Mexico: A Stable Credit in an Unstable Time

By Jonathan Lemco

From an investor's point of view, Mexico has made tremendous economic and political strides in recent years. Economic growth has surged, in part because Mexico has benefited from its membership in the North American Free Trade Agreement. Mexico's crippling debt load of the 1980s and early 1990s has been reduced substantially. Employment is at an all time high with unemployment at only a 3.1% level in September. Inflation has been contained at approximately 4.9% year-on-year. Education levels are slowly improving. And President Fox was elected in the freest vote in Mexico’s modern history.

As a consequence of this improvement, Mexico’s interest rate spreads have narrowed throughout 2002, unlike several other Latin American sovereign credits. Furthermore, the credit rating agencies rate Mexico at investment grade levels (Baa2 with “Moody’s” and “BBB-“ with Standard & Poor’s). As of December 2002, only Chile is higher rated in the entire Latin American region. As its credit fundamentals have improved, Mexico has become an investor darling, and has issued well-received debt throughout this past years. We expect the sovereign, Pemex, Telmex, Cemex and other Mexican issuers to return to the marketplace in 2003.

Of course, there are problems along the way. Mexico's economic future, more than ever before, is intimately tied to the United States. As the US economy slows at year-end, so has Mexico's and earlier growth economists' forecasts for the year have been recently reduced from 1.7% to 1.2% GDP growth. This deceleration, not surprisingly, is directly related to a decline in export-oriented industrial production. Ironically, one of the consequences of the improvements in recent years is that Mexico is now having trouble competing with certain lower wage economies. Most notably, there have been several media stories recently noting how Mexican industry and jobs in selected low-tech industries are leaving for lower wage China. We think this is a natural development in a rapidly modernizing economy, however, Mexican industry will have to adapt to worker demands for higher wages and improved benefits, but there will be an economic cost to this as lower wage countries continue to compete effectively.

It is also worth noting that the structural reform agenda of the Fox Administration is hindered by a tense relationship between the executive branch and the PRI, the main opposition party. Structural reforms in the areas of electricity, labor and education are needed to improve competitiveness and to promote economic growth.

In the next month, investors should pay attention to the political wrangling associated with the next federal Budget. We think that the Budget, when it is finally passed by year-end, will include fiscally prudent provisions. Although President Fox’s administration is assuming a 3.0 % growth rate in Mexico in 2003, it is also proposing a modest 1.9 % real increase in expenditures. Overall revenues are expected to outpace expenditures slightly. Also, projected oil revenues, which are critical to the Mexican economy, are based on a $17.00 per barrel price for the Mexican oil basket. This is almost $5 below the estimated average for 2002. Currently, the Mexican oil mix is hovering near the $20 level. Unless prices collapse, which is unlikely given the uncertainty surrounding a potential war in Iraq, it is difficult to imagine the average oil price in 2003 will be substantially below the budget assumption.

Furthermore, we think the 2003 Budget will include a provision whereby the deficit target will be increased to 0.65% from 0.5%. This slight increase should not be alarming to investors. Away from the budget, investors will also be focused on electricity reform negotiations. If these discussions go well in the next few months, it will send a very positive sign to the financial community.

In short, we expect that Mexico will continue to grow at a steady pace while maintaining fiscally prudent policies. President Fox will have to expend political capital to pass much needed structural reforms, but we think he will be able to do so. The 2003 Budget assumptions are conservative and achievable. At a time of economic and political uncertainty in much of Latin America, Mexico stands out as a positive model.

BUSINESS

German Banks - Tough Times

By Scott B. MacDonald

German banks are an important part of the international financial system. They are critical to the European economy and have been a relatively sound investment in the past. The relative safety of investing in German banks, however, is over. The sector is grappling with difficult structural problems, ratings are under pressure and spreads are generally wider. We expect things to get worse before they get better. HVB Group, Dresdner Bank, and Commerzbank will remain challenged into 2003. Deutsche Bank is in comparatively better shape, but even Germany’s largest private sector bank faces a difficult business environment, especially as the global securities industry has yet to recover. Although we do not expect any of the country’s major banks to fail, we have concerns the sector will end up muddling through the next few years, badly in need of structural reform and growing less competitive with other European and international institutions.

