Market Advisory Features

The Philippines: In Search of a Conspiracy
Private Equity: The Charms of the Discreet Deal

Other People's Money
Russian Roulette
Japan's Energy Crisis

Economic and financial indicators
Europe's Population Implosion



The Philippines

In search of a conspiracy

Jul 31st 2003 | MANILA
From The Economist print edition

THE government of President Gloria Arroyo never appeared in any danger of being overthrown when 296 young military officers and men seized a shopping mall in Manila in the early hours of July 27th and demanded that the president step down. All the same, a soldiers' mutiny, though quickly suppressed, cannot be good for a government. It claimed one top official, the chief of army intelligence, Brigadier-General Victor Corpus. In his resignation letter to Mrs Arroyo on July 30th he said, “I feel the restiveness will not calm with my continued presence.”

The rebels surrendered 19 hours after they mutinied, having failed to elicit any sign of support from the rest of the armed forces or the general public, and having been threatened with attack by besieging troops loyal to the government. Mrs Arroyo declared a state of rebellion and said the full force of the law would be used against the rebels and any civilian politicians involved in the uprising.

Initial police investigations suggested the involvement of Mrs Arroyo's predecessor as president, Joseph Estrada. Mr Estrada denied this. Mrs Arroyo replaced Mr Estrada in 2001, when he was deposed by a popular uprising supported by the armed forces. He is now in jail while he is tried for corruption. But Mr Estrada insists that he is still the rightful president. The theory that the rebellion was an attempt to restore Mr Estrada to power was, at least in the immediate aftermath, weak. Even if the theory is proven, the attempt itself appeared destined to fail.

For days beforehand, the government had been listening patiently to complaints by junior military officers about corruption among the top brass, and the poor pay and conditions of the other ranks. The government discovered that a mutiny was in the offing and, the evening before, Mrs Arroyo ordered the arrest of the suspected plotters. When the mutiny began, 70 young officers and 226 other ranks occupied part of a shopping mall in Makati, the financial district of Manila. The section they seized included a hotel and apartments where a number of foreigners, including the Australian ambassador to the Philippines, were staying. But the mutineers do not appear to have intended to take hostages, and the ambassador and all the other occupants were unmolested.

The rebels were carrying small arms, and set explosive charges around their position. Soon after, they were surrounded by hundreds of troops loyal to Mrs Arroyo. The rebels repeated previous complaints about corruption and pay. And they made public some specific allegations. They accused senior officers of selling ammunition to communist and Muslim separatist guerrillas. They said senior defence officials had instigated two bomb attacks this year in the southern city of Davao that together killed 38 people. The purpose of the bombings, according to the mutineers, was to persuade the United States to give the Philippines more financial aid for its campaign against terrorism.

They accused the president of planning to declare martial law so that she could remain in power after her term of office expires next year. They demanded that Mrs Arroyo and her cabinet, particularly the defence secretary, Angelo Reyes, step down. Confusingly, they denied that they were attempting a coup. Later, it became evident at a press conference in the mutineers' hotel-lobby redoubt that some of the officers were in a highly emotional state, and that they had not agreed among themselves on exactly what they wanted.

Mrs Arroyo announced the creation of two independent commissions of inquiry, one to look into the causes of the rebellion, the other to investigate the particular allegation about the bomb attacks in Davao. The poverty of other ranks is no surprise. A private soldier is paid 5,775 pesos ($106) per month. And corruption among senior officers is no secret. Communist and Muslim separatist guerrillas have acknowledged that they buy weapons from the armed forces. The defence secretary vehemently denied the accusation that the armed forces commissioned the bomb attacks in Davao.

The idea that Mrs Arroyo plans to declare martial law so that she can remain in office is tortuous. She would have a reasonable chance of winning the next presidential election, which is due next year. But Mrs Arroyo has said she has no wish to run. The notion that opposition politicians instigated the rebellion is based on shaky evidence. Still, the mutineers had expensive radios that were not military issue, suggesting that the rebellion may have been financed by outsiders.

After the mutiny, the police raided a house owned by one of Mr Estrada's former ministers, Ramon Cardenas. They say they found firearms and red armbands of the kind worn by the rebels. Mr Cardenas was arrested. He said he was innocent. Government officials said they also suspected an opposition senator, Gregorio “Gringo” Honasan. When Mr Honasan was an army officer he took part in a series of unsuccessful coups against the then president, Corazon Aquino. The mutineers were found in possession of copies of a political tract he had composed. Senator Honasan said he had had nothing to do with the mutiny.

Assuming that the rebellion was, indeed, instigated by politicians, their main purpose may have been only to embarrass the government, rather than overthrow it. If so, the attempt backfired. Mrs Arroyo emerged from the crisis having shown that she was firmly in control, and took credit from her allies for having ended the mutiny without bloodshed. This might even help her chances if, as many sceptics expect, she changes her mind and decides, after all, to run for election.

Filipinos, beset by conspiracy theories, are in danger of overlooking one obvious explanation of the mutiny: that young, idealistic but immature officers, upset by shortcomings in the institution they serve, decided simply to protest in a manner that they calculated, correctly, would get the attention of the nation.



Jul 31st 2003
From The Economist print edition

American consumer confidence dropped unexpectedly in July, according to the Conference Board's index. Rising unemployment was said to be responsible. New-home sales rose by 4.7% to 1.16m in the 12 months to June, a record. The housing market's buoyancy was also reflected in the prices of existing homes, which rose by 7.7% over the year to June.




