KWR International Advisor #8

March/April 2001 Volume 3 Edition 2

In this issue:

The U.S. Economy: Welcome to the Post-Bubble World
Japanese Banks - There Are a Few Roses Among the Thorns
Turkey's Latest Crisis - If It's Broken, Please Fix It
Malaysia - On Edge
Argentina - Back From The Brink?
Emerging Markets Briefs:
Chile - The Economy Cools
Estonia - Steady Progress, but Tough Challenges Ahead
India - Will Reforms Continue?
Latin American Mobile Phone Users Up
Book Reviews


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

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

Publisher: Keith W. Rabin, President

Web Design: Michael Feldman, Sr. Consultant

Contributing Writers to this Edition: Scott B. MacDonald, Keith W. Rabin, Jonathan Lemco, Robert Windorf, Darin Feldman

© 2001 KWR International, Inc. No reproduction is permitted without the express consent of KWR International, Inc.

To obtain your free subscription to the KWR International Advisor, please send a request to . Please forward all feedback, editorial comments, and reproduction requests to

The U.S. Economy -- Welcome to the Post-Bubble World

By Scott B. MacDonald and Keith W. Rabin

When the NASDAQ and Dow were climbing to new heights in 1999 and early 2000, the bulls were a thundering herd.  Although there were those who warned of storms ahead, it was difficult to be hear them as investors charged forward only to experience ever-new levels of rapture.  Now, the dynamic has changed.  To recount: corporate earnings are bad and despite occasional up days, little relief appears at hand. This makes it difficult to believe that a market bottom has been reached.

The tech sector has been rudely hammered. Passive talk of a soft landing or a "V"-shaped recovery has given way to a "U" or even worse an "L" shaped repeat of Japan's experience in the 1990s or the bleak market environment that pervaded the U.S. during the 1970s.  Making matters worse, the gloom and doom has seeped into overseas markets.  Japan has begun to drift back into recession and emerging markets provide no relief as Argentina and Turkey limp along, threatening to fall victim to another round of crisis.  Moreover, Europe appears increasingly less able to pick up the slack of the United States and provide the global economy with a locomotive it needs.

Many analysts believe the U.S. economy will slow to around 2% real GDP growth for 2001. This is more than respectable given the traditional measures of growth thought possible in a mature economy.  Yet it is nowhere near the levels that would seen warranted given the "expectation inflation" that has developed with the extraordinary growth seen over the past few years.  Therefore, while the U.S. may still experience first quarter of 0.5% -- which is technically not a recession -- it is certainly feeling like one. And it is not likely that the U.S. economy will experience a strong recovery until 2002.  The NASDAQ crash caused a lot of wealth destruction and savings levels are even more negative than they have been in the past.  Although unemployment remains low (4.3%), and there remains a lot of hiring going on -- the ongoing downsizing of workers is far more newsworthy and beginning to further dampen consumer confidence.This trend is almost certain to get worse before tapering off.

At the same time, U.S. companies will continue to post poor results and in some sectors such as technology, there will be a lag until late in the year or early in the next.  Companies like Cisco, NorTel and Motorola will survive, but will look very different by the end of 2001. These companies are being forced to reinvent themselves, cutting excess lines of production, selling assets to reduce debt, and adopting new business models to maintain their competitiveness.  Other companies, however, such as Teligent, a data services company, has seen its stock price fall from 65.88 to as low as .25. Many of these companies will be forced to declare bankruptcy. Furthermore, there will almost certainly be more ratings downgrades before stronger companies re-emerge.

More importantly, while this weakness was thought to be confined to the technology sector, in recent weeks we have seen a significant erosion in the Dow and mainstream indexes. Old-line basic industries and almost every sector other than heavily defensive cyclical plays such as commodity producers and defense, are experiencing significant declines.

The profit picture will be the main driver toward a market recovery although the need for a point of psychological capitulation remains.  Based on our economic view, we expect a profit recovery beginning in either late 2001 or early 2002, and growing in strength from that point forward.  As for a point of capitulation, we would hope to see one in the near future, but so far - as most investors - we have been disappointed.  The confusing signs of impending doom, tempered by occasional periods of upward movement and strong energy prices, real estate and consumer consumption, make it extremely difficult to accurately forecast the future. The resulting sense of uncertainty further exacerbates volatility and indecision in the markets, which dramatically inhibits the necessary return of investor confidence.

A strong point in underpinning a recovery over the long term will be repeated cuts in interest rates, and the Bush administration, through its tax cuts, is helping to set the stage for a stock market recovery.  The problem, however, is that the non-discriminatory over-investment seen in technology- and internet-related companies will not be resolved with a quick flick of the interest rate dial or several days of upward movement in the markets.  It will take time to work many necessary painful adjustments through the system.  In fact, in many ways the ascension of the NASDAQ can be at least partially attributed to overly loose monetary policy in the years since Alan Greenspan first spoke of "irrational exuberance" in 1996.   Having resisted the temptation to raise rates lest he choke off the strong growth allowed through the perceived "non-inflationary productivity enhancements" of the "new economy", this became increasingly difficult over subsequent years. While domestic factors might have indicated a need to temper potential speculative excesses -- the Asian financial crisis, fall of LTCM and weaknesses in Russia, Latin America and other emerging as well as mature markets -- necessitated a very different course of action.

The danger is that investors, having seen the miraculously restorative powers of the three almost amphetamine-like interest rate cuts that occurred in 1998 will be tempted to believe this can happen again. They sit by the sides anxiously wondering when it is safe to go back in the water - occasionally jumping in to find themselves sinking further into the sand.  Therefore, while Fed funds rates are now at 5.0% and are expected to decline another 50 bps cut at the May 15 FOMC meeting, with maybe another 50 bps by the August 21 FOMC meeting, these measures will take time.   Investors, however, do not have any patience. They are looking for immediate results. Furthermore, in and of themselves interest rates will not serve to promote the rationalization that needs to occur in the technology sector and arguably could preclude the shakeout that needs to occur.

