Muhammad bin Ibrahim: Recent developments and emerging trends in
Asia
Keynote address by Mr Muhammad bin Ibrahim, Deputy Governor of the Central Bank of
Malaysia, at the Second Annual South East Asian Institutional Investment Summit - "Recent
developments and emerging trends in Asia", Kuala Lumpur, 2 December 2010.
* * *
Let me first thank Asian Investor for the invitation to speak at this institutional investment
forum. I am honoured to be given the opportunity to speak before such a distinguished group
of investors, fund managers and government officials at this important gathering.
My remarks will consist of three parts - the first part, on the current trend of rising capital
inflows to Asia and its implications, secondly on regional market developments and lastly, I
will make some observations on the region's institutional and central bank investing space.
Asia as the investment destination and its implications
It has been three years since the financial crisis first erupted. Emerging market economies
have demonstrated resilience, showing a steady growth path to recovery, well ahead of
major developed countries which face challenges of low growth, high unemployment and
mounting fiscal burdens. Such large disparities in the growth rates and economic environment
have inevitably led to divergence in monetary and fiscal policies. Where developed countries
had maintained low interest rates, expanded quantitative easing policies and implemented
stimulus programmes to revive their economies, emerging markets had started normalising
their interest rate policies.
The recent financial crisis differed from the 1997-98 crisis in many aspects. Emerging
market countries have a much stronger fundamentals, better growth prospect and higher
interest rates. These differences in fundamentals have attracted growing and significant
capital flows to these parts of the world. Net private capital flows into emerging markets was
projected by the Institute of International Finance to rise to USD825 billion by the end of
2010, representing a 42% increase from last year. Many analysts expect the recent Federal
Reserve's policy decision to purchase another USD600 billion of US Treasury bonds under
"QE2" will intensify further flows to the region. Economists estimated that between a quarter
to half of the QE2 liquidity will flood into emerging markets. The inflows if not managed
properly will pose difficulties to Asian and emerging markets. Policymakers would face
several predicaments from policy perspectives.
The influx of capital inflows, have led to a rapid expansion of liquidity translating into rising
prices, leading to concerns on asset bubbles and the possibility of overheating the economy.
However, the impact on each economy will differ depending on the size of the inflows and
the ability of those markets to manage the flows. The upward pressure on the exchange
rates has also been significant as seen by the appreciation of regional currencies at an
average of 4% on a real trade-weighted basis since beginning of the year. Understandably,
such pace of appreciation has raised some concerns among businesses especially in highly
open economies, where movements of exchange rates will certainly impact businesses.
Under this new normal situation, the agility of businesses and the economy to adapt and
adjust to the challenging environment is critical. There are a number of possible adjustments
which can be done including raising productivity and efficiency. In formulating public policy,
policymakers are faced with the challenge to strike a fine balance in handling the capital
flows and its impact to the economy. Because of the enormity of the flows, a combination of
approaches had been adopted by emerging economies to manage capital flows. Even
measures regarded as unorthodox at one time are now being implemented. Most countries
have allowed greater currency flexibility; and many have ended up accumulating foreign
reserves. These inflows were typically sterilised by the central banks to avoid pressure to
domestic liquidity and price level.
Regional market developments
Turning now to the second part of my remarks on key developments in the regional financial
markets. The ability of regional economies to weather the recent financial crisis has its root in
the aftermath of the 1997-98 crisis. Many had use the past financial crisis period to embark
on bold financial reforms and restructure their financial landscape. Of particular importance
were the successful efforts and policy initiatives to develop the bond market. As a result of
these initiatives, the depth and breadth of regional capital markets have reached a level of
maturity which can now absorb and intermediate large and volatile flows without posing risks
to financial stability. The recent financial upheavals offers the most striking evidence given
that there was no disruption to the financial intermediation process, credit flows and
transmission mechanism.
There are, of course, pockets of risks in individual countries, inflation and property market
bubble, to name a few, where different policy instruments could be used. Central to
managing these challenges are macro-prudential tools, which have been deployed by Asian
countries, to prevent, amongst others, price inflation in the real estate sector. A number of
Asian policymakers recently had tightened lending standards by lowering loan-to-value ratio,
imposing limits on non-owner-occupied property purchases and increasing transaction costs,
as pre-emptive measures to temper speculative property investments and to manage or
prevent excessive build-ups in household debt, at a time of fairly low interest rates and
abundance of liquidity.
