Jim Rogers QuantumMagIssue15 LowRes

QUANTUM
Fi n a n ce I n Perspec tive Issue 15 July 2011
The New Global BalanceJim RogersBrazils ConcernsQFINANCESir Howard Davies A Reserve CurrencyCorporate GovernanceChina and the United StatesWilliam Keegan
QUANTUM FINANCE IN PERSPECTIVE
Contents
Lessons to be learned / 4 Roller coaster / 8 American hot / 12
The financial crisis was the nadir of the Washington Consensus, but the speculative culture is still very much with us, says William Keegan. Jim Rogers, one of the worlds shrewdest investors, graphically lays out his view of the new global economic order in a special interview with David Smith. Conrad de Aenlle insists that the United States has the underlying strengths to resist the challenge to its supremacy from rapidly developing rivals.
Talking revolution / 18 Reserve position / 24
China may be slowly moving towards greater international participation but, says David Smith, it will insist on doing so on its own terms. Bretton Woods may finally have had its day, argues Brandon Davies, and the reserve currency system urgently needs modernising.
Meeting of minds / 34
The recent economic meltdown has led to irresistible demands for broader participation in the regulatory process, says Sir Howard Davies.
Setting the standard / 39
12
24
International Financial Reporting Standards are spreading round the world but at a comparatively slow pace. Victor Smart reports.
Corporate powers / 52
As ownership models become increasingly diverse, Fahad Toonsi analyses the strengths and weaknesses of differing methods of corporate governance.
Another cup of coffee / 62

In a letter from Brazil, Brian Caplen says the nations new status as a world power has led to a major spending spree that may not be sustainable.
39
62
Articles from QFINANCE

Unintended Consequences /
Paul Wharton
30
Holding the Curve /

Andrew Milligan
45 58
Dont blame the fog /

Justin Fox
QFINANCE is a financial knowledge base and reference source created by the QFC Authority and Bloomsbury Publishing PLC. See www.qfinance.com
Quantum - Finance In Perspective - Issue 15
Contributors
Contributors
Brandon Davies is senior nonexecutive director of Gatehouse Bank plc and Premier European Capital Limited, a private capital company, as well as chief executive of his own company dRisk.biz Limited. He has more than 35 years of experience in the banking sector. Paul Wharton is chief investment
strategist for Deutsche Bank Private Wealth Management UK. He is responsible for economic and market strategy and the income-oriented portfolios, and serves on the UK and the global investment committees of Deutsche Bank Private Wealth Management.
Sir Howard Davies has been the Director of the London School of Economics since September 2003. From 1997-2003 he was the first Chairman of the Financial Services Authority, and from 1995-97 Deputy Governor of the Bank of England.
Fahad Toonsi is a manager in the Risk Assurance Services department of PwC, specialising in corporate governance and the measurement of performance and efficiency levels of firms, boards of directors and governance systems.
Justin Fox is editorial director of

the Harvard Business Review Group and author of The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street. He also writes a blog for hbr.org and is a contributor to Time magazine.
Andrew Milligan is head of global strategy at Standard Life Investments, having worked previously at the British Treasury, Lloyds Bank, and Smith New Court as an international economist. He was chief economist at New Japan Securities Europe, and director of economic research and business risk at Morley Fund Management. Conrad de Aenlle writes investment columns and features for The New York Times and International Herald Tribune among other publications. William Keegan is the senior economics commentator
of the London Observer, with more than 25 years experience covering international business and finance.
Brian Caplen has been editor of

The Banker since 2003. He joined the Financial Times Group in 2000 from Euromoney, where he had been executive editor for five years. He also worked as a business editor and journalist in Hong Kong and the Middle East for 10 years.
Victor Smart is a communications specialist in the

business, financial and accounting sectors. He is a contributor to the Economist and Financial Times.
David Smith has been Economics Editor of the London

Sunday Times since 1989, where he writes a weekly column. He is the author of several books.
QUANTUM FINANCE IN PERSPECTIVE. TRADEMARK REGISTRATION IN PROGRESS. QATAR FINANCIAL CENTRE AUTHORITY 2011. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic or otherwise, without the prior permission of the copyright holder. Quantum magazine is published quarterly by Camel5 Publishing of London (the Company) on behalf of the Qatar Financial Centre Authority (QFC Authority).Whilst the Company makes all reasonable effort to ensure that information contained in articles (information) is accurate, complete and not misleading, no warranty, representation or undertaking of any kind whatsoever is given by the Company or QFC Authority.The Company, QFC Authority and its representatives shall not be liable, directly, indirectly or howsoever for any loss or damage suffered or incurred by any party using or relying upon the information. Further, no liability whatsoever is accepted for any errors, omissions or statements contained in the information. Accordingly, all third parties accessing, using and/or relying upon the information expressly undertake to carry out their own due diligence and independent verification of the accuracy and completeness of the information.
Editorial
QUANTUM
FINANCE IN PERSPECTIVE
Editorial
The New Global Balance
z The days when the United States and Europe dominated the global
economy and set the rules for how the financial system operated are gone, almost certainly for ever. But it is far from clear how those demanding a place at the top table, including India, China, Brazil and Russia, intend to exercise their power. In this issue of Quantum Finance in Perspective, a quarterly magazine published on behalf of the Qatar Financial Centre Authority, we examine this New Global Balance. In the United States, says Conrad de Aenlle, many bankers and gurus still believe that the countrys fundamental strengths give it a strong chance of remaining economically supreme and playing the leading role is setting the rules for international markets. This view is forcefully rejected by Jim Rogers, one of the worlds shrewdest global investors. In an exclusive interview, he argues that there is now a huge historic move (in economic power) from the United States to Asia, exacerbated by a financial crisis and the mistakes made by politicians. Rogers has no doubt that financial power has already shifted away from Washington and that, while the financial crisis has accelerated the process, the prime cause has been the Wests slide into indebtedness. That debt has been financed by creditor nations, headed by China and the extent to which Beijing wishes to exercise its economic power will be critical to the development of the new global balance. David Smith says there has been a recent change in attitude. Two years ago, China appeared to be backing calls for the IMFs Special Drawing Right (SDR) to replace the dollar as the worlds pre-eminent currency. Today, says Smith, the enthusiasm for reform appears to have cooled, perhaps because analysts have pointed out that a gradual approach is the best way of preserving the value of its huge and growing dollar reserves. The advocates of change to the SDR, headed by Frances President Sarkozy, remain as loud as ever. The banker Brandon Davies argues that the financial architecture designed at Bretton Woods has now passed its sell-by date and the reserve currency system may need to be resdesigned from scratch. Chinas current stance suggests that this is unlikely to happen in the short term but the fact that Beijing can now tip the balance either way shows just how far and how fast real power is shifting away from the West. Q
EDITORIAL BOARD
Sir Graham Boyce Rajat Gupta Lord Jacob Rothschild Sheikha Hanadi Nasser Bin Khaled Al-Thani Sir Kenneth Warren Sir John Stuttard
PUBLISHER
Sarah MacInnes publisher@camel5.com +44 7879 473 221
EDITOR
Nigel Dudley editor@camel5.com +44 208 670 1922
DEPUTY EDITORS
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DESIGN/PICTURE RESEARCH
Marcus Baron
PRODUCTION MANAGER
Hannah Martin
For subscription please visit our website www.quantummagazine.com
Commentary
History is Back
The changing balance of global economic power should not come as a surprise to economic historians. But although it is a fundamental shift, the speed of the transformation should not be exaggerated, says William Keegan.
z One of the more interesting and
beneficial consequences of the 20072009 financial crisis and its aftermath is the rediscovery of economic and financial history. With the rise of mathematical economics and the socalled efficient markets hypothesis, the study and practice of economics became divorced from its historical roots. There was a generation of university graduates, alumni of business schools and trading practitioners who had never lived through a recession, let alone had any knowledge of a Depression, and who genuinely seemed to think that the financial markets had discovered the economic philosophers stone. 4
At the same time, even those members of older generations who ought to have known better seemed to be too wedded to the familiar, and resistant to the idea that we had by no means witnessed the end of history. Certainly, the Bretton Woods system had broken down in the early 1970s, and the prevailing view was now that markets knew best, and that there was a limit to the desirability of intervention by governments. Western economies have not always dominated the global economy. Indeed, at one time China and India dwarfed the economies we are accustomed to describe as advanced. Thus, in the late Angus Maddisons remarkable work The World Economy A Millennial
Perspective, it was estimated that in 1820, shortly after the Napoleonic Wars, China accounted for a third of world GDP, Europe a quarter and the United States less than 2 per cent. Indias share was 16 per cent. The proportions changed dramatically in the course of the 19th and 20th centuries. There were trade cycles, banking crises and periods of very sharp decline but on average world GDP grew year by year. The really interesting contrasts were between the periods 1913-50 and 1950-73, when average annual growth of output went up from 1.85 per cent to 4.91 per cent. This latter, largely Bretton Woods, period was truly the nearest we got
Commentary
to a golden age of growth. And, as Keyness biographer Robert Skidelsky pointed out in Keynes, The Return of the Master, there was a sharp decline in economic growth rates between the Bretton Woods period almost 5 per cent a year and the post-1980 period (1980-2009) when average growth was 3.2 per cent. It is noteworthy that there were no global recessions during the Bretton Woods period, and no fewer than five during the so-called (post1980) Washington Consensus years. These five included the big one the recession caused by the financial crisis of 2007-08, the consequences of which are still with us. This is important when assessing possible future economic trends, because there can be little doubt that policymakers in the rising economic powers headed by China, India and Brazil have fully taken on board the defects of the Washington Consensuss emphasis on the putative wonders of deregulation and maximum freedom for financial markets. Two events stand out as reasons why the emerging economic powers can be forgiven for concluding that the western emperor has no clothes the Asian financial crisis of 1997 and the more recent Great Recession. Washington was still triumphally imperialist in international monetary matters in 1997, and effectively vetoed a proposal for an Asian Monetary Fund. As a result the Chinese and other Asian countries, having seen what had happened to defenceless developing nations in the face of volcanic capital flows, decided that this should never happen again. They built up their own reserves, giving them not only ample ammunition to defend themselves against speculative raids on their
Commentary
currencies, but also massive sovereign wealth funds, which enabled them to invest abroad in both financial and physical assets, including supplies of raw materials. The financial crisis was the nadir of the Washington Consensus. The emphasis had been on price stability rather than control of credit creation. The boom in asset prices was noted, but policymakers refused to take any responsibility. Financial markets were allowed to speculate themselves out of any trust in one another. The western-dominated G7 and International Monetary Fund went along with all this indeed became vociferous cheerleaders. Meanwhile China adopted a cautious approach, picking and choosing what it regarded as the more useful aspects of market capitalism, but remaining a lot more communist than all those western commentators celebrating the collapse of communism seemed to notice. What has become increasingly obvious is the sheer economic clout of China, whose economy has grown by some 10 per cent a year on average for the last two decades, while final domestic demand in the advanced economies (broadly the OECD area) grew at 2.9 per cent a year from 1992 to 2001, and 1.5 per cent a year from 2002-2011. But we still lived in the world where the economic clout of the G7 mattered most. People talked about the rise of China; but, for all its formidable size, it was in global terms a relatively small economy. I shall never forget, for instance, a senior Japanese policymaker telling me in 1997 just what a small proportion average Chinese living standards were of Japans. And they still are, although the gap has narrowed. 6
There should of course be nothing surprising about a large gap between the growth rates of advanced and developing economies. Indeed, some analysts can be disingenuous, if not naive, in contrasting such growth rates. But the interesting thing is that, with its manifestly mercantilist trading policies, its financial power as a result of the accumulation of all those currency reserves and its increasing demands on world resources, China has become a major some would say the major influence on the course of the entire world economy. Thus China may still be only half the size of the US when it comes to economic output less than half by ordinary measures of GDP, more than
half when measured by purchasing power parity. Nevertheless, at the margin and economists love talking about the margin it is enormously important, with hardly a day going by when its influence on the course of commodity prices is not being cited in the financial press. Some lessons have been learned; but only some. As I write, the top bankers are still awarding themselves massive bonuses despite the fact that they have been bailed out by the taxpayers. The speculative culture is still very much with us, not least in the commodity markets. One fashionable theory is that for a decade there was a Faustian bargain between China and the West
Commentary
(still dominated by the US), with the West enjoying cheap goods (with employment suffering at home), but failing to realise that demand from the Asian manufacturing powerhouse would drive up the price of commodities and threaten stagflation slow growth but imported inflation. So far there has been nothing remotely resembling the stagflation of the 1970s. The US Federal underestimated, even if membership eventually proves too much of a strain for some of the peripheral nations. It is also interesting that, as China watches developments, its policymakers give the impression of wanting to assist the eurozone by investing in it as a counterweight to all the financial investment they have made in the US. But, in international economic governance, the time has surely placed more emphasis on the importance of employment, and acknowledged the need at times for capital controls. Moreover, his was a powerful voice in supporting the fiscal and monetary stimulus of 2009. But whether the Fund itself will have learnt its lesson remains an open question, given the strict conditions being applied to the eurozone bailouts. For economic historians the
The financial crisis was the nadir of the Washington Consensus. The emphasis had been on price stability rather than control of credit creation. The boom in asset prices was noted, but policymakers refused to take any responsibility. Financial markets were allowed to speculate themselves out of any trust in one another.
Reserve has remained haunted by the spectre of deflation. Meanwhile the new British coalition government has superimposed a deflationary programme on an economy that has shown few signs of recovery from recession. The eurozone too is in serious trouble that is to say, peripheral economies such as Greece and Ireland are on the edge, while Germany, with its strength in manufacturing and exports, prospers. Germanys happy secret is that other members of the eurozone, such as Italy, can no longer, within a single currency, devalue their currencies to boost competitiveness. The political will behind the eurozone project is not to be come for the heavy presence of the European Union on the IMF Board to be reduced, and far greater weight to be given to the likes of China, India and Brazil. Few would have expected, back in the early 1980s, that in 2011 the eurozone would be by far the IMFs biggest customer for funds. It is ironic that Dominique Strauss-Kahn, the now-departed managing director of the IMF, was able to play a crucial role in assisting the eurozone, while encouraging those who believed that the structure of the IMF and World Bank ought to reflect the fundamental shifts in economic power. Strauss-Kahn recognised that the limits of the Washington Consensus changing balance of economic power in the world should not come as a surprise. But an historical perspective also suggests that one should not exaggerate the speed of change. The US, notwithstanding the re-emergence of China, will remain a formidable force in the world economy for decades to come. Its policymakers leaving to one side those who support the Tea Party have been right to concentrate on warding off a Depression. In the longer run, the deficit, which is seen as a sign of weakness, can in theory be fixed by a combination of renewed economic growth and fiscal adjustments. Whether the US has the political will to hold to such a strategy is an open question. Q
Interview
Global investor par excellence Jim Rogers believes that the 30-year boom in finance is over, but that new opportunities beckon elsewhere. In this special interview for Quantum, he explains his vision of the future to David Smith.
Rider on the Storm

z If anybody should know about the a financial crisis and mistakes made by
new world order, it is international investment guru Jim Rogers. His conversation is littered with historical references. Everything he says is jargon-free, though there is a weight of accumulated investment knowledge behind it. It is hard not to come away convinced. Interviewing Rogers, now 68, is an exhilarating roller-coaster ride. Speaking from his office in Singapore, he doesnt mince his words. Wheres the world going? The worlds going to hell, isnt it? Yet minutes later he will say: Im wildly excited about some things I cant tell you how excited I am. But Im very pessimistic about others, Were in a period of great historic change. He explains: In the 1920s and 1930s there was a huge historic move from the UK to the US, exacerbated by 8
politicians. Most of them didnt notice it at the time. Now were in another huge historic move from the United States to Asia exacerbated by a financial crisis and the mistakes made by politicians and again, most of them dont notice it. Financial power has already shifted away from America, from Washington, not as a result of the financial crisis though that has accelerated the process but of the Wests long-run slide into indebtedness. Debt and credit are central to the way Rogers views the world. The large creditor nations in the world are China, Korea, Japan, Hong Kong, Taiwan and Singapore. Sure, people see that something is happening in China and in Asia. But look at the whole thing thats been going on at the IMF, he says, referring to the upheaval
Interview
Left: Jim Rogers, May 2011
Interview
Jim Rogers, investment biker

