KWR International Advisor #12 December/January 2001-2

Contributing Writers to this Edition: Scott B. MacDonald, Keith W. Rabin, Uwe Bott, Jonathan Lemco, Jim Johnson, Andrew Novo, Joe Moroney, Russell Smith, and Jon Hartzell

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

War in Afghanistan, recession in the U.S., default in Argentina, and more subdued Christmas parties all reflect the state we are in. Welcome to the first major downturn in the global economy in a long time. While we came close in 1997-98, the U.S. consumer and a responsive Fed came to the rescue. The global economy lost steam, but did not putter to a halt. This time around the global economy has puttered to a halt. The United States and Japan are in recession and Euroland is either going into a recession or at the very least threatening to head in that direction. We see the major trends in 2002 being the following:

We expect around 1% real GDP growth for the United States in 2001 and 0.9% in 2002. For Japan we are looking at —0.6% and —0.5% in 2001 and 2002 respectively, with Euroland looking at 1.5% and 1.2% over the same period. Germany, now in recession, will escape 2001 at 0.7% growth and expand a marginal 0.9% next year. Germany, however, continues to face a number of structural issues, including the flexibility of the work force and the fate of state-owned banks. These weigh heavily in our view on German prospects for next year.

The answer to our question of when will happy days be here again is that don’t hold your breath. While we see recovery in the second half of 2002, we expect it to be gradual. The booming 1990s were nice, but they are now history. The 2000s have yet to achieve a moniker, but so far it doesn’t look as though strong growth will come until 2003.

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

It is no secret that economics is an imperfect science at best. However, since the events of 9/11 we have truly experienced a shift of paradigms. Many things that we ordinarily assumed to be constant are uncertain today. The universe of forward-looking scenarios, political as well as economic, has grown and is now nearly infinite. Anything we say or predict must be measured against that stark background. For example, a nuclear attack against a major population center in the United States, and especially against the site of our federal government, Washington DC, is unlikely but far from impossible. The consequences of such attack, i.e. the elimination of government as provided for under our constitution are unthinkable. Therefore, we have to reduce our new universe to something more manageable. This does not mean to assume normalcy. Normalcy as we knew it on 9/10 will not return for a long time, if ever. Yet, policy-makers, analysts and investors have to design a stable platform of assumptions to make decisions that will impact our outlook for the coming years.

My base case in looking at the U.S. in 2002 is one, in which we might continue to fight a war in Afghanistan. At a minimum we will have large concentrations of our military forces committed to that region. We will also continue to pursue the terrorist networks responsible for the mass murder of 9/11. At the same time, we are unlikely to face an attack similar to or worse than that of last September. Obviously, our outlook is so much grimmer should I be wrong in my last assumption, but this is a truly unpredictable scenario as is the likely fallout from it. There is a 20% probability that the war might spread to Iraq, should we determine that Saddam Hussein was directly involved in 9/11 or in the anthrax attacks on our population. Such a scenario would likely have a negative impact on our outlook for the U.S. economy as well, but it is far from clear that it would sharply differentiate from our base case. Much would depend on the way in which such expansion of the war were undertaken and how able the administration would be in shoring up global support for it. Shrewd diplomatic management could considerably reduce costs to the U.S. economy.

Yet, the state of the U.S. economy is weak and will be even weaker at the beginning of the New Year. Growth in the fourth quarter will contract by as much as 2.5% when compared to the fourth quarter of 2000. Interest rates were lowered once again on December 11 by a .25 bp point in recognition of this weakness. At the same time, the Federal Reserve is running out of maneuvering room. Further fiscal stimulus has been subject to partisan debate. The outcome is likely to have negative long-term effects on fiscal stability that far outweigh the short-term benefits. The Bush administration is a already preparing the population for a return to seemingly irreversible budget deficits. This was a very predictable and predicted consequence of a weakening economy and the first phase of the Bush tax cut. The return to years of deficits is partially responsible for the stubbornly rising interest rates in the bond market, a reaction that nullifies much of the Fed action. Unemployment has risen to 5.7% in November and may reach 6% by year end with further bloodletting to be expected.

This is indeed a poor starting position for 2002. It is especially of concern, when one considers that there is considerable room for further softening. In spite of recent events, consumption has remained unreasonably strong with a lot of potential for a downward correction, as has the real estate sector. It has been much noted that our financial system has not experienced any fundamental weakness yet, because the real estate market has remained strong. Given the existing fundamentals as well as a diminishing appetite for mortgage refinancing once interest rates have leveled off, residential and commercial real estate are likely to suffer steep losses in the first two quarters of 2002. This, in turn, will negatively impact the balance sheets of our banks. At the same time it is important to note that the usual remedy to such a downturn in the real estate market, i.e. lower interest rates, will already have been used up by the Federal Reserve, as we approach a zero interest rate policy comparable to that of Japan. The financial system is not mortally wounded by any stretch of the imagination, but the Enron disaster has underlined the lack of transparency even in the sophisticated U.S. market. There are likely to be many skeletons in the closets of the financial system.

Durable consumer goods, and especially cars, have also done extraordinarily well in October of 2001, when car sales reached a record high. This has boosted our monthly retail sales to an abnormally high 7.1% growth rate compared to October 2000. However, this record high was the result of give-away, zero percent financing offers by U.S. automobile manufacturers. This "subsidy" has had a detrimental impact on current earnings expectations for those companies. Moreover, it also reduces volume projections in the automobile sector for 2002, suggesting that the earnings trough for that industry may be a lengthy one. At the same time, this too underlines the danger that monetary and fiscal policy will continue to fail to stimulate the economy, because the most sensitive sectors to such policies have in fact experienced a growth bubble during the third quarter of 2001.

Hence it is likely at this point that the economy will further and possibly more sharply contract in the first quarter of 2002, perhaps by as much as 3% compared to the first quarter of 2001. Unemployment may reach 6.8% in March of next year, which will have a contractionary impact on consumption. A major concern under this scenario is that the continued weakening of the U.S. economy will be exported to the rest of the world. A global recession will diminish prospects of an early and strong recovery in the U.S. A global reduction of trade is a lose-lose proposition. Thus, the economy may continue to contract even in the second quarter of 2002, albeit at a slower pace, maybe around 1.5%.

In my base case scenario of a controlled military exercise with limited further casualties in the United States, we will be confronted by the end of the first semester of 2002 with a negative growth rate of over 2% when compared to the first six months of 2001. This will be characterized by a severely weakened financial sector, an environment of high unemployment (over 7% by June 2002), falling prices (deflation may reach 1-2% in the United States during the first six months of 2002), and a lagging global slowdown that will have peaked during the second quarter.

At that point, opportunities should begin to emerge. A continuously low interest rate environment and accelerating consolidation in the corporate sector will lead to increased efficiencies, albeit to even higher unemployment, and accommodating fiscal policy will allow for a slow recovery in the third quarter of next year. The core of this recovery will likely come from the technology sector that will be considered as oversold at that point. Companies will start to invest again in updating their technologies. Consequently, there will be productivity gains during the second half of 2002 that might compete with those experienced in the late 1990s. The important real estate and automobile sector will be drags on the economy, however, because they were artificially inflated during the early period of the U.S. recession. Growth will be at 1% in the third quarter, rising to 1.5% during the fourth quarter of 2002 because of a recovery in foreign markets. All in all, 2002 will be a calendar of negative growth, high unemployment, falling or stable prices in an environment of low interest rates and loose fiscal policy likely to result in a significant budget deficit for that year.

Towards the end of 2002, the Fed will be on its toes and begin to raise interest rates ever so slowly to prevent inflation in 2003 without choking off growth. This will indeed be a challenge. The Fed has radically driven down rates to levels not experienced for 40 years. At the same time, the Bush administration has put in place fiscal stimulus before and after 9/11. Much of the stimulus put in place before 9/11 will grow exponentially as the decade progresses. This may indeed result in an overheating of the economy in early 2003 accompanied by rapidly rising prices, which will be difficult to contain through interest rate policy alone. Therefore, we are likely to face much greater economic volatility and instability over the medium term in the United States than we did in the second half of the 1990s. Our fiscal position will worsen and it is indeed very likely that most of the gains of fiscal prudence accomplished during the 1990s will have been squandered by 2005. As the Chinese saying goes: We are living in interesting times.

Japan had a difficult year in 2001. The economy again fell into a recession, unemployment rose above 5% and the financial sector remained problematic. The Koizumi government’s reform program inched forward, but still faced considerable resistance from part of the country’s political elite and entrenched interests. Unfortunately the reform effort comes at a time when the global economy has slid into a recession and the export sector, long the engine of growth for the Japanese economy, is feeling the chill effects of the U.S. slowdown. The dual nature of the Japanese economy — an efficient export sector and a protected, heavily indebted and inefficient domestic sector built around construction, retail and agriculture — has run out of gas. Exports were also hurt by a strong yen. We concur with the Bank of Japan’s increasingly bearish outlook for the economy and expect real GDP will contract next year. Sadly, the words of Mark Fields, president of Mazda Motors, ring true: "The only way Japan looks good is if you turn the charts upside down."

