr Trump will really build a Trump Tower in Ulaanbaatar during the next few years.

Infrastructure

Mongolia’s mining boom may stutter if the country cannot solve its infrastructure problems. Infrastructure is regularly listed among the major inhibitors of Mongolian growth, and vast investment is needed, probably in excess of the current GDP of the country.

The Concession Law, adopted in 2010, sets the legal framework for private sector participation in the development of infrastructure projects. The Mongolian government has approved a list of 121 projects in road and railroad construction, power generation and transmission, industrial development, urban development, telecommunications, education and healthcare, inviting private sector investments. Both foreign and domestic companies can participate in the projects individually or jointly. Concessions can be gained via open tender, competitive bidding or direct contract.

The development and expansion of railroad infrastructure is one of the most pressing issues in the Mongolian economy. To support its mining sector, Mongolia is currently focusing on extending its railroads to major mining areas within the country, as well as on opening trade corridors and export routes to neighbouring countries. In the next five to ten years, the country is planning to build about 5,700km of new railroads, providing easier access to Mongolian minerals and exports to neighbouring and international markets. The railroads will be constructed in three stages. The first stage, which has already started, envisages construction of a new 1,100km main rail line from the Tavan Tolgoi coal deposit to Choibalsan, the town connected to Russia by the existing railroad. The new main line will intersect the existing Trans-Mongolian Railway in Sainshand station in Gobi region. Mongolian Railways was selected to implement the project. The project is in feasibility study stage. It is expected to be completed in the next 4-5 years.

In the near future, major infrastructure projects in Mongolia may offer numerous investment opportunities. Construction of new railroads would create opportunities for investors, construction and operating companies. A new US$10 billion development, the Sainshand Industrial Complex near the Chinese border, will be a hub to process Mongolian raw materials for export, and should spur investor interest. A number of other government-priority projects will be open for private bidding in the coming year.

Financial services

Mongolia’s banking industry endured a difficult financial crisis in which two banks failed. But there is a sense that it has returned to health on the back of the growing economy. N Zoljargal, Deputy Governor of The Bank of Mongolia, the central bank, says the banking system has “never been better than it is today. It is very healthy.” Those banks that survived the crisis are now strong. “During the crisis our banks were well managed, beefed up their liquidity, and since then have seen high growth in assets.” Non-performing loans, which at one stage topped 20%, are now around the 6% mark, he says, and “coming down dramatically” as previously troubled businesses in construction and other areas pay back their loans. As Zoljargal says: “It the economy is growing 10%, it’s hard to produce NPLs. You have to be doing something very wrong.”

Some local banks with distinct strategies look healthier still. Xac Bank’s NPLs peaked around 7% and today stand at 1.7%, according to CEO Bat-Ochir Dugersuren, because its portfolios are well diversified. Xac Bank is an interesting study: founded in 1998 under a UNDP program, it is fundamentally a microfinance institution, with a governance and shareholder structure unique in Mongolia (EBRD and IFC are stakeholders, and the board is independent). Today, SMEs are very much a focus for expansion. “We have big corporates in this country but I don’t believe they are going to expand and carry the country’s growth forward,” says Bat-Ochir. “We need a broad base of promising SMEs to allow double-digit growth to take place in our economy.” Xac Bank, like most, gets around 90% of its income from interest, and accepts that growth in other business lines will have to take place to diversify earnings.

Another example of an unusual strategy is Chinggis Khaan Bank. Chairman Sergey Gromov – a pioneer investor in Mongolia whose holdings also including the leading brewery APU and the insurer Mongol Daatgal, discussed below – says the bank focuses on areas like agriculture and building materials, but not mining. “Agriculture has huge potential,” he says, pointing to the sheer scale of land and the as yet limited use of fertilizer or other techniques.

International players such as ING and Standard Chartered have started to appear in Mongolia, though chiefly with representative offices rather than significant on-the-ground commitment so far. PricewaterhouseCoopers, KPMG and Ernst & Young are also represented.

Eurasia Capital is the nation’s leading investment bank today, and it is likely that this will be a growing part of the market in future. “There will be more of a focus on long term investment funds and institutional investors in future,” says Bayarsaikhan D, Chairman of the Financial Regulatory Commission of Mongolia. As the finance ministry interview explains, two quasi-sovereign wealth funds – the Stabilization Fund and Human Development Fund – are being developed, while a development bank focused on long-term infrastructure has been formed and will soon start lending. The development of new investment, capital markets and securities laws, in varying states of readiness, will help growth.

Another area ready for dramatic growth is the insurance industry. Mongol Daatgal, the country’s first insurer, dates from 1924, but the industry is still in its infancy; only one company provides life insurance, while a handful of others provide property and commercial cover. “It is a very virgin market,” says Batzul Tumur-Ochir, Mongol Daatgal’s CEO. “It only holds 7.4% of GDP, and total premium income in 2010 was just US$30 million for the whole industry. People have not understood insurance, or have seen it as a cost in the past; but now the economy is growing because of the mining industry, people have more money from wages and may spend some on insurance.”

On top of general economic growth, legislation will drive the industry too. Mongolia today does not have mandatory insurance for drivers, but this year a new law is likely to change that. “That will automatically give a 30 or 40% increase to the market,” Batzul says. Professional liability insurance will also become mandatory in the near future, while the growth of the mortgage market is also going to feed through to insurance – through corporates and banks, and through individuals. Batzul plans to enter life insurance too within three years, as he also sees momentum for growth there.

