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December/January 2002-03 Volume 4 Edition 4

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Editor: Dr. Scott B. MacDonald, Sr. Consultant

Deputy Editor: Dr. Jonathan Lemco, Director and Sr. Consultant

Associate Editors: Robert Windorf, Darin Feldman

Publisher: Keith W. Rabin, President

Web Design: Michael Feldman, Sr. Consultant

Contributing Writers to this Edition: Scott B. MacDonald, Keith W. Rabin, Jonathan Lemco, Jonathan Hopfner, Caroline Cooper, Sergei Blagov, Jean-Marc F. Blanchard and Andrew Thorson

Complete your Medical Study in the UK. Medical College of London is accepting new and transfer students to fill it’s September 2002 and later classes. MCL is an affiliate of the American International School of Medicine (AISM-UK) and other Academic Institutions in the US and UK, with innovative curriculum based on UK and USA standards of medical education. Basic sciences completed at our Central London Campus, and clinical sciences in the USA, UK and other International locations. Both 4 and 6 year programs available. Contact Program Coordinator Dr. Nasiri or Program Director Prof O. Tulp at Tel +44 1223 528 902, FAX +44 1223 529 545, or Email to: LCMTR.edu@ntlworld.com Send mail inquiries to MCL Admissions, 28A Enniskillen Road, Cambridge, UK CB4 1SQ. We will review your transcript of previous medical education without obligation.

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U.S. Corporate Bond Market - Feeling Good Again?

By Scott B. MacDonald

2002 was a difficult year for the U.S. corporate bond market, despite a rally in spreads in November. What made November such a good month was a number of factors - a 50 bps cut by the Fed, relatively positive economic data, a decline in tensions over Iraq, short covering and HSBC's announcement that it would purchase Household Finance. This combination of factors helped tighten spreads. Those sectors that showed the biggest rate of return were the same that were earlier the most beaten up - autos, telecoms and media/entertainment. At the same time, the new issue market reopened with strength. Following up in December, the new issue machine produced around $27 billion in new bonds.

What's next? We remain constructive about the corporate bond market through the end of the year, though we acknowledge ongoing concerns - Iraq, terrorism, the still bearish nature of the tech market, and concerns over pension funding. The less bullish revenue and earnings forecasts from the major auto companies (Ford and GM), AOLTime Warner and Disney reflect that the economy and corporate America are not completely certain of the recovery story - at least a strong and sustainable recovery. November's 6% unemployment number confirmed this. We also have to admit, with unemployment likely to remain over 5.5% through mid-2003, it will continue to feel like a recession for many Americans. In addition, it is important to watch the housing market, which is beginning to see what are the first signs of cooling. A major slump in this sector would be bad news.

Yet, the U.S. economy has not experienced a double dip recession nor do we see one on the horizon. Indeed, real GDP growth will be around 2.6% for 2002 and we are looking to 2.4-2.8% for 2003. U.S. worker productivity rebounded strongly in Q3, rising by 5.1%, compared to 1.7% in Q2 and well ahead of earlier estimates. The key strengths going into next year will be strong defense spending, other government spending measures, and a more benign regulatory environment (as the Republicans control both houses of Congress). There is already a positive undercurrent of mergers & acquisitions, asset sales, equity offerings and debt restructurings, though the stock market will remain volatile, especially in the first quarter of 2003. Equally important, the new issue market remains open. Although we expect activity in the new issue market to slow as the December holiday season begins, we would expect the market to reopen in January (barring of course a war with Iraq).

Looking into 2003, we see the following trends - a more sustainable U.S. economic recovery (though below the strong growth rates in the late 1990s), a gradual return to more predictable profitability in the corporate sector, the low point in the credit cycle in Q1, and later in the year a rise in interest rates. Probably the first quarter will be the most testing for those of us that do not see a double dip recession. This largely due to the strong possibility of a war against Iraq, mixed news from corporate Q4 results, and a hesitancy among major companies to resume capital spending until it is certain that the U.S. economy is really on track for a recovery. As for Iraq, we see the actual fighting to be short-lived and decisive, allowing markets to rebound after a temporary downturn. (We have greater concerns about what happens in a post-Saddam Iraq due to the traditional rivalries in the neighborhood.) We should add that if the war is prolonged and becomes a drain on U.S. resources, this could push the U.S. back into a recession. Nervousness about the looming Iraqi war has been a factor in mid-December for a rally in gold and oil.

Considering that 2003 is likely to see a start-up for the 2004 presidential elections, the Republicans are going to be keen on making the economy improve. President Bush wants to go into 2004 with Iraq settled and the economy in full recovery. The recent shake-up in the economic team that claimed Treasury Secretary O'Neill, White House economic advisor Lindsey and SEC head Pitt, indicates an important shifting of the gears in Washington on the economy. The new team of John Snow as Treasury Secretary (pending Senate confirmation), Bill Donaldson at the SEC, and Martin Feldstein as White House economic advisor is likely to have a better feel for Wall Street, while having a solid understanding of the non-financial side of U.S. business. Snow and Feldstein are also expected to steer a new fiscal stimulus package through Congress, with a value of somewhere between $200-400 billion and another tax cut. All of this bodes well for the U.S. corporate bond market, underlying our constructive outlook for next year, especially post-Q1.

We want to emphasize that while we are constructive on 2003 for the corporate bond market, the fisrt part of the year has the potential to be highly volatile. This is based on the uncertainty surrounding the issue of war against Iraq. When it happens, the Iraq war will have been one of the most advertised modern conflicts. Yet, the very idea of war generates a high level of uncertainty, including everything from oil prices to the potential for new terrorist attacks on mainland U.S. targets. And we do think that al-Qaeda, the Iraqi government and fellow travelers have cells in the United States and Canada. Consequently, investors are likely to hold their breath in the first part of the year. Advance with caution.

Interview with Yukio Iura, President & CEO of Nippon Angels Forum

By Keith W. Rabin

Mr. Yukio Iura started his career as a banker at the Bank of Japan in 1965. In 1982 he was dispatched to the I.M.F. (International Monetary Fund). From 1989 to 1999 he worked for B.I.S. (Bank of International Settlement) in Basel, Switzerland as a fund management officer, in charge of managing eight percent of reserve assets of the central banks. After resigning from the B.I.S. in 1999 he started the Smart Investors Forum from which he created a group of more than 400 individual investors who are eager to invest their assets in the stock or bond market. In 1999 he also started NAF, a group of angel investors who would assist entrepreneurs both by investing money and by providing advice. As of June, 2000 this group consists of 450 members and holds monthly meeting to help match angel investors with entrepreneurs. He incorporated NAIC in June, 2000, using the core members of NAF. He intends to assist entrepreneurs more effectively and systematically. Mr. Iura holds a Bachelor of Economics Degree from Aoyama-Gakuin University.

Thank you Iura-san for offering our readers this chance to learn about your work. Can you tell us a little about the Nippon Angels Forum (NAF) and Nippon Angels Investment Co., Ltd. (NAIC) and your activities over the past few years?

Following my retirement from the Bank of International Settlements in 1999, I enjoyed a short vacation but soon began to think about the problems facing the Japanese economy. In time I came to view one of the primary challenges being the need to promote entrepreneurship. Japan lags behind the U.S. and many other economies in new business formations. We have ample capital, but promising companies are not able to connect with VCs and other investors who are reluctant to invest in seed stage businesses. This is one of the great tragedies of the Japanese economy. The consequence is that many good business seeds are dying because they are not fed enough money to start-up. As a result I decided to form the Nippon Angels Forum (NAF), which facilitates matchmaking between angels and entrepreneurs.

In addition, I formed the Nippon Angels Investment Company, Ltd. (NAIC) as a means to invest in the most promising firms. The NAF now has 450 members. Half of them are entrepreneurs who want the support of angel investors. Through these members, we identify promising seed stage businesses, which present themselves at our bi-monthly matchmaking meetings. The formula is proving very successful and as a result, we are now receiving inquiries from individuals who are helping us to establish sister organizations across Japan.

Given current market conditions, investor interest in start-ups and angel funding in the U.S. and many other markets has grown very sparse and difficult. Judging from the sense of excitement and mood of the participants and presenting companies at your latest event in Tokyo, however, it seems very alive in Japan. I was impressed by the wide diversity of people in attendance, ranging from young and middle-aged entrepreneurs to private, corporate and institutional investors. Do you view angel investing as a growing phenomenon in Japan and if so, can you explain why this should be the case when at least for the moment it is declining in most other markets?

You have to remember that we started from scratch. Not many organizations in Japan offer a platform for angel investing. Although we are starting from a small base, Japanese angel investors have found a place to exchange information at NAF. In U.S. and other markets, after the IT investment boom went bust, the market was full of suddenly empty forums. Here, we are only starting, and so the reverse trend is seen in Japan.

Your web site (http://www.naic.co.jp) highlights the mismatch between venture capitalists and venture businesses and talks about your goal of providing business acceleration and incubation services to startups and firms. It states "no venture capital companies (VCs) are going to invest in them because they cannot measure the potential of these venture businesses". In the past, however, we have seen firms such as Softbank and Hikari Tsushin in Japan and CMGI or Internet Capital Group in the U.S., which made many, what can be termed "indiscriminate" investments in large numbers of firms. Most of them have not performed well from the standpoint of investors. Can you explain how NAF and NAIC differs from these entities and why your own business model should meet with more success?

Softbank and Hikari Tushin had abundant funds and their policy seemed to be betting on statistics, i.e. ignoring research but with confidence that a large net will catch a star opportunity or two which will more than wipe out the losses incurred by the remaining junk stocks. They had money and time, possessing young presidents and were happy to take on big risks. On the other hand we have very limited funding resources, and therefore choose investment candidates very, very carefully. We have no other measures other than a determination to make careful and sound investment selection. Neither NAF nor NAIC can afford to make "indiscriminate" investments because of our limited financial resources. There seems no other way but doing extensive research work in advance and screening carefully. This, we believe will result in successful investments.

Can you give us some specific examples of the types of companies who have been participating in past NAF's, how they are selected, their success record in gaining funding, as well as your own NAIC investments and their subsequent performance?

Our business flow is as follows: First, we organize start-up company presentations every two months. Each time10 companies make presentations. We choose these 10 companies carefully out of 60-70 candidates. Second after each matchmaking session, we select the 2-3 firms that generate the most positive reaction, who return to make what we call "deep presentations". Here they are able to make detailed business pitches to those angels that showed interest at the initial presentation.

Additionally, through NAIC we are able to make investments in the most promising firms. This structure enables angel investors to make direct investments or to participate in our special purpose funds where they are able to gain the diversify that comes from utilizing a portfolio approach. Through these funds we have made investments in more than 20 companies. I'd like to mention three examples.

First, Business On Line: This company offers quick accounting services to accounting firms. They also offer OEM services to the U.S. firm, Intuit. After having set up their company in August, 2000, they have expanded into various small and medium sized firms and envisage an IPO within 2 years.

Second, Oregadale: This company created a secure Internet messaging method. They have an alliance with Japan Oracle. Their business performance to date has been excellent.

Third, Apparel Web: Japanese apparel companies have close business connections with China. The company helps both Japanese apparel companies and Chinese counterparts to use Internet technology. At the moment China takes care of the manufacturing function for Japanese apparel companies but in the near future China will no doubt become an attractive consumer market for Japanese companies. The company provides useful services for both Japanese and Chinese apparel companies.

