Looking for the Hobgoblins: Explaining the Chaos in the U.S. Stock Market

By Scott B. MacDonald

According to the Oxford American Dictionary, a hobgoblin is "a mischievous or evil spirit." For anyone watching the events of the New York Stock Exchange and the NASDAQ in April and early May, it would appear that an army of hobgoblins has marched through Wall Street sweeping all before it, leaving only the dead and dying. Indeed, an extended hobgoblin assault on the U.S. financial system could become a risk to the economic recovery if it erodes the weak reeds of investor, consumer and management confidence. Until the hobgoblins leave us alone, we expect to see ongoing volatility in both equity and bond markets.

Where did the hobgoblins come from? They were created during the 1990s economic and stock market booms. They emerged from a loosening of accounting standards, the quest for more complicated financial engineering and correspondent erosion in financial transparency, a collusion in the interests between accountants and the companies they audited, and big egos allowed them to run rampant. In a sense, the business culture was "fast and easy", mirroring the times when the stock market rose to ever-higher levels and created a carnival-like atmosphere on Wall Street that gripped most of North America. Investors big and small threw their money into the stock market boom, which finally began to peter out in 2000 and 2001.

Now that the carnival has ended, the mess must be cleaned up. It is a time for finger pointing, hence the arrival of hobgoblins and market volatility. In a sense, we are undergoing what happens each time a boom goes bust - apportioning the blame. As Michael Lewis, author of Liar's Poker, recently commented: "We have arrived at the beginning of the end of a process that seems to be psychologically necessary after every stock market bust. Huge sums of money can't simply have been lost by greedy little investors. Someone must have taken them." Consequently, there is a witch hunt for anything that smacks of the excesses of the 1990s - bloated CEO bonuses, large debt build-ups by companies, and bad corporate practices.

There are a large number of companies that were kings of the carnival during the 1990s that are now struggling against fierce competition, negative investor sentiment and SEC investigations. Enron has already fallen, leaving in its wake an ongoing scandal, angry employees, and an imploding Authur Andersen. Other former high-flyers - Tyco, Xerox, Lucent, and Qwest - are all grappling with deeply depressed stock prices, an acute loss of investor confidence and downward ratings pressure. Most recently, the energy sector has come under renewed scrutiny after Dynergy, CMS Energy and Reliant Resources revealed that they engaged in "round trip" trades, i.e. the purchase and sale of power and gas with the same counterparty at the same price - much like Enron.

Part of the loss of confidence in these stars of the 1990s comes from the role played by the accounting profession. Although there were a few critical voices about the "flexibility" of accounting firms vis-á-vis their customers during the 1990s boom, these were cries in the wilderness. The Enron scandal, however, brought the role of the accounting profession front and center when it was revealed that Arthur Andersen was involved in destroying evidence and other questionable practices. As Richard Breeden, former chairman of the SEC from 1989 to 1993 stated in an interview to Bloomberg: "Senior officials at Andersen have trouble reconciling their duties to investors with their business interests."

While Andersen gained considerable public attention in the aftermath of the Enron scandal, it is hardly fair to single this company alone in having loosened its standards. According to a Bloomberg Magazine study, accountants have given a clean bill of health to more than half of the largest U.S. public companies that went bankrupt from 1996 to 2001. Moreover, shareholders lost $119.8 billion in the 10 largest bankruptcies following audit opinions that had raised no concerns.

Rounding out the picture, a number of major investment banks are now under investigation by the SEC and New York State Attorney General Eliot Spitzer for collusion between their investment bankers and corporate research analysts, one of the many offshoots from the Enron scandal. Yet for all the hoopla, this problem existed well before Enron. As financial industries consultant David E. McClean accurately notes: "The scandal of Wall Street research predates Enron by many years. It did not take an Enron scandal to know that the relationship between research and corporate finance departments has been a troublesome one, although the analyst cheerleading surrounding Enron drew the world's attention, as never before, to how professional stock recommendations really work."

However, the witch hunt of Wall Street research departments does provide a guilty party for people to point to with indignation. Those investors who lost money based on the advice from Wall Street analysts are being converted by the wave of a lawyer's wand into hapless victims. Yet, by investing in the stock market any investor is partaking in something called speculation. There are no guarantees of profits or money back. An investor puts his money down hoping to make more money. Research is meant to help the odds - not to provide a sure-fire get-rich machine.

At the same time, it is important to draw the line that research should not be fraudulent. Wall Street has a long history of rouges and no doubt the 1990s produced its own generation, some of them apparently wearing the garb of research analysts.

Another element adding to the volatility of the stock market it that expectations over the future direction of the U.S. economy are too high. While the 5.6% real GDP growth in the first quarter of 2002 was a strong rebuttal to anyone still clinging to the idea that the recession was lingering, it also generated false expectations that the rest of the year would be as robust. Simply stated, we do not see real GDP growth of 4-5% in 2002, but closer to the 2-3% range. While consumer demand has helped maintain some momentum through the end of 2001 and into 2002, it does not have too much further to go. What was amazing about Q1 2002 was that consumer spending excluding motor vehicle sales rose from 2.6% in Q4 2001 to 6.2%, a substantial uptick. As John Lonski, Chief Economist for Moody's commented: "The performance of household expenditures amid the most pronounced contraction of payrolls since 1991 has been amazing. "Don't expect it to last, especially as unemployment rose in April to 6 percent.

The U.S. stock market is likely to remain a chaotic place for much of 2002. Witch hunts take time. There are political careers to be pumped up, lawyers' fees to be negotiated, and a public to stir with indignation at the infamy of it all. Yet, beyond the froth caused by the hobgoblins, the U.S. economy is making a rebound, albeit one that is slower than many would like. In addition, corporate America is rapidly overhauling its governance practices, the accounting profession is restructuring and hopefully investors are becoming a little more aware of the many pitfalls and bear-traps that await the unwary. We remain cautiously optimistic about the U.S. economy and see 2003 as a better time for the stock market. Hopefully by that time the hobgoblins will be gone and it will be time to get back to business.

WorldCom: An Example of Corporate Excess

By Scott B. MacDonald

Under Bernie Ebbers in the 1990s WorldCom rose to become the second largest long-distance and data services company in the United States. The company followed an aggressive strategy involving 60 acquisitions, the highpoint of which was the $37 billion purchase of MCI in 1996. By 1999, WorldCom generated close to $40 billion in revenues and its stock peaked in the mid-$60 per share range. Ebbers had taken a small company based in Clinton, Mississippi and converted it into a major global player in the international telecommunications industry.

