|KWR International Advisor #7 January 2001
January/February 2001 Volume 3 Edition 1
In this issue:
The U.S. Economy: Rainy Days Are Here, But Will They Stay
What Might We Expect From a George W. Bush Presidency?
The Other North American Election - Oh Canada
Cloudy Days Ahead - Korea
The Dangers of a Slow Pace to Merge - Japanese
Global Telecoms - Supply, Consolidation
The Benefits of a Credit Rating
Editor: Dr. Scott B. MacDonald, Sr. Consultant
Deputy Editor: Dr. Jonathan Lemco, Director and Senior Consultant
Publisher: Keith W. Rabin, President
Web Design: Michael Feldman, Sr. Consultant
Contributing Writers to this Edition: Scott B. MacDonald, Jonathan Lemco, Robert Windorf and Roger P. Nye of Global Investment Advisors.
© 2001 KWR International, Inc. No reproduction is permitted without the express consent of KWR International, Inc.
Please forward all feedback, editorial, circulation and reproduction requests to KWRADVISOR@kwrintl.com.
The U.S. Economy: Rainy Days Are Here, But Will They Stay?
By Scott B. MacDonald
Middle East tensions, lower profit forecasts, concerns about large-scale corporate bankruptcies (as in the case of Xerox), rising energy prices, a tightening of bank credit and a volatile stock market all indicate there are dark clouds on the horizon for the U.S. economy. Rounding out the picture, U.S. savings are at historical lows and the mountain of corporate debt incurred by relentless consolidation is looming as a potential crisis if the economy slows too quickly. Anyone looking at the value of high tech and telecom stocks cannot but help to notice the giddy downward plunge. All of this has left a sense of disquiet about prospects for the U.S. economy in 2001. The critical question is whether the dark clouds on the horizon will blow away or bring a storm. Despite the Feds surprise January 50 bps point cut in interest rates, the storm is already here, especially if you are in the tech sector. For other sectors, rain is quickly coming.
It is important to clarify what we mean by soft and hard landings. A soft landing is economic growth of 2-3%, with the first half of the year remaining in positive GDP levels and marked by a strong comeback in the second half. A hard landing is 1-2% growth, with real GDP growth being in the range of 0.0-1.0% growth in the first half, with a weak recovery later in the year. A real hard landing in the form of recession in economic terms would be back-to-back quarters of economic contraction - something that no one is projecting. We still believe in a soft landing of 2-3% real GDP for 2001, but we wish to emphasize that the 1st quarter of the year is going to be ugly, characterized by considerable bad news in term of disappointing corporate performances, a NASDAQ likely to head under 2,000, and a rising number of bankruptcies, both corporate and personal. For a number of sectors of the economy - high tech, retail, automotive, auto parts and banks- it will indeed feel like hard landing. There is no hiding the pain of inventory build-up, downsizing of personnel and plant closings.
What should keep the U.S. economy from a recession is ongoing moves by the Fed to reduce interest rates, probably by 150 bps in total to a 5.0% Fed Funds rate. Efforts by the Federal Government to stimulate the economy combined with the possibility of a tax cut (which could have short-term positive effects but is not wise in the long term from a prudent fiscal standpoint) will likely keep economic growth in positive territory. The Organization for Economic Cooperation and Development has forecast U.S. growth in 2001 to be 3.5%, indicating that optimism still rules in some quarters. However, none of the measures mentioned above will reduce the pain in the 1st quarter of 2001. There will be a lag between ongoing bad news from the 4th quarter of 2000, which will be reflected in reports of poor corporate results. No matter how much bulls seek to beat the drum that growth will pick up robustly later in the year, the mood is going to remain pessimistic. The danger is that forecasts of doom become self-fulfilling prophecies, setting up the second half of 2001 to be almost as bad as the first.
As for the tech sector, 2000 ended up in a train wreck. The sector entered the year with considerable momentum from heavy corporate sales in 1999 built around the Y2K scare. This was combined with strong economic growth in the U.S., vibrant consumer demand, and considerable investor excitement over the dot.com phenomenon. As the Y2K scare faded and corporations began to digest their new technology purchases, investor attention gradually turned to the sustainability of corporate profits. Moreover, several hikes in interest rates began to brake economic activity, making capital more expensive and forcing banks and venture capitalists to ration credit more prudently.
Consequently, equity prices, which began 2000 in a strong and inflated mode, ended the year beaten to a bloody pulp. Consider that eToys Inc. watched its share prices tumble from a high of $71 a share to 18 cents; Yahoo Inc., from $250 to $30; and PriceLine.Com from $104 to $1.31. Lucent, once one of the bedrocks of the high tech world and now struggling for its survival, began 2000 at $72.375 and ended at $13.50. Even more troubled Xerox began 2000 at around $23 a share, falling to a little under $5 by year-end. There was also considerable carnage in the bond market, with both Xerox and Lucent trading at distressed prices and the telecom sector generally far wider.
The first half of 2001 is going to be difficult for the tech sector. There will be a lot more disappointments and companies that have already disappointed -- will continue to do so. Investors will be searching for any repeats of Xerox (poor management, a bad sales model, loss of institutional memory through firings and heavy debt) and Lucent (poor controls on financing which have left the company with $8 billion in financing receivables outstanding, some of which may not be recoverable). We expect that earnings will be slow in this sector until the third quarter, but a sustained recovery may not be in place until early 2002.
