How to Achieve Balance between Goals of Fiscal Policy and Development of Bond Market:

1. How to Achieve Balance between Goals of Fiscal Policy and Development of Bond Market: Managed Currencies, Reserve Accumulation and Asian Bonds International Bond Market Conference, 2007 Taipei, 14-17 November Hon Cheung 15 November 2007

2. Presentation Overview Fiscal policy is too narrow a consideration for Asian bond issuance • Given broad budget surpluses across Asia, fiscal policy suggests a reduction in Asian government bond issuance. However: • Bond issuance is also tied into managed currency policies across Asia • The resultant build-up of reserves leads to increasing issuance • Therefore, currency policies will act as a positive issuance factor • Moreover, other important government policy issues will make further issuance necessary: • Regulatory capital considerations for banks (local regs. and Basle II) • Growth in insurance businesses across Asia • Pensions and demographics trends

3. Non-Fiscal Matters: How to Create a Sovereign Wealth Fund Simple conceptualization: a 100% public sector export transaction • The government sells goods or services to a foreign country and receives a claim on the foreign country’s goods (i.e. foreign currency) • Using US$ as a proxy for this foreign transaction, simplistically: • SWF = surplus monetary assets created with no underlying liabilities • Government privatized oil revenues are an example of this mechanism US$ Foreign Customer Government Goods Assets:+US$ Liabilities:-none Government “Balance Sheet” Sovereign Wealth Fund

4. Local Cash Private Sector Transactions: Free Floating Exchange Rates Private sector: SWFs normally arise in managed currency regimes • With a free floating exchange rate regime, it is not easy to account for the foreign-customer component for private sector transactions that clear on the open market (exception might be clearly identifiable commodity revenues): • Therefore, SWFs created through private sector transactions (e.g. many of the Asian SWFs) normally arise in managed currency regimes US$ US$ Currency Market Domestic Exporter Foreign Customer Goods

5. Cash Managed FX Regimes: Reserve Management Implications Dynamics of a 100% private sector transaction • A managed currency policy (as used by many Asian governments) ensures that the pace of currency appreciation is controlled: • Foreign currencies are purchased (directly or indirectly) with local cash • Inflationary pressure reduced through the issuance of local bonds (“sterilization”) to absorb excess money supply • Simplistically, the direct (or indirect) consequences are: Domestic Bonds US$ US$ Gov’t Bond Market Domestic Exporter Foreign Customer Government (Central Bank) Goods Cash Government issued “Sterilization Bonds” Assets:+US$ Liabilities:-Bonds

6. No Surplus Assets from Private Sector Transactions Alone A 100% private sector foreign transaction does not create surplus SWF assets – there are also corresponding liabilities • This is the realm of central bank reserve management, not SWF • Managing assets (foreign currency) and liabilities (domestic bonds) subject to: • Managing FX rate; liquidity; sufficient excess reserves for precautionary management Government (Central Bank) Assets:+US$ Liabilities:-Bonds Reserve Management

7. Cash In Practice, the Government is Usually a Stakeholder Private sector transactions include a public sector stake • In practice, the government is always a stakeholder in a foreign transaction: e.g. oil revenues (high stake) or income tax (small stake) • Conceptually, the government’s stake, x, gives rise to SWF assets: US$ US$ (1-x)Bonds Gov’t Bond Market Domestic Exporter Foreign Customer Government (Central Bank) Goods (1-x).Cash Fewer bonds needed to sterilize money supply x.Cash x.Cash Government (Stakeholder) Assets:+x.US$ Liabilities:-none x % Sovereign Wealth Fund Assets:+(1-x).US$ Liabilities:-(1-x).Bonds (1-x) % Reserve Management

8. Cash • Role - policy tool • Sterilization bonds are a large proportion of bond issuance for many Asian markets • Bonds are an important asset class • Risk-free pricing across extended yield curve fundamental to pricing other assets • Role - recycle reserves • Regional trade has increased in Asia • Ultimately, settlement in customer currency will mean CB reserves acquired in Asian local currency • CBs will want to hold reserves in Asian local debt of trade partners • Role - core asset class • For financial focused SWF, asset class diversification is a key issue • Asian local debt has attractive characteristics 1 2 3 The Role of Asian Local Currency Bond Markets Bond markets also serve important non-fiscal roles 1 US$ US$ (1-x)Bonds Gov’t Bond Market Domestic Exporter Foreign Customer Government (Central Bank) Goods (1-x).Cash Fewer bonds needed to sterilize money supply x.Cash x.Cash Government (Stakeholder) Assets:+x.US$ Liabilities:-none x % Sovereign Wealth Fund 3 Assets:+(1-x).US$ Liabilities:-(1-x).Bonds 2 (1-x) % Reserve Management

