SMU Political-Economic Exchange

AN SMU ECONOMICS INTELLIGENCE CLUB PRODUCTION - China 3.0 - GST in Malaysia: Promotes taxation efficiency, burdens the poor - Simplicity versus complexity (Part 1)
The Fortnight In Brief (13th May to 26th May) US: Will they or wont they? Federal Reserve Chairman Bernanke testified before lawmakers last week, defending the central banks monetary policy amid speculation of whether its asset purchasing will be tapered following favorable employment jobs numbers in the past m onths. 10-year treasury yields broke above 2% for the first time since March as the Chairman warned that taper talk could occur in its next few meetings if the US economy showed signs of a sustainable recovery, but stressed that monetary policy would remain highly accommodative. New home sales reaching its second-highest in nearly five years, coupled with gains in housing market, autos and orders for U.S. durable goods is expected to lift the economy in the second half of the year. Asia Pacific: Pessimism Floods Chinas Economy Pessimism continues to spread about Chinas economic prospects as UBS cut its 2013 GDP forecast from 8% to 7.7%. This m ove follows in the steps of Goldman Sachs, JPMorgan, Royal Bank of Scotland, the World Bank and IMF. A combination of factors, including wage growth, weak consumption and tepid exports amongst others, has contributed to the pessimism. HSBC flash PMI for China fell to 49.6 in May from 50.4 in April. This is the first time the index has fallen below 50 since October 2012 and could put pressure on the Chinese government to cut taxes and increase spending to revive its economy. EU: Germany takes bilateral paths to tackle EU jobs crisis Germany is banking on bilateral deals to fight record youth unemployment in the euro zone, agreeing to cooperate with several countries to bypass pan-European bureaucracy. Youth unemployment has reached a record 42 percent in Portugal and 57 percent in Spain as governments implement austerity measures. Berlin is also about to announce a joint plan with Paris to address unemployment, following a deal announced with Spain last month to channel money from private investors into credit-starved small and m edium-sized businesses. Policymakers in Berlin are frustrated by a lack of urgency at the European Commission, commenting that efforts to help such companies are held up by EU state aid rules meant to prevent unfair competition.
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ISSUE 38 27 MAY 2013

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PROUDLY SUPPORTED BY
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STOXX Europe 600

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China 3.0
By Adam Tan, Singapore Management University
The Chinese character (number eight) has always been associated with prosperity and good luck in Chinese culture. However, eight has increasingly been a growth figure out of reach for the slowing Chinese economy. Fund managers and analysts had recently admitted that it is now becoming a growth ceiling instead of a floor for the next decade. Tepid recovery from the United States and the on-going Eurozone crisis is not helping the export-oriented Asian giant either. So, what can China do to keep their admirable growth engine going at a sustainable rate? Lets explore the different possible routes available to them. Structural Reform Over the past years, words of hard landing1 of the Chinese economy have been going around whenever the market starts to turn bearish. Some claim that these are just noise and are of no genuine concern. However, since the turn of the year, the newly selected administration has acknowledged the need for structural reform to pursue quality growth. This led to market speculation in small capitalization technological and services sector stocks listed in Shenzhen forming a possible asset bubble. This speculation is mainly driven by two fundamental reasons: 1) reduction of fixed capital to drive growth, and 2) shift away from the low value- add export to services export model.
Services (%) of GDP
90% 80% 70% 60% 50% 40% 30%

Fixed Capital (%) of GDP

50% 45% 40% 35% 30%

25%
20%

15%
10% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 CN US JP

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
CN US JP

Source: World Bank

Source: CEIC

As seen on the chart on the left, China leads the United States and Japan (the largest and 3rd largest economy in the world) in terms of fixed capital as a percentage of GDP by more than double. This is not a good sign given that most economic growth for the past decade were driven by the coastal provinces and cities (Shanghai, Beijing, Zhejiang and Guangdong). Deleveraging from reliance on fixed capital towards the levels of the United States and Japan will be a point to note for interested investors in the long run.

