Month: February 2011

When the achievements of Alan Mulally, Ford Motor Company’s president and chief executive, are finally added up, the occasion of January’s Detroit motor show will figure large. It was then, in a genuine shock to other automobile firms, that Mr Mulally unveiled the Ford Focus Electric. The latest product of the 107 year old company, the battery-powered car is seen as a game-breaker not just for Ford but for the industry. Not only will the car compete on price with the Nissan Leaf, Europe’s car of the year in 2010, it will charge up faster and probably run longer between plug-ins.

As such, the Focus Electric and its first cousin, the Focus Hybrid, will maintain the momentum of one of the most remarkable comebacks in American business history. Indeed the hybrid model, much to the chief executive’s satisfaction, has outdone arch-rival General Motors because it will have a range of 500 miles, significantly longer than GM’s Chevrolet Volt.

Even better, Mr Mulally rolled out the vehicles in Ford’s home town of Detroit. He could hardly have made a clearer statement that Ford has achieved “the biggest business turnaround of the Great Recession,” as one analyst put it.

In an extraordinary and highly eventful four years, Ford has recovered on three fronts under its unlikely chief executive. It has ground its way out of a crippling mountain of debt. It has re-engineered its global business under the One Ford slogan, releasing a parade of award-winning automobiles that sell worldwide instead of in separate markets. It has achieved a profit, an achievement considered unthinkable when Mr Mulally was parachuted into the firm. And, unlike its other ‘Big Three’ rivals GM and Chrysler, Ford has done so without a cent from Washington.

Although Ford is not entirely out of the woods yet, the facts speak for themselves. In 2010 Ford earned a pre-tax operating profit of $2.9bn – a 650 percent turnaround on 2009. At the same time Ford’s ranking in its heartland US market jumped 1.4 percent – a giant-sized gain in a country where the titans of the global automotive industry are engaged in an endless battle for a point or two at a time. Ford also took over the top spot from Toyota as the best-regarded car brand. Astonishingly, Mr Mulally even achieved a successful revival of the Taurus brand, previously considered extinct.

And outside America and the UK, where it’s been active for much of the 20th century, Ford achieved breakthroughs in the emerging Asia Pacific and Latin America markets – vital territories for the automotive giants.

Along the way, Moody’s awarded Mr Mulally’s turnaround its own seal of approval by rating up its bonds with the verdict that Ford now has “an economic model that is clearly more robust and competitive, capable of maintaining a significant improvement in its performance over the course of time.”

Air to auto
Startlingly, until four years ago the leader of the rescue mission hardly knew anything about the automobile industry – and even less about the firm with the famous blue oval badge. His vehicle of choice at that time was a Lexus built by the current enemy, Toyota. As the sceptics said when he took over, Mr Mulally would find himself hopelessly out of his depth. He was an aerospace guy, hired from Boeing where he was number two, the father of the 777. Even his mother tried to dissuade him from taking the impossible job. “Alan, you’re not a car guy,” she warned.

So how did the aircraft guy achieve this feat in an alien industry? Highly summarised, he did so through a relentless focus on reality, an impatience with any failure to deal with problems, a refusal to accept automotive folklore, a willingness to fire second-raters, and an openness that came as a breath of fresh air in Dearborn, Detroit. Combined, those qualities make for a highly transparent management style.

And he’s in a hurry, says his immediate boss, executive chairman Bill Ford Jnr: “Alan is not a very complicated person. He is driven.”

That drive comes from a sense of mission. “I am here to save an American and global icon,” Mr Mulally declares simply. Others see Ford’s saviour as turbo-charged by a delight in the challenges, risks and, ultimately, the reward of the job. “If enthusiasm is measurable in automotive terms, Mr Mulally is 16 cylinders of it, pedal to the metal,” wrote Automotive News.

Yet when he took over it seemed that no amount of cylinders could save Ford from a slow extinction and, as many feared, an eventual takeover by much more efficient and profitable Japanese brands. In a nutshell Ford had far too many models as well as brands, and some of those models had more options than buyers knew what to do with. Some women buyers, it was reported, were reduced to tears when confronted with the dashboard of the Lincoln Navigator and its 128 options.

The firm also had too many employees with excessively generous benefits, too many plants, much too much debt and, as insiders now concede, too much in-fighting between turf-conscious, power-hungry senior executives.

Man with a plan
Mr Mulally took up residence in a house three kilometres away from the plants – he can see them from his window – and launched into a fact-finding mission. Carrying notebooks everywhere he went, the newcomer studied up on the company, talking to everybody, scribbling notes and typing them up. Eventually, they filled five binders that gave him a fresh overall picture of what had to be done.

Having compiled all that, he set about summarising everything, like a chef reducing a sauce to its essential elements. Mr Mulally is now famous for being able to present the global company’s entire comeback strategy on a single sheet of paper. And, having determined the main elements of the task ahead, he started tackling them one by one. Here are the results.

The global workforce is now 178,000, down from 300,000, and the number of plants has been cut by nearly 30 percent to 80. Capacity utilisation has jumped to a healthy 85 percent.

He dealt ruthlessly with ruinous employee benefits secured by the United Auto Workers (UAW) union in much rosier, pre-recession times. Mr Mulally effectively gave the UAW an ultimatum: take a stake in Ford’s future by converting the benefits to stocks and cash, or face losing the lot. They took the first option and their entitlements came off the firm’s books. Next he took on the impossible, demanding that hourly rates come down to viable levels. Eventually the UAW settled from $76 an hour – a rate that essentially handed victory in showroom prices to Toyota – to $55 an hour.

So far, so good. Ford’s ill-planned and ill-fated excursion into premium brands through the purchase of Jaguar, Range Rover, Aston Martin and Volvo was draining the company of cash and resources. The first two were sold to India’s Tata Motors, Aston Martin went to a British-led consortium fuelled by Middle East debt, and Volvo was eventually snapped up by Chinese manufacturer Geely.

It could be said that all of the above were commonsense decisions that any experienced and determined manager would make. But next, the aerospace guy turned his attention to cars, more specifically the expensively high number of models that had the effect of cutting Ford’s margins to the bone, especially in a fast-downsizing world. Result? Ford now sells fewer than 60 nameplates worldwide under the Ford and Lincoln brands, down from 97. The Mercury marque has been dropped.

But even 35 percent fewer models is too many, and Mr Mulally is in the process of cutting that figure by a further 20 percent while reducing the number of platforms on which it builds cars from 25 to a dozen.

Crucially, at the same time he restored the Ford brand to primacy within the group. That was clearly the biggest decision of all and, say insiders, it was largely Mr Mulally’s.

Simplicity clearly pays in many ways, but particularly in terms of quality. As Ford manufacturing boss John Fleming explains: “Since the orderable combinations will be reduced by more than 50 percent, that means that on half of the cars, it’s significantly simpler for the manufacturing plant. Also, the ability to make a mistake is reduced.” The results showed up quickly in what had long been a discounted brand. In a JD Power survey of initial quality in mid-2010, Ford ranked number one among car brands excluding luxury makes.

Assembled assets
Perhaps Mr Mulally’s biggest coup was rejecting Washington’s offer of a taxpayer-funded bail-out, stupefying most people in the industry, not least Ford’s dealers who predicted a domino of bankruptcies as a result. Of all the former Boeing man’s moves, this was regarded as the most bold and, in hindsight, clear-headed.