At the regional level, safeguards have also been enhanced. Among the lessons drawn from
the 1997-98 Asian financial crisis are the importance of early detection of cross-border risks
and vulnerabilities, followed by a collectively cohesive and firm action to avert any potential
crisis. Over the years, the region has developed an integrated surveillance and crisis
management framework through various groupings such as the Executive Meeting of East
Asia Pacific (EMEAP) members and the South East Asian Central Banks. For example, the
EMEAP surveillance framework focuses closely on regional monetary and financial systems
which also connect international financial institutions and member central banks' reserves
management and money market teams through the Dealing Room Network. Safety nets
have also been developed and enhanced, such as in the form of liquidity support to member
countries via the ASEAN+3 Chiang Mai Multilateral Swap initiative which consists of a
USD120 billion currency swap facility, aimed to support countries with short-term liquidity
needs and to supplement existing international financial arrangements. These various
developments certainly have significantly enhanced the region's capability to holistically
manage the inflows and to safeguard against the risk of sudden capital flow reversal and the
instability that it would bring.
Malaysian market developments
Let me turn to some recent key developments in the Malaysian financial sector. The
domestic financial landscape is undergoing transformation due to our continuous efforts in
financial deregulation and liberalisation. Pursuant to financial liberalisation measures
announced by Prime Minister Dato' Sri Najib Tun Razak, the central bank has granted
5 commercial banking licences to foreign banks in June this year, with mega Islamic banking
licences to follow suit. Foreign equity limits in investment banks, Islamic banks and insurers
have been raised while more operational flexibilities have been granted. In addition, the
government has announced plans to increase foreign investment limits for the government
linked investment companies such as the Employee Provident Fund. Importantly, these
liberalisation measures will further strengthen our inter-linkages with financial markets in
other parts of the world. Contrary to the approach taken by many during the recent crisis,
Malaysia had further liberalised the foreign exchange administration (FEA) rules in our efforts
to promote efficiency, reduce costs and create a more conducive environment for trade,
business and investment activities. The accomplishments in financial sector reforms and the
many policy changes made have augured well for the country, as evident by our ascent into
the top-20 bracket in the World Economic Forum's financial development index this year.
As with other countries within the region, we have also been a recipient of capital flows. As a
result of continuous effort to strengthen the financial sector, our ability to manage the
volatility and other impacts of capital flows has been enhanced. The financial markets and
banking sector have proven their ability to absorb and intermediate these inflows while the
Central Bank is always monitoring the market on a daily basis and is also well positioned to
manage the situation. The domestic economy stands resilient and inflation remains under
control. Furthermore, the pace of ringgit appreciation also reflected the positive underlying
fundamentals of the economy.
Trends of investing by central banks and institutional investors
i) The concept of diversification
Let me now share some thoughts on portfolio diversification. Nearly 60 years since the
proposition of Modern Portfolio Theory by Harry Markowitz, many investors are still grappling
with the challenges of portfolio diversification. Among the sands in the wheel of a
welldiversified portfolio are transaction costs and information asymmetry. In tandem with greater
financial market integration and improved information access in the advent of information
technology, these obstacles have significantly diminished over the decades. The recent
financial turmoil however, has ignited a debate on whether the benefit of portfolio diversification
is overstated considering the relatively low idiosyncratic risk vis-a-vis systemic risk in times of
high volatility, and prevalent correlation breakdowns that occurred among asset classes,
especially at the height of the financial crisis.
In my view, the emergence of such findings does not question the desirability of
diversification, but rather, heightens the need for new and expanded methods to fine-tune the
traditional portfolio optimisation approach. A growing class of investors are steering away
from the traditional portfolio theory's emphasis on a normal bell-curve distribution and
choosing instead to embrace the "Black Swan" idea expounded by author Nassim Taleb or
the "New Normal" proposition by PIMCO, in which the distribution of outcomes are flatter with
fatter tails. The idea basically characterises higher likelihood of outlier events following the
observed major structural breaks from historical trends. To my mind, such non-normal
distribution even further underscores the importance of diversification strategies to attain a
reasonably stable return and the necessity for investors to be nimble in the face of uncertainty.
ii) Diversification by regional central banks and institutional investors
Central banks reserves continue to serve as an important safety buffer for the country and
reflect the strength of the economy. Nevertheless, the issue of diversification continues to
strike a chord among regional central banks and major institutional investors, driven by the
accelerated pace of reserves accumulation in the past decade, low-yield environment in the
G7 economies and changing trends in trade pattern and currency regimes. This necessitates
a rethinking on how reserves should be invested. The fast pace of reserves accumulation
and low yields on G7 assets remained the most compelling reasons for diversification in the
quest to seek better risk-adjusted returns in alternative asset classes, such as emerging
market debt, commodities and equities.
