Market Advisory Features

An Economy Singed
American Jitters

The Value Of Trust
Valuing Stockmarkets
A Profession Under Fire

A Dollar Cliffhanger
   
   

 

Valuing Stockmarkets

Calling for the band to strike up
Jun 20th 2002 | NEW YORK
The Economist


Equity markets are falling, and the explanations are plentiful

NOW should be the time, with America's economy emerging from what seemed a relatively mild recession, for stockmarkets to roar ahead again. When equity prices fell in the weeks after last September 11th, no one could have been shocked. Nine months on, however, amid upbeat economic data, punters still hope the band will strike up again. Instead, share prices continue to slip. In rich countries they are back near their post-attack lows. America's Treasury secretary, Paul O'Neill, who among his many duties presumes to know the appropriate level of share prices, says he finds the falls “inexplicable”. Yet explanations abound.

But first, consider the expectations of investors in America, who over the past 20 years have become accustomed to high, sometimes double-digit, returns from shares. Many, indeed, have come to expect a summer rally like the one that launched America's long bull run back in August, 1982. Today, with share prices broadly where they were in late 1999, the bullmarket wisdom of always buying “on the dips” might seem to apply. Yet this summer—and possibly for some seasons to come—that wisdom may not be borne out.

Sluggish profits are one reason to think so. In good times, equity markets do not need profits, as the dotcom bubble showed. Now, thanks to doubts about the quality of corporate accounts, profits are at the front of investors' minds. While bulls point to rising figures for economic growth, production and consumer confidence, firms are finding that corporate profits are rising rather more slowly, if at all. America's Bureau of Economic Analysis says that after-tax profits grew by only 1% in the first quarter, and remain 27% below their peak in 2000. But companies' own figures are losing credibility.

The integrity of published profits is being called into question everywhere. One measure of valuing shares, the price/earnings (p/e) ratio—the share price divided by earnings per share—is certainly stretched, no matter how you look at it. The range of p/e estimates is also wide, thanks to uncertainty over the “e” side of the ratio. Take your pick from various accounting measures of earnings: pro-forma, operating, excluding extraordinary items, or with or without employee share options as an expense. Depending on the type of earnings used, p/e ratios are now somewhere between the high teens and (rather more likely) the low 40s. In any case, they are far above America's long-term average of 16.

Next, bring out the equity-risk premium—the excess return, over and above riskless government debt, that investors expect for holding risky shares. Not long ago, authors wrote touting targets for the Dow Jones Industrial Average of 36,000 and even 100,000 (it is under 10,000 today). They reasoned that shares as a whole were no riskier than government debt. Investors, recognising this, would demand no more return than that from government bonds. They would bid share prices greatly upwards, and the risk premium down to zero.

Talk of the risk premium's demise was premature. Some analysts, such as Chris Johns of ABN Amro, a Dutch bank, expected the risk premium to rise after September 11th. Instead it fell, partly in response to quick action by the world's central banks in cutting interest rates. Today, though, with interest rates already almost as low as they can go, a new bunch of risks may be occupying investors: geopolitical instability (in the Middle East and Kashmir) as well accounting uncertainties. Investors may demand higher returns for jumping back into shares, implying a fall in share prices to levels that more accurately reflect the risks.

By Mr Johns's measure, American share prices imply a risk premium of around 3%. Traditionally, the risk premium that investors demand has been closer to 6-8%. One rather conservative measure of the risk premium that investors might now reasonably require is 4%, based on the longest period of historical data. If investors today adjust their expectations to this 4% level, they will have to bid share prices down by a quarter.

For well over two years, stockmarkets in America have moved broadly sideways (though the technology component has plunged). Surely “fair” values are not far from catching up with depressed share prices? Not quite. Derry Pickford at Smithers & Co, a London consultancy, has looked at stockmarket valuations using Tobin's Q, a measure of the ratio of market prices to the replacement cost of corporate assets. He judges that American shares are still overvalued by more than two-fifths.

Mr Pickford states the bearish case another way. Even if profits were to grow consistently at a real rate of 7% in the years ahead (and that is an optimistic assumption, to say the least), it would take eight years of sideways share prices to bring valuations back into line.

To the extent that European companies have fewer accounting uncertainties than American ones, and their shares are less highly valued, stockmarkets in Europe might have been expected to outperform. Instead, they have fallen in sympathy with American exchanges. Generally, though, European valuations are not as stretched, with p/e's closer to their historical average. In Britain, however, Tobin's Q paints a picture of inflated prices similar to America's.

One of the best guides to the future may be the one that looks farthest into the past. A study by professors Elroy Dimson, Paul Marsh and Michael Staunton of the London Business School (“Triumph of the Optimists”, published by Princeton University Press), analyses a century's worth of equity returns, for 16 countries. One of their conclusions ought to give shareowners consolation: shares do indeed outperform bonds over the long run, in every country studied. Yet their data shows that this happy result does not quite conform to the iron schedule of 20 years, as the current wisdom of American investors has it. In some countries, in some periods, shares have taken as many as 40 years to outperform. That may be longer than today's investors have bargained for.

 

 

The United States

An Economy Singed
Jun 20th 2002
The Economist


The markets' mood reflects a poor outlook for America's economy

AMERICA'S economy is the healthiest in a generation and the strongest in the world.” So Bill Clinton bragged to his fellow summit leaders when they last met in North America five years ago. The Denver G8 summit marked a high point of American triumphalism, with European and Japanese leaders left to squirm uncomfortably in their cowboy hats as their exuberant host extolled the wonders of America's new economy. For the first time in a quarter-century, they were told, the world had an undisputed model for economic success.

How times change. When George Bush visits the Canadian ski resort of Kananaskis on June 26th for this year's G8 summit, he will have much less to brag about. Certainly as far as investors are concerned, the much-touted American model has lost a lot of its allure. They are fretting over several potential economic weaknesses, and also over continuing revelations of corporate America's shoddy accounting, greedy managers and lousy investment decisions—and they are selling.

The results are clear. For the first time since the 1920s, stockmarkets have been falling during the first few months of an economic recovery. The Dow Jones Industrial Average has fallen in ten of the past 13 weeks, and is now down to the levels of early 1999. And the mighty dollar, long a symbol of America's miraculous economy, continues to slide. Since January, it has fallen by 10% against the euro and by 8% against the yen.

To determined optimists, notably Paul O'Neill, America's Treasury secretary and cheerleader-in-chief, none of this behaviour makes sense. “There is an unbelievable movement in the market without...substantive information,” he said of Wall Street last week. Far from losing its allure, the American model has proved how resilient it is, shrugging off the bursting of the technology bubble as well as a huge terrorist attack, with a recession that was remarkable for its mildness and short duration. With productivity growth continuing to surpass expectations, America's economic future still shines more brightly than anywhere else. Once investors realise this, the argument goes, they will abandon their irrational funk.


Reasons to be unexuberant

Mr O'Neill's analysis may be partly right; but his conclusions are wholly wrong. America's economy has indeed shown a striking resilience during the past year or so. Although the new-economy hype of the late 1990s was hugely overblown, American productivity growth remains impressively stronger than it was in the 1970s and 1980s. But despite this, there are good reasons for the markets' current angst.

Doubts about the pace of economic recovery lie behind much of it. Wall Street is still, by any historical measure, extremely highly valued . In so far as they ever made sense, such valuations assumed a speedy return to the extraordinarily high profit claims of the late 1990s. That assumption seems increasingly far-fetched. Mr O'Neill may not have noticed any “substantive information” recently, but others have. In particular, they fret about signals that the American consumer may be running out of steam. May's retail sales fell by an unexpectedly large 0.9%. With no evidence of a rebound in investment, any hint of a flagging consumer suggests that the recovery will be weak at best, and certainly not the robust boom that markets counted on at the start of the year.

The second and even more intractable cause of the angst is investors' loss of trust in American companies . In the six months since Enron collapsed, many of the titans of American capitalism have been toppled. Andersen, which audited Enron's accounts, was convicted last week by a court in Texas for obstructing justice. It will go out of business in August. Several high-profile chief executives have fallen from grace and been ousted from their jobs. The list of companies facing accounting scandals grows longer by the week.

Almost 1,000 American companies have now restated their earnings since 1997, admitting in effect that they had previously published wrong or misleading numbers. As the Securities and Exchange Commission cracks down on creative corporate accounting, more such admissions lie ahead, even among household names. Phoney accounts mean that much of the profit growth of the late 1990s, the ostensible justification for Wall Street's bubbling up to its ephemeral heights, was equally phoney. It is hardly surprising that investors are so anxious.

Disappointment and anxiety have prompted investors, particularly foreigners, to re-examine America's economic model in a new and more critical light. And, unfortunately, several other long-ignored blemishes are now glaring. Notable among them is the country's reliance on foreign savings. With a current-account deficit of around 4% of GDP and rising, America is absorbing an ever-rising share of global savings—a trend that is ultimately unsustainable. Worse, unlike in the 1990s, these savings are not financing a private-sector investment boom. With business investment flat, foreigners are now largely financing Americans' consumption and, increasingly, a rising federal budget deficit.

Driven largely by last year's recession, America's budget deficit is likely to reach 1.5% of GDP this year. Unfortunately the combination of Mr Bush's enthusiasm for tax cuts and Congress's proclivity for spending suggests that deficits of 1% of GDP or more may linger even as the economy recovers. It is no small irony that, just as the sliding dollar suggests that foreigners are becoming increasingly unwilling to pay for Americans' lack of thrift, the Bush administration and Congress are doing their best to pull America's saving rate down yet further.

Add all these things up, and the great model that Mr Clinton touted at Denver looks a lot less triumphant. That does not mean that any new star has taken its place. Set against Japan's slow-motion implosion and even against Western Europe's still-sluggish economies, America still stands out for its dynamism and flexibility. Its economy remains the “strongest in the world”. But the gap between the United States and the rest has shrunk—and is still shrinking.