2000 began with too much euphoria. It is likely that 2001 will begin with too much pessimism. Markets tend to react in extremes. In early 2000 bad news did not seem to matter. In early 2001 there is zero tolerance for any suggestion of bad news. Indeed, it can be argued there is an overreaction and many investors are ignoring the fundamentals and throwing good companies in with the bad. The same can be said for the general economy as a slowdown can be healthy if companies take advantage of the situation to reduce debt and refocus on operational management and their strategies for the future. It is often said that it darkest before dawn. It is possible that we are now entering into that darkness, with a dawn expected in 3rd quarter 2001.
What Might We Expect From a George W. Bush Presidency?
By Jonathan Lemco
George W. Bush finally made it to the White House. The election was ugly and protracted, leaving a feeling of division. Indeed, the U.S. Senate ended up with a 50-50 head count, reflecting a new political landscape in Washington. President-elect Bush indicated that he was keenly aware of this situation when he stated in his acceptance speech: "I was not elected to serve one party but to serve one nation." What should investors expect from the Bush presidency?
At first glance, the election points to the fact that the U.S. electorate is divided to the point where the next President has no mandate for sweeping change. The margin of victory was so narrow that effective governance will be entirely dependent on cooperation between the executive and legislative branches of government. Therefore, we hope that there will be an unprecedented degree of cooperation in government to get necessary legislation passed. The alternative is legislative gridlock, which would be harmful for all concerned and which would likely relegate Bush to just one term as President.
As things stand now, President-elect Bush lacks the normal bipartisan support needed to enact major shifts in taxes and spending. There may be no "honeymoon" period whereby he can outline his policy priorities and push major legislation. But this situation could change. A substantial degree of bipartisan cooperation is required, and there is some precedent for it on this scale. For example, conservative Democrats helped former president Ronald Reagan push tax cuts through a Democratic Congress in 1981. We can only hope that productive episodes of this kind will be repeated.
We are concerned particularly that the Presidents uncertain mandate could stall fiscal policy in 2001. Then Alan Greenspans Federal Reserve becomes more important than it already is. We expect only modest U.S. GDP growth of 2-3% in 2001. This will force the Fed to continue to seek a balance between fiscal restraint and monetary easing. We hope the Federal Budget surplus will be used to pay off debt, thereby holding down interest rates. But slow growth may make this difficult. Furthermore, the massive U.S. current account deficit could be a recipe for a weak dollar, particularly if European growth rates continue to accelerate. However, there is no evidence of a weak U.S. currency yet. We are also quite concerned that if there is legislative deadlock, Fast Track Authority on new trade agreements will be lost. In short a new era of bipartisan cooperation is required.
If the U.S. economy does weaken in 2001, as seems likely, then yields on ten-year Treasuries could rally to the 5.0-5.25% range. That would offer valuation support to equity markets. But this bond rally, should it occur, may still not offset the earnings weakness that U.S. corporations might experience in 2001.
A Bush administration with a Republican-dominated Congress should be good news for certain federally regulated companies. For example, Verizon Communications, SBC Communications and other large regional phone companies could prosper if the Bush administration overturns restrictions barring local phone companies from the long-distance business. Regulations governing broadcasters in the U.S. could also be relaxed. In addition, the regulations that force a separation between investment banks, insurance companies and other financial institutions, may no longer be enforced as tenaciously. Aerospace and defense could also benefit, as both parties highlighted the possibility of more spending in these sectors. But all of these potential legislative initiatives will come to naught unless this sharply divided government can pass far-reaching legislation in an environment of calm bipartisanship. This will be a tall order. Additionally, president-elect Bush will have to demonstrate that he can be a leader, rather than just delegate responsibility. He will also have to demonstrate that he can master the various issues in depth, something that his critics have serious doubts. Stay tuned.
The Other North American Election-The Liberals Are Reelected in Canada
By Jonathan Lemco
Much of the worlds attention in the past month has been devoted to the U.S. Presidential election. But Canadians went to the polls as well on November 27. The governing Liberal Party led by Prime Minister Jean Chretien was reelected for the third time with a solid majority of 173 out of 301 seats in the Canadian parliament and 42% of the popular vote. As a consequence, investors should expect that Canadas record of economic growth and fiscal prudence should continue. Mr. Chretiens Finance Minister, Paul Martin, has delivered budget surpluses throughout this governments tenure. In so doing, Martin has accomplished the near impossible. He is likely more popular than the Prime Minister and he is certainly the most successful Canadian Finance Minister in memory.
Prime Minister Chretien called this election only three and one half years into his maximum five-year mandate. In large part, this is because his poll numbers are exceptionally high and because of the disarray of his opposition. Five parties hold seats in the Parliament in Ottawa. But the four in opposition are either regionally based or otherwise ineffective. Only the Liberals can claim to be a legitimate national party. The Alliance Party, which is Canadas official opposition party with 66 seats, is perceived by most Canadians as too far to the right and representative only of interests in western Canada. The Progressive Conservative Party, which for much of Canadian history was Canadas other governing party, is but a small shell of its former self and holds only 12 seats in the legislature. The social democratic New Democratic Party attracts the support of less than 10% of Canadian voters and holds 13 seats. Even its trade union base has eroded in recent years. Finally, the Bloc Quebecois, which holds 37 seats in Quebec, runs no candidates outside of that province and is mostly focused on protecting Quebecs interests in Parliament until Quebec becomes a sovereign nation. Many Quebecois support the Bloc for its pro-Quebec stance, although they have no intention of supporting the sovereignty option. In short, only the Liberals have a claim to be a national party, although their greatest strength by far is in the most populous provinces of Ontario and Quebec.
