SMU Political-Economic Exchange

AN SMU ECONOMICS INTELLIGENCE CLUB PRODUCTION - Preah Vihear Temple: The Temple of Dispute - Piled Higher and Higher - Simplicity versus complexity (Part 2)
The Fortnight In Brief (27th May to 9th June) US: High Volatility in Bond Yields As the feds mull over the decision to taper Quantitative Easing (QE), employers added 175,000 jobs to nonfarm payrolls in May, an increase of 26,000 from the revised figure in April, while unemployment rose 0.1% to 7.5%. Meanwhile, Bond yields have experienced substantial volatility and increased from 1.76% at the start of the year to 2.17% last Friday. This is largely due to the feds stance shift to consider earlier tapering of QE. The unemployment figures, while reflecting tepid growth, are widely considered to be favourable for investors who are fearful of the feds lifting QE. Asia Pacific: The Third Arrow of Abenomics Japans Prime Minister, Shinzo Abe has revealed the third arrow of his Abenomics scheme to revitalise Japans economy and escape deflation. He pledged to boost Japan's per capita GNI by over 3 per cent a year and to cut red tape in special economic zones to attract foreign investment and talent. The Nikkei 225 has seen substantial gains since the start of the year but has recently plummeted from a high of 15,627 in May to a low of 12,878 this Friday on news that the US Federal Reserve might start reducing Quantitative Easing. Despite this, the index has remained one of the best performers, up almost 30% since the start of the year. EU: Latvia Enters the Euro Zone Latvia will enter the euro zone and become the bloc's 18th member on January 1, 2014. European Union countries aspiring to adopt the single currency need to fulfill criteria in four areas: inflation, public finances, the exchange rate and long- term borrowing costs. Latvia's inflation was 1.3%, well below the reference value of 2.7% and its deficit fell to 1.2% of GDP in 2012 and is expected to stay at that level in 2013. In addition, the country's general government debt stood at 40.7% of GDP in 2012, below the EUs official limit of 60%. Since May 2005, Latvias exchange rate has been within the plus/minus 1% band around the central rate and has not experienced significant tensions. Its average long-term interest rate over the year to April 2013 was 3.8 percent, below the reference value of 5.5 percent.
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Preah Vihear Temple: The Temple of Dispute

By Tan Kwan Hong, Singapore Management University
An ancient Hindu temple built during the reign of the Khmer Empire in the ninth-century would, centuries later, unknowingly spark a contentious and unsettling bilateral relationship between Cambodia and Thailand. Sitting atop a 525-metre cliff in the Dngrk Mountains, Preah Vihear province in Cambodia, the temple became the source of a lengthy dispute between the two countries since 1962, when both countries contested its ownership. The case was referred to the International Court of Justice1 (ICJ) in The Hague, which awarded the ownership of the temple in Cambodias favor. Decades later, despite the ICJs 1962 ruling supporting Cambodias ownership, the issue has remained far from resolved. In fact, relationships between both countries have gotten so sour that it sparked a standoff, which included several military and armed confrontations during that period. Figure 1: The Preah Vihear Temple

Source: Asiavipa.com Figure 2: Location of the Preah Vihear Temple At the Borders of Thailand and Cambodia

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ICJ and ASEANs Intervention Cambodia has repeatedly turned to the ICJ for help. In 2011, Cambodia approached the ICJ once more on the issue of Thai encroachment on its claimed territory resulting in an ICJ announcement calling for both countries to retract their military presence. Both parties must immediately withdraw their military personnel currently present in the provisional demilitarized zone, then refrain from any military presence within that zone and from any armed activity directed at that zone. ICJ intended for the demilitarized zone to be perceived as a renewed invitation to Thailand and Cambodia to enter into negotiations without any military intervention. It also signaled to Indonesia, ASEANs chair in 2011, to act as ASEANs main representative in overseeing the retraction of troops. Unfortunately, this verdict placed Thailand in a disadvantaged position once more. The provisional demilitarized zone2 prescribed by the ICJ not only included the areas surrounding the temple that was the center of the ownership dispute between both countries, but also an area which further extends deeper into the Thai territory. As a result, ICJs order wasnt well received by the military and the foreign ministry of Thailand, intensifying the crisis. On 18 July 2012, both countries retracted their militaries from the disputed area surrounding the temple. While ASEAN perceived this favorably, the 10-member group had a vested interest to mediate the conflict. Success would positively impact its reputation and credibility. This was in line with ICJs stance that the conflict would be better dealt with at the regional and not international level. However, despite these foreign interventions and the issue being a foreign policy one, the main crux of the dispute paradoxically lies within the confines of Thailands domestic politics. Thailands Local Politicization the Main Cause of Conflict Escalation The resurrection of the conflict between Thailand and Cambodia primarily originated from the active politicization of this issue between various political groups. Political rivals of former Thai Prime Minister, Thaksin Shinawatra, led by the yellow-shirt royalists and the Democratic Party, seized the chance to frame the Preah Vihear issue to undermine Thanksins proxies, accusing him of sacrificing the nations property in exchange for personal business gains in Cambodia. This sparked off one of the worst military confrontations between the countries in decades. Back in Thailand, the protracted internal conflict has continued to serve as an impediment towards any attempts by the Yingluck government to resolve conflicts and build relationships with Cambodia. Conflict Expands Beyond the Temple Today, the unrelenting conflict isnt just about the sovereign rights over the Preah Vihear temple. The dispute of the 4.6 square kilometer area of land adjacent to the temple has 3 Copyright 2012 SMU Economics Intelligence Club