 

 

A Profession Under Fire
Jun 19th 2002
The Economist Global Agenda


The Securities and Exchange Commission and Congress have come up with competing plans for reform of the auditing profession after Andersen was found guilty of obstructing an SEC investigation into accounting practices at Enron. But previous attempts at reform have foundered and it remains to be seen if these will do any better

UNDER Harvey Pitt, the Securities and Exchange Commission (SEC) appears to have dragged its feet over the Enron affair. Matters were not helped by Mr Pitt's own background. As a lawyer, he represented America's largest accounting firms against previous attempts by the SEC to prevent auditors from selling consulting services to their clients. But, according to a recent report, Mr Pitt is about to unveil a far-reaching reform of the profession. The move is probably an attempt to wrest the initiative back from Congress. On June 18th, the Senate Banking Committee approved a sweeping accounting reform bill by an unexpected 17-4 vote. In the House of Representatives, another accounting-overhaul bill was passed in April, though that bill lacked detail and passed responsibility for reform direct to the SEC.

All these reform efforts predate the guilty verdict against Andersen, delivered by a Texan jury on Saturday June 15th. But the verdict has boosted significantly the impetus for changes. This was the final nail in the coffin of Andersen's domestic auditing business because a criminal conviction precludes it from auditing public companies. Andersen has said it will appeal after the sentencing hearing on October 11th, but it has also told the SEC that it will stop auditing public companies by the end of August. The verdict will also make it easier for Enron shareholders and others to sue what is left of Andersen (the firm has already disintegrated outside America). In addition, the verdict should make it easier for prosecutors to pursue Enron executives on charges of false accounting or fraud, although there has also been some evidence in the Andersen trial that may allow Enron defendants to plead successfully that they relied on professional advice.

Mr Pitt's draft reforms are now expected to go much further than was previously thought. He had already signalled that the existing Public Oversight Board, the self-regulatory body that supervises the accounting profession, was due for an overhaul. That board had virtually no disciplinary or investigative powers. And it was widely felt that it was too reluctant to discipline members for fear that this would give ammunition to litigious shareholders and clients. In a fit of pique at Mr Pitt's criticism, the board dissolved itself.

In place of the old board, according to a Wall Street Journal report, Mr Pitt is now expected to recommend a Public Accountability Board. It would have at least six independent members and just three accounting professionals. It would have the power to impose sanctions, such as fines, censures and a ban on auditing public firms. The accountants on the board would have no say in disciplinary matters. At the moment, the SEC does not envisage the board having subpoena power, though that may change after consultation. The new board would still be funded, in part at least, by the accounting profession, though by a mandatory fee. And corporate-audit clients would also have to subscribe to the board's running costs.

So far, the draft reform does not include the key change that critics have long called for: a ban on auditors selling consulting services to their audit clients, which many feel is a conflict of interest that has encouraged accounting firms to relax their vigilance in performing audits. However, such a ban is on a list of matters to be considered further by the board.

The bill that has just passed the Senate Banking Committee, sponsored by Paul Sarbanes, the committee's Democratic chairman, would also end self-regulation for accountants. This much, at least, has cross-party support. Mr Sarbanes's proposed new regulatory body would have the power to inspect the work of big firms and to impose penalties. Unlike Mr Pitt, Mr Sarbanes wants to limit strictly the amount of consulting work undertaken by auditors and to impose compulsory rotation of auditors every five years. Andersen and Enron executives had become much too close, say critics.

Further ideas for reform are likely to arise as prosecutors get closer to Enron itself. Andrew Fastow, Enron’s former chief financial officer, is already a target of prosecutors because he earned tens of millions of dollars from his role in partnerships set up by Enron—a role that apparently conflicted with his duties as chief financial officer. Amazingly, Mr Fastow’s position in the partnerships was approved by Enron's own board. However, evidence emerged in the Andersen trial that Mr Fastow had rejected a particular accounting treatment for some of the off-balance sheet partnerships, adopting instead something that did not conform with American accounting rules. The suggestion that emerged in the trial was that Mr Fastow’s motivation for rejecting the proposed accounting arrangement, which would have made things appear better for Enron, was that it would have reduced the value of his stake in the partnerships.

It will be interesting to see how the Bush administration responds to the Pitt proposals, which are due to be unveiled on June 20th. So far, the administration has argued for lighter regulation and tougher penalties rather than tougher regulation. That would be the right prescription if Andersen and Enron were the bad apples in a good crop. But, as more and more American companies revise their earnings, it appears that greed and dodgy accounting have been the rule and not the exception in corporate America.

 

 

American Jitters

Jun 14th 2002
The Economist Global Agenda


Doubts about the valuation of American shares have led to jitters on stockmarkets the world over. America’s economic growth and productivity both seem to be strong. However, investors are worried about the size of the current-account deficit, and its implications for the value of the dollar

THESE are skittish times for investors. The news of an alleged terrorist planning a radioactive “dirty” bomb attack in America on June 10th, the continuing bloodshed in the Middle East, and the sparring between nuclear-powered India and Pakistan all make the world feel a dangerous place. The prospects for the American economy are cloudy at best. And, even if the economy does well, it is not clear that companies will be able to exploit the upturn by raising prices and improving profit margins. So the American stockmarket, despite rallies this week, is close to the levels it fell to after the September 11th attacks last year, and, in the case of the technology-heavy Nasdaq market, far below the peaks scaled in 2000.

Foreigners, worried about the size of America’s current-account deficit—4% of GDP and growing—have started to sell dollar assets. Partly as a result, the American currency hit a 17-month low against the euro, at $0.95, on June 12th, marking a decline of nearly 14% since last July. And, just when investors need reassurance, the continuing drip-drip of corporate and Wall Street scandals sends exactly the wrong signal. With investors feeling so bearish, stockmarket indices around the world have lost most of the gains made after a concerted round of interest-rate cuts followed the terrorist attacks on New York and Washington last September. This week the Nasdaq-100 index closed at its lowest level since January 1998. The Dow Jones Industrial Average fell by 3.4% last week alone and this week touched a seven-month low of just below 9,500. Markets in Europe and Asia were also effected. This week ended on a grim note, with markets everywhere in turmoil.

Fund managers are divided about the best investment strategy. Many seem to be happy to stand on the sidelines of the market, letting cash pile up. But some strategists say that this bearish moment is the best time to enter the market. Goldman Sachs’s Abby Joseph Cohen, doyenne of the bulls during the stockmarket boom of the 1990s, predicts that the S&P 500, a broad index of America’s leading shares, will end the year at 1300, around 30% ahead of where it is now. Even Barton Biggs of Morgan Stanley, for a long time an arch-bear, argues that now is the time to buy.

The American economy is sending conflicting signals. Economic growth—5.6% annualised in the first quarter—is stronger than expected, though much of this reflects a slowdown in the rate at which inventories are being run down. But the market was nudged lower on June 13th when figures were released showing that retail sales, which had remained buoyant, had finally turned down, by 0.9% in May, or by 0.4% when cars are excluded.

A report in America’s “beige book” issued by the Federal Reserve on June 12th said that growth in April and May had been “modest but uneven”. While some sectors are doing well, “others softened or remained weak.” This struck a noticeably less optimistic tone than the last beige book, in March, and has dampened expectations that the Fed will raise interest rates from their current 40-year low of 1.75%. Part of the problem is what economists call the “quality” of the growth. Economic growth has been sustained by discretionary government spending that, according to Goldman Sachs, is running 10-15% above last year's levels.

And the International Monetary Fund, in a report also issued on June 12th, said that equities appeared overvalued. It said there was a risk of a stockmarket “correction due to disappointing earnings…not only for the US, but also in other regions.”

Despite the share-price declines of the past two years, shares are still expensive by historic standards. The post-war average price-earnings ratio of S&P 500 stocks is 15. But using companies’ own measure of operating profit, that figure is now 26. Adding back in so-called “exceptional” expenses yields a p/e of 41, and adding back the cost of share options brings the ratio to a frightening 50-plus.

Investors are finally focusing on a couple of related long-standing problems, which suddenly seem menacing: the strength of the dollar and the size of the current-account deficit, which will approach 5% of national income by the end of the year. Deficits of this level have a habit of triggering currency depreciation. The dollar has already been weakening, to hit a 17-month low against the euro. UBS Warburg, an investment bank, expects the greenback to fall as low as $1.05 to the euro by the end of next year.

The dollar is very vulnerable to a change in sentiment about the relative attractions of American assets. In the past year, there has been a shift in the flows into the United States. Foreign direct investment financed 91% of America’s current-account deficit in 1999. By last year, that had fallen to 43%, having been supplanted by more fickle capital flows. Foreigners own no less than two-fifths of American Treasury bonds, a quarter of corporate bonds and 13% of American equities.

Moreover, because America’s current-account deficit is growing, even a fall in the rate at which foreigners are buying American assets will trigger a fall in the dollar. Such a fall could not only damage investor confidence in itself, but could dent economic growth. Stephen Roach, Morgan Stanley’s chief economist, reckons that a 20% fall in the dollar over six months could knock up to one percentage point off global growth over the following year.

A modest fall in the dollar may have some benign effects, as it would help spur American exports and growth, and dampen inflationary pressures in Europe. But all markets tend to overshoot and foreign-exchange markets do so more than most. It is by no means certain that the value of the dollar will plunge; but it is enough of a possibility to give investors sleepless nights.

 

 

Wall Street

The Value Of Trust
Jun 6th 2002 | NEW YORK
The Economist


Investors seem to have lost faith in Wall Street. What can be done about it?

AMERICAN stockmarkets fell at the start of this week, even as the economic outlook grew brighter. The Dow Jones Industrial Average and the technology-heavy Nasdaq touched their lowest levels for months. Investors have had their confidence bashed by a series of revelations of corporate malpractice and number fiddling before the stockmarket bubble burst. The continuing sagas of Enron and its auditor, Andersen, have kept their spirits low. Almost any half-suggestion of impropriety can make them twitch. This week they twitched at the resignation of Dennis Kozlowski, chief executive of Tyco International, a once high-flying agglomeration of ill-fitting businesses, days before he was charged with evading more than $1m in taxes on paintings that he bought last year in New York.

