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February 2009

Euroisation of Eastern Europe?

Europe is in a mess, can Western Europe afford the collapse of their eastern neighbors? Or should some Eastern European countries be allowed to join Euro so to avoid further currency devaluation? In any case, European Union now is facing the gravest challenges since the inception of the union, and it is more likely than ever that the European Union will break up.

Source: Economist magazine, Feb., 2009

The bill that could break up Europe, if eastern Europe goes down, it may take the European Union with it

TUMBLING exchange rates, gaping current-account deficits, fearsome foreign-currency borrowings and nasty recessions: these sound like the ingredients of a distant third-world-debt crisis from the 1980s and 1990s. Yet in Europe the mess has been cooked up closer to home, in east European countries, many of them now members of the European Union. One consequence is that older EU countries will find themselves footing the bill for clearing it up.

Many west Europeans, faced with severe recession at home, will see this as outrageously unfair. The east Europeans have been on a binge fuelled by foreign investment, the desire for western living standards and the hope that most would soon be able to adopt Europe’s single currency, the euro. Critics argue, with some justice, that some east European countries were ill-prepared for EU membership; that they have botched or sidestepped reforms; and that they have wasted their borrowed billions on construction and consumption booms. Surely they should pay the price for their own folly?

Yet if a country such as Hungary or one of the Baltic three went under, west Europeans would be among the first to suffer (see article). Banks from Austria, Italy and Sweden, which have invested and lent heavily in eastern Europe, would see catastrophic losses if the value of their assets shrivelled. The strain of default, combined with atavistic protectionist instincts coming to the fore all over Europe, could easily unravel the EU’s proudest achievement, its single market.

Indeed, collapse in the east would quickly raise questions about the future of the EU itself. It would destabilise the euro—for some euro members, such as Ireland and Greece, are not in much better shape than eastern Europe. And it would spell doom for any chance of further enlarging the EU, raising new doubts about the future prospects of the western Balkans, Turkey and several countries from the former Soviet Union.

The political consequences of letting eastern Europe go could be graver still. One of Europe’s greatest feats in the past 20 years was peacefully to reunify the continent after the end of the Soviet empire. Russia is itself in serious economic trouble, but its leaders remain keen to exploit any chance to reassert their influence in the region. Moreover, if the people of eastern Europe felt they had been cut adrift by western Europe, they could fall for populists or nationalists of a kind who have come to power far too often in Europe’s history.

How to avert disaster

The question for western Europe’s leaders is how best to avert such a disaster. Although markets often treat eastern Europe as one economic unit, every country in the region is different. Three broad groups stand out. The first includes countries that are a long way from joining the EU, such as Ukraine. Here European institutions may help financially or with advice, but the main burden should fall on the International Monetary Fund. These countries will have to take the IMF medicine of debt restructuring and fiscal tightening that was meted out so often in previous emerging-market crises.

Things are different for the countries farther west, all EU members for which the union must take prime responsibility. One much-touted remedy is to accelerate their path to the euro, or even let them adopt it immediately. It might make sense for the four countries with exchange rates pegged to the euro: the Baltic trio of Estonia, Latvia and Lithuania, plus Bulgaria. (Slovenia and Slovakia have joined the euro already.) None of these will meet the Maastricht treaty’s criteria for euro entry any time soon. But they are tiny (the Baltics have a population of barely 7m), so letting them adopt the euro ought not to set an unwelcome precedent for others nor should it damage confidence in the single currency. Yet the European Central Bank and the European Commission firmly oppose this form of “euroisation”, even though two Balkan countries, Montenegro and Kosovo, use the euro already.

Unilateral or accelerated adoption of the euro would make far less sense for a third group of bigger countries with floating exchange rates: the Czech Republic, Hungary, Poland and Romania. None of these is ready for the tough discipline of a single currency that rules out any future devaluation. Their premature entry could fatally weaken the euro. But as their currencies slide, the big vulnerability for the Poles, Hungarians and Romanians, especially, arises from the debt taken on by firms and households in foreign currency, mainly from foreign-owned banks. What once seemed a canny convergence play now looks like a barmy risk, for both the borrowers and the banks, chiefly Italian and Austrian, that lent to them.

Stopping the rot

The first priority for these four must be to stop further currency collapse. The second is to prop up the banks responsible for the foreign-currency loans that are going bad. The pain of this should be shared four ways: between the banks and their debtors, and between governments of both lending and borrowing countries. From outside, these two tasks will necessitate help from several sources: the European Central Bank as well as the IMF, the commission’s structural funds, the European Bank for Reconstruction and Development and perhaps the European Investment Bank. Given the scale of the problem, the lack of co-ordination between these outfits has been scandalous. A third aim must be to get eastern European countries to restart the structural reforms they have evaded thus far.

Bailing out the same mythical Polish plumbers who just stole everybody’s jobs will be hard for Europe’s leaders to sell on the doorsteps of Berlin, Bradford and Bordeaux, especially with the xenophobic right in full cry. German taxpayers are already worried that others are after their hard-earned cash (see article). The bill will indeed be huge, but in truth western Europe cannot afford not to pay it. The meltdown of any EU country in the region, let alone the break-up of the euro or the single market, would be catastrophic for all of Europe; and on this issue there is little prospect of much help from America, China or elsewhere. It is certainly not too late to rescue the east; but politicians need to start making the case for it now.

Japan: why unemployment fell during recession?

One simple fact: more people became discouraged, and gave up searching.

source: WSJ

Japan’s Nasty Employment Surprise

Surely the only thing worse than looking for employment and not being able to find it is giving up the search altogether.

