Some people may say I’m too blunt.  But I do this in order to provoke thinking in all of us. It’s too easy to assume, “This time it’s different”. It never is. We’ve been through all this before.  We have the hubris, then we have the crash, then we have the rebuilding, and what always looks dark will turn out to be better eventually, and then the cycle begins again. What we really need to do now is to look at what has gone wrong, and where we need to do some serious thinking. The key question is: Have we looked at what has happened today with old glasses?  And for somebody who’s very short-sighted, I would admit for myself, I previously read the situation wrongly. So I need to ask a few questions, both of myself, and of the whole financial system.

I’m talking about the global financial crisis with pension schemes and how we are doing today – how Asian schemes are doing today. When I addressed this Institute in Singapore in 2007, we already knew that Asia was beginning to follow in the footsteps of the advanced markets, approaching what is known as a perfect storm.  The elderly dependency ratio is rising, and the youth dependency ratio is declining. In other words, more and more old people are relying on fewer and fewer young people for their future.  The crash cost pensions alone $5.5 trillion in 2008, while a $14 trillion cheque was written to bail things out for the world as a whole. The markets have more or less gone back to the values of 2007, while bonuses in the financial sector have increased even more. 

Quantitative easing put a lot of liquidity back into the system, but the serious structural problems have not been addressed.  We are living in a time of grave confusion, when everybody’s concerned about “global rebalancing”.  Is the East rising relative to the West?  Is the Asian population going to have a massive impact on all of us?  Today, we see that Facebook and Twitter can bring down governments.  We have instant decisions, and very complex policy issues are reduced to 140 characters on Twitter, or the “like” and “dislike” function.  When the answer is “dislike”, somebody might have to step down; governments might have to change. And we also have a massive global warming problem, and occurrences like the Fukushima meltdown, that in itself was triggered by a tsunami.  Further examples are the floods in Bangkok and the floods in Vietnam, which will have enormous implications on global supply chains as well as on global food security. 

These are huge issues that we’re dealing with, but at the same time as these things are going on some things are growing very well and doing very well.  Finance is doing very well relative to everybody else, and this is why there is an Occupy Wall Street movement. Seeing that picture of people drinking champagne, watching the protestors beneath them, I realised that this is a Marie Antoinette moment in the 21st Century; it’s not “Let them eat cake”, but “Let them eat tiramisu”.  Some people call it a class war, but there is such a great divide of public opinion that it will take a lot to change all this. 

The problem, in a sense, is that our current tools of analysis have totally failed us; we’ve got the theories all wrong.  All our beautiful models are backwards. These models – even Basel III – have data that is very seriously flawed; that don’t have long-time series; that don’t take into consideration black swan effects, flawed theory, wrong diagnoses and blundering prognoses.  And we’ve been there before. As John Maynard Keynes said, “The difficulty lies not in the new ideas, but in escaping from the old ones.”  All the theories say we live in a perfect world, one with perfect information; perfect prices; where the market knows it all.  The reality is that every single price you can look at today is massively distorted: whether of capital, land, or labour.  The price of capital is zero.  How can the price of capital be zero when the real growth of most of the world is 4 to 6 per cent?  How can the price of labour be so cheap?  The cheaper the labour – because there has been a massive demographic entry into the market –the more the poor are subsidising the rest of the world.  Why is the price of real goods going up and down like a yo-yo, with such high volatility?  All these prices are distorted.  So we’re no longer operating by what our theory tells us, with only slight distortions, slight deviations from the mean. With all the fundamental prices distorted, we’re living in a very different world.  So as Asia begins to move into middle class, we really need to think through what we need to do.

