An investment opportunity that sucks

Over the past 12 years you'd have been better off having your money in a US bank than investing anywhere in Asia except Hong Kong and India. Joe Studwell looks at the myth of Asia's emerging capital markets

Ten years after publication of the American economist Paul Krugman's The Myth of Asia's Miracle, there is evidence that the region is home to a second great fallacy the myth of Asia's emerging capital markets. Not only have stockmarkets in Asia delivered poor returns over nearly two decades, but they have underperformed the developed world's markets and grossly underperformed their peers in the developing regions of eastern Europe and Latin America.

The numbers speak for themselves. In the 17 years since the benchmark MSCI indices were set up for most emerging markets, the only Asian bourse to produce total US dollar returns (cumulative returns with dividends reinvested) ahead of the world average is Hong Kong. Since 1988, most Asian markets produced gains far below what one would have earned by leaving dollars in a time deposit with a US bank.

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From the start of 1993 when there was a short-lived bull run on many Asian bourses performance has been even worse. Over the 12 years to the end of 2004, four Asian markets China, the Philippines, Thailand and Indonesia actually destroyed investment capital, even taking dividends into account. Only Hong Kong and India beat the return on dollars left in an American bank. Asia excluding Japan posted an average 73% gain in the period compared with 213% in the UK, 251% in the US, 250% in Latin America and 385% across Eastern Europe and the Middle East. In short, Asia has been the investment place not to be. This is far from intuitive. Asia has high growth rates, makes many of the manufactured goods we see in the stores of rich countries, and has large and youthful populations that ought to translate into potent consumption trends. So why does Asia suck as an equity-investment proposition?

There are three main reasons. The first is the curse, paradoxically, of high savings rates. When salesmen describe the attractions of Asian equities, they point to the region's world-beating stock of accumulated personal savings equivalent in some countries to an average 40% of personal disposable income. The idea is that these will be unlocked and all manner of profitable business will ensue. But this is a fantasy. From a demand perspective, high savings rates exist in Asia because domestic consumption is weak, because people do not spend money. From a supply perspective, high savings are also a function of low disposable incomes and weak welfare systems. Moreover, there are structural and cultural reasons why this is likely to remain the case. Asians put their money in banks, which is the opposite of what an equity investor would want. Banks become over-liquid, capital too abundant, long-term real interest rates fall close to zero, and centralised, self-important governments encourage and confuse over-investment (all those skyscrapers) with profitable development. Consequently, returns go down the tubes. An equity investor, as the evidence on long-term returns shows, is better off in markets where money is tighter and businessmen are forced to seek higher returns. As Jonathan Anderson, chief Asia Pacific economist at UBS, puts it: "I just can't see a reason why you would want to invest here when you have somewhere like Latin America, which is under-banked, even though growth may be lower."

Which leads to the second Asian curse, that of high growth. Again, the financial adviser recommends Asian stocks because of the region's world-beating growth rates. But once again, a superficially attractive argument proves perverse. Asia's high growth rates are driven by investment, whereas a stock buyer wants to see growth that results from productivity gains which translates into increased profits. Krugman's debunking of the Asian "miracle" employed a form of analysis called growth accounting to show that in Asia most economic expansion comes from spending money (easy when banks are awash with savings), and adding other factors such as increased labour participation.

More recently, researchers at London Business School demonstrated that the best historic stockmarket returns have been totally uncorrelated to national growth rates; indeed, the relationship appears to be an inverse one. Put simply, growth and profits the latter being what drives share performance have nothing to do with each other. But when it comes to Asian mutual funds, investors miss this point. Jonathan Compton, a long-time Asian equity specialist and managing director of Bedlam Asset Management, observes: "People are still buying them [Asian funds] because they are operating on the model that high growth equals high returns."

The worst offender in this context is China, whose total return MSCI index has gone down by two-thirds since 1992, despite the country posting an average growth rate close to 10%. China is a reminder of the false dynamism that characterises much of Asia. Real global competitiveness is all too often restricted to export manufacturing, where much of the profit is captured by brand and technology owners and final distributors in the US, Japan and Europe. Domestic economies, by contrast, particularly in Southeast Asia, are closely regulated carve-ups whose efficiencies only impress by comparison with the previous models of the colonial era.