Discouraged workers are pulling out of Japan’s labor pool. That led the nation’s unemployment rate to drop to 4.1% from December’s revised 4.3%. Economists — expecting the unemployment rate to rise to 4.6% — didn’t quite anticipate this.

[Japan employment]

It’s not difficult to see why job seekers are so discouraged. In January, there were only 67 positions for every 100 job seekers, according to the government — the weakest labor demand since September 2003. Compare that with 85 just six months ago.

There’s more bad news ahead.

Companies are trying to maintain positions by cutting work hours and furloughing staff. These are measures that’ll only last so long. In a separate report Friday, Japan said industrial production plunged 10% in January — a record drop which doesn’t bode well for employment in months ahead.

Recently the hit has been most severe in Japan’s export-oriented manufacturing centers. The home of Toyota Motor, Aichi prefecture, saw the number of jobs available plunge by 20%, the sharpest drop in the country.

So Japan is now fighting a war on two fronts. Consumers account for 55% of the nation’s gross-domestic product and there’s little encouraging them to spend.

Tokyo can’t do much about exports, but even on the domestic front it’s offered few solutions. A planned $120 cash handout has been widely panned, and a potentially massive stimulus package — totaling up to $300 billion — could be delayed by politics.

Japan’s leaders need to stop worrying about their own jobs and act.

Unprecedented state budget shortfall

Graph courtesy of John Mauldin.

The first graph looks at percentage of states that are to meet revenue projections.

The second graph has a longer history, and it looks at the yearly change of tax receipts.

Yuan appreciation: first Dollar, now Euro

How good is economic growth and stock market correlated in China?

The Chinese A share market has been a better indicator of China’s economic fundamentals since the second half of 2005, thanks to the non-tradable share reform and growing composition of institutional investors.

    Chinese A Share

Do Private Equity Firms "Create Value"?

A NBER digest commentary (author: Laurent Belsie) looking at the following research: Do Private Equity Firms “Create Value”?

” Private equity owned companies use much stronger incentives for their top executives and have substantially higher debt levels … (but there is) little evidence that (they)…outperform public firms in profitability or operational efficiency.”

In Managerial Incentives and Value Creation: Evidence from Private Equity (NBER Working Paper No. 14331), co-authors Phillip Leslie and Paul Oyer analyze the differences between companies owned by private equity (PE) investors and similar public companies. They observe that the PE-owned companies use much stronger incentives for their top executives and have substantially higher debt levels. However, they find little evidence that PE-owned firms outperform public firms in profitability or operational efficiency. Leslie and Oyer also show that the compensation and debt differences between PE-owned companies and public companies disappear over a very short period (one to two years) after the PE-owned firm goes public. This raises questions about whether and how PE firms, and the incentives they put in place, create value.

A central tenet of PE investors is that they fix companies by improving their management. A major method for accomplishing this is through managers’ compensation: lower salaries than their counterparts in public corporations, but bigger equity stakes in their company. The idea is that by tying compensation more closely to corporate performance, these managers will make the tough but needed changes. That theory doesn’t always work out in practice, though.

Leslie and Oyer examine 233 U.S. companies that either underwent a leveraged buyout (LBO) between 1996 and 2004 and then completed an initial public offering (IPO) before the end of 2005 or went private between 1998 and October 2007 (and about which there is compensation data available). They supplement that data with interviews of half a dozen experienced executives at private equity firms. They find that since 1996 the highest paid executive in a privately owned firm earned about 12 percent less salary, but got 3.3 percentage points more company equity and 12.6 percent more of his cash compensation through bonuses and other variable pay, than the CEO of a public corporation. And, they claim that it’s not just the CEO who got this treatment: the 20 to 80 top managers typically also got significant equity in the company.

“A very important aspect of the equity programs is that managers are required to contribute capital — managers purchase the equity with their own personal funds,” they write. They say that their study is the first to document the changes in management incentives in private buyouts since 1990, when the PE landscape was far different. The impact of these incentives is less clear, however. “While the incentives given to PE-owned firms’ managers keep their companies operating at average levels of profitability and efficiency, we do not find evidence that they create significant excess profits,” the authors conclude. In only one category they measured – sales per employee – did private-equity ownership have a significant positive effect. Even that effect dissipated in a few years once the company went back to being a public corporation.

Indeed, the high debt levels and pay structure under private equity management also tended to disappear in one to two years after the firm reverted back to a public company, the study finds. Petco, the pet-supplies chain, illustrates the cycle. When it was a public company between 1995 and 1999, Petco’s CEO Bruce Devine owned about 2 percent of the stock. After he took the company private in 2000, his share rose to about 10 percent. When the company went through an IPO in 2002, his share of the company fell immediately to 7 percent. By 2006, when he was chairman but no longer CEO, his share had fallen to 4 percent. The chain’s debt-to-asset ratio tripled after it went private but began to fall back toward pre-2002 levels once it was public again.

The authors concede that their sample is limited because, in most cases, private-equity firms don’t have to report compensation practices. Thus, the sample represents a minority of the private-equity universe: 144 companies that did publish compensation data as part of a reverse LBO (where the private equity owners sell out in an initial public offering). But the authors find no reason that managerial incentives at firms with an LBO should be different from others owned by private-equity firms. The authors control for the other concern — that their sample might be skewed because private-equity firms target companies with already high managerial incentives – by looking at the characteristics of 89 other U.S. firms that were attractive to private equity firms but not yet owned by them.

Although papers published in 1989 and 1990 documented differences in the share of CEO equity ownership between publicly traded firms and firms that had undergone a management buyout, this study is the only one to study the phenomenon on post-1990 buyouts.