U.S. Corporate Bond Market – Uncertain Times

By Scott B. MacDonald

We remain constructive about the rest of the year for the corporate bond market, though there are many uncertainties - the possibility of another terrorist attack, the potential for a U.S. war against Iraq, and a double-dip recession. Another al-Qaeda terrorist attack on U.S. soil would be a blow to confidence, while it is difficult to quantify the impact of a U.S. war against Iraq. A double-dip recession would obviously be a big negative. Although we do not rule out a double dip recession, we expect the U.S. economy to muddle through. The combination of auto sales, mortgage refinancing, and housing, plus one more Fed interest rate cut, will allow the economy to slide by at around 2.5% for 2002. That stated, we still expect investors to remain very sensitive to any negative news on the economy and to remain focused on corporate earnings (in late September and October for Q3). The equity market will continue to be exceedingly volatile, with seismic-like daily shifts.

Much depends on restoring investor confidence. In August, when we enjoyed a short-lived equity market rally, the corporate bond market saw spread tightening and new issuance. During the third week of August, 28 issuers came forward and brought $16.36 billion in bonds to market, the largest weekly number since March 2002's $26.9 billion. While some economic numbers helped nudge the rally, there was also a sense of relief that most major companies made it through the August 14th CEO and CFO earnings accountability signings without major problems. Indeed, the corporate governance issue, barring any new scandals, is likely to fade as a concern.

It is estimated that potential new investment grade corporate bond issuance for the remaining months of 2002 could be between $90-$100 billion, at least part of which comes from the need to refinance as debt comes due. The next major trigger for the corporate bond market is likely to be Q3 corporate earnings, which start in late September. As corporate governance issues fade, attention will return to more fundamental credit concerns about profitability, debt management, and liquidity. Related to this is the pace of the economy. Most economists are looking for real GDP growth in Q3 in excess of 3%, followed a slower pace in Q4. That could help provide some traction for better corporate earnings through the end of the year. However, there remains considerable nervousness in corporate America and most managers are still looking to trim capital spending -- not increase it. The earnings announcements of the large brokerages, such as Morgan Stanley, thus far have not set a positive tone. JPMorgan Chase's problems, including ratings downgrades, have not helped.

It should also be understood that the drop in U.S. unemployment from 5.9% to 5.7% was largely due to job creation in government, while manufacturing actual had a drop in employment. As we see consumer demand remaining in positive territory, the most likely outcome is that the economy on a whole will not get much worse, but it will not get much better. The same can be said for the corporate bond market.

Interview with Korea's Leading Venture Capitalist:
Mr. Ki-Woong Baek, CEO of KTBnetwork

View the Interview IN KOREAN

By Keith W. Rabin

In this issue the KWR International Advisor interviews Mr. Ki-Woong Baek, CEO of KTBnetwork (KTB), Korea's oldest and largest venture capital firm. KTB possesses a twenty-year history, 20% market share and a record of about 1,000 investments and 170 public offerings on the KSE, KOSDAQ and NASDAQ stock exchanges.
Mr. Baek is a leading figure in the Korean venture industry, having engineered many substantial transactions since joining KTB in 1999. This includes eBay's majority investment in Korea's leading cyber-auction house Internet Auction Co. Ltd. in a deal valued at approximately $120 million . Rising to the CEO position in only two and a half years, Mr. Baek joined KTB after a distinguished career as a senior manager at the Hyundai Group and SK Telecom. In this capacity he developed the marketing, planning, financing, and other management skills that have helped him gain one of the most enviable investment records in this emerging sector. Mr. Baek holds a Bachelor of Science degree in Mechanical Engineering from Hanyang University in Seoul, Korea. Mr. Baek has graciously agreed to the following interview with Mr. Keith W. Rabin, publisher of the KWR International Advisor.

KR:

KTBnetwork is Korea's largest Venture Capital company. Can you tell us more about your organization and personnel as well as the emerging venture phenomenon in Korea? How has your organization and venture investment in Korea evolved over the past two decades?

KB:

Most venture companies have suffered over the past two years and we are no exception. Given our financial strength, however, we are using this time to refocus and renew our competitiveness. To facilitate this process, we began working with Bain & Company, a renowned management-consulting firm, last year. The vision that we developed will help KTB to diversify its investment focus and to advance our operations beyond Korea. Our goal is to establish a leading global investment firm by the end of this decade. To achieve this vision, we are actively improving our core capabilities in venture capital and corporate restructuring, while expanding the entertainment and overseas facets of our business. As a result, KTB registered to become the first Corporate Restructuring Company (CRC) in Korea. We are currently the most robust company – domestic or foreign -- in this sector with a number one market position. Since entering this field as a pioneer in 1999, we have assembled a team of top-tier experts, building an excellent market reputation and abundant capital -- totaling 43% of total corporate restructuring funds in Korea. As the undisputed leader, we have, as of the end of last year, invested 336 billion won in 34 companies. This includes positions in StarCo, Wise Control, Samhan and Kumkang Industrial, which emerged from bankruptcy or court receivership status and Curitel, Korea PTG, Dongshin Pharmacy and Samsung Pharmacy, which are rapidly moving to normalize their operations. While the Korean restructuring business is at most three years old, we have made substantial progress and look forward to realizing considerable profits in this sector during the latter half of this year. By introducing this value-oriented and restructuring component to our business we seek to differentiate ourselves from firms such as Softbank and CMGI who retain their primary focus on technology. This will help to stabilize our profitability and revenue flow. I would add, however, that venture capital is a business that bets on the future. Therefore, there will always be an element of uncertainty in what we do. The current market environment exacerbates these inherent difficulties yet I am certain we will overcome these problems and emerge even stronger in the end. READ THE REST OF THE INTERVIEW

