KWR International Advisor #17 March/April 2003

Marc Faber was born in Zurich, Switzerland. He went to school in Geneva and Zurich and finished high school with the Matura. He studied Economics at the University of Zurich and, at the age of 24, obtained a Ph.D. in Economics magna cum laude. Between 1970 and 1978, Dr Faber worked for White Weld & Company Limited in New York, Zurich and Hong Kong. Since 1973, he has lived in Hong Kong. From 1978 to February 1990, he was the Managing Director of Drexel Burnham Lambert (HK) Ltd. In June 1990, he set up his own business, Marc Faber Limited, which acts as an investment advisor, fund manager and broker/dealer. Dr Faber publishes a widely read monthly investment newsletter "The Gloom, Boom & Doom" report which highlights unusual investment opportunities, and is the author of the recently released book "Tomorrow's Gold" and "The Great Money Illusion - The Confusions of the Confusions" which was on the best-seller list for several weeks in 1988 and has been translated into Chinese and Japanese. A book on Dr Faber, "Riding the Millennial Storm", by Nury Vittachi, was published in 1998. A regular speaker at various investment seminars, Dr Faber is well known for his "contrarian" investment approach. He is also associated with a variety of funds including the Iconoclastic International Fund, The Baring Chrysalis Fund, The Baring Taiwan Fund, The Income Partners Global Strategy Fund, The Framlington Eastern Europe Fund, The Buchanan Special Emerging Markets Fund, The Hendale Asia Fund, The Indian Smaller Companies Fund, The Central and Southern Asian Fund and The Regent Magna Europa Fund plc and Tellus Advisors LLC.

Thank you Marc, for agreeing to speak with our readers. Can you tell us a little about your background and current activities?

I am Swiss and have worked in the investment field since 1970, first with White Weld & Co., later with Drexel Burnham Lambert Inc. I have lived since 1973 in Hong Kong and formed my own investment management and advisory company in 1990. I publish the Gloom Boom & Doom Report (www.gloomboomdoom.com ) and have written several books including the latest one entitled “Tomorrow’s Gold”, which is available through Amazon.com.

Until recently the U.S. was perceived as a safe haven and in many ways a beneficiary of global turmoil. This has been changing due to U.S. economic and corporate excesses and the 9/11 tragedy. As a result, investors have been enduring dramatic losses in dollar-denominated assets. This would seem to argue for greater international exposure, yet economists such as Joseph Quinlan argue that investor fear exceeds their desire for greater diversification and outflows from the U.S. -- have to date been minimal. Can you give your thoughts on this and whether this trend will be sustained?

Most investors seem to be brain-damaged. They buy high and sell low. They buy what is perceived to be safe or promising big returns, not what will provide big returns in future. In the late 1980s, they bought Japan and Asia and were negative about the US. In the late 1990s right up to now, they bought the US and shunned Asia, although Asia is following the crisis of 1997 relatively inexpensive.

Alan Greenspan and many analysts have expressed the view that current economic difficulties in the U.S. are largely the result of "global uncertainty" and that once problems with Iraq and other issues are resolved, positive growth and momentum will be restored in the U.S. Do you believe that is the case what is your outlook for the U.S. economy?

The problems of the US economy have nothing to do with “global uncertainty”. Greenspan messed it up so royally that he now has to find an excuse for his disastrous handling of the economy over the last 10 years or so. Now, we are paying the price for the ill-fated US belief that all problems can simply be solved by easing, printing money and expanding credit. Mr. Greenspan should never have been a Fed Chairman and future historians will judge him very negatively.

Throughout much of the 1990s, there was a lot of discussion about the "East Asian Miracle" and the coming "Pacific Century". This talk largely evaporated during the 1997 Asian financial crisis. Do you believe we were too quick to write off the "East Asian Miracle" and does the "Asian Way" represent a real alternative to Anglo-Saxon business and financial practices?

I do not believe so much in stereotype phrases like Asian miracle, the Asian way, etc. When it comes to money all people are of the same religion. In Asia, we have in theory looser controls over the economy than in the West, but recent events in the US and other western countries with respect to the terrible abuses that occurred throughout the economy, the business sector and the governments suggest that the Asian are small town thieves when it comes to plundering companies and ripping off shareholders.

During the Asian financial crisis, the U.S. was viewed by many as a "global economic locomotive" that needed to maintain its performance until Asia and/or Europe could regain its economic footing. Now the U.S. engine appears to have run out of steam and Europe or Japan do not seem ready to take on the load. Can the world regain positive momentum without a locomotive and what are the ramifications of continuing weakness in the U.S., Europe and Japan?

We have to distinguish between markets in terms of dollar sales and in terms of units. Today, many physical markets are already larger in China than in the US. I am thinking of steel, where the Chinese production is larger than the one of the US and Japan combined, with China still importing steel. Also the markets for refrigerators, TVs Radios, motorcycles, cellular phones are larger in China than in the US. Now add the markets of India, Japan, Indonesia, etc to the Chinese market and you actually see that Asia by itself is a huge economy in terms of units. I am a believer in a secular economic military and political decline of the US and a rise of China and other Asian countries. I think the US is today where the UK was at the beginning of the 20th century and that global growth in future will be driven by Asia.

For hundreds of years arguments have been made as to the potential of emerging markets and the potential they offer. What we have seen, however, is higher volatility and what you have termed "gloom boom doom" than one generally finds in more mature markets, especially over the long term. Would it then be fair to say that investing in emerging markets is more cyclically-oriented and a trading opportunity than a long term investment? What should investors who lack the resources of large institutions and ability to buy foreign listed securities watch out for?

I think this is a good point. However, I suppose that in many countries such as China and Russia, there will also be long-term opportunities. I am not sure that these companies already exist, but it is clear to me that China will also one day have a GE, an IBM, MMM, Coca Cola, etc. It is important to understand that rapidly growing economies have wild business fluctuations. In my book “Tomorrow’s Gold” I describe the life cycle of emerging economies and for an investor it is obviously important to time his purchases well. I may add that I include in “emerging markets” also “emerging economies” such as the Internet, the PC, and cellular phones. People who bought stocks in the TMT sector at the wrong time will probably never see their money back, as new players will displace the early leaders of these industries.