Forecasts for real GDP growth vary for Japan. The Economist’s poll of major economists puts 2001’s real GDP growth rate at —0.5%, with —0.4% for 2002. The IMF is looking at —0.9% in 2001, followed by an even steeper 1.3% contraction in 2002. The OECD is equally gloomy as it expects the Japanese economy will shrink until 2003. It also believes the recession could deepen if Tokyo fails to keep markets convinced that it is serious about reining in public debt or dithers on banking sector cleanup. Even Prime Minister Junichiro Koizumi expects the economy to be in recession for the next two years. Prospects for Japan are looking dimmer with the rating agencies. Not to be left out, Moody’s, Standard & Poor's and Fitch have bearish outlooks for Japan and have been active in downgrading the country’s ratings, citing slowness of economic reform, the large and growing public sector debt (130% of GDP), and questions over political will to carry reform ahead.

Next year could be a turning point for Koizumi and his efforts to reform the economy. The Japanese leader and his team are keenly aware of what ails Japan — the mounds of bad loans clogging the banking system, the pressing need for a rigorous banking sector cleanup, fiscal consolidation, and corporate restructuring. The protection for the highly uncompetitive domestic sectors must be ended and the broad reach of the state in the economy must be reduced through privatization and deregulation. While being aware of the problems and having formulated plans to deal with those problems are positive steps forward, implementation remains a critical and as-of-yet unfulfilled step. Rising concern about the troubled nature of the Japanese economy and in particular its banks, is part of the reason that the International Monetary Fund is sending a team to Tokyo to assess the level of bad loans.

While progress has been made in shifting banking assets into the hands of investors, including Ripplewood’s acquisition of the former Long Terms Credit Bank into what is now called Shinsei Bank and WLR’s purchase of the Kofuku Bank in Osaka, major concerns remain. Major Japanese banks reported losses for the semi-fiscal year ended 9/30/01 and on a consolidated basis, the eight major banking organizations (encompassing 15 banks) posted losses totaling ¥607 billion ($5.1 billion). The chief culprits were aggregate loan write-offs of ¥2.2 trillion ($18.3 billion) and unrealized losses on shares owned of ¥1.4 trillion. Only Sumitomo Mitsui and Sumitomo Trust recorded a net profit. Mizuho Holdings, one of the world’s largest banks in terms of asset size, announced a loss of ¥265 billion ($2.2 billion). Moreover, it expects to lose a substantial ¥720 billion ($6 billion) for the full fiscal year which ends on 3/31/02. Considering the grim banking environment, none of the banking groups will be paying a common dividend for the six-month period.

Looking ahead, Japanese banks must also consider the deepening nature of the recession, which will put many companies under pressure on their loan repayments. Consequently, Japanese banks are forecasting a combined loss for the full year ending 3/31/02 of almost Y2.3 trillion ($19.1 billion). Total non-performing loans for the eight banking groups stood at ¥20.7 trillion ($173 billion) at 9/30/01, up from ¥17.6 trillion at 3/31/01.

One of the clouds over the banking sector is a list of 66 companies whose financial position is similar to Mycal, a major retailer that went bankrupt in September. Prior to its collapse, Mycal was rated a Category 2 borrower (according to criteria used by the Financial Services Agency), which meant requiring attention, but well above Category 5, which is bankruptcy. The list was compiled by Toyo Keizai, a respected economic magazine in Japan and includes such companies as Nissho Iwai, Isuzu Motors, Tokyu Department Store, and two construction companies, Hazama and Kumagai Gumi. Needless to say, the list has caused a stir in corporate Japan.

However, having introduced many of the measures and processes needed to facilitate the bankruptcy process, Japan is now better equipped to undertake the restructuring necessary to enhance corporate restructuring and rationalization. Understandably, substantial reluctance remains to the dislocation that is an unfortunate byproduct of this transition. Nevertheless, having been given the tools, it is now essential that Japanese firms and financial institutions begin to embrace the painful steps that will ultimately serve to enhance their long-term competitiveness and profitability.

One of the major battles likely to continue into 2002 is over the reform of public sector institutions. Earlier in 2001, the Prime Minister stated that the Housing Loan Corporation was to be abolished and other state-owned financial institutions would be merged. His team also sought to freeze an expressway construction planned by the Japan Highway Public Corp. Opposition within the Prime Minister’s own Liberal Democratic Party, however, gutted his proposal to halt the highway project and watered down the public sector reform bill, arguing that the corporations in question are indispensable to stimulate the economy and serve the needs of the regional areas. Although the watering down of the reforms was a setback for the Prime Minister, the issues raised are not going away and it is likely that Mr. Koizumi will revisit them again in 2002.

Another major battle in 2002 will be the budget. Prime Minister Koizumi announced in December that he will seek to make a record cut in spending for fiscal year 2002-2003. In an outline released by the Finance Ministry, the government will seek to cut general spending, which excludes debt payment costs and subsidies to local governments, by 2.3% to Y47.6 trillion ($371 billion) for the year starting in April 2002. If passed in the Diet, this will be the first reduction in four years and the largest ever. According to the Finance Ministry, public sector debt will climb to Y693 trillion, equal to 139.6% of GDP, by March 2002. That would be the highest among OECD membership, even above Italy, long the organization’s major debtor country. Key elements of Koizumi’s plan are to slash the public-works budget by 10.7% along with a cut of 10.4% of aid to poor nations. Moreover, the Prime Minister has repeatedly indicated that he will stick to the cap for new government bond sales at Y30 trillion. The budget plan will be submitted to the Diet in January, where no doubt it will be the center of another battle between reformers and anti-reformers. Clearly Kazuyuki Tazawa, a senior economist at Sumitomo Mutual Life Research Institute, has captured the importance of the upcoming battle: "If Koizumi scraps the bond cap, requests for pump-priming spending will explode, and things will get out of control."

While much of the economic landscape is stark, the corporate sector is in the process of restructuring. In many regards it has no other option as it is increasingly more difficult for the government to provide bailouts and public opinion is generally opposed. The steel sector is already in the process of consolidation. A planned merger of Kawasaki Steel and NKK is set for April 2003, while Nippon Steel has moved to secure its position within the industry, recently inking partnership arrangements with Sumitomo Metal Industries as well as Kobe Steel. Although the short-term prospects for the Japanese steel sector cannot be called robust, the trend is to consolidate the "Big Five" into two major groups, which should bring some advantages in finding greater cost efficiency of operations. This trend is evident in other sectors and holds some degree of hope for the future, though the process is proving to be slow.
The Koizumi administration came into office with high expectations. Those expectations have only partially been met and the economic situation is eroding. The yen looks set to weaken into 2002, probably past the Y130 to the US $, possibly as far as to Y150. However, the yen’s weakening is not likely to resolve Japan’s problems and could complicate Tokyo’s relations with its neighbors. The same is true for the eventual U.S. recovery. While a pickup in the U.S. economy will help the export sector and mitigate the harshness of the downturn, the length of the downturn is dependent on the ability of Koizumi to steer reforms through the Diet and the private sector to further embrace restructuring. Without these two developments, the prognosis for Japan is going to be worse. In January 2002 the Koizumi government presents its budget to the Diet. This is the next big battle for the future of Japan and much is at stake.

For much of the past decade, the Canadian economy has grown at a robust pace. This was due in large part to the relative strength of the US economy, and the spillover effects of a continental-wide free trade agreement. In addition, the Canadian government demonstrated world-class fiscal prudence such that the federal and most of the provincial governments were able to realize balanced budgets by the latter half of the decade. However, if the current recession in Canada continues through much of 2002, then not only will economic growth stall, but certain of the provinces will also experience severe budgetary pressures due to declining revenues and increased health care and education expenditures. Since May of 2001, investment in Canada has slowed as unemployment has increased. This has been a worldwide pattern of course. The tragedy of September 11 and the resulting security costs incurred will further strain the Canadian fiscal balance.

Many economists are expecting Canadian economic growth to be in the 1% range in 2002. We share this view, but think this headline figure will mask a second-half turnaround that should take the growth rate to 2.7% from its flat levels today. If the US economy improves in the second half of 2002, then we expect Canadian growth to be in the 3-4% range in 2003. But if Canada does achieve this growth, it will have to overcome certain obstacles. For example, inventory-to-sales ratios are at uncomfortably high levels and more cost-cutting efforts are needed before profit margins can be expected to bottom out. As US companies are ahead of their Canadian counterparts, we look for the Canadian economy to lag the US during the early stages of recovery in 2002. This follows previous patterns as well.

In general Canadian business cycle contractions are less brutal than their US counterparts, averaging 2.5% compared to the US 3.7% since 1962. But the Canadian economy typically takes longer to recover-five months more on average. This difference is explained, in large part, by the exchange rate. Canadian monetary conditions are influenced as much by the currency as by short rates. It is estimated that a 3% depreciation of the Canadian dollar has roughly the same effect on the Canadian economy as a one-point rate cut. In November 2001, the Canadian dollar touched a record low of 62.3 US cents as exports fell and investors turned elsewhere. The lack of pent-up demand in the Canadian consumer sector is another roadblock in the way of a typical post-recession snapback.