Buyside Magazine reaches active institutional investors monthly with news and analysis of the equities markets. Buyside takes readers beyond news of the current business climate to report industry and market trends that are crucial for investors to understand -- not simply the latest business trends or product releases. Buyside and BuysideCanada are available in print, and online at www.buyside.com. Subscriber information is available on Buyside's home page.

By Keith W. Rabin & Scott B. MacDonald

In the face of massive stock market volatility, wealth erosion and concern over almost accounting and corporate governance scandals, there is considerable discussion about the need to cull the few "bad apples" that are giving U.S. business a bad name.

Many analysts and television talking heads note that Main Street is demanding the culprits be apprehended and made to do hard time. Congress has been busy passing legislation to deal with corporate sleaze. This thinking reflects the common perception that most corporations are managed by honest people and that the main task at hand is to root out the egregious examples of fraud that are shattering investor confidence. Then, it is believed, market concern can be alleviated and U.S. firms can return to what they do best - make profits. With U.S. business refocused on profits (as well as better corporate governance), the economic recovery will be assured, the stock market will go back up, and the American public will regain lost confidence in buying securities.
While it is true that most managers are honest and indeed critical to make examples of executives who commit criminal fraud, this type of thinking misses the boat. Yes, the outright deception that characterized the Enron, WorldCom, Tyco and other debacles are special cases, but the late 1990s tendency to engage in highly aggressive accounting practices was highly pervasive -- even though most firms remained within the lines of ethical corporate behavior. It should be remembered that following the Arthur Andersen debacle, there are now 2,400 ex-Andersen accounts forced to reexamine everything that was reported over the last several years. This will have a negative effect on earnings moving forward. It is probable that at the very least a number of firms will have to restate earnings - not a good signal to an already highly sensitive bear market. Therefore, one might view the current paradigm as more similar to exposing the tip of the iceberg than the need to clean out a few bad apples.

As the late 1990s Internet boom accelerated, traditional rules of business behavior and corporate valuation were eroded. In the land grab that characterized this era, growth of market share was seen by many to be more important than profitability. Many concluded it was better to invest in new, speculative firms who had little more than a business plan and venture capital funding. These enterprises enjoyed massive capital inflows without the need to endure the analytical rigors and performance expectations imposed upon companies with real revenues and operating histories. Emerging firms such as Amazon, eBay and eToys quickly amassed market capitalizations that were larger than many Fortune 50 corporations.

To remain competitive, established firms turned to high-octane financial engineers. As if by magic, they transformed balance sheets and income statements in a manner that delivered the progressively improving performance demanded by the financial community. Two exemplars of this trend, Andrew Fastow of Enron and Scott Sullivan of WorldCom, were lionized for their achievements and recognized as being in the forefront of business finance. Each received "Best CFOs" ratings in annual competitions by CFO Magazine. Corporate finance managers recognized this change in sentiment and adapted their institutional values accordingly. The message was clear. CFOs and controllers who wanted to get ahead adopted an aggressive stance. Those that maintained a conservative posture were viewed as old-fashioned relics of the past.

Today, we are presented with a very different dynamic. Many of the practices seen as highly clever and cutting edge only a year or two ago are now viewed as scandalous. Good, conservative accounting practices, which could likely have been grounds for dismissal in 1997-2000, are now seen as desirable virtues. Corporate behavior is beginning to reflect this new reality. This in essence is what is so troubling about the current "bad apple" debate, which maintains that once the few fragrantly fraudulent offenders are rooted out, the "silent majority" of good, honorable companies can regain the valuations they deserve. Matters are not so black and white nor is it a case of good versus evil.

Accounting is far more art than science. As anyone who has engaged in the preparation of complex financial statements can observe, numerous subjective judgements are required as to how to classify and treat each and every item. President Bush acknowledged this phenomenon in a press conference. When asked about Harken Energy, he noted something to the effect "in the corporate world, not everything is black and white and sometimes there are honest disagreements on how to account for complex transactions."

As the smell test of what is normal and ethical shifts from overly aggressive to even mildly conservative, it will have profound implications on the standards that govern audits and the behavior of corporate finance professionals. Most corporations - whether or not they have engaged in any fraudulent behavior -- will be far more reserved in their accounting and corporate profitability will inevitably suffer as a result. This represents an obstacle that has not been sufficiently recognized or factored into the expectations of many analysts and investors.

It therefore does not seem realistic to imagine that even if the U.S. could show dramatic 2002 GDP growth beyond the 2-3% anticipated by most economists, that we will see the earnings revisions that will lead to the rapid upwards valuations needed to lift share prices.

Far more likely is a continuation of the current scenario, in which we continue to slowly work off the excesses of the dot.com era. Real growth and achievements will be masked by a continual procession of announcements concerning accounting and other irregularities - not to mention the major uncertainties caused by the continuing war on terrorism. In the end corporate America will emerge all the stronger. However, a belief that we simply have to uncover all the "bad apples" to rectify all that is wrong with the current market environment will only delay the ultimate resolution of these important issues.

