VIDEO: Stop the Madness: A Recipe to Jump-Start the Global Economy

GBR Faculty Panel: Stop the Madness: A Recipe to Jump-Start the Global Economy, Part One

GBR Faculty Panel: Stop the Madness: A Recipe to Jump-Start the Global Economy, Part Two

In these dynamic GBR videos, a panel of six Pepperdine faculty from the Graziadio School and the School of Public Policy discuss the global economy, which is at a “historic juncture.” Overseas, the Euro crisis continues to boil and Greece is teetering on default, with debt-shackled Spain and Italy not far behind. Here in the United States, angry protestors are condemning financial inequality as banks seem to continue enjoying preferential treatment. After the mishandling of the debt ceiling crisis, and with political posturing dominating the dialogue, the economic landscape is rife with uncertainty.

Our six faculty bring their insights, experience, and opinions to the forefront in this discussion. The discussion questions include:

  • How do we balance the act of helping the economy recover and simultaneously take our deficit down?
  • Should Europe issue a common Euro Bond to stop the unraveling of monetary union?
  • Is monetary policy out of control or is it just the last line of defense?

For ease of viewing, the video has been posted in two parts; Part 1 ends with a discussion on currency which continues in Part 2.

The video panelists are:

Davide Accomazzo, MBA – Moderator, adjunct professor of finance at the Graziadio School, Managing Director at Cervino Capital Management and advisor to Thalassa Capital.

Donald M. Atwater, PhD, practitioner faculty of economics. Don teaches managerial economics, macroeconomics, and international business, and also owns and operates a company dedicated to building goal-driven communities.

Edward H. Fredericks, Jr., MBA, CFA, practitioner faculty of finance and principal of Eastwind Asset Management. Fredericks has expertise in intelligent database technologies, advanced financial asset valuation, and behavioral issues in financial decision-making.

Clemens Kownatzki, MBA, adjunct professor of financial risk management and founder and CEO of FX Investment Strategies, a Registered Investment Advisor. He is also the author of “Market Wrap,” a regular feature on the Graziadio Business Review Blog.

Michael Shires, PhD, associate professor from the School of Public Policy. Michael’s primary areas of teaching and research include state, regional, and local policy; technology and democracy; higher education policy; strategic, political, and organizational issues; and quantitative analysis. He is an active consultant to local and state governments.

Darrol J. Stanley, D.B.A., professor of finance and accounting. Stanley is well-known as a financial consultant with special emphasis on valuing corporations for a variety of purposes. He has completed global assignments as well as having served as Chief Appraiser of International Valuations/Standard & Poor’s in Europe, Central Europe, and Russia.

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

Update: The Price of Oil

The price of oil increased relentlessly during 2004, closing at $53.64 a barrel on October 13, 2004 far surpassing the previous record of $41.15 set in October 1990. One year later, the price of oil approached $70 a barrel, then fell below $60 before returning to the $70 range in late January 2006.

The GBR article “The Crude Facts About the Price of Oil” noted that the high price of oil loomed as a potential barrier to the global economic recovery by raising the specter of inflation. This current article examines the impact that a year of high oil prices has had on the global economies and revisits the causes of high prices: supply, demand, speculation, and refinery capacity.

Impact on the Economy

The U.S. economy remained “solid” through the second quarter of 2005. Consumer and business spending remained strong, while requests for jobless benefits continued to drop, and gross domestic product grew at an annual rate of 3.3 percent.[1]




Photo: Julie Elliott




However, during the third quarter, high oil prices began to take a toll, particularly in some sectors of the economy. In August 2005, Wal-Mart warned that rising oil and gasoline prices were hurting sales and trimmed full-year earnings forecasts.[2] In September, two airlines-Northwest and Delta-filed for bankruptcy protection, citing oil prices as a major factor. In October, American Airlines announced it was suspending 15 domestic routes due to soaring fuel costs.[3]

Increasing costs have also begun to impact European economies. In the UK, transport costs have increased the annual rate of consumer price inflation to 2.3 percent-substantially above market expectations and the highest level since the measurement began in 1997.[4] France faced a record trade deficit during the first six months of 2005, as imports-led by oil-rose 3.5 percent over the previous six-month period.[5] Furthermore, inflation rates in Eurozone countries ranged between 2.5 and 2.7 percent during the third quarter, and are expected to remain above the Central Bank’s definition of price stability (2 percent or below) for the rest of the year.

Asian economies have not been exempt from oil price pressures. Governments in Thailand and Indonesia have faced political protests sparked by high oil prices. Japan and the Philippines initiated energy conservation programs to blunt the effect of increasing costs. Politicians fear that India could face political instability from expected oil price hikes. In addition, Chinese officials sent additional police to Guangzhou to control protests after service stations ran short of gas, and motorists faced lengthy waits and rationing.[6]

Supply Issues

Members of the Organization of Petroleum Exporting Countries (OPEC) continue to pump at or near capacity, with Saudi Arabia (the world’s largest oil producer) agreeing to increase output for the foreseeable future.[7] New supply continues to come on-line, including seven wells drilled in the Sea of Okhotsk off the coast of Siberia-which some experts are calling the “Alaska North Slope” of this decade.[8] Nevertheless, prices remain hypersensitive to any news or event that might disrupt production, including a showdown between the West and Iran over its nuclear activities, labor disputes in Nigeria and other oil-producing countries, terrorist attacks in Iraq and Saudi Arabia, and hurricanes in the Gulf of Mexico.

Rigs and platforms in the Gulf of Mexico supply approximately 28 percent of U.S. crude oil and 19 percent of its natural gas. Hurricane Katrina swept through the Gulf of Mexico in late August of 2005 before battering the Louisiana, Mississippi, and Alabama coasts. Hurricane Rita followed a similar path in September 2005 before plowing into the Texas-Louisiana border. Katrina sank more than 50 oil rigs and natural gas production platforms. Initial damage estimates from Rita revealed one production platform pulled from its moorings, two drilling platforms with visible damage, and 38 mobile drilling units adrift. Though damage was less than feared, 100 percent of Gulf of Mexico crude oil production and 80 percent of natural gas production were shut down in anticipation of Rita. All these facilities required inspection before they were returned to service.[9]

While the human toll-particularly with Katrina-was high, the impact on oil supply and prices was short-lived. Katrina and Rita did, however, highlight the vulnerability of supply from an area deemed safe-or safer-from the usual worries of political unrest, labor disputes, and terrorist attacks.

Demand: Some Relief?

Global demand for energy remains high in 2006 with little change in U.S. demand and increasing demand from developing countries, particularly China and India. However, there are some signs that high prices are beginning to impact consumption.

