Investing in Asia’s Local Currency Debt MarketsPresentation to the Asia-Pacific Finance & Development Centre, 4-6 November 2005

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Woon-Khien.Chia@ubs.comTel: +852 2971 6425

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ContentI. Overview

Evolution – after shocks from 1997 crisis Features – size, liquidity, credit risk, openness (ABF2 weights)

II. Building blocks Policy setting – targets and objectives Regulatory issues – tax, custodian, settlement Market instruments – funding, investing, hedging and

benchmarking

III. Investor base Governments, quasi-govt agencies and multinational agencies Local, largely long-term, investors Foreign real money managers Short-term foreign investors

IV. Investment strategies Different motives => different strategies <= different advice Benchmarking performance

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I: Overview – market evolution

Prior to 1997Post 1997Region of high growth-

high inflation

Monetary policies supported pegged/ quasi pegged currencies

Fiscal policies supported social programs

Growth & inflation moderated

MP: from monetary to inflation targets

FP: austerity, privatisation & debt restructuring

Local investors’ choice – fixed deposits or equities (bonds didn’t feature)

Foreign investors were mainly into short-term FX carry trades

More liquid money markets

Deeper bond markets

More diversity in issuers & therefore, investors

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I: Overview – aftermath of 1997Outstanding Domestic Debt Outstanding Foreign Debt

Foreign Debt as % of Total Outstanding

Source: ADB

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I: Overview – not quite a level playing field

Source: Indexco

Size (US$bn)

Turnover ratio

Credit rating

Market openness

Final weights (%)

China 483 55 A 30 11.2Hong Kong 78 623 AA+ 100 18.3Indonesia 58 102 BB 60 6.0Korea 569 610 AA- 60 20.7Malaysia 107 136 A+ 75 10.7Philippines 25 34 BB+ 60 5.0Singapore 79 536 AAA 100 18.2Thailand 67 229 A 70 9.9

iBoxx ABF Pan-Asia Index

Collecting hard data like market size and turnover was not a straight forward task.

Comparing market openness across the region was the toughest judgment call.

The end result was a set of allocation weights which are far from an allocation based on pure market capitalization.

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II: Building blocks – policy settingBuilding blocks – policy setting

One of the biggest post-crisis policy change is in exchange rate management.

Initial switch into floating regime was guarded by capital and FX controls.

Today, although capital controls have been mostly lifted, FX controls remain.

Monetary policies were also switched from monetary targeting to interest rate targeting.

This has indirectly helped in promoting growth of the domestic bond markets.

FX policy Capital FX Monetary policyregime controls controls target

China Intra-day managed float yes yes 1y FDHong Kong Pegged to USD no no noneIndonesia Managed float no yes 1m SBIKorea Managed float no yes O/N callMalaysia Managed float no yes O/N callPhilippines Managed float no yes O/N callSingapore Trade-weighted float no no noneThailand Managed float no yes 14d repo

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II: Building Blocks – market instruments

Most jurisdictions do not provide non-residents with access to onshore markets for funding or hedging their bond investments.

Except for Korea, bond indices are either not available or not well developed if available, whether for benchmarking or investing.

As a result, non-resident investors usually have to rely on offshore non-deliverable markets to hedge their risk, which at most times, is only adequate for hedging FX and not interest rate risk.

Non-resident FX Tax onaccess residents non-residents restrictions non-residents

China thru QFII irs, repo ndf, nds yes yesHong Kong yes irs, repo, ccs, option irs, repo, ccs, option none only on corpIndonesia yes repo ndf yes yesKorea yes irs, ccs, option, futures irs, nds, option, futures yes yesMalaysia yes irs, repo ndf, nds yes yesPhilippines yes irs, repo ndf, nds yes yesSingapore yes irs, repo, ccs, option irs, repo, ccs, option none only on corpThailand yes irs, repo ndf, nds yes yes

Funding/ hedging instruments

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III: Investor Base

Three types of (non-issuer) investors

Local long-term “buy-and-hold” investors e.g. pension funds

Make up 70-95% of local private non-bank investor base

Horizon: 6M – 5Y

Motives: yield enhancement, liability matching

Foreign real money managers

Horizon: 3M – 12M

Motives: FX gains, yield carry

Foreign short-term investors e.g. hedge funds

Initially only bank’ proprietary desks & corporate treasuries… now institutionalized hedge funds, # from 0 to 100+ in 5 years

Horizon: 1D – 3M

Motives: Zero-cost macro trades, positive carry arbitrage trades

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IV: Investment Strategies – case study

Macro call

Bank of Korea stands pat at its next policy meeting.

Market response

Interest rates to ease, yield curve to bull-flatten, volatility to dip

Investment strategies

Local investors – extend duration

Foreign real money managers – extend duration, hedge FX risk.

Hedge funds – look for arbitrage opportunities with underlying motives to long rates or flatteners outright or through swaptions.

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IV: Investment Strategies – BOK policy setting

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

2000 2001 2002 2003 2004 2005 2006

Feb 2000 : 25bp hike to stem systemic fears over the Daewoo collapse

Oct 2000 : 25bp hike to stem inflation

Feb 2001 : 25bp cut in response to Fed cuts

Jul/Aug 2001 : Two 25bp cuts in response weakening economy

Sep 2001 : BoK's only 50bp cut in history, immediately following 9/11

May 2002 : 25bp hike to counter inflation. Often cited as policy error.

May/Jul 2003 SARS, Iraq war, falling exports and credit card problems lead to two rate cuts

Aug 2004 Surprise cut as BoK goes against global trend to stem decline in domestic consumption

Oct 2004: Followup cut to the August cut

Call rate

Fed funds

Oct 2004 BoK feels confident enough to hike rates after the economy shows signs of life after being in the doldrums for 3 years

In 1999, BOK switched from monetary to interest rate targeting, independent of the Fed.

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IV: Investment Strategies – real money managers

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

Jan-01 Jan-02 Jan-03 Jan-04 Jan-05

% p.a.

BOK O/N tgt 3yKTB

5yKTB 10yKTB

KTBs have sold off since August in anticipation of aggressive rate hikes by BOK.

Real money fund managers’ investment decision is how much duration risk to take weighing between cash and bonds.

Cost of funds is implicitly the 3m CD rate for local investors and the 3m Libor rate for foreign investors.

Ideal performance benchmark is a domestic bond index.

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Bear Steepening

Bull Flattening

Today’s curve

Likely Curve Moves

Bear Flattening

Bull Steepening

Today’s curve

Unlikely Curve Moves

2s5s swaps vs. 3year TB outright

X #REF!Y #REF!

20

25

30

35

40

45

50

3.0 3.2 3.4 3.6 3.8 4.0 4.2 4.4

current

IV: Investment Strategies – hedge fundsAdvice a hedge fund would needDirection on interest ratesCorrelation analyses e.g. correlation between swap rates and curves => directionality of the swap curve

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Buy Receiver Swaption (or Bond Call)

Lose $

Zero Payout… Options are Out of the Money

Make $ $ $Sell Receiver Swaption (or Bond Call)

Conditional curve flattenersNo FX exposure and can be structured as zero costTargets absolute return

IV: Investment Strategies – hedge funds

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