Forbes Interviews Warren Buffett: A Word From A Dollar Bear

A Word From A Dollar Bear
Robert Lenzner Daniel Kruger , 01.10.05
Forbes.com

Warren Buffett's vote of no confidence in U.S. fiscal policies is up to $20 billion.

The dollar has fallen savagely against the euro for the past three years, and the trade deficit is running $55 billion a month. Is the currency rout over? Can the trade deficit be fixed with a rise in interest rates or an upward revaluation of the Chinese currency? Warren Buffett, the world's most visible dollar bear, says the answer to both these questions is no. His bet against the dollar, reported at $12 billion in his last annual report (for Dec. 31, 2003), has gotten all the bigger. Now his Berkshire Hathaway has a $20 billion bet in favor of the euro, the pound and six other foreign currencies.

Buffett has for a long time been lecturing fellow Americans about their bad habit of borrowing from abroad to live well today. He made a big stink about his currency trades in his March 2004 letter to shareholders. FORBES phoned him recently for an update, hoping for the news that the Scold of Omaha had softened his views on the decline of the dollar. What we got was more doom and gloom, more than we have ever heard from the man. In other words, he is not about to cover his short position on the dollar.

Buffett said that he began buying foreign currency forward contracts when the euro was worth 86 U.S. cents, and kept buying until the price reached $1.20. It's now worth $1.33. Buffett said he is not adding new positions now but has been rolling over contracts as they mature. Berkshire lost $205 million on currency speculations in the first half of 2004, but more than made that back with a $412 million gain in the third quarter. It's likely that the December quarter report will show another huge gain.

Since January 2002 the dollar has fallen 33% against the euro. Buffett blames that on bad policy, coming from both the White House and Congress. It does appear that forex speculators are no big fans of George Bush or his Treasury secretary, John Snow. Since Nov. 2 the dollar has fallen 4.4% against the euro.

Says Buffett: "The rest of the world owns $10 trillion of us, or $3 trillion net." That is, U.S. claims on foreign assets run to only $7 trillion. "If lots of people try to leave the market, we'll have chaos because they won't get through the door." In a nutshell, the trade deficit is forcing foreign central banks to ingest U.S. currency at a rate approaching $2 billion a day. Buffett continues: "If we have the same policies, the dollar will go down."

The $20 billion bet has to be put in context. Berkshire has a huge portfolio of investments that includes $40 billion of Treasury securities. Budget and trade deficits are likely to make dollars worth less and bonds worth less. So the currency play is a partial hedge of a large position that can be read as bullish on the U.S.

Still, that Buffett is making a currency bet at all is striking given that this investor has, in his 74 years, rarely made macroeconomic bets. He built Berkshire to a $130 billion market value by acquiring parts or all of lots of businesses, primarily in the insurance sector and primarily in the U.S. Now some of those assets are antidollar assets. Example: In 2002 he bought bonds of Level 3, a telecom company, that were denominated in euros. In 2000 Berkshire picked up MidAmerican Energy, a gas pipeline company. By doing so, Berkshire indirectly acquired the assets of Northern Electric, a utility in England, at a time when the pound was worth $1.58. Now it's worth $1.94, so Berkshire has a paper gain irrespective of any appreciation in the electric company's pound-denominated earning power.

A continuing fall in the dollar "could cause major disruptions in financial markets. There could be unpredictable side effects. It could be precipitated by some exogenous event like a Long-Term Capital Management," Buffett says, referring to the 1998 collapse of a steeply leveraged hedge fund.

How about a soft landing for our deficit-addicted economy? Don't count on it. We're running $100 billion a year in the hole against China, but Buffett doesn't expect that an upward revaluation of the renminbi (stoutly resisted, in any event, by the Chinese government) would greatly reduce this number.

How about a rise in short-term interest rates? They used to say on Wall Street, "Six percent interest will draw money from the moon." Buffett is skeptical, though, that the recent tightening by Fed Chairman Alan Greenspan will do much more than "put off the day of reckoning."

Nor does Buffett support the notion that intervention in the currency markets by one or another central bank can overcome the momentum of a currency that's losing value. "Sooner or later markets win over the intervenors. The intervenors always run out of gas," says Buffett.

What is absolutely necessary to bolster the dollar is "a public policy that brings imports and exports together." Buffett has proposed a grand scheme to force imports and exports into perfect balance by demanding that each dollar of imports be accompanied by a certificate bought from an exporter who moved a dollar the other way. He concedes, using the self-deprecating humor for which he is known, that this scheme has met with deafening silence from policymakers.

Moving beyond cloudland to economic history, Buffett reflects wistfully on the writings of David Ricardo, the 19th-century trade theorist: "In those days the trade imbalances got settled in gold--and when they ran out of gold, people stopped doing business with you." A gold standard? More wishful thinking. But Buffett is no goldbug. It's more that he's an antidollar bug. In dollar terms, gold, copper and oil have all climbed in the past several years; in euros, not so sharply.

So, Warren, what are you buying now? And what's your prediction for the dollar next year? His answers, respectively: No comment, and I'm not making one.

But here's a long-term perspective. He says he may hold foreign currencies "for years and years." And he says that the electorate of the U.S. may be strongly tempted to get out of hock by inflating away the country's dollar debts.

***
Prudent Investor says: No 'gold'...but a quarter of the WORLD's SILVER Supply tacked under Berkshire's Portfolio. Hmmm. Maybe there's more to what he says.

