Month: May 2008

Expecting the unexpected risk

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Internal control has been a major bugbear for big companies lately. The Sarbanes-Oxley Act has forced anyone with a US listing to put hundreds of checks in place in an effort to guarantee that their financial statements are correct. Most have shoveled money into the problem. One argument is that much of this investment is wasted, and the compliance burden is too heavy. The implication is that regulators think internal controls are a good idea, but businesses don’t.

If that were the case, then those companies not forced to tighten up their controls by legislation or regulation wouldn’t be putting more of them in place. The fact is, they are. Three quarters of the companies are planning to invest more in internal control, according to a new survey by accountants Ernst & Young. The survey covers large businesses that do not come under the Sarbanes-Oxley rules. They are spending in this area because they see real business benefits, the accountants say.

“There is now widespread recognition that effective internal control directly impacts business performance in a number of areas,” says Adrian Godfrey, of Ernst & Young’s Risk Advisory Services. “What arises from the survey is that this is a highly dynamic area, with management exploring the ways that taking a more professional approach to internal control can contribute to driving competitive advantage.”

No surprises
One reason why companies are investing more in this area is that investors are calling for more transparency and ‘no surprises.’ They are fed up with companies restating their financial results or fouling up in an area that damages their reputation. Half the respondents in the survey said they were taking controls more seriously because it had a positive influence over investor confidence.

Other drivers for future investments were also business-benefit related, focusing mainly on enhancements to processes and the underlying control structure and on better understanding of major risk areas. These investments are most likely to be in key operational and business risk areas, and specifically in information technology controls.

One in four of the respondents said they were seeking to achieve better alignment of their internal controls to company strategy and the key risks they face. The same proportion were planning to invest in strengthening their company-level controls, such as activities conducted by senior management to set direction – such as policy and tone from the top.

Spending on controls might make investors feel more comfortable, but only if they believe those controls are actually going to make a difference. Many chief finance officers and heads of internal audit in the Ernst & Young survey admitted they still had ineffective controls. The biggest ‘blind spots’ related to over-expansion into international markets, post-acquisition integration, and real estate and construction projects. Controls over IT program change management and user access and security were also singled out as areas of concern.

Even in the area where companies say they are doing well – financial reporting controls – that confidence has to be doubted. In general, the majority of financial reporting activities were seen as areas over which most respondents felt that they had effective controls. Responses attesting that controls were either ‘very effective’ or ‘effective’ ranged from a high of 79 percent for revenue recognition, to 52 percent for contract accounting. However, in all cases, the proportion of respondents claiming that controls were ‘very effective’ was relatively small.

In areas that required a greater degree of judgment or specialist technical knowledge, such as tax and contract accounting, companies admitted to weaknesses or a lack of knowledge about the controls in those areas.

Controlling the situation
The areas where all the companies clearly felt a lot less confident in what they were doing were those relating to business and operational areas. Less than half the respondents said they had effective controls over situations such as expansion into new markets, and post-acquisition integration. These are clearly not trivial issues. Given that these activities are strategic in nature and therefore fundamental to business success, Ernst & Young say it is a worry that survey respondents query the effectiveness or, worse, are unaware of controls.

“This suggests a mismatch between risk priorities and the controls structures and accountabilities to support them,” their report says. “It is possible that capabilities and knowledge required to assess control in certain business areas may not be available to the functional area – likely to be internal audit – charged with this role and may reveal some ‘blind spots’ beyond the scope of controls professionals who are generally tasked with providing an opinion of the overall internal control environment.”

Companies were also performing badly in the information technology area. Again, a lack of relevant skills and knowledge contributed to poor levels of control. The survey found that critical issues such as user access and security – where 39 percent believed their controls to be less than effective and nine percent did not know or failed to answer the question – were a source of potentially major risk for all businesses.

“The criticality of information technology systems across the business and the considerable investments required in information technology are obvious drivers of the need to make sure that controls are effective,” the report said. “The results of the survey show that there is a pressing need to assess risk and establish greater control in these areas and to make sure that once established, control is maintained, particularly given the role that effective information technology plays in improving processes and efficiencies.”

The last big problem area was fraud. Nearly three quarters of the companies in the survey did not have a formal fraud prevention programme in place. That contrasts with the fact that over a third said such a programme was important or very important. In that case, why haven’t they got one? This is a particularly worrying finding given the growth in corporate fraud over the last few years and the reputational havoc a fraud can inflict on a company, even if the amount of money involved is small. These organisations really ought to be looking for ways to make anti-fraud measures more comprehensive and integral to their operations.

Risk and control
Though there is obviously an awareness of the need to invest further in controls in many of these areas, it is critical that senior management take as broad a ‘risk and control’ view as possible of all the business and operational functions that have an impact on bottom-line performance, say Ernst & Young.