Interest rate cuts can however, in the short-term, lead to a resumption of inflation - a force that was deemed banished from world financial markets only months ago.  Although the market remains very focused on the economic slowdown, we would note that inflationary pressures have not entirely disappeared.  Energy prices remain high and precious metals have begun to show signs of strength.  As the Bush administration has repeatedly stated, the United States is in an energy crisis. While the Bush administration's "energy crisis" may be overstated for political reasons, it does point to ongoing heavy demand and lower levels of supply.  California's problems come to mind as does the large import bill for foreign oil.  In addition, unemployment has not shot up nor is it expected to do so in the medium term.  Both wages and energy prices have inflationary implications.  The radical downward trend in interest rates - which only promises to accelerate in coming months -- could set the stage for higher inflation in the future. The Fed certainly has its work cut out for it - navigating an economic recovery through necessary corporate deleveraging and higher energy prices. The erosion of consumer and market confidence will make this extremely difficult.  As seen during the last round of interest rate cuts, this can have a contrary effect. At that time we watched investors driving down averages in their anxiety over the failure of Alan Greenspan to immediately repeal the laws of gravity as he did during the market meltdown in the days of old in 1998.

Investor uncertainty also remains a key concern and might be seen as a partial explanation of the inability of interest rates cuts to work their magic. Uncertainty usually means ongoing spread volatility.  This should be good news for the U.S. bond market, which has recently been buoyed by a steeping yield curve and ongoing need for corporate financing. However, the depressed nature of equity markets and the falling interest rate environment, make us only cautiously optimistic about the corporate bond market.  Although there will be troubled companies and ratings downgrades ahead, the corporate bond market does offer opportunity for those willing to go do their credit work. Not every single A credit will go to BBB.  Moreover, we are nearing the end of ratings downgrades in the telecom sector. We expect that France Telecom, Deutsche Telekom and British Telecom will fall from their current single A's to BBB's. WorldCom has already fallen on one side to high triple B. Yet even the relatively positive trends in bond markets must contend with some of the anguish of a slowing economy and depressed equity markets.

Cooling European Economies….While the U.S. and Japanese economies are struggling to keep away from recession, the European economy continues to grow.  However, its growth is not strong enough to maintain strong global growth.  Also, the pace of European growth is beginning to slow.  This is not good news.

Germany accounts for 35% of the 12-country Eurozone GDP.  There are dark clouds on the German horizon.  The jobless rate climbed for the second month in a row in February, reaching 10.1%. There has also been a fall in manufacturing orders, with overseas orders falling 6.8%.  The U.S. slowdown is beginning to hurt big German companies such as Daimler Chrysler, Deutsche Telekom, and Deutsche Bank. Business confidence is also growing soft.  There are also signs of weakness in other European countries.  In France, Alcatel, the large telecom equipment supplier, recently warned that its first quarter revenues from its mobile-handset unit would be below year-earlier levels, while announcing plans to lay off 1,100 employees in its U.S. work force. Expectations have already been dampened for Finland's Nokia.

In addition, Moody’s noted on April 5th, that credit quality declined in Europe in the first quarter, with more than four times the number of corporate bond issuers downgraded than upgraded. As the rating agency commented: "An inevitable slowing of the once-torrid pace of spending in the U.S. has imperiled debt protection in economies having a considerable dependence on exports to the U.S." This was evident with Italy, which exports 10% of all exports to the U.S. market. Italian factory orders fell 11.5% in January from December, the largest drop in more than a decade.

Looking Out for the Perfect Storm…We would also like to add the need to remain on guard for any potential "perfect storm" in international markets, which could further aggravate tensions in and prevent a good year in the corporate bond and equity markets. Renewed troubles in Asia, including but not limited to problems with Japanese banks, an aggravation of tensions with China, or a debt default by Argentina would be highly disruptive, especially if one or more of these factors were to occur at the same time.  Similarly, one also has to keep their eyes open to the possibility of unexpected bankruptcies or a major investor or financial institution finding itself with unhedged portfolio exposure that gets out of hand.  Although we do not expect a perfect storm, we will continue to look out for such a development.

Notwithstanding the gloom implied in the above, we do not believe the world will end or that markets will continue to descend down to zero. The problem is that in spite of all the turmoil in the past months, with many formerly promising stocks seeing declines of over 90% -- investors have still retained an almost remarkable sense of complacency and Americans are only just beginning to adjust to all that is implied in the slower growth inherent in a "post-bubble" world. Whether this is due to the protracted decline we are experiencing as opposed to a more rapid descent in 1998; the need to reconcile declining equities with strong real estate and still relatively strong employment data; general uncertainty created by an inability to evaluate potential storm clouds on the horizon -- or all of the above, is still difficult to ascertain.

What is clear, however, is that until these discrepancies can be reconciled, it is hard to see how this situation can be resolved. Until that time, we are left with the need to await either the long-awaited point of psychological capitulation and almost unmitigated sense of despair on Wall Street last seen in October of 1998 or a more protracted period of continuing market volatility -- both up and down -- until the current uncertainty can be better defined.


Japanese Banks — There Are a Few Roses Among the Thorns

By Scott B. MacDonald

Japanese banks have clearly become a global point of concern. On his recent trip to Washington, Prime Minister Mori and President Bush even discussed the pressing need to deal with the mountain of bad debt accumulated by Japanese banks, which is now threatening to help push the Japanese economy into another round of recession. Yet, for all the bad press about Japanese banks, not every institution in the world’s 2nd largest country is tottering on the edge of collapse. Consider the case of Shinkin Central Bank, which enjoys some of the highest ratings among Japanese banks by the rating agencies, with an A1/AA-. The strong ratings are equal to a number of lead U.S. banks, such Bank of America (Aa2/A+), PNC Financial Group (A2/A-), Citigroup (Aa2/AA-), and Bank One (Aa3/A).

