KWR International Advisor #10 August 2001


August 2001 Volume 3 Edition 4

(see Spanish version here)


In this issue:

Editor: Dr. Scott B. MacDonald, Sr. Consultant

Deputy Editor: Dr. Jonathan Lemco, Director and Sr. Consultant

Associate Editors: Robert Windorf, Darin Feldman

Publisher: Keith W. Rabin, President

Web Design: Michael Feldman, Sr. Consultant

Contributing Writers to this Edition: Scott B. MacDonald, Arthur M. Mitchell, Richard Casey, Jonathan Lemco, Jonathan Hopfner, Russell Smith, Darin Feldman, Georges A. Fauriol, Uwe Bott, and Andrew Novo

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U.S. Economy Consumer Confidence: A Slow Wilt or Rapid Demise?
By Scott B. MacDonald

It is the quarterly dinner of the Bring It Cheap Club, a group of fixed income investors and consultants. The question is asked: Will the U.S. economy slip into a recession? The group is split evenly, with five believing there will be a recession and five that the U.S. will narrowly escape a technical recession. Despite that difference, all look at the current condition of the U.S. economy and regard conditions as bad and likely to deteriorate further before they get better. Moreover, there is a strong consensus that the Federal Reserve will lower interest rates another 25 bps during its August 24th FOMC meeting. All agree - the key to the economy remains the ability of the U.S. consumer to stay afloat.

Since that meeting in June, second quarter results for the real GDP growth rate came in at a bloodless 0.7%. New reports are indicating that consumer confidence is finally beginning to cool. As we have stated before -- the consumer remains the major prop for the U.S. economy. Subtract the consumer from the calculation and the economy is definitely in a recession. The critical question is: will the cooling of consumer confidence be a slow wilt (which allows the rest of the economy to regain its feet until other factors help to stimulate growth) or will it be a rapid plunge off the cliff (which takes out the last major support for U.S. economic growth)?

The Conference Board reported that consumer confidence in the United States slipped in July, with the main index falling to 116.5, after gains in the two previous months. According to Lynn Franco, director of the Conference Board's Consumer Research Center: "The moderate decline in confidence signals slow economic growth ahead." The Conference Board's index is based on a monthly survey of some 5,000 U.S. households and is regarded as a major indicator due to the fact that consumer spending accounts for about two-thirds of the nation's economic activity.

We take three things from the Conference Board's report. First, the long list of corporate layoffs and bad earnings results is finally having an impact as reflected by the July results. In particular, consumers who described conditions as good dipped to 28.3% in July from 28.9% in June, while those rating current economic conditions as bad rose to 14.4% from 12.2% (no massive swing, but a move in direction).

Second, the U.S. consumer refuses to surrender to pessimism. While concerns have increased about the economic environment, the Conference Board also reported a cautious optimism that the economy would rebound later in 2001. As one observer commented: "Consumers have appeared relatively undaunted by weak corporate earnings, massive layoffs, slumping financial markets and the anemic growth that have hobbled the economy since the second half of last year."

Reinforcing what some may regard as the "irrational optimism" of the consumer, another report was released at the end of July by the U.S. Commerce Department. It announced that consumer spending rose by a larger-than-expected 0.4% in June, following a 0.3% rise in May.

Third, the moderate downward trend in consumer confidence is likely to reinforce the Federal Reserve's tendency to lower interest rates again at its August 24th FOMC meeting. We expect a 25 bps cut, and most economists on Wall Street share this view. Although lower interest rates by themselves are not going to turn the economy around, they do help in laying the groundwork for an eventual recovery.

Another issue drawing attention to the consumer debate is a growing number of bankruptcies and rising credit card charge-offs. Standard & Poor's released a report in late July, which stated: "The economic slowdown is pushing highly leveraged consumers into default and bankruptcies. Although most Americans are in healthy financial shape, thanks in part to the stock market book of the late 1990s, a significant number borrowed more than they could afford to pay back". The rating agency expects a 20% jump in consumer bankruptcies in 2001 and a rise in credit card receivables to 6.6% in 2001 and 6.9% in 2002 from 5.6% in 2000. Yet, for all the gloom and doom, the report states: "These calculations assume that the economy escapes recession." A recession would raise charge-off rates to 7.5% in 2001 and 7.8% in 2002. So far Standard & Poor's is not calling for a recession.

Taking a step back from the many recent and oftentimes conflicting reports, we believe that consumer confidence is undergoing a slow wilt, not a rapid demise. While there is considerable carnage in the economy, most people remain hopeful that things will improve. We do concede that 3rd quarter corporate earnings are likely to be bad, unemployment will continue to rise, and real GDP growth will most probably slow to a trickle (0.3%). This could be the final blow to consumer confidence. Yet, we also see a process of corporate restructuring and delveraging, more realistic equity prices and a far lower base of manufacturing inventories. This could make the 4th quarter see the beginnings of a weak recovery, which should continue into 2002. We caution, however, that we do not see any dramatic return to strong economic growth, but see real GDP around 2% for 2002. The message here is simple: if you don't want a recession, go shopping!


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Are Derivatives A Threat To U.S. Banks?

By Scott MacDonald

In October and November 2000 there was considerable concern that the derivatives market was becoming a dangerous place and could possibly sink the U.S. banking system. Concerns are rising again. Because of the difficult nature of quantifying risk in this market and questions over how risk is managed, derivatives have become a dirty word, reflecting growing unease in some quarters with the size and scope of the market and the depth to which U.S. banks are involved. Indeed, the complexity and size of the U.S. derivatives market pose a unique challenge to risk managers throughout the international financial system. According to the Bank for International Settlements (BIS), the global derivatives market had an estimated value of $95.2 trillion at year-end 2000. Although we share concerns over the derivatives market and the high level of exposure U.S. Banks have to this off-balance sheet item, especially as the U.S. and global economies continue to slow, we do not see any immediate crisis.

A few points to take into consideration:

Our concerns about the derivative exposure of U.S. Banks should not be taken out of context. Their exposure to these financial instruments is large and when compared to bank capitalization, there is some apprehension that the contractual obligations could extend beyond the means of banks to deal with if conditions go strongly against them. The nature of the risk, however, should be qualified.

Notional Amount of Derivatives in Insured U.S. Commercial Bank Portfolios







2001 Q 1

$U.S. trillion







Source: OCC Derivative Reports

First and foremost, what is a derivative? According to the OCC, a derivative is: "A financial contract whose value is derived from the performance of assets, interest rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof."

Why are derivatives used? In large part, derivatives are used to hedge risk. According to the BIS: "…they allow financial institutions and other participants to identify, isolate and manage separately the market risk in financial instruments and commodities. When used prudently, derivatives can offer managers efficient and effective methods for reducing financing costs and to increase the yield of certain assets." BIS data as of year-end 2000 show that the two largest international market segments are interest rate and foreign exchange derivatives.

Notional Amount of Derivatives Contracts of the Top 15 Banks, March 31, 2001

Rank & Bank

Total Assets (US$bn)

Total Derivatives (US$bn)

1. Chase Manhattan Bank



2. Morgan Guaranty



3. Bank of America



4. Citibank



5. First Union



6. Bank One



7. Fleet



8. Bank of New York



9. Wells Fargo



10. HSBC



11. State Street



12. Keybank



13. Bankers Trust



14. Mellon Bank



15. National City Bank



Source: OCC Bank Derivatives Report, First Quarter 2001.

The derivative market has also become highly profitable. According to OCC data, the banks with the 25 largest derivatives portfolios hold 97.7% of their contracts for trading purposes, primarily customer service transactions, while the remaining 2.3% are held for their own risk management needs. Trading revenues from cash instruments and derivatives activities stood at $4 billion in the first quarter of 2001 (lead by interest rate positions). As Federal Reserve System Chairman Alan Greenspan stated in March 1999: " It should come as no surprise that the profitability of derivative products has been a major factor in the dramatic rise in large banks’ non-interest earnings and doubtless is a factor in the significant gain in the overall finance industry’s share of American corporate output during the past decade."

Are derivatives dangerous? Over the past two decades the derivative market has avoided any market-specific disasters. Problems have arisen, but have been institution-specific, such as in the cases of Orange County and Long-Term Capital Management (LTCM). Problems have largely been associated with fraud, incompetence, and excessive dependence on quantitative modeling (as with LTCM). LTCM did result in a situation that potentially threatened the health of the U.S. financial system and was only resolved by a Federal Reserve-led private sector funded rescue. The market is now more mature and the product base is generally more "plain vanilla". Indeed, some 395 U.S. Banks are using derivatives in some capacity.

The large scale of the U.S. derivative market does not come without risk. As the BIS stated in 1994, with equal significance to today: "…the growing complexity, diversity, and volume of derivatives products, facilitated by rapid advances in technology and communications, pose increasing challenges to managing these risks. Sound management practices are an important element in meeting these challenges." As long as sound management practices are in place derivatives should be managed well as a risk. However, there are concerns that risk management in this area is lagging.

First and foremost, the actual size of derivatives is hard to accurately measure. Both the OCC and BIS talk about the "notional" value. This means it is a hypothetical value, assumed to be valid, providing for an estimate. The Value-At-Risk (VAR) model, which probably provides a better picture of derivative values, is also far from 100% correct. Hence, we have only a rough idea of the true value. At the same time, markets have become more efficient in pricing derivatives, especially those that trade. While this is still not perhaps accurate, it probably provides a closer sense of value than notional values. All the same, the market is largely unregulated and much of it depends on trust and confidence in the counter-party. In a time of severe financial crisis, even market valuations can be difficult to properly access risk.

