Modern warfare

At my instigation, the European Commission on November 28, 2007 adopted a set of legislative proposals for modernising the VAT rules applied in the banking and insurance sectors.

The VAT Directive generally exempts most financial services and insurance from VAT. In consequence, these industries do not charge tax on the services which they supply but in consequence they are also generally unable to recover the VAT they pay on the goods and services which they acquire to operate their businesses. This non-recoverable tax is thus a source of revenue to the tax administrations of the member states. It is also one which has grown as financial and insurance institutions have increased their use of specialist third party service providers (outsourcers) or consolidate their operations on a cross-border basis (such as through shared cost centres).

The legislation has never been revised since it was adopted in 1977 and has been showing its age recently. We have found increasing evidence of problems in ensuring a clear and consistent application of the exemption across the Community. This is mainly attributable to how the industries have become more sophisticated and complex over the last 30 years but also in how the move towards a single pan-European market for these services has highlighted inconsistencies. New products have been developed as well as new ways of delivering these products to consumers. Institutions build up operational relationships, sometimes with companies who would not normally be considered to be financial or insurance institutions and it is not always easy to see whether these activities should be treated as exempt financial services.

This ambiguity has led to a significant growth in litigation and the ECJ has been asked to interpret the legislation with increasing frequency. This, however, is a slow and cumbersome way of delivering clarity and the outcome is often uncertain. For tax administrations, there are risks and long-term uncertainties about revenue flows while for businesses, uncertainty inhibits long-term planning and causes the diversion of significant resources to the resolution of tax problems. Modernising the definitions therefore has become a priority. Ideally, this should be achieved as far as is reasonably possible in a tax neutral way that respects both the general limits of the current exemption and the relevant jurisprudence of the ECJ.

Higher costs
We have also found that the EU’s financial services and insurances industries are less efficient than their international competitors. As a consequence, the EU industry in general faces higher costs for financial services and insurances. There are many factors which contribute to this and VAT is probably some way down the list. Nevertheless, embedded or non-recoverable VAT plays at least some contributory role and certainly increases the cost of financial services to business.

Improving the competitive environment for European financial and insurance companies was therefore a key factor in this exercise but must be balanced against the need to assure tax revenues. This inevitably has limited the room for manoeuvre.

The preparatory work also demonstrated that leaving the VAT rules as they are is not an option. The status quo is not stable both because of the increased dependence on the European Court and because the process of market-driven change can impact negatively on existing tax revenues. It is much better to pre-empt this by reforming outdated legislation, even if only to assure the stability of the current arrangements.

All these concerns were expressed during the very broad consultation that we undertook before finalising the current proposal and the preparatory steps have been particularly transparent. We have listened carefully to the views of the industries and the tax administrations through an extensive programme of conferences, seminars, stakeholder meetings as well as direct discussions with representative organisations. Over 100 contributions were received to an online public consultation, a record for a tax consultation.

We contracted for independent studies on the economic consequences of exemption and the way in which VAT recovery rules are applied across the Community in these sectors. Finally, however, the Commission decided not to propose any radical move away from the existing exemption model. We had looked at this in the past and concluded that it would be unworkable. Therefore the proposal concentrates on improving the working of the existing system and addressing some of its negative economic effects.

The first priority was to increase legal certainty for all concerned, from the business sector to national tax administrations and thereby to reduce their administrative burden in correctly applying the VAT exemption. These changes will also ensure a more consistent application of the tax and deliver a level playing field in the internal market, at least as far as VAT is concerned. A second priority was to allow businesses to manage better the impact of non-deductible VAT on their activities, while ensuring equal access to tax relief across the internal market.

Addressing the first priority, I am proposing a modernised set of definitions of exempt financial and insurances services. The scope of the exempt services is being restated in order to ensure that the exemption better reflects the complexity and diversity of the modern industries, while staying broadly within the limits of the existing provisions. Furthermore, by giving a clear definition of the exempt services, the proposal will certainly increase the legal certainty and, over time, reduce the need for litigation. In addition to updating the VAT Directive, we are also proposing detailed implementing regulations which will expand the definitions in a manner which will apply directly in all member states.

Two separate measures respond to the second of these priorities. I am proposing to allow the banking and insurance companies to opt to tax their services if they wish. Such an option to tax already exists in the VAT Directive but is currently at the discretion of member states and not widely used. Its limited availability is distortive in practice and can serve as a basis for undesirable tax competition. On a level playing field basis, I would therefore like to see more general access to this measure and feel strongly that it should be equally accessible across the Community. This will allow institutions to reduce their exposure to non-recoverable tax. It is difficult to gauge likely take-up but it may be particularly attractive in the B2B area. A widespread take-up of this option can only increase neutrality in the tax system and reduce many of the negative consequences of exemption.

The proposal also contains an industry specific exemption from VAT on cost sharing arrangements, including those which are cross-border. Cost sharing relief has been a feature of the VAT system since 1977 but the existing provision is unclear and not uniformly implemented. This change will enable institutions to pool their operations and to share costs between themselves without creating additional non-recoverable VAT. It will for example allow groups of financial or insurance institutions to achieve economies of scale or establish centres of excellence without additional VAT being incurred.

Putting these proposals in place will probably demand some limited VAT revenue trade-offs for the member states, to the extent that financial or insurance institutions take up either of the relief measures just mentioned. I believe however that in the medium-term any such losses will be compensated by the increased competitiveness and output of the sector. The Commission is acutely conscious that the non-recoverable tax is a significant source of revenue to member states and does not want to disrupt this unnecessarily.

However, we are also convinced that the balanced package of measures being proposed is the best option for VAT reform in the financial and insurance sectors, addressing in particular the issue of competitiveness. It will increase certainty for the industries as well as improve budgetary security for member states by reducing the potential for legal challenge. It will also improve the competitiveness of the EU banking and insurance companies by allowing them to manage better their operations without hidden VAT.

When they opt for taxation, banking and insurance institutions will be able to reduce the costs of non-recoverable VAT as well as the cost of their services to EU business. I would not expect that there will be any increase in the cost to consumers here but rather that increased efficiency will benefit them in the longer-term. I now hope that in the Council, member states rapidly start discussions at technical and political levels in order to have these new rules implemented as soon as possible.

Iceland cometh?

Although traditionally better known for its hot springs, fishing and whaling industries, Iceland has steadily transformed itself into a financial powerhouse in the last 20 years. Icelandic investment firms have continued to buy up, for example, significant tranches of the UK retail High Street. Icelandic investment firm Baugur and FL Group now own House of Fraser and MK One, for example and is now tipped to buy Debenhams.

Iceland’s business turn-around is reflected in the former state-run banks which have all been privatised. Prosperous, well-run Icelandic businesses have increasingly been forced to look overseas for M&A targets, given the lack of appropriate targets at home. Hence the slew of Icelandic companies and investment houses chasing cross-border deals.

The UK, unsurprisingly, has been a target for much of the cross-border interest: many Icelanders speak English and the UK economy is one of the most open and dynamic in the world. So Icelandic-Brit deals look unlikely to abate, especially if UK interest rates continue to slip, as looks likely. According to a recent survey by M&A intelligence and research service Mergermarket, more than half of senior Icelandic managers are considering a deal in the next 12 months.

Iceland’s economy though is one that’s increasingly highly leveraged with significant levels of external debt thanks to the large amounts of M&A and private equity activity. Which means the economy has, to say the least, sizeable imbalances and therefore remains vulnerable to economic crisis. The diminutive population means that the financial players generally are likely to know each other and there’s an abundance of cross-company ownership.

Iceland’s racy makeover
So, what is behind Iceland’s makeover from grey, dull fish exporter to hot tourist spot and international financial mover and shaker? At first glance, Iceland remains a country riddled with contradictions. It is not a low tax economy. Its aggregate tax burden is roughly 40 percent of GDP, significantly higher than the UK and the US, though lower than many other European countries. More revealingly however is Iceland’s corporate tax rates are low at 18 percent. Although this is not quite Ireland or Hungary territory (12.5 and 16 percent respectively), it’s still impressive.

Former Icelandic prime minister David Oddsson, who oversaw much of Icelandic’s key economic reforms in the 1990’s, has to take much of the credit for Iceland’s economic rejuvenation. Corporate rate reductions were slashed in order to promote a pro-growth economy; wealth taxes were abolished and a flat tax rate was also forced through. Widespread financial de-regulation followed.

Domestic investment firms have been astute in making the most of Iceland’s economic comeback, embracing cross-border opportunities. Despite high interest rates, many Icelandic investment companies in the 1990’s were able to borrow money from countries with lower interest rates before depositing this cash on home ground, allowing them to quickly build up reserves. Meanwhile, old state-run industries were also being privatised, with new property rights created.

Iceland’s re-vamp has also been helped by environmental issues and concerns. Blessed with a super-abundance of hydroelectricity and geothermal power sources, Iceland is now actively looking at ways it can export hydroelectric energy to mainland Europe. Icelanders themselves are early adopters of mobile technology and broadband penetration is amongst the highest within the OECD.

Still fiercely independent
Today, Iceland’s economy looks generally highly robust: unemployment rates are one of the lowest in the world. Oddities remain though: Iceland is not a member of the European Union, nor does it seem much interested in joining. This is premised on the concern that Iceland would have to give up control over much of its natural resources, including fishing grounds, were it to join. Given Iceland’s booming economy and high growth curve, there seems no pressing urgency – at least for the moment – for it to join, so say Iceland’s powerful anti-EU lobby.

On the other hand, pro-EU Icelanders point to Iceland’s formidably high cost of living, even by central London or Scandinavian standards. Rising Icelandic inflation continues to make imports expensive. However, Iceland is a member of the European Free Trade Association and in 1992 Iceland became a member of the European Economic Area, allowing Iceland – and other countries including Norway – to join in the EU single market without formally having to join the EU.

Another hot issue is the unwillingness by Icelanders to give up sovereignty to Brussels. It remains a fiercely independent nation as well as an increasingly wealthy one: according to the Organisation for Economic Cooperation and Development (OECD) and the International Monetary Fund, Iceland now ranks as the world’s fifth-richest nation.

FDI remains patchy
Iceland’s own internal FDI – most of it from Europe and the US – is rather muted in comparison with its strenuous investment efforts overseas. However, plenty of FDI has been channelled towards Iceland’s own IT and software industry. It’s estimated since 2003 around $800 million has been invested. Some significant FDI investment in Iceland’s aluminium industry has also taken place.

Supporters of Icelandic FDI point to its strong levels of efficiency and productivity (amongst the highest in the world) and one of the lowest corporate tax rates in the world (18 percent), as well as its strategic location as a bridge between the US and Europe. Tax benefits to overseas investors includes no net wealth tax, no legislation on thin capitalisation; there’s also no branch profits taxes on repatriated profits.

Iceland’s legal market remains small. There are no large international legal players based in the capital Reykjavik and most domestic law firms focus on dispute resolution and family law. However, specialty legal work is booming, helped by the buoyant corporate M&A market.

Tourism ramping up
Away from the business news headlines however, Iceland’s economy – an odd mixture of capitalistic market economy supporting an extensive welfare state – is still strongly dependent on the fishing industry. In recent years, Iceland though has cottoned on increasingly as a tourist destination, particularly with eco-tourists and whale-watching.

In 2006, Euromonitor estimated tourism accounted for more than six per cent of Iceland’s gross domestic product. The main attraction for tourists is the unspoilt nature of much of its glaciers, lakes and lava field.

Although whale watching has also proved popular, Iceland is increasingly popular with adventure tourist and farm holidays. However, extreme seasonality means the tourist industry has to be flexible and focused. There also remains concern about the possible resumption of commercial whaling – and the impact this could have on Iceland as a green or nature lovers holiday destination. There is also a question mark about just how successful Icelandair is likely to be in developing its network and also being able to maintain growth.

Real estate prospects remain positive
Icelandic real estate roughly doubled between 2001 and 2007. The average price of an apartment ballooned from almost ISK 15 million in 2001 to beyond ISK 30 million by the end of 2007. Recently, as in the US and in some parts of Europe, there has been concern about falling price inflation, however the Icelandic market appears, so far, robust.

House prices are forecast to stay more or less at a standstill in 2008, due to tighter access to loans and a cooling labour market, followed by an uplift in 2009 when interest rates are anticipated to fall again.

Iceland’s mortgage market, like its banking market, has become more liberalised over the years, resulting in wider access to credit and borrowing, stoking demand and prices.

Summing up
Perched at the top of the Atlantic, Iceland is a tricky country to summarise. There are some glaring contradictions: despite relatively high rates of personal taxation, corporate taxation is amongst the lowest anywhere. Despite close ties to Europe and Scandinavia, it is stubbornly independent of Brussels. Although Iceland has an abundance of cheap, green energy, it has few natural resources. And though Iceland can claim a high degree of IT and technological prowess, from biotechnology to financial services, it still relies heavily on its ages-old fishing industry to provide 40 percent of its total exports. It also belongs to NATO, but has no armed forces (it declared itself a nuclear-free zone in 1985).

Meanwhile Iceland’s centre-right government, led by Geir Haarde, head of the Conservative Independence Party, continues to steer a delicate path of avoiding overheating the economy while promoting a high standard of living. Per capita GDP is estimated at more than €25,000 and Iceland’s pension system is well capitalised.

Iceland fact-box
Population: 312,000 people

GDP total: $18.4bn

GDP growth (2007): 2.6 percent

Inflation rate (2007): 4 percent

Budget (2007) $6bn

Unemployment: two percent

Net public debt: 17 percent of GDP

The harmonisation of banking in Europe

Growth in cross-border banking and the centralisation by banks of key business functions are the main market trends affecting banking supervision in Europe today. These trends create a misalignment between the legal and operational structures of cross-border banking groups; and they present challenges to the smooth functioning of a decentralised supervisory framework and to the implementation of European banking legislation. In reality, the vast majority of the 10,000 credit institutions and investment firms in the EU operate either on a purely national or regional level. This suggests that specific national rules and practices may still be required. In these circumstances, the main objective of the Committee of European Banking Supervisors (CEBS) is as follows: to respond to these challenges by promoting cross-border supervisory co-operation, as well as the safety and soundness of the European financial system, without creating unnecessary supervisory costs or restricting fair competition. CEBS aims to pursue these objectives in an effective and efficient way by adopting good international supervisory practices and by encouraging its members to implement these in a convergent and consistent manner. CEBS’ guidelines foster a common understanding between national supervisors. Co-operation and the exchange of information on the conduct of day-to-day supervisory tasks are encouraged among the relevant national authorities.

