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Archive October to December 2012

Taking risks, making predictions for 2012

December 31

It is a popular past time on news years eve - not only among journalists - to try and predict what will happen in the new year. Here are a few offers of my own. Will any of them come true?

Germany: After further defeats in regional elections, the F.D.P. party self-dissolves as most of its MPs join other parties - just enough to enable to Merkel government to muddle through. Meanwhile, the pirate party enters further regional and local parliaments, but is hit by a series of scandals as its inexperienced politicians say outrageous things, and by the end of 2012 it disappears into the insignificance it came from.
Denmark: The new government stumbles a bit while it learns how to govern the country, but apart from that nothing special happens, and the country stays out of (international) headlines.
UK/EU: After a referendum in the UK, followed by a referendum in Scotland, the UK government negotiates its exit from the EU (surprised that noone else actually cares), while newly independent Scotland becomes the new 27th member. Scotland prepares to introduce the euro by 2016. Subsequently, with the British veto gone, the EU Parliament is strengthened to provide stronger democratic control over the EU Commission.
Eurozone: After Greece defaults on part of its government debt, but continues to use the euro (perhaps in a similar fashion as Montenegro and Kosovo), financial markets calm down in view of quite different economic situations in other countries under pressure in the eurozone, and serious cuts in deficits across member countries.
USA: I do NOT venture to predict who will be the next president of the USA. However, due to even larger polarization of the candidates than at the last election, most voters actually support neither candidate, and demonstrations against 'the banks' and 'the system' will spread from the anti-Wallstreet movement of 2011. For foreign observers, it is obvious that changing the election system to proportional representation would solve the national governance crisis, but no major politician in the USA will support that idea for fear of dislodging their own power base.
France: Francois Hollande will become the next president of France, beating the National Front candidate in a run-off election. The most left-wing candidate in a generation will benefit from a wave of anti-banking - and by implication anti-Anglo-Saxon - popular sentiment.
China: XI Jinping will become next president of China. The government will be increasingly assertive in a nationalist sense: firstly, rejecting foreign "interference" about Chinese policies alleged to create trade barriers, or to violate human rights; secondly, imposing central control over wayward provincial leaders pushing their own pursuit of capitalism too far, and/or being entangled in corruption or other scandals highlighted by local protests.

Amsterdam to Berlin! and London?

December 17

Sitting on Amsterdam to Berlin train, I am reflecting over the state of the European Union. Overall my travels have been smooth and having just one currency in my wallet is just one of the little benefits that European integration has brought for businesses and travelers.

In fact, at dinner in Rotterdam, my hosts kept pointing out the "ships bound for Germany" passing on the river, heading up (!) the river to German river ports such as Duisburg. Rotterdam is an one of the most important seaports serving German industry, and the integration with German industrial base in the Ruhr area is a major strength of the Southern Netherlands region. No-one here would want to get back to the system of small nation states, each with its own currency, and causing each other headaches with their diverse regulations for about everything.

The view looks so much difference from headquarters of the Conservative party in London. The English in their mind have a much greater 'psychic distance' to the rest of Europe, not only they travel much less to their neighboring countries, but because their mindset is informed by the history of their empire, and a supposedly glorious economic past that somehow prevents many opinion leaders to critically engage with the social and economic challenges England faces today (I don't want to repeat myself, so read my earlier blogs).

In our textbook, I had included a discussion point on the relationship between the UK and the EU (chapter 8, p.252), offering the following statements:

"to understanding the ambivalent relationship of the British, or more precisely their political leaders, towards Europe is to understand that most British politicians of the 20th century never appreciated the EU as a political project, but rather focused on the economic benefits."

"Psychologically, many people of Britain see themselves as an independent nation with a major role on the world stage rather than a part of Europe, to which they geographically belong."

I don't really have much to add to that now.

The challenge thus is that the British (or perhaps more precisely the majority of the English) feel that there already is too much integration, while this integration is essential to most other Europeans. Based on this public (or media) opinion, the British government uses its veto to bloc core EU members from developing solutions to their problem. This obviously is highly unsatisfactory. The logical solution seems to be a 'multi-speed' Europe where those who want more integration, and others stay in the outer circle of the European Free Trade area. This is idea isn't popular either because those in the outer circle loose some of their privileges in the single market, and have no influence on regulation that eventually they may have to adapt anyway.

From an economic perspective, the UK leaving the EU would cause more harm than good (especially to the UK). But given the political obstacles in the UK to constructively working with the rest of Europe, it is an option that may serve many interests best.