become the most contentious point. Cambodia has indicated its insistence on the ICJ to clearly declare that the disputed area be under Cambodias jurisdiction. If their wishes materialize, the new ruling could spark off a sense of unhappiness and indignation among the Thais against their neighbors. This would overturn the improving bilateral ties established under the premiership of Yingluck. Further Attempts at Conflict Resolution The only silver lining stems from the key bilateral cooperative frameworks reconvened under the Yngluck government. This includes the 8th General Border Committee meeting held on December 19 to 20, 2011, and the 5th Joint Border Committee meeting held on February 13 to 14, 2012. Both meetings touched on issues pertaining to border demarcation and surveys of the remaining border pillars in areas beyond the Preah Vihear Temple region. However, tangible progress had been minimal. General Neang Phat, Secretary of State of the Cambodian Defence Ministry, asserted that any delay on Thailands part could destabilize the improved sentiments in bilateral relations between both countries. Cambodia has already established its Joint Working Group (JWG) and is now waiting for Thailand to set up its own JWG to deal with impending issues, such as deployment and demarcation [within the border area], he emphasized. Neang Phat also affirmed that the tense political climate in Thailand, where military intervention is known to be relentless, may be the dominant obstacle challenging the progress of the JWG establishment. A Lose-Lose Situation for Both Countries By mid-2013, the ICJ will announce its reinterpretation of the scope of ownership of Cambodias Preah Vihear Temple. It is highly possible that Cambodia might have the upper hand once more, due to the fact that Cambodia was already accorded rightful ownership of the temple back in 1962. Other notable factors, such as Cambodias close working relationship with the ICJ and the United Nations since the conflict started in 2008, might further add to Cambodias favor. Whichever way is ruled, it is expected that the country ruled against will not take it favorably unless a concerted effort is seen from both countries to recognize the legitimacy of the ICJ rulings and to prevent future militarized interventions. Bitter feelings caused by this issue could remain a foreign policy risk3 that either country can unearth for future confrontations. New rounds of nationalistic sentiments could once again be stirred up, leading to more military clashes along the border. This could result in a relationship that might take several more decades to normalize and will in turn further undermine the legitimacy and credibility of ASEAN as a viable platform for successful conflict resolution and security cooperation among its member states.

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1 International Court of Justice

The International Court of Justice is the primary judicial branch of the United Nations. Its main functions are to settle legal disputes submitted to it by states and to provide advisory opinions on legal questions submitted to it by duly authorized international branches, agencies, and the UN General Assembly. 2 Demilitarized Zone A demilitarized zone, is an area in which treaties or agreements between nations, military powers or contending groups forbid military installations, activities or personnel. 3 Foreign Policy Risk Foreign policy risk refers to the complications businesses and governments may face as a result of political decisions made on foreign relations.