Instead of taking the president’s dollar, Mr Mulally borrowed $23.5bn by taking the unprecedented step of mortgaging all of Ford’s assets to a vast consortium of bankers. Even the famous blue oval badge was thrown into the pot. But it only happened after what must have been one of the most persuasive speeches behind closed doors of the year. “I spoke to a room with over 500 bankers,” Mr Mulally recalls. “Why did they give us the money? Because we had a plan.”

That plan was to stack up enough free cash to ride the storm after the collapse of Lehman Brothers in 2008 stopped almost dead the flow of credit that underpins auto sales in the US and in most other markets. Having weathered many a cycle in his 37 years in the aerospace industry, Mr Mulally knew it was time to batten down the hatches.

With the operating finances more or less guaranteed, Mr Mulally launched a none-too-subtle reform of the corporate culture. He particularly disliked the lack of openness at meetings. Senior executives held back bad news about product development lest it reflect badly on them, while others answered their Blackberrys during presentations or talked over their colleagues, infuriating the new boss. In short order he banned Blackberrys and established ground rules for meetings.

“If somebody starts to talk or they don’t respect each other, the meeting just stops,” Mr Mulally told Fortune in the middle of the revival. “They know I’ve removed vice presidents because they couldn’t stop talking because they thought they were so damn important.”

Otherwise many of his managerial measures were simplicity itself. For instance, he insisted on colour-coding reports, with green standing for good, yellow for caution and red for problems needing an immediate fix. At the first few meetings, to Mr Mulally’s surprise, all the reports were marked green.

“We lost $14bn last year,” the stunned boss told them. “Is there anything that’s not going well?” At the next meeting the reports came marked with all colours.

Unsurprisingly, not everybody took to the intruder. Mr Mulally had barely arrived before senior executives started knocking on the executive chairman’s door. Bill Ford Jnr, fourth generation of the Ford family, didn’t open it. He told Fortune: “If I had even cracked the door open an inch to let anybody complain to me or to think that there was ever any separation between the two of us, I think the culture could have overwhelmed Alan and ultimately brought the company down.”

(Some members of the extended Ford family were not entirely happy either, according to reports, about losing their dividends.)

The revival of the Taurus says a lot about the confidence of the non-car guy. The last model had been such a disaster – the family-saloon equivalent of the ill-fated Edsel – that the name had been dead, buried and forgotten. Nobody in the firm had considered resurrecting the clunker.

Such was Mr Mulally’s faith in Ford that he overruled the sceptics and decided to revive the Taurus as a premium brand, a shining symbol of the Dearborn firm’s Lazarus-like comeback. His main argument was that, because it took billions of dollars to establish a brand, there was everything to lose by not re-launching it. Also, as a highly-qualified engineer who had specialised in aeronautical and, unusually, astronautical sciences, Mr Mulally had a lot of respect for Ford’s engineers and other technical people to do the job.

The latest Taurus, released mid-2010, has been hailed as the latest expression of the revival, an automobile that embodies all the driver-friendly, in-cabin digital technology that has underpinned Ford’s recovery from the dark days of mid-2006. As an impressed reviewer wrote: “Ford has taken aim at European and Japanese luxury imports and hit the target with its re-designed and re-engineered Taurus. It can take on any BMW, Audi, Lexus or Infiniti without giving up a thing.”

By now, Mr Mulally could see that, far from hurting him, his experience at Boeing was a big help – especially in the free dissemination of information, lifeblood of a global corporation.

As he explains: “The idea is that there’s nowhere to hide and no reason to either; if you need help, everyone who can help you is present with the necessary information at hand. That’s what I’ve done for 37 years at Boeing.”

Technically, this is known as large-scale systems integration. “You can’t do it well unless everyone plays nice together,” says Mr Mulally. “A car has about 10,000 parts, and an airplane has about four million, but the technology is the same. The sophistication is the same. The parallels are incredible.”

Unlike many turnaround specialists who are better at cutting costs than building revenue, Mr Mulally had conceived an entirely different future for Ford before he sold off the premium brands like Jaguar. Here once again, the outside view helped him see the big picture.

“Everybody says you can’t make money off small cars,” he says. “Well, you’d better damn well figure out how to make money, because that’s where the world is going.”

The result was the Fiesta, a global vehicle for which the German subsidiary was largely responsible, in a bold and largely unprecedented strategy (conventional wisdom decreed that Fords designed in another country pretty much stayed in that country).

Similarly, the new Explorer SUV, which is built on a lightweight Taurus platform instead of a truck one, will be produced for 90 countries from a plant in Chicago.

The first car to get the full One Ford treatment is the latest Focus, embodying Mr Mulally’s overall strategy – one vehicle for all markets – a feat that wasn’t possible perhaps even a decade ago, say automotive experts.

This radical change of direction is based on a shrewd insight:as consumers’ tastes increasingly coincide because of the spread of global communications, it has become possible to satisfy customers with fewer models. “One spin in a Fiesta will tell you as much,” explains an automotive consultant. “It’s as much Milan as it is Milwaukee.”

Introducing new platforms
But Mr Mulally and newly recruited executives also had an insight that tomorrow’s car must be dramatically different from today’s. The result is MyFord and Sync. As Derrick Kuzak, head of global product development, said recently, the purpose is to employ information-age technology to redefine driving: “The experience [must be] so rich they refuse to give it up.”

So saying, Ford has rolled out Sync, a platform providing voice-controlled, in-cabin connectivity to electronic devices, letting the driver keep her hands on the wheel. There’s also EcoBoost, which improves economy and performance, and Blind Spot, which performs a 220-degree search before the driver changes lanes.

Not all customers embraced these developments with wild enthusiasm, especially in Asia where they knew little about Ford. But Mr Mulally is a natural salesman possessed of an almost overwhelming enthusiasm. Plus, he knows how to make an impact.

Late last year, Harriet Luo, buyer of a Ford Focus, went to collect her car from the showroom in Beijing. There to hand over the keys were Mr Mulally, Ford Asia boss Joe Hinrich and his China counterpart Robert Graziano. Naturally, the buyer’s startled reaction made the news and a big statement about Ford’s ambitions in the country.

A big part of Mr Mulally’s success is that he’s clearly very good with people and almost impossible to dislike. Although some find him over the top and almost corny at first (he often remarks how “really neat” it is to be running Ford), most quickly find his relentless enthusiasm, genuineness and optimism just about irresistible. As sister Lenexa remembers, one of his maxims is “learn something from everyone you meet.”

Another factor is his energy. Mr Mulally typically turns up for work at 5:15am and leaves around 12 hours later. He clearly likes the buzz of running a Fortune 500 giant. “I’ve always wanted to do something important, and it had to be in a big organisation,” he says.

And while you might think that one giant-sized job in a lifetime would be enough for the man who managed the development of Boeing’s 777 airliner and had a big hand in earlier models, here he is doing it all over again: “What gets me really excited is a big thing where a lot of talented, smart people are involved.”

However big his jobs have been, the aerospace (and now car) guy has always kept his feet firmly on terra firma, particularly in his native Kansas. “He’s never forgotten where he’s from,” says former classmate Greg Smith, who plans reunions for the Lawrence High class of ’63. “Some people leave Lawrence and never look back. Alan enjoys coming home.”