In late October 2002, chairman of the supervisory board of Deutsche Bank and president of the German banking association, Rolf E. Breuer, denied his country’s banks were in a crisis. He stated “’Banking crises’ is a very risky expression, because usually people think of 1929. We’re not talking about a liquidity problem. We’re not talking about a credit crunch. What we are talking about is a lack of profitability.” While Mr. Breuer is correct that profitability is a major problem facing German banks, the crisis aspect of the matter can be debated. The situation facing German banks is challenging. The German economy remains troubled, corporate bankruptcies are on the rise, and investors are clearly worried. HVB Group, one of the country’s major banks, recently sought to issue bonds in the U.S. market, but finally balked at the pricing – equal to where many high yield bonds trade. In addition, the equity shares of another of the country’s largest banks, Commerzbank, plunged in October to their lowest level since 1996 in October. At the same time, the rating agencies, Moody’s and Standard & Poor’s have downgraded the credit ratings of most major German banks. If not a crisis, it certainly feels like one.

The worrisome thing is that banking conditions in Germany are set to deteriorate further before they get better. On October 22, regional head of corporate clients at Commerzbank, Berkhard Leffers, stated: “We haven’t seen the worst yet; insolvencies and risk provisions are likely to keep rising in 2003.” To this he added that the outlook for an economic recovery in the world’s third largest economy is “very pessimistic.” Indeed, German banks have suffered as a loss of investor confidence due to the increasing risk of deflation, low capital levels, weak core earnings and concerns over the impact of declining equity markets. Real GDP growth is now expected to be around 0.4% for 2002 and a little over 1% in 2003. This is hardly the robust momentum needed to pull the German corporate sector from its doldrums.

The root of the problem for German banking is structural – the vast majority of banks are not in business so much to make a profit, but as to provide credit. The country has over 500 Sparkassen (savings banks), which are largely owned by municipalities and the 12 Landesbanken, regional banks owned by state governments and savings banks associations. Together these institutions, along with a number of other smaller lending institutions, account for 39% of domestic retail and corporate deposits and 35% of bank lending. In contrast, the country’s Big Four – Deutsche Bank, HVB Group, Dresdner Bank and Commerzbank – account for only 14% of deposits and 15% of loans. While the public sector banks benefit from state guarantees, which helps them to contain borrowing costs and lending rates, the Big Four have no such support and consequently see their profitability squeezed.

In addition to the public sector vs. private sector mismatch, German banks are not the most cost-efficient, leaving them with bloated operating costs. There are also too many of them. Germany possesses some 2,700 lending institutions. It also has 42,350 branches -- more than any other major industrialized country except Belgium.

Germany’s private bankers increasingly see the need for change. Commerzbank’s CEO Klaus-Peter Mueller said during a conference in London in early December that he would welcome domestic bank consolidation. The statement fueled investor speculation that the troubled bank may partner up sooner rather than later. The bank is currently in the process of eliminating more than 6,000 jobs to cut costs and boost returns. Commerzbank reported a 3Q02 loss of €129 million.

Pressure is also coming from the European Union and the Basel Committee, a body of major economies that functions as a guide to international bank regulation. Although Germany’s public sector banks are being pushed to reform and are phasing out a number of the state supports, including the guarantees, this is a multi-year process. There is no quick leveling of the playing field.

The danger going forward is that what is required to turn German banking around is likely to take several years and is greatly complicated by domestic politics. Change means consolidation, introducing greater cost-efficiency and trimming personnel. It means charging off a growing pool of bad loans. Consolidation also means vertical integration between the Sparkassen and Landesbanken. Politicians from various regions do not wish to surrender their banks, many of which make critical loans to struggling corporations. With unemployment at 10%, pulling critical credit lines can lead to greater joblessness. This is something that does not win elections for those already in office. Moreover, the closing of bank branches would only add to the ranks of the unemployed.

Is Germany becoming Japan, where many banks are close to or are already insolvent and kept alive by injections of public money and the forbearance of bank regulators? Although deflation is emerging as a major concern and there is a closer relationship between the private and public sector than with Anglo-American economies, Germany is not yet Japan. But, the preconditions are there, including a slowness to act, political resistance from elements of the ruling elite, eroding loan portfolios and steep declines in the value of stockholdings. All this points to the risk of a self-fulfilling prophecy, in which the fears of a crisis grow with the slowness of response and bank counterparties begin the add costs to doing business with what they regard as troubled institutions. This, in turn, raises obstacles to accessing international capital markets, which may need to be tapped to top off capital adequacy ratios.