The survey showed that executives felt there was ‘significant scope for improvement’ in just about every category of internal control. More worrying still was the high level of respondents who replied ‘don’t know’ to the questions about how well their controls were working.

“If the ‘control professionals’ are saying they don’t know what is going on, that’s a major concern for the board and other stakeholders in the business,” says Mr Godfrey. He adds that many companies acknowledged the danger of these blind spots. They were planning to invest in these areas over the next year.

There is no point having controls in place if nobody checks to see if they are working. Most respondents had a good approach to this. They monitored controls in a balanced way, making survey’s that covered strategic, compliance, operational and financial reporting areas. But a significant number are getting it wrong: one in five said they only monitored the controls that made sure their published financial statements were correct.

“This imbalance could mean that controls over some major operational risks may not be receiving any real scrutiny,” says Mr Godfrey. Some companies seem unclear about just what they are doing in this area. The survey suggests that the perception of the status of internal control varies depending on who you ask. While 36 percent of CFOs responding to the survey said that their risk assessment covers operational and business areas, only 19 percent of heads of internal audit believed that these risk areas are assessed in their companies.

That overlap needs urgent attention. “CFOs are beginning to ask questions about where to take the controls agenda wider than compliance,” says Inge Boets, global business risk services leader for Ernst & Young. “The answer is to shift the balance between financial controls and wider business and operational controls.”

Internal infrastructure
There are significant benefits for the companies that can tackle this, she says. “Establishing an internal control infrastructure that effectively covers all parts of the organisation will mitigate the risks in areas that are currently overlooked or underestimated, and this will deliver major business benefits. Businesses need to ask whether they have an agenda for internal control within their organisation, as the ultimate prize from effective controls is not simply a compliant business, it is a better business.”

Of course, it’s no surprise that a firm like Ernst & Young is banging the drum about internal control. Like its fellow Big Four accounting firms, the introduction of the Sarbanes-Oxley Act has generated a huge amount of fee income. Every time a company puts a control in place, it creates a box that has to be ticked, and a role for someone to come along afterwards and check that the box has been ticked. If some companies are struggling to make sure they have all the controls they need, or they simply don’t know what they should be doing, then Ernst & Young will, no doubt, be happy to advise. And the fact that this latest survey shows that the drive to set up internal controls to cover just about every risk has become deep-rooted in a whole range of businesses – not just those affected by Sarbanes-Oxley – will suit the firm just fine.

However, that shouldn’t cloud the issue. It is true that more and more companies are investing heavily in this area. Partly, they are doing it to keep their regulators happy; partly, they are doing it as a way of showing investors how well managed they are.

There must be a question mark about the reality that underpins that second point. People who work in this area usually say that when they try to talk to investors about control and risk management they meet a wall of silence. Nobody is interested. Perhaps they are now listening more closely, as this survey suggests. But are they questioning companies about what they are really doing to improve control, or are they just nodding politely while the finance director makes vague statements about his embedded enterprise risk architecture?

Another problem is this: You can throw as much money at this area as you like, and have a control to match every conceivable risk. But the risks that are likely to do the most damage are often the ones nobody ever thought of; there’s nothing much you can do about those.

Identity crisis

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Identity theft is a growing, global menace. The use of stolen personal information to fraudulently order goods or obtain credit is the fastest growing crime in the US, according to the Federal Bureau of Investigation. In the UK, four out of 10 people say they have fallen victim to identity theft. Banks and credit card companies often reimburse defrauded customers, but the personal inconvenience of getting cards cancelled and reissued is enormous. And it can be harder to apply for legitimate loans or credit in future. But identity theft is not only a pain for private individuals. Companies are, increasingly, finding that their identities are being stolen or that, in more sophisticated cases, they are being cleverly impersonated. Corporate identity theft happens when fraudsters steal the identity of a legitimate company and then trade under its credit and name. It can affect companies through assets being stolen and bank accounts emptied by fraudsters trading on the company’s creditworthiness, for example.

Highlighted
In an increasingly globalised business environment, the crime often has an international dimension, regardless of where the target company is based. In one typical case highlighted by police in the UK, for example, companies in France, Spain, Germany, Portugal and Austria received orders for computer parts and spares from a UK business called PC Specialist. Those that checked the company’s background would have found that it had a good credit rating and trading history. The orders asked the goods to be delivered to an address in London, with invoices sent to the company’s head office, which was in a different part of the country. The orders carried the official PC Specialist logo, and logos from National Westminster and Halifax banks. But they were fraudulent. PC Specialist was a legitimate company, but criminals had stolen its identity. Such corporate identity theft is one of the fastest growing risks businesses face and will cost UK companies £700m a year by 2020, an increase of 1,300 percent on current levels, according to leading commercial insurer Royal & SunAlliance (R&SA). The insurer says that large businesses with over 250 employees will pick up the biggest share of costs. The sectors most likely to be affected are communications, banking, finance and insurance. “Companies are increasingly being affected by corporate identity theft and many are worried about the risks of fraudsters stealing their company identity, as this could lead to a loss of competitive advantage or public confidence,” says Jon Woodman, director of risk solutions at R&SA.

