Year: 2008

The nie and the Iranian nuclear programme

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The extraordinary spectacle of President George W. Bush’s national security adviser obliged to defend the president’s Iran policy against a National Intelligence Estimate (NIE) raises two core issues: How are we now to judge the nuclear threat posed by Iran? How are we to judge the intelligence community’s relationship with the White House and the rest of the government?

The unclassified “Key Judgments” released by the intelligence community to the public begin with a dramatic assertion: “We judge with high confidence that in fall 2003, Tehran halted its nuclear weapons program.” Inevitably, this sentence was widely interpreted as a challenge to the Bush administration policy of mobilizing international pressure against alleged Iranian nuclear programs. It was, in fact, qualified by a footnote whose complex phraseology obfuscated that the suspension really applied to only one aspect (and not even the most significant aspect) of the Iranian nuclear weapons program: the construction of warheads. That qualification was not restated in the rest of the document, which continued to refer to the halt of the weapons program repeatedly and without qualification.

Building warheads
The reality is that the concern about Iranian nuclear weapons has had three components: the production of fissile material; the development of missiles; and the building of warheads. Heretofore production of fissile material has been treated as by far the greatest danger, and the Iranian production of fissile material has been taking place at an accelerating pace since 2006. So has the development of missiles of increasing range. What appears to have been suspended is the engineering aimed at the production of warheads.
The new Estimate holds that Iran may be able to produce enough highly enriched uranium for a nuclear weapon by the end of 2009 and, with increasing confidence, more warheads by the period 2010 to 2015.

That is virtually the same timeline as suggested in the 2005 National Intelligence Estimate. The new Estimate does not assess how long it would take to build a warhead, though it treats the availability of fissile material as the principal limiting factor. If there is a significant gap between these two processes, it would be important to be told what it is. Nor are we told how close to developing a warhead Tehran was at the time it suspended its program or how confident the intelligence community is in its ability to learn when work on warheads has resumed. On the latter point, the new Estimate expresses only “moderate” confidence that the suspension has not been lifted already.

It is therefore doubtful that the evidence supports the dramatic language of the Summary and, even less, the sweeping conclusions drawn in much of the public commentary. For the past three years, the international debate has concentrated on the Iranian effort to enrich uranium by centrifuges, of which some 3,000 are now in operation. The administration has asserted that this represents a decisive step toward the acquisition by Iran of nuclear weapons and has urged a policy of maximum pressure. Every permanent member of the U.N. Security Council has supported the request that Iran suspend its uranium enrichment program. The various countries differ on the urgency with which their recommendations be pressed and in their willingness to impose penalties.

Unacceptable
The NIE then highlights, without altering, the underlying issue: At what point would the nations which have described an Iranian nuclear military program as ‘unacceptable’’ agree to act on that conviction? Do they wait until Iran actually starts producing nuclear warheads? Does our intelligence assume that we will know this threshold? Is there enough time then for meaningful countermeasures? What happens to the growing stock of fissile material which, according to the Estimate, will have been accumulated? Do we run the risk of finding ourselves with an adversary who, in the end, agrees to stop further production of fissile material but insists on retaining the existing stockpile as a potential threat?

By stating a conclusion in such categorical terms — considered excessive even by the International Atomic Energy Agency — the Key Judgments blur the line between estimates and conjecture. For example, the document explains the halt of the Iranian weapons program in 2003 as follows: “We judge with high confidence that the halt . . . was directed primarily in response to increasing international scrutiny and pressure resulting from exposure of Iran’s previously undeclared nuclear work.” The Estimate extrapolates from that judgment that Iran “is less determined to develop nuclear weapons than we have been judging since 2005” and that it “may be more vulnerable to influence on the issue than we judged previously.”

It is to be hoped that the full Estimate provides more comprehensive evidence for these conclusions. A more plausible alternative explanation would assign much more significance to the regional context and American actions. When Iran halted its weapons program and suspended efforts at enriching uranium in February 2003, America had already occupied Afghanistan and was on the verge of invading Iraq, both on the borders of Iran. It justified its Iraq policy by the need to remove weapons of mass destruction from the region. By the fall of 2003, when Iran voluntarily joined the Additional Protocol for Nuclear Non-Proliferation, Saddam had just been overthrown. Is it unreasonable to assume that the ayatollahs concluded that restraint had become imperative?

Enterprise extension
By the fall of 2005, the American effort in Iraq had shown signs of bogging down; the prospects for extending the enterprise into Iran were diminishing. The Iranian leaders could have therefore felt free to return to their previous policy of building up a military nuclear capability — perhaps reinforced by the desire to create a deterrent to American regional aspirations. They might also have concluded that, given the fact that the secret effort had leaked, it would be too dangerous to undertake another covert program.

Hence the emphasis on renewing its enrichment program in the guise of a civilian energy program. In short, if my analysis is correct, we could be witnessing not a halt of the Iranian weapons program — as the NIE asserts — but a subtle, ultimately more dangerous, version of it that will phase in the warhead when the fissile material production has matured.

The Estimate does not so much reject this theory; it does not even examine it. It concludes that “Tehran’s decisions are guided by a cost-benefit approach rather than a rush to a weapon . . . .” But a cost-benefit analysis does not exclude a rush to weapons on a systematic basis. It depends on the criteria by which costs and benefits are determined. Similarly, in pursuing the cost-benefit rationale, the Estimate concludes that a combination of international scrutiny along with security guarantees might “prompt Tehran to extend the current halt to its nuclear weapons program.” That is a policy, not an intelligence, judgment.

A coherent national strategy toward Iran is not a partisan issue, for it will have to be implemented well after the present administration has left office. I have long argued that America owes it to itself to explore fully the possibility of normalizing relations with Iran. We do not need to tranquilize ourselves about the danger in order to pursue a more peaceful world. What is required is based on a specific vision linking assurances for Iran’s security and respect for its identity with an Iranian foreign policy compatible with the existing order in the Middle East. But it must also generate an analysis of the strategy to be pursued should Iran, in the end, choose ideology over reconciliation.

The intelligence community has a major role in helping to design such a vision. But it needs to recognize that the more it ventures into policy conjecture, the less authoritative its judgments become. There was some merit in the way President Nixon conducted National Security Council discussions at the beginning of his first term. He invited the CIA director to brief on the capabilities and intentions of the countries under discussion but required him to leave the room for the policy deliberations. Because so many decisions require an intelligence input, this procedure proved unworkable.

Intelligence community
I have often defended the dedicated men and women of the intelligence community. This is why I am extremely concerned about the tendency of the intelligence community to turn itself into a kind of separate branch of the government, as a check on, instead of a part of, the executive branch. When intelligence personnel expect their work to become subject of immediate public debate, they are tempted into the roles of surrogate policymakers and public policy advocates.

Thus the deputy director for intelligence estimates explained the public release of the Estimate as follows: “Since our understanding of Iran’s nuclear capabilities has changed, we felt it was important to release this information to ensure that an accurate presentation is available.” That may explain releasing the facts but not the sources and methods that have been flooding the media for a week. The paradoxical result of the trend toward public advocacy is to draw the intelligence community more deeply into the public maelstrom than ever.

The executive branch and the intelligence community have gone through a rough period. The White House has been accused of politicizing intelligence; the intelligence community has been charged with promoting institutional policy biases. The Key Judgments document accelerates that controversy, dismaying friends and confusing adversaries.

Intelligence personnel need to return to their traditional anonymity. Policymakers and Congress should once again assume responsibility for their judgments without involving the intelligence community in their public justifications. To define the proper balance between the user and producer of intelligence is a task that cannot be accomplished at the end of an administration. It is, however, one of the most urgent challenges a newly elected president will face.

© 2008 Henry Kissinger. Distributed by Tribune Media Services, Inc.

Looking back at the opening of china

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On what precipitated the beginning of the Nixon administration’s efforts to engage China:
At the beginning of the administration, during the first three or four months, we were preoccupied with Vietnam and with Soviet relations. But then the Soviet ambassador kept coming to the White House to brief me on the clashes (between Soviet and Chinese forces) that were taking place at the Ussuri River. Now, it was not the habit of Soviet diplomats at the time to be transparent about events in which they were engaged. That caused us to study the location of these incidents, which turned out to be close to Soviet bases and far from Chinese ones.

The Soviets did a number of other things, like inquiring how we would react to certain readiness measures on their part vis-à-vis China. So Nixon and I discussed this situation, and he decided that we should move to convey to the Chinese that we were observing this and that we were also willing to improve relations. We decided to warn the Soviets that we would not be indifferent to military action in Northeast Asia.

On early efforts to make contact and the mood at the time:
The Chinese had tried to convey their thinking to us through Edgar Snow, whom we considered a left-wing apologist for them, so we didn’t take it seriously enough. The working level on China in the State Department was, of course, very much in favour of opening to China. But the high-ranking foreign service officers, who were mostly Soviet experts, were very concerned about that possibility. They were experienced enough to understand what we were trying to do. At one point, the four leading Soviet experts in the State Department formally warned Nixon that an opening to China would risk war with the Soviet Union.

One of the dominant feelings we had, and to which especially the younger people on my staff were deeply committed, had to do with the crisis we were going through in Vietnam. That led to huge divisions in our country. And we felt that it was important to demonstrate to the American people – to the young people, especially – that whatever the divisions might be on Vietnam, we had a vision of peace and a sense of constructing a new international system.

On fear of failure:
It’s very rare in public life that you have an opportunity to do something that is totally new. So, of course, Nixon took a big risk in sending me in the first place. On my first trip, there were moments when we didn’t quite know what was going on. Later on, it turned out that while we were there (in Beijing) the North Korean President (Kim Il Sung) was in China and that Chou En-Lai had to go to a dinner in his honour. And so there was a gap of several hours where there were no Chinese interlocutors.

But, if you looked at the exchange of correspondence that had preceded the trip, it was clear that the result of the first visit would be an invitation to Nixon. We were on a road on which it would have been very unwise for either side to blackmail the other. Of course, if we had been sent packing or been humiliated, since Nixon did it largely alone, it would have been a huge political disaster.

On Mao Zedong:
He exuded will power. So do a lot of people who have achieved dominance. He had an extraordinary ability to analyse international affairs. David Bruce (a US diplomat) had known Adenauer and Churchill and de Gaulle, and he said none of them had a grasp of international affairs that exceeded Mao’s. None of this excuses the suffering he imposed on millions.

On engagement and the human rights problem:
The relationship between our capacity to produce democracy in the world and our concept of foreign policy is one of the perennial challenges of foreign policy. Sometimes we don’t do enough, and sometimes we do too much. And one has to look at it in terms also of a historic evolution. As Americans, we have to be committed, and we are committed as a society, to democratic values. But the time in which they can be implemented and the degree of influence we can have must be related to circumstances. And when one doesn’t do that, then one gets into a missionary kind of effort. That can destroy the ability to move toward peace. If one does too little in promoting democracy, then one falls into a kind of stagnation. Where to find the right balance? That’s something that I do not find easy to define. But it surely was not found at the beginning of our relationship with China where the Secretary of State, John Foster Dulles, refused to shake hands with Chou En-Lai.

