The Modi government’s first budget for the year 2014–15 failed to seize the possibilities in front of it. India elected Narendra Modi last year largely on the hopes that he would deliver growth and jobs. Based on his track record in Gujarat of running an efficient, corruption-free government, everyone hoped that he would quickly deliver the reforms needed to power up India’s growth rate and deliver jobs to realise the demographic dividend and avert a demographic disaster.

Instead of concrete steps, backed up by real money, to address the problems that shackle India, the latest budget contains yet more plans and dreams of future action.

The budget has to be judged in two contexts. One is the historic opportunity facing the country, and the other is the urgent need for reform.

India faces a fortuitous situation of falling oil and commodity prices. Since India is a large importer of oil, the falling oil price would benefit it in many ways: it would contain the current account deficit, lower the fiscal deficit and temper inflation. In many ways, this frees up resources that can be invested in infrastructure and education to take the country to a higher level of sustainable growth.

But the government has not taken full advantage of this opportunity. Other than fuel, the budget has actually raised the subsidies for food and fertilizer. It even increased the allocation for the rural employment guarantee programme started by the previous government. Without cutting these expensive subsidies, the country is going to find it difficult to generate resources for investment. This failure to curb the subsidies is one of the most significant shortcomings of the budget.

The budget does plan to provide more funds for developmental expenditure – roads, railways and infrastructure – but only by assuming high GDP growth and tax collections. It assumes nominal GDP growth of 11.5%, which could translate to a real growth rate of 8% to 8.5%. Although the recent revision to the GDP growth calculation has pushed up reported growth to 7.4% in the last quarter, it remains doubtful whether growth can rise enough to match the budget’s assumptions. After all, everyone was forecasting a rate of about 6.5% not long ago. The expected tax revenue growth of 15.8% also looks problematic, coming after a more modest 9.9% for the last year. If the tax collection ultimately falls short, the government will find it difficult to fund all its promises and still restrict the fiscal deficit to the planned 3.9%.

TO ITS CREDIT, the budget contains several good ideas for the future. The planned reduction in corporate tax rate from 30% to 25%, while eliminating many of the tax exemptions, is a step in the right direction, but it will be done over four years. After several years of planning and discussion, the implementation of the national goods and services tax is targeted for April 2016, provided that legislation is agreed. The government has also announced plans to turn the gold holdings of Indians into monetary savings. It aims to improve the ease of doing business and reach a ranking within the top 50 from the current 142. It is considering establishing ‘plug and play’ infrastructure projects with all regulatory clearances and coal/gas links in place. It is planning a new bankruptcy law to deal with non-performing bank assets.

Another positive step announced in the budget is the agreement with the Reserve Bank of India to target inflation of 4% within a band of 2% to 6%. This is likely to bolster the independence of the central bank in setting monetary policy. Once the required legislation is passed, the government intends to set up a monetary policy committee rather than leave decisions to the central bank governor, although the danger is that the committee would be seriously compromised if it is stuffed with political appointees.

THE ISSUE IS that these ideas are all promises for the future. In the meantime, the government has failed to reallocate hard money from wasteful expenditure and subsidies to development. It is not clear if the government will have the luxury of low oil and commodity prices for the next few years. If oil prices start rising, India’s finances will again be squeezed, and these plans may never make it to reality.

The government has also postponed the target of bringing the fiscal deficit within 3% by one year – it now expects to achieve it by 2017–18. While a lower fiscal deficit need not be India’s sole focus, the achievement of that target also depends on oil prices remaining benign.

It is not easy to turn around a large democracy like India, and the Modi government deserves praise for thinking through some important ideas for the future. But it could have been so much bolder in reallocating resources from wasteful expenses to productive uses. After all, opportunity knocks but once.

The first challenge facing Asian credit is the global economic backdrop. The most important hurdle this year is the impending rise in US interest rates and its impact on asset markets. Although the consensus is for rates to finally start rising in the third quarter, the potential pace of that increase is unclear, particularly in the face of the stubbornly low inflation.