One visible sign of change in consumer habits, or at least potential change, can be seen in U.S. automobile sales. Demand for gas guzzling SUVs dropped dramatically in September with sales of the GMC Envoy and Chevrolet Tahoe down more than 50 percent. Sales of other SUVs fell 18 percent or more. In contrast, Asian automobile manufacturers, with their lines of energy efficient models, enjoyed double-digit sales increases.[10] The trend continued in November led by the Ford Explorer, with sales down 52 percent, the Cadillac Escalade, down 48 percent, and the Chevrolet Suburban, down 46 percent from November 2004. Toyota’s U.S. sales, however, were up 13 percent year-to-year.[11]

China continues to aggressively search for energy sources to meet its growing demand. China National Offshore Oil Corporation (CNOOC), after losing its bid to buy Unocal, stated that it would continue to work with foreign governments and companies to expand its overseas oil and gas reserves.[12] Additionally, the Chinese government is considering plans to invest $24 billion in plants that turn coal (which is abundant in China) into gas and oil (which are not). A number of pilot plants are already under construction in coal-rich Inner Mongolia.[13] The Chinese government also recognizes that growing demand will cause energy prices to increase, and price increases could cause a slowdown in China’s economic growth. To combat such a potential slowdown, the government’s latest announced five-year plan focuses on energy efficiency and environmental protection.[14]

Speculators: Maximize Returns

The financial markets have been particularly rewarding to energy investors. Energy outperformed every other type of domestic investment in 2005. Calendar year 2005 economic sector performance, represented by Standard & Poor’s Depositary Receipts (SPDRs) Sector Exchange Traded Funds (ETFs), is outlined below in Chart 1. An ETF is a basket of securities that trade as a portfolio. SPDR Sector ETFs are designed to duplicate the returns earned in the underlying economic sector of the S&P 500′s broad market index. Chart 1[15] illustrates that the energy sector earned more than three times any other sector.

Chart 1. Economic Sector Returns-Calendar Year 2005

Exhange Traded Funds (ETF) Sector Index 2005 Performance*
Basic Industries 1.85%
Industrial 1.13%
Consumer Staples 0.91%
Consumer Cyclical -7.48%
Consumer Services 5.07%
Energy 38.52%
Financials 3.73%
Technology -0.99%
Utilities 12.71%
* Does not include income

The high returns earned by the energy sector-higher than all major indices and asset classes-attracted more and more investors seeking speculative profits. A popular strategy called “price momentum” seeks to identify rapidly advancing assets, thereby enabling an investor to purchase similar assets and “ride along.” The graph below shows the cumulative daily returns from energy futures versus daily volume. The contract under examination is a near-term expiration, continuously rolled into the next contract as it expires. The graph displays how as returns increased (i.e. building momentum), volume increased as well, implying that the higher returns attracted speculators seeking price momentum.

Chart 2. Energy Futures Returns and Volume

Data provided by Reuters[16]

Refineries: Still a Problem

Refinery capacity, or lack thereof, remains a problem. In the U.S., there has been no large investment in refineries in over 25 years. To meet demand, refineries were running at 95 percent capacity in 2005, up from 75 percent two decades ago. Additionally, many plants are deferring scheduled maintenance to limit downtime, thereby raising concerns about long-term risks.[17] Furthermore, these conditions existed before hurricanes Katrina and Rita.

The paths of Katrina and Rita took the two hurricanes into the heart of U.S. refineries. Katrina knocked out four refineries in the New Orleans area, and the lack of electricity kept them closed more than a month after the hurricane. Katrina and Rita each knocked out about 5 percent of U.S. refining capacity. However, damage was less than feared. As one oil analyst said, “… we dodged one of those rocket propelled grenades, but we took a couple of bullets.”[18]

The hurricanes highlighted the need for more refinery capacity. On October 7, the U.S. House of Representatives passed (by two votes!) the Gasoline for America’s Security Act. The bill directs the president to designate sites-including former military bases-for new refineries, streamlines the permit process, limits the different gasoline blends produced to meet clean air rules, allowing easier movement of fuel from one area to another (it is why limiting blends is important), and requires the Federal Trade Commission to investigate alleged energy price gouging. The Senate is drafting its own bill, which includes tax breaks to encourage refinery construction and expansion. The fate of both bills is uncertain as environmentalists accuse Congress of using the hurricanes as an excuse to approve long-term requests from the energy industry.[19]

What Does It All Mean?

To repeat the question asked one year ago, what does it all mean? The U.S. economy grew at a healthy 3.8 percent annualized rate during the third quarter despite the devastating hurricanes. Price inflation, excluding energy and food, rose at a low 1.3 percent annual rate.[20] However, the U.S. trade deficit, driven by increasing energy prices, grew to a record $66.10 billion in September 2005. The University of Michigan consumer sentiment report for November 2005 hit 79.9, down from 96.5 in July due to high gasoline prices and the fear of high heating oil prices this winter.[21] Thus the economic picture is mixed and the future uncertain.

On the supply side, new drilling areas may provide some relief. Royal Dutch Shell has been granted the right to explore for oil and gas off the western coast of Ireland. However, environmental groups continue to fight plans for an on-shore gas refinery and pipeline.[22] In the U.S., proposals are before Congress to relax bans on new drilling off California and the Atlantic Seaboard and to encourage exploration in the Rocky Mountains. However, critics from Governor Schwarzenegger to environmentalist groups have already come out against the plan, pointing to the 191,000 barrels of oil that polluted the Gulf of Mexico after Katrina and Rita ruptured pipelines and battered oil facilities.[23]




Photo: Pam Roth




On the demand side, Americans are still driving their automobiles, but gasoline at $3.00 a gallon increased use of public transportation in Los Angeles and has increased the demand for fuel efficient automobiles. The mild start to the winter in the U.S. also lowered energy prices and increased inventories. However, many forecasters are predicting a colder than normal winter, which could send heating oil and natural gas prices up sharply.[24] The cold snap in early December 2005 emphasized the vulnerability of oil prices to weather by briefly sending the price of oil again above $60 a barrel-up 8 percent in one week.[25]

Conservation is becoming the byword, not only in Asian countries that have announced government enforced conservation policies, but also in the U.S. as well. After hurricanes Katrina and Rita, President George Bush appealed to the public to conserve energy by limiting discretionary driving.[26] Joseph Desmond, chairman of the California Energy Commission, called on residents, businesses, institutions, and government to immediately cut energy consumption and increase energy efficiency-especially of natural gas.[27]

Regarding speculation, as long as the returns in the energy sector far exceed the returns in other sectors, investors will probably continue to participate actively in this market, thereby impacting the price of oil.

Regarding refineries, everyone from Richard Branson of Virgin Atlantic Airways, et al. to oil sheiks in Kuwait is considering building new refineries. However, wanting and having are two different things. Arizona Clean Fuels has been trying for 12 years to get permission to build a new refinery in Arizona. They are still trying to get the necessary permits and approvals over the strong objections of community leaders. Even if plans were approved today, it would take at least five years to design and build a new plant. Therefore, refinery capacity will continue to be a problem, at least in the short term.[28]

Conclusion

Energy prices are a continuing concern to world economies. Most economies have weathered the high prices with only slight pauses and minimal disruptions. However, uncertainty is still high, and oil prices remain hypersensitive to decreases in supply and increases in demand.

So far the warnings of impending problems-reduction in spending (particularly consumer spending), increase in inflation, decrease in GDP growth rates, and decrease in corporate profits-have not appeared. Nevertheless, if oil prices begin to approach 1970s levels ($80 a barrel in today’s dollars), the economy could face a similar fate: sharp recession. The worst may be still to come.

[1] Bloomberg News. “Consumer, Business Spending Revised Up,” The Los Angles Times, 30 September 2005, C-3.

[2] Tassell, Tony. “Wal-Mart warning reflects impact of runaway world fuel prices,” The Financial Times, 17 August 2005, 22.