Russian roulette

Jul 22nd 2003
From The Economist Global Agenda

A turning point for emerging-market bonds

TIMING is not one of Buttonwood's fortés. He left the capital markets in 1990 only to return ten years later, by which time cleverer folk had retired. Well-timed calls are thus almost certainly a matter of luck, not judgment. This has clearly been the case lately in emerging markets.

Russian bonds, which this column touched on a few weeks back, in less-than-glowing terms, have fallen since then. So, too, have those of other emerging countries. This is partly because American Treasuries have fallen sharply, dragging down anything that is priced as a spread over them. But the perceived riskiness of emerging-market debt has also risen: spreads over Treasuries have widened. In the case of Russia, this is because investors have again been alerted to the fact that there is such a thing as political risk. Platon Lebedev, the chairman of the holding company that owns Yukos, a big oil company hitherto held up as a beacon of progress in Russia’s murky corporate world, was arrested in early July. This seems to have been the government’s way of warning Mikhail Khodorkovsky, the boss of Yukos, not to dabble in politics. Russian bonds and stockmarkets have both fallen since the debacle.

But both are still a lot higher than they were at the start of the year—as is just about every emerging market. J.P. Morgan Chase’s EMBI+ emerging-bond index has narrowed by two percentage points (or 200 basis points, bps) since the start of the year, and by 490 bps since October 2002 when spreads started tightening. Morgan Stanley's MSCI emerging-market index is still some 20% higher than at the start of the year.

Where now? The arguments for stocks and bonds seem different. Bonds have behaved like Treasuries on cocaine. But the after-effects tend to be unpleasant. When Treasuries fall, emerging-market bonds fall more, sometimes a lot more. This is what happened in 1994.

Earlier this year, investors had piled into emerging-market bonds for a number of reasons. Low interest rates made people feel as though problems had evaporated. Returns had been good for a couple of years, which sucks in more money. And the market was a good place to search for yield. All of these factors are reversible—and may already be reversing. American long-term interest rates have been rising sharply of late. After the Federal Reserve cut short-term rates by a less-than-expected quarter point in mid-June, investors lost some of their faith in Treasuries but emerging-market bonds suffered more. At one point, their spreads widened by 70 bps. Growing signs of global growth, however anaemic, may herald further woes for emerging-market bonds.

Equities are a different proposition. As any economist will tell you, classifying emerging stockmarkets as an homogenous group is misleading. Russia is different from, say, Argentina, which itself has little in common with South Korea. The same economist will then go on to say with a straight face and no sense of contradiction that the case for investing in emerging markets in the long term (by which he means shares not bonds) is overwhelming because it is these markets that will generate growth in the coming years.

This contradiction is partly reconciled thus: the perennial problem of emerging markets is not one of growth but of whether investors will see any of it. The likes of India and (even more so) China have been the graveyard of shattered dreams. Locals seem to be able to keep any profits going thanks to rigged rules, flimsy corporate governance and crime. Small wonder, then, that the MSCI emerging-market index is still 40% below its peak in 1994, after which crises in East Asia, Mexico and Russia rather dented investors’ enthusiasm for all things emerging.

To continue to take such risk, investors need alluring returns. Despite their sharp rally this year, shares in many emerging markets are cheap. According to The International Bank Credit Analyst, emerging-market equities are trading at ten times next year’s profits—a 40% discount to their ten-year average, and a 50% discount to the average price-to-earnings ratio worldwide. Almost all emerging markets are at big valuation discounts to their long-term averages.

The exception, note the analysts, is Russia. Perhaps this is because Russia has taken China’s place as the black hole into which international investors cannot resist pouring their money. Certainly, under President Vladimir Putin, the rule of law is more entrenched and corporate governance is no longer a term that people snigger at. But as the Yukos example illustrates, Moscow is not Washington, whatever the tipsters might have you believe. And, in any case, investors get paid to find markets that are cheap, not trendy.



Private equity

The charms of the discreet deal

Secretive private-equity firms are behind many of today's biggest corporate deals. What exactly are they up to?

DISENCHANTED with public stockmarkets, wealthy investors have for some time been seeking alternatives. Low returns on quoted shares, and countless scandals over rigged results and the excessive pay of top managers, have encouraged them to look elsewhere. One popular alternative has been private-equity funds, multi-billion-dollar pools of money that are involved in many of today's biggest and shrewdest corporate-finance deals.

The firms that manage these funds are increasingly well known. The doyen is probably the Carlyle Group, which employs a former American president (George Bush) and a former British prime minister (John Major). Its reputation for behind-the-scenes power-broking was enshrined in a recent book (“The Iron Triangle: Inside the Secret World of the Carlyle Group” by Dan Briody). Other leading firms include the Blackstone Group, which has raised over $14 billion of private equity, and Kohlberg Kravis Roberts (KKR), forever famous for its $25 billion leveraged buy-out of RJR Nabisco in 1988, immortalised in the book “Barbarians at the Gate”.

Such firms are not short of business these days. When the owner of America's NASDAQ wanted to rid itself of the American Stock Exchange earlier this year, it turned to a Chicago private-equity firm for help. The Blackstone Group and Thomas H. Lee, another top-ranking firm, are currently trying to help Edgar Bronfman to regain control of Universal Studios, Vivendi's dabble with Hollywood, now that the French conglomerate wants to shed the farther-flung assets that it acquired during the stockmarket boom.

