November 2001 Volume 3 Edition 5

(see latest Spanish edition here - translation
courtesy of Mexican Business Forum


In this issue:

(full-text Advisor below, or click on title for single article window)

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, Keith W. Rabin, Keiichiro Kobayashi, Jonathan Lemco, Jonathan Hopfner, Darin Feldman, Uwe Bott

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Life Among the Ruins?: The U.S. Economy Post-9/11

By Scott B. MacDonald and Keith W. Rabin

The twilight of the Gods has arrived. Gone is the shining hope of the "new economy" and the alleged massive gains to productivity caused by IT. The words of Harry S. Dent, once proclaimed as one of "the world's most prescient forecasters", now appear to be so much intellectual flotsam: "The Roaring 2000s will come with the aging of the massive baby boom generation into its peak productivity, earning and spending years and the emergence of their radical information revolution into the mainstream of our economy. Tighten your seatbelts and prepare for the greatest boom in history: from 1998 to 2008!" We concur that you should tighten your seatbelts, but that the ride is going to be bumpy and there are going to be some big ups and downs. Any forecast is now greatly complicated by geopolitical variables, including the war on terrorism, the fate of governments in Pakistan and Central Asia and the ability of the global economy to proceed toward recovery.

So is it time to store up on food and ammunition and head for the bunker? What are implications of 9/11 on the US economy moving forward? Plunging consumer demand, a 0.4% contraction in Q3 real GDP, ongoing bad news on the corporate front, and rising unemployment reflect the U.S. economy slipping into its first recession in almost 10 years. In addition, expectations are that the 4th quarter of 2001 is going to be worse. While there is a lot of bad news, this must be seen in balance with other forces at work. The U.S. Government now has a $100 billion stimulus package aimed at reviving economic growth. Also the Fed and the Treasury Department are reportedly doing everything possible to turn the situation around. Even after the November 6th FOMC meeting cut 50 bps from the fed funds rate, many economists anticipate further cuts.

Last week also saw the end of the 30-year Treasury bond. Although this took many on Wall Street by surprise, it is a positive for the economy. The suspension of the long bond issuance was done to lower longer-term borrowing costs and stimulate the economy. The Treasury and Fed were worried that long-term interest rates were holding down the economy. The federal government is believed to be doing everything that it can to re-stimulate growth. We think these measures will help set the stage for a recovery in 2002, probably starting in the 2nd quarter (with 1% real GDP growth). At the same time, we emphasize that the recovery is not likely to be robust compared to the dynamic growth of the 1990s. Rather, we expect -1.5% in Q1, 0.5% in Q2, 2.0% in Q3 and 2.5% in Q4, providing a year-end real GDP growth rate of 0.9%. It is important to note that the process to restimulate the economy is going to take time and must contend with higher unemployment (heading toward 6%), reluctant consumers, falling housing starts and depleted personal savings.

The idea that the economy will eventually return to growth is evident in the strategy of the major U.S. automakers. Sales for Ford, GM and Daimler Chrysler were up recently due to their new zero financing programs. This tells us two things: the auto makers are fighting hard to maintain market share and that they are willing to offer such programs until the economy picks up again. Many companies continue to cut costs, reduce work forces, slash debt and sell assets with a view that when recovery sets in they will be well positioned. There is an acknowledgement that the recession is here, but that it is better to take the pain up front. This bodes well for a recovery during the scond half of 2002. .

The U.S. corporate bond market is still making a gradual recovery from what was a very difficult September. This has been partially due to the improved performance of the equity markets. The equity market is being nudged upwards by a lot of liquidity and cash being put to work by mutual funds and other large institutional investors. We expect that the equity rally will continue and that the corporate bond market will be linked to that trend. Additionally, corporate bonds continue to be cheap compared to historic levels and are drawing investor interest.

Another factor helping the corporate bond market is the now widely recognized perception that the U.S. economy is in recession. Large institutional investors are placing their money on companies and sectors such as:

1. Food/agriculture expected to do well during the recession such as Albertsons, Conagra, Kroger

2. Defense and security companies likely to benefit from the war on terrorism

3. Companies that are likely to emerge more rapidly than others from restructuring and debt reduction

Although equity markets are likely to remain volatile, the improved mood on the New York Stock Exchange and NASDAQ have been helpful in sustaining some degree of spread tightening in the corporate bond market. Over the past couple of weeks we have noted that liquidity is continuing to return and the new issue pipeline remains open. While we see trends moving in the right direction, we must add that there remains considerable sensitivity to the possibility of another terrorist attack in the United States. If another major attack occurs, it would certainly be taken negatively with spread widening and raise further concern about airline, travel and entertainment companies. Still, the absence of another attack the corporate bond rally will continue to make slow, yet gradual gains.

For equity markets the short term is likely to be one of volatility, but a gradual swing upward. There is a very real possibility that a new bubble is occurring with a view that stock market improvements will make Americans feel better and with that the consumer will return. We think that any sustainable recovery in the stock market is not likely and that the bears will return, probably in time for Q4 earnings season. Unfortnately there remains a lot more bad news to come. Heavy debt loads, tough competitive markets and a retreating consumer are still going to push many companies into restructuring and, in some cases, into insolvency. Look at the recent troubles of Goodyear Tire. Although Goodyear is not headed towards bankrupcy, it has serious problems in its ability to make a profit in tough markets and is floundering.

One last point we would like to make - U.S. banks are not about to head into a major crisis along the lines of 1989-91. During the last recession in the early 1990s, U.S. banks had a difficult time. There was concern that some of the largest banks were going to fail. Once again there are some analysts arguing that the U.S. banking system is heading into a big crisis. On October 5th the regulators released their annual report on shared national credit or syndicated loans (SNIC). Based on a detailed examination of the country's biggest banks, the data showed a worsening in creditworthiness. In 1998 some 2% of all bank loan commitments were "adversely rated". That rose to 5% in 2000. The October 2001 report shows a marked increase in adversely rated loans, which have risen to almost 10% of all commitments. The expectation is that the next SNIC will show a bigger increase. When the last cycle bottomed in 1991, the shared national credit study cited 16% of loans as having serious problems. The regulators expect that number to be reached in mid-2002.

Despite predictions of doom, the US recession has arrived without any major bank failures nor do we expect any. Indeed, average profitability improved among U.S. banks since Q2 despite increased provisioning and continued restructuring charges. It is often overlooked that the majority of major banks did not make loans to the dotcoms (as they usually lacked any collateral) and, unlike Japanese banks, few U.S. institutions own shares, which means their capital was not directly depleted by the fall in share prices. Moreover, consolidation and restructuring have resulted in a stronger banking industry. The average rate of return on assets is 1.2%, compared with 0.5% in 1989. Capital strength has also improved. In addition, banks that originate syndicated loans are better at placing them outside the U.S. banking system - foreign banks hold 41% of the syndicated loans and non-bank financial institutions hold around 10%. Furthermore, the bankers are benefiting from the lowering of interest rates, which means a lower wholesale cost for its main product, money.

Two last points to remember about U.S. banks. First, as the recession takes hold, the level of nonperforming loans will rise. That happens during recessions. Consequently, we expect to see further deterioration in the creditworthiness of bank loan portfolios going into 2002. Second, U.S. banks are well-positioned to ride through a recession. They do not carry the baggage of 10 years of bad loans like Japanese banks nor will they sink their equity prices. If growth resumes in the second half of 2002, as we suspect, U.S. banks will have weathered this recession in good shape.

The recession of 2001-02 is going to be sharp and will force a tough restructuring on corporate America. We hope that recovery will begin Q2, but caution that many variables exist - the threat of new terrorist attacks, a sharper-than-expected retreat of the U.S. consumer and a worst-than-forecast recession for Japan. There were considerable excesses during the 1990s. Now, the U.S. is watching gravity pull the high-flying economy back to earth. Let's just hope that the landing allows the economy to take off again in 2002.

Addressing the Japanese Non-performing Loans Problem:
Toward Reestablishing the Principles of Capitalism in Japan

By Keiichiro Kobayashi, PhD, Research Institute of Economy, Trade and Industry (RIETI), Tokyo

When financial crises occur, the short-term goal is to minimize the risk of additional losses to restore the credibility of the financial system. At the same time, efforts must be made to advance toward the long-term goal of recovering sustainable growth through structural adjustments in the industrial sector.

In regard to present concerns over non-performing loans (NPLs) in Japan, there is confusion over the ability of the banks and the Financial Services Agency (FSA) to conduct asset reassessments. There is a pervasive suspicion that these asset evaluations are overly optimistic and do not reflect reality. To recover the credibility of Japan’s financial system, it will be necessary for banks and the FSA to conduct assessments based on criteria that would be considered excessive in ordinary times.