New capital requirements
The Capital Requirements Directive (CRD) represents a paradigm shift in banking supervision. The new capital adequacy framework for banks and investment firms not only harmonises capital requirements but also encourages institutions to improve their risk management processes. At the same time, this regime change has provided CEBS with a unique opportunity to foster convergence in supervisory practices. As of January 1, this year the CRD now transpose the Basel II capital framework into EU legislation and complete a long transition from rules-based supervision to a risk-based approach. This new approach relies on internal safeguards being developed by banks themselves and on their ability to apply best practice developments in the marketplace. The more advanced the methods they have in place, the more effectively they can use their capital for business expansion. Good risk management should ultimately benefit customers in the form of a lower cost of capital. The banking sector faces another major challenge in the new International Financial Accounting Standards (IFRS) which will also benefit harmonisation of reporting and public disclosure of financial statements. CEBS is also seeking to seize this opportunity to develop standardized reporting frameworks for European banks.

The role of CEBS
CEBS was established as part of the Lamfalussy approach to financial regulation in the EU – so named after Baron Alexandre Lamfalussy who chaired the process which gave rise to the final report of the Committee of Wise Men on the regulation of European securities markets. This report proposed a four-level regulatory approach which is designed to make the decision-making procedures faster and more flexible, while still ensuring the uniform application of community law. New powers were given to supervisory committees known as Level three committees. They are expected to deliver convergence in supervisory practices and to contribute to a level playing field across Europe. Commencing operations in January 2004, CEBS was mandated with three main tasks: (i) to provide advice to the European Commission; (ii) to ensure consistent implementation of community legislation in the banking field and convergence in supervisory practices; and (iii) to promote supervisory co-operation and exchange of information. These three tasks mirror those set for the other two Lamfalussy committees; the Committee of European Securities Regulators (CESR) and the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS). CEBS issues regulatory guidelines and standards in order to harmonise the supervisory approach across the EU. Although based on voluntary co-operation between members, common guidelines are expected to lead to a gradual convergence of supervisory practices. Decisions are made on a consensus basis and are fully endorsed by the member state authorities.

Level playing field
In working to ensure that banks and investment firms face similar prudential requirements across the EU, CEBS frequently has to take various considerations and challenges into account when drafting guidance. The legal responsibilities of national supervisors do not always correspond with the operational structures of cross-border banking groups, which can be characterised by centralised business lines and risk management functions. Also, small and large banks have different demands and expectations with regard to supervision. Furthermore, the retail markets are still fragmented whereby, for example, deposit guarantee schemes are based on national solutions. The structure of today’s cross-border banking market poses a serious challenge to risk-focused supervision. The bank as a legal entity is not necessarily a self-contained body which performs all the functions relating to the provision of services in that same jurisdiction and which directly controls all the attending risks. By contrast, supervisory responsibilities are allocated on the basis of the country of residence of the legal entity, while the monitoring of the risks may well require access to information that is outside that supervisor’s jurisdiction. The CRD reflects awareness of this issue. By enhancing the tasks of the consolidating supervisor, greater co-ordination between competent authorities is facilitated. This should minimise the scope for duplication and for additional compliance costs. However, all of these provisions – particularly those requiring a joint decision to approve validation of the internal ratings based and advanced measurement approaches – call for supervisory guidelines which more appropriately define the respective tasks of all of the parties involved. CEBS has published guidelines governing co-operation and exchange of information between home and host authorities. These provide a framework for the effective and efficient supervision of cross-border groups – one that should allow for a clear division of labour between all of the authorities involved. It is important to recognise that the degree of involvement and co-operation should be defined according to the significance of a banking entity, with respect both to the business group and to the local markets in which it operates. This principle of proportionality is reflected in all CEBS guidance. The banking sector has been quite vocal in its demands for principle-based guidance as opposed to the more detailed approach adopted by CEBS. In many areas CEBS has not been able to build on existing practices and some detail in the guidelines has been deemed necessary in order to achieve convergence and to deliver a level playing field.

A European supervisory culture
The ultimate challenge of achieving a common European supervisory culture and approach is complicated by differences that are evident across the national supervisory authorities. In some countries the emphasis is more on contacts between the supervisor and the supervised entity through on-site inspections as well as the use of published data. In other countries, supervisors base their assessments on specific data which they request in addition to that already in a public domain. In practice, CEBS has to work towards the development of in-depth convergence in day-to-day supervision and active cooperation across the operational networks of supervisors. These networks will monitor consistent implementation of the CRD and the CEBS guidelines and will aim to address outstanding issues. One important aspect in building a common supervisory culture is the open and transparent manner in which CEBS itself operates. CEBS consults with interested parties before drafting new guidance and all consultation papers, together with responses, are published on the CEBS website). Transparency of banking supervision practice will not be restricted to the EU level but will be applied at national level. Also, CEBS guidelines on supervisory disclosure through the proposed web-based framework will provide a meaningful comparison of rules and guidance implemented across the EU. This greater transparency will help to identify authorities who are diverging from the common approach and will bring about greater consistency. A common supervisory culture can be promoted through training and a programme of staff exchanges. In the future CEBS members could establish joint examination teams to validate internal systems and models and to engage in staff exchange. It is still early days but the first steps have been taken on the road to supervisory convergence. Convergence is not a magic wand that can change the world overnight. It is an ongoing process towards a regulatory level playing field across Europe.

Always believe in gold

Gold supply each year comes from main three sources – mine production, which has remained largely static in recent years, central bank sales, which are regulated by the Central Bank Gold Agreement, and scrap supply, which represented approximately 30 percent of total supply in 2006.

The members of the World Gold Council, which include leading gold mining companies AngloGold Ashanti, Barrick, Goldcorp, Gold Fields, Kinross and Newmont, together contribute 40 percent of global gold production. In a geographic sense, the world’s top six gold producing countries at the end of 2006 were South Africa, the United States, Australia, China, Peru and Russia.

Gold supply feeds three main global markets – jewellery, which represents 67 percent of demand, investment which represents 19 percent and industrial use, which represents 14 percent. Jewellery demand is largest in India, China, the Middle East, and the United States and it is in these regions that WGC centres its jewellery marketing efforts, and has successfully fought off stiff competition from the likes of electronics, spa weekends and other luxury consumer products.

There is no doubt, however, that in recent years, identifiable investment demand in gold has increased very robustly. Since 2003 the investment sector has represented the strongest source of growth in demand, with a year on year increase in value terms of 45 percent by the end of 2006, and a five year increase of around 300 percent. 2006 attracted net inflows of approximately $13bn.

Gold investment
The benefits of a long term strategic investment in gold are well known. Gold is a great portfolio diversifier, preserver of wealth and mitigator of risk. However, many people still remain relatively ignorant as to how to invest in gold. There are a number of ways of buying gold for investment purposes including the purchase of small coins and bars, or by investing in exchange traded gold, gold accounts, gold certificates, gold-oriented funds and structured products.

With the gold jewellery market strong and investor interest in gold surging following the launch of the gold Exchange Traded Funds products in recent years, it is easy to overlook the important role for gold arising from its unique technical properties, and it is here that the rest of this article will focus. Gold, like other important industrial metals, has many unique physical and chemical attributes that mean it is the best, indeed the only, material for certain industrial applications.

Industrial demand for gold hit record levels of 458 tonnes in 2006, largely due to rises in demand for electrical products which use gold in their circuitry. In recent years over 400 tonnes of gold has been used each year in vital industrial uses.

This demand for gold is generated from a myriad of important practical uses. Car air bags, mobile telephones, laptop computers, aero engine brazing alloys, and many other things we consider indispensable to today’s society would not function without the use of gold. Almost all electronic consumer items, contain a small amount of gold, which is critical to the reliable and efficient functioning of the equipment. The chips and contacts found in a car’s ABS anti-lock braking system all contain gold, as do smoke detectors, routinely used in millions of households to protect against fire, which contain a gold alloy placed between layers of another metal.

Golden history
Up to 70 tonnes of gold are used every year in dental restorations including bridges and crowns. Gold is the oldest dental restorative material, having been used for dental repairs for more than 4,000 years and is considered by most experts to be the best available material. Gold-alloys used in dental work are proven to be durable and long-lasting. Most importantly, gold has excellent biocompatibility (it is non-toxic), so allergic reactions to a gold-based dental implant are extremely rare. There are also a number of direct applications of gold in pharmaceuticals (gold has long been used in the treatment of arthritis), medical devices and even in medical testing kits.

Many of the potential new applications for gold are based on the developing markets for nanotechnology. The word nanotechnology (a nanometre is a billionth of a metre) is something of a catch-all term for techniques that permit material of this size to be manufactured and used. A one gram piece of gold will have very different properties to one gram of gold nanoparticles, and these ‘new’ properties may mean gold nanoparticles become essential for uses within applications in the electronics, catalyst and biomedical industries.

Without the use of gold in all these products, they would be much less efficient and reliable than they are now.

Gold technology
In all industries, markets change and develop over time and we are currently seeing some important changes in the end-use industrial markets for gold. In the electronics industry, manufacturers of electronic goods and equipment are demanding smaller and cheaper microchips and circuit boards and this means the amount of gold used in each application continues to be reduced (or ‘thrifted’) with the emergence of each new generation of technology. In the dental industry demand for gold restorations has been severely hit in markets such as Germany, where Government financial support for precious metal restorations has been dramatically reduced.

At the moment, the buoyancy of the electronics industry is creating very healthy industrial demand for gold, but it is an unavoidable fact that the most important end-use markets for gold (electronics and dental) are gradually reducing their traditional reliance on the metal. For participants in the gold industry, particularly mining companies and refiners, the challenge is to uncover, develop and promote important new industrial uses for gold that will provide the foundations for industrial gold demand in the coming years. Thankfully, with the support of the industry, an exciting array of research is being undertaken around the world, looking at new uses for gold in advanced applications. Significant new industrial offtake could be generated over the coming decade as these new industrial applications grow.

Global risk

With a painful credit crunch, a growing regulatory burden, and a worryingly unstable geopolitical climate, business leaders have got plenty of issues to worry about, never mind what’s going on inside their own organisations. So what are the risks keeping leading business people awake at night? A new survey from Ernst & Young and think tank Oxford Analytica lists the top 10.

Global financial shocks and ‘radical greening’ are among some of the biggest risks for international businesses in 2008 and beyond, according to the report, ‘Strategic Business Risk: 2008: the top ten risks for global business.’ The risk of a global financial shock is now a critical issue not just for the financial markets, but for the real estate, biotechnology, oil and gas and utilities sectors, the report says. As one respondent put it, “A crisis in structured finance markets could lead to potential systematic problems. Sustainability of financial sector growth is more fragile than markets realise. There is the potential for dramatic fall out from excessive leverage.” Not a cheery thought.

Raising capital
Few sectors would escape such a shock, the report says. Biotech and utilities companies would have trouble raising capital; banking, asset management, and insurance companies would be likely to suffer direct losses from market movements; and after making high-cost exploration investments – oil and gas companies might suddenly find themselves facing low prices if the global economy moves into sudden recession.

The research for the report started back in April, before the sub-prime crisis provided a real-life demonstration of how highly contagious such shocks can be across sectors – and indeed – globally. The report quotes Rory MacLeod, the former head of global fixed income at Baring Asset Management, who predicted in April that if there was a “worldwide credit crunch – spread widening would not lead to bank collapses, as in the past, but would be spread throughout the financial system.

“There will be unexpected pockets of vulnerability. Disintermediation has replaced international banking as a finance source with a range of specialised credit instruments held widely, with risk exposures that regulators find it difficult to assess. A credit shock could lead to a temporary closing of the market for new credits, while traditional lenders such as banks have moved away from the area.” He wasn’t wrong.

‘Radical greening’ – the growth in environmental concerns – also made its way into the top 10 risks list, although it was considered a very low risk for the pharmaceutical, biotechnology, banking, telecoms and media and entertainment sectors. Gerard Gallagher, head of business risk services at Ernst & Young, was surprised by this finding. These sectors do not consider radical greening a major risk to their business, because they aren’t heavy energy users and their business is not dominated by carbon use or emissions, he said, “but they are wrong to think it does not touch their business.

“The carbon agenda is starting to cut across all sectors and affect consumer demand. These sectors could therefore be exposed if they view this as an operational risk rather than a strategic risk,” said Mr Gallagher. “For pharmaceutical companies, climate change affects disease and how disease is spread. This could have significant impact on pharmaceutical product distribution and future product development.”

Top threats
The ever-present daily risk of global rules, regulations and compliance unsurprisingly featured in the top three threats to business. Regulator intervention was seen as a threat to a healthy competitive environment, which fundamentally changes business models.

The compliance challenges are particularly strong in highly regulated industries such as banking, insurance, pharma, and biotech, where the regulatory burden is increasing fast, and where firms are feeling pressure to demonstrate a return on investment for long-term risk management initiatives.

“Banks are experiencing significant fatigue around managing the myriad of often redundant compliance and regulatory reporting activities, the cost of which is massive and burdensome,” said one banker quoted in the report. Similarly, a biotech analyst said, “A mounting regulatory compliance burden in areas such as privacy, post-marketing monitoring of drug safety and sales force compliance… poses a management and internal controls challenge to biotech companies.”

Increasingly, companies may seek risk convergence initiatives which allow them to co-ordinate the various risk and control processes, reduce redundancy, which drives down costs, and, perhaps most importantly, more comprehensive enterprise-wide risk reporting to senior management and the board, said Ernst & Young.