Europe too is seeing plenty of action. On June 11th, investors led by a pan-European private-equity firm, BC Partners, bought Seat Pagine Gialle, a telephone-directories business, from Telecom Italia for euro3.04 billion ($3.55 billion). This was the biggest private-equity deal ever seen in Europe, and it was won by BC Partners against stiff competition from American firms such as Carlyle and KKR.

The enthusiasm for private over public markets, however, is giving investors no guarantee of superior returns. For one thing, it is extremely difficult to calculate the returns on private-equity funds (more of that later); and for another, those returns depend crucially (and with not a little irony) on the public markets. Most private-equity deals look ultimately to a stockmarket for their returns. Take the example of Yell Group, a telephone-directories business bought from British Telecom in 2001 for some $3.5 billion by a group of private-equity investors. Those investors are currently trying to realise some of their gain (if there is any) through an initial public offering (IPO), a sale of shares on a public stockmarket. The roadshow to advertise the offering began this week.

First find the exit

Private equity has a broad definition—any equity not traded through a public exchange can be included, whether it be a family firm, a young biotechnology start-up, or even Bill Gates's holding in Microsoft . All types of private-equity investment, however, share some basic features:

•The investors are typically wealthy and supposedly sophisticated—they include family trusts, university endowments and big pension funds, especially state-run ones.

•Private-equity firms take substantial stakes in a portfolio of companies, giving them the power to sack managers and appoint new ones, with the intention of building better, more valuable businesses.

•Their route to profit is via an “exit”—a way of selling the firm, or bits of it, at a higher price than was paid for it, on some long but fixed time-scale of between three and ten years. Such a sale often takes place through a public stockmarket.

At one end of the business are the venture capitalists (VCs) who try to get in on the ground floor, building companies from nought. Thomson Venture Economics, a research company, reckons that the returns on venture capital have been better than on other forms of private equity (see chart). But the venture capitalists' heavy involvement in the short-lived telecoms, media and technology boom has turned sour and they are slowly facing up to the painful realities of their tattered portfolios.

Being private partnerships, however, they are under little pressure to be open about the true worth of those portfolios. A common ruse is to carry the value of companies at cost, even when it is clear (as it often is) that a buyer would have to be paid to take the companies off the VC's hands. Lay-offs at prestigious VCs such as Boston's Battery Ventures suggest that all is not well in the industry.

Scott Delman of Capital Z, a private-equity investor, thinks the venture-capital industry still has a long way to fall. Apart from the absence of a big new thing in technology—even investment in biotechnology fell in 2002—he sees long-term structural problems for the industry. As with other forms of private equity, VCs usually find their exit (and hence their reward) by floating off investments through an IPO. But technology-focused investment banks—such as Montgomery, Hambrecht & Quist and Robertson Stephens—which used to serve as the pipelines to an IPO, have either gone bust or been swallowed up by bigger rivals.

An article by William Meehan, a McKinsey consultant, in this month's issue of the Harvard Business Review, predicts a shakeout in the VC industry, “one that in the worst case could force up to half of all current VC firms to close shop over the next several years.” Mr Delman is more precise about the timing: “I see around 50% fewer venture-capital funds in the next two to three years,” he says.

Venturing elsewhere

As the venture capitalists rest, the buy-out side of the private-equity business—the funds that purchase whole companies, or big chunks of them, often borrowing heavily for the purpose—is growing strongly. Huge amounts of money have flowed into private-equity funds in recent years (see chart), though the flow dropped off sharply last year. Much of it has been waiting to find an investment home. For many, buy-outs are proving to be that home.

The opportunities are widespread. The Carlyle Group, for example, is seeking to take advantage of changing political attitudes to aerospace and defence. Along with Finmeccanica, a state-owned Italian defence company, it agreed this week to buy a bunch of aerospace businesses from Fiat Avio, a division of the Agnelli family's troubled conglomerate.

Many funds see Germany—where such big companies as Siemens are struggling to restructure, and medium-sized Mittelstand companies are looking for ways to grow beyond their founding families—as especially fertile ground. Likewise the telecoms industry, where debts taken on in the boom years are now crippling many companies. Typically, the publicly quoted Telecom Italia nudged Seat Pagine Gialle to become private in order to reduce the high debts that it had taken on in the years when nobody said “No”.

Overall, deals such as these are more typical than headline-hitting blockbuster takeovers like the legendary RJR Nabisco deal, although KKR did take a trip down memory lane earlier this year when it (unsuccessfully) tried to take over Britain's Safeway supermarket chain, a company that it had taken private in the mid-1980s before returning it to the public markets (and making a large profit).

Some VCs have switched their business to benefit from this shift to buy-outs. 3i, for instance, is a London-based private-equity fund that once styled itself as a venture capitalist and poured millions into technology start-ups. Yet one of its most successful recent deals has been a traditional buy-out. In 2001, it took a stake in British Airways' low-cost subsidiary, Go, in return for £110m ($175m) of financial backing for a management buy-out. Barely a year later, it sold the stake to easyJet, an independent low-cost airline, for £374m. Not a bad return for a year's work, though it barely compensates for all 3i's technology investments that have gone sour.

Another firm that has adjusted to changing market conditions is Hicks, Muse, Tate & Furst, one of the firms behind the Yell deal. After a disastrous foray into telecoms, it is now most proud of a much less sophisticated deal: a buy-out of the maker of “Hungry Man” frozen dinners. Hicks, Muse is so involved with the company that it even supervised one of its advertising campaigns.