Jim Rogers co-founded the Quantum Fund with George Soros as long ago as 1973, making enough money by 1980 to take time out to travel the world on his motorcycle. Thus was born the investment biker. Over many years he travelled the world on two wheels, riding through six continents including Africa. When China was still highly suspicious of foreign visitors, he rode through it more than once on his trusty bike. In the late 1990s and early 2000s, he entered the Guinness Book of World Records for a journey of more than 150,000 miles in a specially-built Mercedes in the company of his wife. So Rogers has seen the world as well as invested all around it. Today he is chairman of Rogers Holdings and Beeland Interests. He is known as a raging commodity bull, his own Rogers International Commodities Index monitoring the ups and downs mainly ups in recent years of global commodity prices. Famously, Rogers voted with his feet four years ago, selling his mansion in New York and moving to Singapore. Even before the financial crisis had done maximum damage to America, he was convinced the worlds centre of gravity was shifting rapidly away from his own countr y (he is a native of Baltimore). His book, A Gift to My Children, published two years ago, written for his two young daughters, contains lessons on life and investing. He advises his daughters to learn Chinese and beware of boys. He also advises them not to follow the crowd. Following the crowd is not something you could ever accuse Jim Rogers of doing.
leading to the departure of Dominique Strauss-Kahn. The question has been: Which Frenchman or Frenchwoman will head the IMF? The world is moving to Asia, quickly, and people dont understand it, he says. I wrote recently that the Nobel Prize for economics was established in 1969 and in that time nobody from Asia has ever won it. The West has gone down the tubes in that time. The world is heading east. Go east young man, go east young woman. That is a theme we will return to in the conversation, but Rogers has another story central to his view of the world. The 30-year boom in finance is over, he argues, particularly as far as Wall Street is concerned. Making things and growing things will make a comeback. 10
Through history weve had long periods when the financial types were in charge, and weve had long periods when the producers of real goods were in charge. In the 50s, 60s and 70s Wall Street and the City of London were backwaters. Virtually nobody went there or cared about them. I was at Oxford in the 50s and my dons used to say: We dont have anybody like you here. Nobody cares about the City. The City is irrelevant to the world, irrelevant to the economy. That was the status of the City and Wall Street. Believe it or not. when I first went to Wall Street in the 60s, a big day on the New York Stock Exchange was three million shares. These days they trade three million shares before people get up for breakfast.
But not, he suggests, for long. The financial community is going into decline, he says. Let me give you some statistics. In 1958 America produced 5,000 MBAs per year. Nobody else produced any. Last year America produced over 200,000 MBAs as well as the tens of thousands in the rest of the world. That kind of competition in finance, at a time when debts are staggering and when governments are coming down very hard on bankers and investment bankers the laws, the taxes, the regulations means finance is going to be a terrible business over the next 30 years. Finance is now the wrong place to be, he insists, and agriculture is the new growth area. But in his view the
Interview
US is ill-prepared. In America the average age of a farmer is 58. America produces virtually no agricultural or mining graduates every year. Theyre all studying for MBAs to go into finance. One of Rogerss central investment themes is that commodities are a buy. The other side of that is that bonds, and in particular Western government bonds, are to be avoided. He scoffs at the idea that bonds should be seen as a safe haven in the coming years. We have a bull market for commodities, no matter what happens to governments, because supply issues are problematical and demand is up, he says. The US is now the largest debtor nation in the history of the world, and you have the debt skyrocketing at the same time as the US and others are printing huge amounts of money. This kind of thing has always led to problems in bond markets and higher interest rates. So were going to have higher inflation and higher interest rates. What about commodity-based economies? Is he as bullish on those as he is on commodity prices? And are not commodities always hugely cyclical: prone to booms but also spectacular busts? It depends on how commodity countries are managed, he says. Canada has been much better managed than the United States for the past couple of decades. Congo, however, has lots of natural resources but Im not putting a lot of money into Congo. But even the badly-managed ones are going to be doing better. Weve had many long bull markets in commodities in the past, followed by bear markets. I would have to examine my own head if I said it (the bull market) was permanent. It could be. Always in the past, as prices go high, it brings in new supply, or substitution, and it cuts demand. I suspect it will with this one too. The long-term trend, however, is up. The commodity super-cycle, identified early by Rogers, is intact. His belief in China is well known. More surprising perhaps is that, unlike most commentators, he does not see India in the same light. Having visited India many times on his travels and for professional reasons he is unconvinced. I urge people to fly to India and drive across it a couple of times, he says. I dont think they would be quite so enthused. If you could only visit one country in your life you should go to India manmade and natural sights, ethnic groups and religions, women winning beauty contests and men who are incredibly smart. But they are incredibly chauvinistic, they are anti-capitalist. If youre not in bed with the right people youre not going to do well. It is a bureaucratic nightmare. Rogers is also worried about Indias debt. Historically, if you have 90 per cent debt to GDP, thats a point after which it is very difficult to grow dynamically. As for China, the Peoples Republic is in the vanguard of the huge shift towards Asia that he expects. The future shape of the international monetary system is a key factor. China, like a lot of other people, is worried about the dollar, he says. I dont have much confidence in SDRs (IMF Special Drawing Rights) because paper money is bad enough, much less fictitious paper money. Who knows if the world collapsed tomorrow, thats probably what they would use out of desperation. If the US fell into the sea tomorrow they would use the euro, but I dont expect the euro to be around for too many more years either. China has got the only currency that I can foresee in the longer term replacing the dollar on a permanent basis. But it is a blocked currency, so it is almost absurd to bring it up right now. Jim Rogerss views can seem pessimistic, particularly to Americans, most of whom do not share his view of their countrys decline. Maybe, as he would say, they just have not yet got the message. He insists he is not downbeat. Indeed, his voice sings with enthusiasm about what he sees are the opportunities that will open up in the coming years. In 1807 if youd moved to London youd have had a wildly exciting life while other parts of the world collapsed the Austro-Hungarian Empire was in serious decline, France was in serious decline. If you had moved to New York in 1907 you would have seen some phenomenal opportunities. There are great opportunities now, but you are going to see some institutions that have been around for a long time declining just as always happens in periods of great change. Lehman Brothers had been around for 150 years its gone. Bear Stearns had been around 80-90 years its gone. Harvard is essentially bankrupt. Who was it who said: The old order changes, bring on the new? If youre in the new youre going to make some staggering fortunes. I suggest to him that it feels like the creative destruction coined by Joseph Schumpeter, the Austrian economist; the radical changes that breathe new life into capitalism. He agrees. In China theres the concept of Yin and Yang disaster and opportunity are two faces of the same coin. In a catastrophe there are always opportunities for those who adapt and who are alert. Thats why Im wildly optimistic about some things and I hope I can adapt to them. Q
11
USA
Some fear that the United Statess status as global economic leader may be in jeopardy as developing nations expand rapidly. But those in the know insist that Americas fundamental strengths mean it will remain economically supreme. Conrad de Aenlle weighs the evidence.
States of Flux
z Mark Twain famously said that numerous signs of waning power
reports of his death were greatly exaggerated. That was in 1897, just before the arrival of what became known as the American Century. As observers around the world in 2011 ponder whose century the next one will be, the perceived odds against a second coming for the United States appear to be lengthening so much so that Uncle Sam might be inclined to invoke the authors remark, albeit out of exasperation. But just how accurate are the metaphorical obituaries? The commentators who view American leadership in the past tense point to 12
and influence in global economic, financial and political affairs. The rise of emerging economies and other examples of rapid expansion have been making news while in the US, fiscal and current account deficits and the nations obligations to foreign creditors are predominant. Looking at just the last three or four years, the naysayers have plenty to say nay about. American banks did not corner the market in stupidity, but the worldwide financial crisis and recession were largely made in the USA. Perhaps more importantly, critics argue, the economy does not have much to show
USA
USA
for the various measures used to try to revive it, most notably quantitative easing, the Federal Reserve programme to buy Treasury bonds with freshly printed cash. The result, they say, is a shrivelling of American leadership abroad. In terms of American dominance of global affairs, I think it passed in 2007, said Komal Sri-Kumar, a strategist at TCW, an American subsidiary of the French bank Socit Gnrale. Thats my estimate of when leadership switched to Asia. It would have happened gradually over ten to 20 years, but the crisis and our handling of it hastened it. and resentment and a source of potential financial calamity in part because of its impact on the dollar and the fact that the US Treasury and others are on opposite sides of the mother of all foreign exchange trades. The US needs to make sure the banks are OK and (authorities) want to export more through a cheaper currency, but they dont want it to happen all at once, observed Jerome Booth, research director of Ashmore Group, a London fund manager. Emerging market central banks beef is that the dollar is going to depreciate quickly. They would be OK with (further quantitative easing) However even those like Paul Bracken, a professor of management and political science at Yale, who accept that US power and influence has diminished as rivals in the developing world get stronger, question whether American economic might has diminished as much as others think. No question, compared to the 1990s, US political influence in the world is lower, he said, but with the economy its much less clear. Long-term economic data compiled by Haver Analytics and Citigroup Investment Research highlight one clear loser, and it is not the United
In terms of American dominance of global affairs, I think it passed in 2007. Thats my estimate of when leadership switched to Asia. It would have happened gradually over ten to 20 years, but the crisis and our handling of it hastened it.
Komal Sri-Kumar, TCW, an American subsidiary of the French bank Socit Gnrale. US influence appears to be moving in an inverse relationship with the fiscal deficit. The need to borrow trillions of dollars has reduced Americas economic power, Sri-Kumar believes, and also its power of persuasion. We had the moral authority to advise Latin American countries in the 80s and 90s, and we advised Asia in 97 and Russia after the default of 98, he recalled. Every time we said what the correct policy was to get out of a crisis. Everywhere I go today, Im asked why the US doesnt follow the advice they gave us. The deficit is a focal point of doubt 14
if there were a big fiscal adjustment at the same time, but if not theres a risk that theyll stop buying Treasuries. Sri-Kumar expresses similar disdain for Washingtons currency management. A decade of debasement of the dollar and no policy on the currency has made the rest of the world look urgently for a replacement, he remarked. That has gathered more strength than I had anticipated. When it speeds up, it will increase interest rates and reduce our dominance over the rest of the world because we wont be able to print our way out of a crisis.
States. The 15 countries that made up the European Union after the 1995 enlargement accounted for 31 per cent of global output in 1970, the same as the United States, their figures show. The American proportion dipped to 28 per cent in 1982 and held steady through 2009, the last year in the study. Europes share of the pie declined steadily and markedly, to 22 per cent, while mainland Asias share quadruped to 12 per cent. The US economy has held up well because it has many fundamental strengths the ones that helped it
USA
become so dominant in the first place to accompany its shortcomings. The latest edition of the World Competitiveness Yearbook, compiled by the International Institute for Management Development, a Swiss business school, ranked the United States third, pipped by Singapore and Hong Kong but well ahead of such pretenders to the role of global leader as China, ranked 18th, India (31st) and Brazil (38th). The US has weathered the risks of the financial and economic crisis thanks to the sheer size of its economy, a strong leadership in business and an unmatched supremacy in technology, a study detailing the results said. Also working in Americas favour are such factors as a wealth of raw materials, a socially and geographically mobile society and a culture of risk-taking that produces continual innovation, both the technological sort alluded to in the competitiveness study and others that enhance commercial and industrial productivity. Observers who believe that the US has not lost its mojo argue that short-term negatives are obscuring these long-term positives. It is certainly true that the scope of the financial crisis and our policy responses havent engendered overwhelming confidence in our national judgment, acknowledged Kori Schake, an associate professor of international security at Stanford University. The same is true of our debt and deficit spending. But I think the people arguing that America is in decline dramatically underestimate the resilience of our economy. That resilience and the qualities underpinning it engender a sense of trust and security throughout the world, in her view, that will outlive present misgivings. The dollar is the paramount reserve currency because people have
faith in the continued growth and innovation and transparency of the American economy, she said. Schake would feel more comfortable if she could add fiscal rectitude to the list. She hopes that Washington will get its house in order. We should come up with a credible plan to pay down our debt and spend less than we owe, she counsels. Thatll do more to restore the vitality of the American economy and prestige of American power than any other policy choice, foreign or domestic. That is a major part of Sri-Kumars
prescription, too, but hes not holding his breath with the presidential election less than 18 months away. Necessary fiscal changes might cause a steep recession and hit the stock market, he said. That might be political suicide, but it would help the economy, and therefore American stature, in the long run. You have to pay the piper, he said. The more we keep (the economy) going through temporary stimulus, the more well have to pay a price for it. One way for US authorities to obtain a discount is to be more gracious
15
USA
The commodities conundrum