WorldCom's push to become a major powerhouse, however, came at a cost. To wheel and deal in the telecom market a considerable sum of capital was borrowed from the banks and raised by Wall Street firms. Impressed by Ebbers' rag-to-riches tale and his ability to sell the company, investors lined up. By year-end 2001, WorldCom group's debt was a massive $30 billion. In the late 1990's, the money poured in. However, the telecom industry began to undergo a dramatic change. WorldCom's once highly specialized product of long-distance communications shifted into a lower-priced commodity. Fierce price competition ultimately generated less revenue, just in time for the tech bubble burst in 2000-2001, taking WorldCom's stock with it.

Complicating matters for WorldCom was that CEO Ebbers had gone on a buying spree and accumulated a number of personal acquisitions, ranging from a massive timber farm in British Columbia to a boat called the "Aquasition" and a mansion in Mississippi. Ebbers used WorldCom stock to secure bank loans to make these purchases. When stock prices began to fall, the bank called the loans. Ebbers then turned to his board at WorldCom, which first guaranteed the loan and then assumed the debt itself. Consequently, Ebbers came to borrow money, some $366 million, from his own firm, an action that is regarded as poor corporate governance and raises serious moral questions. If nothing else, the loans were a factor in the SEC's decision to investigate WorldCom. Moreover, they represent an ongoing thorn in the side of John Sidgmore, Ebbers' successor in April 2002 as CEO.

The accumulation of falling profitability, questionable corporate governance and a SEC investigation all made WorldCom a focal point for frustrated investors looking for someone to blame. WorldCom's stock has been severely punished and now trades under $3 a share. The company's bonds are now junk bonds, as Moody's and Standard & Poor's have both dropped WorldCom from investment-grade gradings to to non-investment-grade. The sad commentary on WorldCom is that what once was one of the stars of Wall St. is now a company struggling to survive.

By Keith W. Rabin

For almost a decade, U.S. and international investors who ignored the basic tenets of portfolio theory -- which urges diversification into different asset classes - enjoyed the best returns. Favoring large cap U.S. blue chips, which offered the perception of security or high-octane technology plays that promised to enrich all brave enough to throw caution to the wind, investments in international and emerging markets, value-oriented themes and small and mid-sized cap firms suffered in comparison.

In recent months, however, we are seeing some interesting changes. The ongoing cleanup of late 1990s speculative excesses, combined with the impact of September 11th, have caused a major blow to market confidence. Compounded by the Enron and other accounting scandals, this changing sentiment has tarnished the illusion of a "Fortress America" and a belief in an ever rising U.S.-dominated technology sector. Previously neglected areas such as consumer goods firms, retailers, and industrial firms now outperform complex multinationals and focused, cash-flow positive small to mid-cap and value-oriented names are deemed preferable to speculative growth-oriented companies that operate largely on promise and faith.

Interestingly, investor worry about the U.S. has lead to a renewed interest in markets that have been largely ignored in recent years. Emerging markets including Korea, Russia, Indonesia and Thailand are now among the best performers in the world. Some analysts are now pointing to the potential of other under-performing asset classes such as small companies in Japan. This is a far cry from what we had been hearing in the aftermath of the 1997 Asian financial crisis. At that time investors nervously wondered when the storm clouds of contagion would wash up on U.S. shores. This fear, combined with troubles in Russia and LTCM in 1998, prompted the Fed to deliver rapid rate cuts to an already overheated economy. Combined with rapid inflows of foreign capital that sought to benefit from a flight to quality -- U.S. equity markets surged as if they were on amphetamines.

It is now obvious; however, that this speculative era is over. U.S. interest rates if they don't remain static -- are more likely to rise than decline further. Therefore, investment advisors and television talking heads now increasingly talking about "diminishing opportunities" in the U.S. and the potential benefits of international diversification.

A look at the fundamentals reveals the logic behind their reasoning. The U.S. has been actively benefiting from deregulation, restructuring and reorganization for over two decades. Many countries in Europe, Japan and the emerging markets have all or most of these gains before them. Therefore, while the U.S. economy is now showing some glimmers of hope, with many forecasting an end to recession, few if any believe we will see anything remotely approaching the heady growth we enjoyed until about a year and a half ago. Simply put, growth is not likely to deliver sufficient momentum to ignite top-line earnings growth and there is insufficient room to cut costs to make up the difference.

The rest of the world, however, is by and large a different story. As more rapid momentum is achieved in the areas of banking and corporate reorganization -- there is more potential for rapid appreciation. To give one indicator, in 1982 Former U.S. Treasury Secretary William Simon initiated an LBO of Gibson Greetings. Many acclaim this to be the start of U.S. restructuring efforts. At that time the Dow Jones index stood at about 800. More than a decade later in 1995, before the start of the speculative dot.com era, it had appreciated to over 5,000. This was largely driven by restructuring, reorganization and introduction of technological and other efficiencies - the same type of measures now being urged on, and beginning to rake root around the world.

While it may be early to allocate capital to the macro indices, it is clear there are many micro opportunities emerging. For this reason KWR International recently moved to organize a small company investment conference featuring a select group of eight promising small Japanese firms. This event was held in NY on March 12th and attracted over 200 investors, analysts, journalists, executives and other interested individuals. Detailed information on the agenda and conference proceedings is available at http://www.JSCIconference.com .

This conference was organized as a result of the many inquiries we have been receiving from individuals and institutions, who have been receiving the KWR International Advisor and materials we have been developing for clients concerning a wide range of international trade, financial and economic issues. Many have noted they clearly recognize the potential of investments outside the United States. But they have also highlighted the challenges they face in their efforts to identify and access specific opportunities that offer the potential to improve their investment and corporate performance.

With this in mind, we began seeking ways to assist in this process. We recognized the growing demand for international investments among U.S. corporate and financial investors who lack the resources and global networks of major financial institutions. At the same time there is a growing number of public and private companies around the world who recognize the need to internationally diversify their investor base and to create alliances in key foreign markets, but who lack the individual scale and resources needed to organize credible efforts by themselves.