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The chart on the right shows the contribution of the services sector towards overall GDP. This chart provides the ideal solution for Chinas lack of alternative growth drivers. The large gap between the United States/Japan and China signifies huge growth potential as China eventually matures into a first world economy. However, caveat to this lies in how marginal Chinas services sector has grown (39% to 43%) over the past decade and whether they will be able to actually fulfill this potential. The key driver to services growth will be correlated to how quickly the middle class disposable household income growth will be, which brings me to my second point: policy reform. Policy Reform One major problem faced by leaders of many developed countries these days seems to circle around income equality and their Gini Coefficient2. This problem is not unique to China but is a key issue that the Chinese leaders need to address before it gets blown out of proportion. Chinas latest Gini Coefficient estimate in 2012 placed them in one of the top three (at 47.4) slightly behind Brazil and Mexico. This number worsens from the previous estimate of 42.5 back in 2005. This may be a statistical proof to the saying that 80% of the income is made by 20% of the population as evidently the income gap has widened between the top and bottom over the years. The urgency to push forward the implementation of a nationwide minimum wage law before 2015 should command the same priority as the need to tackle graft and corruption in the current administration. Only when gains trickle down from the top of the pyramid to the middle class, will their disposable income increase and help drive growth in the services sector.

Gini Coefficient
Brazil Mexico 48 47

55

China
USA Russia

41
40 36

UK

Source: World Bank

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Long Arduous Journey Ahead Resisting hot money3 inflow and the real estate bubble are other challenges in-progress for the current administration. However, setting the stage right for the future by making the hard decision of implementing structural and policy reform prudently will yield greater growth and prosperity. Quoting the late Chairman of the Communist Party of China, Deng Xiaoping, the current administration needs to cross the river by feeling the stones.
1 Hard Landing

An economic state wherein the economy is slowing down sharply or is tipped into outright recession after a period of rapid growth, due to government attempts to rein in inflation. 2 Gini Coeeficient A measurement of the income distribution of a country's residents ranging between 0 and 100. 0 signifies perfect equality and 100 signifies perfect inequality. 3 Hot Money Flow of funds from one country to another in order to earn a short-term profit on interest rate differences or exchange rate shifts. Due to its fast moving nature, it can potentially cause market instability. Sources: 1. Bloomberg 2. The Financial Times 3. Investopedia

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GST in Malaysia: Promotes taxation efficiency, burdens the poor

By Lee Guojun, Singapore Management University
When Malaysian Minister in the Prime Minister's Department, Datuk Seri Idris Jala said if the new goods and services tax (GST) were to be implemented at 7%, it would increase the Malaysias revenue by RM27 billion, a huge uproar from the public ensued. However, just across the Causeway Singaporeans have been living with a 7% GST since 2007; with some stark differences between the two countrys GST schemes, of course. According to the Malaysias Ministry of Finance, GST is a value-added consumption tax imposed on goods and services at every production and distribution stage, including the stage where goods and services are imported. This means that importers, manufacturers, retailers, and finally the end consumers, would be charged a certain percentage of tax. However, businesses that are registered under GST would be able to claim an input tax credit, which is ultimately borne by the end users. Currently, Malaysia adopts a Sales and Services Tax (SST) where the sales tax is generally fixed at 10% depending on the type of goods sold, and a service tax rate of 5% imposed on services in the food and beverage industry, health and professional and consultancy services. The rationale behind the Malaysian government's plans to implement GST in the economy is to enhance the capability, effectiveness, and transparency of the tax administration and management in Malaysia. The GST would also be more comprehensive than the current SST because it would offer less tax exemptions1 that the SST. Another reason behind the GST implementation is to help the government rein in its ever increasing public debt2. While Malaysia's GDP growth has been averaging a strong 7% over the past 5 years despite the global financial crisis of 2008/2009, much of it has been attributed to large government spending on mega-infrastructure projects. Most of these projects however are slowly becoming white elephants. A short drive through Johor and one would notice the large number of partially constructed commercial buildings have not been completed for several years. The large-scale abandonment of infrastructure projects have produced nearly zero return on investments, and has left Malaysia with an even larger public debt burden, as the country edges closer towards the parliamentary imposed 55% of GDP debt limit3. While the GST's effectiveness in reining in public debt remains a hotly debated topic in Malaysia, imposing a 7% on all goods and services with immediate effect would definitely harm consumers, especially those in the lower income bracket as living costs are already alarmingly high. While it is important to note that implementing the GST would alter consumption patterns and thus encourage savings and investment, it may not be true for 78% of the Malaysian population that earning less than RM2,500 per month, says the People's Justice Party Trade and Investment Bureau Chief Wong Chen. Spending on daily necessities constitutes a large percentage of income for those in the lower income brackets, and the GST would leave little for these households to save. Introducing a 7% "shock" increase in daily necessities could potentially wipe out savings for the lower income groups altogether. Although this author agrees that the implementation of the GST has its benefits in terms of improving the efficiency of tax administration and management and also reducing Malaysia's dependence on direct taxes, current progress within the Malaysian government leaves more 5 Copyright 2012 SMU Economics Intelligence Club

