Busineweek: Four Countries You Must Own

Four Countries You Must Own
Busineweek
December 27, 2004

Every investor needs a stake in Brazil, Russia, India, and China

Once in a great while a trend takes hold that's so powerful, it transforms the entire global economy: the Industrial Revolution of the 18th century, the modern industrial nation in the 19th century, and the emergence of cheap computing and communications in the 20th century.

The newest megatrend? It's the rise of the BRICs. That's shorthand for four dynamic developing nations with large populations -- Brazil, Russia, India, and China. The four now account for less than 15% of the economies of the G6 nations. But collectively they could be larger than the G6 in just four decades, say economists at Goldman, Sachs & Co. (GS ). That depends, of course, on whether they get the fundamentals right: sound fiscal and monetary policies, free trade with the outside world, and massive investment in education. "It's a story for the future," says Robert Hall, portfolio manager for global emerging markets at Russell Investment Group.

That means you might want to start making investments now. You can choose individual equities or take a basket-of-stocks approach with exchange-traded indexed funds or actively managed mutual and closed-end funds. Don't invest a huge lump sum at once. Instead, put your money in over time. The markets are volatile, and there will be pullbacks offering cheaper entry points.

These economies have weaknesses, too. For instance, foreign capital is pouring into China so quickly that some economists fear the combination of a speculative frenzy and a backward banking system will eventually burst the bubble. Watchdog group Transparency International ranks India among the rampantly corrupt nations in its latest Corruption Perception Index. And investors are questioning Russian President Vladimir Putin's commitment to capitalism after the recent crackdown on oil giant Yukos. Any one of those could derail the markets or the economy for a bit.

Still, there is precedent for making a long-term bet on an emerging frontier. In the years after the Civil War, America's industrial output lagged far behind that of Germany, France, and Britain. Yet from 1870 to 1914, America's economy expanded fivefold, and the U.S. became the world's leading industrial power. Along the way there were about a dozen sharp downturns and a handful of financial panics, yet stocks returned an average of 6.5% a year after inflation. "If you can close your eyes for years, you'll probably do well," says Stuart Schweitzer, global markets strategist at JPMorgan Fleming Asset Management in New York.

In part driven by the economic performance of the BRICs, the entire emerging-market sector put on a stellar show this year. The Morgan Stanley Capital International Emerging Market Index is up some 14% through Dec. 10, vs. 6.8% for the Standard & Poor's 500-stock index.

And 2005 looks good, too. Emerging-market stocks are cheap, with valuations about 40% lower than in the U.S. The sinking dollar is prompting investors to send more money abroad, says Brad Durham, a managing director at Emerging Portfolio Fund Research in Boston. Currently, global mutual funds and pension funds are underweighted in the BRICs. As investors become more familiar with the BRICs, says Durham, more money will flow to them.

One strong global theme that benefits the BRICs in particular is demand for industrial commodities. Brazil's Bovespa stock index is up some 15% this year, powered by companies such as Companhia Vale do Rio Doce, a major exporter of iron ore, and CSN, a major steelmaker. Rio Doce, CSN, and other basic industry companies should continue to do well considering the world's voracious appetite for raw materials, especially in China. Russia's Gazprom, for instance, will account for a quarter of world gas production, and it will be one of the international oil giants after buying a chunk of rival Yukos. "It's Russia's Aramco," says James Fenkner, chief strategist for Troika Dialog, a Moscow investment bank, referring to the Saudi Arabian oil company. "You don't need to be born into the House of Saud to benefit from Gazprom."

While commodities are expected to remain strong, many global investors believe rising incomes and growing employment in the BRICs will make consumer companies golden. In a decade, say the Goldman economists, the BRICs' middle class will total more than 800 million, greater than the populations of the U.S., Western Europe, and Japan combined today. The BRICs' middle class now number more than 250 million, says Goldman, and those consumers are already spurring demand for cars, cell phones, and better food, furnishings, and clothes.