9. Role 1: Policy Tool • Sterilization bonds are a large proportion of bond issuance for many Asian markets and are a necessary component of their government’s currency management strategy • However, bonds are an important inherent asset class, so creating liquidity in the government yield curve creates side-benefits: • Risk-free pricing across extended yield curve • Fundamental to pricing other assets • Lack of local bond markets recognized as a contributory factor to Asian crisis (mismatch in currency and maturity in corporate balance sheets)

10. Role 2: Recycling of Asian Reserves • Regional trade has increased in Asia • Ultimately, settlement in the customer’s local currency will mean Asian local currency element of central bank reserves will increase • Asian local currency government debt (particularly of major trading partners) is, therefore, a logical reserve holding for Asian CBs • Cross-holding of each others debt may also result in a better integrated regional central banking framework

11. Role 3: Asian Local Debt as a Core Asset Class • Asset class diversification is a key strategy for SWFs (and other large institutional investors) to meet investment objectives, i.e. given large SWF size, performance will be increasingly driven by their asset class allocation, rather than active manager selection • Asian local currency debt has very attractive asset class characteristics • 1) Strategic asset class • 2) Diversification benefits • 3) Attractive currency markets • 4) Attractive returns with moderate volatility

12. 1) A Strategic Asset Class • More than doubled in size to US$2.7 trillion since 1997* • 10 times greater than G3 denominated Asian bonds • Now commanding 5% of the world’s bond markets • Most markets now offer liquid yield curves of over 10 yrs • Infrastructure greatly improved • Introduction of efficient settlement and clearing systems • Rapidly developing derivative markets • Liberalization of interest rates • Increase in institutional products on offer Source: * HSBC Research, ADB

13. Trend: Rising correlations between major markets vs. US Asian Bonds: Diverse range of currencies Established markets Core markets High yielding markets Asian Bonds: Low correlations with developed markets 2) Diversification Benefits for International Investors Source: SSgA, based on monthly returns of Citigroup Government Bond Indices from January 1996 to September 2007 Source: SSgA, based on monthly returns of iBoxx Pan-Asia Index & Citigroup Government Bond Indices from January 2001 to September 2007

14. 3) Exposure to Attractive Currency Markets • Historically, currencies have been a significant and consistent contributor to Asian local currency bond returns: • Annualized contribution from currency returns = +3.1% • Annualized contribution from market returns = +5.7% • Annualized total return on Asian bonds = +8.8% Rolling 1-Year Returns on Asian Local Currency Bonds (Unhedged) Source: International Index Company, iBoxx ABF Pan-Asia Index as of 30 September 2007

15. 4) Attractive Overall Returns with Moderate Volatility • Over recent history, Asian bonds have delivered good returns with low volatility • Annualized return: Asian bonds = 8.8%Volatility: Asian bonds = 4.3% • US bonds = 4.6% US bonds = 3.9% • 1-year Asian bond returns have dominated the US market Rolling 1-Year Returns on Asian Bonds and Comparable US Duration Adjusted Bonds Source: Citigroup Government Bond Indices, International Index Company and SSGA (as of 30 September 2007)

16. Non-Fiscal Policy Matters • In summary: sustaining managed currency appreciation policy; huge reserve accumulation and sterilization bond issuance programs, suggests the need for continued issuance that counter-balances fiscal considerations • There are other important government policy matters that will also contribute towards further issuance: • Regulatory capital considerations for banks (local regs. and Basle II) • Growth in insurance businesses across Asia • Pensions and demographics trends

17. Pensions and Demographics Trends Source: United Nations Population Division

18. Population Aging in Asia Faster Than Global Average The aging population will increase the need for Asian local currency bond instruments (e.g. life-cycle pension strategies) Percentage of Population Aged 60+

19. Summary • In Asia, the influence of the managed currency policies and reserve build-up will counteract the negative fiscal impact on bond issuance • In addition other important government policy issues, in particular demographic changes, will require robust bond markets • Issuance programs will likely continue, but potential mismatches: • Demand may still potentially exceed supply • Demand for longer maturities; governments may prefer to issue shorter maturities

20. Thank You

21. Biography Hon Cheung Hon is the Regional Director for the Official Institutions Group in Asia and has responsibility for developing relationships with central banks and other related sovereign agencies in the Asia Pacific region. Hon joined State Street Global Advisors in 1996 and has served senior roles in the London, Hong Kong and Singapore offices. He has worked closely with stock exchanges, government bodies, pension funds and other institutions in Asia to advise on investment matters; most recently, he led the team that designed and managed the ABF Pan Asia Bond Index Fund which was successfully launched by Asia’s leading central banks. Hon holds a First Class Honors degree in Mathematics from Imperial College London and a Diploma in Mathematical Statistics, with Distinction, from Cambridge University. He is also a member of the Institute of Chartered Accountants in England and Wales.