A case like PC Specialist relies on a few faked logos, but in more advanced identity frauds the criminals will actually change the target company’s registered details. In the UK, these are held at Companies House, a government agency. Of the 500,000 documents filed here each month, only about 50 are identified as false, but the Metropolitan Police estimate that each false filing can result in a £1m fraud. “The trick appears to be gaining control of a company and its assets as far as third parties are concerned,” says Ian Manson of Digita, an accountancy software firm. A Digita report on identity theft, called ‘Keeping the Record Straight,’ highlights some examples. In one case, fraudsters stole a company’s identity and used it to sell off an office block that it owned in Moscow. “The true owners only found out it was no longer in their possession when they were barred from entering it,” says Mr Manson. In another case, the proprietor of a family owned business found that its registered office had been changed from the address where it had been for over 100 years. To add an extra veneer of fraudulent credibility, the criminals had even stolen the company’s nameplate from the front of its building.

Credible
Other frauds include setting up bogus companies, falsely manufacturing accounts and even stealing the identity of auditors to ensure that these accounts appear to be credible. Mr Manson says that nine audit firms have had their details appropriated to legitimise a false set of accounts over the last nine months. “Another 100 sets of accounts have been set up using completely fictitious auditor details over the same period,” he adds. Prosecutors have scored some limited wins against identity fraudsters. In one recent case a disgraced Russian bank chief was jailed for six years after being found guilty of running an international identity theft gang. The sophisticated operation saw tens of thousands of British, American and Spanish account holders defrauded out of millions of pounds. Police believe the internet-based scam lasted a decade. The criminals used compromised credit cards to buy large numbers of electrical goods that they then sold on eBay, the online auction site. They also used the money for gambling on sports and to set up fake merchant accounts. They created large numbers of false documents and even a bogus legal firm to help generate numerous fictitious identities. Hundreds of bank accounts were then opened in those names for the huge amounts of illicit cash flooding in. At the heart of the scam was Anton Dolgov, the former head of the ill-fated Moscow City Bank, which collapsed in 1994 with debts of up to $120m. As the ‘general manager’ of the operation, he is thought to have a huge fortune stashed in secret Russian bank accounts waiting for him when he finally emerges from prison, according to press reports. Mr Dolgov admitted conspiracies to defraud, to obtain services by deception, to acquire and use and possess criminal property. The FBI is also trying to crack down on international identity theft. It recently targeted one operation that involved the trading of social security numbers, the sale of stolen credit card account information, and phishing, the practice of using email to trick consumers into handing over personal information. The Washington Post reported that an investigation called Operation Cardkeeper had led to the arrests of more than a dozen people in the US and other countries, all of whom are alleged members of online communities that specialize in ‘carding,’ the trafficking of stolen identities and credit card and bank account information. “We are sharing evidence and using sophisticated techniques like never before,” said James Finch, assistant director of the FBI’s Cyber Division. “Cyber criminals will no longer be able to hide behind borders to conduct their illicit business.”

Mutually approved
Combating corporate identity fraud is more difficult. In the UK, Companies House – the official repository for corporate documents – has created an online filing scheme, called PROOF, where only mutually approved documents are registered. It has also launched a monitoring service that lets a company know each time a change of record has been made. There has also been a legislative crackdown. Under a new Companies Act it is an offence for a person to knowingly or recklessly deliver or cause to be delivered (to Companies House) a document that is misleading, false or deceptive in a material particular. Those convicted face up to two years imprisonment, or a fine, or both. “If every company were to opt in to the PROOF scheme tomorrow, and of course guard their company authentication codes as carefully as they guard their bank account PIN numbers, then the phenomenon of company hijacking would almost certainly disappear overnight,” says Mr Manson. But fraudsters are innovative people, and other identity frauds might prove harder to guard against. City of London police warned recently of a new identity con that exploits the international nature of business. Here, criminals are hi-jacking corporate identities with a view to compromising their bank accounts and transferring money overseas. These attacks have been aimed at foreign-based companies, which usually have a representative office in the UK, and have existing accounts with a UK bank. The intended victim will also usually have a ‘faxed indemnity’ arrangement in place with the bank. Popular targets have been foreign airlines, banking institutions and even embassies. The fraud works like this. The criminals contact the relationship manager at the UK bank, purporting to be the genuine client and informing them that they are changing their contact details, usually giving the excuse that a temporary move of office is necessary due to refurbishment. They will then give the relationship manager their new telephone and fax number, and occasionally an email address. These telephone numbers are generally arranged in advance, via the internet, and are able to be diverted to mobiles and ‘fax to e-mail’ facilities. The criminals will then ask for confirmation from the bank, acknowledging the new details, and this will provide them with a headed, signed fax from the bank, which they can copy and manipulate for future use against the intended victim.