One fact of 21st-centur y economic life could limit a decline in US supremacy over the ver y long haul and possibly even reverse it at some point: persistently rising commodity prices. Thats what Jeremy Grantham, chief investment strategist of the Boston fund manager GMO and a widely respected figure in investment circles, believes is occurring. Grantham contends that we now live in a different, more constrained, world in which prices of raw materials will rise and shor tages will be common. He points out that more than a centur y of declining inflation-adjusted commodity prices has been undone in just the last decade. He attributes the strong, abrupt course correction to accelerated demand from developing countries, especially China, and finds that the level of price rises makes it extremely unlikely that the old trend is still in place. In what could be the makings of an economic Greek tragedy, Grantham warns that these conditions will retard long-term growth rates in the developing world. Mature countries are bound to suffer as well, but less so, in his view, and the US economy could be par ticularly resilient. One point in its favour, perhaps paradoxically, is that Americans are wasteful; that leaves plenty of scope to conser ve and to adjust demand as prices rise. The US has plenty going for it on the supply side, too, he points out. The US is, of course, ver y well positioned to deal with the constraints, Grantham explains. First, it star ts rich, both in wealth and income per capita, and also in resources, par ticularly the two that in the long run will turn out to be the most precious: great agricultural land and a pretty good water supply. The US is also well endowed with hydrocarbons. All other countries should be so lucky. Americas status as global economic leader may be in jeopardy, but how much progress are the would-be usurpers making? Growth in developing countries has been impressive, but some authorities on international relations point out that it comes off a ver y low base and warn that maintaining the momentum will be no mean feat. They havent yet made the
16
USA
in dealing with allies and adversaries and accept a more even distribution of power within global organisations, notably the International Monetary Fund, a body where they have the power, if not necessarily the right, to veto any decision. Who is going to ask us to shape up, SriKumar said. The IMF cannot. Emerging economies have capital surpluses. Are we going to ask China and Brazil to finance the US deficit when they essentially have no seat at the table at the IMF? The indications are that the US is more willing to listen more carefully to the views and demands of the newly powerful economies of Asia. The US government is trying to adapt the post-war system to accommodate the rise of new powers, he said. Its now working through the G20, not just the G7. US authorities are also in favour of UN Security Council seats for India and Japan, he noted, although not straight away. Booth, at Ashmore, expects the developing world to be more forceful in global policy arenas. The G13 countries are starting to become more assertive, pressing their agendas on currency and global monetary system reform, he observed. Emerging economies have been pushing for voting reform at the IMF too. How should American officials respond? One view is that Washington will be in a better bargaining position if it recognises that the US is in a worse position than before. The US has the most bargaining power, but for the first time China has some too, Booth argues. Better to sit down and negotiate with China than get completely worked up and do something stupid. If Im the US, I need to realise I can no longer dictate what I want and have (other countries) fall over to do it. By going with the flow and settling into a sedate middle age, Booth believes, the US should continue to thrive and to play the leading role in setting the rules for international markets and organisations, despite all the reports to the contrary. The US is discovering the way the rest of the world has to deal with problems, he said. Its not the end of the world. Were all gaining; its just that emerging markets are gaining faster. The US remains the most powerful country on earth. Q
tricky transition to idea-generating economies, says Kori Schake, an associate professor of international security at Stanford. Theyre still manufacturing predominantly. Paul Bracken, a specialist in global business strategy at Yale, agrees. He sees the rapid development in some countries as being achieved by emphasising quantity over quality. He wonders how sustainable it will be. China has had a relatively easy problem in economic
We now live in a different, more constrained, world in which prices of raw materials will rise and shortages will be common.
management so far because the sources of growth are manufacturing and moving people from the countr yside to the cities, he explained. Even the Soviets were growing under those conditions in the 1930s. Growth rates in emerging economies are much higher than growth rates in the West during the Industrial Revolution, he adds, so theyre going to hit social and environmental limits a lot faster. What they do with that depends on a lot of factors in the future that I dont know.
17
China
Proceed with Caution

Hopes that China may be prepared to countenance liberalisation and the opening up of its financial sector are likely to be dashed, says David Smith. Risk aversion and caution will remain its watchwords as it defines its new global role.
z A couple of years ago, it all seemed Bretton Woods conference in 1944.
fairly clear. At a time when the world economy was teetering on the brink of collapse as a result of the global financial crisis, Beijing appeared to be taking the lead on reform of the international monetary system. After years in which calls for reform usually from France had fallen on deaf ears, suddenly the worlds second largest economy was in the vanguard of the demand for change. Zhou Xiaochuan, governor of the Peoples Bank, the Chinese central bank, set out a vision of reform very much along the lines proposed more than 60 years earlier by John Maynard Keynes at the 18
Instead of an international monetary system based on the dollar the model chosen at Bretton Woods in preference to Keyness version the Peoples Bank governor gave a powerful hint that Beijing preferred to shift the focus on to the Special Drawing Right (SDR), the IMFs currency basket. Just as America was on course to be replaced as the worlds biggest economy by China, so the dollar would lose its global pre-eminence. That, it seemed, was Chinas vision and it was dramatic. Fast forward to late March 2011 and the scene was set for a specially convened G20 high-level seminar
China
19
China
in Nanjing, China, to discuss international monetary reform. While China was host, the French president Nicolas Sarkozy was in the chair as president also of the G20. Sarkozy was maintaining the Elyse Palace tradition of wanting a shake-up of the system and an end to its dominance by the dollar. If he was expecting Chinas wholehearted support, however, he was disappointed. Wang Qishan, the Chinese vice-premier, did his best to correct the impression that his country was pressing for rapid reform. The reform process will be Its enthusiasm for reform has cooled, perhaps because analysts have pointed out that a gradual approach is the best way of preserving the value of its huge and growing dollar reserves. Even on the narrow question of including Chinas currency, the renminbi, in the SDR basket, no progress was made in Nanjing. The Chinese authorities, having appeared at one stage to be enthusiastic, pulled back from even that, not least because Timothy Geithner, the US Treasury Secretary, said only currencies that were truly flexible in other words not tightly use in regional trade transactions, not least by offering tax rebates, and recently issued an RMB6-billion bond in Hong Kong to promote its use in settlements. The lesson, if it were needed, is that China will proceed with caution. What China wants when it comes to international monetary reform is not to rock the boat too much, while heading off external criticism of the undervaluation of her currency. That means Frances hopes of a strong ally for reform in the remaining months of her G20 presidency will almost inevitably come to nothing.
Flying metaphorical kites is not (Chinas) style. Something has changed. Its enthusiasm for reform has cooled, perhaps because analysts have pointed out that a gradual approach is the best way of preserving the value of its huge and growing dollar reserves.
long-term and complex, he said. Official guidance was that the Peoples Bank governors analysis two years earlier had been exploratory, even academic, rather than a programme for action. It may even have been deliberately provocative in the face of Washingtons criticism of Beijings currency policy, with the aim of showing that the world may not be as permanently dependent on the dollar as America likes to think. That, however, is not the way China operates. Flying metaphorical kites is not its style. Something has changed. 20
managed should be included in the SDR. Chinas unwillingness to see the renminbi attain reserve currency status, and certainly Beijings unwillingness to promote it as in any way a rival to the dollar, remains. So what does China want? The current official focus is on the gradual internationalisation of the renminbi, by which it is meant its greater use in commercial transactions and in some third party activity. Chinas Ministry of Finance has been actively promoting the currencys
China doesnt think that theres really much room for progress in the G20 under France, said Zhang Ming, an economist at the Chinese Academy of Social Sciences. The government has become more realistic in pushing instead for yuan internationalisation, something it can achieve itself. It is not as enthusiastic as before about getting into the currency reform issue. Chinas approach to international monetary reform will exasperate those who think it is time the country adopted a more aggressive international role
China
to go with her increasing economic clout. That, however, is the Chinese way. Gradualism is the watchword. Change will occur, but rushing it will benefit nobody; neither China nor her international partners. As always with China, reading between the lines of the official fiveyear plans can be useful. The latest, the 12th, presented by Premier Wen Jiabao in his state of the nation address in March 2011, was notable for two things. The first was the explicit setting of a lower target for growth, averaging 7 per cent over
the five-years (2011-15) of the plan. The second was the pledge to make that growth more equitable and sustainable. The growth target can be taken with a pinch of salt. The 7.5 per cent annual growth target for the 11th fiveyear plan (2006-10) was comfortably exceeded, despite the global financial crisis and recession. Successive Chinese leaders have learned to promise less than they deliver. The other aims are more interesting. In theory Chinese growth, driven more by domestic
consumption, should also be more balanced. A promise to raise the minimum wage by 13 per cent a year 84 per cent over the period of the plan will spread the benefits of growth more widely. Again, however, Chinas approach is evolutionary rather than revolutionary. Stephen Green, an economist with Standard Chartered in Shanghai, said there was nothing in the plan to suggest a big shift in the structure of the economy or a significant narrowing of Chinas current account surplus. Theres
21
China
absolutely no sign that the percentage of investment in GDP is slowing. And there are no signs of liberalisation of the service sector to allow the private sector to take a bigger share of the economy, he said. Indeed, one effect of the global financial crisis may have been to make the Chinese authorities even more cautious about aspects of liberalisation. Hopes among Western banks of an opening-up of Chinas financial sector and an end to the dominance of state-controlled or semi-state banks were disappointed by the five-year plan, which set out no such prospect. From Chinas perspective, the crisis demonstrated the advantages of having built-in checks and balances in the banking system. While the rest of the world was reeling, China was relatively immune. Late last year, China hosted another high-level meeting, this time on macro-prudential regulation in Shanghai, which was attended by representatives of the IMF and most leading economies. Zhou Xiaochuan, the Peoples Bank governor, this time on less controversial ground, offered his diagnosis of why China had come through the crisis successfully. The Chinese financial system has basically withstood the shocks of the recent crisis because first, continued economic growth has created a benign environment, he said. Second, after the Asian financial crisis, joint stock reform of stateowned commercial banks enhanced their overall strength and resilience and strengthened the foundation for financial stability. Third, the financial legislation system and supervision ability has improved. Fourth, the financial market, including delivery of services and product innovation, 22
TRADE SURPLUS ($bn)

50 Unadjusted Seasonally-adjusted (including for Chinese New Year) 50
40
40
30
30
20
20
10
10
-10 2000
-10 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: Capital Economics.
CONSUMER PRICES (% y/y)

9 8 7 6 5 4 3 2 1 0 -1 -2 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Headline Core (excl. food & energy, excl. food only before Jan. 2006) 9 8 7 6 5 4 3 2 1 0 -1 -2
was not sophisticated, and this helped ward off crisis. The last point, and the implied criticism of over-sophisticated financial products as a source of instability in the West, is particularly interesting. Liberalisation will occur at a pace of Chinas choosing. There is a parallel with Japan in the 1980s, which came under heavy international pressure to open up financial services to outsiders. China is likely to take even longer. On this, as on so many
other matters, China will do things her own way. And that may not be the way the rest of the world wants. Even then, the Chinese authorities are aware of the dangers, which range from global economic imbalances to asset bubbles and excess liquidity including in China itself and potentially destabilising structures and products within the banking and financial system. In the past few years, many financial institutions are offering
China
an already tightly regulated financial system. China is determined to move slowly on big-picture reform, and to keep things firmly under control. That applies to the financial system and it applies more generally. The investment banking community is going to have to get used to the rise of Chinese firms with both domestic and global ambitions. Some of that will be achieved by acquisition Lenovos acquisition of IBMs personal computer division a few years ago was a pioneer in that respect and some by other means. For years, China has been accused of stealing technology from the West. Now the process is being formalised. An aspect of the previous five-year plan that is only now coming to fruition has excited much comment and concern, the intention being to substitute indigenous sources of supply for imported technology. With the aim of doubling research and development spending to 2.5 per cent of GDP over the next decade, the plan identified 11 key sectors and 27 breakthrough technologies, including coal liquefaction, genetically modified crops, deepsea mining, quantum physics and stem cell research. The first 16 mega projects are now taking shape, intended to replace imports with indigenous innovation, though innovation based on foreign technology. They will, according to Xi Heping, an official at the Ministry of Science and Technology, reform traditional industries and develop high technology manufacturing. China is moving into a new phase of economic development. No longer will it be a branch economy for Western multinationals. Quietly, without fanfare, China is changing her role. Q
RENMINBI/DOLLAR EXCHANGE RATE

6.45 6.50 6.55 G20 Summit 6.60 6.65 6.70 6.75 6.80 6.85 Jan 10 6.60 6.65 6.70 6.75 6.80 6.85 Apr 10 Jul 10 Oct 10 Jan 11 Apr 11 Renminbi stronger Hu visiting US 6.55 US-China dialogue 6.45 6.50
POLICY RATES (%)

24 Required Reserve Ratio (major banks) 12m Benchmark Lending Rate 20 12m Benchmark Deposit Rate 20 24
16
16
12
12
0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: Capital Economics.
cross-sector and cross-market products; financial share-holding companies have established complex internal structures and moved into diversified businesses; new types of financial institutions are heavily involved in the financial market activities, said Zhou Xiaochuan. Banks and other financial institutions will be even more closely monitored than in the past. China is also fully committed to introducing a macro-prudential regime
supplementing the regulation of individual institutions with systemwide counter-cyclical rules on capital and credit supply. The recent history of China, certainly since the Asian financial crisis of 1997-98, has been one of risk aversion. The global financial crisis threw up the threat of systemic risk. The message from the authorities is that every action will be taken to counter that threat in the future. That means regulating more strictly
23
Liquidity
Liquidity
Lost in the Woods

The Bretton Woods global financial architecture has been remarkably long-lived and its demise has frequently been forecast. This time though, argues Brandon Davies, the reserve currency system may finally need to be redesigned from scratch.
z The international currency system

is a product of the past, says Hu Jintao, Chinas president. And it is hard to argue that it is up to the challenge of dealing with the current financial situation. Today the size of a number of countries surpluses and deficits on their foreign trade accounts and associated funding issues has become an additional source of potential instability in financial markets. There is, though, little consensus about the causes of the continuing banking crisis and the degree of responsibility attributable to the dollar-based reserve currency system. The conventional wisdom that poor incentives in banks encouraged excessive leverage and risk-taking, along with the creation of complex products that no one really understood, does not tell the whole story.
This explanation relies on the idea that supply creates its own demand, whereas any economist holds to the belief that supply responds to demand. Why then was there such a broad-based global demand for US dollar-based assets that appeared to offer low risk and relatively high returns, certainly when compared to US Treasuries. The build-up of excessive surpluses as a number of countries seek to gain from the current reserve currency system means that these countries need to purchase US dollar assets to fund the US deficit the counterpoint to their surpluses for investment purposes and to finance growing levels of world trade. The incentives for innovative bankers to create and for many global financial institutions to buy such assets are obvious, as the US
25
Liquidity
The Bretton Woods System