Secondly, a potential confluence of negative trends could cause a crisis involving derivatives. The U.S. Economy has slowed considerably, bankruptcies are up, and the national level of savings has gone negative. If the economy shifts into a sustained recession, the chances of a default on obligations in one part of the derivative market increase. This could cause a wider-ranging panic or a contagion into other segments of the derivative markets, eventually rippling into other markets as the ability of banks to meet their contractual obligations is called into question. The ultimate fear is that a major U.S. bank will suffer large derivative losses, which will wipe out its entire capitalization.

Thus far, the systemic risk posed by derivatives is not imminent. During the first quarter of 2001 U.S. Banks charged off $2 million due to credit losses from derivatives, or 0.0004% of the total exposure from derivative contracts. Yet, it should be remembered that the largest charge-offs from derivatives came at times of international financial stress as in 1997 and 1998, during the Asian and Russian financial crises. The largest quarterly loss came in the 3rd quarter of 1998 ($445.4 million), in the aftermath of the Russian default and devaluation.

The global economy is in weak shape and the threat of an Argentine default/devaluation recently spooked markets. It is possible that a major downdraft lurks in international markets, which combined with difficult conditions in the U.S., could help spark big derivative losses in a large U.S. Bank This, in turn, could threaten a systemic crisis to the financial system. We do not see this occurring in the short term. However, the potential for such an event rises the longer of the U.S. Economy refuses to recover and increases further if it plunges into a steep recession. We will be watching to see if any major bank develops greater and more rapid exposure to derivatives in the months ahead, which could represent a potential indicator of trouble.


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Why Some Japanese Companies Are Vulnerable to Hostile Takeovers

Arthur M. Mitchell, Coudert Brothers, New York

Accepted wisdom holds that Japan is hostile to "hostile takeovers" but this is about to change. The reason is that the conditions which make such transactions possible in the U.S. are beginning to emerge in Japan.

Since the 1950s, Japanese companies have sought to "stabilize" (i.e., entrench) management and strengthen business ties with strategic partners by purchasing each other’s listed shares. This trend increased in the 1980s but has come under scrutiny lately as the disadvantages have become more apparent. The Financial Services Agency is actively requiring financial institutions to cut back on such holdings and new accounting rules, requiring that such shares be marked-to-market, will have the effect of substantially reducing the return on equity for many companies. In the past, any company facing a "takeover" bid ("TOB") could count on the stable shareholders and main banks to thwart the effort by refusing to sell at any price. This is no longer the case.

The converse of the decline in cross-shareholdings is the increase in the amount of "free-floating" shares (i.e., listed shares that are actually traded). Typically, free-floating shares are owned by individual investors, pension funds and investment trusts. A recent report in the Nihon Keizai Shimbun indicated that foreigners now own almost 20% of the shares traded on the First Section of the Tokyo Stock Exchange, thereby increasing the number of shareholders who will emphasize return on equity, disclosure and management accountability. Since the 1980s, approximately 30% of listed shares were "free-floating". Today, that number is increasing dramatically.

The bursting of the bubble economy in the early 1990s destroyed the fundamental structure of the post-War Japanese financial and economic system. Recently elected Prime Minister Koizumi has pledged to begin work on the real clean-up of the bad debt on the books of Japan's banks and financial institutions but this will only put further pressure on companies to sell their non-core assets and make painful cuts in current operations. Companies in the construction industry and the retail sector are consolidating while the automobile and steel industries are restructuring their financing and management systems. Stable shareholders themselves can no longer afford to hold shares in unproductive industries. According to a Daiwa Institute of Research report, as of April, 2001, 619 of the approximately 1,471 companies listed on the First Section of the Tokyo Stock Exchange had a price-to-book ratio of less than 1.

Japanese procedures for conducting TOBs were enacted in 1971. While the rules differ from those applicable in the U.S., research conducted by the NLI Research Institute indicates that shares in a total of 48 listed companies and 10 unlisted companies were purchased through TOBs in the ten-year period between 1990 and 1999. While a good many of those deals were "friendly" in that they were, in effect, negotiated among the existing shareholders, the acquirer and management, the most famous recent "hostile" attempt, though ultimately unsuccessful in taking control away from incumbent management, involved two Japanese companies. Also, in 1999, the English firm, Cable & Wireless, successfully tendered for the shares of privately held IDC Company. Significantly, the shareholders accepted a hostile bid from a foreign company, which was higher in price and better structured, as compared to a competing bid from Nippon Telephone & Telegraph. Furthermore, very few companies are protected by regulatory prohibitions today.

While almost no one expects that hostile takeovers in Japan will mimic the American market for corporate control, it seems inevitable that this phenomenon will begin to emerge just as it is starting to happen in Europe. But some hurdles will exist. For example, a new Stock Acquisition Company has been established to buy some of the cross-shareholdings of the major banks. While it is still too early to tell, it seems unlikely that those shares will be sold into the open market, thereby limiting somewhat the amount of free-floating shares. It will be interesting to see if the new company will consider a private sale to potential hostile acquirers.

One of the largest barriers will be finding a way to ensure that the target company, once acquired, is properly managed. In the U.S., it is relatively easy to bring in a new management team to direct the operations of the newly acquired company. Because the Japanese employment market is still relatively immobile, it may be difficult to find seasoned Japanese managers who are willing to join the newly acquired company. Even if such individuals are found, they run the risk of being undermined by the remaining employees, who might view them as interlopers even though they are fellow Japanese. But the experience of Ripplewood in acquiring the Long-Term Credit Bank and GE Capital with Toho Insurance and others, suggest that it is not an impossible task. Also, the example of Carlos Ghosn as a foreign president of Nissan demonstrates that joint Japanese/foreign management teams have the opportunity to make dramatic changes in deeply troubled situations.

In the U.S., the existence of investment bankers, lawyers, accountants, and public relations firms with vast experience in hostile takeovers facilitate such transactions. In addition, U.S. courts are quite prepared to deal with novel questions arising under corporate law and to make quick decisions in the context of a request for injunctive relief based on the actions taken by one of the parties to the transaction or third parties who seek to intervene. Because of the relative lack of hostile deals in Japan to date, the professionals who will be asked to assist will have very few precedents to rely upon and it is unlikely that the Japanese court system will supply speedy decisions.

Finally, it is certainly unlikely that incumbent management will merely take the threat of a hostile takeover lightly. It should be anticipated that they will begin "import" some of the techniques that have been developed in the U.S. Certain corporate devices, known as "shark repellents", which make takeovers more difficult, can easily be adopted by Japanese companies. In fact, the Japanese Commercial Code already makes a number of these devices mandatory. It is currently unclear whether "poison pills", which make takeovers more expensive, can be implemented under existing law but creative lawyers will probably find a way.

The game of baseball was invented in America and it is played in Japan but in a somewhat different form. Over the next few years, we will see how the hostile takeover game is played in Japan; both offensively and defensively. The environment is different now because the Japanese government can no longer be expected, in knee-jerk fashion, to protect firms from takeovers. Cross-shareholding barriers are also falling and foreign investment is welcome as a catalyst to economic recovery.



All Eyes On Argentina and Turkey

By Richard Casey, Senior Consultant, Emerging Markets, KWR



Contagion from the economic crisis in Argentina and Turkey to other emerging markets has been limited, so far.


Contagion Returns

The word contagion is back in the vocabulary of emerging markets investors after a brief hiatus. The economic crisis in Argentina and, to a lesser extent, in Turkey have provoked fears of yet another generalized emerging market meltdown similar to those that occurred as a result of the crises in Brazil in 1999, Russia in 1998, Asia in 1997 and Mexico in 1994. All of these episodes caused substantial havoc in G-7 markets as well, with the Russia crises nearly causing a global market collapse.

Argentina is important for emerging bond markets since it accounts for 22% of the index (EMBI+). Argentina and Brazil combined account for 44% of the index. So far, the crisis in Argentina has had limited fallout on other emerging markets and almost no impact on G-7 markets. The main contagion has been on the Brazilian currency and domestic interest rates, although, an electricity shortage and corruption scandals have also contributed to the weakness in Brazil.

Emerging Markets Debt Correlations and Volatility Not Yet At Crisis Levels


Average correlation on

Volatility (%)

Past Crisis


Mexico Crisis



Asia Crisis



Russia Crisis



Brazil Devaluation




Recent Spikes


Turkey Devaluation



Argentina July Sell-off



There was a short lived bout of panic selling across emerging markets assets in early July after a poorly received Treasury bill auction in Argentina. However, most of the losses were quickly reversed. Since the escalation of the crisis in Argentina on July 10, the Argentina EMBI+ index has widened 447 basis points to 1584 and is 811 basis points wider for the year. While the EMBI+ has widened 104 basis points to its widest level since December 1999, it is still well below levels seen in previous crises. The mild fallout is even better demonstrated by the EMBI+ ex-Argentina and ex-Turkey. It has remained well within the range it has traded in for the past year and is actually 49 basis points tighter for the year. The table below shows that, although Argentina debt has returned —14.9% since the ill fated Treasury auction on July 10, most emerging markets countries have actually posted positive returns while negative returns have been modest. In addition, capital markets remain open with Mexico issuing a 30 year $1.5 billion bond last week at a spread of 356 basis points that was three times oversubscribed

EMBI Global Total Returns


July10-Aug 3




















Cote D'Ivoire










































South Africa



South Korea
















Different Backdrop Compared To Previous Crisis Reduces Risk of Contagion

The key question is what will happen if Argentina actually does default or devalue? The comparatively mild reaction of spreads so far could indicate substantial downside risk. While a default or devaluation in Argentina would likely cause another short-term episode of selling of emerging market assets, there is good reason to believe the fallout would be much less severe and more selective than in previous crisis. Under this scenario, it would mainly impact the weaker emerging market credits with a significant need for foreign financing.