One of the reasons for this suspicion lies in the view that under the current assessment criteria there is room for discretionary decisions. For example, some corporations are alleged to "negotiate with banks to get a good asset rating." As long as assessments can be made through these "negotiations," it will be impossible for third parties to believe in the credibility of the assessments conducted by banks.

To maintain credibility during times of crisis, there is a need to restrict the criteria used for asset assessments to strictly numerical criteria.

For example, one method would be that for any major loans in amounts equivalent to 1% or more of a bank’s total credit, assessment criteria would be established as a ratio of outstanding debt to the current cash flow of the project concerned. Doing so would help restore credibility because the assessments would not be influenced by the consideration of uncertain and discretionary factors.

Some argue that excessive provision of reserves will have a negative impact on the profits paid out to the shareholders of banks. Although an excessive provision of reserves may reduce the dividend level paid out in a certain year, if the reserves are excessive, it will translate into greater profits in coming years from assets that are already backed by reserves. This will ensure a higher dividend yield in future years. A thorough provision of reserves, even in excessive amounts for the interim period, will have no negative impact on the long-term dividends paid to shareholders. One more issue that must be considered is the need to establish accounting principles that reflect this approach.

There is a possibility, however, that a bank may fall into insolvency if it provides for sufficient reserves. In this case, the only option would be to use steps, such as bankruptcy procedures, for the bank. Public funds would then have to be used as the source for the reserves. Consequently, if the reserves provided are too large, there is the risk that it will result in a temporary increase in the burden to be borne by the taxpayers. However, if a system were created where profit that is generated ex post facto from assets backed by excessive reserves reverts to taxpayers, the taxpayer burden would also be adjusted at that time.

To restore credibility in the economic system, a hands-on approach to asset evaluation based on strict assessment criteria must be implemented. It will need to determine the necessary amount of reserves that are required, and make the necessary provisions for these additional funds. This is necessary as a stage just prior to a final settlement through measures such as an appropriation of collateral provided by debtors and the initiation of bankruptcy procedures targeting debtor corporations. In other words, if the only steps taken involve the conducting of a strict asset assessment and an increase to sufficient levels of reserves, then it is natural that the market will expect that one or two years should be sufficient to resolve Japan’s NPL problem.

Otherwise, as the FSA recently pointed out, it may take more than seven years to complete final settlements involving the rebuilding and liquidation of debtors.

On the other hand, a strict assessment of assets and the provision of sufficient reserves can restore the credibility of Japan’s financial system. In no way does requiring banks to provide sufficient reserves over the next one or two years amount to excessive interference in market mechanisms. In fact requiring sufficient reserves will helpt to strengthen and restore confidence in market mechanisms.

After implementing strict asset assessments and providing for sufficient reserves to dispose of necessary losses, the ultimate disposal of the non-performing assets (NPAs) or NPLs that are backed by such reserves can be left to the discretion of the banks involved.

In this case, however, an adjustment mechanism must be created which, over the long-term, can realize the capital gains and profits that will result from the disposal of non-performing assets backed by the reserves. These can then be returned to the creditors and taxpayers who incurred the losses.

Towards this end, it would be effective to implement something along the lines of debt-equity swaps. In exchange for absorbing the loss that will accrue from the provision of reserves for NPAs, former creditors of those assets would receive equity rights to future profits that are accrued.

The debt-equity swap is an effective method of ex post facto adjustment, because making efficient use of NPAs that are backed by sufficient reserves and generating profits will benefit former creditors and taxpayers since those gains are returned to them as dividends on their equity rights.

After establishing a mechanism to return profits generated from NPAs backed by reserves, the question will be how to restructure or liquidate corporations for which reserves have been provided.

Items included in the Advance Reform Program, such as enhancing the function of the Resolution and Collection Corporation (RCC) and establishing a quasi-governmental investment fund to support corporate restructuring, are beneficial in rebuilding and liquidating corporations for which reserves have been already provided.

Of foremost importance, however, are the implementation of strict asset assessments and the provision of sufficient reserves.

Some may argue that disposal through the provision of excessive reserves will result in a deflationary spiral, and that compulsory provision of excessive reserves runs counter to the principles of capitalism.

But countering a deflationary spiral is the task of the Government and the Bank of Japan and concerns about deflation do not justify inadequately small provision of reserves by private-sector banks and others. During the Great Depression, the U.S. swiftly implemented a sweeping disposal of NPLs in the middle of a severe deflationary current. As a result, the credibility of the financial system was restored.

Ordinarily, if the credibility of a bank or a corporation is questioned, sufficient reserves are provided to restore that credibility. If not, it is normal for the bank or corporation to go bankrupt quickly.

This practice is not yet prevalent in Japan. The necessary capitalist principles were distorted by a culture in which people regarded banks and corporations as "virtual village collectives," and were therefore not criticized.

Indeed, it is part and parcel of the very principle of capitalism to voice criticism towards the management of banks and corporations that are performing poorly. In addition, taxpayers, who are in fact the shareholders of banks that receive public funds, need to exercise oversight regarding the way that such banks are managed. The disposal of NPLs is a necessary process for reestablishing the principles of capitalism in Japan.

After receiving a Masters Degree in Engineering from the University of Tokyo, Dr. Kobayashi studied at the University of Chicago, where he was awarded a Doctorate in Economics. He assumed his current position as a fellow at RIETI in April 2001.

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Interview with Mr. Yasutaka Miyamoto, President and CEO of Shinkin Central Bank

By Keith W. Rabin

(*Note: all figures noted in this interview reflect end of FY2000/2001 on March 31, 2001 and US$ are converted at ¥120=$1)

Mr. Yasutaka Miyamoto presently serves as the President and CEO of Shinkin Central Bank (SCB), a $200* billion cooperative financial institution that serves 371 regional cooperative shinkin banks and 8.9 million small and medium businesses and individual members throughout Japan. SCB possesses one of the strongest credit ratings among Japanese financial institutions. This includes an A1 rating from Moody’s and an AA- from Standard & Poor's in recognition of its sound asset quality, high liquidity and strong capitalization. This is equal to leading U.S. banks, including Bank of America, Citigroup and Bank One, or others such as HSBC and the major Australian banks. Mr. Miyamoto has graciously agreed to the following interview with Mr. Keith W. Rabin, publisher of the KWR International Advisor.


Hello Mr. Miyamoto. Thank you for taking time to speak with us today.


It is my pleasure. I greatly appreciate this opportunity to speak with the readers of the KWR International Advisor. Before beginning, however, please allow me to first express my deepest condolences to anyone effected by the terrorist attacks in New York and Washington. This tragedy represents a great affront against all democratic and peace-loving peoples and I would like your readers to know the Japanese people share the pain and sadness that has been caused by this needless suffering and loss of life. We believe these terrorist acts were aimed not only at America, but at the entire global community. We wholeheartedly support U.S. efforts to fight the global terrorist menace. As a small token of SCB’s determination to help effected families and to alleviate some of the pain that has been afflicted, I recently instructed our New York office to make a $100,000 donation to New York City Mayor Rudolph Guiliani’s Twin Towers Fund.


Thank you Mr. Miyamoto. We sincerely appreciate this kind gesture as well as the spirit of your remarks. To begin, we’ve been hearing lots of negative news about Japan and Japanese banks for many years. What is the problem?

YM: It is true the Japanese economy has not been doing well for some time now. Many people blame the banks. I wholeheartedly agree with those who emphasize the need to resolve the non-performing loan problem. Yet in my eyes the Japanese banking situation reflects troubles in the overall economy.

Having spent most of my career in the Japanese Ministry of Finance, I witnessed the Japanese miracle from a unique vantage-point. Our progress was simply amazing. However, in retrospect it is clear our financial system did not keep pace with our extraordinary growth. We became a victim of our success and too comfortable and resistant to change. Moving forward, Japan needs to restore the dynamism it exhibited in the past.


Recent moves by our government are a definite step in the right direction. Similarly the bankruptcy of Mycal and other firms show that Japan is not conducting business as usual. These events would have been unthinkable only a few years ago.

Equally important is the emphasis being placed on small and medium businesses -- which employ 70% of the Japanese workforce and constitute the bulk of our economy. These businesses have had a tough time over the past decade, but without a recovery in this sector there is little hope for Japan at large.

Shinkin Central Bank (SCB) has a special interest in this sector as our member Shinkin Banks and shareholder base is composed solely of small and medium-sized enterprises (SME).