Investors have not only lost patience with corporate America's greed and its inability to do what it says it is doing; they have also lost confidence in Wall Street's ability to act as an honest broker between them, the providers of capital, and the corporate users of it. “There is an air of cynicism surrounding every institution that underpins our capital markets,” says Stanley O'Neal, co-head of Merrill Lynch, an investment bank that recently paid $100m to settle a lawsuit over the integrity of its analysts when the Internet hype was at its peak. “This cynicism has gone beyond reasonable questioning, and could easily turn destructive.” What should be done to divert this potentially destructive force?

Although there are important differences, there are also echoes today of the 1930s when, in the aftermath of a stockmarket bubble and the 1929 crash, Wall Street became public enemy number one. Business then went into a severe decline as investors and companies lost faith in the trading and issuance of securities. The Pecora hearings in Congress (named after Ferdinand Pecora, a lawyer who orchestrated the proceedings) provided an outlet for the public's Depression-era fury and humiliated leading Wall Street figures such as Jack Morgan, the boss of J.P. Morgan. (Famously, during a break in testimony a circus midget climbed on to the financier's lap and posed for photographs.)

Congress passed several laws that imposed unprecedented regulation on the business of finance, all vigorously opposed by Wall Street at the time. The quality of this legislation was mixed, though the laws that defined the structure of the industry were worse than those that regulated the conduct of the industry's participants. The Glass-Steagall act, which banned firms from doing both commercial and investment banking, was eventually scrapped in 1999. But the creation of a “cop on the corner” of Wall Street in the shape of the Securities and Exchange Commission (SEC) proved to be a masterstroke, greatly increasing public faith in America's capital markets.

Today, Wall Street once again faces both a prolonged slump in business and the prospect of punishment and further regulation. Trading in shares by institutional investors, especially hedge funds, continues to accelerate. But many individuals who flocked to the stockmarket during the second half of the 1990s are now giving up en masse. Day traders (so called because they buy and sell stakes within the same trading day, thus producing a rich flow of commissions for brokerage firms) are now yesterday's traders. And many people who traded only occasionally, or who put their money into mutual funds, are also bailing out of the market.

According to the June issue of Bank Credit Analyst, a newsletter, retail investors have now “lost most of their profits accrued during the bubble years”. The BCA proxy for the average price paid for shares suggests that the cumulative profits of those investing steadily since 1995 are down to less than 10%, compared with a high of 40%.

Companies, too, are using Wall Street's services less. Both mergers-and-acquisition (M&A) activity and initial public offerings of shares (IPOs) are miles below their highs of 2000. The likelihood is that the depression on Wall Street will continue for some time, and that the recent rounds of job-cutting will not be the last. At the very least, firms will have to get used to much lower revenues and slower growth.

Everybody agrees that action is necessary to ensure that America's capital markets remain the best in the world. But the battle to lead that punishment and reform process promises to be unusually messy. That, in turn, makes the future path of reform highly unpredictable. As well as such assorted congressmen as Paul Sarbanes, Edward Markey, Jon Corzine and Richard Baker, state politicians such as Eliot Spitzer, New York's attorney-general, are jockeying for a share of the limelight.

Mr Spitzer brought the recent case against Merrill Lynch, which focused on internal e-mails in which Merrill analysts—notably their former Internet guru, Henry Blodget—abused Internet firms as “crap” and “shit” while simultaneously issuing research reports that urged investors to buy their stock. Now Mr Spitzer hopes to repeat his victory—Merrill paid $100m to settle the case, though it did not admit any wrongdoing and was never charged with any specific offence—by obtaining e-mails from Morgan Stanley (home to Mary Meeker, an analyst once known as “the queen of the dotcoms”) and Citigroup, whose telecoms analyst, Jack Grubman, is facing growing public scrutiny.

Worried that action by the states might undermine America's federal system of securities legislation, Congressman Baker recently wrote to state attorneys-general warning them that he would propose legislation to curb their activities if they continued to go their own way.

Self-regulatory bodies such as the New York Stock Exchange (NYSE) are also competing to show leadership. On June 6th the Big Board introduced new listing requirements for companies that will, among other things, force them to have a majority of independent directors on their boards. The NYSE boasts that these rules are much tougher than those introduced by the National Association of Securities Dealers (NASD) last month.

In an ideal world, the agenda would be set by the SEC, but it remains to be seen if its chairman of nine months, Harvey Pitt, can overcome a series of political embarrassments that have led to criticism from both right and left. Further complicating matters, countless private lawsuits are pending against financial-services firms that seem likely to drag on for years and may result in huge payouts. They are providing plenty of the sort of bad publicity that encourages politicians to turn up the heat on Wall Street more than might be good for its health.

Shaky analysis

How much punishment does Wall Street deserve, and what reforms does it need? At the most basic level, financial markets stand accused of knowingly selling over-priced shares by claiming they were cheap, and of doing so in ways that benefited some of their customers (and themselves) to the detriment of others. In particular, this boils down to three main concerns. One is about the role of the research that is published by investment banks; a second is about the way in which shares in IPOs are allocated; and the third is about the use of accounting rules to mislead investors.

The focus on research analysts who allegedly advised investors to buy shares at prices they did not really think made sense has intensified since Merrill settled with Mr Spitzer. As well as Mr Spitzer's pursuit of Morgan Stanley and Citigroup, the SEC this week revealed that it is investigating ten cases of possible conflicts of interest involving analysts, while the NASD and the NYSE are looking into 37 such cases.

Even if these turn up no e-mails as lurid as Merrill's, there is every chance that firms accused as a result of these investigations will reach a (doubtless expensive) out-of-court settlement. For a financial firm to go to trial over such matters is to risk bankruptcy. The laws in the area are sufficiently untested for them to prefer not to present their case to a judge.

There is no doubt that Wall Street gave investors an unprecedented amount of bad advice; that those dispensing it often had an inkling that the firms they touted were probably overvalued; and that they had strong incentives to err on the bullish side. On the other hand, every piece of advice issuing from a Wall Street firm comes couched in caveats. If the oldest rule of the marketplace, caveat emptor—“buyer beware”—is to apply in such cases, then anybody slavishly following the advice of a Wall Street analyst has only himself to blame for his future losses.

Ominously for Wall Street, however, on June 3rd a Supreme Court ruling—in favour of an SEC action against a broker—stated that the securities markets' regulations introduced in the 1930s “sought to substitute a philosophy of full disclosure for the philosophy of caveat emptor, and thus to achieve a high standard of business ethics in the securities industry”. Caveat emptor does not go far enough, it seems. Analysts may have a legal duty of care for their retail customers, which means, for example, offering them only such advice as they would give to themselves.

What can be done to make Wall Street fall more into line with this philosophy in future? So far, the focus of reform has been to try to reduce the conflicts of interest that may encourage analysts to feign bullishness. One suggestion is that they should be prevented from owning shares in the companies that they track. But this tackles only one potential conflict. The more powerful arises from the huge rewards that analysts get, directly or indirectly, for promoting their firms' other services. An alternative (if far-fetched) suggestion is that they should be required to invest according to their own advice, but only after a delay to ensure that they are not able to anticipate their customers' future purchases.

There is some talk in Washington of drawing up legislation to ban investment banks from publishing research, which would certainly remove that conflict of interest. But there are not many examples of a firm of any scale surviving for long by selling truly independent research. And since the SEC introduced regulation fair disclosure (FD) in 2000, prohibiting firms from disclosing material information to one outsider before the market as a whole, the main source of competitive advantage for analysts—namely, access to privileged information through meetings with the companies' managers—has supposedly been destroyed. True, it is not yet clear that Regulation FD is being vigorously enforced by the SEC, which has yet to make a single prosecution under it. If it were, though, there would be even less to distinguish the insights of most research analysts from those of an ordinary investor.

In a recent speech, the SEC's Mr Pitt said that the main issue with the second area of concern, the IPO process, was that “valued brokerage-firm clients are given investment opportunities, but only in return for kickbacks to the brokerage firms that made the opportunity available”. This seems to have happened quite often recently. Indeed, one investment bank, CSFB, paid $100m to settle an investigation into its habit of allocating shares in IPOs to favoured clients who repaid a chunk of any profits that they made by subsequently conducting unnecessary trades with the broker.

Friends of Frank

But this is not the public's main concern about IPOs. Their worry is that they never get allocated shares in the initial distribution, and that to participate in an IPO they have to buy the shares at an exorbitant mark-up in the after-market. These are problems that the SEC could do something about (though, distressingly, it shows no signs of doing so), notably by ordering investment banks to use auctions to allocate shares in IPOs to the highest bidders. So far, despite the plucky efforts to promote auctions by W&R Hambrecht, a Silicon Valley investment bank, they are used in less than 1% of all issues.

It is not obvious why auctions should be shunned, especially as W&R Hambrecht charges only 4% of the money raised compared with Wall Street's norm of 7% (a norm so entrenched that it sometimes seems surprising that it has not aroused the interest of antitrust authorities). One possible explanation is that the management of issuing firms may be co-opted into going along with an investment bank's underpricing of their issue by the promise of “friends of Frank” accounts.

Named after Frank Quattrone, an investment banker who led CSFB's technology-industry group in the heyday of the dotcom euphoria, these accounts were given to managers as a reward for hiring CSFB. Through them, they received preferential allocations of shares in future IPOs. In effect, this aligned the interests of the company's managers with those of Wall Street, while putting them in conflict with the interests of their own employer.

A solution to this would be to require full disclosure of any other relationships that managers of companies going public have with their underwriter. Jay Ritter, an economist at the University of Florida, says that it would be even better if there were a total ban on dealings between managers and the underwriter until, say, at least two years after their company's flotation. He expects the next round of lawsuits against Wall Street to target the underpricing of IPOs, especially if (as he thinks likely) the suit recently filed by eToys against Goldman Sachs succeeds.

