Economic and Investment Review

Kelvin Blacklock:

Thank you, Mark. Good morning everyone. I hope the caffeine is kicking in. I'm not sure that listening to a couple of fund managers is the best way to get over jet-lag. What I'd to do in the next 20 minutes is just share our perspective on the region from the fund management angle. Asia has rarely been out to the press. Sometimes these headlines are good, such as the current economic boom in China; sometimes they are bad, such as the financial crisis '96-'97. I think the key message is that the underlying drivers of growth in the region are very much intact. This creates tremendous opportunities for companies like Prudential and fund managers, such as Nick and myself. We'd like to share some of our ideas on that, me from a more macro-economic perspective, and then I'll pass to Nick for focussing on two of the larger growing markets in the region: India and China.
One of the most important effects of the fast growth of regions as seen over the last 30 years is the tremendous amount of savings that this growth is throwing off. This has huge implications for financial markets and it is becoming an increasingly important aspect of the world economy. This creates tremendous opportunities for us, both as a company and as investors in the region. So, I'd like to just kind of focus in a little bit on that angle of it, and than as I've mentioned pass to Nick who shows you how that theme is playing out into the larger countries. I can't overemphasise the scale of these savings; they really are enormous at the moment. One of the themes I'd like to just touch on is the sort of piggyback economics as I talk about, you know, really the savings, investment and balance that this is creating in the world's economy.

Just to set the context, this is a chart of the average GDP growth rate across the region for the last 30 years. You can see that Asia outside Japan is growing more than twice as fast as the US has over a 30-year period. Clearly that is a sustainable level of growth and it has weathered the few hick-ups, such as the SARS crisis, the Asian financial crisis. We think that's set to continue. One of the main impacts of this is going to be the savings of that type of growth throws off. The major impact of Asia growing so quickly is really a significant part of global economy now. At nearly £5 billion Asia generates about two thirds of the wealth that the US economy does every year. At current growth rates it's very likely that Asia is going to overtake the US in terms of wealth generation in the global economy, certainly within the next decade.

The second implication is really: what do you do with all this wealth. The chart here shows the average savings rates across the world. The red bars are the more developed countries; the blue bars are the more developing markets in Asia. You can see that on average 30% savings in Asia is more than double the amount of savings on annual basis as most of the developed economies. Why is this? There is many reasons, I guess, and a lot of them are more related to social economics rather than, you know, investment areas, but I think the chart here just illustrates some of the reasons we believe this trend is going to be sustainable. There is obviously cultural aspects to it: limited social security compared to developed markets; relatively young populations, clearly people are trying to save up and build a stock of wealth for the future; urbanisation clearly a very important trend in places like China. That has a knock-on effect as people try to move away from the traditional network that supports them, so they have to start providing for their own future and their own savings and rely a bit less on families. And increasing education levels; typically this leads to different savings patters as people do have a higher education standard.

Now, maybe if we can just sort of focus in on this savings aspect and turn it into sort of hard Dollars and Cents or Sterlings as we have shown in the chart here. The line show the actual Dollar savings or the Sterling savings on an annual basis for three regions. The red line shows Asia, the yellow line shows the US and the grey line shows Japan. I think the important thing here is that trend is fantastic for Asia. You've seen a growth of something like £200 billion on an annual basis, in excess of £800 billion. So every single year Asia is saving £800 billion pounds. That's more than Japan and it's more than the US now. So that is very significant. I think more important is the trend. In Asia the trend has been steadily rising for the last decade or so, whereas you can see in Japan and slightly older economies with a population demographics are against savings you are seeing a turn-down, a long-term decline in that absolute level. And given the economic background, given the rates of growth we're seeing in the region, this trend is set to continue. Life savings on their own are pretty useful, we normally need to do something with them. Really we have 2 choices: we can either invest them in financial markets, into equities and bonds; or we can invest them in the real economy. Asia's rapid pace of growth obviously needs investment into the real economy. We need to spend money on plants and equipment to sustain this growth. This chart looks at the other side of that savings investment of balance. The net/gross capital formation, the same real assets we are putting into these countries. Again, the red line shows Asia and you can see the same trend is in places on the savings side of the equation. Fantastic growth over the last 15 years or so, and now on an annual basis, Asia is investing something like £700 billion into fixed capital. Again, some other trends in the rest of the world: the US is seeing a decline, or appears to be seeing a decline recently, and Japan has been in a slightly longer term decline since it's kind of its own bubble burst more than a decade ago. Now, like any of your children know, who save piggy-banks, ultimately you have to get your savings invested in balance year, and this chart looks at that savings investment combination across the world. Again, the red line shows Asia and it's a pretty healthy picture. If you remember they are saving about 800 billion and they are investing about 700 billion, so they are throwing off every year something like £100 billion in excess capital that they don't need to use in their own economies. That's in sharp contrast with what's going on in the States at the moment, which is shown in the yellow line. Every year, the US needs to borrow something like £300 billion from the rest of the world to fund its own investment, fund its own growth. Clearly, this has big implications, and I think the thing that really changes is that Asia is now becoming the largest creditor to the world. Asia doesn't need to borrow money from the rest of the world; the rest of the world is borrowing money from Asia. And clearly this is having some visible impact in terms of the purchase of treasure bonds and things like that. But let me show you some other examples of the implications of this. Maybe, just to put that in context, this shows another measure of this saving investment and balance. This shows the current account in the region, which is if you like, the same as sort of working capital in a country-... in a company. Every year if you run a working capital deficit, you also need to borrow from someone, and if you run a surplus you can use that money, put that money in the bank. 196-, 197- saw a crisis in Asia, because Asia sort of ran a current account deficit and the rest of the world didn't want to lend to Asia. The chart here just shows the magnitude of that at the time, it was about $50 billion. In contrast now, look at the magnitude of the saving Asia is throwing off. Something like $150-$200 billion every year of excess savings that the region is generating as a whole. Accumulative effect, that's over a trillion Dollars in the last 6 years that Asia has saved and is able to deploy into the rest of the world's economies.

