KWR International Advisor #9 June/July 2001


June/July 2001 Volume 3 Edition 3




In this issue:


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

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

Associate Editors: Robert Windorf, Darin Feldman

Publisher: Keith W. Rabin, President

Web Design: Michael Feldman, Sr. Consultant

Contributing Writers to this Edition: Keith W. Rabin, Scott B. MacDonald, Jonathan Lemco, Wilbur L. Ross Jr., Uwe Bott, Robert Windorf, Jonathan Hopfner and Roger P. Nye

Advertisers in this Edition: The Asian Wall Street Journal Weekly, J@pan Inc., Global Venture Network, Asia Today, and Global Credit Solutions, Ltd.

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 US Economy: Where Do We Go From Here?

By Scott B. MacDonald

It is mid-year 2001. Most of us are still trying to figure out where the U.S. economy is heading. Considering the many different signals coming from a sea of conflicting data, it is hard to decide if one should stock up on guns and food or go buy really cheap tech stocks in anticipation of a recovery. For the next few months we think its best to avoid the stock market, stay away from tech and look to selectively strong companies that provide essential services and goods. There are still a lot of bears out there. And the economy is not going to make a rapid recovery any time soon. In fact, it could get worse before it gets better.

One possible scenario envisions the US economy slipping into a major recession - which will carry into 2002. This recession will be marked by a major banking crisis, high unemployment (over 6%), and a major upswing in the numbers of bankruptcies. The roots for this development are the IT bubble in the 1990s: banks and finance companies lent imprudently during the boom, manufacturers borrowed heavily to finance acquisitions and build up inventories, and many tech companies provided liberal financing to their buyers. Now all are set to suffer the consequences. After all, the sector is in complete disarray, manufacturers are in full retreat and still dealing with too large inventories, and everyone is actively firing people. The final straws holding up the U.S. economy are the consumer and housing. Once these two falter, the entire house of cards that is the U.S. economy will come tumbling down. The winter of discontent will become a spring and summer of discontent. Considering international trade channels the U.S. slowdown has already hit Asia and Latin American and is beginning to show up in Europe. Better now to stock up on food and ammo and head for some location far from the mainstream and hide.

Another scenario is that of the cheery optimist based on rapidly-departing hopes for a V-shaped recovery. They have contended that the bubble has burst, the bottom was hit or is being hit in the first half of 2001, and that the recovery is going to start in the second quarter. The impetus for this rebound comes from the tax cut, lower interest rates and the ongoing propensity of the consumer to spend. Banks are well positioned to ride through the rest of the down cycle. Maybe we should go buy that boat now.

We believe that reality sits somewhere between these views. The amazingly cheery optimism of the boom years has given way to the gloom and doom of the bust years. Animal spirits provide vast market mood swings, which has lead to substantial volatility in equity markets, driving money into the bond markets. Frazzled is a good way to describe equity markets in the U.S. now and most likely through the end of the year, until clearer direction on the economy, in particular, a recovery is evident.

The rest of the year is not going to be good for the tech sector as well as the more traditional manufacturing sector. The sector, in particular, is still shell-shocked and only gradually finding a degree of equilibrium. According to the latest figures from Webmergers, a research group, 54 internet companies shut down in May 2001 alone. In May last year, when things began to go sour in the internet world, there were 13 closures. Webmerger data also reveals that at least 493 IT companies have folded since January last year. More that half of the failed companies to date have come in the first five months of the year. We expect that there will be shakeout in the tech sector as the ripple effect consumes IT consulting firms and Internet Service Providers.

The pain in the tech sector is not limited to the small dot.coms. Large companies are also caught in the crosshairs of negative economic trends and investor depression. Nortel's $19 billion writedown, Lucent's struggle to sell off its fiber optics company, and stave off another liquidity scare, and concerns over accounting with Qwest Communications all reflect that tough times have come and are not likely to go away any time soon.

Yet for all the corporate carnage, the IT sector is not dead. More importantly, the data from Webmergers indicates that the IT sector is undergoing a massive consolidation. There is a considerable rise in mergers and acquisitions activity, with buyers spending just over $3 billion during May to buy 110 IT companies. This compares with $2.6 billion for 115 IT companies the previous months.

Looking ahead we expect to see the recession/not-a-recession debate continue. The latest round came in late June when the National Bureau of Economic Research stated that the "data normally considered by the committee indicate the possibility that a [U.S.] recession began recently." It did, however, stop short of declaring an outright recession: "The economy has not declined nearly enough to merit a meeting of the [recession-dating] committee or the determination of a peak date." This, in turn, made U.S. Treasury Secretary Paul O'Neill reiterate his view that the U.S. had dodged a recession due to tax cuts and lower interest rates both of which will be felt soon.

No matter how the new flow of data is spun, the bottom line is that the U.S. economy has cooled and that it can cool further. Inventories and production capacity remain high. Yet, interest rates could go lower (though not a lot) as we move forward. Consumer spending and housing are also holding stronger than anticipated while unemployment hardly reflects recessionary numbers. At the end of the day, all eyes will be on the U.S. consumer, watching and waiting for him to buckle under the pressures of too much debt, creeping unemployment, and nagging doubts about corporate America's ability to make a rapid march back to the safe harbor of growth and fiscal prudence.

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.

We do not see a technical recession of back-to-back quarters of negative growth. We admit that the 2nd quarter could be in negative territory, but not the 3rd quarter. The U.S. economy will skate by -only just. It is now in the trough of the slowdown. The first quarter GDP growth was 1.3%. It is likely that the 2nd quarter is going to be slower, with only a marginal improvement in the 3rd quarter. The 4th quarter is not likely to be a barnburner, but it should reflect a weak, yet growing momentum that will become more evident in 2002. We are downgrading our real GDP forecast from 1.7% for 2001 to 1.3%. In 2002 we look to 2.0-2.5% growth. All the same, we don't rule out the possibility that the economy can slip into negative territory for at least one quarter, maybe two (which would be a recession).


Unique Opportunities in Japan for Investors in Distressed Assets

By Wilbur L. Ross, Jr., Chairman & CEO, WL Ross & Co.

(Please click here for PDF file (140k) containing supporting exhibits to this article)

Japan is the second largest but most troubled economy in the world. Bankruptcies there totaled more than $200 billion of liabilities as of March 31, 2001 (Exhibit 1). The sheer size of the market is the major reason why investment in distressed securities there is timely.

A second reason is that a dollar-based investor can hedge the currency risk in a very favorable way. Because Japanese interest rates are so much lower than those in the US, the forward Yen exchange rate is typically fewer Yen to the dollar than the spot rate. Therefore if you can approximate the duration of your proposed investment, you can be easily protected against currency translation risk and simultaneously earn a return of 3% or so per annum.

The third reason is that there is a good chance that the free fall has ended and that the severe deflation of asset classes over the last decade may begin to reverse into appreciation over the next few years.

Let us start by looking at some basic economic facts. Japan continues to have favorable trade balances with each of its three major trading partners: Europe, the US and the rest of Asia (Exhibit 2). This is an important driver for the economy, especially because it is concentrated in high value added products. In contrast, Japan's imports tend to be the commodities it lacks in its own natural resources, especially hydrocarbons and metals.

Most governments issue their bonds both domestically and internationally, but because interest rates in Japan are so close to zero, virtually all of the Federal debt is both Yen denominated and locally owned. This is important because the deficit spending of recent years has resulted in rapid growth in Federal indebtedness (Exhibit 3). The Japanese central government borrowed about $40 million per hour, 24 hours per day, seven days per week for the most recent fifty-two weeks, and is forecast to have total obligations equal to 130% of Gross Domestic Product by the end of the present Fiscal Year. If they had to pay Western rates of interest the cost would be almost $100 billion per year higher than it is. This savings, 2+% of Gross Domestic Product, makes Japan's debt burden relatively affordable and its domestic ownership makes it safe from the whims of global money managers.