The erstwhile Internet toyshop claims that it was deprived of cash that could have kept it alive because the investment bank deliberately underpriced its IPO in 1999 so as to gain illegal kickbacks from investors who were allocated shares in it. Given that total IPO underpricing during 1999-2000 amounted to $66 billion (based on the difference between the price at issue and the price at the end of the first trading day), the payouts in such cases could eventually be huge.

There may be trouble too if underwriters are shown to have known more than they let on when selling securities in firms that later stumbled. J.P. Morgan Chase is suing insurers who are refusing to pay up on a $1 billion surety bond tied to Enron, claiming the bank misled them about the risk. And on June 4th it emerged that the SEC is investigating claims that Citigroup underwrote shares in Adelphia, having earlier made undisclosed loans of $3.1 billion to the scandal-hit telecoms firm and its founders, loans which were used to support its share price.

Called to account

The issue troubling investors more than any other, however, is the third of the three main concerns: the quality of financial information that is provided by companies. This is largely due to failures of accounting and corporate governance that are not, at first glance, really Wall Street's fault. However, it was the investment banks that supplied much of the financial alchemy that firms have used to hide the truth—such as at Enron, with its various off-balance-sheet financial structures.

It is in responding to this concern that Mr Pitt's SEC may yet turn out to be revolutionary. Despite criticism over potential conflicts of interest due to his previous employment as a lawyer working for big accounting firms, Mr Pitt is starting to transform the way in which accounting standards are set, and the legal obligations on companies to use accounting data to promote a true picture of their financial condition and risk. He has started to tell the Financial Accounting Standards Board (FASB), America's main accounting-standards setter, what its agenda should be, and he has ordered firms to make clear the most important assumptions they have made in their choice of accounting treatments (and to show how other choices would have made a difference).

He is also requiring firms to announce material changes in their outlook at the earliest opportunity, and is even taking action against firms which abide by accounting principles but do so in misleading ways. For example, Edison Schools, a school-management company, was recently told to stop booking revenues that never really passed through its coffers, even though this did not technically breach accounting rules.

As for better corporate governance, the NYSE's new rules are a step in the right direction. Much will depend on how committed the exchange is to ensuring that the rules are honoured in the spirit as well as by the letter. Greater independence of non-executive board directors is certainly desirable. Too many American bosses fill their boardrooms with yes-men who have neither the character nor the financial incentive to challenge the boss's grandiloquence. Ultimately, however, governance is unlikely to improve much until the institutions that own large chunks of corporate America start acting as real owners, by keeping a sharper eye on their boards and their management.

Joseph Grundfest, a former SEC commissioner, argues that Wall Street firms may be less to blame for the corporate messes currently unfolding than corporate managers and boards, or their auditors. “Wall Street firms,” he says, “clearly have the deepest pockets” at a time when angry investors are looking for any recompense for the sins of the past—which means that they are probably in for a torrid few years, a time in which they will find out how much it costs to lose the trust of investors. It is easy to see why Merrill Lynch's Mr O'Neal is worried about the destructive possibilities of today's air of cynicism.

 

 

A Dollar Cliffhanger
Jun 6th 2002
The Economist Global Agenda


A weakening dollar could be good news for the American, European and world economies all at once. But this will only be true if the dollar’s decline is gradual and moderate, and this cannot be guaranteed. A sharp fall could spell troubl

CURRENCY forecasters who have long predicted its decline have seen the dollar climb inexorably for years. At last it seems to be turning. Since February the dollar has fallen by 9% against the euro, to a 17-month low of $0.94. It has also hit a six-month low against the yen, of ¥123. It may well fall further over the coming year.

Two factors weigh against the dollar. First, it is by most yardsticks overvalued. Its trade-weighted level, adjusted for inflation differentials, remains well above its average over the past couple of decades. And second, America’s large current-account deficit, at more than 4% of GDP and growing, looks unsustainable. If the dollar stays roughly where it is as the economy rebounds, then the deficit will grow. As a rule, once a country’s external deficit approaches 5% of GDP, its currency tends to fall.

To trigger a slide, foreign investors do not have to become net sellers of American assets. The dollar will fall if they merely reduce the pace at which they add to their holdings. It will fall even more if American investors continue or expand this year’s buying of foreign assets, notably European equities.

Until recently, net capital inflows more than covered America’s current-account deficit. Yet investors are now reassessing their expectations about future relative returns. Recent data appear to confirm that America’s recovery is on track. Indeed, The Economist’s latest poll of forecasters suggests that the American economy is again expected to outpace Western Europe and Japan this year.

Still, the part of this growth that finds its way into company profits is in greater doubt. America’s productivity growth may have risen, but the fruits have so far gone mainly to workers and consumers, rather than to profits. And a growing band of investors guesses that higher potential returns now lie in Europe and Japan—so long as governments carry out reforms and firms continue to restructure.

Over the past year, America has had to rely more heavily on fickle short-term capital flows, into bonds and equities, in order to finance its current-account deficit. Figures from Credit Suisse First Boston show that foreign direct investment financed 91% of America’s current-account deficit in 1999. By last year the figure had fallen to only 43%; this year it has probably slipped further.

Most forecasters predict another fall in the dollar, but they generally expect it to be gradual and relatively painless—except, of course, for foreigners with large dollar holdings. For example, UBS Warburg expects the dollar to fall to $1.05 to the euro and to ¥115 by the end of 2003—a drop of around one-sixth from its peak earlier this year. George Magnus, the bank’s chief economist, argues that a gradual fall in the dollar would benefit the world economy. It would underpin America’s recovery, by helping to bolster exports, profits and investment. A stronger euro and yen would also intensify the pressure for structural reform and corporate restructuring in the euro area and Japan.

By helping to hold down inflation in Europe, a strong euro would also reduce the pressure on the European Central Bank (ECB) to raise interest rates. For Japan, however, a weaker dollar would be bad news, threatening to choke a nascent recovery. With interest rates already close to zero, the exchange rate is one of the few policy tools left for the Bank of Japan. GDP figures for the first quarter, due to be published on June 7th, are widely expected to show strong annualised growth of around 5%. However, Japan’s GDP figures are notoriously volatile, and many economists reckon that output will stumble again in the second quarter.

The Bank of Japan has intervened four times in the past two weeks in a bid to hold down the yen. Yet intervention rarely has much effect unless it is carried out jointly with other central banks. A new paper by Takatoshi Ito, an economist at the University of Tokyo, finds that joint intervention in the 1990s was 20-50 times more effective than intervention by the Bank of Japan alone. This time round, the Federal Reserve and the ECB are unlikely to join in, as both would be reasonably happy with a weaker dollar.

America’s economy would certainly benefit from a moderate fall in the dollar. Some economists fret that this would push up inflation and thus force the Federal Reserve to raise interest rates. Yet the Fed would probably be happy to see some increase in inflation. America’s GDP deflator, the broadest measure of inflation, rose by less than 0.5% at an annual rate over the past two quarters, its lowest for almost 50 years. This is getting close to deflation.

While a moderate decline of the dollar might be benign for the world, a sudden plunge would be another story altogether. It would probably trigger a slump in American share prices, and a rise in bond yields, as foreigners pulled out their money. Foreigners own fully two-fifths of American Treasury bonds, a quarter of corporate bonds and 13% of American equities. Share prices around the world would probably be hit.

A further drop in share prices would erode consumer and business confidence, and harm world growth. There is also a question over whether the ECB would react fast enough to a dollar crash by cutting interest rates to offset the deflationary impact on the euro-area economies. Stephen Roach, at Morgan Stanley, estimates that a 20% fall in the dollar over six months could knock up to one percentage point off global growth over the following year.

For now, most economists are sanguine, expecting a moderate fall in the dollar towards its “fair value”, rather than a plunge. These are the same forecasters who in 2000 failed to predict a bear market in shares (the S&P 500 is now one-third below its peak) and who last year ruled out a recession. Currencies almost always overshoot, downwards as well as upwards. From its 1985 peak, the dollar fell by half against the D-mark within two years. A repeat performance is possible.

 

 

America : Why No Longer So Alluring?

May 30th 2002 | WASHINGTON, DC 
The Economist

Investors are intriguingly wary of America's recovery

A FEW years ago, America was reputed to have a charmed economy. Thanks to the productivity miracle, output grew fast enough to push unemployment to historic lows without fuelling inflation. From across the globe, investors could not get enough of this magical state of affairs. 

In many ways, today's economic recovery is equally alluring. Despite the bursting of the stockmarket bubble, last year's collapse of corporate investment and the terrorist attacks, the recession has been remarkably short and mild. The economy surged in the first three months of 2002; productivity growth remains extraordinarily strong; consumers remain resilient; corporate profits, as measured in the national income accounts, are showing signs of life, and inflation is nowhere to be seen. Yet investors are unimpressed. Share prices have been lacklustre, and the dollar this week reached a 14-month low against the euro. Why has America's economy lost its power to charm?

The obvious explanation is that the economic outlook remains uncertain. Certainly first-quarter GDP growth—5.6% at an annual rate, according to revised figures released on May 24th by the Commerce Department—was unexpectedly strong. But much of that surge was driven by temporary factors, particularly a reduction in the pace at which firms slashed their inventories. Between January and March, this inventory adjustment added a hefty 3.5 percentage points to annualised GDP growth. Although the inventory cycle still has some way to go, and may add 1.5 percentage points to second-quarter GDP growth, inventory adjustment is incapable of being a sustained source of growth.

The broader outlook for corporate investment is still murky. The good news is that firms' profits appear to be on the mend, boosted by radical cost-cutting coupled with strong productivity growth. Higher profits should bode well for future investments. The bad news is that profits are paltry compared with their pre-recession peaks, and that by most measures America's firms still have plenty of spare capacity. In the short term, few expect investment spending to offer much of a boost to the overall economy. 