Now what are the problems? We started with a private debt sub-prime problem in the United States, and we ended up with a banking crisis in Europe.  Most people did not realise that European banks borrowed probably $10 trillion from the US interbank market, and then re-exported it back into the shadow banking system. Their collapse of the middle-tier banks, together with sovereign debt problem, has brought Europe almost to its knees. It’s not quite there yet, but we have a serious political problem because politics cannot catch up with the financial markets; the theory cannot catch up with the reality.  And the problem is huge.  If we were just to look at Greece, it’s a 60 billion euro problem, but if we include Ireland and Portugal, it’s 80 billion euros.  If we include Belgium, the Spanish, and the Italians, it’s 200 billion - but the spillover is likely to be 300 billion euros.  But now we’re talking about rescue plans of a trillion or more.  This is no longer a national problem.  No single country in the world today is able to solve this problem. 

Just to put this issue into perspective, Thailand is twice the size of Greece, and received aid in 1997 of $17 billion dollars.  Greece received 150 billion.  Korea, the second largest industrial economy in Asia, in those days received $60 billion.  And I was just in Beijing when the former Korean Prime Minister said to people from the IMF – “Look, how come the conditions for Greece are much fewer than those imposed on Korea back in 1998?”  These are very complex issues, and there’s a lot of emotion involved. 

Finance has become too large, too leveraged and too speculative to serve the real sector, and it’s a serious problem that we have not yet resolved.  Finance is now four times larger than the real economy in terms of asset size.  Because of proprietary trading, finance is no longer an agent of the real sector.  In some sense, it has become its master.  And you may think that I’m demonising finance, but that is not my intention. What I’m really saying is that the system has lost its main purpose.  Finance is there to serve the real sector, and it’s time to get real.  Even though Asia was less hurt by the European crisis, we face huge problems.  Asia has a lot of the world’s poor.  Asia needs to get its act together in many, many areas, including in the pensions area, as this is a problem that is not simply going to go away. 

When we talk about rebalancing, what do we mean?  The growth of the rich countries is slowing. In contrast, the emerging markets – basically because of younger populations – are still rising. Rich countries will face deleveraging, slower growth, devaluation and deflation, while the emerging markets will face inflation, with bubbles from capital flows and revaluation. These capital flows are huge.  They are so huge that even a country dedicated to finance like Switzerland had to say, “Stop. Enough is enough. We peg ourselves 1.20 to the euro.  We’ll protect our exchange rate.”  So the whole game has changed. The world is one big network. We’re all tied up together – we’re all in it together.  Your problem is my problem, and my problem is your problem.  And finance is that massive interconnectivity which we need to totally understand and completely re-think. 

One of the problems of present day theory is that it’s all partial.  A model makes a simple assumption: ceteris paribus, or other things being equal.  We now know that other things are not equal.  If anything, other things are interactive, and that interactivity is what’s changing the game. People forget this. We deconstruct a system to its parts, and the trouble is that the world is now too much in silos and everybody is blaming everybody else. 

We need to re-think the whole global financial architecture.  This is not about East versus West, North versus South, etc.  We’re all in this together. We must ask ourselves what the real problem is, and the answer to that is that we’ve overspent. Over-consumption financed by over-leverage, in which finance played a very major role.  And pension fund managers have a very serious role in this.  They are also influenced by the financial engineers.  They must also have quarterly reporting.  They must have total transparency.  But if these pension fund managers follow hedging, they are also leveraging their balance sheets, and the minute they leverage their balance sheets, they are part of that volatility.  So we need to think through all this and go through it very, very carefully.

Let’s put everything in a bigger picture, with thanks due here to Mr Bindu Lohani at the Asian Development Bank [ADB]. I participated in an ADB project on what Asia will look like in 2050. I was the main author of part of the chapter on finance, and what we found was very interesting.  Based upon the real growth rates, Asia in 2050 will probably account for half of world GDP and roughly half of world financial assets, which means that we will have very major financial centres in Asia. By that time, the yen, the renminbi and the rupee will probably be serious global currencies, and the global financial architecture may change very dramatically.  The reality, now, of course is that Asia relies very much upon the dollar and the euro and London and New York, and it’s that interconnectivity that ties it all together.  But people tend to forget that 30 to 35 banks account for 90 to 95 per cent of the total derivative markets globally.  They continue to dominate the emerging market business, but Asia needs to have its own footprints. I might mention China here, but in fact China is not the only player in Asia. India is following up very, very rapidly; the Middle East is a major force; and Central Asia is also rising very, very rapidly. 