It must have been a major adjustment to move from the Bank of Japan where you worked for so many years to dealing with the concerns of these smaller, privately-held enterprises. Can you give us an idea of the challenges you have had to face?

After monitoring the Japanese economy from outside of Japan for many years, I decided that helping start-up companies and venture capitalists is one of the most important factors needed to revitalize Japan's depressed economy. At NAF and NAIC we are trying to revitalize the Japanese economy from the firm level, for which many of my colleagues at BOJ have also expressed concern. In Japan with 10 years of almost no growth, high unemployment rate and strong downward pressure on prices, it is extremely difficult for start-up companies to build their businesses. But Japanese individuals have huge assets and I am trying to lead some of those assets to flow into start-up companies.

Your experience as a central banker combined with your new role as a provider of advice and capital to private enterprises give you a unique perspective on the Japanese economy. International media coverage on the Japanese economy has been quite negative for several years now. Is this justified and how do you perceive the general outlook moving forward?

I often quote from Franklin D. Roosevelt - "The only thing to fear is fear itself." Many Japanese economists and professors together with various media sources repeatedly make negative comments on Japan's economic prospects. This results in a negative perception by Japanese people on the future, letting them wait for the worst to come. In my opinion a vicious circle of pessimism makes Japanese people weary of taking risks in their investments. Of course the Japanese have their own problems.

Nonetheless, I feel such problems are common in the U.S and Europe as well. We all suffer from various problems one after another. In the past we experienced Oil Crises, the disastrous earthquake in Kobe, serious deflation after the bubble bust, and a lot of large companies have been trying hard to restructure and re-organize to maintain their integrity in a mature economy. Continuing bad debts, deflation, deep-rooted problems in the banking system, the weak stock market and a lack of consumer demand and confidence, are all negative factors for the prospects of venture capitalists. That is no doubt about it. For us, we just do what we can do with our limited funding resources. The venture capital market is declining in Japan. That has affected new start-up companies. We are trying to make every effort to encourage investors as well as start-up companies and C level companies.

In a large, complex economy such as Japan's there are always bright spots, no matter the state of the overall economy. In fact, some would argue these very problems are driving and giving rise to many unprecedented and exciting opportunities. Can you comment on whether you believe this to be the case and talk about some of the sectors and areas that offer the most potential to corporate and portfolio investors. If possible can you give us some examples of specific companies that will benefit from these emerging trends?

Currently various liquor shops and rice selling shops are beginning to suffer from changing pricing policies by the government. A number of these liquor shops' profits are declining sharply. In addition, "gofuku" or "kimono" shops are suffering from weak demand from young women. But some of them are trying to build networks with other similar small shops. Some are converting themselves into supermarkets or convenience stores. In the case of "kimono" shops, some are developing brand businesses, using their well-known names to market handbags and jewelry.

One interesting example is Suzuran International Corp. This company is a Japanese "sake" producer in Iwate Prefecture. They are small but produce one of the best sakes in the Tohoku region. They established a network of small liquor shops and now their annual sales total 250 million yen. The president of this company founded a Japanese sake bottler in Australia, where rice prices are 1/8-1/9 compared with that of Japan. Down there the company can produce sake at less than half the cost in Japan. By importing sake produced and bottled in Australia back to Japan, they are selling via a distribution channel of networked small liquor shops around Japan. Suzuran International has made individually weak and unorganized small liquor shops a high performance retail network by realizing such a unique idea. This is one of the good examples how one can revitalize scattered and depressed small retailers.

There are various business opportunities in severely regulated sectors including agriculture, education, and medical industries. Mr. Taguchi, the former executive officer of Misumi, introduced the possibility of medical doctors without hospitals. The idea is to send doctors directly to patients' home. Visiting doctors can save patients' time.

In Japan, there are many established firms, which are fundamentally sound, but need to adopt more competitive financial, marketing and other business practices. In many ways these firms, which are not dependent on the development of new technologies and who already possess infrastructure and customer and business networks would seem to have less risk to investors -- who can gain dramatic increases in valuations through standard restructuring practices. Can you comment on the importance of restructuring and reengineering in Japan?

In the case of Nissan, Carlos Ghosn has been very successful in restructuring its operation and has made Nissan regenerate profits. There are many other examples similar to Nissan type restructuring. Especially construction companies and distribution sectors are suffering from very weak profits base and many manufacturing companies need to re-orient their business prospects. Now many consulting firms are helping such large and small companies to reorient themselves. I think Nissan is the tip of the iceberg. Gradually that trend (restructuring and reorienting) is spreading to small companies as well.

Foreign investors do not seem to understand the geographic diversity offered by Japan, believing that all business is conducted in Tokyo and perhaps Osaka. Can you talk a little about opportunities outside of these major metropolitan areas and the attractions offered by different local economies in Japan?

There is no doubt that 25-30% of companies are situated within a radius of 100 kilometers of Tokyo or in Kanto Plain. Many other parts of Japan seek opportunities in Tokyo and its suburbs as possible marketing places to raise funds. However, there is a very good chance for various Japanese and non-Japanese firms to establish themselves outside of Tokyo. The central government of course helps in such efforts, and prefectures and cities are also prepared to support those who will do business in local cities. The central and local governments find NAF quite useful to access such private sector needs. We hope to cooperate with such public sectors and provide matching coordination for private entities.

Can you also talk a little about the emergence of China, Japan's relationship with Korea, and other relevant factors as they pertain to foreign investors that are looking to increase their exposure in the region and with small to mid sized firms in particular.

China has a big presence in Japan and it is my belief that the emerging China will be favorable to Japan. China and Japan have been influencing each other through our long-term relationship, for 2000 years or more. China has always been a good partner of Japan. China is the main exporter to Japan and Japan exports cosmetics, underwear, and other vital items to China. We have cultivated a mutually profitable relationship. South Korea is also clearly an important partner for Japan, and I hope South Korea has the potential to become another Singapore in terms of developing a free economic zone concept.

One major problem foreign investors have when dealing with Japanese firms is their intense domestic focus and difficulties in understanding Japanese business and accounting practices and most importantly, monitoring investments after a transaction is completed. Cultural and language differences also often represent a real problem. Do you think that small to mid sized Japanese companies have a capacity for dealing with outside investors - both foreign and domestic?

Integrated and international companies such as Sony, Hitachi, and Toyota, these companies operate internationally and domestically. But are you aware of the "Ichiro effect", Hideki Matui , another of our baseball stars, has just signed a contract with the New York Yankees. Today Japanese individuals are becoming international stars in many fields. And after the successful World Cap Soccer Games held in Korea and Japan I feel internationalization is beginning to penetrate into smaller companies in Japan as well.

Some of the foreign investors and financial intermediaries we deal with are considering a funds-based approach to investing in Japan. Through these vehicles they are seeking to achieve additional diversity as well as the ability to rely upon professionals who are better able to interact with, and monitor, these companies and accelerate their long-term performance. From your perspective, which approach makes more sense for foreign investors and are their any particular factors, i.e. size of companies and investment, etc. that are especially important to consider when considering either option?

Definitely we propose a funds-based approach. Look at NAF and NAIC. We can interact between foreign investors and Japanese companies. We are in the same group offering various services for growing Japanese and foreign companies, offering both direct investment and funds.

Iura-san, you clearly have come a long way in only a few short years. What are your plans for the future? How would you like to see NAF/NAIC develop over the next few years? Do you have any plans to expand in markets outside Japan?

I have growing confidence in creating a new angels market in Japan thanks to the past three years' experience at NAF and NAIC. When the Japanese economy hits bottom, our activities will expand fairly quickly just like a forest fire. For the moment we are not planning on exploring other markets, say in U.S. or other part of the world although in the long run we envisage opportunities in the U.S. as well as Chinese and Korean markets.

Thank you so much for your time and attention. Do you have any final points you would like to make to our readers?

Media reports are always very negative and not productive. By activating sleeping finances, new businesses will bloom. I am confident that there are enough business opportunities in Japan, those areas, which Japan has neglected over the past 50 years.


CAN ANYONE TELL US WHY JAPAN'S TECH ECONOMY IS BROKEN? Is Japan's high-tech economy broken? We don't think so. Derailed perhaps. But if you understand the mechanics, you can gain access to amazing opportunities for business and technology in Japan. Nobody else knows Japan like we do. Find out what's going on, direct from Tokyo, weekly and free. Four great newsletters at http://www.japaninc.com.

Japan - Trials and Tribulations

By Scott B. MacDonald

FY2002 was another difficult year for Japan. The Koizumi government's reforms were consistently attacked and weakened by conservative elements in the ruling LDP-led coalition, the banking sector remains a headache, and the hope that export-led growth would trickle down into the domestic economy and stimulate wider-based growth appears less and less likely. The fiscal situation has not improved and Japan's ratings took a beating. Even the opposition (that is those opposed to the LDP outside of the government alliance) spent the year in disarray. Yet, not all is lost.

Prime Minister Koizumi remains committed to reforming the Japanese economy and reforms, though not as strong as originally intended, have been passed. He still has a team of like-minded reformers in his cabinet, including Economy Minister Heizo Takenaka, who clearly wants to overhaul the banking and corporate sectors. Although Takenaka's comments that no bank or company was too big to fail roiled the markets and evoked considerable resistance, Koizumi has remained steadfast in his support for his minister and not entirely given up on bank reform.

One result of Takenaka's bluntness was that it appears to be pushing Japan's major banks into reforming themselves. Japan's four major banks - Mizuho Financial Group, Sumitomo Mitsui Financial Group, UFJ Group and Mitsubishi Tokyo Financial Group - have all recently announced plans to restructure and dispose of nonperforming loans. The banks were already feeling the pressure of plummeting stock market prices, which was raising the delicate issue of their capitalization. Then came Takenaka. The combination of market forces and the threat of greater government intervention helped push the banks into what is hopefully a better approach to the bad loan problem.

Indeed, Mizuho is undergoing a substantial reorganization to create a new structure that allows for the efficient provision of banking and securities services to different sets of clients, ranging from the biggest corporate customers to small depositors. While announcing the programs is one step, the real test has yet to come - implementation. However, there is at least some momentum on this front, where before it was a glacial pace.

The Koizumi government has also had to deal with road rage. In early December, there was a dramatic end to the highway debate, which involved a government panel mandated with the privatization of four heavily indebted public highway corporations. The four companies together have a debt of 40 trillion yen ($320 billion). In a heated meeting, the head of the panel, Takashi Imai, who favored continuing certain highway projects, resigned in protest. Imai had earlier sought to present a report that included both a recommendation to continue road works and to discontinue them.

A clear majority -five out of seven members - objected to this and regarded it important to send a clear message of the panel's preference. Consequently, the five forced a vote, which provoked Imai to resign in protest. However, the majority sent a report to the Prime Minister clearly advocating the creation of a new entity to take on the four corporations - debts and assets. The report also states that the privatized companies should buy highways back from the new ownership entity 10 years later. This would be done to force the companies to concentrate on maintaining profitability from their inception. The task ahead for the Koizumi administration is to clean up the report, convert it into a bill and present it to the Diet in the 2004 session, with a view toward privatization in 2005.