That leaves the onus where it has long been—on the American consumer. Contrary to the fears of many pessimists, consumer spending has yet to peter out. Consumption rose by a monthly 0.5% in April, less than many predicted, but perfectly consistent with a moderate recovery. There is little sign that Americans have, as yet, lost their appetite for ever more big-ticket purchases. Motor vehicles (which almost single-handedly sustained consumption at the end of last year) sold even faster than their first-quarter average in April. And according to one dealer survey, they are running 7% higher in the first two weeks of May than in the same period last year.

For the economy to fall back into recession, consumption would have to collapse dramatically. There are few signs of that

For the economy to fall back into recession, consumption would have to collapse dramatically. And there are few signs of that. According to the Conference Board, the consumer-confidence index rose in May to its second-highest level since the September 11th attacks (although by slightly less than Wall Street expected). Though financial markets are lacklustre, consumers' balance sheets are still buoyed by a booming housing market. Sales of existing houses rose sharply in April, and the price of the typical American house is up 7% from a year ago. 

Americans' incomes are still rising, albeit more modestly than they were earlier this year. The labour market still looks weak—the unemployment rate, at 6%, is at an eight-year high, and, despite the robust growth, in the year so far almost 100,000 jobs have been lost. But for those in work there has been no income collapse. Despite the recession, pay packets have held up surprisingly well, and tax cuts have also added to Americans' spending power. 

That could change. For pessimists, the prospects of a double-dip recession hinge on further weakness in labour markets. Many make comparisons with the “jobless” recovery of the early 1990s. Stephen Roach of Morgan Stanley, for instance, foresees big job losses in middle and senior management, as firms try to slim down what he sees as bloated executive ranks. Others point out that wage growth looks increasingly sluggish. Optimists, in contrast, reckon preliminary evidence suggests that hiring may be about to take off. Economists from J.P. Morgan, for instance, point out that employment of “temporary” workers, which often presages employment trends for permanent jobs, has risen sharply in recent weeks. 

Another, though much smaller, component of GDP growth remains indubitably on an upward trend: government spending. Along with inventory adjustment, government spending buoyed first-quarter GDP, and it shows little sign of disappearing. According to economists at Goldman Sachs, discretionary government spending is running 10-15% above last year's levels. 

Taken together, this evidence leads most economists on Wall Street to conclude that the most likely scenario is continued growth, albeit at a more moderate pace than in the first quarter. So why are investors, and particularly foreigners, in such a funk? 

One reason has less to do with immediate economic prospects than “Enronitis”—the shrinking of investor confidence in American capitalism in the wake of Enron and subsequent corporate scandals. As the roster of dodgy accounting extends from Xerox to Global Crossing, investors' faith in American firms has taken a sharp knock. Dashed expectations also play a role. A moderate economy is not what financial markets were betting on earlier this year. As output surged, Wall Street assumed that fast growth and fat profits were round the corner.

Finally, with investor confidence weakened and with economic performance moderate rather than exceptional, economic weaknesses (long ignored by investors) loom larger. In particular, America's enormous current-account deficit—set to reach 5% of GDP this year—has risen sharply on the radar screens. Although economists long argued that America's current-account deficit was unsustainable and the dollar too strong, foreigners' confidence in the economy kept both going. Now that foreign sentiment appears to be turning negative, one of the biggest risks to America's economic outlook is a sharp adjustment. For many Wall Street economists, a sudden dollar collapse is the biggest threat to the recovery, aside from a terrorist attack or another oil shock. It is a cruel irony that if foreigners give up on America too quickly, they will ensure that the charmed economy disappears. 

 

Argentina : Spoilt For Choice

May 31st 2002 
The Economist Global Agenda

Five months after the collapse of Argentina’s ten-year-old currency board, and the subsequent plunge in the value of the peso, the country has at last taken an important step towards restoring economic stability, by repealing a much-criticised banking law. But Argentina’s painful experience remains a warning for emerging-market economies struggling to choose the right exchange-rate regime

FOR the ordinary citizens of Argentina, it is bad enough living in an economy now in its fourth year of recession, and to have seen the value of their savings plunge by around two-thirds this year. But they also have to put up with a system of government which enables political leaders to spend their time arguing with each other, eyes firmly on their prospects in the presidential election due next year. 

An important step towards reform was at last passed by the country's Senate on May 30th, when the controversial economic-subversion law was repealed. This meets one of the preconditions for any international rescue package for Argentina. Even so, the road back to economic and financial health is going to be long and painful. Economists are still arguing about what might have been done to prevent the catastrophic breakdown of the country’s ten-year-old currency board. The debate is being watched closely by the governments of other emerging-market economies and their advisers. They want to know where Argentina went wrong, and whether they could avoid a similar disaster.

In the aftermath of such a crisis there is, of course, plenty of mud-slinging. In Argentina’s case—and in many similar episodes in the past—the International Monetary Fund (IMF) comes close to the top of the list of targets. Even now, many Argentines cannot understand why the IMF did not do more to help, and there is genuine puzzlement as to the IMF’s continuing refusal to reach a deal with the government. Every now and again, a member of the government talks about an imminent deal. Repeal of the economic subversion law shows that, at last, a start is being made on the more difficult economic reforms demanded by the IMF and its paymasters, the G7 industrial countries. 


The Ministry of Economy in Argentina posts information on the country's economy. The Institute for International Economics publishes “Managed Floating Plus” by Morris Goldstein, and posts research on dollarisation and currencies and exchange rates. The IMF reports on its dealings with Argentina, and publishes more detailed background information. 

Despite abundant evidence of political irresponsibility, it is hard not to feel some sympathy for Argentina. The latest conventional wisdom is to argue that the country was badly mistaken to cling for so long to the currency board, which pegged the peso at parity with the American dollar. It is also widely accepted now that the $8 billion rescue package which the IMF put together for Argentina in August last year was a mistake—encouraging the then government to prolong the pain imposed on the economy by its exchange-rate regime.

Yet there were few voices advising Argentina to move to a different exchange-rate regime when a switch might have been less painful. Nor was there much dissent when Argentina introduced the currency board in 1991, or when it pointed to the dramatic falls in inflation for which the hard-currency peg got the credit. 

No wonder, then, that emerging-market economies are confused about the right exchange-rate regime to pursue. Economists are confused too. If there is any truth in the old joke that says for every two economists you get three opinions it surely applies to discussions of exchange-rate policy. 

The challenge is not a shortage of evidence, but interpreting it. One of the biggest obstacles is also one of the most basic—working out which exchange-rate regime is actually being applied. There is often a considerable gap between what countries say their policy is—known as the de jure classification—and what policy the government actually follows in practice—the de facto approach. 

Correct classification is important because it enables economists to measure the supposed benefits in terms of reduced inflation, for example. And the costs of a regime going wrong can be high. A long list of emerging-market exchange-rate crises in the 1990s is a reminder both of how painful such crises are for the country concerned and how great the impact can be on the international financial system as a whole. 

The crises of the 1990s did, however, tend to have one thing in common: they all had some kind of fixed exchange rate, often a fixed peg or link to another currency, usually the dollar, or an exchange-rate band, again usually linked to the dollar. The “tequila” crisis in Mexico in 1994; Thailand, Indonesia, Malaysia and South Korea in 1997; Russia and Brazil in 1998; Turkey in 2000 and 2001, and, of course, Argentina, all had some kind of peg. None was floating. Indeed, studies have shown that even when emerging-market economies say they are floating (as Malaysia, for example, used to), they tend to rely more heavily than the industrial countries do on interest-rate policy and foreign-exchange market intervention to limit actual movements in the exchange rate.

Yet Argentina’s experience provides clear evidence that even currency boards, where the rate is fixed by law, and where the domestic currency has to be backed by hard-currency reserves, are not immune from crises. And such hard exchange-rate regimes do not offer suitable policy instruments for domestic economic management: Argentina’s monetary policy was, in effect, made in Washington and was often inappropriate for Argentina’s needs. Nor was the government able to use fiscal policy to stimulate the economy when the recession started, because of the fragile nature of the country’s external-debt position.

One of the biggest problems in emerging-market economies is currency “mismatching”, where most of the debts in an economy are denominated in one currency, whereas many of the borrowers’ assets are in another. When a crisis erupts the consequences are far more serious because of the mismatch. Thus, in Argentina, many loans were taken out in dollars: this had catastrophic consequences for borrowers once the peg collapsed, since dollar loans suddenly surged in peso terms. 

Argentina’s experience has prompted a large number of economists to come forward with their prescriptions. Most recently, Morris Goldstein, of the Institute for International Economics, has made a persuasive case for a framework he calls “managed floating plus”. By this he means a managed floating exchange-rate, giving the country the advantages of flexibility by allowing it to pursue its own monetary policy while still being able to adjust in response to external shocks. This is combined with the “plus”: policies such as inflation-targeting and measures to reduce currency mismatching. 

There are many other distinguished economists, however, who argue that the attempt to come up with a formula which all countries can use is in itself flawed: circumstances vary and so must policies. And none of the present debate will bring much comfort to Argentina in the short term, of course. But those arguing for returning to the currency-board regime at a different rate, or for full dollarisation, which would eliminate any policy flexibility for the Argentine government, should at least be given pause for thought.

 

China : The Withering Away Of The Party

May 30th 2002 | BEIJING 
The Economist

Economically, But Not Politically

IN URBAN China, the Communist Party's roots are weakening fast. In the late 1990s, the number of city dwellers employed by state-owned enterprises dropped to fewer than half the workforce. As the state sector crumbles, so too do the party branches that once controlled the lives of urban Chinese. Party officials talk of the urgency of setting up branches in non-state enterprises, but they are making little progress. 

