Year: 2010

Actuary

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The word actuary derives from the Latin actuarius, who was the business manager of the Senate of Ancient Rome. It was applied to a mathematician of an insurance company in 1775 in the Equitable Life Insurance Society of London.

Actuarial science
This provides a structured and rigid approach to modelling and analysing uncertain outcomes of events that may impose or imply losses or liabilities upon individuals or organisations.

Given that uncertainty is a main characteristic of actuarial events, it follows that probability must be the cornerstone in the structure of actuarial science. Probability in turn rests on pure mathematics.

In order to enable probabilistic modelling of actuarial events to be a realistic and representative description of real-life phenomena, understanding of the “physical nature” of the events under consideration is a basic prerequisite. Pure mathematics and pure probability must therefore be supplemented with and supported by the sciences that deal with such “physical nature” understanding of actuarial events.

Actuarial practice
The main practice areas for actuaries can broadly be divided into: life insurance and pensions; general/nonlife insurance; and financial risk.

There are certain functions in which actuaries have a statutory role. Evaluation of reserves in life and general insurance and in pension funds is an actuarial process, and it is a requirement under the legislation in most countries that this evaluation is undertaken and certified by an appointed actuary. The role of an appointed actuary has long traditions in life insurance and in pension funds. A similar requirement has been introduced by an increasing number of countries since the early 1990s.

The involvement of an actuary can be required as a matter of substance in other functions. Then there are functions where actuarial qualifications are neither a formal nor a substantial requirement, but where actuarial qualifications are perceived to be a necessity.

Life insurance and pensions
Assessing and controlling the risk of life insurance and pension undertakings is the origin of actuarial practice and the actuarial profession. The success in managing this risk comprises the following:
•understanding lifetime as a stochastic phenomena, and modelling it within a probabilistic framework;
•evaluating the diversifying effect of aggregating lifetime of several individuals into one portfolio;
•estimating individual death and survival probabilities.

By analysing historic data and projecting future trends, life insurance actuaries constantly maintain both first-order and second-order bases. Premium and premium reserve valuation tariffs and systems are built on the first-order basis. Over time emerging surplus is evaluated and analysed by source, and in due course reverted as policyhold¬ers’ bonus.

General insurance
Over the years actuaries have attained a growing importance in the running of the nonlife insurance operations. The basis for the insurance industry is to accept economic risks. An insurance contract may give rise to claims. Both the number of claims and their sizes are unknown to the company. Thus insurance involves uncertainty and here is where the actuaries have their prerogative; they are experts in insurance mathematics and statistics.

Finance
Financial risk has grown to become a relatively new area for actuaries. Those who practice here are called “actuaries of the third kind”.

It is different from ordinary insurance risk in that increasing the size of a portfolio does not in itself provide a diversification effect. For actuaries it has been a disappointing that the law of large numbers does not come into assistance.

The most fundamental and innovative result in the theory of financial risk/mathematical finance is probably that risk associated with contingent claims can be eliminated by appropriate portfolio management.

This theory is the cornerstone in a new practice field, called financial engineering. Activities include quantitative modelling and analysis, funds management, interest rate performance measurement, asset allocation, and model-based scenario testing. Actuaries may practice financial engineering in their own right, or they may apply financial engineering as an added dimension to traditional insurance-orientated actuarial work.

A field where traditional actuarial methods and methods relating to financial risk are beautifully aligned is asset liability management (ALM). The overriding objective of ALM is to gain insight into how money is best allocated among given financial assets, in order to fulfill specific obligations represented by a future payment stream. The analysis of the obligation’s payment stream rests on traditional actuarial science, the analysis of the asset allocation problem falls under the umbrella of financial risks, and the blending of the two is a challenge that requires insight into both and the ability to understand and model how financial risk and insurance risk interact. ALM is today a key component in the risk management of insurance providers, pension funds, and other financial institutions.

A new challenge on the horizon is the requirement for insurers to prepare financial reports on a market-based principle, which the International Accounting Standards Board has had under preparation for some time. In order to build and apply models and valuation tools that are consistent with this principle, actuaries will be required to combine traditional actuarial thinking with ideas and methods from economics and finance.

This article is an edited version of an entry in the “Encyclopedia of Quantitative Risk Analysis and Assessment”, Copyright © 2008 John Wiley & Sons Ltd. Used by permission.

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Consumer products

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Each year consumer products are involved in millions of injuries and thousands of fatalities. Responsibility for this rests with the manufacturers. Most developed countries have also established government agencies that provide regulatory oversight. In the US, the Consumer Product Safety Commission (CPSC) maintains regulatory jurisdiction over more than 15,000 types of consumer products.

Consideration for public safety can improve product development and product quality. Formal tools of quantitative risk assessment add value by improving decision making at different stages.

Product characteristics and analysis of historical data on product-related injuries and deaths can inform safety assessment of a product design before it is manufactured.

Unintended declines in the quality of consumer items can pose safety hazards to consumers, causing unexpected financial burdens and potential legal liabilities to manufacturers. At the beginning of the production process, companies may implement acceptance sampling plans to ensure the quality of raw materials or components. The acceptable quality limits (AQLs) used in such plans can be chosen on the basis of a quantitative risk assessment. Standard tools for statistical process control are routinely deployed by manufacturers to provide checks on quality. A motivating principle is that successful business operations require continuous effort to reduce variation in process outputs. End-of-line testing is typically performed before manufacturers approve products for shipping to customers. In some industries such testing may be required by government regulation.