One reason for a likely more benign impact is that the crisis in Argentina has evolved differently than previous emerging market crisis, all of which were sparked by some combination of largely unexpected devaluations, defaults or banking crisis. Argentina has, so far, suffered none of these. Instead, Argentina has experienced a gradual erosion of its perceived credit worthiness due to a number of factors including a three year recession, global economic slowdown, deterioration in its terms of trade due to its fixed exchange rate and low agricultural commodity prices, a lack of needed fiscal adjustment, failure to implement reforms to make the economy more competitive and political squabbling.

The poorly received Letes auction on July 10 was the last straw that escalated the magnitude of the crisis by provoking widespread fears that Argentina no longer had access to either domestic or international financing. At this point, nobody should be surprised by an Argentina default/restructuring and the market has already priced in a significant probability of such an event. There is not a large amount of leveraged money such as was invested in Russia at the time of its default, which caused a snowballing of selling across global markets. Crossover money is largely absent and dedicated investors are heavily underweight Argentina.

In addition, fundamentals in emerging markets are, generally, better than during previous crisis. This includes such indicators as reserves, short-term debt and soundness of banking systems. The country most at risk to contagion from Argentina is Brazil. This is due more to its heavy financing needs than direct trade ties. If a default by Argentina led to a meltdown in Brazil, it could cause serious problems since together they account for a large chunk of Latin America. This risk has led the IMF to provide a preemptive $15 billion support package for Brazil. This should be enough to allow it to withstand a credit event in Argentina.


Emerging Europe: One Eye on Argentina, The Other on Slowing EU growth

By Richard Casey, Senior Consultant, Emerging Markets, KWR

The EMEA countries (Eastern and Central Europe) experienced an intense but short-lived bout of contagion from Argentina. Especially hard hit were the currencies of Poland, Hungary and South Africa. These markets had been attracting significant short-term capital inflows due to their high nominal interest rates and appreciating currencies. EMEA debt markets are now showing across the board flat to positive total returns since the early July Argentina induced sell-off, with especially strong gains by the Ukraine. EMEA’s resilience to Argentina contagion should continue for the following reasons:

Exchange rate regimes are either free floats or currency boards. Floating exchange rates can act as shock absorbers in times of market turbulence by taking pressure off domestic interest rates. Fixed exchange rates, other than currency boards, attract speculators and often cause central banks to waste reserves in futile attempts to defend them


Russian Debt and Equity Among The Year’s Strongest Performers

Russia has gone from nearly causing a global financial market meltdown less than 3 years ago to becoming a star performer this year. The Russia EMBI+ sub-index has returned 26% for the year through August 7, despite some recent Argentina related selling. Equally impressive is the 30% return year to date of the RTS stock market index during a period of generally dismal global equity market performance.

Russian markets did experience a brief bout of selling as a result of the Argentina crises in early July. The Russia EMBI+ index widened 142 basis points in three days. However, it rebounded quickly and has regained all but 18 basis points of that widening. Russia should be relatively immune to Argentina contagion given its extremely strong balance of payments position, the lack of foreign money in its domestic markets and increasing local demand for Russian debt. However, Russia was, and remains, vulnerable due to technical factors. Investors have been heavily overweight Russian debt. During times of crisis, investors tend to reduce their overweight positions, especially in high beta credits like Russia, so as to be closer to the index weighting. Russia’s quick recovery from the July sell-off shows that there are still investors waiting to buy the dip. This should limit the extent and duration of any Argentina related selling.

Economy Continues in the Sweet Spot

The superior performance of Russian financial markets is a reflection of the strong performance of the overall economy, steady progress on structural reforms and extremely comfortable fiscal and balance of payments positions. In contrast to most other emerging market economies, where growth projections have been gradually scaled down due to exposure to the slowing U.S. or EU economies, Russia registered better than expected 5.4% GDP growth in the first half of this year. Expectations were for much weaker growth due to lower oil prices and continued real appreciation of the ruble. However, domestic demand has been supported by a strong increase in real wages, up 23% year over year, and gains in employment. With energy exports accounting for over 50% of total exports, the high price of oil over the past 2 years has resulted in a windfall for the economy. The surge in earnings from energy exports has fed through to the rest of the economy through increased profits, wages, investment and consumption. The recent weakening of oil prices is being partially offset by increased volumes, up 6%, as a result of strong investment in the energy sector.

2003 Debt Payments Should not be Problematic

The current account registered a massive surplus of $45 billion, 18% of GDP, in 2000 and 17.4% of GDP for the 12 months ending in Q1 2001. As a result, foreign exchange reserves have risen steadily to over $36.5 billion. The fiscal accounts, which are heavily reliant on taxes on the energy sector, ended the first half of 2001 with a primary surplus of 7.2% of GDP and an overall surplus of 3.7% of GDP. Due to fiscal revenues once again running well above the level in this year’s budget, the Treasury has accumulated more than $10 billion at the central bank. The government has stated that these funds will largely be set aside to assure its ability to meet debt payments in 2002-2003. Thus, the spike in debt payments to $18.5 billion in 2003 no longer appears to be problematic. The government will likely be able to refinance some of its maturing debt in international capital markets, if it chooses, given its much improved payment capacity. Russia is also on good terms with the IMF, which is monitoring the government's economic program.

The one downside to the huge current account surplus is that it has pressured money supply aggregates and inflation. The central bank has operated a de facto pegged exchange rate since early 2000. This has enabled it to accumulate the large amount of reserves. However, it has also led to a rapid growth of the monetary base despite some sterilized intervention and the large fiscal surplus. The impact on inflation has been softened by increased demand for money due to strong GDP growth and remonetization. Still, inflation is running at over 20% and rapidly reversing the competitiveness gains of the 1998 devaluation. Even if oil prices continue to weaken, reduced capital flight as a result of the reform agenda will likely keep net capital inflows at a high level. While this is a nice problem to have, exchange rate policy will likely become more of an issue in the future.

Structural Reforms Gaining Steam

Progress on structural reforms has been gaining pace this year. This is important for Russia to maintain its positive credit outlook, especially if oil prices continue to weaken. The slow pace of reform since the break up of the Soviet Union is the reason Russia has lagged all other countries in the region, except the Ukraine, in GDP growth. Even after the strong gains of the past two years, GDP is still 40% below its level in 1989. Investment has increased but remains low at 18% of GDP while foreign direct investment is negligible. Capital flight appears to have moderated but is still estimated at $5 billion during the last quarter. Structural reforms are vital to keep domestic capital in the country to finance investment as well as to attract foreign investment and the technology it brings. If Russia fails to do this, it is destined to become the Venezuela of the EMEA with a small and inefficient non-energy sector and large swings in economic activity based upon the price of oil.

Reforms that have either been implemented, approved or are working their way through the Duma include tax reform, deregulation of the economy, property rights, reduction of barter transactions, restructuring natural monopolies, social security, banking and judicial reform.

Tax reform has been the most significant so far and includes aspects that many people in the U.S. would like to see implemented. A flat personal income tax rate of 13% has helped boost tax collection by 30% in 2001. A similar bill to reduce the corporate tax rate and eliminate exemptions will be introduced in 2002. This could also help boost tax revenues through decreased avoidance and stimulate investment as well. A bill on regulating the private ownership of non-agricultural land should get final approval this year and is also seen as vital for boosting investment.

The growing momentum on reform is likely a major factor in Russia’s recent strong relative performance versus Venezuela. Russian debt has sharply outperformed Venezuelan debt since oil prices began to weaken earlier this year. Venezuela is generally seen as a pure oil play given the political turmoil and its lack of coherent economic policy.


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Brazil -The Light Grows Dimmer for Now

By Scott B. MacDonald

2001 has not been a good year for Brazil. Economic growth has faltered, hit by a combination of a severe energy crisis, slower export growth and turbulence in international markets caused by Argentina. Indeed the difficulty of the Argentine economy to regain the confidence of foreign investors rolled over into Brazil, in particular into the valuation of its currency, the real, and prices for its external debt. It certainly was a factor in foreign investors shying away from the largest economy in Latin America. In addition, the strong U.S. dollar, in which most of which Brazilian external debt is valued, has made the amount of debt increase.

Complicating matters, the government of President Henrique Cardoso is unpopular and the country’s political elite is becoming more concerned about the October 2002 presidential elections. Although there is a long way to go to the polls, the left appears ready to field a competitive contingent of candidates, while the right is scrambling. Is Brazil beginning to slide into a new economic crisis?

Prospects for Brazil are not encouraging. External debt has grown from $136 billion to $237 billion in 2000 and remains a substantial burden on the country at a little over 50% of GDP. Despite recent gains, the fiscal deficit is expected to widen to 6.5% of GDP (partially inflated by the bailout in July of two large federal banks). In addition, the current account balance of payments deficit is set to grow to 5.6% of GDP, up considerably from 2000’s 4.1% deficit.