In view of the scale of bankruptcies noted earlier, it may surprise you to learn that Japanese businesses (Exhibit 4) actually have been de-leveraging their balance sheets and adding to their liquidity for some years.

Management attitudes toward capital also are changing. Historically, Japanese managers, like those elsewhere in Asia, were extremely top line growth oriented, but, given high financial leverage at low interest rates, did not focus much on return on assets (Exhibit 5). As a result, Japanese industry has had chronic over capacity and the resultant low operating rates have caused fixed costs to be amortized over relatively small unit volume. As uneconomic plants close, operating rates will go up thereby lowering unit costs.

The change in management practices is being accelerated by the early effects of growing Foreign Direct Investment. For the Fiscal Year of 2000, which ended on March 31, 2001 Foreign Direct Investment Surged to about US$25 billion, almost five times the level of 1997 (Exhibit 6). While this growth is impressive FDI in Japan is still much lower percentage of GDP than in Korea, a much smaller country.

FDI has been stimulated by the size of the Japanese markets and by their cheapness. Even at today's values, Japan's securities markets are the second largest in the world. Yet, the total value of Japanese equities is only 102% of Gross Domestic Product as compared with 167% in the U.S. The Nikkei average was recently as low as 11,819 (3/13/01) versus its peak of 38,915 on (12/29/89). Several hundred Japanese companies' stocks are trading for prices that are less than their net working capital per share. It is not just stocks that have declined (Exhibit 7). As you can see, real estate has had an even sharper decline and is now below the 1983 levels. But the most precipitous fall has been in golf course membership prices. They have dropped by 90% from their highs.

In contrast to the strengthening of corporate balance sheets, the destruction of household balance sheets by the severe asset value deflation of the last 10 years is only now beginning to be repaired (Exhibit 8). Such an erosion has no parallel in the U.S. since the Great Depression. Imagine how conservative your spending plans would be if your assets had diminished over the last decade.

In my view the two biggest keys to Japanese consumer spending are first protecting their income so that they have the where-with-all to spend and second, convincing them that they are safe and that the economy will get better. I have believed for some time that the average Japanese citizen was far more ready to accept the consequences of reform than the political leadership was. The Koizumi phenomenon proved that this was true. His plans to finance the accelerated write off of weak bank loans and simultaneously to extend both the duration and amount of unemployment benefits deals effectively with these issues. His initiative to amend the Constitution to provide for direct election of the Prime Minister weakens the power of the party bosses and makes the population feel empowered. The Japanese people crave strong leadership with a vision. The environment is right for change. Koizumi is the first post bubble Prime Minister who seems to appreciate the need for dealing both with economics and with psychology. His 80+% popularity rating proves that he is right in both regards.

Yet, both investment analysts and general media commentators are constantly negative regarding Japan. One of the hallmarks of market turning points is that they are preceded by protracted periods of universally negative opinion. Deviations from expectations are what move markets and expectations for Japan are so low right now that any surprise is likely to be a favorable one. It is also true that markets tend to lead economies. This makes it probable that stocks will start to run up a year or so before the economy turns. My belief is that we are no more than two years away from an upturn in the economy and that we therefore are less than a year away from a market turn.

Even pre-Koizumi there were some signs of change. On my last trip to Japan, which ended the weekend of his election sweep, the major banks were clearly planning massive sell offs of loans in the September semester, and not just loans in actual default but also the so-called category 2 loans. Post Koizumi's election even the most hide bound bureaucrat has become a reformer, so there is no doubt that the process will accelerate.

If I am right that Koizumi is a real agent-for-change, by the time the cherry blossoms bloom next year Japanese stocks will be blooming as well and the air will be filled with talk about a turnaround in the economy.

Regardless of whether or not the equity markets change, distressed debt opportunities will be available in Japan in size for some time to come. My best estimate is that there is a trillion dollars of present and prospective non-performing loans and even at a 5 to 10% recovery rate that would mean a universe of $50 to $100 billion of which probably 25% to 35% will actually change hands .



Germany and France - Feeling the Slow Growth Blues

By Scott B. MacDonald

Slowing exports and factory orders and renewed concerns about growth and unemployment are beginning to hit continental Europe's two largest economies, Germany and France. Part of the problem is that the U.S. economic machine that gobbles up European exports has decelerated. The European Central Bank has also failed to provide the expected leadership to maintain confidence in the euro and the ability of Europe's economy to keep moving at a moderate pace. The situation has been made even murkier by the rejection of the Treaty of Nice by an Irish referendum, which has cast a shadow on the timing of the enlargement of the European Union to the East. We believe that conditions in Europe are going to get worse and that the euro will remain weak to the U.S. dollar (probably in the range of 82-85 euros to the $).

The German economy is in the process of sharply slowing. It is possible that it could experience back-to-back quarters of negative economic growth. Some analysts have downgraded their real GDP estimates down to 1%, well below the government's 2% target. Indeed, Ifo, one of the country's leading economic institutes, in late June halved its forecast for the German economy from 2.4% to 1.2%, with a forecast for 2.2% in 2002.

Two factors have hurt Germany - a slowdown in exports to the United States and a long period of high oil prices. These trends have pushed up inflation, with annual prices reaching an eight-year high of 3.6% in May. Although that trend appears to have crested, high prices have dampened consumer demand. The construction sector remains in a recession. The situation is more complicated by the pressing need for labor deregulation. Although new reforms have been discussed, advances are now running up against a political landscape conditioned by elections a little over a year away. As a center-left government, the Schroder administration must think about political survival. While tough, more market-oriented measures are required, it is doubtful the German Chancellor will move in a direction to upset his own Social Democrats or the unions. Consequently, the German economy looks set to sputter in the third quarter and only weakly rebound in the 4th, with better prospects of recovery in 2002.

The French economy is also beginning to slow. A government confidence index based on a survey of 2,000 executives fell for a seventh consecutive month, declining from 102 points to 104 in May. This means that manufacturers are likely to scale back production in upcoming months to deal with slackening consumer demand. Adding to this increasingly negative outlook, French Finance Minister Laurent Fabius lowered his outlook for GDP this year to 2.5% from 2.9%, though we expect the slowdown could take real GDP in 2001 to 1.8%.

Complicating matters further on the economic front, questions are being raised about the impact of the 35-hour workweek. As the French economy appears set to slow, policies to rectify the situation are likely to be hindered due to the mix of politics and costly labor policies. In addition, government-business relations have deteriorated over the Jospin administration's decision to subsidize the 35-hour workweek by raiding the social security system.

Pro-labor legislation since 1997 has led to considerable improvements in guaranteed workers health care, retirement packages, workers compensation and unemployment insurance. The government also recently announced a plan to extend maternity leave and allow paternity leave. In addition, the Reduction du temps de travail program (RTT), which has provided the 35-hour workweek is highly popular with workers and has provided greater labor flexibility.

The problem for the government, business and ultimately the workers is that as growth slows -- so do revenues. Growth is slowing, partially due to global conditions and partially due to the negative impact of the RTT on productivity. According to the French employers association (MEDEF), the 35 hour workweek has already resulted in a 2.5% decline in the entire economy's productive capacity. This is due to the higher costs associated with hiring that go into benefits. Hiring is now more expensive and the government is now helping a number of companies to finance these added costs. According to the Brookings Institute, the French government spent $15 billion or 110 billion francs in 2000 to keep a number of companies going. If the economy has a hard landing, which is a possibility, all of these costs will grow. Furthermore, in January 2002 the shortened workweek goes into effect for smaller companies. The government faces the unpleasant prospects of an economy in the midst of a slowdown, unemployment on the rise, and elections drawing closer.