New contact details
At the same time, the criminals will also make contact with the finance director, or equivalent, of the targeted company purporting to be the relationship manager of the UK bank. They will provide the same, new telephone and fax contact numbers to the company using the excuse that the bank is experiencing computer problems or their records need updating. Again, they will request confirmation from the company acknowledging the new contact details, and a headed, signed fax will be forwarded to the criminals, which they can then use in their correspondence with the bank. Once these steps have been taken, the criminals are then effectively in control of the direct line of communication between the bank and its client. The criminals then do one of two things. They either request that a new account be opened with the UK bank and the company’s existing overdraft facility be extended to this account, or they continue to forward any faxed indemnity transfer requests they receive from the victim to the bank as normal. After a short period of time, the criminals will then fax the bank a number of high-value transfer requests, from the existing or newly opened account, to recipient accounts, usually based in Japan or Pakistan, resulting in substantial losses to the victims. This kind of identity fraud requires a great deal of planning and research. “It is apparent that the criminals carry out ‘homework’ before making the approach to the bank and the intended victim,” says a police briefing note. “They usually know the management structure of the target company and will use the name of the relevant finance director or similar in their correspondence. They will also usually know the name of the relevant relationship manger at the bank, to whom they need to speak.” More companies will have to adapt their fraud controls to deal with this and other kinds of identity theft, says Simon Wallace of the Centre for Economic and Business Research. “We are on the cusp of a potential boom in corporate identity theft,” he believes. “With almost universal computer usage and internet coverage in the business environment, the potential for corporate identity theft is more significant than ever. Those willing to hack, scam and defraud will find new and technically advanced methods to open up the necessary loop holes and steal a firm’s identity.”

Offshoring 2.0

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Those same businesses realized that they could drive costs down still further by sending their outsourced work abroad. Low-skilled service jobs like telephone call centres, data input and in manufacturing, component assembly could be done at a fraction of the cost in countries like India or China. Some thought then that this was the high watermark of globalisation. But they are about to be proven very wrong. The truth is we have only just got started. There is a fundamental imbalance in the global economy; in the post-industrial nations, capital is cheap, but labour is expensive. Conversely, in the developing world, capital is scarce but labour is plentiful. Economically this would suggest the huge potential for mass immigration. Yet politically with today’s pressures on emerging multicultural societies, it is a total non-starter.

That’s why offshoring could be seen as the most acceptable route forward to politicians and businessmen who embrace globalisation. Thanks to the advances in low cost digital communications, the world economy is on the verge of Offshoring 2.0 – a revolutionary new paradigm in the way we do business. In the very near future, for small and medium size businesses, having partners in the Pacific Basin will no longer seem exotic, but the norm. Bookkeeping? Email your tax returns to a Chartered accountant in New Delhi. Need a long production run in a short period of time? Go to Southern China, the new workshop of the world. Even Governments are flirting with offshoring, contracting out exam marking to developing countries. It will be big business though who takes the lead. By some estimates, up to 40% of their currently outsourced jobs, could be next in line to be sent offshore. In 2003, just 3 – 4 % had been moved abroad. The lower ranks of the professional classes – lawyers, accountants, medical practitioners, computer programmers and even financial analysts – are next in the firing line. Are we all ready for this?

Certainly there will be losers. In his recent book, “Outsourcing the American Dream”, Christopher England argues that offshoring is a short-sighted way of making profits, while eliminating your most valuable asset, your employees. But the vast majority of us will be winners. The new jobs that are created tend to be higher paid and more interesting. 12 years ago, huge and successful companies like Google or Amazon did not exist. 12 years from now, there will be many others. The falling cost of manufactured goods like DVD players from China has enriched all living rooms, whilst call centres in India can reach us after work at home. The arrival of the digital age has massively reduced the costs of communication and this is pricing in three billion workers from the developing world. A recent report by the Association for Computing Machinery on globalization and offshoring of software stressed the mutual benefits to India and the USA in jobs and profits in increased trade.

Nor is this just a phenomenon of the Anglo-Saxon world. It’s a strange twist of fate that Senegal, who’s introduction to France was enforced slavery 600 years ago, now is the low cost location of choice for France’s call centre companies. Even Japanese companies have set up call centres in Northern China (where Japanese is spoken). Perhaps the biggest question is – where does it all end? One would have to speculate on what the industries of the future will be. Intellectual property, alternative energy, maybe even artificial intelligence. What we do know is that the global economy is almost certainly going to continue down the route of mass specialisation and the constant redivision of effort. Offshoring is just starting to open up huge opportunities. Tomorrow’s financiers will be very, very busy.