Bloomberg's Andy Mukherjee: Asian Stocks May Ride Out Tough 2005 in Style

Asian Stocks May Ride Out Tough 2005 in Style
By Andy Mukherjee

Dec. 27 (Bloomberg) -- For investors fretting over the many risks to the world economy next year, here's a pleasant prospect: Asian stocks may ride out a turbulent 2005 in style.

For Asian equities to put up a good show in the face of a declining dollar, cooling Chinese demand and still-high oil prices, the region's central banks need only lift the lid off local money supply, giving households and companies more spending power.

Make no mistake, a declining dollar and slackening U.S. demand probably will bring no cheer to investors in Taiwan and South Korean semiconductor and electronics manufacturers, which are facing margin pressures. Taiwan's exports rose at their slowest pace in 14 months in November. At the same time, a spurt in Asia's money supply -- a weapon the region's central banks have yet to fire -- could be good news for banking, property and other stocks dependent on domestic demand.

``We like domestically focused stocks in Asia,'' says T.J. Bond, chief Asia-Pacific economist at Merrill Lynch & Co., who says he favors banks and telecommunications shares because ``the Asian consumer in Japan, in China and the rest of the region will rise to the challenge in 2005.''

The key to stoking Asia's consumption and investment demand lies with the region's central banks, which have for the past two years resisted appreciation in their currencies by lining up their reserves with dollars brought in by exporters, investors and speculators. Then, to make sure the money they released into the banking system in order to purchase the dollars wasn't inflationary, they sold bonds to ``sterilize'' the cash. The net effect was that local demand in Asia remained on a tight leash.

Credit Growth

In a recent report, Sailesh Jha, Dong Tao and other Asia economists at Credit Suisse First Boston cite the example of Singapore. Between 2000 and 2003, net foreign assets of the Monetary Authority of Singapore, as a ratio of gross domestic product, jumped by a whopping 15.4 percentage points.

Yet, thanks to aggressive sterilization, the central bank's net domestic assets, as a ratio of GDP, shrank 14 percentage points in the same period. As a result, the ratio of monetary base to GDP, a measure of new money created by the central bank, expanded a measly 1.4 percentage points.

``The anemic pickup in the monetary base has been one of the key reasons why credit growth has yet to explode in Singapore, in spite of an expected 8.4 percent GDP growth in 2004,'' the CSFB researchers say. Singapore isn't alone. In Taiwan, the entire 35 percentage point increase in the central bank's foreign assets between 2000 and 2003 was nullified by a fall in the bank's local assets, reducing base money growth as a ratio of GDP to zero.

Sterilization Costs

Why should it be any different in 2005? For one, Asian central banks will be able to sell more local-currency bonds only by paying higher yields -- much higher than what they earn on their foreign assets. Second, a weakening dollar will drive more overseas capital into Asia to gain from currency appreciation.

``Overburdened by accelerating capital flows to their economies and domestic investors' tolerance for buying domestic government securities diminishing, Asian central banks may reduce their pace of sterilization in 2005, '' says the CSFB report. More money sloshing about in the Asian banking system in 2005 will help fuel consumer spending on property, cars, consumer durables and financial assets.

From an Asian central bank perspective, it would be good to have the American consumer buying the region's exports of cars and computers. Still, it won't be the end of the world if the overspent U.S. consumer stays home. Asia's own consumers will pick up some of the slack.

Asian Consumer

``Even if Asia is set to decelerate,'' say Sebastien Barbe and Claire Dissaux, economists at Calyon, the investment banking arm of France's Credit Agricole SA, ``it should continue to do much better than Europe. We see non-Japan Asia's GDP increasing by 6.7 percent year-on-year in 2005, compared with only 1.7 percent for Europe.''

Most Asian nations can afford to expand their monetary base, except China and India, where inflation is already a headache and more liquidity in the banking system is only going to make matters worse.

Asian equities may be the dominant investment theme in 2005. ``We're big believers in Asia,'' says Emiel Van den Heiligenberg, who oversees $97 billion in assets at Fortis Investments in Amsterdam. ``The second motor of the world economy has been Asia. We see a lot of good developments in the domestic economy in Asia: domestic demand is growing, the political situation on average is improving, currencies are strengthening.''

That will surely be a pleasant prospect for investors in a volatile 2005.

New York Times: Argentina's Economic Rally Defies Forecasts by Larry Rohter

The Prudent Investor says: Hearken you perennial cynics!! Having frequently used the Argentine bugaboo as the likely path of the Philippine economic setting, this article is for you to feast on....

Argentina's Economic Rally Defies Forecasts
By LARRY ROHTER

BUENOS AIRES, Dec. 23 - When the Argentine economy collapsed in December 2001, doomsday predictions abounded. Unless it adopted orthodox economic policies and quickly cut a deal with its foreign creditors, hyperinflation would surely follow, the peso would become worthless, investment and foreign reserves would vanish and any prospect of growth would be strangled.

But three years after Argentina declared a record debt default of more than $100 billion, the largest in history, the apocalypse has not arrived. Instead, the economy has grown by 8 percent for two consecutive years, exports have zoomed, the currency is stable, investors are gradually returning and unemployment has eased from record highs - all without a debt settlement or the standard measures required by the International Monetary Fund for its approval.

Argentina's recovery has been undeniable, and it has been achieved at least in part by ignoring and even defying economic and political orthodoxy. Rather than moving to immediately satisfy bondholders, private banks and the I.M.F., as other developing countries have done in less severe crises, the Peronist-led government chose to stimulate internal consumption first and told creditors to get in line with everyone else.

"This is a remarkable historical event, one that challenges 25 years of failed policies," said Mark Weisbrot, an economist at the Center for Economic and Policy Research, a liberal research group in Washington. "While other countries are just limping along, Argentina is experiencing very healthy growth with no sign that it is unsustainable, and they've done it without having to make any concessions to get foreign capital inflows."