27 minus 1: Why the UK exit might be good for Europe

December 14

At the conference I was attending, the British colleagues had to endure a fair bit of jokes. Or they took it proactively: The host of the 2012 conference offered the prospect of a European on conference held outside the EU - in Brighton. With the repeated statements from the current British government in their domestic communications that they wouldn't lift a small finger to help their neighbours (friends is obviously not the right word here), it should have come little surprise to find the rest of the EU proceeding without the UK.

At the same time, conservative backbenchers 'threatened' to call for a referendum on EU membership. Let me make a prediction: If the UK went ahead with the referendum, I suspect the yes-to-exit campaign will be in for a surprise: They would receive from massive support from across Europe. Despite broad appreciation of many aspects of British culture, language, etc, many people across Europe are getting fed up with British politicians enjoying their 'pain in the neck' role. Obviously, many people will see the UK exit as a failure, which it probably is. But there are positive sides for the EU too:

The EU will be able to strengthen the European Parliament, which is directly elected, vis-a-vis the European Council, which is essentially the heads of the national governments. Such strengthening has long been opposed by the UK fearful of loosing their national veto on key EU initiatives.
The EU will not longer have a member that receives an extra discount in terms of the taxes it transfers to the EU (negotiated famously by Maggie Thatcher), an issue strongly resented by other net contributors such as Netherlands, Germany and the Nordic countries.
The EU will be able to move forward with its revision of the regulation of the banking sector, another area currently held back by British opposition.
The EU will have one strong-willed partner less at the table when it comes to negotiations over any other issues, such as product standards. Even so, if the UK was still in the European Free Trade Area, it would have to implement many rules even though they were not at the table when they were negotiated - or face trade barriers.
The EU will no longer be the scapegoat for everything that goes wrong in Britain, the Brits will finally have to realize that most of their problems (a fragile yet overblown banking sector, a weak education system outside the elite, a squeaking infrastructure, and large and growing inequalities and the resulting social tensions) are home-made and can only be addressed in at home.
The EU will not be drawn into political conflicts at the other end of the world, out on the frontiers of the former British empire (or commonwealth), where the British feel they ought to send an army.
The EU can appoint someone as foreign affairs representative (one of the highest offices in the EU, currently held by a Brit) who someone who actually has experience in international politics and diplomacy and does need to learn the basics on the job.

Among the disadvantages from the EU perspective three are important ones:

An important lobbyist for free markets, less government intervention, and simpler regulation would no longer be at the table (though in current years this influence seems to have been weak anyway as British governments focused on getting exemptions rather than making the rules better).
An important trade partner is likely to be separated by some barriers to the free flow of goods, investments, services and people. If we assume the UK remains in the European Free Trade Area it would become like Norway now. That means that most of these four freedoms would remain - as long as the UK adopts the relevant EU regulation. But, over time regulations are likely to diverge, standards are no longer mutual, and hence trade would decline. As the UK is less important to the EU than vice-versa these losses will fall mainly on the UK.
One country in the EU would probably be a second looser: Ireland exports a lot to the UK. But then, Ireland may be able to compensate for that by presenting itself as the most important English speaking location within the EU!

It seems, overall, 27 minus 1 is a formula that "Europe" (in the usage of the word common in England) could live with quite well. Charles de Gaulle would not be surprised.

No alternative!

December 12

As I spend a day traveling I ended up reading a lot of newspaper columns on the EU summit - lots of people being unhappy with the solution put on the table (especially British newspapers) but no-one seems to know any viable alternative. I have spend the weekend at a conference with academics from across Europe - and I can tell that none of my colleagues from across Europe is happy with the solution. But noone could provide a solid suggestion what to do instead.

Doing nothing - apparently preferred by the British government and the British media - is certain to make things worse. Sometimes I really wonder what the critics of the euro really want: braking up the euro will make a lot of things a lot worse for about everyone. For some mysterious reasons a lot of journalists and politicians in Britain seem to think it is not theirs to worry about. Actually, as the British economy is more dependent on the financial sector (as % contribution to GDP) than most other countries in Europe, and the British private sector has a high net foreign debt, the British economy is going to suffer more than most if we have a new financial crisis.

It is obvious that mistakes have been made in the past - see yesterday's blog. But 'what would have been if' does not help us forward. Nor does 'I told you so' - because I certainly can't recall anyone warning of a bank bail-out of the scale that happened. May be, letting Greece go bust right at the beginning of the crisis would have been better - but even that seems now unrealistic speculation.