The hope of the Cardoso years was to break the chain of boom-bust cycles that have plagued the Brazilian economy throughout much of the 20th century and now into the 21st century. The belief was that more prudent fiscal management and monetary policy, restructuring of the trade sectors and rescheduling of debt would provide Brazil with a strong platform from which to embark upon a path of economic development characterized by business growth as opposed to boom-bust cycles. Despite considerable efforts, Brazil seems to be sliding into another bust.

Brazil’s problems are partly political. The energy crisis has been in the making for years. It was known for a long time that Brazil ran the risk of power shortages because the expansion of capacity was not accompanying growth in demand. Plans for building new plants were obstructed by local political interests, corruption and environmental objections. Hydro-electric power is critical for the country. Consequently when an extended drought occurred, Brazil began to feel the pinch on the energy side. Moreover, the drought took place during a time when international oil and natural gas prices were much higher. The end result was a national energy crisis, in which an estimated 1-2% of real GDP growth was clipped off for 2001. In response the government has imposed a stiff regime of rationing.

While the energy crisis points to the inability to break the boom-bust cycle, Brazil’s neo-liberal economic experiment during the Cardoso years (1994-2002) has not resolved some of the other more difficult issues confronting Latin America’s largest economy. While Cardoso can rightfully claim to have provided stability from years of hyperinflation and made considerable strides to adding greater efficiency to the economy and state finances, Brazil still suffers from one of the region’s worst levels of economic inequality. An estimated one third of the population live below the poverty line. Most major cities struggle to provide law and order throughout most of their neighborhoods, while Brasilia, the nation’s capital, has been marked by a number of corruption scandals and investigations. Indeed, it can be argued that many congressmen spend most of the year swapping corruption allegations rather than passing reforms or pushing for the privatization of the remaining state banks, energy and water companies.

These harsh reflections of Brazilian reality have made many wonder about the ability of future governments to maintain economic reforms. As Edmar Bracha, one of the authors of the 1994 Real Plan which stabilized the economy and tamed hyperinflation, stated in a recent interview in the Estado de Sao Paulo: "The central concern is whether the government of Fernando Henrique was an interregnum between two disastrous economic strategies or a permanent shift in the way economic policy is conducted."

The ill-at-ease nature of Brazilian society has only been deepened by the relatively poor performance of the nation’s soccer team. Although still in the running to qualify for the World Cup, the Brazilian team is struggling. Moreover, Brazil was ousted in late July from the Copa America, Latin America’s oldest tournament, after a stunning 2-0 loss at the hands of tiny Honduras which was a last minute replacement for Argentina. Favored to win the Copa America, Brazil was forced to bow out in the semifinals, a humiliating turn of events. It has only added to a sense of pessimism and national angst.

Despite the seeming drift of Brazil and the bad run of events, there is some hope for the country. Progress is being made on the fiscal deficit, with Brazil coming in ahead of what it agreed with the IMF. Moreover, Brazil is likely to have additional support from Washington to make certain that Latin America’s largest economy does not fall into recession if Argentina defaults or devalues. Finally, there is more of a consensus on the right and left about economic policies. It is doubtful that any of the major presidential candidates will call for suspending debt repayments or to nationalize the banks. Yet, the presidential elections increasingly loom on the horizon, adding an element of unpredictability.

The leading candidate to date is Luis Inacio "Lula" da Silva, the standard-bearer for the center-left Workers Party (PT). Lula has come close to winning the presidency three times, but was hurt by middle class suspicions of what a PT victory would bring. Indeed, the PT had been an active proponent of suspending debt payments and favored the nationalization of the banking system. It was highly critical of the role played by foreign investment.

During the 1990s there has been a gradual transformation in the PT from being a leftist party, to a more center-left party. The PT now has the experience of running several large municipalities as well as having a contingent of Congressmen in Brasilia. Moreover, Lula is working hard to project a more moderate image, capable of broadening the PT’s support, in particular with the middle class. The PT platform now calls for reducing the current account deficit, a more active industrial policy to boost exports (including more credit to exporters and tariff protection for import substituting industries), attracting high tech firms to Brazil to reduce electronics imports, and stimulate small business.

Lula is not alone on the center-left. Also in the running is former financial minister and governor Ciro Gomes and former president, now governor of Minas Gerais state, Itamar Franco. While Gomes favors tax and pension system reform, Franco in many regards is a populist, with a strong anti-foreign investment bent. Franco has also taken considerable joy in seeking to overturn Cardoso’s economic policies whenever he is able. The sole government candidate from the center-right is Jose Serra, the health minister. Serra’s candidacy is still young and the center right has yet to throw its weight behind him. Indeed, the center right has not exactly settled upon Serra as its standard bearer.

The presidential elections pose an interesting question for Brazil. Can the country live through the victory of the leftist candidate and not undergo the political turmoil that wracked the country in the past when the left won in the 1960s? Lurking behind this question is another — although the PT is seeking to project a more moderate centrist image -- has the tiger really lost its spots?

The center-left party remains wed to greater social spending on schools, hospitals and agriculture and is strongly opposed to overhauling labor laws that place substantial burdens on small businesses and foreign companies. In addition, it maintains many of the left’s old dislikes in the international arena. As the Financial Times Geoff Dyer stated (July 19, 2001) of the PT program: "the document bristles with hostility towards the U.S. And the proposed Free Trade Area for the Americas, while calling for alliances with China, Russia and India and a stronger Mercosur." While a PT victory would no doubt delight the likes of Venezuela’s Hugo Chavez and Cuba’s Fidel Castro, it would complicate U.S.-Brazilian relations and the PT’s economic policies would generate considerable friction with other members of Mercosur due to their protectionist nature.

Brazil, as always, has critical tests ahead. Although prospects for Argentina have improved, chances of a debt default and devaluation still exist. This means that Brazil has little room to maneuver in its economic policies. Progress must continue with reducing the budget and current account deficits. External and domestic debt both must be cut and made more manageable, and government spending must become even more accountable. This would curtail official corruption. None of this is easy and the downturn in the international economic environment clearly makes matters more difficult as well as urgent. Failure to stay on a clear course of tough economic measures will only hurt Brazil. The extension of an additional $15 billion to Brazil from the IMF and vows of deeper budget cuts and other austerity measures add some degree of promise on the Brazilian front. Our view is that Brazil needs anything and everything that it can get -- before the eventual Argentine default. Once it rains it will still seem like a flood and the risk of contagion is likely to remain.

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The Mexican Sovereign Credit: Still an Investor Favorite

By Jonathan Lemco

For more than a year, the Mexican credit has been a superior performer in the international debt capital markets. The election of PAN leader Vincente Fox to the presidency was an important reason for this, of course, for his election was a signal that a meaningful multiparty democracy, however fledgling, was possible in Mexico. The era of one party leadership and pervasive corruption may be finally coming to an end. It was equally important to investors that Fox was pro-business, pro-NAFTA, and an advocate of fiscal prudence. So the political story in Mexico was a positive one this year, and investors were responsive. But this is only part of the story.

Since the implementation of the NAFTA, Mexico has gradually become an economic success story. Mexico is the United States’ second largest trading partner after Canada, and could become the first within ten years. Freer trade has been an economic boon for Mexico. Also, increasing numbers of Mexicans are now able to work legally in the U.S., And their remittances back home have helped local economies. The Mexican public and privates sectors have reformed substantially in the past decade, and this has promoted economic growth. But Mexico has also been in the extremely fortunate position of sharing a long border with the most dynamic economy in the world, and has reaped tremendous benefits as a result.

From a debt investors’ perspective, Mexico has largely disentangled itself from other, more troubled, Latin American credits. Indeed, Mexican bonds have been among the best performers worldwide over the past year. During the recent Argentina debt crisis, Mexico’s interest rate spreads were largely unaffected. The two leading credit ratings agencies, Moody’s and Standard & Poor’s, rate the Mexican sovereign credit "Baa3/BB+". That is, Mexico is of investment grade quality with the former and non-investment grade with the latter. But S&P has indicted it will increase its rating of Mexico to investment grade as soon as a series of fiscal measures are passed by the Mexican congress. We expect that to happen in early 2002. When that occurs, investors should expect Mexico’s interest rate spreads to tighten further.

In fact, Mexico’s long-awaited fiscal reform package has gained more urgency in the current economic climate. Given the development needs of Mexico and its narrow tax base, the passage of these tax measures will improve the annual non-oil intake of the country.

Since the passage of the NAFTA ten years ago, the Mexican economy has become increasingly tied to the United States. It should not be surprising then, that as U.S. Economic growth has faltered, so has Mexico’s. In July, the Mexican Central Bank acknowledged that the economy had grown by less than 1% year over year in the second quarter and revised its 2001 GDP forecast to less than 2%. By contrast, the Mexican economy grew by 7% in the year 2000. Unemployment is also on the upswing. However, inflation remains low and the current account deficit should be only 3% of GDP. The government’s prudent debt management has also contributed to Mexico’s relatively low external debt burden. Furthermore, the Mexican peso and FDI flows have remained strong despite the financial turmoil in South America. In short, Mexico remains an investor safe haven amidst great volatility in the emerging markets sector.

Thaksin’s off the hook — but what about Thailand?

By Jonathan Hopfner

After months of uncertainty, Prime Minister Thaksin Shinawatra and much of the Thai public were able to heave a collective sigh of relief on August 3. In a dramatic conclusion to a controversial case, Thailand’s Constitutional Court cleared the recently elected leader of charges of attempting to conceal his assets four years ago.