Greater challenge
As companies become increasingly global, compliance becomes a greater challenge, forcing them to manage
diverse regulations in different markets. “Managing regulations in 10 jurisdictions is one thing,” said one executive quoted in the report. “What happens when a firm has significant markets in 30-40 countries at varying levels of development and with very different regulatory traditions? This is not to say that global regulatory diversity is necessarily increasing; but rather, that corporate exposure to existing diversity is increasing.”

The importance of understanding local regulations, as well as major global industry regulations, is crucial to those companies expanding their global reach, said Fiona Sheridan, head of risk advisory services at Ernst & Young. “Globalisation continues to cause a major compliance headache for many organisations, which are frequently being forced to manage diverse regulations as they expand into new markets. The response from business to these challenges has largely been either to back away from opportunities because of regulatory restrictions or to build up a ‘layer cake’ of internal risk activities that barely touch each other.”

An increasing strategic risk for the majority of industries is the threat posed by workforce and consumer aging, the report says. Sectors such as asset management and insurance are experiencing dramatic shifts in demand and competitive battles are being fought for savings products that will appeal to the growing group of older consumers.

Other firms, for example, those in the auto sector, are facing severe competitive challenges because of their aging workforces, the report said. “A number of industries are experiencing dramatic shifts in demand – often dramatic growth – as a result of the rising average age in, for example, Europe, North America, and Japan.” Sectors most affected by these shifts include pharma, biotech, consumer products, insurance, and asset management companies, which could lose their competitive edge if they cannot effectively respond to these new opportunities.

“People reaching retirement age have very different financial needs,” said an insurance expert quoted in the report. As a result, a struggle is now emerging between insurance and asset management firms to deliver the innovative products that will meet these needs, such as income maintenance and health care spending. “To be competitive, companies will need to gain an understanding of the specific needs of these new consumers, and many will need to have an aggressive approach to key competitors that may increasingly come from outside their sector,” the report said.

Next five risk
The other strategic challenge posed by an aging population is workforce aging, a risk issue that figures highly in oil and gas and is perceived to be a ‘next five risk’ for sectors such as banking (see figure 2). These sectors are already experiencing a significant human resource challenge, the report said, adding that the most extensive example of this threat can be seen in the US auto industry, which is particularly weighed down by pensions and health care costs. “There remains a possibility of insolvency in the US auto industry, and a long line of dependent component companies have yet to construct a path to safety,” it said.

With regard to emerging markets, the report said that, while many companies have been in these markets for some time, emerging markets remain dynamic for developed market (DM) companies. Over 60 percent of DM companies have been in these countries for less than 10 years, and almost 20 percent less than two years. In most cases, global firms are competing with other global players for opportunities in these markets, although in several sectors, emerging markets firms are themselves entering the global stage.

Often companies are being driven to these markets by the saturation of existing markets, said the report. It quoted one consumer products executive who said: “Over the next few years nearly all of the increase in world population will take place in the developing countries. In the meantime, other established markets will reach maturity.” Similarly, in real estate, “Intense competition for a limited pool of desirable assets, combined with yield compression in most global markets, has resulted in real estate funds needing to broaden their geographic search for opportunities. This has created an increased number of competitive variables in real estate markets,” said another executive.

For other sectors, such as biotech and consumer products, emerging markets offer supply chain advantages, the report said. It quoted one biotech executive who said, “The sources of biomedical innovation will become more diverse in a globalised marketplace. The implication is that while, in the past, the main source of competitive advantage for firms throughout the industry has been technology, in the future the supply chain will be important as well. Global companies will need to form networks with firms in many markets.”

Identifying risks
What are the boardroom implications of the report? “The global heavyweights of tomorrow are already identifying these risks and developing strategies to use them as a point of competitive advantage in the race for increased market share,” said Ernst & Young’s Mr Gallagher. “Someone’s challenge is frequently someone else’s opportunity – and how an organisation exploits strategic risk will be what separates the winners from the losers.”

Ms Sheridan agreed. “This report is just a snapshot of the risks we see now,” she said. “Risks, and the business perception of them, will change over time. If we had done this exercise 10 years ago, it is unlikely that climate change would have placed so highly. That is why it is so important for global businesses to be looking at all risks, not just the critical risks of today, but also those sitting just below the horizon. They could rapidly become critical.

“CEOs need to be more open-minded about risk – they should look beyond financial and regulatory risks to the wider environment in which their organisation operates. It is important that all boards have strategic business risks on their radar – ignoring them is not an option as they can be the quickest and most permanent destroyers of stakeholder confidence and that’s not good news for CEOs.”

Emerging risks
The emerging risks likely to make the top 10 in three years time:

1.  The war for talent

2.  Disease pandemic

3.  The rise (and possible fall) of private equity

4.  Inability to innovate

5.  China setback

 Source: Ernst & Young

The top 10 strategic business risks
  1.  Regulatory and compliance risk

  2.  Global financial shocks

  3.  Ageing consumers and workforce

  4.  Emerging markets

  5.  Industry consolidation/transition

  6.  Energy shocks

  7.  Execution of strategic transactions

  8.  Cost inflation

  9.  Radical greening

10.Consumer demand shifts 

Industry pioneers

In London to sign off a new Murabaha transaction geared towards a wider European and Asian investor base, the former Hull University graduate says GFH’s investment strategy is widening. “We did some sizeable transactions in the UK and Spain during 2006. Recently we were in Germany doing a real estate transaction for €650m. But that’s not our real focus now. We’re looking at private equity and asset management in the UK, France and Italy as well as Eastern Europe.” Mr Janahi insists GFH is not simply diversifying their business model simply along traditional accepted institutional lines. He says it’s about creating business models alongside existing, solid infrastructure projects, like oil and gas development. “For example, Energy City in India where there’s a mercantile exchange and residential and commercial development. But we’re looking overall at the whole economy to see where the growth potential is. Also, a lot of financial institutions will tend to focus on one market – say, Eastern Europe – simply because of the overall good conditions or economic indicators.” Such an approach is obviously too loose for his taste.

The growth potential of India and China he says is also looking interesting. GFH’s investment approach, he says, comes down to three basic principles. “I call it an A,B,C approach,” he says. “A stands for a positive attitude for all opportunities; B for belief, in the sense that we are strong believers in the transactions that we provide. And C is for commitment. We have strong commitment to the deliverables we promise.” His track record in deliverables appears strong. From GFH’s 1999 inception GFH says they’ve launched projects and investments exceeding $12bn. Projects range from Bahrain Financial Harbour to the Gateway to Morocco and a recent transportation infrastructure development project in Egypt. Exit profits from investments, GFH claims, run between 45 percent and 170 percent in the last three years. And their just-completed Murabaha transaction was considerably oversubscribed from European investors. Sharia’a-based banking is on a roll, obviously.

 Nevertheless some argue still that though its rise is welcome, the lack of a clear law or practice applicable to all Sharia’a banking issues – both retail and commercial – is a concern. Put this to Mr Janahi, though, and he says it’s an issue past its sell-by date. “These concerns are old economy concerns of the 1980’s and 1990’s when the industry was just establishing itself. Today when you talk about Islamic banking, you’re talking about $500bn under management with double digit growth potential. There are a lot more sophisticated players in the market too now, like the JP Morgan’s of this world. And accordingly they have their own cross-checking of compliance issues relating to Sharia’a law. Of course, everyone’s had a short learning curve. But these are old economy concerns.” What of Gordon Brown’s claim to make the UK the most Islamic-friendly economy in the world? Is Mr Brown succeeding on this front? “From an Islamic finance point of view, looking at both Europe and the US, most of the focus is still with London. Business comes to London. For example, we have a lot of transactions in the Gulf region. But we came here because you have the right indexation, the right pricing. So, yes, I think it is coming Mr Brown’s way.” However, the adoption of Islamic banking is not without complications for Western partners. When GFH snapped up a £41m property in the Gatwick Business Park in 2002 – now leased to BT – Mr Janahi acknowledges it was a tough learning experience for all, including mortgage provider Nationwide, the deal was one of the first of its kind in the UK constructed on Sharia’a principles. “We had a very good team, and Nationwide were good listeners. “And I think other British banks and institutions learnt a lot from that deal. We are pioneers. And we do share the information with others because we want the industry to grow with us.” Mr Janahi doesn’t spell out the specific problems encountered, but when pressed, he says issues came down to differing mind-sets; Islamic banking in the UK was, until then, primarily retail based. “The learning curve was not just about ethical standards but technical know-how.” Meanwhile, a swathe of established banking names – HSBC, CitiBank and UBS – are now actively mining the Islamic banking sector. Not surprising perhaps when you look at its growth potential. “It’s a good business to be in.” says Mr Janahi, “because if you capture just $1bn this year, your growth potential for the following year – or the next year after that – is very big. You can double your funds under management within two or three years.” He goes on; “If you ask me as a businessman sitting on a board where growth comes from, whether from a region or a product, the first is likely to be single digit, the other double digit. It is a convincing story for decision makers. But you need the right intellectual assets around you. Today you have a lot of graduates that have that know-how. Ten years ago it was much more difficult.”

Brief biography
Name: Esam Yousif Janahi

Position: CEO and Board Member of Gulf Finance House

Nationality: Bahraini

Date of birth: 1965

Honours: Master in Business Administration (Hull University), BA in Industrial Management

The ambitious plans of Dubai

May this year the ruler of the little Gulf enclave of Dubai, Sheikh Mohammed bin Rashid al-Maktoum, announced to applause at the World Economic Forum in Jordan that he was making a $10bn donation to set up an educational foundation in the Middle East, to improve the standard of education and research in the region. It was one of the largest charitable donations in the history of the world, and it made newspaper front pages around the globe. It was yet another ‘Dubai superlative,’ to go with a string of others, from ‘World’s Tallest Building’ to ‘World’s Biggest Golf Green.’ Like everything else that puts Dubai into the newspapers, the Sheikh’s donation is part of an effort to use oil wealth to create a sustainable future for Dubai itself, for the United Arab Emirates of which it is a part and for the Middle East as a whole. In Dubai’s case, the time when the oil runs out is not far away: when oil was first struck in 1966 it was known that, unlike Abu Dhabi next door, reserves would run out just 30 or so years after drilling started. Almost from that moment the ruling Maktoum family decided that this bonus from the sands would be invested as wisely as possible, to ensure that when the wells ran dry the sheikdom did not revert back to what it had been in the past, a dusty principality centred on the Dubai creek with nothing much happening except pearl fishing and shipping. Dubai’s great advantage, apart from its oil wealth, is its position between Europe and the East, with comparatively easy access to travellers from the EU, from India, from South East Asia, Japan and Australia. This was recognised as long ago as the 1870s, when Britain, which took a special interest in the Gulf area because of its proximity to the trade route to India, declared Dubai its main port in the area. One of the first projects the Maktoum family undertook after the discovery of oil was the building of Port Rashid, which, upon it completion in 1972, was the largest deep-water harbour in the world. The port was complemented a few years later with the building of the port of Jebel Ali, the world’s largest man-made harbour and the biggest port in the Middle East.

View of the future                     
However, trade is now only a small part of the Dubai economy. Instead the Maktoum family’s plan is to replace oil income with income from ‘knowledge,’ in its widest sense, and, above all, tourism. Earlier this year Sheik Mohammed bin Rashid declared that his intention was to make his emirate “a pioneering global city” that would be “free of the direct influence of oil price fluctuations.” To that end the country has invested in excess of $100bn on new projects. In 1975, oil revenues made up 64 percent of Dubai’s GDP. By 2010 the plan is for 25 percent of the economy to be devoted to the knowledge economy, encompassing everything from education and media to biotechnology, and 70 percent from tourism, with just five percent from oil and gas. By 2015, the intention is to have increased GDP from its current $31,000 a head to $44,000, a thumping 11 percent annual growth rate.

One of the main tools in promoting Dubai as a technological centre has been the establishment of ‘free-zones’ that allow companies setting up in them 100 percent repatriation of profits, 100 percent tax-free operations (including no income tax), special customs exemptions and fast-track visa services, as well as other benefits such as a single window for government services, long-term leases and easy company incorporation. The result is a staggering list of projects involving organisations and companies from all over the world. Dubai Internet City, which has been combined with Dubai Media City under the banner of Dubai Technology, Electronic Commerce and Media Free Zone Authority (TECOM), for example, is home to such world-class companies as Oracle, Microsoft, IBM, Sun, Nokia, Siemens and Hewlett-Packard, and media organisations including CNN, Reuters, AP. In one of the most recent developments, The Times and Sunday Times of London began printing daily editions in Dubai for distribution in the region. Dubai Media City also includes Dubai Studio City, due for completion this year, which will include eight ‘boutique’ studios, three giant sound stages, a 15-storey tower and a retail area. It is looking to attract the complete spectrum of movie-making service companies, including production and post-production facilities, animation studios, dubbing, makeup and costume designing specialists, stage designing and building, and even casting agencies. Another part of the TECOM free-zone houses Dubai Knowledge Village, a one kilometre-long campus designed to attract universities, colleges, training centres and the like. Since it opened in 2003, Dubai Knowledge Village has brought in more than 300 ‘partners,’ including Heriott-Watt University, and Middlesex University from Britain, Mahatma Gandhi University from India, the Royal College of Surgeons in Ireland, the University of Wollongong from Australia, the University of New Brunswick from Canada and Saint-Petersburg State University of Engineering and Economics from Florida in the United States. Dubiotech, more properly the Dubai Biotechnology and Research Park, is a vast technology park devoted to research in the biotechnology, pharmaceutical and life sciences sectors due to open early in 2008. Already, at the last count, 22 companies have signed up to take space in the park, including, according to reports, three of the top five global biotech groups with another 15 companies going through the process of being licensed. Another project due to open in 2008 is the $1.8bn Dubai Health Care City, which will have 17 hospitals covering everything from plastic surgery to sports medicine. It will include a teaching hospital and post-graduate medical training centre affiliated with Harvard Medical School. A host of private property developments are also under way, including Dubai Festival City, a $2.5bn, 1,600-acre project on the north-east side of the Dubai Creek which includes two million square feet of retail, 19,000 residences, offices and hotels, and a marina and Meydan City, another marina development, which is next to Meydan Racecourse, due to open in 2010. The racecourse development also includes conference facilities to add to the considerable slice of the world’s conference and exhibition business Dubai hopes to grab.