So, what are the alternatives? After reading a lot of newspaper space, I can see a lot of opinions, but no solution that is better than the one on the table.

What went wrong with the Euro?

December 11

Twenty years after the Maastricht treaty was signed, the mood in Europe is rather somber. As everyone seems to be concerned about the future of the Euro, let's step back an analyze what went wrong.

The first set of reasons relates to the budget deficits run by the governments of the eurozone. The Maastricht clearly stated a limit of 3% of GDP in any year - along with a maximum level of inflation, and a maximum level of debt. However,

Greece was admitted to the euro despite unsustainably high levels of debt, and budget deficit data that turned out to be incorrect (some say, deliberately misleading).
the treaty was not clear on how to enforce that 3% limit: Would countries be punished, and how? As it happened the European Commission tried to enforce the criterion and penalize the first offenders, some smaller countries. But then both Germany and France broke the and were granted exemptions, which made the rule rather soft, to say the least.
the fixed 3% limit does not allow budget deficits to be adjusted to business cycles, as most macro-economist suggest they should be. In other words, 3% in a recession is OK if the money is paid back in a boom period.
the decision making process in the EU implied that major decisions concerning to the eurozone, such as the negotiations last weekend, still need approval of all EU members, even those that are not member (and even those who have a contractual exemption meaning they are not committed to ever joining: the UK and Denmark).

The resolutions of last weekend aim to address the above issues by creating and enforcing new rules on budget deficits. This is clearly important. Yet, it addresses only part of the problem. In fact, it assumes that the budget deficits are the outcome of unsustainable government spending in the past. This, however, is true really only in the case of Greece. In other countries - notably Ireland and the UK - the budget deficit is primarily a consequence of the bank bail-out of the years 2007/08. Politicians rarely tell you that because that would severely inhibit their ability to enforce expenditure cuts or tax rises on their distrusting populations. Thus, there is a different way to interpret the current crisis:

The Maastricht treaty did not consider the possibility of a massive crisis such as that of 2007/08, and the consequences it had for government budgets. Even with a different set of rules, they would probably have done those bail-outs.
As a consequence of the bank bail outs, governments issued large volume of debt now held by banks. Hence the default of some countries would affect banks across Europe, reportedly especially French banks, but also German banks and various other countries - with the UK banks heavy exposed to Irish debt. It is this fear for their banks and the possibility of a domino effect that drives governments not to allow default of any country.

This analysis suggest that reform of the banking sector should be the first priority. It would include making the banks - and their leaders - pay for the benefits they received from taxpayers in 2007/08/09 would be the appropriate approach to the crisis. But few in power seem to take any serious steps in that direction - perhaps unsurprising given the close ties between Wallstreet and Washington, and even more so between the city of London and the Conservative party of Britain (who receives reportedly half its donation from the financial sector).

European Brand Value in China

December 7

Chinese consumers love European brands. It must be like paradise for the brand manufacturers of French cosmetics, German engineering, Swiss watches and Italian fashion! All the the big name brands have not just one, but loads of sales outlet in the fashionable districts of Shanghai. And many more, that I have never heard about!

The love for European brands brings fore some very peculiar effects. For example, Chinese companies buy up German companies not because they are interested to selling to Germany, but because the German affiliation and brand names helps them sell their produce in the world largest domestic market, China. An interesting example is Pearl River Piano. My co-author had written up the case, and mentioned their acquisition of the German piano maker Ritmuller as key strategic move to build an international premium brand. Problem was, I had never heard of the brand. So, I called up an expert on German musical instruments industry (my dad) to ask him, and he had never heard about them either. So, I got surfing. Yes, the brand existed - but mainly in the sales catalogues of antique dealers. For all I could find out, the company went bankrupt in the word financial crisis. That was in was the crisis of 1928. Ever since it has only been a retailer of pianos. Yet, for Pearl River the brand name was still a desirable asset to acquire to help building a brand associated with the German piano-making tradition.

For another example, try to google my name when you are in China. You are likely to come to the website www.klausmeyer.cn, which belongs to a knife maker in central China. As far as I could infer, they acquired a small company (or only the rights to the name?) established in the 1920s in Solingen, the centre of German knife making craftsmanship. I could not find any contemporary linkages between the company and Germany. (and, to be sure, I have no relation to them).