Asiamoney meets Secretary of Finance Cesar Purisima in a booth in a Hanoi conference centre, promoting Manila’s role as the next host of the Asian Development Bank annual meeting. He is flanked by images of the rolling chocolate hills of Bohol, while a TV shows idyllic beaches. It’s an agreeable backdrop and, given the Aquino government’s push to boost tourism infrastructure, not wholly incongruous. But it’s in contrast to the more rugged challenges that Purisima faces in dealing with the Philippine national finances.

Foremost among them is the tension between two competing goals. On one hand, the country’s GDP deficit – 3.74% of GDP at the end of 2010 – takes valuable money out of the country and pours it down the black hole of interest payments; clearly that deficit has to come down. But on the other hand, there is a need for investment in almost all areas of the Philippine economy, so as to foster growth. Doing both seems a near-impossible trick, while oil and food inflation make matters harder still.

But Purisima, who projects an enthusiastic calm, is full of ambitious targets  – not least a sovereign upgrade to investment grade. He points out that a 3.74% deficit was actually better than the country’s 3.9% target last year, and that this year’s target is 3.2%: Ps300 billion, but coming down. The long term aim is to get it down to 2% of GDP by 2013.

But must that come at the cost of impeding vital spending? He says not. “When that [his 2% target] happens, our interest to GDP ratio will go down, creating more fiscal space for additional investment,” he says. “And when you do that, you get into a more virtuous circle. Our hope is we will be rewarded with an upgrade to investment grade.”

At a time when the US, Japan and a host of European economies are staring down the barrel of a downgrade, Purisima’s hopes seem unusual. But he’s not that far out of line, and indeed Fitch Ratings upgraded the sovereign to BB+, the highest level before an investment grade rating, in June. Standard & Poor’s and Moody’s are the next notch down. Purisima is a keen student of peer country economic indicators, and sees a mismatch: for example, debt to GDP, at 56.5% in the Philippines, is almost identical to India’s 55.9%, yet India is investment grade. Furthermore, if a sinking fund for bond redemption is netted out, he says, the real figure is just 43%. “We have never defaulted in our long history,” says Purisima. “We have proven to be good creditors. And all our numbers have been improving dramatically: foreign exchange reserves are at historic highs, NPL ratios are below 3%, our industries are growing and we have a favourable demographic.”

“The market is already allowing us to borrow at close to investment grade prices,” he says. And an upgrade would have a dramatic impact on the Philippines. “The flow of investments will increase, more jobs will be created, more taxes, less deficit, and less debt. That will be crucial in reducing poverty in the Philippines.”

Analysts do see some progress. “The budget deficit has improved a lot,” says Luz Lorenzo, economist at ATR Kim Eng in Manila. “This year in particular it’s way below what the government was targeting.” But she doesn’t accept that it’s come without reducing spending. “It’s mainly because spending has actually been contracting. Revenues are growing, so that’s fine, but spending has been cut drastically.” Since the government has pledged no new taxes, the best way to reduce spending without reducing growth is to cut corruption, and that has been the government’s focus to date.

Will that be enough in the long run? “Fiscal consolidation is important to ensure that debt levels come down further,” says Prakriti Sofat at Barclays. “Rating agencies are also focusing on the fiscal/debt trajectory closely. The administration is going after tax evaders and we are seeing some traction with revenue growth being robust.” But she is not sure the tax promise is sustainable. “In order to really boost the tax to GDP ratio to create the fiscal space to increase infrastructure spending, our sense is that some increment in tax will be needed.”

One of the ways in which this government, and others before it, have sought to improve the lot of the Philippines has been to increase the role of the local currency, the peso, in debt markets funding. In July – subsequent to our interview with the finance secretary – the Philippines completed a record peso bond exchange, which extended maturities by an average of two years. More than Ps100 billion of shorter-dated notes were exchanged for new 10.5 and 20-year bonds, which had the dual effect of freeing funds for investment today, and improving liquidity at the longer end of the curve in the Philippines generally. It was the sixth such swap the Philippines has attempted, and they are proving increasingly successful: a previous deal, in December, attracted Ps50 billion of demand for a 2020 bond and Ps150 billion for 2035, in stark contrast with a local currency swap deal launch in Indonesia around the same time, which failed.

In July another exchange was announced, this time from dollar bonds into global peso notes, in an attempt to reduce further the foreign debt load. Already, the yields on local currency debt are looking very favourable, from a state perspective: 4.68% on its January 2016 bonds in July, compared to well over 6% earlier in the year.

When we spoke with Secretary Purisima, he said the aim was to borrow 73% of funds in pesos in 2011, and 27% from foreign markets, compared to 67/33 the previous year – which was, itself, a heavily local split compared to previous years. Purisima says his long term goal is for foreign currency debt to account for just 20% of total national debt.

“In the first months of the Aquino administration we have floated peso bonds twice: once for 10 years and once for 25, the first in Asia to do so,” he says, referring to the December fundraising (as the July swap took place after our interview). “We plan to continue to do that, especially for liability management.”

These efforts have impressed the investment community. “The Aquino administration has a clear strategy to improve the debt dynamics of the sovereign by not only reducing reliance on external borrowing but also making a concerted effort to diversify the sources of funds and extend duration of debt,” says Sofat at Barclays. And it’s not just handy because it alleviates foreign exchange exposure, but has a potentially very important impact elsewhere.

One of the reasons Purisima is so keen to shift to peso funding is because he believes a long-dated curve in pesos will help with infrastructure development. “Opening up the 25-year market was a move in preparation for infrastructure financing. That will allow project proponents to fund projects in pesos, matching their revenues in costs.”