Despite the symbolic importance of the reformers winning the battle over the panel's report, the opposition to any such reform remains strong. Influential LDP members are still pushing for new highway projects. As in anything that threatens the old political economy, passage of highway reform will face many trials and tribulations.

While the road reform is still moving, the government plan to overhaul eight public financial institutions, including the Development Bank of Japan, was shelved. The government stated that -financing by public lenders was essential- in an environment of continued economic deterioration. The plan was not completely abandoned, but the timetable for reform was pushed back.

Although it is easy to be critical of the Prime Minister and his team for not pressing ahead at a faster pace, it must be remembered that the task he faces is no less than to remake Japan - to restructure a political economy in which there are vested interests opposed to reform - many of them within the ruling party. Ironically, the LDP, both the backward-looking conservatives and the forward-looking reformer, need Koizumi. While the conservative hardliners like Taro Aso (the LDP policy chief) seek to stop reform and look to a weaker yen to help boost exports again in the forlorn hope of seeing some type of cyclical growth, Japan's foreign competitors (especially China and Korea) will continue to make inroads into their markets. Consequently, Japan is likely to have another year of trials and tribulations in 2003 - much the same as in 2002. If only they let Koizumi be Koizumi.

Korea's Economy Comes Full Circle: From Domestic Demand Back to Exports

By Caroline Cooper, Director of Congressional Affairs and Trade Policy at the Korea Economic Institute (KEI) in Washington

Visitors to Korea over the past year have witnessed a new phenomenon there - a surge in domestic demand. Domestic demand, rather than exports, sustained the Korean economy during the worst of the global economic downturn last year and for the first half of this year. But that trend is now changing. A recent Bank of Korea report shows that domestic demand as a portion of gross domestic product (GDP) decreased from 50.7% in the second quarter to 28.7% in the third quarter. Exports as a percentage of GDP increased from 49.3% in the second quarter to 71.3% in the third quarter. The return of exports as the primary driver of Korea's economic growth brings with it new challenges and opportunities. If trade is to sustain Korea's growth over the long-term, new emphasis must be placed on importing and diversifying Korea's export base.

Once Considered Bad, Consumption Proved Good for a Time

Despite the global economic downturn and a 6%+ drop in real GDP growth from 2000 to 2001, Korea managed to experience positive growth in 2001 and through much of this year. This was due in part to pro-growth policies of the government and a surge in household spending. The latter was the most surprising.

The Korean economy, which developed from a sustained high household savings rate, saw that rate plummet as consumer spending and credit card usage increased. The Korean government encouraged credit card use, in part according to the Ministry of Finance and Economy, "to bring the taxable income of the high-income self-employed more into the open."

The plan worked and brought with it a new credit culture in Korea. The majority of banks shifted their credit provision policy away from corporations to households. Koreans - both young and old - easily obtained credit cards and began spending. The results were at first positive - private consumption rose to never before seen levels, facilities investment increased, as did domestic production. The negative result, most evident in the past two months, read across the headlines of major global newspapers from The Wall Street Journal to Korean dailies such as the Chosun Ilbo: "Credit Card Usage Out of Control."Koreans, some not yet debt-ridden, were reported as taking on personal debt to bail out friends in severe financial turmoil - a sign that individualistic spending habits had taken a firm hold in Korea. According to the Chosun Ilbo, the average credit card default ratio rose to a record 7.3% in the third quarter.

The Financial Supervisory Service has stepped in to curb defaults, imposing caps on cash advance limits and raising the reserve ratio for credit provision at lending institutions. But these efforts coincide with a sharp decline in consumption, sparking fears among analysts that trends will worsen as the government continues its efforts to reign in spiraling household debt. A recent Bank of Korea report shows that the consumer goods sales index (measured year on year) declined by 25% from the first quarter of this year to the third quarter. According to the Samsung Economic Research Institute, the consumer expectation index and consumer evaluation index - leading indicators of consumer attitudes in Korea - each declined for the fourth straight month in October.

Imports and Exports are Both Good

Korea has long been fearful of an increase in imports, and that attitude does not appear to have changed. Higher consumption over the past year resulted in an increase in imports - both of consumer goods and capital goods. This precipitated a rise in import prices and fears among experts that a further increase in imports could threaten Korea's current account balance. According to the Bank of Korea, this reached a surplus of $459.7 billion in September.

A primary concern has been a worsening of Korea's terms of trade. While exports - now totaling $117 billion - continue to outpace imports, the latter grew at a faster rate than exports from the second quarter to the third quarter. Bank of Korea data also shows that import prices increased at a faster rate than export prices during the first three quarters of this year.

Analysts need not be worried. An increase in imports is positive and normal as an economy's shift becomes more fully developed, and production focuses more on services than manufacturing. Indeed, the government thinks that imports are positive. In a recent op-ed piece, Commerce, Industry, and Energy Minister Shin Kook-hwan wrote:

"Korea's trade policy has stressed the export aspect of trade and overlooked the magnitude of imports - the country should shift its trade policy toward an integrated one balancing imports and exports. The liberalization and expansion of imports contributes greatly to the honing of national economic competitiveness."

Proof that Korea's economy is changing in the right direction can be seen in the data. Increases in imports of capital goods and raw materials are indicative of investment by manufacturing companies. Minister Shin argues that "cheap, but good quality, raw materials and machinery component imports contribute to international competitiveness." The biggest percentage changes in imports from the second to third quarter were seen in raw materials such as iron and steel and chemicals (35% and 77% increase month to month), and in capital goods (43% increase), not consumer goods.

Another positive sign that Korea's economy is changing is that services now account for a larger percentage of Korea's GDP than manufacturing. According to the Bank of Korea, services as a percentage of GDP increased from 55.8% in the second quarter to 64.3% in the third quarter. Manufacturing as a percentage of GDP now accounts for only 38.7%.

Diversification Also Includes Services

In balancing its trade strategy, Korea needs to consider diversifying its export base - common advice given by experts. Korea's top exports are information technology goods (i.e., computers, semiconductors, and wireless telephony) and old favorites - heavy industry goods (i.e., autos, ships, steel, and chemicals). Diversifying this export base should mean that Korea puts priority on increasing production of more advanced IT goods and on opening IT service markets.

As has traditionally been the case in Korea, technology is first developed and tested in the home market before being exported. As the first country to commercialize Qualcomm's CDMA (code division multiple access technology) in 1996, Korea used its domestic market to capitalize on producing wireless handsets. These are now its top export item. Companies such as Samsung Electronics and LG Electronics have become world-class producers of CDMA handsets.

Korean's fascination with the Internet and limited landmass provided it with a logical testing ground to also develop a competitive wireless communications service industry. Capitalizing on technology already in place from fixed line broadband, Korean wireless service providers such as SK Telecom have developed wireless broadband products for export. But they are not looking to develop new opportunities in the United States, recognizing that the market there is not ripe for investment and that the economy is still in a downturn.

SK and other Korean fixed line and wireless telecommunications service providers are heading to China - now Korea's largest export market (including Hong Kong) - for business opportunities. They are smart to do so, especially as the domestic market becomes more saturated with service options, and demand in China's nascent wireless telecommunications industry keeps growing. Other Korean services industries would do well to follow suit, especially finance and retail, which could profit from increased e-commerce made available through advanced telecommunications service delivery in China.

Caroline Cooper is the Director of Congressional Affairs and Trade Policy at the Korea Economic Institute (KEI) in Washington. The views expressed here are those of the author and not KEI or KWR International.

This year's exciting theme is China Communications Define New Global Standards. Come to meet and hear from senior telecom and IT executives in charge of Asia and Pacific markets, and forge new relationships with domestic Chinese partners. Supported by China Telecom, CNC, China Mobile, China Unicom and CRC, and sponsored by Nokia, Samsung, China Putian, and Datang, ChinaTech 2003 is the conference to gain a better understanding of China Communications market in 2003. 

An (Un)Happy Birthday? China's WTO Accession One Year Later

By Jean-Marc F. Blanchard, Ph.D.

One year ago, China embarked on an uncertain journey when it became a member of the World Trade Organization (WTO). Pessimists argued forcefully that China's existing economic problems coupled with the high demands of the WTO would cause China irreparable economic and, in its wake, political harm.

At the time, China's economic problems included slower rates of economic growth than it enjoyed over the past two decades, high un- and under-employment, inefficient and unprofitable state-owned enterprises (SOEs), a troubled state-owned banking sector, and government budget deficits. The doubters predicted that WTO accession would aggravate these problems by requiring China to open its protected agricultural, manufacturing, and service sectors, to lower tariff and nontariff barriers, and to adhere to international intellectual property right standards.

Several analysts even asserted that WTO-fueled increases in imports and larger numbers of foreign corporations operating in China would bankrupt many SOEs, massively increasing agricultural unemployment, and engendering bank runs. In tandem, these changes would bring about severe political turmoil and perhaps the collapse of China (see the review of The Coming Collapse of China in this KWR International Advisor).

Earlier this month, this vision of a troubled future for China seemed to receive affirmation when 2,000 unemployed textile workers in China’s Northeastern Heilongjiang province blocked a major railway line and cut off traffic to protest unemployment, corruption, and the arrest of follow protestors. Moreover, the economic problems noted above have not disappeared.

It is indisputable that China suffers from serious economic and political problems, but the WTO has not yet brought China to the brink of collapse or anything close to it. The pessimists were wrong in their views about how disruptive the WTO actually would be. Moreover, they incorrectly assumed that economic problems would translate directly into political strife.

Analysts forecast job losses in the tens of millions as a consequence of China’s membership in the WTO. In actuality, however, many of these losses had already occurred as a result of the Chinese government’s efforts to close unneeded factories, lay-off surplus labor, and terminate relatively smaller money-losing SOEs. In addition, as the economist Nicholas Lardy has observed, China had been reducing or eliminating protectionist barriers throughout the 1990s. This meant that WTO accession did not produce vastly higher levels of imports and foreign competition. Furthermore, the Chinese already had allowed the prices of many goods sold domestically to equalize with the prices of goods on international markets.

The WTO not only has imposed less pain on China’s economy than the pessimists predicted, it also has brought about gains. It has promoted greater productivity, opened previously closed exporting and partnership opportunities, and facilitated further inflows of foreign capital and technology. The pessimists also seem to have neglected the fact that the Chinese government had a variety of strategies at its disposal to counter the effect of WTO-induced unemployment. These strategies are manifested by its further empowerment of the private sector, the enlargement and improvement of its financial and capital markets, and the selective fulfillment of its WTO obligations. It also can embrace strategies like appreciating its currency.

Forced to lend in large amounts to unprofitable SOEs, China’s banking sector has accumulated at least a 40-50 percent ratio of non-performing loans to assets. Since the assets of China’s four big state-owned commercial banks run around $1 trillion, this means that the Chinese government has about $400-500 billion of bad loans that must be resolved. This is an incredible 40-50 percent of GDP and is sustainable only because the Chinese populace has lacked alternatives and believes the government fully backs their deposits. Pessimists argued that the arrival of foreign banks would cause a huge outflow of deposits leading to a banking crisis that would overwhelm the Chinese government.