[3] Camerson, Doug. “American Airlines to suspend core routes as the price of jet fuel surges,” The Financial Times, 1-2 October 2005, 1.

[4] Swann, Christopher, Arnold, Martin and Tiesenhausen, Friederike. “Oil fuels world economy fears,” The Financial Times, 17 August 2005, 1.

[5] Thornhill, John and Atkins, Ralph. “Oil helps push France into record trade deficit,” The Financial Times, 18 August 2005, 4.

[6] Iritani, Evelyn. “Asian Economies Starting to Feel Effect of Oil Prices,” The Los Angeles Times, 29 August 2005, C-1.

[7] Douglass, Elizabeth. “Crude Oil Price Again Hits Record,” The Los Angeles Times, 9 August 2005, C-1.

[8] Brooke, James. “Texas Tea From a Russian Sea,” The New York Times, 28 September 2005, C-1.

[9] McNulty, Sheila and Hoyos, Carola. “Energy industry surveys Rita legacy,” The Financial Times, 27 September 2005, 4.

[10] Vincent, Roger. “Sales Downshift at Ford, GM,” The Los Angeles Times, 4 October 2005, C-1.

[11] Freeman, Sholnn, “SUV Sales Down Sharply,” washingonpost.com.

[12] Lague, David. “Aggressive Search by CNOOC For New Oil and Gas Seen,” The New York Times, 5 August 2005, C-4.

[13] McGregor, Richard. “China looks at $24bn coal-to-oil plan as Beijing bets on oil prices staying high,” The Financial Times, 27 September 2005, 6.

[14] Yang, Zhou, “China Hands Investors a Map,” The Wall Street Journal, 11 November 2005, C-14.

[15] Daily pricing on SPDRS from http://www.finance.yahoo.com, January 5, 2006.

[16] From Reuters through http://www.taosgroup.org (data from April 30, 2004 to October 21, 2005).

[17] McNulty, Sheila, “Refineries defer maintenance to keep oil flowing,” The Financial Times, 19 September 2005, 6.

[18] Douglass, Elizabeth. “Energy Prices Fall on Refinery Check,” The Los Angeles Times, 26 September 2005, C-1.

[19] Simon, Richard. “House Bill Calls for New Refineries,” The Los Angeles Times, 8 October 2005, A-14.

[20] Preciphs, Joi and Hilsenrath, Jon. “U.S. Economy Marks Solid Growth, Despite Storms,” The Wall Street Journal, 29-30 October 2005, A-2.

[21] Hitt, Greg and Preciphs, Joi. “U.S. Trade Deficit Swells to a Record,” The Wall Street Journal, 11 November 2005, A-2.

[22] Brown, John and Catan, Thomas. “Shell allowed to explore for oil off the Irish coast,” The Financial Times, 18 August 2005, 18.

[23] Simon, Richard and Weiss, Kenneth. “Plan for Coastal Drilling Emerges,” The Los Angeles Times, 3 October 2005, A-1.

[24] “Oil Prices Lowest Since July,” The Los Angles Times, 11 November 2005, C-4.

[25] Covel, Simona. “Crude Oil Rises as Cold Snap Hits,” The Wall Street Journal, 6 December 2005, C-5.

[26] McNulty, Sheila. “White House moves to prevent run on petrol,” The Financial Times, 29 September 2005, 6.

[27] Lifsher, Marc. “Conservation Urged to Cut Energy Bills,” The Los Angeles Times, 5 October 2005, C-1.

[28] Douglass, Elizabeth. “Hurricanes Aid Push for refineries,” The Los Angeles Times, 3 October 2005, C-1.

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

Do Japan’s High Tech Failures Open Doors for Western Firms?

Japan’s technology woes will impact U.S. business practice as technology trade increases.

Should U.S. companies concern themselves with the prolonged recession in Japan? If so, what are the opportunities and challenges firms should consider? Arguably, the growing interconnections between advanced economies require firms to navigate the economic complexities of critical trading partners. As Japan remains the United State’s number-one trading partner, there is no question that the economic situation there has a considerable impact on business practice here. This being the case, what is the current climate and which industrial sectors should we consider most carefully? Many firms are reluctant about involvement now that Japan’s economic bubble has burst, but there are trends creating business opportunities in the midst of these struggles. (Click here for data on Japan’s GDP and investments for the period 1955 – 1999.)

The last year of the century was an extremely difficult one for Japan. The country was shaken by a series of accidents and failures in high-technology fields. The ever reliable shinkansen or bullet train railway experienced infrastructure failures. A major accident took place at the nuclear-fuel processing facility in Tokaimura, and the H-2 rocket failed twice. These mishaps fed lagging Japanese confidence in its high-tech system and created an impetus toward a careful analysis of Japan’s science and technology policy. The collective opinion in both government and the private sector is that, in order for Japan to continue to grow economically, socially, and politically, it must continue to focus on science and technology despite these setbacks.

However, structural problems in Japanese society (in the educational, economic and political systems) must be resolved in order for science and technology to flourish. The resulting changes would provide not only a different business environment but emerging opportunities as well, particularly in sectors that are thriving amidst the difficulties. In order to find these opportunities, businesses must first understand Japan’s measures for dealing with its ongoing technology struggles and then identify the commercial sectors that are moving ahead.

Dealing with High-Tech Failures

Tokaimura: Many believe that cost-cutting measures and efforts to compete more efficiently with overseas rivals were the ultimate causes of the accident that occurred at JCO’s Tokaimura uranium processing facility. However, others believe there would have been no accident if management had conformed to sound economic principles. The company had survived only because of the government’s policy of protecting the domestic nuclear industry, a policy that seems to have allowed a company to survive that could no longer ensure safety. JCO was unable to compete on cost due to its outdated processing facilities. The accident occurred when it tried to create fuel for the government’s experimental test-breeder reactor using old equipment that was not adequate for the job. The accident itself was therefore linked to efforts to improve nuclear reactor capabilities.

The difficulties in the nuclear realm resonate with other high-tech problems of 1999. Structurally, Japan is struggling to develop a sophisticated science and technology policy that stimulates research and development in the private sector, maintains strong academic and basic research capabilities in key areas, and still encourages market dynamism. In the meantime, firm R&D in most sectors is down, and licensing of overseas technology is on the rise.

Difficulties in the Space Program: The successive failures of the H-2 rocket have forced Japan to rethink its space development program as well as the potential commercial rewards in this sector. Prior to these setbacks, the National Aeronautics and Space Development Agency (NASDA) had a 30-year history of tremendous success in developing domestic rockets and satellite technology, even if the rockets were not commercially viable. However, two satellite and two launch failures have seriously marred the agency’s reputation, particularly in a culture where failure is not tolerable.

The real issue is to understand why the mishaps are occurring. One key is that while the NASDA budget has increased 50 percent over the last decade, staff numbers have risen only 14 percent, suggesting the agency is trying to do too much with too little. The problem is not isolated to NASDA. There has been a decline in science and technology graduates in Japan, particularly those with advanced degrees. While the focus is still on developing internal technology capabilities, businesses are suffering in terms of R&D funding and application.

Railway Issues: The famed shinkansen or bullet train had trouble with slabs of concrete falling from tunnel walls on the Sanyo Shinkansen and other lines. It was subsequently discovered that the concrete used in the tunnels was made with improperly desalinated sea sand and consequently lacks sufficient strength. Japan’s railway system has long been a symbol of the country’s success in techno-economic development. The structural issues in the railway system are now seen as symbolic of issues currently facing Japan’s science and technology policy system.