This is a familiar subject in the Philippines – and frankly one that causes foreign investors to roll their eyes. Successive administrations have shared grand visions for public private partnerships and infrastructure finance in the Philippines; most efforts have foundered.

The Aquino government is no less optimistic than predecessor governments; Purisima says there are 73 PPP projects in a preliminary list, to be updated each quarter, with a thrust in tourism, airports, roads and ports, along with energy, mass transit and tollways. There are also PPPs planned in education and hospitals. “It’s a broad effort,” he says. “We are confident we have made enough changes in our PPP framework to make it attractive.”

What changes? Examples include Aquino guaranteeing that approvals will come within six months for solicited projects; a steady pipeline of projects (“so that companies will be willing to invest in a theme in the Philippines, knowing that if they lose in one project there will be others to follow”); the opening of the capital markets to longer term borrowing; greater transparency; and centralizing the unit for processing approvals under one roof. “We are doing a lot of things. The Philippines is now open for business under management, better governance, and an environment that offers a great future with the integration of Asean.”

That’s the sort of quote that’s designed to wrap up interviews, and indeed articles. But not everyone shares his enthusiasm. Asked what is happening in privatization, Lorenzo says: “Nothing. This is the biggest disappointment from this government.”

But, that said, she hasn’t given up on them. “On the other hand, they say they want to get it right. The PPPs are actually an offshoot of the BOT programs from before, so it’s not as if this is totally new; in the past it has been filled with corruption, with a lot of unnecessary spending, and they want to get it right and to make sure the right safeguards are in place. That’s a valid reason.” If it results in proper projects, then the slow progress can be understood, she says. “If you have to face up to delays in projects but the trade-off is that they will more efficiently administered, with spending that is more productive than in the past, then that’s a good trade.” There is something of a precedent here: privatization in the power industry was expected to bloom after legislation was passed in 2001, but nothing happened until 2004, and even then only with small plants. “People were asking why it was such slow going, and they said: we were trying to get it right. Then the sales became much faster and there’s no taint of corruption in those transactions.” It will be a while before it becomes clear if the government is going slow to get things right, or just going slow.

Another challenge the Philippines faces is inflation. It’s not as intense as in some places in Asia, as the country has enjoyed strong rice harvests and so has had relatively stable food prices, but fuel is a consistent challenge. Purisima says he believes the Philippines is “ahead of the curve”, but Bangko Sentral ng Pilipinas opted to keep its policy rate steady (at 4.5%) at the last meeting when some, like Barclays, had expected a hike. After the meeting, the assistant governor of the BSP called policy setting “a balancing act”, between price pressures and supporting growth. It is also concerned about, to use his words, “a flood of inflows”, and inflation is running above the bank’s 3-5% target, though it forecasts a full-year number of 4.7%. In truth, the Philippines is being saved from greater inflationary pressure by a strong peso and a weak dollar, mitigating the cost of imported items. And since that clearly can’t be relied upon forever, Aquino has pledged to improve agricultural productivity, something that is probably going to need greater access to financing among farmers and a lot more investment in irrigation. “If there is going to be sustained pressure, it will have to be productivity that delivers,” says Purisima.

Aquino took power with the largest ever mandate of a Philippine president; so what’s he doing differently? Purisima says his priorities are corruption, infrastructure and some policy issues. Previous administrations have already proven the country is quite capable of building strong new industries out of nowhere: BPO outsourcing is the obvious example, but it’s increasingly true of shipbuilding too. And, beneath these images of Boracay and Bohol, it’s clear that tourism is being relied upon to deliver a lot of growth. Purisima calls it “a low hanging opportunity”, partly because he expects the number of traveling Chinese tourists do double to 100 million, “and the Philippines is well positioned to take advantage of that.” The skies around Metro Manila have been opened to allow new airlines to fly in – Air Asia will be the latest example, following ANA – and there is an initiative to position the Philippines as “right in the centre of the coral triangle”, as Purisima puts it. Much of the proposed infrastructure PPP work revolves around infrastructure to drive those tourism arrivals.  “The beauty of tourism is it is 100% value added,” he says. “Jobs will be created all over the Philippines, in rural areas where poverty is highest, and you have multiplier effects into food, services and tourism. We’re hopeful our 3.5 million tourist arrivals will double within a short period of time. There’s no reason why we can’t reach that number.”

Purisima is also pinning a lot on integration of Asean, where he claims a level of seamlessness which is not always apparent to the outside world. “You’ve seen it in the electronics industry,” he says. “People used to say our industry was not sustainable because the supply cluster and the customer cluster were not there. But it’s one of the 11 industries to be integrated in advance of 2015 integration, and now moving products from Manila to Penang to Singapore is like moving them from Chicago to the Silicon Valley. It’s harmonized. It’s all efficient now.” He is clearly a believer in Asean as a powerful, homogenous bloc. “ You’re going to have an economy worth $1.6-1.8 trillion, a very favourable demographic. And the Philippines is very well positioned to participate in that: we have a 100 million population, who are very mobile – 10 million of them are outside the Philippines right now – and speak English.”

This brings us to the extraordinary Philippine diaspora: Lorenzo estimates that remittances from overseas Filipinos make up 12-13% of national GDP. And it’s the very first thing she mentions when asked about threats to the Philippines. “The main concern right now is the appreciation of the peso because we have such a huge dependence on our overseas workers.” She’s also troubled to see Saudi Arabia seeking to use more Saudi nationals rather than migrant workers; a wider use of that policy could have a significant impact on the Philippine economy.