In Europe, growth is stalling even for countries with strong balance sheets, and the economy is inching closer to deflation. Greece’s sudden elections may trigger renegotiations with other eurozone countries and raise the spectre of a currency breakup. Japan remains an experiment in progress, with the success of Abenomics far from assured in the face of faltering growth and sluggish exports.

By contrast, the economic picture in Asia is much brighter. Although various indicators have repeatedly shown that the Chinese economy is slowing, there is enough room for fiscal and monetary relaxation to maintain a growth rate close to 7% for 2015. India’s new government faces a rare confluence of positive factors. Lower oil prices will bring the current account closer to balance and reduce inflation, enabling interest rates to be cut and fuelling a pick-up in growth. The new government in Indonesia has also begun to take difficult decisions to cut fuel subsidies and devote more funds to infrastructure development. Its reform agenda is likely to support a gradual uptick in growth.

Overall, the International Monetary Fund forecasts Asia ex-Japan to maintain its growth steady at 6.3% for 2015, beating the outlook for other emerging regions, including Russia, Eastern Europe and Latin America and attracting investors to raise their allocations to Asia.

ACCORDING TO THE JP Morgan Asia Credit Index, Asian spreads ended 2014 exactly where they started: 262bp. While investment-grade spreads ended up at 188bp, just 8bp tighter, non-investment-grade spreads widened modestly by 58bp to end at 534bp.

At the current levels, Asian spreads are still much wider than before the 2008 global financial crisis: investment-grade spreads are more than double (188bp versus 83bp) and non-investment-grade spreads are more than thrice the pre-crisis levels (534bp versus 167bp).

In comparison to US spreads, Asian investment-grade corporate bonds provide a yield pick-up on average of 120bp, and Asian non-investment-grade corporate bonds pay 190bp more at the same rating and maturity. While some of this may be attributed to poorer liquidity, more complex legal systems and macroeconomic vulnerabilities, it still indicates the premium that Asia can provide.

Although the year has begun with a potential bond default by China’s Kaisa Group, a multitude of defaults through the year is unlikely in view of the reasonable economic growth and sustained liquidity for refinancing. The gradual relaxation of property policies in China should also support the Chinese property sector.

International bond issues from Asia hit a record of US$210bn last year, and there should be no problem in finding buyers for another year of heavy supply. One positive development in the last five years has been the superior ability of Asian investors to absorb Asian bonds, taking 57%–58% of last year’s new issues, up from 40%–45% of a much smaller volume pre-crisis. While the share of retail investors has declined (to 10% last year from 14% in 2013 and 16% in 2012), institutional investors have stepped up to absorb the ever-increasing supply.

That brings us to the question of what will happen when interest rates start rising. Based upon previous rate cycles, there is no evidence to support an automatic widening or narrowing of credit spreads; rather, spreads depend on the prevailing macro and credit environment. For example, in 1993–94, as the Fed raised rates by 300bp, average BBB credit spreads declined by about 30bp; in 2004–06, when the Fed raised rates by 425bp, spreads fell 80bp.

GIVEN THE REASONABLE economic growth, subdued default rate, higher spreads in Asia and the growing investor base, our base case is that Asian spreads would contract by about 20bp this year, delivering a total return of about 3% assuming five-year Treasury yields rise about 70bp. While this is lower than last year’s total return, it must be remembered that about 60% of last year’s return came from falling Treasury yields, a supporting factor unlikely to be repeated this year.

However, our forecast is not meant to rule out high volatility or idiosyncratic risks during the year. If oil and commodity prices continue to decline, or if the Russian situation gets worse, emerging markets in general could suffer and a contagion effect could reach Asia as well. While it stands to reason that Asia would be a net beneficiary of lower oil prices, and investors should be able to differentiate Asia from other emerging markets, volatility may still affect valuations in the interim.