What should investors anticipate in the near term? We think that Canadian officials will continue the existing dual policies of tax cuts and debt reduction. Approximately 56 per cent of the fiscal surplus is expected to go to debt and taxes between 2001-02 and 2004-05. Most of Canadas ten provinces now have balanced budgets, and we think that all will be in balance within four years. Social advocates in Canada are quick to add however, that more of Canadas ballooning surplus should be spent on social issues such as childcare and revamping Medicare. We suspect that only modest budget increases (already accounted for in an October 2000 mini-budget) will be targeted to these public concerns. Clearly, the interests of the pro-business wing of the Liberal Party will dominate public policy formulation.
The equity markets should benefit slightly from the governments plans to cut the capital gains inclusion rate to 50%. There are also new Canadian government-sponsored incentives to promote high-tech investment and production totaling about U.S. $650 million. We also expect passage of a long-awaited bill that would increase the stake any one shareholder can hold in a Canadian bank.
The Liberal victory should have only a negligible impact on the relative weakness of the Canadian dollar versus its U.S. counterpart. The Canadian dollar suffers largely because the U.S. dollar is strong worldwide. Also, Canada is a major commodity producer at a time of weak commodity prices worldwide. Finally, it is possible that the Canadian industrial workforce is slightly less productive than their U.S. counterpart. Whatever the reason for the weak Canadian currency, we dont expect this election result will have much of an impact.
When investors look to the Canadian economy of late, there is much to cheer. Canadian industrial productivity is rivaling the United States. Economic growth rates are solid (5% in 2000). In particular, business investment is robust and accelerating. Unemployment is around 7%, which is exceptionally low by Canadian standards.
In addition, for the past five years the current account deficit has averaged less than 1% of GDP, and the ratio of external liabilities to GDP has improved steadily. Furthermore, we have witnessed a concerted drive among Canadian firms to adopt the latest and most advanced technology. In fact, it is activity in the high-tech sector that is accounting for the bulk of the nations economic growth. To the extent that growth slows to a forecast 3.5% in 2001, it will be largely due to an expected soft landing in the U.S. coupled with higher energy prices and higher interest rates (especially in the housing sector). The United States imports 85% of total Canadian exports. In a very real way, the Canadian economy is dependent on the United States.
There have been structural improvements as well. In the past five years, we have witnessed financial sector reform, tax reform, and pension reform. All is not perfect of course. The level of public sector debt to GDP is falling but is still too high (85%). Also, Canada is still a net external debtor. Finally, the national unity issue is dormant at present, but it never completely goes away. At any time, about one-third of Quebecois favor a sovereign Quebec, however that term is defined. Although we think it unlikely that Quebec will form its own nation in our lifetime, the issue never goes away and drains valuable resources away from more productive efforts.
The governing Liberal Party and all four of the opposition parties claim to be champions of fiscal prudence, although the Bloc and the NDP, are probably less supportive. In any case, Jean Chretien and Paul Martin will remain the most prominent political actors in Canada. From an investors perspective, that is good news indeed.
Cloudy Days Ahead -Korea
By Scott B. MacDonald
Although the reduction of tensions on the Korean peninsula appears to be moving ahead as reflected by U.S. Secretary of State Albrights October 2000 trip to North Korea, all is not well in the South. To be sure the South Korean economy enjoyed a strong real GDP growth pace in 2000 in excess of 9%, foreign exchange reserves are around $100 billion, and inflation remains under control. There are no major financial threats on the horizon, making a repeat of the crisis of 1997-98 unlikely. To many in the international financial community, Korea has been a poster child of IMF-guided economic recovery and restructuring. Yet beneath a thin veneer of robust confidence, there is a growing sense of insecurity in the Land of Morning Calm. There is concern that the slowing in economic reforms, compounded by a slowing U.S. economy, could lead to bigger problems.
What is causing this sense of insecurity, partially evidenced in the lackluster performance of the Korean stock market in 2000? Recent declines in DRAM prices, the negative impact of rising oil prices, and Fords decision to withdraw from its bid to purchase Daewoo Motors are all taking their toll. Moreover, progress has been slow in two significant areas of structural reform -- corporate sector debt and non-bank financial institutions. These factors have generated further concern about the increased financial distress among borrowers, which in turn has caused a retrenchment in the supply of credit. As a Goldman Sachs Emerging Markets FX Views (October 26, 2000) letter commented: "In fact, Korea is now included, on a regional perspective, among the same group of countries (along with Thailand, Philippines and Indonesia) against which investors should adopt a cautious view, especially in absence of an easing in global monetary conditions." That view has not gone away in early 2001 and a number of investors have shown even deeper concern.
The perception is that corporate reform has lagged. This thinking became accentuated in October when Daewoo Motors and Hanbo Iron & Steel companies failed to be purchased by foreign investors. Daewoos future is cloudy, although it is hoped that GM and Fiat will purchase the bulk of the companies assets. Hyundai has also has its own set of problems. As Moodys stated in December 2000: "The highly leveraged Korean industrial sector is under increasing pressure to restructure, but dismantling the large and highly complex chaebol system is easier said than done. Strong family control, and heightened social tension arising from the feat of mass unemployment, provides a powerful resistance to change, even though the governments committee is resolute." The bottom line is that corporate restructuring is essential for Korea to maintain its competitiveness, but such reforms will take a long time and the costs will be carried by the government (i.e. the Korean taxpayer) and the banks.
This situation has meant that the Korean banking sector remains unsettled. Last December it was announced the Korean government would recapitalize six of the nations weakest banks with an estimated $5.8 billion cash infusion before consolidating them under a new state-run financial holding company. Yet, this consolidation has been complicated by labor opposition in the form of an abortive strike and vocal discontent about the looming prospects of personnel downsizing.