So is the juggling act of reducing the deficit, maintaining spending and not raising taxes achievable? It all depends on how successful Aquino is in cutting corruption from the system. “The drive to reduce corruption is the main platform of this government, and an important one,” says Lorenzo. “When investors talk about the Philippines, one of the usual complaints is the level of corruption: the difficulties and high costs involved in doing business here. If it is reduced, it may be a catalyst for the Philippines finally making it on to foreign direct investors’ maps.”

Thailand will dissolve its parliament next week, setting the stage for a July election that will judge whether the government has succeeded in tackling the issues that led to violent protests last year.

Areepong Bhoocha-oom, Permanent Secretary of the Ministry of Finance, told Emerging Markets that the final cabinet meeting had taken place on Tuesday and that formal dissolution was waiting on the signature of the country’s king, who is in hospital. Once parliament is dissolved, the election will take place in 60 days, suggesting early July.

“Up to now the main issue is about the wealth of the people and inequality of income,” Mr Areepong said. “The government is attacking this issue to narrow the gap.” He said that specific measures included reducing the influence of loan sharks so as to lower people’s debt burdens, and widening the country’s social safety net. “We have about 40 million people in the labour force, but only 10 to 15 million – not more than 30% – are in the system” of unemployment benefits and retirement funds, he said. New laws aim to broaden coverage of social security.

He also highlighted development of microfinance to increase financial inclusion, and investment in irrigation to support the country’s farmers who were the backbone of last year’s protest movement. “A massive amount of money needs to be put in,” he said. “Thailand is already the top exporter of rice; in the future, if we do this, we can do alternative agricultural products and be much more productive.”

The question is whether these measures are enough, or in time, to convince the doubters who will go to the polls in July. “It takes time,” Mr Areepong said. “There are definitely certain groups of people where the message has not got through enough. That’s why there will be an election: we will see how we have done.”

While Thailand has had a volatile time socially, its finances have rarely looked better and it remains well-regarded by foreign investors. Its stock market was up 34.3% in the 12 months to May 3, the best in the Asian region and the best of any significant market worldwide bar Argentina. Thailand grew 8% (Areepong refers to “real growth” of 9.7%) in 2010 – the year that included much of the unrest – while both FDI and foreign portfolio investment have remained strong. As a food exporter Thailand was on the right side of commodity price rises, although oil price hikes have had to be insulated through a subsidizing oil fund. Also, crucially for Thailand, tourist numbers have revived. “If this peace keeps going on, this year we will register good growth,” Mr Areepong said.

The oil fund is not, though, a sustainable measure in its current form. “At inflationary times, this kind of mechanism is helpful,” Mr Areepong said. “But the fund will run out if this keeps going on. Hopefully by that time the Middle East will settle down and the oil price come down.” If not, he said, a task for the new government would be to tackle that issue. “We have started saying the price will have to reflect costs more.”

Oddly, analyst attention on Thailand has focused less on the election, or Thai-Cambodia border conflict, than the Japan tsunami. Thailand’s automotive industry is closely linked with Japan’s. Nomura analyst Tomo Kinoshita said he had worked out a simulation of the impact of a 50% reduction of automobile production by Japanese auto manufacturers in the second quarter and found that real GDP would be cut in Thailand by 1.3 percentage points if it happened. Mr Areepong acknowledged that car manufacturing would be hit, and that a previous target of producing two million cars this year would not be met, but expected to produce 1.8 million nevertheless.

One of the many initiatives that would follow the establishment of the CMA was a requirement that all Saudi financial institutions hive off their asset management, brokerage and investment banking units into separate entities, and in the wake of that it set about issuing new licences both for established players and new ones who wanted to set up these investment units. It swiftly became clear that it was going to issue plenty of them. From eight authorised persons – the formal title for licensed bodies – at the end of 2005, there were 45 by the end of 2006, 80 by 2007 and 110 by the end of 2008. A peak was hit that year – 12 more were issued in 2009, but 12 more revoked, leaving the final number the same – and while the CMA does continue to issue new licences, such as to Lazard Saudi Arabia last June and QInvest in January, today the AP list runs to a more modest 92 and is expected to come down from there.

So far this year, far more CMA announcements have been about cancellation of licences than issuing of new ones. Financial Transaction House, which grew out of the corporate finance arm of Anderson Worldwide and was one of the very first to be licensed in June 2005, had its authorization as an arranger and advisor on securities cancelled in April; Assets Financial House Company, another early licensee back in 2006, went the same way in March; and Arab Experts Capital and Kuwait’s The National Investor had their licences cancelled in February. In each case, the CMA said this was at the company’s own request. Elsewhere there is consolidation, such as the merger of CAAM Saudi Fransi and Calyon Saudi Fransi into Fransi Tadawul, which was then re-named Saudi Fransi Capital. The whole thing is affiliated with Banque Saudi Fransi, which in turn is 31.1% owned by Credit Agricole. Others are amending their licences, such as GIB Capital, which in April had its Dealing as an Agent licence replaced with a Dealing as a Principal and Underwriter licence.

Further consolidation is seen as inevitable. “There are way too many players at this point,” says Jawdat Al-Halabi, CEO of NCB Capital. “The market is big enough to manage a good number of players, but the issue is that from my perspective everybody wants to do everything. That is not sustainable and I believe we will see consolidation and a rationalization of services.”