It was at Kansas University where he met Nikki Connell, his wife of 40 years. And shortly after being named one of Time magazine’s 100 most influential people, he was back where it all started at Lawrence High, serving as grand marshal for a parade with his 90 year-old mother alongside him in a convertible. As a thank you gesture, he recently donated a 15-passenger van in her honour to a senior citizen centre. After his mother died last year, Mr Mulally gave the keynote speech for a school fundraising.

Attaining goals
According to his early friends, Mr Mulally was always chronically ambitious. As well as studying aeronautics at Kansas University (Kansas is one of the great aviation states), he was so inspired by the Mercury astronauts later immortalised in Tom Wolfe’s The Right Stuff that he added astronautics with a view to being launched into the heavens.

But that ambition was stymied by the discovery of a form of colour blindness and he turned to aircraft design. Hence Mr Mulally’s admiration for engineers in an industry that often seems to be overtaken by the marketers. He recalls his professor’s dictum about the importance of teamwork: “If we make a mistake, we can cause people to die. So you better damn well work together.”

These days, in what must surely be his last big job, Mr Mulally retains the relentless focus of his youth. “I’m rarely offline except during major family holidays,” he admitted in a recent interview. “Then I enjoy playing with my kids, being in nature and cooking for family and friends.”

And for a man who’s on the brink of pensioner status, his facility with social and other forms of media is unusual, regularly using Flickr, Twitter and LinkedIn to stay in touch with family and friends. And – because a steel-trap mind has enabled him to reduce global problems to single sheets of paper – he still has time for a lot of extra-curricular reading about the environment, technology and other burning issues.

Despite his success at Boeing, Mr Mulally’s head-turning stint at Ford will probably be his main legacy. The hard yards covered, he’s now in the home stretch. Barring further recessions, analysts say Ford will post rising profits in 2011 and future years. Soleil Securities, a firm that keeps a close eye on the automobile industry, estimates Ford can boost operating profit margins from the current seven percent to 13 percent, adding a further $7bn to operating profits on projected sales of $118bn. The firm still has a $27.3bn debt to pay back but it’s not federal debt and, for once, the bankers are happy.

And so is Alan Mulally. Having rescued what was four years ago regarded as a brand in the doldrums, he’s after much bigger fish. “Our competition now is really Toyota and Volkswagen, because they are pursuing the same fundamental strategy — a full family of cars and best in class,” he explained in a recent interview.

As recently as two years ago, Toyota and the Volkswagen group would have laughed at such outrageous ambition – but Mr Mulally believes it’s only logical and, given his boundless optimism, perhaps even inevitable. “I’ve lived 40 years of producing safe and efficient passenger transportation – first with commercial airplanes and now with automobiles,” he explains. “And we will never, never go backwards. Every year it will get better and better.”

You could say the same for the blue oval.

Man of the Year: Alan Mulally
Born in Oakland, California in 1945, Alan Mulally is a native of Kansas. He joined Boeing in 1969 at the age of 25 after graduating in aeronautical and astronautical engineering from Kansas University. He moved steadily up the organisation, taking growing responsibility for a series of aircraft up to the 767. In 1994, he became responsible for all aeroplane development including flight tests and certification. Before being named chief executive and president of Ford Motor Company in September 2006, he was president and chief executive of Boeing Commercial Airplanes. According to the latest remuneration information for 2009, Mulally earned from Ford a total $17.9m in salary, bonuses and options.

The recipient of numerous awards, Mr Mulally has been named “Industry Leader of the Year” by Automotive News and one of “The World’s Most Influential People” by TIME magazine. He serves on the President’s Export Council, formed in 2010 to advise President Obama on export enhancement.

In his leisure time he flies a private aircraft, plays recreational tennis and reads. Married to the former Nikki Connell for 40 years, the couple have five children.

There is no doubt that cash is an expensive convenience. Its anonymity offers the opportunity for tax avoidance and money laundering, both of which cost governments billions. The business costs of handling cash are escalating, too.

According to a recent study by analysts at McKinsey, the cost of cash to society is about €200 per person; European banks alone could save between €45bn and €90bn per year by eliminating cash from their systems. The costs include both the security and the labour involved in processing and transporting cash, maintaining automated teller machines (ATMs) and removing cash from circulation.  

But handling money is what banks are about, and many see the provision of payment services through current accounts as a way of capturing customers who can then be sold additional, more profitable products. With this in mind, the banking industry in many developed economies has favoured cashless technologies that allow customers to make payments at point of sale terminals with credit or debit cards. By linking these card accounts to a bank account, the banks ensure that the customer is still firmly in their grasp.

Use of these cards has become popular as a replacement for the use of cheques on high value items, making payment service providers (PSPs) very wealthy. Visa, the largest retail electronic payment network in the world, posted income of $774m for the fourth quarter of 2010. But cards have not replaced the use of cash. According to the latest figures from the UK’s Payments Council, over 60 percent of payment transactions are still in cash, although this accounts for only 23 percent of retail payments by value.  

The reason for the discrepancy is that cash is still used for low value purchases, such as the daily newspaper, a sandwich or the bus fare, where the cost of a credit or debit card transaction makes its use prohibitive. To address this end of the market, several banks and PSPs are introducing ‘contactless’ payment systems using NFC (near-field communication) technology. This involves a chip embedded in either a card or a mobile phone, which can be presented to within four centimetres of a reading device that will automatically deduct the funds. No user authorisation such as a signature or a PIN number is required, making the transaction simple and fast. Limits are currently in place restricting each transaction to below €15 and four transactions per day without authorisation to protect the customer from fraudulent use.

Despite heavy development and marketing investments on the part of the banks and their partners, however, these systems are not going to replace the use of cash overnight. While retailers and PSPs argue over who will bear the cost of installing the point of sale equipment (it is estimated that there are nearly 30 million point of sale locations in the world), mobile phone manufacturers are still busy developing the next generation phones that will accommodate the NFC chip.  

In the meantime, demand is patchy. Customers in some regions are resisting the use of these systems due to concerns about security and the lack of a paper trail. In others, society is demanding rapid implementation to protect its citizens. Sweden’s unions, for example, have demanded the early introduction of cashless systems because they are fed up with the high levels of armed robbery targeting the movements of large amounts of cash around the city.

As momentum slowly gathers, the old problem of technology standardisation comes to the fore. With the major players all jockeying for position in what promises to be a lucrative market, retailers and customers will be faced with a confusing array of options. The city of Istanbul, which had little established payments infrastructure in place, has become a testing ground for cashless systems with no fewer than five different pilot projects running over the past five years. Each one has a different combination of bank, PSP, telco and technology provider participating. Clearly the will to move to cashless is there but working out the scheme details, building in security, negotiating profit shares and installing the infrastructure will all take time.

A different paradigm
Compare this to the developing world where huge segments of the population have never had access to a bank. In many rural areas bricks and mortar banking infrastructure does not exist, and the low incomes typical of the area mean that banks have frankly not seen any market potential. In Nigeria, where GNI averages £3 per day, it is estimated that 74 percent of the population have never used a bank; 40 percent of the municipalities in the Philippine islands do not have banks within their jurisdictions. 