Also hurting the reform process are government scandals. Last year there were a number of incidents involving bankers embezzling customers money and extending illegal loans in return for kickbacks. One bank employee was even arrested for bank robbery. The latest scandal in October involved officials at the Financial Supervisory Service (FSS). Allegations have been made that FSS officials accepted bribes from businessmen in return for overlooking irregularities at financial service firms under their supervision. Although the government moved quickly to investigate the matter and has vowed deal sternly with those involved, the scandal has further deepened the publics distrust of the nations financial sector and government-led economic reforms.
Higher oil prices are also a point of concern. They aggravate the problems of heavily-indebted companies, which could further raise worries for the countrys banking sector. Additionally, higher costs may erode Koreas trade position. Demonstrating a strong surplus in recent years, Korea is now looking at the possibility of a current account deficit in 2001. This depends on whether oil prices remain high. KWR estimates that if oil prices remain over $30 a barrel over the next 6-8 months, Koreas forecast for a $10 billion current account surplus in 2000 can be expected to shift into $1 billion deficit. Another point of concern is the drawing down of reserves. In late October it was revealed that emergency oil reserves stood at 60 percent of the optimal level. All of this has accentuated the need for a new energy policy in Korea. As it now stands, Korea depends on the Middle East for close to 75% of its oil.
Koreas trading position could also be hit hard by declining DRAM prices. As real GDP growth is expected to decline in the United States in 2001, there is a growing apprehension that demand for semiconductors will fall. Semiconductors account for more than 15% of Koreas exports. According to certain sources, every $1 decline in the price of dynamic random access memory chips will shave $500 million off Koreas trade surplus.
Korea faces a difficult transition in 2001. It needs to regain momentum on the reform path. The Kim administration is seeking to do this, but faces opposition from many quarters. What should help to ward off a repeat of the 1997-98 meltdown is that there have been a number of gains. Foreign exchange reserves stood at a record $96.2 billion in December and the current account surplus is expected to stand at around $10 billion as of year-end 2000. Despite concerns of an export slowdown, real GDP growth should be in the range of 5%, down from the blistering 9.3% pace of 2000. It is likely that the slowdown could be helpful from the perspective of serving to remind the Korean corporate sector of their ongoing vulnerability to international economic trends. Those trends are now more bearish and less tolerant of foot-dragging on corrective measures. A number of U.S. companies, such as Xerox and Lucent, have already felt this lack of tolerance in terms of falling sales, problems with access to credit and plunging stock prices. Why should Korean companies be any different?
The Dangers of a Slow Pace to Merge - Japanese Banks:
By Scott B. MacDonald
Japanese bank mergers have created some of the largest banks on the planet. Indeed, the three-way merger of Industrial Bank of Japan, Fuji Bank, and Dai-Ichi Kangyo has been called the "Godzilla Bank", as this $1.3 trillion asset-sized bank decidedly looms over the Tokyo landscape. There are others mergers in process including that of Sakura and Sumitomo and Bank of Tokyo-Mitsubishi and Mitsubishi Trust. Clearly, Japanese banking is in the process of revolutionary change. Yet, there are problems. In particular, the slow pace of consolidation can prove to be an Achilles heel if not addressed in the short-term. Bank mergers in Japan need to proceed with greater speed.
There are a number of differences in the merger process between the United States and Japan. In Japan, mergers are announced, but not followed by staff reductions, the sale of non-core assets or the creation of a single management team. The average bank merger in Japan is expected to take two years or more. The adoption of one computer system takes a long time, with each company having its own unique software. Moreover, in Japan committees are created to study the idea of cost-efficiency and to give the appearance of balancing interests. A sticking point can be arriving at an acceptable name for the new bank. Furthermore, the slowness of mergers allows time for infighting to occur and slows the pace of consolidation.
the United States, the approach is considerably different. The goal
is to move toward rapid consolidation, to achieve the best cost
efficiencies, and to maximize profits, are soon as possible. The
management team is often agreed upon during the merger talks. Credit
Suisse First Bostons purchase of Donaldson, Lukfin & Jenrette
was announced in September and departments were merged in October
2000. The management team of the new entity was announced within
weeks of the merger. At the same time, there is usually a hard and
quick examination of each business unit. Those businesses not regarded
as essential are sold or disbanded. Extra staff members are fired.
There is also a concerted effort to merge computer systems. The
lack of a unified computer system means lost money. Furthermore,
there is an effort to quickly come up with a new name. Within days
of J.P. Morgan and Chase Manhattan Banks announced merger,
the bank had a new name. It is understood it is important to get
a new name out to customers quickly. Good name brand promotion can
mean millions in revenues.
The rating agency Standard & Poor's recently warned that "Japanese banks have a poor track record of implementing consolidation. New financial groups will need to chart their course carefully to avoid repeating these mistakes." One example of this is the so-called Godzilla Bank, formerly called the Mizuho Financial Group. While Mizuho moved rapidly to establish a new corporate name, the pace of consolidation has been slow. Under the merger plans timetable, the three banks will continue to operate as separate entities until 2002, when three years after the first announcement, they will be reorganized under a single holding company as retail, corporate and investment banking units. In sharp contrast, Chase Manhattan and JP Morgan are planning to complete their merger in about six months.
As the Financial Times Gillian Tett notes of Mizuhos gradualist approach: "This has created endless internal feuding: the banks have yet to decide, for example, who will be president or how they will organize their information technology. Furthermore, it has failed to find a business focus." It is well known that Mizuho could not reach a consensus on which of the three banks information technology systems to adopt. Consequently, it was decided to combine several systems. This costly and time-consuming exercise is in sharp contrast to most U.S. and European mergers, where IT technology is one of the first things decided upon, considering the critical importance of technology in todays banking.