The old Japanese National Railway (JNR) system used to be regarded as the pinnacle of Japan’s civil engineering pyramid. Contractors who took part in JNR construction projects were said to have demonstrated 10 percent or even 20 percent higher performance than required by contract specifications. The situation began to change during the period of high economic growth, however, when more and more contractors met only 70-80 percent of requirements. Government control loosened, but the private sector failed to solidly establish itself. The myth that the shinkansen was ‘perfect’ prevailed even though quality control was hindered by the structure of the Japanese construction industry which involves complex, and often shady, relations among general contractors and myriad subcontractors.

These complex relationships characterize much of Japanese industry and are one of the critical challenges Japan seeks to address. However, institutional changes of this magnitude are both difficult and time consuming, particularly in a society driven by consensus-style decision-making. Deregulation seems to be a key issue, but institutional capacity to avoid cronyism during the transition remains elusive.

Addressing the Challenges

Prime Minister’s Initiative on Improving Industry’s Competitiveness: In order to address the circumstances described, Prime Minister Keizo Obuchi has organized the Industrial Competitiveness Council to improve Japan’s international competitiveness. This Council consists of all the Ministers from relevant portfolios, including International Trade and Industry, Science and Technology, Education, Posts and Telecommunications, and Finance. It also includes chairmen of leading firms. This Council was intentionally created to resemble the council in the Reagan Administration that published the ‘Young Report’ and the ‘New Young Report.’

A draft strategy was released in December 1999 designed to enhance linkages between universities and industry, with universities (rather than industry) taking the lead in disseminating innovative technologies into the marketplace. The new plan attempts to completely alter the traditional Japanese Science and Technology structure. In addition, significant administrative reform is underway throughout the Japanese government. R&D institutions are becoming independent entities managing their own R&D programs.

It is important to understand this administrative reform in the context of deregulation. Deregulation, or kisei kanwa, has required the Japanese to rethink their extensive network of formal and informal controls imposed on the economy. However, the emphasis is still on administrative reform (gyosei kaikaku) rather than wholesale deregulation. Consequently, change has been incremental at best. In many industrialized nations, the emphasis in deregulation has been on increasing competition to provide benefits to consumers. In Japan, the concept of deregulation means the ‘relaxation of regulation,’ a much less ambitious goal. It refers primarily to selective market opportunities based on a combination of strategic concerns, the political clout of certain business factions, market factors, and pressure from foreign governments. In contrast to reform based on expanding consumer welfare, Japan’s initiatives are based on the need to strengthen Japan’s international competitiveness. Therefore, the focus of deregulation in Japan is the selective relaxation of regulations when this increases the competitiveness of Japanese business.

Private Sector Prospects – IT Diffusion and Capturing the Momentum of the Digital Revolution: Another key area on which businesses are concentrating is information technology penetration in order to capture the momentum of the digital revolution. Even though Japan is a leading producer of Information and Communication Technology (ICT), it has a relatively low-level of ICT diffusion. The number of Personal Computers (PCs) per 100 white-collar workers is among the lowest in the OECD, and the average number of PCs per 100 inhabitants in Japan is far below that in the United States. While at least 50 percent of U.S. households are now online, only 10% of households in Japan even own a PC.

In response, the Japanese government is promoting three key reforms: liberalization, internationalization and informatization. Liberalization involves the deregulation of telecommunications and related markets, where they have made a slow start. The focus in internationalization is on international movements related to electronic commerce as well as the global trend of integrating telecommunications and broadcasting. Informatization has been centered on PCs and the Internet.

Preliminary results of these policy changes are encouraging, although Japan still lags the U.S. and Europe. Internet commerce in both the products and services markets doubled in 1999. A serious problem, however, is the cost of connecting to the internet. Internet service providers (ISPs), though much more expensive than their overseas counterparts, are relatively inexpensive compared to other services in Japan. The real issue is the cost of actually making a phone call to connect to the ISP, implying that the effects of deregulation policy (lowered service costs) have not yet reached the level desired. Furthermore, the Ministry of Posts and Telecommunications does not anticipate that local telephone rates will be comparable to international rates until the end of 2001. These costs are also born by R&D institutions, scientific laboratories, and the private sector, impacting the desired network effects for enhancing science and technology.

One area of particular strength related to the Internet is Japan’s growing capabilities in mobile Internet services. While PC penetration is lower than in many OECD countries, mobile services are amongst the world’s highest. Largely due to Japan’s adherence to popular formats such as Wireless Application Protocol and WideBand CDMA, some innovative companies such as Mobilephone Communications International (MTI) are world leaders in developing internet content for digital phones. This content is specifically designed to facilitate transmission and reception of web pages adapted for the smaller screens characteristic of mobile devices. While most content is still geared toward the ‘seedier’ side of the Internet and not yet integrated into the larger, more legitimate business-to-business e-commerce environment, there is tremendous potential in these other e-commerce areas.

Interestingly, this Internet strength in the mobile area in Japan highlights the U.S. weakness in its lack of standardization in the mobile phone market. The very deregulatory cacophony driving low telecommunications prices and booms in certain sectors has also tied the technology (particularly in business-to-consumer e-commerce) to personal computers rather than mobile phones.

Some issues related to these technology choices are cultural. Japan is a cash-driven society where credit card use is relatively small. This being the case, different structures for electronic business transactions are established. In the mobile communications market, as in the rest of the telecommunications market, payment for services is usually deducted from a designated bank account with advanced arrangements or paid monthly along with the phone bill. This arrangement is significantly different from the U.S. market where the transaction is made at the point-of-sale by credit card. Consequently, the structures in Japan lend themselves more easily to the provision of content driven services (easily facilitated by phone) rather than online purchases (more easily facilitated by PC). The dramatic growth in mobile communications in Japan bodes well for ongoing strengths in this technological area, particularly as mobile phone systems and services advance globally.

Opportunities and Lessons for U.S. Firms

While R&D in Japan is diminishing in some mature manufacturing sectors, many of Japan’s leading IT firms continue to power ahead. Areas of continued global leadership include video games (both hardware and software) and the extensive growth in mobile-based Internet services. This new mobile platform for e-commerce bodes well for economic growth in Japan, with opportunities emerging for net-savvy U.S. talent. Of particular note is the growing trend of licensing U.S. computer software to Japan. International royalties paid to U.S. firms are growing at 17 percent annually, and Japan licenses most of this technology. As the digital economy continues to grow in the U.S., opportunities for expansion in Asia continue to similarly increase as infrastructure there expands. However, smart involvement necessarily requires a close understanding of the evolving infrastructure, changes in government policy and Japan’s technological struggles.

References and supporting data are available from Professor Charla Griffy-Brown at

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

Re-Assessing the Health of the Asian Tigers

Major changes in the global economy impact business decisions.

Until mid-1997, the rapid growth of the East Asian economies was widely regarded as a miracle. This growth had propelled Asia to such heightened importance in the world economy that the next millennium was already anointed “The Pacific Century” by some. Then, in 1997 many of the Asian tigers and “tiger cubs” were suddenly tamed. They went from being an economic miracle to needing one.