So, as I mentioned, what do we do with all those savings? To some extend just having the savings on their own doesn't really help as much. So I think the key message now is that historically Asia has struggled a little bit invested efficiently. We now think that's changing. I think that is creating tremendous opportunity both for financial services companies, but also for investors.

This just shows a chart of what people do with their savings in the world. The red bars are really the ones to focus on. That's savings in cash and deposits. And clearly in Asia there is about two thirds of people's assets are sitting in those relatively low yielding assets. That's in sharp contrast to the US. So, I think the message here is really that I think Asia has struggled to get its savings invested efficiently in contrast to the US, which has much better developed capital savings markets. So, clearly, as this trend changes in Asia, we are going to see an impact on the global economy.

Now, why is that? Why did those savings distortions exist? Again, there is many reasons. One of my guesses might be really that sort of a few government related distortions either through government guarantees on underlying savings such as maybe the post office savings in Japan, the SPF in Singapore, which offers people a very safe, a relatively high guaranteed return. Other reasons might be that money is simply trapped in the domestic economy. Historically Asia has been a bit nervous about letting money flow freely outside its economies. So, you've got too much money in some of these domestic economies. As I mentioned, broadly we think these savings distortions are being lifted as a result of de-regulations across the region and here is just a number of illustrations of that kind of deregulation. Perhaps the biggest one that we are hoping for is something like a deregulation of the post office in Japan, but there's been many smaller examples, such as the banks being privatised in Korea and Singapore, the creation of the MPF in Singapore, which is a government sponsored savings scheme; and to more sophisticated measures, such as securitisation laws, which allow people to restructure their balance sheets and allow investors to have more access to these assets. And there is a very visible way to see the impact of these de-regulations coming through and actually the return on equity that these businesses are able to generate. I think historically Asia has been thought of as relatively inefficient return on assets.

This chart shows the return on equity that UBS estimates for next year. You can see that nearly 16% ROW of Asian business on average is about the same level that you ask businesses to generate on an average. So I think this more efficient use of capital is starting to show up in the region very visibly. Now this is publicly listed companies, again, it should be very visible to the rest of the world.
Interestingly enough, it doesn't seem to be that the market quite believes this. This is the p-multiple that Asian equities trade on compared to the rest of the world. It's something like 12 times. People clearly aren't quite willing to pay the same for these return on equity that the rest of the world is. So we think that as the deregulation story and the more efficient use of capital story starts to become a little bit better understood, you will see a re-rating of Asian equities. From a fund management perspective we do think this is one of the best investment opportunities that exist in the world at the moment.

Let me show you one more example, before I pass on to Nick. This time it's more directly linked to the savings and what they are actually being used for at the moment. The chart here shows the Taiwanese banking sector and it shows the amount of money that is sitting in Taiwanese banks that isn't deployed into the real economy; so it's actually excess savings. You put your money into the bank. Normally the bank lends it out, and let the banks run a rough, you know equilibrium there. And you can see that for a very long period of time that worked quite well. Post the Asian crisis the investment levels have fallen and savings has risen, so you are seeing a tremendous build-up in excess deposits in the banking system, or from the other side of the equation, low loan to deposit ratios. This number is huge. It's about 50% of GDP in Taiwan. It's about £180 billion. And clearly the banks have to do something with money and normally they park it in the bond market as a safe kind of yielding asset for them to buy. This has huge implications in what's happening in the bond market.