There are reasons, however, to be optimistic about the Canadian economy going forward. The Bank of Canada has dramatically eased interest rates and, coincident to this, long-term credit spreads have tightened 35 basis points since November 1. In fact, we think the Bank might reduce interest rates another 50-75 basis points in the first quarter of 2002. Canadian stock market prices are up 25% from their bottom, and industrial commodity prices have improved by 5% from their worst levels in 2001. Inflation is negligible. These are all encouraging market signals that the Canadian economy is about to make the transition from contraction to expansion.

Investors should also note that Prime Minister Chretien and the Federal Liberal Party remain popular and would easily win an election if it were held in the near-term. A federal election is unlikely in 2002 however. Furthermore, investors might note that the sovereignty movement in Quebec, although never dead, is completely dormant at the moment. There is little political risk of sovereignty for the foreseeable future. Rather, the priority of the Quebec government — like all of its counterparts in the other nine provinces -- are elsewhere. All are facing substantial fiscal pressures due to slowing economic growth and increased demands for health care and education expenditures. Although, all of the provinces are committed to balanced budgets in 2002, we think there is a 30% chance that Quebec and Ontario will have operating deficits due to these budgetary pressures.

According to BMO Nesbitt Burns Inc. the combined provincial balance of (CDN) $11 billion in surplus in 2000 will turn into a deficit of almost $2 billion in 2001. From Newfoundland, which forecasts an $80 million deficit in 2001-2002, to British Columbia, which is braced for a $2 billion shortfall, the provincial outlook is beginning to look very difficult in the next year. In general, provinces that eliminated their deficits quickly and began paying down their debt, like Saskatchewan and Alberta, are in better fiscal shape. By contrast, Nova Scotia continues to run deficits and its debt is now a whopping 46% of its entire economy.

So we have a mixed bag. The global recession has hurt the Canadian federal and provincial economies, but the national government is poised to recover fairly quickly. Indeed, net public debt is expected to be CDN $547.4 billion in 2002, which is less than 50% of GDP for the first time in 17 years. By contrast, several of the provinces may be hard pressed to deliver balanced budgets. In short, we think that Canada will remain an attractive investment destination in 2002 as the nation emerges from recession. But we caution that fiscal pressures will remain for the foreseeable future.

On the face of it, international conditions couldn’t be much worse for Australia’s economy. The global economy was already mired in a rare synchronous recession when terrorist attacks on the U.S. dealt a blow to business and consumer confidence worldwide. Japan, Australia’s largest trading partner, is now in the midst of its third technical recession in the last decade. The slowdown and the additional injection of uncertainty have put further downward pressure on the prices and volumes of several of Australia’s commodity exports, and caused the Australian dollar to temporarily slump to new lows on trade-weighted basis.

As was the case in 1998, however, when the Asian economic crisis led to widespread discounting of Australia’s economic prospects, we think its performance will prove more resilient than the consensus of current forecasts. In fact, were it not for the global economy’s malaise, we’ve little doubt that Australia would be seeing quite robust growth in 2002.

Can Australia avoid recession? We’re confident it will. The downside risks to Australia’s performance in 2002 stem primarily from global economic forces. We expect these forces will slow Australia’s growth in 1H02, but not cause an economic contraction. Here’s why.

First, Australia’s momentum in 2001 was considerable: its economy expanded at a 4% pace in the first three quarters of 2001, compared to a flat performance from the U.S. and growth of 1% in the Euro Area. While the economy will likely slow in the first half of 2002 (to perhaps a 1% to 2% annualized rate), we doubt that even a significant decline in export volumes would be sufficient to offset this domestic momentum.

Recent history supports this view: Australia weathered a much more serious decline in its exports volumes during the Asian economic crisis of mid-1997 to early 1999 with real growth averaging 4.7% over that period. Moreover, that global slump centered on Asia, the destination of much of Australia’s exports, whereas the current weakness is centered in the U.S., where Australia sends only about 10% of its exports.

Can this domestic momentum continue? Although there’s some risk that a prolonged global slump could erode the domestic outlook if the labor market weakens substantially, the latest data on investment intentions, consumer confidence, and credit growth suggests that the economy is still in good shape. Businesses have revised up substantially their planned investment spending for 2001-02 in the two latest surveys, suggestive of about a 6% expansion in nominal terms from the prior year. The Westpac/Melbourne Institute survey of consumer confidence rose 3.4% in November, partly offsetting its 9% fall in October. The rebound is all the more remarkable since the survey was conducted just prior to the Federal election and just after news of a sharp rise in the jobless rate. RBA credit measures have shown bank lending to be growing at still healthy clip, underpinned by housing finances. While the housing boom is expected to wane over the coming year -- presenting some downside risks to growth -- we do not expect a substantial fall.

In addition to growth momentum, we also see the value of the currency and the stance of monetary policy supporting the economy’s continued expansion. The Australian dollar was at extremely competitive valuations in early 2001, and remains so today despite a significant widening in interest rate differentials in favor of the $A. Policy interest rates, for example, are currently 250 bp higher in Australia than in the U.S. (they were 25bp lower in Australia at the start of the year). Despite that, the $A/USD exchange rate remains 6.5% below its average level in December 2000, while the trade-weighted A$ index is off 2.1% over the same period.

The Reserve Bank has been well aware of the risks that the global slump posed for Australia in 2001. The RBA has been easing policy since February 2001, paring its Cash Rate by a cumulative 200 bp, including two 25-bp cuts since the events of 11-September. Likely the RBA will make at least one more 25-bp move in 1Q in response to the global economic outlook. With inflation at the mid-point of the RBA’s 2% to 3% in the September quarter, it seems a safe assumption that the RBA will remain focused on the downside risks to growth emanating from the U.S. and Japan.

Not only do we believe that Australia will avoid recession in 2002, but there’s a good chance that its currency and financial markets will outperform those of other industrialized nations in the recovery that is widely expected in 2H02.

Although there may be additional volatility in 1H2002 (until the global recovery becomes more certain), the Australian dollar should be supported by three significant factors in the medium-term: interest rate differentials, Australia’s better performance on growth (both in the year to date and, we assume, in 2002), and the continued improvement in its terms of trade. That last factor, which has been boosting Australia’s national income since 1999, is a function of the continued decline in the prices of manufactured goods, particularly high-technology items. The slide in information, communications and technology equipment prices has helped to restrain the upward price pressure on imports overall that has come in the wake of the currency’s depreciation. As a result, the implicit price deflator for Australia’s basket of imports has risen by less than that of its exports, yielding a rise in its national income (and standard of living). This experience is a sharp departure from the nation’s experience during the Asian economic crisis, when Australia’s terms of trade fell sharply with the slide in commodity prices. Looking ahead, while a global recovery holds the prospect of a cyclical improvement in Australia’s export prices, the same can’t be said for prices of manufactured goods — particularly technology items.

Longer term, the Australian dollar’s prospects are quite good. In a speech delivered in late November, David Gruen of the RBA’s Economic Research Department made a compelling case for the long-term outlook for the Australian dollar (the speech is available on the RBA’s website, www.rba.gov.au). Dr Gruen argued that the forces that have brought about the decades-long trend decline in the currency should be abating in the years ahead. He cites the RBA’s commitment to inflation targeting, the improvement in the nation’s terms of trade, its labor productivity growth, and the stabilization in its ratio of foreign liabilities to GDP as factors which should arrest if not reverse the trend decline in the various measures of Australia’s exchange rate.

To conclude, while we can’t rule out the possibility that the global economic slump will get worse before it gets better, Australia’s prospects remain better than that of just about any other industrialized nation. With the currency at competitive levels and monetary policy likely to remain accommodative, Australia is poised to outperform in the global economic recovery.

On November 7th, the Italian government announced its intention to commit 2,700 of its military personal, including the aircraft carrier Garibaldi to the forces currently engaged in Afghanistan. The Italian lower-house, the Camera, passed the resolution by a stunning margin of 513 to 31. This announcement came the day after Germany had offered some 3,900 troops to the war effort. The tangible offer of military aid from Italy is just the most recent affirmation of support from Prime Minister Silvio Berlusconi’s center-right government for the American-lead campaign against terrorism.

Mr. Berlusconi has been committed to setting Italy squarely on the side of the United States in this conflict. Among Europe’s leaders, this puts him with Prime Minister Tony Blair as the two leaders most committed to the American war against terrorism. Among other leading European nations, France has been the most hesitant about the possible commitment of troops, while elements within Prime Minister Schroeder’s left-center coalition government in Germany have spoken out strongly against the war. In Spain, Prime Minister Filipe Aznar has voiced his support but not offered any material military aid, while because of Turkey’s support for the war effort, Greek support has been lukewarm. A more affirmative Italy in foreign affairs is a decided departure from its approach over the last several decades.