While substantial attention has been devoted to national and larger city banks, Japans regional banks are also under considerable pressure. Outside Tokyo, many regional economies are in bad shape and the corporate climate is not encouraging. The depressed nature of many regional economies is reflected by the fact that the majority of Japans prefectural governments are in the red for the second straight year in fiscal 1999-2000. They have been hard hit by a combination of swelling interest expenses on outstanding debt and lower-than-expected tax revenues. In many cases, nonperforming loans are at higher levels than those of the city banks and rising. Balance sheets show a deterioration due to unreserved bad assets. Moreover, regional banks are facing greater competition from the city banks and other financial institutions. As one Merrill Lynch report commented: "In our view, regional banks need to implement radical structural reform to resolve their problems." Part of this restructuring could be mergers.
The difference in speed is critical to the future development of Japanese banks. The slow pace of Japanese bank mergers invites a loss of efficiency. Moreover, big bang reforms are adding new competitors to the bank sector. Non-banks like Sony, BMW and Ito-Yokado (a supermarket chain) are all applying for banking licenses. Consumer loan companies, such as Acom and Promise, are busy expanding into businesses such as credit cards. The big brokerage houses have their own plans for financial expansion. The clear risk for banks is that they will fall even further behind the pack as they become caught up in the technical difficulties and business culture difficulties that complicate their mergers. Time is marching on and the competition is growing.
Telecom - Supply, Consolidation and Volatility
By Scott B. MacDonald
The telecom world ended 2000 bruised and battered. While the dot.com sector was crushed by investors fleeing the NASDAQ, higher costs of funds due to several interest rate increases and a massive volume of new bond issuance pummeled telecoms. In late 2000, telecoms came to market with over $50 billion of new bonds. On top of that surge came some nasty shocks as equipment makers NorTel and Lucent announced diminished earnings expectations and Xerox struggled to stave off concerns that it was heading into a liquidity crunch that could lead to bankruptcy. Almost across the board, telecom stock prices fell.
What is next for the global telecom sector? Looking ahead we believe there are four major forces set to shape the sector in 2001 - supply, consolidation, deterioration of credit and volatility. These forces are interrelated. Consequently, the momentum in each area is linked to what is happening in the others.
In terms of supply, telecoms face a massive amount of new issuance in both stocks and bonds. In the first half of 2001, the bond market is likely to see $35-40 billion in new paper. This includes new issues from France Telecom and Telecom Italia and follows an active month in December 2000 which saw a $10 billion British Telecom deal, a $4 billion Verizon deal, a $1.8 billion floating rate note from BellSouth and a $2 billion private transaction for WorldCom.
While the bond market schedule looks busy in the first half of 2001, the equity market is equally onerous. European telecoms have a particularly heavy schedule. France Telecoms Orange subsidiary has a Euro 5-6 billion stock issue in February, which will be closely watched. This deal has already been scaled back from an earlier Euro 8-10 billion IPO. Waiting in the wings are a bevy of other companies, including subs of British Telecom and others. Even China Telecom is planning to issue $6-10 billion in shares sometime in 2001. All of this means a massive amount of supply that needs to be digested. Unsuccessful IPOs will slow debt reduction programs and complicate consolidation in the industry.
While supply is a major issue, consolidation also remains a key factor. By consolidation, we mean restructuring business along different revenue streams, which means the buying of key assets and selling of noncore assets. These trends resulted in a number of mergers in the United States, which have been followed by a scramble for assets in Europe. As companies sell assets, other buy them as priorities drive strategies to concentrate on core business streams as well as reduce debt. To a degree, this process of offloading peripheral, and purchasing new, assets key related to core business streams was replicated in Asia, Latin America and Australia (i.e. with Cable & Wirelesss decision to sell off most of C&W Optus).
The momentum for large acquisitions appears to have abated as reflected by the failure of the planned WorldCom/Sprint merger and Deutsche Telekoms stalled bid to buy VoiceStream. However, the process of selling assets to streamline operations and reduce debt is likely to continue. This is evident in Motorolas decision to sell off assets in Latin America and the Middle East (Israel and Egypt) as well as British Telecoms announcement in January that it plans to sell and leaseback its $3 billion UK property portfolio. This is the first major dent for the company with its $45 billion debt and follows earlier announcements made by Deutsche Telekom and Telecom Italia.
The sweeping changes in the telecom sector have lead to a deterioration in the creditworthiness of many companies. The driving forces behind this trend are huge increases in debt related to 3rd Generation wireless licenses mainly in Europe, as well as capital spending and higher costs of funding due to interest rate hikes in 2000. While the U.S. telecom sector has already gone through a round of ratings downgrades or warnings (as with AT&T, which is expected to be downgraded by both Moodys and Standard & Poor's), European telecoms are in the middle of that process. In 2000, European telecoms went from an average ratings of AA to single A ratings. In 2001, this trend will continue, with the average probably falling to the low single A level, though some firms, like the Dutch firm KPN, could tumble into the BBB range.
Two factors which could result in a more rapid and severe deterioration in creditworthiness are the slowdown in the U.S. economy and the related more difficult environment in which to sell assets and launch new equity issues. The latter, of course, ties into market volatility. Both equity and bond markets were highly volatile in 2000, a trend which we expect to continue into 2001. There is zero tolerance for any disappointments in terms of poor earnings, botched acquisitions and strategic missteps. Moreover, there are a number of potential events that will have an impact. These include ratings downgrades, a decision from the U.S. Senate on whether to let Deutsche Telekom proceed with its purchase of Voicestream, and what happens to the tech sector (i.e. Lucent, NorTel and others), which trades in sympathy to telecoms. The positive trend in interest rate reduction will also be a factor.