 On Taiwan:
China has been very insistent on reclaiming Hong Kong and Macao and Taiwan. I have experienced it as an enduring reality of Chinese conviction. But one also has to say that we are now in 2007, 36 years later, and the US and China have managed to develop their relationship by respecting each other’s principal concerns on this issue, the Chinese concern being that there’s only one China, our concern being that we want a peaceful solution.

One can also hope that the evolution of economic relations, of the internal structures of both countries, both societies, will make it possible to create a one-China solution that respects the autonomy of Taiwan. But that is something that may have to wait. In the meanwhile, one should be careful that nobody wrecks the current restraint. One should have one vision of how this process might lead to a solution.

On the number of books about you and the documentation and scrutiny of the Nixon era:
It never occurred to me that it would reach the current point! Whereas we may have produced too much material, now there’s very little material for historians. Most top policymakers, knowing our experience, are writing a minimum number of memoranda and are not very revealing in the memoranda of conversations that they leave to their successors.

What happened, especially in relation to China, is that there’s a school of thought that thinks it knows exactly what we should have done. And then they criticise us for not doing what they think we should have done, which we never intended to do. But we were not going to China to try to solve every conceivable problem. We thought everything depended on establishing confidence and a relationship between these two societies that had had no contact with each other for larger geopolitical ends.

On Deng Xiaoping versus Mao Zedong:
Mao was a figure hovering above the day-to-day contact. He would speak in sort of cryptic sentences and conduct his conversations as a kind of Socratic dialogue, in which he would throw out a proposition, then you’d comment, and he would reply. But Deng was focused on seemingly pragmatic problems, raising specific issues. He always had a spittoon in front of him and spit into it from time to time.

On one occasion, Deng had what he called private banquet for about 70 people – I was sitting with him, and I asked him a sort of political science question: How was he going to reconcile centralisation and decentralisation? He began to talk in a very soft voice. It got very quiet in the room, and everybody wanted to hear what he had to say. He wound it by saying, ‘Well, we can’t afford another mistake, because we’ve already made too many.’ And he stuck to that notion for all the time that I knew him.

On Tiananmen:
It was a tragedy and introduced a tenseness into the political side of the reform that might have been avoided, if it could have evolved in a more gradual manner.

On China and Russia’s divergent paths to development:
The Chinese Communist system had not been in power as long as it had been in Russia. China had the advantage of Deng Xiaoping, who had a vision and who concentrated first on economic reform. And it may also be that in China there is now more self-confidence in the society than there is in Russia. If one tells the Chinese people that with great effort they can be the greatest people in the world, they tend to believe it. In Russia, the feeling about the role of the national mission is more ambivalent.

On China versus India:
I know there’s the idea that one can use India to balance China. I think it’d be a grave mistake for the United States to conceive of our role in that manner. India will pursue its own policies. They represent their own way.

On the potential for an arms race:
If China were to go the route of the Soviet Union and to amass long-range missiles by the thousands, it would create enormous anxiety and repeat much of the same pattern that existed in the relations with the Soviet Union. I think this is unlikely.

On the present state of US-China relations:
When we started the relationship with China, it was a world of states, and there was a Cold War. So there were dominant themes in international affairs that could be viewed in terms of the power politics of historical experience. Now we’re in a world in which the state, as it was formed in the 17th century, is beginning to disintegrate in many parts of the world. Secondly, there are now issues that were not thought of when the relationship was created. We were not concerned with the environment as a global, international issue.

Moreover, I think the competition for resources, when you have limited supplies and growing demand, can lead to a kind of competition similar to the colonial rivalry of the 19th-20th centuries. Through the Cold War, the prospect of war between countries had to at least be considered part of a strategic assessment. Today, wars between major countries would be a catastrophe for everybody and have no conceivable political objective. So one has to think of organising the world without some of these traditional pressures of historic diplomacy and include subjects that didn’t used to be diplomatic issues. And in this effort, I think China and the United States can play a key role, not an exclusive role, but a key role.

On what the relationship will look like on the 50th anniversary of his first visit (14 years from now):
I’m optimistic, because I’ve seen now a succession of American presidents committing themselves to the importance of the relationship and to make the adjustments that were needed. And I’ve seen a succession of Chinese leaders who have moved in a parallel direction. So I’m basically optimistic. But, of course, we are now coming into a period where new types of people — more attuned to the current technology, less conceptual, more geared to Internet-type of cognition — are getting into power on both sides. And how that trend will be related to long-term policy is, to me, going to be a big challenge.

© 2007 Tribune Media Services, Inc

The world needs more speculators

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When the economy is in turmoil, no one is demonised more than the speculator. First, we are told, speculators have driven up the price of oil, condemning us to expensive heating and driving. Then, they have driven down the price of bank shares, dealing vicious blows to the nation’s noblest banks. All of this, we are supposed to believe, is immensely profitable and highly destabilising.

With one exception—I’ll come to it—I am not persuaded. I struggle to understand how speculation is supposed to be both profitable and destabilising all at once. Profitable speculation requires buying low and selling high. Destabilising speculation requires the opposite: short-selling shares in a trough, thus deepening the trough, and betting that frothy shares will become frothier. In other words, destabilising speculation means selling low and buying high. If that is a recipe for profit, I am missing something.

Profitable speculators, in contrast, are veritable philanthropists. When they think oil is going to become more expensive, they buy and hoard oil, or they buy oil futures, encouraging others to buy and hoard. This raises oil prices when they are relatively cheap and lowers them when they are relatively expensive.

Speculative pricing
True, when speculators make mistakes, that is destabilising. But in the case of oil prices, it’s hard to see that speculators are playing much of a role. For one thing, inventories don’t seem to be rising. If the inventory data are correct, consumers were burning all that €85 oil.

For another, speculation and prices don’t seem to be closely correlated. BP’s recent Statistical Review of World Energy points out that while few speculators have been betting on a spike in the price of heating oil, its price has soared even more rapidly than the crude oil price. More striking, speculators have been betting that natural gas prices will slump. Natural gas prices haven’t.

If the intellectual case against speculators is weak, one can always fall back on the emotional one. Short sellers are a particularly easy target: Their hope that prices will fall hardly seems constructive. It is not much of a stretch to move from abhorrence at the idea of short selling to the implausible conclusion that it is the short sellers who are dragging down prices. As the great investment writer Fred Schwed Jr commented, “Only the thoughtful ask, ‘What is happening to us?’ The popular cry is, ‘Who is doing this to us?’ and its satisfying sequel—’Just let me get my hands on him!’ “

Proving the rule
In some rare cases, the short seller really is the one causing the problem. For example, it might be possible to sell a retail bank’s shares short; start unfounded rumours about the bank’s liquidity; and cause a run on the bank, making the rumours self-justifying, destroying a valuable asset, and earning money in the bargain. We should never feel comfortable about short sellers who also (independently of their short-selling) possess the power to destroy—be they rumourmongers, board members, or just a sportsman backing himself to lose.

This is the exception I mentioned earlier. But I can’t help feeling that the “sell short, start rumour, make a killing” strategy is more easily planned than executed.

No, the world needs more speculators, especially of the short-selling variety. There is nothing inherently wonderful about inflated prices, but it is not easy to bet that prices will fall. More short sellers in the dot-com bubble of the late 1990s, and the housing bubbles of the past few years, would have added a welcome dose of stability and sanity. Alas, there were not enough of them—and the only people complaining about them at the time were their impoverished families.

© 2008, Slate.com. Distributed by United Feature Syndicate, Inc.

The new New Deal

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In the 1930s, Franklin Delano Roosevelt saved American capitalism from its own self-inflicted wounds by erecting a new financial infrastructure – often over the vociferous opposition of the bankers and investors whose poor judgment had helped precipitate the Great Depression. During the New Deal, the government reacted to a disastrous systemic failure by creating the sort of backstops, insurance, and risk-spreading mechanisms the market had failed to develop on its own, such as deposit insurance, federal securities registration, and federally sponsored entities that would insure mortgages.

Despite sustained efforts to tear down the New Deal – from the repeal of the Glass-Steagall Act in 1999 to President George W. Bush’s ill-fated 2005 efforts to dismantle Social Security – the 1930s-vintage infrastructure has proved remarkably durable. And this crisis has elicited new experiments in policy, just as the Great Depression did. The Federal Reserve has been systematically lowering its standards for what it will accept as collateral for loans. In April, Hillary Clinton called for a national panel to recommend solutions to the housing morass. (She said the group should include former Federal Reserve Chairman Alan Greenspan, which is a little like Chicago appointing a cow to a panel on preventing disastrous fires.) But as the nation once again confronts a systemic failure in housing and housing-related credit, the Bush administration is going back to the future, using New Deal-era agencies as the cornerstone of its response.

Although the Tennessee Valley Authority has yet to pitch in, four 70-year-old agencies are helping to cushion the blow of the housing bust. Let’s count them.

1. The Federal Home Loan Bank system. Last year, the model of originating and securitizing mortgages began to break down in the wake of the subprime debacle. Mortgage companies that relied on the capital markets (rather than deposits) to raise the money for mortgages suddenly found themselves starved for cash. Many of them turned to the FHLB, which was created in 1932 (so let’s give that one to Herbert Hoover) and provides capital to lenders. Indeed, had it not been for the FHLB, it’s possible that the nation’s largest mortgage lender, Countrywide Financial Corp., might have gone under. Sen. Charles Schumer, D-N.Y., noted last fall that Countrywide borrowed a whopping $51.4bn from the Atlanta FHLB as its troubles mounted. On Monday, the FHLB pitched in again, relaxing regulations on member banks to allow them to double the number of mortgage-backed securities issued by Fannie Mae and Freddie Mac that they can hold on their books for the next two years. The FHLB noted that this measure could allow member banks to purchase more than $100bn worth of such securities.

2. The Federal Housing Authority. The FHA, which was created in 1934, insures mortgages made by approved lenders to borrowers who are creditworthy but not particularly affluent. As the mortgage market grew like Topsy and subprime lenders peddled credit to underserved markets, the FHA may have seemed outdated. But in the wake of the subprime debacle, the FHA has suddenly become an important part of the effort to stanch the rising tide of foreclosures. Last summer, it created FHASecure, a program that lets certain borrowers switch from adjustable-rate mortgages into fixed-rate mortgages. “From September to December 2007, FHA facilitated more than $38bn of much-needed mortgage activity in the housing market, more than $15bn of which was through FHASecure, FHA’s refinancing product.” As part of the recently passed stimulus package, the FHA is also temporarily jacking up the size of the mortgages it will insure (in high-cost housing areas) from $362,790 to $729,750.

3. The Federal National Mortgage Association (Fannie Mae), which was created in 1938. Fannie Mae purchases so-called conforming mortgages (mortgages under a certain size) made by other lenders and packages them into securities, which it effectively insures. Fannie Mae and its brother government-sponsored enterprise, Freddie Mac, are playing a central role in the federal response to the housing crisis. The stimulus package boosted the size of the loans Fannie and Freddie can buy, from $417,000 to “125 percent of the area median home price in high-cost areas, not to exceed $729,750.” And then earlier this month, OFHEO, the body that regulates Fannie and Freddie, said it would lift the cap on the amount of capital they could use to buy mortgage-backed securities and make loans, providing “up to $200bn of immediate liquidity to the mortgage-backed securities market.”