questions than answers. There are improvements that needs to be done before the GST can be rolled out in Malaysia. One such improvement that the Malaysian government should consider is to exempt daily necessities such as food, utilities, and accommodation from GST for 3 to 5 years, ensuring that the savings of low-income households are not adversely affected in the short run. Singapore comes into mind when Malaysians debate the impact of GST on their consumption and savings pattern. As the Malaysian Ministry of Finance continues to crunch numbers in search of the ideal GST rate (current research has concluded that the GST rate should be between 4-6% although it is unconfirmed), Singapores version of GST offers something to ponder on. One way is for the Malaysian government to slowly adjust the GST rate to 7% over a period of at least ten years. Singapore introduced the GST in 1994 starting at 3%, which held on for nearly 9 years before being increased to 4%, and subsequently to the current rate of 7% on 1st July 2007. This slow adjustment of the GST rate has not only made it easier for households to cope with higher living costs, but has also helped Singapore reduce its reliance on direct taxes, especially corporate tax. This scheme allows the Singapore government more room to cut direct tax rates, ensuring that Singapore remains competitive in attracting international capital and labor to grow its economy. Besides committing to a no increase in tax rate for a number of years before readjustment, offset packages were also offered to households to help allay the short-term shock of increased living costs. Although the GST faces stiff opposition from the public and particularly Malaysias opposition parties, the tax if implemented properly, would serve as a great tool in reining in Malaysia's public debt and reduce its reliance on income through direct taxes. With its ASEAN neighbors such as Singapore and Vietnam undergoing economic reform to address their domestic concerns, it is high time that Malaysia gets its GST implementation right, in order to remain competitive in the region.
1 Tax Exemption

To be free from, or not subject to, taxation by regulators or government entities. A tax exempt entity can be excused from a single or multiple taxation laws due to various reasons. 2 Public Debt Public debt is the debt owed by a central government usually used to finance a government deficit (a difference between government receipts and spending). 3 Debt Limit The maximum debt a government is allowed to hold. Sources: 1. News Straits Times 2. Ministry of Finance Malaysia 3. Royal Malaysian Customs Department 4. FreeMalaysiaToday.com 5. The Malaysian Insider 6 Copyright 2012 SMU Economics Intelligence Club