Tourism growth
Tourism is Dubai’s biggest hope for a revenue earner, however, and the main project in Sheikh Mohammed’s plan to attract 15 million tourists a year by 2010 (up from 6.5 million in 2006) to the emirate is Dubailand, a $20m leisure ‘city’ covering more than 100 square miles, twice the size of all of the Disneyland/DisneyWorld resorts put together, and divided into six ‘theme worlds.’ The first phase opens in 2008, with the final completion date not due until some time between 2015 and 2018. Much of the funding is coming from Dubai’s government through Dubai Holdings, its holding company, but at least $6bn will be private investment money. When finished, Dubai-land will have 45 ‘megaprojects’ and 200 sub-projects, including, to cover just a tiny selection, Kids City; Auction World; Women’s World; Eco-Tourism World; a 500-acre zoo; a huge snowdome,; a dinosaur theme park being developed with the Natural History Museum in the UK, and the Dubai Autodrome. Visitors will be housed in 31 hotels totalling nearly 30,000 rooms. Among the tourism projects designed to bring in -high net-worth’ visitors, the best-known is ‘the World,’ a huge manmade archipelago of 300 islands in the shape of a world map currently being built off the coast of Dubai. It is one of a series of artificial island projects in the emirate, along with the Palm Islands, developments in the shape of huge palm trees. Each island in ‘the World’ will be six to 21 acres in size (23,000 to 84,000 square metres), with 50 to 100 yards of water between islands. Prices per island will range from $15m to $45m. There is also the Burj Al Arab hotel, which boats of being the world’s first ‘seven-star’ hotel, and which has an iconic sail-like shape that has become as emblematic of Dubai as the Taj Mahal is or India or the Eiffel Tower is of France (replicas of both of which can be found in Dubaiworld). Tourism today includes shopping, and Dubai currently has a dozen shopping malls open, with two more giant projects due to be completed in the next couple of years. The most spectacular, currently, is the Mall of the Emirates, which, as well as the usual mall attractions, including a 14-screen cinema, a video gaming area and all the big-name stores from Bulgari to Yves Saint Laurent, also contains the Middle East’s first indoor ski slope, Ski Dubai, which has, naturally, one of the largest indoor ski slopes in the world. The Emirates mall’s dominance will be challenged over the next couple of years, however, when two even larger malls open, the Dubai Mall, which will cover 50 acres and 1,000 stores, and will include an Olympic-sized ice skating rink; and Mall of Arabia, being built as part of City of Arabia in Dubailand, with a planned 10 million square feet of shopping space.

Sporting attractions
Sport has not been forgotten. There are golf courses designed by professionals such as Colin Momtgomerie and Ernie Els, an equestrian and polo centre, and Dubai Sports City, another section of Dubailand, which will be the main plank in Dubai’s bid to host the 2016 Olympics. The first part of Sports City is due to open later this year, and when completed it will include a 60,000-seat outdoor stadium for athletics, football, and rugby; a 25,000 seat cricket ground; a 10,000-seat indoor arena, and a 5,000-seat hockey stadium. Cricket and hockey are not big sports in the Middle East – but they are in India and Pakistan, two places from where Dubai hopes to attract many visitors. All this building, which includes infrastructure projects such as the Dubai Metro and the Palm monorail service, and a planned 9,000-megawatts power plant that will also produce 600 million gallons a day of desalinated water, together with projects elsewhere in the emirates, means that the UAE is reckoned to be home currently to almost a quarter of the world’s 125,000 construction cranes, with some estimates saying Dubai alone has 18 percent of the world total – more than 22,000 cranes. With $300bn of active projects, the UAE as a whole has a market for construction machinery estimated at over $500m, with growth of 15 to 20 percent forecast for the next five years. Passenger traffic at Dubai International Airport has rocketed from 7.1 million in 1995 to an estimated 29 million in 2006. A third terminal is now being built, which will enable the airport to handle 70 million passengers a year. This, however, is not regarded as enough: a new airport, Dubai World Central International airport, costing $8.2bn, is due to open its first stage this year, and will eventually be able to handle more than 100 million passengers a year. It may seem, like much else in Dubai staggeringly ambitious, but the little principality seems to have borrowed for its unofficial motto the words of the Kevin Costner movie: ‘If You Build It, They Will Come.’

The Burj al-Arab (Tower of Arabia), 321 metres (1,053 ft) tall, and totalling 60 floors, designed to look like the sales of an Arabian dhow, is the tallest hotel building in the world. It is said to be the world’s most expensive hotel, with prices ranging from $1,000 to $28,000 a night. The Burj Dubai, due for completion in 2008, is designed to be the tallest building in the world: fear of competition from rivals means no final height has been released, but it will certainly be over 700 metres (2,275 feet) and possibly as high as 1,000 metres or more, with more than 200 floors. It will have the world’s fastest lifts, travelling at 65 km/h, or 40 mph. The base of the tower will house a luxury hotel designed by Giorgio Armani, with flats and then offices on top. A two-bedroom apartment on the 73rd floor sold recently for $1.5m. The Mall of the Emirates, with 2.4 million square feet of shops, is the largest shopping mall in the Middle East and the 19th largest in the world. It will be overtaken in late 2008 or early 2009 by the Dubai Mall, and then the Mall of Arabia, both currently under construction, which will, in succession, take the title of World’s Largest Mall at nine million square feet and 10 million square feet of retail space respectively. The Jumeirah Palm development is the world’s largest man-made island. The Asia-Asia hotel in Dubailand, when completed, will have 6,500 rooms, making it the world’s largest hotel. The par-three 13th hole at the Montgomerie Golf Course, in the Emirates Hills development, has the largest single green in the world. Dubai World Central International Airport will have a passenger handling capacity when completed of more than 120 million, more than the world’s currently busiest airport, Atlanta, in the United States, which in 2005 handled 84.8 million people.

Third time lucky?

An amitious plan to buy a rival stock exchange scuppered by an investor revolt? Deutsche Bourse has been here before. Two years ago the German market’s shareholders blocked Chief Executive Werner Seifert’s audacious plan to buy the London Stock Exchange. Then last year’s effort to buy the Euronext market saw the bourse lose out to the New York Stock Exchange. Now questions are being asked about its plan to take control of the International Securities Exchange (ISE), a derivatives exchange in Chicago.

News of discontent first emerged in the Financial Times newspaper, which reported that Atticus Capital, which owns an 11.7 percent stake in the bourse, had said it was ‘furious’ at the proposed $2.8bn takeover of ISE and had lost confidence in its management. London’s Sunday Times then quoted an Atticus executive as saying: “We are not against Deutsche Bourse doing deals in principle. But they must be done with financial discipline and benchmarked against doing a buy-back. What we mean is that if they can find a better deal than buying their shares back then fine. But this isn’t one of them.”

The paper said shareholders controlling more than half the German exchange’s stock have told the board they strongly oppose its plan to buy. Heavyweight hedge funds it named included TCI, Highfields Capital Management, Third Point, Lone Pine, Tiger and Tudor. They have echoed the calls made in the letter from Atticus. Together, their funds speak for 50-60 percent of the total shareholder base.

Under German corporate law, Deutsche Bourse does not need investor approval to buy ISE, but insiders said shareholders had warned the company they would seek to remove shareholder-elected members of the supervisory board if it continued to act without reference to its owners.

One investor told the Sunday Times; “This company is unbelievable. After all they’ve been through with investors, they still refuse to consult us or listen to our reservations.”

In the letter dated May 4 this year, Timothy Barakett, Atticus’s Chief Executive, wrote that he was “especially concerned about the management’s and the supervisory board’s emerging pattern of ignoring shareholder concerns and input … We have lost confidence in management’s financial and strategic discipline in analysing transactions.”

Unanimous support
In a move that was strikingly reminiscent of its attempt to quash the investor rebellion of 2004, the bourse retaliated by declaring that the deal had unanimous support from the supervisory board. A spokesman told reporters; “While some of our shareholders have expressed reservations…we are convinced this combination will create significant mid-term and long-term value for all of our stakeholders.”

Investors are also concerned about the amount the company is planning to pay for ISE. At j67.5 per share, the price represents a premium of nearly 48 percent on ISE’s share price at close before the offer was announced. The deal will combine ISE with Eurex, the options platform that the bourse joint owns with the SWX Swiss Exchange, creating the world’s largest options market.

Speaking at the company’s annual general meeting, Andreas Preuss, Head of Eurex at Deutsche Bourse, defended the bid price saying it had been set after an extensive due diligence process involving both internal and external experts. “These experts determined that the price was justified,” he said.

Mr Preuss said the premium many are quoting seems extremely high because of volatility in the US stock market, which has affected ISE shares. The premium is only 35 percent above the average value of ISE shares over the past year, which is an appropriate level for such a takeover in the US, Preuss said. Under the terms of the purchase agreement, Deutsche Bourse will contribute 85 percent of the total purchase price, while SWX will pay 15 percent.

The reasons behind the deal are pretty clear. In a sector where size is everything, the merger will create the largest transatlantic derivatives marketplace with significant dollar and euro product coverage, and with significant operations and revenues in both the US and Europe. It will also strengthen Eurex’s position as the leading global derivatives marketplace and will create the undisputed market leader in individual equity, equity index and interest rate derivatives worldwide with a combined overall trading volume of 2.1 billion contracts in 2006.

Apart from size, Eurex and ISE also say they have complementary member bases and product portfolios. This should provide significant growth opportunities across asset classes and national boundaries. They see more upside potential in joint product and business development opportunities.

Deutsche Bourse Chief Executive Reto Francioni said the merger agreement was “a strategic milestone for us that will further fuel our strong growth prospects and create significant value for shareholders.”

On the ISE end of the deal, David Krell, President and CEO, says ISE has “transformed the US options market” since the company was founded 10 years ago. “Our innovative products, electronic trading model, technology, market structure and entrepreneurial organisation have enabled us to remain at the forefront of the options industry,” he says. “Our principle strategic objective is to further grow our business both in terms of new products and new markets and in partnering with Eurex, we will be able to achieve our goal.”

Gary Katz, ISE’s Chief Operating Officer, stressed that the company already has a strong working relationship with the management at Eurex. “We also share a common vision that the exchange model is evolving toward global, multi-asset class, electronic marketplaces,” he says. “Our combination will allow both of our organisations to remain at the forefront of this competitive industry. Our cultural fit and common vision will serve as the basis for our successful future collaboration.”

The merger of Eurex and ISE combines two of the fastest growing players in the financial services industry, both with proven track records of innovation. ISE pioneered electronic trading in the fast growing US equity options market and continues to show strong, positive financial performance on the back of market leadership in the US.

ISE’s extensive membership base will significantly strengthen Eurex’s position in the US. Some 164 registered US broker-dealers are ISE members while Eurex currently has 63 US members. It also adds 600 million traded contracts to the number of contracts originated in the US; at Eurex, 112 million contracts originated in the US. ISE’s product portfolio is fully complementary to that of Eurex, and with the acquisition, Eurex is investing in a high growth business while further balancing its product portfolio.

The combined group will be the largest transatlantic derivatives marketplace with powerful distribution capabilities in two of the world’s most important capital markets. Its wide range of both US dollar and euro denominated products will be unique in the market, the parties say. The combination will be home to the eurozone interest rate and equity index benchmark derivatives products and will offer options on all major US and European companies. A combination of the two companies will offer huge growth opportunities, mostly through cross selling of existing products in both markets, as well as through the introduction of new products in the future, they claim.

Significant value
Despite the carping from some of its shareholders, Deutsche Bourse says the merger will create significant value for them, and for shareholders in the SWX Swiss Exchange. There are estimated pre-tax synergies of $50m a year that have already been quantified. Half of the total synergies will be achieved in 2010, with the rest in 2012. That figure includes $15m of efficiency gains and around $35m from revenue synergies, mainly through the cross selling of existing products.

The merger has certainly come at a time when both markets are on the up, at least in terms of trading volume. ISE’s volume in equity options has grown at 55 percent a year over the last five years, outperforming the market for US equity options. It now has a 32 percent share of the overall US equity options market, making it the leader.

Trading volumes on Eurex are at record levels. Volumes in April increased by 24 percent year-on-year to 151 million contracts. Average daily trading volume was roughly eight million contracts. Total trading volumes in 2007 reached 618 million contracts in the first four months – again, a 24 percent increase year-on-year. In April, equity derivatives set a new record with a total of 53 million contracts, an increase of approximately 50 percent.

Naturally, rival markets are not just going to sit around watching all this happen. The Chicago Board of Trade, the second largest US futures exchange, is pondering two competing offers, but is under increasing pressure to walk away from both. The call is for it to retain its independence or seek a richer bid next year.

The option of walking from a deal agreed in outline with the larger Chicago Mercantile Exchange is becoming increasingly popular. The value of the deal has fallen to 31 percent below a competing unsolicited offer from the Intercontinental Exchange, which is now worth $10.6bn. Both offers are all-stock and their value has see-sawed since the ICE sought to break up the all-Chicago tie-up, which was agreed last October. If that deal went through it would create the world’s largest futures exchange.

Retaining independence
The slumping value of the CME deal has encouraged some CBOT members to push for it to retain its independence. They argue the franchise has been strengthened by the successful launch of side-by-side electronic trading of agricultural futures last August. While trading of financial futures, mainly treasury bonds, dominates volume at the CBOT, the volatility in the corn and soybean markets helped push agricultural dealing up by more than 50 percent over the past year. More than half of the deals are now made electronically, and agricultural trades carry fatter margins than the financial futures.