One is continually hearing now about the danger of deflation yet gold, oil and many other commodities are at, or approaching multi-year highs. Can you explain this phenomenon and its implications for investors? Are we beginning to see both forces exist simultaneously in a manner last seen during the "stagflation" years of the Carter administration?

Very few people understand the phenomena of inflation and deflation – both of which can occur at the same time. We have in many industries over-capacities and the opening of China and so many other countries is putting terrific pressure on the prices of manufactured goods. At the same time, these new countries will have a strong demand for commodities –especially oil and food products. Therefore, although prices of manufactured goods could continue to decline, prices of commodities may rise much further. In addition with Mr. Greenspan not hesitating to print money and expand credit and the prospect of Mr. Bernanke becoming Fed Chairman, and the possibility of a War, you have a favorable environment for commodities.

Technology and the Internet have had tremendous implications on our lifestyle and the way business is conducted around the world. After several bad years we are beginning to see investor interest in smaller Asian Internet companies such as SINA, PCNTF, REDF, SIFY, etc. and other such as IGLD in Israel. Is this a meaningful trend and what are your thoughts on technology in general?

Yes, I think that out of the ruins there will be some winners. I just don’t know which ones will really make a lot of money.

The Dollar has been weakening and most U.S. investors are unaware that even investments that have broken even are down double digits when measured against the Euro and many other currencies. Do you think this trend will continue and what are the trends that will arise as a result? Which currencies other than the Euro will be beneficiaries of this trend?

The dollar has been far too high considering the economic fundamentals of the US and considering the policies of its economic decision makers who don’t care at all about “sound money”. Therefore, I believe that the dollar has entered again a secular bear market, whereby it will lose in due course once again 90% of its value. The question, however, is against what the US dollar will lose value. Probably it will still decline against the Euro, as European fundamentals will improve with the inclusion of so many new countries into Euroland. However, I think the real weakness will occur against a basket of commodities and against hard assets.

Many of our readers represent corporations and governments in Asia and other markets that are seeking to position themselves to appeal to the international financial community. Do you have any thoughts or words of wisdom on steps they might take to make themselves more attractive in this regard?

The best way to get exposure to investors is to perform well and not to constantly lie to the investment community. Companies should spend more time running their businesses than talking to investors, while the executives would do better to read once a while something else than Newsweek and spend their time on the golf course.

For over a decade there has been a lot of talk about globalization and the integration of world financial markets. While this has perhaps slowed down in recent years, we are seeing increased after hours trading and firms seeking dual listings or even bypassing their national markets to list on foreign exchanges that they believe will deliver more attractive valuations. Can you comment on these developments and their implications for investors and public corporations?

We are moving towards a global market place where financial assets will be traded 24 hours a day. With this development it is clear that some shares will be more actively traded during European or NY hours than in Asia. After all, whereas the physical markets in Asia are huge, the financial markets are disproportionately large in the US compared to real economic activity. Thus, the high trading volume in the US compared to other countries.

The events of 9/11 have had a dramatic effect on corporate and political behavior. What are your thoughts on the implications of the "global war on terrorism"?

I am not so sure this statement is correct. 9/11 has given companies an excuse for poor performance and to cut travel and entertainment budgets. It has also given every dumb and totally uninterested expatriate wife, whose life consists of patronizing the local American Club, to force the husband to move back to the US for fear that he might find “something” more attractive in a foreign country.

Even before 9/11 we began to see a more vocal backlash against globalization, as seen in the disruption of the Seattle WTO meeting and the IMF/World Bank deciding to reschedule and scale down their annual meetings. Now we are beginning to see large-scale demonstrations around the world against U.S. policy toward Iraq and other international initiatives, which in many ways are similar to those we last saw during the Vietnam-war era. Do you think these are related and can you comment on this trend?

In the sixties, there was the saying about the “ugly American” because the world was afraid that America would take over the world economically. Now, we have anti American sentiment for the US arrogance and lack of sensitivity towards other views and customs. I admire in many ways the American way of life, but unfortunately American leaders know and understand what is going on in the world no better than my four Rottweiler dogs. Moreover, whereas my dogs only have one standard – to eat – the US has many different standards depending on their economic interests.

One economy that continues to defy gravity is China, and there seems to be a growing anxiety all over the world about its continuing strong growth and the displacement it is causing, particularly in the manufacturing sector. Can you talk a little about China, the role it will play in the world economy and what it means for investors, the U.S. and other countries in the region.

China today, is where the US was in the second half of the 19th century. At the time it became extremely competitive on world markets and its entry into the global economy led to a significant price fall between 1873 and 1900. The opening of China will depress prices for manufactured goods for a long time. At the same time China will become Asia’s largest customer for commodities and its tourists will be the largest group.

Similarly, Businessweek recently wrote an article comparing the movement of manufacturing jobs from the U.S. in the 1970-80s to a current displacement among service workers today. Given the improved communication and infrastructure that allows one to base an operation almost anywhere in the world, how will higher-wage and cost economies sustain their competitive advantage?

I don’t see how in the long run the US and Europe will be able to compete with tradable services from Asia. India will dominate the software industry and China the way China will dominate manufacturing. Research labs will also move to Asia as we have an endless supply of highly qualified and motivated people who can innovate and invent.

I notice you are more positive on Southeast Asian countries such as Indonesia, Thailand and the Philippines as opposed to markets such as Korea, Taiwan and Japan which possess superior infrastructure, more educated workforces, higher percapita consumption and a greater corporate and technological base. Can you tell us why this is the case?

I think that Korea, Taiwan and Japan will suffer to some extend from the competition of China. The resource based Asian economies will on the other hand benefit from the rise of China. This does not mean that stocks in Korea, Taiwan and Japan will not perform well, as companies can shift their production to China and, therefore, cut their costs.