The consequences of that decision can be seen in government statistics and in stores, where consumers once again were spending robustly before Christmas. More than two million jobs have been created since the depths of the crisis early in 2002, and according to official figures, inflation-adjusted income has also bounced back, returning almost to the level of the late 1990's. That is when the crisis emerged, as Argentina sought to tighten its belt according to I.M.F. prescriptions, only to collapse into the worst depression in its history, which also set off a political crisis.

Some of the new jobs are from a low-paying government make-work program, but nearly half are in the private sector. As a result, unemployment has declined from more than 20 percent to about 13 percent, and the number of Argentines living below the poverty line has fallen by nearly 10 points from the record high of 53.4 percent early in 2002.

"Things are by no means back to normal, but we've got the feeling we're back on the right track," said Mario Alberto Ortiz, a refrigeration repairman. "For the first time since things fell apart, I can actually afford to spend a little money."

Traditional free-market economists remain skeptical of the government's approach. While acknowledging there has been a recovery, they attribute it mainly to external factors rather than the policies of President Néstor Kirchner, who has been in office since May 2003. Increasingly, they also maintain that the comeback is beginning to lose steam.

"We've been lucky," said Juan Luis Bour, chief economist at the Latin American Foundation for Economic Research here. "We've had high prices for commodities and low interest rates. But if we want to grow in 2005, we're going to have to settle the debt question and have foreign capital come in."

The I.M.F., which Argentine officials blame for inducing the crisis in the first place, argues that the current government is acting at least in part as the I.M.F. has always recommended. It has limited spending and moved to increase revenues, a classic prescription when an economy is ailing, and has built up a surplus twice the size of what the fund had asked before negotiations were put on hold several months ago.

"The return to these encouraging numbers has been helped a lot by a fiscal discipline that is almost unprecedented by Argentine standards," said John Dodsworth, the senior I.M.F. representative here. "We've had a primary surplus which has increased steadily over these past few years at both the central and provincial levels, and that has been the main anchor on the economic side."

But some of that record budget surplus has come from a pair of levies on exports and financial transactions that orthodox economists at the I.M.F. and elsewhere want to see repealed. About a third of government revenues are now raised by those taxes, which have surged.

"The I.M.F. wants these taxes to be eliminated, but on the other hand they also want Argentina to improve its offer to creditors and also pay back the fund so it can reduce its own exposure here," said Alan Cibils, an Argentine economist associated with the independent Interdisciplinary Center for the Study of Public Policy here. "In other words, they are saying, 'You have to pay out more and take in less,' which is a sure prescription for another crisis."

Because of the absence of a debt accord and a stalemate over utility tariffs, some investors, mainly European, continue to shun Argentina, citing what they call the lack of "judicial security." But others, mainly Latin Americans used to operating in unstable environments or themselves survivors of similar crises, have increased their presence here amid expanding opportunities.

"These are slogans that people repeat without thinking, as if they were parrots," Roberto Lavagna, the minister of the economy, said when asked about the predictions that investment would disappear. "In 2001 and the beginning of 2002, all kinds of contracts were destroyed," he said. "So why are they investing? Because today clearly they can get a very good rate of return."

The Brazilian oil company Petrobras bought a stake in a leading energy company. Another Brazilian company, AmBev, has acquired a large interest in Quilmes, Argentina's leading beer brand, and a Mexican company has bought up control of a leading bread and cake maker.

Asian countries, with China and South Korea in the lead, have begun to move in. During a state visit last month, the Chinese president, Hu Jintao, announced that his country plans to invest $20 billion in Argentina over the next decade.

But the bulk of the new investment comes from Argentines who are beginning to spend their money at home, either bringing their savings back from abroad or from under their mattresses. For the first time in three years, more money is coming into the country than is leaving it.

That has given Mr. Kirchner the luxury of taking a hard line with the monetary fund and with foreign creditors clamoring for repayment.

"The thing is that Argentina has a current account surplus, so they don't really need so much foreign investment," said Claudio Loser, an Argentine economist and the former Western Hemisphere director for the I.M.F. "Domestic investment is taking place because there are opportunities in agriculture, oil and gas."

Just this week, the government announced that reserves of foreign currency have climbed back to $19.5 billion, their highest level since the crash and more than double the low recorded in the middle of 2002, a year with a net outflow of $12.7 billion.

"The peak of investment in the 1990's was 19.9 percent" of gross domestic product annually "and today it is at 19.1 percent, having risen from a low of 10 percent," Mr. Lavagna said. The Kirchner administration continues to seek an accord on the $167 billion in debt that is still outstanding, and plans to make what it calls its final offer early next month. But the turnabout here has inspired such a sense of confidence that the government is not only talking about cutting its last ties to the I.M.F. but also insisting that any payback to bondholders be linked to Argentina's continued good economic health.

"It's very simple," Mr. Lavagna said. "Nobody can collect from a country that is not growing."

****

The McKinsey Quarterly: Treasury management in emerging-market banks

The Prudent Investor: This featured article is dedicated for those of you in the Treasury Departments of any Financial institutions...

Treasury management in emerging-market banks

Elevating the treasury from a support function to a bank’s primary instrument for managing market risk can have a far-reaching impact throughout the organization.

Alberto Alvarez, Hugo A. Baquerizo, and Joydeep Sengupta

The McKinsey Quarterly, Web exclusive, November 2004

Banks in emerging markets have worked hard to hone their credit-risk-management skills over the past decade, and many of them deliver credit-related services and returns on par with those of their world-class competition. Yet they lag behind their counterparts in developed markets in managing market risk and in applying this knowledge to the treasury unit.