5 Copyright 2012 SMU Economics Intelligence Club

Piled Higher and Higher

By Ma Weimin, Singapore Management University
With the investment companies owned by the local government selling 283 billion worth of bonds in the first quarter of 2013, the provinces, cities, counties and villages all across China are now estimated to owe RMB 12 trillion, which almost double the figure given by the National Audit Association in 2011 and is equivalent to 20 to 40 percent of the size of its economy. This has caused huge concern for Chinas auditors, government officials and international institutions. With such radical progress to sell bonds, many analysts now worry that the sluggish growth of government revenues cannot pay back the loans on time and the huge amount of debt would then become the Chinese version of subprime1. However, it seems more are still optimistic and think the risk of default is low because the central government will pick up the mess if things go wrong. With that said, another problem still exists. The debt is not transparent and no one knows exactly how it will be handled. To be more precise, the particular concern is the tendency for Chinese officials to let the political expediency override economic sense. So how exactly does the local government use these investment companies to sell bonds to raise funds and why has it led to a heated discussion on whether the central government should make new policies to slow down this process? To answer the question, we have to go back to 1994, when the failures of the then Prime Minister Zhu Rongjis reform left local governments with huge spending burdens - everything involving city construction from providing water to the building of skyscrapers, as they were expropriated the right to keep taxes and prohibited from issuing government bonds or municipal notes2. However with such burdens, this prohibition was eventually breached with the local government setting up investment companies as special financing vehicles to help borrow off the budget from state- owned banks. At that time, behind the capital raised, there was neither transparency nor discipline. As a result, with the central government backing all the borrowings and the special financing vehicles being stuffed with whatever assets they needed, and being unable to generate profits, quite a few local government and state-owned enterprises were bailed out in the late 1990s. A Hong Kong analyst pointed out at that time, about 33 percent of the local government financing vehicles generated insufficient cash flow to even pay off the debt and 68 percent were reported to make return on debt less than the lending benchmark. As a matter of fact, the banks were making losses at that time. So how can this seemingly already infeasible method still be implemented for another decade, while Chinas economy grew at more than 10 percent every year? More importantly, why has it become a problem again? Well, the answer lies in China Development Bank, which was initially established as a policy bank, but is now gradually turning into a hybrid of a commercial bank, investment bank and policy bank. China Development Bank helped numerous local governments set up their own special financing vehicles, and more importantly, helped transform these financing vehicles into profit-generating giants. In the late 1990s, when most local government financing vehicles took China Development Bank as the incarnation of the treasury department and requested for endless funding used for various city projects, there came the new governor of China Development Bank, the son of Chen Yuan, whose decisions held great sway over the countrys two leaders in the 20th century - Mao Zedong and Deng Xiaoping. As Chen Yuan took over leadership of China Development Bank, he started to change the mechanism of the local government financing 6 Copyright 2012 SMU Economics Intelligence Club

vehicles by injecting urbanization into them. Chen firmly believed that urbanization is the power for the development of the city and the growth of the economy. In addition, he felt that only with urbanization could labor be freed and start to add value to the economy. Therefore, he carried out this thought in a city called Wuhu in Anhui province, where China Development Bank turned the huge base of civil deposits into bonds and created a market out of nothing. It helped bring in commercial banks, private lenders such as trust companies and set up a myriad of different companies handling different projects. It also turned fiscal revenues into equity and good and bad projects could even be bundled together so that good projects with low risk and high profits could make up for the losses of bad projects. Moreover, during the process of urbanization, by acquiring land from farmers, local governments then had the resources and could turn the land in their hands into printing press. As local governments sold the land rights to developers, the additional value of the land generated not only made payments of interests and principles but also added to the credit of local governments. Furthermore, in the following decade after the 1998 Asian crisis, this mechanism worked pretty well for China, and everyone seemed happy with it. Nonetheless, hit by the financial crisis in 2008, Chinas government introduced the 4 billion RMB stimulus package to boost the economy. Overnight, the backlog of projects from 30 years of reform was nearly all approved. China rushed to projects, with projects that had been killed in the past coming out. The local government financing vehicles began to immoderately issue bonds to raise money for huge infrastructure projects in the effort to propel urbanization to a higher level. However, with the growth of land prices gradually slowing down, these large scaled bonds now become ever dangerous.

Under the circumstances, things are obviously too big to fail. Thus, what could China do to prevent its system from failing? Some think that its unlikely that China runs into a runaway inflation3 and has a economic hard landing, as the problem will eventually be resolved when the debt is extended and the steadily growing local government revenue fill up the holes. However, to really cure this over-borrowing decease, maybe the panacea is still transparency. With the local governments revealing how and where the money raised from issuing debt is used - how the city acquires land from farmers (with how much money to compensate for one unit of land) and what infrastructures to be built (let citizens vote on the various projects to make sure these projects can both make economic profits and benefit the citizens).