This is apparent in two ways. The first is the manner in which the Asian financial crisis put so few of the region's dominant conglomerates out of business. In countries such as Indonesia and Thailand all the usual "tycoon" suspects are still in business, albeit some of them in a weakened condition. Looked at another way, the Asian crisis signally failed to throw up (or let through) a new generation of entrepreneurs. As Christopher Wood, author of Asia's best-known weekly markets commentary, Greed & Fear, puts it: "A genuine, valid criticism since the crisis is that you are not getting new businessmen and comp-anies emerging. It's not that dynamic."

The third Asian equity problem and the only mundanely obvious one is that minority shareholders are regularly ripped off. In the wake of the financial crisis, the World Bank, an institution that had done more than most to talk up Asia in the 1990s, commissioned the Chinese University of Hong Kong to conduct a large-scale study of shareholder expropriation in Asia. The results which used pre-crisis data for more than 2,000 public companies can be summarised as follows: across Asia's nine leading economies, including Japan, the eight largest conglomerates exercise effective control over a quarter of all listed companies, while the top 22 conglomerates control a third of listed vehicles. Influence is exercised through a mechanism known as "pyramiding", which delivers a level of control far in excess of equity ownership. It is simple mathematics. If a conglomerate owns 50% of firm X, which owns 40% of firm Y, which owns 30% of firm Z, then the conglomerate has 6% ownership rights in firm Z, but 30% voting rights enough to call the shots. This is the basic web structure of Asian business.

By measuring dividend payouts, which are made to all shareholders on apro-rata basis, researchers showed that minority investors are most systematically expropriated at the bottom of pyramids usually at a level of 10% to 20% ownership where a conglomerate's influence is not widely noted, but where it still manages to exercise control. These distant satellites in Asian corporate families are used to provide cash to, and take risk away from, their ultimate parents in a manner that is diametrically opposed to the interests of minority investors. The mechanism is often an unequal intragroup joint venture for a new investment project in which the "less-owned" partner is forced into a raw deal. As the American Economic Review declared in 2001: "The problems of East Asian corporate governance are, if anything, more severe and intractable than suggested by commentators at the height of the financial crisis."

So will things get better? Optimists point to two things: improved aggregate dividend payouts since the crisis and greater transparency among public companies. Both are undeniable. Among 715 Asian stocks tracked by CLSA Asia-Pacific Markets, 88% will pay a dividend this year, while the total payout has risen by more than 20% a year since the nadir of 1998. On the corporate governance front, South Korean companies now produce consolidated financial reports, insider trading is at last a criminal offence in Hong Kong, and many new reporting requirements have been introduced in Southeast Asian markets leading to what David Webb, Hong Kong's best-known activist on corporate governance, calls "slightly better disclosures".

These signs of change, however, pale in comparison with the bigger Asian picture. The region's efficiency is defined in terms of (ultimately foreign-controlled) manufacturing exports, with more and more of the activity consolidating in China. The equity investor is often best-advised to share in profits, not in Asia, but at the point of final consumption through a firm such as Wal-Mart, for instance, that spends $15bn a year sourcing in China alone. And while overinvested domestic economies drive down margins within Asia, they also create profitable investment opportunities during cyclical import booms in developed country stocks. Commodities exporters such as BHP Billiton and Rio Tinto have been prime beneficiaries of Chinese demand in the past couple of years, even as China's own stockmarkets languish at six-year lows.

This does not mean there are no opportunities in Asia. Webb made enough money to retire early in comfort by playing small-cap stocks in Hong Kong. But he did so with local knowledge and acute attention to detail that is not present in the average mutual fund, and he also traded in and out of the market. That is not the same as the long-term investment proposition offered by US and UK stockmarkets that have beaten returns on bank deposits and bonds throughout the course of the past century. And that, in turn, is why the promise of Asian investment funds to do the same, or better, is built squarely on the myth of Asia's emerging capital markets. As Wood observed in the gloom of the immediate post-crisis fall out in Asia: "There was only one real emerging market in the 1990s the United States."

Joe Studwell is editor-in-chief of China Economic Quarterly. His next book, a modern economic history of southeast Asia and Hong Kong, will be published in 2006. Reprinted from The Far Eastern Economic Review 2005 Review Publishing Company Limited. All rights reserved.