The WTO has and need not tip the banking system from its current equilibrium to a state of crisis. That is because foreign entrants are and will be constrained in the amount of deposits they can take due to regulatory requirements. It is also unlikely that foreign banks will want hundreds of millions of small depositors. The number of high-quality lending opportunities in China also will serve to restrict the amount of deposits that foreign banks seek.

China’s banking woes are daunting, but the government has been addressing them. Increased economic growth has helped as have requirements for the Big Four to set aside increased loan loss reserves. Going forward, China can sell stakes in the Big Four, tap into international capital markets to recapitalize and restructure the Big Four, sell off larger stakes in SOEs that burden its banks, and collect special taxes to stabilize its banking system.

Even if the WTO increases unemployment or banking difficulties over time, the Chinese government can move to reduce unemployment and stabilize the banking system. Although it is unlikely they can eliminate these problems, it is another matter to conclude this will mean the collapse of China or even significant political instability.

The domestic tranquility the U.S. enjoyed during the 1930s Great Depression highlights that more than unemployment is needed to foment major political instability. Political fallout from unemployment in China has and is likely to be controlled as the government can directly aid, albeit in limited ways, the unemployed with welfare schemes. It will be very difficult to organize the unemployed for sustained action as they partly blame “the market” for their unemployment. The government can also enact political reforms to allow the unemployed to vent their anger, and can also utilize coercive tools to repress the unemployed.

The political consequences of banking crises are more uncertain since a nationwide banking crisis would present more severe management problems than a local or regional crisis. In any event, Turkey’s recent banking crisis and South Korea’s banking woes in the late 1990s demonstrate that banking crises do not necessarily translate into political crises. Before that stage is reached, the government can pay individuals whose money is at risk, or has been lost. They can also ease credit, or take steps to deflect blame.

There is no doubt China has real economic problems and that the WTO has presented new challenges and intensified others. It is unlikely, however, to bring about an economic catastrophe. Furthermore, it is fallacious to assume that China’s economic problems will lead to significant political turmoil. Doubters raise the possibility of unforeseen events such as a war over Taiwan to challenge more sanguine assessments. Nevertheless, it is hard to envision many of these “unforeseen” scenarios. Furthermore, the Chinese leaderships’ intelligence, willingness, and desire to tackle these problems bode well. Dreams of a vast China market may be unfounded, but a paralyzing fear of economic and political chaos is equally unwarranted.


Russia's Economic Sustainability Remains on the Agenda

By Sergei Blagov

The Russian economy has picked up somewhat following a decade-long decline. However, economists warn that a lot must be done to secure the country's sustainable development. In 2002, annual growth of Russia's Gross Domestic Product (GDP) is expected to reach 4 percent -- a drop from the 5.5 percent it achieved in 2001, which itself was substantially lower than 2000’s 10 percent growth rate.

Despite this slowdown, Russia outpaced many other nations in GDP growth for the second year running. However, last year the Kremlin went ahead with daring reforms, notably implementing a new Land Code and restructuring the pension system. Moreover, high prices for gas and oil exports had boosted Russia's revenues. In 2002, Russia expects its foreign trade surplus to exceed $30 billion - still lower compared to the $65 billion it generated in 2000. Correspondingly, according to the Central Bank the nation's gold and hard-currency reserves rose to nearly $48 billion, almost quadrupling the level of late 1998.

Riding on top of commodity exports, Russian government officials have depicted a rosy picture of the country's booming economy. However, experts warn that continued over-reliance on oil and gas, may eventually push the nation into a vicious circle of debt crises and an increasing dependence on commodity prices, a pattern well known among developing nations.

Russia's financial health has improved significantly since the 1998 crisis, largely due to high world market prices for its main energy and commodity exports. Its performance since the crisis has been impressive. However, Nobel laureate Joseph E. Stiglitz, professor of economics and finance at Columbia University, estimates that the country's GDP still remains almost 30 percent below where it was at the beginning of the 1990s. Stiglitz notes that at 4 percent growth per annum, it will take Russia another decade to get back to where it was before the beginning of transition.

Furthermore, another potential challenge to Russia's sustainable development is the country's foreign debt level. About $140 billion is owed to Western governments and banks, the World Bank and International Monetary Fund. Although Russia has managed to reduce its debt over the last three years, this debt still represents $1,000 per capita.

Russia is sitting on the world's richest natural wealth, priding itself with an impressive ranking in the oil and commodity ratings. It is the world's biggest natural gas producer and exporter, producing some 550 billion cubic meters (bcm) a year -- pumping over 200 bcm abroad. With the country's proven 12 billion metric tons of oil deposits, Russia is the world's second biggest oil producer, generating more than 7 million barrels per day (bpd).

However, most of Russia's oil and metals industries were sold to well-connected tycoons at dirt-cheap bargains. Oil and metal magnates have opted to siphon their cheaply-acquired assets out of the country via obscure off-shore entities – instead of investing in actual production. Now the top 65 private companies in Russia are controlled by no more than eight holding companies.

This concentration of ownership rights, the attendant small numbers of new firms entering the market and the lack of economic diversification all suggest that, despite its considerable achievements, there is still much reform work to be done, argued Christof Ruehl is World Bank chief economist for Russia.

In fact, Deputy Economic Development and Trade Minister Arkady Dvorkovich warns that the economy will start shrinking as early as 2004 if the pace of reforms is not accelerated.

If the governmentit wants sustainable growth, argues President Putin's top economic adviser, Andrei Illarionov, it must cut expenditures by nearly a third, . He said the government should cut spending to 25 percent of GDP from the current 35 percent. If the ratio remains at its present level, economic growth will average 2.9 percent a year through 2015, according to Illarionov's Institute for Economic Analysis. But if spending drops to 25 percent of GDP, he believes growth would average 8.9 percent.

President Putin has pledged that the average Russian will "be happy" by 2010. However, that date is well after the expiration of his maximum constitutional presidential term.

In 2002, Russia still seemed to be heading toward the light at the end of the tunnel. Favorable economic factors gave athe Kremlin yet another chance to secure the country's sustainable development. On the other hand, Russia faces a problem of the uncertainty over oil prices, fueled by worries of possible U.S. military strikes against Iraq. Since Russia is still dependent on oil, it remains a matter of debate whether the country can sustain its current level of growth with potentially lower commodity prices.

Doing the Rounds: ASEAN's New FTA Commitments

By Jonathan Hopfner

After years of warnings that they were failing to capture the attention of a foreign investment community increasingly fascinated with China as a market and production base, the members of the Association of Southeast Asian Nations (ASEAN) may now stand accused of doing too much. At an early November summit in Phnom Penh, Cambodia, the leaders of Thailand, Laos, Cambodia, Myanmar, Vietnam, Indonesia, Singapore, Brunei, Malaysia and the Philippines not only pledged to boost intra-ASEAN cooperation - in the areas of tourism and counter-terrorism in particular - but also committed themselves to closer economic linkages with the meeting's three guests - China, Japan and India.

On the surface, the summit was hailed by Cambodian Prime Minister Hun Sen as "historic" it does indeed appear to have produced some impressive results. Chief among these is the "Asia-China Framework Agreement on Economic Cooperation," designed as a blueprint for the creation of an ASEAN-China Free Trade Area (FTA) within the next decade. Under the framework pact, negotiations will begin on the elimination of tariffs on a range of agricultural and livestock products earmarked for an "early harvest" program next year. This is seen as a preliminary step toward free trade and investment in "substantially all" products and areas by 2010. The pact was particularly kind to ASEAN's newer, and less developed, members – Myanmar, Laos, Cambodia and Vietnam – who will be given an extra five years to prepare their fledgling markets for the initiative. They were also granted special trade concessions by the Chinese government.

The agreement was far-reaching enough for ASEAN Secretary-General Rudolfo Severino to tell the press shortly after the summit that ASEAN had shown, once and for all, that it was taking concrete action to address the issue of China grabbing an ever-larger share of the region’s foreign direct investment flow – apparently by adhering to the old adage that “if you can’t beat ‘em, join ‘em.” Severino argued that the creation of an ASEAN-China free trade zone would encourage foreign firms to use ASEAN as a production center and “gateway” to China’s billions of consumers, while the ASEAN business community would have free access to the world’s most potentially lucrative market.

That ASEAN firms would stand to gain at least some degree from China’s elimination of tariffs on their products is difficult to contest. Trade between the two sides has already evidenced steady growth, reaching US$38 billion in the first three quarters of this year, a 27 percent increase on the same period in 2001. But it may prove more difficult to reap other promised benefits.

The region's firm belief that signing on to an FTA with China will increase its luster as a production center seems misplaced. Two factors have driven much of the recent rush to establish manufacturing facilities on Chinese shores - market access and cost. While theoretically, ASEAN could indeed act as a "gateway"to the mainland in an FTA situation, especially considering Beijing's recent ascension to the WTO, most firms determined on doing business with China will no doubt elect to set up shop there. The current trend of shifting production to China has already demonstrated that the often superior infrastructure and comparatively friendly investment environments that ASEAN’s more developed members possess have done little to convince companies that Southeast Asia is the best place to be based.

In addition, while countries like Malaysia may be able to compete with China for some time yet as manufacturing centers for high-end goods such as computer parts, automobiles and electronics, those that have established themselves as outsourcing centers for more basic goods such as food and textiles - including Thailand, the Philippines and Indonesia - will still find themselves unable to compete with China's skilled labor costs, FTA or no FTA. Even the members of ASEAN able to compete with China on the pricing front – Cambodia and Vietnam, for example, both of which possess burgeoning textile industries – seem set to fall behind in terms of infrastructure and human resources. This is to say nothing of the region’s perceived instability, which could again be highlighted if the Bush administration launches an attack on Iraq, angering Southeast Asia’s millions of Muslims in the process.

Less obvious, but still far from addressed, are concerns that despite the agreement, an ASEAN-China FTA may not arise by 2010 - or at least not in the shape so ambitiously laid out in the framework pact. Negotiations will commence with agricultural products, perhaps because consensus on these may be hardest to reach. While Singapore, unable to produce enough food of its own, may have no problems slashing excise taxes on Chinese vegetables, the other nations of ASEAN will no doubt find the process more trying. Farmers in Northern Thailand are already up in arms over an influx of cheap Chinese garlic and mushrooms, a situation that their leaders will no doubt capitalize upon come election time. This pattern is likely to repeat itself throughout ASEAN as heavily agriculture-based economies prepare themselves to deal with sudden onslaughts of Chinese goods. Past experiences in the implementation of the ASEAN Free Trade Area (AFTA) itself have shown that when the time comes, certain nations simply refuse to discard sensitive aspects of their import tax regimes, regardless of their past promises – witness Malaysia's reluctance to liberalize its auto sector and the Philippines' backpedaling on its commitments to drop duties on petrochemical products. What may emerge from the China-ASEAN FTA, if the 10-year deadline is to be adhered to, is an agreement so hobbled by compromises and "exceptional cases" that it does not resemble an FTA at all.