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1 Subprime

A classification of borrowers with a tarnished or limited credit history. Lenders will use a credit scoring system to determine which loans a borrower may qualify for. Subprime loans carry more credit risk, and as such, will carry higher interest rates as well. Approximately 25% of mortgage originations are classified as subprime. 2 Municipal Note Debt issued by state and local governments to finance capital expenditures such as construction projects. Municipal notes are appealing to investors because they mature in one year or less, offer fixed income and are often exempt from income tax at the local, state and/or federal levels. 3 Runaway Inflation Very rapid inflation, which is almost impossible to reduce Sources: 1. National Bureau of Statistics of China 2. Economists 3. Investorwords 4. Investopedia

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Simplicity versus complexity: What are the limits of structured financial products? (Part 2)
By Shane Ai, Singapore Management University
Last week, Shane continues his discussion of structured financial products Another argument is how structured products embody high levels of complexity, falling in line with the thought-terminating clich Dont invest in what you dont understand. Contrary to popular belief, structured products actually make investors lives easier. Issuers of structured products are typically bulge brackets1, which tap into their economies of scale, expertise and access to tough-to-reach markets to engineer the products. Replicating similar payoff profiles for products with more features, like CPPTs, imposes unnecessary transaction costs and hassle. Unparalleled flexibility is another upside for institutional investors, who are looking to take views on a variety of unconventional parameters, such as volatility and correlation, and gain varying levels of exposure to multiple underlyings. Further cementing products versatility are studies concluding that their addition improves risk-return profiles of already diversified portfolios by shifting the efficient frontier2 up and to the right. Next, it is important to identify the true limits of structured products, which go beyond retail phobia. Regulations are highly variable across borders, with some imposing extreme limits on the industry. An appropriate regulatory initiative would be setting rules of engagement and plugging the issuer-investor information gap. This is more prevalent in highly financially sophisticated markets, such as Switzerland. However, other countries have imposed bans on more complex products, or made them highly difficult to access. A typical retail investor in Hong Kong today cannot purchase products like credit-linked notes and minibonds. Once a hotbed for product sales, Hong Kong has seen a 40% decline in total volumes since 2010 (last available date). Defining a product based on whether it is good or bad is overly simplistic and inherently flawed. Theoretically, the net effect stems not from the product itself, but from its place in a larger portfolio within an institutional context. It then follows that banning is not a long-term solution. Nonetheless, product governance is highly challenging, with some regulators fearing the moral hazard3 involved if a ban is absent and public backlash if a product fails. Product demand is also sensitive to demand for the underlying. Recent years have seen poor equity market returns, rendering equity-linked products unpopular. In addition, the current macroeconomic climate, resulting from rampant monetary easing and represented by low rates, correlations and volatilities, have made structuring products with attractive payoffs tougher. A recent encouraging development has seen structured products being highlighted as being more amenable to classification than other asset classes, having precise terms and payoffs. In addition, this would be supplemented by the anticipated robust growth trajectory of emerging markets, resulting in larger investor pools with similar investment needs as those in developed nations currently. However, obstacles include varying country-specific regulations, making a global benchmark standard tough to achieve. Nevertheless, this bodes well for structured products, with them taking the lead in pushing for financial harmonization. Taking a Darwinian perspective to the industry might shed further insight. Instead of seeing an industry subject to numerous limits, it could simply be a temporary setback in placing it 9 Copyright 2012 SMU Economics Intelligence Club

back on the right direction. Current regulatory shifts would lead to a more resilient system, one with increased product transparency and investor protection. Additionally, complex instruments have returned to institutional and private client territory, where investors typically have the knowhow to extract alpha from them. Further substantiating this is a 2006 HKSFC survey, which showed that retail investors holdings of structured products were inversely proportionate to their investment experience, reflecting mis-selling. Structured retail products now comprise much simpler structures with publicly familiar underlyings, like currencies, compared to highly diverse pre-crisis offerings. Ultimately, many limits of the industry stem from stakeholders imperfections, with much left to be done. Nonetheless, with risk-focused mindsets going forward, it is highly probable that a superior and more robust system will be born out of the ashes of the 2008 crisis. Structured products ought to be welcomed back, but only in prudent and informed steps. For the continuation of Shanes discussion on structured products, please refer to next weeks publication.
1 Bulge Brackets

The bulge bracket comprises the world's largest and most profitable multi-national investment banks whose investment banking clients are usually large corporations, institutions, and governments. 2 Efficient Frontier The efficient frontier is a concept in modern portfolio theory introduced by Harry Markowitz and others. 3 Moral Hazard A moral hazard is a situation where a party will have a tendency to take risks because the costs that could incur will not be felt by the party taking the risk. 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 10 Copyright 2012 SMU Economics Intelligence Club

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 Ma Weimin (Writer) Undergraduate School of Economics Singapore Management University weiminma.2011@economics.smu.edu.sg Tan Kwan Hong (Writer) Undergraduate School of Economics Singapore Management University kwanhongtan.2009@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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