Through arrangements with venture capitalists, financial and service professionals and promotional partners, we sought to identify, prescreen and promote a portfolio of promising firms. In addition to providing the array of services normally provided by a public/investor relations firm, our objective has been to create a structure that can provide hands-on support and the essential preparation and follow-up needed to complete successful transactions and achieve ongoing success in international markets.

Based on our initial success we are now speaking with a growing number of companies, venture capital firms, brokerage and securities houses, investors, government agencies and other entities that are interested in participating in initiatives of this kind. These inquiries have been coming -- not only in respect to opportunities in Japan - but from interested parties all over the world. We appreciate this interest and look forward to hearing from more of you as we move to further develop this concept moving forward.

China and WTO Compliance: The Glass Will Remain Half Full

By Dr. Jean-Marc Blanchard, Sr. Consultant

After 15 years of tortuous negotiations, China finally became a member of the World Trade Organization (WTO) last December. American policymakers were ecstatic about this development, arguing it will eliminate subsidies, enhance intellectual property rights, and encourage the development of a Chinese legal system. They point to a mix of lucrative opportunities occasioned by China's involvement in the WTO system, including newfound market access for American banks, telecommunication companies, and other service providers and the ability to export an additional $2 billion of agriculture goods. The central issue, though, is whether American businesses can truly count on China to fulfill its agreements. The argument here contends that China will comply in large measure, though not fully, with its commitments.

China's deep involvement in the global economic system gives Chinese leaders incentives to meet their WTO obligations. As well, Chinese leaders see participation in the WTO as a way to spur competition and limit corruption. Other Chinese elites view the WTO as a bludgeon they can exploit to restructure money losing state-owned enterprises (SOEs). American policymakers are not relying solely on these interests to ensure Chinese compliance. According to government documents, in public speeches and bilateral forums, officials habitually encourage Chinese compliance. In addition, they have threatened to use the WTO dispute settlement process if the Chinese renege on their agreements.

On a more concrete level, the U.S. government has reoriented its agendas, made organizational changes, and established various mechanisms to promote Chinese compliance. In Washington, the government has created an interagency Trade Policy Staff Committee Subcommittee on China WTO compliance, consisting of members from the Departments of State, Commerce, Agriculture, and Treasury. Within the Department of Commerce, officials have established a rapid response China Team. Paralleling these efforts, the American embassy in Beijing has established a WTO Implementation Coordination Committee and an Intellectual Property Rights working group. These initiatives aim to coordinate information-gathering, track and analyze changes in Chinese laws and regulations, monitor China's implementation plans and enforcement activities, and communicate issues to Chinese officials.

The U.S. government also is engaged in a serious effort to enhance China's capacity to fulfill its WTO obligations. It is training Chinese officials, academics, and SOE managers in WTO requirements, hosting workshops, and developing video and Internet courses. Complementing this, it is furnishing law books, translating documents, and giving seed-grants to capacity building programs such as a WTO e-learning program.

DragonVenture, the premier Cross-Pacific venture capital, consulting, and merger & acquisition company, is a critical bridge between the United States and Greater China markets.

Chinese interests and American efforts will ensure a good degree of Chinese conformity with the WTO. China's desire to achieve great power status gives it added incentives to perform its obligations because fulfillment will help it develop a trustworthy reputation and discredit claims it is bent on overhauling the world capitalist system. Nevertheless, it remains doubtful that China will fully observe its obligations partly because of the sheer volume of requirements. More fundamentally, China will not comply completely because of its domestic political situation, lack of implementation capacity, and its economic might.

China is not a democracy. Its leaders, though, still must preserve their standing among the public and key constituencies - e.g., the People's Liberation Army and Communist party officials - if they wish to stay in power. This means they have powerful incentives to ensure that the WTO produces less rather than more unemployment and smaller rather than larger income inequalities. Related to this, they have incentives to minimize the influx of subversive foreign ideas. Given these pressures, it is probable that Chinese leaders will fail to or will slowly implement parts of their WTO agreements. They will be prone to enforce WTO rules in a non-aggressive fashion. They are liable to provide illegal subsidies and exemptions to Chinese SOEs to buffer the impact of China's WTO membership and they are likely to take steps to control the influx of foreign ideas. Importantly, if the leadership's political power diminishes, then its willingness to violate its accession accords could increase dramatically.

Another factor that will limit China's performance of its obligations is its inadequate implementation infrastructure. Beijing can command, but subnational entities and citizens are unlikely to obey unless the government can expand its training activities. Beyond this, the Chinese government has to socialize multiple governmental levels to embrace "alien" WTO norms, which emphasize transparency, market mechanisms, and the rule of law. In conjunction, it needs to enhance its ability to monitor compliance while establishing genuine mechanisms for penalizing WTO violators.

A final factor that will reduce China's compliance levels is its economic might. As suggested by American and European defiance of WTO rulings, China's economic power should allow it to absorb the relatively small cost of WTO sanctions. Of course, an economically-powerful China can leverage its strength against companies that will be inclined to complain about Chinese noncompliance or that might threaten to exit China. As an economically powerful country, China too does not have to rely as much as other states on reputation since it can bestow economic rewards that others covet.

Over the long run, there are several trends that will encourage Chinese compliance. For instance, China's participation in the WTO system will lead to the creation of new agencies, the incorporation of WTO-norms into bureaucratic procedures, and the production of research. These developments, in turn, will create knowledge, beliefs, and behaviors that encourage compliance. Second, the continued growth of Chinese exporters and multinationals will create a constituency for WTO observance. Third, the expansion of free trade and investment regimes in East Asian will encourage the adoption of WTO-friendly practices.

To conclude, over the short- and long-term, many factors will push China to meet its commitments. These factors will take China only so far, however, because they are counteracted by the forces enumerated above. It is encouraging, therefore, that the U.S. is cajoling China and facilitating its capacity building since these initiatives push China further than it might go on its own. Unfortunately, recent U.S. government responses to WTO decisions, which suggest it is playing by its own, rather than WTO, rules risk undermining these efforts by setting a bad example.

 

Hot on the heels of a year of profit warnings and dire economic predictions, the current mood among the member states of the Association of Southeast Asian Nations (ASEAN) is one of unbridled optimism. At a recent meeting of ASEAN finance ministers in Rangoon, Burma, officials expressed a uniformly positive outlook for the months ahead. "I think we've seen the light at the end of the tunnel," Haji Abdul Aziz Umar of Brunei told reporters. His Indonesian counterpart, Finance Minister Boediono, echoed this opinion. "The overall mood is toward the better at the moment, so I think we all feel that positive sentiment." Even the normally cautious Asian Development Bank jumped on the bandwagon, releasing a statement that said the region was expected to witness a "moderate" economic rebound in 2002.