4. The Federal Deposit Insurance Corp. The FDIC, which was founded in 1933 and insures bank deposits, is playing more of a passive role. Many of the financial institutions that have failed or suffered near-death experiences in the current crisis-subprime lenders, jumbo lenders like Thornburg Mortgage and Bear Stearns-essentially fell victim to runs on the bank. Once customers and counterparties came to believe that it wasn’t safe to do business with these firms, their days were numbered. But one sector has been largely immune from runs on the bank-banks themselves. Even as banking companies have racked up significant losses on soured loans, and even as some tiny banks have failed, Americans haven’t rushed to yank their cash out of their checking and savings accounts. The reason: In the event of a failure, depositors with $100,000 or less at FDIC-insured institutions are made whole.

Oriental express

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China’s reorganisation of its telecoms industry opens the door for foreign companies to the world’s largest telecoms market, but government inertia and protectionism could keep the floodgates shut for now. The world’s biggest industrial overhaul has removed some uncertainty that had kept strategic investors at bay, and China’s telecoms operators are certainly hungry for more capital, technical expertise and marketing skill.

“There’s never been a better time for foreigners to get into the industry,” said Daiwa Institute of Research’s Marvin Lo.
“And on the Chinese side, they want the capital and knowhow that global firms will bring to the table.” At present, foreign telecom operators, such as Britain’s Vodafone Group Plc and Spain’s Telefonica SA, are confined to tiny stakes in the largest operators. The restructuring, announced recently, is aimed at boosting competition between operators, and could trigger billions of euros of orders for equipment makers like Ericsson Nokia, Nortel, Siemens and Motorola Inc.

Foreign companies, many of whom face slowing growth at home, are already queuing up. Qualcomm, SK Telecom and Singapore Telecom are courting the larger of China’s two fixed-line players in the hope an investment will cement future cooperation, media reports say.

Blooming portfolio

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Instead of being defeated by the political upheavals in Lebanon, the nation’s leading financial institution has acquired valuable banking lessons from repeated domestic crises as it embarks on a second wave of growth beyond its home borders. Blom Bank is parlaying its historic reputation for low-risk, innovative trade finance into full-service operations in some of the fastest-growing, most promising regions in the world.

Liquidity highly-prized
In troubled times, as Beirut-headquartered Blom Bank has learned, liquidity is the secret to survival and prosperity. Like other financial institutions in Lebanon, it maintains levels of reserves that most western-based banks would regard as ultra-cautious. But Blom Bank’s chief executive Saad Azhari is not apologising. “We maintain very high levels of liquidity because of the unstable situation,” he says. “The banking industry here is very conservative in general, far more so than any other region. Actually, the banking system is very strong. It has to be because the economy depends on it.” Also, as the market leader Blom Bank clearly feels an obligation to set the standard.

Thus Blom Bank’s own internal guidelines are tougher than those laid down by the central bank, the Banque du Liban. For instance, the rules require that 15 per cent of deposits are liquid. Nor are banks permitted to invest in foreign bonds below investment grade. Also there are specific rules for investment by geography with certain countries being rated higher-risk than others. At home, lending to higher-capitalised companies scores higher marks than to lower-rated corporates.

However Blom Bank, which changed its name in 2001 from the Banque du Liban et d’Outre-Mer, maintains higher levels domestically as well as internationally. As extra security, it stores funds with foreign banks against emergencies. “We respect the central bank’s guidelines. There are very strict provisioning requirements,” summarises Mr Azhari. “But we are tougher with our own”.

A platform for expansion
The institution’s hard lessons in crisis management have helped pave the way for a new era of offshore development. Blom Bank has always been outward-looking – it opened a branch in Jeddah, Saudi Arabia – as early as 1952, just one year after it was first established at home. In part because of its expertise in trade finance, Blom Bank expanded beyond its borders in the seventies and eighties. However this was mainly in Europe in order to service the commercial and private banking needs of expatriate and travelling Arabs and Lebanese. Jointly with Swiss and Arab shareholders, it opened a branch in Paris (Banorabe) in 1976, followed by offices in Geneva (Banque Banorient) in 1979, in Muscat in 1982 and in London in 1983. These were niche banks, at least until recently.

But now that restrictions on entry have eased, it is hanging its shingle out in the Middle East and the Gulf regions. The latest phase of expansion started with a branch in Syria in 2004 where only state-owned banks had been permitted, and quickly followed with three new branches in Jordan. Four years later, Blom Bank is moving rapidly to a full-service operation in both countries. In Syria, for instance, it already offers corporate and retail services, has won permission to open an insurance business, and has applied for a share-broking licence.

At the latest count, Blom Bank had opened three new branches in Jordan since last year, doubling the size of the network. In Syria, it now has 11 branches and plans to open another seven between now and early 2009.

“We are always looking to expand overseas,” explains Mr Azhari. “It is very good for us now that these markets are opening up. We have the lowest cost-to-income operation in Lebanon and we are finding we can replicate our systems and format in these new countries.”

Rapid turnaround in Egypt
Normally a notoriously difficult banking market for foreign investors, Egypt underscores Mr Azhari’s point. Blom Bank was not permitted to open a new office there because of an embargo on the issue of licences, so in late 2005 it bought the loss-making MISR Romanian Bank. The business was turned around within the first six months of Blom Bank’s ownership and posted a €6.9m profit in 2006. That was followed by a €12m profit last year and will be much higher this year. As in Syria, the renamed Blom Bank Egypt is moving quickly to a full-service operation with a fast-expanding branch network. In the 12 months to June, the Egyptian bank opened 13 new branches to give it a total of 23.
 
Encouraged by success in Egypt, Blom Bank will open in Saudi Arabia before the end of the year, in Qatar by October, and has applied for a licence in Algeria. At first it will operate under limited licences in these places, but the institution has bigger ambitions. “We are probing for opportunities all the time,” adds Mr Azhari. “We are gradually heading for full-service operations across the Levant.” The overall expansion strategy is based on building business in countries that the bank considers low-risk while offering high potential for growth.

Simultaneously, the bank has steadily rebranded its far-flung empire under the Blom Bank name as it brings all its offices under the one wholly-owned roof.

Innovative trade finance
“The maximum security with the minimum risk” is how Mr Jacques Sabounji, long-serving senior manager of trade finance, describes Blom Bank’s long-held principle in facilitating cross-border deals. Although the institution runs full-service operations at home and abroad, its trade finance division has long been regarded across the Middle East as a standard-bearer in innovation. In the financial year ending March 2008, it posted more than half a billion dollars in volume of transactions. The bank’s trade finance portfolio extends to all kinds of transactions in the ten Middle East nations where it is active – documentary credits, letters of guarantee, collections, back-to-back financing, factoring, forfeiting and other technicalities of the world’s oldest banking skill.

Much of the bank’s trade-financing expertise is put to use in arranging deals between Lebanon and fast-growing manufacturing nations such as South Korea and China which are the source of a steady flow into Lebanon of all kinds of goods from vehicles to consumer durables. Many of these arrangements are complex, requiring detailed knowledge of the goods concerned as well as of shipping, finance, insurance and other arrangements. Typically, Mr Sabounji’s department takes into account not only the technicalities of trade finance but broader risk-based issues such as sovereign exposure, customer’s liquidity, the viability of the transaction, market competitiveness and international pricing norms. Hardly surprising then that Blom Bank’s authority on trade finance is in demand all over the region. Mr Sabounji provides advice to governments and lectures at universities.  

IT platform underpins deals
Blom Bank is rolling out a new IT trade financing strategy that is designed to minimise operational risk to the contracted parties as well as to itself. The IT platform will in time be made available to customers in a measure designed to speed up processing and enhance the accuracy of contracts.

One reason for investing in advanced IT programmes is that the total sums involved have been steadily mounting. One recent contract was to finance a €31m deal to import cars from South Korea.

Ever more innovative arrangements are required, especially as the credit crunch reduces the availability of debt and raises doubts about the liquidity of counter-parties. A truck-importing deal illustrates the challenges. As Blom Bank sources explain, the bank was asked to confirm a letter of credit for €5m on September 1, 2007, bearing a validity date of May 30, 2008. The letter stipulated multiple shipments with 90 percent of the payment made on sight, the remaining 10 per cent against the presentation of the commissioning certificate. However the bank intervened to rewrite the letter of credit to help its customer’s liquidity. Thus the customer ended up with an advance payment representing 17 percent of the letter of credit’s total, equal to around €0.9m. The rest of the total was paid 73 percent on sight, 10 per cent against delivery of the commissioning certificate.

In all these transactions involving the delivery of capital products, the role of the middle-man is paramount. “The key is that both parties have total confidence in the intermediary,” explains Mr Sabounji.

Biggest and most profitable
Now well into its third consecutive decade as Lebanon’s largest financial institution, Blom Bank is not neglecting its home base. By early 2009, it will add another six branches there for a total of 56.

It also firmly established itself as Lebanon’s most profitable bank, despite sky-high provision for liquidity. Last year it posted net profits of €130m with a return on equity of 15.65 percent, a ratio that would more than please many beleaguered western banks right now. The other numbers would also make them envious. Blom Bank’s cost-to-income stands at just over 34 percent, more than 10 percent better than nearest rival Byblos with 46.7 percent. The bank certainly won’t have a Lebanese version of the subprime crisis – its lending guidelines are more than responsible with only gold-plated borrowers getting 90 percent of a residential property’s value. In fact, 50 percent is more common.

Its sharebroking business dominates the Beirut Stock Exchange with 24 percent of all transactions. And the bank has shouldered its share of sovereign liquidity obligations – in early 2007 it successfully lead-managed the first government bond offering following the disruptions in capital markets of the July 2006 war.

Corporate deals on the up
Corporate financing is taking off despite the obvious challenges in the domestic commercial sector. Domestically, Blom Bank funded 24 project-finance deals last year for a total €339m. Its corporate loan portfolio is bounding ahead, rising by nearly 22 percent a year, and now stands at €0.7bn. An Islamic subsidiary, Blom Development Bank, has been launched to deliver tailored solutions to customers with religious borrowing principles.

Meantime Blom Bank builds on its growing international presence with landmark corporate deals; earlier this year it completed the first M&A transaction between Lebanese and Egyptian non-financial institutions. It is likely similar synergies will emerge between Blom Bank’s home and international operations as its expansion gathers pace.

For further information tel +96 1174 3300; email blom@blom.com.lb; www.blom.com.lb

Future shock

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Business isn’t what used to be. It’s increasingly about blogging, buzz marketing, pay-per-click ads, search engine optimisation and, just like the Phoenicians all that time ago, the global sharing and selling of knowledge, goods and services.

Little more than 10 years ago the Internet was little more just another business buzzword. A buzzword however that kept increasing in use, along with other nouns like ‘revolution’ and ‘transformation’. Big words and, some alleged at the time, a lot of hype.

Yet it was true. Internet technology was not only changing people’s lives in how they communicated with each other – witness the rapid emergence of email – but also how global business traded and defined themselves. Exceptional talents lay behind some of the early e-commerce names – Yahoo, Demon, Planet Online, Telinco, the Internet Book Shop, eBay, Vossnet, nCipher, BibioTech, Binary Star, Netscape and Dixons Freeserve. A few became household brands; others have since slipped from view.