The party itself is still expanding. It now has 64m members compared with 50m in 1990. But this is no reflection of the party's popularity among those who work in the most dynamic and productive area of urban China's economy. Take Wuhan, for example, a city of 4.4m people on the banks of the Yangtze. In 1993, a mere 0.9% of its party members worked in private or foreign-invested enterprises. Six years later, the proportion remained virtually the same. Or take similar-sized Shenyang, north-east China's biggest city. In 1999, some 640,000 people worked in non-state enterprises there. That year, the party managed to recruit only 29 of them as new members. Data on party membership are patchy. But according to one party journal, only 17% of private firms employed party members in 1999 and just 3% had any kind of party organisation. Foreign-funded enterprises are often formed in partnership with state-owned firms. Yet only 35% of them employed party members that year and a mere 17% had party cells. 

Officials sometimes boast of successes. One example they cite is the party organisation in Motorola (China) Electronics Ltd, a factory complex in the port city of Tianjin owned by one of the biggest American investors in China. It produces mobile telephones and other electronic equipment. According to party publications, a branch was established in the company in 1990, even before its official founding. But the organisation remained clandestine, not wanting to alarm the foreign bosses. 

Four years later, party leaders of the development zone where the Motorola plant is located decided to tell the company what was going on. A party journal said the foreigners were “pleasantly surprised” to find that members included most of the company's top technicians and managers. The journal said the company not only agreed to the establishment of a bigger party branch, but also offered a place for it to meet (Motorola itself refuses to comment on its dealings with the party). Now the company's party organisation boasts 300 members, though this is still only 3% of the workforce.

But does even this rare success make any difference? In state-owned enterprises, the party committee usually runs the factory. Often the factory manager serves as the party branch leader. At least until the 1990s, when the collapse of the state sector began in earnest, workers aspired to be party members because membership gave them power. But even where the party has managed to gain a foothold in private and foreign-owned enterprises, its role is inevitably far less important.

Officials say that one function of party cells in the non-state sector is to help ensure that such enterprises uphold the law. But unlike in the state sector, employees are on short-term contracts if they have any contract at all, and are hardly likely to challenge bosses for violating regulations. This could be one reason why China's party chief, Jiang Zemin, decided last year to end the party's ban on admitting private-enterprise bosses as members. At least if an enterprise is led by a party member, the party might retain a modicum of influence. But as one official journal put it: “The party constitution requires party members to hold themselves responsible to the working class. The Company Law requires managers to hold themselves responsible to the board of directors.”

Pan Wei, of Beijing University, says that even in stodgy state enterprises, the party is losing its grip. “Party organisations at the grassroots have been decaying. Regular party activities have virtually stopped,” he says. In a few years' time, this could mean that in urban China at least, the party's grassroots activities will be confined mainly to government departments and institutions, in which party membership remains a prerequisite for advancement. “It will be pretty much a bureaucratic party,” says Mr Pan.

 

Argentina's Collapse 

Scraping Through The Great Depression

May 30th 2002 | ROSARIO 
The Economist

As Argentina's politicians stumble towards an IMF agreement, its new poor scrabble to survive

IN HIS backyard, behind a makeshift fence to keep his two scrawny chickens from digging it up, Raul Alaniz has a tiny patch where he keeps earthworms, feeding them food scraps, which they will turn into organic fertiliser, which he hopes to sell. Unlikely as this sounds, Mr Alaniz, an unemployed bus driver, says that several of his equally desperate neighbours in Las Delicias, a district of Rosario, are doing the same, in the hope of earning a few pesos. Others are raising snails and frogs to sell to restaurants. Across the road, in an abandoned house that has been turned into a community centre, a group of women bake bread, while others make children's clothes from old jeans.

Such is the penury to which this once-grand city, known as the “Chicago of Argentina”, has been reduced. Rosario is a river port, and the economic hub of the farming province of Santa Fe, on the fertile “humid pampas”. It is where much of Argentina's huge agricultural output is traded, processed and despatched. Las Delicias used to be a comfortable working-class district; jobs were plentiful in nearby meat-packing plants. But, like the rest of the city, and Argentina as a whole, it had been in decline even before the economy imploded late last year. Now, in Las Delicias, some have gone straight from being solidly middle-class to depending on food parcels, says Nora Molinari, the secretary of a local residents' association. 

Unemployment in greater Rosario is now 25% and rising (see chart). With accelerating inflation eating into living standards, more are falling into poverty every day, says Artemio Lopez, a sociologist. Locals say some shops have raised the price of basic foodstuffs several times within a week.

To break this downward spiral, President Eduardo Duhalde's government is seeking a new accord with the IMF. It hopes that this will unlock loans to ease poverty, rebuild the shattered banking system and get the economy moving again. Because of Argentina's failure to comply with previous accords, the IMF has imposed tough preconditions for any new deal. These include amending a bankruptcy law which favoured debtors, scrapping an “economic subversion” law which courts have used against bankers, getting provincial governments to cut their spending, and taking steps to restore confidence in the banking system.

Apart from amending the bankruptcy law, Mr Duhalde has made little progress in complying with these. Last week, he threatened to resign if Congress and the provincial governments did not swiftly put in place the remaining preconditions. His threat produced a reaction: at a meeting on May 27th with the 14 provincial governors (out of 24) that belong to his Peronist party, 11 reiterated their promise to cut their deficits by 60% as the IMF wants. Felipe Sola, the governor of Buenos Aires, the biggest and most indebted province, said he would make cuts of around 50%, apparently with the IMF's acceptance. But, said Mr Sola, he would cut only if he got aid from the national government.

Even if these promises are kept, there are still big obstacles to an IMF agreement. One involves the banking system, paralysed since December 1st by a hugely unpopular freeze on deposits (known as the corralito, or little fence). Last month, Congress rejected a plan to turn the frozen deposits into bonds, provoking the resignation of the economy minister, Jorge Remes Lenicov. His replacement, Roberto Lavagna, is expected to announce a new scheme to lift the corralito shortly. Despite it, the banking system has continued to bleed money, leading two foreign banks (Canada's Scotiabank and France's Crédit Agricole) to abandon their Argentine subsidiaries. More may flee unless a rescue plan is enacted swiftly. 

Hitherto, the Central Bank has been printing pesos to lend to the banks to keep them afloat. If it continues to do so, inflation will soar. Yet many Argentines do not even have the luxury of being paid in devalued pesos. Governments, both national and provincial, are paying some of their bills using a growing number of quasi-currencies (bonds which look like banknotes and are used for everyday transactions). Furthermore, in countless devastated districts such as Las Delicias, “swap clubs” have sprung up, in which people trade goods and services using locally printed vouchers—yet another form of quasi-money, whose issuance is even more unrestrained.

In Las Delicias at least, all this funny money has retained its value against the (declining) peso, though some small shops will not touch it. Finance officials insist that, after an IMF deal is signed, all of the government scrip will be gathered up and exchanged for pesos at face value. Few believe them, so nobody is saving the stuff. 

Officials insist that for the first time in many months, there are some reasons for optimism. Besides the new agreement between Mr Duhalde and the governors, they point to an increase in tax revenues in May as hinting at recovery. Some of Rosario's idle meat-packers and engineering firms have started to talk of reopening, to take advantage of the huge competitive gain that devaluation has brought. 

But it is far from clear that Mr Duhalde has achieved anything more than another brief respite. And even if Argentina has in fact reached a turning-point the gloom in Las Delicias's community centre will not lift soon. Asked how long he thought the recovery would take, an unemployed man there shrugs and says: “maybe three generations”. That is as long as it took Argentina to fall from its former glory as one of the world's wealthiest economies to its current, miserable condition. 

 

Currency Markets : Fasten Your Seatbelts

May 24th 2002 
The Economist Global Agenda


Fears of a war between India and Pakistan, along with new warnings about terrorist attacks on America, have given the world’s financial markets a collective attack of nerves. The world’s big currencies have suddenly grown more volatile and at least one central bank has intervened to try to calm the markets. But could the latest uncertainty also signal the long-predicted decline of the dollar?


PASS the smelling salts. The world’s currency markets have started to panic about what’s going on the world: they don’t like what they see, but they’re not quite sure how to react to it. The short-term consequences are clear—the big currencies have started to fluctuate in value as traders and investors change their minds, almost from minute to minute, about where to put their money. The longer-term implications could be more serious if this temporary volatility leads to a realignment of currencies, which in turn affects the economic outlook in the world’s biggest countries.

It is easy to see what is driving the latest attack of nerves. In America in recent days, the Bush administration has been issuing ever more alarming warnings about another terorrist attack. Such fears have had an immediate practical effect: on May 22nd, the Brooklyn Bridge in New York was closed temporarily after a suspect package was found. But the warnings, and the reaction to them, have also alarmed the financial markets. Suddenly, the dollar seemed a less attractive prospect: it has lost some of its allure as the traditional safe-haven currency. Gold, long unfashionable, jumped on May 22nd to its highest level in two years. Significantly, in dollar terms, it rose above the value it reached in the aftermath of September 11th last year, when it had also enjoyed a very brief resurgence.

Fears about American security have coincided with growing alarm about the stand-off between India and Pakistan. It is not just a war between the two countries that the rest of the world fears, but that nuclear weapons might be used, with potentially catastrophic consequences. 

America's Federal Reserve, the European Central Bank and the Bank of Japan publish information and research on monetary policy. Japan's Ministry of Finance posts news and statistics. Eurostat provides euro-zone economy statistics. See also the IMF and the Bank for International Settlements.

Foreign-currency traders are easily scared by international political developments. Misjudging the prospective value of currencies can have a big impact on the profits—or losses—which traders and their investors stand to make. Hence the apparent overreaction to each nugget of news, as traders try to digest what it might mean for the currency outlook.

Short-term currency volatility is a fact of life, and is hard to prevent. The latest upheavals have come as a bit of a shock, partly because the world’s big currencies have been relatively stable in recent years. True, the euro declined steadily (aside from the odd blip) after its introduction in 1999. And the dollar has been weakening against both the yen and the euro in recent weeks. But the wild swings common in previous periods of currency turbulence have been absent, until now. This may be about to change, as the Kenneth Rogoff, chief economist of the International Monetary Fund (IMF) acknowledged on May 22nd.