Overseas money – that is, money coming out of Asia – not just in portfolio terms but in direct and foreign direct investment, is going to be much larger than people think.  India is already beginning to be a player in this, even though India is a very major importer of capital.  The integration is coming.  The integration after the Asian crisis consisted of a multilateralisation of the Chiang Mai Initiative, and in Singapore today there is the Asian Asset Management Research Office – AAMRO. It’s a very, very big title, but essentially its job is to multilateralise the Asian safety net.
Now let me move on to investment. There is a Melbourne Global Pension Index which looks at adequacy, sustainability and integrity.  That’s the only one that’s available to rate the pension funds.  And if you look at it, the Netherlands, Australia and the Nordic countries have performed well, and the average is 60 points. What is very interesting is that Asia has not done well at all.  Asia is below 60 points, and it’s below in the area of adequacy, sustainability and integrity on the governance issue.  Now you may or may not believe this, and I don’t always believe indices, but it’s a very good sort of measurement of where we need to improve.

And so I looked at that, and I said “okay, what is it that we need to improve?”  Well, if you really look at what has happened with the global assets under management, they’ve recovered in Asia 2020.  This is based upon the McKinsey Global Asset Management database.  Now the assets have improved, but the flows have not. Money flowing into assets under management has not improved that much. The inflows into emerging markets are still happening, but not necessarily into the mature markets. If you really look at institutional investors globally, they were $3 trillion down from 2007 and that’s largely due to the collapse of the stock market.  And if you look at what’s happened, sovereign wealth funds have grown, pension funds have largely been hit, and alternative asset management has increased. Institutional investors have grown from 100 per cent of GDP to 174 per cent of GDP.  Finance is still growing.  And the trouble is, if more and more pieces are out there and the actual GDP growth is growing at a much slower basis, are we building in inflation?  Are we actually pretending to ourselves that we’ve got prosperity when maybe we have not?  And that’s where I come from, with possibly unorthodox thinking. Finance is still a veil.  Finance is only shuffling pieces of paper.  What matters is what is happening on the ground, and on the ground people are losing jobs and they’re getting increasingly angry.

If you really look at what’s happening with the assets under management, you see that pension funds have maintained roughly 25 per cent of the money they get. Insurance companies have done a little bit better.  Sovereign funds have grown significantly.  Retail has been hurt, and that’s the real problem.  People don’t realise that retail is abandoning markets because they suddenly find they can’t beat the professionals. And the professionals can’t beat the market.  So who is beating the market and why are they beating the market?  It is no longer considered a fair game.  And when the masses don’t think it’s a fair game, something is going to happen and that something is politics.  So I’m just repeating to you, as bluntly as possible, that things aren’t going to be the same anymore.  Asset allocation and equity share is growing, but what has happened in this crisis is that alternative assets are rising: real estate, hedge funds, private equity, commodities. Alternative assets have grown from 11 per cent to 15.6 per cent.

As I mentioned before, Asia is growing and increasingly Asia’s investments will be in alternative assets.  They’re moving into alternative assets because the traditional financial assets are not paying them real returns.  That’s a hard fact of life.  If we look at the global share of capital markets, we see that world GDP is $63 trillion. Total assets, traditional assets, are $250 trillion.  So finance, traditional finance – the stock market, debt market and bank assets – is four times GDP.  Europe is 550 per cent of GDP, North America is four times.  Asia, excluding Japan, is 2.4 times. Asia as a whole is 3.5 times, with Japan at 5.4 times GDP.  And how much bigger are notional finance derivatives then this? Sixteen times bigger. How much is bank capital as a percentage of all this?  Probably less than 4 per cent – which means that when the markets are moving with this volatility, and volatility is 10 per cent and your capital is only 4 to 8 per cent, you’re gone.  And the only reason that banking systems are surviving is because they’re underwritten by a lender of last resort and a state guarantee.  But what has not changed is that stock market cap, and the numbers show that what has grown largely is the debt numbers, and those debt numbers are mostly due to sovereign debt – which is government debt – take-up, and what has grown is finance borrowing and lending amongst itself.  Unfortunately that’s a large issue.