A buyer not a seller be

Many of today's buy-out opportunities have arisen out of the hangover from the investment boom of the late 1990s and the world economic downturn. Firms in a host of distressed industries are looking to dispose of non-core businesses, and the buy-out funds are eager to help them. A private-equity firm called Texas Pacific, for example, snapped up the assets of Swissair's catering operations after the carrier went bust. And, on top of its aerospace deal with Carlyle, Fiat also recently unloaded some of its other assets to a French private-equity-style fund called Eurazeo.

A number of private-equity groups have taken advantage of the agony of the telecoms industry to buy companies' cash-rich yellow-pages subsidiaries. In Britain there was the Yell deal, and last year saw the biggest leveraged buy-out since that of RJR Nabisco: the $7 billion purchase in August by two firms of QwestDex, the yellow-pages subsidiary of Qwest, an American telecoms firm in difficulties.

America's bankruptcies, from WorldCom to Enron, and a host of distressed companies, such as Tyco and Adelphia, have provided further opportunities. Adelphia, a cable-television company, went so far as to approach a small private-equity firm to offload its stake in a New York hockey team.

Vivendi Universal, whose ill-fated expansion under Jean-Marie Messier was largely unwound last year, gave birth to one of the biggest private-equity deals of 2002: Houghton Mifflin, an old Boston publishing house, was sold to a group of private-equity funds for 25% less than Vivendi paid for it a year ago. Both American and European private-equity firms are salivating at the prospect of disposals to come from the likes of ABB, Deutsche Telekom, France Telecom and Siemens.

The pressure for returns

Deals would be even bigger were it not for constraints on the ability of private-equity funds to borrow in order to leverage their buy-outs. Back in the 1980s, a buy-out firm would put up only 5% of the value of a deal in equity; the other 95% would be financed by debt, in the form of bank loans and/or junk bonds. By the late 1990s, however, the required equity stake had widened to 20% of a deal's value. Now, with big banks' balance sheets stretched, the buy-out specialists are finding that they have to put up around 30-40% in cash.

Raising that much is not necessarily an obstacle, especially when firms work together (as they increasingly do). But lower leverage threatens to yield sharply lower returns in future. As it is, returns on private equity are notoriously hard to measure because investors' cash is put into many different companies at many different points in time. Since most companies in a portfolio have no stockmarket listing, there is no reliable guide to their value.

Comparing a private firm with the share price of a similar listed company is one way to get a figure, but it fails to account for the extra value of holding a controlling stake. The only true measure of returns is the cash that is received when the portfolio firms are sold, either to other companies or through an IPO. In the meantime, investors have to rely on the “internal rate of return” (IRR), a mathematical calculation of returns that gives many a rocket scientist a headache.

Moreover, there is no single accepted formula for calculating the IRR. And the figures that go into the calculation are often fudged, relying as they do on a fund manager's whimsical judgment of what a company could be sold for. Rarely does this estimate fall below the cost of the investment, at least until the day of reckoning comes. In the private-equity world, such sunny optimism in valuation is referred to as “sticky” pricing.

Dodgy valuations also arise when private-equity firms sell or swap assets among themselves, an activity that is growing in popularity. This provides them with a way to rejuggle their portfolios, but it does have a downside: the prices that they record for these deals may have nothing to do with the prices that the assets would fetch on an open market.

The public side of private

The desire of investors to shuffle their assets has fed a burgeoning, though still highly secretive, secondary market in private equity. This allows them to cash out of their holdings long before a fund reaches the end of its life. Jeremy Coller of Coller Capital recently raised a $2.5 billion fund to invest in this secondary market—larger than most primary-market funds. The move is likely to create more trading, and eventually more price transparency, for shares in private-equity funds.

Transparency has recently received a boost. Two big pension funds in California and Texas have thrown more light on the shadowy world of private equity than has been seen since the industry's inception. Prodded by lawsuits, CalPERS and UTIMCO, a University of Texas endowment fund, have published their performance figures—including the IRRs of their private-equity portfolios. Most worrying is how little help most of the IRR figures are, since most private-equity investments have as yet returned precious little cash.

There is another concern for private-equity investors apart from the lack of transparency. The stealthy and scrappy investors who used to run the business are being joined by the establishment. Some of the world's best-known bosses are finding second careers in private equity: GE's former boss, Jack Welch, is at Clayton, Dubilier and Rice; Jacques Nasser, who once ran Ford, is with One Equity Partners; recently, Lou Gerstner, IBM 's former chief, joined the Carlyle Group. Mr Gerstner's arrival has led to speculation that the firm is looking to be the first private-equity firm to make its own exit and go public.

Others have already tried to take steps in this direction. KKR tried last autumn to sell part of itself to the Washington and Oregon state pension funds. Another big firm, Thomas H. Lee, has formed an alliance with Putnam Investments, a high-street vendor of mutual funds. The holy grail of private equity is to allow individual investors to put their money into private businesses. Surely, critics say, the end is nigh when private-equity firms themselves are no longer private.

It's the management stupid

The firms' high-profile recruits are a belated recognition that they need to improve their management skills. They all now make noises about being more than just buyers and sellers of companies, or of chunks of them. Financial engineering, which used to be the buy-out firms' primary focus, is now out of fashion. Firms today claim to be helping the managers of their portfolio of companies with everything from strategic advice to headhunting to, in one case, sending in their high-cost MBAs to ring up customers and collect unpaid bills. With the spate of recent deals, however, some are sceptical that the firms are up to the task of turning round so many struggling businesses at once.