Information about the performance of a product after release to consumers comes from returns, warrantee programmes, and complaints. Records of incidents involving failure of a product during operation typically include information such as model and serial number of the unit, production date or date code, incident date, and location. In monitoring field performance, a manufacturer needs to determine whether an adverse change has occurred and, if so, assess its implications for product reliability and safety. If a background level of event risk is accepted, statistical methods can determine whether adverse events can be explained by random variation or require attention. Production, shipping, and sales records typically provide the raw data for such analyses.

Confirmation of a problem raises a series of questions: How bad is it? Do field data point to a particular production period or facility? A quantitative risk assessment can address these questions using statistical estimation and hypothesis testing. Risk analysts review the information about production history and seek changes in time period, plant, process, equipment, design, or supplier that are associated with subsequent problems. Parametric statistical models are frequently used to fit time-to-failure distributions in engineering applications.

Product recalls require identification of the units affected, typically by time or source of production, and determination of whether affected units will be repaired or replaced. Increasing globalisation challenges manufacturers and regulators of consumer products, as a product may contain components from different nations and be sold all over the world.
The process for implementing corrective action varies from country to country. In 1997 the US CPSC adopted a “Fast Track Product Recall Programme” for reports filed according to Section 15(b) of the Consumer Product Safety Act (CPSA). This programme requires manufacturers, distributors, and retailers of consumer products to notify the commission of certain defects, unreasonable risks, or noncompliance with voluntary or mandatory stan¬dards. Under the CPSC Fast Track programme, the staff refrains from making a preliminary determination when firms report and implement an acceptable corrective action plan. The plan submitted to CPSC must describe the recall action (refund, repair, or replace) that the company will take to eliminate the identified risk, and provide sufficient information on the product design, incident, and testing to allow the CPSC staff to determine whether the proposed action can correct the identified problem.

An effective risk assessment must link measured levels of risk to specific corrective actions. Supporting tools have been developed, particularly in the EU.

A community rapid information exchange system known as RAPEX assesses the risk of potentially hazardous consumer products by first considering (a) the probability of health damage from regular exposure, and (b) the severity of injury from the product. Depending on the probability and severity of damage the RAPEX method then classifies the overall gravity of an adverse outcome on a five-point ordinal scale ranging from very low to very high. The final judgment of whether the risk requires corrective action considers three additional factors: (a) the vulnerability of people exposed to the product, (b) whether the hazard is obvious to nonvulnerable adults, and (c) whether the product has adequate warnings and safeguards. The RAPEX methodology is sometimes viewed as the preferred approach in countries adopting a risk-averse approach to consumer product safety based on such rough scoring.

Although consumer products are required to be safe, safety does not mean zero risk. A safe product is one that has reasonable risks, given the magnitude of the benefit expected and the alternatives available. In managing consumer product risk, quantitative risk assessment and associated statistical methods are used to frame substantive issues in terms of estimable quantities and testable hypotheses, to extract infor¬mation on product performance from data on field incidents and manufacturing records, and to com¬municate findings to upper management, regulatory authorities, and consumers.

This article is an edited version of an entry in the “Encyclopedia of Quantitative Risk Analysis and Assessment”, Copyright © 2008 John Wiley & Sons Ltd. Used by permission.

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Enterprise Risk Management

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Enterprise risk management (ERM) is a recent technique, practiced increasingly by large corporations in industries throughout the world. Sensible risk management flows from the recognition that a dollar spent on managing risk is a dollar cost to the firm, regardless of whether this risk arises in the finance arena or in the context of a physical calamity such as fire. ERM thus proposes that the firm addresses these risks in a unified manner, consistent with its strategic objectives and risk appetite.

Most corporations adopt the definition of ERM proposed by the Committee of Sponsoring Organisations of the Treadway Commission (COSO) in their 2004 ERM framework. It intended to establish key concepts and techniques for ERM. In this framework, ERM is defined as “a process, affected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives”. This definition highlights that ERM reaches the highest level of the organisational structure and is directed by corporations’ business strategies. The concept of risk appetite is crucial. Risk appetite reflects a firm’s willingness and ability to take on risks in order to achieve its objectives.

As a rising management discipline, ERM varies across industries and corporations. The insurance industry, financial institutions, and the energy industry are among the industry sectors where ERM has seen relatively advanced development in a broad range of corporations. Recently, even the public sector, are becoming aware of the potential value of ERM and risk managers are increasingly bringing it to top executives’ agendas.

Notwithstanding the attractiveness of ERM conceptually, corporations are often challenged to put it into effect. One of the main challenges is to manage the totality of corporation risks as a portfolio in the operational decision process, rather than as individual silos, as is traditionally done.

Operationalisation of ERM
The core of the challenge lies in operationalising ERM. Integration of risks is not merely a procedure of stacking all risks together, but rather a procedure of fully recognising the interrelations among risks and prioritizing risks to create true economic value. Important components of this procedure include risk identification, risk measurement, risk aggregation/other modelling approaches, risk prioritisation, and risk communication.

The four major categories of risks considered under an ERM framework are hazard risk, financial risk, operational risk, and strategic risk.