This chart shows the current level of yields minus the recent average of the last 5 years. I've used about as long a period as I could find to show all the countries in Asia. And the message really is that most market in Asia and across the globe have actually seen bond yields being depressed at the moment. That feels a little bit odd, because we have seen a very strong period of economic growth, we have seen an insurgence in inflationary pressures around the world, so my sense here is that some of that excess savings is really depressing bond yields, particularly in the region, where you do have relatively small bond markets and the stock of savings sitting right next-to them. So, I think one of the big opportunities for us also is that we are probably going to see a normalisation of bond yields over the next few years, really as these savings are deployed more efficiently. You know, if you just think that the people take their money out of the banks and spend it or they stick it into the equity market, you know the banks will pull the money out of the bond market and you should see yields normalise over time. So again, I think that presents a tremendous opportunity for companies like us, because we are receiving lots of premium (kinds?) invested at higher rates in the future.
But with that, let me just pass over to Nick, we will drill in a little bit into the two big regions and show how these factors are actually playing out into the larger countries.

Nick Scott:

Good morning, everyone. Thanks very much, Kelvin. I'd like to hone in on two specific markets, which are having a huge influence in the global market place today, namely China and India.

Let's first ask why China and India are so important to Prudential. The first region is the financial services market in those countries is very immature. Secondly, with the growth of income and the rising middle class in those two countries, we expect more purchasing of financial services products, which obviously plays into the hands of companies like Prudential. Thirdly, the growth in China and India is also going to spur a lot of growth in the rest of Asia. And fourthly, Prudential has two very significant businesses, both in fund management and life insurance in China and India. So we are very well established and we can gain from these two markets. In terms of asking a couple of important questions. I think a lot of people have been sceptical about China in the quality of growth. We all know about historical success, but can the quality of growth improve? Second: India is lagging behind China in terms of GDP to capita, it's behind 10 years behind China. Remarkably, in 1982 they had same GDP per capita levels. So can India sort of catch up and grow above historical trends?

If you learn from the other Asian tigers, it looks like there is going to be some kind of S- curve in terms of income growth across Asia. As countries move between (primary production?) through labour intensive manufacturing, capital intensive manufacturing, along to services. If you look at Hong Kong, Singapore and Japan, they have 6 time the GDP per capita to China, and China has got double the GDP per capita than India. So there is tremendous potential for these countries to move up the income curve.

China initiated de-regulations. A lot of you know 1978 after Deng Xiao Ping opened up the country's special economic zones, and ever since then the country has been growing at rapid pace. But actually, interestingly enough, in 1998, if you look at the share of global exports, that pace of growth has actually increased. In fact, if you look at share of global exports from 1980 to the current day, they have doubled up to 6% just in the last 6 years. So the pace is gathering and I think this momentum is incredibly hard to derail.

India has had a different sort of story. Actually, percentage share of exports in the world has actually fallen from 1950 to 1990. De-liberalisation came in India in 1991, as a lot of you know, and the pace there has picked up. And we think it's a raising trend and basically we haven't reached full potential for India, but the trend is in the right way.

Just looking at the labour advantage China and India have. There are basically huge pools of talented, cheap labour in both these countries. There is a huge pool of workers in the country side to supply cheap labour. In terms of the concept of urbanisation, there is a huge move from the rural areas to the urban areas. And just to give it some perspective, an urban worker can probably earn five times the amount a worker in the rural area in China. That cost advantage also spreads to other areas as well. If you look at low-end productive workers, and again, giving comparative countries, Mexican low-end productive worker would pay 5 times what you are doing in China. In the chart on the right there, it's actually on the average cost of IT workers. And if you again take a comparable country like the Philippines, an IT worker in the Philippines pays 7 times the amount of someone in India. So there is massive potential for these countries still to have a huge cost arbitrage.
China and India are very big, but just to remember one key statistic, they make up 40% of the world's population. Over the next 6 years, they'll add a staggering 139 million workers. And that is a phenomenal boost to growth. If you compare that to-... if you add up US, Western Europe and Japan, they only actually add a net 10 million workers in that time. By 2030 India will have overtaken China in terms of working population. So from a demographic perspective there is massive potential for India to catch up.

China is being incredibly successful at creating a sort of virtuous cycle: increased productive workers, higher savings, greater investment leading to greater growth. They seem to have got that cycle totally in sync. But if you examine the age dependency ratio, that is the ratio of non-working to working population, this is a very positive trend for both countries. The age dependency ratio has been falling in both countries since 1970. But in China it will peak in 2015, so well into the future. In India it's better still, peaking in 2040. The right hand chart demonstrates the link between age dependency and increased savings and increased investment. And I think the historical trends have been very clear. They've had very different growth models, China and India. China has been much more (allowing?) on foreign direct investment, had a very strong central government backing them. India has been much more dominated by the private sector, the domestic private sector, and they've had a more gradual sort of demographic approach. But it's quite clear that China is becoming certainly a stronghold of manufacturing, and in India's case it's becoming a major outsourcing services centre. But both countries have got new and different industries emerging.