“When the split between the commercial banks and investment banks took place, it was followed immediately by the crash,” he adds. “So most companies, still in start-up mode, faced an extremely difficult time.” If, as some expect, the minimum capital levels are increased for the investment banking industry – they’re already high by international standards on the commercial banking side – then that is likely to thin the field further. “It will remain to be seen if every player is willing to commit additional capital, because that’s going to require a return,” says David Dew, CEO of SABB.

Five years on from the beginning of the new licensing process, Euromoney asked three CEOs of investment banking businesses spun off from established heavyweights how the market had changed for them, and where the opportunities lie today. In some sense these are the groups that had it easiest: they had established businesses to start with, and they could continue to use the branch networks of their affiliated commercial banks as a way to source customers.

NCB Capital, for example, came out of National Commercial Bank, and was the first investment banking arm of a local institution to be approved by the CMA in 2007. Among other things, this group was behind the Al Ahli mutual fund range, which remains the biggest in asset terms in Saudi Arabia and the region as a whole; all told NCB Capital now has over a million clients and US$15 billion under management. Al-Halabi likes to believe that “we do not rely on what we had from our parent,” and points to new funds and a discretionary portfolio management business that have been built since separation, but acknowledges “NCB were the pioneers of this business.”

Correspondingly, wealth management is the biggest growth area for NCB Capital, including asset management and wealth advisory. “We are the Kingdom’s largest manager of wealth and this is where our greatest opportunity is today,” Al-Halabi says. He also sees potential for growth in brokerage, and in underwriting sukuk issues. “It’s still a nascent market but the need to issue sukuk to finance projects and companies is growing, and there aren’t that many players focusing on that.”

Al Rajhi Capital came out of Al Rajhi, the largest Islamic bank in the world by assets. Its CEO, Gaurav Shah, tries to develop his asset management, brokerage and investment banking businesses in tandem. “The challenge for me as CEO is to ensure that we have the right business mix: enough stable annuity income from asset management and brokerage, with a healthy business pipeline within investment banking side, which is more deal-focused,” he says.

Another house with a long-established asset management business – he puts the group’s market share in Saudi Arabian mutual funds at 9.2%, with a near doubling of assets in the last two years – Shah also sees this as one of the key areas for growth. “Diversifying the client base is very important, and there are emerging new clients,” says Gaurav Shah, CEO of Al Rajhi Capital. “If you look at the west, insurance is the backbone of the asset management industry; it’s still an emerging sector in Saudi Arabia. I’m very positive about the contribution of this sector to the growth of the local asset management industry.” Al Rajhi has made a point of trying to bring international appetite into Saudi Arabia too, and launched a Saudi equities fund in Luxembourg recently on the Credit Suisse platform.

Another theme is diversification by asset class and product. “To achieve greater diversification and predictability of returns, you need a developed fixed income or sukuk marketplace combined with a multi-asset class approach to investors. It is essential for product providers such as us to offer investors this choice and a more diversified offering,” Shah says. He sees the biggest challenge in asset management not so much as other competitors, but the nature of investors themselves. “When 10 to 12 companies account for 60 to 65% of market cap, a lot of investors feel they can invest on their own. Building a managed investment culture, which asset management provides, takes time.”

To Shah, investment banking has some distance to go, though he feels advisory is a growing trend. And he believes opportunities are growing in institutional brokerage rather than just the retail area that has been the focus to date.

And what of Islamic? Al Rajhi is one of several purely Islamic banks in Saudi Arabia, and is often considered to be among the most strict Islamic institutions in the world in terms of compliance. It’s clearly a point of difference but Shah is keen to avoid that being the only selling point. “We compete with conventional and Islamic banks based on our products, people, processes and the risk-adjusted returns we aim to generate on a long-term basis,” he says. “Competition is always fierce and the product selection is always based after benchmarking with the entire industry – Islamic and conventional.”

Nevertheless, the momentum of Islamic finance in Saudi Arabia is overwhelming, particularly on the retail side (HSBC estimates 80 to 90% of retail banking product is now Islamic); with every passing year it becomes a more dominant force in the mutual fund industry. And providers say it is becoming an institutional story too.

HSBC Saudi Arabia was in the first round of newly licensed entities under the CMA, spun out of SABB, which was formerly known as Saudi British Bank. HSBC owns 40% of SABB; SABB in turn earns 40% of HSBC Saudi Arabia, and HSBC the other 60%. Walid Khoury, the chief executive of that business and formerly SABB’s treasurer, is building the business on the foundation that HSBC is both a global institution and one with a long-standing historical attachment to Saudi. “The mission as we view it is to bring international expertise to Saudi Arabia, and bring international connectivity to Saudi customers through our network.”

Khoury believes that “the deal flow does not justify that very large number” of APs in Saudi Arabia, and expects M&A among them. He notes that “the premise from which a lot of APs started – being everything to everybody – is not tenable in the long term.”

For institutions like these, it will be interesting to see how the internationalisation of the Saudi capital markets continues in years to come. It has already opened some distance: until recently foreigners could only get access to the Saudi stock market through mutual funds, and even then were restricted. Now a swap arrangement allows for synthetic exposure to Saudi securities. “In coming years there probably will be an opening,” says Khoury. “Right now foreigners can have access to the Saudi stock market through swap products, but a lot of fund managers cannot use these instruments because they are deemed as derivatives. They have to have direct access, and we believe over the next few years that will happen – with some rules, of course, like in some other markets around the world.” When it happens, Khoury says, “it will bring new institutional money, and more stability, as this money will be sticky if it is coming from long-only managers.” From that would follow entry into world stock market indices, a corresponding weight of capital, and a great deal more business for the brokerage operations of all these competing operations in Saudi.