Under ERM, the identification of individual risks in different categories should facilitate successive prioritisation and integration of risks to best achieve business objectives within the corporation’s risk appetite. Any event that may adversely affect the corporation’s achievement of its objectives is considered a risk under ERM. Proper objective identification is a prerequisite for risk identification. For example, business objectives can be described by certain key performance indicators (KPIs), which are usually financial measures such as ROE, operating income, earnings per share (EPS), and other metrics for specific industries, eg, risk adjusted return on capital (RAROC) and risk-based capital (RBC) for financial and insurance industries. Risks are then recognised by means of these company performance metrics.

Prioritisation
To realise effective risk integration, ERM also promotes risk prioritisation. Risk prioritisation stems from the fact that risks are not equally important to corporations. Prioritisation should reflect different aspects of the company’s strategies and risk-management philosophy, eg, cost to tolerate that risk, reduce it, elicit and apply management’s risk preferences, etc.

ERM and compliance
ERM at first arises from corporations’ efforts to comply with laws and regulations. To this end, it is seen more as an efficient internal control process. Within a corporation, it is often conducted with internal control functions and supervised by internal auditors. The most significant regulatory forces responsible for the rise of ERM are the Sarbanes Oxley Act of 2002, the Basel Capital Accord II, and rating criteria set forth by rating agencies such as Standard & Poor’s (S&P).

ERM future – value creation
ERM practices may have been initially driven by compliance needs, but developments should continue to serve as an internal control function for better corporate governance. One common objective for corporations is to maximise firm value. ERM provides a framework for corporations to consciously optimise risk/return relationships. This optimisation is achieved through the alignment of corporate strategic goals and risk appetite. At the operational level, the alignment guides virtually all activities conducted by the corporation. Specific risks are identified and measured. They are prioritised and integrated by recognising the interrelations and relative influences affecting different risky outcomes. Risk management strategies are developed for the entire portfolio of risks and their effects are assessed and communicated.


This article is an edited version of an entry in the “Encyclopedia of Quantitative Risk Analysis and Assessment”, Copyright © 2008 John Wiley & Sons Ltd. Used by permission.

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Nigerian growth

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Yar’Adua has been in hospital in Saudi Arabia for more than two months being treated for a heart ailment but has not formally transferred powers to Vice President Goodluck Jonathan.

He signed a supplementary 2009 budget which runs to the end of March from his sickbed but there has been concern over what will happen if he is still absent at the end of next month and is unable to sign the 2010 budget.

“I want to give you strong assurance that the growth trajectory and prospects for the Nigerian economy remain positive … We have not relented in our efforts to steer the economy and the vice president has been actively engaged,” Muhtar said in an interview in Abuja.

“We have a very positive outlook of maintaining a minimum of six percent GDP growth … This is going to be fuelled basically by stimulus spending and a massive increase in spending on infrastructure embedded in the 2010 budget,” he said.

Yar’Adua in November sent a 4.1 trillion naira ($27bn) budget proposal to parliament, a 32 percent rise from planned 2009 spending. If approved, this would push sub-Saharan Africa’s second biggest economy to a fiscal deficit of 4.79 percent of GDP.

Sources involved in the debate have since said parliament wants to increase the planned budgetary spending further to pay for new projects in power, roads and development in the restive, oil-producing Niger Delta.

Muhtar said Nigeria’s budget laws meant the government was able to start spending funds for the first quarter of the 2010 budget based on last year’s assumptions even though it had not yet been passed into law, as well as spending funds brought over from last year and the 2009 supplementary budget.

“In effect, for the first time in Nigeria, we are actually executing three budgets this quarter,” he said, noting that the cabinet had continued to award contracts in Yar’Adua’s absence.

Muhtar confirmed parliament had agreed to increase the benchmark oil price assumption in the 2010 spending plans to $60 a barrel from an initial proposal of $57, saying current oil prices of around $70 would still leave a comfortable margin that would compensate for any production shortfall.

He said foreign reserves of around $43bn were sufficient to meet all domestic and external obligations.

CIT hires new CEO

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CIT Group Inc has hired former Merrill Lynch CEO John Thain as its new chief executive, the commercial lender said in early February, wagering that the well-traveled executive can guide its post-bankruptcy turnaround.

Thain, 54, immediately replaces interim CEO Peter Tobin, who will remain a director. Former CIT chief Jeff Peek, another past Merrill executive, retired on January 15.

CIT said Thain was hired partly for the expertise he gained restructuring the New York Stock Exchange, as it looks to reestablish itself after a disastrous foray into subprime lending, and one of the largest bankruptcies in US history.

Within the last decade, Thain was the number two executive at Goldman Sachs Group Inc, the number one at both NYSE Euronext and Merrill Lynch, and was fired by Bank of America, which acquired Merrill in the midst of the mortgage-market inspired financial crisis.

CIT is not concerned about Thain’s reputation after his short but controversial stint at Bank of America, and the board performed the appropriate due diligence before hiring him, said a person familiar with the company’s thinking.

No specific terms of the contract were revealed.

Thain’s compensation will be “in line with expectations in this day and age,” John Ryan, CIT’s lead director, said in an interview, adding Thain didn’t want to stand out at a time that Wall Street executives are
under fire for what is seen as out-sized compensations shortly after a recession.

CIT declined to say whether it was also in contract talks with Nelson Chai, who worked with Thain at Merrill and at NYSE Euronext, and who was reported as possibly involved in a contract deal that included Thain.