Nick Scott

In China, the automobile sector and petrochems have been two major growth areas, and they will be in the future. In India, it's textiles, engineering and capital goods are emerging sectors. So these countries are converging. India is getting more into manufacturing, exports; China is getting more into services. But there is still a lot of growth coming out of new sectors. Just taking one example, because people ask, well yeah, in reality what are the sectors that really make a difference? Textiles is one of them. To illustrate the potential for growth in manufacturing exports this is a very key sector. India has lagged behind in manufacturing exports and they, I think, have a great opportunity in this regard. World trade in textiles is deemed grow from about 360 billion to 650 billion in the next 6 years after quota's are removed in the first quarter of 2005. China and India, according to WTO studies have been a major... have been restricted in this sector because of all these quota's and they are going to be the beneficiaries in this sector.

Just homing in on China in a couple of slides. By IMF estimates, approximately half of the GDP growth in the 90's came from fixed investment. This was supported by very high natural savings rates, low real interest rates and also very strong FDI.
Many have argued that the creditor's percentage of GDP at 140% and fixed investment as a percentage of GDP at 40% is totally unsustainable. And we would concur with this. We expect consumption to play a much bigger part in the whole GDP mix going forward, and the quality of growth to improve.

China, I think, is raising rates on Friday by 27 basis point was all about liberalising the interest rate structure and improving the growth in the system. Another reason we think the quality of growth in China will improve is a rise of the private sector. From 1994 to 2002 the private sector is a percentage value-added industry rose from 15% to 42%. In general the state-owned enterprises are less efficient than the private sector. They have less stringent capital return targets. But even if you look at the state-owned enterprises, they are getting more efficient. The SOE's are listing their price assets, mainly in Hong Kong, and those assets are a great role model for the rest of the inefficient state-owned industry sector.

And what's amazing to me is China is growing despite quite a dysfunctional banking system. This chart shows the average MPL's, the big 4 state banks. The big 4 state banks are 55% of all banking assets in China, so they are incredibly important. And although MPL's have fallen from roughly 30% to 21%, that's are still a huge burden for the economy. The banking reform is the key priority for the Chinese government and they plan to list all 4 state banks by 2007 and it looks like they are going to get 2 away: China Construction Bank and Bank of China by the end of 2005.

Efficient banks meaning: increased savings into productive investments. That's the key point. People say: well, that's great, but there is so much more work to be done. They will get on to legal reform, they will look at property rights, and they will continue to develop the capital markets, so it is a dynamic phenomena.
With India it has been a different story. Services are being the great growth sector. And they continue to move up the value chain in India. I think it is very interesting to recall a lot of analysts in 2000 saying that the software companies in India are just a Y2K phenomena. Post 2000 they are all going to die, they are not going to be around, it's low-end work. Well, actually quite the opposite has happened. They go from strength to strength. If you look at this chart here, we expect, or Nascom expects that we get 22% growth in the decade up to 2008, in IT and IT enabled services sectors. That's incredible growth. Likewise, in pharmaceutical there is phenomenal opportunities for the Indian companies.

India historically had very high interest rates. Credit to GDP is only 35% compared to 140% in China. But interest rates have clearly come down a big way. If you look at the blue line, that is the 10-year bond yields, and essentially they have halved over the last 6 years to just over 6%. This is going to be a massive boost to fixed capital formation. We are already starting a new investment cycle in India and there is capacity utilisation that hits very high levels.

India has very clear structural problems, which have acted as an impediment to growth. They are well flagged: an unfavourable tax structure, low savings rate, low FDI, bad infrastructure, inflexible labour laws, etc. But these issues have been known for a long time and at the margin the trend is actually positive. Certainly we've illustrated or tried to illustrate the demographic profile is very supportive of savings and investment. The government are trying to simplify the tax structure, and certainly improve tax rates or collection of tax. There has certainly been improvement in infrastructure; many people who have flown to Mumbay wouldn't agree with this, but in terms of telecom, ports and highways, they are making quite good progress. And sectors are opening up to foreign direct investment, including aviation and telecom.

So, in summary, Asia's high savings have turned Asia into the world's biggest creditor in global markets. De-regulation will allow Asia's excess savings to be employed more efficiently, which is obviously good news for a company like Prudential. Personal savings should shift out of low-return banking deposits into other financial products, life insurance pensions and mutual funds. China, we think, is set to become the new economic powerhouse of Asia. I don't think there is any doubt on my mind that is the case. And in terms of their income growth, it is hugely supported by positive demographics. So, in conclusion, we think Asia, the economic environment is incredibly positive, particularly for financial services providers.
With that, I'm going to pass you on to Mike, who is going to take you through some how to exploit these exciting opportunities. Thank you very much.

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