The World War II allied powers wanted to create the foundations for post-war prosperity. They assembled in Bretton Woods for a conference dominated by the US Treasur ys representative, Harr y Dexter White, and the British Treasur ys representative, John Maynard Keynes. Dexter White proposed a system of exchange rates semi-fixed against the US dollar, which itself would be convertible into gold. The establishment of an International Stabilisation Fund to manage the system was executed in a way that placed the entire burden of maintaining the balance of trade on the deficit nations. It would impose no limits on the surplus that successful exporters could accumulate. The eventual outcome, which was ver y close to the US position, was the establishment of the International Monetar y Fund and The World Bank. The proposal for an international organisation to encourage free trade was blocked by the US, but eventually the General Agreement on Tariffs and Trade (GATT) treaty and the World Trade Organisation (WTO) achieved the same objective. Much of the system still sur vives, though the system of semi-fixed exchange rates did not. Under pressure from financing the war in Vietnam, the US abandoned gold convertibility in 1971. As a result the semi-fixed exchange rate system became a semi-floating rate system, though a number of emerging market countries effectively fixed their currencies exchange rates to the US dollar, while a number of European Union member countries created a single currency area with the euro. The British backed a ver y different model to the American system that was eventually adopted. Keynes proposed a system that would encourage both debtor and creditor nations to take action to adjust their economies. A global bank, called the International Clearing Union (ICU), would issue its own currency (the Bancor), which would be exchangeable with national currencies at fixed exchange rates; it would become the unit of account between nations, which means it would measure a countr ys trading position.
Keynes proposed a system that would encourage both debtor and creditor nations to take action to adjust their economies.
The aim was to secure creditor adjustment and debtor discipline. All international transactions giving rise to surpluses or deficits in the balance of payments would be settled through clearing accounts at the ICU, while countries central banks would buy and sell their currencies against debits and credits with the bank. Each countr y would have an overdraft facility in its ICU Bancor account equivalent to half the average value of its trade over a five-year period. Countries should clear their Bancor accounts at the end of each year so that they had neither a trade deficit nor a surplus. To achieve this, any countr y with a trade deficit equating to more than half of its
26
Liquidity
trade deficit must be balanced by US dollar investments. Triple A-rated bonds that pay well above US Treasuries have obvious attractions in these circumstances. If this argument is valid, then the incentives that created the current crisis will not go away just because the capital or the liquidity of banks is being increased. Banks are not the cause of the crisis but bit-part players in a much bigger global currency game driven by the perverse incentives built into it and seen to have been built into it 70 years ago. Moreover the need to change the global currency system is far more pressing than anyone is willing to admit, as unless this happens the forces that created the financial crisis are going to re-emerge. The only conclusion one can draw is that the underlying cause of the financial crisis is the global reserve currency system, which was based on the Bretton Woods agreement in 1944 (see box). While it is clear today that Bretton Woods is no longer fit for purpose, the same could not be said in the aftermath of World War II when its deficiencies were to a great extent disguised. The underfunded International Monetary Fund placed far too much emphasis on forcing deficit countries to devalue and rapidly deflate their economies. The World Bank, similarly short of funds, was unable to fulfill its role as a significant source of capital injection for countries requiring reconstruction and development. However these problems were masked, first by the massive injection of investment from the US Marshall Plan and the willingness of US companies to invest abroad (in the face of full employment in the US), and then by the move to floating exchange rates. Today the US has moved from being the worlds biggest creditor nation to the worlds biggest debtor, and it no longer has full employment. The systemic deficiencies became clear during the emerging market crisis in 1982 in Latin America and 1997 in Asia. The emerging market economies responded by fixing their exchange rates to the US dollar at levels that ensured their competitiveness and consequently they have amassed very high levels of reserves.
Bancor overdraft allowance would be charged interest on its account, be obliged to reduce the value of its currency and to prevent the export of capital. There would be similar pressures on surplus nations, as any countr y with a Bancor credit balance of more than half its overdraft facility would also be charged interest, be obliged to increase the value of its currency and to permit the export of capital. If, by the end of the year, its credit balance exceeded the total value of its permitted overdraft, the surplus would be confiscated. In Keyness ICU-based system, any nation with a surplus would thus be incentivised to eliminate its surplus by exporting capital to deficit countries, thus reducing their deficit. Keynes believed that the system proposed by White would lead to countries attempting to create a currency surplus through competitive devaluations, and to the hoarding of foreign exchange reser ves by surplus countries.
27
Liquidity
These consequences are similar to those feared by John Maynard Keynes, who argued at Bretton Woods in 1944 that the system proposed by the US Treasurys Harry Dexter White would result in countries attempting to create a currency surplus through competitive devaluations, and in the hoarding of foreign exchange reserves by surplus countries. Indeed the evidence today is that Bretton Woods created a system which encourages and allows the reserve currency country to run persistent and large deficits. However, countries holding these US dollar reserves are exchanging their goods and services for pieces of paper that represent claims on future US production (or tax receipts, though this amounts to the same thing). There is a point at which the ability of the US to honour these claims certainly at the same real rate of exchange at which they were accumulated is called into doubt. And it looks as if that point has now been reached. But there is no agreement as to what to do. Politicians, most notably in France and China, are calling for a new Bretton Woods, but none of them has put forward a cohesive solution. However, there are alternatives. Earlier this year Joseph Stiglitz, the Nobel Prize winning economist, proposed creating more Special Drawing Rights (SDRs) so that they could play a greater role in the global currency reserve system and act as a supplement to the role of the US dollar. There is, though, the more radical way of expanding the role of SDRs as a replacement for the dollar as the worlds reserve currency. This is arguably the only way to respond to what is already happening in the real world.
Special Drawing Right (SDR)