But what many people in these areas do have is mobile phones. “In Ghana,” says Bruno Akapa, from MTN Ghana, “less than ten percent of the population has access to a bank, but 50 percent have access to mobile telecommunications. We can build on that infrastructure to provide banking services to a much wider segment of the community.” MTN Ghana, a telecoms network provider, launched a service called Mobile Money in 2009 and now claims that 88 percent of the population has access to its service. The service allows mobile owners to store and transfer money, pay bills and purchase goods, without needing a bank account.

To the consternation of the banks, a number of non-bank entities are jumping in to a market they considered their own fiefdom. Telecommunications companies are in the forefront of offering mobile money solutions, while in many rural areas all across developing countries in Africa, Asia and South America, local shops are becoming agents for taking cash deposits and making payments against digital money transfers. Using this system, a young man working in Nairobi can send money via an SMS message from his mobile money account to his family in the country, safely and securely. The recipient of the message can take her phone to a local agent who will pay out the cash once the SMS has been properly validated.

Should the banks be worried? Many are. Despite a rapid increase in demand-driven schemes starting up around the developing world, some banks are turning to legislation in an attempt to resist this incursion into their traditional business activities. The Indian Reserve Bank, under pressure from internal banking institutions, has set out some stringent rules about how mobile banking should work that effectively excludes non-licensed participants. Within this protected environment, the banks are introducing their own mobile schemes but growth is slow compared to the telco-led initiatives in other countries.

Time for a new business model
“This supports my argument that the banks would be better off letting the telcos and PSP specialists deliver payment services and concentrating their efforts on creating other products to sell on the new platforms,” comments Dave Birch of Consult Hyperion.

For most European banks in normal years, Birch points out, payments account for around a third of income and 40 percent of costs. Strip out the payments and you increase the profitability of the bank. Payment services can then be handled by specialist organisations operating under payment institution rather than the more onerous credit institution licenses, giving them much lower cost burdens.  

These specialist PSPs will also have the flexibility to handle the very low value transactions that many experts believe will drive the final push to a totally cash free society. Recent innovation has produced end-to-end transaction aggregation which reduces the per transaction cost by eliminating the need for per transaction reconciliation, posting or processing at any point in the value chain.   

Once these facilities are in place, the market potential is huge. Forget the people buying a single apple or the daily newspaper: savvy marketers are eying the potential for monetising online content such as music, gaming and journalism. “Zynga, an online social game developer with 360 million active monthly users, is currently the second biggest merchant on PayPal, and that is all clocked up from low value payments to buy virtual goods within the game scenario,” notes Birch. “The market potential for low value transactions is vast.”

Mobile banking in less developed economies is also opening new markets, in addition to helping people with the basic necessities of life. In Haiti, an initiative that has the backing of the William and Melinda Gates Foundation and the US Agency for International Development is enabling residents to access the money needed to rebuild lives shattered by last year’s hurricane. Around the world in Senegal, people in outlying areas with no access to banks were able to use their mobile phones to send payment to satellite providers and watch the World Cup.

The most successful mobile money scheme to date is M-PESA, launched in Kenya in 2007, which today has an estimated 12 million users. A recent study has shown that the incomes in households with M-PESA users have increased between five and 30 percent and the banks are beginning to wake up to the opportunity this represents.   Equity Bank Ltd., Kenya’s largest provider of small loans, has recently formed a partnership with Safricom to allow Kenyans to open bank accounts through M-PESA.

“This service has, [by September 2010], already led to something like 750,000 new accounts being opened,” notes Birch, “so it’s absolutely clear that mobile money provided by non-banks not only does not compete with banking services, it can actually turbocharge them.”

But if the global credit crisis and subsequent economic fallout has taught investors one thing, it’s that we are not living in normal times – this evidenced by central banks across the Western World employing quantitative easing measures (with varying degrees of success) to kick start their domestic economies in order to avoid slipping back into recession.

Meanwhile, currency debasement – not least that of the US dollar, which many analysts now argue is in a long-term bear trend – has become the watchword. And with the value of paper declining, gold, unsurprisingly, has consolidated its position as a long-term store of value and the investment of choice.

Yet this doesn’t tell the full story. Indeed, in many ways gold proved to be a sideshow in 2010 – its 28 percent increase in value paling into insignificance against the 97 percent gain for palladium and 80 percent for silver as global industrial demand began to accelerate. While the latter’s price touched a 30-year high of $30.49, the gold-silver ratio, denoting each metal’s relative performance, touched a four-year low, ending the year at 46.0, after having been at 64.9 as of end-2009.

Add into the mix the eurozone debt crisis, culminating in multibillion bailouts for Greece and Ireland, and it isn’t difficult to find the major drivers of investment demand for gold and other precious metals.

Latest available data (Q3 2010) from the World Gold Council illustrates the point. It shows total gold demand at 922 tonnes, an increase of 12 percent from Q3 2009. In value terms, demand grew 43 percent to $36.4bn over the same period. Demand for gold jewellery increased by eight percent from Q3 2009 (a record $137.5bn in value terms), with four of the best performing markets – India, China, Russia and Turkey – accounting for 63 percent of global demand.

Elsewhere, retail investment rose 25 percent (from Q3 2009) to 243 tonnes – the largest contribution to total demand growth coming from bar hoarding, which increased 44 percent from the previous year.

The total value of net retail investments during the quarter was a record $9.6bn, representing a 60 percent increase from Q3 2009.

However, total gold ETF (Exchange Traded Funds) demand fell by seven percent from Q3 2009 to 39 tonnes, following a surge in the previous quarter due to heightened sovereign risk and ever-present currency worries.

Industrial demand has now recovered back to pre-crisis levels of 110 tonnes, reflecting an increase of 13 percent from Q3 2009 – the recovery having been driven by improving demand for consumer electronics goods globally, in particular from emerging markets such as China and India, as well as an increased range of new technology products with gold components.

Despite the largely positive fundamentals, Charlie Morris, who manages HSBC Global Asset Management’s Absolute Return Service, errs on the side of caution. Thusfar the bank has maintained a significant position in the metal for three reasons. First and foremost it is seen as a ‘value trade,’ where the long-term target, according to the bank, is $2,600/oz – based on comparisons to commodities, money supply, inflation and other real assets. However this target could take several years to be realised.

Secondly, structural demand exceeds supply with a queue of potential buyers ranging from central banks to private individuals, but a relatively tight supply from the mines. Therefore, falls in the gold price are likely to be limited by supportive buyers.

Finally, the behavioural characteristics have been more attractive than either equities or other commodities, as gold has lower volatility, high liquidity and offers diversification benefits due to its low correlation.

“That said, following the strong rise in price, the correlation with generic ‘risk assets’ has increased and so the diversification benefits have slipped away at a time when it is quite extended from trend in dollar terms,” says Mr Morris. “We have therefore taken the prudent course of action and halved our position in gold bullion to six percent to reflect the fact that we remain bullish over the long term but acknowledge that gold has run ahead of itself at a time when the diversification benefits have become less obvious.”

Meanhile Tom Kendall, gold analyst at Credit Suisse, believes fears over the past year of currency debasement, political upheaval and inflation – resulting in substantial flows of money moving into gold from institutional and private investors – will continue in 2011, albeit at a more sedate pace.