Why Hasn't China's Income Grown as
Fast as its Output?

By C.H. Kwan, Senior Fellow, Research Institute of Economy, Trade and Industry (RIETI), Tokyo

Technological innovation in recent years in the form of modularization has brought drastic changes to the pattern of division of labor among companies, as well as among nations. Multinationals have been relocating their low value-added production processes to developing countries in pursuit of lower cost. China has taken this opportunity to establish itself as a major production base for multinationals. The fast pace of industrialization, however, has not been accompanied by a rapid increase in China's national income in dollar terms, as it have been forced to sell at lower and lower prices in international markets.

Modularization is to decompose industrial processes into segments, or modules. In the case of personal computers, for instance, respective modules such as a hard disk and a display are first produced separately, and then integrated into a complete system. In an industry where this modularity concept is widely applied, there exist established design rules and standards concerning the construction of respective modules. At the same time, modularization also provides flexibility to accommodate new methods of production within these rules. Processes within each module are independent from each other, neither affecting nor being affected by processes in other modules. This makes it far easier to place orders with different companies to undertake different production processes, or to become specialized in the production of a specific module.

Thanks to modularization of production, in many industries, the profitability at various stages of production has come to follow a U-shaped curve – high at the upstream and downstream processes and low at the midstream processes (Figure 1). Stan Shih, Chairman of Taiwan-based Acer Inc., is said to have first coined the term "smiling curve" to describe this phenomenon. Regarding personal computers, for example, value added is high at the upstream, which includes the development of operating systems (OS) and central processing units (CPU), and at the downstream, which includes maintenance services. Profitability is lowest in the midstream process, which involves such labor-intensive processes as assembly.

Modularization eliminates the need for a company to keep all the production processes in a single place or within the same company. Today, it is far more efficient to decompose production into a number of processes linked through a network of suppliers. Indeed, corporate and industrial reorganization has been taking place in a way that shifts away from the conventional integrated production system – typically from raw materials to finished products – to one concentrating resources on a specific area of strength. Likewise, business relations between companies are no longer limited to trade and capital participation, but also include such diversified forms as technology tie-ups and original equipment manufacturer (OEM) contracts.

Along with the progress in trade and investment liberalization in developing countries, inter- as well as intra-company production networks have become increasingly globalized. In accordance with respective countries' comparative advantages, labor-intensive processes tend to concentrate in developing countries that offer low wages, whereas high-tech processes, such as research and development (R&D), are undertaken by developed countries. As a result, there have been growing flows of trade in manufactured goods – especially of parts and intermediate goods – between developed and developing countries. This phenomenon has been called the "horizontal division of labor," as such exchanges are being made within the same industry. It had better be termed "vertical division of labor," however, given the way that processes are being divided between developed and developing countries respectively, with the former concentrating on high value-added and the latter on low value-added processes.

Against this backdrop, China has been taking advantage of its cheap and abundant labor to attract direct investment by multinationals, thereby accelerating the pace of industrial development. Exports of manufactured goods have increased sharply in recent years to account for 90 percent of China's overall exports in 2001. Processing trade, which represents roughly half the overall trade of China, has come to play a more important role in the Chinese economy. With its share of the world's manufactured exports rising, China has been widely recognized as the "factory of the world."

In terms of the smiling curve, however, the segment accessible to China (as well as other developing countries) is largely limited to the part around the tip of the chin, i.e., fields where value added is the lowest. Until the 1970s, as a newly industrializing country, Japan was fortunate that it did not have to compete with low-wage countries because manufacturing was highly concentrated in the industrial countries. Following the end of the Cold War and the integration of the former socialist countries into the global economy, however, cheap labor has become more readily available, and developing countries have been watching their profits fall amid intensifying competition. The smiling curve is thus getting steeper and steeper. For China, this means a decrease in the relative price of the labor services it provides against advanced technologies imported from developed countries, and a worsening of its terms of trade. In the sense that an increase in production has not necessarily led to an increase in real income, China is trapped in a grave situation of immiserizing growth. To set itself free from this trap to become a developed country, China must promote development focusing on the two ends of the smiling curve. But for this, improving the stock of human capital is vital, and China has a long way to go.

Figure 1. The Smiling Curve

Reference:
Aoki Masahiko and Ando Haruhiko. Mojuruka: Atarashii Sangyo Akitekucha no Honshitsu (Modularity: The Nature of New Industrial Architecture), RIETI Economic Policy Review 4, Toyo-Keizai Shimposha 2002

Related story: "Don't Confuse ‘Made in China' with ‘Made by China,'" C.H. Kwan, China in Transition, April 26, 2002 http://www.rieti.go.jp/en/china/index.html

Since the "Asian Financial Crisis" of 1997-98, South Korea has made the greatest tangible effort to restructure its financial services industry, reform its Chaebols, and improve public policy making. The leading international credit rating agencies have taken notice, and have raised the nation's sovereign credit rating to A3 (Moody's) and A- (Standard and Poor's). This is the highest rating of any of the Asian nations most affected by the financial crisis four years ago. It also reflects the fact that Korea has now graduated from the ranks of the "emerging markets" to "developed" economy status. This is not to suggest that there is not more work to be done. Inefficiencies remain in the financial, economic and political system. But the progress made thus far has been admirable.