As soon as the United States’ military campaign began against Afghanistan on October 7, Mr. Berlusconi announced that Italy was "ready to participate in military operations" in support of "his friend" President Bush. Mr. Berlusconi has announced his intention to provide the United States with both "moral and material support." These policies are consistent with the Prime Minister’s hope for Italy to play "a direct role" in the war against terrorism. The offer of military personal for use in the campaign in Afghanistan, with an eye to becoming a possible force of occupation following the fall of the Taliban, is the latest step in the Prime Minister’s attempts to bring Italy to the forefront of international affairs. In Mr. Berlusconi’s own words to the Camera, "We must do our part" and act as a united nation. Mr. Berlusconi is anxious for Italy to play a major role in the international community, building on her deployment of peace-keeping troops in the Balkans. What Berlusconi does not want, is for Italy to be reduced to an insignificant secondary role as happened during the 1991 Persian Gulf War. These actions make it clear that the Berlusconi government is intent on pursuing a high-profile international policy — but there are risks.

Italy’s recent economic troubles put her in a delicate situation. While the wave of anti-terrorist sentiment has been enough to sustain Mr. Berlusconi’s ambitious plans, any setback will force a reassessment, certainly among the less than enthusiastic supporters. Popular sentiment is now geared for deployment and combating terrorism, but the dissipation of the Taliban is bringing the urgency of these cries to a halt. The alliance was given an important boost on November 16th, when Germany’s troop deployment of 3,900 men was passed, tied to a vote of confidence for Prime Minister Schroeder’s left-center government. While Schroeder faced opposition from Green and Social-democrat party members within his coalition, they closed ranks and supported the bill with only a few dissenting votes. However, recent poles show that the majority of German people (as high as 55%) do not support the commitment of German troops to the war effort. Italy faces a similar division among its citizens.

For Mr. Berlusconi’s government, the issue of confidence is not as pressing at the moment, but support can only be maintained by continued success. The Prime Minister’s loud support for the United States operations has made him a prime target for any opposition within the country. While the Camera and Senate seem strongly behind the Prime Minister, there are elements within Italian society that are much less pro-war. This was demonstrated quite clearly by the peace march in Assissi during October. It drew a quarter of a million communists, pacifists, and conservative Catholics to call for peace.

In addition, Italy and Mr. Berlusconi’s government face a more challenging set of political and economic concerns than any other ally in America’s camp. Italy’s economic situation was poor upon Mr. Berlusconi’s accession to power earlier this year, and his Minister of Finance, Mr. Julio Tremonti, was raked over the political coals to bring about a solution to Italy’s fiscal problems over the past summer. At the moment, concerns of world safety, and Italy’s commitment to "do her part" have overridden calls for peace. Italy’s less than ideal encounter with the G8 meeting in Genoa over the summer has perhaps contributed to the belief that in the case of "international issues," no country is safe and that all nations must look to their safety.

However, all of these current supports for the war against terrorism have their foundations in the successful conduct and conclusion of that struggle. The success thus far of the war on the ground has strengthened the government’s hand. Mr. Belusconi’s call for troops to fight the war was a bet that worked. Now the challenge is how to win the peace and for Italy to have a role in making things work. Considering that the former Afghan king lived for many years in exile in Rome, Italy could have a role to play. All the same, Italy appears ready and willing to be more assertive in international and European affairs. Will this bring benefits to Italy? Only time will tell.

By Scott B. MacDonald

By mid-December 2001 Argentina had completely run out rabbits to be pulled from its magic hat. The wizard of high finance Domingo Cavallo resigned on December 20, following President de la Rua’s fateful decision to order a state of siege following wide-scale riots against austerity measures. It is reported that over 20 people died in the riots and looting. De la Rua was to shortly follow his economy minister out of government, resigning and leaving the presidential palace by helicopter. The long expected, but painfully arrived at, last days of the currency board appear on hand. With the government in crisis and riots in the street, the country is done with attempting to pay its foreign debt and must contend with a new reality — falling off the map to international investors for a period as it renegotiates what it can pay.

For Argentina to adhere to its promises of living within its means on its budget, there must be political will. That is going to be difficult to find. After four years of recession and unemployment heading toward 20%, debt fatigue has clearly set in. The public no longer has much faith in the leadership elite. There is considerable frustration that painful austerity measures were undertaken without any tangible result at breathing life back into the economy. De la Rua and his administration were totally discredited and Carlos Menem, who is seeking to set the stage for re-election under the Peronista banner, is regarded as one of those responsible for the huge build up of $132 billion in external debt. The bottom line for many Argentines is where did all that money go? Corruption is clearly suspected, leaving a bad taste for many in the unemployment lines. At the end of day whoever assumes the mantle of leadership in Argentina has few choices. The International Monetary Fund has turned its back on its once model student and left it to fend for itself.

Argentina must now live with a formal default and go through the process of rescheduling its debt. Moreover, it is likely to devalue the peso, hence dismantling the currency board. Dollarization is not an option considering the fall in foreign exchange reserves. The banks sit on the edge of a major systemic crisis. In the short-term this is going to hurt Argentina more. The population of 37 million will face a harsher environment and no doubt more radical voices will be raised calling for an end of the market-oriented economic policies that got the country into its current mess. Populism could become a danger to the country.

Although conditions are grim for Argentina, there are some silver linings in the dark clouds. As the country makes the shift from a currency board to a floating peso it will be able to gain a higher degree of competitiveness for exports. This is important if the country is going to return to growth. Moreover, an agreement to move ahead with an official default and rescheduling removes the Argentine crisis from the headlines, begins to normalize its credit conditions, and allows the country to start the process of moving beyond what had appeared to be a perpetual crisis mode. However, none of this is to be easily achieved. There are definitely questions over political will to deal with the painful decisions that need to be made. De la Rua lasted only two years into his term.

It is likely that Argentina will eventually have a grand coalition or unity government to take the place of the departed de la Rua and short-lived Peronista administrations, operating with the support of at least part of the opposition. History will remember the short-lived Saa government for defaulting on the countryÕs $132 billion debt. Eventually, a new election is to be held on March 3, 2002.

A new economic team must be formed and calm restored to the streets. The whiff of tear gas is not the sweet smell of an economy and society working in harmony. Moreover, support for basic human needs must be made available for the poorer segments of Argentine society. Then and only then can Argentina return to the bargaining table with its creditors to discuss what can be done.

Argentina’s slow motion wreck has been sad to watch, but the very gradualistic nature of its demise has been a blessing to the rest of Latin America. Although the move to default and eventually devaluation will send tremors throughout the region, this time around it should not push Latin America into a major crisis, such as the one that occurred in 1994 with Mexico’s abortive devaluation. Mexico has benefited from NAFTA, making closer ties to the United States and moving its economy along a more stable business cycle as opposed to boom bust cycles. For Brazil, the Argentine situation has forced the major government political parties to close ranks, pass important legislation and push for a single presidential candidate in the elections in October 2002. In addition, there has been a gradual de-coupling of regional currencies and securities values from Argentina’s.

Foreign banks have a little over $64 billion of loans, bonds and deposits in Argentina. Most of the major international banks have some exposure, including Citigroup, Banco Santander, and J.P. Morgan Chase. FleetBoston, the 7th largest bank in the United States, has already indicated that Argentina is hurting its bottom line, noting that Q4 earnings are down by $750 million, partially due to a write-down on loans to the South American country. Although this hurts a number of bank’s bottom lines, the default is not expected to send any major bank into a crisis. There has been a lot of time to prepare what has happened. Santander has already stated that it plans to set aside $900 million and inject as much as $500 million into its Argentine unit to cover potential losses. BBVA, Spain’s second largest bank and another major player in Argentina, plans to set aside 400 million euros.

2002 will be another testing year for Argentina. A new government will have to tackle how to return the country to growth and normalize relations with the international creditor community. None of this will be easy. However, the magicians are now gone. The wizard’s hat has been put away. The time for rabbits is over. The time for material changes is now.

Initially the focus of an interested outside world in the early 1990s, Central Asia faded as a point of attention by late in the decade. Many foreign investors walked away frustrated by a slow approach to economic reform and the opaque nature of government, while geo-political risks associated with Afghanistan and the emergence of radical Islamic groups overshadowed the region, helping make it a dangerous, off-the-beaten track backwater. In a sense, by 1998 Central Asia had become part of a new "Great Game" of power and influence, where only the most daring of investors and companies ventured. The events of 9/11, however, changed Central Asia’s geo-political role. No longer a distant point on the map where the major newspapers and TV networks did not think of sending correspondents, Uzbekistan, Turkmenistan and Tajikistan are now filled with journalists, seeking to be on the cutting-edge of "discovering" Central Asia.