Another potential difficulty is the fact that ASEAN may simply be too busy – given the likelihood that negotiations on a FTA with China will be time-consuming and fraught with obstacles – to give the framework pact the attention it deserves. Before the ink had even dried on the China-ASEAN agreement, ASEAN leaders signed on to a Comprehensive Economic Partnership (CEP) with Japan, which also commits both sides to work toward a FTA in the next decade. Just a day later, the leaders of ASEAN and India released a statement after their Phnom Penh meet that claimed they would also explore the possibility of creating an India-ASEAN free trade zone by 2012. Add to this the US’s recent unveiling of the “Enterprise for ASEAN Initiative,” under which Washington plans to establish FTAs with ASEAN nations meeting certain economic conditions, and the host of bilateral trade agreements that individual ASEAN countries have already or are striving to seal. This includes Singapore with the US and Japan and the US with Thailand and the Philippines. The result is a host of programs, dialogues and deadlines that will no doubt tax the region’s severely limited manpower. Secretary-General Severino himself has admitted that there are “valid concerns” surrounding ASEAN’s capacity to juggle so many obligations at once.

The effort to forge partnerships with nations outside ASEAN’s borders may also take a toll on AFTA itself, which is set to come into full force in the new year. While many intra-ASEAN tariff cuts have been implemented successfully, heavy duties on politically sensitive products remain squarely in place, customs procedures are still disjointed, and trade in services is no freer now than it was a decade ago. ASEAN leaders would do well to remember that their work within the grouping itself is not done – and plan carefully their efforts to establish FTAs with other countries, or risk losing the credibility they are fighting so hard to gain.


Indonesia - Passing An IMF Test

By Scott B. MacDonald

TIn early December the International Monetary Fund completed its seventh review of Indonesia's performance under a SDR 3.638 billion (about US$4.8 billion) Extended Fund Facility arrangement. This paves the way for release of a further SDR 275.24 million (about US$365 million), bringing the total amount drawn under the arrangement to SDR 2.262 billion (about US$3 billion).

The key points of the IMF’s report were that Indonesia’s macroeconomic developments in 2002 were favorable, with steady economic growth, moderating inflation, and a strengthening balance of payments. The IMF report did, however, note that the economic outlook deteriorated as a result of the recent terrorist attack in Bali in November. As the IMF stated: “The attack poses new challenges, which must be met, on the economic front, through the continued firm implementation of the government's reform program.”

Indonesia was given credit for the important progress achieved during 2002 in laying the foundation for a durable improvement in macroeconomic fundamentals, including generally prudent policy. The recently-approved 2003 budget is regarded as striking the “appropriate balance between ensuring further fiscal consolidation to reduce the public debt and providing support for the economy in the aftermath of the Bali attack.” The terrorist attack in Bali will clearly have a negative impact on tourism, a significant source of income for the local economy. The budget also preserves development and social spending as well as eliminating remaining fuel subsidies with the exception of those on household kerosene. The budget also targets an appropriately ambitious non-oil and non-gas revenue increase through improvements in tax administration and additional tax policy measures.

The IMF also gave Indonesia a positive nod for the continued recovery of bank and state enterprise assets. This is important in reducing public debt levels. IBRA's broad-based loan sale program has been successfully concluded, with the new priority being the sale of IBRA's remaining assets and to collect payment from cooperating debtors under the revised terms of the bank shareholder settlement agreements. The IMF did note that it was necessary to take enforcement actions against debtors who remain noncompliant with their settlement agreements. This remains a problem, especially if Indonesia wishes to attract greater foreign investment. It also cuts to the heart of what kind of Indonesia the new democratic government wants to create. A more sustained effort will also be required to consolidate the momentum of the government's privatization program, which was reinvigorated with the sale of a small stake in PT Telkom and the intended sale of a strategic stake in Indosat. The momentum of bank divestment has been restored with the sale of Bank Niaga despite some degree of protests. The focus has now shifted to the sale of a majority stake in Bank Danamon, to be followed in 2003 with the sale of Bank Lippo and, thereafter, the remaining IBRA banks.

The IMF report concludes: "Accelerated progress in implementing legal and judicial reform and establishing the rule of law is critical to improve governance and strengthen the investment climate, which continues to suffer from the widespread perception of judicial corruption and weaknesses in the legal framework. Establishment of the Anti-Corruption Commission, ongoing reform of the commercial court, and revisions to the bankruptcy law will be important milestones in this effort."

Venezuela - Big Strikes Weigh Heavily on the Country

By Scott B. MacDonald

Venezuela has become the major political flashpoint in Latin America. Despite the ongoing civil war-like conditions in Colombia and the long downward economic spiral in Argentina, Venezuela has come front and center as leftist President Hugo Chavez is seeking to cling to power in the face of a determined opposition that wants elections in early 2003, well before the end of the presidential term in 2006. Outright civil war or a military coup cannot be ruled out, considering the highly polarized nature of the country’s political arena. Although we remain hopeful that there can be a negotiated settlement through the good offices of the Organization of American States, tensions run high and hardliners on both sides increasingly lean in the direction that power grows out of the barrel of a gun.

The opposition to President Hugo Chavez initiated a large strike in early December, which eventually came to include the country’s oil industry. The strike at the state-owned oil company, PDVSA, has in effect taken more than 2.5 million bpd of crude and refined product out of circulation in international markets. The strike is also disrupting daily life in most of the major cities and towns in Venezuela as food and other basic staples of life are only reaching markets with difficulty.

Venezuela remains a highly polarized political arena, with an opposition of big business, labor unions, the middle class and parts of the armed forces favoring an early referendum on whether President Chavez should leave office. They also expect to win such a vote, considering that Chavez’s popularity has fallen from 80% to around 30% in opinion polls. There is a strong feeling within opposition circles that Chavez and his leftwing civilian advisors want to take Venezuela through a Cuban-style revolution. This view has been bolstered by Chavez’s close personal relations with Fidel Castro, the appointment of a number of leftist intellectuals to government posts and a foreign policy clearly geared to anti-U.S. forces in the global arena. Chavez has also managed to ruffle relations with the country’s oil industry leadership, claiming that the top executives lived in “luxury chalets where they perform orgies, drinking whisky.” Rounding things out, he also has been critical of the Catholic Church.

While poking at the U.S. and the old order in Venezuela, Chavez has mismanaged the economy. For an oil-rich country, the last couple of years of higher oil prices have not translated into a boom. Instead, the economy is in shambles, with real GDP expected to contract in excess of 8% for the year. The 4th quarter could see a contraction of 10%, considering the damage to the national economy from the strike. Complicating matters, the government is seeking to bridge the fiscal deficit and Venezuela has no access to international capital markets. President Chavez’s ordering the army to break up the strike in the oil industry on December 5 only reflects the dire nature of the confrontation Venezuela faces. The military is seeking to restart the shipment of oil, but this is proving to be a difficult process.

Chavez, the promoter of his own hazy Bolivarian revolution, maintains the support of the country’s lower classes, left wing intellectuals and elements of the military. Having already survived one coup attempt in April 2002, which briefly ousted him from power, he is showing little inclination to be caught unaware a second time. However, Chavez can take little comfort when leaders of the opposition, such as Carlos Ortega, president of the largest labor union federation, the Confederation of Venezuelan Workers, states: “The active national strike continues until the resignation of Chavez.”

The scenarios ahead for Venezuela are either a slow-moving slide into civil war, another coup, or a negotiated settlement leading to early elections, probably in August 2003. The ongoing political uncertainty, of course, is not good news for the Venezuelan economy or foreign investors. Venezuela has a little over $12 billion in foreign exchange reserves. This is enough to keep making its payments on its external debt - in the short term. However, if the political crisis continues through 2003 and oil exports are negatively affected, there could be problems on the repayment front. Above all else, Venezuela depends on oil to generate capital. The oil industry accounts for around 75% of GDP.

An additional factor concerning Venezuela’s political and economic crisis is what role Washington want to play. U.S. policy has been keenly focused on the Middle East. A war against Iraq could disrupt oil prices and flows from the Persian Gulf. It is in the U.S. national interest to have some degree of stability in Venezuela before a new Gulf War, possibly as early as January. Venezuela accounts for 13-15% of U.S. oil imports and is one of its major sources in the Western Hemisphere. Having no oil flowing from this South American country would be bad news with a war in the Middle East, as it would no doubt push oil prices up even higher. In turn, higher oil prices could hurt the U.S. economy, which is in the midst of a sluggish recovery. Consequently, we see greater U.S. pressure on all the actors, both in the opposition and in the government. It is not in the U.S. interest to have Venezuela in the middle of a civil war.

Venezuela has some dark days ahead. The struggle between the Chavez government and the opposition is now a bitter affair in which it is difficult for either side to compromise. However, considering the stakes for the United States and other Latin American nations as well as the country’s population, a negotiated settlement could produce results, creating a timetable for an early election. Getting to the point where a compromise can take place will be difficult. Until then Venezuela will continue to be Latin America’s flashpoint.

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Mexico: A Stable Credit in an Unstable Time

By Jonathan Lemco

From an investor's point of view, Mexico has made tremendous economic and political strides in recent years. Economic growth has surged, in part because Mexico has benefited from its membership in the North American Free Trade Agreement. Mexico's crippling debt load of the 1980s and early 1990s has been reduced substantially. Employment is at an all time high with unemployment at only a 3.1% level in September. Inflation has been contained at approximately 4.9% year-on-year. Education levels are slowly improving. And President Fox was elected in the freest vote in Mexico’s modern history.

As a consequence of this improvement, Mexico’s interest rate spreads have narrowed throughout 2002, unlike several other Latin American sovereign credits. Furthermore, the credit rating agencies rate Mexico at investment grade levels (Baa2 with “Moody’s” and “BBB-“ with Standard & Poor’s). As of December 2002, only Chile is higher rated in the entire Latin American region. As its credit fundamentals have improved, Mexico has become an investor darling, and has issued well-received debt throughout this past years. We expect the sovereign, Pemex, Telmex, Cemex and other Mexican issuers to return to the marketplace in 2003.

Of course, there are problems along the way. Mexico's economic future, more than ever before, is intimately tied to the United States. As the US economy slows at year-end, so has Mexico's and earlier growth economists' forecasts for the year have been recently reduced from 1.7% to 1.2% GDP growth. This deceleration, not surprisingly, is directly related to a decline in export-oriented industrial production. Ironically, one of the consequences of the improvements in recent years is that Mexico is now having trouble competing with certain lower wage economies. Most notably, there have been several media stories recently noting how Mexican industry and jobs in selected low-tech industries are leaving for lower wage China. We think this is a natural development in a rapidly modernizing economy, however, Mexican industry will have to adapt to worker demands for higher wages and improved benefits, but there will be an economic cost to this as lower wage countries continue to compete effectively.

It is also worth noting that the structural reform agenda of the Fox Administration is hindered by a tense relationship between the executive branch and the PRI, the main opposition party. Structural reforms in the areas of electricity, labor and education are needed to improve competitiveness and to promote economic growth.

In the next month, investors should pay attention to the political wrangling associated with the next federal Budget. We think that the Budget, when it is finally passed by year-end, will include fiscally prudent provisions. Although President Fox’s administration is assuming a 3.0 % growth rate in Mexico in 2003, it is also proposing a modest 1.9 % real increase in expenditures. Overall revenues are expected to outpace expenditures slightly. Also, projected oil revenues, which are critical to the Mexican economy, are based on a $17.00 per barrel price for the Mexican oil basket. This is almost $5 below the estimated average for 2002. Currently, the Mexican oil mix is hovering near the $20 level. Unless prices collapse, which is unlikely given the uncertainty surrounding a potential war in Iraq, it is difficult to imagine the average oil price in 2003 will be substantially below the budget assumption.