Nevertheless, there is a premium today on more traditional skills, such as choosing a management team and building relationships with customers and suppliers. For example, when Texas Pacific bought Burger King from Diageo, a food-and-drinks conglomerate, one of its first moves was to add an expert in restaurant turnarounds to the management. Obvious stuff, perhaps, but this is the way in which private-equity firms expect to be able to add value in future.

The importance of these more pedestrian skills may explain the rise of niche funds that aim to tackle buy-outs in only one industry, be it health care, fitness centres or publishing. With cash piles in the hundreds of millions rather than the billions, these are better placed to devote time, effort and industry expertise to turnarounds. One such fund, Falconhead Capital, specialises in consolidating suburban health-and-beauty shops in America's roadside shopping centres.

Improving management and operations is something that the American funds talk about more loudly than the Europeans. Firms in Europe are seen primarily as catering to management buy-outs (MBOs), in which a fund acts as a source of money for existing managers to take over their own operations. The fund then remains in the background on most of the big operational decisions.

The Americans had hoped to make a big splash in Europe with their different approach. Many big funds, such as KKR and Clayton Dubilier and Rice, made much of taking on Europe at the turn of the century, counting on corporate restructuring and a hoped-for boom in M&A in Germany. But it has not worked out quite as planned. Clayton had to write off $400m when Fairchild Dornier, a German aeroplane-maker which it bought in 1999, went bust last year. And KKR's adventures in Russia left its fingers badly burnt.

Nevertheless, private equity's best hope is to become what it has long claimed to be: an improver of companies. As one industry insider puts it: the 1980s were about financial expertise, and the 1990s were about specialisation and deal-making. But the next phase must be about improving operations. That means the industry's smart MBA types will have to roll up their sleeves and get much more involved in management.



Other people's money

The fund-management industry used to make money without even trying. Now it has to work for its living, says Tamzin Booth

LIFE as a fund manager in the 1990s was sweet. Sitting on a mountain of investors' money during the bull market was a powerful, highly paid and fairly easy job. Fund managers rarely got fired, even if they performed persistently worse than their peers. And there were plenty of perks. Stockbrokers competing to buy and sell shares for fund managers lavished treats on them—polo lessons, for instance, or test-driving the latest Porsche near the factory in Stuttgart. A stockbroker whose fund-manager client had handed back his tickets for the New York Yankees at the last minute spotted the client watching the game from better seats, courtesy of a different bank. At the time, this was nothing unusual. The fund managers' customers—pension funds, mutual funds and ultimately millions of individuals saving for things like education and retirement—were unconcerned because their wealth was rising along with the stockmarket.

Now their world has changed. Fund-management leaders have reason to be depressed, says Charles Ellis, the founder of Greenwich Associates, a consulting firm in Connecticut. A huge chunk of their investors' money has been wiped out by the fall in the world's stockmarkets over the past three years. Fund managers are having to explain the losses—to individual investors whose plans for the future have been wrecked, and to people entrusted with insurance or pension money who can no longer keep the promises they made to their customers in better times.

The bear market has also dealt a severe blow to the industry's own business model. Fund managers live on a percentage of the money they invest on behalf of others (“assets under management”). Those assets have plunged in value, partly because of the drop in stockmarkets and partly because people have started to move their money out of stocks and back into the bank (see chart). In America, the total assets managed by firms tracked by Morgan Stanley fell by 30% between the first quarters of 2000 and 2003.

Last year's model

Yet even as revenues shrink, fund managers' costs remain at the bloated levels of the late 1990s. On the volume of assets they have now, about half the fund managers in London are losing money every day, says Glyn Jones, chief executive of Gartmore Investment Management, a British fund-management company.

That fund-management businesses can lose money has come as a shock to the banks and other financial institutions that snapped them up at high prices during the past decade. When things are going right, meaning that the stockmarket is rising steadily each year, there are few industries that can legally make as much money as this one. A fund-management firm with a cost base of, say, $150m can invest and administer $80 billion of its customers' money just as easily as $50 billion, so the fee on the extra $30 billion goes more or less straight to the bottom line. Unlike banks, which have to comply with the Basel capital regime, fund managers have not needed to undergo a capital-adequacy test. They have small capital bases and therefore, in the good times, enormous returns on equity—often as much as 30%, sometimes much more. And fees just kept rolling in steadily year after year.

Now, bosses of banks and insurance companies are trying to rid themselves of their asset-management arms. Commerzbank, a struggling German bank, has tried to sell Jupiter Asset Management, a British fund manager, and Zurich Financial Services has just disposed of Threadneedle, also British. Many asset-management businesses are being quietly hawked around, especially in Europe, though the managers themselves may not know it yet.

Their parent companies now think that fund management thrives only when stockmarkets soar—not the sort of business to offset the volatility of, say, mergers and acquisitions. They fear that the days of high growth (revenues grew by over 15% a year in the 1990s, according to a joint report by UBS, an investment bank, and Mercer Oliver Wyman, a consultant) may be gone forever. Disenchantment with the way fund management works, combined with excess capacity, is likely to bring a long wave of consolidation.

And yet the long-term outlook for fund management should be bright. Populations in the developed world are getting older and living longer, meaning that more people will need to live on invested capital. Governments are trying, slowly, to shift the burden of paying for pensions off the state and on to individuals. That will boost demand for savings products.