For banks in developed markets, the treasury unit has long been a source of profit, but it remains a support function for many institutions in emerging markets. We interviewed executives at 14 banks in Latin America, the Middle East, and Southeast Asia. At 9 of them, the focus of treasury activities was short-term liquidity management: ensuring that funds are available to meet regulatory reserve requirements and the immediate needs of customers. Board members and top managers at many of these banks view certain common treasury activities—for example, trading securities and developing derivatives contracts—as forms of casino finance.

In much of the developed world, a bank's treasury, in addition to managing liquidity, is responsible for managing assets and liabilities, trading in currencies and securities, and developing new products. High-performing treasuries systematically identify, mitigate, and profit from market risk—that is, risk associated with changes in interest rates, exchange rates, and the value of securities and commodities. When board members and top executives understand market risk, they see that good treasury management is anything but a gamble. A capable treasury unit that actively manages market risk can create significant value for a bank's shareholders. To convert the treasury function into a profit center, the bank must develop a clear business plan, educate its leadership about market risk, and get treasury personnel more involved in other bank activities.

Treasury's potential

For many banks in unstable financial markets, liquidity management has evolved into a source of competitive advantage. But although these institutions can manage short-term liquidity, they fall short in other activities, such as trading, product development, and actively managing the balance sheet structure and their exposure to market risk. Without a clear understanding of market risk, managers can neither protect a bank's capital nor profit from it.¹ Several problems constrain innovation in this area: a bank's leaders may be poorly informed about the profit opportunities in treasury, local money and capital markets may be thin, and customers may not demand products available in developed markets. As a result, the treasury unit often accounts for less than 10 percent of the net profits of banks in emerging markets. For those few institutions that have turned the treasury into a profit center—primarily innovative banks in larger financial markets such as Brazil, Mexico, and Singapore, as well as local subsidiaries of global banks—its contribution tends to be much higher: from 25 to 35 percent of net profits.

Emerging-market banks with a profitable treasury function keep their strategies simple and close to home. Taiwan's Chinatrust and Venezuela's Banco Mercantil, for example, offer their large, affluent customer bases standard products such as currencies or local securities contracts, for which the treasury is responsible. These wealthy people give the banks better access to retail funds and a steady stream of income from trading, both of which allow banks to make the most of their existing customers and branch networks.

Only global players such as Citibank and HSBC have the capability to dominate all treasury segments and products. Scale advantages give these institutions superior access to markets and information, allowing them, for example, to become market makers in specific currencies. Other large banks, such as Deutsche Bank and J. P. Morgan Chase, focus on providing the full scope of treasury services to the largest corporate segments. Specialized institutions such as Goldman Sachs also serve large corporate players but aim to capture market share in specific product lines. But banks in most emerging markets, where the treasury is a support function, seldom have such explicit strategies.

Putting together a mandate

Building a treasury unit calls for an annual business plan, which includes revenue and volume targets by product line and activity—the main ones being asset and liability management, trading, and new-product development. These plans also typically include a detailed description of risk considerations, the business potential of various kinds of products, and the treasury's posture: that is, whether or not the bank should attempt to make markets and profit from price movements or simply follow market prices and fill orders from customers.

The bank's asset and liability committee should review and define the treasury's specific objectives, in what is commonly called a mandate, on a monthly basis to shape the bank's balance sheet and its exposure to market risk. This analysis examines the balance sheet with respect to target structure, short-term forecasts of interest rates, exchange rates, and the price of securities and commodities.

Managing assets and liabilities

In developed markets, treasuries act as risk managers for banks. By using internal transfers—a standard accounting practice in banks—the treasury buys and sells funds among the bank's client-facing units in order to isolate and remove maturity and interest-rate mismatches from corporate and retail business units. For the fund transfers, these banks use sophisticated pricing that allows their treasuries to account for and hedge the liquidity and interest-rate risk of each asset and liability on their balance sheets.

But most of the emerging world's banks, including 73 percent of those we surveyed, still apply a single-rate transfer price to most asset and liability contracts. By awarding the same internal transfer price to all short- and long-term funds, banks give managers no incentive to offer funds of varying maturities and repricing characteristics.² The result is an improperly structured balance sheet: since the bank can't break out the credit risk and market risk components from the net interest margin, it lacks an accurate measure of true profitability in the product or client categories.

If treasury units in emerging markets hope to compete with the local subsidiaries of global banks, it will be necessary to learn how to set transfer prices appropriately. The first step is to incorporate the maturity and interest-rate characteristics of every contract a bank holds, for both assets and liabilities.

Trading and holding positions in currencies, securities, and derivatives

Large banks in emerging markets usually generate 5 to 35 percent of their total treasury revenues from trading. The actual percentage depends largely on a bank's ability to benefit from its customer relationships. Credit-related products in foreign currencies, such as working-capital lines of credit and trade-financing letters of credit, often generate the majority of foreign-exchange trading business for corporate clients. Banks that derive a relatively high proportion of their revenues from trading rely on the treasury and their client-facing units, such as the corporate-banking group, to develop a clear understanding of their customers' needs. Product-development managers in the treasury of such a bank have developed skills in structuring contracts, and corporate-account executives know best what their clients want. Thus, when the treasury and client-facing units collaborate more closely to plan accounts and set sales strategies, it's much more likely that the bank will create attractive products for its clients and generate more revenue.