So what’s happening in Asia?  I’m going to give you that broad picture.  In the deposit-taking institutions – that’s banks – the demographics are changing the game. Where the interest rate margins are being squeezed, they’re moving more and more into wealth management – the insurance risk-pooling institutions, largely still foreign dominated – with demand growing very, very fast.  Contractual institutions have huge liquidity pools but lack some professional skills. The market-makers are still largely the Big Five globally, and foreign fund managers are still their key clients. With specialised sectoral financiers, there is a major re-think of banking policy and this is something that people need to be aware of.  Alternative finance is coming.

Within the fund industry within Asia, the most interesting point is that central bankers have now become major equity investors.  You haven't seen all of it yet, but it is happening more and more.  And the reason for this is that central banks have traditionally been also the very large pool of official savings.  And sovereign wealth funds are also growing. The ETFs [exchange-traded funds], the REITs [real estate investment trusts], and commodity funds are rising.  The investment strategy under a situation of zero interest rate policy and quantitative easing is to chase for yield.  And that in itself is a major problem.  Because of these fast, flash computer algorithms, those of us who are retail and less equipped in that area can’t compete, and that itself adds a major volatility issue. So as I said, retail investors have moved onto the sideline. 

Now I’m going to question investment finance because I think the investment theory of the last 30, 40 years needs to be seriously questioned.  We all know that the market is not efficient, and that the markets are not random.  The markets can be manipulated.  There’s a huge amount of insider trading and market manipulation going on, and retail is beginning to realise they’re not getting a fair game. This counter cash flow analysis - this is the key area where we value assets.  How do you value an asset when the interest rate is zero?  What is the value?  It is a massive bubble, right?  So discounted cash flow analysis cannot evaluate a real valuation.  We thought bonds were safer than stocks. And guess what happened?  You hold a sovereign bond, and suddenly you’re told it’s getting a 50 per cent haircut.  And we invest in bonds because we think that with the lower interest rate we get lower risk.  This is completely unorthodox now.  And we invest in stocks, but we suddenly find corporate governance has huge problems, and why?  Large institutional investors mostly say, “I don’t care about the corporate governance.  I’m going to sell out.”  But if that is the case, who is in charge of these corporations?  The insiders. 

And so all of this should lead to a complete re-thinking, as financial theory models are too idealised. They have no connection with the real world, and the real world is telling us, “You’re wrong”.  The markets are telling us, we’re wrong.  The market is right; your theories are wrong. You’d better change your theories and you’d better start re-thinking all these issues. 

All I’ve been saying is that diversification reduces risk. All markets are highly correlated, and the only thing that is not highly correlated is short selling.  We can run from this, but we can’t hide, because all of us are behaving in the same way. All of us every day look at Bloomberg and Reuters, and if on CNBC or BBC they say the market is tanking, we all get in a panic.  Some of us – the pension fund managers, at least - are supposed to be objective long-term thinkers, not part of that herd.  The whole comparative advantage of pension funds is long-term, cool, objective investments.  But because your models are telling you VaR (Value at Risk) is high, you’ve got to sell, and because next quarter your shareholders are going to tell me I’m out of a job, I also sell.  But if you sell when the thundering herd also sells, the market becomes self-fulfilling.  So we are all responsible for this, and we really need to re-think the whole game. 