Some go even further, and simply invent a European brand name and association. Using a foreign sounding brand name is of course not new, US-firm Haagan Dasz does it, many aspiring entrepreneurs in China follow the idea. But some go as far as claiming to be imported from Europe. They earned themselves a not very flattering article in the China Daily, the Chinese government's newspaper. One company even went as far as feature a picture of the Italian trade representative in the publications. In fact, he was visiting to investigate the firm's fraudulent claim of being 'made in Italy'.

Why do European brands sell so well in China - real or fake? I believe there are two reasons. Firstly, association with brand names are a very important means for Chinese to express status and self-esteem, and "imported" conveys higher status than "local". In addition, "imported from Europe" also conveys a higher product quality as Chinese consumers still distrust their home made produce in many sectors, there just is too much sloppy produce around. Chinese entrepreneurs are slowly starting to build their own brands, but even in their home market they face an uphill struggle in terms of challenging into the premium segment.

China Daily, 2022, Faux 'imported' brands that are made in China, December 7, page 17.

The World's Coffee Shops

December 1, 2011

A fascinating aspect of globalization is the spread of coffee shop chains around the world. While coffee shops have been around for decades - especially Vienna once was famous for them - an American entrepreneur popularized the concept, created a franchise concept and took it around the world. Soon, Starbucks, Costa Coffee and The Coffee Bean started popping up around in virtually every town and city around the world. Indeed, Shanghai is said to have more Starbuck's than New York of London. Does that imply the world will soon resemble Seattle, Washington?

In fact, this globalization of the coffee shop is more in appearance (and profits) than in substance. While coffee is consumed in all these shops (or should I say bars), they actually play a very different role in different societies. In Shanghai, where quite space is scarce, offices are cramped and homes are small and shared, the coffee shops provide peaceful atmosphere - not really quite except early in the morning - that serves many social purposes. Today, while working quietly on a paper, I have been observing in the same shop a group of business people negotiating, a group of young women preparing for a fashion photo-shooting, a young couple on a date, two different business persons working on their Laptop, and a couple having, well, a 'difficult conversation' (she was crying, I was glad NOT to understand Chinese...). Last week I was witness to two different job interviews - in both cases Westerners - in addition to the usual crowd of housewives chatting, students flirting, and tourists munching a convenience lunch.

Coffee shops must be a dream research field for cultural anthropologists, different people using very similar spaces in so widely different ways is telling a lot about the societies in which we life.

Why are the Rating Agencies so Powerful?

November 11, 2011

In summer of 2002, I was attending a comparative economics (EACES) conference in the medieval Italian City of Forli near Bologna. One of the key note speakers - my memory tells me John Eatwell, but apologies if I got the name wrong - delivered a key note address in which he attacked the (then) new banking regulation known as Basle II. Essentially, he argued that this regulation forced all banks to use the same formal models to model the risk of their investment portfolio - and in classifying the risk of individual assets they would henceforth all use a small set of external indices. These models using those external indices thus are critical for key performance variables of the banks, notably the equity that they have to hold. In simple laymen's terms, the more risky investments they have, the more own capital they need.

The central bankers and financial sector regulators - and in fact most commentators at the time - thought that is a good idea, because it provides some sort of objective criterion to assess how risky a bank is - and weather our savings with the bank are save. Eatwell dared to disagree. He argued that the new rules would increase the systemic risk in the banking sector. Basically, if everyone was using the same risk models and the same external indicators - those provided by the rating agencies - then a small change in any of the indices would result in all the banks having to make adjustments in their investment portfolio - in other words they have to rebalance the risk-profile of their portfolio quickly to prevent their own rating to be affected. Hence, a downgrading of an asset will trigger a lot of sales of that asset in a short time, resulting in a substantive change in the price of the asset, and consequently increased volatility of the price of those assets. If all banks then have to revalue this particular asset at the same time, this would increase the systemic risk - i.e. the chance that many banks experience financial difficulties at the same time.

Of the audience, few appreciated Eatwell's argument, and I suspect many did not even understand his arguments as most were general economists, not banking specialists. Yet, in recent weeks, I often had to think of that talk in Italy as politicians were lambasting the rating agencies as being too powerful. Actually, they are powerful because the legislation that followed Basel II made them so powerful.

The reliance on indices by rating agencies exposed its first flaw when the financial crisis of 2008 broke because the agencies obviously did not rate certain complex assets correctly, keyword mortgage backed deposit certificates. Their own models (as far as I understand) considered each asset in isolation, and insuffuciently (or not at all) considered the interdependence of different assets.