“We expect most of those concerns to persist through 2011,” he says. “The forecasted creeping rise in US interest rates, particularly at the long end of the curve, would pose a challenge to higher USD gold prices were we in a more ‘normal’ global environment.”

“However, although we expect the recovery in global industrial production and fixed asset investment to continue, financial markets are likely to remain ‘sub-normal’ for some considerable time to come,” he says.

Despite US interest rates expected to begin creeping up, Mr Kendall says short term interest rates in real terms are expected to remain near zero or negative. Both factors should help feed bullish gold market sentiment.

Inflation will also continue to feature high on the list of gold investors’ concerns in 2011.

While gold is by no means an exclusively macro-economic play, flows in the physical markets remain hugely relevant to understanding both price direction and, in particular, support and resistance levels. And with central bank/sovereign funds expected to be net buyers of significant volumes in 2011 – for the first time in many years – the bullish portents remain good.

Mr Kendall argues that not only has gold re- established strong credibility as a reserve asset over the last two years, he also believes there has been more of a ‘generational’ shift in thinking rather than a temporary change in sentiment.

The investment bank, which says the gold bull market will persist into a tenth year in 2011; is forecasting an average price for the year of $1,490/oz but expects it to trade above $1,600 at some point before year-end.
Like Mr Kendall, currency debasement is a theme taken up by Suki Cooper, precious metals analyst at Barclays Capital. In its 2011 Outlook, issued in January, BarCap is forecasting the price of gold to average $1,495/oz, with a high of $1,620.

“We expect investment demand to propel gold prices to fresh record highs this year,” says Ms Cooper – this based on a clouded macro environment against a backdrop of low interest rates, growing uncertainty surrounding currency debasement and medium-term inflation fears, as well as geopolitical tensions continuing to stoke investors’ appetites for a portfolio diversifier and a safe haven.

Conversely, jewellery demand is expected to weaken, though scrap supply will likely respond to higher prices, resulting in a notional gold surplus. However, the bank expects this to be absorbed by investment demand.

Looking ahead, the elephant in the room will remain, as ever, China – the Beijing authorities in December raising one-year lending rates and the one-year deposit rate by 25 basis points to 5.81 percent and 2.75 percent respectively.

The rate increases – the second since mid-October – had been flagged well in advance after Chinese leaders announced in early December a shift to a ‘prudent’ monetary policy from a ‘moderately loose’ one in response to inflation hitting a 28-month high in November of 5.1 percent.

Market consensus is for three further rate hikes of 25 basis points this year.

For gold, higher interest rates may negatively hit domestic demand as it raises the opportunity cost of holding the metal. And that may have an effect on the market more generally in terms of gold’s price potential on the upside.

Despite tighter monetary conditions in China, demand for high tech goods and electronics due to the metal’s well-known resistance to oxidative corrosion and excellent quality as a conductor of electricity should provide some price underpinning.

Moreover, the People’s Bank of China issued guidelines in August 2010 outlining the further development and deregulation of the domestic gold market – the implication being that the Chinese government is supportive of investment in gold. Despite changing macroeconomic conditions in the interim there is little likelihood of the government retreating from this stance in the short to medium term at least.

On the industrial front, global mine supply, after years of underinvestment in the 1980s and 1990s, has failed to respond to record high nominal prices in the interim. Expectations are for little likelihood of this changing for the next several years at least – an imbalance that may be further aggravated as advancements in nanotechnology, as well as environmental and biomedical applications, lead to greater demand for the yellow metal.

When FIFA President Sepp Blatter announced in December last year that the 2022 football World Cup would be played in Qatar (to the astonishment of almost all observers), it was a victory for more than just the soccer fans of the tiny Arabian Gulf state. It also meant that for the next 12 years Qatar will receive a crescendo of publicity, putting its name in front of hundreds of millions, if not billions of people – and thus giving a massive, if indirect, advertising boost to all its institutions, financial and commercial, at a time when the country is fighting for attention against much better-known Gulf investment destinations such as Dubai, Abu Dhabi and Kuwait.

Before its successful World Cup bid, Qatar, which occupies a mostly-desert, 80 mile wide and 150 mile long peninsular sticking out into the Gulf from Saudi Arabia, was best-known for being the world’s largest exporter of liquified natural gas (LNG), and the owner of the third-largest natural gas reserves on the planet, after Russia and Iran. Even those westerners who have heard of the Al Jazeera television network, the Arab world’s most popular, probably fail to realise it is based in Qatar.

Until the 1930s, Qatar’s sources of income were restricted to activities such as pearl-fishing – a trade wrecked by the development in Japan of artificial pearls. However, the discovery and exploitation of oil and gas has propelled what was a previously impoverished Muslim emirate to the country with the second-highest GDP per head in the world.

Qatar’s economy grew 11 percent in 2009, and was predicted by the IMF to grow at 16 percent in real terms in 2010 and at 18.6 percent in 2011. The country’s population has leapt to almost 1.7 million people in 2010, from just 70,000 in the 1960s and only 500,000 in 1997. Qatari citizens make up less than a quarter of that total, as expat workers have flooded in from the rest of the Arab world, the West and, in particular, South Asia.

But Qatar’s oil is expected to run out in 2023, the year after the World Cup arrives, and while it has enough gas reserves to supply global demand for more than a century, like other economies in the Gulf, the country is looking to boost its non-oil and gas income and reduce its reliance on the energy sector. With the huge amounts of cash that the oil and gas industries have brought to the Gulf, there has been an increasing need for a locally based financial services industry to handle all that money. The Qatari government has announced it will be investing more than $130bn in an attempt to create a “modern, sustainable and industrialised economy,” while the entire Gulf Co-operation Council (GCC) area, which includes Kuwait, Qatar, the UAE, Saudi Arabia, Bahrain and Oman, has planned investments of more than $1.2trn.

At the same time, the Gulf’s geographical position, between Europe and Asia, give it an extra attraction, as a base for financiers looking to do business in both directions. In 2005 Qatar inaugurated the Qatar Financial Centre, prompted, perhaps, by the opening the previous year of the Dubai International Finance Centre in the neighbouring United Arab Emirates, which now contributes more than one percent of the GDP of the whole UAE.

Restrictive access
Gulf countries are generally surprisingly restrictive when it comes to letting foreign companies start businesses within their borders, insisting that the business has to be a partnership, at the least, with one of their own citizens. Some sectors are especially ring-fenced – Qatar’s retail banking sector, for example, remained closed to foreign financial institutions. In addition, rules covering foreign workers are often strict, with tight controls on working visas and limits on employees’ ability to move to new jobs once they get into the country.

However, recognising that the financial services industry is a special case, Gulf countries have taken pains to give investment banks, insurance firms and the like as liberal an environment as possible. The Dubai International Finance Centre, for example, is a 110-acre “free zone” in Dubai with its own laws, regulations and courts.

The Qatar Financial Centre likes to boast that, unlike its Dubai rival, it is “not a property development,” and that the laws that set up the QFC allow any buildings in Doha, Qatar’s capital, to be designated as QFC sites.

However, firms licensed by the QFC still enjoy advantages other companies operating in the emirate do not necessarily have. The QFC allows 100 percent ownership by foreign firms, while all profits can be remitted outside Qatar. It also has its own (more liberal) immigration and employment laws, and its own civil and commercial court. The QFC regulatory authority has brought in regulators from Europe and the US and closely modelled its legislation on other leading financial centres, such as the City of London.