As in Germany, the economic situation is a difficult factor to control and government actions will be calculated to minimize the impact on those who vote in their favor, the unions and workers. This has unfortunately pushed MEDEF to announce that it will formally abandon in July its joint administration of France's social security system with the unions and the government for the first time in 55 years.

Europe is not immune to the global slowdown, but it does have the option to mitigate its effect through good policies. Considering the political landscape, with major elections within 14 months in France and Germany, prospects look set to worsen. Furthermore, the European Union's decision against General Electric's takeover of Honeywell, is only adding another negative note to doing business in Europe, especially if you are a foreign company. The message to other OECD countries and Emerging Markets is simple - don't count on Europe as an alternative engine of growth, especially as domestic political considerations weigh heavily on key decision-makers.


Is Japan's high-tech economy broken? We don't think so. Derailed perhaps. But if you understand the mechanics, you can gain access to amazing opportunities for business and technology in Japan. Nobody else knows Japan like we do. Find out what's going on, direct from Tokyo, weekly and free. Four great newsletters at

Sovereign and Corporate Investor Relations in a "Post-Bubble" World

By Keith W. Rabin

In recent years, governments and corporations have come to realize the need to effectively present their economies to investors and other important external constituencies. This knowledge has not, however, necessarily translated into action. Many public and private sector decision-makers have remained confident of their ability to muddle along -- so long as the U.S. economy galloped at high speed. With the U.S. now losing steam, this approach needs to be reexamined.

Even in cases where efforts have been made, these have generally consisted of discrete activities to support a transaction or overseas visit, rather than concerted, ongoing initiatives with the necessary planning and follow-up necessary to generate sustainable results.

Corporations and governments that can match their underlying potential with focused outreach programs will find many sympathetic investors. To maintain the high returns to which they are accustomed, investors are now forced to look beyond the U.S.-based wonder-stocks that drove market performance in recent years. Foreign entities that can communicate an ability to offer an environment or business model that offers superior performance will benefit from this shift in portfolio allocation.

Whereas only a year ago, speculative excesses encouraged a "high tide lifts all boats" environment, capital today is far more discriminating. That is not to suggest it is not available. Many funds, particularly those dealing with private equity, cannot find a sufficient number of investment vehicles. One is constantly reading about the need to return capital raised in the go-go world of a year or two ago, rather than have it sit idly in cash accounts.

Today's operating paradigm requires the definition of a clear advantage. An institutional infrastructure that promotes ongoing, interactive communications is also essential. Corporations and governments need to make things investor-friendly. This is not to say that one must sacrifice control, but that one must first motivate interest. Basic risk theory teaches that a premium will be charged for the unknown. The clarity afforded by more precise communications translates into easier and faster negotiations. It also allows a higher success rate and valuation model.

For corporations this means a competitive technology or business model is not enough. Unless one is seeking to license or sell assets or partner with a company that can actualize the necessary income stream, investors need to see both the underlying potential and the management vision, expertise and capabilities needed to operate a dynamic, profitable enterprise. If this involves cross-border expansion - and most foreign investors are seeking global scalability -- a successful operation in one's domestic economy is not likely to be sufficient.

Finally, if an investor is not confident that they will be rewarded in an appropriate manner, it does not matter how viable the business or technology -- there is little motivation to get involved. Companies and governments must present a clear idea as to why they are seeking investment and what they are looking for and offering in return. A transparent corporate governance model that recognizes shareholder interests is essential. That is one of the critical lessons of the era that we have just endured.

Corporations and governments must also recognize the implications of globalization. There is no such thing as a local strategy in the Internet age. There are certainly differences between the U.S., Asia and Europe. However, technological advances now allow for rapid information dissemination - and corporate and institutional decisions - with input from all over the world.

Therefore, while road shows are generally organized in New York, London and other locations, these activities are rarely integrated into worldwide outreach efforts. This is perhaps due to the mistaken assumption that events should be restricted to local audiences. However, corporate transactions usually involve the input of many individuals. More often than not these individuals do not work in one location or even on the same continent.

KWR has been quite successful in promoting localized events to a global audience through web-based delivery mechanisms. (See KWR's Library and Pressroom page for examples). This dramatically expands their reach and impact, amortizing costs over an audience of thousands, rather than the smaller number of participants attending any one event. It also lengthens the life cycle as information can be accessed and passed on for months after the event.

At the same time, attention must be paid to local audiences. Even in cases where an entity has a large operating presence in the host country, we see a lot of interest from U.S. financial institutions, corporations and media in meeting with foreign managers and officials during their U.S. visits. The reverse is also true. This allows senior executives to develop communications channels that complement those obtained through their own overseas offices. Additionally, we have found attendance at U.S.-based events to be partially driven by offshore managers, who seek to familiarize their locally-based colleagues with key issues and other developments in their region.

It is important to note that investor relations does not mean, and should not be restricted to, elaborately designed brochures and presentations. In and of themselves, they are not likely to be well received -- especially if they lack substance. At the same time, any government or firm with international aspirations must understand the need to provide materials that are well written in a clear, concise style that makes sense to a native speaker.

Similarly, materials that rely on "cut and paste" statements are unlikely to add value. For example, KWR recently attended a road show where numerous local governments declared themselves the most "competitive location" with "educated workforces" and attractive "tax and investment incentives".

While important, these statements can be applied to thousands of locations. They do not define the advantage needed to entice investor interest or to close a transaction. While many of these entities came with volumes of materials highlighting incentives, tax regimes, depreciation schedules, etc., they lacked what has been termed an "elevator presentation". This means a concise summary designed to interest potential investors in the short time it takes to make an elevator ride. Therefore, investors were not convinced it would be wise to allocate the time and resources to conduct the costly due diligence required to evaluate a transaction.

Similarly, start-ups and other firms should not make bold statements, such as declaring themselves to be "industry leaders", unless these claims have been validated by the market. This turns off investors. While a company may possess the underlying potential and be admired for their aspirations, an inability to differentiate between objectives and reality damages their overall credibility.

An especially important point is the need to view investor relations as an ongoing program rather than a series of discrete activities. Even the most effective presentation, road show or brochure is likely to add little value if it is not preceded and supported by the follow-up needed to maintain momentum and continuity.

The decision to invest in a company or country is a complex one. It requires a lot of information and the participation of many individuals. This is not likely to happen on the basis of any one event - no matter how brilliant or persuasive the content. Careful attention must be devoted to developing a plan and the mechanisms that can develop and nurture the interest of investors over time.

Investor-friendly corporations and governments that provide a clear vision as to their ability to offer a superior return in accordance with the risks that must be assumed will suffer no shortage of capital. In fact, their prospects may only be enhanced by the current downturn as investors move to consider alternatives in order to maintain the performance they once assumed as their natural birthright.

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Capital Flows to Emerging Markets: Down, But not Out

By Uwe Bott, Managing Director, GE Capital

(The views expressed here are solely Mr. Bott's and do not in any way reflect those of GE Capital)

Ever since the Asian currency crisis in 1997, capital flows to emerging markets have taken a beating. This is especially true on the lending side. According to the IIF, private creditors channeled $125.7 billion in new money to emerging markets in 1997. Net lending was reduced to a trickle by 1998, and three years later the IIF projects net outflows from emerging markets at the order of $8 billion.

Lending to emerging or developing countries has a spotty record. During the 1920s, broadly held bonds were the only vehicle available for cross-border financing. A huge build up of bond debt accrued largely by Latin American and Asian countries culminated in a crisis, in which 27 developing countries defaulted between 1928 and 1939. They remained in default for a combined 305 years, or an average of 11.3 years. By 1937, 70% of all sovereign debt issued in the United States had been defaulted on. For all practical purposes, developing countries were cut off from most private capital flows for more than three decades.