The driving force behind these new hopes is, of course, recent indications of an economic recovery in the United States and Europe. Major ASEAN players such as Thailand, Singapore, Malaysia and Indonesia are heavily dependent on Western nations as buyers for their products, with the U.S. alone representing 30 percent of Thailand's export market and accounting for almost half of the country's gross domestic product. Gains in the U.S. stock markets and consumer confidence levels have had a corresponding effect in Southeast Asian countries, with a mid-April Straits-Times poll showing Singaporeans are increasingly upbeat about the economy and their job prospects. Rating Agency Malaysia announced just weeks later that, thanks to a government stimulus package and an increase in electronics orders from the U.S. and Europe, the country was on the road to recovery. In Bangkok, Bank of Thailand governor Pridiyathorn Devakula recently claimed that economic growth for 2002 was likely to exceed earlier estimates of two to three percent, due to the turnaround in the U.S. and recent leaps in domestic consumer spending.

ASEAN's newfound self-assurance has been further boosted by steps forward in the organization's effort to present a united front to the world at large. At the finance ministers' summit in Rangoon, officials stated that a series of currency-swap agreements signed by Asian nations over the past year - among Japan, South Korea, China, Thailand, the Philippines and Malaysia - had set the stage for an Asian Monetary Fund. This would help support regional currencies in the event of a recurrence of a crisis like the one that rocked the continent in 1997. "It's a seed," said Philippine Finance Minister Jose Isidro Camacho, "that can evolve into something more formal." In addition, Indonesia and Thailand are poised to sign an agreement in which Bangkok will trade 200,000 tons of rice for fertilizer and top-dressing aircraft - one of the first transactions to take place under the trading account system first mooted by ASEAN nations last year.

But despite these recent advances, and an apparently brighter global economic picture, many of the problems that have dogged Southeast Asian governments since 1997 have yet to be resolved. ASEAN officials are increasingly willing to admit that the ascendance of China presents a formidable challenge to their markets. "We know that over the last two years FDI to the ASEAN region has gone down sharply compared to what is going into China . . . we have to work out schemes to try to re-attract FDI," Singapore's Second Finance Minister Lim Hng Kiang remarked at the Rangoon conference. Yet so far intra-ASEAN discussions on the China issue have produced no concrete initiatives to court foreign investment.

In addition, recent studies indicate that Southeast Asia is still viewed in a less than positive light by foreign investors. Commenting on Thailand's inability to achieve a sovereign credit rating upgrade, Thailand Rating Information Service President Warapatr Todhanakasem stated that the situation would not change as long as the country failed to address its significant public debt and reform its corporate, legal and financial systems. While Singapore took top honors in an Economist Intelligence Survey of the best places to do business in Asia, Vietnam and Indonesia languished in the bottom rankings. At an early April meeting grouping ASEAN economic officials and the U.S. Trade Representative, the U.S. said a bilateral free trade agreement with ASEAN was "unlikely," given the radical differences between the organization's members and the hindrances to U.S. trade and investment currently in place.

Also, as the recovery in the U.S. appears increasingly fragile - the weakness of the dollar, grim corporate earnings and volatile oil prices are all factors that could derail the progress seen thus far - ASEAN nations cannot count on their largest export market boosting their economic prospects. The Singaporean Trade Ministry's recent announcement that talks on a China-ASEAN free trade agreement would commence in Beijing in late May are an encouraging indication that ASEAN governments may be making efforts to diversify their export markets. But given that there is a ten-year time frame in place for the establishment of an FTA encompassing the two sides, and the bureaucratic tangling that characterizes intra-ASEAN negotiations, these efforts are unlikely to bear immediate fruit.

Nonetheless, this shows that Southeast Asian governments may have begun to realize what analysts and investors have told them for so long. They must simultaneously look within and not forget the rest of the world in courting the developed nations of the West if they are to achieve sustainable growth and attract the investment they so desperately need.

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The Korean Economy: Still Powering Along

By Jonathan Lemco

The Korean economy continues to demonstrate strength as we enter the mid-year point. This growth is driven by an increase in exports, primarily to the United States, but also is the result of a series of prudent fiscal measures. In fact, it is likely that of all of the post-1997 stricken Asian economies, South Korea has done the most to help itself and to emerge as strong as ever. The major credit ratings agencies have been champions of this Korean reform effort and have steadily upgraded the credit to A3 (Moody's) and BBB+ (Standard and Poor's). We think that they will upgrade the Korean credit again by one notch before year-end 2002. Wall Street investment banks have bought the Korea story and recommend Korea to their investor base. In April, Barclays Capital went so far as to suggest that Korea and Japan (AA1/AA) might enjoy the same rating by year-end 2003. Their presumption is that the Japanese credit would continue to falter as Korea's improved.

We would not go so far as Barclays to suggest that the two Asian sovereigns would have the same rating in the next year. But we would stress that Korea has made tremendous progress. Investors worldwide have been paying attention, and Korean interest rate spreads are trading at their tightest levels since the economic crisis four years ago.

Why are we confident about Korea's prospects? First, Korea has been registering solid economic growth since the 1997-98 crisis and we expect it to be the strongest growth engine in Asia (ex-China) in 2002. GDP grew 5% in 2001 and we think that it will increase to 5-6% in 2002 and 6% in 2003. This growth has been driven by strong domestic consumption and increased export volume. Specifically, as the third largest exporter of electronic goods in the world (U.S. $58.7 billion in 2000), Korea stands to gain dramatically as the global recovery drives a resurgence in technology spending. DRAM prices are finally rising and the semiconductor book-to-bill ratio-a leading indicator of export growth-shows that demand is rebounding after considerable weakness in 2001. In addition, Korean consumer confidence has risen to near post-crisis highs, and is reflective of low unemployment (2.9% seasonally adjusted) and the wealth effect from increasing asset prices.

Also, the Korean sovereign's net external debt has fallen of late as foreign exchange reserves have risen dramatically and political progress is made on the reform agenda. External liabilities totaled U.S. $122 billion in January 2002, well below the end-1997 level of U.S. $159 billion. The debt/export ratio has fallen from a high of 94% in 1997 to an estimated 63% in 2002. Further, the nation's foreign exchange reserves were an impressive $106 billion in March 2002. This testifies to Korea's ability to withstand future external economic shocks. In turn, this has encouraged investor confidence in Korea's external position and its stable currency.