For consumers, the benefits of internet commerce have been huge: cheap ‘phone calls, digital music downloads, buying online, often with the help of price comparison websites. It’s also hugely widened the range of goods available, saving large amounts of time and eliminating the inconvenience of limited shopping hours and lack of choice. Shopping online has not just made prices cheaper thanks to increased transparency.

For business, the internet has brought even more changes: template and automation tools, email, sophisticated analytics, buzz marketing, you name it, the ability to reach consumers quickly, discreetly and – the real advantage – cheaply. The internet has completely revolutionised the way business is done. Indeed, many businesses main tool remains just email and the internet with few if any staff.

Payment transactions have been revolutionised. Even a few years ago many would not think of sending sensitive information like bank account details over the internet. Yet today many businesses rely completely on their clients trusting them with deeply sensitive personal information, often using Internet banking in preference to telephone banking or a local branch.

Then, there’s how we network together – again, a word that has taken on a different dimension with the internet – with professional networking. Just look at LinkedIn. LinkedIn has an estimated 20 million users bringing together professionals from more than 150 different backgrounds.

A powerful business combination
It’s not just about the power of the internet. Digital technology is also having a huge effect on the way business sells and promotes their products, services and credibility. Shifting media consumption is changing consumers’ information sources says analyst Benjamin Ensor. Take, he says, how financial services sell and market themselves. “Digital technologies have unleashed a range of new information and entertainment technologies. Europe’s rapidly growing broadband penetration is encouraging Net users to spend more time online. The result is a fragmenting audience for mass media and the growth of a range of new information sources like comparison-shopping sites, discussion boards and blogs, changing the way financial firms need to market them.

And new entrants are making financial services increasingly competitive. Direct banks, direct insurers, and supermarket banks are exploiting new distribution channels to win customers with better rates, better service, or both. And of course, comparison shopping websites increase transparency, making it easy for customers to shop around.

The buying patterns are also changing in a big way due to the new channels, services and technologies. Financial channels like mobile phones and the Web and new technologies like chat and SMS continue to change consumers’ financial behavior, encouraging cross-channel interactions says Mr Ensor. “Many financial firms struggle to work out which channels customers want. Trust in financial firms is declining. Financial scandals in countries like Italy and the UK have tarnished the entire retail financial services industry in these countries. A shocking number of consumers distrust both financial firms and advisors. Established firms can no longer rely on what was traditionally one of their greatest assets — trust.”

The next revolution
Web 2.0 has already had a huge impact on business – particularly for collaboration and content use. Web 2.0 basically means it is easier to build applications and services around the internet. Content and user participation are a richer, more effective experience. It also has a profound experience on how businesses use Web 2.0 to reach their target audience through advertising – and business is still coming to grips with its impact. Many Web 2.0 sites rely on members of the public to swop and add information, whether it’s writing their own blogs or posting content such as videos or photos. And these sites are amongst the fastest growing on the internet, such as social networking sites like MySpace and Bebo. And because these sites are popular, it means the potential for advertising and product placement becomes a great deal more powerful.

A recent report from Gene Phifer and David Mitchell Smith at Gartner reckons the impact of Web 2.0 will have an on-going impact on business in the future. “CEOs and top managers will need to identify which key organisational business and technical processes will most likely be impacted and, in many cases, redefined by web business models,” they said. “Although the organisation’s web business model in the first wave of the dot-com boom was seen primarily as a marketing adjunct, except for highly targeted industries that were media- and information-based, and other industries such as travel, its web business model will now affect a range of non-sales and marketing-related processes, including manufacturing, research and development and finance.”

Certainly social websites like MySpace, which Rupert Murdoch snapped up for €374m and attracts approximately one in four Americans, are now starting to prove their worth. The secret, it seems, is to create website features that encourage users to use the website more often. That means creating features that allow them to join social or even political causes. Recently Yahoo and eBay also got onboard, backing a MySpace initiative to allow users to bring their own network and profiles to such sites. It’s all about advertising, of course, and data mining – but using information that doesn’t alienate end users in the process.

Threats and opportunities
The opportunities for many SMEs has also been stupendous, offering the chance of global exposure, all from a few clicks of a computer mouse. Yet business, small and large, needs to continually differentiate itself from the competition. Some experts predict that as consumers become increasingly confident with using the internet, the ability to price services and goods will come under increasing pressure.

The client experience will also need to be enhanced they say, particularly in retail services. It’s one thing selling a widget at a competitive price; but how do you ensure loyalty the next time, especially if you can compare prices with other widget sellers with a few mouse clicks?

Also, how does business finesse the hugely complex of pricing, be it online or at source, as well as offering price guarantees while managing regular promotions? It’s a fearsomely complex process to handle.

Yet plenty of opportunities remain. Like finding out what your clients really want – and in real-life conditions. One method is to host chat boards or discussion forums where your clients can actively discuss your service or products, often rating them and then sharing this information with other clients. P&G and Unilever are both large conglomerates which do this. The internet, said a branding officer recently for one of the world’s biggest retailers, has the ability to involve consumers with a brand or services in a much richer way than so-called conventional media. “We find that when we get the right ‘pull’ for consumers into interacting with the brand, consumers spend much more time and are much more involved than they are when they’re watching a TV commercial or reading a magazine.”

US retailers still lead the online boom
Online retailing is proving a goldmine for many businesses. US online retail reached €112bn in 2007 points out Sucharita Mulpuru from Forrester Research and is projected to grow to an eye-watering €216bn by 2012. “Business-to-consumer eCommerce continues its double-digit year-over-year growth rate,” she says, “in part because sales are shifting away from stores and in part because online shoppers are less sensitive to adverse economic conditions than the average US consumer.” Despite the continued growth of the internet channel, online retailers face several challenges to growth says Mulpuru. “Online stores are broadly perceived as a second choice for shoppers, online retail is becoming increasingly seasonal, and online shoppers rarely admit to browsing, which can drive valuable incremental dollars during their Web shopping experiences.”

Mulpuru also claims online retail is less sensitive to economic shocks because online shoppers tend to be more affluent than average consumers – their overall retail behaviour exhibits less sensitivity to changes in economic conditions. “In fact, only 20 percent of consumers in a survey that we conducted prior to the holidays — just as the subprime mortgage conundrums were gaining traction — said that they would reduce spend during the holiday season due to uncertainly around the US economy. In contrast, other surveys canvassing the entire US population report significant consumer cutbacks in spending in 2008.”

Yet their spending patterns are likely to remain. Consumers who have been buying via the Internet for more than five years, shopping online become second nature, commented a recent PricewaterhouseCoopers report. “They shop across a broad range of categories. Some are buying very high value items, like cars. Consumers with less experience buy fewer categories of goods online, but their willingness to shop across categories increases as they become more accustomed to the technology. They are also prepared to consider buying higher value items. The current crop of novice online consumers is more adventurous than the net novices of a few years ago. While today’s net vets started out by buying simple items, like books and CDs, net novices nowadays are starting by buying clothes online.”

The personal touch
The internet has had a liberating effect for many businesses. However Peter Robinson, director of information technology consulting at BDO Story Hayward in London, says that people, despite the dramatic changes technology has bought, people still tend to buy from people, especially when it comes to professional services. “People are generally price-led when it comes to retail goods. But in terms of selling services, relationships remain key. With our key clients we have an extranet service where we can share key points of information, work plans and draft letters together. That gets us closer to our clients. It also makes business generally that more accessible. People buy from people they like, especially in the beginning. Or they buy the culture. It’s not just about a glossy proposal.”

Yet technology now has become a fundamental component of the way a company chooses to plan their strategy. It helps companies reach well beyond boundaries to create new value from which they can profit, often handsomely. Only a few years ago, much of this would have been thought unachievable. Customers are now active participants in your business. Managing to navigate the new economy brings huge pitfalls. But it also – as the Phoenicians discovered with their own new economy – brings huge rewards.

Growing pains

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Following the collapse of the US sub-prime mortgage market last year and the heavy hit that the world’s banks have taken as a result of their former lax approach to lending, it is unsurprising that the flow of money is slowing to a trickle, prompting governments to tighten their belts, cut growth forecasts and raise interest rates to stem rising interest rates.

Even the US Federal Reserve – the bell weather of the world economy – has hinted that interest rates may have to rise. It has also hinted that, if needs be, it would favour prolonging a period of stagnation, rather than risk stagflation.

So far, no country has admitted that they are actually undergoing “stagflation” – high inflation rates combined with low growth – but it seems likely that it is only a matter of time before either a central bank governor or finance minister does so. And it is unlikely that the count will stop at one. Furthermore, the first country that utters the “s” word could as easily come from Europe as it could from the developing world, though economists agree that the impact of stagflation on the latter will be more acute, politically as well as economically.

According to June figures released by four countries in the region, inflation is accelerating in Asia, raising the likelihood that central banks will be obliged to increase interest rates in spite of rising fears of slowing growth. Furthermore, Asia remains home to two-thirds of the world’s poor, and protests over soaring prices are threatening to further weaken governments that are struggling to contain unrelated unrest, such as ethnic tensions in Malaysia and protests over beef imports in South Korea.

With signs that an economic slowdown might already be taking place, South Korea’s central bank cut its 2008 growth forecast to 4.6 percent – well below the six percent promised by Lee Myung-bak when he took office as president in February. South Korea’s finance minister also said that the country could be heading towards stagflation. “It’s premature to say we are experiencing stagflation but the economy is moving that way,” said Mr Kang Man-soo.

In Japan, the closely watched Tankan survey showed confidence among manufacturers at its lowest level in four years, while in Vietnam, one of Asia’s fastest-growing countries, the government said first-half growth was the slowest in at least seven years at 6.5 percent.

Provoking action
“I think we are definitely crossing a threshold and the kind of inflation numbers that we are seeing will have to provoke central banks into tightening policy,” said Duncan Wooldridge, Asian chief economist at UBS. “Ultimately there is a risk of stagflation if central banks don’t have the stomach to tighten more aggressively.”

Adding to the growing concern about economic downturn, the IMF warned that surging food and oil prices could “severely weaken” the outlook in about 75 developing countries, including populous Asian nations such as Pakistan and Indonesia.

Thailand has also said inflation had risen to a 10-year high of 8.9 percent in June from 7.6 percent in May, while South Korea said consumer prices were 5.5 percent higher than a year earlier – the biggest annual jump since November 1998. In Kazakhstan, inflation accelerated to 20 percent year-on-year in June, the highest in more than eight years. A similar scenario is developing in Sri Lanka, where inflation rose to 28.2 percent in June – its highest in more than five years.

At the beginning of July, Bank Indonesia raised its key interest rate 25 basis points to 8.75 percent in a move designed to control soaring inflation, which hit a 21-month high in June. Boediono, the central bank’s governor, hinted strongly that further rate rises would be necessary, saying that year-on-year inflation could rise from 11.03 percent to 12.5 percent by year end because of “economic uncertainties”.