What are your thoughts on Japan? What do you make of the debate between promoting inflation and demand vs. structural reform and industrial revitalization? Do you think we are at or near the bottom? Finally, do you think the best opportunities are with the export-oriented success stories such as Toyota or Hitachi or more the domestically-focused and/or distressed companies that will benefit from an economic turnaround?

I believe that in 2003, the Japanese stock market will bottom out and that good opportunities will arise. I am negative about Japanese bonds because I see a weaker Yen ahead and also the aggressive monetizing of the debt is likely to lead to higher inflation and interest rates.

Korea is viewed as one of the great "post IMF crisis" success stories. The country has shown a rapid willingness to reform and investor interest has grown to the point that companies such as Samsung now enjoy a larger market capitalization than Sony. It has also a rapid adapter of new technologies and leader in areas such as online trading, broadband and mobile telephony. At the same time, consumer debt is rising, unemployment is beginning to increase and troubles with the North are becoming a growing international concern. What are your views on Korea and it s economic prospects?

I think Korea will do just ok. I am not such a great believer in the success story of the last few years, which was built on excessive consumer debt. The stock market is somewhat over-sold and could rally from the present level by 20% to 30% this year.

Any thoughts on the emerging markets of Latin America, Central and Eastern Europe and the Newly Independent States and Africa you can leave with us?

I like some Latin American countries, because they are resource rich and will benefit in the environment I outlined. The price level of Argentina and Brazil is low and stocks may actually surprise on the up-side.

You recently authored a book named "Tomorrow's Gold" that has been attracting a lot of attention. Can you tell us about it?

Yes, it is doing very well and it will be translated into several foreign languages. Many people have written to me that the book is one of the most readable and interesting investment books. In my introduction to the book, I wrote that I owe all my knowledge to people from whom I learned a lot including Henry Kaufman. Sydney Homer, Charles Kindleberger, and all the classical and Austrian economists. I also learned a lot from Alan Greenspan, so if I am one day the head of the Zimbabwe Central Bank, I won’t repeat the same mistakes….

Thank you, Marc for a most informative discussion. Do you have any closing remarks for our readers.

"Follow the course opposite to custom and you will almost always do well"
J.J. Rousseau.

Many analysts predicted a weakening Korean economy last year in the face of an emerging China, a slow growing Japan and continuing market turmoil in the United States. To the contrary, a revitalized Korea exhibited a strong performance. It attracted substantial investor interest -- and the Korean stock market registered one of the world’s strongest performances during the first six months of 2002.

This achievement began to erode, however, during the latter half of the year and has accelerated in recent months. The simple truth is that Korea -- no matter how competitive its economy, and how rapidly it implements reforms and expands its corporate capabilities -- is not large enough to act as an engine of world growth by itself.

In a nation seeking to establish itself as the "Dynamic Hub of Asia", the perceptions of foreign investors and business executives matter more than ever before. Without them, Korea cannot attract the physical, human and financial resources needed to position itself as a global technology and financial center or to enable its companies to develop the value-added strategies that are essential to maintaining the rapid development Korea has exhibited in the past.

Rising tensions in the North, increased media focus on Anti-Americanism, burgeoning consumer debt and this week's downgrade of Moody's outlook for Korea's sovereign credit rating all contribute to a growing discomfort among international investors and executives. Their uneasiness is compounded by the recent election of Korean President Roh Moo-hyun, who ran on a populist platform and is largely unknown -- not only outside of Korea -- but also among many Korean business leaders. The world therefore nervously watches to see whether Korea will continue to deserve its hard-earned reputation as the Asian country most eager to embrace reform after the IMF crisis and as a result offered some of the world's most attractive investment and business opportunities.

While Koreans tend to hunker down and turn inward when faced with adversity that is precisely the opposite of what is necessary at the present moment. Korean business and government leaders – if they are to maintain the good will and positive perception they been gained in recent years – must reach out and confront the problems they are facing. Investors are not seeking to punish Korea or to retreat from the peninsula. Like everyone else they are simply seeking the reassurances they need to justify their decisions.

For example, rising tensions in the North lead Moody's this week to change its outlook for Korea's sovereign credit rating from positive to negative. Their belief is based on the assumption that increased provocation by the North, which has resulted in an open resumption of its nuclear effort, heightens South Korea's security risk and the possibility of a military response from the United States.

This development surprised many investors and business and government leaders. It has raised their anxiety level, particularly after several months of media coverage depicting a growing "Anti-Americanism"in Korea. Several U.S. government leaders have even gone so far as to question whether it is wise to maintain American security forces in the nation. One might rightly ask if Moody's actions and the resulting uncertainty it created were a key factor leading to an intra-day decline of over 6% earlier this week off the five day KOPSI index average and whether this is a portent of things to come.

The answer largely depends on the actions of Korea's new government and its corporate community. The U.S. until recently was perceived as a safe haven and in many ways a beneficiary of global turmoil. This has been changing due to U.S. economic and corporate excesses as well as the loss of innocence following the 9/11 tragedy. As a result, international investors and executives, who have been enduring dramatic losses in dollar denominated assets, have by necessity begun to regain their appreciation for greater international diversification.

This theoretically creates a great opportunity for Korea-related projects and Korean companies who can position themselves as globally attractive investment opportunities -- yet it will not happen by itself. Rather than reach inward, Korea-related entities must reach out and explain current dynamics from their own perspective in a way that makes sense and which increases their attractiveness to the international investment community.

Korean opinion leaders need to emphasize while recent actions by the North are certainly important and need to be addressed, they do not represent a fundamental change from the security dynamics of the past fifty years. They might also point out the low historical correlation between economic growth in South Korea and changes in South-North relations. Furthermore, the rise in what is seen as Anti-American sentiment in the South might be interpreted more as the inevitable result of a young, maturing, empowered, growing democratic economy. Korea’s rising stature and educated workforce is giving rise to a truly dynamic human resource pool. It is seeking greater self expression – not only in its delivery of cutting edge products, technologies, corporate structures and a growing range of cultural exports – but also as a nation that seeks to independently determine its national destiny.