The Shinkin banks were established under the Shinkin Bank Law of 1951 and are small cooperative institutions focusing on deposit and lending activities with members (generally small, locally oriented companies and individuals). The Shinkin Central Bank (SCB), also referred to as the Zenshinren Bank, plays the role of central bank for the 370 shinkin institutions, which serve their 8.5 million medium and small business and individual members. The Shinkin Central Bank’s position in this Yen 100 trillion (US$1 trillion) cooperative system provides it with a large and stable funding base. It has around $202 billion in assets. These financial fundamentals, especially its strong capitalization, allowed the bank to successfully minimize the asset deflation pressures of the 1990s.

Since the beginning of this decade, Japanese banks have come under increasing strain. While the problems with bad debt are well publicized, there are other challenging issues, including the growing threat of competition from foreign banks, local nonbank financial institutions, and the pressing need to adopt costly, yet essential new technology. Although the process has been slow, consolidation is gradually occurring through mergers and acquisitions. All of these forces are hitting the Shinkin banks. A March 2001 Moody’s report made note that the niche franchise value of member shinkin banks are now coming under pressure and that the financially weaker shinkin banks are "facing increasing pressure to improve regulatory capital ratios under the Prompt Corrective supervisory framework and thus may seek future capital support from the Shinkin Central Bank."

The SCB is seeking to lead its group of banks into a new era of competitiveness. While it is actively encouraging the implementation of new technology, it is also pushing along consolidation within the sector and working to trim bad debt. The SCB’s non-performing assets as of last fiscal year 2000, stood at about 1% of its total loans, much better than the average for Japanese banks.

In 2000 the SCB introduced a new credit system to its members by assigning credit ratings when extending loans to small and midsize businesses. The system groups borrowers into 11 categories on the basis of their financial standing. The SCB’s system is programmed to adjust the balance sheets of many small businesses to more accurately deal with hidden profits and losses on real estate and securities holdings.

In 2001 the SCB is taking a more pro-active stance in dealing with the changing bank environment. Two small shinkin banks in Kyoto that were in bad financial shape were taken over by the SCB and cleaned up. On April 1 a system was established by the SCB to inject capital into affiliated financial institutions whose capital-to-asset ratio has weakened. With the reimposition of the 10 million yen limit to government deposit protection within the year, SCB hopes to prevent failures of affiliated banks and boost public confidence in the institutions. This is an important step forward in developing more prudent banking practices. Under the new system, SCB will inject up to 25% of the equity capital of a shinkin bank by buying preferred subscription certificates or extending subordinated loans. Significantly, after providing the capital the SCB will monitor progress of the restructuring to guarantee that the loans can be collected.

The SCB is also supportive of the consolidation of the shinkin banking system. The number of shinkin banks has already fallen from around 400 a couple of years ago to around 370 now. That trend will continue as reflected by the announcement in March 2001 that four Tokyo-based shinkin banks plan to merge next January.

The SCB is being pro-active in a difficult banking environment. It is one of the few Japanese banks with AA/A ratings, something it is likely to maintain, considering its efforts to restructure its sector and introduce a sounder credit culture to its members. Although it is too easy to write off all Japanese banks as troubled, there are still a few roses among the thorns.



Turkey’s Latest Crisis: If It’s Broken, Please Fix It

By Robert Windorf

Since the release of our last publication, to the casual observer it may seem that not much has changed within Turkey: the embattled politicians remain the perennial bane of the enterprise economy’s existence; the bloated state bureaucracy wallows in the mire of numerous debt service obligations; the convoluted banking system still has too many ill-managed and corrupt institutions; etc. However, while all of the former remain true, over the past two months, Turkey’s political crisis of confidence and resultant sharp currency decline made it to the front pages and op-ed sections of many global newspapers which otherwise would normally pay scant attention to it. Nevertheless, for those of you who may have missed the recent installments of this long-running modern Ottoman melodrama, we offer the following synopsis. Plus, a few predictions for how the plot may continue to thicken.

Since his election last May, President Ahmet Necdet Sezer had been leading an arguably effective anti-corruption campaign. This coincided with Prime Minister Bullent Ecevit’s continuing pledge to carry out necessary structural reform policies. On February 19th, Ecevit stormed out of a meeting with Sezer. The president reportedly criticized him for his reluctance to take a harder stance on anti-corruption efforts, especially within the banking sector. The shoving back and forth of a copy of the republic’s constitution across the table led to Ecevit’s action which immediately led the markets to fear that this spat might cause the government to crumble and derail the structural reform policies. Consequently, capital flight quickly drained the central bank’s reserves, which lead to an eventual peak in short term interest rates of approximately 1,200% and the stock market to lose more than 20% of its value in the first few days following Ecevit’s tantrum. With no choice but to preserve its dwindling reserves, the central bank eventually removed the lira’s crawling peg, which thus far has led to more than a 30% decline in the currency.