Korea's position as the world's largest manufacturer of computer memory chips, a staple component for computer systems, made the country's exports particularly sensitive to the slowdown in sales of personal computers in 2001. But the U.S. consumer has resumed its appetite for high tech products. This is contributing to Korea's GDP growth. The reform effort is evident in the banking sector as small and unprofitable banks are allowed to fail or are being merged into larger and more productive entities.

We think that the Korean reform effort has been a model for all of Asia. For example, six of eleven public enterprises slated for privatization had been privatized by the end of 2000, and the rest face 2002 deadlines. Corporate restructuring has been slower, but progress has been made here as well.

Korea has a diverse economy and varied manufacturing base. The country's labor force has shown that it could adapt to the massive changes brought about by the financial crisis by taking nominal wage cuts with minimal labor strife.

With its foreign exchange reserves rebuilt ($ 100 billion and rising) and burgeoning strength in domestic demand, the major hazard to continued improvement in the Korean economy may come from outside the country's borders. Japan's ongoing economic slide continues to be potentially destabilizing to Korea's exchange rate. This is because Japan is a destination for much of Korea's exported goods, and because Korean and Japanese industrial concerns compete in third markets. In the near term however, Japanese policymakers support a generally stable exchange rate.

Rising oil prices could pose another problem for Korea, which imports U.S. $18.6 billion (4.4% of GDP) worth of petroleum products annually. According to Lehman Brothers, a $10/bbl increase in oil prices would reduce Korea's real GDP growth rate by 1.1% and increase CPI by 2.0%. But although oil prices are high now by historical standards, they are far from a point at which they would be debilitating for Korea.

It should also be acknowledged that the process of private sector restructuring remains incomplete. The government has strengthened minority shareholder and creditor rights, improved accounting standards, and opened the economy to foreign investment. But there remains much to do. The government remains the owner of most of the banking sector. Many of the Chaebol (large conglomerates) remain inefficient. This being said, Korea has made far more progress in addressing these issues since the financial crisis than any of its neighbors.

Finally, the enormous issue of peninsular integration remains unsettled. North and South Korea remain in a technical state of war. Both entities devote tremendous resources to sustaining large armed forces that might be better spent in developing economically viable enterprises or improved public and private sector infrastructure and services.

Notwithstanding these problems, the fact remains that the Korean economy is growing, Korean industry seems to be thriving, and the quality of life for many Koreans in now on an upward trajectory. From a Korean bondholders perspective, Korean paper has realized tremendous gains this year. From an equity holders perspective, the Korean stock market has rallied 22% in 2002. International investors are increasingly likely to see Korea as a profitable and safe haven in north Asia.

Latin America and the Caribbean - Fork in the Road

By Scott B. MacDonald

2002 is going to be a busy year on the electoral front for Latin America and the Caribbean. In South America, Brazil, Bolivia, Colombia and Ecuador go to the polls, while Costa Rica does the same in Central America. Argentina could also go to the polls, depending on what occurs with the economy and a supreme court justice opinion pertaining to the legality of the Duhalde government. In the Caribbean, elections are scheduled in the Dominican Republic and Haiti and are likely in Trinidad & Tobago, where the two major parties share an equal number of seats in parliament and cannot agree on a speaker. Although there has been some occasional rule-bending, it would appear that with the exception of Venezuela (where there was a recent coup attempt in April) and Cuba (a dictatorship), Latin America has come to accept change through the ballot box. This does not mean that democracy is well-entrenched, but rather that democratic rules are in place at least in a superficial sense.

Latin American remains an important region for the United States, Europe and industrialized Asia in terms of trade and investment relations. Yet, the current struggle to recover positive growth momentum is having an effect in the region's politics. Argentina, once the prize pupil of the neo-Liberal economists, has imploded under the weight of an onerous external debt burden, inflexible labor laws, and a political elite wracked by corruption and scandals. Although the region largely avoided contagion from Argentina, the longer that country's economic crisis continues, the greater the risk that other countries will be sucked in, which appears to be the case of Uruguay.

While Argentina sinks, there is increasing evidence that globalization has not lived up to the high expectations of many well-wishers. Clearly, the downturn in the U.S. and Canadian economies was accompanied by downturns throughout Latin America and the Caribbean. As Anne Kruger, First Deputy Managing Director for the International Monetary Fund noted in May, 2002: "Finally, the synchronized downturn reflected separate but coincident local disturbances, including the bursting of the IT bubble in the U.S., the energy crisis in Brazil, natural disasters in Central America, an outbreak of foot-and-mouth disease in Uruguay and - most dramatic - the crisis in Argentina."

The cyclical economic downturn and increased sensitivity to the international economy in Latin America has also led some to criticize globalization as a force for negative change. According to the United Nations Economic Commission for Latin America and the Caribbean (ECLA), the "increasing demands for competitiveness posed by globalization harmed employment, education and social protection interests in the region." ECLA's most recent data indicates that 44% of Latin Americans lives below the poverty line, with a further 25-30% of the population having a good chance of slipping below it in the near future.

The difficult economic environment has led to the rise of a class of populist politicians who call for simple solutions to complex problems. This includes Hugo Chavez in Venezuela, Eduardo Duhalde in Argentina, and presidential candidates such as Brazil's Ignaco da Silva (popularly known as Lula). Considering that globalization has made Latin America much more sensitive to the ups and downs of the global economy, a simple response clearly has an appeal. That response is that market capitalism must not be left unfettered, but controlled and channeled from commanding heights by the government. While this thinking clearly has neo-Marxist groundings, most of the populists grudgingly recognize it will be difficult to overturn many of the earlier reforms that opened up their economies. Consequently, Latin America's political terrain has become an uneasy competition between those still favoring market-oriented reform and open economies and those preferring greater regulation, controls and protectionist trade policies. Ironically, the Bush administration's protectionist trade policies are giving Latin America's populists something to cheer about, considering that the most "free trade" nation is happy to slap on protectionist measures to win domestic votes - something they would like to do as well.