The most successful investment-driven banks in emerging markets generate up to 60 percent of the treasury's total revenue by holding inventories of, or positions in, currencies, securities, and derivatives. For maintaining profitable positions, access to information and the ability to liquidate positions are crucial. Banks in emerging markets are usually well acquainted with trading and holding positions in local and sometimes regional securities markets. Since these banks lack the experience and resources to research other markets adequately, they often delegate investing and taking positions in global securities markets to third parties. When a small or midsize bank in Dubai or Riyadh, for example, needs to purchase US Treasury bills and bonds, it may delegate the task to a large institutional investor with better market access.

Developing new products

In general, bank treasuries in the emerging world don't create and market new products themselves, since a relatively unsophisticated local customer base doesn't push them to develop a wider variety of offerings. In some markets, top corporate customers structure their own products and use the banks merely to execute transactions.

Most often, treasury products are associated with the credit and cash-management needs of corporate customers—off-balance-sheet and tax-efficient loans or project finance, for example. To sell new, more sophisticated products, banks should involve the treasury in segmenting corporate clients and in creating tailored offerings based on the needs and behavior of customers.

The treasury can also play an important role in structuring products to hedge the bank's own capital. These products—typically derivatives contracts—protect the bank's capital exposure to a particular currency or to market factors such as changing interest rates and commodity prices.

Taking the treasury seriously

To build an effective and profit-oriented treasury unit, the leadership of banks in emerging markets must develop a better understanding of and appreciation for market risk. This cultural shift must start with board members and top management and continue through the treasury organization and the rest of the bank. Implementing an effective decision-making culture means making everyone understand how the bank manages and profits from market risk.

The creation of a treasury unit that follows global best practices—with clear treasury and market-risk-management roles—is a critical step in gaining this understanding. Centralizing the treasury unit and streamlining business, support, and control processes are also vital to building a profitable treasury. For many banks in emerging markets, market risk management and activities such as liquidity management and the holding of currencies and securities are conducted in an uncoordinated way outside the treasury: It may handle foreign-exchange trading for only, say, traditional retail and corporate clients, while other business units might trade for corporate and commercial clients that demand trade finance products (import and export financing, such as letters of credit, for example). Or perhaps the treasury manages local-currency liquidity while the international-banking unit handles liquidity for foreign currencies. In such cases, it's far more difficult for the bank to monitor and manage risk, since decision making is decentralized.

Banks can better manage and profit from risk by making the treasury the lone department with access to the financial markets and the single repository for currency and securities inventories. One Latin American bank, for example, was dominant in its market but had a relatively unsophisticated and decentralized treasury unit. The bank consolidated its liquidity-management operations for all currencies under a single money-market desk and created a clear distinction between the trading and sales functions. It also adjusted its asset- and liability-management processes and tools to help the treasury take a more active role in handling market risk and in developing new products. In just 18 months, the treasury unit's contribution to the bank's bottom line increased to 25 percent, from 12 percent.

How to proceed? In our judgment, hiring experienced traders and product developers allows both frontline and top managers to build new skills in less time than would be needed if they merely watched and learned from the market itself. In addition, many banks that lack skills at the top of their treasury organizations would be wise to recruit new treasurers from global banks. For most banks in emerging markets, developing and implementing a new treasury model takes three to five years. When top management is committed to the new goals, and the bank's competitive position in the market is favorable, the transition can be completed much more quickly. Two banks in Latin America, for example, achieved significant benefits—increased profits from the treasury unit and better risk management—just 18 months after launching their transformation effort. An efficient, committed management team can increase the treasury's contribution to net profits by more than 20 percent.

The most critical aspect of the evolution of the new treasury is ensuring that the board and the top-management team are committed to it. Other key stakeholders—such as traders, account executives, and branch managers—must learn how it operates. But unless the board is well educated in the advantages of the new model and has confidence in it, all may be lost. The board must develop an understanding of market risk management in order to provide direction, while top executives must acquire a new mindset as well as the tools to implement it. The risks and rewards—increased vulnerability to the vicissitudes of the market, on the one hand, substantially higher profitability, on the other—are too large to ignore.

About the Authors

Alberto Alvarez is an associate principal in McKinsey's Caracas office, Hugo Baquerizo is a principal in the Bogota office, and Joydeep Sengupta is a principal in the Delhi office.

Notes
¹ For a broader summary of channel options, see John M. Abele, William K. Caesar, and Roland H. John, "Rechanneling sales," The McKinsey Quarterly, 2003 Number 3, pp. 64–75.
² The frequency with which a price can change, regardless of the fund's maturity date. The contract for a three-year loan, for example, might stipulate that the loan be repriced every 90 days.

Businessweek: The Economy Five Wild Cards For 2005

The Economy: Five Wild Cards For 2005

What could throw the economy for a loop? Here are some threats worth watching

There's an old saying in economic forecasting: The consensus is always wrong. That's why the key to investing wisely in 2005 may well lie in considering how the economy will stray from expectations. To evaluate the risks and possibilities for 2005, BusinessWeek asked the economists in our annual outlook survey to think outside the box of their basic forecasts by identifying the wild cards that could have a positive or negative impact on the outlook. That's not to say consensus forecasts are useless. Far from it. They provide an important baseline for judging the economy's performance as it plays out. For 2005, the 60 forecasters we surveyed expect, on average, that the economy will grow 3.5% from the end of 2004 to the end of 2005. That's a bit below the 3.8% pace expected for 2004. The consensus view is that profit growth will slow to 6.7%, and inflation will fall, as oil prices slip to $39 per barrel by the end of 2005. The Federal Reserve will keep lifting the federal funds rate, to nearly 3.5% by yearend, from 2.25% now, and the yield on 10-year Treasury bonds will increase from 4.3% to 5.1%. In general, economists see the dollar slipping at a gradual pace of about 10% against major currencies and 5% vs. all currencies. The jobless rate should fall from 5.4% to 5%.