The crisis caused the December 2000 new stand-by IMF arrangement ($7.5bn) to collapse and forced Ankara to seek immediate solutions to the crisis. The new IMF loan had been primarily designed to help support the anti-inflation program and the country cope with the devastating economic consequences of the 1999 earthquake. Following a few unsuccessful attempts to stabilize market conditions, the government summoned home Kemal Dervis from his 23-year stint at the World Bank to take control as the new economy minister. A former academic and advisor to Ecevit while he served as prime minister in the 1970s, Dervis soon assessed the situation and returned to Washington for meetings with the IMF, World Bank, and members of the new Bush administration. He estimates that at least $12 billion in new credits will be needed to help bolster the banking system and to allow for real privatization efforts to begin. Before returning to Ankara, he also met with the Paris Club and the major German banks to garner support for his new program. However, while the EU gave needed encouragement to Turkey’s new structural reform plan, member states presented a challenging list of numerous economic and social conditions that would have to be improved dramatically prior to the commencement of serious membership discussions.

When the crisis erupted, Turkey was in the fourteenth month of an IMF-sponsored anti-inflation and privatization program. While significant progress had been made on the inflation front (a decline to around 30%), the government’s privatization efforts remain chronically disappointing. At the end of March, Dervis revealed a comprehensive plan that calls for tough economic stabilization measures, including the directive for the parliament to pass 15 emergency laws within 15 days (by April 15th). Given parliament’s usual lethargic approach, his radical intentions immediately led PM Ecevit to plead that such a task would be next to impossible. (We would agree.) These laws focus on the following areas: a supplementary budget; banking laws; closure of remaining investment funds; arrangements within the Repossession and Bankruptcy Law to facilitate dissolving banks; a new central bank law; the sale of 51% of Turk Telekom’s shares; the tobacco industry; the sugar industry; state tenders; a nationalization law; debt obligations; civil aviation; oil and natural gas; abrogating the decrees and laws on duty losses; and a law for the provision of tax deductibility of loan provisions. Of the fifteen proposed laws, reportedly only two, those concerning sugar factories and civil aviation, are currently on parliament’s agenda. It has been reported that virtually all of the remainder has yet to be drafted. Further adding to the legislative burden, Ecevit recently presented to parliament a national reform program comprising 200 new regulations and amendments to be debated over the next 5 years.

Over this past weekend, Dervis also announced that his plan calls for a total of $3 bn in government spending cuts, representing savings of 1.5% of GNP. Nevertheless, as a result of the crisis, he estimates GDP will decline 2% in 2001. The markets were also expecting the government’s approval of long-over due measures to restructure the ailing banks, which are at the heart of the financial crisis. A proposed new law would create enforceable limits on the banks’ ability to lend funds to other businesses controlled by their owners. The local press has estimated that this ‘connected lending’ was at least ten times greater than other loans by most of the 13 failed banks under the government’s administration. Further, it was reported that the government would soon announce the creation of a special council to be charged with the downsizing of three-state owned institutions that have estimated accumulated losses of at least $20 billion. Additionally, at a tentatively scheduled late April IMF board meeting, Dervis hopes to present a recapitalization plan for the weaker private sector banks. Reports have also surfaced about the Deposit Insurance Fund’s mid-April deadline for the conclusion of negotiations to privatize Demirbank, the largest bank under the administrators’ plan. Potential bidders reportedly include a consortium led by Aydin Dogan (owner of the largest Turkish media group), HSBC, and UniCredito of Italy. The Fund assumed the bank’s operations last December.

Key to the overall success of Dervis’ restructuring program would be the eventual successful privatization of several state-owned companies. However, following with the realization late last week that no real bidders responded to the government’s latest attempt to sell THY, the state-owned airline, the successful passage of the legislation mentioned above concerning the majority sale of Turk Telecom creates heightened urgency.

So, where do things go from here?

Given the fluidity of the present situation, we believe any new heightened cause for concerns undoubtedly would again jolt the markets. Based on a reported estimate of only approximately $20 bn in reserves, without regular market debt rollovers, the central bank does not have much to meet the financial system’s expected demands. Since the Ecevit government is on heightened alert, parliament could surprise us with more effective debates on certain draft law topics. However, we do not foresee the passage of many of the fifteen key laws for several months. Yet, that may not cause a total setback to a new IMF-led plan. If Dervis and company can convince key international decision-makers that for once parliament is moving in the right direction on several of those laws, a conditional funding agreement could be struck.

Economy Minister Dervis is scheduled to return soon to Washington for follow-up meetings with the IMF, World Bank and the U.S. Treasury. However, in light of the Bush administration’s troubling restrained international posture, its response has been supportive, but hardly enthusiastic toward Dervis’s efforts. Yet again, Turkey is revealed as the forgotten strategic NATO ally who has helped keep watch of Iraq’s activities. Additionally, there is reportedly still no agreement between Ankara and the IMF team on which mechanism will be used to ensure that the treasury can get through its peak debt redemption period between May and August without offering the market unsustainable high yields in return for its debt rollovers. Such a challenge suggests that Dervis’ cost cutting measures may still be optimistic. Yet, with the high tourist season approaching, more liquidity may find its way into the system and in turn give much needed support for the lira.

On the political front, the economic crisis has once again brought attention to the republic’s flawed political system. Last week, the Turkish National Security Council reportedly dismissed suggestions for the need of an ‘interim regime’ to run the country. The fact that the council made this public assertion could be viewed as a sign of serious back room political tensions. The local media has recently reported that leaders of Ecevit’s three party coalition government has played down Dervis' calls for urgent action to restore market confidence and economic stability. Moreover, we would argue that the council’s message underlines the military's reluctance to intervene (directly) in the political process, particularly given the republic’s modern history of three coup d’etat experiences that have noticeably delayed the maturing of its democracy. We can only surmise that the military’s influence on the council helped to reach an agreement between parliament and the Sezer government to work toward restoring economic and political stability.