Optimists in the fund-management industry, therefore, are waiting for the markets to start rising again, hoping that investors will come back to equities and high profits will return. But things may never be quite the same again, because these days all financial services are finding themselves under much closer scrutiny. So far, it has been mainly investment banks and auditors that have come under attack for sharp practices. The fund-management industry, with trillions of dollars of other people's money in its care, has seen surprisingly little fraud, points out Alan Brown, global chief investment officer of State Street, an American fund-management firm. But people in the business, as well as regulators, reckon that some of the industry's practices are damaging investors' interests.

In Britain, two reports on fund management written in the past couple of years, by Ron Sandler and Paul Myners respectively, pinpointed various problems. For instance, “softing” arrangements, common in many rich countries, involve a fund manager paying commission to stockbrokers out of the investor's pot of money—over and above the percentage fee for fund management. In return for these commissions, fund managers get newswire services, access to people who analyse stocks—and, from time to time, tempting invitations. Mr Myners said that softing ought to stop.

In June, Richard Baker, chairman of a congressional sub-committee on capital markets, insurance and government-sponsored enterprises, introduced legislation that would require investors to be given more information about mutual-fund fees and other features of the business, such as fund managers' pay. Part of the reason for the increased scrutiny is simply that fund managers are losing money for their investors. When markets earned them double-digit returns, few people looked closely at the costs of fund management, either the visible or the hidden sort. But in thin times they take an interest in such matters, squeezing the industry's margins.

More radical reform might follow, especially if the stockmarkets continue to produce disappointing returns. The most important conclusion of the Myners report was that pension-fund trustees—who are big clients of the fund-management industry—need to become more educated about financial matters. Trustees are the guardians of pension money, yet many of them, it seems, do not know enough about investing. In America and Britain, many of them put too much money in equities. As it happens, shares are the most profitable asset class for fund managers and for the investment banks that serve them. “Our industry and the stockbrokers ripped off the trustees and got ourselves a lot of Porsches in the process,” says a fund manager at a London-based outfit owned by a European bank.

Greed and fear

Individual savers are even less likely than trustees to make sensible investment decisions. They tend to be motivated by greed and fear, which the fund-management industry plays on. Because its customers have a limited understanding of financial products, the industry has always faced a dilemma. Should it sell people what they think they want, or should it offer them the conservative investments that may be more appropriate for their future needs?

During the late 1990s, many fund managers decided to put their own business interests first and pushed products they knew would sell, whether or not they would turn out to make money for their customers. “Now they are reaping what they sowed,” says Barry Bateman, vice-chairman of Fidelity International. The present travails of Janus and Putnam, two American fund managers that specialised in growth funds, serve as a warning to their peers: their assets under management fell by over 40% between the first quarters of 2000 and 2003.

Mr Bateman hopes that lean times will cause the most unscrupulous fund managers to leave the industry; but there is little chance that investors will ever stop clamouring for the latest hot investment product at the wrong point in the economic cycle. Up to now, the industry's regulators have mostly relied on the “buyer beware” principle. But next time the industry markets inappropriate products to savers, they will be watching more closely. After all, it is governments that ultimately underwrite people's financial survival in retirement.



Japan's energy crisis

Darkness falls on Tokyo

Japan's electricity industry is in turmoil. This may have a big impact on the world's energy markets

WALK into the Ministry of Economy, Trade and Industry (METI), and you will find most of its lifts shut down, the corridors dark, and—although it is hot and humid—the air conditioners barely working. During the lunch hour, office lights are switched off, and on rainy days (this is Tokyo's rainy season, so there are plenty) bureaucrats can be seen straining to catch what little light comes through the windows as they work through their break. Sometimes offices get so dark that their solar-powered calculators stop working.

The ministry, which oversees the electricity industry, is gearing up for a power shortage that could leave Tokyo facing unprecedented blackouts this summer, when demand for electricity reaches its peak. The reason: Tokyo Electric Power (Tepco), the world's largest private electricity company, had to close its 17 nuclear reactors after it was caught last September falsifying safety records to hide cracks at some of its power plants. Three have now restarted, but it is unclear when the local authorities will allow others to do so.

As these nuclear reactors usually supply almost half the electricity for the region centred on Tokyo, Tepco reckons that it may fall short of expected demand by almost 10% this summer. It is begging the public to conserve energy. Companies such as Honda, Nissan Diesel and Toshiba have agreed to shift some of their factory operations to weekends or nights. Big shops, banks, brokers and even the Tokyo Stock Exchange are using dimmer light bulbs and setting air conditioners to higher temperatures. Workers face a sticky summer, though some bosses are letting them take off their ties. Sadly for bureaucrats at METI, its minister has decided that, as they also oversee the tie industry, they will not be allowed to do this.

Nuclear meltdown

Less well-known is that this summer's sweat may be a mere prelude to much worse problems. The electricity industry faces challenges that could undermine Japan's entire nuclear-power policy. Japan may then have to increase sharply its imports of oil, coal and liquefied natural gas, causing a surge in demand in world energy markets. With few natural resources of its own and one of the lowest energy self-sufficiency ratios among industrialised countries, Japan is already the second-biggest importer of oil and the biggest importer of natural gas. To illustrate the scale of what is involved, Kazuhiro Sakuma, an analyst at Daiwa Securities SMBC, reckons that, if Japan closed its 53 nuclear reactors and switched entirely to oil (in practice, it would probably switch also to coal and gas), oil imports would rise by 30%.

Japan's nuclear reactors were built as part of an environmentally “clean” energy policy developed after the oil shocks of the 1970s. (They may also play a covert security role, giving Japan an option, subject to constitutional change, to use nuclear material for military ends.) Critics now liken this policy to “building a house without a toilet”, for there is no coherent strategy for disposing of spent nuclear fuel.