Al-Halabi says “the opening of the market is a great thing and will expand the opportunity here,” but adds: “doing it gradually is in my view very prudent. You don’t want to create chaos in the market. We know the CMA is heading towards more openness, but you will not see it all in one go.”

At the same time, domestic institutions are becoming increasingly savvy. The Saudi Arabian Monetary Agency, the country’s central bank, fulfils some of the roles of a sovereign wealth fund but is generally conservative and fixed income-dominated in its allocations. But newer state investment entities, such as the endowment fund of the King Abdullah University of Science and Technology, are already becoming known for a sophisticated approach to questions of asset allocation and investment technique. Much of this capital will flow overseas – indeed, the whole business model of many of the foreign businesses licensed by the CMA is to assist it in doing so – but the increasing savvy of local capital ought also to support the sustainability of the industry.

For the long-standing commercial banks, less has changed. “The pace of change in commercial banking is slower than in the investment banking arena,” says Dew. There are some relatively new players – Bank Al Bilad and Alinma Bank being the main ones – while some subsidiaries of foreign banks are attempting to enter wholesale banking and develop corporate and treasury businesses, catering for the biggest companies in the country. “So there’s some level of increased competition for sure, but not as extensive as on the investment banking side.”

Here, too, the sense of growing openness is a prompt for growth. Dew is on a second stint in Saudi having been chief operating officer from 2001 to 2004. “There is no question from an economic perspective Saudi is now more open,” he says. “Trade and investment flows in both directions are significantly stronger and the core economic strategy of the country does make a huge amount of sense.” That is, at its core, an oil and gas story, with an increasing downstream element in petrochemicals, but increasingly mining and minerals are being developed along with financial, shipping and other supportive sectors. “The economy is playing to its strengths and engaging with the rest of the world on its own terms,” he says.

Across the board, there is pressure on headcount. One person who used to work at an executive level in Saudi Arabian banking considers this the biggest problem the industry faces. “The banking system remains shambolic,” he says. “There are poor levels of human capital, very high staff turnover, and high levels of absenteeism and lack of engagement, driven by Saudization [a national policy to increase local Saudi employment in the private sector], generous pensions and CMA requirements for qualified staff.” This last, he says, “should be good, but it has ignited a bidding war for the very small pool of talent. And the Arab Spring is likely to further deter new talent arriving without further pay rises.”

While bankers on the ground today agree that competition for talent is still intense, many feel that it was at its worst when the new licences were being awarded en masse between 2006 and 2008, not now. There is also widespread agreement that the talent pool is better than people think. “In Saudi there is a huge focus on education,” says Shah, “with very, very bright local Saudi talent. You have to compete to retain people, but that’s not special to Saudi: you have to create the right work culture, training opportunities and sophistication of product so you are where everybody wants to work.” Khoury at HSBC says “there is very strong competition and a strong bid for Saudi talent”, but says firms like his have developed programs to grow the available pool, hiring graduates fresh from universities and training people “to make the leaders of tomorrow. Salaries and packages have evolved normally; they’re not that different from what we might see elsewhere.” David Dew on the commercial banking side at SABB says “we continue to get a reasonably good supply of Saudi graduates: the quality is good and probably getting better every year. We do see that as talent emerges it has more and more opportunity; people can move up fairly quickly and can begin to command pretty attractive packages. The starting point hasn’t changed a great deal, but competition for talent and the leaders of tomorrow is quite intense.”

Al-Halabi agrees. “The key issue is to have the right environment for our people, their development and training, and the right compensation for the team,” he says. “New entrants with deep pockets can buy anybody. But if we, as an industry, want the financial sector to grow and be successful, everyone should be willing to invest in developing local talent.”

BOX: Saudi and regional unrest

As soon as it became clear that the protests in Tunisia and Egypt were spreading around the Middle East, investors started casting a nervous glance towards Saudi Arabia.

“The biggest risk to the market is the possibility of political unrest reaching Saudi Arabia,” says Joe Kawkabani, chief investment officer for MENA equity at Franklin Templeton Investments in Dubai. But his fears – from the perspective of investor stability – haven’t been realised. Pro-democracy campaigners announced intentions to protest on Facebook, attracting thousands of followers, but fewer turned up for protests on the ground. Subsequent attempts have attracted fewer and fewer people. The government tightened security, and – crucially – religious scholars issued statements outlawing protests in the country as unIslamic. “It’s important to note the big role the army and clergy play in the country,” Kawkabani says. “When the government, army and clergy are aligned, it’s very hard to implement change.” Behind the scenes, King Abdullah also held meetings with tribal chiefs, many of whom subsequently pledged allegiance.

To cement all this, on March 18 the King announced a series of measures designed to head off any dissatisfaction before it got going. He set a new minimum wage of R3,000 (US$800) for all Saudis – a 38% increase; announced a bonus of two months wages to all government employees and students; new unemployment benefits; 60,000 new jobs in the military; and funds to construct 500,000 new social housing units. In total, it has been reported that these measures involved some $93 billion of spending. And this all followed $37 billion of handouts the previous month. “The reaction on the streets was overwhelmingly positive,” says Kawkabani. “The next day was a public holiday and people were driving around waving pictures of the king.”

None of this is the democratic reform that has been called for in other Middle Eastern states, but it appears to have been enough to keep the population content for the moment, and does have broader economic knock-on effects. “It’s beneficial to the economy and will promote consumption and bank lending,” says Kawkabani. “The only downside we can see is wage inflation across the country.”