Furthermore, we think the 2003 Budget will include a provision whereby the deficit target will be increased to 0.65% from 0.5%. This slight increase should not be alarming to investors. Away from the budget, investors will also be focused on electricity reform negotiations. If these discussions go well in the next few months, it will send a very positive sign to the financial community.

In short, we expect that Mexico will continue to grow at a steady pace while maintaining fiscally prudent policies. President Fox will have to expend political capital to pass much needed structural reforms, but we think he will be able to do so. The 2003 Budget assumptions are conservative and achievable. At a time of economic and political uncertainty in much of Latin America, Mexico stands out as a positive model.

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German Banks - Tough Times

By Scott B. MacDonald

German banks are an important part of the international financial system. They are critical to the European economy and have been a relatively sound investment in the past. The relative safety of investing in German banks, however, is over. The sector is grappling with difficult structural problems, ratings are under pressure and spreads are generally wider. We expect things to get worse before they get better. HVB Group, Dresdner Bank, and Commerzbank will remain challenged into 2003. Deutsche Bank is in comparatively better shape, but even Germany’s largest private sector bank faces a difficult business environment, especially as the global securities industry has yet to recover. Although we do not expect any of the country’s major banks to fail, we have concerns the sector will end up muddling through the next few years, badly in need of structural reform and growing less competitive with other European and international institutions.

In late October 2002, chairman of the supervisory board of Deutsche Bank and president of the German banking association, Rolf E. Breuer, denied his country’s banks were in a crisis. He stated “’Banking crises’ is a very risky expression, because usually people think of 1929. We’re not talking about a liquidity problem. We’re not talking about a credit crunch. What we are talking about is a lack of profitability.” While Mr. Breuer is correct that profitability is a major problem facing German banks, the crisis aspect of the matter can be debated. The situation facing German banks is challenging. The German economy remains troubled, corporate bankruptcies are on the rise, and investors are clearly worried. HVB Group, one of the country’s major banks, recently sought to issue bonds in the U.S. market, but finally balked at the pricing – equal to where many high yield bonds trade. In addition, the equity shares of another of the country’s largest banks, Commerzbank, plunged in October to their lowest level since 1996 in October. At the same time, the rating agencies, Moody’s and Standard & Poor’s have downgraded the credit ratings of most major German banks. If not a crisis, it certainly feels like one.

The worrisome thing is that banking conditions in Germany are set to deteriorate further before they get better. On October 22, regional head of corporate clients at Commerzbank, Berkhard Leffers, stated: “We haven’t seen the worst yet; insolvencies and risk provisions are likely to keep rising in 2003.” To this he added that the outlook for an economic recovery in the world’s third largest economy is “very pessimistic.” Indeed, German banks have suffered as a loss of investor confidence due to the increasing risk of deflation, low capital levels, weak core earnings and concerns over the impact of declining equity markets. Real GDP growth is now expected to be around 0.4% for 2002 and a little over 1% in 2003. This is hardly the robust momentum needed to pull the German corporate sector from its doldrums.

The root of the problem for German banking is structural – the vast majority of banks are not in business so much to make a profit, but as to provide credit. The country has over 500 Sparkassen (savings banks), which are largely owned by municipalities and the 12 Landesbanken, regional banks owned by state governments and savings banks associations. Together these institutions, along with a number of other smaller lending institutions, account for 39% of domestic retail and corporate deposits and 35% of bank lending. In contrast, the country’s Big Four – Deutsche Bank, HVB Group, Dresdner Bank and Commerzbank – account for only 14% of deposits and 15% of loans. While the public sector banks benefit from state guarantees, which helps them to contain borrowing costs and lending rates, the Big Four have no such support and consequently see their profitability squeezed.

In addition to the public sector vs. private sector mismatch, German banks are not the most cost-efficient, leaving them with bloated operating costs. There are also too many of them. Germany possesses some 2,700 lending institutions. It also has 42,350 branches -- more than any other major industrialized country except Belgium.

Germany’s private bankers increasingly see the need for change. Commerzbank’s CEO Klaus-Peter Mueller said during a conference in London in early December that he would welcome domestic bank consolidation. The statement fueled investor speculation that the troubled bank may partner up sooner rather than later. The bank is currently in the process of eliminating more than 6,000 jobs to cut costs and boost returns. Commerzbank reported a 3Q02 loss of €129 million.

Pressure is also coming from the European Union and the Basel Committee, a body of major economies that functions as a guide to international bank regulation. Although Germany’s public sector banks are being pushed to reform and are phasing out a number of the state supports, including the guarantees, this is a multi-year process. There is no quick leveling of the playing field.

The danger going forward is that what is required to turn German banking around is likely to take several years and is greatly complicated by domestic politics. Change means consolidation, introducing greater cost-efficiency and trimming personnel. It means charging off a growing pool of bad loans. Consolidation also means vertical integration between the Sparkassen and Landesbanken. Politicians from various regions do not wish to surrender their banks, many of which make critical loans to struggling corporations. With unemployment at 10%, pulling critical credit lines can lead to greater joblessness. This is something that does not win elections for those already in office. Moreover, the closing of bank branches would only add to the ranks of the unemployed.

Is Germany becoming Japan, where many banks are close to or are already insolvent and kept alive by injections of public money and the forbearance of bank regulators? Although deflation is emerging as a major concern and there is a closer relationship between the private and public sector than with Anglo-American economies, Germany is not yet Japan. But, the preconditions are there, including a slowness to act, political resistance from elements of the ruling elite, eroding loan portfolios and steep declines in the value of stockholdings. All this points to the risk of a self-fulfilling prophecy, in which the fears of a crisis grow with the slowness of response and bank counterparties begin the add costs to doing business with what they regard as troubled institutions. This, in turn, raises obstacles to accessing international capital markets, which may need to be tapped to top off capital adequacy ratios.

We return to Mr. Breuer’s denial of a crisis. It is fair to state that German banking is not in a crisis – along the lines of 1929. Support from the German government should prevent that, while pressure from the European Union helps push reform. However, until local political support for the public banks is curtailed and reforms are pushed in a more meaningful fashion, there is a risk that German banks will head into a crisis. If the banking system of the world’s third largest economy slips into a crisis, it would be only one more force pulling the global economy toward a potentially lengthy recession. In contrast, a German banking system on the mend would have much to offer in helping drive the European economy and reducing the current heavy dependence on the U.S. economy as the sole engine for global

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.

The Pension Fund Issue

By Scott B. MacDonald

The issue of pension fund shortfalls was given considerable media time in October when General Motors (GM) declared that its pension plan may be under funded by as much as $23 billion by year-end 2002. This prompted Standard & Poor's to downgrade GM’s BBB+ ratings to BBB. GM is hardly alone. Over the past couple of months, a number of major companies have indicated that pension shortfalls are a growing concern – Ford, Maytag and Whirlpool to name but a few. Pension funding shortfalls are the next issue which have the potential to disrupt the stock market, due in large part to the complex nature of funding and accounting rules, the large size of numbers involved and rating agency reactions. We would add that although this may cause spread widening, equity price volatility and negative ratings actions, not all companies have this problem. Some of the companies with pension plan shortfalls, like IBM and Boeing, are in much better shape to make up any differences compared to AMR and Delta, which will be hard-pressed with a multitude of other problems. The bottom line is that companies that are already on the margin with their ratings (for other reasons) are very likely to be negatively impacted by this issue. Our recommendation is that with any company that you are examining, take the unfunded portion of pension plans and treat that as debt. If the impact on leverage is significant, you should be concerned.

The roots of the pension shortfall are to be found in the excesses of the 1990s. Many companies used gains from pension investments to inflate profits. They were allowed to do this by accounting rules that permitted corporations to mingle pension income with operating earnings. While this worked well in an upwardly mobile stock market, it has hurt when the same market has had two consecutive years of steep declines and 2002 looks like it could be year number three. This is painfully evident by Standard & Poor's 500 Index of companies with defined benefit plans, which indicates that there will be a $243 billion shortfall in 2002, the first since 1993.

The critical issue for many companies is that if the stock market does not recover, a number of companies will be forced to divert earnings and cash to make up the difference. This takes capital away from capital spending at a time when capital spending is already tight. It also reduces the availability of funds to help the process of reducing debt. Moreover, the pension funding issue is a bigger concern to the industrial sector of the economy than it is to financial services.

We see three major trends emerging from the pension funding issue:

  1. Investors will avoid companies with large gaps in pension funds unless those companies can clarify that they have the means to deal with the situation. We have already seen this in the case of the autos;
  2. Rating agencies are looking more closely at the issue and are likely to downgrade those companies that are unable to satisfactorily demonstrate that they can handle the situation without resorting to a further buildup of debt. S&P already downgraded GM and placed Ford and auto-parts maker Delphi on watch for possible downgrades. (Delphi’s unfunded pension obligations increased in 2002 to $3.5 billion);
  3. Pension shortfalls can become a political issue if there is enough pain from the workers and if taxpayers’ dollars must make up the difference. This could result in accounting changes as well as greater regulatory oversight. Pension shortfalls in the United States do not mean that retirees stop receiving benefits. Ultimately, benefits are backed by the Pension Benefit Guaranty Corp (PBGC), a federal agency, which guarantees benefits for around 44 million U.S. workers in 35,000 pension funds. The PBGC is paying benefits for 624,000 workers of 2,975 under-funded plans that have been terminated since the agency was created in 1974.

We are seeing companies respond to the pension fund issue. IBM has stated that it will add as much as $1.5 billion a year to its pension fund in 2003 and 2004 because it expects declines in the value of the plan’s assets. United Technologies also announced that it would put another $500 million in cash into its pension plan, taking total contributions in 2002 to $1 billion. Boeing announced that it expects no pension income in 2003 after getting $500 million in 2002. However, the lack of pension income in 2003 contributed to a cut in the aerospace company’s 2003 profit forecast.

The U.S. corporate sector has been through a succession of tough challenges in 2002. Corporate scandals, an anemic economic recovery, and concerns over a host of geopolitical issues have created a difficult business environment. Now as Q3 earnings have a better tone, we have pension fund shortfalls. In reality this is not a new problem, but something that has been quietly building up as the stock market has deflated. However, as the economy remains weak and companies still lack traction for stronger growth and earnings, the financing of shortfalls in pension programs will be a major issue. And, like all the fear and loathing over scandals and the state of the economy, the scare over pension fund shortfalls has the potential to be overblown.

The Asbestos Issue

By Scott B. MacDonald

The asbestos issue is not likely to go away any time soon, but there is some good news. Recent announcements of settlements in asbestos cases for Sealed Air Corp., Halliburton and Honeywell indicate there is a positive trend in this direction. Although the settlements have large price tags, they begin to quantify the costs related to the issue and start to remove some degree of the uncertainty that has been hanging over a number of companies and their employees many of whom were threatened with job losses related to possible bankruptcies. Equally important, the push on the part of the companies, with their insurance companies in tow, puts more pressure on the U.S. Congress to pass reform legislation on torts.