Thaksin’s narrow victory — eight judges ruled in his favor, seven against him — was hailed by many Thais as a victory not only for their leader but also for the country as a whole. If found guilty, the premier would have been removed from office, an event that many feared would lead to an extended period of political instability. Swept into power by an overwhelming majority in January’s general elections, Thaksin is still an immensely popular figure. The court’s efforts to debate his case were punctuated by noisy demonstrations, massive signature campaigns and a steady stream of pleas by farmers, laborers, academics and political allies to leave his post intact. Many feel the recent ruling has given Thaksin a new mandate to carry on with his populist policies and complete the most pertinent task before him — salvaging Thailand’s battered economy.

Local markets were quickly caught up in the general euphoria. Investors that had until now lingered on the sidelines, spooked by potential political hiccups, leapt back into the Thai bourse with a vengeance. The Stock Exchange of Thailand (SET) surged 4.2 percent on the news of Thaksin’s acquittal, largely on the strength of shares linked to the premier. Shin Corps, the Thai telecommunications powerhouse that Thaksin founded, and subsidiary Advanced Info Service were among the best performers. The Thai baht also gained ground against the U.S. dollar.

An obviously relieved Thaksin vowed after the ruling that there would be more good news to come. He reiterated his determination to push ahead with his government’s key programs. These include the establishment of an asset management corporation to take over bad loans from private banks, the privatization of flagship carrier Thai Airways and petroleum monopoly PTT, as well as the establishment of an SME bank and an IT ministry. Initiatives like these combined with Thaksin’s grassroots action plans, such as "village funds" for rural communities and universal health care, are touted by his Thai Rak Thai party as the recipe that will pull the country out of the vestiges of the 1997 Asian economic crisis, once and for all.

Heady thoughts to be sure, but the court’s ruling has given rise to new concerns as well as general elation. Political activists and academics are warning that the court’s decision — which ran against expectations and seemingly contradicted earlier rulings — could tarnish the image of Thailand’s nascent democracy. Rumors that wealth and vested interests swayed the judges’ decision abound, and Thailand’s main opposition party has already pledged to launch an inquiry into the matter.

Potential storms are also brewing on the economic front. Thailand’s newfound political stability aside, analysts have been quick to note that the positive sentiment stirred by Thaksin’s victory will dominate the market only in the short-term. Just one week after the court ruling, profit-taking had already begun to push the SET index down. Thaksin’s name may have been cleared, but the deep-seated problems that have dogged the Thai economy for years remain. "Although the verdict was positive in terms of political stability, a rally isn’t likely to be sustainable in view of the current dull macroeconomic fundamentals," said one senior strategist at Phillip Securities in Bangkok.

The economy’s performance for the remainder of the year will depend less on Thaksin’s leadership than the fate of the biggest buyers of Thailand’s exports — the United States and Japan. Thailand is heavily dependent on exports of computer peripherals and electronic goods, and with the global tech sector floundering, the government was forced to downgrade its growth forecast on several occasions in the first half of 2001. The Commerce Ministry, which aimed to increase exports by 9.4 percent at the beginning of the year, recently admitted that they could drop by about 2.6 percent.

But it’s not all doom and gloom for the second half. Thaksin, a savvy businessman at heart, has long recognized the effects the global downturn could have on the Thai economy. He has had the foresight to concentrate on developing one of the country’s more unique commodities — tourism — and assisting SMEs that produce traditional mainstays such as seafood, handicrafts and furniture. Having built his fortune on high-tech, it’s no surprise Thaksin’s not neglecting this sector either. Long-overdue plans to privatize Thailand’s state-owned telephone operators are in the pipeline, as is a blueprint for a government IT agency that will promote the development of domestic e-commerce.

The buoyant optimism evoked by Thaksin’s court victory may cause political watchdogs and more hard-nosed analysts to shake their heads, but short-term jubilation could turn into long-term gains for Thailand’s economy if the premier plays his cards right. With the dark clouds over his term in office removed, he will now be free to put the initiatives he has promised into action, and prove — as he stated on the campaign trail — that he has the know-how and determination to usher the country into a new age of relative prosperity.

India’s Reforms — Slower, Slower…

By Scott B. MacDonald

Prime Minister Atal Behari Vajpayee threatened to resign in early August, forcing the 23-party ruling coalition to make a rare show of unity. Although the Prime Minister stayed, the business environment remains poor, reflected by the government’s announcement that it would postpone the privatization of VSNL, the country’s monopoly international telecommunications provider. Unfortunately this is the second recent postponement to sell VSNL. On August 9th, it was announced that Enron Corporation, a major U.S. power company, is ready to sell its stake in the troubled Dabhol Power Company This signals that what was once proclaimed as India’s largest foreign investment project is now becoming a failure. Adding to the disappointing news were the decisions of Moody’s and Standard & Poor's to make changes in their ratings on India, mirroring the deterioration of some of India’s macroeconomic fundamentals.

India continues to have considerable potential. Everyone recognizes its competitive high tech work force, large domestic market and massive potential in the consumer market. It also has some internationally competitive companies. Yet, obstacles remain, hindering the advance of foreign investment. India sadly lags far behind Brazil, China and Turkey in this area.

Indeed, foreign investors are leaving India, especially in the energy sector. Enron has already made clear its intention to depart. AES, a U.S. power generator with plants in 27 countries (including Brazil, China and Turkey), announced in early August that it was willing to give up its 51% stake in an Indian power distributor to the local government to rid itself of a money-losing contract (due in large part to power thefts and unpaid bills). Considering the pressing need for energy in India the loss of such international power companies does not help general economic development and signals that the country is not open for business. It is estimated that India needs $200 billion to double generating capacity and avoid the power failures common in many Indian cities. The comments of Haresh Jaisinghani, managing director at AES Transpower Pte, about AES’s operations in the State of Orissa do not sound like an invitation for investors: "Our people face extreme intimidation by locals each time they try to recover debts. There’s no law and order support from the Orissa government…they even put two of our team-leaders in jail."

The government stated that the postponement of VSNL will push the sale date back from August to October "at the earliest" because bidders requested more information about the company’s contracts with other telecom carriers. At the same time, it was acknowledged that the sale of other state assets, including Air India, could also meet delays. The comments of Pradib Baijal, permanent secretary at the Ministry of Disinvestment, did not leave foreign investors with any great hope: "We would hope to push through the sale of three or four public sector units by the end of October but there are many serious potential obstacles and vested interests to contend with."

No matter how the government spins it, opposition to foreign investment remains deeply ingrained. Many Indians look back to when the British took over their country for trade and investment reasons. In certain quarters foreign investment is regarded as a potential path to the loss of control of the local economy. While one can sympathize with past injustices, we are now in the 21st century and globalization means greater competition for fewer international funds. Privatization is one platform for attracting foreign investment.

Sadly India’s privatization program in recent years has not been a success. The sale of Balco, a state aluminum smelter, earlier in 2001 was marred by widespread allegations of corruption. Air India’s privatization continues to drag on. The government, which should be spearheading the effort, has been caught with other pressing issues, such as conflict with Pakistan over Kashmir and surviving as a viable government. Moreover, the Congress-led opposition has been articulate against privatization (at least under the ruling coalition).

India needs privatization. VSNL would have been a major step forward. It would have raised R540 billion, badly needed to help contain a widening fiscal deficit. Last year’s fiscal deficit to GDP ratio was 10%; and is expected to widen to 12% for fiscal year 2001-2002. Complicating matters, a government-sponsored bill to limit the size of the fiscal deficit has been held up by the opposition in parliament for over eight months.

The slowing pace of India’s reforms is drawing greater criticism at home and from afar. A local rating agency announced on August 10th that India will fall short of the government’s goal for economic growth. As ratings agency ICRA stated: "Faced with adverse external conditions, a policy environment that remains cluttered and discouraging of enterprise, it is difficult to see how economic growth will exceed 6 percent." Moreover: "Domestic policy appears to have been reduced to fire fighting."

ICRA is not alone in flagging the slowing pace of reform and growing number of problems in India. In early August both Moody’s and Standard & Poor's acted on their India ratings. Standard & Poor's cut India’s local currency credit rating and shifted its outlook on the foreign currency ratings (BB) from stable to negative. The main reason was that it believes the general government deficit, which includes the federal and state governments, may exceed 10% of GDP this year. Moody’s followed a couple of days later, changing its outlook on India’s Ba2 foreign currency rating from positive to stable, also based on concerns over the budget deficit.

The slowing pace of reform, inability to make headway in privatization, and growing budget deficit come at a bad time for Asia’s fourth largest economy. Drought has hurt agricultural production and the international business environment, in particular the IT industry, has deteriorated. The government is preoccupied with probes into scandals (such as an insider trading scam in March and payment crisis at state-run Unit Trust of India, the country’s largest mutual fund). If India is to improve the standard of living for the vast majority of its population, which the government has claimed as one of its goals, then it is critical to move reform forward again. This requires making tough decisions, strong leadership and developing a new consensus. Anything less and India will continue to lumber along, reaching only a small portion of its potential.

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Global Trends and Implications of Insurance Company Demutualizations

By Darin Feldman

The legal configuration of an insurance company can take many forms. Stock companies and mutuals however, are the two most popular ownership structures. Under stock ownership, the company and its residual assets are owned by the shareholders. Under a mutual structure, the company and its related surplus is owned by the policyholders. While most policyholders find it difficult to discern the differences between a stock and mutual company, there are numerous distinctions that make mutuality an increasingly difficult structure to operate under in the consolidating insurance industry. Consequently, the luster of mutual ownership is gradually fading. As financial markets continue to converge on a local and global level, many companies have decided to "demutualize", a process by which a mutual company reorganizes itself into a stock company. The merits and fairness of demutualization are constantly being debated as companies undergoing the process are often criticized for transferring wealth to shareholders at the expense of policyholders. While the controversy surrounding demutualization is worthy of a discussion in and of itself, the more pertinent issues are the implications to competition in the insurance industry on a global level.