Despite this sudden interest by the Western media, Central Asia has long been "discovered", and during the 1990s it underwent substantial changes. Central Asia’s experience since being suddenly thrust into independence in 1992 has been one of often-extreme volatility. Long part of the command economy of the Soviet Union, the republics of Kazakhstan, Kyrgyzia, Tajikistan, Turkmenistan and Uzbekistan were hardly prepared for statehood. Greatly complicating matters was that the old system of command economics was badly discredited, yet the existence of an elite with the necessary skill sets to implement and manage a market economy were sparse. Independence also entailed a new exposure and vulnerability to changes in international commodity prices, the ups and downs of far away markets, and the fickleness of international investors. While Central Asia held considerable promise in terms of vast natural resources, the inability to rapidly transform the Soviet era political economy into a market-friendly system resulted in disappointed national aspirations, frustrated foreign investors, and skeptical multi-lending agencies.

When the Asian economic crisis hit in 1997, followed by the contagion in Russia in 1998, Central Asia appeared to have hit the bottom. If foreign investors were skittish about Russia, there had absolutely no appetite for Tajikistan, Uzbekistan or Turkmenistan. The Central Asian republics were far away, heavily dependent on commodity exports, lacked direct access to the sea, generally had political problems (including Islamic radicals), and were caught up in the geo-political game of influence played out by Russia, China, Turkey and Iran. It did not help these countries that Uzbekistan, Turkmenistan and Tajikistan shared borders with Afghanistan, then under the Taliban, who were actively engaged in helping Islamic radicals to seek the overthrow of its neighbors’ governments. In addition to geo-political concerns, Central Asian countries had trouble creating some of the key support structures for market economies, including working legal systems, transparency and disclosure in financial transactions, as well as soft infrastructure (defined as personal safety, adequate communications, personal transportation and hotels up to international standards).

Yet, Central Asia was not ready to be written off. Despite its label as "the Wild East", each of the republics gradually began to develop a sense of local nationalism, while the secular nature of the state was reinforced. At the same time, there was a growing awareness of the rough-and-tumble nature of global politics and economics. Reform efforts in Kazakhstan and the Kyrgyz Republic began to improve economic performance. Moreover, the uptick in international oil prices in 1999 and 2000 provided a tide of hydrocarbon profits that helped to lift the economies of Turkmenistan and Uzbekistan. Kazakhstan even used the oil and natural gas windfall to establish an oil stabilization fund. Real GDP growth throughout the region shot upwards from 1998 through 2001. Kazakhstan had real GDP growth of 2.8% in 1999, followed by 9.5% in 2000, with 6% expected for this year. Turkmenistan is expected to record 10% growth for 2001, with Tajikistan and Kyrgyz Republic coming in around 5% each and Uzbekistan with approximately 3% growth.

The oil boom, however, did not extend to all Central Asian republics. Tajikistan and Kyrgyzia lack the oil wealth of Uzbekistan, Turkmenistan and Kazakhstan. Tajikistan is still recovering from the civil wars that hit shortly after independence. Tajikistan also has a heavy debt burden, which the IMF estimated at 129% of GDP in early 2001, with a debt service ratio of 44%, "leaving little room for pursuing measures to alleviate poverty." In Kyrgyzia, poverty alleviation is equally pressing. An IMF study indicates that more than half of the country’s population is poor and nearly a quarter of the population lives in extreme poverty.

The War on Terrorism and the enhanced role of the United States and Europe in Central Asia, however, has once again changed the geo-political situation for the Central Asian republics. Most of the governments are aware that there is a pressing need to maintain prudent macroeconomic policies, increase the pace of privatization, continue with trade liberalization and other structural reforms. Yet, there will be a temptation to sell base rights to the United States and harvest extra funds from the West for their assistance in the war against the Taliban in Afghanistan instead of furthering the process of reform. This will not help to promote economic growth over the long term. Moreover, oil prices are going to be lower in 2002. This will dampen growth prospects for Uzbekistan, Kazakhstan and Turkmenistan.
Central Asia’s importance will not decline as rapidly this time as the last. As Afghanistan moves into its post-Taliban phase, the region will remain a critical jumping off point for Western aid and support. Moreover, a post-Taliban Afghanistan is going to need to restore trade ties and rebuild its devastated economy. In this its Central Asian neighbors are essential.

French authority on Islam, Olivier Roy has noted political Islam has been stimulated by such things as poverty, uprootedness, crises in values and identities and decay of educational systems. These socio-economic realities are alive and well in Central Asia. They have already given birth to radical Islamist groups, seeking to overthrow the old order. They have gained supporters in the face of official corruption, ethnic and tribal segmentation, and personal rivalries. As the West rediscovers Central Asia it needs to be fully aware of the ground upon which it is walking.

It would be a vast understatement to say that 2001 was a difficult year for the tech sector. Companies across the board saw revenues plunge and capital expenditures decline in the telecommunications sector. The industry was faced with concerns over overcapacity, too much debt, questions of vendor financing (Lucent), and questionable business models (Xerox). Many of the weaker tech companies filed for bankruptcy, while the larger firms opted for downsizing personnel, selling off core assets, and seeking to get additional liquidity when and where they could. All of this turmoil was reflected in drastic falls in stock prices from late in 2000 to lows in 2001 as investor confidence fled and ratings fell. Northern Telecom (NT) went from a high of around $82 a share on the New York Stock Exchange to around $7 a share in December 2001. Other highfliers, such as Lucent, Motorola, Cisco and Oracle, all saw their stock values take a major hit.

What is next for the tech sector? The outlook for the next 6 months is difficult. On a global basis, telecom capital expenditure is expected to decline further, possibly as much as 20% for all of 2002. This is based on a round of announcements by U.S. telecom companies. Qwest, SBC, BellSouth and Sprint are set to reduce costs further, including deeper cuts in capital expenditure. This situation is not helped by the fact that long distance fiber remains heavily oversupplied in both North America and Europe. A reflection of this came in August 2001, when Corning (GLW), announced that slowdown in orders across fiber product lines was severe and unprecedented. Corning also indicated it will idle its optical fiber manufacturing plants and that fourth quarter fiber sales volumes will be less than half of 2000 levels.

Consequently, we see the first half of 2002 as an extension of the major trends evident in the second half of 2001 — ongoing corporate restructurings, which entails reducing fixed-capital expenditures, downsizing personnel, selling non-core assets, and outsourcing of services. Companies such as Marconi (MONI) will be hard-pressed to survive (we regard this UK company as a candidate for takeover). There will also be some level of consolidation. Corning has taken advantage of this downturn to expand, having acquired optical components makers from Pirelli and Cisco and NetOptix Corp. The ability of companies to access capital markets and bank lines will be even more critical than before, especially as banks seek to securitize their loans. Equity values will remain low and volatile.

In December we saw Motorola (MOT) announce the cut of an additional 9,400 jobs over the next 12 months. At the same time, MOT reaffirmed Q4 earnings (which are a small profit), but provided guidance that it expects a loss for Q1 2002. The company indicated that expected sales from operations will fall by about 5-10% from 2001 levels, due to cutbacks in spending on telecom infrastructure equipment in the wireless, broadband and wireless markets. These latest cuts will bring the total number of positions cut at MOT over a two year period to 42,900. This is more than 28% of the total workforce. MOT is hardly alone. We expect to see Lucent and NorTel’s equity prices be highly volatile in the months ahead.

What will make the difference in the second half of 2002 is that the U.S. economy will gradually begin to recover. Demand for tech equipment will slowly begin to pick up, and some of the current overcapacity in the industry will be reduced. Although this does not translate into a quick recovery, it does mean that tech survivors will be well-positioned for a stronger paced recovery in 2003. For the tech sector the trough is in Q4 2001 and Q1 2002, with some degree of stabilization in Q2 and Q3 and recovery in Q4. 2001 was a bad year for tech. 2002 will be marginally better. The saving grace in all of this is that the need for what tech offers -- greater efficiency in the market, office and home -- is not going away. By 2003 companies and peoples will hopefully have the money to buy what is offered in far greater demand.

The issue of transparency and disclosure has been a major point of concern in any discussions about China’s economic development. Indeed, lack of disclosure is often cited as a major risk in doing business in China. This is something that was repeatedly brought up in Beijing’s efforts to gain membership in the World Trade Organization. In November, the China Securities Regulatory Commission made a move to diminish some of these concerns, announcing changes in rules pertaining to delisting companies that trade on the Shanghai and Shenzen stock markets. Although there remains much to be done to improve transparency and disclosure in Chinese markets, the new measures, if implemented, will be a positive step.

Pressure to tighten rules and regulations on China’s stock exchanges derived from criticism that the authorities have allowed loss-making firms to continue trading, despite their inability to restructure without government support. Indeed, it is acknowledged that a number of listed companies either falsify profits or are not expected to ever generate returns for investors. Moreover, in some cases this has led to circumstances where investors bet heavily that the company will be bailed out by the government, especially considering that almost all listed firms are state-owned enterprises, a status that provided political leverage in initially getting listed. Consequently, political connections have at times meant more than market realities. For a China seeking to demonstrate that it can be a member of the WTO -- poorly working and influence-peddling dominated stock markets are not acceptable.