In the 1970s and early 1980s a new lending boom to developing countries was spearheaded by commercial banks. The Mexican debt crisis of 1982 spread to 45 countries, most of them in Africa and Latin America, who defaulted on their loans to foreign banks. They remained in default for a combined 360 years or an average of 8 years. The crisis remained unresolved until the so-called Brady plan converted substantial amounts of defaulted bank loans into bonds. Once again, this opened the doors for emerging countries to tap the capital markets. The Mexican peso crisis of 1994/95, the Asian crisis of 1997/98, the Russian default and devaluation of 1998, and the Brazilian devaluation of 1999, cast serious doubt over the appropriateness of any private sector lending to emerging marketst.

At the same time, many emerging countries had made great progress in reforms that liberalized and deregulated their economies. Privatization of state assets introduced further economic efficiencies. Hence, foreign investors reckoned that the safest way to invest in emerging markets might be to take direct equity stakes. However, direct investments were concentrated in a few emerging markets (China, Brazil and Mexico accounted for 67% of the total in 2000 as reported by the IIF).

Going forward, emerging markets are faced with the following challenges: First, new BIS capital adequacy rules might create a further disincentive for commercial banks to lend to emerging markets. The new rules are to be agreed upon by the end of this year and will be implemented by 2004. According to current proposals, risk weighting of lending to emerging markets would lead to greater capital requirements than under existing rules. Consequently, commercial banks may wish to limit their exposure to such markets.

Second, multilateral intervention in crisis resolution, especially in the fixed income market through so-called bail-ins, i.e. the forced restructuring of emerging market bond-debt has clearly impacted the risk appetite of international capital markets. This is moral hazard of a different kind. Few investors will buy new bonds, if they believe the IMF or other multilaterals might later encourage the issuing country to default on these instruments.

Third, emerging markets must repair damage on the direct investment side, where many investors have been discouraged by disappointing returns or by government-induced contract frustration. Regardless of the scope of further privatization, profitability and feasibility of large infrastructure projects, especially in energy, depend to a large degree on the type of political, legal and regulatory framework that the public sector provides. This has all too often been a suboptimal experience for investors.

Fourth, I predict that there is likely to be increased global competition for a relatively stable stock of capital. Capital gains tax reform in Germany combined with the introduction of 401(k) private retirement funds will be a boost to the German equity market over the next five to seven years. Banks and insurance companies will sell off their holdings in German corporates and German private savers as well as foreign funds will try to take positions with very high return potential. Yet, country risk is virtually a non-issue. The distressed debt market in Japan is another non-traditional "emerging" market. This market is estimated at $1.2 trillion. If investments in Japanese distressed debt were to coincide with structural reforms under Prime Minister Koizumi, this might lead to an enormous amount of capital inflows to Japan over the next five years with great upside.

Therefore, emerging markets will have to compete for this global capital stock. They must either reduce country risk through further reform or provide highly attractive returns. This creates great opportunities for investors. Capital flows to emerging markets may not grow at a rapid clip over the next five years, but the risk/reward relationship should be more appropriate, resulting in better returns for investors. Assuming a low interest rate environment in the United States -- at least in the short term -- and that U.S. equity markets will not experience another bubble in the medium term, capital will seek returns elsewhere. Of course, this is not all good news and may reduce the baseline growth potential for the U.S. economy. Large capital inflows have allowed the U.S. to run an above-trend current account deficit (or savings/investment gap) during much of the 1990s. This has been the single most important factor for the boom we experienced during the second half of the 1990s. But more balanced economic growth in the U.S. and globally will create greater stability and allow the shift of capital flows to be beneficial to emerging markets and G7 countries alike.


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Argentina: Still Not out of the Soup

By Jonathan Lemco

Earlier this month, Argentina completed a successful $30 billion debt swap. This has given it about eighteen months of fiscal breathing room, but it is hardly a panacea. Most of the debt was scooped-up by domestic investors. International investors remain more wary.

If Argentina were not so important to investors, it would not have attracted so much attention. But Argentina's debt comprises about 25% of the JP Morgan Emerging Markets Index, and its troubles move the markets substantially. Furthermore, bad news emanating from Argentina inevitably affects Brazil, Mexico and most other Latin American countries. Finance Minister Domingo Cavallo initiated the debt swap in an effort to give his government more time to meet the nations' debt obligations. The presumption is that there will be sufficient future economic growth resulting from foreign investment to justify the substantially higher interest rates (about 16%) that Argentina will have to pay on its massive debt load. Although there is little evidence of foreign investor interest in massive investment in Argentina, one can hope.

In the real world, we are concerned that Argentina has exchanged its short-tern debt burden for a medium and long-term debt headache. The nations' debt-servicing costs until 2002 are a manageable $16.3 billion. But between 2006-2031, the public debt load alone will rise to $63.8 billion. In short, there is a net increase in the nominal cost over the life of the new bonds of nearly $52 billion.

Other recent economic news from Argentina is also worrying. Construction activity, supermarket sales and other economic indicators have declined. International reserves have dropped by $5 billion since the beginning of the year to their current $21.7 billion. This is particularly troubling since the most recent reserve decline was announced at about the time Cavallo was announcing the implementation of a dual exchange regime. This effectively devalued the peso by 8% for foreign trade. There is a debate at present about whether this signals that a broader devaluation is inevitable. We think that it isn't and, most interestingly, the government's action has not prompted significant deposit flight by Argentinean bank deposit holders. Clearly, they believe in their government's economic policies thus far. The same could not be said for international bondholders. The day after the dual exchange rate was announced, interest rate spreads widened 63 basis points over US Treasuries and Argentine stocks plunged nearly 5%. The markets have settled down a bit since, but Argentina's financial securities remain under pressure.

We remain very cautious about the Argentina credit. The nation's medium and long-term debt load is extremely high. The credit rating agencies hint at further downgrades.

The government insists that new investment will solve all of the economy's problems. That may be, but before that occurs the headline risk will have to turn positive.


Iran: A Struggle for the Popular President

By Robert Windorf

On June 8th, reformist President Mohammad Khatami won 78% of the vote in a landslide re-election victory. Of his nine conservative opponents, the strongest, Labor Minister Ahmad Tavakoli, garnered only 15% of the vote. While Khatami's victory was easily predicted, the surprising high level of voter participation delivered a strong message to hard-line conservatives that the Iranian people still support Khatami's reformist vision and his respect for the rule of law. However, during his second term he will still put forth his mandate with the limited powers granted by the contradictory constitution which places the Supreme Leader, Ayatollah Ali Khamenei, in charge of appointing the judiciary, overseeing the military, the police, and the conservative state broadcasting monopoly. During Khatami's first term, which in many ways he considers a failure, the conservative clerics used those powers to stall his reforms, shutting liberal newspapers and imprisoning numerous activists. Such activities ironically co-exist with a parliament led by moderate reformists.

Iran is a contradictory society. Veteran journalists like Elaine Sciolino have noted that Khatami's first term in office exposed the fault lines present at the creation of the Islamic Republic, as ÂIslamic' implies the rule of God under the Koran and ÂRepublic' is defined as the rule of the people. Now, twenty-two years after Ayatollah Khomeini's Islamic revolution, the strong will of the people has demonstrated that changes must occur as Khatami declared in his campaign message that he will not surrender to the hardliners' extremist positions.

Khatami's landslide victory may free him to name a more reformist cabinet over the next two months. Despite the many challenges posed by the clerics' dictatorships, he and his future cabinet are not expected to ignore the growing societal pressures from a weak economy, stymied by high unemployment and an anxious population now comprising 65% under the age of 25. An element of euphoria remains surrounding Khatami's victory that he may achieve certain degrees of reform that could inspire the west to bring much needed foreign investment. Ironically, should that eventually occur, many of the clerical elite would enjoy profitable returns.