Nuclear power plants are running out of capacity to store the stuff. Japan used to send spent nuclear fuel to France and Britain to be reprocessed. But the latest contracts with these countries have ended, and the government has no plans to send more fuel abroad. It would face big political obstacles were it to try. America—which has considerable clout with Japan's government—might oppose the shipping of radioactive material halfway across the world on security grounds. Instead, the government is pinning its hopes on Japan's first big reprocessing plant, now being built by Japan Nuclear Fuel (JNFL), a consortium including nine of Japan's ten electricity firms, in Rokkasho, a village on the northern tip of mainland Japan.

Some nuclear power plants have only enough storage space for another two or three years' worth of spent fuel. Strict regulations bar transfers of spent fuel from one plant to another. The earliest a temporary storage facility can be built is 2010. Only if the reprocessing plant starts operating in July 2005, as JNFL insists it will, can nuclear plants avoid prolonged closure.

But as one bureaucrat in METI's Agency for Natural Resources and Energy admits, that is unlikely. Delays could last months, if not years. The ¥2.1 trillion ($17.5 billion) reprocessing plant is already six years behind schedule. Although most of the construction is now finished, only the first of four stages of testing has been completed. And this has raised more than 1,000 problems that need to be fixed.

Worse, the third stage of testing, using uranium, requires approval from local authorities. Yet JNFL recently discovered that one of the three pools used to store spent nuclear fuel, built by Hitachi, is leaking. Kenji Furukawa, the mayor of Rokkasho, insists that, until all leaks are repaired, the uranium test cannot go ahead.

Even then, the reprocessing plant may be unable to open unless the politically charged problem of what to do with the plutonium produced during reprocessing is solved. Normally this is combined with reprocessed uranium to make mixed oxide (MOX) fuel. In principle, this could be used in two ways. The one that would use up the most plutonium would be to deploy it as fuel in a fast-breeder reactor. Alas, Japan's efforts to develop the world's first commercial fast-breeder reactor were halted earlier this year by a court ruling criticising “serious and unforgivable mistakes” by the government over safety regulations at a prototype plant.

The second option would be to use MOX as a substitute for enriched uranium at existing nuclear plants. But this again requires local approval, and already some regional governments are refusing to allow the use of MOX on safety grounds. This follows a series of scandals, ranging from Tepco's cover-up and government failures to disclose safety problems, to data falsification by British Nuclear Fuels over tainted MOX shipped back to Japan, to a disaster when two workers died after using buckets to load a uranium-processing plant. Eisaku Sato, the governor of Fukushima, where Tepco generates 25% of its electricity, says his prefecture has scrapped all plans to permit the use of MOX fuel.

Add to this the vexed, and so far largely unaddressed, question of the cost of reprocessing, should it ever happen, and of disposing of the radioactive waste it generates. High-level radioactive-waste disposal costs alone, now estimated to be ¥3 trillion, could balloon, while other, as yet unquantified, disposal costs could add tens of trillions of yen more, declares Tetsunari Iida, a director at the Institute for Sustainable Energy Policies. Some electricity companies are said to be so concerned that they are privately reluctant for the reprocessing plant to start operating.

Japan's electricity prices are already the highest in the industrialised world, even without these extra costs. The outlook is further complicated by the government's plans to deregulate the market to lower prices, so as to help other industries become more competitive globally. Last month, parliament approved a bill that will deregulate electricity for all large and medium-sized users by 2005. Gas, steel and oil companies are entering the market, putting pressure on incumbents. Deregulating the market, but at the same time pushing nuclear power, which has high start-up and looming, unquantified back-end costs, makes no sense, says Hiroaki Fukami, a professor at Keio University.

If the incumbent electricity companies, as generators of nuclear power, have to foot the bill, they will pass these costs on to households, the only part of the market that will not be deregulated—resulting in a public outcry. Yet imposing some of the burden on new entrants would lead to price hikes across the board, defeating the purpose of deregulation.

One solution would be for the government to follow most others and nationalise the nuclear industry, or at least underwrite its long-term costs. Whether Japan's politicians will do this is debatable. So far they seem to be in denial that there is even a problem, at least in public, and, for the most part, in private as well. That they have already temporarily shut a large part of the country's nuclear industry once is a sign that they may be unable to avoid further temporary, or even permanent, closures in future—with nasty consequences all round.


Economic and financial indicators


Alan Greenspan reassured markets that the Fed would keep American interest rates low for “as long as it takes” to speed an economic recovery. His remarks caused ten-year American bond yields to jump to just under 4.0%. Producer prices and retail sales both rose by 0.5% in June.

America's visible-trade deficit widened by $46.8 billion in May. This increase came despite the recent weakness of the dollar.

In the euro area, Germany saw a sharp and unexpected rise in business sentiment in July. Thirty-year German government-bond yields rose to a three-month high.

French consumer-price inflation edged up to 2.0% in the year to June. Thanks to a series of strikes, and perhaps also to a strong euro, French industrial production fell by 1.4% in May, after a 0.8% decline in April. Industrial production was also down by 1.5% in the 12 months to May.

In Italy, industrial production fell by more than it did in France in the 12 months to May: it suffered a decline of 7.0%. Consumer prices in Spain rose by 2.7% in the 12 months to June.

Consumer-price inflation in Britain eased unexpectedly in June to 2.9%, helped in part by cheaper holidays. That is still, however, higher than the Bank of England's 2.5% target. The inflation figures came after the Bank had already cut interest rates by a quarter-point to 3.5%.