After numerous failures to deliver and effectively implement a decisive structural reform plan, the international community is yet again waiting to see whether the Ecevit government can implement the necessary tough decisions. The spat between Sezer and Ecevit sparked the current crisis. However, it revealed Turkey’s chronic problem: a nation mired in the lethargy of a fragile financial system dominated by state-owned banks, which operate within an overburdened and bloated economy. A radical clean up of the system is sorely needed. Strong evidence suggests for many years the state banks have destabilized the system where in many cases their excess funds have been used for short-term populist means. Reform of the ‘democratic’ political party system and its bloated bureaucracy is also urgently needed.

Will Dervis be convincing enough to garner the strong financial commitments necessary to get Turkey through its latest crisis? Will Ecevit be able to push necessary reform measures through parliament within a reasonable time frame? Will privatizations go as planned? If not, how quickly and radically will the markets react the next time around?

Stay tuned!



Malaysia -- On Edge

By Scott B. MacDonald

Malaysia is on edge.  Although the Southeast Asian nation is not threatened by ethnic and factional upheaval nor is it likely to witness the outburst of people power seen in the Philippines, which ousted the corrupt President Estrada from power, it is in the process of change.  The days of Prime Minister Mohamad Mahathir are numbered.  This is not because any opponent has the ability to oust him from office, but because he is increasingly likely to engineer a gradual exit from day-to-day administration, while remaining as a powerful Senior Minister.  At the same time, public discontent with Mahathir and divisions within the largest and political dominant Malay or Bumiputra community are increasing hurting the ruling United Malays National Organization (UMNO) and its multi-ethnic coalition, the Barisan Nasional (United Front).  The political drama comes with the backdrop of a slowing economy.  The slowdown of the U.S. economy, to which Malaysia exports 23% of all its exports (mainly electronics), is hurting.

In March 2001, Malaysia witnessed ethnic tensions between the majority Malays (Bumiputras who make up 58% of the population) and the Indians, the smallest minority group, which left a number of dead.  While the immediate concern was that Malaysia was heading in the direction of the 1967 racial rioting (between Bumiputras and Chinese Malaysians), there was no major social upheaval and the authorities moved to regain control.  However, the March ethnic tensions reflect that Malaysian society remains on edge.  Since the 1997-98 Asian financial crisis and the falling out between Prime Minister Mahathir and his Deputy Prime Minister and Finance Minister Anwar in 1998, Malaysian society has become a more competitive political cockpit.  Although Mahathir remains the dominant political power in the country and Anwar sits in prison, the opposition has become emboldened and more aggressive.  In the last elections, the Islamic-oriented PAS (Islamic Party of Malaysia) has made gains at the expense of the ruling UMNO coalition, largely due to the Prime Minister's growing unpopularity.

There are other issues at work in Malaysia as well.  The economy is beginning to slow, the stock market is slumping, and concerns are rising about the slow pace of corporate restructuring.  There is also rising public discontent with insider deals done by the government to bail out the well-connected companies, such as the one owned by the Prime Minister's son.

For all the societal edginess, it is doubtful that Prime Minister Mahathir will be forced out of power.  He continues to have the support of the hierarchy of the ruling UMNO party and others with the Barisan Nasional (National Front) coalition.  We suspect that he will engineer a gradual shift out of office, much like Prime Minister Lee Kwan Yew did in Singapore.  This would mean that the day-to-day administration would fall to a selected successor who would become Prime Minister.  Mahathir would become Senior Minister, remaining the power behind the throne, but with the intention to quietly reduce his involvement over time.  This would also allow him to protect his business cronies and others who have been loyal supporters through the years.

What this means for investors looking at Malaysia is to expect a certain degree of societal tension as the economy slows in 2001.  Real GDP was 8.5% in 2000.  The World Bank downgraded its economic forecasts for Asia in March, taking Malaysia's initial 6% real GDP forecast down to 5%.  Prime Minister Mahathir recently announced a number of stimulus measures for the economy.  Interestingly, he also loosened the regulations on foreign equity ownership and announced that it would be easier for foreigners to purchase property and other assets.  Moreover, the Prime Minister is eager to find foreign companies to set up shop in Malaysia's new IT park, which is still mostly empty.  It would appear that past anger against evil Western imperialists and theatrics over globalization has left many a foreign investor cautious about picking Malaysia.  All of this adds up to new pressures on the Prime Minister and his ability to dominate the political landscape. The note of unease about Malaysia was confirmed on April 5th, when Standard & Poor's changed the outlook on its sovereign ratings from positive to stable due to concerns about shrinking foreign exchange reserves and growing "political uncertainty" as Prime Minister Mahathir’s control is eroded.



Argentina: Back From The Brink?

By Jonathan Lemco

For the past six months, the Argentina credit has provoked the most concern to emerging market fixed income investors. In large part, this is due to the fact that its outstanding debt issues comprise about 25% of the entire JP Morgan Emerging Market Index. Argentina headline news, which has been mostly bad, immediately moves markets. The fundamental problems of Argentina, including too much outstanding foreign debt ($124 billion), slowing economic growth, weak domestic confidence in the economy, etc. remains in place. However, the appointment of Minister of the Economy Domingo Cavallo has spurred a modest rally in Argentina bond spreads. We would stress "modest", because at this writing spreads are still in the 900 basis points over Treasuries range.

Cavallo is widely and accurately regarded as a deficit hawk. He was also the lead player in curtailing the hyperinflation that ravaged the Argentinean economy some years ago. Cavallo has long been regarded as a political challenger to President de la Rua, so we regard it as a sign of the government’s desperation with the sad state of the economy that Cavallo was brought on board. His mandate is broad, for the congress has granted Cavallo emergency powers enabling him to revamp ministries, change tax codes and simplify regulations.