The fate of Iran lies in the will of its people. There is only so much that Khatami can do alone. The next few months should present an interesting picture. We shall watch Iran closely for future developments.

Looking At Latvia for Investment Opportunities

By Roger Nye

It has been ten years since the three Baltic countries threw off the Soviet yoke and became independent republics. Since 1991 Estonia, Latvia and Lithuania have made great strides in transforming their economies into a market model, putting democratic institutions in place, strengthening their banking systems, and reorienting their trade toward the West. Given their strategic location on the Baltic Sea, all three countries are focusing steadfastly on gaining both EU and NATO membership, which they rightly assume will provide a safer, more prosperous future.

American and Asian investors have not paid sufficient attention to the Baltic States, focusing their attention more on the larger economies of Poland and Hungary. Perhaps this is a result of their assumption that the Baltics' combined population of less than eight million translates into sparse market potential. However, the Baltics, and in particular Latvia, deserve a closer look.

First, it is important that Latvia not to be confused with other former members of the Soviet bloc (Ukraine, Moldova, Belarus, Bulgaria) that have hardly begun the transition to Western norms, retains elements of the command economy, and cannot be considered economically or politically stable. The Latvians were once part of the mainstream of European development but were sidetracked in the 20th century by events beyond their control, namely wars and occupations.

The evidence supporting Latvia's remarkable revitalization is clear. Over the past ten years, pro-reform governments in the capital of Riga have enacted legislation opening up the country to Western trade and investment. Successive governments in Latvia have reiterated their single-minded adherence to the goal of membership in the European Union. Indeed, Latvia has already met many of the EU's conditions for entry. Latvia was the first Baltic state to become a full-fledged member of the World Trade Organization in February 1999, thereby permitting the expansion of economic relations under the most-favored nation clause.

Economic growth has averaged 4.5% over the past five years with inflation trending down to an annual rate now of just 2.5%. Government budget deficits are modest (2% of GDP) and declining. Both internal and external debt ratios are moderate at 13% and 50% of GDP respectively. The privatization of formerly state-owned industrial enterprises has neared completion. English is the language of business, and Latvians have almost caught up to Western Europe in terms of internet banking and mobile communications.

Latvia has a number of attractive features that draw foreign direct investment:

1. Given its strategic location, Latvia is a natural launching pad for exports into other Baltic countries, home to 100 million people, Russia (300 million), and the European Union (300 million). Exports to the EU now total about 60% of all exports, a major turnaround in the past decade.
2. One of the lowest corporate tax rates and highest percentages of scientists and engineers in Europe, a well-educated work force, and investor-friendly rules.
3. A well-developed transport and communications infrastructure with three major ice-free ports.
4. Modern banking practices, increased capital, and financial stability through Scandinavian ownership in local banks.
5. Labor costs that are 20 times lower than in Germany; a legal system that supports foreign business; excellent foreign-language skills; and a long tradition of doing business with Russians.

As a result, the stock of FDI has grown from nil in 1990 to $2.1 billion through 2000, and Latvia places fifth among central and east European countries in terms of accumulated FDI per capita. The largest capital flows into Latvia originate from Denmark, Germany, Sweden, and the United States, followed by Russian and the United Kingdom. The European Union countries account for the largest flows of FDI (more than 50% of the total). Aside from Singapore (2.1% of Latvia's FDI in 2000), Asian countries do not represent a significant presence in Latvia. At present, three significant US direct investors include: Polarbek, which placed $42 million in hotel services in Riga; New Century Holding, which placed $50 million in real estate and insurance; and Intersource International, which placed $12.5 million in fast food and pharmaceuticals.

The most attractive sectors for foreign investment in Latvia have been transport and telecommunications, which has received one quarter of the total stock of FDI. In manufacturing, the food and wood processing industries have been the most popular, drawing on the availability of raw materials at competitive prices. Other foreign investments range widely from engineering to financial services and from pharmaceuticals to real estate.

The government is actively encouraging foreign investment in information technology (IT), aiming to be the recognized regional leader in the IT and telecommunications sector. The goal is to make Latvia a powerful exporter of software services and to promote the country as a favored location for high-tech manufacturing and assembly. Latvia's competitive advantages in this sector include an availability of skilled, low-cost IT professionals; advanced systems and software engineering; and a well-developed telecommunications and logistics infrastructure comparable to that of EU countries.

As with other transition economies, Latvia does has its share of problems about which Western investors need to be cognizant. These include a legacy of corruption and cronyism from the Soviet era, delays in privatization, frequent changes of government (although the pro-Western policy orientation does not change), and a chronic trade deficit of 15-20% of GDP. Weighing all the pluses and minuses, the international rating agencies have assigned solid investment grade BBB ratings to Latvia, which tell fixed income investors that there is a low risk of default on Latvia's debt obligations.

The trends in Latvia are clear: an unflinching orientation to the West, an open investment climate, and a gateway location to a market of millions of consumers.

Thailand and the Telecoms Superhero

By Jonathan Hopfner

Telecom tycoon-turned-politician Thaksin Shinawatra's landslide victory in Thailand's general elections in January afforded the new leader a mandate never before seen in the history of Thai democracy. The combination of his attacks on the then-ruling Democrat party's apparent failure to cement the nation's nascent recovery from the 1997 financial crisis and his Thai Rak Thai (Thais Love Thais) party's populist policies - including a debt moratorium for the country's impoverished farmers and development funds for each of Thailand's 70,000 rural villages - proved irresistible to a populace that had largely failed to benefit from the previous government's economic liberalization efforts.

Pledges to address the plight of Thailand's poor may have swept Thaksin into power, but, as an increasing number of pundits are warning, it's not only the destitute who are in need of aid. While its faster-paced regional neighbors have rushed headlong into the information age, Thailand's forays into the new economy have been curtailed by vested interests and bureaucratic tangles. The country has only 13 phone lines available per 100 people, and just over 1 million people have Internet access out of a total population of over 60 million. Mobile phone penetration remains at just 6.4 percent. Thai technology firms are largely involved in manufacturing peripherals and remain dependent on countries like Japan and Taiwan for semiconductors and other cutting-edge products.

Resistance to change is often cited as the reason for the present state of affairs. Two state-owned telecom operators, the Communications Authority of Thailand (CAT) and the Telephone Authority of Thailand (TAT), dominate all aspects of the country's communications market, including Internet service providers. The two organizations have granted only a limited amount of concessions to private operators, and these are based on revenue sharing agreements that put a damper on the firms' efforts to reap healthy profits. "It's still not anything comparable to an open market in any way, shape or form," said Ross Klinger, COO of, which operates one of Thailand's largest English-language portal sites and provides web solutions for both domestic and international firms. "And you can see that in the pricing and in the quality of service." Mobile phone services and Internet access are prohibitively expensive, and remain well beyond the reach of the average person in a country where the minimum wage hovers around 5 US dollars a day.

Investors and analysts alike believe there must be a relaxation of the rules governing private operators and an effort to open the market to further competition. "The main issue is liberalization," said Andy Chan, senior telecom analyst at ING Baring Securities in Bangkok. "Revenue-sharing arrangements must also be addressed."

Governments past have attempted to do just that. Former Prime Minister Chuan Leekpai pledged years ago to establish an independent National Communications Commission (NCC) to tackle market liberalization head-on, but conflicts over the nomination process for the body have prevented it from materializing. Thaksin has expressed his intention to push ahead with the NCC plan, and is also mulling the establishment of an IT ministry.