Currently the QFC occupies two towers in the West Bay area of central Doha which are home to 120 or so licensed firms, local and international; the QFC Authority; the QFC Regulatory Authority; and the Qatar Finance and Business Academy, sponsored by Barclays Bank, which has five floors to itself providing courses in subjects such as Islamic finance, training and even a simulated dealing room.

The QFC has now attracted big investment banking names from around the world to open branches in Doha, including JP Morgan, Goldman Sachs, Rothschild, Barclays, RBS, Credit Suisse, Deutsche Bank, Industrial and Commercial Bank of China, State Bank of India, Nomura and Bank of Tokyo Mitsubishi. The number of people employed in the financial services sector had risen from just 6,200 in 2006 to an estimated 20,100 at the end of 2010, an increase of 35 percent every year.

Ironically, however, considering that Qatar’s economy and investments came through the global financial crisis of 2009 in a much better state than Dubai (overseas investment in Qatar rose from $3.63bn in 2008 to $20.75bn in 2009, while Dubai’s debt problems have still not been completely resolved), the QFC failed to wrestle much investment banking business from its UAE rival. Instead, last year, it announced a “new strategic phase,” focusing on asset management, captive insurance and reinsurance. To help boost those sectors, firms operating in them were exempted from all corporate income tax, already at a low 10 percent. In asset management in particular, the QFC Authority announced it was developing new regulations that would allow authorised firms to operate foreign funds, and establish a regime for QFC-registered retail funds, allowing foreign funds to be marketed to retail customers. At the same time, however, 100 QFC employees, a third of the total headcount, were made redundant as some of its functions were outsourced.

Despite claims by the QFC Authority of an investment of $2-3bn in the asset management sector to boost the country’s financial services industry, the QFC will not necessarily find it easy to make headway in the Gulf’s asset management world. The leader here, traditionally, has been the island state of Bahrain, just to the east of Qatar, which last year had 2,711 funds managing $8.55bn, according to the Central Bank of Bahrain. All the same, Doha is already attracting considerable interest from China, according to Shashank Srivastava, the QFC Authority’s acting CEO, who visited Beijing in November last year. There he announced that the authority was in talks with a dozen Chinese financial institutions, including state-owned banks, about them opening offices in the Qatari capital.

Mr Srivastava, who is also chief strategic development officer at the QFC Authority, is an evangelist for Qatar’s potential as a financial centre. In an interview last year, he declared: “It is our goal to build a world-class financial services marketplace where all participants, both domestic and international, will benefit from the considerable local market potential. They can use it not only as a springboard into other countries in the GCC, but also as a powerful regional base from which to tap into the broader growth markets of the Middle East, North and sub-Saharan Africa and the Indian subcontinent.”

Qatar, Mr Srivastava said, “is opening itself up to the world across many fields. These include culture, education and sport. We are also striving to become an attractive destination for international investment, one of the world’s leading locations for international business and finance and a pre-eminent financial services marketplace. Our goals may seem at first to be somewhat ambitious, but we have no doubt that we will achieve them.”

The country’s bid to stage the World Cup must have seemed wildly ambitious at first as well, until the victorious Emir of Qatar, Sheikh Hamad bin Khalifa al Thani, shook hands with Sepp Blatter in Zurich in December, as the world watched open-mouthed.

It is not surprising that the world’s bond markets have looked less and less appealing since their role in the financial crisis and their performance subsequent to it. What is more, experts predict that there is not likely to be much pick up in developed markets this year, or at least in the first half of it.

In 2010 bonds lost some of their attraction as a safe option. The European bond market in particular is heading for another turbulent year in 2011, with investors groping for direction in the face of an uncertain US recovery and a stubborn debt crisis in the eurozone. Sovereign bonds issued by eurozone members had a rough ride as a result of the debt and deficit debacle in Greece and huge financial pressures on the Irish banking sector. Both countries were eventually bailed out by the EU and the IMF. German and French bonds were the exception, with their yields falling to their lowest levels as investors who feared for the fate of the US economy saw such assets as a refuge.

The criticism of the EU’s poor handling and slow response to the Greek crisis rattled the market further, especially as banks held massive amounts of debt bonds issued by Portugal, Ireland, Greece, and Spain – financially weak countries on what became known as the eurozone’s ‘periphery.’ Eurozone officials moved faster in response to the Irish banking crisis, determined to shield Portugal and Spain from having to be rescued with outside money.

But even with the help of the European Central Bank, which since May has been trying to stabilise the market by buying bonds issued by periphery countries, the eurozone’s financial difficulties are likely to persist.

In particular, investors are looking closely at Spain’s long-term borrowing operations as the country could find itself unable to finance its debt on the market. Spain’s economy ranks fourth in the eurozone and a rescue would be far bigger than anything seen to date in Europe. The size of its economy is twice that of Greece, Ireland and Portugal combined.

Several solutions have been put forward, notably the creation of a permanent, well-endowed rescue fund – already approved in principle at an EU summit – and the launch of joint eurozone bonds, which would increase the chance of financially weak countries finding buyers for their debt. There is likely to be debate as well on whether governments should pursue growth or austerity as a means of securing stability and whether the ECB should step up its bond-buying programme.

The EU has already begun the first part of its euro rescue operation. In January it launched a multibillion-euro triple-A rated bond to raise money for the effort to rescue Ireland’s finances, in this year’s first important test of investor sentiment for Europe’s troubled government debt markets. Bankers say that there was strong demand for the bonds from European, Asian and Middle Eastern investors, even before the official opening of order books.

The EU sold about €5bn ($6.7bn) in five-year debt, the first part of some €50bn in bonds that will go towards the Irish bailout over the next two years. Strategists hope the auction will ease tensions in the eurozone bond markets, amid worries that this could be one of the most difficult starts to a year for the European government bond markets.

At the same time, investors fear that the auction could pose problems for some eurozone governments as fund managers opt to buy the EU debt instead of bonds of countries such as Portugal and Spain.

The euro bond, issued by the European Financial Stabilisation Mechanism on behalf of the EU, is underwritten by Barclays Capital, BNP Paribas, Deutsche Bank and HSBC. A further €5bn was due to be issued by the European Financial Stability Facility (EFSF) on behalf of the 17 eurozone members towards the end of January as World Finance was going to print, which would also go towards the Irish bailout. The European Commission has said that as much as €34.1bn will be raised for Ireland in 2011 and €14.9bn by Europe’s two financial aid funds.

The EU has been issuing bonds since the end of December 2008 when it launched its first bond since 1993 to help fund a loan package for Hungary. It launched another bond in February 2009 to support an assistance programme for Latvia. The EFSF bond is seen as a landmark for Europe’s markets as it will be the first issued by the eurozone as one entity. Some investors say it could be the first step towards a common eurozone bond, which may excite the market, particularly as some EU governments are cancelling their own bond sales. For example, Austria has cancelled a bond auction scheduled for January, opting to issue debt through a syndicated deal instead. Some bankers suggested this highlighted the pressures for eurozone governments as syndications are often used to issue bonds that are difficult to sell.