Looking forward to the final months of 2002, we expect Korean economic growth to slow but to remain fundamentally healthy. Exports are poised to continue demonstrating strength, having increased by 19.9% year-on-year in July and August 2002. Furthermore, Korea's solid external balance sheet is reinforced by its strong net foreign asset position of US $44.3 billion in July. Government finances are stable and in balance. The annualized fiscal surplus is currently at about 2% of GDP, and surveys of leading financial economists reveal that the Korean budget surplus is likely to be in the 1.4% range in FY 2002. At this time, inflation is not a serious worry. The core CPI was up by 2.8% in August 2002, and has been consistent throughout the year.

To the extent that there is reduced economic activity in 2003, it will likely be due to global weakness rather than any general stagnation in the Korean economy. Domestic demand was down from the torrid pace of the first quarter of 2002. We expect Korean growth of about 6% in FY 2002 and 5.6% in FY 2003. It was 6.3% in August. Under current economic circumstances, this is quite robust for an industrialized nation.

Furthermore, the government is cutting back on its economy-boosting infrastructure spending, such as for roads and other civil engineering projects, as the economy improves. Government spending rose 4.9% in the second quarter of 2002, compared with 5.5% in the first quarter.

There are obvious challenges to the Korean economy of course. On the political front, the December presidential election is too close to call between three viable candidates. Furthermore, relations between North Korea and South Korea, although much warmer of late, will remain unpredictable for the foreseeable future.

It should also be noted that some analysts have suggested that if oil prices spike up due to a potential invasion of Iraq and the consequent turmoil that might follow, a big "if", then Korea's current account could be pushed into a deficit of –1.0% of GDP in 2003. This is because as oil imports increase and exports weaken, global growth could soften. Higher oil prices would effect Korean domestic consumption, production costs, and net exports such that GDP growth in 2003 could deteriorate by 0.8% in 2003. In addition, the balance of payments surplus that allowed Korea to accumulate $116 billion in foreign exchange reserves could fall. But we are not forecasting dramatic increases in oil prices for the foreseeable future. This is because it is most unclear at this time that there will be an invasion and, even if there is, it is also the case that Iraq exports only a fraction of the oil that it did before sanctions were imposed.

So Korea remains one of the best economic stories in Asia. Unemployment remains relatively low at 3.0%. Also, Korea has developed a consumer culture that was absent before the crisis. Credit cards are used everywhere and consumer debt is increasing at a pace typical of OECD levels. But Korea's high savings rate (32.4% in 2000), its strong household balance sheets, and the resilient underlying economy suggest little reason for concern about the sustainability of the debt.

In addition, the nations' financial institutions continue to improve their balance sheets, although much work remains to be done in this regard. Non-performing assets have been substantially reduced though sales, write-downs and restructurings. Overall, capital at the nation's banks has risen 22% since 1998 and non-performing loans have dropped to just 4.1% of total loans (down from an "official" peak of 18% of loans in 1998 and an "estimated" peak of 25%).

We are confident that barring global calamity, Korea will remain an economic powerhouse in Asia. In fact, since the end of the financial crisis, investors have been amply rewarded for their confidence in the Korean credit.

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TRADE TRIALS: Supachai Panitchpakdi and the new WTO

By Jonathan Hopfner

When former deputy prime minister of Thailand Supachai Panitchpakdi succeeded Mike Moore as the director-general of the World Trade Organization (WTO) in September, he carried the hopes of much of the developed world with him. As the organization's first leader from Asia and from a developing country, many non-industrialized nations are confident that Panitchpakdi will ensure their interests are better represented on the global stage.

Judging from Panitchpakdi's conduct so far, these hopes seem well founded. Both before and after assuming his new post, the director-general has continuously emphasized the need for the WTO to be more responsive to the demands of its poorer members. At a conference on global trade held at the United Nations' regional headquarters in Bangkok in mid-July, he warned that the failure of past global trade rounds to address the issues crucial to developing countries – such as the continued refusal of wealthier members to open up their markets to agricultural and textile imports – risked alienating many Asian and African nations. He called on the world's economic powers to bring "much-needed concessions to the negotiating table" at future trade meetings. In addition, he has publicly mulled the idea of establishing a WTO representative office in the heart of the developing world, most likely Africa, as many WTO countries lack the resources to operate permanent missions in the organization's current headquarters of Geneva. This severely dampens their ability to participate fully in everyday trade negotiations.

Conscious of the WTO's image as a force that seems answerable to no one, Panitchpakdi has pledged to increase the organization's accountability by boosting its cooperation with local governments, non-governmental organizations and the public. This, he stated at the conference, would "create more understanding" regarding the WTO and its raison d'etre. He has also expressed a determination to overhaul the WTO's complex – and frequently bogged-down – dispute resolution processes, by making litigation more difficult for members to initiate. "We need to emphasize that developing countries should be helped more than in the past and that the process of dispute settlement is conducted in such a way to postpone litigation as long as possible – litigation is too costly. We must find other options," he told participants in the Bangkok conference.