The SDR was created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system by creating a supplemental reserve asset. Subsequently US dollarto-gold convertibility ended in 1971. Two years later the Bretton Woods system was altered significantly, and the major currencies shifted to a floating exchange rate regime; the SDR became a potential claim on the freely usable currencies of IMF members. Today the SDR basket consists of the euro, Japanese yen, pound sterling, and US dollar. In addition to its role as a supplementary reserve asset, the SDR also serves as the unit of account of the IMF and some other international organisations. The SDR is calculated as the sum of specific amounts of the four basket currencies valued in US dollars, on the basis of exchange rates quoted at noon each day in the London market. The basket composition is reviewed every five years by the Executive Board to ensure that it reflects the relative importance of currencies in the worlds trading and financial systems. In the most recent review last November, the weights of the currencies in the SDR basket were revised, based on the value of the exports of goods and services and the amount of reserves denominated in the respective currencies held by other members of the IMF. These changes became effective on 1 January 2011. The next review will take place by 2015.
28
Liquidity
A number of large surplus currency countries are no longer holding their structural surplus foreign exchange balances overwhelmingly in US-dollar Treasury bonds. Instead they are beginning to diversify their reserve holdings, most notably into euros, as well as limited amounts of Swiss francs, sterling and gold. They are also placing a significant structural currency which would operate as a unit of account in trade. A lot depends on how this idea is taken forward, but it could involve revisiting one very important aspect of Keyness proposal a system that incentivises adjustment by both deficit and surplus countries. Each country would hold its reserves in SDRs. And the component incur claims on its future production; so such a system would pass Keyness incentive test rather well. But there is one significant difference in that this solution is more markets-based. This means it would suit the greater development of and reliance on markets that is a feature of the modern global economy and was not a significant factor in 1944.
There is some support for using the SDR as a so-called basket currency which would operate as a unit of account in trade. A lot depends on how this idea is taken forward, but it could involve revisiting one very important aspect of Keyness proposal a system that incentivises adjustment by both deficit and surplus countries.
element of their surplus into long term investments in both emerging and developed economies through their Sovereign Wealth Funds. In addition, China has been taking action through bilateral arrangements to internationalise the renminbi as a currency of account for bilateral trade although, as the renminbi is not freely convertible into other currencies, this process is as yet strictly limited in its applicability. Moreover, there have been a number of comments that imply that Keyness rejected Bretton Woods solution is being re-examined. It appears that there is some support for using the SDR as a so-called basket parts of the SDR basket currency would be regularly recalibrated, for example according to the relative GDP (or possibly relative per capita GDPs) of a wide range of countries whose currencies would comprise the reconstructed SDR basket. There would be clear implications for any country growing its GDP relative to other countries and running a trade surplus. It would see an increasing proportion of the value of its reserves becoming a claim on its own future production, as the SDR basket would be re-weighted towards its currency. In those circumstances, it would become pointless for a country to export goods and services and However, if this idea were adopted, the SDR would itself need to differ significantly from its current form, both as to its component parts and to its process of revaluation. Clearly the ideas about a new reserve currency are not yet as well developed as those of Keynes and White were in 1944. But we would be deluding ourselves if we thought that the financial challenge today was not extremely serious, so it is important that new ideas are explored. There is an old saying: If it aint broke dont fix it. Well, the current global reserve currency system clearly is broke it just has not broken down yet, But it will unless we get on with fixing it. Q
29
Finance
Unintended Consequences
Attempts to stabilise currencies in the wake of the monetary crisis could impose new strains on the delicate balance of global trade, Paul Wharton of Deutsche Bank UK examines where the fault-lines may develop.
z One of the most significant aspects spend more to buy the same amount weaken too much against the euro.
of the currency wars currently taking place is that there is still a race to the bottom, as growth economies dependent on exports try to weaken their currencies, even as continuing weakness in the US dollar drives those currencies upwards. Clearly no exporter likes to see their currency strengthening unduly, since it damages their ability to sell into foreign markets. At the moment China and Germany seem to be the main winners, with Germany coming out rather better than China. The linkage with the dollar means that the yuan weakens as the dollar weakens, and that helps to make Chinese exports even more pricecompetitive. However, the major negative consequence of this is that it creates serious inflation in food prices in China, since the Chinese have to 30
of grain. Food prices rose by a third in 2010, and this in turn threatens to lead to social unrest in China. So for them there is a very marked downside to the second round of quantitative easing (QE2) being implemented in the United States. Germany also has its difficulties. On the one hand there is a real irony in the fact that the more the European sovereign debt crisis perturbs the markets and weakens the euro, the more it boosts Germanys burgeoning export sector. On the other hand, much of the burden for funding the bailouts falls on Germany as the European Unions biggest economy. However, since the European sovereign debt issues have very little to do with the currency wars, one would have to say that Germany will remain a net beneficiary, provided that the dollar doesnt
Our official view is that we think that China will allow the renminbi to appreciate by around 4 per cent against the dollar in the medium term and will allow wage costs to rise. That will put more money into the pockets of workers and will also help to rebalance the global economy. We have already seen some quite sharp wage rises in China, and more along these lines would be very helpful. If China were to revalue the renminbi, the cost of their food imports would drop, and it would also have the beneficial effect of making the Chinese focus more on domestic consumption, since it would generate some falling off in exports. Manufacturers would have to look to sell the extra capacity locally. The Chinese labour force is 850 million strong, more than 20 times the size of
Finance
the entire UK labour force. Moreover, economic commentators are starting to talk about the end of the global export model, since the big importer of last resort, the United States, is running out of steam. No country can both de-leverage massively and import strongly. This could be good for China in the medium term, since it should force them to become much more effective when it comes to deploying their investment cash. China has really got to stop wasting resources. The country looks like a late-cycle version of the Asian tiger economic boom, the problem there being that ever-increasing investment generated ever-smaller rates of return until we were suddenly hit by the Asian crisis of 1998. All investment booms fizzle out if consumption and final demand are not able to keep pace with the capacity that the investment is generating. The most interesting element of all these linkages which we see particularly vividly in the currency interrelationships is perhaps the unexpected and rather unintended consequences of globalisation, where everything ends up being linked to everything else.There was, for example, a problem in US mortgages along with a problem about excess savings in China generating massive capital flows to peripheral eurozone economies. The debt that generated cannot be revalued away, so we now have a very fragile global model. The challenge for policymakers now, as they address this fragility, is to manage an orderly adjustment of the major developed economies and, in doing this, the fiscal stimulus that we saw in the United States, the United Kingdom and the European Union, as well as in Japan and China, is important.
31
Finance
The next step has to be a reappraisal of the German and Chinese economic models toward much greater domestic consumption and an expanded domestic economy. In Germany, for example, the savings ratio is around 20 per cent. If it was that high in the US, it would be sucked into a depression to rival the 1930s. So global trade has to be expanded by growing consumption in Northern Europe and in China. Without this happening, there really does not seem to be a viable plan B. There are some severe risks for The other side of the coin, of course, is to accept a considerable lowering of living standards. In fact the now-departed managing director of the International Monetary Fund, Dominique Strauss-Kahn, recently warned that Europe would have to accept drastic reductions in its social care and benefits systems if it did not undertake very significant reforms that at least prepared the way for fiscal union further down the road. These are very broadbrush sketches, but they fill in a very way into the real economy but instead went to boost risk assets like equities and commodities. The second round is doing much the same so far. There is no strong demand for borrowing in the corporate sector, and where there is demand, the bigger corporates are bypassing the banks and going direct to the capital markets. There is a tremendous demand for corporate debt, as investors hunt for higher-yielding assets in an environment of near-zero real returns on bonds and negative returns on cash.
We now have a very fragile global model. The challenge for policymakers now, as they address this fragility, is to manage an orderly adjustment of the major developed economies and, in doing this, the fiscal stimulus that we saw in the United States, the United Kingdom and the European Union, as well as in Japan and China, is important.
China too, if it cannot get a grip on inflation while maintaining the 7 per cent or so growth it requires to keep the flow of new jobs in synch with movement of people from the countryside to the cities. Failure here carries a very high risk of social unrest which, at the least, would severely impede Chinas ability to drive global growth in the medium term. It is a paradox that many in the West who regard liberal free market capitalism as fundamental to incentivising innovation and growth are hoping that Chinese economic development will bail out the global economy. 32
worrying set of downside scenarios. Into this already complex mix we now have to add the second round of quantitative easing in the US, and see how it will affect its relationship with China, currency issues, and the European sovereign debt crisis. The interactions between all these factors makes it next to impossible to predict the outcome. Market participants do not have a clear perspective on how this is going to end up. What we can see is that in the first round of quantitative easing, the cash that the US Federal Reserve pumped in to the system did not find its
The big risk of printing cash is that it fuels rallies in paper assets. As for the eurozone, there is no doubt that the markets are testing its resolve, and there are definite parallels here with Britains unfortunate experience in trying to defend its membership of the European exchange rate mechanism (ERM). Everyone knows how that ended, but it would also be wrong to underestimate the political will in Europe to keep the euro going. From an investment standpoint, one thing that emerges very strongly from this is that Germany will probably be one of the safest homes for some time to
Finance
come. The UK is also well placed, with good exposure to emerging markets through the major players in the FTSE 100. So, in terms of equities, it is a good place for investors to get exposure to fast-growing markets while still having their investments in an environment of enforceable property rights and strong protection for intellectual property. The big downside risk for the medium term is an outright collapse of the US dollar as a result of rolling the printing presses. The Federal Reserve chairman, Ben Bernanke, is the worlds foremost scholar on the US Great Depression. He is determined not to fall into those traps, so everything now is a mirror reverse of the policies that were pursued by the US administrations of the 1930s. This is why we are seeing the worlds biggest-ever expansion of fiat currency through the avowedly unorthodox policy of quantitative easing (a fiat currency being any currency that is not backed by gold, but simply by the markets belief in the government and economy that is issuing the money). On the positive side, it is well understood in the academic literature that those economies which came off the gold standard fastest recovered fastest. The problem for the eurozone, however, is that the European Central Bank (ECB) is wholly committed to price stability and keeping inflation close to, but under, 2 per cent. The UK, on the other hand, has been able to effect a de facto devaluation of sterling with respect to its trade index by some 30 per cent. In fact the monetary policy committee of the Bank of England has made it as clear as it can that a weak pound is very much part of the UKs recovery strategy. In the eurozone, though, it is clear that Germanys extremely high productivity and competitiveness
mean that the ECB policy framework is just too tight for southern Europe, which is being asked to come into line with German practice. This is next to impossible. And in the absence of full fiscal union, there is no mechanism other than the bailout funding to effect a transfer of payments from stronger to weaker eurozone economies such as you get in the US. There are really only two options for southern European countries. Either they have a second currency regime put in place with a floating currency rate, which would allow a basket of southern European countries to deflate, or there
has to be full fiscal union. At present, nothing of the sort is on the table. This makes Europe the next official, major problem, since the economic elastic is being stretched ever more tightly. If the eurozone were to split you would see an immediate flight of capital to the north followed by hyperinflation in southern European economies. No one should underestimate the savage economic distress that would result. Our view, though, is that the chance of Europe breaking up is close to zero. The most likely scenario is bigger and bigger bailout funds to enable Europe to muddle through. Q
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Regulatory
Regulatory
Historically, the US and Europe have dominated the bodies within which international markets operate. But since the economic crisis newly powerful nations such as China and Brazil are insisting that their views are taken into account. Sir Howard Davies examines how this will affect global financial regulation.
A Question of Balance
z The shift in the worlds centre of rival centres of economic power.
of economic gravity from west to east has been under way for some time now. Similarly, the financial markets of Asia have been growing fast and expanding their share of global transactions. Yet until 2009 the G7 group of industrialised nations, de facto led by the United States, maintained a stranglehold on the bodies which set the rules within which those markets operate. Occasional meetings of the G8 introduced as a sop to post-Soviet Russia were the only partial concession to the growth The same was true of the regulatory bodies working below the intergovernmental meetings. The G10 central bank governors kept a tight rein on the Basel Committee of Banking Supervisors, the most important of a range of standard-setters. Until the turn of the Millennium, nine of the 12 members were from Europe, and when an additional seat was added, it went to Spain rather than to China or India. Both the politicians and the regulators feared that admitting new
35
Regulatory
members from economies at different stages of development would reduce the coherence and effectiveness of the global bodies. And, though they did not put it quite in this way, they were anxious lest the influence of the US and the EU be reduced, with unpredictable consequences. Better to let the headmaster, and a few trusted department heads, get on with setting and policing the rules rather than consulting the pupils who, heaven help us, might even disagree. In the middle of the crisis, everything changed. The major western markets were keen to attract capital from China and elsewhere to shore up their banking systems. In those circumstances it seemed inelegant, at best, to continue to exclude them from the key decisionmaking forums. So in November 2008 George Bush convened a G20 summit in Washington, which was followed by another in the following April in London. By that time the genie was well and truly out of the bottle, and while the G7 does still meet from time to time the decisive summits are now those of the broader grouping. From a financial market perspective the G20 is not, perhaps, the most obviously logical grouping. It includes Argentina, for example, whose financial markets are of little international significance and whose banks have almost no international presence, yet Spain is not (formally) a member. The two big Spanish banks, Santander and BBVA, are undoubtedly of systemic importance, and the Spanish debt market has recently been the focus of much international attention. The G20, however, had the great advantage of existing already. Set up in 1999 at the recommendation 36
of Paul Martin, then the Canadian Finance Minister, its first decade of existence was undistinguished. But it did include the BRICs and a few others, and had some legitimacy. So, faute de mieux, it was pressed into service. Not everyone is happy with the outcome. A UN report, from a committee chaired by Joe Stiglitz, argued that all 180 or so UN countries should have some influence on the decisions it makes. But for now the G20 is where the action is, albeit with a certain amount of outreach with non-members. Furthermore, the change quickly affected the composition of the main regulatory groupings. The Financial Stability Board (FSB) had to open
its doors to 13 more countries, as did the Basel Committee and a number of other standard setters in banking, securities and insurance. So what difference has this broader participation made? How well are the newly reconstituted groups working? The first, banal consequence is that there are now some exceedingly large meetings. The FSB has finance ministries, central banks and regulators from each country involved in its meetings. The attendance of G20 x 3, plus the international financial institutions, the chairs of the regulatory committees, and a few hangers-on from other global or regional bodies, dictates the need for a sizeable hotel ballroom.
Regulatory
The hospitality industry, and the airlines, have seen a helpful boost to their business. But in spite of these jumbosized meetings the change does not seem to have slowed the work of the regulatory committees. Indeed the new Basel rules, Basel III, were produced in record time little more than two years while Basel II was over a decade in gestation. Of course the political pressure, post-crisis, was much stronger, but it nonetheless seems it has still been possible in a much larger group to reach agreement on some tough and complex rules. On Basel III it is clear that the dominant influences have so far remained the US and Europe. Much of the intellectual horsepower has come from the Federal Reserve, the Bank of England, the FSA and the Swiss National Bank, but the new participants have been broadly supportive. That is not a question of deference: it is evident to everyone that the US, UK and Switzerland, among the large financial centres, have experienced the biggest problems, so it is not surprising that their representatives should take the lead in finding solutions. So far, so good, therefore. But tensions are now beginning to emerge. While the developing countries, as we still anachronistically term them, were broadly content with the basic framework of Basel III more capital and more tier one capital in particular they are much less sure about the need for additional buffers for the so-called Systemically Important Financial Institutions. There is a lively argument under way about which banks (or insurers) should be regarded as systemically significant, but whatever definition is chosen it is hard to imagine that ICBC, or Bank
37
Regulatory
of China, will not be included. Their market capitalisations are in the top half dozen in the global league table. And the Chinese are not yet persuaded that they need to adopt the hair-shirt approach being recommended in London and Zurich in particular and to a slightly lesser extent in New York. After all, their banks did not get involved in the kind of highly risky lending and trading strategies which brought some western institutions to their knees and thrust them on the mercy of their taxpayers. More capital will have an impact on the cost of credit and on economic growth. They are not convinced that is a price they need to pay. So there is some push-back from the new members in that area, and there are straws in the wind elsewhere which suggest that the balance of financial power may be beginning to switch. That is hardly a surprise, as the moral authority which US policymakers held before the crisis has undoubtedly taken a knock. Gone are the days when the rest of the world waited with bated breath for the latest pearls of wisdom from Alan Greenspan, and the US wielded an effective veto. The latest International Monetary Fund paper on capital controls is a case in point. Capital controls have long been anathema to Fund officials, and indeed to most western governments I say most, as the French have always been somewhat ambivalent on the subject. The Fund took the view that they were ineffective, at best, and almost certainly harmful to the country imposing them. Controls could not compensate for fundamental economic or financial imbalances. The influence of countries like Brazil has now caused the IMF to 38
take a much more nuanced approach. The Brazilian government has argued strenuously that US monetary policy zero interest rates and quantitative easing has placed intolerable strains on some of its trading partners. The Brazilian Real has risen sharply as hot money flows in, in search of a positive return. The resulting large currency appreciation is causing disruption. Raw material exports are fine, but the tourism industry is struggling. So the government has imposed controls on inflows. Consequently the new IMF doctrine acknowledges that capital controls may be a legitimate tool in some circumstances. It is not just in this area of policy that one can detect a subtle shift in approach. The Chinese have long believed that they need a range of tools to cope with credit bubbles, whether generalised or property-related. They adjust reserve requirements up or down, they impose loan to valuation limits, they increase required deposit percentages for property purchase. All these controls had fallen out of fashion in London and New York. We believed that the short-term interest rate was the only tool we needed, together with some by-and-large capital requirements, which did not vary through the cycle. Now western supervisors are increasingly coming round to the view that they need a wider range of golf clubs in the bag. The favourite addition is the macroprudential mechanism, whereby capital requirements can be varied up or down as credit expansion speeds up or slows down. But the FSA and the Federal Reserve are also debating more fine-grained interventions in the mortgage market, in particular. So in banking supervision we are seeing signs of an intriguing
convergence of approaches. The Chinese are discussing a more flexible approach to interest rates, while we are taking more interest in their more diversified toolkit. It is too early, though, to be sure how well the new G20-led dispensation will operate. We do not know yet what the Chinese and others want to get out of it in the longer term, or what their attitude to G20 agreements will be. After the Japanese were incorporated in all the regulatory bodies, it took some time for them to become full-hearted participants. Often their representatives would sit quietly until some proposal which might have a particular effect on Japan was advanced. Only then would they speak up. Will the Chinese, Indians and others adopt a similar, defensive approach? Or will they instead decide to position themselves as co-equals with the US and Europe, confident enough to take on key chairmanships, and to advance their own policies and be ready to debate them? That is the question which Western representatives are now asking themselves, with a degree of nervousness. If China does take a tougher line, it will pose challenges for the West, and especially for Europe. So far, Europe has maintained a heavy weight of representation, in numerical terms at least. But the EU does not yet speak with one voice. If China joins the US as a Big Two which is widely forecast Europe, if it wishes to be heard, will have to develop a common position. David Camerons new-found friendship with Nicolas Sarkozy, forged in the heat of the Libyan conflict, may be tested in some equally delicate financial policymaking before too long. Q
Accounting
International accounting standards are vital to make allocating capital easier and more effective on a global scale. But there is significant variance in the pace at which they are being adopted, while regionalisation threatens to change the shape of the market. Victor Smart reports.
Standard Procedure
z The unglamorous business of strip to
coalmining illustrates the imperative for the BRIC nations and other newly powerful countries as they seek to play an increasingly important role in setting global accounting standards. China is by far the worlds largest coal producer extracting no less than 3,000 million tonnes a year. But in mining nowadays commercial success rests as much on favourable accountancy treatments as on monster-sized earth-moving machines. In Chinas case, having adopted the International Financial Reporting Standards (IFRS) two years ago, its strip mines must now conform standards set internationally. But recent proposals for the sector are, in the words of PricewaterhouseCoopers Yvonne Kam, completely impractical. Put simply, an accounting treatment is under discussion on how to allocate the costs of stripping away topsoil against the value of the emerging coal. The IFRS interpretation committee planned to apportion the cost of removing specific lumps of soil against the value of specific lumps of coal. Kam says: No operator can work like that. A rethink is under way, proof enough that nowadays China has a potent 39
Accounting
voice in how things are done. The BRICs and other countries have been comparatively slow to assume the mantle of global standard setters. Not so long ago the developed world could take it for granted that it would have a monopoly of influence. Indeed when, in the 1960s, accountancy bodies first embarked on what has proved a slow, tortuous and still far from complete path to international accounting standards, just three countries were invited to watchword is harmonisation rather than standardisation. One oddity is that the US is still keeping everyone guessing about when and how it might, in practice, move to IFRS. According to Frank Vibert, global governance expert at the London School of Economics, participating in international accountancy standardsetting has all the hallmarks of soft power. Rather than a treaty-based international institution, the IASB merely makes recommendations: Gomes, as a full-time board member. All this discussion filters up to head-of-government discussions in the G20, where global accountancy issues are now aired. The Asian countries have been among the first to create their own regional standardsetting group. The Asian-Oceanic Standard-Setting Group (AOSSG) now represents 30 per cent of world GDP, 60 per cent of the world population and nearly 40 per cent of market capitalisation.
It has long been a fiction that accountancy standards are set apart from politics. Politicians in the US in particular have become increasingly interventionist in accountancy post-Lehman Brothers, for example. Countries fight their corner for their own interests.
frame them: Canada, the United Kingdom and the United States. IFRS, which has its headquarters in London, insists it is an independent, not-for-profit private sector organisation working for the public interest. Its avowed objective is to develop a single set of highquality, understandable, enforceable and globally accepted international financial reporting standards through its standard-setting offshoot, the International Accounting Standards Board (IASB). The 40
official national accounting bodies must adopt and enforce them. Argentina, Brazil, Canada, India and South Korea are all due to switch to IFRS this year. Translation of English-language exposure drafts is still patchy, making it difficult to respond quickly. But the rising countries are gaining key posts. It is no coincidence that IASB now has a former Brazilian finance minister, Pedro Malan, as a trustee, and a past head of financial system regulation at the Central Bank of Brazil, Amaro
One significant topic, in a region which encompasses so many populous states with Muslim communities, is Islamic accounting. Countries like Malaysia are happily integrating IFRS into Shariah-compliant banking, amending where necessary. But Islamic finance is fundamentally rooted in cultural beliefs which do not sit entirely easily with westernoriginated accounting principles. And some experts doubt whether IFRS is actually compatible with Shariah banking. There are a variety
Accounting
41
Accounting
TIMELINE FOR IFRS HARMONISATION/CONVERGENCE AMONG THE G20