While the current appetite for bonds in the European market may be subdued, investor interest has moved towards emerging markets, particularly Latin America. Barclays Capital has launched a new emerging market local currency bond index. The Markets Tradable Local Currency Bond Index is composed of debt from about 16 emerging market nations and is a rules-based tradable subset of the flagship Barclays’ local currency government benchmark index.

The portfolio is rebalanced semi-annually and includes representative and liquid benchmark-eligible bonds from four different regions – Latin America, Eastern Europe, Middle East and Africa, and Asia. The index is the latest addition to BarCap’s emerging markets index platform, which includes benchmark bond indices, tradable bond indices, FX indices, equity indices, and interest rate swaps indices.

Also, at the start of the year Acadian Asset Management, which has $48bn in assets under management, announced the launch of its emerging markets debt fund, tapping a developing world its manager believes presents long-term investment opportunities. The Acadian Emerging Markets Debt Fund, trading under AEMDX, is starting off with just over $10m under management. John Peta, whose group oversees $30m in emerging market debt, said the improving fundamentals and convergence of sovereign credit ratings between the developing and advanced economies will offer further upside in emerging markets debt. In particular, Mr Peta likes Brazil and Peru which are benefiting from strong domestic demand and exports to China. “If you were somebody from Mars and looked down at these countries and forget their names, looking at just the characteristics, often times, emerging countries look a lot better,” Mr Peta says.

His views have been echoed by Bill Gross, the manager of the world’s biggest bond fund, Pacific Investment Management. In 2010 he urged investors to buy emerging market bonds to protect themselves from “mindless” US deficit spending and its inflationary consequences. Rising inflation reduces the real returns offered by fixed income investments.

Over the past 10 years, sovereign credit ratings have narrowed between developed and developing markets, says Mr Peta, with the convergence happening from both ends. The emerging markets that were often associated with high risk of default are now predominately investment grade, while established countries such as Italy, Greece and Ireland have suffered downgrades.

Last year, funds focused on developing-nation debt made handsome returns, with many portfolio managers anticipating more in the coming year. The T. Rowe Price Emerging Markets Bond fund posted 12.95 percent returns in the past year. Its manager, Michael Conelius, believes that six percent plus returns are likely this year, citing improving credit quality among the emerging markets. Others such as the Payden Emerging Market Bond fund and PIMCO Emerging Market Bond A Load, each posted more than 12 percent in returns last year.

“The debt dynamics in emerging markets have always been equal or better on average than developed markets,” Mr Peta says. “People don’t realise that, still thinking emerging market countries are a basket case.”

Yet it isn’t just foreign investors who are getting excited about Latin America’s potential: some of the region’s own companies want to enjoy a piece of the action. Several Brazilian companies have moved or plan to tap overseas debt markets to take advantage of a hunger for assets in the South American country. In January the government-controlled Banco do Brasil SA, Latin America’s largest bank by assets, raised €750m by issuing eurobonds, paying an annual yield of 4.625 percent. Demand for the issue reached €1.4bn, underlining the strong interest in Brazilian assets, which analysts attribute to a recovery in commodity prices and the resilience of the Brazilian economy during the global financial crisis.

Brazil’s economy fell into a recession in 2009 on the heels of the global credit crisis, with GDP shrinking 0.6 percent. But 2010 saw a robust recovery, aided by ample government and private credit and a series of tax cuts aimed at encouraging consumption. GDP is expected to have risen by more than 7.5 percent last year. For this year, the country’s economy is likely to post a 4.5 percent expansion, which is fuelling investor appetite and local companies’ willingness to raise cash.  

Since the start of 2011, Brazil’s largest shopping centre operator, BR Malls Participacoes SA, raised $230m by issuing overseas perpetual bonds. Also, medium-sized bank Banco Cruzeiro do Sul SA priced a five-year bond worth $400m, offering a yield of 8.375 percent. Other local companies have also issued debt.

And Latin America is not the only emerging economy that is toying with exploring foreign debt markets to raise cash. Union Bank of India has started meeting investors in order to raise at least SWF125m ($128.5m) in its first sale of debt, denominated in the European nation’s currency. The Mumbai-based bank is selling 3.25 per cent, 4.5-year bonds. Union Bank officials met investors in Zurich, Geneva, Lausanne and Vaduz during November. The bank’s general manager VK Khanna believes that markets in Switzerland are stable and there’s still appetite for emerging-market bonds.

Union Bank is selling Swiss franc bonds to reduce costs and expand its investor base, pricing the notes to yield 200 basis points more than the swap rate. Barclays is helping sell the debt. The bonds mature on July 8, 2015. Indian companies more than tripled the sale of foreign-currency bonds to $8.7bn in 2010 as the central bank drove up rupee borrowing costs with six interest-rate increases. This compares to record sales of $9.3bn in 2007.

But not all emerging markets are benefiting from investor appetite. Some are seeing cash move out of the country, rather than flow in. For example, foreign investors sold a net R23.4bn worth of South African bonds between October and December last year, after net inflows of R75.3bn in the previous nine months, according to the Reserve Bank. Jeff Gable at Absa Capital said that investments in emerging market bonds had slowed, but the reversal in flows was “South Africa specific.” One reason was “the market’s expectation that the November rate cut would be the last.” The central bank cut the repo rate 5.5 percent that month, from a peak of 12 percent in December 2008. “Investors… holding South African bonds during the period of rate cuts may have taken the opportunity to lock in some of the profits from earlier trades,” Mr Gable said. The value of bonds rises when rates fall.

Fund managers say that both longer-term investors and speculators had been investing in local bonds, and that the recent outflows represented profit taking by hedge funds and other speculative investors. In contrast to these hot flows, they say, investment by pension funds was more stable, with investor horizons of up to five years. In the year as a whole, local bonds attracted nearly R52bn in non-resident funds while only R36bn went into Johannesburg Stock Exchange-listed shares.

JP Morgan has estimated a record $75bn flowed into emerging market bonds with the bulk of the flows coming from longer-term investors. The bank also predicts that net inflows into fixed income instruments in emerging markets will stay between $70bn and $75bn this year.

Yet perhaps the biggest casualty of bond market volatility has been Islamic bonds. The UK, Europe’s largest market for Shariah-compliant financial products and services, has cancelled what would have been the first sale of sovereign Islamic bonds by a Western federal government as issues fell 15 percent in 2010. The UK government has decided not to issue sovereign sukuk because it is judged not to provide value for money, according to a spokesman at the Treasury. It says that the UK will “keep the situation under review.” The Treasury has been mulling the sale of Islamic bonds denominated in pounds since at least April 2007.

Growth in Europe’s Islamic financial hub has been hampered by slowing economic expansion and the government’s attempt to plug a budget deficit, according to Moody’s Investors Service. The German state of Saxony-Anhalt became the first European borrower to sell bonds adhering to Islamic law in August 2004 with €100m of five-year sukuk, while International Innovative Technologies Ltd, a clean energy company in Gateshead, sold a $10m, four-year convertible sukuk in July 2010, becoming the UK’s first corporate Islamic bond.

Despite the UK’s decision to dump the sales, some institutions are inclined to carry on. The Bank of London and the Middle East Plc, a Shariah-compliant bank, is in discussions with two UK-based companies to sell as much as £200m of Islamic bonds in the next six months.