Simplicity versus complexity: What are the limits of structured financial products? (Part 1)
By Shane Ai, Singapore Management University
The Parable of the Prodigal Son tells a story of a son, who squanders his inheritance, only to realize his folly and return home to his fathers welcoming arms. Similarly, structured products, once heralded as the peak of financial innovation, have suffered tremendous backlash in recent years. Till today, opinions between regulators, issuers and investors on their credibility remain divided. While addressing the limits of structured products1, perhaps a more pertinent question would be: Should they be welcomed back at all? A familiarity with their origin will help in tackling this issue. Investment banks began with engineering these products for institutions, which were essentially vanilla instruments2 wrapped into highly customized payoffs. This proved to be win-win for both clients and issuers, as firms could issue cheaper debt and banks enjoyed higher margins. Another significant development dates back to 2000, when the dotcom bubble burst. Heightened risk aversion led to retail investors wanting to participate in higher returns without the risk, so issuers offered Capital-Protected Notes to the public, among others. Further fanning their proliferation were technological advances and favorable market conditions. In line with investors insatiable desires to have their cake and eat it too, financial engineers created products that occupied the middle ground between the impossible trinity of return-seeking, premium-resistant and risk-averse behaviors. Before examining the 2008 crisis fallout, structured finance should be understood on a deeper level. Conventional innovation provides direct utility to its users, with or without cons. Proponents of financial innovation have extended this contention to finance, which is too simplistic at best. While certain forms of financial innovation does make lives easier (think ATMs), it remains unclear if easier credit confers any utility at all. To illustrate this point, the benefits of owning a watch are certain, but securitization simply allows for credit to be obtained in newer ways. Whether this leads to overall positive outcomes depends on economic agents involved. Pre-2007, severe incentive misalignment and unsound risk assessment plagued the entire US mortgage securitization3 chain. What is apparent now, in hindsight, is that the actions of economic agents catalyzed the crisis, not the innovation in itself. The economic benefit of securitization is primarily the distribution of risk to a broader investor base. Ironically, risk concentration occurred instead, as financial institutions were easily able to lever up their exposures to this asset class. Subsequently, when the soundness of subprime mortgages was questioned, a CDO fire sale was triggered, resulting in write-offs on bank balance sheets and a system with little liquidity. It is safe to say that structured products have found their limits in the potential for abuse in securitization. Fundamentally, it is nave to assume that there will be an inexhaustible source of future revenue streams to pawn la MBS. Since the crisis, the structured credit sector has undergone significant deleveraging and current global CDOs outstanding are at 38% of their 2007 levels. Tougher lending standards and regulations have also led to issuer phobia, with 2011 new issues falling 90% from 2007. Hence, current systemic damage potential from 7 Copyright 2012 SMU Economics Intelligence Club

securitization has largely been stemmed and it is unlikely that we will see a repeat of 2008 vis--vis structured credit. Moving beyond structured credit, it is crucial to scrutinize the post-2008 structured product stigma. A fallacy of composition, the structural shortcomings of US structured credit were extended to all structured products. Viewing them as one encompassing asset class is erroneous. Besides annuities (including CDOs), structured products come in other wrappers, namely insured CDs, notes and funds. Issuer risk was inconceivable pre-crisis, given the counterparties were financial titans. This led to massive public outcries in Singapore and Hong Kong, where investors were furious that their Lehman-linked notes were not fully Principal-Protected as believed. Also, structured products offer not just protection, but variable levels of investor participation as well. Thus, the flawed products and their imperfections comprise merely a small subset of the entire product universe. Populist notions have also demonized structured products by claiming that financial institutions are using the products to reap high margins at the publics expense. Upon closer inspection, this proves to be untrue. Retail income only accounted for one-third of total income from structured product pre-crisis sales. The importance of this share has since diminished, with the majority of product clients being private banks and institutions. Structured products have become the second-favorite (2010: 24%) among alternative investments for Asian HNWIs, further boosting the significance of this client segment. Next, regulatory pushes, like further product pricing transparency from Basel III and Dodd-Frank and in certain jurisdictions, extremely stringent product approval procedures, have led to greater costs and compliance complexity for structurers and distributors, effectively making retail sales an impracticality. Given how heavily distributors were penalized in 2008, this issue is very prevalent in Asia, where white-labeling dominates structured retail. Combine this with how global on-exchange volumes have declined 30% from 2011, and it is not so ironic that activity is declining despite more regulation. Lastly, issuer reputational risk is extremely relevant today, given ever increasing scrutiny by regulators and the public. Putting this into perspective is how retail notes took 4 years before reappearing in Singapore post- Lehman, with only one offering. Next week, Shane continues his discussion on structured products and their viability
1 Structured Products

A structured product is generally a pre-packaged investment strategy based on derivatives, such as a single security, a basket of securities, options, indices, commodities, debt issuance and/or foreign currencies, and to a lesser extent, swaps. 2 Vanilla Instruments The most basic or standard version of a financial instrument, usually options, bonds, futures and swaps. 3 Mortgage Securitization The turning of a mortgage into a security or a bond which represents a claim on the cash flows from mortgage loans.