In early December, Sealed Air Corp., maker of Bubble Wrap, agreed to pay $856.3 million in stock and cash to settle asbestos and bankruptcy-fraud claims connected with its 1998 purchase of W.R. Grace & Co.,’s food-packaging unit. Grace creditors and asbestos-injury claimants sought to prove the chemical maker fraudulently transferred assets before filing for Chapter 11 protection in 2001. What was regarded as positive from the settlement was that it was well below expectations in terms of cost. Stated in another way - Sealed Air can afford the settlement.

The news concerning asbestos settlements continued into mid-December with the announcement that Halliburton, an oil services company with 85,000 workers, has offered to pay about $4.2 billion to settle more than 200,000 claims and create a trust to handle future claims. It was also announced that Honeywell, a diversified manufacturer with 115,000 employees, agreed to settle a similar number of claims against one of its subsidiaries and ensure that all claims against the unit are paid.

Related to these recently announced settlements is the expectation that the new Republican-dominated Congress may finally reform U.S. tort law, under which asbestos litigation falls. Both U.S. business and labor are growing more concerned that asbestos will be increasingly more damaging in terms of lost jobs. A recent report commissioned by the American Insurance Association noted that so far 60,000 jobs had been lost due to asbestos-related bankruptcies. In addition, the report noted that worse is yet to come if there is no reform as only about a quarter of the costs of asbestos claims have yet been paid. The eventual price tag is expected to range between $200-275 billion. This has gotten the attention of Congress.

Over the last several years, Congress has considered a number of bills aimed at creating a system for resolving asbestos claims outside the judicial system. The Democrats, backed by trial lawyers, have consistently blocked any changes in the law. The recent settlements could represent an important breakthrough. In the Sealed Air case, approval of the settlement is required from the judge overseeing Grace’s Chapter 11 case, filed in U.S. Bankruptcy Court in Wilmington, Delaware and several creditors’ committees. If the judges approve the settlement, there is a strong possibility that other companies in similar cases will follow suit, seeking to settle out of court. This, in turn, could provide additional pressure on the Congress to reform tort laws, which would make sense out of a judicial system that is largely stacked against the companies. If nothing else the threat of legislative reform of the tort code could force settlements.

12 -14 February 2003 - United Nations Conference Center, Bangkok, Thailand

Managing Small to Medium-Sized M&A Opportunities in Japan

By Andrew Thorson, Partner, DORSEY & WHITNEY LLP (Tokyo Office)

Changes in the world and Japanese domestic economy have resulted in increased opportunities, not only for large but also for small and mid-sized foreign companies seeking financial and strategic opportunities in Japan. Foreign investors, once scared off by linguistic and cultural barriers, the high cost of doing business and a lack of market access, are now taking a second look.

Distressed assets and strategic tie-ups are hot. In the wake of Japan’s so-called “Big Bang” financial reforms, investment barriers are slowly loosing ground to market realities. Nonetheless, closing cross-border acquisitions in Japan is not easy. Foreign investors must understand the local dynamics. Here are some tips they should keep in mind:

Find the right advisors. Japan has a rich and complex business environment embracing both traditional and modern aspects of business culture. As the sophistication level of M&A has risen in Japan, so has the importance of in-depth experience with sophisticated structures and transactions. More importantly, taking advantage of recent deregulation and newly opened doors for state of the art transactions in Japan demands that the acquisition team and its advisors have in-depth experience utilizing cutting edge tools.

Examples of such opportunities include recently adopted laws facilitating M&A techniques such as MBO’s and the “new shares reservation right” (shinkabu-yoyakuken) which has a function similar to that of an option. To name only a few of the other significant advances, the Japanese Commercial Code has been revised to: permit a two-tier governance structure similar to the U.S. model comprised of directors and officers; prescribe stock-for-stock acquisitions; and relax burdensome restrictions on contributions-in-kind, stock options and the issuance of preferred and other types of stock. Most notably, Japan has also enacted a new Civil Rehabilitation Law, which can expedite the restructuring of debt-ridden companies. Recent changes in accounting rules are also anticipated to facilitate cross-border acquisitions.

This new environment provides opportunities for foreign investors to engage in creative strategic and financial investments. Optimizing the acquisition possibilities requires a team, which is equipped to think outside the traditional box in Japan. Unfortunately, such professional advisors in Japan are not inexpensive, and there is a shortage of qualified, experienced and bilingual service providers. Accordingly, it is important for small to mid-sized investors to consider potential transaction costs in the planning stages.

Communicate on a business level. It is said that Japanese executives prefer to do business with people that they know. During business negotiations, the Japanese negotiating team will often try to establish direct personal ties with foreign counterparts. If foreign negotiators fail to engage in effective personal interaction, Japanese counterparts might doubt their sincerity. Worse, they may be reluctant to provide frank information to the acquiring company.

In addition, Japanese companies also tend to rely less on outside attorneys and advisors. As a result, phrases like “our attorneys” or “our advisors will be contacting you regarding this” are heard less often. The hurdles to closing a deal are often overcome without lawyers present in a less formal setting outside of the conference room. In practice, deal-killer issues are often resolved informally by smaller groups over a discrete dinner or whisky and water.

Effective communications requires establishing personal ties at not only the executive, but also the managerial and operations levels. There is no substitute for an acquisition team, which can expedite person-to-person contacts with, and learn first-hand knowledge from, the target company itself. This is one aspect of doing business in Japan in which small to mid-sized companies that have a "hands on" management might find they have a natural advantage.

Keep concepts simple. Japanese executives often disdain complex, legalistic proposals. Instead, one often hears Japanese executives’ state “we should work things out together as Japanese do.” Typically, this requires compromises together with a deference to trust and pre-existing relationships.

The emphasis in Japan on informality and simplicity in cross-border M&A arises from both practical and cultural causes. On the practical side the parties often negotiate in English. Like international executives from most countries, many high level Japanese businesspeople are fluent in English. However, negotiations are more manageable when the documentation and proposals are in “plain English” and do not include convoluted provisions and concepts. Quite often the Japanese team faces a greater disadvantage than might the typical European or American negotiators when having to deal in the English language.

More than likely, the transaction will be reviewed at various levels by senior executives within the Japanese corporation. These executives may be unfamiliar with and even suspicious of Western ways of dealing. And it is quite likely that they will be unfamiliar with the mechanics of Western-style mergers and acquisitions. Senior Japanese executives are more likely to okay a transaction if it is as straightforward as possible.

Understand the dynamics of your counterpart. Some Japanese companies are trying to encourage greater flexibility in decision-making. But many large Japanese companies still operate under a burdensome managerial hierarchy. While Western companies give mid-level executives discretion to negotiate deals based on their independent judgment, Japanese negotiators may be expressly or implicitly required to consult closely on minute details with senior executives before accepting any proposal.
Negotiating in this environment is usually challenging for Western executives. In addition to patience, a few simple techniques may minimize frustration.

Western negotiators should put their proposals on the table early to allow a timely response by their Japanese counterparts. Western negotiators also should avoid surprises. That will help their Japanese counterparts, who must achieve consensus among senior executives. Reaching a new consensus often requires time. Worse yet, going back to the executives provides them an opportunity to raise additional new issues.

For the reasons above, the Japanese negotiating team itself may also seek to minimize the involvement of its executive decision-makers. This urge to avoid senior executives may lead Japanese negotiators to reject even reasonable requests out of hand. Surprises can kill a deal.

On the contrary, it is not uncommon for a Japanese negotiating team to raise untimely last minute demands based upon suggestions by executives who have not been involved in the transaction to date, but who also cannot be ignored once they become involved. Sometimes Western negotiators misinterpret these untimely proposals as a bad faith change in the deal terms. Quite often it is simply a matter of poor management of the negotiating process.

Understanding the source of a counterpart’s reactions to proposals and untimely demands requires patience. It is also an essential requirement for determining appropriate responses.

Understand the inter-company relationships. In Japan, companies in certain industries often form a tight web of relations with affiliates, customers and suppliers. Such networks are loosely referred to as “keiretsu.” In cases where suppliers and customers own stakes in each other’s companies, these ties are obvious. But companies often maintain less obvious ties by sharing technology, production and management. Inter-company debt guarantees are also common.

Commonly, ongoing transactions and other important relationships within networks are poorly documented or not documented at all. Nevertheless, investors should strive to evaluate and clearly understand these relationships and the inherent liabilities early in the acquisition process. Otherwise, foreign investors may learn about such issues only at the last minute when closing appears inevitable. Such untimely disclosures do not necessarily indicate bad faith. Often, it reflects the complex nature of the Japanese keiretsu. Even the target company itself might fail to understand or appreciate the impact of keiretsu relationships on the proposed deal.

Accordingly, early clarification of these relationships is absolutely crucial. Investors must confirm transactions that are not at arms length, insider deals, and inter-company guarantees, etc.

Unfortunately, Japanese companies also provide notoriously conservative and vague disclosures. To avoid misunderstanding and stonewalling later, investors should consider walking the target company’s management through due diligence requirements in the planning stage. Management interviews are also an important means for understanding the target company and for finding any hidden “land mines” not disclosed in documentation.

Japan is truly a complex blend of the traditional and modern and often defies Western attempts to fully understand it. Nevertheless, the right team and knowledge of the basics can help ensure that valuable transaction time is not wasted and that deals that should have happened are not lost. Hopefully, this article has offered a useful guide, but these are only generalizations. Each situation must be evaluated first-hand by qualified individuals with extensive knowledge of Japanese language, culture and business environment.

Emerging Market Briefs

By Scott B. MacDonald

Burma – Passing of an Era: General Ne Win, long time dictator of Burma and then power in the shadows, has finally died at the age of 91. He rose to power as one of a group of former students who fought with the Japanese against the colonial British during World War II. Joining the Burmese military in its early days, he became one of the key players in Burma’s politics. In 1962 he took power and quickly moved Burma into many decades of self-imposed international isolation. The Ne Win regime used a blend of socialism and Buddhism as an ideological fig leaf, while the top-ranking members of the military pursued their own set of development activities. Ne Win developed his own reputation for liking good food, gambling and women. This was a sharp contrast to the long-term downward trajectory of the Burmese economy and difficult living conditions faced by most Burmese.

Although Ne Win kept his country non-aligned during the Cold War and avoided embroiling it in any major conflict, there was a significant price. On the economic front, Burma missed the boom starting in the late 1970s that lifted the economies of most of Southeast Asia and made substantial improvements in daily life. On the political front, Burma long remained a bloody arena of contending regional and ethnic factions, some of whom relied heavily on the international drug trade for funding. Ne Win frequently purged his regime. Despite the brutal approach to any opposition (real and imagined), his regime was unable to completely control the country. By the time Ne Win resigned in 1988, Burma was regarded as one of Asia’s most backward countries and the country was strongly identified as a core part of the infamous Golden Triangle for the global heroin trade. Since his resignation, Ne Win and his family sought to maintain some control over the military junta and he is regarded as an obstacle to opening up the political system. Recently, members of Ne Win’s family were arrested, indicating that old dictators actually due fade away.

Finally a Free Trade Agreement With the United States: After more than a decade of trying, Chile and the United States finally appear to be on track for a free trade agreement. It was announced on December 11th that the two countries had reached an agreement. If approved by the U.S. Congress, the agreement would eliminate tariffs immediately on 85% of goods traded between the countries and tariffs on all goods within 12 years. This is positive news for Chile. The North American country is Chile’s major trade partner, with the total of goods and services traded between the two standing at close to $9 billion.