Thankfully, SCB, which I head as President and CEO, stands as one of the strongest banks in Japan. We are now moving to draw on our strength to promote the competitiveness of our member banks and their shareholders. Utilizing a strong consolidated capital ratio of 16.52%, a sound asset structure that includes a risk management asset ratio of 0.92%, efficient management (per head $166 million, triple that of the major city banks), an expense ratio of 0.13% (1/8 of major city banks), and one of the highest ratings of all Japanese financial institutions ( S&P long term counter party rating of AA- and A1 from Moody’s, we believe we are up to the challenge. This will allow us to support our member banks and through them to facilitate small and medium businesses activity in this vital sector.

Click here to read the complete text of KWR’s interview with Mr. Yasutaka Miyamoto of Shinkin Central Bank

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Canada: Headed into Recession, but Economic Recovery Should Return in The Spring

By Jonathan Lemco

The September 11th terrorist action has had dismal economic implications for many of the United States’ allies. Not surprisingly, one of the most affected is Canada, which is the largest trading partner of the U.S. by far. Prior to the tragedy, the Canadian economy had been limping along with modest growth, with little new investment in its vitally important commodities sector. But the events of September 11th, and the resulting uncertainty, have been the "icing on the cake". In fact, investors should expect continued economic weakness in the Canadian credit for the remainder of 2001, but expect some economic pickup by the second quarter of 2002 as the U.S. economy begins to recover.

For now, Canadian exports will decline in volume. As well, increased security at the border with the U.S. will result in a slowdown of cross-border flows. The automobile industry is particularly vulnerable. However, Canada remains a "safe harbor" compared to the volatile emerging markets. For investors seeking safe, if unspectacular results, Canada and its provinces offer adequate and fairly predictable returns.

In the near term, what might we expect of the Canadian economy and polity? First, interest rates will continue to hover around historic lows and thereby provide support for economic improvement next year. Consumer confidence will remain low (it fell 4.5 points in Q3 to the lowest level seen since the 1997 Asian crisis), as consumers postpone the purchase of big-ticket items. Housing starts fell 7.6% month-to-month in September. Business confidence has also fallen dramatically and is likely to remain stagnant through the second quarter of 2002.

Inflation is of virtually no concern to the Bank of Canada at the moment, and it can devote its attention to easing interest rates as a spur to the moribund economy. In the next six months, investors should expect flat or marginal (perhaps 1.5%) economic growth. Unemployment is currently at 7.2% and could rise to about 8.0% early in 2002. But it should then decline to about 7.5% by December of next year.

In early October, Ontario government took the lead on the fiscal front by accelerating personal and corporate income tax cuts originally scheduled for the beginning of next year. When the full impact of the economic stimulus in the U.S. and Canada takes effect by year-end 2002, growth may accelerate to 2.5% or so.

The Canadian dollar, which is worth about U.S. $0.63, is competitive on a world scale and thereby supports the broader Canadian economy. For international investors and tourists alike, Canada is a tremendous bargain. Given the likelihood of world economic uncertainty for the foreseeable future, we think there is little chance of Canadian dollar appreciation. Once the uncertainty eases however, we think that Canada’s positive fundamentals, i.e. low inflation, a shrinking debt load, and a sizeable current account surplus, should push the struggling Canadian dollar higher.

The Federal and Provincial governments’ fiscal prudence in recent years has been rewarded without ongoing credit rating upgrades by the major credit rating agencies. We think that Canada’s fiscal performance will remain strong despite the current economic slowdown. In fact, the federal government should still enjoy a modest budget surplus through the end of 2002. It will be difficult to pay down much more of the federal debt, however, despite the government pledge to pay down $3 billion of debt next year.

Many economists forecast an economic recovery in the U.S. by the second quarter of 2002. Whenever the U.S. economy strengthens, Canadian exports should see an attendant improvement. In the meantime, the Canadian federal and provincial governments will continue their policies of fiscal prudence, balanced budgets, etc.

Of particular interest to fixed income investors is the province of Quebec. Quebec paper offers modest yield to investors, but that is acceptable at a time of economic uncertainty worldwide. In recent years, the province's political leaders have followed the model of their federal counterparts and registered balanced budgets or surpluses. The sovereignty issue, although never dead, is dormant. We think that Quebec bonds offer good relative value to conservative investors.

To conclude, we don’t mean to dismiss the negative impact of the worldwide recession and the events of September 11th on Canada. But we would balance this situation with the acknowledgment that the Canadian economy is fundamentally healthy and should be quick to recover in six months or so when the major world economies begin to grow again.


Will a stronger China spell doom for ASEAN economies?

By Jonathan Hopfner

Already hit hard by political instability and the slowdown in global markets, ASEAN countries now have a new issue to grapple with — China’s rise as an economic power and pending entry into the World Trade Organization. As China makes further moves to court foreign investment and streamline local industries, Asia’s "little dragons" are increasingly worried that the very advantages that fueled their own growth — cheap, educated labor, efficient production techniques and mass exports — will help China eclipse them completely.

More pessimistic observers are predicting that as China’s billion-strong market opens to the world, foreign manufacturers will rush en masse to establish a presence there, pulling out of traditional production bases such as Thailand and Malaysia. There are rampant concerns that the ensuing job cuts and investment losses could devastate these countries’ already fragile recoveries from the 1997 financial crisis.

There is certainly ample evidence to confirm these fears. Hong Kong, for instance, recently recorded a near record-high unemployment rate of 4.6%, largely fueled by the growing number of local firms that have shifted their operations to mainland China to cut costs. By 1999, foreign direct investment flows into China had surpassed those into all the ASEAN countries combined. While the governments of technological powerhouses like Singapore warn their citizens to tighten their belts and prepare for a recession, China is expected to post a growth rate of 7.0-7.5% this year.

Despite these trends, the views expressed by ASEAN leaders on China’s WTO accession are almost uniformly optimistic. "[China’s WTO entry] presents a tremendous opportunity, offering a large — in many cases, new — market for ASEAN exports and products of companies operating in ASEAN," Secretary-General Rodolfo C. Severino told the ASEAN forum in Guangzhou earlier this year. Indeed, ASEAN exports to China have surged from $8.9 billion in 1993 to over $32 billion in 1999, and are set to climb further as Beijing drops tariffs to comply with WTO rules.

International financial authorities have also been quick to play down the potential for a pan-ASEAN fallout. Ex-IMF deputy managing director Stanley Fischer recently called the China threat "exaggerated," claiming that each ASEAN nation has unique resources and attractions that will continue to appeal to foreign investors. Thailand, for example, can bank on its status as a tourist mecca, Brunei can build on its budding reputation as an Islamic banking center, while Singapore and Malaysia will continue — at least in the short-term — to enjoy their positions as regional purveyors of high technology.

Less talked about, but becoming increasingly apparent, is the fact that foreign companies probably won’t find China nearly as great a place to base themselves as the rest of Asia thinks. Beijing’s accession into the WTO, while it may break down some of the obstacles that have prevented foreign forces from operating there in the past, does not mean Chinese authorities will throw the country’s doors open to all and sundry. Many analysts have pointed out that China’s 1.3 billion-strong domestic market is far from a unified force -- formidable trade barriers exist even among the country’s many provinces, with the distribution of tobacco, alcohol and agricultural products severely restricted. For the foreseeable future, the country’s complex bureaucratic mechanism and prickly nationalism will likely remain firmly in place. Credit Suisse First Boston found this out recently when the Chinese government barred it from future business deals after the investment bank invited senior Taiwanese officials to two of its overseas conferences.

In addition, while few ASEAN countries are likely to be able to compete with China’s cut-rate labor costs, they will continue to win out on other fronts; international trading and marketing know-how, business and transport infrastructure, English language skills and corporate governance. While China has its size going for it, countries like Singapore and Malaysia have the virtue of experience, making them much more attractive to firms involved in top-end businesses such as banking, information technology and telecommunications.

The sense of urgency in Asia stoked by China’s economic awakening may bear further fruit for the entire region. ASEAN has doubled its efforts to conclude a free-trade pact among its members, believing that by acting as a coherent unit all Southeast Asian countries will be better poised to compete with China. Inter-ASEAN tariffs for 90 percent of member states’ products have already been slashed to 5 percent, and the ASEAN Free Trade Agreement (AFTA) is scheduled to take effect for the "older" members — Brunei, Indonesia, Malaysia, the Philippines, Singapore and Thailand — in 2002.

Few would deny that the ASEAN nations have taken significant steps toward integration, but the unified front presented at regional gatherings belies a number of conflicts that simmer beneath the grouping’s surface. The stark political and economic disparities between the ASEAN founders and the organization’s newer additions — Laos, Cambodia, Myanmar and Vietnam — mean it could take years for these poorer countries to adopt the free trade pact and begin to enjoy its benefits. Malaysia and Thailand are locked in a diplomatic battle over Kuala Lumpur’s reluctance to open its automobile market according to the AFTA schedule. And Singapore is often accused of courting independent trade deals with Western powers at its ASEAN allies’ expense.