Trinidad and Tobago: Insight into a Gas-based Future

By Trevor M. Boopsingh

Trinidad and Tobago contains less than one percent of known global reserves of natural gas. Despite this small share of gas reserves, the country has been successful in establishing one of the leading gas based export centres in the world. These exports are principally ammonia, methanol, steel and more recently, liquefied natural gas (LNG). In both the cases of ammonia and methanol, Trinidad and Tobago is already the world's leading exporter. In the case of LNG, by the time Trains II and III are on stream in 2003, it will be among the top five exporting countries.

Trinidad and Tobago has therefore been uniquely successful in the global marketplace in creating an environment in which gas-based export industries flourish. Given the small size of both the country and of its reserve base, a priori, this success must have been predicated on some unique combination of institutional, commercial and regulatory arrangements. The development of the majority of these Gas-based industries (excluding LNG at Point Fortin) was predicated on an original plan for an Industrial Estate at Point Lisas which was modified and adapted almost on an as needed basis, as the scale and size of the industries grew from the very modest first efforts by W.R. Grace with a 150 tonne per day ammonia plant to more than twenty-five world-scale units producing a variety of products and utilizing progressively newer technologies and larger economies of scale.

Gas reserve development has been significantly advanced particularly over the last decade as the markets for natural gas in Trinidad and Tobago grew, particularly as an LNG export project got underway in 1994-95. Reserves in Trinidad and Tobago are now estimated at approximately 32 TCF - more than twice the level of ten years ago - and it is expected that for at least the next decade reserve appreciation will continue at similar rates.

Trinidad and Tobago has become a most important NODE or HUB for natural gas for the GLOBAL gas industry, serving markets as far south as Brazil, and across the Atlantic into Spain and Europe. It will become one the three critical gas nodes for the Western Hemisphere. This is due to a combination of:

Future natural gas industrial development must therefore recognize the likelihood of a continuum of further expansion of the industrial base in Trinidad and Tobago, in size, breadth, depth, diversity and increasing complexity. This will include developments based on:

At present, while there are now four gas suppliers, with the dominant supplier controlling more than 70% of the market, and also being the single largest holder of the acreage in the gas prone offshore environment, it may be very likely that this will increase to almost 10 over the next decade. The midstream sector, i.e. gas transmission, comprises two providers, one of which is a wholly owned state enterprise and important elements of the de facto regulatory framework remain informal. Currently nine consumers account for upwards of 95% of consumption of natural gas and this will expand to maybe 20 in the same time frame.

Maximizing national returns in new and existing industries requires inquiry beyond immediate technical and commercial feasibility. One such area is the relative potential for both backward and forward linkages to the domestic economy. Traditionally, such inquiry has been restricted to some research and sporadic attempts to engage in partnering exercises about downstream possibilities.

However, the advent of LNG may have generated the critical mass necessary to sustain the emergence of a domestic capability in a whole new range of activity linked to the upstream sub-sector. The industry has, therefore, now moved to a new threshold, one in which the three pillars, apart from expansion and replacement for future development must be:

b) risk mitigation on the economy as a key aspect of future development

c) increasing the overall benefits which accrue to the nation through enhancing the role of domestic capital in the sector, labor including management by nationals, the application of appropriate technology, and local institutional and business development

In the first round of expansion of the sub-sector in the 1980's, the Government of Trinidad and Tobago was the principal source of equity in ammonia, methanol, steel and electricity projects. Major local private-sector participation arrived with the CMC methanol joint venture in the early 90's. With divestment of much of Government's equity interests in the nineties, and, with the second round of expansion in ammonia, methanol, LNG and electricity being dominated by foreign direct investment, there is now a clear and present need for strategic interventions by way of Government policy and judicious injections of Government equity to ensure that the benefits of the resource accrue to national stakeholders.

The impact of the continued development of the natural gas industry into the future, on the Environment, and the Health and Safety of the neighboring communities will become much more critical in this next phase of the gas industry's development. In particular much more attention will have to be given to the impact of future development on the neighboring communities and in particular its human impact. As such, the opportunity now exists to develop a planned approach to a comprehensive industrial development program envisaging at least twenty-thirty more years energy related industrial and commercial development with a clear opportunity to continue such activities for another twenty years. A key starting point will be in the identification of potential industrial sites suitable for such activity, with the potential for expansion far into the future. Medium term planning is therefore, now critical, if the issues of resource allocation, industrial relocation of people, facilities and plant, environmental constraints, and social harmony, are to be properly addressed and a pleasant and rewarding future for all the citizens of Trinidad and Tobago realized.

Ukraine: A Bumpy Road Toward Democracy

By Robert Windorf

On March 31st, Ukraine held parliamentary elections. While the overall results were not unexpected, they produced a major setback for the Communists and arguably paint a tougher picture for President Kuchma's remaining year in office.

The party, For a United Ukraine (ZYU), dominated by corporate interests and loyalists to Kuchma, won 12% of the vote. However, following the results of single-seat, first-past-the-post constituencies, it forged past the two largest vote getters, the Communists and the party, Our Ukraine, which secured 20% and 24%, respectively. Of the Verkhovna Rada's (the parliament) 450 seats, half were chosen by proportional representation with the other half decided after tough regional battles. Direct contests were overwhelmingly won by ZYU, primarily at the expense of Communist candidates. As a result, the new parliament will contain 119 seats occupied by ZYU, while Our Ukraine will hold 112 seats. The Communists, the largest party in parliament for the past decade, will now only have 66 seats. The remaining winning parties, also strongly anti-Kuchma, are relatively small and are expected to join or support the ZYU. Despite the large contingent of western observers, many contend that the election was still marred by suspicious activities.

The Communists dominated parliament from independence until January 2000 when a peaceful coup by centrists and some right-wingers expelled them from key legislative committees. A former central bank governor, Viktor Yushchenko, was then endorsed as prime minister. However, he was voted out of office in April 2001 by legislators loyal to Kuchma and the Communists who feared that he had greatly diminished their deep-rooted influential standings.