Before we leave you with an entirely gloomy scenario, we hasten to add that while we regard the first part of the year to be difficult due to a huge load of supply in both debt and equity, downgrades and price and spread volatility, the second half of the year should be ready to see a rally in this sector. By the fourth quarter the supply overhang should be greatly reduced, ratings actions completed, and uncertainty over U.S. economic performance abated. Patience could be rewarded.
The Benefits of a Credit Rating
By Roger P. Nye
President, Global Investment Advisors, Inc. (GIA)
Credit ratings continue to make news around the world. The financial markets follow with keen interest all the new ratings published by major rating agencies plus their upgrades and downgrades of countries, corporations and commercial banks. This article explains the role and benefits of ratings with particular attention to Asia.
To begin, we should be clear about what credit ratings are. Ratings are an estimate of the default risk a lender faces. They are a professional opinion by an independent body of the ability of a borrower to repay his debt obligations. Ratings are powerful symbols and useful tools that help all participants in the capital markets&endash;issuers, investors, intermediaries, and regulators&endash;operate more efficiently. The obligations can be denominated in local or foreign currency. They can be short-term (less than one year) or long-term (more than one year) in maturity. Ratings are assigned to domestic as well as international borrowings. They can be a measure of likely repayment of a particular debt or a borrowers inherent financial strength.
Why are ratings growing in importance in Asia? There are three basic reasons:
- Asian economies are rebounding and restructuring following the financial crisis of 1997-1998, which increased the borrowing needs of Asian entities. They are also less able to rely upon commercial banks and other traditional funding sources. For example, companies wishing to finance expansions or acquisitions, banks wishing to diversify their funding, and governments wishing to upgrade their countrys infrastructure or to repay existing debt are all in the market for capital.
- Investors who may be considering loaning money to Asian borrowers are using credit ratings as one of their assessment tools. If an Asian company wants to tap the international capital markets but does not have a rating that investors can rely on, that company will most likely have to look elsewhere for funds. This could raise its borrowing costs. The greater the risks that investors perceive, the more they demand ratings as a measure of the risk that they may not be repaid.
- The major rating agencies (Moodys, Standard & Poors, and Fitch) are competitively seeking to expand their global market share and thus are pursuing sovereigns, banks and companies that do not yet have ratings.
Companies seeking a rating for the first time may legitimately ask, "Why should we get a credit rating, given the time and expense involved?" Or, "Isnt the whole rating process rather intrusive, and wont we be forced to reveal confidential information to a foreign rating agency?" The following responses cover the great majority of cases.
- A rating opens up an important alternative financing option for both short-term and long-term needs&endash;useful to have in both stable and volatile business climates.
- A rating usually brings lower financing costs, always important in Asias highly competitive business environment. A successful rating will pay for itself many times over.
- A rating is a "passport" to a wider audience of investors, lenders and business partners. A rating will give you international visibility and make your name known to potential foreign partners and customers.
- A rating is an independent "seal of approval" that will help you prepare for more profitable participation in the globalizing economy.
- Many of your peers worldwide will soon have ratings. Having a rating brings business benefits, as it sets you apart from your competitors.
- Having no rating at all may imply that your record is weak or that you have defaulted on obligations in the past.
- Going through a rating exercise imposes a useful discipline on senior management and creates an awareness of global credit standards.
- A rating is a useful tool for corporate executives because it shows how their company compares to similar borrowers or peers worldwide.
- A first-time rating would be a path-breaking event and an important legacy for the current management of the company.
- Requesting a rating from a rating agency avoids an imposed, unsolicited rating and allows you to be in control of the process.
Potential borrowers may also ask, " What if the rating we get is low? What good will it be?" Our experience has yielded a number of answers to these valid questions.
- Any rating is better than no rating. Without a rating, investors, lenders, suppliers and potential partners assume the worst.
- "Low" is a relative term. It is better to be seen as open than as secretive.
- Any rating, even if relatively low, shows you have passed a test of international scrutiny that most companies in the world have not passed.
- A countrys rating often limits or caps company ratings, so your rating as a bank of corporation may not reflect the real financial health of your company.
- If you wish a trial period, you can ask for your first rating to be provisional, indicative and confidential and therefore not released to the market.
- One must start the process somewhere. Ratings can be upgraded in the future.
- Any rating adds new information to the market and builds investor confidence.
- A low rating is not an insult; it is simply an outsiders opinion of your current financial strength; it is an opinion that will change over time.
To summarize: ratings are an inevitable part of todays global financial infrastructure, and the benefits of a rating to borrowers can be large in terms of lower financing costs, longer maturities, increased financial flexibility, and wider markets.
Emerging Market Briefs
By Scott B. MacDonald
Hong Kong - Slowing Growth: Concerns about slowing growth in the United States and prospects for another downturn in Japan are spelling bad news for Hong Kong. After making a substantial recovery in 1999 and early 2000, the process of slowing activity was felt in the third quarter. Real GDP growth for all of 2000 is likely to be around 9%, but the second halfs pace will be considerably slower. First quarter real GDP growth was 14.3%, followed by 10.8% in the second. However, in the third quarter growth slumped just below 8% and the expectation is that the fourth quarter will be down considerably, possibly under 3%. Looking into 2001, our expectation is that growth will fall to 4%, conditioned by a slowdown in exports. Despite the prospects of an economic slowdown, KWR still regards Hong Kong as a well-managed economy and that the peg to the U.S. dollar will be maintained. This means that developments in U.S. monetary policy will continue to be the dominant factor of Hong Kong monetary policy parameters. Considering that the Fed has already cut rates once and more cuts are expected, Hong Kongs high real interest rates can be expected to fall in 2001. Lower rates could help modify a downturn in exports.