The allure of mutual ownership is predicated on the idea that there is an inherent conflict between policyholders and shareholders. Whereas shareholders want an insurance company to be managed for profitability, policyholders strive for affordable coverage, flexibility and strong service. Under the traditional mutual philosophy, the goals of shareholders and policyholders have been considered to be mutually exclusive. Over the years, this attitude has changed as the objective of self-preservation has outweighed the benefits of a legal ownership structure that is well intentioned, but extremely limited in its ability to compete in a changing environment.

There are many advantages to being a mutual insurer, including strong policyholder loyalty, high retention of capital and greater flexibility in implementing longer term strategic plans. However, companies operating under such a structure are handicapped in their ability to compete globally and against financial service firms outside of the insurance arena. As a result, various mutual insurers across the world have opted to demutualize, a conversion process that can take anywhere from 18 months to 2 years to complete. At the end of this tedious process, the former mutual company, now turned stock, hope to have achieved the following:

    1. Greater Financial Flexibility — The biggest disadvantage of being a mutual insurer is having limited access to capital. Although not impossible, borrowing in the capital markets is often difficult. More importantly, the lack of a currency in the form of stock is a significant disadvantage for companies looking to expand via acquisition. By converting to a stock form of ownership, the mutuals can make strategic acquisitions without sacrificing the integrity of their balance sheets. Without having a stock as a currency, many mutuals will have to sit on the sideline during consolidation. This consolidation will put mutuals as a major competitive disadvantage as stock companies gain economies of scale, expand geographic boundaries and add both insurance and financial products to their arsenal.
    2. Better Discipline - A common criticism of mutuals is that their management is not held accountable for performance, efficient execution and proper implementation of strategic initiatives. Policyholders are the only source of oversight and given that they are usually uninterested in the daily affairs of the insurance company, performance of senior management is left unmonitored. Consequently, relative to stock companies, their operating performance is usually sub-par. Furthermore, capital is often deployed inefficiently and risk versus return considerations are often ignored. Under a stock ownership structure, shareholders and the appointed board would be the source of oversight that would most likely bring about greater discipline, including a more regimented reporting schedule for accounting.
    3. Retain Key Employees - Similar to not having stock as a currency for acquisition, mutuals do not have an easy and transparent mechanism for rewarding employees on a long term basis. While stock companies can reduce out of pocket cash expenses by offering stock options and other stock compensation incentives, mutual companies have to rely on cash compensation. This not only puts an extra cash burden on mutuals relative to stock companies, but makes it harder to keep employees as they are not locked-in to potentially lucrative stock compensation packages.

As evidenced by the number of demutualizations that have taken place in recent years, it is clear that companies consider the advantages of mutuality to be outweighed by the disadvantages. The demutualization wave has occurred across insurance sectors and borders. In the U.S. well-known companies including John Hancock, MetLife, Mutual Life Insurance Company of New York, and StanCorp have all demutualized in the last 5 years. The wave has been equally strong in Canada where companies like Sun Life, Clarica Life, Manulife and Mutual Life have all given up their mutual status. Outside of North America, Old Mutual, one of the largest financial service companies in South Africa underwent demutualization in 1999 while, Scottish Widows, a large life insurer in the U.K. recently took similar action. While demutualization has not been as prevalent in Asia, it is expected that the Japanese market will soon be flooded with companies looking to demutualize. Two Japanese companies currently contemplating this move include Daiichi Fire & Marine and Kyoei Fire and Marine.

The demutualization trend presents an opportunity for some and a competitive threat for others. The main impact of demutualization will be the increased consolidation of the insurance industry. As with any industry, consolidation brings about efficiency, and as a result, forces uncompetitive companies to seek an exit strategy. Companies eager to expand now have a whole new universe of companies to consider for strategic acquisitions, both those that have actually demutualized as well as those who are open to converting. It is equally important for potential acquirers to realize that as companies demutualize, they too have a greater chance of being acquired. Demutualized companies with newly established capital in the form of stock will face increased pressure by its shareholder base to put that capital to use. This will inevitably lead to more acquisition activity.

The impact of demutualization will not only be felt within insurance circles, but across the financial services industry. The repeal of the Glass Steagall act in the U.S. opened the door for banks, securities firms and insurance companies to come together under one umbrella. Consequently, it should not come as a surprise to see newly demutualized companies, particularly on the life side, undertake an acquisition or merger with a well established banking franchise. While banks, due to their much larger balance sheets and in most cases client relationships still clearly have the upper hand in the convergence within the financial services industry -- there are some large insurance enterprises that have the opportunity to be the acquirer as well.


KWR Viewpoints

The following articles reflect the views of the authors and do not necessarily reflect those of KWR International, Inc. If you would like to submit or suggest an article for consideration, please contact:

What Happened to the Free Trade Consensus? Why Does it Matter?

By Russell L. Smith, Willkie Farr & Gallagher

Washington, D.C. - For trade observers with long memories the current debate over "trade promotion authority," clouded with much demagoguery over specific issues from steel to catfish, is producing a decidedly sour mood and some very serious concerns about the future of global open trade. The problem is not that forces of protectionism and economic nationalism are seeking to stop or severely restrict U.S. international economic leadership. Modern trade politics have involved such pressures since 1980, when presidential candidate John Connally threatened to keep Japanese cars and television imports out of the country. Beyond that, America has been through successive waves of demands for auto, steel and textile quotas, and every aberration of anti-foreign economic regulation that can be imagined. The problem is that those forces are succeeding.

Until the early 1990s, trade confrontations resolved themselves in a comfortably predictable fashion. There was a strong free-trade coalition in Congress, mainly composed of Republicans but often led by highly committed, articulate Democrats who were ready to brave the assaults of anti-trade constituencies--in particular organized labor and sectors that needed or benefited from import limits. Joining the Congressional free-traders was a string of consistently strong free-trade Presidents who were also willing to stand up to those constituencies when circumstances demanded. Of course, almost no one was a "pure" free-trader, so periodically Congresses and Administrations achieved major, long-term trade objectives by making short-term, distasteful but tolerable concessions. Steel and auto "voluntary" restraints, a few safeguard actions, and GATT and WTO cases are good examples of such moves.

But in virtually all of these situations, two significant factors were present. First, the free traders on Capitol Hill and the various Presidents strongly, vocally, and repeatedly defended the principles of open markets. They avoided the language of accusation and confrontation. Second, they took care to work closely with U.S. trading partners to avoid the fact of confrontation. So Presidents Ford, Carter, Reagan and Bush (the father), and Congressional leaders like Tom Foley, Dan Rostenkowski, Sam Gibbons, Patrick Moynihan, and Howard Baker, while responsible for some of the less-than-pure trade actions listed above, also obtained fast-track trade negotiating authority, initiated and completed negotiations on NAFTA, and vetoed or stopped all manner of truly extreme initiatives.

As this pattern of threat, small compromise, survival and even progress continued, the champions of free trade, and their supporters in the business community, as well as major U.S. trading partners, took the outcome for granted. The other side, stung by repeated defeats, set out to turn their situation around. Organized labor and industries like steel, textiles, semiconductors, and others, now backed by public interest groups claiming concern for the environment or social welfare, gathered their forces, polished their anti-trade messages, and began working at the grass roots to elect candidates who would support their goals.

Incrementally, helped by changes in Congress and the White House, they succeeded in redefining the trade issue and in breaking down the historic free-trade coalition. By 1993, Bill Clinton, while professing to be a free trader, came perilously close to losing NAFTA. He was forced to demand that U.S. trading partners agree to highly objectionable, last-minute changes in the Uruguay Round agreements on dumping and other issues because of Congressional resistance, threatening to abandon the entire Round unless other nations capitulated. There were highly charged confrontations with Japan over autos, photo film, and dozens of other issues. U.S.-EU relations were marked with ongoing tensions over agriculture and steel. Even NAFTA, Africa trade and new help for the Caribbean were marred by major disputes over tomatoes, trucking and textiles. The U.S. And Canada fought repeatedly over lumber.

Yet, it was not simply the existence of the disputes and problems that destroyed the free-trade consensus. It was the way in which those disputes were addressed. Rather than being treated and described as aberrations in the overall U.S. commitment to open trade, they became the centerpiece of U.S. International economic policy. A growing faction in Congress, Democrat and Republican, well-represented in the leadership in the House and Senate, put the President under constant pressure to "get tough" on one or another trade issue. The White House responded with both the language and the action of confrontation. Threats of trade sanctions, and in some cases sanctions themselves, became the regular order. The rhetoric was nasty, brutish, and short.

Little was said about the necessity for open trade, the benefits of both imports and exports to the U.S. Economy, the responsibility for U.S. leadership, or even the objective facts involved in a particular dispute. Moreover, the U.S. business community, preoccupied with higher priorities, was often silent in cautioning reason or in stressing the positive. The result was as predictable as it was avoidable--trade has become what the pollsters call a "wedge issue." Those opposing open trade now have the advantage--they have convinced many Americans that trade is bad, and they have in turn eliminated or intimidated the free traders.