The ISE/Eurex deal has also encouraged some CBOT members – who retain 80 percent of its shares – that premiums are likely to remain in the exchange sector. CBOT shares would fall in value if it said no to either deal, but the thinking is that they would soon bounce back, and a better offer might emerge. The CME would have to raise its current offer by 40 percent to reach what people say is the knock-out level – over $2.10 a share. Under the terms of the agreement with CME, CBOT can change its terms up until a meeting scheduled for July 9 this year.

So that could mean two done deals are not quite as buttoned-down as they at first seemed. For CBOT, jilting both its suitors in the hope of a better deal might prove a sound strategy. But the options for Deutsche Bourse are more bleak. If it doesn’t tie up the marriage between Eurex and ISE, it will be its third failed deal in as many years. 

The Bahrain financial harbour

The financial sector in Bahrain has managed assets totaling approximately $377.5bn in 2005. Of this the financial services accounts for over 27.6 percent of the total GDP output in Bahrain and Stephen Rothel, CEO of BFH, strongly believes that with the significant infrastructure projects, government and regulatory initiatives (US FTA etc) for the sector that are nearing completion, the sector’s contribution to the economy as a whole is only going to increase significantly.

The strength of the economy
Over the years Bahrain, due to its strategic location and strong economic fundamentals and regulatory framework, has emerged as an ideal investment destination and has gained the reputation of being the financial capital of the Middle East. The macro-economic statistics amply validate this claim. Bahrain today boasts of some of the best economic statistics in the region. With an inflation rate of 2.7 percent (2005), a trade surplus of 19.3 percent of the GDP, a real GDP CAGR of 5.9 percent (2000-2005) and a per capita GDP of $20,500. It is no surprise that Bahrain has received sovereign ratings of A, A3 and A from S&P, Moody’s and Fitch respectively. Furthermore, with an upgrade of the Kingdom’s sovereign ratings from stable to positive and with over 370 financial institutions, Bahrain has also re-enforced its position as a strong international financial centre in the Middle East. Mr Rothel said; “This is a position we strongly believe that will only be strengthened post the formal launches of the various development projects being undertaken in the Kingdom such as the Bahrain Financial Harbour, the Bahrain-Qatar Friendship Causeway, to mention just a few.” In 2006 Bahrain’s GDP continued its expansion growing approximately 11.3 percent (as per an HSBC report). This growth has primarily been non-oil in nature and has not only resulted in Bahrain being voted as the freest economy in the Arab World but has also resulted in significant job creation – a trend that has also seen a significant influx of expatriate workers. The Kingdom has also been ranked as the number one country for the last 10 years in terms of human development by UNDP. Bahrain also boasts of highly investment friendly central policies promoted by the government and a world-class regulatory framework. Bahrain also boasts of one of the highest literacy rates in the Gulf Co-operation Council (GCC), a highly and well-educated bilingual workforce and excellent work ethics.

The case for BFH
The $1.5bn BFH was conceived with the aim of re-enforcing Bahrain’s position as the financial capital of the Middle East and further enhancing the attractiveness of Gulf Co-operation Council nations as a whole for global financial sector players. Additionally, Mr Rothel says; “it aims at playing a key role in the development of emerging financial tools and trends such as Islamic finance, along with creating an environment that is at the forefront of innovation and best-practices, thus creating a distinct position for the region in the global financial markets.” Furthermore, Bahrain currently does not have a focused ‘financial district.’ At best it can be termed as a scattered financial district. As is the case with most rapidly evolving economies, there is limited physical space in Manama, Bahrain’s capital, for the continued growth of the financial sector, causing an increase in congestion. Moreover, there are no such waterfront developments in Bahrain. This has resulted in the urban centres moving away from the shoreline. Mr Rothel says BFH was conceived to address these problems. “It has been designed to offer a financial sector that is focused, world class and to be a fully integrated master-planned water front development,” explained Mr Rothel. “It is the first development of its kind in the Middle East. It will uniquely combine business, leisure and residential components under one canopy and by evolving a highly focused, committed and advanced financial environment.”

The location – why the harbour?
The reason for reclaiming land from the sea for BFH was that most of the financial sector in Bahrain is focused in its capital Manama. However, being an island and a rapidly expanding economy, the strain on available land resources in Manama was very high and it was not capable of supporting a project of the scale of BFH. “Additionally we wanted BFH to be a waterfront property to significantly enhance the attractiveness of the project in line with leading international business districts such as Hong Kong for example. Thus, the best route available to us at the time was to reclaim land of the Manama coast for BFH. Attempting to place BFH in the centre of the city would have only added to the congestion in Manama and have been limited by available infrastructure. BFH through careful master planning, has been able to incorporate new purpose designed infrastructure that will perform to international standards, said Mr Rothel.

From hydrocarbons to finance
It has been some time now that the Middle East economies have actively been diversifying their economies to reduce the contribution of petro-dollars. Bahrain is no different. Today the financial services alone contribute over 25 percent of the GDP and this is being actively supported by growth in the tourism and manufacturing sectors. Additionally, the recently signed FTA agreement with the US and the announcement of the causeway with Qatar will only add momentum to this trend.

The rise of Islamic finance
BFH is also ideally placed to take advantage of Bahrain’s central role in the sphere of Islamic finance, which is one of the fastest growing sectors in the financial world. Having emerged as one of the fastest growing segments in the global financial landscape, Islamic finance however started being practiced in an organised manner only 30 years ago post the Organisation of Islamic Conference recommendation of establishing an Islamic economic system. Media reports last year quoted the British Financial Services Authority estimates of assets under management in Islamic finance is in the range of $200 to $500bn. Other semi-official statements by GCC officials suggested that ‘Islamic’ deposits account for 10 percent to 20 percent of total deposits in those countries. Traditionally, centres such as Bahrain have spearheaded the Islamic finance movement. Bahrain not only houses over 25 of the world’s largest Islamic finance institutions but has also played host to some of the regions most innovative and successful Islamic finance instruments such as Mudaraba and Sukuk issues. On January 12, 2002, the Central Bank of Bahrain became the first central bank to issue regulations for Islamic banks, under the title ‘Prudential Information and Regulations Framework for Islamic Banks’ (PIRI). Through these regulations, which in essence formed the base for setting international accounting and auditing standards in Islamic finance, Bahrain became the first country to publish a legal framework for Islamic finance.

Bahrain’s regional competition
“The regional financial marketplace is one of the fastest growing in the world and as frontrunners in the sector, we feel that it is our collective responsibility to develop and promote it. I don’t think that there is overcrowding in the Gulf market for financial services or that along with the other financial centres in the region (Dubai and Qatar) we will cannibalise each others’ business for two key reasons. Firstly, all three markets have a distinct focus and although there is some amount of overlap, their broad agenda remains vastly different. And secondly the financial markets in the region are at a very nascent stage and there has never been any integrated development such as these in the region before. Thus, not only would these centres help collectively enhance the profile of the region as a whole but will also help cater to the rapidly growing need for such facilities in the GCC,” continued Mr Rothel.

Perfect location
BFH, with its first mover advantage, excellent and unique product offering and strategic location of Bahrain is well-equipped to play its part in this endeavour. Bahrain’s perfect location, at the international crossroads of the major continents – facilitates 24/7 global trade with access to over $1.5trn regional private wealth and the highest literacy rate in the GCC. With one of the oldest and most robust regulatory bodies in the Middle East, the Central Bank of Bahrain has also over time developed the reputation of being the most respected regulatory body in the Middle East. But there is another significant factor, as outlined by a leading English daily in Bahrain, which has in recent times gained tremendous significance while determining to a large extent the sustenance of economic success of any city or country – the low cost of living. It is here that Bahrain gains significantly against more prominent economies in the region. It is ranked amongst the lowest in the GCC on the Cost of Living Index making it an attractive destination for both expatriates and businesses alike. All these factors together present a very compelling investment rationale for any global financial sector company setting up in the region to do so through Bahrain. “Given this overall backdrop, we at BFH are very confident that the region driven by Bahrain and other emerging centres will be able to once again drive the next wave of exponential growth in the Islamic finance sector, which would see it establish its position as a significant alternative to conventional finance not just within the region but also on the global landscape. Furthermore, we are also confident that BFH, with an integrated model ideal for the co-existence and co-operation between academics, researchers and financial institutions in the space along with its strategic location in Bahrain, will emerge as a significant enabling centre in this incredible growth story,” add Mr Rothel.

The regulatory framework
Financial freedom (with the appropriate non-interfering regulation) is a must anywhere in the world. In Bahrain the model has now entered a stage of maturity and the benefits are visible for all to see. A significant component of this model is flexibility in the ability to swiftly adapt to change. The regulatory framework set up in Bahrain has insured that this flexibility is maintained and thus allowing Bahraini business to constantly adapt to changing marketing dynamics in the process ensuring them a significant competitive edge.

The future
Bahrain is the largest financial centre in the region and already boasts of over 370 financial institutions (the largest in the Middle East). With projects such as BFH, the Friendship Causeway to Qatar, the US-FTA agreement and others the Bahrain Financial Harbour success story will only be strengthened with better and better year-on-year performances from the sector in the Kingdom. “We think there is much to look forward to,” concluded Mr Rothel.

For further information:
Tel: +973 17 563 563

Absorbing the shock

Just how much damage could a downturn in the US inflict on the world economy? Doom-mongers say the outlook is grim. But a more upbeat assessment from the World Bank suggests that the developing markets might ride to the rescue, with their healthy growth providing a timely shock-absorber to developed-world economic woe.

Spurred on by the rapid adoption of new technologies, the bank says resilience in developing economies is already cushioning the impact of a US slowdown, with real GDP growth for developing countries expected to ease to 7.1 percent over the next 12 months. High-income countries are predicted to grow by a modest 2.2 percent.

Its Global Economic Prospects 2008 report notes that world growth slowed modestly in 2007 to 3.6 percent compared with 3.9 percent in 2006, a downturn due largely to weaker growth in high-income countries. In 2008 global growth is expected to be 3.3 percent.

The soft landing prognosis is a cheering one, but a weaker US dollar, the spectre of a North American recession, and rising financial-market volatility could all spoil the party. These risks would cut export revenues and capital inflows for developing countries, and reduce the value of their dollar-investments abroad. In this context, the reserves and other buffers that developing countries have built up in past years may be needed to absorb unexpected shocks.

“Overall, we expect developing-country growth to moderate only somewhat over the next two years. However, a much sharper United States slowdown is a real risk that could weaken medium-term prospects in developing countries,” said Uri Dadush, director of the World Bank’s Development Prospects Group and International Trade Department. The report’s authors assume that credit turmoil in international markets will persist into late 2008, but that costs to large financial institutions will remain manageable. Moreover, they predict that spill over from problems in the US housing market on consumer demand will remain limited.

Fundamental trends
The World Bank says developing economies are benefiting from more prudent macroeconomic management. And it also highlights a fundamental trend: rapid technological progress has helped increase productivity and real income growth in developing countries over the past 15 years. In fact, technological progress in developing countries has helped to raise incomes and reduce the share of people living in absolute poverty from 29 percent in 1990 to 18 percent in 2004, its report says.

The technology gap between rich and poor countries remains enormous, and the capacity of developing economies to adopt new technology remains weak, says the bank. Nonetheless, “Technological progress increased 40 to 60 percent faster in developing countries than in rich countries between the early 1990s and early 2000s,” said Andrew Burns, lead economist and main author of the report. “Nevertheless, developing countries have a long way to go, given that the level of technology that they use is only one quarter of that employed in high-income countries.”

The World Bank report notes that recent progress reflects increased exposure to foreign technologies. As a share of GDP, high-tech imports and foreign direct investment levels have doubled since the early 1990s. “Rising trade and investment contacts with high-income countries, often facilitated by migrant groups, have been central to technological progress in developing countries,” said Uri Dadush, director of the World Bank Development Prospects Group. “However, openness alone is not enough. To continue catching up, countries need to strengthen educational achievement, governance, basic infrastructures, and links to migrant groups.”

The report stresses that the weak diffusion of technology within countries holds back overall technological achievement in many countries. Thus, while major centres and leading firms in Brazil, India and China may operate close to the global technological frontier, most firms in these countries operate at less than a fifth of the top productivity level.

Technology levels
While the level of technology used in all countries has increased rapidly, it has done so quicker in developing countries and quickest in low-income countries. Of course, the initial level of technology in lower-income countries was much lower to begin with. But there is strong evidence of catch-up between middle-income and high-income countries. In Chile, Hungary, and Poland, the overall level of technological achievement increased by more than 125 percent during the 1990s.

Despite the rapid pace of technological progress, the technology gap between high-income and developing countries remains wide, with developing countries employing only a quarter of the level of technology in developed countries, the report says. Levels of technological achievement in high-income countries are more than twice those in upper-middle income countries. This group, in turn, has levels of achievement that are more than double those in low-income countries.

Technological achievement can also vary widely within a country. Main cities and leading sectors often use more sophisticated technologies than the rest of the economy. For example, the IT-enabled services sector in urban India employs world-class technologies, but less than 10 percent of the country’s rural households have telephone access as of 2007. So, while one might have expected India to have better overall technology diffusion than other countries at similar income levels, in fact, it does not. “Over time, the digital divide between rural and urban India is expected to narrow, especially in high-income states and near major cities, but it may well worsen in some areas,” the report said.

Another key finding of the report is that technological progress in developing countries – almost universally reflects adoption or adaptation of pre-existing technologies rather than at-the-frontier inventions. Scientific invention and innovation – measured by the number of patents and journal articles – plays virtually no role in explaining the level of technological achievement in developing countries. This is not the case in rich countries.

Developing countries are scarcely active at the global technological frontier. This is mainly because many developing countries lack the critical mass of technological competencies necessary to participate at the global technology frontier.

This does not mean that top-level scientists do not exist in these countries, the report says. It points to research suggesting that many people from developing countries perform cutting-edge research in developed countries. In the US, around 10 percent of the 21.6 million working scientists and engineers were born in developing countries.