The game has changed.  Look at what is happening in Asia.  Look at the biggest, richest market in Asia. There are very large savings in Japan, but the income flows are low because of very low interest rate policies.  Now I’m not blaming anybody; I’m just pointing out the facts.  If Asia follows the Japanese model, we will be super savers with no retirement income, right?  And that’s just some fundamental problem that we need to re-think.  We need to re-think the financial system’s relative position and role with the real sector.  People don’t realise that Asia has been blessed with a demographic endowment.  That means a young population coming into the global market; they’re willing to work for very low wages and that gave rise to very low, almost zero inflation globally.  But as China reaches its Lewisian turning point where demand for labour is now increasingly equal to the supply, real wages rise by the day.  The Chinese five-year plan says – and people don’t read this – the minimum wage of China will be rising 13 per cent every year for five years.  What does that tell you?  If there’s no real supply-side inflation for global products, I’ll eat my shoes!  Costs are rebalancing. 

As Asia begins to age, more money will be spent on healthcare, on medical support, and they’ll need more income.  So with the saver and the depositor getting lower returns than the true inflation, something’s got to give.  And the government cannot fund this anymore because government debt in the advanced countries is already 100 per cent of GDP.  So we really need to completely re-examine the role of pension funds in this model. Take corporate governance, for example.  If Asian corporations – and I don’t blame Western corporations by the way – if Asian corporations still pay very low dividends because the insiders want to use this money for their large investment projects, etc., what is the retirement population going to live on regarding cash flow?  Upon the rising market?  The market’s not rising, you know!  How are we going to ensure that these models impact on our labour mobility, market efficiency, consumer expenditure and fiscal position?  How can we continue to subsidise finance with zero transactions tax and almost zero capital gains, when the budget hole is more than 10 to 15 per cent of GDP every year?  We completely need to re-think the game. 

I’m not going to try and tell you I  know all the answers.  I don’t.  I’m just taking a systems-wide perspective – I’m positioning myself like a Martian in relation to all of this; I’m the wild man from Borneo, I don't know anything.  But when I come in here and I say this doesn't fit, the facts don’t add up - we really need to think through this.  Long-term funds are not exploiting the comparative advantage of being long term.  Hedging and quarterly reporting are making long-term funds pro-cyclical. The market can only be balanced when the short-term guys want to sell and the long-term guys want to buy. When both short-term and long-term want to sell, we’re in deep trouble.  The volatility – that’s what’s happening.  We really need to re-think corporate governance and social responsibility.  What is the true role of long-term institutional funds in corporate governance?  We can’t allow insiders to do it for their own benefit.  That’s the heart of the corporate governance issue, the principal Asian problem.  So long-term funds need to think long-term, not say that - well, this is something that policymakers in the Ministry of Finance look at every five, 10 years and say, “Oh, that’s fine.”  But if you don’t look long-term, nobody else will.  And that’s the heart of the problem.  We’re all in it together, because we have all lived only for tomorrow but ultimately that doesn’t add up.  When all of us want to consume today, and leave the problems for our grandchildren, our grandchildren will grow up in a world with less resources and more social conflict. 

So this is the main message from me to you today.  It is a message of great hope, because amidst all the total distortion that’s going on, pension funds have a social responsibility to think long-term about structural issues. In advanced markets, the problems of yesterday are already catching up today.  The problems of the future will not wait.  In fact, this is even more urgent in Asia.  We never thought about our pensions because we thought we were young.  In India, the average age is less than 24.  In China it’s less than 35.  But in Japan the average median age is more than 40.  Old age is already beginning to catch up with us.  But what are we going to leave our children and our grandchildren?  We have structural hardening.  Our economies are no longer so flexible.  We have fiscal unsustainability and we have massive distortions to the incentives, the corporate efficiency and the financial fragility. These are the major issues that we need to think about.  I hope this will be useful, and that it’s been entertaining, if not challenging. Thank you very much.