We return to Mr. Breuer’s denial of a crisis. It is fair to state that German banking is not in a crisis – along the lines of 1929. Support from the German government should prevent that, while pressure from the European Union helps push reform. However, until local political support for the public banks is curtailed and reforms are pushed in a more meaningful fashion, there is a risk that German banks will head into a crisis. If the banking system of the world’s third largest economy slips into a crisis, it would be only one more force pulling the global economy toward a potentially lengthy recession. In contrast, a German banking system on the mend would have much to offer in helping drive the European economy and reducing the current heavy dependence on the U.S. economy as the sole engine for global .

The Pension Fund Issue

By Scott B. MacDonald

The issue of pension fund shortfalls was given considerable media time in October when General Motors (GM) declared that its pension plan may be under funded by as much as $23 billion by year-end 2002. This prompted Standard & Poor's to downgrade GM’s BBB+ ratings to BBB. GM is hardly alone. Over the past couple of months, a number of major companies have indicated that pension shortfalls are a growing concern – Ford, Maytag and Whirlpool to name but a few. Pension funding shortfalls are the next issue which have the potential to disrupt the stock market, due in large part to the complex nature of funding and accounting rules, the large size of numbers involved and rating agency reactions. We would add that although this may cause spread widening, equity price volatility and negative ratings actions, not all companies have this problem. Some of the companies with pension plan shortfalls, like IBM and Boeing, are in much better shape to make up any differences compared to AMR and Delta, which will be hard-pressed with a multitude of other problems. The bottom line is that companies that are already on the margin with their ratings (for other reasons) are very likely to be negatively impacted by this issue. Our recommendation is that with any company that you are examining, take the unfunded portion of pension plans and treat that as debt. If the impact on leverage is significant, you should be concerned.

The roots of the pension shortfall are to be found in the excesses of the 1990s. Many companies used gains from pension investments to inflate profits. They were allowed to do this by accounting rules that permitted corporations to mingle pension income with operating earnings. While this worked well in an upwardly mobile stock market, it has hurt when the same market has had two consecutive years of steep declines and 2002 looks like it could be year number three. This is painfully evident by Standard & Poor's 500 Index of companies with defined benefit plans, which indicates that there will be a $243 billion shortfall in 2002, the first since 1993.

The critical issue for many companies is that if the stock market does not recover, a number of companies will be forced to divert earnings and cash to make up the difference. This takes capital away from capital spending at a time when capital spending is already tight. It also reduces the availability of funds to help the process of reducing debt. Moreover, the pension funding issue is a bigger concern to the industrial sector of the economy than it is to financial services.

We see three major trends emerging from the pension funding issue:

The Asbestos Issue

By Scott B. MacDonald

The asbestos issue is not likely to go away any time soon, but there is some good news. Recent announcements of settlements in asbestos cases for Sealed Air Corp., Halliburton and Honeywell indicate there is a positive trend in this direction. Although the settlements have large price tags, they begin to quantify the costs related to the issue and start to remove some degree of the uncertainty that has been hanging over a number of companies and their employees many of whom were threatened with job losses related to possible bankruptcies. Equally important, the push on the part of the companies, with their insurance companies in tow, puts more pressure on the U.S. Congress to pass reform legislation on torts.

In early December, Sealed Air Corp., maker of Bubble Wrap, agreed to pay $856.3 million in stock and cash to settle asbestos and bankruptcy-fraud claims connected with its 1998 purchase of W.R. Grace & Co.,’s food-packaging unit. Grace creditors and asbestos-injury claimants sought to prove the chemical maker fraudulently transferred assets before filing for Chapter 11 protection in 2001. What was regarded as positive from the settlement was that it was well below expectations in terms of cost. Stated in another way - Sealed Air can afford the settlement.

The news concerning asbestos settlements continued into mid-December with the announcement that Halliburton, an oil services company with 85,000 workers, has offered to pay about $4.2 billion to settle more than 200,000 claims and create a trust to handle future claims. It was also announced that Honeywell, a diversified manufacturer with 115,000 employees, agreed to settle a similar number of claims against one of its subsidiaries and ensure that all claims against the unit are paid.