While Panitchpakdi's sentiments are clearly noble – and provide good reason for developing nations to celebrate – the realities of his new position are somewhat less encouraging. The foremost pressure on the new director-general is time; bickering over who would take the WTO's top post led members in 1999 to split the six-year term between Panitchpakdi and his predecessor, Moore. This gives him only three years to bring much-needed change to the corridors of power in Geneva.

Even before his three years are up, Panitchpakdi faces a more pressing deadline. At talks in Doha, Quatar, last November, WTO members agreed to conclude the next round of trade negotiations by 2004. As the organization's leader, Pantichpakdi's primary task is to push the WTO countries to wrap up these talks ahead of the deadline, a task that is almost certain to be an uphill battle. The negotiations span an unprecedented range of topics and issues. Nearly all of them are contentious, including the liberalization of trade in services and the establishment of international rules governing intellectual property, competition, and countries' biological resources.

Recent unilateral moves by the WTO's more powerful members will likely make future trade talks even more trying. The US has demonstrated its resistance to compromise by passing a bill that grants massive subsidies to domestic farmers and imposing tariffs on a variety of imported steel products, angering many developing countries in the process. In addition, the various members of the WTO can by no means be grouped into clear-cut "developed" and "developing" camps. Even nations of similar economic status often find themselves at loggerheads, as demonstrated by the European Union's WTO-sanctioned decision in September to levy $4 billion of tariffs against American products as retribution for a US foreign-sales tax break. Despite the WTO's promise to focus the next round of trade talks on poor countries, high-profile cases like these show it is economically powerful nations that are once again poised to top the agenda. Though he appears to be facing formidable obstacles, Panitchpakdi has spared no effort to emphasize his confidence that the talks will proceed on schedule. "It is sometimes arduous in pursuing negotiations, but we'll meet the deadline as best as possible," he said in Bangkok. "I'm optimistic we'll be on track."

Crucially, Panitchpakdi seems to have realized that his position itself is a delicate balancing act. His leadership has been championed for so long by developing countries, it is only natural that the WTO's industrialized members would view him with some degree of suspicion, a fact that he seems to have taken into account. Though he has called for developed nations to make room for further imports in their markets, he has been equally critical of poorer nations, many of which have established protectionist barriers of their own. And his views that the WTO needs to streamline some of its inner processes could hardly be contested by members on any side of the political divide.

Thus far, Panitchpakdi has demonstrated foresight, a keen perception and diplomatic savvy. Though it remains to be seen if his tenure will bring about the much-needed change so many voices – from both within and outside the WTO – are calling for, the proposals he has put forward seem to bode well for the future. Even the implementation of one of the initiatives he has discussed – the establishment of a WTO office in Africa, for example – would go a long way toward convincing the WTO's critics that it has taken their concerns into account.

Cuba on the Mind: Foreign Investment Hurdles

By Scott B. MacDonald

Cuba has long held an attraction for U.S. business. Indeed, there is now an intense debate in the U.S. Congress over whether to abandon the U.S. economic embargo on the country, with the U.S. agricultural lobby pushing hard for the right to sell its goods to Cuba. Well before the break between the United States and Cuba following Fidel Castro's coming to power in 1959, American businessmen were highly active in the island-state. Since the 1960s, U.S. business has been almost entirely absent, forced to leave the field to the Europeans, Canadians, Japanese and other Caribbean and Latin American economies. Yet, for all the criticism U.S. policy toward Cuba has received, especially over the boycott on investing in the Caribbean nation, it is not been smooth sailing for the Europeans, Canadians and others. Indeed, Cuba has been a difficult business environment.

Foreign companies operating in Cuba contend with excessive red tape, lengthy negotiations with the government, and sometimes a lack of skilled talent. The European Union, the largest foreign investor, recently complained to the Cuban government about a lack of information on business laws and regulations as well as their discriminatory application vis-à-vis foreign firms. In addition, the EU indicated that its country's businesses operating in Cuba were forced to repeatedly renew visas and work permits, eating up valuable time.

Although the Cuban government became more flexible in terms of allowing foreign investment into the country during the crisis years of the 1980s, it remains opposed to the idea of privatization nor will it provide foreign investors access to much of the economy. Tourism, once a shining new sector that helped to generate badly needed foreign exchange, has slumped and investment which averaged $268 million over the last five years, trickled to a meager $38.9 million in 2001.

The E.U.'s official complaint was acknowledged by the Cuban government, which indicated it would seek to reduce red tape and shorten the length of negotiations between the local bureaucracy and foreign companies. These negotiations currently take about a year.

The Cuban government has another incentive for easing foreign business regulations. Considering that Cuba is largely dependent on external energy sources, it is actively courting foreign companies to invest more in offshore oil exploration. Some 59 exploration contracts in Cuba's 112,000-sq km section of the Gulf of Mexico have been put up for auction. As the London-based Latin American Caribbean & Central America Report (August 2002) commented: "By opening up its oil sector to joint ventures with foreign companies, Cuba has increased its oil production sixfold over the last decade, to the 3.4 m tones (27 m barrels) recorded last year. It is understandably keen to increase foreign investment."

Two other reasons for greater flexibility from Cuba exist – it badly needs foreign investment to diversify away from sugar and investment prospects would be enhanced if the U.S. ever ends the economic embargo. Economic diversification is critical considering that sugar prices have languished throughout 2002 and that Cuba's industry is not cost efficient. The government has embarked upon a plan to restructure the sugar industry by closing plants and cutting jobs. It is also promoting other forms of agriculture, both for export and domestic use. This too requires foreign investment.