The world needs more private equity, not less

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After a record long period of low inflation and high profitability, the world economy is awash with cheap capital. One of the unforeseen consequences of this is that we have a new mainstream asset class to get excited about – private equity (PE). Some analysts looking to the near future, forecast a world where the typical portfolio contains a 5-15 percent weighting in private equity. But are they right, and just how did private equity rise so far and so fast and what is all the fuss about?

Before setting out the case for private equity, it’s worth understanding the uncomfortable truth that public markets aren’t quite as good as we think they are. Stock markets have four intractable problems; large numbers of inactive shareholders, large shareholdings by fund managers who value instant performance over long-term investment, rising compliance costs in corporate social responsibility, reporting and media activity and finally, ‘free cash flow dispersion.’

The last point is perhaps the most crucial of all. Back in 1986, Michael Jensen, now a Professor at Harvard Business School, theorised that the managers of public companies when generating more profits than they can reasonably invest in their industry, instead of returning the cash to shareholders, all too often hold on to the cash and diversify. These new investments are typically aimed at a new field where they have less expertise and generate lower returns. This trend, the dispersal of cash flow by vested corporate interests, arguably, has led to the rise of the underperforming conglomerate, so idealised in the 1950s as the benevolent corporation.

The initial backlash to this corporate sloth occurred in the early 1980s, led by financiers funded by the cheap debt of the day, junk bonds. Their aim was to asset-strip (or reallocate) the conglomerates’ assets and return the value back to the shareholders in cash. This continued until the late 1980s when a slumping economy and rising interest rates put paid to their financing by cheap debt.

Twenty years on, private equity financiers are again drawing down debt, re-tuning businesses and starting new ones. Asset-stripping is not a principal activity of theirs, far from it.

But what private equity financiers do do, which is virtually identical to the 1980s is to take an ‘active investor’ role. Back in the 1980s, James Goldsmith defined the active investor as the following: “An active investor is not a manager, not a particularist, he’s not a man who thinks he can double-guess management, he’s not a person who thinks he can do a better job of management than the management he can hire. An active investor has to ensure that the right management is in place, the right management is properly motivated, the right management, properly motivated, then runs the company according to a reasonable strategy and doesn’t chase industries it knows nothing about. That is the job of an active investor. If he does not consider the management is right, he fires it and replaces it.”

So some of us can see that active private equity investors are far more of a corporate tonic than having a couple of fund managers on your back. The resurgence of private equity is the quite right and proper claim of capital to reassert its interest against the onslaught of political and regulatory distraction.

PE critics meanwhile point to the “major transparency and accountability gap” outlined by the Walker Report which they say needs closing. They seem all to ready to ignore that businesses, as long as the law is obeyed and competition is free, need only be transparent and accountable to their owners. And private equity has long done this far better than any public company.

Moreover, as the number of easy deals declines in the Anglosphere, PE will start to reach out much further afield. And be under no doubt, a global private equity boom will be unleashed when cosy corporatist nations like Japan, France and others feel the whip of the active investor.

Japan, more than anywhere else in the world could benefit from aggressive private equity. Many companies hold underperforming assets in property, all too often, one of the largest assets on the balance sheet. Private equity could be the divine wind that shakes corporate Japan to its core, igniting the animal entrepreneurial spirits the country so desperately needs. Still today, many Japanese companies seem to think that their company is run for the workers and managers, while shareholders are only entitled to a bond-holding interest.

The truth is that PE is an obvious example of how business succeeds with lower taxes and minimal political interference. London in the meantime, has a chance to make itself a world leader in private equity by cutting tax on carried interest still further. Politicians and trade unionists should either shove off or join the ride.
The global private equity revolution has only just begun.

Dan Lewis is Research Director of the Economic Research Council www.ercouncil.org

The nightmare of a Chinese economic collapse

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In 2001, Gordon Chang authored a global bestseller “The Coming Collapse of China.” To suggest that the world’s largest nation of 1.3 billion people is on the brink of collapse is understandably for many, a deeply unnerving theme.

And many seasoned “China Hands” rejected Chang’s thesis outright. In a very real sense, they were of course right. China’s expansion has continued over the last six years without a hitch. After notching up a staggering 10.7 percent growth last year, it is now the 4th largest economy in the world with a nominal GDP of $2.68trn.

Yet there are two Chinas that concern us here; the 800 million who live in the cities, coastal and southern regions and the 500 million who live in the countryside and are mainly engaged in agriculture. The latter – which we in the West hear very little about – are still very poor and much less happy. Their poverty and misery do not necessarily spell an impending cataclysm – after all, that is how they have always have been.