Relying on reserves
Analysts expect the bank to sell dollars to support the country’s currency, the rupiah, which has fallen 2.2 percent this year, in addition to raising rates to control inflation. Boediono forecast that economic growth would slow to 6.1 percent-6.2 percent, from 6.3 percent last year. Most economists believe rates will have to rise to about 9.5 percent by the end of the year but that the central bank will be reluctant to go much higher than this because it expects inflation to fall to below eight percent next year. Inflation began climbing after the government raised the price of subsidised fuel, which accounts for 95 percent of consumer use, by 28.7 percent in May. The month-on-month inflation rate in June was 2.46 percent. Increasing oil prices are going to pressure the government even more.

But such pressures are not limited to Asia and its developing economies. Europe is also showing signs of struggling with the spectre of stagflation. The ECB raised interest rates in the Eurozone for the first time in more than a year in July as it stepped up efforts to control mounting inflation pressures. The ECB lifted its main interest rate by a quarter percentage point to 4.25 percent – the first rise in Eurozone borrowing costs since June last year.

The increase came just days after official figures showed Eurozone inflation had hit four percent, the highest since the launch of the euro in 1999 and more than double the ECB’s target of an annual rate “below but close” to two percent. Based on reconstructed-historic data, Eurozone inflation was last higher in May 1992.

Ahead of the ECB announcement, the Riksbank in Sweden – which is not part of the Eurozone – said that it was increasing its main interest rate by a quarter percentage point to 4.5 percent, adding that it expected to tighten monetary policy twice more during the year. Still, Eurozone growth is showing clear signs of slowing, especially in member states such as Spain and Ireland, hit by property market corrections.

The Spanish economy grew at its slowest quarterly pace in nearly 13 years between January and March, as a tumbling housing market and the global credit crunch brought a sharp deceleration in economic activity. The economy expanded by 0.3 percent in the first quarter of this year – the lowest rate since the third quarter of 1995, the national statistics institute said.

The slowdown appears to have caught the recently re-elected socialist government by surprise, even though the Círculo de Empresarios, Spain’s biggest business lobby, warned only in June about the risks of stagflation. Pedro Solbes, finance minister, recently lowered the official growth estimate for 2008 from 3.1 percent to 2.3 percent. But on the basis of the economy’s recent performance, even that revised forecast looks optimistic, say analysts.

Grim outlook
Economists are worried about the impact of the slowdown on employment and government revenues. Between 2004 and 2006, Spain created one-third of all new jobs in the EU, many of which were filled by Spain’s 4.5m immigrants, who make up 10 percent of the population. Unemployment is now rising as construction and services industries shed jobs – last month it topped 2.3m, 15 percent higher than a year ago.

Although slower growth could reduce inflationary tensions, the Eurozone economy appears to be slipping towards stagflation, say manufacturers based in the region. In the latest example of such trends, the German chemicals association said it expected chemicals prices to rise by 3.5 percent this year, rather than the two percent it had previous expected. At the same time it revised down its forecast for growth in production – to just 2.5 percent, compared with the three percent it had previously expected.

Such announcements are hardly inspiring investors to part with their cash, and manufacturers and fuel-reliant industries, such as the automotive and aviation sectors, are finding that the flow of money from investors and customers is drying up. According to a recent poll of global fund managers carried out by stockbroker Merrill Lynch, investors are more pessimistic now about equity markets than at any time in the past decade. The survey also found that sentiment towards equities is even more negative than between 2000 and 2003 when the sell-off in global stocks was much sharper.

Merrill Lynch’s survey of 204 asset allocators and fund managers found that investors have cut their exposure to both equities and bonds and are moving into cash as fears of stagflation grow. A net 27 percent of investors surveyed (the net figure is the balance between those respondents who favour an asset class and those who do not) were underweight in equities relative to other asset classes, while a net 42 percent were overweight in cash, up from a net 31 percent in May.

Rotting at the core
The outlook for global growth and profit expectations is deteriorating as investors brace themselves for higher inflation and interest rates, the survey noted. A net 81 percent of respondents believe that consensus earnings estimates for the next 12 months are too high. Europe has borne the brunt of investors’ shift from equities, with the Eurozone moving from investors’ most favoured region to least favoured over the past 12 months. A net 22 percent of investors are underweight in Eurozone equities. But the bearish stance towards the eurozone is dwarfed by the negative view of the UK. A net 38 percent of respondents are underweight UK equities, the most negative stance in a decade. A net 62 percent of respondents are overweight oil and gas, while a net 62 percent are underweight in banks.

“Investors don’t know where to go. They are favouring oil and commodities plays in equity markets, which shows that inflation is playing havoc,” said Karen Olney, chief European equities strategist at Merrill Lynch.

Unlocking Japan

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Japan was once an entirely closed economy. Foreign traders were, until the middle of the nineteenth century, required to live on Dejima, an artificial island in Nagasaki harbour. Their route to the mainland was across a narrow causeway that was open only during the day, and even then only to those with a special permit. At night, the traders were locked out.

EU Trade Commissioner Peter Mandelson reminded Japanese business and government figures about Dejima when he gave them a speech earlier this year. Dejima was the only opening in an otherwise entirely closed economy, he said. From one perspective, it represented the persistence of trade, even when barriers are erected against it. But it was also a symbol of suspicion of the outside world – suspicion of trade.

Dejima is a thing of the past, said Mr Mandelson. But it served as a useful metaphor for understanding Japan’s position in the world today. Globalisation had transformed the economies of Europe, but in Japan it was still unfinished business. Barriers to investment had kept productive EU investment out of the Japanese economy, despite the fact that Europe had been welcoming such investment for decades.

“As a foreigner looking at Japan from the outside, what I see is a globalisation paradox,” said Mr Mandelson. “For decades Japan has taken advantage of an open global investment climate. Both it and the host economies have benefited from that investment. Yet at home it remains the most closed investment market in the developed world…. Japan went global long ago, but at home it holds back from becoming globalised.”

Especially at a time of global economic uncertainty, “the single greatest threat to the economic openness that underwrites our prosperity in Europe, the US and Japan is a return to the Dejima mindset – The economic nationalism and protectionism that makes us see foreign participation in our economies as a sign of vulnerability,” said Mr Mandelson. “This is an argument that is increasingly powerful in the US and Europe, especially as the global economy and the growth of world trade has slowed.”

Closed door?
Mr Mandelson is right. Europe has benefited in competitiveness terms from welcoming Japanese investment, but Japanese rules are leading EU companies to invest in China and elsewhere in Asia, rather than in Japan. Japan’s limitations on foreign direct investment are costing the country in terms of productivity and competitiveness.

Japan’s net investment outflows rose to more than €30bn in 2006 – a 16-year high. But inflows were paltry. Europe invested a net total of less than half a billion euros in Japan in 2006. That means for every euro Japan invested in the UK and the Netherlands alone, for example, European companies were able to invest a net total of only three cents in Japan. “This is, frankly, hard to understand,” said Mr Mandelson.

Europe is the biggest exporter of FDI in the global economy. It has about three trillion euro invested globally. Yet only €47bn is in Japan – less than three percent. “Nowhere else in the developed world is EU investment so thin on the ground,” he said. “In fact, Japan is the only country in the developed world with which the EU has a negative balance of investment flows.” FDI stocks in most European countries are around 20 percent of GDP. In Japan they are less than three percent of GDP. In fact, Japan is the second largest economy in the world, but Europe trades more with Switzerland.

Restrictions
Why is the situation so one-sided? Partly, there are still too many restrictions on FDI in Japan, far more than Japanese companies face in Europe. European companies cannot participate in the agricultural sector, the forestry sector or maritime transport. There are also disincentives that operate at one remove: European construction companies put off Japanese plans because they are unable to secure public procurement contracts in open tenders.

But the main cause, said Mr Mandelson, is the lack of a developed mergers and acquisitions market, which is an obvious precondition for FDI flows and the basis of most FDI globally. A review last year of Japan’s mergers laws to allow triangular mergers of foreign companies with Japanese companies have widened the possibilities for foreign participation, but the merger between Citibank and Nikko has been the only result so far, and was more an internal realignment than an example of a genuine merger. Many Japanese companies have responded to the prospect of mergers by creating poison pill schemes.

Indeed, Mr Mandelson made his speech just after Tokyo rejected, on national security grounds, a proposal by The Children’s Investment Fund, a UK activist fund, to double its stake in J-Power, an electric power wholesaler, to 20 percent. Japan needed to recognise that investment brought trade, technology and management skills, said Mr Mandelson. “We are not talking about fly-by-night short-term players who are going to earn a quick buck at Japan’s expense and then clear off. And that’s how I think Japan views outside investors too much,” he said.

Governance failings
Mr Mandelson couched his comments with a litany of respectful asides, in the hope that he might avoid giving offence, but were greeted frostily nonetheless. However, his is not the only voice calling for change. The Asian Corporate Governance Association has since told Japanese public companies to improve their corporate governance standards or risk further undermining the confidence of foreign investors. It said improvements were essential for Japan’s economic health.

The ACGA published a white paper on the topic which argued that “the system of governance in most Japanese listed companies fails to meet the needs of stakeholders or the nation.” Its report – Japan White Paper – represented the first time that global institutional investors have worked together to raise concerns about corporate governance issues in Japan. The paper has the support of leading global pension funds and fund mangers, including: Aberdeen Asset Management, from Singapore; the California Public Employees’ Retirement System (CalPERS), from the US; and F&C Asset Management, from the UK.

The paper argues that governance practices are failing for three reasons. They do not provide sufficient supervision of corporate strategy; they “protect management from the discipline of the market” by making takeovers difficult; and they limit the returns on equity investment.

Sound governance
The ACGA says that corporate governance is essential to the creation of a more internationally competitive corporate sector in Japan and to the longer-term growth of the Japanese economy and its capital markets. Some leading companies in Japan have made strides in corporate governance in recent years, but “the system of governance in most listed companies is not meeting the needs of stakeholders or the nation.”

Its paper argues that the corporate governance systems of some leading companies continue to evolve and improve. However, it says the current Japanese model of corporate governance has its roots in the period of rapid reconstruction and growth in the 1950s and 1960s.

This was a time when the population of the country was much younger, when few, if any, Japanese companies had achieved the dominant positions that so many now enjoy, and when investment capital was comparatively scarce. “It was a model that was often driven by a uniquely Japanese pattern of intense, oligopolistic competition and a resolute pursuit of the internal generation of capital,” the paper says. “This served Japan well at that time but it is less appropriate to the needs of the nation in the circumstances prevailing today, in which companies are not starved of capital and a more open model of corporate capitalism is required.”

That’s why the paper calls for a fresh look at the basic tenets of Japan’s corporate culture and, particularly, its system of corporate governance.

Falling confidence
The high water mark of confidence in the old Japanese model of corporate strategy was seen in the early 1980s, but public confidence in it declined sharply from 1990 onwards and this has been felt nowhere more strongly than in Japan itself, the paper says.

In March this year, for example, Nihon Keizai Shimbun carried a front-page article reporting that large Japanese corporate pension funds, dissatisfied with returns from the domestic equity market, were increasing their weightings of foreign equities and other asset classes.

A symptom of the longer term decline in domestic investor confidence can also be seen in the fact that the majority of net buying of stocks over the past five years has been by foreign funds. Yet since late 2007 even foreign confidence has fallen sharply, helping to drive the Nikkei Index down by more than 20 percent. “This has significant implications for the Japanese economy as a whole,” the paper says.