The latest volatility also coincides with speculation among economists that the world’s currencies are anyway overdue for a big realignment. Central to this is the role of the dollar. The greenback has remained defiantly strong, largely unaffected by the ups and downs of the American economy. When the American recession started last year, many people assumed the dollar would weaken in consequence, and that the euro in particular would rise. In fact, nothing happened—except that many European economies juddered to a halt, making the euro a much less attractive investment prospect.

Figures released on May 24th showed that America's economic expansion in the first three months of this year was marginally weaker than previously thought: GDP grew at an annual rate of 5.6%, revised from the first estimate of 5.8% (though the final figure, which could also be revised, will not be available for some time yet). 

The recovery is remarkably steady and comes after the mildest recession on record. But as fears about a double-dip recession subside, the country's huge current-account deficit has become the focus of attention. Few economists are forecasting that the world’s biggest economy will surge ahead and match the pace of expansion it enjoyed in the late 1990s. With recovery taking place in Europe, some economists have started to question whether the rest of the world will remain content to lend America the billions of dollars it needs each year to deliver the capital-account surplus it needs to offset its current-account deficit. (Others have harboured these doubts for a long time.)

Traditionally, an unsustainable current-account deficit—where foreigners are no longer willing to lend—is solved by a currency devaluation. Such adjustments are often sudden, leading to a very sharp fall in the value of a currency: this was highlighted in new research published recently by the Federal Reserve, America’s central bank. If this were to happen to the dollar, the principal consequences for America would be a marked improvement in the competitive position of American exporters, as the price of their goods fell relative to those of other countries; and a corresponding rise in the price of imports which would bring with it inflationary pressures. The Fed might be forced to raise interest rates faster than it would like, or than would be helpful to a still-recovering economy.

The consequences for the rest of the world would be no less dramatic. Alarm bells are already ringing in Japan, now in its third recession in a decade. Figures released on May 23rd showed the first pick-up in exports in over a year, bringing the hope of an external stimulus to the economy. A rising yen would wreck those prospects, which is why the Japanese government acted swiftly to intervene in the markets, to stop the rise of the yen against the dollar. The Ministry of Finance confirmed on May 23rd that it had already intervened, was monitoring the market closely and would take “appropriate action as necessary”. 

But central-bank intervention in foreign-exchange markets is notoriously difficult to pull off successfully. In particular, research suggests it is almost impossible to push the market in the opposite way to its current direction with any long-term success. Temporary fluctuations might be smoothed out, but that is probably all. History is littered with examples of failed international agreements on currency movements—and most of those predated the open capital markets of today. The European Central Bank had to admit defeat in its efforts to prop up the euro when these resulted in nothing more than a temporary blip on the currency’s downward path.

And a good thing too, many European businesses probably think. With the euro area’s growth prospects still decidedly weak—the German economy is recovering from recession much more slowly than America—a rebound in the euro would not be helpful for Europe’s exporters.

So are we now seeing the start of the big realignment? Predicting long-term currency movements is a mug’s game—something always happens to upset projections. The international political climate and the resultant market turbulence make it even more difficult than usual to see what is happening to the underlying value of currencies. The gloomy political outlook probably means that will remain true for some months yet.

 

Bush’s Russian Romance

May 24th 2002 
The Economist Global Agenda


In Russia as part of a a six-day trip to Europe, President George Bush has signed a treaty agreeing mutual reductions in deployed nuclear weapons, and hailed a “new era” of friendship. Why is he so enamoured of President Vladimir Putin's Russia? 

A special relationship?

WHEN the cold war ended in 1991, Russia seemed relevant to America only because it had nuclear weapons. As that nuclear arsenal was reduced, Russia’s importance would surely shrink too. After all, Russia’s economy was about the size of Portugal’s. Without nukes, that fact would tell. While Russia would plainly matter a little more than Portugal to America’s geostrategists—its regional interests stretch from the Baltic to the Bering Strait, from sea to frozen sea—it would become a second- or even third-order country.

It would be replaced, at least from America’s point of view, by rising China and rich Europe. The challenge of China was obvious to all, and remains so. But to some of the camp-followers of the older George Bush, the president at the time, the opportunity for Europe was no less striking. With its shared democratic values, an even larger economy (the single market opened in the beginning of 1993) and, with luck, a single foreign policy, Europe, led by Germany, could become the most important partner in the New World Order.

To begin with, the younger George Bush seemed to accept parts of that doctrine: his advisers talked about Russia only in nuclear terms. Not any longer. The meeting at which he signed the three-page Treaty of Moscow at the Kremlin on May 24th, was his fifth get-together with Vladimir Putin in less than 12 months. Mr Bush is spending three days in Russia, but less than a day each in mainland Europe’s two largest economies, Germany and France, whose leaders he is meeting for the first time on home soil. With Mr Putin, Mr Bush has “looked into the man’s soul”; by contrast, he has difficulty even looking Gerhard Schröder and Jacques Chirac in the eye.

The White House posts news of Mr Bush's progress. The State Department has just published its annual report on the Patterns of Global Terrorism which helps explain the importance of Russia's co-operation. The European Commission details the EU's relations with America. 

With the exception of Tony Blair, whom Mr Bush seems to regard as an honorary American, the Europeans often seem like wallflowers at the Kremlin ball. America’s relations with Russia are now better than at any time since the end of the second world war and are improving, while transatlantic relations are probably as bad as they have ever been. 

In Berlin, Mr Bush did his best to put this right, or at least to gloss over the cracks. In a speech to the German parliament—which was punctuated by applause—Mr Bush stressed the interest America and Europe share in defeating “the enemies of freedom”. In a joint press conference with Mr Schröder, he called Germany “an incredibly important ally”. Mr Schröder said there were no differences between Germany and America over the issue of Iraq—one of the main concerns of the large street protests which greeted Mr Bush.

Mr Bush's reception in Berlin, the city of John Kennedy’s “Ich bin ein Berliner”, shows how misguided is one commonly espoused view in the American media—that Russia now loves America more than Europe does. Yes, his arrival was accompanied by hostile demonstrations. But the only reason why protests in Moscow were so much smaller was the deterrent effect of Mr Putin’s more heavy-handed security services. Yes, the elites of Germany, France and every other European country harbour plenty of anti-American sentiments: they have sneered at Mr Bush’s “unilateralist overdrive” and fumed at America’s backing for Ariel Sharon, Israel’s belligerent prime minister. But none of them can hold a candle to Russia when it comes to being rude about American foreign policy—or, for that matter, when it comes to anti-Semitism. 

Similarly, Mr Bush’s warmer feelings for Mr Putin cannot be explained solely by Russia’s exemplary behaviour after September 11th. Mr Putin certainly won points by refusing to kick up a fuss about either American bases in Central Asia, or Mr Bush’s withdrawal from the Anti-Ballistic Missile treaty. But those perfidious Germans and French also rallied round America, invoking for the first time Article 5 of the NATO treaty (on mutual self-defence) and stepping up intelligence co-operation.

Indeed, the difference in warmth has largely been on America’s side. While the administration made relatively little of NATO’s offer of military help in Afghanistan, though it would have been easy to accept, Mr Bush happily agreed to Mr Putin’s demand to enshrine the mutual nuclear-arms reductions in a verifiable treaty, casually abandoning his strong preference for a gentleman’s agreement by handshake. Which leads to an uncomfortable conclusion: that Mr Bush’s people really do think Russia has more to offer America than any other country.

In the world after September 11th, Mr Putin has three reasons to command Mr Bush’s attention that western Europe (often mercifully) cannot match. First and most important is nuclear security. This reflects Russia’s weakness. The biggest danger facing the United States is the threat that terrorists will steal weapons-grade plutonium, or radiological material for a dirty bomb. Russia is the most likely source. Of course, the new missile treaty will reduce that threat—but only a little and over ten years. For the foreseeable future, America must rely on the Russians to guard thousands of warheads—and, if Russia cannot guarantee that on its own, America will have to help. In contrast, Mr Bush can take the safety of French nuclear weapons for granted.

Second, Russia is the world’s third-largest oil producer and has the world’s largest gas reserves. It is the country best able to reduce America’s dependence on oil from the Gulf. If (a big if) it can increase oil output at current rates for five years, it could outstrip Saudi Arabia as an oil exporter. That would increase America’s freedom of action in the Middle East (something conservatives in America are whispering about).

Third, Russia is needed in the war against al-Qaeda. Russia has closer ties with all the “axis of evil” countries than has Europe, so it is a better conduit for diplomatic pressure. And although the Europeans can be relied upon (more or less) to do what America wants in the war on terrorism, Russia cannot, quite. In Iran, for instance, it is helping to build a nuclear reactor. Left to itself, it might provide Iran (which it regards as a responsible Central Asian power) with nuclear fuel, not too many questions asked. In exchange for closer ties with America, though, it might impose stricter controls on fuel supplies. 

This new appreciation of Russia is thus mostly based on the country’s shortcomings. Short-term opportunism on Mr Bush’s part could be very useful. But longer-term alliances are based on trust—swapping intelligence and so on. Those are things that the Europeans do without bidding, let alone treaties. Pray that they do not conclude that the only way to make Mr Bush love them is to stress their differences with America still more.

 

One Small Step For Free Trade

May 24th 2002 
The Economist Global Agenda


The American Senate has voted in favour of giving President George Bush authority to negotiate trade agreements with other countries, raising hopes of progress on liberalising world trade. But Mr Bush and America’s trading partners still have plenty to worry about

RAMPING up to ramp down. That’s how America’s topsy-turvy policy on free trade has been characterised of late. According to this convoluted analysis, the only reason President George Bush decided to impose new duties on foreign imports of steel, and to sign an expensive and protectionist bill to support American farmers, was to secure what is known as trade promotion authority (TPA). This would enable Mr Bush to negotiate trade deals with other countries which Congress could accept or reject—but not unpick line by line. The decisive Senate vote in favour of TPA on May 23rd appeared to clear the way for the president to get what he wants. 