But it does illustrate the inequity of Chinese monetary policy. For many years, the Chinese yen has been held at an artificially low value to boost manufacturing exports. This has clearly worked for one side of the economy, but not for the purchasing power of consumers and the rural poor, some of who are getting even poorer. The central reason for this has been the inability of Chinese monetary policy to adequately support both Chinas.

Meanwhile, rural unrest in China is on the rise – fuelled not only by an accelerating income gap with the coastal cities, but by an oft-reported appropriation of their land for little or no compensation by the state.

According to Professor David B. Smith, one of the City’s most accurate and respected economists in recent years, potentially far more serious though is the impact that Chinese monetary policy could have on many Western nations such as the UK. Quite simply, China’s undervalued currency has enabled Western governments to maintain artificially strong currencies, reduce inflation and keep interest rates lower than they might otherwise be. We should therefore be very worried about how vulnerable Western economic growth is to an upward revaluation of the Chinese yuan. Should that revaluation happen to appease China’s rural poor, at a stroke, the dollar, sterling and the euro would quickly depreciate, rates in those currencies would have to rise substantially and the yield on government bonds would follow suit. This would add greatly to the debt servicing cost of budget deficits in the USA, the UK and much of Euro land.

A reduction in demand for imported Chinese goods would quickly entail a decline in China’s economic growth rate.

That is alarming. It has been calculated that to keep China’s society stable – ie to manage the transition from a rural to an urban society without devastating unemployment – the minimum growth rate is 7.2 percent. Anything less than that and unemployment will rise and the massive shift in population from the country to the cities becomes unsustainable. This is when real discontent with communist party rule becomes vocal and hard to ignore.

It doesn’t end there. That will at best bring a global recession. The crucial point is that communist authoritarian states have at least had some success in keeping a lid on ethnic tensions – so far. But when multi-ethnic communist countries fall apart from economic stress and the implosion of central power, history suggests that they don’t become successful democracies overnight. Far from it. There’s a very real chance that China might go the way of Yugoloslavia or the Soviet Union – chaos, civil unrest and internecine war. In the very worst case scenario, a Chinese government might seek to maintain national cohesion by going to war with Taiwan – whom America is pledged to defend.

Today, people are looking at Chang’s book again. Contrary to popular belief, foreign investment has actually deferred political reform in the world’s oldest nation. China today is now far further from democracy than at any time since the Tianneman Square massacres in 1989. Chang’s pessimistic forecast for China was probably wrong. But my fear is there is at least a chance he was just early.

Dan Lewis is Research Director of the Economic Research Council www.ercouncil.org

The decline of Wall Street

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The answer is London, Switzerland and to some extent, even Germany. It is astonishing that over the same period, the UK’s surplus went from $7.6 billion to $25.3 billion. And Switzerland, the world leader for offshore finance, nearly doubled from $6.6 to $11 billion.

There is tremendous competition for financial services and America – as a domicile – is not winning. Take initial public offerings for example. 10 years ago, it was all the rage for companies to list on Nasdaq. Today, some of those same foreign companies are delisting themselves, finding the quarterly reporting requirements amid other costs, just too onerous. According to a report commissioned by the London Stock Exchange, The Cost of Capital: An International Comparison, in 2005, the European exchanges raised more new money from IPOs and attracted more international IPOs than the US exchanges.

It is particularly prevalent amongst smaller companies. Underwriting fees in Europe at 3-4% are half what they are in the USA. The clear winner though has been London’s junior market, the Alternative Investment Market or AIM. This accounted for 52% of Europe’s IPOs last year. AIM is winning the business because it does not require that a company have any minimum market capitalization, stockholders’ equity, trading volume or share price. Add to that for small to mid-cap IPOs in the $20 to $100 million range – getting analyst coverage is perceived to be easier in London than in New York. So for London at least, small has become the new big.

IPOs may well be the headline grabbing business, but now there are new markets like credit derivatives that have come from nowhere to a notional $7.5 trillion in just 10 years. Derivatives were invented by the Mesopotamians thousands of years ago. But in the 19th Century, Chicago led the way with its futures markets for grain and pork bellies. This has not been since translated into a comparative advantage in derivatives – made ever more complex with the help of computer modelling. London now has 40% of the world derivatives market.

The underlying lesson is that capital is moving faster and more efficiently than ever before. If higher returns can be found out of America or indeed anywhere else there are no real barriers to its reallocation. So perhaps that’s why Hank Paulson is dropping strong hints that he is in favour of reform of the Sarbanes Oxley Act.It is pricing American markets out of a future that used to be theirs. No question, America’s financial regulation has become a burden. And only competition in the form of globalisation is forcing Americans to confront this reality.

Global financial innovation and competition have only just got going. And not even America can afford to rest on her laurels. 

Prepare to wobble

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They cannot achieve equilibrium and overshoot continuously by over-supplying or under-providing any given good or service. This led to a ‘dynamic disequilibrium’ and always resulted in bubbles, booms, recessions and downturns.