Indias IT Industry- Turn on the Lights!: India has gained a reputation as one of the upcoming tech powers, based on a young and well-educated population, imbued with an entrepreneurial spirit. In 1999 and early 2000 there was considerable excitement about the high tech sector and a number of new companies sprang up and attracted global attention, with several obtaining NASDAQ listings. Despite supportive legislation by the Indian government, the IT industry is struggling in the aftermath of the global equity market shakedown. Moreover, problems are hitting at home.
On the domestic front Indias high tech industry has a major problem - the lack of reliable power. This was underscored in early January when northern India was hit by a massive power grid breakdown. The area affected by this outage holds a population of 226 million people. The crisis hit train services, water supplies and telephone networks. Transportation, water and phones are all critical soft infrastructure for the high tech industry.
India regularly suffers from power problems due to a lack of funding to upgrade infrastructure, bureaucratic hurdles, and ongoing hostility to foreign investment in the sector. It is estimated that around 30% of the countrys electricity is stolen by individuals and groups that illegally tap power lines. While there is a pressing need for assistance, foreigners who have the necessary expertise and capital are deterred by long approval procedures, inadequate payment mechanisms, local government suspicion and sometimes outright hostility, and higher returns to be found elsewhere with less hassle. Most recently, PowerGen from the United Kingdom and another company left India. Enron, which has been the most visible foreign actor in the country, has had ongoing problems. If India is to maintain momentum as a high tech center, the weakness of its power sector can be highly damaging.
The power issue comes at a difficult juncture for Indias IT sector. While 2000 began with considerable promise, the year ended with the industry in the process of market shakeout and consolidation. Satyam Infoway, one of Indias premier Internet and e-commerce companies saw its ADRs (SIFY), fall from a high of $106 a share in February 2000 to a low at year-end of $3.63. Indeed, as early as October, Indias Information and Credit Rating Agency in its "Indian Internet Business Report" indicated that only 5 to 10 percent of the existing content providers/dotcoms in the South Asian country were likely to survive. At that point, there were around 50,000 dotcoms which were of Indian origin or India-related. Although the numbers are not available, it is highly probable the number has already shrunk considerably and is set to fall further in 2001.
Indonesia - Good News on the Rating Front: Indonesia was once firmly investment grade, having a Baa3 from Moodys and a BBB from Standard & Poor's. Then came the Asian financial crisis of 1997-98 and the downfall of the long-lived Suharto regime. The Indonesian economy tumbled and with that development came defaults on both sovereign and corporate debt. Indonesia is still struggling to achieve a sustainable economic recovery and is desperate for access to international capital. Consequently, there was some good news when it was announced in late September that there was a ratification by
Indonesia and its bank creditors of a rescheduling of two foreign currency syndicated loans, with $850 million outstanding since April 17, 2000. The debt restructuring was important from the standpoint that it satisfied the private-creditor burden-sharing conditionalities of Indonesias second Paris Club rescheduling of $5.8 billion of bilateral principal, due in the two years to the end of March 2002. Consequently, Standard & Poor's raised Indonesias sovereign rating from SD (selective default) to B-.
Standard & Poor's noted that the upgrade reflected its assessment that Indonesias macroeconomic conditions were gradually improving and that net government debt will peak this year, at around 65% of GDP as will its net public and publicly guaranteed external debt at around 90% of exports. In addition, the rating agency noted that high international oil prices and improvements in the Southeast Asian nations underlying revenue position are driving strong export and budgetary prospects. It also emphasized that Indonesias ratings remains constrained by political uncertainty, including tensions between the political center (Jakarta) and the regions (Aceh, Irian Jaya, etc).
Most recent economic data reflects an improving trend. Real GDP growth is now estimated for 2000 at 4.8% and close to 5% is forecast for 2001. The current account remains in surplus in 2000 and higher energy prices have helped reduce the fiscal deficit. The critical issue remains the political situation, in particular, President Wahids ability to exert control over his governments policies and to maintain unity in a country that faces tremendous fragmentary pressures. If the political center is able to hold and meet many of the demands from other parts of the country, then Indonesia faces the strong possibility of a sustainable economic recovery and a gradual return to investment grade ratings. If not, Indonesia will loose economic momentum and slide into a political quagmire of separatism. Big tests loom on the horizon in 2001.
Chalmers Johnson, Blowback: The Costs and Consequences of American Empire (New York: Metropolitan Books Henry Holt and Company, LLC, 2000). 268 pages. $26.00.
By Scott B. MacDonald
Chalmers Johnson, president of the Japan Policy Research Institute and professor emeritus at the University of California, is well known for his strong views and usually solid research on Asia. His MITI and the Japanese Miracle: The Growth of Industrial Policy, 1925-1975 is regarded as a classic and something that all students of Japanese politics and economics should read or at the very least be aware. The same cannot be said for Johnsons latest book, Blowback: The Costs and Consequences of American Empire. All in all, it is a disappointing book. Blowback is a written with a sharp, almost venomous edge that compares the U.S. experience of "informal empire" in Asia as similar to that of the Soviet Union in Eastern Europe.
Although Johnson makes some good points such as the U.S. problem of often lacking expertise to deal with specific countries in Asia, the overall thrust of the book comes off as a call for isolationism and appeasement. All U.S. involvement in Asia since World War II has been "on the wrong side of history". Johnson maintains that the U.S. interventions in Korea and Vietnam were far worse than the Soviet Unions military interventions in Hungary and Czechoslovakia. After all, the U.S. "killed a great many more people in losing than the USSR did in its two successful interventions." [Perhaps the U.S. should have studied Soviet repression tactics better.] Johnson ultimately blames the U.S. for Cambodias Pol Pot, the rise of Suharto, the fall of Suharto, and Asias financial crisis in 1997-98.