The impact reverberated around the world. Because of the global nature of the economy, the cost of supplies, of labor, and the prices of competitive products were affected for many businesses throughout the world. The deflation in East Asia helped keep inflation low in the US. Now, with the East Asian recovery apparently underway, the dynamics will change. Interest rates, prices, and competition all may be different. Business people everywhere need to keep informed about these changes and plan accordingly.

The Tigers Tamed

When the Thai government was forced to abandon the peg of the baht to the dollar on July 2, 1997, it sounded an alarm throughout the region. Investor sentiment changed overnight. Within days, speculators attacked the currencies of Malaysia, Indonesia, and the Philippines. Not even the “grown-up” East Asian economic tigers, Hong Kong and Korea, were spared from the attack. The currency crisis spread rapidly throughout the region and beyond and finally grew to include much of the emerging market arena.

While the countries most impacted by the crisis differed in important respects, they also shared some important characteristics. They generally had policies fostering low levels of inflation and fiscal discipline by the government, and all had experienced rapid economic growth in the previous years. The openness of their economies, and high savings rates, combined with the low cost of production, encouraged foreign investment. In the early 1990′s, what had been a reasonably modest inflow of capital increased more than six-fold.

In the early 1990′s, the Federal Reserve set the US interest rate artificially low to stimulate the American economy. Given that the exchange rate of the tigers was tied to the dollar, and the growth rate of their economies was strong, they looked very attractive. More money flowed in than could be profitably used at modest risk. Much of the investment moved into ill-conceived real estate projects. These projects, in turn, became the collateral for a great deal of debt.

When the dollar began to recover in mid-1995, the exports of the tigers became less competitive. Pressures on their currencies grew because their underlying economies were not growing in tandem with the dollar’s rise. The pace of capital inflows slowed and investors had difficulty obtaining credit. Local exporters, who might have increased their sales abroad in a period of devaluation, faced fierce competition from the same region in which they had tried to export their way out of the crisis. Furthermore, with the entire region under pressure, exporters from several countries were competing with each other to try to export their way out of the crisis. The shift in perceived future investment risk impacted the stock markets of these countries, and pressure mounted even further, especially on countries with large current account deficits. Then the real estate bubbles burst, and the drop in real estate values left banks holding huge portfolios of bad property loans. The risk of default sparked a wider financial crisis.

There were, however, some key domestic factors that also contributed significantly to East Asia’s financial crisis. These included inherent weaknesses in the financial systems of these countries: little regulation and lax supervision, little reporting of financial data that would allow outsiders to evaluate a business, poor management of risk, and continuous lending to politically well-connected firms, sometimes at the government’s direct behest. There was often little due diligence regarding the creditworthiness of the borrower or the economic merit of the project for politically-favored enterprises.

Particularly in Korea, domestic enterprises were dominated by poorly-managed, but politically well connected, conglomerates, or chaebols, that were highly financed by debt. These conglomerates soaked up most of the available credit, leaving little left for small businesses, thus creating an unbalanced industrial structure that found itself in competition with both the low-wage economies in the region and with Japan.

The Tigers Lick Their Wounds

In the early phase of the East Asian crisis, the immediate issue was recapitalization. This was accomplished with external financing from rich nations and international agencies. This capital injection was designed to cushion the effects of the credit crunch and provide trade financing to small and medium-sized firms. Funding also was required for the hemorrhaging financial institutions. They were, and in many cases still are, buried under piles of non-performing loans.

In Japan, South Korea, Thailand, Indonesia, and Malaysia the governments set up their own versions of the US Resolution Trust Corporation (RTC) to close down or merge failed institutions into stronger ones and dispose of the non-performing loan portfolios.

In Indonesia the banking sector eventually is to be reduced through closures and nationalization from the more than 200 to 40 – 50 banks. Revised banking laws will open up banks to 100% foreign ownership, require an audit for all banks, and make the central bank independent in November. All of this is dependent, of course, on the nascent democracy being able to survive and the new political leaders being able to withstand pressure from the previously powerful.

Thailand has begun to recover. Consumer spending and exports, led by cars and electronics, are on the rise. The Thai government has not required further IMF funds and has even begun to make payment earlier than expected. The biggest stumbling block to recovery in Thailand is the slow pace in its restructuring reforms, especially the sale of troubled banks. The heavy public debt could eventually handcuff fiscal policy. Private-sector debt is under better control.

In Korea, the state-run Korea Asset Management Corporation (Kamco) has been entrusted with the task of buying non-performing loans from the financial sectors and resolving them or reselling them to foreign investors. In an effort to reform the undercapitalized banks, the Korean government plans to nationalize the moribund banking industry. As part of the negotiations with the government, the Korean chaebols have agreed that overlapping subsidiaries in the seven chaebols will be consolidated through mergers, acquisitions, and joint ventures.

Malaysia reacted to the crisis by adopting radical measures, including currency controls and debt write-offs. This was done, at least in part, to avoid taking money from the International Monetary Fund. The IMF requires tough economic reforms that demand austerity on the part of the people and government alike for some time to deal with excesses in the economy. The doomsday scenarios predicted by many have not materialized in Malaysia thus far. Economic growth for 1999 should be better than 4%, driven by export and government spending. The ringgit’s fixed rate of 3.80 to the US dollar makes it undervalued relative to its regional neighbors and that has helped to boost exports.

The government is pursuing expansionary fiscal and monetary policies to reflate the economy, but at the same time has created a budget deficit of more than six percent of GDP. While not alarming, this is not sustainable. Capital controls may have saved Malaysia from the severe social and financial upheavals that its neighbors suffered, but its disengagement from the global financial system may still cause some long-term problems.

The Philippines is also beginning to move forward. Manufacturing output has not yet begun to grow, but the import of raw materials has increased, suggesting that factories are beginning to revive their production.

Singapore was able to basically sidestep Asia’s economic crisis. The city-state had swallowed its own economic medicine earlier, when the dose was smaller. Beginning in mid-1996, the government introduced measures to deflate a swelling property bubble, including high property taxes, a restriction on early real estate sales to avoid speculation, and an increased housing supply.

Japan is a unique case for several reasons. There is not space to discuss it here, but without recovery in Japan, it will be difficult for the rest of the region to truly recover.

Prognosis

In one sense it could be easy to renew one’s faith in Asian miracles when observing the rate of economic recovery in these economies over the past year. Factories are scrambling to keep up with soaring export orders and increasing domestic demand. Stores are jammed and corporate earnings are surging. The Institute of Developing Economies forecast in mid-December of 1999 that, excluding Japan, East Asia’s ten biggest economies would expand 6.5% in 2000, up from 1% in 1998, when six of the economies actually contracted. Table I provides an overview of past and predicted GDP growth for the original group of ASEAN nations.

ASEAN GDP GROWTH RATES 1995 – 2000

195 1996 1997 1998 1999* 2000**
Indonesia 7.3% 7.8% 4.6% -13.7% 0.1% 5.1%
Malaysia 9.6% 8.2% 7.5% -6.2% 4.9% 4.6%
Philippines 4.8% 5.5% 5.1% 0.3% 2.1% 3.0%
Singapore 8.9% 7.0% 7.8% 1.2% 6.3% 5.0%
Thailand 8.5% 6.7% -0.4% -7.7% 2.5% 2.8%
*Estimated
**Predicted
Source: Asian Development Bank

Yet, while the worst of the crisis seems to be over, the risk of setbacks cannot be excluded. Some fundamental problems remain. The region is still suffering from the collapse in asset prices. While the smaller companies are recovering, the large conglomerates still have excess capacity. There is an escalation of corporate bankruptcies, and even the overall rate of growth has slowed down from its peak in mid-summer, 1999.