Today, this is a mainstream view. Many now accept that markets are in a permanently quixotic quest for efficiency, so it’s fair to say that at any stage, the world economy is unbalanced. But that does not mean that it is unstable. In recent years, there has been an ominous change. Volatility has been growing, the wobbling, shown in America’s sub-prime liquidity crisis, has begun. In 2007, the world economy could lay claim to $167trn of financial assets.

Those assets are looking seriously overweight in high-risk trailer trash debt, Anglo-Saxon and Iberian Real Estate and above all, US dollars.
But the really big change in the near future will be who will have the most momentum, or ‘the big mo’ behind the next investment wave?

According to an October report by the McKinsey Global Institute, ‘The New Power Brokers of Global Capital Markets’ are increasingly going to be Asian central banks, oil investors (both of which you could categorise together loosely as sovereign wealth funds), private equity and hedge funds. Looking ahead, the projected infusion of capital from these intermediaries means that they are going to take over from mutual funds, pension funds and the banks as the chief arbiters of global capital.

And that’s no bad thing. They will collectively go some way to righting the imbalances of the world economy by seeking an honest return. And we will enter an even more liquid financial world.

Yet there is no escaping the imbalances, the overshoots, in the world economy. The question to ask though is exactly what is causing them?

The main culprits are fixed exchange rates, a liquidity explosion at the bottom, the state ownership of natural resources and above all, a lack of financial imagination. Authoritarian governments have a weakness for fixed exchange rates, believing that they have superior knowledge over the market of what the true value of their currency – and economy – should be.

In China’s case, this tends to favour large exports of manufactured goods, albeit at wafer-thin margins. This has for China created an enormous pool of foreign currency reserves, some $1.2trn. Yet the Chinese implicitly understand that money, even dollars, are not a store of value, merely a transferable token of debt. That’s why they are diversifying out of these dollars, setting aside $300bn for investment purposes – a figure that can only rise.

Meanwhile, the poorer parts of the global economy are woefully short of debt. As Hernando de Soto wrote in his award-winning book, ‘The Mystery of Capital,’ the world’s poorest lack basic property rights, which would enable them to secure debt financing, to raise capital to do anything.

The long-term answer has to be for developing world central banks and governments to return their surplus cash flows from central banks and state-owned natural resources in the form of vouchers or tax cuts to their people. This could engender the evolutionary flexibility and portfolio diversification that is the key to success in the 21st century economy as described by Eric Beinhocker in his excellent book, ‘The Origin of Wealth.’

No question, markets are going to become more and more efficient at allocating capital to maximise returns. That suggests dollars and euros, will lose out in the long-term value stakes to the Chinese Renminbi, physical commodities and emerging market equity. Like the cult exercise regime of Pilates, these wobbles can only make the world economy stronger. And be assured, without them, we’d be all the poorer.

Urbanisation 2.0: the mother of all building booms

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In a recent video conference lecture, Ex-Vice (and still wannabe) President Al Gore said; “in the next 40 years, there will be more building than in the previous 3,000 years.” In this of course he saw great environmental risks. Global financiers on the other hand should see huge opportunities. When most of the world’s 3.54 billion rural population decide to move into the cities, a massive shift in their expectations occurs. Think about it. These ex-villagers will want clean, hot water on tap, not the stagnant kind from the well. They will require grid-tied electricity and air-conditioning, not a smoke-filled hut. And above all, they will demand a space to call their own, probably a car and plenty of good places to shop.

Urbanisation 1.0 which accompanied the West’s industrial revolution in the 19th Century was trivial compared to the scale and speed of what is happening today. Even by 1900, just 220 million of the world’s people, 13 percent, were living urban lives. That’s why Urbanisation 2.0 – the 21st Century version – is a mega-trend that can’t possibly be ignored and is one that investors must embrace.

For sure, the infrastructural challenges are enormous; bringing transport, housing, energy and water to a few billion people for the first time. Naturally, there are those who would say this can’t or it shouldn’t be done. They should be ignored. Progress, ultimately, is unstoppable. The pertinent question to ask though, is how can it be done, financially?

At the micro level, these new – but poor – urban slum dwellers, will eventually want loans, credit and insurance. On housing at least, you can forget them taking out 25 year mortgages. In 2001, prize-winning Peruvian economist Hernando de Soto argued very persuasively in his book ‘The Mystery of Capital’ that what was lacking in developing nations were legally enforceable property rights and that’s what kept them poor. In other words, because most of the world’s poor have no formal ownership deeds, they are unable mobilise those assets – be they businesses, property or livestock – to use as collateral against debt. Micro-finance then, has the potential to go a very long way from here.