Investing in the consumer sectors of these countries has been hard because of a scarcity of good, publicly traded companies. But that's changing. New opportunities are opening in Brazil, for example, after a rash of initial public offerings there. Among the IPOs were Natura, a cosmetics company, and Grendene, a footwear maker. In Russia, mobile-phone companies such as Mobile Telesystems are benefiting from growing usage. When Putin came into office in 2000 there were some 1.5 million cell-phone subscribers in Russia. Now there are more than 50 million. India's Pantaloon Retail is building both food hypermarkets and clothing stores that appeal to young buyers. Same-store sales are expanding at a 12% to 15% annual pace.

FOOLHARDY -- OR FARSIGHTED?

In China, consumers are also inveterate savers, salting away some 40% of their incomes. That's good for financial-services firms such as China Life Insurance (LFC ), a favorite of Agnes Dang, an investment manager for Standard Life Investments in Hong Kong. China Life is the country's biggest insurer, and its premium income is growing at 15% a year. Phillip Ehrmann of Gartmore China Opportunities Fund, a U.S. mutual fund, expects a number of state-run Chinese banks to go public in 2005, and they may make attractive investments. You heard that right. China's banks have a reputation for bad loans and poor management, yet Ehrmann thinks some of them will clean up their acts because the government wants them to go public.

For sure, those who invest in those Chinese banks -- or in the BRICs -- will be called foolhardy by some doubters. But much the same was said in the 19th century about those who invested in a wild and raucous nation called America.

By Christopher Farrell with Frederik Balfour in Hong Kong, Jason Bush in Moscow, and Jonathan Wheatley in São Paulo

Chicago Tribune: World economic growth is seen slowing in 2005

World economic growth is seen slowing in 2005
Asia is predicted to be top region
By Viorel Urma
Associated Press
Published December 27, 2004

Buffeted by the soaring cost of oil, the world economy is expected to moderate in 2005, led by a slowing of the expansion in industrialized countries.

Spurred by China and India, developing countries should enjoy solid growth. Predictions are that Asia will lead the global economic race--though Japan is facing a slowdown--and that the United States will still outrun Europe.

The World Bank sees global economic expansion slowing in 2005 to 3.2 percent from an estimated 4 percent in 2004 because of high and volatile oil prices, a decline in investment growth due to higher interest rates, and concerns about the growing U.S. trade deficit.

"The global economy is slowing, but it will likely keep expanding on the basis of a recovery in the U.S. and Chinese economies," Bank of Japan Gov. Toshihiko Fukui said.

The Organization for Economic Cooperation and Development said in November that oil prices have already taken their toll on the major economies, prompting it to cut its growth forecasts for 2005.

Across the OECD's membership of 30 industrialized countries, it expects growth of 2.9 percent next year, down from the 3.4 percent it forecast in May.

For the 12-nation euro zone, the Paris-based global economic think tank expects the United States to lead the global recovery but cut its growth forecast for 2005 to 3.3 percent from 3.7 percent. For Japan, it now forecasts growth of 2.1 percent, down from the 2.8 percent previously forecast.

Here's a region-by-region look at predictions for the global economy in 2005:

Asia

China's economic boom is expected to continue to power fast expansion throughout the region, despite efforts by Beijing to slow 9 percent growth to a more sustainable level by cutting public spending and bank lending, and raising key interest rates.

Strong exports and domestic demand in the country of 1.3 billion are boosting trade throughout the region, a trend likely to continue as long as U.S. and European consumers continue to snap up made-in-China products.

Helped by India, East Asia is expected to remain the world's fastest growing region, with 7.1 percent growth in 2005, the World Bank projects.

By contrast, Japan's economy appears headed for another slowdown, government data indicate. After more than a decade of stagnation, the world's second largest economy has been witnessing a modest rebound, marking six straight quarters of expansion. But fears have been growing that a decline in exports will push down growth, while a rebound in consumer spending will not be enough to keep the recovery going.

United States

The U.S. economy is expected to grow about 4 percent in 2004, and economists forecast growth at or above the economy's trend rate of about 3.5 percent in 2005.

"This year it is on track to complete the third year of recovery with a strong 4 percent growth," Treasury Undersecretary John Taylor told business executives during a recent trip to India.

November's weaker employment report was a disappointment, but employment growth has averaged 185,000 monthly since the start of the year, fast enough to take in labor market slack.

While the oil price has boosted day-to-day inflation, core inflation pressures have remained under control.