The company, which emerged from bankruptcy in December, said this month Chief Financial Officer Alexander Mason is set to step down February 26 as it revamps management and its board.

Goldman, NYSE, Merrill, Bank of America… CIT
After Thain left Goldman Sachs he lead the NYSE’s transformation from a floor-based market to a mostly electronic model. That restructuring “is similar to what CIT has to do going forward,” Tobin, the interim CEO, said in an interview.

About a year ago, Thain helped orchestrate the deal for Bank of America to acquire Merrill. The Charlotte, North Carolina-based bank fired Thain a few weeks later, and later dealt with the fallout of surprisingly large losses associated with its acquisition, as well as bonuses Merrill employees.

Some criticise Thain for being slow to recognise troubles at the storied investment bank he ran; others say he saved Merrill from the most devastating effects of the worst financial crisis since the Great Depression.

The Harvard-educated executive also attracted controversy when news broke about his lavish $1.2m office renovation at Merrill, including an infamous $35,000 antique commode.

Although Thain’s background is largely in investment banking, his first tasks will likely include reducing CIT’s debt and reestablishing it as a lender for small and medium-sized businesses.

CIT’s new CEO will likely have to negotiate with regulators to allow it to move some of its best businesses to its bank, where it can fund them with deposits.

“CIT can and will serve an important role in the recovery of the US economy and the creation of jobs,” Thain said in a statement. The company did not make Thain available for an interview.

Nakamura rebuffs government pressure over deflation

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Bank of Japan policy board member Seiji Nakamura rebuffed government pressure for more BOJ action to fight deflation, saying that pumping liquidity into the financial system alone will not put an end to debilitating price falls.

The heavily indebted government fears deflation and a strong yen could push Japan back into recession in the run-up to upper house elections. Analysts say it may urge the central bank to buy more government debt or expand a funding operation it introduced in December to prevent that.

Nakamura suggested the bank wasn’t likely to oblige by increasing its debt buying, however, warning the government that it needs to get to grips with its fiscal problems.

“The economic recovery has shed light on fiscal discipline,” he told a news conference after giving a speech to business leaders in Fukuoka in southwest Japan.

“It would be a grave issue if yields rose because of a risk premium or investor fears over the risk of holding government bonds. The government needs to tackle the issue before the markets start moving,” he said.

The prime minister and finance minister have been calling on the central bank to do more to help ease deflation, but they haven’t said exactly what steps they want the BOJ to take.

“Nakamura is resisting government pressure and asserting the BOJ’s independence,” said David Cohen, director of Asian economic forecasting at Action Economics in Singapore.

“The BOJ tried quantitative easing a few years ago and didn’t enjoy much success. This also highlights its impotence.”

The BOJ is reluctant to ease monetary policy further partly because it expects the pace of falls in prices to ease gradually. Last week it said deflation would be milder than it previously forecast in the fiscal year from April and the following year.

Pushing back
Nakamura said the fight against deflation, where price falls and weak demand feed into each other as buyers wait for prices to slip even further, must be shared.

“In order to solve demand shortages, it is important for the BOJ, the government and private sector firms each to play their own role,” he told business leaders.

He stressed the need for innovation in the private sector for creating demand, but offered few other clues on what fiscal or monetary policy options there were to get prices rising.

For its part, the government, whose support rate is slipping ahead of upper house elections due in summer, has little room to lift demand by spending more as the national debt is already nearing 200 percent of GDP.

Standard & Poor’s last month cut the outlook on Japan’s AA debt rating to negative, saying the policy bind could lead to a downgrade unless measures were taken to stem fiscal and deflationary pressure.

“It is natural for central bank policymakers to call for fiscal reconstruction when debate about exit strategies globally is focusing more on fiscal issues than monetary policy,” said Masamichi Adachi, senior economist at JPMorgan Securities Japan.

The BOJ is virtually alone in expanding monetary easing. The Federal Reserve and the European Central Bank have said they will start phasing out their emergency lending and liquidity facilities in light of improvements in credit markets.

“The government and the BOJ need to talk to each other more about the fiscal problem, but that hasn’t happened in Japan so far,” Adachi said.

The Japanese economy started to recover from the second quarter of last year and it is expected to post fairly robust growth for the fourth quarter.

But Nakamura said the downside risks were still larger than those on the upside and that the bank won’t rule out any policy options in responding to economic conditions ahead.

Most economists think the economy will slow down in the first half of 2010 and, as the recovery is driven mostly by strong exports to Asia, it could be hurt by any further rise in the yen.

Nakamura said strong demand in Asia may cause Japanese firms to shift production abroad, thus limiting a recovery in domestic capital spending and jobs even as the overseas economy recovers.

Swiss siege

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German Finance Minister Wolfgang Schaeuble sent shivers through the large Swiss private banking industry this week when he said Berlin was prepared to pay for stolen data belonging to potential tax cheats at a Swiss bank, raising the bar in the fight against tax evasion.

Now, the Dutch, Belgian and Austrian governments have also flagged interest in obtaining a copy of a compact disc with tax-sensitive data that Berlin may soon buy from an informant.

Swiss Finance Minister Hans-Rudolf Merz said recently that the Swiss would not help Germany or others hunt tax cheats on the basis of stolen Swiss bank data, but tried to defuse the escalating row by saying Berne would not retaliate.