Much will depend on the global picture. The young tigers cannot grow themselves out of recession domestically. They do not have sufficient aggregate demand. The credit crunch will hamper their attempts to export themselves out of recession, but the key issue is whether there will be a slowdown in the US economy and, if so, whether the economies of Japan and Europe can sustain enough growth to compensate. The rise in global oil prices could also make inflation a major concern.

The massive debt overhang from the last two years of financial crisis will continue to impact the region. Overextended firms must start to sell off their assets or shut down operations. Even though there are cheap bargains available, many prospective buyers have been unwilling to take over the mounting debts of these companies, and the creditors still refuse to write off these debts as bad loans. On the other hand, American automobile companies are bidding for some of the prize Korean assets.

What began as a currency crisis became a credit crisis, and this led to a crisis of confidence. Investors are no longer motivated by the expected rate of return that once led them to invest in these countries. For many of them, there is a fear of being burned again. But some major players are beginning to return including the Soros Quantum Fund and the American International Group.

In the longer term, the key issue is whether these countries are willing to make the difficult, but crucial, reforms in their financial and political systems. There is widespread agreement that there must be much more transparency in their banking systems. Adopting generally accepted accounting standards is part of that. Crony capitalism, where loans are made on the basis of political connections rather than on the merits of project, will have to give way to much better risk management. New regulations are needed along with a legal infrastructure that will enforce them. Finally, there must be an openness to competition in the banking industry. Foreign banks can bring new technology and people experienced in data management, risk control, internal oversight, and external supervision. Prior to the crisis, most of the countries in the region restricted the entry of foreign-owned banks. That has begun to change.

South Korea is now actively promoting small and medium-sized businesses. The newly-elected government in Indonesia is redirecting economic resources from capital-intensive industries such as aerospace and automobiles to labor-intensive manufacturing and agribusiness. At the same time it is investing more in education. And Thailand has been lowering barriers to foreign investment in retail and consumer finance.

Structural reforms are painful. They involve loss to people who have benefited under the prior system, especially the politically well-connected. On the other end of the economic scale, they often translate into unemployment and social pain that may cause social upheaval and rioting. Yet, unless progress is made on structural reforms, foreign capital will not flow into the region. It will require political resources and courage to stick with these reforms.

One of the real problems of a quick partial recovery is that the impetus for structural reform could be sidetracked. For those countries willing to make the changes – or which are forced by events they cannot control to make such changes – the prospects are positive. Some important macroeconomic fundamentals are in place. The region has a high savings rate. The labor force is young, well-educated, hard working, and disciplined. Real estate prices have dropped to realistic level. Asia is a cheap export base still, as well as home turf to a burgeoning consumer class. Most of the governments are pursuing free market policies, and democratic movements are getting stronger.

The question is whether the tigers will decide to stay in the arena and compete in the free market or will be tempted to crawl back into their dens and hope for a different kind of miracle. The answer to that question will affect not only businesses in those countries, but those around the world.

“Fixing Asia’s Bad-Debt Mess” provides an updated look at one aspect of the problem.

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

Russia at the Crossroads

When Russia defaulted on her debts and devalued the ruble last August, Americans felt the effects as well.

When Russia defaulted on her debts and devalued the ruble last August, Americans felt the effects as well. Investors were concerned that this might signal another round of attacks on the currencies of emerging economies. Russia may account for only one-half of one percent of American exports, but investors feared that if speculators were successful there, they would move on to Latin America. The impact of speculation in those currencies would have a much greater impact on American businesses. This fear helped trigger a dramatic downturn in the American stock market.

In addition, some financial institutions had substantial exposure through investments in Russian securities, and they incurred real losses. Chase Manhattan Corporation, for example, was reported to have lost $200 million for the months of July and August. Other American companies doing business in Russia lost sales as the ruble fell and imports became too expensive for the Russians to buy.

Since August there have been other economic impacts as well. The United States and the European Union made commitments in November to provide five million tons of food aid to Russia this winter to help counter the effects of a bad harvest. Potential impacts on the American economy include the price of wheat, availability and cost in the transportation sector, and government expenditures for buying and storing surplus commodities.

Americans need to be aware of what is happening in Russia for even more important reasons however. Russia has great natural resources and a well-educated population. It could become a significant source of markets and competition, and a formidable force in the world economy if the country can work its way through the immediate crisis and move quickly toward greater economic freedom. On the other hand, if the immediate crisis is not satisfactorily resolved, there is the possibility of social unrest and/or a move to re-establish an authoritarian government that would rely on military might. Russia is still a major force in geo-politics given her size, her history, her store of nuclear weapons, and the knowledge base of her scientific community. Americans need to understand and stay alert to what is happening in this vast country.

The previous communist regime created economic catastrophe and instilled an anti-capitalist mindset that older citizens may never lose. However, many younger people have embraced the ideas of change, freedom, and markets. Their initial experiments in capitalism may resemble the American Robber Baron period more than they do contemporary western markets. Certainly the disparities in wealth remain enormous. Nevertheless, the basis for a viable market economy is being established. It must be nurtured, however, for it could easily be delayed — or even derailed — by the current crisis. Success is not inevitable.

The recent crisis in the Russian financial markets again highlighted the fundamental structural deficiencies of the Russian economy. That economy is likely to worsen during the next year unless a profound structural reform is initiated and maintained.

The Problem

The Soviet economy was value-subtracting rather than value-adding throughout its life span. Explained simply, the world market value of almost all Soviet-made products was below the world market value of the natural resources and direct labor used to produce those products. The seemingly inexhaustible supply of easily-extracted natural resources made this possible. These resources were traded to communist allies in exchange for desperately needed manufactured goods and agricultural commodities. This “picking the low-hanging fruit” policy sustained the Soviet government until the late eighties, but the economy began to disintegrate as the demands of the deprived consumers and bloated military increased. Much of Russia’s enormous gold stockpile was sold off to prolong the inevitable, but the empire collapsed in 1991. The tragic irony of this debacle is that most Russians believe that the economy imploded because of the fall of the communist government, not the other way around.

This foolish misunderstanding is a major contributor to the current reality. Seven years after the breakup of the Soviet Union, the overwhelming majority of its industries and enterprises have been inherited from the late Soviet Union, and remain value-subtracting.

Accentuating this problem is the fact that world markets presently show little interest in anything from Russia other than her natural resources and, interestingly enough, her people. Many thousands of Russians are currently employed by multinational organizations as managers, analysts, engineers, and scientists both in Russia and abroad.

The Importance of the Private Sector

Falling oil prices triggered the current Russian economic crisis. However, the fundamental problem lies in the structural deficiency of the Russian value-subtracting economy. The crisis cannot be overcome by reversal of crude oil prices, or by an IMF-sponsored debt restructuring. This latest quick fix arguably may actually deepen and prolong the crisis. At best these remedies are a bandage on a cancer. At worst they will permit inefficient industries to persist, encourage more fraud, rationalize tariff increases, and make it even harder to reverse the downward spiral. The crisis can only be overcome when new value-adding industries are built.