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Sources: 1. Europe's Unemployment Problems Worsen, published by World Street Journal ,by Art Patnaude and William Horobin 2. Capgemini. (2011). Asia-Pacific Wealth Report 2011. Retrieved from http://www.ml.com/media/114333.pdf 3. Mgge, D. (2009). Tales of tails and dogs: Derivatives and financialization in contemporary capitalism, Review of International Political Economy, 16:3, 514-526 4. Johnson, S. (2009, April 18). Financial innovation for beginners. Retrieved fromhttp://baselinescenario.com/2009/04/18/financial-innovation-for-beginners/ 5. Zeisberger, C. (2007). Pervasiveness of structured products too much structure too little strength?. Retrieved from http://www.insead.edu.sg/asiafinance/documents/StructuredProducts_May07_JW.pdf 6. Enskog, D. (2012, October 30). Structured products adapt to the new market environment. Retrieved from https://infocus.credit- suisse.com/app/article/index.cfm?fuseaction=OpenArticle&aoid=371687&coid=118&lang =EN 7. Moiseiwitsch, J. (2012, August 20). The decline and fall of structured products . Retrieved from http://www.scmp.com/business/money/investment- products/article/1018369/decline-and-fall-structured-products 8. Collins, H. (2012, November 13). Structured products europe: Investors unaware of regulatory improvements, say speakers. Retrieved from http://www.risk.net/structured- products/news/2224515/structured-products-europe-investors-unaware-of-regulatory- improvements-say-speakers 9. HK SFC. (2006). Stock investor survey. Retrieved from http://www.sfc.hk/web/doc/EN/speeches/public/surveys/06/stock_investor_survey_060 602.pdf 10. Chew, V. (2010). Lehman brothers minibond saga. Retrieved from http://infopedia.nl.sg/articles/SIP_1654_2010-03-19.html 11. Millers, V. (2012, November 5). Structured products could lead the way in new nomenclature standards. Retrieved from http://www.risk.net/structured- products/news/2222494/structured-products-could-lead-the-way-in-new-nomenclature- standards 12. SIFMA. (2012). Statistics. Retrieved from http://www.sifma.org/research/statistics.aspx 13. Anderson, J. (2012, January).http://media.pimco.com/documents/featured solution anderson peterson structuredcredit jan 2012.pdf. Retrieved from http://media.pimco.com/Documents/FeaturedSolution Anderson Peterson StructuredCredit Jan 2012.pdf 14. Bhat, S. (2009, November 27). Taking stock of structured products. Retrieved from http://business.asiaone.com/Business/My+Money/Building+Your+Nest+Egg/Investments +And+Savings/Story/A1Story20091125-182276.html

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The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large- cap common stocks actively traded in the United States. It has been widely regarded as a gauge for the large cap US equities market The MSCI Asia ex Japan Index is a free float-adjusted market capitalization index consisting of 10 developed and emerging market country indices: China, Hong Kong, India, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand. The STOXX Europe 600 Index is regarded as a benchmark for European equity markets. It represents large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

Correspondents : Vera Soh (Vice President, Publication) vera.soh.2011@economics.smu.edu.sg Singapore Management University Singapore Samuel Ong (Publications Director/ Editor) samuel.ong.2010@business.smu.edu.sg Singapore Management University Singapore Ng Yongxiang (Marketing Deputy) yx.ng.2011@accountancy.smu.edu.sg Singapore Management University Singapore Adam Tan (Writer) Undergraduate Lee Kong Chian School of Business Singapore Management University adam.tan.2009@business.smu.edu.sg Lee Guojun (Writer) Undergraduate School of Economics Singapore Management University guojun.lee.2010@economics.smu.edu.sg

Ng Jia Wei (Vice President, Operations) jiawei.ng.2012@economics.smu.edu.sg Singapore Management University Singapore Yingyu Zeng (Liaison Officer) yingyu.zeng.2010@economics.smu.edu.sg Singapore Management University Singapore Darren Goh Xian Yong (Editor) darren.goh.2010@business.smu.edu.sg Singapore Management University Singapore Shane Ai (Writer) Undergraduate School of Economics Singapore Management University changxun.ai.2010@economics.smu.edu.sg

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