So while ASEAN has begun to shed its reputation as a body of "all talk and no action," it has further work to do before it can present itself as the unified market that so many business leaders and economists believe it must be if it is to compete effectively with China. So far, the prospect of a financially powerful middle kingdom has prompted the organization into a semblance of cohesion. ASEAN leaders must now seize this momentum and use it to build a potent regional force free of the infighting that has dogged Southeast Asia in the past.

Buyside Magazine reaches active institutional investors monthly with news and analysis of the equities markets. Buyside takes readers beyond news of the current business climate to report industry and market trends that are crucial for investors to understand -- not simply the latest business trends or product releases. Buyside and BuysideCanada are available in print, and online at Subscriber information is available on Buyside's home page.

9/11 and the Impact on Insurance

By Darin Feldman

The incomprehensible tragedy of September 11, 2001 has already been marked as the worst catastrophic event in the history of the insurance industry. The final tally of insurable financial damages is still unknown and will be so for a long time. This uncertainty has unnerved many investors, both equity and fixed income. Consequently, the pricing volatility among insurance company securities has been significant. Some investors have aggressively purchased insurance securities with the expectation that premium rates will surge in response to the losses. Others have shied away from the sector in fear of the financial harm that the industry may be facing. Unfortunately, media headlines are driving many of the investment decisions and not fundamental analysis.

Advocating an investment position in the insurance sector, either to buy or to sell is certainly difficult given the magnitude of the event and unique circumstances that each company faces. But a key factor to consider is that each company in the industry should be treated individually and not lumped together as a whole. Following the attack on September 11, airlines and insurance companies collectively became synonymous with financial distress. In the October 5, 2001 "Heard on the Street" column of The Wall Street Journal, the subtext of the headline reads "The recent attacks directly damaged the aviation, insurance and tourism businesses, but how deeply could other industries have been hurt in the last three weeks of the quarter?" This statement seems fairly innocuous, but is extremely misleading.

While the events certainly impacted airlines and insurance companies to a greater extent than any other sectors, the consequences are dramatically different for the two industries. The primary difference is that September 11 represents for the airline industry as a whole. For insurance companies, the problems will really be limited to individual companies. In fact, many insurance companies stand to significantly benefit from the September 11 events. The key distinction to consider in treating the airlines as an industry problem and insurance companies on a case by case basis is as follows. The terrorist attacks are a major business problem for airlines, but for insurance companies, only the balance sheet has been impaired. The implications of this are that it is a lot easier to fix a balance sheet than it is to fix a business.

An insurance company that has taken a hit to its balance sheet can easily raise more capital if investors are convinced that the pricing environment will yield generous returns. Once this happens, the insurance company has restored its balance sheet strength and now actually has better growth prospects. Obviously, this comes at a cost to the company. However, unlike within the airline industry, the financial losses from this catastrophic event are truly costs of doing business for insurance companies. For the airlines, the event is not a cost of business, it results in the loss of business. The simplest way to see this will be to look at the respective income statements of the two industries in the 3rd quarter. For the airlines, the catastrophe results in a loss of revenue. For insurance companies, the catastrophe is an expense item. Even more telling will be a comparison of the revenue lines for airlines and insurance companies in the fourth quarter. Airlines are likely to see a precipitous decline in revenue. For insurance companies, premium rate increases and higher demand for insurance following the catastrophe should result in visible top line growth for many carriers.

In a somewhat twisted, but interesting way, many insurers view the payment of catastrophe claims as a form of advertising that over the long term, increases the value of the organization via goodwill. On a day-to-day basis, insurers face difficult challenges in promoting the value of its product and differentiating itself from the competition. The product of an insurance company is a promise. This is a promise that in return for a fixed premium, the insurance company will indemnify a policyholder for an insurable and covered loss. Fortunately for most policyholders, the opportunity to collect on that promise does not frequently present itself. However, when a policyholder files a claim with an insurance company, the individual or business has the chance to see what they purchased. A company that effectively handles the claim can have a policyholder for life as well as the benefit of word of mouth advertising. If handled poorly, it will be an insurer’s worst advertising campaign. The bottom line is that insurance is a product that no one likes, but everyone needs. Unfortunately, the best proof of that comes during times of loss.

So does all of this suggest that September 11 automatically created a buying opportunity for insurance securities? Absolutely not. What it does suggest is that well capitalized companies that can withstand the hit to capital from the devastation and be around to reap the benefits of a firmer pricing environment are worth investor consideration. Although the insurance industry as a whole has a significant amount of capital, there are many companies in the sector that are thinly capitalized. Those are the companies that investors should fear. It is this point, which makes it extremely important for investors to pay as much attention to the balance sheet strength of an insurance company as it to look at its earnings. Unfortunately, many investors only appreciate the value of a strong balance sheet after the catastrophe took place. Those companies that have solid balance sheets will reap the benefits of greater product demand. This is not to say that a high frequency of catastrophes is good for insurance investors, because insurance companies are not adequately compensated to pay catastrophic losses on a frequent basis. They are however, most of the time, compensated to cover the large, yet hopefully infrequent losses.

Once again, this article should not be construed as a blanket investment advocacy position for insurance stocks and bonds. Unfortunately, some companies will deeply suffer financially and operationally from the events of September 11. The purpose of this commentary is twofold: First, investors need to understand that the airline and insurance industries were financially impacted by the tragic events of September 11, but in very different and material ways. Second, when a catastrophe does occur, insurance investors should not be concerned with near term earnings implications. The only matter of consequence is balance sheet strength. Ultimately it is a strong balance sheet that enables an insurance company to deliver on its promise, which in turn, increases the value of the franchise. Investors must get past the headlines and look at the fundamentals that drive a business. The events of September 11 are tragic beyond words. But it is important to remember that the main purpose of insurance is to cover unexpected, and sometimes devastating losses. Insurance companies sell protection. For well-capitalized companies that are able to get through the events of September 11, the opportunity to sell more protection should be enormous.

Being Down and Out in the Caribbean: Ripples from the U.S. Recession

By Scott B. MacDonald

Many Caribbean countries have made a substantial effort to promote their countries as key points on the map for over-worked and vacation-needy, yet affluent North Americans, Europeans and Japanese. Ad campaigns emphasize lush tropical climates, smiling natives and ready service. Indeed, many in the United States, Canada, the UK, France and Japan are willing to board a jetliner and make the trek for a little tropical paradise, especially in winter. The harsh winter months in Montreal, New York City, and Chicago are enough to make many think about the advantages of sitting in the warmth of the Caribbean sun, having a rum drink and thinking only about what to do for dinner.

While this may appear to be a bit superficial in terms of hopes for national development, the hard reality is that the tourist industry is a central element in most Caribbean economies. It is estimated that tourism generates around $2 billion and employs one in four Caribbean citizens. Tourism is also the largest earner of foreign exchange in 16 out of 28 countries in the region. Consequently, when the U.S. economy heads into a recession, the impact on the Caribbean is significant.

Prior to the 9/11 attacks on the United States, the U.S. economy was already slowing and with it prospects for the Caribbean tourist sector were dimming. In many Caribbean countries, there is now real concern that the lights could be turned off. The tourist is now like an endangered species for many Caribbean countries — there are few left. As David Jessop, the Executive Director of the Caribbean Council of Europe notes: "But now as passengers fearful of traveling beyond their national borders cancel flights, air carriers reduce services, cruise ships operators abandon destinations, hotels retrench staff and investment in tourism contracts, the outlook for this key Caribbean industry is bleak."

Throughout the Caribbean, national airlines, hotels and service industries have been hurt badly. In the days following the 9/11 attacks Air Jamaica lost $11 million and only now is beginning to regain customers. All the same, 2001 is likely to go down as one of the worst years for regional airlines, many of them already struggling.

On the hotel side, the economic downturn also hurts. In Jamaica, 70% of all tourists come from the United States. No U.S. tourists means empty hotel rooms, which in turn translates into lay-offs. These are also spillover effects of a blow to tourism — suppliers in manufacturing, food processing, agriculture, ground transportation are all hit. Ralph Taylor, President of the Caribbean Hotel Association, stated in late September, 2001: "This is a very tough situation in which we find ourselves. It has already been a difficult year for us because of the global economic slowdown in general and the downturn in the U.S. in particular."

