Published Date: 19 February 2008

Keynote Address by Mr Heng Swee Keat , Managing Director, MAS, at the IMAS 9th Annual Conference

Financial Turmoil: Challenges and Opportunities in Asia for Asset Managers

Distinguished Guests, Ladies and Gentlemen

1   It gives me great pleasure to join you at this IMAS’ 9th Annual Conference, and to join so many prominent speakers. This conference aims to examine the changing face of investing in Asia. This is timely, given the recent turbulence in financial markets, as well as the economic transformation in Asia. I will touch on these two themes, and the implications for asset managers and policy makers.

2   Markets and perceptions of economic outlook change rapidly. This time last year, the global economic outlook was positive. Today, it has become a lot more uncertain. What started as a housing market correction quickly led to large losses for investors in mortgage-backed securities (MBS). This triggered a loss of confidence in the wider structured-credit markets, where risk premia rose sharply, and liquidity conditions worsened. As the crisis unfolded, even markets where the foundations had been sound became destabilised. The effect was widespread across equities, bonds, forex, and interbank markets. More recently, attention has shifted to where new pockets of risks may be, where vulnerabilities may have built up but losses have not come to light. The focus is currently on monoline insurers, and the damage they could inflict on the bond and credit derivatives markets should there be further ratings downgrades.

3   What is striking is that the securitisation of loans was meant to be a mechanism for risk transfer. Instead it became a channel through which shocks are amplified and transmitted throughout the system in unpredictable ways. These shocks have now started to have an impact on the real economy. In the US, the housing-sector correction is leading the slowdown in the economy. Consumer spending is constrained by high debt levels. Financial institutions have sustained large losses. And this is driving the turn of the credit cycle, which means restraint on both consumer spending and corporate investments.

4   Indeed, at this point there is a risk of being caught in a negative spiral. Tightening credit standards and reduced credit availability will be mutually reinforcing with the slowing of the macro economy. The extent to which this spiral takes hold determines the extent of the US slowdown, and the extent to which the rest of the world will be affected.

5   Hence, the immediate challenge for policy makers is to contain the spread of the credit crisis to the real economy, to prevent this spiral. This has not been an easy exercise, as the full extent of the exposures is not yet known, and central banks face different degrees of slow-down and inflationary pressures in their economies. The complexity of the challenge at hand has fostered a recognition that we need a multi-prong approach, coordinated across jurisdictions where necessary, to tackle these challenges. The situation is fluid, and we need to remain vigilant.

6   The last seven months have not only been testing times for banks, but also for fund managers. As significant investors in the capital markets, fund managers are experiencing the impact of volatile and illiquid markets. Several asset managers with exposures to sub-prime and structured credits have folded. Several others who have been forced to de-leverage and to meet cash needs have had to liquidate positions in other asset classes, adding to the volatility, especially in the equities markets.

7   The crisis has uncovered some key structural issues that asset managers and their clients will need to address. I will highlight three of these issues. First, fund managers will need to re-assess, on the one hand, their liquidity buffer, the mode of operation and the pace of redemptions they allow their investors. While all funds have been affected by this liquidity crunch directly or indirectly, money market funds with cash-plus strategies, as well as those which are highly leveraged and reliant on short-term financing are especially vulnerable to liquidity risks. Unlike banks, asset managers do not have direct access to liquidity from central banks. Hence, liquidity management is critical in such stressful scenarios. If managers are forced to sell more assets to meet liquidity needs, this would set off further valuation declines. So far, not many funds have faced critical redemption pressures from investors. But if asset prices continue to decline, investors may react differently. This is a risk we need to watch.

8   Another issue, related to liquidity, is the valuation of complex and illiquid products. Market participants typically use three types of valuation techniques - mark-to-market, mark-to-matrix or mark-to-model. Each has its short-comings. Mark-to-matrix is typically anchored on independent credit ratings. For complex securities or in stressful environments, credit ratings can be an extremely unstable anchor. As we saw, ‘AAA’ tranches of subprime CDOs can become junk-rated in a matter of weeks. Mark-to-model relies on historical data, which by definition are backward looking and thus, perceived to be unrealistic. Mark-to-market, which is arguably most reflective of current market conditions, will nonetheless be undermined when there is market dislocation, such as now.