Related to these recently announced settlements is the expectation that the new Republican-dominated Congress may finally reform U.S. tort law, under which asbestos litigation falls. Both U.S. business and labor are growing more concerned that asbestos will be increasingly more damaging in terms of lost jobs. A recent report commissioned by the American Insurance Association noted that so far 60,000 jobs had been lost due to asbestos-related bankruptcies. In addition, the report noted that worse is yet to come if there is no reform as only about a quarter of the costs of asbestos claims have yet been paid. The eventual price tag is expected to range between $200-275 billion. This has gotten the attention of Congress.

Over the last several years, Congress has considered a number of bills aimed at creating a system for resolving asbestos claims outside the judicial system. The Democrats, backed by trial lawyers, have consistently blocked any changes in the law. The recent settlements could represent an important breakthrough. In the Sealed Air case, approval of the settlement is required from the judge overseeing Grace’s Chapter 11 case, filed in U.S. Bankruptcy Court in Wilmington, Delaware and several creditors’ committees. If the judges approve the settlement, there is a strong possibility that other companies in similar cases will follow suit, seeking to settle out of court. This, in turn, could provide additional pressure on the Congress to reform tort laws, which would make sense out of a judicial system that is largely stacked against the companies. If nothing else the threat of legislative reform of the tort code could force settlements.

12 -14 February 2003 - United Nations Conference Center, Bangkok, Thailand

Changes in the world and Japanese domestic economy have resulted in increased opportunities, not only for large but also for small and mid-sized foreign companies seeking financial and strategic opportunities in Japan. Foreign investors, once scared off by linguistic and cultural barriers, the high cost of doing business and a lack of market access, are now taking a second look.

Distressed assets and strategic tie-ups are hot. In the wake of Japan’s so-called “Big Bang” financial reforms, investment barriers are slowly loosing ground to market realities. Nonetheless, closing cross-border acquisitions in Japan is not easy. Foreign investors must understand the local dynamics. Here are some tips they should keep in mind:

Find the right advisors. Japan has a rich and complex business environment embracing both traditional and modern aspects of business culture. As the sophistication level of M&A has risen in Japan, so has the importance of in-depth experience with sophisticated structures and transactions. More importantly, taking advantage of recent deregulation and newly opened doors for state of the art transactions in Japan demands that the acquisition team and its advisors have in-depth experience utilizing cutting edge tools.

Examples of such opportunities include recently adopted laws facilitating M&A techniques such as MBO’s and the “new shares reservation right” (shinkabu-yoyakuken) which has a function similar to that of an option. To name only a few of the other significant advances, the Japanese Commercial Code has been revised to: permit a two-tier governance structure similar to the U.S. model comprised of directors and officers; prescribe stock-for-stock acquisitions; and relax burdensome restrictions on contributions-in-kind, stock options and the issuance of preferred and other types of stock. Most notably, Japan has also enacted a new Civil Rehabilitation Law, which can expedite the restructuring of debt-ridden companies. Recent changes in accounting rules are also anticipated to facilitate cross-border acquisitions.

This new environment provides opportunities for foreign investors to engage in creative strategic and financial investments. Optimizing the acquisition possibilities requires a team, which is equipped to think outside the traditional box in Japan. Unfortunately, such professional advisors in Japan are not inexpensive, and there is a shortage of qualified, experienced and bilingual service providers. Accordingly, it is important for small to mid-sized investors to consider potential transaction costs in the planning stages.

Communicate on a business level. It is said that Japanese executives prefer to do business with people that they know. During business negotiations, the Japanese negotiating team will often try to establish direct personal ties with foreign counterparts. If foreign negotiators fail to engage in effective personal interaction, Japanese counterparts might doubt their sincerity. Worse, they may be reluctant to provide frank information to the acquiring company.

In addition, Japanese companies also tend to rely less on outside attorneys and advisors. As a result, phrases like “our attorneys” or “our advisors will be contacting you regarding this” are heard less often. The hurdles to closing a deal are often overcome without lawyers present in a less formal setting outside of the conference room. In practice, deal-killer issues are often resolved informally by smaller groups over a discrete dinner or whisky and water.

Effective communications requires establishing personal ties at not only the executive, but also the managerial and operations levels. There is no substitute for an acquisition team, which can expedite person-to-person contacts with, and learn first-hand knowledge from, the target company itself. This is one aspect of doing business in Japan in which small to mid-sized companies that have a "hands on" management might find they have a natural advantage.