All in all, that's not too shabby. But what could throw the consensus for a loop? Here are five economic wild cards for 2005 that bear close scrutiny as the year progresses. They're especially important because they are interrelated: A surprise in one area could generate unexpected consequences elsewhere. These wild cards are the most credible threats to the general forecast -- and to the value of your portfolio.

WATCH OUT FOR FALLING DOLLARS

A possible crash in the U.S. dollar surpassed even oil prices as the biggest question mark on economists' minds for 2005. "This has been my worst nightmare for some time," says Nicholas S. Perna of Perna Associates in Ridgefield, Conn. The growing concern is America's ability to attract the massive amount of foreign capital it requires to finance both private and public investment. The trouble: A rising federal budget deficit subtracts from the available pool of domestic savings, even as the widening trade deficit adds to the financing needs.

The danger, says Perna, is a loss of confidence in the U.S. economy and those running its economic policy that could play out in a rerun of the 1980s. Early in that decade, the stimulative effects of budget deficits helped to push up the dollar and the trade deficit. But in 1985-87 the dollar plunged 40% vs. major currencies, yields on Treasury bonds jumped two percentage points, and stock prices plunged 30% in October, 1987.

Economists already see some increasing reluctance by both private investors and central banks to hold U.S. Treasury securities. But if the greenback really tanks, "the primary effect will likely be on the U.S. corporate bond market, where overseas investors -- largely Europeans -- account for about half of new-issue buying," says Vincent Boberski at RBC Dain Rauscher in Minneapolis.

Sharply higher interest rates would be especially damaging to a frothy housing market, the stock market, and heavily indebted consumers. More ominously, higher rates would increase the risk of an outright recession.

AVOIDING ANOTHER OIL SLICK

Unlike the dollar, oil is a wild card that could swing either way. On the negative side, another spike in oil prices could slow consumer demand just as it did in 2004. "If oil remained at $50 to $55 per barrel, it would lower gross domestic product growth next year by about one percentage point," says Richard D. Rippe at Prudential Equity Group. Other economists worry that, given the right geopolitical upheavals or supply disruptions, oil could hit $60 or $70, a shock that would further crimp household buying power and pummel corporate profits. "Oil prices at $80 would undermine business and consumer confidence sufficiently to cause a mild recession late next year," says Kurt Karl of reinsurance firm Swiss Re.

But economists see an equal, if not greater, chance that oil prices could fall, perhaps to $25 per barrel. That could be precipitated by several factors, including an expected slowdown in global demand, a mild winter, or an easing of Mideast tensions either in Iraq or between Israel and the Palestinians. Cheaper oil "would spark a period of very strong growth in the U.S. as consumers and companies respond to the cash flow gains generated by the drop, pushing growth towards perhaps 6% for a time," says Ian C. Shepherdson of High Frequency Economics in Valhalla, N.Y. Stock prices would benefit handsomely, and the wealth effect would support consumer spending. However, don't expect falling oil prices to keep rates down. "The Federal Reserve would probably continue to raise interest rates with the economy growing above its potential," says Lynn Reaser at Banc of America (BAC ) Capital Management in St. Louis.

INFLATION BREATHES FIRE

Oil and the dollar have one thing in common: the potential to affect inflation. That may well explain why our survey's inflation forecasts vary more than usual, from 1.2% to 4.4%. Consumers and businesses could easily adjust to a return of low inflation after 2004's oil-fueled rise. But if prices pop up 4%, that would send both bond investors and the Fed scrambling. "We believe there is a significant risk that inflation will be higher than expected," says Lynn O. Michaelis at Weyerhaeuser Co. (WY ), noting that the dollar's drop and higher commodity prices are just beginning to wend their way into final goods prices. Matters could be worse if China revalues its currency higher. "This would result in revaluations of other Asian currencies and allow U.S. businesses to become more aggressive in their pricing," says Mark Zandi at Economy.com Inc.

Bear in mind that many of the factors that held inflation down during the 1990s are reversing. And it's not just the weaker dollar or costlier energy. First, productivity growth is slowing, as it does when a recovery matures. That, together with a tightening job market, will push up unit labor costs. Second, factories are busier. "The Fed's capacity numbers understate the true capacity utilization rates," asserts Robert Shrouds at DuPont (DD ). "Based on the experience at my company, utilization rates are high across a broad range of products." Lastly, monetary policy is still unusually accommodative, with the Fed's target interest rate still close to zero after adjusting for inflation. An inflation surprise would cause the Fed to lift rates more and faster than expected.

POP GOES THE HOUSING BUBBLE

If rates rise faster than the consensus expects, housing is especially vulnerable, say some economists. "Houses that look affordable now would not look so with mortgage rates two percentage points higher," says Nariman Behravesh at Global Insight Inc. in Waltham, Mass. If mortgages rise to 8%, many buyers would have to scale back their aspirations, and some homebuyers would be priced out of the markets, causing a downshift in home demand.

More important, a weaker housing market would prick any bubble in prices, deflating household wealth. Consumers would have to save more and shop less. And with mortgage rates up, refinancing would dry up, also crimping spending.

AS THE WORLD CHURNS

Another wild card foremost in our economists' minds is a sharp slowdown in global growth. "The euro area is weighed down by currency appreciation and the absence of any domestic demand dynamic," says Bruce Kasman at JPMorgan Chase & Co. (JPM ), "and Japan's recovery could prove disappointing." If China's efforts to cool off its economy rip its fragile financial fabric, that could have global repercussions. The risk is that weak demand would cut into U.S. exports, thwarting the chances for a lower dollar to help stabilize the trade deficit.