Sweden's industrial production fell by 1.1% in the 12 months to May. Consumer prices rose by 1.8% in the 12 months to June, slower than the 2.0% growth in the previous 12 months. The Swedish central bank cut interest rates by a quarter-point to 2.75%.

The Bank of Canada followed the Swedish model by cutting interest rates by a quarter-point, to 3.0%. The Canadian economy has been weak because of SARS, and also because of a sharp rise in the Canadian dollar against America's. Unemployment eased slightly to 7.7% in June.

Japanese industrial production grew by a revised 1.7% in the 12 months to May. Producer prices fell by 1.0% in the 12 months to June.



Europe's population implosion
Jul 17th 2003
From The Economist print edition

Europe's population is shrinking and greying—with grim consequences

THE convention on Europe's future finally packed its bags last week in Brussels. At one of the many events to celebrate its achievements, Valéry Giscard d'Estaing, an elderly former president of France who has been chairing it, was asked to address an organisation called Friends of Europe. With unintentional irony, the event was held in the dinosaurs' hall of the Natural History museum in Brussels. The image of a 77-year-old man standing in front of a diplodocus was uncomfortably apt. The dramatic change in Europe's demographic profile will weigh far more heavily on the continent's future than the institutional minutiae that have been preoccupying the conventioneers.

Fertility rates across Europe are now so low that the continent's population is likely to drop markedly over the next 50 years. The UN, whose past population predictions have been fairly accurate, predicts that the world's population will increase from just over 6 billion in 2000 to 8.9 billion by 2050. During the same period, however, the population of the 27 countries that should be members of the EU by 2007 is predicted to fall by 6%, from 482m to 454m. For countries with particularly low fertility rates, the decline is dramatic. By 2050 the number of Italians may have fallen from 57.5m in 2000 to around 45m; Spain's population may droop from 40m to 37m. Germany, which currently has a population of around 80m, could find itself with just 25m inhabitants by the end of this century, according to recent projections by Deutsche Bank, which adds: “Even assuming (no doubt unrealistically high) annual immigration of 250,000, Germany's population would decline to about 50m by 2100.”

Combine a shrinking population with rising life expectancy, and the economic and political consequences are alarming. In Europe there are currently 35 people of pensionable age for every 100 people of working age. By 2050, on present demographic trends, there will be 75 pensioners for every 100 workers; in Spain and Italy the ratio of pensioners to workers is projected to be one-to-one. Since pensions in Germany, France and Italy are paid out of current tax revenue, the obvious implication is that taxes will have to soar to fund the pretty generous pensions that Europeans have got used to. The cost is already stretching government finances. Deutsche Bank calculates that average earners in Germany are already paying around 29% of their wages into the state pension pot, while the figure in Italy is close to 33%.

Governments are in a bind. It is no accident that in the past year France, Austria, Italy and Germany have all experienced angry outbreaks of labour unrest, sparked by attempts to make their pension systems less generous. But the longer governments wait, the worse the problem. Pension obligations will only get more onerous; and as voters age it will become ever harder to persuade them to cut pensions back. A struggle for resources will emerge between generations. Pensioners will press for higher taxes to fund the pensions and health care they believe they have been promised. Younger workers will demand cuts in increasingly onerous taxes.

Tensions are also likely between countries in the European Union. Britain and the Netherlands, which have high levels of private-pension provision and whose populations are predicted to remain more or less stable, are better placed to cope with the pensions problem. But they might still be affected by the financial problems of other EU countries, which could force up interest rates across Europe and undermine the euro. The fact that Europe's population is shrinking and ageing will inevitably also affect the aspirations of some Europeans to create a superpower to rival the United States. A recent report from the French Institute of International Relations predicts that, by the middle of the century, the EU's GDP will be growing at just over 1% a year compared with more than 2% in North America and at least 2.5% in China. The EU, the report gloomily concludes, faces a “slow but inexorable ‘exit from history' ”.

But while the EU has a rich, old and shrinking population, countries on the Mediterranean's other side have poor, young, growing ones. The tide of immigrants, legal and illegal, crossing the sea is an obvious reaction. So shouldn't Europe be more liberal about immigration, to redress its population imbalance? An appealing idea. But the OECD calculates that immigration might have to be between five and ten times its current level just to neutralise the economic effects of ageing populations. Even today's inflow is causing political strains, with anti-immigration politicians like France's Jean-Marie Le Pen, Italy's Umberto Bossi and the Netherlands' late Pim Fortuyn popping up all over Europe.

A very European muddle-through

Persuading Europeans to have more children is the obvious alternative answer. Part of the problem may be what Italians call the “partial emancipation” of women, who are free to go out to work but are then still expected to bring up children, look after the grandparents and do the housework. Making family life easier or less expensive might help keep up the population. France, which has some of the most extensive state-funded child care in Europe, also has one of its highest birth rates. Sweden boosted its birth rate in the early 1990s by raising tax benefits for mothers. But the effect of that tailed off after a while. And as well as being costly and unpredictable, policies to encourage childbirth also make some Europeans uneasy, since they are associated with authoritarian government.

So Europe will probably try to muddle through its demographic problem. There will be some pension reform, a bit more immigration, more family-friendly policies, higher taxes, growing fiscal problems for many governments and slower economic growth. With luck the European Union will avoid or postpone a really huge economic crisis. But the political and economic renaissance of Europe that was predicted at the European convention is likely to be stillborn.