The building of new industries must be initiated and managed entirely by the private sector. Left alone, small competing firms eventually will gravitate to those products and services that best serve Russian talents and interests, and then will evolve into industries where Russia can sustain international competitive advantages. Historically, most successful new businesses initially operate at a loss to finance aggressive expansion, develop at least one core competency, and, most relevant to Russia, create significant added value.

However, the current Russian tax environment inhibits the creation of value-adding new businesses in three punitive ways:

  1. By aggravating inevitable losses inherent to all young expanding businesses by vigorously enforcing pre-profit taxes such as mandatory contributions to a suspect national pension plan, tariffs on imported production equipment, and road taxes;
  2. By discouraging foreign investment with a wide assortment of anti-business regulations such as minimum wages, customs abuse, visa harassment, and currency controls;
  3. By imposing a value added tax (VAT) on intermediate goods produced by outsourcing or subcontracting, thereby defeating efforts to create a single core competency.

The final point requires a more detailed treatment. The existence of VAT creates a tremendous disincentive to outsource or subcontract domestically, forcing a business to do as much as possible in-house. The existence of tariffs further aggravates the problem by creating an even stronger disincentive to outsource or subcontract internationally. Finally, currency controls do not allow Russian businesses to invest abroad, thereby eliminating the advantage of using low-wage countries for labor intensive production requirements. Not incidentally, these currency controls also inhibit exports by penalizing (or forbidding) expenditures on marketing and distribution in high-income countries.

To make matters worse, the Russian government continually introduces new import tariffs and increases old ones. For example, the tariff based on the weight of a traveler’s luggage doubled between March and July of this year. This discourages businesspeople and insults other visitors. Incredibly, last fall some Russian officials even proposed imposing an import tariff on the wheat that the United States was donating as food aid! Import tariffs may produce short-run revenue for the state’s coffers. However, the negative long-run effect on business and economic development should be obvious even to a free-market neophyte.

The Importance of Oil

The dearth of value-adding industries makes Russia extremely vulnerable to world natural resource markets. The precipitating cause of the present turmoil in the Russian financial markets was the dramatic fall in world oil prices. Oil prices dropped 32% in 1998 on the New York Mercantile Exchange from $17.64 per barrel at the end of 1997 to $12.07 a barrel at the end of 1998. This was even up a little from its December 10 low of $10.72.

Oil is Russia’s primary export commodity, and depressed oil prices devastate the Russian current account. This weakens the ruble, and both Russian and international investors make speculative attacks on it. The Bank of Russia responded to a May speculative attack by temporarily raising interest rates to 150% and then subsequently lowering them to 60%.

Devaluation of the ruble and default on debt payments in August worsened the situation further. The government has experienced intense political pressure to print money to pay pensions, salaries, and other obligations to the Russian people. This is inflationary of course. Average daily inflation was 0.285 percent during the first two weeks of January 1999, and that was down from a daily average of 0.355 percent in December.

The Continuing Danger

Given the economic crisis of last August, the accompanying inflation increases, and the continuing dependency on oil as a primary export, Russian interest rates will continue to fluctuate. In this financial environment, the Russian banks will most likely return to speculating in government bonds and interbank loans and abandon their trade financing practice. The banking system may even go one step further and limit its functions to currency exchange alone because of the uncertainty following the Russian government’s recent default on domestic bonds. Rising interest rates create an enormous incentive for corrupt government officials and crooked industry managers to hold up wages and pensions in order to participate in these wild speculations. This will cause a new wave of wage and pension arrears similar to what happened just a few years ago and bring increased pressure on the government to print money.

Exacerbating the problem is the current crisis in food production. It is estimated that Russian grain output was only about 52 million metric tons in 1998, down 39.5% from the previous year’s crop. This was partially due to a severe spring drought combined with heavy fall rains. It was also partially due to inefficient production methods. There was some debate late last fall about whether or not Russia actually needed to import food to avoid widespread starvation this winter, with some arguing that the problem was simply one of distributing existing supplies or lowering the import tariffs on food so that the market would work. The concerns about shortages are real enough, however, that the United States and the European Union are providing almost five million tons of food aid. Some of this is an outright grant, and some is to be paid for through long-term loans.

The most serious shortages of food were initially reported to be in the far northeast. However, without this aid — and without changes in the government-run distribution system — the major cities of Russia could well have faced serious shortages as the winter progressed. They import 60-80% of their food. By mid-winter the inhabitants likely would have faced increasing food prices, limited quantities, and limited varieties. In the current inflationary environment their incomes would also pay for less of what was available. In such a situation, the outcome is predictable: widespread, politically dangerous social disruption — especially in the cities — which would be enthusiastically supported (if not directly inspired) by those seeking to destroy the present government.

The Immediate Remedy

A real and legitimate concern in Russia is that if the usual practices of government distribution are followed, supplies provided by the West will be siphoned off for private gain by a few well-connected individuals and not reach the sectors of the population that need them. To guard against this, the donor countries are providing the supplies in installments rather than all at once. They have also demanded the right to monitor food distribution. Shipments will cease if it appears that supplies are not being distributed as promised.

This may be helpful as a short-term solution this winter. However, it cannot be overemphasized that in the longer term, profit-seeking private enterprise is the only way to ensure the successful distribution of food. In the food business, the perishable nature of inventory requires undivided attention and hands-on, around-the-clock participation. The only way to encourage this kind of effort is to allow food distributors to reap whatever profits the market may offer.

The Long Term Priorities

Russia’s heavy dependence on oil exports must end. The building of new value-adding businesses must not be obstructed. In practice, this will require dismantling currency controls and shifting the bulk of the government revenues from VAT, excise taxes, and tariffs to individual and corporate income taxes.

In addition, an accounting reform emphasizing compatibility with International Accounting Standards is in order. Requiring these reporting standards, coupled with an absence of tariffs and a dismantling of currency controls, would attract more foreign investment than any conceivable program of government or multilateral guarantees.

More importantly, along with foreign capital must come much-needed modern business practices. Russia surely has the best-educated citizens among the less developed economies of the world. They can, and will, learn quickly to combine the concepts and models imported by their international peers with their own knowledge of Russian realities and the Russian consumer.

It is our considered belief that the people of Russia, not her natural resources, are the true source and cause of Russia’s present endurance and future prosperity. The Russian people deserve peace, liberty, and the just rule of law. A freely elected government must deliver these to maintain its existence and preserve Russia’s future.

Nikolai V. Chuvakhin is a professor in the Market Economy Fundamentals Seminar Program in Moscow, Russia.

Steven T. Ekstrand is an International Attorney and Director of the Market Economy Fundamentals Seminar Program in Moscow, Russia. He is a graduate of Pepperdine University’s joint J.D./MBA Program.

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

Southeast Asia: Crisis To Recovery

In terms of economics events, the 1990′s will best be remembered as the decade of financial crises. In 1992-93, it was the European monetary system, and in 1994-95 the Mexican peso crisis. The Asian financial turmoil, which started in July 1997, is the latest crisis to rock the international currency markets. This crisis highlights the prominent effects of international capital flows and the interdependency of the world’s economies. Excessive lending from global liquidity, weak financial sectors, a lack of transparency in corporate and financial sector borrowing, all contributed to the Asian woes.