Better governance will not fix all the problems afflicting Japan’s stock market and economy, but it will be an essential element in the rebuilding of confidence. Improved investor confidence will bring funds flowing back into Japan, the paper argues. “It will encourage Japanese domestic investors, both retail and institutional, to re-enter the market; and it will assist the development of the financial services sector, an important new area of growth for the Japanese economy and a provider of employment in future.”

That means a move towards global governance standards is in Japan’s national interest, and this will be even more true as the government tries to turn Tokyo into a leading international financial centre.

Fair treatment
For the ACGA, fairer treatment of shareholders is an integral part of this process. “It is important to restore shareholders to their rightful, legal place as the owners of companies and to ensure that their interests are protected alongside other stakeholders,” its paper argues. “Shareholders invest their savings in companies because they trust that management will look after these funds and provide a fair return. When managers fail to do so, they effectively break their most fundamental contract with shareholders.”

Moreover, the provision of healthy returns to shareholders requires that capital is utilised efficiently. Inflated balance sheets and undisciplined acquisitions and diversification are signs of management inefficiency and corporate weakness, not strength. Over the medium to long term, the total shareholder returns of Japanese companies that pay higher dividends outperform those that pay lower dividends, according ACGA analysis. “A healthy dividend policy, therefore, reflects a healthy company and does not, as many managers appear to believe, mean that a company is simply ‘giving money away’,” it says.

Better treatment of shareholders is not the only reason why the ACGA wants governance practices to change. There are also long-term demographic and social factors that will require higher investment returns in Japan, namely the ageing of the population and the rapid rise in the number of pensioners.

It is estimated that by 2025, the percentage of Japanese people over the age of 65 years will be approximately 30 percent – one of the highest ratios among developed countries. The pressure on listed companies to generate income for pension funds in Japan, therefore, is likely to increase. “Improved shareholder value will be vital in order to achieve positive social outcomes,” says the ACGA.

The fair treatment of shareholders can and should be aligned with the fair treatment of other stakeholders, it says. Indeed, most of the institutional investor members of the ACGA are “long-term shareowners who seek to invest in well-managed companies that are both profitable and good corporate citizens,” it says. “While the interests of different stakeholders may differ over the short term, they can be aligned over the medium to long term through sound management and good governance. Indeed, this is one of the primary tasks of a board of directors and senior management. Successful companies perform this balancing act well.”

The paper makes recommendations on six issues. These include removing poison pill takeover defences, introducing more fairness and transparency on shareholder votes, and bolstering independent supervision of management. “It is still common for listed companies in Japan to be run as if management, not shareholders, were the owners,” the ACGA says.

Japan is often lauded for its version of “stakeholder capitalism”, where the business balances the interests of shareholders with other groups, such as employees and the wider community. But this view “is outdated and fundamentally inaccurate,” the paper says.

And it is right. Japan and its companies have enjoyed the open door policies of Western nations for decades. Now it is time for them to return the invitation.

Let them eat cake

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The UK is now facing the highest rate of inflation since the summer of 1992, whilst economic growth is forecast to slump to one percent by the end of the year, down from three percent in 2007. With no end to increases in food and oil prices, a slump in house prices and a growth in unemployment, analysts are questioning the Governor of the Bank of England’s reluctance to cut interest rates.

According to Mervyn King, in a recent speech at Mansion House, “the value of paper money rests on only one thing – trust. Trust in the ability and determination of those setting interest rates to monitor the value of money. Central to that is the independence of the Bank of England”. It is likely that this trust has been severely diminished, as the number of repossessions skyrockets, as heavily indebted consumers default on payments, and as the Bank of England refuses to cut interest rates to stimulate the UK’s stumbling economy.

Of little comfort to UK workers, was the Chancellor’s discouragement of pay rises in the following recent statement, ‘to return now to inflationary pay settlements would undermine rather than raise people’s living standards, with a damaging circle of wage increases eroded by steadily increasing prices’. Whilst urging restraint in pay settlements may help to ward off inflation, there is a feeling that sky-rocketing oil and food prices are something that the UK has no power over, and are necessities rather than affordable luxuries. As such, the result of Mr King’s inactivity will be a serious tightening of consumers’ budgets, with poorer families in particular having to suffer a serious drop in their standard of living. Thanks to the credit crisis, the situation cannot be remedied by personal loans, as mortgage providers and banks become stricter with who they lend money to.

The fall-out from the credit crisis could however, be far worse than low economic growth and a slight drop in living standards. Economists have warned that more than 1,200 people a day will lose their jobs over the next 18 months, and official figures released in June showed that unemployment hit 1.6 million in March, up 14,000 since January. The situation is equally bad for businesses, with the Home Builders Federation warning of widespread redundancies in an industry which employs 300,000 directly, and many thousands more indirectly.

Rather than implement measures to counter these impending redundancies, Mervyn King said the economy was rebalancing and the Bank should not try to prevent that adjustment. Rather than accept such macro-economic explanations for the current turmoil, UK businesses should be questioning how accountable the Bank of England is for the current instability. According to Jonathan Loynes of City analysts Capital Economics, “the message would seem to be that the Bank’s rate setting committee expects to cut rates only once more at the most. It’s inability or reluctance to cut rates further now increases the chance that the downturn in the economy will be both deep and prolonged.”

The period of stagflation culminated with the end of the Labour government. Whilst union strength has diminished considerably since the 1970’s, there are signs that a previously apathetic UK electorate are likely to vote in a new government, partly due to unease over Labour’s economic policy. As Peter Hennessey recently said, “the brute force of the voters with stagflation made Mrs Thatcher possible”. If no further monetary policy action is taken, it is likely that New Labour will go the same way as Old Labour, and face an extended period in the political wilderness.

Captain’s knock

Posted on by itsupport

Editor’s note
This is an archived article. For the cover story concerning Sir Allen Stanford please click here.

Sir Allen’s new and innovative cricketing enterprise is merely the latest innings in a business empire that spans financial services to upmarket real estate development, hospitality and professional sports. We talked to the Sir Allen about his ability to keep investments on track, whether there’s a formula for making financing work, and his interest in cricket.

Wise investment decisions
Tireless research, meticulous planning and hard work have been the core principles of Stanford Financial Group’s success since the first Stanford enterprise was begun by Sir Allen’s grandfather in 1932. Like other investment firms Stanford Financial offers its clients diversified portfolios fine tuned to meet their financial objectives; near, mid and long-term. Where the firm differs, however, is in the way it measures performance.

“Certainly global diversification across asset classes, economic sectors and currencies is critical to the Stanford Investment Model (SIM) strategy, but we do not measure our performance against current market indices,” says Sir Allen. “Instead of benchmarking as most firms do, we set our own Return on Investment goals. Our SIM strategies are a fluid, therefore constantly evolving process guided by the parameters set by our investment committees. Our investment strategies have always been one of long-term consistency. The current market conditions we find ourselves in today are no exception.”

“We do not invest in anything that we do not fully understand, and often we don’t follow current trends when making investment decisions,” emphasises Sir Allen. “For example, the reason we had no exposure to the securitised debt meltdown was that after doing our own internal research and risk analysis we simply could not get our arms around the underlying assets and their associated risk, therefore any perceived profits became irrelevant.”

Sir Allen also points to the quality of the people working for Stanford Financial as instrumental in the firm’s performance. “A financial advisor who delivers true world class wealth management service to his clients must also be supported internally and externally by world class talent,” says Sir Allen. “At Stanford, that external support is provided by advisors and money managers with whom we have had, in some cases, relationships going back three decades. Internally over the years we have continuously invested considerable sums of money to grow our policy research, financial analyst, equity research and fixed income teams, in spite of current trends to outsource these disciplines.”

The internal Stanford team includes over 100 people constantly searching for opportunities across the globe in order to meet the firm’s ROI goals with palatable risk. As Sir Allen notes, the fact that the housing market in the United States is in distress, yet in Brazil new home construction is booming, shows how important it is to take a global approach to investment strategy, and to thoroughly understand the economies in each country that support the industries being invested in.

“The bottom line is this, there is no short cut to quality investing, or magic formula for making money, it is a process of discipline and hard work.” says Sir Allen.

Identifying opportunities
You do not become a billionaire entrepreneur without having a good understanding of the global economy, and Sir Allen’s opinions on the regional economic prospects and possible investment opportunities for the future are well worth noting.

On the US economy, Sir Allen has concerns. “With a sluggish economic base, dependency on imported oil, tight credit, inability to substantially grow exports with a weak dollar and now commodity prices that are certain to bring on inflationary pressures, and a €0.6bn a day cost to fight the Iraq and Afghanistan wars; any economist will tell you that this scenario points towards stagflation,” he warns. “I hope that I am wrong and the US economy can weather these current storms, but the challenges are in a number of sectors that have been hit hard, and it will take some time for them to recover.”

In the emerging markets, however, Sir Allen sees a number of opportunities, although not necessarily where you might imagine. China, on its way to becoming an economic superpower, is perhaps overexposed, he says. “I am lukewarm for investing in China right now, if for no other reason than everyone else is already in China, the cost of living and wages are guaranteed to rise, and they have some serious environmental issues, which they will soon have to deal with.”

“India has created pockets of great wealth and great investment opportunities, but it is a volatile place for investing that will eat the ill-informed alive.” Says Sir Allen

He sees the Middle East and Africa as the last true emerging market with this observation. “This part of the world is definitely one where relationships determine your success and there is almost no correlation to the rest of the global economy from these oil exporting, enormously wealthy countries.”

Sir Allen is bullish on Russia, currently undergoing a transition from communist society to capitalism, (but with the added caveat that you need to do your homework), just as he is on Latin America, and Brazil in particular.

“Capital inflows have increased significantly in most Latin American countries over the past few years indicating a confidence and enthusiasm for a part of the world with enormous untapped natural resources and a burning desire to move up the economic and social ladder. Most governments are committed to investing in their countries’ infrastructure and the political risk of investing, at least in most countries, is acceptable,” says Sir Allen.

“Just look what a success story Brazil has become, for example. Back in the 1970’s no one took Brazil seriously, except in soccer. Today Brazil is South America’s largest economy, it is a true global player, and produces all of its energy needs internally. If the government can keep inflation in check and give as much attention to the environment and ecology of the country as it has to its economy, then Brazil has an incredibly bright future.”

There is a bright future ahead for the Stanford Financial Group too, according to Sir Allen. “In these turbulent and uncertain times, I see great opportunities for Stanford. I certainly wish that the current chaos and confusion in the markets could have been avoided, but there are great buying opportunities and huge opportunities to grow our business now,” he says. “We had no sub-prime exposure, were extremely conservative in our use of leverage, and our business model has proven highly efficient in the current market conditions.”

A new game
Despite his considerable business success, restless entrepreneur Sir Allen, shows no signs of letting up the pace, with a number of new enterprises on the go, or at the planning stage.

One well publicised venture is Sir Allen’s foray into the world of cricket, shaking up the sport with the relentless vigour of a man not used to failure. While Sir Allen’s commitment to the 20/20 form of the game, and the €12m prize for the winner of the England versus Stanford’s All Stars game on November 1, 2008, may have diehard traditionalists choking on their Pimms, there is no denying Sir Allen loves the game and wants to secure a successful future for it – regardless of format. He is also keen to revive the flagging fortunes of the West Indies national side.