“It is obvious that such a theft is a criminal act,” Merz said. “Switzerland should therefore not offer administrative (tax) assistance in such cases either now or in future.”

But he added that Switzerland would continue to engage in talks aimed at signing a new treaty with Germany.

Coordinated action by European governments poses a serious headeache for Merz at a time when Berne is struggling to honour a deal with Washington to end a tax row against UBS. Merz came under pressure to resign last year for his handling of the UBS case.

Switzerland, which remains under siege as the world’s top offshore centre despite having promised to relax bank secrecy, has named seasoned diplomat and UBS dealmaker Michael Ambuehl to a new tax job to help it defuse the many tax spats it faces.

Pressure from all sides
Many European governments are under pressure to raise tax revenues after injecting billions of euros into several large banks to fight the financial crisis.

A Dutch finance ministry spokesman said the Netherlands, where deputy finance minister Jan Kees de Jager is pushing through a crackdown on tax dodgers, told Berlin they would be interested in having any data on Dutch taxpayers.

Austria, which protects its own bank clients with secrecy rules, also showed an interest.

“Should there be evidence that the CD [with the stolen bank data] contains information on Austrian taxpayers, we would naturally have great interest in analysing those,” a spokesman for Austrian Finance Minister Josef Proell was quoted as saying in Der Standard newspaper.

Belgian newspaper De Standaard said Belgium, which is giving up banking secrecy, also wanted copies of the Swiss data if Germany got them. The finance ministry declined to comment.

Former German Finance Minister Peer Steinbruck repeatedly accused Switzerland of helping tax evaders and was likened to a Nazi by one Swiss parliamentarian after he compared Swiss politicians to “Indians” running scared from the cavalry.

Switzerland promised in March to sign a raft of new tax treaties to avoid ending up on an global blacklist. But it still needs to seal tax deals with large neighbours Italy and Germany.

Nearly $6trn of wealth is managed in Switzerland, with potentially almost one-third of it undeclared, analysts have said. Bankers fear the latest set of attacks could undermine the country’s entire private banking model.

Several European governments have tried to lure back some of the money hidden in tax havens by launching tax amnesties.

Wealthy Dutch savers last year declared $3.01bn under a penalty-free amnesty, with a third of the declared accounts hidden in Switzerland.

Britain has also targeted wealthy residents with hidden offshore money via a so-called voluntary disclosure programme.

The most successful amnesty so far has been a Italian one, which recouped nearly 100 billion euros in three months, most of it hidden in the Italian-speaking Swiss canton of Ticino.

France and Germany, on the other hand, have not launched amnesties but have accepted stolen bank data from informants.

Irish services contraction fastest in six months

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Ireland’s services sector shrank by its fastest rate in six months in January, when a marked fall in new orders indicated that unusually bad weather was not solely to blame, a survey showed this week.

The NCB Purchasing Managers’ Index fell to 44.4 from 48.3 in December, when it had reached a level last equalled in February 2008 and begun to close in on the 50 mark that separates growth from contraction.

The sub-index measuring new business slipped to 45.5 from 48.7 in the previous month, retreating to its lowest level since September last year.

“Worryingly the level of new orders fell back sharply, highlighting that this was more than just weather-related problems,” said Brian Devine, economist at NCB Stockbrokers, commenting on the services PMI data.

“The latest data highlight how fragile domestic demand is in the Irish economy.”

Markit, which compiles the data, said anecdotal evidence suggested that poor economic conditions were largely responsible for the latest reduction in the headline figure.

However, despite most sub-indexes continuing to contract in January, new export orders increased for the fifth successive month, albeit at the slowest rate in that sequence.

Another PMI survey on Monday showed a similar pattern, with orders from abroad in Ireland’s manufacturing sector accelerating to their highest level since October 2007 although the headline PMI index worsened at a faster month-on-month rate.

“New export orders increasing for the fifth month in a row highlights the dichotomy between the domestic Irish economy and the global economic recovery,” NCB’s Devine added.

Obama seeks record $708bn in 2011 defense budget

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The budget calls for a 3.4 percent increase in the Pentagon’s base budget to $549bn, plus $159bn to fund US military missions in Iraq, Afghanistan and Pakistan.

Obama’s spending freeze on other parts of the budget, designed to rein in the deficit, did not apply to the military.

“Even though the Department of Defense is exempt from the budget freeze, it’s not exempt from budget common sense,” Obama told reporters at the White House.

He said the fiscal 2011 budget proposal included cuts of “unnecessary defense programmes that do nothing to keep us safe,” including annual spending of $2.5bn for C-17 transport planes built by Boeing Co that has been added to the federal budget by Congress in each of the past four years.

“It’s waste, pure and simple,” Obama said.

At the Pentagon, Defense Secretary Robert Gates announced a major shake-up of Lockheed Martin Corp’s F-35 fighter – at $300bn the largest weapons programme in history.

Gates also said he would strongly recommend a veto of any moves by Congress to keep alive the C-17 programme or a second engine for the F-35.

He said it was “important to take a final stand” against lawmakers and ensure those programmes were eliminated.

Cutting the alternate engine programme would save $465m in fiscal 2011, which begins October 1, and more than $1bn longer-term, according to Pentagon documents.

The engine is being developed by General Electric Co and Britain’s Rolls-Royce as an alternate to the main engine built by Pratt & Whitney, a unit of United Technologies Corp.