Robert DiClemente, head of U.S. economic analysis at Citigroup, expressed concern about the strength of the global economic expansion and said the huge current account deficit in the United States, a key factor in the plunge of the dollar, will narrow as the Bush administration pushes policies to cut its budget gap and encourage private savings.

The OECD's chief economist, Jean-Philippe Cotis, warned that the burgeoning U.S. current account deficit--5.7 percent of the gross domestic product--was a major source of disturbance in the world economy and called on the Federal Reserve to raise interest rates gradually, encouraging greater savings to rein in the gap.

According to OECD, the U.S. current account deficit--the broadest measure of foreign trade--is estimated to widen from 5.7 percent of GDP in 2004 to 6.2 percent in 2005 and 6.4 percent in 2006, or about $825 billion.

Europe

After a relatively strong first six months in 2004, growth in the 12-country euro zone has slowed sharply. GDP rose by just 0.3 percent in the third quarter, as exports suffered from a strong euro and household spending remained flat.

The European Central Bank cut its projection for economic growth in 2005 to between 1.4 percent and 2.4 percent.

Central Bank President Jean-Claude Trichet said Europe's modest recovery remains on track but will slow next year due to high oil prices.

South America

Brazil, which has South America's largest economy, is poised for a second straight year of growth in 2005 and hopes to build on its strong exports while benefiting from rising consumer demand among its 182 million citizens. Economists predict Brazil's economy will grow 3.5 percent in 2005 following estimated growth of 4.7 percent in 2004.

Argentina's economy is expected to expand 5.4 percent following estimated growth of 8 percent in 2004. But South America's second-largest economy faces a big challenge: the country's debt default. In 2002, it was the largest ever by a sovereign country, with payments stopped on some $100 billion in public debt.

Creditors have resisted offers by President Nestor Kirchner to pay as little as 30 cents on every dollar. The negotiations are being closely watched on Wall Street and in Europe. Argentine officials say they hope to resolve the issue in 2005 with a formal debt exchange.

Copyright © 2004, Chicago Tribune

Manila Bulletin: Nation’s biggest mining conference set this February

Nation’s biggest mining conference set this February
By GENALYN D. KABILING
Manila Bulletin

President Gloria Macapagal Arroyo has promised to put premium on the environment and the people rather than accommodate business interests when she hosts the biggest mining conference in the country in February next year.

While she intends to lure foreign and local mining firms to tap the country’s profitable mineral reserves, the President said the government would also consult with non-government organizations (NGOs) to craft a comprehensive strategy for sustainable mining operations during the summit tentatively scheduled in the first week of February.

The President vowed to ensure that mining operations, which are expected to increase following the Supreme Court decision upholding the constitutionality of Mining Act of 1995, would not be "disastrous" for the environment and instead would have a "sanitary effect on the economy."

"This February, I intend to attend to the issue of mining not just on investor confidence in mining, we will have meeting and consultation with the NGOs on how best to preserve and protect the interest of the indigenous people and the environment," she said last Monday night in a press conference in Baguio City.

If necessary, Arroyo said she would ask Congress to pass a legislation that would guarantee the protection of the environment from mining activities in the country.

Arroyo earlier hailed the Supreme Court ruling on the Mining Act of 1995 allowing foreign companies to undertake mining in the Philippines, believing it would bring in vast revenues for the government and create more economic opportunities and jobs for Filipinos.

The President said she believes the Philippines, which she considered the world’s fifth mining power, would gain considerable economic benefits from its mineral riches estimated at $840 billion or ten times the annual gross domestic product (GDP).

"This can easily wipe out our foreign debt of $56 billion while leaving much more for future generations," she said. "This can give a lot of income to our people. But let us all work together to make sure that it is going to be socially responsible mining."

Aside from the environmental and social safeguards of the Mining Act, Arroyo noted that today’s mining operations, which utilize modern technology, are "very pro-environment."

"I do not even think that the funding agencies, JBIC (Japan Bank for International Cooperation) for instance, would be funding any project that have not undergone the test of environmental consciousness," she said.

Total reserves of gold in the Philippines have been estimated at a total of 162.7 million metric tons, and its copper reserves at 4.05 million metric tons.

***
Prudent Investor Says: "I told you so!"

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.