2005
AUSTRALIA: IFRS required for all privatesector reporting entities and as the basis for reporting in the public sector. EUROPEAN UNION: all member states required to use IFRS as adopted by the EU for listed companies. FRANCE, GERMANY, ITALY AND UK: IFRS required via the EUs adoption process. SOUTH AFRICA: IFRS required for all listed entities. INDIA: phased convergence with IFRS starting in April. SOUTH KOREA: IFRS required for listed companies. US: this is the target year for the substantial convergence of US Gaap with IFRS. A decision about the possible adoption of IFRS for domestic companies is expected in 2011, with an effective date no earlier than 2015.
2012
INDONESIA: a decision about a target date for full IFRS compliance is expected next year. JAPAN: a decision about the mandator y adoption of IFRS by 2016 is expected next year. MEXICO: IFRS required for listed companies.
Source: PricewaterhouseCoopers www.snipurl.com/1lmd2m
2007
US: IFRS allowed for foreign issuers.
2008
BRAZIL: IFRS required for individual company accounts. TURKEY: required for listed entities.
2010
CHINA: national standards converged with IFRS. substantially
JAPAN: IFRS permitted for a number of international companies. RUSSIA: IFRS required for banking institutions and some other securities issuers, permitted for other firms.
2011
ARGENTINA: companies. IFRS required for listed
BRAZIL: IFRS required for consolidated financial statements of banks and listed companies. CANADA: IFRS required for all listed entities and permitted for private-sector entities and no-for-profit organisations.
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Accounting
of options here, including refusal to deal with the entire IFRS structure or a carve-out, a familiar device used to exempt particular countries from particular parts of international standards. But many of the current disputes are over more prosaic issues. One concerns the rule over sales of real estate, specifically yet-to-becompleted apartments and other residential properties sold offplan. AOSSG complains that the on changes to IAS 41 so that rubber trees which provide regular outputs get an accountancy treatment more akin to plant and machinery. Personnel in senior IASB boards may be starting to reflect the new shifting realities, but the westerncentric worldview is still entrenched. Kevin Stevenson, vice-chairman of AOSSG, explains: Some people are out of touch with the pace at which countries are developing. If you visit cities in our region today many is that they make allocating capital easier and more effective on a global scale. Foreign investors, in particular, should find it more straightforward to compare the financial reports of companies in different countries. But sceptics will doubtless feel that those involved in the endless and frustrating process of convergence may have failed to lift to their eyes to what is going on beyond it: that globalisation may be faltering, that China is far less inclined to follow the
Some people are out of touch with the pace at which countries are developing. If you visit cities in our region today many of them look more prosperous and smarter than cities elsewhere. There is resentment that our views are not being heard as much as some of the squeaky wheels which stand out in Europe in particular.
Kevin Stevenson, vice-chairman of the Asian-Oceanic Standard-Setting Group.
rules fail to understand the unique aspects of contracts in their region. In countries like Singapore, buyers have guarantees that in the event of the collapse of a construction company their building will still be completed; hence it should be accounted for before the keys are handed over to the buyer. Many other countries with property booms agree. There is a similar spat over the tax treatment of agricultural assets such as rubber trees. States such as plantation-rich Malaysia are insisting
of them look more prosperous and smarter than cities elsewhere. There is resentment that our views are not being heard as much as some of the squeaky wheels which stand out in Europe in particular. But are the stresses among international standard setters about the BRICs winning a right to have their voice heard? Or is it a confrontation between clashing cultures or trade blocs with diametrically opposed interests? The rationale for the international accounting standards
Anglo-Saxon model of governance in the wake of the Wests financial crisis and that, consequently, the argument about efficient global allocation of capital may look a lot less relevant in a decades time than it does today. It has long been a fiction that accountancy standards are set apart from politics. Politicians in the US in particular have become increasingly interventionist in accountancy postLehman Brothers, for example. Countries fight their corner for their own interests. But there is a difference
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Accounting
between mere horse-trading over specific standards and exploiting accountancy as part of promulgating a wider worldview and extending geopolitical power. Certainly, it is hard to see some great ideological difference underpinning a clash over accounting for rubber trees; and even on the issue of strip-mining other producers including Australia and Canada were on side with China. And in the view of Stevenson: China is very utilitarian about accounting. But China clearly is not seeking to influence simply the specifics of accounting standards. Accountancy as a profession scarcely existed in China 30 year ago. But it has been given a strong impetus under Wang Jun, who is credited with reforming the Chinese accountancy profession as vice-minister of finance. A further factor is that China is noted for its conservatism in accounting standards and wary of exotic financial instruments permitted on Wall Street. It has no ideas for or interest in upending the system if anything it is the Westerners who are the mavericks, permitting their investment banks to undertake transactions such as the notorious Repo 105 manoeuvre that Lehman Brothers used to shift billions on and off the balance sheet to disastrous effect. China did have fundamental difficulties with IFRS because the red background of so many state or previously state-owned companies meant there were massive conflicts of interests. But coping with this web of intermeshed interest was a matter resolved at a technical level. And, officially at least, that is where the matter rests. It is also true that the developing 44
countries adopting IFRS are massively preoccupied with the internal struggle to harmonise the changes with their national standards. The arrival of international standards of accounting exposes many unseen abuses of power, such as the deliberate understatement of a companys profits to reduce tax and serve the interests of powerful individuals. Governments moving from an authoritarian and autocratic model and adopting international standards face enormous upheavals, comments one senior technical expert. Crony capitalism, for example, makes it necessary for payments to be moved around the system at will; rigid accountability and transparency, the core tenets of IFRS, are patently incompatible with this. Sometimes central governments may embark on reform and then discover that they are stirring up a firestorm, as the rules that allow daylight to flood into the darker corners of the economy challenge powerful interests. But soft power has a way of turning to hard economic power. China is making no bones of its attempt to topple one the Wests most powerful business groupings, the Big Four, from their pre-eminent position: the authorities intend to nurture a band of indigenous Chinese accountancy businesses as rivals of the four Western-based international accountancy firms, Deloitte Touche Tohmatsu, Ernst & Young, KPMG and PwC. With a total workforce of 600,000 and revenues of almost $100 billion, the Big Four handle the vast majority of audits for publicly-traded companies, as well as many private firms. Paradoxically, Chinas plan to smash this oligopoly is a policy goal sought unsuccessfully by many reformers
in the West. Chen Yugui, head of the Chinese Institute of Certified Public Accountants (CICPA), recently declared: Internationally and nationally we dont think its a good phenomenon that the Big Four take a dominant position, as it will harm the sustainability of the profession. Within the next ten years China would have around five accounting firms with a Chinese name, based on a Chinese market and, significantly, playing an ever bigger role in international issues and in the boardroom of global corporates. The rise of the Chinese accountant in applying international accounting standards has already begun. Earlier this year Chinas Tsingtao Beer dropped its international auditors for a subsidiary listed in Hong Kong. The eclipse of the Big Four by a clutch of Chinese rivals would open up the prospect that they could win contracts to audit big western firms such as Apple, Ford, and Walmart within little more than a decade. It would also mean the end of the Big Fours grip on the nexus of experience and skills and western cultural assumptions on which international accounting standards have been made. Stevenson believes that the future of global accounting standards settings lies with greater regionalisation. Latin America, Africa and other regions will follow the AOSSG model and create organisations to funnel through their collective voices to IASB. London might welcome the process, he says, as it would make it easier and quicker to handle a range of views. But undeniably such a process of regionalisation would spell the end of the days when international standard setters could comfortably live with the old western-centric biases. Q
Finance
The global insurance industry emerged from the financial crisis with a business model rather more intact than that facing many commercial banks, says Andrew Milligan. However it must also respond to new challenges, such as volatile financial markets, weak household savings, and growing levels of international regulation.
Holding the Curve