It is also worth noting that Korea represents an increasingly attractive consumer market in an of itself. This has helped to give additional depth and strength to its economy. While representing a highly positive and important trend over the long term, Korean leaders need to acknowledge investor concern over the rapid rise of consumer debt. Foreign media reports highlight alarming statistics such as the record 7% rise in the average credit card default ratio during the third quarter of 2002. Steps that the Financial Supervisory Service has taken to curb defaults, including the imposition of limits on cash advances and higher reserve ratios on lending institutions receive far less attention and need to be emphasized.

To maintain Korea’s continuing integration as a vital link in the global chain of commerce and finance, efforts must be made to communicate both the evolving growth of the Korean nation as well as the workings of individual entities on the firm level. By providing well thought out reasons why foreign investors and business partners would be wise -- not only to maintain -- but to expand their involvement with Korean enterprises; in addition to explaining the factors that drive their behavior, investors will be far more likely to understand that volatility moves in both directions.
This will help to lead them to the conclusion that current tensions with the North and other economic problems in the face of a global slowdown are only temporary interruptions in the long-term growth pattern that Korea has consistently exhibited for over half a century. Therefore, they will come to understand that any present trend downward, which may continue in the current incendiary environment, represents nothing more than a long term buying opportunity.

Interview on Japanese M&A Environment with Mr. Kiyoshi Goto, Director-General, Department of Business Development, Development Bank of Japan

Mr. Kiyoshi Goto joined the Development Bank of Japan (DBJ) in 1978. His overseas experience and successful assignments in internationally related work are extensive, totaling fifteen of his 25-year experience at DBJ. He received his MBA from the Amos Tuck School at Dartmouth College in 1984. In 1987 he was dispatched to the International Energy Agency in Paris, the energy forum of the OECD, and worked as an energy economics analyst for three years. From 1995 to 1997 he was in DBJ’s International Department, in charge of extending loans to foreign companies investing in Japan. Then Mr. Goto was named Chief Representative of DBJ's Washington D.C. office, where he worked hard to provide a better understanding of DBJ's activities as well as the Japanese economy and society through thirty plus presentations and lectures in three years. Last April he was given a new mission, to lead a team providing M&A advisory service, a new business for DBJ.

Hello Goto-san, it is a pleasure to speak with you again. Can you tell our readers something about the Development Bank of Japan, its role and mission, as well as your own background and activities there?

The Development Bank of Japan (DBJ) is a governmental financial institution established in 1951. DBJ's mission is to contribute to the development of the Japanese economy and society via the provision of “quality” financial services that usually cannot be accommodated by private financial institutions. DBJ's contribution to Japan's wealth, I believe, has been widely acclaimed. Since readers of this newsletter mostly work outside Japan, I should emphasize that DBJ has made strenuous efforts to assist foreign firms wanting to enter the Japanese market. In 1984, DBJ crafted loan programs specifically designed for foreign companies investing in Japan, and those programs have been well received. In fact, the 1996 Economic Report of the President noted our efforts in this area. I have never heard of any Japanese institution other than DBJ being named in the Report.

I have devoted more than half of my career at DBJ to international-related business. After having assisted foreign companies for two years through the loan programs I mentioned, I went to Washington, D.C. and worked as a public relations officer for DBJ—and even for the Government of Japan—giving talks on a wide variety of issues including DBJ's loan programs and the state of the Japanese economy. You may recall that in the Business Opportunities in Japan symposium organized by the Japan External Trade Organization (JETRO) in November 1997, I gave a presentation titled, “Investing in Japan: A New Trend”, which pointed out the growing importance of M&A in Japan. Last April I was assigned to lead the newly established department in charge of M&A advisory services.

The development of M&A deals is a new area for DBJ. Can you tell us why DBJ is moving in this direction and how the "culture" of the institution is changing as you move to initiate this type of activity?

Yes, we are a Johnny-come-lately in this field. But we already realized how important M&A was for the Japanese economy a decade ago and carefully studied how DBJ, as a policy-implementing body, could supplement the market. We started this new service mainly for two reasons. First, M&A, once regarded in Japan as a malicious business conduct, is gradually becoming accepted as a useful business tool, but some distaste for M&A remains. We thought that an advisor whose mindset differed from that of private advisors was needed in order for M&A to become rooted in Japan, that is, an advisor who seeks a triple equilibrium. You may have heard talk of “win-win” deals, deals in which both the sellers and the buyers get fair shares of the value from the transactions. That, however, is easier said than done. The reality is that one side usually wins more than the other, sometimes unjustly. Being a governmental institution, we thought we should aim to assure that nobody goes overboard in an M&A transaction, and we do this by taking into account not only the benefits to the sellers and to the buyers, but also to the economy as a whole. I call this the “triple-win” approach. The second reason we started an M&A advisory service is that even though M&A has gradually become a business tool in Japan, only blue-chip companies have had the luxury to use it. Many small-to-medium-sized firms are ignored in this market because the deal size cannot generally justify the costs for professional services. We thought that we should give a helping hand to such companies to support the healthy development of the M&A market. Thus, we decided to jump into this new area.

This movement, adding M&A advisory services to DBJ's menu, meets the diversifying needs of corporate clients and increases the value of DBJ's financial services. This move also has a positive impact internally at DBJ in the sense that a solution-oriented approach is setting in; we should provide not only funds but also knowledge. Also this service offers DBJ a new avenue to a fee-based business.

Can you give us some specific examples of M&A deals you have completed or been working on and the type of deals you are targeting in the future?