9   Financial institutions, asset managers and the asset servicing and accounting industry will have to develop better methodologies and standards to guide the pricing of complex and illiquid products and derivatives so as to reduce risks associated with mis-valuations. It is important that asset managers and financial institutions demonstrate that these products are being valued in a fair and transparent manner. Investors’ confidence can be restored if they are assured that valuations are reliable and the worst of the write-downs is behind them.

10   Third, with a better understanding of valuation practices and liquidity risks, a more effective risk management process can be developed. The last few months have exposed a weakness in risk management models which is that they tend to encourage herding behaviors. For instance, Value-at-Risk or VAR models are triggered by a rise in market volatility. Thus, as markets fall, volatility rises, triggering VAR limits, thereby causing more selling and further falls in prices. In other areas, credit ratings, mark-to-market stop-loss limits, margining practices, and capital requirements also carry this risk of procyclicality. In a stressful situation, this can be a source of systemic risks. Investors and managers will need to develop risk-management tools that are more differentiated and can better reflect the different orientations of different investor groups.

11   The current turbulence in the markets presents one of the most severe stress tests. The immediate priority for asset managers and other players is to get through this phase, and to re-examine many of the assumptions in our risk management practices. This work will be critical, and we need to remain focused.

12   Let me now turn to the developments in Asia and the implications for the asset management industry. How will developments in the US and Europe affect Asia? The ‘coupling’ versus ‘de-coupling’ debate has been lively, and recent market behaviour suggests rapid swings in these views. Ten years ago, few analysts would have even ventured the idea of de-coupling. That this debate is now taking place shows the extent of structural change that has taken place in Asian economies.

13   Certainly, the fundamentals of the economies and financial markets in Asia have improved significantly since the Asian Financial Crisis. Most Asian economies have large foreign reserves and current account surpluses. There is a sizable educated and skilful labour force, and a growing middle-class that forms a broad consumer base. Asian corporates and households are also in a strong cyclical position after four years of robust growth. Asian capital markets are better developed. Banks in Asia are better capitalised, have lower non-performing loans on their books, and are better supervised and managed.

14   These are significant changes. However, a long-term or structural de-coupling of Asia from the US is possible only when the economic linkages through trade, investment and finance are significantly weaker. Studies by MAS, and other economists, show that this is not the case at this stage. What we are likely to see, however, is the weaker synchronization of business cycles. The underlying momentum in the Asian economies will allow Asia to ride out the slowdown in the US if it is mild and short-lived. But a sharp and deep contraction will trigger the threshold where all economies will be affected, albeit in different degrees depending on their reliance on external demand. A significant unknown is how sharply investors’ expectations and confidence will change.

15   Hence, barring any sharp deterioration in the global economy, the short-term outlook of Asia remains generally positive. Indeed, Asia ex-Japan as a group is currently forecast to grow at a fairly healthy pace of around 7.8% in 2008, one percentage point lower compared to last year.

16   I believe that the decoupling thesis is really about the confidence that investors and analysts have regarding the structural changes and reforms taking place in the Asia economies. The story about the on-going growth and transformation of the Asia economies has not changed. This growth story provides four key drivers of opportunities for asset managers based in Asia.

17   First, Asian markets have become an attractive investment destination. Foreign inflows of direct investment into East Asia has more than doubled from its lows of US$84 billion in 2002 to nearly US$200 billion in 2006. Foreign portfolio investment inflows grew by even more, from US$15 billion to about US$130 billion in same period. Global investors have sought to diversify into Asia and have done so through the public markets, private equity and real estate funds.

18   Second, Asia’s growth has contributed to significant private wealth creation. Already, Asia boasts three of the ten largest economies in the world –Japan, China and India. The growing middle class will demand more wealth management services. For instance, some players have estimated that the penetration of mutual funds as a percentage of total household financial assets was around 6% in 2005 compared to 16% in Europe and 20% in the US. At the top end, the number of high net-worth individuals in Asia is growing rapidly. Indeed in 2006, India, Indonesia and Singapore had amongst the fastest growing HNWI populations in the world. Collectively, Asian HNWI assets rose by over 10% to reach over $8 trillion. Besides asset management services, these individuals will also demand estate management and family office services.