z If one looks at the devastation system that has sprung up in recent
wrought on the global finance community, there is no doubt that the insurance sector came out of the crisis in rather better shape than did banking. Certainly there were important casualties, notably AIG in the United States. However this was a special case, with AIG being much more of a financial conglomerate than a pure insurance company. The reasons for the better outturn were complex, but one of the key factors was that there was no parallel in the insurance industry to the way the banks and the shadow banking years leveraged themselves. Relying on a constant supply of new wholesale funding to keep their business models running meant the liquidity crunch left certain banks high and dry. Both the banking and insurance sectors are having to face up to a brave new world though. Insurance too has to deal with the aftershocks of the economic downturn: volatility in the stock, bond, and property markets, plus considerable movements in annuity rates, all of which pose serious challenges. For example, the shape of the yield curve is of considerable importance.
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Finance
At the start of the crisis, central banks slashed short-term interest rates, leading to steep yield curves. When growth failed to respond, the next step was quantitative easing (QE) buying hundreds of billions of dollars worth of private and public sector assets. Government and mortgage bonds were top of the shopping list. Such QE policies intentionally flattened the interest-rate structure, which in turn had an impact on annuity rates. Moving to today, the situation looks 46
rather different. Yes, the level of longterm interest rates is more correlated with the state of the economy than with the supply of new government bonds. However, global activity should recover from its current weak spot, while the Fed has announced that QE will end in June. Markets still have to digest sizable public sector debt issuance in the next few years about $1.5 trillion a year in the US for example even if the Democratic-Republican negotiations make progress.
Yield curves are likely to steepen again, indeed there could be some peculiar curve shapes in the years ahead. Either way, coordination between the Bank of England and the Debt Management Office in the United Kingdom, and their counterparts in other countries, will be vital. The shape of the yield curve matters as it has strong implications for the real economy. Interest rate changes do impact fairly quickly on economic activity, but the precise interest rate
Finance
in something other than cash. For example, it has become clear that there is a growing demand for longer-term bank deposits (say 2-4 years). Those investors who classically need a 5 per cent return on their money to finance their retirement still have several options, although each has its own risks. These include buying corporate bonds, dividend-paying equities or even high-yielding commercial property. Corporate bonds have a good yield; however, investors should note that as and when the economic recovery begins, government bonds are likely to be sold off. Corporate bonds will then also suffer, though by less than public sector debt. Equities remain subject to volatile economic activity, while the liquidity of the property markets remains poor. The shape of the yield curve also gives signals about investor sentiment. During crisis periods, odd things can happen. For example, for a few days back in December 2008, the interest rate on three-month US Treasury bills actually went negative. This meant buying those bills and holding them to maturity would return less than the capital sum, even before the impact of inflation was factored in. The explanation was risk aversion when people fear there is no safe haven for cash, they will take a slightly negative rate as the best way of conserving whatever possible value. The desire for safety can still be seen today the yield on US three-month Treasuries is only some 5 basis points! Equally important for insurance companies is how regulators and bank management are dealing with the overhang of bad debts, especially in the commercial property sector. Many such toxic assets have been made special purpose vehicles to remove them from banks books. In the short term this does help to stabilise prices, but continually extending poor loans evergreening as it is called does mean that market clearing prices are delayed for some time to come, thereby logjamming a market as transactions are restrained. Three years on from the start of the crisis, it is clear that governments still need to act on a number of fronts. A range of fiscal, monetary, liquidity, regulatory, and QE measures are required to support the recovery. The high bond yields being paid by some countries, especially in Europe, and the widening in credit default swap (CDS) spreads on sovereign debt show investor nerves about this process. CDS are a financial instrument akin to an insurance policy, which pay out should a government default on its debt. One of the most significant risks for European insurance companies would be some governments defaulting on their debt. It is fair to say that the word default has to be carefully considered when it is applied to a government rather than to an individual or a company. There have indeed been recent examples of sovereign default, with Russia and Argentina declaring that they were not going to meet payments on foreign-currency debt. For most major western governments, particularly the UK or the US, going down this route is not credible. Governments have a range of options when they are in difficulties, not least because they can print money. Generating inflation lowers the real value of the debt. This may also depress the domestic currency versus the creditors currency, which again makes the debt easier to pay. In other words, modern states generally do not default on the nominal amount of the debt, but the true cost to an overseas lender of some actions
matters. The UK may have very low base rates, but, in fact, the mortgage market is very heavily based on the level of two- to five-year interest rates. In the US, it is the 30-year bond yield which matters more for mortgages. European companies are generally financed by a mix of medium-term bank lending and corporate bonds. There is a major impact on savers, who are affected by very low base rates. This produces a strong incentive for people to spend, or to invest
47
Finance
taken by a government can be severe. However, the current situation in Europe is both complex and different. Markets are certainly pricing in that a country such as Greece with its 10year bonds currently yielding about 16 per cent will restructure its debt by 50-70 per cent some time in the next few years. The only question is where, when and how. Some European during the recent recession the debt burden ruled out certain avenues of action such as major public sector infrastructure investments. Western governments must perform a difficult balancing act as they try to encourage consumers to start spending again, while giving a priority to reducing historically high debt levels. These two goals cannot be constant dialogue with wealth managers and financial advisers. Advisers remain anxious about the ability of the stockmarket to deliver reasonable dividend growth in the next few years. At the same time, such investors want help in trying to determine the outlook for deflation in the short term, and inflation in the longer term. The insurance sector has to concern
The insurance sector has to concern itself with savings decisions, and peoples attitude to midto long-term savings. Right now, there is a generational shift in wealth from older people, who tend to have built up significant savings, to younger people, who do not have much of a savings profile and who have been buying on credit.Younger people are net gainers, as interest on credit has come down significantly, while older people are seeing the income from their savings plummet.
insurance companies could be affected by the fall-out. The performances of Italy and Japan, both of which are OECD economies with very high public sector debt-toGDP ratios, show that one impact of debt on this scale is to constrain future growth. Japan has created a very flat interest-rate structure, partly to ensure that the burden of servicing such debt does not become too onerous. The Italian economy still functions, but 48
achieved simultaneously, so one option which investors are debating is whether governments eventually choose the route of generating inflation in order to drive down the real value of the stock of debt. Whether governments can generate inflation at will is questionable, but easy monetary policy, weak currencies, and massive liquidity stimulus can have an effect. Insurance companies must assess these possible outcomes as part of their
itself with savings decisions and peoples attitude to mid- to long-term savings. Right now, there is a generational shift in wealth from older people, who tend to have built up significant savings, to younger people, who do not have much of a savings profile and who have been buying on credit. Younger people are net gainers, as interest on credit has come down significantly, while older people are seeing the income from their savings plummet. Negative real
Finance
49
Finance
deposit rates start to erode the value of the savings pot after, for example, adjustments have been made for inflation. This equates to a transfer of wealth from the older generation to the younger generation. Long-term investors such as insurance companies need to look ahead beyond the immediate factors that are playing out in the economy today. Some obvious examples would be not just how the US government deals with a public sector deficit of 10 per cent of GDP a year, but also how it begins to address its off-balance sheet liabilities such as Medicare and Medicaid worth several tens of trillions of dollars. The willingness of overseas governments to continue to buy a very large part of the American debt is going to be very material for the dollar and US long-term interest rates. Looking elsewhere, investors in the fast growing Chinese economy need to assess how the slowdown in population growth will affect that economy, for example in terms of much higher wages for a smaller population of working age. Insurance companies are also global investors, and therefore sharp changes in currency levels will matter considerably. A prime example was the precipitous drop in the value of sterling in 2008, when it lost 25 per cent of its value against a basket of currencies consisting of all the UKs major trading partners, not just the dollar and the euro. To put this fall into context, it was larger than the roughly 20 per cent fall sterling experienced when the UK fell out of the Exchange Rate Mechanism. However, currency movements should be seen as neutral by investors. They have both positive and negative impacts. The export of goods and services is much easier for a devalued currency. As a service sector, UK 50
Finance
insurance firms are well placed to profit from the fact that pricing has moved in its favour as it seeks to sell its services in Asia, Europe, and the Americas. Similarly, there is also more of an appetite from overseas investors for good value in the UK, for example, demand for prime commercial property has been very noticeable. The Bank of England is focusing on another economy to rebalance, lengthy though that process may be. The insurance sector will hope that, as governments seek to formulate and impose new regulatory regimes on financial services, especially banks, hedge funds and commodity traders, they do not rush into judgment on the insurance sector. It seems clear that the sector has done a good job under difficult UK, while in the US the regulators are slowly working through the Frank-Doo legislation. The likely outcome is that specific tools will be used for regulating different sectors. For example, interest rates changes by the MPC will not be the only lever for directing the economy, but macro-prudential regulation will stand alongside. The insurance sector needs to be closely involved in
It seems clear that the (insurance) sector has done a good job under very difficult circumstances. They are still doing the basics: taking in premiums, investing them, and providing payoffs, be it in, for example, pensions or protection products, at a future date. The business model for all insurance companies is tougher, as can be expected after the worst financial crisis in 60 years, but the industry is generally sound.
consequence: because the prices of imported goods are higher due to the drop in the value of sterling, this helped move the economy out of deflation and triggered inflation again. In addition, overseas investors can buy and, according to the latest statistics, are buying more UK debt, particularly gilts, because they can buy more bonds for their euros, for example, than they used to. This is a good example of the positive and negative impacts of currency movements a necessary process in helping the circumstances. They are still doing the basics: taking in premiums, investing them, and providing payoffs, be it in, for example, pensions or protection products, at a future date. The business model for all insurance companies is tougher, as can be expected after the worst financial crisis in 60 years, but the industry is generally sound. It is clear that the top 20 or 40 banks in the world are going to be subjected to much more searching regulation in future. The Independent Banking Commission will report shortly in the this debate, not least because we own shares in a large part of the economy, particularly the financial sector. Improved regulation is needed, not just by the public sector but also by the private in other words, non-executive directors and major shareholders of the financial services giants. Insurance companies, as long-term investors, have to see that the organisations in which they have invested, create value in a prudent manner rather than taking irrational risks with their clients money. Q
51
Governance
Competing models of corporate governance have grown up as cross-border ownership of major financial institutions becomes more prevalent. Dr Fahad Toonsi analyses the strengths and weaknesses of the different systems in play round the world.
Cultures of Control
z As cross-border ownership of reflect their different characteristics, for
banks, other financial institutions and companies becomes more common particularly as Asian and Middle East organisations buy more western institutions than ever before questions inevitably arise about the impact on their corporate governance culture. In principle the ownership structure is the primary determinant of a corporate governance system. Dispersed ownership can make it difficult for shareholders to monitor what is happening, while concentration of ownership in the hands of large block-holders gives them greater incentive to do so. The recent surge of interest in understanding corporate ownership has revealed many differences in transnational corporate governance systems. The variety of labels given to them 52
example, dispersed ownership marketbased Anglo-American systems; concentrated ownership European and Asian systems; rules-based and relationship-based systems and market- and bank-based systems. In market-based outsider systems, ownership is dispersed and completely separated from control, companies benefit from sophisticated capital markets and thus incur lower debt-toequity ratios, stakeholders are rarely formally represented and do not participate in company management. A hostile takeover is the severest sanction for management misconduct. Outside investors in these systems are less interested in the strategic longterm goals of the company than in the short-term returns available in the market. The United Kingdom and the United States are the prime
Governance
Governance
examples of the outsider system. By contrast, ownership in insider systems is concentrated and closely associated with the managerial control of companies. Companies have closer relationships with banks, which means higher debt-to-equity media and financial services. However it is also blamed for the inherent volatility and short-termism that have left some industrial sectors stranded and caused occasional stockmarket crashes. German corporate governance has oriented, with dominant holdings by the state, families and industrial groups. Such protective ownership concentration provides for stability, long-term investment horizons and strong relationships with different stakeholders, allowing each country
The Anglo-American model supports a dynamic market with fluid capital that enables companies to pursue market opportunities whenever they occur. This agility has enabled the US and UK to capitalise on the new economy of electronics, software, media and financial services. However it is also blamed for the inherent volatility and short-termism that have left some industrial sectors stranded and caused occasional stockmarket crashes.
ratios and a higher rate of bank credit. Stakeholders including other companies, banks and employees are formally represented on the board of directors. Takeovers are rare and there is often a dense network of supportive relationships with related businesses. Europe, the Middle East and Asia Pacific are primary examples of this insider system of corporate governance. Each system has its strengths and weaknesses. The Anglo-American model supports a dynamic market with fluid capital that enables companies to pursue market opportunities whenever they occur. This agility has enabled the US and UK to capitalise on the new economy of electronics, software, 54
traditionally been focused on longterm industrial strategies supported by stable capital investment and enduring relationships with key stakeholders. These qualities enabled the German economy to capitalise on industries that require long-term investment and high levels of skills, including luxury automobiles, precision instruments, chemicals and engineering. In the same way, the depth of the relationships between different stakeholders has led to a lack of flexibility in both labour and product markets, which can ultimately inhibit new businesses and industries. The Latin system of corporate governance, as typified by the French and Italian systems, is highly network-
to specialise with notable success. In France, for instance, statesponsored prestige industries including aerospace, nuclear and hightech train-building are flourishing, along with a range of leading international luxury goods companies. Italy is a world leader in high-quality fashion goods, particularly designer clothing and leather goods. Yet, in this system, weak accountability to shareholders, pyramidal structures and frequent networks weaken the integrity of capital markets and lessen the involvement of minority shareholders, since the strength of block-holders relationships precludes all others from getting involved.
Governance
Finally, the Japanese system of corporate governance is the most network-oriented of all, with the company as the institutional centre for deep and enduring relationships between investors, employees, suppliers and customers. This approach yielded the longest investment horizons, to which the Japanese success in dominating the US and European markets in electronics and low-cost automobiles and motorcycles is frequently attributed. However, when the speculative bubble burst in 1990s and the economy came to a halt, the systems unaccountable governance and secretiveness was blamed for much of its weakness. The relative merits of the different systems of corporate governance have been the centre of considerable debate in the academic literature. Much of this literature compares the AngloAmerican outsider system with its strong security markets and higher disclosure standards to the insider models of Germany and Japan. These studies often favour the former as a more advanced and efficient mode of corporate finance and governance, and therefore conclude that a shift of the European and Asian systems of governance to an Anglo-American model is inevitable. Those who make this argument cite a number of factors in its favour. They point to the growing international financial flows to countries and companies that could meet certain minimum international corporate governance standards. They also stress the increasing influence of Anglo-American stock exchanges such as the NYSE, NASDAQ and the London Stock Exchange, where the largest corporations have access to global capital regardless of their home
How different systems evolve

There is considerable debate about the evolution of different systems of corporate governance. Some stress the importance of legal and regulator y constraints in shaping national corporate governance systems. Others assume that the fundamental determinants are the extent to which a countr ys laws protect investor rights and the extent to which those laws are enforced. A third group, while acknowledging the importance of investor protection, property rights and the supporting legal institutions, claim that modern politics is an alternative explanation for divergent ownership structures and the differing depths of securities markets. In particular, they argue that the power of financial institutions such as banks and insurance companies in the US were curtailed by the governments decision to limit their involvement in corporate ownership. As a result, these institutions do not play a significant role in the American corporate governance system. By contrast, financial institutions are greatly involved in corporate governance in Germany and Japan because a different political climate allowed them to become major players. Others have attempted a more philosophical approach. They consider the business organisation as the product of trust and thus regard different corporate governance systems to be the result of national differences. In the same vein, some believe that a nations culture is the most important determinant of that nations corporate governance system. A nations unique set of cultural values might affect the development of its laws in general and its corporate governance system in particular.
55
Governance
CORPORATE GOVERNANCE
Feature Anglo-American Germanic Latin Japanese
Orientation
Representative countries Prevailing concept of the firm
The board system
Main stakeholders to exert influence on managerial decision making Importance of stock and bond markets Is there a market for corporate control Ownership concentration Compensation based on performance Time horizon of economic relationships Strengths
Weaknesses
Source: Adapted by author from Keenan and Aggestam (2002), Clarke and Bostock (1994)
} } }
Market-oriented (an active external market for corporate control) US, UK, Canada, Australia, NZ Instrumental (as a means for creating shareholders value) Market-oriented (relatively oligarchic, influenced by networks of shareholders, families and banks) Germany, Netherland, Switzerland, Sweden, Austria Institutional (autonomous economic units coming out of a coalition of shareholders, corporate managers, suppliers of goods and debts and customers) Two-tier (executive and supervisory board, the latter monitoring, appointing or dismissing managers; large shareholders on the board and high pressure from banks) Industrial banks (mainly in Germany; in general oligarchic group inclusive of employees representative) Moderate or high (legal and regulatory bias against non-bank finance) No One-tier (governance with one level of directors, making no distinction but executives and non-executives) Shareholders High (requiring continued action and performance) Yes Low High Moderate or high (very high in Germany) Low Short-termism (Management and governance myopia) Dynamic markets orientation, fluid capital, internationalisation extensive Volatile, shorttermism, inadequate governance procedures Long-termism Long term industrial strategy, very stable capital, robust governance procedures Internationalisation more difficult, lack of flexibility, inadequate investment for new industries
Network-oriented
France, Italy, Spain, Belgium, Brazil, Argentina Institutional
Optional (France) in general one-tier
Financial holdings, the Government, families, in general oligarchic groups Moderate or poor
No
High Moderate
Long-termism
} }
Network-oriented Japan, China, India and the Middle East Institutional Board of directors, offices of representative directors, of auditors, de facto one-tier City banks, other financial institutions, employees in general oligarchic groups Poor (legal and regulatory bias against non-bank finance) No Low or moderate Low Long-termism Very long term industrial strategy, stable capital, major overseas investment Financial speculation, secretive governance procedures, weak accountability
56
Governance
country. They cite the expanding activities of Anglo-American-based institutional investors, who are pushing for risk-mitigating strategies, including rigorous western-style corporate governance practices. However, these arguments fail to appreciate the significance of different cultures and the general concept of a firm.This is mostly because historically rooted trajectories of growth created by national institutional networks are considerable diversity in the systems of corporate governance around the world. Different objectives, values and traditions will undoubtedly produce different outcomes in governance, which will relate closely to the choices and preferences people exercise when engaging in business activities. As such, if there is convergence of corporate governance practices, it will be to a variety of different forms. It is indeed as likely that there will be as to the accuracy or completeness of the information contained in this article, and, to the extent permitted by law, PwC does not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. 2011 PwC. All rights reserved. PwC is the brand under which member firms of PricewaterhouseCoopers
Ownership in insider systems is concentrated and closely associated with the managerial control of companies. Companies have closer relationships with banks, which means higher debt-to-equity ratios and a higher rate of bank credit. Stakeholders including other companies, banks and employees are formally represented on the board of directors. Takeovers are rare and there is often a dense network of supportive relationships with related businesses.
not prone to rapid transformation. These trajectories are characterised by the time of industrialisation and the institutionalisation of this process, including the role of the state in regulating property rights, the rules of cooperation and competition, and the national organisation of social elites. Thus these systems are resistant to convergence. A more plausible perspective is that there will continue to be divergence away from the shareholder oriented Anglo-American model as convergence towards it. Q This article has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this article without obtaining specific professional advice. No representation or warranty (express or implied) is given International Limited (PwCIL) operate and provide services. Together, these firms form the PwC network. Each firm in the network is a separate legal entity and does not act as agent of PwCIL or any other member firm. PwCIL does not provide any services to clients. PwCIL is not responsible or liable for the acts or omissions of any of its member firms nor can it control the exercise of their professional judgment or bind them in any way.
57
Finance
Business leaders today face many political and economic uncertainties. But, says Justin Fox, this should not be used as an excuse for caution as there are real opportunities for companies prepared to act decisively.
Dont Blame the Fog