Because we are a latecomer in this field, we do not yet have many completed deals to prove the effectiveness of DBJ's “triple-win” approach to M&A advisory services. However, a deal we completed last November may illustrate DBJ's approach. We served as an advisor for Meidensha Corporation, a heavy electric machinery manufacturer, on a deal between its affiliate, Meiden Hoist System, and KCI Konecranes, a world leader in the crane market. Meiden Hoist System had been struggling in the depressed and over-crowded market, and KCI Konecranes, though long aspiring to enter Japan, had not found a suitable arrangement. This strategic alliance not only benefited Meidensha and KCI Konecranes, both of whom received a fair share of the value, but also achieved national policy objectives, namely, business restructuring and promotion of foreign direct investment, thus significantly contributing to the Japanese economy. KCI Konecranes included DBJ's name in its press release on this alliance, which, I believe, is quite remarkable since an advisor is not usually mentioned in this kind of release and furthermore we served as an advisor for Meidensha -- not for KCI Konecranes. This deal clearly demonstrates that our aim is truly for “win-win” transactions. Perhaps one might wonder if KCI’s praise was earned at Meidensha’s expense—that is, some might think that Meidensha was underrepresented and the notion of triple equilibrium is a joke. One thing is evident: Meidensha could have terminated the contract with us anytime they wanted and would have done so if they had not been satisfied with our services.

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Let me tell you how I understand M&A. M&A is an economic transaction that really does create value that did not formerly exist. The seller provides a platform for value creation and the buyer offers managerial, technical and other expertise. Unless the buyer and seller get fair shares of value created, the deal won’t close and nobody will gain. Yes, an advisor works for a client, either the buyer or the seller, and gets fees. However, if you regard M&A as a game of win or lose, you are quite likely to lose fees you could otherwise have earned. The fact that more than half of M&A deals end up as failures, according to various surveys and studies, may back up my notion. We at DBJ have a mindset to make a project as feasible as possible in the long run, which we have done through our financings since the bank’s establishment. As part of our implementing policy, we have to make sure that the projects we finance will have positive impacts on the Japanese economy and society. This approach is also the backbone of our M&A activities. On the other hand, take an example whereby a client comes to us and says that it is looking for an M&A opportunity simply to boost its earnings per share by acquiring a company with a low price-earnings ratio. We do not provide advisory service for such clients. I hope this will help explain our M&A advisory policy. We are targeting deals that will contribute to corporate/business restructuring, revitalization of local economies, and promotion of foreign direct investment.

Substantial wealth has been created in the U.S. by investor groups who assume possession of distressed or underperforming assets and then move to reduce costs and introduce other "re-engineering" techniques to restore profitability. One might imagine there are many opportunities of this kind in Japan given the depressed economic environment it has experienced over the past decade, yet we have yet to see this become a defining trend. Can you give us some of the reasons why and whether this might change in the future? Additionally, what is the likelihood that virtually bankrupt corporates or financial institutions will be allowed to fail?

An active market for distressed assets in Japan cannot be created overnight. But one is developing. Evidence is that the number of MBOs increased significantly in Japan, from thirteen transactions in 2000 to forty-two in 2002. Recently, UK-based 3i withdrew from the market. However, major foreign funds are still in Japan and Japanese players are becoming active in the distressed-asset market. Unison Capital, Advantage Partners and MKS Partners have been quite visible. DBJ also plays an important role in this regard. DBJ put equity into Nippon Mirai Capital, a new entrant in this field and we have been investors in several corporate restructuring and turnaround funds. Our loan function also supports the activities of turnaround private equity. For example, Unison Capital made equity investment in ASCII, a publisher of PC-related magazines and books, which had been in serious trouble for so many years despite twice changing management. DBJ appreciated Unison’s turnaround scheme and, together with other commercial banks, provided funds necessary for its smooth turnaround. ASCII made a surprisingly speedy and dramatic comeback. In Japan I expect those “hands-on” style investors—in your words, those introducing “re-engineering” techniques—to be the key for Japan’s recovery.

About the George Romero question, by that I mean the question about “zombie” companies, I would like to respond with a quote from Charles Darwin’s The Origin of Species: “It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change.” This is the philosophy behind Unison Capital, which I heard from its founder, Ehara-san. According to Darwin’s law, the answer is crystal clear.

With the Nikkei at twenty year lows, many investors have been ignoring Japan in favor of China and other Asian markets that they believe offer more dramatic growth and potential. Can you tell us why they should devote more attention to Japan and about some of the opportunities they may be missing?

China is regarded as the country of the future by many. China’s entry into the WTO indicates that an immense market is finally opening. But I think there is still a rocky road ahead. Risks in China’s financial sector alone could ruin the economic potential. Since the stakes for prosperity coming from China are so huge, every multilateral and bilateral effort should be made to ensure her healthy growth. Still you should keep in mind that your love for China might sometimes blind you to her faults. Talking about Japan, it is, no doubt, saddled with numerous problems. However, according to World Economic Forum's Global Competitiveness Report 2002, Japan's position improved considerably, from 21st in 2001 to 13th in 2002. Technology represents the key driver for this improvement. The report points out that the country’s innovative power has remained very strong, which compensates for drops in the macroeconomic index and public institutions index. This implies that once the macroeconomic situation improves and the governance problems can be addressed properly, which admittedly are not easy tasks, “the sun should also rise.” Investors should follow Japan carefully, that’s for sure; I see no reason to ignore Japan.

Many analysts view the primary economic problem in Japan as being the need to deal with non-performing loans, and they maintain that little can be done until this problem is addressed in a definitive manner. Furthermore there is also a common perception that there is little or no demand for commercial loans among borrowers. Do you share the view that no progress can be achieved in Japan without resolving the NPL issue? Furthermore do you believe that there is little or no demand for new commercial loans?

Oh, boy! This has been extensively discussed among high-profile economists and I may not be the right person to answer this. My opinion is that the NPL problem should be properly addressed. However, I think we should distinguish between two types of NPLs: NPLs stemming from the burst of the bubble and NPLs stemming from the deepening deflation. The former had long been left disregarded partly because banks thought they could be disposed anytime as unrealized gains on securities but most of them have been written off. The latter is a new pile of bad loans springing up like mushrooms due to worsening deflation. Since the problem we now face is the latter, what is most needed, I think, is comprehensive counter-deflationary measures. I will leave what the measures should be to policy-makers and economists, though. A lot should be done to address the NPL problem properly.

