The Times They are A-Changin’…Thoughts on Reform in Asia


“Reform is not pleasant, but grievous; no person can reform themselves without suffering and hard work, how much less a nation.”

— Thomas Carlyle (1795-1881) British historian and essayist

Recent events in Asia illustrate three different approaches to economic reform in the region’s three largest economies. Japan is trying to dig itself out from two decades of deflation and minimal growth, China is battling to change the focus of its economy from investment to consumption while avoiding a potential financial crisis, while India needs to restart growth and move away from state dependence.

Japan: It’s not all over . . .

After great enthusiasm in 2013 regarding the promise of Abenomics, the Nikkei had fallen over 10% by the end of May as investors – and particularly the “tourist” macro funds – have sold stocks on the perceived lack of progress on Abe’s third “arrow” of structural reform, compounded by the effects of a hike in the consumption tax at the beginning of April. Hopes of loosening up of the labor market, deregulation of various industries and, most importantly, the negotiation of the TPP (Trans-Pacific Partnership—a free trade zone encompassing the Pacific rim) seem to have floundered against entrenched interests.

Does this mean the Japan story is all over? We think not, particularly for hedge funds. Inflation is rising, most of it admittedly on the supply side but even the tax hike has failed to slow it. At today’s level, the TOPIX both historically and empirically is trading cheap at 12.4x forward earnings and at 1.1x book; more than 10% of the biggest 1000 companies boast cash in excess of half their market cap; and buy-backs totaling nearly 1% of the index have been announced year-to-date. Moreover, the GPIF (the Japanese government pension fund), at approximately $1.3 trillion in assets the largest pension fund in the world, has indicated that it will move a significant portion of its JGB holdings into equities. At the start of 2014, the new Nikkei 400 index based on profitability, increased ROE and strong corporate governance was launched and is gaining traction. Much of listed corporate Japan is now “lean and mean” and has tremendous operational advantages going into a global recovery. Finally, a recent Goldman Sachs report anticipates an improving environment for alpha generation in Japan. The report highlights a decline in pair-wise correlation and widening earnings dispersion.1 All of these factors should be supportive for long short equity managers. While the eventual success of Abenomics remains unclear, there is sufficient evidence to suggest that investing opportunities still remain.

China: The opportunity set keeps growing . . .

In China the slowing economy is being countered by a robust response from the government. As a command economy and with strong political backing, the government has gone full steam ahead with its reform program. Recently, for example, they have announced that ten provinces, accounting for around 45% of GDP, will be able to independently issue municipal bonds. The recently announced “through train” linking the stock exchanges of Shanghai and Hong Kong is being vigorously promoted. This will, along with expanded QFII programs,2 allow more access to onshore investment. Through swap structures, hedge funds are now able to do limited shorting in the A-Share market, too.3 Other policy easing measures and reforms are being announced on almost a daily basis, including initiatives to liberalize urbanization, encourage private investment, allow securitization, etc. The banks are looking to recapitalize ahead of further bad loans and the “bad banks” such as the recently Hong Kong listed Cinda AMC are also raising capital. New bank licenses have recently been issued to private entities suggesting future competition with the state-owned entities.

This does not mean that all is rosy in China’s garden. The anti-corruption drive demonstrates the difficulty of overcoming entrenched local interests while certain regions and local governments have funding difficulties. Property prices seem to be slowing not just in the third and fourth tier cities but also in major urban areas such as Beijing and Shanghai. Some of the estimated 70,000 property developers are going bust (although many have the balance sheets and land banks to survive a turndown); there have been defaults and there will be more. From our viewpoint, hedge fund investors can benefit from increased access to China’s financial markets​ and the events surrounding these changes. Defaults, refinancings, and government reform measures are creating fertile investing grounds in equities, credit and fixed income.

India: Can the enormous potential be realized . . .

The recent landslide election victory by Nahendra Modi and the BJP (Bharatiya Janata Party) in India presents an opportunity not seen in India since the country gained independence in 1947. Other than the sympathy vote for Rajiv Gandhi after his mother’s assassination in 1984, this is the first true majority government. Modi has shown a willingness in his home state of Gujarat to encourage investment and focus on the economy. Many of his tycoon supporters certainly hope that he can reignite growth and implement reforms, particularly in the banking and infrastructure sectors. Unlike China, however, India is a democracy and the state governments have enormous power; the bureaucracy is slow, unwieldy and riddled with graft. Further, India’s infrastructure is in need of significant investment. The outlook for India depends upon Mr. Modi’s ability (and willingness) to overcome these substantial barriers. The market is obviously optimistic – the NIFTY is up nearly 15% YTD as ofthe end of May and is trading around all-time highs at over 17x earnings. The rupee is also much stronger this year.

For investors, there are challenges beyond the valuations and hopes for the new administration in India. There is still much uncertainty over the tax liabilities of both foreign direct investment (Vodafone, BP and Nokia have all recently gone to international arbitration on tax claims) and Foreign Institutional Investment (FII) investors. Shorting can only really be achieved through single stock futures which are limited in number and come with the attendant roll risk. Further, the non-deliverable nature of the currency makes hedging very expensive. In this case, the opportunities for hedge fund investors are further off but if Modi is successful – and that is a very big IF – they could be enormous.

Three different economies, three types of government and three reform packages: opportunities in the region still abound. Markets are growing both in breadth and diversity of securities, access is improving and becoming cheaper, and inflows of foreign capital are being encouraged. ​

*Bob Dylan (1964)

1  Goldman Sachs Global Macro Research-Japanese Equity Active Portfolio Strategy research entitled “Return of a Stock-Picker’s Market” published May 22, 2014

2  Foreign investment is only allowed through a tightly-regulated structure known as the Qualified Foreign Institutional Investor (QFII) system.

3  Shares in mainland China-based companies that trade on Chinese stock exchanges such as the Shanghai Stock Exchange and the Shenzhen Stock Exchange. A-Shares are generally only available for purchase by mainland citizens.​

David Walter is a Director in PAAMCO’s Portfolio Management Group based in the firm’s Singapore office. He is responsible for Asian-focused hedge fund investments and acts as Head of Research for Asia and Sector Specialist for the Pan Asia Portfolio Solutions funds. Prior to joining PAAMCO, David performed a similar role for KBC Alpha Asset Management. Before KBC, he co-founded Arbiter Fund Managers, where he established and managed a dedicated Japanese long/short equity fund. Previously, David worked at London at Oxford Capital Markets, was Head of Japanese Equity Product at Sanwa International Securities, and was a Japanese convertible and warrant trader at Barings Far East Securities. He has twenty-eight years of investment experience. David is currently a member of the AIMA Singapore Executive Committee. David graduated from Christ Church, Oxford, with an MA (Honors) in Modern History.

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