According to the report, improving capacity to absorb foreign technology is critical in low-income countries, as well as in those middle-income countries that have exploited low-wage comparative advantages rather than strengthened domestic competencies. It calls on governments to strengthen domestic technology dissemination channels as a high priority. These include transport infrastructure and the capacity of applied R&D agencies to orient themselves to markets through improved outreach, testing, and marketing.

The weakness of basic infrastructure systems is another area to address, the bank says, as this limits the range of technologies that can be employed in many countries. “Policies should ensure that critical enabling services, such as roads and electricity, are widely available, whether delivered by the private or public sector.” For example, in Sub-Saharan Africa, just 8 percent of the rural population has access to electricity.

Ineffective or uneven access to quality education is another hindrance on countries’ ability to exploit technologies. This is important, as even simple technologies can have big impacts, the report says: “For example, relatively simple skills are needed to build rainwater collection systems, which improve access to clean drinking water and reduce infant mortality by lowering the incidence of diarrhoea.”

Poor infrastructure and chronic inequality are hardly simple problems to solve. But as the economic outlook for the developed world darkens, the renewed incentive to help developing nations to meet these challenges is clear – for reasons of self interest if nothing else

Technology access
Technology now spreads much more quickly between countries. In the early 1900s, new technology took over 50 years to reach most countries; today it takes about 16 years.

Technology tends to spread slowly within countries. Main cities and leading sectors use more sophisticated technologies than the rest of the economy. For example, the IT-enabled services sector in urban India employs world-class technologies, but less than 10 percent of the country’s rural households had telephone access in 2007.

Use of some new technologies, such as mobile phones, has risen quickly. Nevertheless, some technologies have spread only slowly. Three-quarters of low-income countries have 15 or fewer personal computers per 1,000 people, and a quarter have fewer than five.

A riskier environment

It has been a good few months for Neelie Kroes, the European Commissioner responsible for competition law. Her efforts to show companies that Europe is serious about busting cartels and cracking down on those that abuse their dominant market positions shows signs of paying off.

Kroes is intent on opening Europe’s energy markets to more competition and has been building up to a confrontation with the continent’s leading utilities players. But when the showdown came at the end of February, one of them, a leading German utility E.ON, spectacularly and unexpectedly caved in. The company agreed to sell part of its power grid, and in doing so demolished the argument of certain European Union member states that are resisting reform in the hope that they can still allow national “champions” to dominate their home markets.

Kroes has been investigating energy companies like E.ON for suspected abuse of their dominant position in the market. E.ON’s offer to sell its power grid was made in an effort to settle two antitrust investigations – and was immediately praised by the Commission. “E.ON’s announcement is definitely very much welcome,” said Andris Piebalgs, the EU’s energy commissioner and one of the leading proponents of breaking up the energy giants. “It definitely makes a huge impact on the debate.”

The company’s willingness to appease the Commission underlines the message from legal experts that Europe is becoming a more risky place for companies that flout its competition laws. The Commission is taking a more aggressive attitude to errant companies and its member nations are playing hardball, too – taking tougher action on their own, and working with each other to share intelligence across borders.

The crackdown doesn’t relate to any significant changes to European law, according to legal experts, but stems from a renewed political zeal to ensure fair competition, and a shift in tactics to frighten misbehaving companies. US businesses, in particular, should be aware that the likelihood of an investigation is higher, and the consequences of being found in breach are more severe, they say.

The scale of the Commission’s crackdown is clear from the rapid increase in the total fines it has imposed on companies forming illegal cartels. These have rocketed upwards from €400m in 2000 to €3.3bn in 2007. The total could exceed €5bn this year, predicts Mark Powell, partner in the competition law practice at lawyers White & Case. Enforcement action is continuing to intensify, he says, and guidance that allows the Commission to calculate much bigger fines will start to kick-in this year.

The Commission is also becoming more aggressive with its investigatory tactics. Earlier this year it launched high-profile dawn raids against some of Europe’s leading pharmaceutical companies, including GSK, Johnson & Johnson and AstraZeneca. Normally it reserves such heavy-handed tactics for cases where it suspects companies are breaking the law, but these raids were “just the starting point of a general sector inquiry.” The Commission is concerned that European pharmaceutical companies are not developing new products fast enough. “They really are using their teeth and using dawn raids in novel scenarios,” says Rebecca Holmes-Siedle, senior associate in competition law at law firm Stevens & Bolton.

Procedural breaches are being severely punished, too. In January, the Commission fined E.ON €38m for its behaviour following a raid on its premises. Investigators used a plastic seal to close a roomful of sensitive documents so E.ON employees couldn’t tamper with them overnight; when they came back the next day the seal had been broken. Competition Commissioner Kroes said the heavy fine “sends a clear message to all companies that it does not pay off to obstruct the Commission’s investigations.”

The Commission has also showed how tough it is willing to be on companies that fail to comply with its decisions. In February it hit software company Microsoft with a record €899m fine for non-compliance. The fine relates to the company’s failure to meet its obligations under a 2004 Commission ruling that required it to make information about its products available to other software companies.

The non-compliance fines imposed on the company now total nearly two-and-a-half times the penalty levied for its original offence. In its 2004 ruling, the Commission fined Microsoft €497m for abusing its powerful market position. The Commission added a further €280.5m fine in July 2006, claiming the company had not complied with its ruling – the first time it had ever had to fine a company for non-compliance.

Commenting on the latest penalty ruling, Kroes said it reflected “a clear disregard by Microsoft of its legal obligations.” She added that the record fine was “a reasonable response to a series of quite unreasonable actions.”

The Commission’s original ruling found that Microsoft was stifling innovation by charging prohibitive royalty rates for information that other companies needed to ensure their products worked on Microsoft’s Windows operating system. After that ruling, Microsoft offered to charge a royalty for the information; it has lately promised to provide it for a flat fee.

Microsoft recently published a statement promising to make interoperability information more available in future and Kroes said it appears as though the company has now come into compliance with its 2004 decision. However, the Commission is continuing with two other anti-trust investigations into the company’s practices, which it launched in January, and one of these concerns the same issue of interoperability. Kroes said she had noted the Microsoft statement, but added: “a press release does not necessarily equal a change in a business practice.”

More widely, she said, the non-compliance fines imposed on Microsoft were a lesson to companies contemplating similar illegal action. “Talk is cheap; flouting the rules is expensive,” she said. “We don’t want talk and promises – we want compliance.”

Lawyers say this tougher line has been building up since at least 2005, when Kroes took office. The notable recent shift is the focus on cartel activity. “That’s happening in the European Commission, and it’s also happening in the national competition authorities,” says Powell. “They are recognising that if they want to achieve results for consumers, it is through cartel policy that they are going to do it.”

Last year the Commission secured judgements against eight cartels, which involved 45 companies in total – that compares to just five cartels busted in 2003. The largest cartel case last year, which was also its biggest ever, involved a stitch-up of the market to maintain elevators and escalators. That concluded with fines totalling €992m, half of which fell on one company, ThyssenKrupp – another record. However, Kroes said in a recent speech that there was still a huge “enforcement deficit” in European anti-cartel law: “The wrongdoers are getting away with far too much and they owe their victims billions of euros.”

Getting tougher on enforcement is one way that Kroes hopes to bridge that deficit, but there are other initiatives underway, too. A policy White Paper due before the summer will set out plans to make it easier for people who feel they have suffered at the hands of a cartel to join together in class actions, which are very rare in Europe. The paper will also float the idea of enabling courts to award double-damages plus interest against what Kroes calls “hard core” cartels.

The Commission has also strengthened a leniency programme that grants complete immunity to companies that blow the whistle on cartel activity. “This has really worked as a carrot,” says Holmes-Siedle. “Whereas before they had to sniff out and detect cartels, which is difficult because they are by their nature secret, companies are applying for leniency and shopping everyone else,” she says. Powell notes that as the size of fine imposed continues to increase, the option of blowing the whistle via the leniency programme becomes even more attractive.

The enforcement environment is becoming more hostile at member-state level, too. In the United Kingdom, for example, the Office of Fair Trading, a government agency responsible for competition, has received a big boost to its resources; and new laws have made involvement in cartels a criminal act – the first prosecution will reach court this year. In Belgium, the government has changed the rules about what size of merger the competition authority has to scrutinise so that it can divert more resources to cartel-busting.

Member states are also doing more to co-operate with each other, through informal networks and newly created official channels. Regulations took effect in 2004, for example, that encourage national competition authorities to work with the Commission. “What is true across the whole of the European Union is that resources are being diverted to focus on this and the sanctions are increasing,” says Powell. “There is a more regular exchange of best practice between the authorities, they are learning from each other.”

In March, for example, Commission investigators carried out “unannounced inspections” – Brussels-speak for raids – at the premises of a number of international airline passenger carriers: its officials were accompanied by their counterparts from the national competition authorities involved. Lufthansa, the German flag carrier, said it was one of the companies raided.

The investigation relates to suspected anti-competitive behaviour in providing long-haul flights to Japan. Lufthansa, which in December was granted conditional immunity over its alleged participation in a freight transport cartel, said that investigators had visited the carrier’s Frankfurt offices in connection with allegations of price fixing. “The commission has information that passenger aviation companies, including Lufthansa in Europe and in Japan, may have taken part in anti-competitive price-fixing and collusive behaviour in traffic between the EU and Japan,” it said in a statement.

While Lufthansa might be the most recent company to find itself in the Commission’s firing line, it certainly won’t be the last. Europe is now a much riskier place for companies that flout its competition laws: Ms Kroes means business.

Thailand in trouble?

These are difficult times for Thailand. Last year’s military coup was a major shock in a country that foreign investors regarded as relatively stable. Since taking power, military leaders have made worrying noises about shutting the door to investors from overseas. The new government is insisting that it will press ahead with changes to investment laws that would make it harder for foreigners to control Thai companies, even though its trading partners believe they would breach the country’s commitments to the World Trade Organisation. But Pridiyathorn Devakula, the government’s leading economic policymaker, has been trying to play down the effect of the plans, saying they are simply closing a loophole in existing rules and that foreign manufacturers, exporters, or companies with investment privileges would be unaffected.

Even so, foreign executives are unsettled. Several have appeared in media reports saying that it is too early to know whether the changes would force them to sell some Thai holdings or not. The British Chamber of Commerce, meanwhile, has said all foreign investors would be “forced to divest shares currently held by nominees.” That would leave some firms with a choice of selling down their holdings to be truly Thai-owned, or of restructuring and applying for licenses to operate as a foreign-owned company. Western diplomats complain that the legal overhaul would give Bangkok too much control over the activities of foreign companies. One diplomat told the Washington Post that the government was “playing with matches.” He added; “It is a clear policy decision that at least in the service sector Thailand will be a closed market and foreign capital will only be authorised if it is a minority both in shareholding and in control.” Yet the government insists it does not want to limit inward investment. Mr Devakula has insisted that the government was forced reluctantly to overhaul the laws after the furore that surrounded Temasek Holdings’ takeover of Shin Corp, the telecommunications empire founded by ousted former Prime Minister Thaksin Shinawatra. Last year, the commerce ministry ruled that Temasek had violated Thai foreign equity restrictions and asked police to investigate – alarming other foreign companies using similar structures for their Thai holdings. The legal changes relate to Thailand’s Foreign Business Act 1999, which regulates the rights of foreigners to carry on certain businesses in Thailand. The details of the act are quite complicated, but the basic structure is simple, according to a briefing produced by lawyers Herbert Smith.

Governmental approval
Foreigners are prohibited from carrying on certain businesses that are especially reserved to Thai nationals. These ‘list one’ businesses include, for example, media ownership and certain farming activities. Foreigners are also prohibited from carrying on other ‘national interest’ and similar businesses without government approval. These ‘list two’ businesses include weapons production, domestic transportation and domestic airlines, mining, and Thai arts and cultural activities. Finally, and of greatest impact in practice, according to the lawyers, foreigners are prohibited from carrying on various other businesses without official permission. These so-called ‘list three’ businesses include accounting, legal and other professional services; advertising businesses; many construction and engineering services; retail and wholesale businesses, with some exemptions; hotel ownership; and other service businesses. The government’s plan is to change the act, and draft proposals are working their way through the legal system. “It is not clear when these changes may come into force, though it is likely to take several months. Neither is it clear what form they may finally take,” says Herbert Smith. “The current proposals have attracted significant criticism in Thailand and overseas, and there is scope for further changes during the legislative process.” The controversial element of the changes to emerge so far is that ‘foreigner’ will be redefined under the act. Currently, a foreigner is a foreign national, a foreign-registered company or a Thai company with majority foreign shareholding. Under the new proposals, this definition will be extended to include companies that are currently treated as Thai due to majority Thai share ownership but where foreign individuals or foreign companies have more than half of the voting rights by law, agreement or under the articles of association. Many foreign businesses have previously adopted such structures in order to be treated as Thai while maintaining effective foreign control of the business. This enabled them to carry on a business in list one, two or three without having to comply with the Foreign Business Act. “The effect of the proposed amendment will be to re-classify such companies as ‘foreign’ and therefore to bring them within the scope of the Foreign Business Act,” says Herbert Smith. “They will therefore become subject to all of the restrictions that apply under that Act.” Foreigners wishing to set up a new Thai business after the changes come into force will have no choice but to comply with the amended law. That is why worried observers have said that the revised law will deter new foreign investment. “There is concern that the extended scope of the Foreign Business Act will deter foreigners from investing in Thailand and will encourage them to look elsewhere,” says Herbert Smith. “It remains to be seen whether these fears are well-founded.”

Notification date
However, the lawyers point out that for businesses already operating in Thailand, the draft amendments contain important relief’s. Any such company that falls within the scope of the Foreign Business Act will have one year from the effective date of the act to notify the Ministry of Commerce of that fact and to apply for a certificate to continue trading. The criteria for getting a certificate are not yet known. But once a company gets one, those from list one or list two activities will have two years to restructure their shareholdings or voting rights in order to ensure full compliance with the law. Those engaged in list three activities will be allowed to continue to operate indefinitely, without any need to restructure, until the business is finally dissolved. Herbert Smith says that this ‘grandfathering’ arrangement could mean that businesses already operating in Thailand will be able to continue under corporate structures that will not be permitted to new market entrants, unless they apply for permission under the new laws. However, there’s not enough information to know yet, they add. The changes to the law also propose a redefinition of what types of business fall into the list three category. “Primarily, this is simply to remove certain businesses that are now regulated under other laws, but one very important change is to remove an exemption that previously applied to retail and wholesale businesses with capitalisation above prescribed levels,” says Herbert Smith. “All retail and wholesale businesses will now be included, irrespective of capitalisation.”