Regarding the demand for commercial loans, if you look at some macro statistics on liquidity or free cash flow of non-financial firms, you see that in aggregate firms have excess cash. Demand for commercial bank loans has been weak because of the slack economy. Banks themselves have changed their lending policies, leaning toward charging premiums applicable to the risks involved, which I think is the right direction. These two factors have caused the decrease in commercial bank loans.

When talking about direct investment in Japan, much of the emphasis has been on greenfield rather than M&A projects. Part of the problem has been the dichotomy between, one, domestic constituencies and management who want to maximize valuations and/or are resistant to change and, two, foreign investors who seek to introduce efficiencies and achieve maximum gain. This adversarial relationship is standard practice in the U.S., but is often perceived to cause excessive tension in a consensus-driven Japan. Is it simply a matter of time before Japan takes more fully to U.S.-style M&A as a corporate finance tool?

I do not fully share your view. First, even the Japanese government (the Japan Investment Council headed by the prime minister) a long time ago realized the importance of promoting foreign direct investment via M&A and in 1996 made an official statement “On the Preparation of an M&A Environment in Japan.” It was so epoch-making that the media bashed it, claiming the government was selling off Japanese firms. Secondly, although Japanese have been highly allergic to M&As because of negative aspects such as greenmailers and hostile takeovers in the U.S. in the 1980's, their attitude has been changing. Carlos Ghosn of the French company Renault successfully revived Nissan Motor and French coach Philippe Troussier energized the Japanese soccer team. Is Mr. Ghosn still a public enemy in Japan? Definitely, not. We all know that we need foreign management know-how to rejuvenate the Japanese economy. When I was studying at Amos Tuck in 1982–1984, the U.S. was eager to learn from Japan, and you guys did it right. You benchmarked Japan and adjusted the Japanese model to meet the U.S. context. It’s our turn, isn’t it? M&A has become recognized in Japan as a common corporate finance tool; there is no doubt about it. Looking from North America, it may seem a snail's pace. But our team has been working hard to assist Japanese firms to benefit from M&A, especially cross-border M&A, and hope to change that perception.

In the U.S., many business owners and entrepreneurs look to sell all or part of their companies for the right price, even when they are doing well, for either strategic reasons or to realize some of the underlying equity, and these transactions when properly executed are perceived as positive achievements. In Japan, however, they are often viewed as failure. For that reason, it has been rare to see healthy Japanese firms turn to M&A as a means to realize value or to enhance their competitiveness. Do you think this is a fair statement, and, if so, what can be done to change this perception in Japan?

Well, since corporate/business restructuring has been the single most important issue in Corporate Japan recently and M&A has been used as a restructuring tool, you might have such an impression. But Japanese blue-chip companies have become focused on corporate value creation and have used M&A to increase the value-based metric, best known as “economic profit” or “economic value added.” In short, we are too busy restructuring. But you should note that restructuring also increases corporate value and that, usually, the more ambitious the restructuring the more the growth. You may have in mind something like Jack Welch's 1987 swap of GE's consumer electronics business for the medical systems interests of Thomson of France. If that's the case, I admit it may take a decade for Japanese to see such a deal. But didn’t the GE-Thomson deal frighten even the U.S. people to death?

Even though one can make a good argument as to why Japan offers an attractive investment opportunity, many companies and investors we deal with find it extremely difficult to identify attractive companies that possess a sufficient understanding and appreciation of the investment process -- despite a professed desire to attract foreign investment. Furthermore, business practices and sensibilities can be very different. As an ivy-league MBA graduate, can you give any advice to foreign investors on how they might identify specific investment opportunities in Japan and not only go about facilitating transactions but also to maintain good relations with their Japanese counterparts after they are consummated?

To expedite successful M&A in Japan, I would advise them to choose an advisor who has expertise in cross-border transactions as well as a good understanding of Japanese corporate culture. Marriage between two different parts of the world can never be easy and there are a lot of difficulties to overcome. An advisor who is well-versed in cultural differences could successfully build a bridge between the two. Our team has strong competence in cross-border deals since DBJ has for almost twenty years accumulated vast know-how in cross-border transactions through its financial assistance to foreign firms entering the Japanese market. The Meidensha–KCI Konecranes deal I introduced earlier demonstrates our capabilities.

Part of the problem in initiating M&A deals is the complexity of, and large amount of time that must be devoted to, individual transactions. Many people point to the scarcity of qualified service professionals in Japan, even in large-scale transactions. This can be even more problematic within the smaller scale transactions you are focusing on as they lack the scale needed to amortize the costs needed to allow successful closure. Can you comment on this problem and how if might be addressed?

Japan’s M&A market is very young, relative to that in the U.S., and an overemphasis on lending activities by Japanese banks accounts for the lack of qualified M&A advisors here. However, competence in this business is quite different from the one in the derivatives house. You do not have to know the Black and Scholes model to be a good advisor. The weapons you should have are basic tools in valuation and some of the buzzwords in this world. What makes you an excellent advisor are an analytical capability to formulate corporate strategy and communication skills, which can be cultivated through work experience. Therefore, Japanese advisors could sooner or later be parallel to their U.S. counterparts. Regarding the cost recovery issue in smaller deals, a clear-cut answer cannot be expected. The amount of work required for an M&A transaction, unfortunately, hardly changes with deal size. Therefore, an institution like us should contribute for the time being, subsidizing smaller deals. Since DBJ alone cannot support smaller M&A deals, a more comprehensive approach should be devised: by giving technical assistance to the M&A sections of local banks, for example.

When foreign investors talk about investing in Japan, they are largely talking about Tokyo and perhaps Osaka. Can you talk a little about other geographic areas of Japan and the potential that they offer?