China –
Industrial Production Up: China’s industrial production rose 14.5% year-on-year in November. It is expected this strong performance in manufacturing should ensure that China finishes 2002 with real GDP well above 8%. This is far above most other Asian nations. Real GDP has benefited from steady domestic demand and recovering exports.

China – Big Time Entertainment Goes to China: On December 6, it was announced that Universal Studios plans an $870 million amusement park in Shanghai. The park could open as early as 2006, spanning a two-square-kilometer patch in Shanghai's booming Pudong development area. The move comes after months of negotiations. Universal is expected to invest less than $100 million on the Shanghai park as it has partnered with the logistics company Waigaoqiao Group and developer Shanghai Jinjiang Holding Co., which will together own a majority stake in the project. Universal would retain around one-third of the project and supervise its operation.

Disney is also in talks to build a park in Shanghai, a move that is likely to upset officials in Hong Kong. Disney is already constructing a Disneyland on 310 acres near the Hong Kong airport. That park is due to open in 2005. The Hong Kong government awarded Disney substantial incentives to come to Hong Kong, counting on a HK$148 billion ($19 billion) boom in tourism, particularly from China. Disney, however, did not sign an exclusivity agreement, meaning it can also build copycat parks in the mainland.
These developments come amid a development boom in Shanghai. Hong Kong-based Sun Hung Kai Properties said this week it will spend HK$8 billion ($1 billion) to develop a project in Pudong. Universal is also in discussions to build a park in Beijing.

Saudi Arabia –
Feeling the Heat: The Saudi government is increasingly under pressure about its ability to deal with Islamic radicalism. The latest flap came from revelations that money donated by a Saudi princess possibly ended up in the hands of an Islamic charity that helped finance one of the 9/11 terrorists. Although the Bush administration officially claims that Saudi Arabia is still a good ally, tensions have risen since 9/11 between the two countries. In particular, the high number of Saudi nationals involved in the 9/11 attacks (a clear majority), the track record of Saudi money going to radical Islamic groups outside of the country and a rising number of attacks on Westerners inside the Kingdom have fueled Western criticism of Saudi Arabia for “turning a blind eye” to the rise of anti-Western groups. Now, German prosecutors are investigating possible links between the alleged al-Qaeda terrorist on trial (Moroccan Mounir al-Motassadeq) and diplomats and Islamic activists from Saudi Arabia. The Saudis find themselves in a difficult situation as they are caught between Western pressure to clamp down and domestic discontent with the U.S. push to go to war with Iraq. In addition, many Saudis see the ruling royal family as corrupt and unable to manage the economy. This is compounded by the lack of political freedom, which has pushed tensions just beneath the surface. Saudi Arabia will be a country worth watching in 2003, especially if the U.S. goes to war with Iraq.

Singapore –
Cutting its Growth Forecast: Singapore remains highly vulnerable to the ups and downs of the international economy. Along these lines, 2002 was a trying year as export expansion did not meet initial expectations due to the sluggish nature of the U.S. economy. In addition, the region’s growing political worries related to rising activity by radical Islamist groups, including the bombing in Bali, have put a dent in the city-state’s tourist trade. Many travelers use Singapore as a hub from which to visit Indonesia, Malaysia and Thailand. Exports to the U.S. shrank by 5.7% in October. Considering all this bad news, the Government of Singapore has cut its real GDP growth forecast for 2002 from 3-4% to 2-2.5%.

Book Reviews

The Coming Collapse of China, by Gordon Chang (New York: Random House, 2002) 368 pages. $26.95

Reviewed by Jean-Marc F. Blanchard, Ph.D


Click here to purchase The Coming Collapse of China, directly from Amazon.com


Much is at stake in China’s future: huge foreign investments, billions of dollars of trade, the global energy equation, the lives of more than a billion people, and the geopolitical situation in the Asia-Pacific region. It is not surprising, therefore, that policymakers, academics, and writers devote so much attention to this topic. What is surprising, however, is how individuals looking at the same facts can arrive at such diametrically opposed conclusions. On one hand, some envision a bright future. On the other, some see a looming disaster on the horizon.

In The Coming Collapse of China, Gordon Chang forcefully argues the pessimist’s case. For Chang, glitzy Shanghai, increasing foreign trade and investment, and a developing high-tech sector do not represent the real China. Instead, the real China is characterized by increasing unemployment and underemployment, massive banking problems, failing state owned enterprises (SOEs), corrupt and repressive Chinese Communist Party (CCP) rule, dissident movements like Falungong, and separatists in Tibet and Xinjiang. Indeed, the situation is so critical that “Beijing has about five years to put things right.” Unfortunately, he believes, the shock of China’s WTO obligations, the government’s lack of fiscal resources, the straitjacket of Communist Party ideology, the Party’s lack of ideological authority, and the power of the Internet mean there is no hope. China is a lake of gasoline and one individual “will have only to throw a match.”

Before taking the money and running, however, businesspeople and policymakers need to consider the following. Chinese leaders and bureaucrats are not hamstrung by ideology and are well aware of the problems they are confronting. Second, Chinese elites are moderating the effects the WTO has on the country. Third, however gradual, China truly is reforming its SOEs, establishing social safety nets, and changing the political system (e.g., by incorporating private entrepreneurs into the Party). Fourth, the Party retains solid control over all the instruments of coercion. Fifth, although the outside world in the form of the WTO will pressure China, the outside world in the form of international investors and financial institutions, and neighboring countries also will help.

As for the merits of Chang’s analysis, it is important to remember that multiple and potent domestic and international factors have to come into alignment for states to collapse or regimes to fall. In addition, unemployment, even massive unemployment, or dissatisfaction with the CCP does not necessarily translate into revolutionary political action. Moreover, the existence of fiscal deficits does not mean the Chinese government has run out of policy options for reflating its economy. Finally, it is true that Marxist-Leninism cannot provide any legitimacy for the CCP, but there are other factors such as nationalism and performance legitimacy that can.

The Coming Collapse of China is repetitious and contradictory at times. It does not offer much new information, and contains some noteworthy factual errors. Nevertheless, I still recommend its purchase for three reasons. First, it is an entertaining book full of colorful anecdotes and quotable statements. Second, it highlights, in one place, all the major challenges that now confront China’s current leadership. Third, it forces us to think about the effect that China’s WTO admission will have on the country. The Coming Collapse of China may not be an apt title, but A Dramatically Changing China would be a hard title to dispute.

Pakistan: Eye of the Storm by Owen Bennett Jones, (New Haven: Yale University Press, 2002) 328 pages $29.95.

Reviewed by Scott B. MacDonald

Click here to purchase Pakistan: Eye of the Storm directly from Amazon.com

Afghanistan was long a forgotten backwater in global politics and this was amply reflected by a sparse literature concerning the country. The Soviet Union’s invasion of Afghanistan in 1978, however, changed this. Afghanistan soon became a center of attraction for both academics and journalists. Having the Taliban in power only helped this, considering the quirky and ruthless nature of the regime. Now, it would appear it is Pakistan’s turn. Long the realm of a handful of academic works and a rare journalistic sortie, Pakistan is becoming a “topic”. Indeed, it is important to have a better understanding of this strategically located country in South Asia which borders Afghanistan, Iran and India. Owen Bennett Jones, a journalist who has worked for the BBC, Financial Times, and The Guardian, has written what is likely to be one of the better new books on Pakistan. Pakistan: Eye of the Storm is well-written, thoughtful, and thought-provoking. While critical of much of what he sees, he clearly is not anti-Pakistani, making his book credible.

The fundamental thrust of Jones’ book is that Pakistan’s creation as a country was done so in such a fashion that its insecurity would remain a central preoccupation of the ruling elite. This insecurity is broadly defined as a long and vulnerable border with India (especially for East Pakistan which became Bangladesh), the frequently fractious nature of its ethnically mixed population (divided between Punjabis, Baluchis, and many others), and lack of strong institutions beyond the military. The overwhelming military threat from neighboring India, with its longstanding dispute over Kashmir, clearly helped maintain the Pakistani military’s central and usually dominating role in its nation’s politics. Hence, the arrival of General Pervez Musharraf upon the scene in 1998’s coup was no surprise nor was it a departure in the country’s political tradition. The other related thread running through the book is the battle over Pakistan’s soul – fought between those who envision a modern country and Islamic radicals, who would prefer a hardline Muslim state, governed by sharia.

Within this complex country, the forces of Islam are having their own civil war. On one side is Musharraf, who has clearly sided Pakistan with the West and a more tolerant world order, and the Islamic radicals on the other. In a sense, Huntington’s clash of civilizations is fully believed by the radicals. As one Islamic radical leader stated: “We believe in the clash of civilizations and our Jihad will continue until Islam becomes the dominant religion.”

Jones concludes that Pakistan is likely to remain in search of a national unifier. Neither Islam nor Urdu has brought greater national cohesiveness. Musharraf does have a vision of a more modern, developed Pakistani nation, less divided by ethnic and religious strife. Yet, Jones ends his book: “If General Musharraf is to transform his vision of Pakistani society into a reality he will need great reserves of political will, and a more effective bureaucracy. He has neither. And while he still believes that the Pakistan army is the solution to the country’s problems, he shows no sign of accepting that, in fact, it is part of the problem.”

Pakistan is an important country in what has become a critical region in international relations. We strongly recommend Jones’ Pakistan: Eye of the Storm.

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KWR International, Inc. (KWR) is a consulting firm specializing in the delivery of research, communications and advisory services with a particular emphasis on public/investor relations, business and technology development, public affairs, cross border transactions and market entry programs. This includes engagements for a wide range of national and local government agencies, trade and industry associations, startups, venture/technology-oriented companies and multinational corporations; as well as financial institutions, investment managers, financial intermediaries and legal, accounting and other professional service firms.

KWR maintains a flexible structure utilizing core staff and a wide network of consultants to design and implement integrated solutions that deliver real and sustainable value throughout all stages of a program/project cycle. We draw upon analytical skills and established professional relationships to manage and evaluate programs all over the world. These range from small, targeted projects within a single geographical area to large, long-term initiatives that require ongoing global support.

In addition to serving as a primary manager, KWR also provides specialized support to principal clients and professional service firms who can benefit from our strategic insight and expertise on a flexible basis.

Drawing upon decades of experience, we offer our clients capabilities in areas including:


  • Perception Monitoring and Analysis
  • Economic, Financial and Political Analysis
  • Marketing and Industry Analysis
  • Media Monitoring and Analysis


  • Media and Public Relations
  • Investment and Trade Promotion
  • Investor Relations and Advisory Services
  • Corporate and Marketing Communications
  • Road Shows and Special Events
  • Materials Development and Dissemination
  • Public Affairs/Trade and Regulatory Issues


  • Program Design and Development
  • Project Management and Implementation
  • Program Evaluation
  • Training and Technical Assistance
  • Sovereign and Corporate Ratings Service

Business Development

  • Business Planning, Development and Support
  • Market Entry, Planning and Support
  • Licensing and Alliance Development
  • Investor Identification and Transactional Support
  • Internet, Technology and New Media

For further information or inquiries contact KWR International, Inc.

Tel:+1- 212-532-3005, Fax: +1-212-799-0517, E-mail: kwrintl@kwrintl.com

© 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.