But investment analysts say that the UK Treasury’s decision will discourage other governments from selling sukuk. “If the UK says that sukuk aren’t value for money, it’s likely other governments may reassess their positions, and the number of sovereign issuers new to Islamic finance may drop,” says John A Sandwick, a Geneva-based Islamic wealth and asset management consultant.

“Nothing is more useful than water; but it will purchase scarce any thing; scarce any thing can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.”

Renowned father of economics, Adam Smith, identified the diamond-water paradox in 1776 and economics graduates to this day have revered it. Yet the modern day investor may find some cracks in Smith’s proposal.

Water, it seems, will purchase almost anything.

It is the ultimate commodity, currently underweight, and with the investment potential to provide financial and social return beyond that of your conventional resource stock.

Its value proposition is the ever-widening supply and demand imbalance and the lack of a comparable alternative. Unlike diamonds, water is not ‘forever’ and its finite supply is set to send prices soaring. Thirsty global investors should look no further than to the tides of the Asia Pacific for big business.

Water as an emerging asset class
Climate change, population growth and increased food production are all placing undue stress on water supplies and it is diminishing quickly relative to demand. Consider that over the past century, while the global population has tripled, water use has increased six-fold. In fact, the OECD estimates that by as early as 2030, 47 percent of the world’s population will be living in areas of high water stress unless new policies are introduced.

Governments alone can’t fix the problem, and business will need to be part of the solution.

Thus, the concept of Business Water is born: water that does more than just quench your thirst. Savvy global investors are already buying up what has been labelled ‘blue gold,’ and in a most unexpected location.

The land down under
Hydrogen two parts, oxygen one, and Australia the key ingredient. It may sound ironic that the earth’s driest inhabited continent has spawned the world’s most sophisticated water market – yet statistics show the market is positively raining returns.

In 2009, $3bn worth of water rights changed hands in the land down under.

Aside from having access to clean water, Australia’s water market whets investment appetite for a few key reasons.

It is one of the only countries to have a formal water-trading system, offering players in the space the opportunity to engage in what is effectively water brokerage. The ability to monetise the resource is certainly attractive.
Various intermediaries can buy and sell water from one another in the form of water access entitlements, governed and distributed by the government. The trading system, in theory at least, enables water to be allocated to the highest value user. Introduced in 1983, the market effectively unbundles title to land and water. The marketplace is diverse and includes small, unconnected water markets as well as large, linked systems such as the prized Murray-Darling Basin.

And it’s working well. Jopson & Snow note that in 2009, $2bn worth of water trade took place in New South Wales alone, making the state’s water market equal to the total value of the country’s wool exports.

Government buy-backs are integral to the market’s effectiveness. In times of drought, the Federal Government repurchases water from farmers, effectively inflating the price by reducing supply. Most recently in 2009, the government bought back $1bn worth of water as droughts hit. Since the scheme was introduced, the price of water has jumped from around $900 a megalitre to over $1,200. Forget rising house prices; this ‘liquid gold’ is often worth more to a farmer than his own land.

The Australian market is also attractive because foreign investment is virtually uncapped. Not surprisingly, the national water market is predominantly controlled by foreign interests. Around $80m worth of entitlements are owned by the likes of US firm Summit Global Management through an Australian subsidiary; by Singapore’s Olam International; and by Tandou Limited which has considerable foreign ownership.

Investors also trust Australian water management. Years of perfecting the art of water cultivation in a dry, arable climate has resulted in a country recognised for expertise in demand and catchment management, trans-boundary water-resource management and urban water supply.

Philanthropic water
‘Business water’ also represents a new and emerging space at the intersection of money and meaning, falling into the Impact Investment category and offering good-Samaritan investor types with a torrent of ways to create value.
Impact investment, which is investment geared toward generating social and environmental benefit, was recently recognised by JP Morgan and the Rockerfeller Institute as a new asset class tipped to be worth between $400bn and $1trn in the coming decade.

Water may be the final frontier of socially motivated investment. It is a unique commodity; unlike gold or oil, we simply can’t live without it. Like a diamond, it is multifaceted and has many sides to it. It is at once an issue of health, gender, security, education and economics. Access to safe water is still a pressing development issue, with The World Health Organisation (WHO) estimating that 80 percent of all sickness is attributable to unsafe water and sanitation.

Yet when the market discovers a problem, Smith’s ‘invisible hand,’ generally guides it toward a solution. Water as a development issue has produced a number of market based responses which investors can tap into and potentially achieve triple-bottom line returns.

The market is also being utilised to set the standard and direction of good governance policies. Initiatives such as the CEO Water Mandate and the concept of ‘corporate water stewardship’ promote best practice around sustainable management. Locally, Westpac Banking Corporation is leading the pack, as signature to the CEO Water Mandate and with a staff-community partnership focused on funding water and sanitation projects in East Timor.

Impact investment opportunities exist close to Australian shores, with two thirds of those without access to safe water living in the Asia-Pacific.

How to get in on the water game
Creating a splash in the water market is relatively easy and there are a number of investment options.
For the risk-averse investor, trading access entitlements is probably where the water flows strongest. Capital growth return is estimated to be around three or four percent plus dividends. The much anticipated revised Murray-Darling Basin Plan is set for release this year and will present a number of business opportunities. Furthermore, more government buybacks are on the cards with climate specialists predicting less rainfall in the region over the coming years.

Ambitious investors may be interested in large-scale desalination, water recycling and agricultural irrigation projects that are currently being implemented Australia wide. The Australian Government Department of the Environment, Water, Heritage and the Arts (DEWHA) assists in co-ordinating public and private sector opportunities and may provide a good starting point for interested parties.

Water funds and investment into water via superannuation is touted to be the next big thing, although the number of service providers offering exposure is still low.

The market for trading local water stocks is relatively illiquid. Generally, there is very little movement in price, with stocks trading in narrow bands and underperforming the market in the last few years. This is likely the result of an Australian business community slow to recognise its own strengths coupled with a market dominated by foreign interests distorting competition. Australian asset management firms have been quick to note the emerging trend of water but few are willing to take an equity position for fear of wading into a market that is still too shallow. At a macro level, investment in local firms cannot hurt, provided the investor enter with a long-term horizon.

Water Credit is one option for impact investment. This branch of microfinance involves the provision of small loans to those removed from traditional credit market. It is seen as a culturally-sensitive method of financing that allows local communities to develop water systems best aligned to their own needs. According to WaterCredit.org, a provider with the majority of its operations in Asia, such philanthropic investments stimulate commercial lending.

Similarly, investors seeking equity positions in development projects can look to AUSAID, which increased Asian development assistance by $300m from 2008-11. The government body has actively stated its desire to partner with foreign investors.

‘The value of water flows upward, towards money’
By the time you’ve finished this article, the value of the glass of water next to you may well have risen. Your liquid gold is set to become an increasingly important asset and bargaining tool in both economic and political circles, as supply is evermore constrained.

They say money doesn’t grow from trees, but it very well may come from the seas. Further to offering potentially lucrative financial returns, water as a socially responsible investment gives credit to the use of business as a creative response to poverty. And this is rare; few resources can be spoken of in both banking and international development circles. The multi-faceted appeal of water has both crowds bullish on the resource.

It may be ironic that the world’s driest inhabited continent has the most lucrative water market. Yet, perhaps Smith got something right when he asserted that the price of water is highest in the desert. If only he knew how scarily accurate he would be.