It would seem that Thaksin would be just the man to address the telecom sector's woes. This is, after all, the savvy mogul who founded Shin Corps, a communications conglomerate that is now one of the country's biggest success stories. Shin is actively involved in the mobile phone, satellite and Internet fields and regularly competes with a host of other operators to win bids for massive projects in countries such as India.

The new Prime Minister's pedigree has sparked a certain amount of optimism in the telecommunications sector, with analysts like Chan expecting his government to "handle [telecoms] practically, whereas the old administration handled it academically." These hopes have been tempered, however, by numerous concerns.

One of the prime worries is the possibility that Thaksin may not be in power long enough to make any significant changes at all. The new leader is currently facing the Constitutional Court on charges of concealing his assets in 1997, when he was deputy prime minister. If convicted, he could eventually be forced to relinquish his post and banned from politics for up to five years, though the local press has downplayed the issue and most analysts feel the chances that Thaksin will be ousted are remote. "We think he'll hold onto power," says Amarit Sukhavanij, senior telecom analyst at Merrill Lynch Phatra Securities. "Even in the worst case scenario, if he's forced to step down, his party will still be running the country."

Also of concern to many new economy executives are Thaksin's nationalist leanings. Foreign forces are still viewed by many Thais as largely responsible for the devastating financial collapse that rocked the country three years ago, a fact that Thaksin took into account when concocting his campaign strategy. He has vowed to review the previous government's privatization policy and to stop selling Thai state assets to foreign firms, meaning a much-hailed plan to corporatize the CAT has been placed in jeopardy. Foreign nationals working in Thailand's IT industry fear the country may be cut off from the investment and know-how it so desperately needs.

There are also persistent rumblings that though Thaksin claims to have abandoned his holdings in Shin Corps and no longer runs the firm on a day-to-day basis, conflicts of interest are inevitable when he formulates business policies. But some industry watchers take a more pragmatic viewpoint. "It's not necessarily a bad thing [Thaksin's connection with Shin Corps]," says ING Baring's Chan. "We should have fair policies available, and any policy good for Shin will be good for everyone - equal access, lower tariffs, and so on. Everything will be fair game now, whereas before the government stood in the way."

"I don't think his business interests are a danger," says Merrill Lynch's Amarit. "He'll be under close scrutiny from all sides, so transparency will be key."

The controversies surrounding Thaksin's leadership have done little to scare investors away from the benchmark Stock Exchange of Thailand (SET) index, which, despite dipping slightly on the announcement of Thaksin's cabinet lineup, remains one of the better-performing markets in Asia this year. Though so far financial and bank stocks have driven its growth, the outlook for Thailand's major telecom firms, especially Shin subsidiaries such as mobile phone operator Advanced Info Service (AIS) and Shin Satellite, is overwhelmingly positive. Amarit recently upgraded his earnings per share estimate for AIS in 2001 by a whopping 17 percent. "[Telecoms] are definitely a great area for investment, particularly the cellular side," he says. "The penetration rate is low so there's a lot of growth potential."

Turkey's Economic Recovery: Promises Must Be Kept

By Robert Windorf

As expected by the international markets, the IMF approved a new $15.7 billion financial rescue program for Turkey on May 15th, making it the eighteenth time that the institution has come to Ankara's rescue. The program granted a much needed immediate infusion of $3.8 billion, with the availability to draw down an additional $9.0 billion during the remainder of the year. Should Turkey take the program's full amount, it would become the IMF's largest borrower. It is estimated that by the end of June, a total of approximately $7.0 billion will have been drawn as the central bank has attempted to stabilize the lira and bring down interest rates in the aftermath of February's political crisis of confidence that caused a 40% devaluation of the currency and unemployment and business closures to escalate.

While Turkey has been a long-time international borrower, on the heels of last year's financial crisis, the IMF and the international community made the toughest demands to date for it to receive the new bailout program. Prime Minister Ecevit heard from many supporting nations that his nation could not go forward without both strict political and economic reforms. Economy Minister Kermal Dervis, the former IMF official who was summoned home to Ankara in March to design the new stringent recovery program, has thus far succeeded on many fronts in persuading the stubborn parliament to approve all of the necessary legislation required for approval of the IMF program. The passage of the new banking law and the bill to allow Turk Telecom's privatization were key victories. While parliament quickly instituted several reforms, the desperate Ecevit government also experienced a cabinet shakeup. Earlier this month, Interior Minister Sadettin Tantan was dismissed for permitting corrupt investigations that led to Energy Minister Cumhur Ersumer's resignation in May. Tantan's dismissal also coincided with the trial of nine of the fifteen energy officials and businessmen charged with corruption surrounding state energy tenders. Additionally, in late May, Privatization Minister Yuksel Yalova resigned after the markets plunged over suspected potential delays in the plans for the tobacco industry's privatization - one of the government's key pledges in return for the IMF package.

While necessary political reform measures have slowly begun, Turkey's economic recovery will only succeed with a significant overhaul of the chronically weak and bloated banking sector. The overhaul of the banking system has been estimated to cost a surprising $40 billion (approximately 25% of GNP). In line with the IMF's demands several measures already have been implemented. For example, Ziraat Bankasi and Halk Bankasi were turned over to a care-taking board to prepare each institution for privatization; Emlak Bankasi's operating license will soon be withdrawn; the state-owned banks no longer participate in the money markets and their obligations are now covered by specially issued government bonds. In addition, the disposal of 13 failed private banks has begun; ten other banks will be merged into one of two Âtransition' financial institutions that are to be sold or liquidated; the thinly capitalized private banks finally released their plans for meeting capital adequacy requirements by year-end; and, parliament has brought banking legislation up to prudential and international practices. The most important piece of the banking reforms remains the continued downsizing of the state banks. The markets are now keen to see if these reforms will lead to the Italian banking group Intesa's prospective purchase of a stake in Garanti Bankasi from the Dogus conglomerate. The government and the business community are hoping that this potential deal will reinvigorate much-needed foreign investment and technical assistance for the industry.

As a result of Turkey's continued reliance on international support, it has reached the limits of debt manageability. Net public sector debt is now forecast to rise from 58% of GNP at year-end 2000 to 79% by the end of this year. However, this ratio is forecast to decline to 70% next year and to 65% by the end of 2003. This forecast assumes a fall in real domestic interest rates to the 20% level and a strong rebound in economic growth. We believe the targets for lower interest rate and growth levels are rather ambitious, especially amidst a global economic environment now exhibiting signs of slower growth.

While the government has made notable strides over the past few months, much work is still needed to meet the IMF's demands. Economy Minister Dervis' ambitious economic reform mandate has finally caused parliament to realize the severity of the nation's economic and political predicament. With further EU enlargement looming, which will again leave Turkey further behind other prospective member states, the international financial community has once again done its part to keep Turkey's economy afloat. As one western banker recently stated, "We've done our part, now it's up to them!"


Telecom Notes:


Choppy Seas Now, Calming Waters Later

By Scott B. MacDonald



The telecom sector in both equity and bond markets has been highly volatile over recent months; a trend that is likely to continue through the summer. We expect, however, that in the 3rd quarter conditions are likely to change for the better on the bond side, followed by an improved performance in the 1st half of 2002 for equities. It is also important to emphasize that there are some big differences in determining market outlook between bonds and equities.

Choppy Seas: Volatility has been a factor and most likely will remain so, as many investors have been badly burned by the telecom sector, especially in equities. Anyone holding equity names such as British Telecom (BT), Qwest (Q) and KPN has felt pain. The telecom sector has also been badly savaged due to problems in the related tech sectors. In a sense, telecom has been lumped in with the tech wreck of dot.coms and struggling equipment makers, such a Lucent, Motorola, and Nortel. In the bond market, there has been a distinction between the telecom sector (with a few exceptions such as KPN) and the tech sectors, with telecom performing far better on average.