The Growth Period

The economic growth of the Southeast Asian economies in recent years has been the envy of the world. During the decade from the mid-80′s to the mid-90′s the average real GDP growth in Thailand, Malaysia, and Indonesia averaged more than eight percent. Even the Philippines, considered to be the sick man of Asia, was showing positive growth. Per capita income was steadily growing in each of these countries as well. The rates of inflation were generally holding steady or falling slightly. Unemployment was low. The level of poverty was dropping while literacy was rising. The savings rate was high and the work ethic strong.[1] These countries seemed to have all of the right ingredients for investment.

Global Liquidity

Following the 1990-91 recession in the United States, the US Federal Reserve kept the federal funds rate at an artificially low level, a policy which enabled US banks to repair their balance sheets. The owners of capital moved their resources to the economies of Southeast Asia for higher rate of return. In addition, weak domestic demand in Japan and in Europe made their banks all too willing to lend to the tiger economies as well. This led to a steady inflow of capital into the region.

Growth Without Development

The growth in these emerging markets was thus increasingly funded by foreign short-term credit and portfolio investment. The foreign borrowing was used primarily to increase investment rather than consumption. However, much of the investment was in speculative ventures, especially real estate and equities. With their currencies pegged to the US dollar, financial and corporate borrowers did not bother to hedge their short-term dollar-denominated debts, even given their exposed position, assuming that the currency peg would hold and that expansion would continue.

Financial Sector Weaknesses

The developing crisis exposed the “underdeveloped” state of the capital markets, especially among the young cubs of Southeast Asia. Market capitalization there is largely dominated by banks. Since institutional underpinnings are barely existent, there are weak controls over the banking sector. Capital reserve requirements are inadequate for the risk level of the investments, and lending is often done without rigorous credit scrutiny. Requirements for public disclosure and transparency in financial statements are not up to the international standards. Given this type of situation, it is easy to ignore due diligence requirements.

Crony Capitalism

In addition, there is the issue of ‘moral hazard’ in many of these countries. That is, traditionally those making the loans are not really at risk should the loans turn bad. In part this relates to the close political and personal connections that have existed between the government and the financial sector. The fact is that government officials have often pressured banks to make loans based on political or personal considerations rather than business decisions. The other side of the implicit agreement is that the government will bail out the banks if the borrowers default. Thus those making the loans have little personal risk and consequently little reason to worry about the soundness of their loans.

The Fall

The credit boom made these economies vulnerable to a shift in the market conditions. The need to raise interest rates to control the overheating of the economy and to defend the exchange rates caused a fall in property values and a corresponding increase in non-performing loans. The low quality of these bank assets led foreign investors to move out of the Southeast Asian markets, causing further depreciation of their currencies. The bubble burst in the second half of 1997, beginning with the forced devaluation of Thailand’s baht in July, then the attacks on Malaysia’s ringit, followed by the pressure on the Indonesian rupiah, Philippine peso and even the Singapore dollar.

These devaluation’s reflect a very fundamental fact of international economics: central banks can either intervene in the foreign exchange markets to defend their currencies. or in the domestic market to try to affect interest rates and domestic growth. In the long term, they cannot successfully do both.

What Needs to Happen Now

The crisis in Southeast Asia is not uniquely a regional issue. There are implications for the rest of the world as well, given the increased global interdependence among nations. Their problems cannot be solely solved internally, although reforms must begin with these economies.

  1. First, there must be structural reforms in the financial sectors of the countries whose currencies have come under attack. Their governments need to clean up the banking mess by closing the insolvent banks, setting up sophisticated regulatory systems and deposit insurance plans, and better supervising their banks. They need to adopt tough financial standards that are comparable to the international standards in order to gain the market’s confidence. This crisis differs from many previous ones because it is not government debt that is the issue here. The problem is more a matter of overextension of private lending, albeit lending which is closely tied to government activities and pressure. The banking systems must increase the transparency of their actions so that investors can judge the credit-worthiness of their loans. The owners or shareholders must b held liable for their lending decisions by having their own capital at risk. Specifically, capital cronyism must give way to decision-making based on the merits of the project and the financial stability of the borrower. This would squeeze out speculative investments. In addition, the governments must learn not to interfere unduly. The government should put in place sound economic policies, while central banks must be careful not to establish conflicting policies in the domestic money market and the foreign exchange market which could send distorted signals to the market.
  2. As the region’s largest economy, Japan must be part of the solution. The Japanese government needs to boost its domestic demand to help absorb the exports which these tiger economies must depend upon to get their economies moving again. Whereas Japan has traditionally tried to stimulate its economy by increasing exports, this time it must work to increase demand internally.
  3. China is also a pivotal actor in the region. It is important for China to maintain its exchange rate. This will require a level of sacrifice since it is likely to result in slower growth and higher unemployment. If China chooses to devalue the yuan to compete in the export markets, it will only exacerbate the problems.
  4. The industrialized world, including US and Europe, must provide an open market and help these economies get back on track. This will mean an increase in the trade deficit for a time, and pressure on prices and profits for some domestic producers.
  5. Finally, the International Monetary Fund must keep its focus on providing liquidity, and not rely on bailing out these economies. The IMF must insist that these countries face up to the fundamental structural reforms which are required in their financial sectors as a condition of receiving IMF assistance.

Some believe that the we are only at the beginning of the Asian crisis and that the real effects are just beginning to take place. Among the big concerns is the fact the most Asian companies are facing their fiscal year-end. Deadlines for many major debt extensions and outstanding financial contracts are tied to these dates. This may force banks and other lenders to revisit their financial positions. Tight fiscal and monetary policies, some mandated by the IMF, make it harder for companies to meet their debt obligations. This, in turn, can potentially lead to more bankruptcies which would further strain the banking sector and destabilize the financial markets. A severe market disruption could have a dampening effect on the entire world.

Yet, the ASEAN countries have to learn the ruthless reality of globalization and be willing to work on the political and economic reforms. Southeast Asian economies still have many strengths. The fact remains that their economic macrofundamentals are still strong. There is evidence that some countries are showing the political courage to take the necessary steps. Others may be less certain at this time. Overall, these tigers could bounce back, better and stronger. The question is “When?”

While events continue to unfold, it is difficult to identify when and where to invest in Southeast Asia. In making such decisions, one must be very aware of the degrees to which countries are making the necessary political and structural reforms. Since the current crisis is structural in nature, structural reforms are needed. Whether or not the time is ripe for investing in an ASEAN country depends on the seriousness of economic and financial reforms taking place.

With every crisis comes opportunity. Investors must focus on long-term fundamentals. Economic success in this region depends on governments, as well as investors, making and keeping their long-term commitments.

Endnote

[1] State Department, US Government. 1996 Country Reports on Economic Policy and Trade Practices.

For More Information

TRADEPORT
The premier international trade web site on the Internet!

Want more information on Southeast Asia and other foreign markets?

Wondering what trade shows and events are going on? Looking for a banker, freight forwarder or trading company to help you export your products?

Just beginning to export but need some help from an interactive international trade tutorial?

Explore the pages of TradePort by clicking the link above or call the Los Angeles Area Chamber of Commerce at 213-580-7528.

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1