Europe still has the potential to emerge as a significant source of volatility, if either Greece were to depart the currency union, or QE fails to revive growth and lift inflation. Closer to home, China could roil the markets, too, if it struggles to rev up its economy or if Chinese local-government debt becomes a challenge.

The consolation in these cases is that the Fed might be pushed to slow the pace of rate increases, and equity markets may perform worse than expected, again prompting higher allocations to fixed income.

Within Asian credit, although we are tempted to say that high-yield bonds would outperform investment-grade bonds in view of their higher carry, volatility in high-yield is likely to be much higher this year and one or two mistakes could wipe out the returns from a high-yield portfolio. Individual risks have risen in Chinese property, and some lower-rated issuers may find it difficult to refinance their maturing bonds. Issuers from the resources sector from Indonesia and China are at risk of a further slide in commodity prices. Subordinated debt issues from banks are also pressuring higher-rated high-yield bonds. Our preferred strategy is to overweight investment-grade, while maintaining an exposure to high-quality high-yield names.

This is the reproduction of an article in IFR Asia.

To many global investors, bonds from China’s property sector are toxic nuclear waste, not to be touched at any cost. To others, they come with a more pragmatic “handle with care” warning. I belong to the latter camp.

From just a handful of bonds 10 years ago, the sector has grown to contribute 9.5% of the Asian US dollar bond market with US$51bn of bonds trading. That is nearly a third of all high-yield corporate bonds in the region.

Over this period, the sector has gone through three cycles of downturns and upturns. Several Chinese property companies have issued, redeemed and refinanced their offshore bonds. Companies with credit ratings ranging from Single A to Triple C have managed to issue bonds, which trade actively in the secondary market. Yet, a feeling of unease persists.

Perhaps the first source of discomfort is the fact that offshore Chinese property bonds are deeply subordinated, since they are issued by offshore-incorporated entities, which inject the bond proceeds as equity into their onshore companies and service their debt only out of equity dividends received back from the mainland. The difficulties in repatriating equity funds out of China mean that the offshore principal effectively has to be refinanced. In case of bankruptcy, the onshore lenders have the first claim over the onshore assets.

While this structural weakness is undoubtedly true, it applies to every other bond issued by Chinese businesses, including investment-grade bonds far beyond the property sector, since the structure was born out of regulations prohibiting the issuance of debt or guarantees by mainland companies. (Only recently have the authorities begun to relax this prohibition, and the first few offshore bonds are now coming out with direct guarantees from mainland operating companies.)

ANOTHER SOURCE OF discomfort is the government’s meddling in the property sector through various measures, including the flow of credit to the builders, rules for financing land purchases, obtaining mortgages, and mortgage down-payment requirements. The harshest controls came in 2010 when the government restricted the number of apartments that an individual could purchase.

Property prices are a sensitive subject everywhere, and China is no exception. The government presses the brakes if the prices are speeding too fast and pushes the accelerator if property construction flags too much so as to threaten the overall economic growth.

This government intervention makes asset values volatile in both equity and debt markets, and raises the cost of capital to the sector.

Some investors have also been scared away by stories of oversupply and ghost cities. The property development business model, by definition, consists of a long operating cycle, and there may be genuine demand/supply imbalances, as in any other industry, but the overwhelming majority of Chinese properties are built in response to actual demand from a rapidly urbanising population. The same goes for talk of speculative buying, when the reality is that most of the properties are bought for self-occupation. Buyers have to put up a minimum 30% down-payment, they are not over-leveraged and there is no subprime lending.

WHEN IT COMES to investing in Chinese property bonds, one should realise that there has already been one level of filtering – only those companies large enough to go through a rating process and the expense of issuing offshore actually end up selling dollar bonds. They are all listed offshore, most of them in Hong Kong, and are subject to audits and disclosures that go with the listing status. The additional scrutiny from equity analysts and investors that comes with listing also offers additional information for bond investors.