Obama and Gates tried to kill both programs last year, but lawmakers revived them during the budget process.

Planning for the unexpected
Gates said the 2011 budget and related strategy reviews were “shaped by a bracing dose of realism” about risks and resources, noting that programs already cut in 2010 would have cost taxpayers $330bn.

The new budget built on those decisions, Gates said, adding the determinations were strengthened by the Quadrennial Defense Review, which is completed once every four years.

“The department’s leadership now recognises that we must prepare for a much broader range of security challenges on the horizon,” Gates said, pointing to sophisticated new technologies being developed by enemies overseas, threats posed by militant groups, and other unexpected scenarios.

“We have learned through painful experience that the wars we fight are seldom the wars we planned,” he said, saying the US military needed versatile capabilities to prepare for future threats.

Overall, the budget includes $112.8bn for weapons procurement, up from $104.8bn in fiscal 2010, and $76bn for research and development, down from $80bn.

The Pentagon’s budget also kills plans for development of a new Navy cruiser, scraps plans to replace the Navy’s EP-3 intelligence aircraft and halts work on a missile early-warning satellite, opting instead to upgrade the Space Based Infrared System satellite being developed by Lockheed.

The budget proposal also calls for a delay in replacing two new Navy command and control ships until after 2015, a move the White House said would save $3.8bn across the Pentagon’s five-year defense plan. The Navy had planned to buy one command ship in 2012, and a second one in 2014.

Procurement of a new amphibious vehicle being built by General Dynamics Corp for the Marine Corps would be delayed by one year, saving $50m in fiscal 2011 and cutting risk by allowing more time for testing.

The budget includes $25bn for shipbuilding programmes; $9.9bn in continued funding for ballistic missile programmes; $9.6bn for new helicopters; and about $4bn for long-range strike programmes.

F-35 shake-up
The budget also includes nearly $11bn for the F-35 programme, including plans to buy 43 planes under a revamped strategy to “stabilise its cost and schedule.” Gates said the Pentagon could buy even more planes in fiscal 2011, depending on contractor performance.

He said he was docking Lockheed $614m in performance fees because the programme’s progress and performance had not met expectations over the past two years.

Chris Geisel, a spokesman for Lockheed’s F-35 programme, said the company had been working with Gates on a plan to get the programme on track and was “committed to stabilising the F-35 cost, affordability and to fielding the aircraft on time.”

Gates said the Pentagon also bore responsibility for the programme’s “troubling performance record,” so he was replacing the Pentagon’s manager in charge of the programme, Major General David Heinz, a two-star general, with a three-star officer. Gates did not name the new programme manager.

The budget also pays for more unmanned planes, helicopters, electronic warfare capabilities and cybersecurity measures.

West eyes Iran central bank

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Western powers have called for a fourth round of UN measures against Iran for refusing to halt uranium enrichment activities as demanded by five Security Council resolutions.

Iran insists it has a sovereign right to produce nuclear fuel for what it says is a peaceful civilian atomic energy programme. The west fears Tehran’s programme is aimed at developing nuclear weapons.

The US, Britain, France and Germany want to reach an agreement this month with Russia and China – which have veto power on the Security Council and have opposed tough sanctions in the past – so that they can begin work on a new UN sanctions resolution as soon as possible.

Western diplomats told reporters that officials at the US State Department have circulated a paper outlining possible new sanctions to senior foreign ministry officials in London, Paris and Berlin.

Officials from the four Western powers will hold a conference call soon to try to agree on a sanctions proposal to put to Moscow and Beijing, the diplomats said, speaking on condition of anonymity.

At a meeting in New York last month, senior foreign ministry officials, known as political directors, from five of the six powers discussed Iran’s nuclear program. Diplomats said China sent a low-level envoy who declared Beijing felt it was not the right time to pursue further sanctions against Tehran.

US plans to sell $6.4bn in weapons to Taiwan, diplomats noted, could complicate negotiations with China.

Diplomats in New York said the four Western powers wanted to present as ambitious a sanctions package as possible to Russia and China, which have lucrative economic ties to Iran, because it would be watered down in subsequent negotiations.

They said the confidential US proposal, described as a working document that would be revised, covered general areas where new or broader sanctions could be imposed – including expanding existing travel bans and asset freezes to other Iranian individuals and companies.

Targeting Iran’s energy sector?
Several diplomats told reporters the Western powers would like to target Iran’s central bank, which they said was a key player in financing Tehran’s nuclear and missile industries and in skirting U.N. sanctions.

It was not clear which other banks would be targeted. One diplomat said they were looking at Iran’s five biggest banks.

Two previous sanctions resolutions passed in March 2007 and March 2008 blacklisted Iran’s Bank Sepah and urged countries to “exercise vigilance” over the activities of all Iranian financial institutions, above all Bank Melli and Bank Saderat.

Iran’s energy sector could also be a target, diplomats said, although they doubted Russia and China would support such measures.

“The French are pushing the strongest for energy sanctions,” one diplomat said. “They say energy sector revenues are helping to support the missile and nuclear industries.”

Another diplomat confirmed this.

Diplomats said Britain and the US do not oppose energy sector sanctions, although they want a quick consensus among the five permanent Security Council members and Germany.

“If they go for the energy sector, Russia and China will oppose it,” one diplomat said. “If they want to get a resolution to the Security Council quickly, and to get Russia’s and China’s support, they can’t target the energy sector.”