Jamaica is hardly alone. The Bahamas is also highly dependent on tourism. In 2000 it had 4.2 million visitors, with 92% of them staying overnight and the other 8% on cruises. Together they spent $1.8 billion. Tourist-related activities account for two-thirds of economic activity. The downturn in the industry presents a stiff challenge to the Bahamian economy.

The global economic slowdown is also likely to hurt worker's remittances, most importantly in the Dominican Republic, Haiti and Jamaica. Such remittances are often a critical lifeline for working people in the region. In Jamaica it is estimated that remittances bring in for many families $700 a year, an important supplement that keeps people just above the poverty line. However, the as the U.S. is in recession and millions of jobs are lost, Jamaicans living abroad will have less discretionary cash at their disposal. As one Jamaican editorial commented: "Less money will be sent home. The capacity of Jamaicans who live on remittances to consume will decline. Poverty will worsen." In addition, the lack of remittances runs the risk of translating into social unrest that can easily lead to riots.

These negative conditions will also hurt the ability of most countries to access international credit markets. Although Barbados, Trinidad & Tobago, and the Dominican Republic have been able to access international capital markets over the last 12 months, many other countries, like Guyana and Suriname, will not have that option. Caribbean countries can also be hurt in capital markets when Argentina defaults.

The impact of 9/11 will also hurt the flow of drugs, due to enhanced national security against terrorism in the U.S., Canada and Europe. While this is positive, it could complicate the flow of legal goods into the United States and Canada. Moreover, new and tougher anti-money laundering laws being introduced in the United States and in Europe should bring Caribbean offshore financial centers under greater scrutiny — rightfully or wrongfully.

Substantial challenges sit before Caribbean governments. The regional economy had already begun to slow. However, 9/11 accelerated the slowdown and has cast many governments into a painful reassessment of the economic landscape. Prospects for 2002 look better, but will remain dependent on larger geo-political factors, such as the success or failure of the War against Terrorism. Sadly, the blow against the trade towers and the Pentagon was also a blow against the Caribbean and its people.

Egypt- Coping with 9/11 and the Global Slowdown

By Scott B. MacDonald

With the events of 9/11 and the U.S. assault on Afghanistan, business throughout the Middle East and North Africa has suffered. Egypt, in particular, is racing to deal with a slumping tourist industry, falling exports to the West and creaky public finances. The Egyptian economy is strongly linked to the West, through trade and tourism as well as worker remittances. Consequently, the global economic slowdown has a sting, which although painful, is manageable.

Egypt has come a long way since it started down the road of an IMF-sponsored economic reform and stabilization program in 1991. This program focused on trade liberalization, land reform, exchange rate unification and devaluation, the privatizations of parastatal enterprises, and the reduction of food and other subsidies. All of these programs created a foundation for a more efficient economy. Private sector participation in the economy increased significantly over the past decade as a consequence of these changes and stimulated a quicker pace of economic expansion. In addition, the planned development of the country's significant natural gas resources is promising for future export expansion. This would go a long way to reduce the traditional heavy dependence on tourism, workers' remittances, and Suez Canal fees for foreign exchange earnings.

While considerable progress has been made, the reform process has slowed in 2000 and 2001. The privatization of parastatals has slowed and public sector debt remains high. Growth is expected to slow to 3% in 2001 and the government is struggling to contain large fiscal expenditures. The budget deficit is expected to be a substantial 5.4% of GDP by year-end. The rating agencies, which give the country Ba1/BBB- credit ratings, are also growing increasingly bearish, especially Standard & Poor's which has a negative outlook. With a slowdown in global economic growth, Egypt is clearly feeling the pressure. Consequently, the market increasingly expects a further devaluation of the Egyptian pound before year-end. According to a recent Reuters poll, analysts expect the pound to weaken against the dollar to 4.33 by end-2001 and 4.75 by end-2002, from 4.25 at present. The currency has been trading at the weaker end of the band since its 6% devaluation in August 2001 (it is allowed to trade +/- 3% around a central rate of 4.15).

We expect that tourism revenues are likely to decline by around 25% year-on-year over the next 12 months (a decline in FX revenues of about US$ 1bn). Two other key sources of foreign exchange for Egypt are also likely to fall due to the slowdown in the international economy - remittances from workers abroad (about US$ 3.0-4.0bn per annum) and Suez Canal revenues (US$ 2bn per annum). The Central Bank of Egypt is reportedly once again restricting the supply of hard currency to local companies and banks, to artificially support the currency and maintain FX reserves. This is a practice that has been criticized in the past as it could lead to the re-appearance of a black market for hard currency. Despite the delicate nature of such maneuverings, Egypt still maintains $14 billion in foreign exchange reserves. This is equal to three times the level of Egypt's short-term public external debt.

The most recent IMF Article IV report (released November 5, 2001) commended Egypt for the "progress made in strengthening the economy over the past decade by substantially reducing the fiscal deficit, bringing inflation to low levels, improving debt service indicators, and advancing structural reforms." It also noted that the "key challenge in the period ahead is to restore strong economic growth and robust job creation, while maintaining macroeconomic stability." A renewed emphasis on structural and financial reforms, including the long-discussed privatization of a number of banks, was advocated. In the medium term, the IMF also recommended a reduction in public sector debt (including foreign debt), equal to 64% of GDP.

It is important to underscore that Egypt is advancing the reform process, despite a somewhat slower pace. Parliament approved in June 2001 a law promoting the development of a mortgage market. This includes provisions for strengthening the potential claim of lenders over property collateral. In addition, a draft money laundering law has been prepared to criminalize this activity, reinforce penalties, and create a central authority to supervise and coordinate detection and enforcement efforts. On the privatization front, a number of smaller companies were privatized last year as was a large cement company in September 2001.

Like most Middle Eastern countries, Egypt faces a challenging economic future in which it must balance public opinion and economic realities. Although a large part of the Egyptian public is opposed or lukewarm to the U.S. war on terrorism (especially the military action against Afghanistan) and is often ambiguous about its relations with the West, the economy is strongly linked to Europe and the United States. The country receives around $2 billion a year from the United States and is regarded as a key ally in the region. The likelihood of a new conflict with Israel is remote. Moreover, the connection with Europe is improving. In June, 2001, the Egyptian government signed an Association Agreement with the European Union which, once ratified, will provide for a phased, multi-year reduction on tariffs on EU imports. This is expected to help boost Egyptian exports to key European markets.

The fundamental challenge for the Mubarak administration is to balance managing the economy with an eye toward those strong economic links to the West and the need to be supportive of international trade and commerce with a public that is not thrilled by the seemingly pro-Israeli tilt of Washington. Moreover, radical Islamists though defeated, have not been entirely crushed and have the potential for creating greater problems (especially vis-à-vis the tourist industry). One of the ironies of the terrorist attacks on America is the consequential economic pain to one of Islam's largest countries in the form of an economic slowdown. Considering the geo-strategic importance of Egypt to the West and the Mubarak government's own interest in seeing Islamic radicals defeated, one of the battlefields in the war on terrorism is the Egyptian economy. This could mean a higher level of U.S. economic support and clearly, if needed, more active assistance from multilateral agencies such as the World Bank and International Monetary Fund.

Egypt has made considerable progress on the economic front since the 1980s when there was deep concern that the country might default on its external debt. Now that threat is far removed, but many of the challenges remain in what is now a more difficult international environment. Much will depend on the government's ability to balance the needs of its population with tough geo-political realities.

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The Concert No Longer Plays

By Scott B. MacDonald

During a recession companies usually undergo restructurings designed to provide cost efficiency and reduce debt burdens. Although painful, such actions are critical if companies are to rebound when the recession ends and the economy rebounds. The telecom industry clearly reflects this process. As debt was accumulated with considerable gusto throughout the telecom universe (and credit was cheap and in ready supply), deleveraging is now advancing with equal fervor since most corporate heads recognize that the good times are over. In this light, AT&T (T), one of North America’s major telecom companies, and British Telecom (BTE), one of Europe’s major telecom players, decided to end Concert, a 50/50 joint venture.

Two years ago, AT&T and British Telecom (BT) created Concert, which was to provide multinational companies with a single global telecom service. Concert, however, proved unable to hit the right notes and the company became a financial drain for both AT&T and BT at a time when they were themselves confronted with difficult market conditions and internal restructurings. Complicating matters further, Concert ended up competing with its parents. According to a number of Wall Street analysts, losses this year were set to hit $800 million.