There has not been a single default in the sector so far, and only two distressed exchanges in 2009, both at 80 cents to the dollar. Some companies did go through financial distress during previous sector downturns, but they managed to sell land or unfinished projects to stronger players and stave off default.

This is not to argue that we would never see a default in the sector. We will, sooner or later. But the sector has genuine fundamentals, strong and weak players, and saleable assets that can be realised in times of distress.

So, how should one approach investments in Chinese property bonds? First of all, investors need to be prepared for the volatility that comes with the regulatory changes. Any crash in value following a regulatory tightening offers an opportunity to pick up the higher-quality bonds at more attractive prices. In fact, such moves also enable the stronger players to buy out the weaker ones or to acquire assets from the struggling players, and increase their market share.

The current downturn in the market is no different. It is true that the stock of unsold property is running above average; that the leverage has increased in the last 12-18 months in response to slowing sales; that margins are under pressure due to the pressure to liquidate stock; and that some of the weaker companies are likely to experience a liquidity crunch in the next 12-18 months, unless they slow down their expansion. But the current downturn is also an opportunity to pick up bonds issued by stronger companies, which will benefit from the tight conditions in the sector. The challenge is reading the credit fundamentals carefully enough to identify the winners.

Asian bonds have had a good run so far this year, producing a total return of 7.8% according to J.P. Morgan Asia Credit Index (JACI). But, looking back over the last three years, yields and spreads have steadily declined, so much so that “high yield” has become an oxymoron!

That has raised the question in the minds of many people: Is there a bubble in Asian fixed income?

The “B” word has been applied variously to different asset markets, such that it has become an amorphous thing … one that everyone talks about all the time, but no one knows precisely what it means!  Let us try to keep the dreaded word in perspective for our discussion. One definition of a bubble is when the prices are far in excess of the fundamental value of the assets. Another way to look at a bubble is as an unsustainable and fast rise in prices. Either way, a bubble carries the potential to hurt investors when it eventually suddenly bursts.

Keeping this in mind, let us examine the evidence in the Asian U.S. Dollar bond markets. The first evidence for the existence of a bubble is the contraction in both yields and spreads. It is true that the current yield to maturity of 4.6% for JACI seems too tight, particularly when compared with the high level of 11% during the Global Financial Crisis. But if we disregard the spike in yields during the GFC and the period when the interest rates were slashed in its aftermath, average yields have moved in a narrower range of 4.2% to 5.5% in the last four years and the current yield is near the middle of this range.

Similarly, if we consider the history of spreads, the current spreads over Treasury of 243bp appears tight when compared with the GFC high of over 800bp. But in the last four years, they have ranged between 214bp and 450bp; and if we disregard the mini-spike during the European sovereign crisis, they have moved between 214bp and 320bp. Compared to this range, the current spreads do not appear so alarming. In fact, they are more than double the tight levels of 109bp reached in 2007 before the GFC.

Compared to the U.S. domestic bonds, Asian spreads still offer value. Asian investment-grade corporate bonds, for example, trade at 180bp over Treasury, while spreads for U.S. industrial bonds with equivalent credit quality and maturity trade at spreads of 100bp.

When we consider the fundamentals, another key factor is the default rate for bonds. According to Moody’s, the global high-yield default rate was 2.1% for July 2014, well below the historical average of 4.7%. In Asia-Pacific, Moody’s predicts a default rate of 3.3%.

While such low default rates are one of the supports for the current tight spreads, we must remember that they are themselves partly the result of loose liquidity conditions and easy monetary policy. That brings us to the one of the key reasons to question whether the Asian bond market might collapse in a bubble-like fashion when rates start rising and liquidity begins to ebb. It is doubtless true that the bond valuations have benefited from the falling rates. In 2014 so far, of the 7.8% return generated by Asian bonds, 3.6% has come from a fall in Treasury yields and the rest from tightening spreads.

This comfortable environment would change as the Fed starts raising rates in the second half of 2015. Not only will longer-duration bonds face capital losses, but weaker companies would find it more challenging to roll over maturing debt – in turn leading to higher default rates.