But appearances can be deceptive. There are still many obstacles in Mr Bush’s path. The bill passed by the Senate might be, as one senator described it, “the most forward-looking trade bill that Congress has passed in 15 years”, but that isn’t actually saying very much, given the recent protectionist record of America’s legislators. Five previous presidents secured the “fast-track” negotiating authority Mr Bush wants. But the authority lapsed in 1994, and President Clinton never managed to renew it. 

President Bush has been granted Trade Promotion Authority. The Office of the US Trade Representative, headed by Robert Zoellick, posts information on America's increasingly protectionist trade policies. The WTO details the Doha trade talks. The EU's Directorate-General for Trade provides information on the EU's often frosty trade relations with America.

Mr Bush knows full well that he and his trade negotiating team, led by Robert Zoellick, can never hope to conclude international trade negotiations without TPA. They can start such negotiations, and indeed have already done so: talks are under way with the aim of extending the North American Free-Trade Agreement, or NAFTA, to the whole of the American continent; and last November, a new round of world trade negotiations was launched under the auspices of the World Trade Organisation (WTO) at Doha, in Qatar. Both are due to be completed by January 2005 and Mr Bush would like to see them all but sown up earlier, before he stands for re-election in November 2004. 

Without TPA, though, no country will sign up for a trade deal with America, since Congress might then try to unpick it. Trade agreements are complicated, and always involve carefully negotiated trade-offs between the different parties. Who is going to offer up a sacrifice in the hope of a bigger prize if there is a risk that prize will then be snatched away by protectionists on Capitol Hill?

The legislative hurdles are daunting enough, and indeed are not yet overcome. The bill passed by the Senate now has to be reconciled with one passed by the House of Representatives at the end of last year, which differs in several crucial respects. The Senate bill comes with two conditions Mr Bush would rather not have. One is an offer of extra financial help for workers who, allegedly, lose their jobs as a result of free-trade agreements. This could come to $12 billion over ten years. Worse is the right conferred on Congress to reject elements of a world trade deal which affected American anti-dumping laws: powerful lobby groups from industry want America to keep the right to act against what they claim are unfairly cheap foreign imports. Critics say this is, in effect, a wrecking amendment.

There can be no guarantee that a bill Mr Bush feels able to sign will reach the White House. Even if one were eventually to land on his desk, though, plenty of America’s trading partners already feel the administration has undermined its commitment to free trade almost beyond repair. Overseas anger has been provoked by the new tariffs on imported steel, which took effect last month; and the new farm bill, which the president signed on May 13th. 

Several of America’s big trade partners, including Japan and the European Union, have launched formal proceedings against the steel duties in the WTO. In theory, it could take more than a year for the WTO disputes procedure to be completed, but Europe has threatened retaliatory action much sooner. The rapid deterioration in transatlantic trade relations—not helped by arguments about other policies, including the war on terrorism—could yet spell disaster for any hopes of a Doha round deal. One WTO official was reported this week to have said that at best the timetable has now slipped significantly.

The farm bill could, in the end, be even more damaging to global trade relations. By nearly doubling the amount of aid given to American farmers over the next ten years, America has sent a signal to the rest of the world that agricultural protection is acceptable. Yet America has been one of the strongest critics of Europe’s notoriously expensive and protectionist agricultural policy. The Europeans only reluctantly agreed to put agriculture on the Doha agenda. Their incentive to offer up significant concessions to other countries wanting access to European markets has been virtually eliminated by the American move.

The European Union and other industrial countries, long used to American hectoring on the subject, are amazed and appalled by Mr Bush’s decision to sign a bill which he did not initiate and which he accepted had shortcomings. Developing countries, pushed into a round of trade negotiations they did not particularly want, are furious that they are, in practice, going to be denied access to the lucrative Western markets they badly need. America’s treasury secretary, Paul O’Neill, on a trip to Africa to explore the effectiveness of foreign aid and debt relief, got an earful from the South African finance minister on May 23rd. A South African official said it was a case of giving with one hand and taking back with the other.

The American administration tacitly concedes its actions on steel and agriculture were politically motivated. The president’s defenders say these moves were the price he had to pay to secure TPA. More cynical critics of Mr Bush think it is has much more to do with electoral politics. The steel decision greatly increased his Republican party’s chances of winning West Virginia in the Senate in this November’s mid-term elections, and so giving the Republicans chance to wrest back control of the Senate. The farm bill should give Republican candidates a boost in the Midwest prairie states. 

Mr Bush himself is not a candidate this time: in theory he doesn’t yet need to worry about his electoral prospects in 2004, and anyway, he’s riding high in the opinion polls. But he is determined not to be a one-term president like his father. The evidence of the past few weeks shows that he is willing to compromise his reputation as a free-trader if that is what it takes. In that case, the effort to secure TPA could turn out to be a waste of time. 

 

Nasdaq And Its Rivals 

May 23rd 2002 | NEW YORK 
The Economist

The world's second-biggest stockmarket faces the battle of its life


WHAT a difference two years make. In early 2000, there seemed no limit to what Nasdaq could do. Just as the technology and dotcom shares that it listed soared ever higher, so the marketplace itself seemed set for world domination. Not only was the New York Stock Exchange (NYSE, the world's biggest stockmarket) squarely in its sights. Partners and potential acquisitions were also being courted in Europe and Asia. Nasdaq's goal was nothing less than to be the first truly global marketplace for shares, fully electronic and open 24 hours a day.

Supposedly, that dream is still alive—enough for Nasdaq to be mentioned recently as a suitor for the London Stock Exchange. But the world may have to wait, for Nasdaq has a ferocious battle for its home market, against a gang of electronic share-trading systems, known as ECNs. It is not certain to win. And that may jeopardise a planned flotation.

Along with the Nasdaq Composite index, down by two-thirds since its March 2000 peak, trading volumes have plunged (see chart). Although shares in bigger firms, such as Microsoft and Intel, remain as liquid as ever, trading has dried up in many smaller companies. Falling demand has combined with thinner spreads (the difference between buy and sell prices) for market-makers, in part thanks to decimal pricing, introduced last year. Many firms have stopped making markets, at least in less heavily traded companies.

Liquidity concerns have led to a steady stream of company defections from Nasdaq to the NYSE. Many more have been delisted for no longer meeting the requirements of Nasdaq, not least that the shares be worth something. Some 4,730 firms were listed on Nasdaq at the end of 2000, but only 3,990 this March. Listing fees matter, as they account for nearly one-fifth of Nasdaq's revenues.

The prospects are even more troubling in two other business areas. Last year, transaction services—fees for the various activities involved in executing a trade—raised $409m (48% of total revenues), and the sale of market information raised $241m (28%). Both are now threatened by a price war between Nasdaq and its electronic rivals. Although one, Instinet, has been around since 1969, most other ECNs were created following the introduction in 1997 of new order-handling rules, after a scandal over price-fixing by Nasdaq market-makers. These rules allowed electronic marketplaces to charge other Nasdaq market participants an access fee for using their buy and sell orders. Competition among ECNs helped to narrow spreads and later drove down trading costs and access fees. ECNs now account for 37% of Nasdaq's trading volume.

Nasdaq has long worried about the ECNs, especially Island, which overtook Instinet last November. This year, the war intensified. Nasdaq charges market-makers (including ECNs) when they give Nasdaq their buy and sell quotes and trading data, which it then sells to investors. Frustrated by seeing this money disappear, Island recently started to publish a chunk of its Nasdaq trades on the rival Cincinnati Stock Exchange, which returned to Island 75% of the revenues it made from selling the data—much of which Island gave back to the investors. That did the trick. In February Nasdaq started to share data revenues with ECNs and other market-makers. This could badly dent Nasdaq's revenues.

In March Island cut its “25/10” pricing system, which had become the Nasdaq norm: somebody posting a buy or sell order gets a rebate of ten cents for every 100 shares as a reward for providing liquidity, and somebody fulfilling the order pays 25 cents for removing liquidity. Island's new pricing formula is 19/11. Nasdaq has responded by raising revenues through various other charges, notably one for regulatory services based on the number of quotes a market-maker or ECN generates. That falls disproportionately on Island, says Matthew Andresen, its boss: “Nasdaq thinks we are an ATM, not an ECN.”

The endgame may come with the launch in July of Nasdaq's new trading platform, SuperMontage. As originally conceived, as a consolidated order-book for all the quotes from ECNs and other market-makers, it would probably have driven the ECNs out of business. The impact of the current version of SuperMontage, watered down by ECN lobbying, is harder to predict, not least because ECNs are no longer obliged to participate in it.

A report by Celent, a research firm, argues that, because liquidity begets more liquidity, SuperMontage will win a market share of over 50% by the end of 2003. But this assumes that most of the big ECNs join SuperMontage—which is unlikely. One of them, Archipelago, has bought the equity-trading arm of the Pacific Stock Exchange, and may quote there and not on SuperMontage. Island had said it would join, but it is now reconsidering, with speculation that it will be bought by Instinet, which itself has yet to decide.

Instinet has lost its way of late and recently ousted its chief executive. But a merged Instinet-Island could be a formidable competitor to SuperMontage, says Benn Steil at the Council on Foreign Relations. The compromises required to get all the different Nasdaq participants to join might hold back SuperMontage against a rival marketplace with plenty of liquidity. Between them, Island and Instinet have over 20% of Nasdaq trades. Still, the SEC might constrain a merger, for fear that it would overly fragment the share-trading system, says Mr Steil.

Whatever happens to SuperMontage, the profitability of market-making in Nasdaq shares is heading inexorably lower. Competition among exchanges is fiercer than among airlines, says Larry Harris of the Marshall School of Business, soon to be chief economist of the SEC. “Entry costs are high but zero marginal costs mean that profit-making prices are extremely difficult to maintain.” Nasdaq likes to advertise itself as “the stockmarket for the next 100 years”. It faces a challenge even to be the stockmarket for this year