Yuschenko has attracted centrist forces with strongholds in the east and central regions, whereby the right-wingers' power base lies in Kiev and the nationalist western part of the nation. However, the majority of election swing votes come from the heavily populated and more ethnically mixed eastern part of the country. Yuschenko's base, Our Ukraine, is comprised of a group of ten small parties, separated by ideological and regional differences, but unified by his strong popularity and standing for honesty in a nation rife with corruption. The parties within the middle of the political field arguably create the most threats to democracy. Formed by the ruling elite that rose from the ruins of the Soviet state, the right created corrupt regional clans and bureaucratic Kiev groups that reportedly give strong loyalty to Kuchma to uphold democratic and market reforms. However, like similar political parties in other transition states, recent examples show that the right's actions arguably differ from their rhetoric. The clans' conflicting interests continue to make it tougher for coalitions to unite and place Ukraine's fledging democratic ideals on credible ground. Democracy has arguably been threatened in many rural areas as larger cities are becoming more and more depopulated, the result of poor economic conditions. Although the president is empowered to choose a prime minister following a parliamentary election, in light of the present tricky environment, Kuchma is expected to retain Anatoly Kinakh. Thus, at present, any hopes for a straight path toward democracy arguably continue to rest with Yushchenko, who now is undoubtedly thinking ahead to unseat Kuchma in next year's presidential election.

A new IMF survey reports that the economy performed well in 2001 with a 9% rise in GDP following a rise of 6% in 2000. However, the majority of the reported economic gains were short-term in nature and derived from traditional sectors, especially agriculture (following a lessening of certain government controls) and industrial production. However, very good progress was made in taming inflation, helped in part by a more stable exchange rate. External debt burdens were eased with a new Paris Club rescheduling agreement reached last July. Although on the surface gains were achieved, significant progress is still required in many areas. Structural reforms, including additional privatizations, continued reforms within the banking system, and a clean up of overdue pension arrears all must be achieved long before Ukraine arguably would have any hopes to eventually join the WTO. The IMF and World Bank forecast GDP growth this year in the range of 4-6%. Further positive developments could lead to a second programmatic adjustment loan.

In late May, officials declared that they began the process to seek membership in NATO and the notice would be formalized on July 9th during a visit of NATO dignitaries. It is obviously too soon for a membership target date to be set since Ukraine needs to bring the economy, the democratic process, and human rights record up to international standards. Following independence from the Soviet Union in 1991, Ukraine's relations with NATO had reportedly irritated Russia. However, now with Russia's own NATO agreement, both nations may have reached reconciliation on international security issues, especially in the defeat of global terrorism.

The road toward democracy will be very bumpy and given the ongoing interesting diplomatic developments between Russia and the U.S., we believe developments within Ukraine bear watching.

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Emerging Market Briefs

By Scott B. MacDonald

Brazil - Trade Ahead!: Despite political concerns raised by polls over the lead of leftist Igancio da Silva for October 2002's presidential contest, Brazil's macroeconomic numbers continue to be relatively strong. The trade surplus for April was $481 million (from exports of $4.641 billion and imports of $4.160 billion), bringing the annual total to $1.508 billion, compared to a deficit of $561 million last year over the same period. Trade is likely to remain strong until September or October, based on seasonably-conditioned exports.

Chile - Economic and Political Cooperation Agreement with the EU Advances: On April 26, Chile and the European Union (EU) announced they had reached consensus in all matters for the Economic and Political Cooperation Agreement, which they have been negotiating for the past 18 months. This is an important development for Chile as the EU is the main destination for its exports, reaching $4.6 billion in 2001. Under the agreement, there is a progressive and reciprocal liberalization of access to markets including goods, services and government procurement. The liberalization of more than 90% of their trade of goods, services and investment was obtained for a term no longer than eight years beginning from the date of entry into the agreement. It will enter into force once the European Parliament and the Chilean Congress approve it.

East Timor - New Country, New President: In April 2002 East Timor went to the polls for the first time to elect a president. Although it was not much of a contest, with former guerrilla leader Xanana Gusmao won over 80 percent of the vote. The election is highly significant as it provides a degree of legitimacy to the new state, reinforcing the idea of democracy and civil society, and providing the local population with its own leadership as opposed to rule by the international community. Although one election does not make a democracy -- nor does it necessarily result in good governance -- it is an important step forward for one of the world's newest nations. One thing that could be a big boost to the world's newest state is natural gas. East Timor sits on some of the world's largest newfound supplies of natural gas. With a small population and an effort to tap these resources, East Timor could find itself a prosperous nation in a few years. A little bit of money, if properly managed, could make East Timor's democracy even stronger. If could also lead to massive corruption. If nothing else, East Timor faces interesting times ahead.

Ecuador - Good Numbers for 2001: In the late 1990s, Ecuador became the butt of many a joke concerning the lack of a political class to govern the country and manage the economy. That was then and this is now. In 2001, real GDP rose by 5.6%, well ahead of 2000's 2.3%. It was one the fastest levels in Latin America. The strong rate of growth was due to strong domestic demand, government investment and relatively high oil prices. Growth in 2002 is expected to remain strong with the Central Bank looking at 4.0-4.5% real GDP expansion. Helping to maintain strong growth is the new pipeline being financed by the government, which is expected to by completed in mid-2003.

Indonesia: Moody's raised its rating outlook to positive from stable on its B3 rating. The agency cited the recent Paris Club agreement, improved relations with official creditors and the progress made so far in key policies, including cuts in fuel subsidies, IBRA's asset sales (particularly the BCA sale) and adequate FX reserves. A ratings increase will depend on continued progress in these areas within the overall context of political and social stability

Korea - Telecoms on the Move: South Korea's Ministry of Information and Communication ordered the mobile network companies to lower interconnection fees. Overall, numbers were slightly more negative than expected for SKT, and slightly more positive than expected for LGT (and relatively neutral for KTF). Over the past few trading days the market has generally absorbed this information. Korea Thrunet said it will bid for a stake in Powercomm Co. when the government seeks to sell part of the company for a second time. Lehman Brothers commented on this statement, noting "Thrunet still needs a financial backer to take part in the bidding as its stake in Powercomm will likely be limited."

In related news, the South Korean government announced it will seek to sell its entire 28.36% stake in Korea Telecom (88.57m shares) on May 17-18 in a final bid to privatize. The authorities will offer 14.53% of KT's shares to various local investors (of which about 5.7% will be available to company employees), 2% will be placed with local institutions, 1.83% with individual investors, and 5% with an unnamed strategic alliance partner. The remaining 13.83% - will be offered to local investors in the form of exchangeable bonds.

Russia - Climbing Up: In early May 2002 Fitch upgraded Russia from B+ to BB-, reflecting a steady improvement in economic policy and the economy. The key factor for the upgrade is the expectation that Russia will have the ability to make its external debt payments in full in 2002, regardless of oil prices. Fitch has given Russia a positive outlook. Attention now turns to Standard & Poor's, which rates the country B+ and has had a positive outlook since February 2002.