It is based on such fears that some predicted a mass migration of funds from fixed income to equity, calling it the Great Rotation. But so far, in the Asian bond markets, there has been scant evidence of such a shift. New issue volumes are touching record levels, with USD 120 bn of new bonds so far this year, representing a growth of 35% over the same period last year. Although private banks have taken up only 9.7% of new issues this year, down from 16.2% and 13.9% in the last two years, the gap has been more than adequately filled by institutional funds.

At a very fundamental level, Asian economic growth is holding up reasonably well, although all eyes are on China’s and India’s growth rates to see how these two economies perform. For the Asian bond market, China is a key variable, particularly the Chinese property sector.

So, finally, is there a bubble or not in Asian bonds? Although Asian bond valuations are stretched at the moment, they are not beyond belief and entirely divorced from fundamental factors. Some of the supporting factors such as rates and high liquidity will diminish over the next two years, but I believe the correction would be orderly and not a sudden collapse. Asian bond valuations may be tight, but they are not a bubble.

One year ago, when Bernanke first mentioned the possibility of tapering, the asset markets took fright that the Fed would take away the punch bowl. The U.S. Treasury yields spiked immediately, leading many commentators to predict an Armageddon in the fixed-income markets resulting from a combination of rising rates, falling asset prices, shifting of funds to equity markets.

However, the reality so far has turned out to be very different. As the Fed began the actual tapering, interest rates have gone down this year. The 10-year Treasury yields ended the last year at 3%, but have since retreated to 2.6%, reflecting the hesitant performance of the U.S. economy as well as the additional monetary stimulus from Japan and the possibility of a stimulus from the ECB.

Neither has the “great rotation” out of fixed income into equities materialized. The equity funds covered by EPFR have received USD 46 bn of inflows this year, while the bond funds have gathered USD 84bn. It is interesting to note that both figures are lower than those recorded in the same period last year (USD 140 bn for equity and USD 100 bn for bonds). However, these figures mask a striking contrast between developed-market and emerging-market funds: the former gained USD 68 bn in equity and USD 90 bn in bonds, while the latter lost USD 23 bn in equity and USD 7 bn in bonds.

If one were to observe the Asian USD bonds, however, one would certainly believe that the good times are still rolling on. New bonds worth USD 80 bn have been issued in the first five months of 2014, at par with the corresponding period of last year. (Note that the chart below includes EUR and JPY as well).

Asian USD bonds have so far produced a total return of 5.6% (see table below), split roughly equally between the returns from the falling US Treasury yields and the tightening spreads. Split another way, coupons have generated about 2% so far, while rising bond prices (both due to US Treasury and spreads) have produced 3.4%. The table below shows that investment-grade has outperformed high-yield so far. This is mainly thanks to the concerns over the Chinese property credits and the impact of the falling coal prices on Indonesian mining credits.

This total return looks quite respectable when viewed against the overall equity market performance. MSCI Asia ex-Japan equity index is up 2.8% this year, thanks mainly to emerging markets such as India. Hang Seng, on the other hand, is flat.

Regular readers of this blog may remember our recommendation for this year to overweight high-yield. We still expect high-yield to outperform investment grade. While we still believe in that prognosis, investors would be well advised to follow two other broad strategies:

• Stick to better quality names: While liquidity is still comfortable, there will come a day when companies with lower credit quality will find it difficult to refinance themselves. Already, bonds with lower ratings have underperformed: as the chart below shows, the best returns have come from “BBB” bonds, while the worst have come from “B” and “C” rated bonds.

• Control the duration: While the decline in the interest rates have taken many people by surprise, thereby enabling the longer-duration paper to do well, it is difficult to conceive of the rates falling further. In fact, discussions have already started in the Fed about when the first rate increase should take place. At this juncture, it is better to shorten the maturity of the portfolio towards five years rather than longer. Many perpetual bonds look increasingly riskier, unless the issuer has a strong incentive to call the bonds earlier.