Nowhere is this more evident than on the question of a new round of multilateral trade negotiations. In 1997, when President Clinton first sought "fast-track" negotiating authority in preparation for the 1999 Seattle WTO Summit, USTR Mickey Kantor responded to the forces of economic nationalism and antiglobalization with three demands--incorporate enforceable labor and environmental standards in new trade agreements, and take trade remedies like dumping and safeguards "off the table." The proposals and the approach were confrontational, and they sharply divided Congress and alienated developed and developing nations alike. These divisions played themselves out in two failed attempts to pass fast-track, a U.S. effort to impose a one-sided agenda on the rest of the world at Seattle, and a disastrous setback for open trade.

Since Seattle, the situation has not improved appreciably, and in 2001 we can again see the effects of the transformation of trade from a positive, bipartisan, benefit of United States economic and strategic power to a politically-charged, highly controversial issue often characterized as "lose-lose" from a political standpoint. Ironically U.S. failure to engage effectively with the rest of the world on trade, and the strength of the domestic opposition to that engagement have had little effect on the pace of globalization by U.S. And foreign multinational corporations. Put more bluntly, trade is more important to Americans than ever before, at the same time that America’s ability to make good trade policy has been effectively crippled.

The current effort to give President Bush authority to lead a new round of multilateral trade negotiations is another opportunity to restore the consensus on trade, but so far the familiar lines are being drawn as sharply as ever. There is talk of compromise, yet compromise requires that those with responsibility in government and in business be willing to face down the anti-trade extremists. They must insist on the flexibility to craft a credible negotiating agenda, and commit themselves in both word and deed to outcomes that broaden and deepen open trade. Whether that can or will happen is, regrettably, still an open question.


Waiting for Latin American Policy

By Georges A. Fauriol

Director, Americas Program

Center for Strategic and International Studies (Washington, DC)

Washington, DC - Washington's attention to the Western Hemisphere received high marks early in the new Bush administration. This was fueled by two factors: earlier campaign rhetoric and related expectations that a Texan leadership had a good rapport with all matters Hispanic, as well as an impressive record of activity by the White House in the first four months of the year. All the signs pointed in the right direction as the new President met early with nearly all of his counterparts in the region (except, obviously, Fidel Castro), many one-on-ones, and attended the hemispheric summit in Quebec City in late April.

However, a telltale sign that things were not quite right after all was that much of this activity generated very little that was memorable. Since then, Latin American and Caribbean issues have been drawn back into a select list of occasional priorities without a well articulated overall strategy. Attention is clearly elsewhere as the administration attempts to put its political arms around domestic policy priorities and is drawn into various foreign policy emergencies. An indicator of Washington's cautious ambivalence has been its management of five significant--and quite different-- hemispheric policy issues: Colombia, Haiti, the Argentine crisis, trade, and senior administration appointments.

The long-standing debate regarding U.S. aid to support Colombia's war on drugs and democratic stability, engaged significantly if belatedly toward the end of the Clinton years, now divides the new administration from within. The Pentagon is quite reluctant to expand engagement, while the broader focus on some form of a narcotics strategy for U.S. policy as a whole awaits political direction in Washington. The shift from the Clinton (actually, the Pastrana government's) Plan Colombia to the Bush Andean Initiative is a matter of degrees and tactics (more regional in character) rather than any fundamental reassessment. "Stay the course" is the governing concept as Washington watches Bogota enter its presidential campaign season later this fall and an uncertain transition next summer.

Haiti was the subject of a few seconds of sharp attention during the second Bush-Gore campaign debate last fall. Gore was understandably defensive and Bush had the more interesting message: in effect, Haiti's dismal record overall did not provide the policy basis for the deployment of U.S. military power let alone the related close--almost personal-- diplomatic activity (as was the case throughout the 1990s). Expectations, and fears, ran high in Port-of-Prince that the new White House would be an unforgiving partner. U.S. Policy has indeed been dramatically downgraded and streamlined, but arguably also devolved toward multilateral diplomacy headed by the Organization of American States. The situation on the ground remains convoluted and increasingly desperate while a generally disinterested Washington hopes matters will not go belly-up.

The fundamentals of Argentina's financial and economic crisis predate the Bush administration but early on it became quite evident that the latter's response would be shaped by broader conceptual considerations. U.S. Treasury Secretary Paul O'Neill's almost philosophical opposition to large-scale bailouts, and even more so of economies already in deep crisis, has dogged Washington's response and influenced the reaction of the International Monetary Fund. O'Neill has gone out of his way to assign to Argentine leadership the primary responsibility for creating their own problems and has consistently re-enforced the dual view that the patient must take strong medication and that there are also more pressing priorities--such as isolating Brazil's economy from Argentine contagion. The ensuing debate is now not only over who has the correct economic response but also whether Washington is politically willing to allow Argentina to further deteriorate and possibly undermine the bases of U.S.-Latin American relations.

This is not an abstract debate among finance types but bears directly on the Bush administration's ability to engage the Western Hemisphere on what logically is the core of a strategic policy for a Republican White House: achieving a free trade area of the Americas by 2005. Here, interests overlap with broader policy considerations and the short-term outlook is too uncertain for comfort. This begins with building the political coalition in Congress for Trade Promotion Authority (TPA). Without it the administration will be eventually ham-strung to achieve results on a number of bilateral trade deals (most notably one with Chile), let alone the FTAA, or viable terms to kick-start World Trade Organization talks later this fall after a two-year post-Seattle hiatus.

Expectations that the FTAA would be front and center were probably misleading and reinforced by the rhetoric of the Quebec City summit last April. The administration's only senior political appointment so far with some Latin American experience, U.S. Trade Representative Robert Zoellick, has been tiptoeing around Capital Hill and the region to identify weak links and possible political alliances but this appears at times a lonely campaign. In practice, unless the White House makes this a real presidential priority and brings in heavy-duty constituencies (senior business leadership, Hispanic community groups, consumers, trade-related state governors, some strategic substantive and media gravitas), the odds are that this entire area of policy will not see daylight until early next year. Because 2002 is a mid-term election year, the window of opportunity will be brief.

There is growing rumbling among affected constituencies in the region and among supporters of the administration in Washington that the White House is not focused and courting serious loss of momentum. Already, the White House is being quietly accused of failing to read correctly the congressional fracas over allowing Mexican trucks on U.S. highways. The administration was rebuffed on a matter that the President had personally staked out. And while Mexico has become a policy highlight, this is an area in part self-propelled by Mr. Bush's creative Mexican counterpart, Vicente Fox. Possible inattentiveness was also the cause of a U.N. defeat this spring where the United States found itself outvoted by its own allies and booted off a human rights commission relevant to its policy toward Cuba. Some are also arguing that while the White House has touted its commitment to energy and national security, not much has been said about one strategic energy partner, the difficult relationship with Venezuela and President Chavez.

This sense of uncertainty is reinforced by a looming debate regarding appointments. Only a handful of individuals are involved but their absence affects the leadership and tone of U.S. engagement in the region. The poster boy for critics of the White House is Ambassador Otto Reich, by most yardsticks a highly experienced and gifted public policy official, whose apparent sin is that he was associated with the Central American conflict fought by the Reagan administration. (For the sake of transparency, Reich is also a Senior Associate of CSIS, where the author of this column resides).

The real challenge for the administration is how much public savvy and backroom toughness it wants to deploy to push through nominations. Almost nine months past the President's inauguration, this is now a purely political matter. In the interim, regional policy is in limbo. This does not match the genuinely broad interest in hemispheric affairs by the President in tandem with the active political commitment to reach out to the Latin Diaspora in the United States. In the end George W. Bush is most likely the best spokesman for that policy and the Latin world may be the area of U.S. foreign relationships where he is the most at ease. But most observers agree that he needs the people to make it happen and this may ultimately be the most significant issue for the final quarter of 2001.


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Latin America: Stuck in a Rut for Twenty Years

By Uwe Bott, G.E. Capital (the views expressed here are solely his own and not necessarily those of GE Capital)

Stamford - For twenty years, Latin America has experienced very volatile economic times. The outbreak of the debt crisis in August 1982 is an important timeline in that regard. Since then things have gone — as a Spanish expression goes — from Guatemala to Guatepeor for most of Latin America from a debt perspective. In Argentina debt/exports amounted to 346% in 1982, but were 393% in 2000, while their debt service ratio deteriorated from 79% to 84%. Brazil’s debt/GDP ratio has deteriorated substantially and its debt service ratio rose form 89% in 1982 to 93% last year. Colombia, long the darling of the investors’ community, has experienced a deterioration of its debt service ratio from 21% in 1982 to 48% in 2000. Of course, the most dramatic improvements have been made in Mexico and Chile during those 18 years.

It should be remembered that this debt malaise comes against the background of various debt restructurings and most importantly the Brady Plan. In spite of that and numerous Paris Club reschedulings as well as more astute debt portfolio management by Latin American governments, the region is more indebted today than it was in 1982. This makes for a very weak foundation, on which to build economic reform.

At the same time, Latin America’s savings rates have been dismal. Of course, the lack of savings combined with high investment rates had led to the borrowing spree prior to the 1982 debt crisis. But what is most disappointing is that the region has been unable to raise domestic savings following the crisis. Savings rates in Argentina fell from 24% to 17% of GDP between 1982 and 2000. Brazil’s rate remained nearly stagnant, rising from a mere 15% in 1982 to 16% in 2000. Colombia did much worse with its rate dropping from 14% in 1982 to 9% in 1999. Even Mexico’s rate deteriorated from 24% in 1982 to 22% in 2000. Only Chile improved dramatically, but its rate of 22% pales compared to the rates in most Asian countries, whose savings exceed 35% of GDP.