Thailand - New Budget: Prime Minister Thaksin Shinawatra has directed the Finance Ministry to increase investment items in the fiscal 2003 budget by 30 billion baht to support economic recovery. The 2003 Budget Act is under revision by the Finance Ministry, the Budget Bureau and other associated agencies. Various spending projects worth some eight billion baht have already been cut or delayed to free up funds for new investment. Another 10 billion baht is expected to be realized through budget changes for local administrations and agencies, allocating a total of 81.1 billion under the 2003 fiscal budget. Of the budget, 10 billion baht has been allocated without any supporting projects. Sources said the government was also looking to shift funds from the 40 billion baht in revenues gained in value-added tax collected for local administrations but as yet unallocated for specific projects. Government officials have complained the practice by the Budget Bureau to allocate funds without any particular spending purpose limited financing for key policy programs. The fiscal 2003 budget projects a deficit of 174 billion baht, or 3 percent of gross domestic product, representing Thailand's seventh consecutive year of budget deficits. The 2003 budget, which starts in October, currently projects expenditures of 999.9 billion baht, with 21 percent dedicated to new investment.

Vietnam - Coming to Market?: While many Asian nations have made access to international capital markets an almost routine event, Vietnam has lagged behind. It now appears the Southeast Asia nation is going to issue an international bond, possibly up to $500 million. In the mid-1990s, Vietnam had considered a bond issue, but the reform process slowed to a snail's pace and the 1997-98 Asian financial crisis left international investors shy of sovereign bonds from the region. Vietnam has restarted the economic reform process, is working closely with the IMF and World Bank, and Asian bonds are back in vogue with international investors. With a B1 rating from Moodys and new ratings coming from Standard & Poor's and Fitch later in the year, Vietnam is moving toward issuing debt. Much will depend on the pace of reforms, how much debt the IMF and other donors are comfortable with and market conditions later in 2002.

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Book Reviews

Scott B. MacDonald and Albert L. Gastmann, A History of Credit and Power in the Western World, (New Brunswick, N.J., and London, Transaction Publishers, 2001), 314 pp., $39.95

Reviewed by Robert Windorf

Click here to purchase "A History of Credit and Power in the Western World" directly from Amazon.com

Amidst the numerous concerns and questions about the state and direction of today's global economy, author and KWR International Advisor editor and analyst Scott B. MacDonald and Professor Albert Gastmann's timely book presents a very fine historical analysis of the often forgotten relationship between credit and power. While eminent historians such as Simon Schama and Fernand Braudel's numerous volumes on economic history cover much of the same material presented in the early sections of this book, MacDonald and Gastmann concisely and effectively tell the story of the importance of credit from its documented origin found within the Code of Hammurabi (1726 B.C.) continuing with its development and usages throughout the ages all the way to today's global financial and trade centers. Without credit, they insist, power would not exist.

In their detailed analysis, the authors argue that six major themes exist at the core of the relationship between the nation-state and credit surrounding the issue of power and how it continues to evolve over time. Those themes are: 1) Wealth represented by credit augments political power; 2) Different kinds of political power promote different kinds of economic behavior; 3) Throughout much of credit's development, certain societal groups were able to embrace the dynamics of the relationship between credit and trade in a much more holistic way than others (especially seen in the historical economic successes of the Jews, Italians, Dutch, English, and Americans); 4) The Western credit system evolved in tandem with the development of the nation-state; 5) The development of the global credit system occurred with considerable volatility; and, 6) Over time, the spread of credit, originally the privilege of the wealthy and the powerful, has become available to vast numbers of North Americans, Japanese, and Europeans. (While the final theme ignores the fact that other global regions' citizens now also enjoy credit access, it is believed the authors meant to emphasize that the nationalities mentioned far outpace others in that respect.)

The authors present numerous historical examples of the relationship between credit and power, concentrating initially on the rise and fall of early empires and their trading prowess via the development of and their access to credit sources. Naturally, credit influenced numerous monarchs' legitimacies and fueled Europe's industrial development and trade and later led to the exploration of the new world. Throughout trade history, city-states (original models for the later day nation-states) rose to fame as centers of credit, trade, and power. They subsequently fell, replaced by those that became even stronger, often following military conflicts, while other times as new trade routes became more prominent. Rome gave way to Milan, which was overtaken by Amsterdam that led to the rise of London and the eventual succession of New York as the center of global trade and finance. However, today, some may speculate that with the rising prominence of the European Union, Frankfurt could eventually assume New York's global credit role.

Also included in MacDonald and Gastmann's analysis is a detailed view of how the omnipotent culture of modern consumerism (originally a phenomenon in the U.S.) created a steady demand for credit and ultimately stimulated financial innovation leading to the formation of today's global financial industry and its myriad of retail and wholesale investment products. The founders of the Dutch East India Trading Company could have never imagined that a future Hong Kong housewife would be able to obtain a credit card from the Vancouver office of a Mexican bank!

After a long historical journey, the authors bring the reader up to the present day with a powerful concluding chapter that focuses on the role of credit and power amidst the growing presence of globalization. They correctly argue that the nation-state, once a key force in the development of the global credit system and the provider of the rule of law inspiring confidence in the free flow of credit, has seen its power eroded in two major ways. As viewed over the past few years, it is becoming exceedingly challenging for nation-states and regulatory institutions to control global capital flows; and, such a phenomena that gave rise to the information technology economy has now consequently empowered forces that increasingly diminish the role of the nation-state. Additionally, the tragic events of last September chillingly remind us of the 'power' that terrorist organizations today may hold as financed by their rather easy access to credit within the international credit and funds transfer system.

MacDonald and Gastmann's very fine book could not have come at a better time to explain the important historical symbiotic relationship between power and credit. It would be invaluable to anyone who seeks a better understanding of the financial markets' reactions to historical and current global political and economic events.

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© 2002 KWR International, Inc. This document is for information purposes only. No part of this document may be reproduced in any manner without the permission of KWR International, Inc. Although the statements of fact have been obtained from and are based upon sources that KWR believes reliable, we do not guarantee their accuracy, and any such information may be incomplete. All opinions and estimates included in this report are subject to change without notice. This report is for informational purposes and is not intended as an offer or solicitation with respect to the purchase or sale of any security.