After months of negotiation, AT&T and BT agreed that AT&T will take a total of $5.3 billion in charges (against 3Q01 earnings) in two parts. This includes a $3.5 billion charge related to the unwinding of Concert and the assumption of BT’s interest in AT&T Canada (ATTC) and a $1.8 billion charge related to AT&T’s stake in ATTC. These are non-cash charges. Finally, it appears the value of ATTC is being written down to $1.2 billion from $3 billion. BT said the break-up would lead to a 1.2 billion pound ($1.7 billion) charge, plus a further 200 million pounds to cover its share of redundancy and unwinding costs.

The partners will divide Concert's working capital between them, with BT receiving an additional $400 million to reflect the allocation of business to the venture. BT said that extra money effectively covered $180 million of annual losses for two years at the parts of Concert it will reclaim.

BT and AT&T will take back most of the parts of Concert they originally contributed. However, there will be a net loss of jobs as there will be no jobs at the parent companies for 2,300 of Concert's 6,300 employees. About 800 to 1,000 of the job cuts will fall in the UK, with the rest in the United States.

The end of Concert has important ramifications for the Canadian telecom market. AT&T will take full ownership of the joint venture through which it and BT own stakes in AT&T Canada. AT&T, therefore, takes on BT's share of the venture's obligation to buy publicly traded shares in the Canadian company by June 30, 2003, which would have cost BT 725 million pounds. This also means that ATTC will be a more competitive player in the Canadian telecom market, something that the British Columbia-based Telus (TU) will have to consider in its drive to be the North American country’s major provider.

The end of Concert is an important millstone in the restructuring of the international telecom industry. For BTE, the end of Concert is the final stage in an ambitious restructuring and clears the decks for it to split into separate fixed-line and mobile telephone businesses next month. AT&T is taking similar steps to separate its major divisions. It indicates that major telecom companies have reassessed the strategic realities in today’s markets and are willing to cut their losses. As BT Chief Executive Peter Bonfield said on a conference call "If we can reduce the cost of operations, this business should be able to return to profit within two years,"

For both BT and AT&T the exit from Concert is one step of many that these companies need to make to restructure their operations and develop better business models. Following the sale of Concert, both Moody’s and Standard & Poor's moved to downgrade AT&T from its A2/A ratings to A3/A-.

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Japan: Give Prime Minister Koizumi a Break

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

Every time I visited Japan over the last ten years things seemed to have gotten a little bit worse with diminishing hopes of a turnaround. Whichever way one looked at Japanese fundamentals, they caused grave concern. Throughout the 1990s and into this millennium, Japan suffered from low growth to no growth. Fiscal stimulus packages kept the economy from falling into the abyss. At the same time, these packages increased output volatility, a factor that had a negative impact on the underlying structure of the economy. Moreover, they were focused almost entirely on public works programs in a failed Keynesian approach to Japan’s fundamental problems.

Japan’s economic dilemma can be summed up as follows: The successful industrial policy of the post World War II period created an industrial complex in Japan made up of conglomerates, who prioritized volume growth and market share. Profitability was only of secondary interest. The long-term perspective of these conglomerates was much envied in the U.S. and Europe during the 1980s and it was broadly assumed around the world that Japanese companies would be propelled to be leaders in every major industry in the 21st century.

This did not come about for two key reasons. First of all, there was a drive towards global integration of markets, especially during the 1990s. This process entailed that the incumbents in key industries had to restructure to maintain their competitiveness in the future. Such restructuring required a flexible labor market that did not exist in Japan. Second, technological progress took a quantum leap in the 1990s. During the 1950s to 1980s, Japan had been masterful in adapting technology developed mainly in the U.S. to its industrial processes, hence producing superior goods in the electronics and automobile sectors in particular. However, Japan failed to adjust its educational system to prepare for the technological challenges of the mid- to late 1990s. As a result, the country was left with an outdated industrial structure, diminishing competitiveness and the economy missed the shift from the post-industrial age to the information age.

All of this occurred against the background of a bubble economy that burst in the early 1990s, and a permanently impaired financial sector due to its weak capital structure as well as its poorly performing assets. Consumer confidence never recovered and external demand was weak. Concerns about a rapidly aging population added to the medium-term pessimistic outlook. Fiscal and monetary policy completely failed to address the growing crisis. As a matter of fact, they made matters worse. Expansionary fiscal policy led to record public sector debt by any measure, and monetary policy set in motion a deflationary process that seemed unstoppable and that was likely to snuff out any recovery of domestic demand.

Government officials seemed completely unfazed by all of this. The Finance Ministry defended its ineffective prime pumping and discounted the danger of rising debt. Government officials also regarded concerns about the financial system as exaggerated. Finally, the Central Bank defended its monetary policy, suggesting that aggressive injection of new money would foster inflation. By the same token, the Bank of Japan officials insisted that commercial banks would not lend anyway because of their balance sheet problems even though the two concerns were mutually exclusive. There was an existential struggle between the Finance Ministry and the Bank of Japan, with the latter insisting that a further loosening of monetary policy would occur only if the government restructured the economy. Yet, the political system was too stale to force dramatic change. Many foreign observers had come to similar conclusions as I did regarding Japan’s predicament as well as to the most promising tools that could lead to a recovery.

Then, something truly extraordinary happened in April of this year. The Liberal Democratic Party (LDP) feared for its survival during July elections to the upper house of parliament. It removed the highly unpopular Prime Minister Yoshiro Mori and to the surprise of analysts at home and abroad replaced him with a political maverick, the John McCain of the LDP, Junichiro Koizumi. Had it been left to the party elders this revolutionary change would not have taken place, but Mr. Koizumi enjoyed such broad-based grassroots support that it simply overwhelmed the establishment. Mr. Koizumi said all the right things — so far as foreign analysts were concerned. He planned to rein in government borrowing, stop gold-plating the Japanese infrastructure, concentrate on restoring health to the financial system and introduce reforms that would return the Japanese corporate sector to competitiveness. He was very open about the immediate consequences of his reforms: more unemployment, a culture shock to the system and a slow recovery. Most foreign analysts immediately embraced this new leader with a boyish look and long hair. They continued to be concerned about his political pull to execute his ambitious plans, but they were nevertheless thrilled with the prospect of a new and rejuvenated Japanese economy.

Unfortunately, this foreign support proved to be fickle. Soon after Mr. Koizumi took over it became more and more apparent that the U.S. economy was in a greater slump than had been thought. At the same time, Europe started to slow down as well. All of a sudden, we were faced with a global economic slowdown last experienced in the early 1980s. This changed everything in the minds of many analysts and observers. All of a sudden talking and writing heads in the Western press began to turn against Mr. Koizumi. His policies would lead Japan into a sharp recession and they would only make things worse. Some of his critics were the same people that were outspoken proponents of structural change in Japan until April.

This self-serving, opportunistic criticism of Mr. Koizumi’s reform proposals (and as of now they are just that) is unfair and unhelpful. Mr. Koizumi was right and continues to be right in recommending fundamental, structural changes in Japan. I would add that his reforms should be accompanied by using public funds to introduce a basic unemployment insurance program that would help those, who loose their jobs in the process so that they can make it through this difficult period (there is practically no support for the unemployed at present). And yes, the Bank of Japan has to do its part through an aggressive loosening of monetary policy. Japan’s problems must be addressed on the supply side and on the demand side. But the country’s problems have not changed because the world economic outlook has deteriorated. Mr. Koizumi has enough challenges at home to convince the old hands in the LDP to go along with his reforms. It is a difficult political balancing act to sell austerity to his people, yet the Japanese seem ready and willing to sacrifice.

We have learned a lot about the importance of soft factors, such as "confidence" in successfully managing an economy and international markets over the last ten years. All too often perception becomes reality. Yet, we have learned too little about how to create fertile perception. In Japan’s case all hinges on that. The Japanese people have to believe that they now have competent and forceful leadership in place, and that dramatic and painful structural changes will be beneficial in the long run. They must understand that Japan is a wealthy country in terms of its people and its financial assets and that a more efficient reallocation of both will make them successful again. Foreign analysts and observers can help in forming this perception. They can further add to the new beginning by making complementary proposals to Mr. Koizumi’s reform plans. At the end, a sustainable Japanese recovery will be a blessing to all.

It’s Foreign Policy, Stupid!

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

In much of America’s recent history, we have listened closely to polls and focus groups in order to determine, which qualifications matter to the U.S. electorate in a presidential candidate. Sometimes, party and fund-raising support has been based on criteria outlined by such surveys. Political junkies — like myself — often complained that few of our primary candidates had national experience and even fewer had any exposure to foreign policy issues. Of course, the political pundits were always quick to remind us that foreign policy experience was largely irrelevant, because U.S. presidential elections were won on a strong domestic agenda. The record seems to support their reasoning: Jimmy Carter, Ronald Reagan, Bill Clinton and George W. Bush all had been governors before they were granted the great privilege of leading our nation. Thus, the pundits are probably right, but the American people are most definitely wrong.