Intra-regional trade in Asia has surged from 32% of total exports in 1995 to an average of
50% in 2008, while the use of regional currencies for trade settlement has started.
Furthermore, most Asian economies have gradually shifted from a US dollar focus to a more
flexible exchange regime against broad basket of currencies, a trend which underlies the
rationale of diversifying away from US dollar. In tandem with the rising savings and reserves
accumulation by regional central banks, these reinforce the argument for more intra-regional
investments which will contribute to the goals envisioned by the Asian Bond Fund (ABF)
initiatives. The ABF was a fund launched by EMEAP, comprising foreign reserves held by
regional central banks for investments in regional bonds with the aim of contributing to the
development of regional bond markets. Today, we are near the juncture of achieving a key
milestone, where formal setting is no longer required to mobilise intra-region fund flows such
as in the case of ABF1 and ABF2.
Instead the intra-regional investments are becoming more self-reinforcing. As a proof of this,
we now have more anecdotal evidence on the rising proportion of the regional central banks'
reserves invested in Asian local currency debt.
iii) Credit risk assessment approach
As we tread into uncharted territories of new asset classes, there is a growing need to
enhance analytical capabilities, resources and risk controls. For example, many central
banks and institutional investors have gradually moved away from over-reliance on credit
rating agencies to an internally-based credit rating assessment practice in portfolio
management. In the wake of the US financial crisis and recent European sovereign issue,
one would question the credibility of credit rating agencies in flagging the risks built up in
banks and sovereigns, ahead of the crisis. Most credit rating agencies also tend to apply
ordinal ranking of credit, rather than specific risk metrics that can be mapped to default
probabilities or expected losses. In my view, one of the major weaknesses of credit rating
agencies is their objective to establish rating stability by applying smoothing methodology
that can potentially delay minor downgrades, but trigger cliff-like and abrupt downgrades in
the event of sharp credit deterioration. The abrupt regrading of credits tend to spook markets
and is certainly not good for investors with a heart condition.
Regional central banks and major institutional investors are aware of such limitations; hence
the best way forward is to complement rating-embedded investment guidelines with a more
robust and rigorous internal credit risk evaluation framework. In tandem with diversification
into alternative asset classes, there is a growing emphasis to improve the sophistication of
risk modelling, taking into account how risk can be initially understated when herding
behaviour dominates, but rears its ugly head during reversals.
iv) The growing importance of Islamic finance
As events unfolded in the midst of the financial crisis, the sustained expansion of global
growth and development in Islamic finance has emerged as one of the most prominent
trends in global financial landscape. The industry continues to draw significant interests from
all corners of the world. The global financial crisis underscores the potential role and
relevance of Islamic finance as a viable approach in investing. Due to the Shariah prohibition
of excessive leverage and unproductive cash hoarding, Shariah-compliant funds have
outperformed their conventional peers since the onset of the crisis. As a result, there has
been greater appreciation of the principles of Islamic finance, as evidenced by the expansion
of interest and demand for Islamic financial products on a global scale. In line with the rapid
growth of Islamic finance, emphasis has been placed on the development of the international
financial infrastructure such as setting prudential standards and international best practices,
a role spearheaded by the Islamic Financial Services Board. The most recent significant
development was the establishment of International Islamic Liquidity Management Corporation
in Kuala Lumpur. This corporation will act as a conduit to issue highly rated short-term
Islamic instruments to enhance cross-border liquidity management and provide Islamic
financial institutions with an additional avenue to manage their short-term liquidity.
Complemented by other initiatives under the "Malaysian as an Islamic Financial Centre", I am
quite confident that Islamic financial markets in Malaysia, for both ringgit and foreign
currency, is set to thrive in the coming years.
Recently, we have allocated a small portion of funds to be disbursed to prospective and
existing Islamic Fund Management Companies to invest primarily in foreign currency sukuk.
This will provide a platform for fledgling fund managers to build track records and spur their
growth of asset under management, besides broadening the sukuk market in Malaysia. In
parallel, this initiative is also expected to catalyse the development of end-to-end value chain
capabilities, encompassing the areas of secondary market trading and supporting
infrastructures.
Conclusion
I would like to end my remarks by concluding that in the current global economic
environment, uncertainties loom large and we have to be mindful of the challenges ahead,
either as an investor or policymaker. This conference is indeed very timely to encourage
open discussions on key themes in global investing, and hopefully we can all gain new
insights in managing the exciting and challenging times ahead.
Thank you for your kind attention.