The new rules will go into effect on January 1, 2002. Under the new guidelines, companies will be suspended from trading for six months as soon as they record three straight years of losses. If they fail to turn a profit during this period they can be delisted by either the Shanghai or Shenzhen exchanges. Currently there are 15 companies thought to run the risk of being put on probation for six months, while another 50 companies are thought to be questionable with a dismal track record of two years of losses.

While the move to tighten rules and regulations and standards for China’s stock exchanges is positive, the real test comes in how rapidly the authorities will move to close companies that violate the law, either through intentional misrepresentation or just plain bad business practices. The track record is not encouraging. However, this year there were encouraging signs, as seen in the delisting of three companies, a trend which we hope will accelerate moving forward. Announcing rules and regulations is one thing, implementing is another. As China enters 2002 as a future member of the WTO, the whole world will be watching.

The concept of open trade, the rule of law, and the world trading system are going through their best and worst times now, and the ultimate outcome of the challenges they are facing is not predictable. Each new initiative and commitment toward an open and stable world trading system seems to be creating a corresponding real or potential setback. Will we move two steps forward for every step backward, or will we lose ground even as we struggle to address our problems?

All trade observers know that as world trade leaders hesitantly headed for Doha, it was not easy to see how a meaningful consensus on new global trade initiatives would emerge from the meeting. While there was a draft declaration with which many WTO member nations agreed in principle in major areas, each trading bloc, and many influential, individual countries, had their own agendas or their own limits. These individual demands threatened whatever consensus existed at the beginning of the conference.

This delicate climate makes the outcome of Doha all that much more extraordinary. The easy, and expected result would have been a relatively bland agenda of "built-in" items and a few add-ons that everyone could accept with few ruffled feathers. Instead, USTR Robert Zoellick led an effort to bring the conflicting agendas together. This the negotiators did beyond the expectations of almost everyone in the world trading community. The Doha Declaration holds out the promise of meaningful progress on agricultural subsidies, dumping and countervailing duties, services, developing country issues, and much more. The masterful crafting of a compromise that was both diplomatic and substantive represents a significant rejection of the anti-globalization movement and the new protectionism.

Doha has been followed by the wholly unexpected U.S. House of Representatives passage of Trade Promotion Authority ("TPA") legislation. TPA provides new trade negotiating authority for the President, and sets the priorities for negotiations, including those in the WTO and efforts to conclude a Free Trade Agreement of the Americas ("FTAA"). TPA also provides that any agreement the President brings to Congress for approval cannot be amended, and must be voted "up" or "down" after limited debate. The single vote margin by which TPA passed, after two prior failures, demonstrates the determination of President Bush and his Administration, and the Republican leadership in the House, to affirm the outcome at Doha.

It is important to note that while the Bush Administration and Congressional leaders did some very narrow, sector-specific "horse trading" to obtain the necessary votes to pass TPA in the House, they did not promise, and were not even asked, to agree to adverse changes in U.S. trade remedy laws, or to take any key negotiating point "off the table" in either the WTO or the Free Trade Agreement of the Americas. Those who recall the "fast track" and Uruguay Round legislative battles of 1988 and 1994 know that the usual price for these victories was substantial U.S. backtracking on key issues like dumping, subsidies, and unilateral retaliation (the infamous "Section 301").

However, the same one-vote margin also makes clear the determination and strength of the opponents of open trade. These interest groups have loudly and roundly condemned the Doha Declaration. They have vowed revenge on every Member of Congress who votes in favor of TPA. They have extracted concessions, albeit limited, that will complicate the negotiating process--and they have succeeded in all but stopping further progress on removing trade barriers for textiles and apparel. This latter setback is most disappointing, since the U.S. textile industry is now following the very successful campaign of the U.S. steel industry for new protection and subsidies when the Agreement on Textiles and Clothing expires at the end of 2004. Textiles and apparel will be the next major trade battleground. Finding a way to address the problems it can create is a trade policy challenge for the U.S., its major trading partners, and the developing countries.

Those opposed to open trade are determined to prevent the U.S. Senate from adopting TPA. Ironically, the victory in the House seems to have energized some in the Senate to seek to craft acceptable compromise legislation which follows the House-passed more closely than might have been expected. That is in part because the House bill truly represents a concession to many traditional demands for attention to labor and the environment, greater Congressional oversight, and reform of the WTO processes. At the same time, there are individual Senators who have no interest in either open trade or compromise, and they have announced their intention to block any trade bill from coming to the Senate floor. Whether the Administration and the U.S. business community can gather 60 votes to overcome these obstructionists will be the key trade test of 2002. The failure of TPA in the U.S. Senate will not prevent WTO negotiations from moving forward, but it will undermine dramatically the prospects for the success of those negotiations. Passing TPA will further strengthen the U.S. leadership position.

The same can be said for the effort to conclude an FTAA. Liberalizing U.S. trade with the Americas has been the centerpiece of President Bush’s efforts to strengthen U.S. relationships in the region overall. A successful FTAA will reinforce the progress that Brazil, Argentina, and other Latin American countries have made in eliminating highly protectionist trade regimes, state-dominated economies, and heavy subsidies. But even with TPA, concluding an FTAA is itself a challenge. Many Latin American products are subject to trade restrictions in the U.S., and unless the U.S. is willing to be flexible in dealing with these specific restrictions, most major trading partners in the Americas believe they will gain little from a new agreement. The restricted U.S. products are, of course, those with the most politically powerful constituencies, so, as in Doha, success will depend on how well the Bush Administration balances these competing demands.

TPA is not the only challenge that will impact on the successful implementation of the Doha Declaration and the FTAA. The U.S. farm bill that will be enacted into law in 2002 presents both the opportunity to affirm the need to eliminate agricultural subsidies that is incorporated into the Doha Declaration, and the very substantial risk that instead the U.S. will set a precedent for new subsidy programs that will sacrifice its global and regional leadership on this issue. Reaching a balance that can be "sold" to the larger U.S. agricultural community is the responsibility of the Bush Administration and a very few Members of Congress who understand the debilitating effect of endless subsidies on world food production and trade.

The final problem is steel trade, and even here, while the probability of new U.S. import restrictions is high, so is the possibility that there will be progress on addressing global structure and capacity issues.

The short term challenges to open trade continue to threaten to obstruct and even stop the long term progress that has been made over the last few months. Right now, there is reason for optimism, which can be capitalized upon to make progress before protectionist forces can regroup. The coming year will prove whether 2001 was a watershed in trade policy or a one-time success, not to be repeated.

(The views expressed here are solely those of the author and do not express those of Dresdner Kleinwort Wasserstein, where he is the Director of Corporate and External Affairs. Mr. Hartzell had previously worked as a Deputy Comptroller at the Office of the Comptroller of the Currency in Washington, D.C.).

We are currently living through a tidal wave of interest in the forces of corporate governance. This has much to do — at least in the United States — with the prominent and increasingly activist role of institutional fund investors as corporate shareholders, bent on securing top performance from their investments. An aggressive shareholder demand for corporate responsiveness has spilled over into other countries, as fund managers have diversified their portfolios internationally and set an example for local investors elsewhere.

But there is also an international public interest in good corporate governance that intersects in many ways with what the investor and corporate communities are pursuing. This is especially the case for financial institutions and their public sector supervisors, regardless of whether those institutions are widely-held stock companies of interest to professional asset managers.

Internationally active financial institutions find themselves particularly challenged by the need to promote a corporate governance ‘tidal wave’. First, they must work hard to understand, and adapt strategies and operations to, a great diversity of national practices, traditions, laws, regulations, and political and market structures. And second, their possibilities for implementing an American style of "good corporate governance" are often constrained in a given context or a given country by legal, cultural, economic, or even purely logistical factors.

Some institutions do a better job of pressing ahead than others. But all of them, because they must have some kind of dialogue with their supervisors, shareholders, and other ‘stakeholders’, have the possibility to accelerate international awareness of good corporate governance practice. Over time, this awareness can force public authorities and business leaders in different countries to recognize where their policy and practice may fall short, and give them incentives to do better.

Despite all the discussion and analysis that we encounter these days, succinct definitions of corporate governance are not easily found. Before offering one definition — let me precede it with a brief bit of history.

According to Norman Veasey, Chief Justice of the State of Delaware, the concept of corporate governance began in the U.S. early in this century when a number of states, most notably Delaware, passed "enabling statutes" known as general corporation laws. These created a legal framework in which stockholders invested in corporations — becoming owners — which were separated from the managers of those corporations. Board of directors were formed which included managers and the officers they hired. Over time it was held that boards had fiduciary duties of loyalty and care in the wise management of the corporation in the best interests of its owners. A key element in this was the independence of directors from undue influence by interested parties at the expense of the corporation’s welfare.