In its short six-year life, the offshore Renminbi bond market in Hong Kong, also called ‘Dim Sum’ or ‘CNH’ bonds, has emerged as an investors’ favorite. A range of issuers, including the Chinese government, Chinese banks and companies and foreign companies, have issued debt in this market, raising the total outstanding value to over RMB300bn for bonds and another RMB250bn for certificates of deposit.

From the investors’ point of view, CNH bonds were attractive because their total return came from not only the underlying bond yield, but also the expected appreciation of the Renminbi. In addition, CNH bonds were less volatile than Asian USD bonds, although less liquid too. Some investors felt they could park their money in CNH and enjoy a steady and superior return.

Investors’ expectations were validated as the Renminbi had climbed steadily at an annual rate of 3.4% against the dollar from August 2010 until January 2014, after being frozen from 2008 to 2010 during the peak of the financial crisis.

But recent developments have shaken the expectations. Since January 2014, in just over 60 days, the Chinese currency has weakened 2.8%. On March 15, the People’s Bank of China widened its daily trading band to 2% around the central value from the previous 1%, raising the possibility of further depreciation in the currency. Whether the currency falls further or not, these changes have raised the volatility of the currency.

The reasons for the currency fall are not far to find. The Chinese economy has been slowing perceptibly over the last two quarters. There are rising concerns over the significant amount of credit creation in the economy. These concerns have led to the exit of some hot money from the currency. There is also the possibility that the currency depreciation may actually be welcomed by the Chinese authorities in the face of slowing exports from China.

Whatever the reasons, the currency fall has shaken one significant support to the CNH bond market. But the surprising fact is that the CNH bond values have hardly budged in the last two months (see table below). Reflecting that, the HSBC CNH index has held steady from 107.45 at the beginning of the year to 107.81 on March 21. One reason could be that investors, particularly the private-bank investors, view the currency weakness as temporary.

Is the CNH market still attractive for investments, despite the currency moves? To answer that question, we have compared several names that have issued in both the CNH and USD bond markets (see table below). It is evident that, for several investment-grade Asian names, CNH bonds offer higher yields for the same or shorter maturities. Even after accounting for the cost of hedging the currency exposure, the CNH market offers a pick-up of 50 to 100 basis points over the USD market. However, for non-investment-grade names, the USD market offers better yields.

It is clear that the CNH market has not lost its allure for investors even after the recent currency gyrations. It will take much more than a couple of months of currency weakness to shake their faith.

Within Asia, the north-eastern countries (Japan, Korea and Taiwan) have progressed much faster in the last 50 years than the south-eastern countries (Indonesia, Philippines, Thailand and Malaysia).

Would you believe that, in 1950, Philippines was richer than Korea and Taiwan? Or that there was hardly any difference between Taiwan, Korea, Indonesia and Thailand? Or that China was lagging Indonesia and Philippines? Here are their GDP per capita figures for 1950: Japan $1,873, Philippines $1,293, Taiwan $922, Korea $876, Indonesia $874, Thailand $848, China $614, India $597*. Today, Japan, Korea and Taiwan have all ascended to the developed country status, while Indonesia, Philippines and Thailand have been left behind. The question is why.

In his latest book, "How Asia Works", Joe Studwell tries to answer that question. He identifies a magic formula with three ingredients: land reforms; state-supported manufacturing development; and state-controlled  financial sector being harnessed to support manufacturing.

The first one, land reforms, consists of restructuring agriculture  into labor-intensive household farming, which maximizes agricultural productivity by making use of the excess labor available in the initial stages of development. This results in a surplus that creates demand for goods and services and sets the stage for the second initiative, development of state-supported manufacturing.

State-supported manufacturing means channeling investment towards manufacturing rather than other types of businesses. This creates productive jobs for workers with limited skills as they migrate out of agriculture. For this process to be successful, Studwell lays down two essential conditions: rapid learning of advanced manufacturing technologies and subjecting manufacturing to export discipline to make sure that only the globally competitive industries survive.