Yes, the only city in Japan that many foreign investors can name may be Tokyo—outside of, perhaps, Osaka, because of its international airport and Universal Studios Japan—so, it’s no wonder that most foreign direct investment and M&A has focused there. However, this should not be construed to mean there is a lack of opportunities in other parts of Japan. It is just difficult for foreign investors to find the hidden jewels in areas other than Tokyo. I can name some of the areas which may appeal to foreign investors: Sapporo City in Hokkaido, where high technology companies cluster together; the northern Kyushu area, as a gateway to East Asian countries; and the Nagano area, where Japan’s manufacturing prowess can be found. As for how to mine these mother lodes, DBJ can assist in many ways. As I mentioned, DBJ has assisted foreign companies investing in Japan for more than twenty years using our network all around Japan: our branch offices, local governments and other related institutions, such as JETRO and the Japan Industrial Location Center. In terms of M&A, we have a network with forty local banks and regularly exchange information. We think it would be prudent for your readers to keep us in mind.

Thank you Goto-san for sharing your thoughts with our readers. Do you have any closing thoughts or comments you would like to leave with us?

Let me close by borrowing from the final scene of the 1985 movie Rambo: First Blood II:

"Kiyoshi, non-performing loans, deflation, everything that happened here may have been wrong. But, damn it, Kiyoshi, you can't hate your country for it."

"Hate? I'll die for it."

Yes, our team will serve the country via M&A to the death.

Companies investing, acquiring or operating subsidiaries in Japan should consider using the “silent partnership” or “TK” (known in Japan as a Commercial Code tokumei kumiaia) as a tax efficient vehicle for their transactions. By using the TK vehicle, in certain circumstances investors can realize substantially reduced Japan-side tax burdens which would otherwise set up a road block to viable returns on an investment.

In the typical scenario, the sole-shareholder of a Japanese company might fund the company solely via additional share purchases. In such cases, the shareholder could be paying an effective tax rate of up to 47.8% including combined Japanese local and national taxes plus the 10% withholding tax on dividends paid to the U.S. shareholder. What if the shareholder could reduce the tax burden in Japan to 20%? Depending upon the circumstances, financing the Japanese company via a TK could result in such a reduction.

What is a TK? A TK is not a business entity. TKs are contracts between silent “investors” and business “operators”. The investor contracts to provide an asset (cash or other property) for use by the operator in its business. In exchange, the operator pays the investor an agreed percentage of the business’s pre-tax profits.

Under the TK contract, the investor receives no ownership right in the business. The investor receives only a right to profits. Furthermore, while the TK contract may provide the investor with certain investigatory and informational rights, the investor receives no management rights. TK contracts are simple and often require little more than an agreement upon scope of the subject business, the allocation of profits and losses, and terms relating to termination/expiration.

A TK is not a loan agreement or a leasing agreement. However, the operator deducts payments to the investor on a pre-tax basis. Usury limitations do not apply on payments of profits to the investor. This is one advantage of the TK when contrasted to inter-company loan financing.

Potential Tax Efficiencies. As indicated above, if properly established and monitored, use of a TK structure for a Japan investment could reduce the effective Japanese tax rates for certain Japan investments.

Take the simple example of financing a wholly-owned subsidiary. When a U.S. investor purchases or establishes a wholly-owned corporation in Tokyo the effective tax rate on profits can be estimated at 47.8% (approximate combined corporate tax rate of 42% plus a 10% withholding on dividends to U.S. companies under the Japan – United States tax treaty).

If properly structured, the tax burden in Japan could be reduced to a 20% withholding tax on TK profits paid to the U.S. investor. TK structures have been used in more complicated structures as well, for example in aircraft and other asset leasing arrangements wherein they lawfully reduce tax burdens in Japan.

Freedom of Contract and Limitations on TK Uses. The Commercial Code of Japan prescribes the fundamental legal foundation of the TK structure but TK structures are generally subject to the principle of “freedom of contract”.

The TK structure is, however, not without limitations. An investor is at risk and does not receive fixed payments as a lender might. The investor also has no right to payment when the business has no profits. If the asset is fully consumed by the business, then the investor receives nothing upon termination or expiration of the TK.

Furthermore, a silent investor may enjoy certain contractual rights of investigation and access to information, but participation in the management of the entrepreneur’s business could result in the silent investor being treated as an ordinary shareholder for tax purposes. Such participation could also result in joint and several liability, or the nullification of the legal validity of the TK. For this reason, the TK investor should not be a shareholder of the TK business, but could be an affiliate of the TK business’s shareholder – and could be an affiliate domiciled in a tax haven.

Potential scrutiny by Japanese tax authorities is perhaps the material concern in structuring a TK. Generally speaking, however, the material concern of tax authorities relates to treaty shopping.

Consider, for example, the case in which US Parent Inc., a U.S. corporation, establishes an entity, X Inc., in country X where the tax treaty between country X and Japan provides that TK profit distributions to companies of X are entirely free from Japanese taxation. If X Inc. was established for the sole purpose of taking profits from Japan Sub K.K. via a TK to avoid Japanese taxes, then this is the type of case wherein Japanese tax authorities might consider issuing an assessment notice. Under such circumstances, X Inc. lacks real substance and could be considered a treaty shopping vehicle established to avoid Japanese taxes otherwise payable by a U.S. corporation. Some commentators indicate generally the importance of being able to demonstrate to Japanese tax authorities a rational basis for entering into a TK before taking into account associated tax benefits.

Scrutiny of TKs. The TK is a typified form of commercial code contract, which is used by some well-known Japanese corporations in various capacities. Use of a TK in and of itself is not generally considered suspect activity or harmful to the reputation of an investor.