Greatly complicating matters for Cuba's economic transformation, the Caribbean nation has a debt problem. Many of the same governments that have been willing to let their nationals trade and invest in Cuba have also provided trade finance. Most have found themselves out of pocket. Cuba earlier in the 1980s defaulted on its external debt. As Moody's noted in August 2002: "Faced with major financial difficulties, the government has fallen behind on its external financial obligations and has defaulted on short-term debts and supplier payments. The situation has forced several foreign creditors to roll over short-term debts or to reschedule financial obligations." The rating agency also commented that the attitudes of European governments and investors toward Cuba have "soured in recent years leading to a significant decline in foreign investment inflows, which fell to $39 million in 2001, compared with an annual average of $280 million during the previous five years."

In September, it was announced that the French government froze $175 million in short-term credit to Cuba after the Caribbean nation failed to repay an earlier loan. Other countries have indicated that Cuba is in arrears, including Japan (which it owes $1.7 billion), Argentina, Spain, and South Africa. Any new move to provide U.S. credit to finance trade to Cuba should consider the Cuban track record in repayment Consequently, while many U.S. companies look with envy upon their European, Japanese and Canadian counterparts conducting business in Cuba, they should be aware that the grass is not always greener on the other side.

Global Credit Solutions Limited provides a top-level service in the collection of commercial and consumer accounts, skip tracing, asset and fraud investigations and credit information on companies and individuals, globally. Visit them on the web at http://www.gcs-group.com or join their free monthly newsletter specially designed for credit professional and managers.

South Africa's Privatization Program: A Parting of the Ways?

By Scott B. MacDonald

Privatization is always a potentially contentious political issue. Any decision to sell state assets carries with it concerns over how such assets and the services they provide will be used. What kind of balance will be made between the public good and profits? This is clearly one of the key issues facing the government of President Thabo Mbeki of South Africa.

Since the apartheid era ended in the early 1990s, first the Mandela and then Mbeki government have followed prudent economic policies, including tight fiscal policies. As a result, the fiscal situation is well under control, stronger economic growth appears to be taking root, and inflation is low. Despite some tough challenges, the South African economy remains one of the powerhouses in Africa, with the best industrial infrastructure, most skilled work force and most sophisticated financial systems.

The soft underbelly for the South African economy is high unemployment (28.8% according to the IMF for 2001). Together with still considerable discrepancies between rich and poor, partially along racial lines, the issue of privatization is highly emotional in national politics. At the core of this issue is the question – will privatization entail greater unemployment as the private sector ownership seeks greater cost efficiency in a former public enterprise? The answer to this question has become a divisive issue between the ruling African National Congress (ANC) and two of its long-term allies in the struggle against apartheid – the South African Communist Party (SACP) and Cosatu, the country's largest labor federation.

The government's challenge is to maintain and strengthen economic growth, improve the standard of living and address social inequalities. To do this, it requires some degree of foreign investment. To attract foreign investment, the ANC has stepped away from its neo-Marxist roots and adopted a more pragmatic approach, part of which embraces privatization. Last year the government budgeted for $1.8 billion in privatization revenues, a clear sign that it expects to move forward on this issue. Although the process has been slow, the restructuring of public enterprises that was launched in 2000 is gaining momentum. Telkom, the state telecommunications company, is now expected to be divested by March 2003 and the restructuring of Denel, the state defense corporation, is well ahead of schedule.

Along side with the restructuring and sale of state enterprises (also referred to in South Africa as parastatals), amendments to the country's labor legislation are about to come into law. These entail more flexible work practices and streamlined arbitration and conciliation procedures. While such advances may win accolades from foreign investors, South Africa's private sector and the International Monetary Fund, they are becoming a bone of contention with the SACP and Cosatu, the latter of which has members in the government.

For the SACP and Cosatu, state-owned enterprises should be used to reverse the effects of apartheid by delivering affordable services to poor people. As a spokesman for the SACP stated in July: "The SACP calls for the retention of public ownership over parastatals and for them to be strongly aligned with functional government departments." The SACP is basically calling for the government to maintain control of large public corporations in order to redistribute the national wealth – or at least part of it. The Mbeki government raises the not inconsiderable issue of who will pay for it. The last thing South Africa needs is a substantial increase in state spending. Indeed, prudent fiscal policy has been a landmark of the two ANC administrations.

Cosatu is now threatening a two-day national strike in October to protest against possible job losses from privatization. In particular, the union accuses the government of having implemented macroeconomic policies that had destroyed employment and deepened poverty since 1994.

President Mbeki has responded to the attacks from SACP and Cosatu by maintaining his government's policies and in late July by pulling out of the opening address of the SACP annual conference. The snub was intentional and related to the growing contention over privatization.

The privatization issue is a clear reflection that South African politics are entering a new era. The old parties of apartheid have largely been dismantled, while the opposition parties operate on the margin, appealing to a limited segment of the white, colored and Asian populations. In contrast, the ANC has largely represented the majority black population. Although the ANC's roots were neo-Marxist, the party has steered a moderate and pragmatic course through difficult waters of the post-apartheid world. Despite many predictions that an ANC would be a disaster for the South African economy, the party of Mandela and Mbeki has pursued policies that are largely market-oriented.