The third intervention is to control and harness the financial sector to provide the necessary capital for the agricultural and manufacturing development, rather than other types of businesses, including services and personal consumption. The financial sector could also be used as a tool to ensure export discipline for the manufacturing industries.

Well, that's it - the magic formula. Having explained this right upfront in the foreword, Studwell spends the rest of the book mainly presenting the historical evidence for his theory. Much of his evidence is anecdotal and historical; not much of statistical tables and charts, but a lot of narrative economic history. In between, the narrative is interspersed with his observations from his travels in some of the countries, in so far as they are related to his theory.

In general economic commentaries, we do not generally read much about state-directed manufacturing and finance as elements critical to economic development. Hence Studwell’s theory is an interesting one. But I could not help questioning it as I read along.

One issue is whether these historical lessons are still relevant. In other words, can the lesser-developed countries start implementing this formula today and achieve development? For instance, it can be argued that what is holding back India are misdirected and wasted subsidies, corrupt and inefficient bureaucracy and the plutocratic political class. For India, the solution has to start with dismantling the current economic and political structures rather than more state-directed support for selected manufacturing industries or state-directed lending for farming and manufacturing.

In many places, the book comes across like extolling central planning and state control. Studwell praises the economic model followed by Park Chung-hee, Korean dictator from 1961 until his assassination in 1979. It so happened that Park’s economic policies contained some of the positive elements such as manufacturing development, rapid technological acquisition and development of globally competitive industries, which helped Korea’s fast economic development. But central planning and government control over the economy can easily turn into crony capitalism, as it happened in Indonesia’s Suharto period or in India until the economic liberalization of 1991. Russia is another ongoing example of how state control has not managed to lay the foundations for sustained economic performance – the country remains sorely dependent on oil and gas revenues. The point is that, for every one successful state-directed economic development, there are myriad examples of misdirected, corrupt and failed attempts of state-directed economy.

It is not clear to what extent Studwell’s model applies to China’s incredible rise in the last four decades. While China has followed the export-led growth model and turned itself into the world’s factory, it has yet to prove its ability to acquire and develop advanced technologies. Although Studwell provides some figures about the growth in the total profits earned by state-owned firms, there is a lot of other evidence that their return on capital invested is much lower than that achieved by private firms. It is then no wonder that China's incremental capital-output ratio has been rising. China today stands at a crossroads, when it needs to shift from export-and-investment-led growth to domestic-and-consumption-led growth.

A good question may be worth more than one good answer. As such, books should not be judged solely by their ability to provide answers. In that sense, Studwell’s book provokes many interesting questions. For example, how is India going to achieve economic prosperity and provide jobs to its expanding young population without developing its manufacturing sector? Its vaunted information technology sector has created 3m direct jobs, hardly enough to scratch the surface, leave alone making a dent in the country’s employment levels. While Indonesia has ridden the commodity boom for the last 10 years, how is it going to climb further without a coherent competitive strategy? Malaysia has got stuck in the middle-income trap without a clear strategy of how to develop further.

As Studwell points out, the economic profession seems to have adopted the mantra of free market, the government’s role being only to build the infrastructure, provide the legal and institutional framework and set the monetary policy, leaving the manufacturing and services sectors to decide their growth strategies. This book raises interesting questions about whether governments should legitimately play a more interventionist role in fostering development.

I had immensely enjoyed Studwell’s earlier book, “Asian Godfathers”. It was a riot of a read about Asia’s business tycoons and their escapades, although with a solid message about how they had cornered the economic systems to their own advantage. “How Asia Works”, on the other hand, is much more of a slow and difficult read.

* "All countries compared for Economy> GDP per capita in 1950, Angus Maddison. Aggregates compiled by NationMaster." 1950.
<http://www.nationmaster.com/country-info/stats/Economy/GDP-per-capita-in-1950>.