Keep concepts simple. Japanese executives often disdain complex, legalistic proposals. Instead, one often hears Japanese executives’ state “we should work things out together as Japanese do.” Typically, this requires compromises together with a deference to trust and pre-existing relationships.

The emphasis in Japan on informality and simplicity in cross-border M&A arises from both practical and cultural causes. On the practical side the parties often negotiate in English. Like international executives from most countries, many high level Japanese businesspeople are fluent in English. However, negotiations are more manageable when the documentation and proposals are in “plain English” and do not include convoluted provisions and concepts. Quite often the Japanese team faces a greater disadvantage than might the typical European or American negotiators when having to deal in the English language.

More than likely, the transaction will be reviewed at various levels by senior executives within the Japanese corporation. These executives may be unfamiliar with and even suspicious of Western ways of dealing. And it is quite likely that they will be unfamiliar with the mechanics of Western-style mergers and acquisitions. Senior Japanese executives are more likely to okay a transaction if it is as straightforward as possible.

Understand the dynamics of your counterpart. Some Japanese companies are trying to encourage greater flexibility in decision-making. But many large Japanese companies still operate under a burdensome managerial hierarchy. While Western companies give mid-level executives discretion to negotiate deals based on their independent judgment, Japanese negotiators may be expressly or implicitly required to consult closely on minute details with senior executives before accepting any proposal.
Negotiating in this environment is usually challenging for Western executives. In addition to patience, a few simple techniques may minimize frustration.

Western negotiators should put their proposals on the table early to allow a timely response by their Japanese counterparts. Western negotiators also should avoid surprises. That will help their Japanese counterparts, who must achieve consensus among senior executives. Reaching a new consensus often requires time. Worse yet, going back to the executives provides them an opportunity to raise additional new issues.

For the reasons above, the Japanese negotiating team itself may also seek to minimize the involvement of its executive decision-makers. This urge to avoid senior executives may lead Japanese negotiators to reject even reasonable requests out of hand. Surprises can kill a deal.

On the contrary, it is not uncommon for a Japanese negotiating team to raise untimely last minute demands based upon suggestions by executives who have not been involved in the transaction to date, but who also cannot be ignored once they become involved. Sometimes Western negotiators misinterpret these untimely proposals as a bad faith change in the deal terms. Quite often it is simply a matter of poor management of the negotiating process.

Understanding the source of a counterpart’s reactions to proposals and untimely demands requires patience. It is also an essential requirement for determining appropriate responses.

Understand the inter-company relationships. In Japan, companies in certain industries often form a tight web of relations with affiliates, customers and suppliers. Such networks are loosely referred to as “keiretsu.” In cases where suppliers and customers own stakes in each other’s companies, these ties are obvious. But companies often maintain less obvious ties by sharing technology, production and management. Inter-company debt guarantees are also common.

Commonly, ongoing transactions and other important relationships within networks are poorly documented or not documented at all. Nevertheless, investors should strive to evaluate and clearly understand these relationships and the inherent liabilities early in the acquisition process. Otherwise, foreign investors may learn about such issues only at the last minute when closing appears inevitable. Such untimely disclosures do not necessarily indicate bad faith. Often, it reflects the complex nature of the Japanese keiretsu. Even the target company itself might fail to understand or appreciate the impact of keiretsu relationships on the proposed deal.

Accordingly, early clarification of these relationships is absolutely crucial. Investors must confirm transactions that are not at arms length, insider deals, and inter-company guarantees, etc.

Unfortunately, Japanese companies also provide notoriously conservative and vague disclosures. To avoid misunderstanding and stonewalling later, investors should consider walking the target company’s management through due diligence requirements in the planning stage. Management interviews are also an important means for understanding the target company and for finding any hidden “land mines” not disclosed in documentation.

Japan is truly a complex blend of the traditional and modern and often defies Western attempts to fully understand it. Nevertheless, the right team and knowledge of the basics can help ensure that valuable transaction time is not wasted and that deals that should have happened are not lost. Hopefully, this article has offered a useful guide, but these are only generalizations. Each situation must be evaluated first-hand by qualified individuals with extensive knowledge of Japanese language, culture and business environment.