With a soaring oil price and foreign exchange reserves of over $400 billion, it’s not hard for Saudi to spend its way out of trouble. And few on the ground feel any sense of political change. “What’s happened in the region in the last three months does impact investor sentiment, but we strongly believe the fundamental outlook and trend over the next four to five years in Saudi Arabia remains solid and has not changed,” says Shah.

Al-Halabi agrees. “With all these things that have been happening around us, I was worried we would see flight of capital,” he says. “On the contrary, we have seen little of that.” And Dew at SABB speaks of “a mood of cautious optimism and stability. There are headwinds but there are more reasons for a positive than a negative outlook, and the sense is that is mirrored by our customers.”

Qatar is just weeks away from finding out if it will be included in the MSCI Emerging Markets index – a potentially pivotal event not just for the country’s stock market, but the whole GCC region. The Gulf has long been an oddity in index terms: prosperous, developed and resource-rich nations that don’t feature in major world benchmarks. Finally, the anomaly may be about to be corrected.

Gulf markets have been missing for a variety of reasons. Saudi Arabia, much the biggest and most liquid, can only be accessed by foreigners through a swap structure, which counts it out of major indices. Kuwait has accessibility issues too; and most of the rest have been deemed too small, too young, and often restricted as well.

But last year MSCI served notice that things could be about to change. The index provider reconsiders where countries fit in its indices once a year in its annual market classification review, completed at the end of May each year and announced in June; any changes then take effect a year later, giving markets and fund managers time to adjust. Last year, MSCI declined to move Qatar and the UAE from its frontier markets index, where they reside today, to the closely-followed emerging markets index. But it declined in such a specific way that the signal was very clear: deal with the issues we’ve identified, and you’ll be in next year.

In Qatar’s case, MSCI highlighted two things: strict foreign ownership limits (there is a 25% ceiling), and the frequent use of dual account structures, with segregated custody and trading accounts. The use of these structures, MSCI said, “because of unlimited access by local brokers to trading accounts remains an issue that needs to be addressed for the market to meet emerging marker standards.”

There’s a lot to be gained from market inclusion. Ryan Salam at Franklin Templeton Investments estimates that Qatar would take up 62 to 100 basis points of the MSCI Emerging Market Index if included, and since about $400 billion of institutional capital tracks the fund, that would translate to $2.5 billion to $4 billion of capital coming into Qatar (the UAE, by contrast, would get about $1 to 1.5 billion). “If you look at the last six months trading, that translates to a 70 to 100% increase in traded value in Qatar,” he says. “And if you assume all emerging funds are to track the index you can more than double those numbers.”

Qatar Exchange could clearly see the opportunity, and set about a review of its market infrastructure, upgrading its trading technology in September and then announcing a key new reform on March 17. This is the adoption of the Delivery Versus Payment (DVP) rules. These rules allow custodians to participate in the cash settlement cycle, and to confirm or reject trades for settlement, with rejected trades remaining with the broker for settlement. This means that custodians have full control of their securities – and so the dual account structure that MSCI objected to becomes optional (though it is not being removed outright). This was clearly done to comply with MSCI concerns – indeed, the potential upgrade was explicitly mentioned in the exchange’s March statement – and will be followed by other reforms: the exchange mentions a central counterparty, direct market access through sponsored access, securities lending and borrowing, margin trading and covered short selling as possible further innovations. “I strongly believe that Qatar will be included to the classification this year,” says Abdul Hakeem Mostafawi, country head for HSBC in Qatar – which, as the only custodian bank in the market, has been instrumental in the reform process and has been working with Qataris public institutions on the MSCI issue since 2007. “Every passing year the market has improved its systems and possesses growing investor confidence. The Qatar market has been able to live up to its promises and has been able to deliver on time.”

There hasn’t, though, been any mention of a change in foreign ownership rules, which is partly because it’s not the exchange’s place to change them. Instead, some close to Qatar believe that the foreign ownership limit could be lifted – perhaps to 49% – by an Emiri decree before the end-May deadline, that being the quickest way to get such a change through. Others are less sure. “There is still sufficient headway for foreign investments,” says Mostafawi. “I am confident during the coming months listed companies will work on improving their foreign ownership levels. Increasing the foreign ownership levels freely could have an adverse impact on the entire market. Therefore it has to be done systematically.” But others feel that, particularly if foreign ownership is perceived to be a deal-breaker, Qatar’s rulers are likely to think raising the limit a sacrifice worth making.

Salam says it’s not the end of the world if Qatar is not included. “There hasn’t been much chatter about it until last week, and it hasn’t been priced in,” he says. But it has become another reason for more and more investors to start to look more closely at the island state. Until now, global fund managers with any interest in Qatar – or any Gulf market – have had to express it through an off-index bet, which is a risk and an effort. Inclusion would not only alleviate that effort but also make it essential for global emerging market managers to consider the market. Under that arrangement, omitting Qatar would become the off-index bet instead.

Qatar has found itself in something of a sweet spot, and sometimes for unexpected reasons. The headlines are well known: one of the world’s largest bounties of natural gas, 16% GDP growth in 2010 which the IMF expects to grow to 20% in 2011, compound annual growth rates of 40% and 53% respectively in imports and exports between 2006 and 2009, and a diversification strategy anchored by $145 billion of projects over the next seven years. That’s before one considers the trophies: the successful World Cup bid for 2022, and the somewhat brazen asset-gathering approach of its sovereign wealth fund, the Qatar Investment Authority.