Not surprisingly, the threat of terrorism looms over all. "A terrorist strike in the U.S. or marked escalation of the conflict in the Middle East could result in an attendant drop in business confidence that would undermine the expected recovery in investment and employment," says Tim O'Neill at BM Financial Group/Harris Bank in Toronto. Another attack could hasten the dollar's decline, roil the financial markets, and harm the economy.

The problem is that terrorist attacks are impossible to forecast. But that only illustrates how one day's events can derail a yearlong consensus forecast. If all goes according to the forecasters' plans, 2005 should be a decent year for both the economy and a well-balanced portfolio. But investors should heed the lesson of recent years: Expect the unexpected.

By James C. Cooper & Kathleen Madigan

Japan Times: China's power prevents Japan from invading Asia again: Lee

China's power prevents Japan from invading Asia again: Lee

SINGAPORE (Kyodo) Japan is unlikely to again go down the militarist path and invade its Asian neighbors as it did before and during World War II because China's growing economic prowess has created a new balance of power, according to Singapore's elder statesman.

"I do not see a return to a situation the Japanese were in during the 1930s and 1940s. That Asia will not come back," Lee Kuan Yew, 81, told a dinner organized by the Foreign Correspondents' Association on Monday.

"We have an Asia now that is completely different with China . . . economically growing 8 to 9 percent. So I don't see a repetition of the old behavior, but an evolution into a new balance."

In response to a question, Lee said Prime Minister Junichiro Koizumi's visits to Yasukuni Shrine, the dispatch of ground troops to Iraq and preparations for a more significant role for the Self-Defense Forces reflect a "gradual evolution" that could turn out to be positive.

"I see this as a development that the U.S. would be happy with and will fit in with the balance that eventually must be established between the U.S. and Japan on the one, and China on the other," he said.

He said the United States needs Japan to continue as a partner.

"A U.S. without Japan would be at a great disadvantage in Asia," he said.

Lee was Singapore's first prime minister, holding the reins for more than three decades until 1991. In the 1990s, he quipped that allowing Japan to rearm would be like giving liquor chocolates to an alcoholic.

In his memoirs, published in 1998, Lee says 50,000 to 100,000 mainly Chinese people in Singapore were massacred by the Japanese military during the 1942-1945 occupation.

On an East Asian economic community, Lee said: "If we want an economic community, I think it is possible, but it will take many years. But to be an East Asian union, that is different. To have one currency, that will take many decades."

The Japan Times: Dec. 22, 2004
(C) All rights reserved

New York Times: China in Line as U.S. Rival for Canada Oil

China in Line as U.S. Rival for Canada Oil

By SIMON ROMERO

CALGARY, Alberta, Dec. 21 - China's thirst for oil has brought it to the doorstep of the United States.

Chinese energy companies are on the verge of striking ambitious deals in Canada in efforts to win access to some of the most prized oil reserves in North America.

The deals may create unease for the first time since the 1970's in the traditionally smooth energy relationship between the United States and Canada.

Canada, the largest source of imported oil for the United States, has historically sent almost all its exports of oil south by pipeline to help quench America's thirst for energy. But that arrangement may be about to change as China, which has surpassed Japan as the second-largest market for oil, flexes its muscle in attempts to secure oil, even in places like the cold boreal forests of northern Alberta, where the oil has to be sucked out of the sticky, sandy soil.

"The China outlet would change our dynamic," said Murray Smith, a former Alberta energy minister who was appointed this month to be the province's representative in Washington, a new position. Mr. Smith said he estimated that Canada could eventually export as many as one million barrels a day to China out of potential exports of more than three million barrels a day.

"Our main link would still be with the U.S. but this would give us multiple markets and competition for a prized resource," Mr. Smith said. Delegations of senior executives from China's largest oil companies have been making frequent appearances in recent weeks here in Calgary, Canada's bustling energy capital, for talks on ventures that would send oil extracted from the oil sands in the northern reaches of the energy-rich province of Alberta to new ports in western Canada and onward by tanker to China.

Chinese companies are also said to be considering direct investments in the oil sands, by buying into existing producers or acquiring companies with leases to produce oil in the region. In all, there are nearly half a dozen deals in consideration, initially valued at $2 billion and potentially much more, according to senior executives at energy companies here.

One preliminary agreement could be signed in early January. A spokesman for the Department of Energy in Washington said officials were monitoring the talks but declined to comment further.

China's appetite for Canadian oil derives from its own insatiable domestic energy demand, which has sent oil imports soaring 40 percent in the first half of this year over the period a year ago. China's attempts to diversify its sources of oil have already led to several foreign exploration projects in places considered on the periphery of the global oil industry like Sudan, Peru and Syria.

In Calgary, however, the negotiations with China have focused on the oil sands, an unconventional but increasingly important source of energy for the United States. Higher oil prices have recently made oil sands projects profitable, justifying the expense of the untraditional methods of producing oil from the sands. Large-scale mining and drilling operations are required to suck a viscous substance called bitumen out of the soil.

"China's gone after the low-hanging fruit so far," said Gal Luft, a Washington-based authority on energy security issues who is writing a book on China's search for oil supplies around the world. "Now they're entering another level of ambition, in places such as Venezuela, Saudi Arabia and Canada that are well within the American sphere."

Canada's oil production from the sands surpassed one million barrels a day this year and was expected to reach three million barrels within a decade. The bulk of output is exported to the Midwestern United States. That flow pushed Canada ahead of Saudi Arabia, Mexico and Venezuela this year as the largest supplier of foreign oil to the United States, with average exports of 1.6 million barrels a day.