z One of the major complaints in the uncertain political direction of the
period following the global economic crash has been a continued stream of mixed messages, both from markets and government. This uncertainty of economic argument, it is said, makes it essential for boardrooms and management teams to adopt a cautious strategy. However this need not be the case. Companies prepared to trust their own judgement and not use the political, economic and market conditions as an excuse for inaction have the opportunity to rule the roost. The US business community has complained about what it sees as the 58
Obama administration. The argument, often championed by the less than politically neutral US Chamber of Commerce, is that the ambitious legislative agenda in Obamas first two years made it hard for companies to understand the environment in which they would be operating. It is true that constant rulechanging by government does make it harder for both businesses and individuals to make investment decisions. But rule changes were inevitable when the Democrats took control of the Congress and the White House for the first time in 16 years.
Finance
Finance
New rules can be criticised, but it is a little weird to berate legislators for the very act of legislating. The key mistake, though, is to see only the negatives of political and market uncertainty. In fact, these conditions offer companies an opportunity to differentiate themselves from the competition. History shows that the largest rewards are there to be reaped in troubled times. In contrast, investments made at the height of a boom period, when companies have a great deal of confidence that they can see the way forward, frequently turn out with the benefit of hindsight to be disastrous. Bubbles are a classic case. Markets, and the companies that comprise those markets, take a very myopic view. There are all kinds of factors that are not correctly priced into peoples calculations while a bubble is going through its inflationary cycle. In particular, the risk that the bubble will burst is almost invariably accounted for in company thinking. CEOs should stop blaming the fog and instead set about doing better than their competitors. They should forget about political uncertainty and concentrate on the forces creating the real uncertainty, which are so much bigger than the issue of who holds power in Washington. The reality is that it is business which will drive the US economy out of the recession. To achieve the success that will make this possible, companies have to stake large bets on what they think is coming next and to make the correct forecasts. To do that senior executives need to know their markets and be bold. At present some are not particularly enthused about the opportunities markets seem to be offering them; but those who act decisively now are more 60
likely to enjoy spectacular payoffs later, while those who sit on their hands through the fog certainly will not. Those who do nothing may not lose money directly, but they will lose opportunities and that comes to the same thing in the long run. Part of the problem is cultural. Managers today have come to accept the conventional academic wisdom that it is very hard for investment professionals to beat the market with any kind of consistency. This is a totally reasonable position: there is very little evidence, for example, of unit trust managers achieving persistent outperformance. But it is a huge leap from there to say that therefore the prices in the market at any point in time must be the best possible estimate of the value of what is being traded. It is true that investors struggle to outsmart the market consistently (by picking the value that the market misses). But that does not prove the assertion that the market does a good job at all times. There is incredible excess volatility in any market pricing and that needs to be taken into account. Markets can do a very good job of pricing perceptively for quite long periods. However, they have a tendency to get the small things right and the really big things, the game-changing things, completely wrong. Then you get violent market corrections. There are also difficult decisions to make about the state of the global economy. But there is enough clarity about what will happen to enable companies to make judgements which have a strong chance of being accurate enough. There has to be a short- to medium-term shakeout in China, though the timing is hard to predict.
There is a real estate bubble, which the Chinese government is trying to damp down, but there is also real growth. A lot of US companies have already decided that the major growth of the next decade is going to come from the BRIC countries (Brazil, Russia, India, and China) and are positioning themselves to benefit from that. One chief executive told me he no longer talked about emerging markets, but about slower and faster-growth economies. Judgments also have to be made about the direction of the US deficit and its impact on the economy. There are two elements to the deficit, one caused by the economic slowdown, the financial sector bailouts, and the Obama stimulus package. The other derives from the gigantic looming shortfalls in Medicare, the taxpayerfinanced healthcare system for older Americans. When the economy truly begins to recover, the first set of deficitcausing factors will automatically go away. The latter wont, and so far there are no signs of any real progress in combating the problem. In fact, all weve seen is an expansion of healthcare coverage. Some advocates of the Obama health reforms argue that the present US system is so illogical and dysfunctional that putting together a more efficient system must generate price efficiencies, which will more than make up for the added cost of expanding coverage. Perhaps they will, perhaps they wont. Then there is the question of pensions. The US Social Security Administration isnt nearly as broke as its critics make out, but it does face funding challenges in coming decades as the population ages. And the funding assumptions behind state employee pensions have been shot
Finance
to pieces by the financial crash and market performance over the last few years. That, too, creates a big fiscal problem. However, I am something of an optimist on deficits. There was a remarkable consensus prior to the Bush years on not running big federal deficits. Then that went out the window, and it is going to be very hard to put the spending genie back in the bottle. However, in 1994 budget surpluses looked like the stuff of fairytales, yet we had a surplus within five years. So we could be surprised again. Finally there are a series of currency-related issues that managers have to address, particularly those linked to the eurozone. The euros bid to overtake the dollar as the worlds reserve currency has clearly run into difficulties. The northern versus southern European productivity crises are clearly going to have to be worked through, and that will generate some pain and continuing difficulties for the euro. Short of some really disastrous monetary policy decisions by the US, it is hard to see the euro displacing the dollar. That is not to say that there arent significant problems with the dollars role. Having a national currency serve as the global reserve currency tends to result in massive current account deficits and global imbalances. There has been a lot more talk of a replacement reserve currency and a lot of debate about the International Monetary Funds special drawing rights being bumped up in some way to take on some of the burden of being a global reserve currency. It is also possible that at some time in the future the renminbi could put in a bid for global reserve currency status. But that is decades away. Q
The regulation process

Regulators often regard markets with alarm, particularly when violent swings occur. The idea that markets have a tendency to overshoot in both directions is clearly accepted in the United Kingdom, though in the United States it is a lot more difficult to talk of direct inter vention in the markets. Obviously it is not reasonable to argue that we can constitute a Bank of England committee or a Federal Open Market committee that will always know better than the market. But, at least in the United Kingdom, it is accepted that that some level of leaning against the wind is important. The problem is that this is extremely hard to do when times are good. There is an old saying that it is the central bankers job to take away the punchbowl when the party gets started. But this is too often deemed to be impractical or at least unpopular by whoever has to make the call. The alternative, which seems to attract regulators, is to establish a semi-automatic process that would damp down exuberant greed once it started to build up a head of steam. In a sense this argument goes all the way back to Milton Friedman, who wanted to see a set of rules based on the money supply. The problem for Friedman was that no one agreed on how to measure the money supply with the degree of finesse required for such a rule-based mechanism to be implemented. However sensible any trigger measure might look when it was selected, by the time it was close to being triggered it might no longer be relevant because of changed circumstances. The problem is that replacing Friedmans semi-automatic rules-based model with a committee of the great and the good provides no guarantee that they will get it right.
61
Comment
Shop Till You Drop

Brazil is one of the worlds boom nations but the current spending frenzy may be masking underlying economic problems which could yet bring the spree to a crashing halt, says Brian Caplen.
z Brazils new status as one of the worlds major economic how successful increases in bank reserve requirements,
powers is reflected in the decisions to award it both the 2014 football World Cup and the 2016 Olympics. There is a new confidence in the country, but also a growing realisation by politicians, bankers and business leaders that success brings its own policy dilemmas. There is, for example, an unhappy combination of the worlds highest interest rates (12 per cent), an overvalued currency (by 30-40 per cent) and inflation (6 per cent). The central bank should be raising rates to counter inflation but is moving cautiously for fear of pushing the Brazilian currency, the Real, even higher against the US dollar and so jeopardising manufactured exports. Instead the Banco Central do Brasil, under the leadership of Alexandre Tombini, is experimenting with macroprudential measures to slow down hot money inflows and to cool off the countrys burgeoning consumer credit boom. Not everyone is convinced. Economists are divided on 62
higher bank capital allocations for consumer lending and taxes on loans will be in slowing things down. Nor do they agree on whether failure to get things under control will cause short-term problems or lead to a more deep-seated malaise. In the meantime Brazilians are embarking on a shopping spree that dwarfs anything that has gone before. The memories of past hyperinflation have created a culture in which saving is for fools and spending your entire salary right now this minute is smart. Wealthy Brazilians are travelling to Florida to buy a complete house of furniture and shipping it back in a container with the Real so strong and the dollar so weak they are still ahead even after the shipping costs. Not that Brazilians seem to mind paying for things there is one aspect of the local shopping culture that veers towards buying the most expensive of two items, even when they
Comment
are broadly the same, just to be sure of not doing anything by halves. One story goes that there is a restaurant owner who has two identical businesses one in Sao Paulo, one in Madrid. Costs are more or less the same, but he can charge 20 per cent more in Brazil just because Brazilians like to pay more. They are certainly getting the chance at the moment with prices for most goods and services in Sao Paulo and Rio de Janeiro creeping higher than their equivalents in New York and London. There is a key difference between this shopping boom and previous ones. In this case 30 million Brazilians have been lifted out of poverty into the lower and middle classes. They are buying their first car, their first laptop and their first high definition TV and all of it is being paid for on credit. The collective impact of this consumer credit boom is firing economic debate in Brazil. Paul Marshall, chief
investment officer at hedge fund Marshall Wace, and Amit Rajpal, portfolio manager of MW Global Financial Funds, argue that while total credit to GDP in Brazil is relatively low at 46 per cent, the debt service burden has risen to 24 per cent of disposable income and is set to rise further. By contrast the US subprime crisis erupted when the debt service burden hit a mere 14 per cent of disposable income. That view is, though, rejected by most Brazilian economists and bankers. In their view the country is catching up. Gustavo Marin, Citibanks chief executive in Brazil, says: Social mobility here has created a new type of consumer with 30 million moving out of poverty into the middle class. There are a lot of questions about whether it is a bubble, but this consumption has a real economic basis as a result of repressed consumption in the past. There will be a problem only if the economy stops growing. This brings the debate back to macroeconomic policy, and particularly whether the new government under president
63
Comment
Dilma Rousseff will accept lower growth (the rate was 7.5 per cent last year) as the price for bringing inflation down. Opinion in Sao Paulo is deeply divided. Eduardo Camara Lopes, chief executive of the investment company Ashmore Brasil, feels that politically the government may opt for higher growth and tolerate the subsequent higher inflation; and the danger of this approach will be that the central bank could lose its hard earned reputation for enforcing a tough monetary policy. In contrast, one of Brazils leading investment bankers Andre Esteves whose firm BTG Pactual has just sold an 18 per cent equity stake to a range of sovereign wealth funds and individuals including Abu Dhabi Investment Council, China Investment Corporation and Government of Singapore Investment Corporation is more relaxed. He says that Brazilian inflation, while high, compares well with rates among its fellow BRICs Russia (9 per cent), India (8 per cent) and China (5 per cent) and argues that, as long there is an easy monetary policy in the US and Europe, global inflation is inevitable. There is more consensus on the currency. Lopes says: It is a question of the dollar tanking, not the Brazilian Real being too strong. If you look at the terms of trade of Brazilian exports, they are broadly tracking the currency movements. Esteves says that Brazil is going through a transformation of its economy from emerging to developed, and currency appreciation is inevitable the same was true in other major economies such as Japan and the US during similar periods of development. But the Brazilian finance minister Guido Mantega has accused other countries of provoking a global currency war by keeping interest rates and their currencies too low. His remarks are thought to refer to both the US dollar and the Chinese renminbi. The transformation in the past two decades has been extraordinary. Brazil is now a strong and stable economy, there is an independent central bank and billions of dollars are being invested in key growth sectors. These include agriculture, which uses the latest technology, enabling Brazil, which barely a decade ago was a net importer of food, to become a world-class exporter of crops such as soya. Employment opportunities and welfare programmes have helped to lift millions out of poverty. But bankers and business leaders are still worried about the amount that still has to be done. Brazil has some of the worlds most archaic labour laws, a hideously complicated tax system, and a sprawling government that huge sections 64
of the population rely on for wages and pensions but which gets in the way of private enterprise. A huge challenge will be for companies to complete the infrastructure needed to host the World Cup and the Olympics while working around the red tape and the bureaucracy. At the World Economic Forum meeting on Latin America held in Rio, one foreign businessman operating in this area complained that smaller taxes and bureaucratic processes were preventing his company from getting its work completed. Frederico Fleury Curado, the chief executive of Brazilian aircraft manufacturer Embraer, acknowledges that this is a legitimate complaint. We (Brazil) are late with these projects and it is very challenging. There is a lot of bureaucracy, a lot of licences to obtain, and they are not necessarily straightforward. So if we do not simplify the whole system its going to be tough to get the investment, he says. Brazils legalistic and labyrinthine system applies to everyone from big companies to individuals. One foreign executive working in Sao Paulo says that he has been taken to court by two different maids working in his home, both unhappy about having their employment terminated. He lost on both occasions. The dilemma is even more acute in the public sector. It is almost impossible to sack anyone from a public sector job. Yet shrinking the state and improving public finances would have considerable benefits, making interest rate reductions easier, a move which would in turn facilitate growth and investment. But what is economically beneficial is almost certainly not politically possible in the current climate. A Brazilian government that tried to remove privileges from public sector workers (the system has been described by some commentators as socialism for the middle class) can expect to lose ground in elections fairly rapidly. All this means that for achieving things on a day to day level it is necessary adopt the Brazilian approach of dar um jeito, literally to give a throw, or be flexible and find a way around the complications. At the macro level the Brazilian situation is certainly a conundrum a countrys currency cannot stay overvalued for too long without causing damage. As long as commodity prices keep increasing, the machine will keep going. But, if there is a slowdown, the country may regret not carrying out reforms in the good times, and taking tough decisions on government spending and inflation, when it had the chance. As for those shoppers, they are not saving even one Real for the day when the party stops. Q

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QUANTUM

Fi n a n ce I n Perspec tive Issue 15 July 2011

QUANTUM FINANCE IN PERSPECTIVE

Talking revolution / 18 Reserve position / 24

Setting the standard / 39

Another cup of coffee / 62

Articles from QFINANCE

Holding the Curve /

Dont blame the fog /

Quantum - Finance In Perspective - Issue 15

Justin Fox is editorial director of

Brian Caplen has been editor of

Victor Smart is a communications specialist in the

David Smith has been Economics Editor of the London

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Rider on the Storm

Left: Jim Rogers, May 2011

Quantum - Finance In Perspective - Issue 15

Jim Rogers, investment biker

The commodities conundrum

Quantum - Finance In Perspective - Issue 15

Proceed with Caution

Quantum - Finance In Perspective - Issue 15

TRADE SURPLUS ($bn)

Source: Capital Economics.

CONSUMER PRICES (% y/y)

Source: Capital Economics.

RENMINBI/DOLLAR EXCHANGE RATE

Source: Capital Economics.

POLICY RATES (%)

Lost in the Woods

z The international currency system

The Bretton Woods System

Quantum - Finance In Perspective - Issue 15

Special Drawing Right (SDR)

Quantum - Finance In Perspective - Issue 15

Quantum - Finance In Perspective - Issue 15

Quantum - Finance In Perspective - Issue 15

TIMELINE FOR IFRS HARMONISATION/CONVERGENCE AMONG THE G20

Quantum - Finance In Perspective - Issue 15

Holding the Curve

Quantum - Finance In Perspective - Issue 15

How different systems evolve

Quantum - Finance In Perspective - Issue 15

Representative countries Prevailing concept of the firm

The board system

France, Italy, Spain, Belgium, Brazil, Argentina Institutional

Optional (France) in general one-tier

Quantum - Finance In Perspective - Issue 15

Dont Blame the Fog

The regulation process

Quantum - Finance In Perspective - Issue 15

Shop Till You Drop

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