It is the lack of domestic savings that limits the region’s medium-term growth potential, because most countries have to draw heavily on foreign savings (i.e. accruing large current account deficits), a course of action which has proven unsustainable in a highly indebted region.

Naturally, the hemisphere’s poor export performance and lack of diversification has not helped the situation. In 2000, exports as a share of GDP amounted to only 9.5% and 9.2% in Brazil and Argentina respectively. 51% of Argentina’s exports were agricultural products. Colombia exported 14% of its GDP in 1999, but 42% of its exports were coffee and petroleum. Venezuela exported 20% of its GDP in 2000, 80% of it oil. Not even Chile has done well in diversification. Yes, the country exports 26% of its GDP, yet 40% of those exports are copper. Let’s compare this performance with many of the Asian markets. South Korea exports 38% of its GDP, Thailand 55% and Malaysia 114%. Most of the products exported by those countries are manufactured goods.

Latin America has also failed in providing a more equitable income distribution. Almost all countries are doing poorly with Brazil "outperforming" everybody else. Depending on the year, Brazil ranks last or second-to-last according to the World Bank. Of course, this creates great potential for social and political instability. The rise of Hugo Chávez in Venezuela is living testimony. Most importantly however, uneven income distribution breeds shallow domestic demand and low savings rates, all of which stunts economic growth.

Finally, the rule of law, or the lack thereof, has been a serious impediment to the region’s development over the last twenty years. Many Latin American countries have made great progress in implementing modern laws be they bankruptcy laws, investment laws or contract laws. But implementing laws is just like having elections. The latter are a necessary but not sufficient condition for democracy and the former need to be fairly and predictably applied to meet the test of a society governed by the rule of law. There is much left to be done in most emerging markets in this area and a lack of progress will seriously impede foreign direct investment in the medium to long term.

Yet, there are great opportunities. First of all, Latin America has the best demographics in the world. High population growth rates declined dramatically in nearly all countries, but have left the region with a large population of 18-40 year olds. This can create very powerful dynamics, while admittedly also presenting challenges.

Secondly, in most countries, economic reform, deregulation and liberalization of markets has advanced with considerable pace providing for a strong base from which to develop successful economic models.

Third, privatization has been broad-based and few sectors have been exempted. Most success was accomplished in the financial sector with many foreign participants. They have created a more stable environment, greater efficiency of resource allocation, and they have provided modern management techniques. Supervision is still a problem in some countries and must be addressed forcefully to maintain the gains of past years.

Fourth, it appears — at least at this juncture — that the Bush administration has made it a priority to negotiate a free trade agreement with all of Latin America. The U.S. has to make some concessions, especially in the agricultural sector. The U.S. sugar regime, for example, has long been a lightning rod for proponents of free trade at home and particularly in the Caribbean. Yet, at the end of the day Latin American countries will have to make greater changes in their trade regimes. However, they are likely to be richly rewarded by much needed foreign direct investment, just as Mexico was.

On balance, I believe there is an urgent need to address the overwhelming debt burden of most countries in the region. There will be no progress without a comprehensive resolution of that problem. The much-heralded second wave of reforms is also long overdue in most Latin American countries. There is little political consensus for these reforms because of the lengthy period of deteriorating living standards. If one were to provide debt reduction to countries, which adopt a series of second wave reforms, however, one could forge a reform consensus because of the expectations that participating countries might finally turn the corner and meet their potential. Alternatively, we can continue to try and stem the tide by adding sandbags to an ever more porous dam. The result will be that we will be overcome some day by a force so powerful that it will sweep away much that has been accomplished. It will bring even wider spread poverty to Latin America, it will bankrupt multilateral lenders and it will render worthless the assets of private lenders to the region. How difficult a choice is this?


Emerging Markets Briefs

By Scott B. MacDonald and Andrew Novo

China — Exports to U.S. Fall: The cooling nature of the U.S. Economy is clearly rippling into Asia. We have already seen this in the cases of two major IT producers, Singapore and Taiwan. Now, it appears that China is finally beginning to feel the slowdown, though we do not see it falling into a recession. In early August it was revealed that China’s exports to the United States, its Number 1 market, shrank. Shipments to the United States fell 0.4% in June from a year earlier to $4.7 billion. Exports to the United States rose 6% in the first six months to $25 billion. While the numbers remain impressive, China’s trade surplus with the United States is starting to narrow. In June it narrowed 6.9%. Although China is expected to maintain a trade surplus with the United States through 2001, the actual size of the surplus is expected to fall. This will obviously impact growth in China. Consequently, the government is increasing spending on roads, railways and other public works to compensate for decreasing foreign demand. Chinese trade trends are well worth watching. If trade falters, it will increase pressure on China to devalue, something which could have a negative impact on Southeast Asian economies, as well as Korea and Japan.

Israel — IMF Reviews the Economy: While the IMF praises Israel for past years of economic reform, it has made note that the economy has now entered a more difficult period. As the Executive Board Assessment to the annual Article 4 exam stated: "…security problems since end-September 2000, together with a global turnaround of the high-tech boom on which growth had largely depended, led to a sharp contraction in the following quarter and a lackluster subsequent performance." Looking ahead, the IMF strongly recommends concentrating on macroeconomic stabilization, while minimizing the economic costs of the current slowdown and strengthening the structural foundations for future growth. The IMF noted that real GDP growth of 6.2% in 2000 would not be repeated. Rather real GDP growth for 2001 will be 1.75%, "pulled down by weak exports and fixed capital investment". Inflation will be around the target range of 2.5-3.5%. Looking to 2002: "Provided that the security situation and the global demand improve, growth next year could rise to 4-5 percent reflecting Israel’s high potential."

Taiwan — S&P Downgrade: The downturn in the global electronics market (n particular semiconductors), combined with the inability of the government of President Chen Shui-bian to put together an economic policy package to deal with the deteriorating fundamentals has caused Standard & Poor's to downgrade Taiwan from AA+ to AA. This puts Taiwan on a par with Italy, Portugal and Bermuda. The outlook is negative. Chen’s minority government, which ended the KMT’s 51-year grip on power in March 2000, has been reluctant to force indebted companies into bankruptcy for fear of driving up unemployment. At the same time, mounting bad loans are making banks cautious of extending credit, further slowing growth during a period of declining exports. As S&P stated: "The government’s economic management has been unconvincing during a worse-than-expected downturn. A likely ensuing credit crunch could prolong this slowdown and increase the potential fiscal cost." S&P also noted that non-performing loans have climbed to an estimated 10% of GDP, a worrisome development considering that the government is now more focused on the upcoming parliamentary elections to be held around the end of 2001. With real GDP growth expected to be around 2% for the year, Taiwan’s ratings may be cut further if its budget deficit widens and problems in the banking system are not addressed.

Book Review:

Alex Kerr, Dogs and Demons: Tales from the Dark Side of Japan

(New York: Hill and Wang, 2001). $27.00. 432 pages.

By Scott B. MacDonald

Beyond the interesting title, Dogs and Demons: Tales from the Dark Side of Japan, Alex Kerr has written a depressing book about Japan. Kerr’s thesis is that Japan once embarked upon a development strategy that worked well, but now is well past its prime and slowly strangling the country. The end goal of the old system was to stimulate manufacturing growth. This Japan did, hence the glory days of the economic miracle in the 1950s and 1960s. However, the system has soured and has left the country dangerously adrift since the end of the bubble economy in 1989-90. Kerr’s focus is on how all of this has impacted other aspects of Japanese life. In his venture into life beyond bad economics, Kerr asks "why Japan’s supposed ‘cities of the future’ are unable to do something as basic as burying telephone wires; why gigantic construction boondoggles scar the countryside (roads leading nowhere in the mountains, rivers encased in U-shaped chutes); why wetlands are cemented over for no reason; why the movies industry has collapsed; or why Kyoto and Nara were turned into concrete jungles." The situation is not simply one of economics, but something much more. Kerr states: "These things point to something much deeper than a mere period of economic downturn: they represent a profound cultural crisis, trouble eating away at the nation’s very soul."

The roots of this crisis of the soul stem from the Meiji period when everything was to be sacrificed to industrial everything for industrial growth. As Kerr states: "Over time, a wide gap opened up between the goals of this policy and the real needs of Japan’s modern society."

Kerr spends his close to 400-plus pages providing us with what a horrid place has become. The environment is concrete and increasingly an industrial wasteland, the educational system hopelessly wed to the past, and the financial system a near-shambles and probably not repairable. He likens the collapse of the Taisho Renaissance of the 1910s and 1920s to the Heisie Depression of the 1990s: "In both cases, systems of inflexible government and education stifled a generation of freedom and creativity. The same mechanisms that caused Japan to veer off course before World War II — a ruling elite guiding a system aimed single-mindedly at expansion — are at work today." At the end of the day, Japan must get in touch with itself and go back to the more high-mined cultural values that cherish nature and seek a balance between development and growth and more humane values.

In many regards, Kerr covers old terrain about what ails Japan. His lens, culture, is slightly different than most analysis of Japan. Yet, the book suffers from repetition, which goes beyond reinforcing a point, but rather beating the reader over the head with the same point. The same book would have had a greater impact if it were half the length. Although I cannot put this in the must read category, it provides an interesting argument for those interested in defining Japan.

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