Transport is another area fraught with huge difficulty. In China, cities with a few million people are being erected in mere years and national vehicle ownership is forecast to rise from 30 million to 140 million by 2020. Already they have 16 of the world’s 20 most polluted cities, principally due to exhaust fumes. To their credit, the Chinese are working on this furiously, no doubt motivated by the possible embarrassment of choking athletes at next year’s Olympic Games in Beijing. It is however a universal problem and there can only be three solutions; cleaning up personal transport, increasing public transport and reducing urban density. My guess is that the most likely outcome is that as oil prices drift upwards, markets will deliver the first and politicians will talk up the second while quietly endorsing the third, by expanding the suburbs.

But can you plan for efficient future cities?
The West unfortunately does not have a great deal to teach the developing world in planning. Urban design as a profession is at least 2,000 years old. Today’s municipal planners dream wistfully of Timgad, a perfectly symmetrical, self-contained grid-laid Roman town in Algeria built in 100 AD. Instead they have given us the likes of Milton Keynes in the UK, one of the world’s first ‘New Towns’ and by common consent, a soulless failure. Looking back, it would have been far better to expand London. So the lesson for planners is this; urbanisation works at its best where scaleable infrastructure is put in place, first and citizens are given maximum choice to expand from the existing hub, second.

The future city of the West in 2040 will have resolved many of those issues that currently elude us; clean air, reliable public transport and effective municipal government. Between now and then in developing world cities, all of these will probably get worse before they get better. But catch up they will. Competing in the global economy is like a race without a finish. And only those cities which offer both good economic prospects and a high quality of life will stay ahead. So take a long bet on cement, bricks and mortar. Urbanisation 2.0 has only just begun.  

Dan Lewis is Research Director of the Economic Research Council. www.ercouncil.org

The end of the global real estate boom?

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And these last few years, its value has been booming. In the US alone, one-quarter of the jobs created there since 2001 have been in construction, real estate and mortgage finance. The world economy has withstood a dotcom bust, international terrorism and high oil prices. Yet many are now starting to believe that a real estate bubble has been propping up the World Economy and it’s about to burst. The trigger – they contend – could be a sharp fall in the US Housing market. This is because America is 30 percent of the world economy and its consumer spending has been part-fuelled by rising house prices.

No question, the returns in property have been unprecedented, both in the size of the gain and the spread of countries involved. In the last five years, the price of the median US home is up an inflation-adjusted 50 percent. The world’s highest return though has been in South Africa, 227 percent from 1997-2004, according to The Economist House Price Index.

The hard question is why?
In many countries, one could fairly cite a shortage of supply, cheap credit and planning restrictions. But that’s not the whole story. Real estate is being touted as an investment, appreciating faster than inflation and incomes for many years to come. This is nonsense.In many ways, real estate is a terrible asset class. It’s illiquid, it’s expensive – there are high transaction costs and it usually involves taking on very large debts. Curiously, it is nothing like as well researched as much smaller stock, bond or even forex markets by analysts or economists.

We have all also somehow being led to believe that a rise in house prices is good for the economy. It is not. When property prices rise faster than incomes – as they have done in most economies for at least a decade bar Japan and Germany – this has made people much poorer in real terms. Unlike companies that sell more products more profitably, housing stock does not intrinsically improve its output. It is merely valued on future rental income or more worryingly, anticipated capital gains – the definition of a speculative bubble.

To use the jargon, the world economy is overweight in real estate. In the UK, 59 percent of £6trn of assets is tied up in property. That’s three times the annual GDP output. Yet whilst the value of real estate is a floating market price, the cost of its underlying debt is a hard-numbers certainty. That means that the fallout from a global housing bust could be pretty spectacular.

It is at the top end of the housing market that prices have gone into the super league. In 2004, according to Forbes, there was only one home in the world priced over $100m. In 2005, there were four. There is a new class of internationally mobile wealth driving this end of the market. It started with the Russians moving into London. Many anticipate that the same will happen with China, Brazil and India.

So how long can the property market keep booming?
America is key and it is cooling off fast. With the US Fed rate recently raised to 5.25 percent, the days of cheap money are over. Consumer spending – part financed by mortgage equity withdrawals – has been outpacing income and this is not sustainable. Economic historians will tell you that housing booms always precede recessions. Another factor is the rise of the teleworker, already millions strong, made possible by broadband internet connections. 10 more years of improving bandwidth just might truly internationalise the global workforce and signal the end of the high density and expensive commercial city centre rents. Anyone who thinks a property bust (a fall of more than 30 percent) following a boom will not happen need only look at Japan. From 1991-2005, Japanese property prices dropped for 14 years in a row, by 40 percent.

So any retiring Western couple intent on selling their home and moving abroad to the sun should try something else. Rent out your home, rent more cheaply abroad and live off the difference. Your assets – property, stocks or otherwise – should perform for you, not the other way round.

Dan Lewis is Research Director of the Economic Research Council
www.ercouncil.org