Maximum fine
Finally, the new proposals will significantly increase the fines that may be imposed on Thais and foreigners found to be in breach of the amended Act, including directors and shareholders who connive in the commission of offences or who do not prevent the commission of offences. The maximum fine will be raised to five million baht, which is around $140,000. Despite the legal changes, Prime Minister Surayud Chulanont, an army general, has been telling foreign businessmen and diplomats that the country welcomes foreign investment and businesses. He told a lunch organised by the Joint Foreign Chambers of Commerce in Thailand that changes to the Foreign Business Act and capital control measures were meant to strengthen transparency and good corporate governance within Thailand. He said the moves were just part of the government’s efforts to create a level-playing field and remove obstacles to foreign investment activities. While uncertainty always worries investors, Thailand’s underlying economic performance has remained strong. According to the latest edition of the Asian Development Bank’s Thailand Economic Monitor, the country’s GDP growth will remain at 4.5 percent in 2006, the same as in 2005. High export growth has greatly contributed to Thailand’s economic performance, even as domestic demand has remained depressed. Growth this year is expected to be 4.6 percent – a notch higher than 2006. Domestic demand is expected to perform better, but export growth will be held back by lower growth in the global economy and world trade.

Economic crisis
Looking back further, average GDP growth has fallen from the six percent levels achieved in the years between 2002 and 2004. “This is in part because the easy gains from utilisation of post-crisis excess capacity are over,” says Kazi Matin, World Bank Lead Economist for Southeast Asia – referring to the country’s 1997 economic crisis. “Higher growth can now come mainly from efficient adjustment to high oil prices, higher private investment to expand capacity,” he added. “As a middle income country, Thailand’s growth must come more and more from more rapid productivity growth, and for that the firms have to innovate products and processes, the workers have to acquire more skills to compete with labour in China, Vietnam, India and other competitors producing technology intensive goods, and the government has to urgently support these initiatives of firms and workers through policies and investments.” Thailand needs to focus on supply-side reforms to promote private investment and higher productivity growth and several measures can be taken quickly with good effect, he says. Reducing regulatory burden is one and this could include rationalisation of price controls, clarification of foreign ownership rules, speeding up customs processing, and so on. Renegotiating a US trade deal that is about to expire and signing a treaty with Japan are two steps that would help to sustain strong export growth. Similarly, supporting improvements in secondary education, and vocational training including English language and IT skills and promoting greater private participation in education service delivery can relax skill-constraints that companies have said are holding back investment and productivity growth. Also, actions to improve infrastructure services could reduce costs and raise rates of return to private investment. Can all that be achieved? Despite the recent crisis, “Thailand’s strengths in terms of sustained macro-stability and increasing openness remain,” says Dr Kirida Bhaopichitr, country economist and author of the Thai Economic Monitor. The fiscal situation remains strong, with the government running a balanced budget this year and a slight deficit next year,” he said. Public debt as a share of GDP is 41 percent and is projected to remain below 50 percent over the next five years. Dr Bhaopichitr also said that Thailand’s external vulnerability is low – with a current account in surplus and pre-coup foreign reserves standing at $59bn. Also, total external debt is around 28 percent of GDP, one of the lowest levels in the region. A military coup is hardly the sort of event to settle investors’ nerves, but Dr Bhaopichitr says that “political uncertainty has diminished” since the interim government was established in October. “Nevertheless, both consumers and investors are waiting to see the policy direction of the interim government.” 

Mixing outsourcing with corporate governance

These are challenging times for the outsourcing industry. The mega-deals of the 1990s seem to be gone forever. And while companies are outsourcing like never before, they are giving out smaller contracts, for shorter time periods. That means service providers are having to fight tooth and claw for business, while developing new strategies to ensure that they have business models that will carry them successfully into the future.

The back end of 2006 was the worst fourth quarter for new outsourcing business in the last five years. True, there was a record number of contracts agreed in the year as a total – 350 compared to 341 the year before, according to the regular index produced by outsourcing advisory firm TPI. But the value of new contracts on the market fell by eight percent in the fourth quarter.

That is in part due to an underlying trend highlighted by the index. Companies are assigning shorter and smaller contracts, combined with more specialist and single process deals. “Outsourcing providers are obliged to compete more often in order to secure the same level of business,” says Duncan Aitchison, Managing Director of TPI in the EMEA and Asia-Pacific region.

At the same time, competition has been heightened with more providers competing for market share. The number of providers winning contracts has increased by 64% in the last four years, from 55 in 2002 to 90 in 2006. The Big Six of outsourcing (Accenture, ACS, CSC, EDS, HP and IBM) are winning a decreasing proportion of those deals valued at over $50m and their share of market globally by total contract value has fallen from 71 percent in 2002 to 46 percent in 2006.

“In general terms, this increased competition is clearly good for buyers,” says Aitchison “However, greater diversity and specialisation amongst suppliers, combined with more frequent tendering, does mean more complexity in both the procurement process and the management of outsourcing contracts.”

Specialist deals
Those service providers head-quartered in India, such as Wipro, Tata, and Infosys are reaping the benefits of the trend towards single-process and specialist deals. These providers, alongside the Big Five in Europe as well as other smaller and niche providers, are encroaching upon the Big Six’s market share. In 2006, the India-based providers achieved seven percent of the total market share. This is a massive increase compared with their 2002 market share of less than half a percentage point.

The India-based service providers are particularly successful in the Applications Development and Maintenance (ADM) sector, having grown their market share from 8% in 2003 to 36 percent in 2006. In contrast, the Big Six have seen a decline from 76% of the ADM market in 2003 to just 38 percent in 2006.

“The figures clearly show a maturing of the India-based service providers, as they challenge the established players by taking an incremental approach and signing a large number of small, specialist contracts,” says Aitchison. “In the ADM space, for example, the difference between the market shares of these groups is now marginal. India-based providers are clearly considered an attractive and credible alternative to traditional players and over the next few years we expect to see them competing directly with the Big Six for larger value contracts.”

Despite the overall decline in new outsourcing contracts, demand in a number of individual industries is going from strength to strength. In Europe, the financial services sector represents an increasing proportion of the overall market, with both the volume and value of contracts let in 2006 up 26 percent and 20 percent respectively on 2005 levels. The European telecoms industry is also experiencing significant growth, with its share of the total European market increasing from 14 percent in 2005 to 21 percent in 2006.

These figures support the argument in a new book from management consultants Booz Allen Hamilton that the outsourcing industry is entering a transitional period. The most sophisticated suppliers and customers are shaping the structure of the business-to-business service environment worldwide, according to Managing Business without Borders. The book highlights the speed at which the outsourcing industry has evolved and makes some forecasts about future corporate outsourcing strategies and service provider solutions. “Every business will eventually be plugged into a network of interoperable, interwoven processes, and tapping this network will be an absolute requirement for success,” the consultants say.

Leading outsourcing players are globalising their operations, which is in turn eroding the distinctions between Western and offshore vendors, such as capabilities and pricing, the argument runs. Like their clients, providers have expanded beyond India, China and the Philippines to make the most of international diversity, balancing the capabilities, languages, cultural affinities and cost structures of a variety of regions. And just as multinational companies are developing standardised processes and systems globally, outsourcing leaders are adapting to meet these emerging needs.

“In place of the mega deals of the 1990s, today’s service providers are building robust, highly tailored offerings that deliver economic, strategic, operational and human resource benefits,” says Booz Allen. “The menu of sophisticated end-to-end services continues to expand in human resources, finance, and procurement, along with clinical trials, research and analytics, advanced customer care, product development and innovation.”

Many providers are also differentiating their offerings by standardising business processes within industries to meet customer demands for cost savings, as they will no longer pay a premium for custom-built processes. The consultants says that the firms most likely to prevail are the large, full-service vendors that work on a global scale with multinational clients and immense resources, as well as the specialist firms that serve niche markets, like animation production houses for media companies.

Even so, there are a number of challenges that will continue to inhibit the industry. Among them are the need to demonstrate credibility and reliability, particularly for knowledge-centric work, ample security safeguards and a clear labour sourcing strategy, along with global training and workforce management programmes.

“Outsourcing any business activity is still not a guaranteed safe choice, but companies that do it right can capture significant value,” says Vinay Couto, Vice President of Booz Allen Hamilton and leader of the firm’s work in outsourcing advisory services.

“We have seen the industry’s growth attract new entrants with exciting new business models forcing established suppliers to revitalise the strategies that made them so successful.  Corporate customers are more enthusiastic and aggressive in expanding their outsourcing strategies, as they navigate this constantly evolving landscape,” he adds.

The book suggests that an evolving set of skills is coalescing into a body of best practices as the industry matures. It argues that certain key trends will shape the future of successful service delivery.

The globalisation of operations, for example, will erode distinctions between Western and offshore vendors, such as capabilities and pricing. The increasing sophistication of the contracts that companies are assigning will lead more service providers to differentiate their offerings by standardising business processes within industries to meet customer demands for cost savings, as they will no longer pay a premium for custom-built processes.

The need for interoperable, commoditised services will drive further standardisation, which in turn will give rise to a more accessible market.  In the future, instead of committing to a five- or ten-year agreement, companies will be able to plug into services for short-term needs.  But for this to happen, vendors will need to build capabilities around a common set of standards.

As for the companies buying outsourced service, the book identifies five key factors that help firms to get outsourcing right.  First, they should commit from the top and move quickly. Outsourcing requires explicit resolve from senior management, and the most successful programs are enacted quickly. “Aside from the operational and cost virtues, executing swiftly and deliberately sends an unmistakable message of resolve,” say the consultants. As one executive quoted in the book argues: “The biggest risk of all is indecision. Know what your strategy is as an organisation, align with it, know what you’re accountable for delivering, and then make some decisions and move forward.”

Compelling rationale
Second is to have a clear understanding of why you’re engaging in outsourcing and to articulate those reasons clearly.  The decision to outsource must have a compelling business rationale, be it cost reductions, optimised processes, better service levels or innovation, and those priorities must be kept in mind in evaluating options. Equally critical, outsourcing decisions should be based on a business case that is built on hard analysis. “Getting that baseline straight was a very intense and very important effort,” says Kris Hillstrand, chief information officer and senior vice president of business operations, at energy company TXU, who is quoted in the book.

Third is to be a partner, not just a customer.  Executives who reap the most benefit from their outsourcing arrangements have built relationships of mutual trust with their vendors. “Enlightened companies have figured out the right balance between rigor and flexibility so that they don’t micromanage and at the same time they don’t ‘turn over the keys’ to the outsourcer,” says Ashok Divakaran, principal at Booz Allen. He added that these companies rely on clearly defined decision rights from the executive level down to day-to-day users of the service.

Fourth is to embrace complexity and learn to manage it. Outsourcing used to represent a fairly limited menu of options, but complexity has crept in, in terms of the number of vendors, the number of countries from which they can deliver services, delivery models (onshore, nearshore, offshore), scope of offerings and variety of contractual models. “You have significantly less control than you would have with people reporting directly to you and salary management control, performance reviews, and other tools at your disposal,” according to Filippo Passerini, chief information and global services officer at Procter & Gamble, where he oversees $4.1bn in outsourced services. “This new model is more challenging, and more demanding to manage, but it is significantly better for our business.”

The final factor identified by Booz Hamilton is to be a visionary. “As outsourcing becomes more strategic, so too must the role of business leaders who control IT and business process outsourcing,” they argue. “The new generation of outsourcing leaders is always thinking beyond the boundaries of their own function, and in some cases, even beyond the boundaries of existing market capabilities.”

One consequence of this transition is that companies need to work harder than ever before to ensure their outsourcing arrangements are debated at board level: this is now a strategic governance issue. Smart companies have risen to this challenge. “They are looking beyond service levels or generic guidelines and want details on the best ways to achieve and demonstrate value to their business,” says Shawn McCray, partner and practice leader for service management and governance at TPI. “If client organizations get outsourcing governance ‘right,’ they exponentially increase the value they realise through outsourcing,” says McCray. “If organisations get it ‘wrong,’ the risks are high and there is a downward spiral of poor results.” Ultimately, he says, the costs of poor performance in governance are significantly higher.

Finding FDI hot-spots

After a depressingly dismal spell, a spectacular return to corporate deal making last year gave a knock-on boost to global foreign direct investment levels. The outlook is good for this year too, with another big increase expected, although some countries are set to benefit far more than others. Foreign direct investment (FDI) inflows surged ahead in 2006, clocking up the third consecutive annual increase, according to figures produced by the United Nations. The total for 2006 was $1.2trn, a 34 percent increase on 2005, and just a few deals shy of the record $1.4trn set in 2000. The rapid rise in FDI flows largely reflects high economic growth and strong economic performance in many parts of the world, according to the United Nations Conference on Trade and Development (UNCTAD), which calculates the figures. Such growth has occurred in both developed and developing countries. Increased corporate profits and resulting higher stock prices have boosted the value of the cross-border mergers and acquisitions (M&As) that constitute a large share of FDI flows. UNCTAD said continued liberalisation of investment policies and trade regimes gave FDI levels a further kick. But there are warning signs, too. In some African and Latin America countries there were notable changes in economic policy towards a greater role for the state, says UNCTAD, as well as changes in policies that directly concern foreign investors or industries, in particular the natural resources industry. These are likely to depress FDI growth.