19   Third, as the population in Asia ages, there is greater emphasis on retirement planning and healthcare financing. By 2050, Asia’s population above 60 years old is expected to quadruple to 1.2 billion people, or about the same population as China today. While the West took many years to age, Asia is aging more rapidly. One benchmark of an "aged society" is when 14% of the population is aged 65 and above. Europe took 60 years to reach this. Japan took 24. China is estimated to take 23 and Thailand, just 18. Singapore also faces the same situation. These shifting demographics will create demand for pension, annuity and other life-cycle products. The recent introduction of CPF Life, a new annuity scheme in Singapore, is a case in point.

20   Fourth, as Asian governments accumulate foreign reserves, they will also have to reach out to fund managers to manage part of their funds. Total AUM by SWFs at this moment are estimated to be about $3 trillion. Asian central banks hold over $3 trillion of foreign reserves. There is an estimated $3 trillion of petrodollars which are seeking more exposure to Asian assets. Altogether, SWFs, particularly the newly formed ones, could outsource a significant percentage of their assets to be managed externally.

21   All these trends present substantial opportunities for the fund management industry – both in terms of inflows into Asia and outflows from Asia. During 2007, net inflows to stock and bond funds in Asia were about US$450 billion. This figure is nearly double the US$250 billion net inflows in 2006 and higher than the total net inflows in 2007 for the U.S. and Europe combined. Fund managers based in Asia are well–placed to intermediate these flows.

22   With these drivers, I believe Asia’s capital markets and the asset management sector will undergo significant developments in the coming years.

23   First, not withstanding the recent problems with capital markets in the US and Europe, Asian economies will continue to push ahead to develop their domestic bond and equities market. There will also be greater interest in a wider range of investment vehicles – venture funds, private equity, real estate, commodities and infrastructure funds, ETFs and Shariah-compliant funds. In tandem with the development of domestic markets develop, there will be greater cross- border flows. Policymakers in the region are well aware that concentrating investment in the domestic markets can fuel asset bubbles, and there are benefits of global diversification. For this reason, they are encouraging capital outflows, albeit in a controlled way. All these developments will allow Asia to create deeper and more liquid capital markets, and a smoother and stronger flow within Asia, and between Asia and global markets.

24   Second, as markets develop further, there will be greater emphasis on understanding risks – both in the inherent instruments, as well as the risk characteristics within Asia. Asian markets are diverse and at different stages of developments, and certain risks models that are adapted from developed markets may not be appropriate. I hope our universities and institutes like the Risk Management Institute can help catalyse collaboration with the industry in this area. With the growing importance of Asian markets, it will be increasingly difficult to manage investments into Asia, from outside Asia. We therefore welcome fund managers to site their operations in Asia and Singapore, not only to capture opportunities, but also to better manage risks.

25   Third, regulators and financial institutions alike will need to focus more on investor education. We need to encourage savers to invest wisely for the long-term, and to seek the benefits of diversification. Anecdotally, in many markets in Asia, the holding period (from purchase to redemption) of typical fund investors in Asia is well below two years. The industry will need to create products that are suited to investors’ long-term needs and to keep administrative and distribution costs down. On our part, MAS will commit more resources to the "MoneySENSE" initiatives and work more closely with the industry.

26   The economic environment today is challenging and uncertain. Growth in the short-term is clouded by prospects of a US slowdown and how well we contain the credit crisis. In this state of flux, central banks and financial regulators need to be on heightened alert and respond decisively to developments that might further threaten global growth or financial stability. Asset managers will also have to pick their way through these turbulent waters and will have to build stronger boats going forward. They will need more prudent liquidity management, better valuation mechanisms, and better risk management systems. But the growth story in Asia in the medium term remains intact, and we should take this opportunity to consolidate and strengthen the fundamentals so that we can play a meaningful part in the coming developments. Thank you.