“I looked very carefully at how we could take a sport that was dying in the Caribbean, bring it back to life and give it a future. In the process, we needed to change the entire cricket fan demographic from being male dominated to one that was family oriented and particularly exciting for young kids. The 20/20 format, no doubt about it, is the future of the sport,” says Sir Allen.

“As a point of reference the TV rights for the recently completed Indian Premier League were sold for €0.6bn. Our business model goal for the Stanford 20/20 is for our costs to be covered within three years through TV, sponsorship and other direct revenue streams. With the Stanford 20/20 Tournament, we firmly believe we have created something that will capture a huge global audience and promote the Stanford brand to new and exciting markets.”

On another front Sir Allen is planning something even more ambitious. “I am presently working on a series of projects within a project that is unequalled in the world. I have been working on this for over nine years with some of the world’s top architectural, engineering and design firms,” he says.

“Hopefully we are in the last phases of negotiations with government officials and I am optimistic it will all come to a positive conclusion very soon. This mega project will transform one island nation into a model for sustainable, ecologically correct development, while providing a foundation for future economic and social improvement for an entire population for generations to come.”

The sustainability focus is very apt. For there is one considerable cloud on the horizon, says Sir Allen.

“Poor global leadership, nuclear or biological war, man’s inhumanity to man, greed, religious intolerance, exponential growth of human enterprise… they are all overshadowed by global climate change,” he says. “I am not talking about saving planet earth. I’m talking about saving civilisation. For the next generation to have a future, we as nearly seven billion people living on a planet with finite resources, must immediately begin the process of restructuring the global economy before we reach the tipping point of massive market failure and the collapse of social, economic and government structure.”

And given his track record, there is little doubt that Sir Allen will play a significant role in tackling the challenge of global climate change, applying the same meticulous preparation, dynamic energy, and appetite for sheer hard work, that has made him such a successful businessman, to help knock this global threat for six.

For further information www.stanfordeagle.com

Transfer pricing and over-regulation

Posted on by itsupport

What is transfer pricing?
It embodies the fundamental pricing calculation when services, tangible property and intangible property are bought and sold across international borders between related parties. The arm’s-length principle is formally defined in Article 9 of the OECD’s model tax convention as following:

“Where conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.”

As the IRS’s section 482 puts it more plainly, transfer pricing regulations are necessary to prevent related taxpayers in differing taxing jurisdictions from easily and artificially shifting items of income and expense between these different tax jurisdictions (with differing rates of tax). The intent of the law is to ensure that an arm’s-length price is charged in all related-party multi-jurisdictional transactions.

Under the umbrella of “best method”, the most important factors to be taken into account for each inter-company transaction is “the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparable, and the quality of the data and assumptions used in the analysis”.

For tax authorities, the pricing calculation is vital because it fixes the profits of the business that are subject to tax in particular jurisdictions. Increasingly these authorities are prepared to re-calculate inter-company pricing if they consider the agreed price would be different from that agreed between two unrelated – or arm’s-length – parties. In short, they are on the look-out for transactions they regard as manipulated in order to obtain a tax advantage. When that happens tax charges can be expected to increase, especially when extra interest and even penalties are applied.

There are important inconsistencies and disagreements between different tax authorities over the interpretation of the arms-length standard. But the OECD’s methodologies have become the gold standard in transfer pricing calculations. Thus the use of arm’s-length provides a measure of certainty and, if properly observed, is likely to keep any adjustments to a minimum. Essentially, it is based on a transfer price being reached that would have been arrived at by unrelated parties for the same transaction.

Regulations Versus Principle
The dominance of the internationally accepted arm’s-length standard in all issues of transfer pricing has tended to blunt the effect of the multiplicity of regulatory changes introduced over the last twenty years. This is because the principle of arm’s-length requires that the prices employed in related-party transactions must make commercial sense. Thus, unlike most other areas of tax law, the measure is not based on explicit rules but a principle grounded firmly in issues of economic substance. As a result it hardly matters what new set of regulations is issued by a taxing authority or even by the OECD because the analytical process required to justify the prices reached in a particular related-party transaction remains the same. Namely, the arm’s-length standard. Therefore arm’s-length, essentially an economic issue, remains pre-eminent as the cornerstone of transfer pricing methodologies.

For example, many countries specify a hierarchy of transfer pricing methodologies to be used (e.g., direct price comparisons are first in the hierarchy and gross margin comparisons are second and third). Before the mid-1990s, the US too specified such a hierarchy in its 1969 regulations. Then the US abolished the hierarchy. Did the change in the US alter real practice? No. “Under the old 1969 rules I never saw a situation in which both parties agreed that method B was better than method A, but nonetheless method A was used because it was higher up in the regulatory hierarchy” Greg Ballentine, of The Ballentine Barbera Group, a CRA International company, explains. “If one party preferred method A and the other method B, they had to debate the issue on the basis of the accuracy of the method employed.”

The introduction in the US in the early 1990s of the best method-rule, replacing the hierarchy, has hardly changed things at all. “We are still seeing the same debate we had until the changes were made,” Mr Ballentine adds. “But it now occurs in the context of the best-method rule.”

It would be overstating the case to claim that all the modifications of the past 20 years have had no effect. Some have manifestly served to clarify issues around the edges. However there is a strong argument that in summary those changes have tended to confuse the issue. In particular they give the impression that, as long as one reads the local taxing authority’s regulations and follow them step by step, the prices reached must therefore be acceptable regardless of the degree to which those prices may clash with commercial reality. In fact this is deceiving because the nub of the arm’s-length standard is that it essentially requires commercial commonsense, whatever the local rules may say.

An international issue
The most important issues in transfer pricing over the last twenty years relate to the heightened scrutiny by taxing authorities around the world. Transfer pricing long seemed like a purely US issue but it is now very much a multinational one. The authorities in many countries are rapidly training up auditors to cast a cold eye on transfer prices, even in those jurisdictions with relatively low tax rates and/or tax holidays where they would not be expected to take much interest. It increasingly seems there is no escape as taxing authorities catch up with the international dynamics of the commercial world.

The implications for taxpayers are obvious – they must take every care to fulfil compliance obligations under the relevant jurisdiction’s tax laws. According to UK-based accountancy firms, documentation should cover sales prices, purchase prices, management fees, interest paid on any loans, and even the price paid for general use of facilities such as office space and computer systems. After amending its own regulations in 2004 [see below], Her Majesty’s Revenue and Customs allowed a documentation holiday of two years but the requirements are now fully in force. In the absence of complete records, jurisdictions may feel free to construct the facts as they see fit, which is not generally in taxpayers’ interests.

However in the existing system the taxpayer risks falling between two stools. On the one hand there is a need for local documentation or some well-supported form of defence under the particular jurisdiction’s specific rules. On the other there is the need for a worldwide consistency. The latter becomes especially important as local taxing authorities increasingly seek pricing information in jurisdictions other than their own. For instance, BBG/CRAI regularly finds that, despite a client’s documentation declaring sufficiently high local, taxable profits to satisfy the relevant authority, the IRS also wants to sight the documentation under its own set of transfer pricing rules.

State of flux
The entire transfer pricing issue is highly dynamic, with constant modifications occurring in many arenas. For example, in late 2007 US Treasury urgently recommended measures to combat what it termed transfer pricing abuses. Arguing that the original regulations had remained in force essentially unchanged for almost 40 years, it added: “These regulations have proven to be inadequate to handle the increased volume and complexity of multinational operations and transactions that have occurred since that time.”

US Treasury singled out in particular the absence of updated regulations for the transfer of services which “has led to discontinuities between transfer pricing for services and transfer pricing for tangible and intangible property”. Just one area ripe for attention, US Treasury said, was global dealing rooms.

And in 2004 the UK government amended its rules so they encompassed for the first time transactions between connected UK companies. This was because Her Majesty’s Revenue and Customs feared it could be successfully challenged in the European Court of Justice on the grounds it discriminated against companies from other EU countries because the rules did not apply to transactions between UK companies. Other countries have also been busily updating their regulations in their determination to maximise tax revenue.

Even the OECD, which has made the international pace on transfer pricing, is in the middle of a review of its approach. As of this moment it is weighing up responses to its proposals to modify its application of transactional profit methods, specifically on the issues of profit split and net margin. It is considered highly likely that modifications will result. Indeed the OECD sees the harmonisation of transfer pricing rules as a significant element in fostering world trade.

Economists in demand
As further proof of the economic nature of the arm’s-length principle, BBG has seen a marked swing recently towards the use of economic expertise as clients and governments alike struggle to settle transfer pricing issues. Until relatively recently, BBG/CRA’s economic expertise was in demand by US-based clients because that is what US Treasury-devised laws require whereas, outside the US, clients believed they needed accountants. “I am convinced that a major reason for this is that the IRS relied on economists while foreign tax authorities did not”, adds Mr Ballentine.

However like much else in transfer pricing, this is changing. The Canadian Revenue Authority, which has for years employed economists on transfer pricing audits, has called them in as expert witnesses in transfer pricing trials there. The Australian Tax Authority, another entity that employs economists, has enquired whether BBG’s economists would serve as expert witnesses on several cases heading towards trial. And in New Zealand, clients have tapped BBG/CRA’s expertise and that of other US economists in cases taken by the New Zealand authorities. Similarly in Britain where HMRC has sounded out BBG/CRA’s US-based economists about supplying expert testimony in possible trials there.
Taken together, these examples support the case that arm’s-length is less a tax regulation-based issue than one grounded on economic substance.

For further information tel 202.662-7831; email gballentine@crai.com; www.crai.com

The rising sun

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Japan’s big banks, unburdened by heavy subprime losses, and stuck with sputtering growth at home, are once again investing and lending abroad, but investors should not expect a string of blockbuster buyouts. Only a few years removed from a bad-loan crisis that pushed many lenders to the brink of collapse and sparked widespread industry consolidation, Tokyo banks will continue to keep their acquisitions conservative, bankers and analysts say.

Recently, Sumitomo Mitsui Financial Group, Japan’s thirdlargest bank, said it would pay about €1.5bn to take a two percent stake in Britain’s subprime-scorched Barclays. This would inject funds needed into the market. Earlier this year Mizuho Financial Group injected €1.7bn into Merrill Lynch & Co. Although big news by recent standards, the deals are minor-league compared to the overseas shopping spree of the 1980s, when at one time Japan was estimated to control more than a quarter of California’s banking market.

Most of those investments were later sold as Tokyo faltered under mounting bad loans. Now that the subprime crisis hasasked questions of some western financial firms, Japanese bankers acknowledge they have a chance to rebuild overseas.

“We would of course consider investing in financials where capital has been depleted by the subprime,” Tatsuo Tanaka, Deputy President of the core bank of Mitsubishi UFJ Financial Group told reporters at a recent press conference. But Mr Tanaka acknowledged that Mitsubishi UFJ, Japan’s largest bank, would take a cautious tack in building up overseas. “There’s a difference between a financial investment and a strategic investment. Rather than looking to boost our shortterm profits, we would build a mid- to long-term relationship with a financial firm,” he said.