Now, ideological differences are resurfacing within the ruling coalition, which could give rebirth to a right-left divide in South Africa, placing the majority of the ANC leadership on the center-right. The SACP and Cosatu are gradually evolving into a center-left opposition. The difficult task ahead is how the country's political elite will manage those differences ahead of the next elections in 2004. In the year ahead, there will be ongoing pressure to move back from privatization. This will be a critical test for the Mbeki government. If Mbeki postpones the Telekom privatization, the center-left will be emboldened to go for greater clout in economic policymaking and that in turn could jeopardize the ability of South Africa to continue along a moderate and prudent path to sustainable economic growth, aided in part by foreign investment.

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Questions over Russia's New Rapprochement with the West

By Sergei Blagov

In the wake of September 11, the US-Russian reinvented partnership has been heralded as an end to the Cold War Era. However, Moscow's recent overtures towards the "axis of evil" serves as an indication that Russia still faces immense challenges on the path toward integration with the West.

In recent years, the concept of "multi-polar world" has been Moscow's favorite mantra, designed to argue that the US should not be allowed to dominate the world as a single super power. However, in the wake of September 11 the Kremlin presumably came to realize that building a multi-polar world as a counterweight to US dominance has not really worked, while Iraqi or North Korean endorsements did little to sustain Russia's role as a world power.

In the wake of September 11 Russia has undertaken a series of friendly gestures towards the US. Last October, the Kremlin announced a shut down of its Cold War era military facilities, a spy radar station in Lourdes, Cuba and a naval base in Cam Ranh Bay, Vietnam to spare more money for the Russian armed forces.

Russia's initial opposition to the stationing of American military forces close to its borders in Central Asia made its neighboring Central Asian states reject the idea of letting American forces use their territories for their operation in Afghanistan. However, Russia eventually changed its position due to its interest in seeing the Taliban regime fall, as well as in expanding its ties with the US.

Russia's pro-Western course after September 11 quickly reaped major benefits for Russia. Notably, last May Russia and the US signed a legally binding treaty to reduce the two countries' long-range nuclear weapons by two-thirds and "liquidate the legacy of the Cold War." In recognition of Putin's help in the war on terror, the new NATO-Russia Council gave Moscow a role in drafting and implementing a number of joint policies.
Russia's new cooperative face secured U.S. backing for Moscow's efforts to join the World Trade Organization. Russia also received full membership in the G8 group of the most industrialized countries.

The US administration has visibly toned down its criticism of Russia's use of force in Chechnya. There has also been a talk of revoking the main economic sanction against Russia remaining from the cold war, the 1974 Jackson-Vanik Amendment.

Therefore the Kremlin's recent series of advances toward Iraq, Iran and North Korea, could be interpreted as an indication that Russia's perceived drift towards the West is far from irreversible.

For instance, on Sep.2 Russian Foreign Minister Igor Ivanov, after conferring with his Iraqi counterpart Naji Sabri, warned that military action by the United States could entail further troubles in the volatile Middle East.

Moscow's involvement in Iraq dates back to the Cold War era, when the Soviet Union cultivated client states in the Middle East. Thousands of Soviet experts worked in Iraq, and Moscow used to be Baghdad's top arms supplier. Russia is still the largest trading partner of Iraq, which owes Moscow $7 billion in Soviet-era debt. Some inflation-adjusted estimates put the figure at $11-12 billion. Russian oil companies are doing business in Iraq and expect more lucrative deals in the future.

Moreover, Russia and Iraq are now negotiating a 10-year trade agreement, including 67 cooperation agreements in oil, agriculture, transportation, railroads and energy. Iraq's ambassador to Russia, Abbas Khalaf, has said the deal is worth $40 billion. However, neither Sabri nor Ivanov mentioned the proposed agreement, which was seen by analysts as a "Potyomkin deal." Presumably, Baghdad attempted to use the $40 billion figure as a bite to press for more Russian support, while Moscow - by publicizing the figure - might be indicating that it wants to be compensated for lost profits following Saddam's demise.

Obviously, Russia is keen to safeguard its economic interests. Russia is Iraq's largest supplier in the UN oil-for-food program. Of the $18.3 billion in oil-for-food contracts approved by the Security Council since the program began in late 1996, some $4.2 billion went to Russia.

Iraq possesses the world's second largest proven oil reserves, currently estimated at 112.5 billion barrels or 11% of the world's total. It is seen as the ultimate bounty by Russia's oil firms. Baghdad offered Russian oil companies billions of dollars in concessions during the 1990s as it sought to build support in the United Nations. LUKoil, Russia's biggest oil company, signed a 23-year $20 billion contract in 1997 to develop part of the West Qurna field in southern Iraq with estimated reserves of some 700 million metric tons. However, the project has remained frozen under U.N. sanctions, and subsequently ties between Iraq and LUKoil deteriorated because the Russian firm was reluctant to begin work at West Qurna despite the sanctions. As a result, LUKoil was excluded from the oil-for-food schemes.