Thus far, Mr. Cavallo has embarked on a whirlwind tour of various foreign financial capitals to reassure investors that Argentina will meet all of it debt obligations and abide by all IMF agreements. He has also been visiting leading corporate investors, for Argentina desperately needs new manufacturing plants and related "hard" investments. For now, the Economy Minister also insists that the currency peg will remain and that the peso will not be devalued. We have concerns about this, because we think that that in the long run, the convertibility regime is holding back economic recovery. But for now, the government’s priorities seem to be reassuring international and domestic investors that Argentina is committed to fiscal prudence. To this end, cutting public sector salaries and possibly jobs will rein in public expenditures. We think that improving domestic consumer confidence is also very important.

Cavallo has also announced that the government could withdraw payments of public-sector deposits at Banco Nacion to meet its debt payments if interest rates remain too high in the domestic markets. The government may also issue an uncollateralized domestic bond or a syndicated loan of $2-3 billion.

We think that the next step will be to renegotiate the external debt load such that short-term debt is rolled over or replaced with longer-term loans. But this is a short-term panacea. Argentina will still have too much debt, and the only way out of this morass will be to encourage far more foreign investment to help the economy grow. The best way to do this would be to abandon the peg in favor of a crawling one. But this would have to be handled very sensitively. International investors would have to be convinced that their interests would not be endangered. Presumably, the IMF and the US Treasury would also have to be supportive. At the moment, we have no idea how the Bush administration would respond.



Emerging Market Briefs

By Scott B. MacDonald

Chile - The Economy Cools: Despite growing concerns about Argentina and its possible impact on the rest of Emerging Markets, Chile continues to look relatively strong.  Fiscal management remains solid, inflation is low (at 3.8% in February), foreign investment continues to be strong, the political system is weathering the issue of what to do with aging former dictator Augusto Pinochet, and negotiations have resumed with the United States over joining NAFTA.  However, the slowing pace of growth in the United States is hurting Chilean exports, international copper prices (still accounting for around 38% of all exports) are trending downward, and consumer spending is falling.  Recent data demonstrates that the Chilean economy is indeed cooling.  Real GDP growth for 2000 was 5.4%, down from some optimistic forecasts of 6%.  Moreover, the 4th quarter was the slowest of the year, with real GDP coming in at 4.5%.  Real GDP for January 2001 was even slower -- 3.6%.  This trend is expected to continue.  Retail sales fell 1.7% in February from the same period last year and are expected to show another decline in March.

Is Chile heading into another recession?  We think that it is too early to call, but that 2001 will see real GDP growth in the range of 3.5-4.0%.  The central bank has already cut interest rates three times this year and will probably move again. Moreover, Chile's banks are in good shape and non-performing loans are under control. Yet, conditions in Chile are largely determined by external factors -- the U.S. economy, commodity prices especially for copper, and what happens in Argentina.  While we do not see these factors causing a hard landing, they will leave Chile as well as other major Latin American economies vulnerable and in a slow growth mode.  Chile is likely to adjust to the new circumstances.  We have our doubts about some of the other countries in the region.

Estonia - Steady Progress, but Tough Challenges Ahead: Estonia has clearly emerged as one of the most economically developed of the former Soviet bloc countries.  It has one of the region's highest per capita incomes, is actively engaged in international trade and is open to foreign direct investment, much of it from neighboring Finland and Sweden.  Estonia has also done a reasonably good job in following prudent fiscal policies, closing its fiscal deficit for 2000 at around 1.3% of GDP.  All of this is reflected in the country's strong Baa1/BBB+ ratings, which standout when compared to Russia, Ukraine, and most of the Balkan states including Bulgaria, Romania and Turkey.  While Estonia has made considerable advances since the end of the Soviet Union in 1992, it has some tough challenges ahead.  Unemployment, around 13.7% in 2000, is high and needs to be reduced.  There is some disagreement about going ahead with railway privatization and Prime Minister Mart Laar is under pressure from the largest opposition party, the Center Party, to resign.  Although Prime Minister Laar should be able to maintain his government, this indicates that there are some clouds on Estonia's horizon, which could complicate its movement toward membership in the European Union. Along these lines, both the government and the opposition have agreed to hold a referendum vote on joining the EU, a vote that would likely be held in the middle of 2003.  The latest polls indicate that Estonians are now evenly split on the issue of membership.

India - Will Reforms Continue?: India has been hard hit by the almost comical revelations of corruption at the Ministry of Defense. Longstanding Defense Minister George Fernandes and others within the ruling Bharatiya Janata party (BJP) have been forced to resign.  The opposition Congress Party is clamoring for the government to resign and that new elections be held.  All of this turmoil is causing many to question whether the reforms recently outlined by Finance Minister Yashwant Sinha will go ahead or become the victim of a political frolic.  However, it is not likely that the reform process, such as it is, is going to fade away.  L.K. Advani, the Home Affairs Minister, stated late March that "the government is keen to ensure the reform process moves ahead quickly."  India has little choice on the political front but to advance with reforms.  The country has substantial economic problems -- a large and unsustainable budget deficit that exceeds 10% of GDP, energy shortages, and a rising population in need of basic social services and employment.  Consequently, the government cannot afford to backslide too much on the reform process.  Although the pace will most likely generate only tepid excitement among foreign investors, we would expect some progress on restarting the stalled privatization program, easing India's rigid hire and fire laws; and improvements to the system of power and food subsidies, which have kept India's fiscal deficit large.

We would also add that the defense ministry scandal has also revealed the power of the world.  Although the global high tech sector is undergoing a difficult period, it is not going away.  More importantly, India's sector is penetrating it's old boy political system and making what was for decades an opaque operation painfully clear to the public.  This is an important step forward for the creation of more efficient and transparent government, something that cannot but help the development of the economy and reinforce the reform process.