Foreign policy experience does matter and the events of 9/11 drive this point home with brutal clarity. During the first eight months of his presidency, George W. Bush seemed to pursue an isolationist, unilateralist and largely indifferent foreign policy. His Secretary of State, Colin Powell, was quickly isolated within the administration and he seemed strangely out-of-the-loop on several occasions. He expressed his surprise, when the U.S. was ousted from the UN’s human rights commission in May. The Powell State Department announced that it was "surprised" again in June, when General Musharraf declared himself President of Pakistan. Although these admissions were admirable in their honesty, they did not instill great confidence.

The Bush administration thought it could safely withdraw from the U.S. role as a peace-broker in the Middle East. Granted previous administrations had shown marginal success in this conflict, but U.S. involvement was not so much about resolving this mess, but to contain damage. Only the Palestinians and Israel have it within their power to create a more peaceful environment that eventually (generations from now) may result in a world were both peoples can live with each other without violence. The main role of the U.S. was and continues to be to prevent the worst from happening and to attempt to nudge both sides towards compromise.

The Bush rejection of the Kyoto Accord and the ABM Treaty were other signs of unilateralism and isolationism. George W. Bush had criticized the Clinton administration for its interventionist approach and its failed effort in "nation building", as President Bush likes to call it. However, during the first eight months of his term, the president seemed to have replaced that strategy with "going it alone", an approach at the other end of the foreign policy spectrum.

But like other presidents before him, this aloof and foreign policy-averse president was soon confronted with the realities of this world, albeit in the most horrific fashion since Pearl Harbor. Sure, FDR created social welfare programs, but most will indeed remember him for Pearl Harbor and World War II. President Truman too had to deal with World War II and made the fateful decision to drop the world’s first nuclear bombs. He then struggled with the beginning of the Cold War, which stretched into the Eisenhower administration only to be overshadowed by the war in Korea.

Jack Kennedy had little foreign policy experience and had been in office for just a few months, when he was confronted with the Cuban missile crisis. The Berlin Wall was erected during his times, and the seeds for the Vietnam War were sowed. LBJ saw the crisis in Southeast Asia grow. Richard Nixon fought the Vietnam War to the bitter end and at the same time opened up to China. Jimmy Carter too was defined by events abroad. He was faced with a war in the Middle East, an oil-embargo and a hostage crisis in Iran. Yet, Jimmy Carter also brokered the Camp David agreement between Egypt and Israel.

The Soviet Union began to unravel during the Reagan administration, a process that was possibly accelerated by Reagan’s simplistic but highly effective threat to launch war in space against the "evil empire". On the other hand, the Iran-Contra scandal almost brought down his presidency. George Bush Sr. had great foreign policy depth. He needed it. The Iraqi invasion of Kuwait and the U.S. response to it was his defining moment. With hindsight, he exited that war prematurely on the advice, among other people, of Colin Powell. Exhausted from the war effort he chose to ignore Serb genocide in Bosnia by leaving a resolution of this conflict to Western European countries that acted without resolve.

Of course, as governor of Arkansas, Bill Clinton had little foreign policy experience and interest himself, when he took the oath in January 1993. His agenda was strictly domestic. Many thought he could afford it, because the fall of the Soviet Union and the end of Communism had ushered in a new chapter, one devoid of history. Health care was at the top of Bill Clinton’s agenda and it turned into his greatest failure. On the other hand, foreign policy quickly became an overriding issue as the situation in the Balkans deteriorated. The Dayton peace accord, admittedly a shameful document that gave the Serbs too much, was the best that could be negotiated after the Europeans, the Bush administration and the early Clinton administration had neglected to intervene earlier. President Clinton was a quick study and he did not repeat this mistake in Yugoslavia’s attack on Kosovo. He used his military power and coalition building to defeat the Yugoslav regime, a defeat that ultimately led to the removal and deportation of Yugoslav President Milosevic.

Bill Clinton also played a role in the Oslo Peace Accord signed by the PLO and Israel in 1993, although Norwegian intermediation was very effective in this context. Clinton’s interest in said conflict waned in years to come. This lack of follow-through led to a flurry of diplomatic activity during the last eight months of his administration. The deadlines of various conditions of the Oslo accord had passed and the most important issues stood unresolved. Unfortunately, intermittent neglect wrote the script of ultimate failure.

So it appears that many presidencies are indeed defined by foreign policy events, that most U.S. presidents have little experience or interest in foreign policy, and that it is a mistake that the American people do not give proper weight to foreign policy expertise during the electoral process. At the same time, it is also clear that foreign policy and defense policy are squarely and exclusively in the domain of the federal government. Moreover, these policies are largely controlled by the executive branch. Most domestic polices are in conflict or competition with policies at the state and local level and the legislative branch of the federal government wields considerable control of their nature.

For example, the federal government provides only 7% to overall educational funding. Its influence in determining the nature of curricula is and should be very limited. It is very appealing to candidates and even to the electorate to search for the Education President, but he/she does not exist and never will. Bill Clinton’s failure to address the country’s health care system at the federal level is another good example. Solutions at the state level seem much more effective. Finally, there is the economy. Well, a president can do a lot of harm by undermining public confidence through ill-conceived rhetoric. But over the last twenty years, the federal government has self-reduced its influence in this arena. Deregulation, liberalization, small, but efficient government and fiscal prudence have become generally accepted principles, where the political parties differ only on the margin. Consequently, government has removed itself from interfering in markets.

This leaves us with the constitutionally exclusive right of the federal executive: foreign policy and defense. There is no question that the President of the United States and his cabinet are the key creators of our nation’s foreign policy and that the President is the Commander-in-Chief. Hence, it follows that the American people must pay attention to the foreign policy credentials of their leaders and that our leaders pay attention to what really matters. It might — in the end — determine the success or failure of their terms and decide their place in history. Fund Research tracks country/regional weightings and fund flow data on the widest universe of funds available to emerging market participants, including more than 1,500 emerging market and international equity and bond funds with $600 billion in capital and registered in all the world's major domiciles. also offers customized financial analysis, data and content management services on emerging and international markets for corporate and financial Internet sites. For more information, contact: Dwight Ingalsbe, Tel: 617-864-4999, x. 26, Email:

Emerging Market Briefs

By Scott B. MacDonald

Brazil — The Candidates Start to Line Up: It is now formal. The Brazilian government has announced that next year's elections will take place on 6 October 2002, with a second round on 27 October if necessary. This has clearly pushed potential presidential candidates to a more active mode of operations. José Serra, health minister and close confidant of President Fernando Henrique Cardoso, indicated on 9 October that he would at the very least be standing for a seat in the senate. He was already a member of the senate for Sao Paulo, but stepped down when he was appointed minister. However, the Health Minister clarified that he looking to higher office instead of merely retaining his seat. During his press conference he pointed to his strong track record as health minister. He noted this should help him secure the nomination of the ruling coalition, which he hoped would remain in place. He also reminded voters that he was not just a party politician, rather a member of the `health party,' as reflected by successful campaigns and programs introduced by his ministry. Giving his conference the traditional politician stance, he picked up a baby and kissed it for the benefit of the cameras.

Others are indicating that they have presidential aspirations as well and want the support of the ruling coalition, the foremost of which is Tasso Jereissati, governor of Ceará. The Governor is well-connected, including the President and the influential family of the late governor of Sao Paulo, Mario Covas. He is also supported by other influential figures, including education minister Paulo Renato Souza, communications minister Pimenta da Veiga, PSDB governors Marconi Perillo (Goiás) and Almir Gabriel (Pará), and PSDB president José Aníbal (who has inherited the Covas mantle). One weak point in Jereissati’s campaign is allegations of irregularities in the state bank, BEC, during his governorship. There may have to be a primary between Serra and Jereissati in March or April.

Trinidad & Tobago — Off to the Elections: On December 10, 2001 the citizens of Trinidad & Tobago will go to the polls to elect a new government. The outgoing government of Prime Minister Basdeo Panday lost its legislative majority in October due to a rift within his United National Congress, which forced it to call new elections. The rift was caused by allegations of corruption against the Prime Minister by members of his own government, including the former Attorney-General Ramesh Maharaj, who Panday fired from his cabinet. Consequently, the UNC is threatening to split into two parties, one loyal to Panday, the other formed around Maharaj. At the same time, the opposition People’s National Movement (PNM) under former Prime Minister Patrick Manning is well-positioned for victory. The smaller National Alliance for Reconstruction (NAR) is also gearing up for the electoral contest. It is in discussions with former finance minister Wendell Mottley and his group of "concerned citizens" about contesting the election. Despite the fluid nature of the election, it is important to emphasis that the major political parties, the PNM, UNC and NAR, all are supportive of market-oriented policies and favor foreign investment. The issues dominating the campaign are likely to be crime, corruption and the economy.