For bonds then, we look beyond the summer to a shift toward greater stability in spreads. The summer months will still reflect the process of de-leveraging, asset sales, and bad "animal spirits" in equity markets.

The issue of debt build-up and how to escape it is probably the biggest concern. The tech boom of the 1990's pushed telecoms into a new and tumultuous world of mergers and acquisitions, debt increases, and equity issues. It also marked a substantial deterioration in credit quality. As a report by Standard & Poor's (May 30, 2001) noted in 1990, 92% of telecom ratings were investment grade. Today, only 17% are investment grade, with 45% being in the single "B" category, suggesting a considerable amount of credit risk. Fifteen percent of rated issues in telecom are in default. S&P also notes that the credit slide was not limited to the U.S., but included Europe. Throughout Europe, the withdrawal of government support and deregulation, which substantially increased competition, had an impact on credit quality as many companies went on major spending sprees. The task now is to escape the bounds of debt.

What is going to have an impact on improving telecom bonds is a considerably lesser supply of new issue in the second half of the year (probably in the range of $1-2 billion, which includes possible downgrades with only KPN and AT&T being on watch by rating agencies), and hopefully, an improving macroeconomic environment in the United States. It is also likely that we are now at the bottom of the credit cycle, with deleveraging now the biggest driver in determining spread valuations.

For telecom equity markets the turnaround is likely to take longer. While the major telecom companies are seeking to reduce debt burdens, issuing more equity remains an option (though not always easily executed). British Telecom (BT), after its recent management change and around $13.5 billion in asset sales, was able to raise $8.2 billion in a new rights offering. Significantly, BT's new team was able to demonstrate a commitment to debt reduction and a willingness to take painful structuring actions, which generated enough confidence for the company to issue more equity. The troubled Dutch telecom company, KPN, in contrast badly needs to issue more equity (around $5 billion) to reduce its close to $20 billion debt, but a lack of firm direction has precluded the move to equity markets. The stock, traded as an ADR on the NYSE, has been savagely pummeled: trading at around $60 a share in mid-June it fell under $5 a share, before staging a rally on rumors of a possible merger with Belgacom, Belgium's state-owned phone company. That merger is still a long shot.

Telecom stock performance will also remain linked to the tech sector. Of particular concern in the 3rd quarter will be Lucent's ability to sell off its fiber optics company for $2-4 billion by September, when some large bills come due. Nortel's ability to deal with slumping sales and ensuring that it does not fall into liquidity problems will also sensitize investors to anything remotely related to technology, such as telecom. We also see that potential stock investor concerns could come with Deutsche Telecom, which is reducing debt, but remains acquisitive, and AT&T which remains in the midst of a massive restructuring. Consequently, telecom stocks look set to go through ongoing volatility through the 4th quarter, without real longer-range improvement until the first half of 2002.

Caribbean: Cable & Wireless Plc (CWP), one of the UK's best-known Internet and networking providers has long been a fixture in the structure of communications in the Caribbean. Now as C&W is restructuring and seeking to become more focused, it is thinking of selling its assets, mainly telecommunications licenses, in the British Virgin Islands, Barbados, St. Lucia, Jamaica and Trinidad & Tobago. Earlier in 2000, C&W put in motion the sale of part of its Australian assets, C&W Optus, to SingTel. The value of C&W's Caribbean assets are thought to worth $5.7 billion. The most likely buyers would be Telefonica (TEF) and Bell South (BLS), both of which are already active in the Caribbean.

KWR Viewpoints:

The IMF and the New Financial Architecture
A House of Cards in an Earthquake Zone

By Uwe Bott, Managing Director, GE Capital

(The views expressed here are solely Mr. Bott's and do not in any way reflect those of GE Capital)

IMF bashing is nothing new and conservatives as well as liberals have participated in it. What is new, however, is that in recent years traditional ideological demarcations have faded and many centrists have joined classical IMF-skeptics. In the past, it was easy to equate overall distaste for multilateralism with conservatives. Charles Lichtenstein, then Deputy Ambassador to the United Nations expressed these sentiments best, when he encouraged the United Nations to leave New York in 1985 and stated: "We'll be at the dockside waving you a fond farewell as you sail into the sunset."

Conservatives had misgivings with the organizations of the Bretton Woods accord largely because they felt uneasy with the transfer of sovereignty to international organizations. On another level, many conservatives rallied behind British economist, Lord Peter T. Bauer, who extensively wrote on the apparent ineffectiveness of foreign aid in the 1980s. These ideological reservations were often complemented by pragmatic claims from moderate conservatives that multilaterals often preferred academic pretentiousness to practical solutions.

Liberal criticism centered on IMF conditionality and its social consequences. This position was deeply rooted and vocalized in such studies as the report of the Brandt Commission, which stated in 1980 that the policies of the IMF pose "unnecessary and unacceptable political burdens on the poorest, on occasion leading to ÂIMF riots' and even the downfall of governments." Over time, liberal objections to the IMF have come in different incarnations, the most recent one consisting of anti-globalization activists.

The chorus of IMF critics has been given greater credibility since it was joined by the political center following the Asian crisis of 1997/98. The criticism of the centrists strikes at the core of the raison d'Õtre of the IMF. The Fund was created in a world of fixed exchange rate regimes, limited current account convertibility and closed capital accounts. This all began to change in 1971, when President Nixon closed the gold window, a move that ended in the abolishment of the fixed exchange rate system two years later. At that time, the IMF lost its original purpose and since then has been in search of a mission. This search gave increasing justification to Lord Maynard Keynes's prophetic comment on the Bretton Woods agreement in 1948, when he said "the Bank should have been called the Fund, and the Fund should have been called the Bank."

Consequently, several centrists have come to the conclusion that these changes in global economic fundamentals make the IMF superfluous as an institution. In my view, this is not the optimal solution. As a matter of fact, the purposes listed in Article 1 of the Fund's Articles of Agreement are still in many ways timely. It should be the role of the IMF to promote and monitor these goals in order to support the stability of the international financial system.

The Fund also has a role in providing liquidity to countries with balance of payments problems, which might otherwise be destructive to national or international prosperity. The forthcoming broad leadership changes at the IMF allow for a unique opportunity to adopt a fresh, creative and pragmatic approach that could help avoid a repeat of the volatility during the last decade. Here are six ingredients to accomplish this objective:

1. Regain focus, both in scope and substance. Scope: The IMF is not a development bank, but a lender of last resort. The Fund should abandon efforts to provide a panacea for all ills, but instead aim its financial resources strictly on balance-of-payment support.

Substance: IMF programs often lack focus. They should focus on technical requirements for countries to regain access to capital markets. Conditions should be tight and limited in number.

2. Take political analysis seriously. Before entering into a financial support program, the IMF must internally assess the political realities of the country in question. Such analysis would have resulted in a rejection of assistance to Russia in the summer of 1998.

3. Be accountable. Accountability may be achieved by developing a dashboard of indicators against which the institution will be measured. A Six-Sigma approach to policy effectiveness should be developed.

4. Increase concentration on prevention. While crisis management will continue to be high on the IMF agenda, the institution should create new tools for crisis prevention. The work of Carmen Reinhardt and Graciela Kaminsky could create the basis for such work. A collaborative effort with the BIS should strengthen financial systems around the world.

5. Don't bailout, but don't bail-in either. If the government of a country has ignored IMF policy advice, violated conditions under existing programs or failed to generate the internal political consensus to adopt necessary reforms, there is little justification for a bailout other than a systemic risk to emerging markets or to the international financial system. The risk/reward relationship of private sector lending to such country should have properly incorporated the probability of non-payment. IMF lending should not resume until conditions for a successful adoption of a program have fundamentally improved. Bail-ins should also be avoided.