But on top of that, unrest elsewhere in the Middle East has, if anything, served to help Qatar so far, particularly in comparison to neighbouring Bahrain, which until this year had built much of its prosperity on being a peaceful entrepot through which to serve the far bigger economies of Saudi Arabia and Kuwait. When the region’s landmark asset management conference, Fund Forum, announced that this year for the first time it will be held not in Bahrain but in Doha, it underlined the sense that Qatar (like the UAE) has been able to gain some of that stable and steady reputation. Qataris are, to be blunt, absolutely loaded: the country had the world’s highest per capita GDP in 2010, according to the IMF, and the wealth is distributed more widely than is sometimes the case elsewhere, with housing grants upon graduation, free land and amenities and almost 100% employment rates. There is little reason to revolt in such an environment, but the Prime Minister has nevertheless announced some changes in the elected parliament system to head off challenges; unlike Bahrain, it doesn’t face the issue of a minority group ruling over a majority (in Bahrain’s case, Sunnis ruling a majority Shia population).

“In my view, political stability in Qatar is very positive and will continue for the foreseeable future,” Mostafawi says. Indeed, following on from Qatar’s role hosting peace talks about Libya, he believes the country may be gaining a role as a moderator and mediator. While not all are quite so optimistic, there’s no question Qatar has escaped much of the unrest elsewhere in the region. Youssef Nizam, head of equity research at Audi Capital Saudi Arabia, sees the country’s size and GDP as clear assets. “They have deep pockets to tap, and with a small population it might be easy to minimize – not avoid, but minimize – political risk coming from unrest,” he says.

Nizam has made Qatar his key overweight. “The major reason is the GDP growth,” he says. “Qatar has made huge investments into the natural gas business and many investments are starting to materialise now and will be reflected in the economy. It is a country rich with resources but small enough to be able to deploy those resources within the country: a small prototype that is easily manageable compared to other countries in the region.” With MSCI inclusion, Nizam says, “definitely the multiples will tend to expand. It will be more covered by foreigners and Qatar will have its share of the huge inflow of funds that tracks the index. It will definitely be a positive catalyst.”

This coverage point is one of the many slow-burning benefits inclusion would bring, and in some senses the main one. “A lot of people are already cognizant of how attractive Qatar is economically,” says Emad Mansour, CEO of Qatar First Investment Bank, “so I’m not sure it’s going to lead to a major movement of assets into Qatar in the short term. But in the medium to long term I think it means the market becomes more in focus, with more companies covered by the big brokerage houses.”

MSCI inclusion would also be a major shot in the arm for the Qatar Financial Centre, which has so far not attracted the same volume of foreign institutions as has the Dubai International Financial Centre (though whether the DIFC has succeeded in bringing in much foreign capital, as opposed to helping foreigners to take capital out in the other direction, is a different question). The QFC shifted its focus some years ago to a focus on insurance, reinsurance and asset management, and on the last of these MSCI inclusion would clearly help. “Developing Qatar as the pre-eminent hub for asset management in the region is one of the Qatar Financial Centre Authority’s key strategic objectives,” says Yousuf Al-Jaida, director of strategic development for asset management and banking at the QFCA. “Qatar’s accession from frontier to emerging market status would therefore be hugely beneficial in delivering that aim as well as a big endorsement of what has already been achieved in Qatar developing world-class regulatory and financial market infrastructure.”

Al-Jaida says allocations to MENA-wide assets are going up already, and that MSCI inclusion “will clearly add a lot of momentum to Qatar’s financial services industry. We expect the long term upside for volume growth in assets management out of Qatar to be significant, beyond the direct benefits to the Qatar Exchange itself in terms of liquidity and capital inflows.”

BOX: Knock-on effects

If Qatar does get MSCI approval this year, it may well be joined by the UAE. Last year MSCI said it “continues to be encouraged by the planned future enhancements by the Emirati regulator,” which included increased foreign ownership limit levels, equal foreign access to the local equity market, and a DVP settlement system like Qatar. MSCI noted, though, that “these future enhancements were announced some time ago”, and that “international institutional investors are hopeful that [financial turmoil] will not bring any further delay in the implementation of the proposed enhancements. Investors would also welcome a public roadmap from the regulator and the exchanges providing visibility on the timetable of implementation of these changes.”

At the time of writing, the UAE was continuing to make the right noises but appeared to be behind Qatar in implementing changes. It is now running short of time, but fund managers in the region think the benefits of inclusion are such that the necessary changes will be made. The fact that the UAE has historically had three separate exchanges adds some complexity but is not considered likely to be too problematic as the MSCI has never raised it as an issue before.

An interesting question is whether the demonstration effect of new inflows coming into Qatar or the UAE, if included, could prompt others to act. Kuwait used to be considered a likely candidate for index inclusion, but the MSCI last mentioned it as a candidate in 2009, and then said access restrictions were too difficult. Might Kuwait change those restrictions in order to join GCC peers in the market?

But the bigger question is about Saudi Arabia – by far the largest economy and stock market in the Gulf. There has been a gradual opening up of the Saudi market to foreigners: where once they could only get access by buying mutual funds (and even then under some restriction), they can now get exposure to Saudi stocks through swap arrangements. This is some way short of the direct access that index providers would require, but clearly a step in that direction.

If Saudi did further liberalize, there would still be one headache to resolve: the fact that MSCI and Saudi Arabia are scarcely on speaking terms following a dispute about commission, royalties and licence approvals. That, though, is probably an argument for another day.