Asian dollar bonds ended in the red last year with a total return of -1.3% according to the JP Morgan Asia Credit Index (JACI). However, this figure masks a large variation between different segments. At the low end, investment-grade sovereigns lost 8.2%, while at the high end, high-yield corporates produced a return of 4.3%. Within high-yield corporates, Chinese property credits were the best performers, earning a return of over 7%.

The negative return was mainly due to the pick-up in Treasury yields, particularly after May 2013 when talk of tapering emerged. Spreads on Asian bonds performed well, with the overall spreads steady at 260bp despite the ructions in market.

The outlook for 2014 will again be dependent on both Treasury yields and the underlying credit fundamentals. With the Fed poised to taper the quantitative easing over the course of the year, and as the US economy continues to accelerate, we can expect further increases in Treasury yields. After the 10-year Treasury yields have already touched 3%, they are unlikely to rise at the same pace as last year, and a rate in the mid-3% area for 10 years seems appropriate for the end of 2014.

Asian spreads are still higher than their pre-crisis levels (see chart below). In addition, the table below shows that Asian dollar bonds provide a yield pick-up over US bonds for same/higher ratings and shorter maturities. The yield pick-up is about 30-60bp for investment-grade and about 180bp for high-yield bonds. Given these factors, there is scope for a further contraction in Asian spreads by 25-50bp. This should cushion the impact of the expected rise in Treasury yields.

The other supporting factors for spreads are the likely low default rates and steady credit ratings in Asia. The underlying economic picture should also be supportive for credit quality – the US economy is likely to further pick up this year, Europe is expected to limp back to stability after recession, and Asia should be supported by the improving external economic environment.

If Treasury yields rise and spreads contract, the net effect could still lead to a positive return for Asian credits as a whole. The average yield on Asian bonds is 5.3%, composed of 4.6% for investment grade and 7.5% for high yield, according to JACI. As long as Treasury yields do not rise steeply, the overall return should be close to the yield. Of course, the net return depends on the extent to which Treasury yields rise.

For instance, if 10-year Treasury yields reach 3.5% and spreads contract 25-50bp, then the total return could reach close to 4%.

With the Asian credit universe, high-yield corporates are once again set to outperform investment-grade credits. High-yield bonds should do well as long as default rates stay low and the refinancing environment remains comfortable. Hence it makes sense to overweight high-yield bonds in Asia.

That brings us to the concept of the two interest rates: one that applies to the investments and the other to leveraging the portfolio. Over the course of this year, as the Fed tries to taper down its quantitative easing, longer-term interest rates are set to rise further, negatively affecting the market values of bonds. Hence, it is important for investors to focus their portfolios towards the short-to-medium-term maturities of, say, around 5-7 years.

The short-term interest rates, on the other hand, are likely to stay low, as the Fed will continue to keep the short-term rates close to zero for an extended period of time, perhaps until the end of 2015, and raise the rates only in small steps after that. Investors can use this to leverage their portfolios by borrowing short-term funds.

There is one final element in the construction of the portfolio strategy in Asian credit, and that is to choose credits carefully with regards to their fundamentals. While the refinancing environment may be reasonably easy in 2014, the same cannot be said of the years after that. As liquidity tightens in 2015 and as cost of funds rise, not all the borrowers will find it easy to refinance maturing debt. That in turn could lead to mark-to-market losses for weaker credits, perhaps later in 2014 or beyond. Investors must position their portfolios by carefully avoiding such weaker credits.

So, let’s put together the main elements of the suggested investment strategy in Asian credits:

1. Keep the portfolio maturity towards the lower end, i.e., 5-7 years.
2. Continue to employ leverage to improve returns.
3. Overweight high-yield over investment-grade.
4. Choose the credits carefully and avoid fundamentally weaker credits, even if their yield is attractive.

By carefully managing the portfolio, it is possible to generate returns of up to 8-10% from Asian dollar bonds for 2014.