In November, Security Council diplomats said Western powers had resigned themselves to the impossibility of getting the Security Council to back sanctions on Iran’s oil and gas industries due to Russian and Chinese resistance.

One area where the four Western powers are in total agreement, diplomats said, is the Iranian Revolutionary Guard Corps (IRGC).

“We all favour designating key IRGC members and IRGC-controlled entities,” a diplomat said.

A senior US State Department official denied that Washington, London, Paris and Berlin would reach a consensus among themselves before turning to Moscow and Beijing.

“We have consulted all of them,” he said, adding the six powers were “some time away from putting any specific actions into the form of a draft resolution.”

Diplomats said the Western powers hope to have an agreement among the six this month so they could turn it into a draft resolution that could be put to a vote in the 15-nation Security Council before the end of March.

Toyota braces for sales hit from recall, costs mount

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US auto sales for January are expected to show a sharp drop for Toyota after it pulled eight of its most popular models from showrooms last week following complaints over sticking accelerator pedals.

In the first public comment from an executive at Toyota’s head office, the company’s executive in charge of quality said he was expecting a bigger-than-usual impact from the recall.

“The sales forecast is something that we’re extremely worried about,” Executive Vice President Shinichi Sasaki he told a news conference in the central Japanese city of Nagoya.

“Already, I am hearing that sales have been affected somewhat in January,” he said.

On top of a separate recall for slipping floormats also linked to unintended acceleration, Toyota said some 9.1 million vehicles are now being recalled, more than its total group sales last year.

Although Toyota says the occurance of problems is rare, public confidence is being shaken by coverage of the saga, including the harrowing details of the crash of a Lexus blamed on unexpected acceleration that killed an off-duty California state-trooper and three members of his family last year.

Sasaki, who appeared alone in front of more than 100 reporters, offered no deep bow of apology as has been seen at other ‘scandal’-related media conferences in Japan.

Koji Endo, director at Advanced Research Japan, said there had been a lack of communication from the top of Toyota.

“I’ve never seen Toyota like this. Until recently, they had a culture of reacting swiftly to problems. But the impression I get now is that PR is not functioning very properly.”

Toyota President Akio Toyoda, the grandson of the company’s founder, has not formally addressed the public or media on the recall problems. While in Davos, Switzerland last weekend, he appeared briefly on broadcaster NHK and apologised to consumers.

The company’s US head, Jim Lentz, appeared on TV on Monday and also expressed his regret as part of a public relations blitz in Toyota’s largest market.

Sales monitored
Toyota detailed its plans to fix the faulty pedals on at least 4.2 million vehicles in North America and Europe with a small metal shim, or spacer, to prevent sticking.

Toyota said it would restart on February 8 production of the eight models including its popular Camry, Corolla and Rav4 models after an unprecedented one-week shutdown at six plants in the US and Canada.

Sasaki said costs were not taken into account with the recall and said they would monitor sales before reviewing their 2010 forecast.

Toyota last month forecast global auto sales to rise six percent this year but has since said that did not take the impact of the recalls into account.

The costs for the recall and the shutdown now look to come to roughly 100 billion yen to 200 billion yen ($1.1bn to $2.2bn), two analysts estimated.

“It’s a positive that we now can grasp what the direct costs might be, but Toyota has yet to address uncertainties about indirect costs, such as litigation costs and costs of incentives to win back customers,” said JP Morgan analyst Kohei Takahashi.

“The size of these indirect costs is of far greater importance” for Toyota’s future, he said.

Shares in Toyota rallied almost five percent in Tokyo on Tuesday following the company’s US announcement on the fix and restart for production.

The jump in its shares comes after about an 18 percent tumble over the last seven business days that wiped out more than $20bn in market capitalisation. A weaker yen also boosted shares, some investors said.

Lawsuits, delays
Toyota faces a growing number of lawsuits claiming it and its US supplier CTS Corp endangered drivers by not acting sooner to fix problems with faulty accelerator pedals.

Lawsuits announced on Monday in the US claimed Toyota had ignored signs of trouble with some of its top-selling models. The suits are part of what is expected to be a wave of litigation against the automaker for claims ranging from losses on car resale values to injury and death.

Analysts and dealers said it would take months for the automaker to fix all of the vehicles at risk of having an accelerator pedal stick in the open position.

Rivals such as General Motors Co, Ford Motor Co and Hyundai Motor Co have been offering discounts targeting Toyota customers.

Australia central bank skips a hike

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Australia’s central bank shocked markets by skipping an interest rate rise this week, citing the impact of higher mortgage rates at home while noting tighter policy in China and concerns over sovereign debt abroad.

The Reserve Bank of Australia’s (RBA) decision to keep its key cash rate at 3.75 percent confounded expectations of a rise to four percent and hammered the local currency as investors slashed estimates for how high rates might go this year.

Yet, RBA Governor Glenn Stevens also emphasised that, should the domestic economy continue to improve as expected, then further hikes would likely be needed over time.

“This is a pause, not a stop,” said Peter Jolly, head of research at National Australia Bank. “It’s just that they paused earlier than most thought.”

“I don’t think they have radically changed their view,” he added. “We still think they need to lift rates again and we see rates at 4.75 percent by the year end.”

The market was badly caught out, however, having almost fully priced in a hike at the policy meeting.