Recovered position
FDI performance has varied greatly among regions and countries. Investment in developed countries rose by 48 percent last year, well over the levels of the previous two years, and reached $800bn. The US recovered its position as the largest single host country for FDI in the world, overtaking the UK, the top FDI recipient in 2005. The European Union (EU) as a whole continued to be the largest host region, accounting for 45 percent of total FDI inflows in 2006. But UNCTAD warned that several risks for the world economy – most of them not new – may have implications for FDI to and from developed countries. Global current-account imbalances have widened dramatically and could cause abrupt exchange-rate shifts. High and volatile oil prices have caused inflationary pressures, and a possible tightening of financial market conditions can’t be ruled out. High fiscal deficits in Europe, in combination with rising interest rates, could lead to tax and wage pressures. “All these considerations underline the need for caution in assessing future FDI prospects for developed countries,” it said. For now, these countries are doing well. FDI inflows to developing countries and economies in transition – which comprises south-east Europe and the Commonwealth of Independent States – rose by 10 percent and 56 percent, respectively, in 2006. Those are both record levels. In Africa, FDI inflows in 2006 exceeded their previous record level of 2005. “High prices and buoyant global demand for commodities were once again a key factor,” says UNCTAD, “particularly in the oil industry, which attracted investment not only from developed countries but also from some developing countries.” Cross-border M&As in the extraction and related service industries of Africa tripled in the first half of 2006, as compared to the same period in 2005. However, UNCTAD warned that, “the regional FDI picture is not uniformly bright across sectors, countries and sub-regions.” Most of the inflows are concentrated in the West, North and Central African sub-regions. “Inflows will continue to be small in low-income economies lacking natural resources,” it said. FDI inflows to Latin America and the Caribbean slowed in 2006. Mexico and Brazil, in that order, remained the largest recipient countries with inflows remaining virtually at the same level in Mexico and increasing by six percent in Brazil, in spite of a fall in cross-border M&As. FDI inflows to Chile increased by 48 percent due to a continued rise in reinvested earnings resulting from windfall benefits from mining. FDI inflows to Colombia and Argentina decreased by 52 percent and 30 percent, respectively, because of a decrease in cross-boarder M&As.

Additional changes
In the Andean countries, growing demand for commodities and resulting higher prices propelled changes in policy in the direction of more control by the state. That resulted in less favourable fiscal regimes for investors in such countries as Bolivia, Ecuador, and Venezuela. The possibility of additional regulatory changes and of their extension to more countries may have raised uncertainty among investors in the primary sector, resulting in the decrease in FDI flows to the region. In addition, high commodity prices and resulting improvements in current-account balances have led to an appreciation of the value of many countries’ currencies. That could affect prospects for FDI in export-oriented manufacturing, said UNCTAD. FDI inflows to South, East and South-East Asia, and Oceania maintained their upward trend in 2006, reaching a new high of $187bn, an increase of 13 percent over 2005. Investments in high-tech industries by trans-national corporations (TNCs) are growing rapidly, particularly in China. Meanwhile, other countries, including India, are attracting increasing FDI for traditional manufacturing. At the sub-regional level, a shift continues in favour of South and South-East Asia. China, Hong Kong and Singapore retained their positions as the three largest recipients of FDI in the region. India surpassed the Republic of Korea and became the fourth largest recipient. Outward FDI from the region surged with China consolidating its position as an important source of FDI. India is rapidly catching up, with 2006 FDI outflows almost doubling. China and India are challenging the dominance of Asia’s newly industrializing economies as the main sources of FDI in the developing world. In West Asia, FDI flows, both inward and outward, maintained their upward trend in 2006. Turkey and oil-rich Gulf States continued to attract most FDI inflows, accounting for a record level in 2006 in spite of geopolitical uncertainty in parts of the region. Energy-related manufacturing and services were the most targeted industries. FDI outflows from the region increased, mainly from the Gulf countries led by the United Arab Emirates. Cross-border M&As, particularly by state-owned enterprises, continued to be the main mode of outward FDI. Such outflows are increasingly taking place in energy-related activities, supported by the region’s tightening ties with China and India and other economies in Asia and Africa.

After a minuscule increase in 2005, FDI inflows to the 19 countries of South-East Europe and the CIS expanded significantly in 2006, the sixth year of uninterrupted growth of FDI in the region. The Russian Federation, the region’s largest host country, experienced a mini-boom, with inflows almost doubling. UNCTAD says that FDI is likely to be particularly buoyant in the countries that joined the EU on January 1, 2007 – Bulgaria and Romania – and in the large economies such as the Russian Federation and Ukraine. FDI prospects for the Russian Federation are, however, affected by the impact of tightening Russian natural resource regulations and by disputes that emerged in 2006 over environmental protection and extraction cost, such as those involving two major oil development projects in Sakhalin. “It is uncertain whether large increases in such sectors as chemicals and petrochemicals, services, and real estate – categories where investor confidence is currently high – could fully compensate for a possible slowdown of oil-related FDI,” said UNCTAD.

One of the most significant developments in FDI over the past two or three years has involved natural resources and related industries. Despite some bad news for foreign investors in such industries, high demand for natural resources – and, as a result, the opening up of new potentially profitable opportunities in the primary sector, such as gas and oil development in Algeria – are likely to attract further FDI to the extractive industries. Economic growth in 2007 is projected to slow moderately. Continuing global external imbalances, sharp exchange rate fluctuations, rising interest rates, and increasing inflationary pressures, as well as high and volatile commodity prices, pose risks that may also hinder global FDI flows. Combined, those factors “could lead to a slowdown in the fast growth in global FDI registered over the past few years,” UNCTAD believes.

Tough on corruption?

The UK’s reputation for cracking down on bribery and corruption has taken a battering in recent months. The decision to halt a police investigation into allegations that defence company BAE Systems bribed officials in Saudi Arabia to secure a lucrative contract provoked international outrage. Now the government has reneged on a promise to introduce new anti-corruption laws this year.          

The Serious Fraud Office (SFO) stopped the Saudi part of its BAE investigation in December after the Attorney General, Lord Goldsmith, advised that, if continued, it would threaten national and international security. The SFO is still investigating other allegations against BAE involving South Africa, Tanzania and the Czech Republic. The company denies any wrongdoing.

Lord Goldsmith didn’t elaborate on the nature of the security threats created by the Saudi probe, but stressed that commercial or national economic interests had nothing to do with the decision.

If such factors had been taken into account, the government would have fallen foul of section five of the OECD Convention on Combating Bribery of Foreign Public Officials. The convention, introduced in 1997, is part of an effort to get countries around the world to enact anti-bribery and corruption legislation similar to the US Foreign Corrupt Practices Act. The United Nations has produced a similar Convention Against Corruption for countries not in the OECD.

Laurence Cockroft, UK head of anti-corruption lobby group Transparency International, describes the BAE decision as ‘a huge setback’ in efforts to get governments to tackle bribe-paying companies. Despite what the government says, the block on the enquiry has been seen around the world as an act of political expediency, he says, creating the impression that “the guys with the big bucks, in this case the Saudis, can call the shots.”

In a letter to the head of the OECD, the group said the decision to stop the Saudi investigation “poses the most serious threat to the success of the OECD Convention since it was adopted. The credibility of the UK Government commitment to prohibit foreign bribery must be rebuilt, in order to restore the collective commitment on which the success of OECD Convention depends.”

Transparency International now wants the government to make BAE publish a statement clarifying the business practices it has in place to prevent bribery and corruption, and what steps it takes to ensure compliance is independently verified. “It is essential to clear the air for future international transactions,” the group said.

Like many other countries around the world, the UK has done little to enforce the OECD convention. According to a Transparency International monitoring report, the UK has not brought a single prosecution for bribery of overseas officials. The group’s latest report – for 2006 – found no prosecutions in Australia or Japan and only one in Canada. But other countries are starting to become more active. France prosecuted eight cases in 2005, with three in Germany and three in Belgium.

Annoyed at the BAE decision, the OECD has decided to launch an inquiry into the UK’s efforts to fight bribery.
Its working group on bribery and corruption, which brings together all 36 countries that have signed and ratified its convention, said in a recent statement that the UK had made some progress, but not enough. The government has made efforts to raise awareness of the issue, but has repeatedly failed to enact modern foreign bribery legislation. The Working Group said it was ‘seriously concerned’ that the UK hadn’t implemented legal changes requested by the OECD. In addition, UK law on the liability of legal persons remains deficient and the Working Group reaffirmed that it should be modified. 
In 2005, the Working Group recommended that the UK monitor decisions not to open or close foreign bribery investigations.

Remaining vigilant
Ironically, before the Al Yamamah decision caused such a furore, the UK had shown signs of raising its game. In December 2005 the Home Office set out proposals to reform the law on bribery, at home and abroad. “Although the crime of bribery remains relatively rare in the UK, it is vital that we, through our actions and principles, remain vigilant and promote high standards of propriety at home and abroad,” Home Office Minister Fiona Mactaggart said at the time.

Ms Mactaggart noted that in 2001 the government gave courts the power to investigate overseas, but said the existing criminal offences stem from the common law and the Prevention of Corruption Acts 1889-1916 and are widely considered to be fragmented, outdated and unclear. They are not used often, and a lack of clarity in legal definition can lead to acquittals on technicalities. The government wants to ensure that UK nationals and companies do not contribute to bribery in other countries, and clarifying the law will make investigating corrupt activity easier, she said, adding: “The existing law is complex and outdated, and can be difficult for law enforcers to use. I want to make the law clearer for all concerned.”

There were further positive steps six months later when Prime Minister Tony Blair unveiled new measures to tackle international corruption. He appointed Hilary Benn, the International Development Secretary, to be the ‘ministerial champion for addressing international corruption.’ This new role would see him “working with other Ministers across government to tackle corruption wherever it threatens to undermine the fight against poverty.”

At the same time, Blair said the government would establish a new team to investigate international corruption, including money laundering in the UK by corrupt politicians from developing countries, and bribery by UK businesses overseas. This would include members from the City of London Police and the Metropolitan Police Service, funded by the Department for International Development. “The UK has a responsibility to tackle money laundering and bribery where it stems from our own shores, and to support developing countries in fighting corruption,” said Blair. “We have to recognise that where there are bribe takers, there are also bribe givers. The new taskforce for investigating corruption will help to put the UK at the forefront of efforts to tackle international corruption in all its forms.”

But in March this year a vital part of these efforts – the legal reforms led by the Home Office – was postponed. After at least three years of consultation, the government said there was broad support for reform of the Prevention of Corruption Acts, and that it was committed to a fundamental reform of our bribery laws, but it would not push ahead with the draft Bill it published in 2003.

Home Secretary John Reid told the House of Commons there was ‘significant and influential opposition’ to the Bill and it was unsuitable for presentation to Parliament. The problem, he said, was a lack of agreement about what the new offences should look like. Instead, he asked the Law Commission to undertake a thorough review of the UK’s bribery laws “with a view to fundamental reform.” The Commission has already considered the issue at length, but Reid said that “the context of reform has moved on.” In particular, the Commission will take into account “the issues and views that have emerged” since the Bill was published, including “additional practical experience of UK law enforcers in operating the existing law and other countries’ experience of implementing international conventions in this area.”

Cockroft says the referral back to the Commission was ‘very bad news’ and ‘absolutely ridiculous.’ There is unlikely to be a new draft bill before the end of 2008. “They are going to be at least two years behind their own deadline, and this creates a lot of uncertainty.” Transparency International has contributed to a Private Member’s Bill on corruption that Lord Chidgey has introduced to Parliament. This defines the necessary offences perfectly well, says Cockroft. And while some countries might be slack to prosecute overseas bribery and corruption, the US has prosecuted over 100 cases over the last two year. Cockroft, and other campaigners, says the UK needs to show that it is still committed to fighting overseas corruption. He wants so see accelerated legal reform but, more importantly, some prosecutions. Otherwise, the UK risks not only damaging its own anti-corruption goals, but also undermining the efforts of countries that are starting to take the issue more seriously.

The halting of the Saudi probe is frustrating for anti-bribery campaigners because it comes at a time when other EU countries have started to pursue high-profile investigations. In Germany, engineering giant Siemens is embroiled in claims that staff paid bribes to win contracts. In France, the authorities have become much more active, encouraged by the successful prosecution of two senior employees from oil company Elf Aquitaine, including its CEO, who were sent to prison for paying bribes to win overseas contracts.

Such activity seems long overdue. It’s now 10 years since the OECD published its Convention, and all of its member nations are committed to implementing its measures. But, to date, most have done little. Since 2005, Transparency International has published a progress report on enforcement of the Convention. Last year it had little activity to report. France had prosecuted eight cases, with three in Germany and three in Belgium. But Italy only had one, and the UK had none at all. The situation was worse in the Czech Republic, where the authorities had brought no prosecutions and hadn’t even started any investigations.

Other countries have shown what can be done. A week after it chastised the UK for its inaction, the OECD praised Norway for the progress it has made towards implementing the convention. It published a report commending the country’s ‘impressive effort’ and said Norway had satisfactorily implemented all of the OECDs recommendations.

The country has raised awareness and improved corruption detection measures. It has also brought two successful prosecutions involving the bribery of foreign public officials. In the first case, the defendant company and an executive of the company were fined €2.4m and €24,000 respectively. In the second case, three defendants were convicted of violating bribery laws and sentenced to imprisonment for periods of between ninety days conditional and 14 months (of which four months were conditional).

Corruption team
Norway has also taken significant steps to enhance the institutional framework for investigating and prosecuting cases of corruption. For instance, the Corruption Team at the Norwegian National Authority for Investigation and Prosecution of Economic and Environmental Crime has been permanently assigned a police solicitor, and all local police districts have established multi-disciplinary economic crime sections, which will be closely monitored by the Ministry of Justice, Police Directorate and Prosecution Service.

Other measures include the production of a manual by the corruption team, for publication in 2007, on the detection, investigation and prosecution of corruption cases. There has also been a heightened focus on the confiscation of the proceeds of crime, reflected in a significant increase in the number of confiscation orders. If international efforts to tackle bribery and corruption are to succeed, more countries need to show the same kind of enthusiasm as Norway. The UK’s lame performance is so troubling to the OECD because it gives other laggard countries a further excuse to do nothing.