Even so, there is the perception among many in Alberta's oil patch that Canada's rapidly growing energy industry remains an afterthought for most Americans. That might change, industry analysts say, if Canada were to start exporting oil elsewhere.

"A China agreement might serve as a wake-up call for the U.S.," said Bob Dunbar, an independent energy consultant here who until recently followed oil issues at the Canadian Energy Research Institute.

Executives at energy companies and investment banks in Calgary say an agreement with the Chinese could materialize as early as next month. Ian La Couvee, a spokesman for Enbridge, a Canadian pipeline company, said it was in talks to offer a Chinese company a 49 percent stake in a 720-mile pipeline planned between northern Alberta and the northwest coast of British Columbia.

The pipeline project, which is expected to cost at least $2 billion, would send as much as 80 percent of its capacity of 400,000 barrels a day to China with the remainder going to California refineries. Sinopec, one of China's largest oil companies, was said by executives briefed on the talks to be the likeliest Chinese company in the project.

A rival Canadian pipeline company, Terasen, meanwhile, has held its own talks with Sinopec and the China National Petroleum Corporation about joining forces to increase the capacity of an existing pipeline to Vancouver. Richard Ballantyne, president of Terasen, said it had supplied almost a dozen tankers this year to help Chinese refineries determine their ability to process the Alberta crude oil blends.

"There's been significant interest so far, but the way I understand it, their refineries are still better suited to handling Middle Eastern crude than ours," Mr. Ballantyne said. "That has to change if they're intent on diversifying their sources of oil."

Separately, Marcel Coutu, the chief executive of the Canadian Oil Sands Trust, a company that owns part of one of the largest oil sands ventures in the tundralike region around the city of Fort McMurray in northern Alberta, said he had recently met with officials from PetroChina, one of China's several state-controlled energy concerns, and had agreed to send it trial shipments of oil.

In an interview, Mr. Coutu described PetroChina's interest in a deal as very serious, but he declined to say when one might materialize. "China can become one of our capital sources, enabling us to go a bit further afield than the New York market for our financing," Mr. Coutu said.

Additionally, Chinese companies are also said to be considering investments in smaller Calgary-based companies, like UTS Energy, that have approved leasing permits for parts of the oil sands. Officials from the Chinese companies said to be negotiating in Calgary - PetroChina, Sinopec and CNPC - did not respond to requests for comment.

Wilfred Gobert, vice chairman of Peters & Company, a Calgary investment bank, said Canada's main attractions for the Chinese are the stability of its political system and its sizable reserves. Canada ranks behind only Saudi Arabia in established petroleum reserves, now that its oil sands are included in international estimates of Canadian oil resources.

Before prices rose and the United States expanded its calculation for estimates of reserves, oil sands were often scoffed at as an uneconomical way to produce oil. They still involve risks not normally associated with conventional oil exploration.

Large amounts of capital are necessary to produce oil from the sands, with companies having to acquire large shovels, trucks, specialized drilling equipment or supplies of natural gas to make steam before producing one barrel of oil. So, the price of oil needs to remain elevated, at a level of $30 a barrel or so, for ventures to remain profitable.

[Oil prices for February delivery slumped 3.3 percent, to $44.24 a barrel, in New York on Wednesday, the biggest slide in two weeks.]

An entry into Canada would assure the Chinese of a steady flow of oil, even if the profit margins from the activities were to pale in comparison to what the international oil companies expect from their investments, said Kang Wu, a fellow at the East-West Center in Honolulu who follows China's energy industry. "For China it is foremost about securing supply and secondly about profits," he said. "That explains the incentive in going so far abroad."

China's growing demand for oil is responsible for much of the increase in worldwide prices in the last year. Mr. Kang of the East-West Center estimates that demand in China could grow from 6 million barrels a day to as much as 11.5 million barrels within a decade. China's domestic production is expected to remain nearly stagnant, Mr. Kang said, resulting in aggressive efforts to import more oil from sources like Canada.

"China needs oil resources and has a big market," Qiu Xianghua, a vice president at Sinopec, said in a speech in Toronto this month. "Canada needs markets."

Alberta, a province of 3.1 million people, is keenly aware of the potential for Chinese involvement even as American companies like Exxon Mobil, Burlington Resources and Devon Energy remain prominent in its energy industry. Ralph Klein, the premier of Alberta, traveled to Beijing in June to drum up investment in the tar sands.

And yet officials and authorities on Canadian energy supplies are cautious not to suggest that Canada will ever turn off the spigot to the United States. At a time of a highly competitive market for global oil, in fact, some analysts see greater interest in Alberta's oil reserves as a healthy avenue for China to explore, even if it were to push the United States to seek an even greater diversity for its own energy needs.

"The pipeline system that connects Alberta to the U.S. isn't going to be lifted out of the ground and put into the Pacific," said Daniel Yergin, chairman of Cambridge Energy Research Associates. "The flows to the U.S. will continue, but it should be expected and welcomed for China to meet the challenge of its growing dependence on imported oil."

Still, the prospect of dealing with China has many here pondering relations with the United States. The last time any significant oil-related friction arose between the nations was in the 1970's, when Ottawa became concerned over what it perceived as too much American control over Canadian oil, leading to greater federal involvement in the oil industry.

"Watch the Americans have a hissy fit if a Chinese incursion materializes," Claudia Cattaneo, a Calgary-based energy columnist for The National Post, recently wrote. "So far, the Americans have taken Canada's energy for granted."