In recent years the tax authorities have found TKs widely used in business practice, yet until somewhat recently, aircraft leasing has been perhaps the only major transaction in which TKs were regularly utilized. We understand that rumors of a disallowance of TK tax benefits have been surfacing annually for several years now, but based upon informal discussions with officers of related authorities, believe there is no impending move within the tax authorities to eliminate such benefits. There have been quasi-governmental study groups formed to research the current uses of the TK structure in Japan, however, a change in law to prohibit the use of TKs could be difficult for the government. Tax authorities are perhaps more likely to crack down on misuses of the form (such as in treaty shopping) rather than abolish it.

As discussed above, a TK must be used appropriately. In structuring a TK for a Japan investment, particular care must be taken to ensure that the intended benefits are supported by sound commercial rationale and will achieve the intended benefits. The ultimate decision of whether or not a TK is suitable for a Japan investment will rest upon the results of a comprehensive review of all of the relevant facts and associated tax concerns.

While the war on Iraq is in the early stages, another, a less prominent conflict drew to a close March 22, when checkpoints on the Thai-Cambodia border were officially reopened after remaining shut for nearly three months in response to the torching of the Thai embassy in Phnom Penh.

The Thai-Cambodia dispute registered as little more than a blip on the global radar, but despite both governments’ insistence that they consider the matter resolved, could yet have serious implications for relations between the two countries and the fragile unity of the 10-member Association of Southeast Asian Nations (ASEAN).

The conflict was also a potent reminder that in Southeast Asia, ancient history continues to exert a forceful, if often unnoticed, influence on present events. The furor was sparked when a Thai actress popular in both her native country and Cambodia, Suwanan Khonying, allegedly commented that she would not visit Cambodia until it returned the 1100 year-old Angkor temple complex to Thailand. While Khonying insisted she uttered these lines in a role on a soap opera that aired in Thailand two years ago, her words appeared in the Khmer press early this year, prompting Cambodian Prime Minister Hun Sen to comment at a rally in January that Khonying was “not worth a blade of the grass that surrounds Angkor.”

What happened next stunned even those well accustomed to Cambodia’s political instability. On January 29, bands of protesters that had gathered in front of the Thai embassy in Phnom Penh broke into the compound and set the building alight. Having exhausted government targets they next turned their attention to the private sector, burning and looting Thai-owned businesses throughout the capital. By the time order was restored over 30 firms, including hotels, restaurants and airline offices, were damaged or destroyed; Thai Prime Minister Thaksin Shinawatra had sent five planes to the capital to evacuate Thai nationals and the Cambodian ambassador to Bangkok was expelled. Future tallies estimated the riots cost Thai companies at over 2 billion baht, but it is more difficult to gauge the fiasco’s effect on the already tenuous relations between the two nations.

Theories as to the true causes of the incident abound; Thai Ambassador to Phnom Penh Chatchawed Chartsuwan implied upon his return to Bangkok that the riots were not spontaneous and that the Cambodian police were slow to respond to his requests for assistance. Many observers accused Hun Sen of deliberately whipping up nationalist sentiment ahead of nationwide elections in July; a time-honored tactic of Cambodia’s current administration. The Cambodian government itself accused opposition leader Sam Rainsy of fomenting disorder to discredit Hun Sen and his party; a charge Rainsy has hotly denied.

More insightful analysts have suggested that the Cambodian unrest had been brewing for some time. Thailand and Cambodia have been trading salvos for years over two other temple complexes on the Thai-Cambodian border that both countries lay claim to. More of a factor may have been Cambodians’ increasing resentment over what they see as Thailand’s economic colonization of their country; trade along the border reached 18.7 billion baht (US$420 million) last year, with Thailand recording a surplus of a whopping 17.76 billion (US$396 million). Much of Cambodia’s nascent infrastructure, including its mobile phone network, is wholly or partially owned by Thai firms. Even tourism, which the Cambodian government has upheld as a key engine to the country’s development, has grown under Thai auspices; three of the largest hotels in Phnom Penh are Thai-owned and Bangkok Airways enjoys a virtual monopoly on the lucrative route from Bangkok to Siem Reap and the temples of Angkor. Thai music and television is so favored among Cambodian youth that Senior Minister Sok An last May asked local television producers to impose a moratorium on Thai films, soap operas and game shows.

The aftermath of the riots only highlighted to many Cambodians the extent to which they are dependent on their wealthier neighbor. As border posts closed, the economies of towns in Cambodia that rely heavily on cross-border trade and traffic such as Poipet were devastated.

With the border situation returning to normal on March 21 after Hun Sen paid 252 million baht (US$5.8 million) in compensation to Thailand for the destruction of the embassy, relations between the two countries look set to steadily improve. But several thorny issues remain unresolved. Though the Cambodian government has agreed in principle to pay an additional 2 billion baht (US$46.6 million) to businesses affected by the incident, trust between Phnom Penh and Bangkok remains at an all-time low, as evidenced by Shinawatra’s insistence that Cambodia compensate at least one business before the checkpoints were opened. Hun Sen may also have some difficulty persuading his largely impoverished people – many of whom, correctly or not, believe too much Cambodian money already ends up in Thai coffers – that settling the outstanding bill is in the nation’s best interests.

This is to say nothing of the conflict’s wider implications, especially for the investment climate of Cambodia itself and ASEAN as a whole. Many of the grouping’s nations are locked in an uneasy coexistence. Disputed areas exist between Thailand and Myanmar, Thailand and Laos, and the Philippines and Vietnam; Singapore and Malaysia frequently lock horns over issues such as waste and water supply, and Malaysia regularly accuses Indonesia of failing to control illegal logging and immigration along their border on the island of Borneo. The shared history of Thailand, Myanmar, Laos, Cambodia and Vietnam is one of war and conquest; foreign investors may rightly wonder now whether the nationalist tendencies that crop up in all these countries could once again give rise to events like those that took place in Phnom Penh. Business and trade will soon recover, but the real casualty of the Thai-Cambodia spat may be the image of stability and unity that ASEAN has been struggling to project to investors in the face of increasing competition from China. At the very least the incident is a powerful reminder that in Asia, old habits die hard.