Latin American Mobile Phone Users Up: According to a study from the Yankee Group, Latin America is expected to have 162 million mobile phone users by 2007.  This projection is based on the assumption that there will be annual growth of 17.9% between 2000 and 2006.  Latin America's mobile markets attained a regional average growth rate of 58.6% during 2000, while mobile penetration rose from a regional average of 10% by year end-1999 to 15.6% by year end-2000.  The attractiveness of this market is reflected by the persistent and heavy involvement of Spain's Telefonica Europa and Telecom Italia.


Book Reviews

Roger Lownstein, When Genius Failed: The Rise And Fall of Long-Term Capital Management (New York: Random House, 2000) 264 Pages, $26.95.

By Darin Feldman

Roger Lowenstein, a former reporter for the Wall Street Journal and a current columnist for Smart Money magazine, puts the realities of the market versus investment logic under a microscope in his newest book, When Genius Failed.  An unauthorized account of the 1990's most spectacular collapse of a financial institution, When Genius Failed gives readers a deep understanding of how Wall Street almost came to a grinding halt in 1998.  Long Term Capital Management (LTCM), an obscure hedge fund in Greenwich Connecticut, had Wall Street's most prestigious investment banks scurrying for cover when word leaked out that this unknown institution, boasting a balance sheet of $100 billion in assets, was on the brink of financial ruin.

When Genius Failed gives great insight into the temperament of Wall Street when a crisis occurs.  The book is easy to read, educational and for the most part, provides a balanced view of how a small unknown hedge fund gained notoriety.  While the book is a particularly valuable resource for anyone active in the capital markets, it will also serve others well who are in the business of managing risk; which is just about everyone.

Lowenstein combines descriptive detail of the individual personalities that ran the infamous hedge fund, the euphoria of Wall Street and how LTCM became the envy of the investment community.  Interwoven throughout the book are well-explained examples of popular LTCM trades, which on the surface, appear very simple, but have little margin for error when borrowed money is involved.

Evident from the interviews conducted by Lowenstein with investment banks and employees of LTCM, the partners of LTCM never worried about making a wrong decision as in their opinion -- they weren't taking any risk.  They were simply exploiting "irrational" behavior.   But Lowenstein's succinctly points out the flaw of this logic with the following statement: "While a losing trade may well turn around eventually, assuming, of course, that it was properly conceived to begin with, the turn could arrive too late to do the trader any good-meaning, of course, that he might go broke in the interim."  The rest of the book feeds off of this theme, giving readers an appreciation for the arrogance of a group of academics that ignored the human element of investing.

The real appeal of the book however, is Lowenstein's characterization of the Wall Street community before the crisis ignited. Lowenstein aptly shows how top tier investment banks were as reckless as LTCM in protecting the stability of the financial community.  The essence of the problem went beyond the banks' greed for business, which LTCM clearly had to give.  Senior management of the most esteemed banks on the street bought into the story of LTCM and the academic credentials they haughtily touted.  Unwilling and afraid to challenge LTCM on the basis that it would lose business, investment banks continued to let LTCM's assumption of risk remain uncurbed.  While the outcome of the saga may not come as a surprise to many, the activity behind the scene between some of Wall Street's most prominent figures will be entertaining to some and alarming to others.


David F. De Rosa, In Defense of Free Capital Markets: The Case Against a New International Financial Architecture (Princeton: Bloomberg Press, 2001). $27.95 230 pages.

By Scott B. MacDonald

David De Rosa, an adjunct professor of finance and Fellow of the Center for International Finance at Yale University, can hardly be called shy in his views.  His new book, In Defense of Free Capital Markets, is strongly opinionated, well-reasoned and worth reading for anyone interested in international finance and economics.  He clearly argues that the clamor for broad-ranging reform of the international financial system, especially more regulation, is not the right response to the financial crises of the 1990s.  The root issue is what causes financial crises in the first place.  According to De Rosa: "One lesson rings loud and clear, that a country's choice of a foreign exchange regime is one the most important decisions that it makes.  For example, fixed foreign exchange rate systems, but not floating systems, are in fact the breeding grounds for great financial crises." De Rosa supports his views by carefully examining the financial crises in Southeast Asia, Mexico, Russia and Brazil.  He also touches upon Japan as an example of bad monetary policy.

De Rosa offers a refreshing common sense view of international finance at a time when it appears simpler to propose new international bureaucracies and regulations to "manage" the market. He correctly notes that there is a tendency to forget that our current state of economic development is in large part a result of international capital flows, which have allowed surplus capital in the more developed countries flow to the lesser developed countries in order to help push economic development along.  Bad domestic policies have usually led to crisis, not the flow of capital. Timely, provocative and interesting, DeRosa's In Defense of Free Capital Markets is a must reading for anyone involved in the international economy.

Elaine Sciolino, Persian Mirrors: The Elusive Face of Iran (New York: The Free Press, 2000). 402 pages. $26.00.

Geneive Abdo, No God But God: Egypt and the Triumph of Islam (New York: Oxford University Press, 2000). 223 pages. $25.00.

By Robert Windorf

Islam, the world’s fastest growing religion, in general, continues to be misunderstood by the West. Despite the many societal approaches to its practice, as the developing phenomenon of globalization continues to reveal, Islam is arguably not some monolithic structure, as perceived by many westerners. Two recent books written by veteran journalists, Elaine Sciolino and Geneive Abdo, support that viewpoint with examinations of Islam’s different influences within the Middle East’s two largest and among its most influential countries, Iran and Egypt.