The second flaw became apparent throughout the spring and summer of 2011 when each blink from a rating agency triggered a flurry of real trading activity in government bonds of various countries. Essentially, even the expectation of a change in a rating makes it more expensive for a borrower to get money from the banks, to roll over credits, and in worst case can case default. The rating agencies are private, US-based financial institutions that produce the indices for their clients, who pay for the privilege; they (may) know how financial markets work in the USA, but their understanding of financial instruments used elsewhere is sometimes limited.

To change the system, legislators would have to re-think their banking regulation and supervision - which is tricky because it is embedded in international agreements of Basle II and now Basle III. However, to take that systematic risk and the increased volatility out of the markets again, regulators need to allow for (and encourage) a greater diversity of risk models and indices. If everyone is forced to act in the same way, systemic risk will continue to create bubbles and crises on a global scale.

Quietly Overtaking? Chinese Motorcycles

November 8, 2011

Walking the streets of Pudong - the modern side of Shanghai - during rush hour, one has to pay attention not only to cars that seem to know few traffic rules but to motor cycles zooming along the slow lane. What makes those motor cycles tricky for pedestrians is that they come quietly. How can they be sooo quiet? The answer is down the road in the department store, right next to the teddy bears. Here at Carrefour, they are for sale for 2,000 to 3,500 RMB (about €300 to €400): electrical motorcycles! That's about half the price I paid for my bicycle in Denmark - a really nice one though.

Meanwhile, in Europe the politicians are quibbling about the appropriate standards, and about loads of health and safety rules that electrical vehicles will have to fulfill. Everyone seems to expect miracles of energy conservation from them, but only few rather expensive electrical vehicles make it on the roads, and mostly in the luxury segment.

I just wonder who, once the standards have been approved, will be best positioned to produce an affordable electrical bike? The Chinese are rapidly sliding down the learning curve, moving up the standards curve may take them a bit longer, but not that much longer.

However, there still is a little problem. Many drivers, in the true spirit of energy conservation, seem to switch of their lights, making them tricky to spot for pedestrians or cars to spot in good time. That shouldn't be a problem though in countries like Denmark or Germany where the police happily fines even cyclists for not using proper lights.

Welcome to Growth, Chinese Style

October 30

A few weeks ago, I moved to China. The country is challenging and perplexing, yet exciting in many ways, and thus I have taken a 'time-out' on my blog to digest my impressions before sharing them with the world. There are a lots of first impressions, that on second sight tell a very different story.

The question that has been most occupying me in the last days is the "insane" growth expectations that entrepreneurs and business leaders are chasing. If I say "insane" I mean that from a European perspective where we might see high growth in some niche technology markets, but generally consumer market or GDP growth are in single digits - if they grow at all. Yet, here annual growth expectations for entire industries are rarely in the single digits. Yesterday, I spend the day listening to car executives - both Chinese and foreign investors - discussing the car industry in China. Their growth ambitions are huge, both in terms of getting a share of the domestic market, and (for domestic firms) to bring Chinese cars to world markets. In line with this, huge investments are made in both R&D and in production capacities.

The (apparently shared) baseline expectation on which these strategies are build are annual growth rates of car sales in China in the magnitude of 20%, with China accounting for one third of the global car market in 2016. China is already the largest car market by units sold - way ahead of the US and Japan. But 1 in 3 cars sold in China? China counts for one fifth of the world's population - so this one-fifth is going to buy one-third of all cars? How realistic is that?

Forecasting is always a dangerous business, and I suspect that some of these forecasts are simply extrapolating growth rates of early industry growth not taking into account saturation effects. Actually, according to numbers I picked up from a magazine distributed at the conference suggest growth in 2011 of about 5% - and mainly for foreign brands with on average zero growth for domestic brands. Yes, there are still lots of people without a car, but where are they going to put their cars - the roads are already congested and parking spaces scarce. Moreover, with a few years lag after the initial surge in car ownership, and new competitor to the car industry will enter the market, the 'used car industry'. That will change the dynamics of the industry again.

So, the real question is, is the investment in car industry manufacturing capacity soon doomed to create overcapacity and sharp price competition, or am I just a pessimistic European who just doesn't understand China?

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Note: C-numbers relate to chapters in: M.W. Peng & K.E. Meyer, 2011 International Business, London: Cengage.

March 2012