Investors now doubted if the RBA would move in March either, with futures pricing in around 35 percent chance of a rise. Expectations for the next 12 months were pared back to show around 80 basis points of tightening, compared to 105 basis points before the announcement.

“It implies that the RBA feels it has done enough for the time being,” said Stephen Roberts, a senior economist at Nomura. “You’d think there would be a pause for a few months before lifting to four percent by mid-year. It’s going to be a slow process getting the cash rate higher.”

One eye offshore
The RBA’s caution was warmly welcomed by the Labor government which faces a tough election fight later this year.

“Families will welcome this decision and businesses will welcome this decision,” Treasurer Wayne Swan told parliament. Mortgage rates are a sensitive topic in Australia, where home ownership is a national obsession.

Analysts suspected recent events offshore may have added to the case for a pause. In a brief policy statement, RBA chief Stevens noted China had begun to rein back stimulus in its economy, global credit conditions were difficult and worries had grown over debt levels in some countries.

China’s tightening have rattled investors globally as they worried demand from the world’s major growth engine could falter. South Korea’s finance minister told reporters last week that the government needed to prepare to offset the impact of any policy moves in its biggest export market.

“So maybe a little bit more of international concern stayed their hand and they want to see how that evolves,” said Joshua Williamson, an economist at Citi.

“But there is a risk given the underlying strength of the (domestic) economy that this was a missed opportunity and they’re going to have to potentially go a little harder in the second half of the year if they don’t make this up in the next few months.”

Indeed, the RBA was resoundingly upbeat on the domestic outlook saying the economy had proved stronger than expected with unemployment peaking much lower than feared, resource investment strong and house prices up sharply.

The source of doubt seemed to be that lending rates in the economy had risen faster than the cash rate, as banks sought to cover increased funding costs caused by the global credit crisis.

The RBA has estimated that effective rates across the economy were now more than 100 basis points above the cash rate, far higher than before the credit squeeze.

This means that a neutral rate, one that neither stimulates nor retards economic growth, is also lower than in the past.

As governor Stevens often says when quized on where neutral is: “We’ll know when we get there.”

Kenya’s MPC sees no risk with domestic inflation

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Kenya’s inflation rate is likely to remain low in the near future as the performance of east Africa’s biggest economy improves, the central bank’s Monetary Policy Committee (MPC) said on Friday.

In a statement expounding upon the MPC’s decision to keep its key central bank rate (CBR) at seven percent on Tuesday, Central Bank of Kenya Governor Njuguna Ndung’u said overall inflation rates were “low and stable”.

Kenya’s inflation rate fell precipitously after the statistics agency adopted a new calculation method in October.

It is expected to ease even further with the February data when the country changes the basket of goods it uses to compute inflation, most likely lowering the weighting for food items.

“Given the higher growth prospects for emerging economies in 2010, coupled with the convergence of Kenya’s inflation to that of its trading partners … there are no upside risks to domestic inflation in the near future,” the MPC said.

Kenya’s inflation rate was at 17.9 percent September but fell to 6.6 percent in October after the calculation change. In comparison, inflation in trading partner South Africa was below six percent in October and November, the committee said.

There was, however, the threat that high fuel prices could put pressure prices. Kenya relies on generators running on diesel for a fair amount of electricity production at the moment after sparse rainfall hit the levels of dams producing power.

Oil prices are, however, rising much slower than would have been expected during the current extreme winter in the northern hemisphere and are unlikely to increase to the record highs seen in mid-2008, the committee said.

The MPC reiterated that the CBR – which the central bank uses to signal where it sees short-term rates – had failed to bring down commercial lending rates, nor lengthen the maturity of loans to the private sector.

The committee asked the central bank to explore ways of restructuring commercial banks’ credit markets so that they are more responsive to monetary policy signals.

“The failure of the banking system to extend the maturity of their loan products appears to have been a consequence of the structure of their deposits,” the MPC said.

“However, economic growth could be supported by institutional developments that support development banking products and lending to small scale enterprises.”

Too big to fail

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White House adviser Paul Volcker will urge Congress to curb the risks taken by large banks to help prevent them from being treated as “too big to fail,” according to a testimony.

Detailing a recent proposal known as “the Volcker rule,” the former Federal Reserve Chairman will tell lawmakers that commercial banks’ proprietary and speculative activities should not be protected by the government.

He will also urge international consensus on “appropriate” actions to restrict commercial banks’ activities.

Volcker – an adviser to President Obama whose star has risen in recent weeks – will appear before the Senate Banking Committee to defend the administration’s latest proposal to rein in the banks.

In January, Obama proposed limiting commercial banks’ ability to engage in proprietary trading, to end their ties to hedge funds and private equity funds and to restrict the future growth of large banks beyond a new market share cap.

In his testimony, Volcker will say there are strong conflicts of interest inherent in participation by commercial banks in proprietary or private investment activity.

“I am not so naive as to think that all potential conflicts can or should be expunged from banking or other businesses,” Volcker said in his prepared remarks.

“But neither am I so naive as to think that, even with the best efforts of boards and management, so-called Chinese walls can remain impermeable against the pressures to seek maximum profit and personal remuneration,” he said.

Taken on board as an adviser early on by Obama, Volcker initially seemed to have not much of an impact in the administration. But that has changed since the Democrats lost a special Senate election in Massachusetts and Obama moved to a more populist stance, proposing new bank restrictions.