Johnson also contends that Japan is still part of the U.S. empire. As he notes: "Just as the two satraps of the German Democratic Republic faithfully followed every order they ever received from Moscow, each and every Japanese prime minister, as soon as he comes to office, gets on an airplane and reports to Washington." Along these lines, Okinawa is an American colony, Japan is closely tied to the U.S. and Washington remains apprehensive over anyone who could upset the nature of this relationship.
The problem for the United States and all its incredibly wrong policies is that history will get even with it. The evil empire based in Washington "is the worlds most prominent target for blowback, being the worlds lone imperial power, the primary source of the sort of secret and semisecret operations that shore up repressive regimes, and by far the largest seller of weapons generally." Blowback is the unforeseen and unintended consequences of such bad (and covert) policies, as yesterdays allies (and stooges) become the futures enemies. This means terrorist attacks against U.S. targets, such as that the USS Cole in Yemen in October 2000 and ongoing problems with Afghanistans Islamic radicals.
There are any number of issues to dispute Johnson on. For example, if the United States has been so utterly vile as a superpower, how come the bloc it led during the Cold War survived and the Soviet Union-led bloc did not? Could it be that maybe, just maybe some U.S. policies succeeded (Marshall Plan in Europe) in supporting economic reconstruction and democratic government. At the same time, his depiction of Asian leaders and governments is that of being hapless lackeys of their powerful white masters. If this indeed the case, how did communist China emerge? If all Japanese prime ministers are puppets of the American empire, how come we have had huge differences over trade? Why should the all-powerful Americans put up with a negative balance of payments with Japan and China?
Johnson also makes a call to reject globalization. In his view, this is U.S. economic bullying. The U.S. should support "economic diversity". While this sounds politically correct, this can also be interpreted to mean U.S. business and investors should not be bothered by a lack of transparency and disclosure in Asian economic systems, protectionism, support for highly inefficient agricultural, construction and manufacturing sectors that create unfair trading advantages, and a lack of corporate governance laws (supportive of creating civic societies). The problem here is that many of those people Johnson believes should be allowed to maintain their economic diversity are also the same people coming to the U.S. and other developed countries for credit. Should that credit be blindly given? Or should these countries seek to go on their own, much like North Korea has done since 1989 (and what a model that is)? Many banks, investment funds, and investors already feel burned by Mexico in 1994 and Asia in 1997-98. The other option is not to extend credit to those countries seeking economic diversity. If nothing is given, then nothing will be lost, though nothing will be gained in terms of development. Reality is often more complicated that ideological musings.
Despite the many sharp-edged attacks, Johnson does make one very valid point. It is time to reassess the U.S. commitment overseas. He is correct in his assertion that the United States runs the risk of imperial overreach. With peace possibly looming on the Korean peninsula it is time to consider the future role for the U.S. in that critical region, especially in balancing the sometimes conflicting national interests of China, Japan and the two Koreas. Johnson clearly states in the conclusion: "More generally, the United States should seek to lead through diplomacy and example rather than through military force and economic bullying." While one can certainly agree with this, the eye-poking and shrill proselytizing of the rest of the book clearly detracts from what is an important idea.
Marvine Howe, Turkey Today: A Nation Divided Over Islams Revival (Boulder, CO: Westview Press, 2000). 310 pages. $26.00
By Robert Windorf
Veteran journalist Marvine Howe has written a timely and very readable account of Turkeys current socio-political climate. Early on in her narrative, she carefully states that the structure of her book is built on the scores of interviews she held to allow the Turks to speak for themselves about current conditions. Much of the book holds true to this premise and presents an interesting perspective. However, more of her insightful opinions would have helped several of the books weaker points. Nevertheless, it is admirable that Ms. Howe gained access to a broad spectrum of Turks from all walks of life, especially given the numerous challenges she overcame to achieve that.
Ms. Howes narrative interview style presents the account of Turkeys current dilemma as it exists between two worlds: the secular, western-driven model challenged by the dictates of Islamic fundamentalism. Whether Turkey is defined as a Muslim democracy or secular republic, it will continue to face numerous challenges in the years ahead. Her narrative is supported by several interesting statistics including the fact that more than 80 percent of the population considers itself Muslim under a secularly governed society. The author presents many good detailed accounts of Attaturks rise to power, the creation of the republic, and descriptions of his secular legacy for Turkeys 60 million plus citizens. However, what is missing from Ms. Howes narrative is a deeper analysis of Turkeys many complex challenges. Yet, for the reader unfamiliar with Turkeys long, rich, and colorful historical past and interesting current dramas, this book provides a fine introductory read.
Interested observers, especially the new Bush administration, should take note that over the next several years Turkeys political and religious leaders will continue to face pressing and developing problems. At the top of that list are the challenges blocking the republics full entry to the European Union, a dubious human rights record (especially concerning the governments questionable tolerance of the Kurdish minority) and an enterprise economy frustrated by overwhelming public sector domestic and foreign debt. Cracks in the republics proud secular structure will continue to worsen as the government endeavors to co-exist with the heightened pressures from the numerous and growing Islamic influences that have crept into virtually every sector of society. While Turkeys precarious internal socio-political and economic situation appears to remain isolated within its borders, its many neighbors remain on watch as to its potential impact on the Balkan and Middle East regions as a whole.
In terms of presenting Turkeys current challenges, Ms. Howes important focus on the troubling aftermath of 1999s devastating earthquake in western Anatolia brings the reader up to date. The continued repercussions of the governments reported inadequate and lethargic responses to that crisis, Ms. Howe argues, will continue to be felt for the next several years.
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