South Africa - Ratings on Upgrade Track: Moody's has placed South Africa on review for a possible upgrade from its Baa3 to Baa2. The rating agency stated that "the South African government's macroeconomic policy track record has been impressive beyond expectations in recent years, particularly in the fiscal policy arena but increasingly in monetary and exchange rate policy as well." South Africa also gained accolades for its debt management, acceleration of its privatization program, and an improved liquidity position. South Africa has had a positive outlook from Moody's since February 2000. Standard & Poor's rates South Africa BBB-, with a stable outlook.

Indonesia Faces S&P Downgrade: Indonesia has made a substantial transformation since the downfall of Suharto in 1998. It has held parliamentary elections, had three different presidents (none of whom left through acts of violence but via constitutional procedures), and managed to resume a modest level of economic growth. However, the Southeast Asian nation remains challenged by a heavy debt burden which the government is seeking to reduce. In light of this they have indicated Indonesia was seeking to reschedule $2.7 billion in sovereign debt at the next meeting of the Paris Club of creditor nations in February 2002. Coordinating Dorodjatun Kuntjoro-Kakti also suggested that the government was also considering asking its official creditors to convert debt into grants. Standard & Poor's regards such an approach from a standpoint of higher risks of default. S&P in particular believes that if the official creditors provide another rescheduling of official government-to-government debt, they will also demand the same treatment from private sector creditors. The rating agency thinks that this would include the $400 million Yankee bond due in 2006. Consequently, Indonesia's sovereign rating was downgraded from CCC+ to CCC, with a negative outlook. S&P also noted that if a restructuring were to reduce Indonesia's debt burden materially, "subsequent ratings in the single-B category could be achieved."

Book Reviews

cover Eric Margolis, War at the Top of the World: The Struggle for Afghanistan, Kashmir, and Tibet (New York: Routledge, 2000). 250 pages. $26.00

Reviewed by Scott B. MacDonald

Click here to purchase War at the Top of the World directly from

With the "War Against Terrorism" focused on Afghanistan, Eric Margolis’ book, War at the Top of the World is a must read. The author is a contributing foreign editor to the Toronto Sun and has spent considerable time in the region that he examines. Writing in a somewhat manly style of "I was there with the guys", he recounts his experiences in Pakistan, India, Afghanistan and Tibet. He states in the beginning of the book: "I have covered or explored South Asia as a political journalist, war correspondent, and old-fashioned adventurer for the past twenty-five years." This is decidedly an easy, well written book for anyone interested in how the crisis with Islamist terrorists developed. Moreover, the author is very concerned about the future line-up of China and Pakistan versus India.

Margolis regards the problems posed by South and Central Asia as the nuclear rivalry between India and China, the potential for internal collapse of China, Pakistan and India, and the clash of civilizations between Islam and the West and possibly between Islam and Hindu India. The most significant threat, though is tension between India and China. As he states: "History demonstrates that new powers, or resurgent older ones, invariably challenge the status quo, which we euphemistically term ‘stability’. As new powers expand and flex their strategic muscles, they must clash with the old powers of the status quo, and inevitably, destabilize the existing world order. In Asia, we see the unique spectacle of two ancient nations that are fast emerging as the newest superpowers in the midst of a fragmented, unstable region composed of small, weak states and a wounded, revanchist Russia." He believes that there is a good chance that within the next two decades India and China will clash.

Margolis also has a view on Osama bin Ladeen, who he regards as partially created by U.S. involvement in Afghanistan’s war against the Soviet Union in the 1980s. He rightfully points out that bin Ladeen "was widely seen as a hero across the Islamic world, a Muslim David standing up to the American-Israeli Goliath."

Margolis also contends that Afghanistan’s problems are homegrown. Although the United States walked away after the Soviet defeat, it was the Afghans who "won the war, but the lost the peace. Jealousy, tribalism, and the lust for power had replaced the holy war. It was a demoralizing spectacle, humankind at its lowest ebb: politics as usual." This of course, opened the door to the rise of the Taliban, supported closely by Pakistan. As for the Taliban, Margolis notes: "Led by the one-eyed Sheik Omar, the new faction preached a medieval faith that often employed Islamic terminology to foster the most archaic customs of tribal Afghanistan."

For anyone looking for a scholarly book with a sea of footnotes and theoretical posturings, War at the Top of the World is not for you. It is a highly journalistic account of the hot spots in Central and South Asia, based on first hand experiences and written in a breezy style. This is good travel reading.

Olivier Roy, The New Central Asia: The Creation of Nations (New York: New

York University, 2000). 222 pages

Reviewed by Scott B. MacDonald

Click here to purchase The New Central Asia: The Creation of Nations directly from

Central Asia is back. In the aftermath of the Soviet Union's collapse, Central Asia gave birth to five new countries - Kazakhstan, Turkmenistan, Tajikistan, Kirghizstan, and Uzbekistan. This large region, ranging from the borders of Russia and Iran to Afghanistan and China, was regarded with considerable interest. Long isolated from the rest of the world during the Soviet period, these new states were busy establishing governments, recasting institutions, and reforming both their economies and societies. Moreover, Kazakhstan, Uzbekistan and Turkmenistan had vast reserves of oil and natural gas, which soon gained the attention of major Western energy companies. In many regards a new world has opened up. However, slumping commodity prices in the mid-1990s, corrupt and inefficient governments, and geographical remoteness brought a sharp decline in interest from the outside world. Russian influence remained strong, especially in Tajikistan, which underwent a civil war involving a pro-Russian quasi-Soviet style government on one side and a divergent coalition of Islamists and democrats on the other. With Afghanistan caught up in a long civil war and then the Taliban regime, Central Asia sank into a sense of relative isolation by the end of the decade. The Great Game of rivals over oil and gas became a shadow game, largely beyond the glare of media scrutiny.

9/11 changed the fortunes of Central Asia. The U.S. "war against terrorism" has suddenly propelled the Central Asian states into the glare of media attention. U.S. troops have landed in Uzbekistan and bases in Tajikistan are under consideration for use by U.S. bombers. The Taliban has threatened to send troops against Uzbekistan, which is fighting its own radical Islamists in the Ferghana Valley.

Outside a handful of U.S. oil companies and a few academics, Central Asia remains largely obscure to the vast body of the public in the West. One book worth reading to provide an excellent background on the region is Olivier Roy's The New Central Asia. Although originally published in French in 1997, the book retains significance due to what the author calls "the evolutive geostrategy of an area in the making". While not covering Afghanistan, Roy focuses on the painful creation of states in Central Asia. He believes that one major problem for the Kazakhs, Tajiks, Uzbeks, Kirghizs and Turkamens is the legacy of Sovietism, which functioned not so much as an ideology, but as "an apparatus, a techinque of power and an organization of the social". The result at independence in 1991 was the adoption of "the model of the strong, personalized state tending towards a monolithism which is challenged not by democracy but by regionalist factionalism and ethnic diversity." That monolithism was defined by efforts to create Kazahk, Tajik and Uzbek nationalism, based partially on ethnic identity, but largely precluding Islam. Against this was another tendency, that of "the continued existence...of traditional society, with its new potentates, its clanism and ethnic quarrels that date back to the beginnings of time." As opposition forces were sidelined (mainly democratic groups seeking to play by the "rules"), the role of opposition fell to a number of Islamic groups, some of which were ready and willing to take up arms against the state.

Roy also argues that geography is playing a major role in Central Asia's political development from the standpoint that all the nations are landlocked. This has meant that Russia plays an ongoing role in the movement of any goods. The other choice, Iran, is not appealing to the region's leadership. Consequently, the new states must contend with the challenges of integrating with regional blocs and attracting external assistance, i.e. Europe or the United States. This, of course, has not pleased the Russians and has lead to a degree of tension at times. The new round of politics related to the U.S. war on terrorism and the quest for regional bases must be observed in this light.

Roy provides an important background to a critically strategic region. He has conducted research and provides insights as to how Central Asia is now responding to the rise of the Taliban (which threatened in a religious and ethnic sense vis-a-vis the secular regimes) and the U.S. campaign against radical Islam. Sadly, he also provides us with an understanding of the difficult nature of the land in planting the seeds for Western-style democracy. Central Asia's political development will not be easy. For anyone wanting to gain a better graps of the geopolitically important region astride Afghanistan, The New Central Asia is worth reading.

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