Throughout her excellent book, Ms. Sciolino, a senior correspondent for The New York Times who has covered Iran for more than twenty years, reveals a fascinating and insightful portrait of a frequently misunderstood country. Her colorful narrative presents a contradictory and frustrated society where improvisation is key to living on, and the understanding of, the shifting socio-political landscape. Iran, the world’s only modern theocracy, prevails as an Islamic republic based on the strict tenets of Shi’ism more than twenty years after the Khomeini-led revolution, despite the many predictions of its earlier demise. Supported by her years of encounters and interviews with a broad spectrum of Iranian clerics, politicians, and citizens, Ms. Sciolino proposes that most Iranians (many with connections to the U.S.) love their country and see no reason to emigrate, in spite of the government’s strict and oftentimes repressive actions. Contrary to such restrictions, her intimate analyses reveal a developing civil society bolstered by a vibrant economy and democracy, in which women partake in nearly all the roles of a modern culture. However, in public, women must be covered from head to toe, lest otherwise they suffer the penalties of the morals squads. Yet, in private, as Ms. Sciolino reveals in numerous examples, women courageously stretch the limits of the theocracy’s tolerance.

Ms. Sciolino sees the soul of a nation under attack on numerous battlefields. The primary struggle is increasingly between the cleric-inspired conservatives versus the liberal-minded reformers. With the shutdown of the reformist press last year, many have told her they believe that the theocracy is now in some respects as repressive as the Shah’s. Although a reformist parliament was elected in 2000, it endures a daily struggle with the judiciary, which Ms. Sciolino sees as a brewing political crisis. (At this writing, President Khatami has yet to announce if he will seek reelection in the upcoming elections.) She believes the most dangerous battlefield is the mosque; since within Shi’ism, it is very common for levels of authority to come under debate and the younger clerics are now continuing this tradition. As seen on the state-controlled television networks, Supreme Leader Khameini arguably wields more power than Khatami. However, despite the theocracy’s public restrictions, television has increasingly become its laboratory for exposing social problems, as the daily soap operas present all the typical socials challenges, e.g., divorce, broken families, jealously, etc., as seen on those broadcast in the west. Another battlefield is the street, which Ms. Sciolino claims is becoming more dangerous for the regime. While the zealousness seen in the early years of Khomeini’s regime, she argues, has faded, there are still occasional fights on the streets as to what is acceptable for women to wear in public. The student demonstrations in the summer of 1999 in 24 cities were led by anti-Khameini chants. Iran’s increasingly sophisticated population, is now composed 65% by people under the age of 25 years (the result of Khomeini’s edict to have larger families) These youths have no memory of Khomeini or even the Iraqi conflict.

As Ms. Sciolino sufficiently documents, Iran will continue to pose an interesting challenge for the West and its regional neighbors. With the upcoming presidential election on the horizon, the political structure increasingly and ironically viewed as an exporter of democratic ideals across the region, closer ties recently established with a friendlier Russia, and the Bush administration’s ambiguous stance toward Saddam Hussein and potential cooperation agreements (as initiated by the Clinton administration), Iran should appear more often than not on the radar screen over the next few months.

Recently expelled from Iran, along with her BBC reporter husband, for exhausting the regime’s tolerance, Geneive Abdo, a veteran reporter for The Guardian, presents a timely and well-documented account of the Egyptian Islamic revival at the grassroots level. Like many other Middle Eastern states, Egypt is caught in the struggle of existing between a secularist, western-inspired world and another deeply rooted in religious traditions. Throughout her work, Ms. Abdo presents a very good historical analysis of Islam’s fixture throughout Egypt’s proud history. Especially noteworthy is her historical focus on the state’s relationship with the Ikwan al-Islamiya (Islamic Brotherhood), the forerunner of many of today’s numerous Islamic organizations.

From Ms. Abdo’s many encounters and interviews in both urban and rural settings, the reader learns that a large and growing number of faithful Egyptian Muslims do not seek a violent revolution to topple the Mubarak regime, unlike the militants who carried-out Sadat’s assassination. (Yet, public and clandestine disciples of such militants continue to haunt the regime.) Instead, contrary to numerous media reports, we learn that that societal representation believes their Islamic ‘peaceful’ values are indeed compatible with the regime’s secularism. The pious grassroots model, Ms. Abdo unveils, however, does suggest a somewhat increasing popular desire for transforming many of the state’s secularist ideals toward a more Islamic-minded society which has begun to inspire other Muslim nations.

Like for Ms. Sciolino, the advantage of being a woman allowed Ms. Abdo to meet with many women from all walks of life to understand their ‘turn toward the veil’ or continuation of western-style dress, sometimes with or without the approval of their husbands or mothers. Many of these women reveal an amazing about face from their secular upbringings. One striking comment from one of these women is, "When I put on the veil, I put my brain on." Additionally, Ms. Abdo’s meetings and attempts to arrange them with many cleric ‘media stars’(several of whom have ‘converted’ many upper class women) reveal amazing portraits of their phenomenal popularity. Many of these clerics operate outside the influence of the al-Azahr and arguably have a far greater societal impact. Such attention presents several daily challenges for the regime.

Also noteworthy in her book is the detailed presentation of the years of struggles between the successive regimes and the unions of Muslim professionals (lawyers, doctors, engineers, etc.). The Muslim doctors and engineers unions were especially helpful in the aftermath of the recent earthquake and became a major embarrassment for Mubarak’s regime with their very timely and efficient response to help many desperately needy communities. A brutal campaign against these unions resulted and they were ‘officially’ shuttered under an obscure state regulation.

For the foreseeable future, Egypt will continue to seek the many forms of support granted by the West. It is arguable that such support is conditioned upon the Mubarak regime’s ability to balance the nation’s societal pressures. While threats from Islamic terrorist groups recently appear to have quelled, one should not underestimate the regime’s readiness to re-launch a decisive strike. Additionally, observers should take note that while the regime must endure the daily domestic socio-economic balance, it remains the centerpiece for the Arab world. Thus, in light of the scope of present regional pressures, the old adage, "No war or peace without Egypt," arguably continues to ring true today.


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