In the 1930s and in the aftermath of the stock market crash, there was something of a public debate over the evident inability of shareholders, often small and widely dispersed, to assure that boards and their appointed managers were in fact operating in the best interests of owners. Flash forward to the 1980s and you will recall, perhaps vividly, the climate of excitement and controversy surrounding the wave of hostile takeovers, leveraged buyouts, management buyouts, junk bond financing, ‘poison pills’, and the general merger frenzy of those days. With shareholder interests again at issue, the corporate governance debate revived and large institutional investors began to be heard.

In the 1990s, it has been primarily these institutional investors in the form of pension and retirement funds — along with the legal, accounting, and consulting professions — who have driven the development of concepts of corporate control and accountability. Their main focus has been on the role of the board of directors and more particularly, those directors who are not also senior executives of the corporation, i.e., the outside directors.

At the same time, for U.S. banking institutions and their supervision by public sector regulatory authorities, there has been a very distinct shift over the last two decades to a supervisory approach based effectively on corporate governance — the accountability by boards of directors for the condition and performance of the bank. While the ultimate objectives of bank supervisors are somewhat different from those of bank shareholders, many of the precepts and tools are the same.

There are also other groups of interested parties, in addition to shareholders and regulatory authorities, who have a stake in the sound management of a corporation. These may include creditors, employees, customers (including, for banks, the special category of depositors), government policy-makers, and even the general public. All of these groups are represented by the term "stakeholders", those whose interests could be materially affected by good or bad corporate governance.

With so many groups and different viewpoints, trying to find a comprehensive definition of corporate governance may be dubious. Nevertheless, I prefer one suggested by former colleagues in the staff of the Basle Committee on Banking Supervision, the international committee of bank regulatory authorities sponsored by the Bank for International Settlements. In their formulation, "corporate governance is defined as the system of rights, processes, and controls established internally and externally over the management of a business entity with the objective of protecting the interest of all stakeholders."

That may seem too broad to be practical, but it does convey the reality that different stakeholder groups will focus on different criteria and elements in deciding what makes up good corporate governance as they see it. For example, shareholders probably attach greatest importance to maximizing the market value of company shares on a sustained basis. They will look for devices, primarily strong board oversight of management, independence of boards from the influence of insider and other special interests, and accessibility of boards to shareholders, to protect that possibility. Policies to control excessive board and management compensation also play an important role here. Of course, not all enhancements to a corporation’s intrinsic or book value are necessarily reflected in the market price of its shares — which can present a shareholder-conscious management with difficult business decisions from time to time.

A bank regulator’s corporate governance view, on the other hand — while it might include a secondary interest in the share price in terms of an institution’s greater or lesser ability to raise capital, or how the market perceives the bank’s quality — is relatively more focused on bank policy and operational issues. These might include whether there is demonstration of a strong board commitment to effective risk management and internal control systems; or whether the board has the will and skill to correct serious problems, once detected. This supervisory point of view is well represented in the excellent corporate governance guidelines from the BNA. You may have noticed that, as a supervisory policy document, the guidance notes make very few references to shareholder issues.

Yet another perspective comes from the general public, which wants to be sure the corporation treats customers fairly and has sensitivity to its impact — socially, environmentally, fiscally — on the local community. And corporate employees, for their part, want assurance the company will compensate them properly, provide opportunities for advancement, offer training and career development assistance, and help with their retirement planning.

All of these responses to stakeholder expectations or needs are examples of some kind of good corporate governance. They actually appear in some formal statements of corporate government policy by large business entities like Philip Morris and General Motors. They make the point that "corporate governance" is a fairly elastic concept, with a multitude of practices and guidelines that respond to the concerns of particular groups.

At the same time, there are elements that can be distilled from the various concepts and are commonly recognized, at least in the U.S., as indicating a company’s strong commitment to good corporate governance. These include:

All of this can reduced to one sentence: although good corporate governance generally begins with a strong, independent board of directors, there is a lot more to the story, in terms of policies, systems, and performance.

Japan has long been the major economic power in Asia. Indeed, it can be said that Japan’s national identity is closely related to its economic achievements in the postwar era. While Japan’s leaders squabble over political rules and the economy remains troubled, China is rapidly making gains on Tokyo’s once dominant position as Asia/Pacific’s economic leader. Entry into the World Trade Organization is freeing Chinese manufacturers to offer fierce competition in many global markets that Japan has long felt secure. Although still lagging in technology, Chinese companies are poised to rapidly catch up. China is a clearly a rising power determined to flex its muscles and enlarge its sphere of influence in the region. This is a process that will come at Japan’s expense. It should be remembered that China’s foreign policy is driven by how to further modernize its economy.

Japan should wake up to the challenge represented by China. This year there have already been a number of trade disputes. As cheaper agricultural Chinese goods (mainly shiitake mushrooms, scallions and rushes) have sought entry into highly protected Japanese markets, Tokyo moved to impose high tariff duties. China responded in kind. Chinese exports of fresh and frozen vegetables have significantly increased, reaching 632,000 metric tons in 2000, nearly doubling the figure for 1996. The simple fact is that Chinese veggies have a greater price competitiveness as well as having an improved quality, partially due to the guidance of Japanese companies. Japanese farms, in contrast are small in terms of acreage and their farming methods are cost intensive. Although Japan and China agreed to scrap the punitive tariffs on each other’s goods in December, Tokyo was served notice that Beijing will be assertive in penetrating Japanese markets.

More tensions over trade can be expected as China continues to develop and modernize its economy. Consider the following:

Japan must wake up to the competitive challenge emerging from China. China is already the "workshop of the world", making everything from Christmas tree ornaments and screw-drivers to AK-47s and satellites. China’s industrial infrastructure is gradually moving upscale to include electronics, semi-conductors and cell-phones. The Nikkei Weekly’s headlines on November 26, 2001 heralded: "China Adds Software to Export Arsenal". The Japanese newspaper stated: "Now the Middle Kingdom is set to rock Japanese industry even more by exporting software." There is even talk of further developing the local Chinese automobile industry with an eye to export. The message for Japan is clear — as long as the country’s leadership struggles with repairing the economy, China will make many gains at its expense.

Since the raucous 1999 meeting of the World Trade Organization in Seattle, we have grown accustomed to the violent disruption of international gatherings of elected politicians, bankers and private investors. All of this has taken place under the banner of the "anti-globalization" movement. Of course, there is no coherent position represented by the thousands of protesters. Their agendas vary, but all view themselves more or less against "globalization". In reality, globalization is a code word. For some it simply stands for anti-American, for others anti-poverty, some believe it means anti-trade or anti-coal, anti-nuclear energy, or anti-petroleum. As so many grassroots movements before them the anti-globalization forces only articulate the many things they are against without providing or proposing workable alternatives. The fuzziness of the anti-globalization movement itself is partially a function of the fuzziness of the term globalization. It is also partially intended to give refuge to disgruntled and bored members of generations X and Y.

Even a fragmented grassroots movement usually carries some message that has been overlooked by the political establishment. In reaction to such movement and to protect its own position, the establishment usually picks up some of the ideas of the movement, takes ownership and hence undermines its medium-term impact. The world has done so in abundance since the WTO meeting three years ago. As a matter of fact, some claim that the World Bank and its President James Wolfensohn have bent over backwards to accommodate each and every one of the protesters. Some even believe the World Bank has become the resident apologist for the undemocratic means with which some of these groups are trying to force their minority view on the world’s vast majority. The IMF too tried to be come a gentler and kinder monetary fund, introducing poverty reduction and other ancillary programs that were in clear deviation from its mandate.

Finally, in a near Chamberlain-like appeasement effort, the World Bank and IMF cut their planned annual meeting in September 2001 from the traditional five days to two and sharply reduced private sector participation out of sheer fear that 100,000 demonstrators threatened to descend upon Washington DC. The meeting was subsequently and appropriately canceled altogether following the events of September 11. The organizers of the meeting could not have done themselves a greater disservice with their decision pre-September 11, however. There was no doubt in my mind that those few, who had violently hijacked the diffused and often confused, but democratically legitimate causes of the "movement", were going to act in even greater violence in Washington DC after the decision of the organizers. They smelled blood. They were indeed succeeding in curtailing free and unencumbered exchange of ideas among representatives from the world’s nations. Had the meeting not been cancelled for other reasons, this might have been the last World Bank/IMF meeting of its kind.

In a strange way, September 11 may have altered our behavior permanently. The majority of the world’s population wants a prosperous, peaceful and equitable world. They wish to benefit and share the benefit of a world that has grown ever closer since the invention of the wheel. After September 11, the majority of the world has become to realize that it needs to stand up to defend these values against those who prefer the Stone Age or pure anarchy.

At the same time, a U.S. recession magnified by the terrorist attacks of this fall is helping us to define globalization more clearly and understand the downside of it. At 10 trillion dollars of GDP, the U.S. economy is by far the largest and it has been the largest economy in the world for many decades. As such, U.S. economic prospects have influenced global economic growth directly and indirectly ever since. European economies have usually lagged with their own underperformance following a U.S. recession.