Bail-ins are defined as situations, where the IMF makes it a pre-condition for renewed support -- implicitly or explicitly -- that a country first default on its obligations to private investors. Such a mechanism creates moral hazard of a different sort and might eventually cut off most private sector financial flows to emerging markets. Ecuador's default was rumored to have occurred under such circumstances.

6. Enforce program conditions vigorously and uniformly.

For many years, emerging markets have overlooked the importance of the rule of law for economic success. Rule of law means that effective laws are in place, that their enforcement is fair and that sanctions for non-compliance are predictable and have a degree of certainty. What's true for the rule of law at the national level, applies equally to such things as IMF conditionality. Conditions have to be few, frontloaded, clear and unambiguous. Their enforcement must be predictable and certain. Waivers should only be granted in truly exceptional cases or they too create moral hazard.

Keeping these six guidelines in mind, the IMF could -- with laser-like accuracy -- target clusters of instability in the international financial system. The approach would be admittedly less ambitious, but it promises to yield a much higher rate of success.

Emerging Market Briefs:

Scott B. MacDonald

Chile: In mid-May it was announced by Budget Director Mario Marcel that the central government posted a budget surplus in the 1st quarter 2001 of US$330 million (equal to 0.5% of GDP). Despite this good news, the projection for the entire second half of 2001 is expected to be negative due to lower-than-expected copper prices. The average copper price under the 2001 budget is US$/lb. 0.88, while the year to date average has been only US$/lb. 0.79. Net fiscal revenues from copper sales fell 23% in real terms in the first quarter compared with the same period last year. Tax revenues in real terms rose 2.5% year-on-year.

Hungary: Hungary's prudent economic management, steady advances in privatization, reform of the banking sector and relatively stable politics helped get the country a ratings upgrade in late June from Standard & Poor;s. The ratings agency took Hungary from BBB+ to A-, maintaining its lead over most other Central and Eastern European nations (except the Czech Republic and Slovenia). As S&P noted: "Prospects for strong well-balanced growth over the medium term are supported by the ongoing structural reforms and subsequent expected accession of Hungary to the European Union within the next few years."

Korea: The Bank of Korea has cut its economic forecast for 2000 from an initial 5.3% forecast made in December. Reflecting the cooling global economy, especially those of the United States and Japan, real GDP growth is now projected at 3.8%. This is a considerable drop from 2000's 8.8% pace. Those sectors most hurt by adverse international markets are companies exporting semiconductors, mobile phones and computers. Total exports are now being projected at $168 billion, which would be a 2.5% drop in 2001 over 2000. Exports accounted for 45% of Korea's GDP last year. Although the economy is slowing, the central bank must be careful in using interest rate cuts due to concerns about accelerating inflation. The Bank of Korea acknowledged that consumer prices will probably rise by an average of 4.4% this year. Higher oil prices have been a factor in rising inflationary pressures. Not all news is bad. Oil prices are expected to decline in the second half of the year and imports are falling as consumer demand has tapered. This means that the current account balance of payments surplus may actually grow from $11 billion in 2000 to $13 billion for 2001. Looking to 2002, the Bank of Korea is looking for 4.5% real GDP growth.

Lithuania: In mid-May Fitch raised Lithuania's long-term foreign currency rating from BBB- to BBB+, due to improvements in the economy in 2000. Only Moody's continues to rate the Baltic country as non-investment grade at Ba1. We think that based on current trends, there is a good chance for an upgrade over the next 6-8 months.

Peru: Peru has been in the doghouse with foreign and local investors throughout 2000 and 2001. Now, with the June 3rd elections over and President Alejandro Toledo in charge, Peru is gradually re-emerging on international investor screens. However, there will not be any rapid return to the strong growth of the mid-1990's. Indeed, real GDP for 2001 is expected to be a disappointing 2.5%, following only 3.6% in 2000. President Toledo has already acknowledged that the economy is in a crisis and will not meet its budget deficit target with the IMF. Despite the negative tone, the World Bank announced that it is granting Peru a $150 million loan to cut poverty, build roads, help improve transparency and accountability of social services. Furthermore, the World Bank indicated that it will provide further support if President Toledo's administration is able to meet its pledges. Also important, the World Bank support opens the door for a similar loan of $200 million from the Inter-American Development Bank. Toledo was a former consultant at the World Bank, something which no doubt did not hurt Peru. An IMF team will visit the Andean country in July to negotiate the deficit target, while President Toledo is visiting Washington, DC to meet with President Bush and World Bank and IMF officials.

Russia: For a country that defaulted on its debt in 1998 and was almost out of money, Russia's foreign exchange reserves have made a nice recovery. Fueled by higher oil and gas prices, Russian exports are up, which has brought in more cash, helping the fiscal situation. As of June 15th, foreign exchange reserves stood at a healthy $33.7 billion. Although real GDP growth in 2001 is expected to slow to 4.0% from 2000's dynamic 7.5%, the pace is still strong. Moreover, inflation, which stood at 41.8% in 1999, is expected to fall to 22% in 2001. Russia's improving prospects are further bolstered to the point that most of the oil windfall appears to have been saved. Considerable challenges still remain in the governmentÂs July 2000 long-term reform program, the most significant of which are banking and tax reforms.

Book Review

Hernando de Soto, The Mystery of Capitalism: Why Capitalism Triumphs in the West and Fails Everywhere Else (New York: Basic Books, 2000) 275 pages. $27.50

Reviewed by Scott B. MacDonald

Hernando de Soto is the President of the Institute for Liberty and Democracy in Peru and the author of a well-known earlier work on development, El Otro Sendero (The Other Path). His new book greatly expands the scope of the first as it ponders: "Why does capitalism thrive only in the West, as if enclosed in a bell jar?"

In finding the answer to this riddle de Soto rejects cultural reasons and such "excuses" as "missing the Protestant Reformation or that Third World nations are burdened by the disabling legacy at colonial Europe, or that the population's IQ's are too low." The main thrust of his view is "to demonstrate that the major stumbling block that keeps the rest of the world from benefiting from capitalism is its inability to produce capital. Capital is the force that raises the productivity of labor and creates the wealth of nations. It is the lifeblood of the capitalist system, the foundation of progress, and the one thing that poor countries cannot seem to produce for themselves, no matter how eagerly their people engage in all the other activities that characterize a capitalist economy."

The missing link is a legal system, which is supportive of property rights, which in turn allows "dead capital", i.e. property, to have a value that can be used for collateral. De Soto argues that Western nations suffered their own difficult process of industrialization, booms and busts, pervasive mafias, widespread poverty, and corruption. Yet, somewhere along the developmental path, property rights became important and a legal system supportive of those rights evolved. Significantly, the legal system was also market-friendly and geared for commercial application. As de Soto notes: "Western legal property also provides businesses with information about assets and their owners, verifiable addresses, and objective records of property value, all of which lead to credit records. This information and the existence of integrated law make risk more manageable by spreading it through insurance-type devices as well as pooling property to secure debts."

While we generally concur with De Soto's views, we do find that he is a little too dismissive of the cultural factor. While he lauds the development of a social contract in the West that supports property rights, he does not give much credence to the socio-cultural background that helped reinforce the ideas of a social contract and the importance of the rule of law. While making generalizations he cannot explain why it was the Italian city states, followed by the Dutch and English who made major strides in the development of capitalism. He also leaves out the success of Chinese-influenced economies such as Singapore, Hong Kong, Taiwan and Korea, versus the relative failure of some other Asian countries as well as much of Africa and Latin America. The cultural point should not be overstated, but neither should it be easily swept aside as having no relevance.

De Soto has written a thought-provoking book, that is well worth the time. We strongly recommend it for anyone interested in development issues and international business.


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