Top Mitsubishi UFJ bankers, including the president of the group’s main bank, have said the bank aims to take minority stakes in overseas firms, and then build business alliances. This would aid both Japanese, an western banks. Mitsubishi UFJ’s brokerage arm in April raised its stake in Singapore’s Kim Eng Holdings to about 15 percent. Together the two firms operate a joint venture in asset management.

Typical Japanese
The strategy of taking a small portion in an overseas firm – such as Sumitomo Mitsui’s two percent stake in Barclays – is too meek to deliver real results, said Kristine Li, Banking Analyst at KBC Securities in Tokyo. “It’s very typical Japanese style: first you put a little capital in and try to do some kind of tie-up,” Ms Li said in a recent interview with reporters.“I just don’t think it’s Western style and I don’t think it will really deliver anything significant.”

Dubbing the strategy as “typical Japanese” doesn’t bother Sumitomo Mitsui’s President, Teisuke Kitayama. “We (Japanese) are not big hunters. We are agricultural people,” he told a summer summit. “So far our tentative conclusion is to stay with the current, present investment. That’s it. And then sometime in the future we will decide whether we will make more investment or not.” The banks have agreed to tie up in areas such as private banking and overseas commercial banking. Sumitomo Mitsui will also consider other investments in the subprime-hit West, Mr Kitayama said.

While acquisitions abroad are likely to come at a slow pace, Japanese banks have been rapidly expanding overseas lending as they are able to step in to fund cash-strapped Western rivals. Sumitomo Mitsui saw loans outside of Japan rise 44 percent in the year to March 2008 from the previous year, with much of the growth in Europe and North Asia. Mitsubishi UFJ has said it is increasingly approached for bridge loans, a kind of short-term funding, overseas. Expanding overseas lending is critical for Japanese banks, because they face fierce competition and slack demand in the domestic market.

While Japanese banks have yet to once again take big overseas stakes, their renewed outward focus demonstrates growing confidence. “Arguably a single digit percentage doesn’t make much difference, but it’s the first step,” said Steven Thomas, Head of Mergers and Acquisitions for UBS in Japan. “Will we see some dramatic, large scale acquisitions overseas by financial services companies? In my own view, we may in the future but it will still take quite a long time until the stars will be aligned for that to happen.”

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A long a painful journey

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Just how bad is the global economic outlook? The lack of a consensus answer to that question is telling. Normally, the financial institutions that steer the world economy show a degree of agreement. But these are uncertain times. The International Monetary Fund said recently that the credit crunch had cost financial firms a stunning $945bn; the Bank of England slated that estimate as “misleading”. The IMF was confusing credit losses with losses “implied by market prices,” it said. Those market prices were unrealistic, and the losses they pointed to would not materialise, the Bank argued – things were not as grim as they seemed.

Maybe not, but they are grim enough. The Bank argued in its latest Financial Stability Report that there are cheap assets going begging. In its analysis, sub-prime mortgage backed securities with a total par value of about $900bn should be worth about 81 percent of their face value, but in the open market they are trading at about 58 percent of their value. Put the accuracy of this complicated claim to one side and look at what the Bank is doing here. Basically, it’s advising market players on their investment strategy, pointing out that sub-prime securities are heavily under priced. Nobody is rushing to cash-in on this apparent investment opportunity, which means either nobody trusts the Bank’s analysis, or everyone is still too scared – with burnt fingers still smoking, they won’t touch these assets with a bargepole.

Either explanation is worrying. The Bank has a good record of calling the market – if its view is disregarded now, that points to a huge loss of credibility. If investors are still reluctant to come back into the market, that suggests they are still keeping their risk appetite at starvation levels.
This is bad news. The Bank predicted in its report that investors would get their confidence back soon and the market would start returning to normal. “While there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months,” said John Gieve, deputy governor. But the report also warned about what might happen if they don’t. If investors do not re-appraise risks and start buying again, there is a moderate risk of the credit crisis leading to a vicious circle of a sharper economic slowdown and further problems for banks, it said.

The fact that the Bank stuck its neck out and called the bottom of the market might help to reassure investors, but it might not. The Bank’s argument that sub-prime assets now look cheap is based on one assumption: current prices imply an unprecedented level of mortgage defaults in the US. The Bank reckons that it is unrealistic to believe that such a high level of defaults will materialise. But there’s a big difference between unprecedented and impossible. Just because it has never happened before, doesn’t mean it won’t happen now. Interbank rates are still noticeably high, suggesting banks don’t trust each other yet. And two highly critical reports have slammed banks for their woeful risk-management practices. It was the collapse in the value of sub-prime mortgage backed securities that exposed how out of control bank risk-taking was, but these assets only represent a tiny fraction of their overall investments. The question has to be this: what other stupid investments has their sloppy risk-taking exposed them to? Are there still skeletons that a continued downturn will bring out of the cupboard?

Investors could well decide that being unrealistically cautious is the only realistic option in the current climate. Julian Jessop, chief international economist at Capital Economics, made a similar point in a recent note to clients. He went on to argue: “The immediate threat of a full-blown meltdown has indeed been avoided. But for the wider economies, particularly the US and UK, the worst is still to come.”

The US Federal Reserve is making far more pessimistic sounds than its UK counterpart. After cutting interest rates to two percent, it warned about falling consumer spending, stressed financial markets, tight credit conditions and a worsening situation in the housing market. The Fed’s view is that it has already done a lot to allay these concerns, and that given the time-lag that delays the impact of monetary policy changes, it should not do anything more for a couple of months.

Gloomier still is the International Monetary Fund. It warned in April that the US will grow by only half a percentage point this year and next. It also said US woes were hurting Europe. “Europe has so far been relatively resilient to the US slowdown and the global financial turbulence, but the historical record suggests these will increasingly take their toll,” said Michael Deppler, director of the IMF’s European department.
The IMF said that the fallout from the credit crisis would combine with the near-record strength of the euro and soaring food and energy prices to knock inflation-adjusted GDP growth across Europe to 2.6 percent this year from 3.9 percent last year. Growth rates in all the advanced economies are projected to fall well below potential for some time, it said. The countries most exposed were those seeing a cooling of once-hot property markets, particularly the UK and Spain. Politicians in Paris, Berlin will no doubt be thanking those conservative continentals who prefer to rent their homes rather than borrow-to-buy. Also vulnerable are emerging economies — such as eastern European countries — with large current account deficits and high external debt, because they would be “especially vulnerable to shifts in investor confidence.”

To make sense of these myriad risks, observers tend to reach for alphabetic metaphors. They talk about whether a recession will be V or U-shaped: a sharp and deep down and up, or a more prolonged but shallower dip. Or maybe we’ll experience a W-wobble, where the US economy bobs up and down for a while, sending out unpredictable waves or ripples that knock other economies off course. A recent report from the Economist Intelligence Unit extends that watery metaphor. “What happens if financial turmoil capsizes the global economy?” it asks. Specifically, how will the credit crunch play out as it spreads beyond finance into the real economy?

The report outlines three alternative views of the future. The first scenario, which it says has a 60 percent likelihood of occurring, is that the US economy dips into recession in 2008, but responds to monetary and fiscal stimulus, rallying in 2009. Other developed economies slow sharply, but avoid outright recession. World trade growth and commodities prices stay high, and major emerging markets suffer only a modest slowdown in activity – this might even be a good thing, for some of them.

The second scenario (30 percent likelihood) is that the US economy ignores the Fed’s kick-start efforts and slides into a long and deep recession. This would be a seemingly interminable stretch of sub-par growth, comparable to Japan’s “lost decade”.

This would lead to a stall in other developed economies, and through a halt in world trade growth and a sharp correction in commodities prices, a severe slowdown in developing countries, including China and India. There would be a massive, worldwide flight from risk, causing asset values to plunge, banks to collapse, credit to contract and the world economy to stall.

The third scenario (10 percent likelihood) is that the Fed’s efforts actually give the US economy such a boost that it starts overheating. To calm everything down, and keep a lid on inflationary pressures, the Fed has to start tightening policy again. A rapid u-turn like that would dent its anti-inflation credentials and make it harder for the Fed to make fine-tuning adjustments to policy in the medium term, which would prolong the current downturn.

The nightmare scenario is clearly option two. While it only has a 30 percent probability of occurring, when the EIU last produced a report on the impact of the credit crunch in August last year, it put the same likelihood on the possibility of the US economy falling into recession, which has since occurred. So start worrying.
The report finds that the US economy is vulnerable to some of the conditions that afflicted Japan in the late 1990s, including the failure of conventional monetary and fiscal policy to stimulate economic recovery. As happened in Japan’s downturn, the combination of a prolonged correction in the housing market, and the rebuilding of regulatory capital by banks, risks choking off both demand and supply for loans.

Clearly, recession is part of capitalism; the US endures a recession every 8-10 years. But the slump that is now under way could become the worst in more than half a century, with virtually no growth this year, a sharp contraction in 2009 and another year of falling output in 2010, according to the report. The US could lose as many as 5m jobs by the end of that period, with the unemployment rate jumping to well over eight percent.

That would have serious implications for other economies. Japan is highly vulnerable because it has no room for manoeuvre. Interest rates are still ultra-low, but, with the sickliest public finances in the developed world, Japan has no scope for fiscal loosening, the report notes. A sharp fall in commodity prices, coupled with a strengthening yen and economic stagnation, leave Japan vulnerable to a renewed deflationary shock.

Optimists say that breakneck economic growth in China and India will keep the global economy afloat, but the EIU report is gloomy here, too. The growth express train could run into the buffers, as both economies face pressure from the global slowdown and a build-up of domestic problems. Under the report’s nightmare scenario, growth in China and India falls sharply in 2009 and rebounds only modestly in 2010. The rest of emerging Asia is also severely hit.
If the dampeners were to fall on the developed world economies, that might at least take some of the heat out of commodity prices – but no it won’t, says the EIU report. A shallow and short dip would not do much to help. But a more marked and prolonged decline that included the major emerging markets would kick the floor out from under commodities – knocking down prices too far. The oil price could drop towards $50 a barrel in 2009-10, creating problems for oil producing countries with vulnerable fiscal positions, such as Nigeria, Venezuela, Syria and Iran.
The economic carnage would have another effect, which many would not welcome. Economic and financial policy wonks – who did so little to foresee and fend off the current crisis – would feel the need to “help out”. If the global economy slumps, continued balance-sheet stresses and the threat of further financial failures would encourage policy makers to become more interventionist. Tougher regulation would limit the ability of the financial sector to “innovate” its way out of the crisis. But financial innovation is what got many of them into this problem in the first place.

There is another reason why the global economy will be so hard to fix. When the US Federal Reserve rescued Bear Stearns, the investment bank, in March it elevated the sub-prime mortgage meltdown to historic levels, alongside the 1987 Black Monday stock-market crash, the 1992 attack on the British pound, Mexico’s 1994 “tequila” crisis and 1997-8’s triple whammy of Thailand’s currency devaluation, Russia’s debt default and the collapse of an iconic US hedge fund. Serious indeed. But as the economist Wolfgang Munchau argued recently, the problem is not that we face a credit crisis, or a banking crisis. It is wider. There is a property crisis, a food crisis and a commodity crisis, too. The world economy has reached a turning point. The markets might be recovering from the credit crunch, but that is just the beginning.