There are some things, however, that have changed permanently and irreversibly during the last 15 to 20 years. First of all, trade liberalization has led to a tremendous growth opportunity around the world. Compared to 1980, trade accounts for 26% of economic activity today -- an increase of nine percentage points. Capital flows have also been liberalized and global capital allocation is more efficient than ever (to pre-empt any critics, this is not to say that capital allocation is optimal in its efficiency).

As this has brought us closer together, it has also deepened the world’s dependence on the largest player of the lot, the United States. The fallout from the Mexican Tequila crisis of 1994/95 was quickly overcome not only because of prudent policy-making but also because a rapidly growing U.S. economy helped Mexico recover. The Asian crisis of 1997/98 was not as catastrophic as it might have been in the late 1970s, because strong U.S. growth allowed Asian exporters to lift their countries out of the economic morass.

All of this testifies to the fact that the U.S. economy has critical mass in today’s world economy and that trade and financial flows, and hence the prospects of other regions, whether emerging or in their post-industrial state, depend on the U.S. growth outlook more than ever. This is part of the resentment that has been the basis for the anti-globalization forces.

There have been also technological changes that have impacted the cyclicality and increased synchronization of economic cycles. Ease of transportation has made multinational companies truly transnational. Inventories have come down as just-on-time delivery systems have been developed. This has lowered costs and helped price inflation to be moderate, even in periods of high rates of growth. It has also shortened the transmission period of an economic slowdown between and within the United States and other economic regions. Our pain is felt more quickly elsewhere. The ease of financial flows simplified especially by the Internet magnifies this development. This leads to economic downturns, which may be smoother, yet more widespread and hopefully shorter than global recessions in previous decades. Thus, at the end there is not just a win-win situation deriving from closer integration worldwide in times of economic prosperity, but there is even a reduced loss position in times of economic contraction.

This does not suggest, however, that all economies will be synchronized more or less going forward. The above only applies to the consequences of natural business cycles. Countries with structural fundamental problems will underperform regardless of U.S. growth. This was true for Japan, especially, during the 1990s and continues to be the case today. It is also true to a lesser degree for the European Union and for many emerging markets.

For 2002, this means that we will indeed experience a global recession during the first and may be second quarter of 20002, because our world is greatly integrated via trade and financial flows and because of the high transmission velocity of cycles. During the third and fourth quarter global growth will feed on itself and by 2003 we might experience the beginning of yet another extended economic boom period.

Brasil Telecom Launches ADR: In mid-November, 2001 Brasil Telecom, with an estimated market capitalization of $1 billion, listed its ADR on the New York Stock Exchange. It is the first Brazilian telecoms company to list since the 1998 privatization of Telebras, the national carrier. Brasil Telecom is the third largest fixed line operator in Brazil, covering 33% of the nation’s territory and 23% of the population. What is significant about the Brasil Telecom launch is that investors appear to have decoupled Brazil and Argentina. Since the dark days following 9/11 Brazilian telecoms have enjoyed a strong rally. Now with Brasil Telecom’s ADR, that trend is continuing.

Egypt — Doing What It Takes: On December 12, 2001 Egypt devalued its currency, the pound, by about 8%. With this action, the Egyptian pound will trade in a band of 4.5 pounds per US dollar +/-3%. We regard this as another encouraging sign that the Egyptian government and the central bank are adopting a gradually more realistic approach to exchange rate management. Simply stated, the devaluation will help reduce the need for foreign exchange rationing to defend the currency peg due to additional balance of payments pressures deriving from the impact on tourism of the events on September 11. The IMF currently has a delegation in Cairo. Prime Minister Atef Obeid met with the delegation yesterday, and it was reported that the two sides are discussing an IMF program that would make it easier for Egypt to cope with the financial consequences of the events of September 11.

Iran — Improving Creditworthiness: In November Moody’s has placed Iran’s B2 ratings on review for a possible upgrade. The key reason behind the rating agency’s decision is the significant improvement in Iran’s external debt position. Iran has benefited from higher oil prices, while the government has maintained prudent fiscal policies, all of which strengthened the country’s foreign exchange reserves. Iran also got points for creating an Oil Stabilization Fund (OSF), which is expected to help it during a downturn in oil prices. Moody’s also noted that Iran continues to face challenges, including a powerful and highly conservative opposition and growing public disenchantment of the inability of the government to move ahead with economic and political liberalization in the face of this opposition. Moody’s stated that it will also take into consideration "contingent liabilities that could arise from the banking sector and state-owned companies, on the prospects for subsidy reforms and trade liberalization, and on the depth and effectiveness of economic management."

Korea — Against the Tide: South Korea’s credit ratings are going against the tide of downgrades usually associated with recessions. In November, Standard & Poor's upgraded Korea from BBB to BBB+, the first such move in two years. Although economic growth is slowing, S&P gave Korea credit for making headway with asset sales (Daewoo Motor and Korea Tobacco & Ginseng Corp.), having foreign exchange reserves now in excess of $100 billion and a budget deficit of less than 1% of GDP. According to the rating agency, all of this "will probably allow Korea to avoid a recession during the current global downturn." S&P also noted that risks remain, in particular the government’s ownership of "most of the financial sector". Moody’s rates Korea Baa2, with a stable outlook.

Malaysia — Slower Growth Numbers: The global economic slowdown is taking its toll everywhere, including the highly-export oriented Malaysia. Posting a dynamic 8.3% real GDP growth rate in 2000, the Malaysian economy is struggling to stay in positive territory for 2001. Exports plummeted by 21% in September from a year earlier, while third quarter GDP actually contracted by 1.3%. According to the Malaysian Institute of Economic Research (MIER), growth is now expected to be 0.3% for 2001, down from an earlier forecast of 2.2%. MIER also cut its growth forecast for 2002 from 4.5% to 3.2%. Malaysia’s central bank also announced that growth will be lower at around 1%-2% for both years. The central bank governor Zeti Akhtar Aziz stated that to counteract the slower growth, the government will spend an additional M$4.3 billion (US$1.1 billion) on infrastructure projects in addition to a M$3 billion stimulus package announced in March 2001.

Warren I Cohen, Distinguished Professor of History at University of Maryland Baltimore County and Senior Scholar at the Woodrow Wilson International Center of Scholars, has written an ambitious historical tour de force, East Asia at the Center. The main thrust of his book is that East Asia, often dominated by China, has long been at the center of its own international relations system. Indeed, China throughout its early dynastic history was usually the only major global civilization, surrounded by "barbarians". By the time, the European arrived to "open up" China and the rest of Asia, the region had a well-established international relations system. Over time, China lost power in a relative sense and other East Asian countries, such as Japan, Korea and Vietnam emerged as largely sinofied civilizations. The barbarian threat, however, remained in the vast hinterland of Central and northern Asia, first with the Mongols, and later with the Europeans.

Yet, as Cohen amply demonstrates, China and other Asian countries have a long history of international relations. As he notes: "Realpolitik and machtpolitik as concepts of international politics may evoke images of amoral Germanic statesmen, of Otto van Bismarck and Henry Kissinger, but the Chinese were practicing — and critiquing — them while Central Europe was still populated with Neolithic savages."

East Asia at the Center also discusses often-overlooked facts, which supports his views. These facts include:

What is refreshing about East Asia at the Center is that it is not filled with sweeping dramatic comments that often accompany such efforts. He presents a cogent and well-documented historical overview of East Asia’s place in the world. What he does particularly well is to demonstrate how China-dominated East Asia has dealt with other civilizations as reflected by the region’s relations with the Islamic world during the 13th-17th centuries and the emergence of an European-defined international system in the 18th and 19th centuries. His discussion of the differences between China, Japan and Korea in adjusting to a world dominated by European (eventually Western) powers is very worthwhile reading. Simply stated, Japan adjusted and more rapidly assimilated; China’s long and proud tradition of being the center of its own world order as the Middle Kingdom made such adjustment and assimilation more difficult and ultimately more painful. Korea had a much more difficult time in adjusting into a Western dominated international system, given its size and proximity to a competing China and Japan.

In the 20th century, Cohen acknowledges that East Asia underwent massive changes. Japan went from being a regional to a world power to a defeated country in the aftermath of the Second World War to an economic giant in the 1960s through the 1980s. China went from the dynastic rule of the Qing to warlords to the failed Republican period, invasion from Japan to civil war between the Nationalists and Communists. China’s years under the Communists, in particular, under Mao Zedong brought further upheaval, only settling into a more stable period in the post-Mao period, first under Deng Xiao-ping and later under Jiang Zemin. Today, China is resuming its place as a major world power, a process which is causing tensions with the other, largely Western and Westernized powers (like Japan). As Cohen states as a reason for his book: "The path to an understanding of the emergent international system leads through more than a thousand years of Chinese history." In other words, the approach to understanding the evolution of international relations, especially the current period, is usually done through the lens of looking at the Western powers, with Asia of secondary importance. That must change, especially as China increasingly seeks to play a greater role in the world and reassert its traditional dominance over East Asia. After reading Cohen one is reminded of that basic lesson of history — those that forget history are condemned to relive it.