These days Zarubezhneft, a state-owned oil company that has worked in the Middle East since the 1970s, has emerged as Russia's leading oil player in Iraq. Zarubezhneft has received UN permission to drill 45 exploratory wells in northern Iraq's Kirkuk oil field. Zarubezhneft also had a contract to drill some 100 wells in the North Rumaila field. Now Iraq is reportedly mulling plans to grant Zarubezhneft the rights to develop the Bin Umar oil field with estimated reserves of 3.3 billion barrels. Another Russian company, Tatneft, is to drill on behalf of Zarubezhneft at West Qurna after sanctions are lifted. Additionally, in 2001, state-controlled Slavneft clinched a deal to develop the Luhais oilfield in southern Iraq with estimated reserves of some 500 million barrels.

Moreover, Russia is understood not only to fear losses of the oil concessions that have been signed off by Saddam. Analysts argue that although threats of the US military action against Iraq has kept crude oil prices high -- a victorious US war could presumably entail skyrocketing Iraqi crude exports, pushing oil prices down. Such a scenario could entail annual losses of billions of dollars in Russian oil-export revenues.

It is understood that by flirting with Saddam's regime and other "rough states," Russia has probably aimed to signal to the West that its post-September 11 policy of backing the US has certain limits, notably when Russia's vital oil interests are concerned.
As recently as July 2002, Russia announced that it intended to build five more nuclear power reactors in Iran over the next decade, which was, indeed, a pointed broadening of the scope of its persistent cooperation with Tehran, in defiance of US pressure to the contrary.

Last August, Putin agreed to a trip by President Kim Jong-il of North Korea. Officially, the visit of North Korea's "Dear Leader" was supposed to boost sluggish bilateral trade as well as to discuss Pyongyang's plans to opens its part of the railway as a means to funnel South Korean goods into Europe across Russia.

These actions, combined with long-standing Russian fears and suspicions over Western intentions, demonstrate that Moscow still faces a long path towards full-scale partnership with its Cold War Era foes.

Ukraine: Takin' It to the Streets

By Robert Windorf

Over the past few weeks, political tensions in Ukraine have escalated to troubling heights. Despite court orders to ban them, several nationwide protests by tens of thousands over the past two weeks have called for President Leonid Kuchma's resignation. With Kuchma recently away in Austria in an endeavor to convince political and business leaders to support Ukraine's struggling efforts to join the EU, protests began around the second anniversary of the disappearance of investigative journalist Heorhiy Gongadze. Opposition groups hold Kuchma responsible for his murder, along with the economy's chronic malaise, and alleged fraudulent activities during the March parliamentary elections.

The present political situation has left the Ukrainian parliament in a state of paralysis. Although a recent poll revealed more than 70 percent of the people support Kuchma's removal, the popular former Prime Minister Viktor Yushchenko and other opposition leaders assert strong pro-Kuchma forces have continued to pressure legislators to support the beleaguered president. While opposition parties won the majority of the popular vote in the spring, they have since failed to control parliament, making it very tough to remove the Kuchma regime. Nevertheless, following Yushchenko's participation this past Monday with socialist, communist, and capitalist party leaders at a Kiev rally that reportedly drew more than 20,000, he returned to parliament to negotiate a new coalition, resigned to the premise that no real mechanism exists to force Kuchma to resign. However, it remains to be seen how successful such negotiations will be.

Despite his popularity, Yushchenko has frustrated the hopes of many who seek immediate and radical solutions to the nation's troubles, as he reportedly prefers calculated negotiations to achieve solutions. With the presidential election two years away, Yushchenko and his supports will arguably have plenty of time to unseat Kuchma. However, given the circumstances surrounding the present heated political environment, it should not be ruled-out that a snap parliamentary election could be called before 2004 that might then possibly lead to some dilution of Kuchma's parliamentary power. Given Yushchenko's history of messy disputes with the president's affiliated parties, at present, we believe he will continue to endeavor to work on a new potential coalition; however, his efforts are probably more suited toward the 2004 election.

A spate of unfortunate events during the past year including the unintentional downing of a Russian passenger jet by a missile, a military air show crash, and a coal mine explosion have continued to expose the Kuchma government's apathy and ineffectiveness. While Russia has moved closer to the west during the past year, Ukraine continues to lag far behind. Much is at stake for both sides. Ukraine, a nation of 50 million with important natural resources, represents a strategic bridge between east and west. Aligning it to the west also would no doubt influence Russia to remain in Europe, as well. In addition, on the heels of reports that Iraq may have recently acquired military surveillance equipment from Ukraine in its supposed efforts to prepare for a potential conflict with the west, developments in Ukraine will continue to attract attention.

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eBusiness Japan: Interview with Keith W. Rabin

This month's interview is with Keith Rabin, president of KWR International, a consulting firm specializing in the delivery of research, communications and advisory services with a particular emphasis on public/investor relations, business development, public affairs, cross border transactions and market entry programs. Keith frequently speaks on trade, investment and economic issues and has authored numerous articles for publications including Bridge News, Journal of Commerce, Market: Asia Pacific, Korea Herald, and Asia Pacific Economic Review. KWR hosted the Japan Small Company Investment Conference in March, when over 200 investors, venture capitalists, corporate and technology executives, analysts, government officials, journalists and other targeted individuals met with eight promising Japanese companies in New York to explore mutually beneficial investment and business transactions and partnerships.

This interview courtesy of from the September 2002 issue of eBusiness Japan