Stocks are simple. All you do is buy shares in a great business for less than the business is intrinsically worth, with management of the highest integrity and ability. Then you own those shares forever. I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.

February 13, 2009

5-10 trillion needed for bailout (KENICHI OHMAE)

What is needed to make the U.S. financial bailout plan a success

By KENICHI OHMAE

Special to The Japan Times

The refusal of the U.S. House of Representatives to pass the $700 billion bailout plan Monday may turn out to have been appropriate if the Congress correctly understands the priorities at hand. The issue is not whether the situation should be left to the market or whether the government should save those who lose their house due to foreclosure. The main challenge at this moment is to provide liquidity to the market, particularly to failing financial institutions.

From the experience of Japan throughout the 1990s, and also from the experience of Nordic countries, it is clear that the U.S. financial crisis is also going through a sequence of events — almost physical and also psychological — that are very similar to what happened elsewhere in the world.

The problem is that the U.S. leadership does not seem to understand exactly what happened and what lessons to reflect on, as is clear in the impulsive and almost heroic actions that they have exhibited over the last three months.

Now that the Paulson bailout plan is temporarily suspended, it may not be too late to state what I have been talking and writing about in Japan with regard to the problems of the U.S. approach to resolving its financial crisis and a possible solution to the imminent threats of meltdown of global banking systems.

There are three principles that must be observed in resolving a major financial crisis: (1) treat it as a systemic failure and do not act on individual situations; (2) know the sequence of events, so the right problem can be solved at the right time; and (3) construct a universal system later to prevent similar problems from occurring again. The U.S. government seems to be violating every one of these principles and mixing the sequence of events, hence aggravating an already dire situation.

What the U.S. needs to do under this scenario is to get help from the rest of the world in setting up a gigantic credit line, on the order of $5 trillion, to provide the necessary liquidity that will allow troubled financial institutions to come in and work on their assets and liabilities without fear of punishment and catastrophic failure.

This is similar to the "Emergency Room" that the Swedes set up in the early 1990s during their financial crisis. But the credit line should be far, far greater this time to eliminate any doubt that the liquidity will run out.

In setting up this facility, two principles should be observed. One is that the U.S. government should not be asked to print more money. It has already printed too much. One problem with Paulson's approach is that he is trying to solve all the problems with internal resources. The U.S., even before the $700 billion bailout package, had issued a lot of promissory notes that will in effect dilute the value of the dollar, a scenario that sparks fears worldwide. The second principle is that the facility should be big enough to eliminate any doubt that the money might run out.

During the Korean crisis of 1997-1998, the International Monetary Fund came in to replace the over-extended American banks. This time there is no trace of the IMF on the horizon, other than its occasional forecast of what the bad debts would be (currently at $1.3 trillion, but escalating over time).

From the U.S. perspective the IMF is too European. Maybe, but if the IMF does not work, this would be a good time to call for the establishment of a global pumping station, a place where financial institutions could come to receive an unlimited supply of liquidity transfusion until they have worked out their problems.

I stated that this facility should have at least $5 trillion because it should be large enough so people do not think it is a shallow oasis. It would seem that $5 trillion is an enormous number and unfounded. But we know that the Japanese poured in $3 trillion either in the shape of public funds or foregone interest to help their banks survive.

My personal calculation at the beginning of Japan's property bubble bursting was on the order of $2 trillion, while the government was admitting only $130 billion in bad assets in 1994. Former Bank of Japan Gov. Toshihiko Fukui admitted 15 years later that the burden of the bailout on the public was actually $3 trillion. So, while I am not in a position to calculate the right size of the liquidity facility for the U.S., any number smaller than the amount that the Japanese required would be a source of trouble. It has to be on the order of $5 trillion to $10 trillion.

The only way to get this kind of money assembled is for the U.S. to ask for donations of mercy, not only from its taxpayers but also from those who have piled up dollar-denominated instruments around the world — who will be hurt if the value of the dollar or U.S. government securities falls.

For example, China has piled up $1.5 trillion in foreign reserves through its trade surplus, which is mostly in dollars. Japan can contribute $1 trillion, which it does not need returned in a hurry. Taiwan and Russia could come up with $500 billion each, and the oil-rich Gulf states certainly could support Uncle Sam easily with $2 trillion. We can ask the European Union to contribute collectively something like $2 trillion if we make the facility available to their financial institutions. That totals $7.5 trillion, and if the U.S. adds $2 trillion to the pool it brings it close to the maximum I am talking about $10 trillion.

We are not going to lose this money. It is money on which we can even expect to earn 3 percent interest. After this liquidity facility is dissolved in three to five years time, when good banks are healthy again, donor countries can expect to receive back the amount they loaned.

For this to happen, the Bush administration will have to rethink its diplomatic relationship with quite a few countries. U.S. foreign policy has been built upon the fight against terrorism. Now Washington has to repair its relationships with some countries to gain their cooperation in the fight against financial terrorism, which Wall Street has triggered and spread around the world.

Judging by the experience of Japan, the major financial crisis will go through three phases, each requiring a different measure.

The U.S. is now experiencing the first phase, which mainly comes from the liquidity crisis. The Federal Reserve Bank has provided a credit line close to $1.4 trillion and major institutions are now at the mercy of this facility. Japan lost Yamaichi and Sanyo Securities in the first phase of crisis because they could not pull money from interbank facilities.

The second phase of the crisis comes mainly from working out the bad assets. In this phase the write-offs far exceed the equity, and financial institutions cannot raise fresh capital from the market because their share price has fallen to a meaningless level. The Long-term Credit Bank, Nippon Credit Bank and Hokkaido Takushoku Bank all failed due to write-offs on loans to failing or failed companies. At this stage, it is important for the government to inject fresh capital to let the banks revive and return to normal operation.

In doing so, the government could end up owning a bank directly or through debt-equity swap. Paulson's rescue plan is appropriate for this phase as its main purpose is to buy bad assets. But I think it could be implemented much later in the game as the more urgent need is for the banks to survive without the fear of being in a "wolf pack."

The reason for this is that we are faced with a systemic problem, not a collection of individual banks. The nature of the problem at hand is a lack of liquidity. In group theory this syndrome is known as "wolf pack." While the wolves are good at attacking the victim as a team, they have a tendency to attack the weakest of the cohort should extreme hunger prevail. The banking crisis resembles this metaphor, continuing until a few mega-banks are left.

The third phase is characterized by the massive failures of operating companies. This is because the financial institutions that have survived are under severe government scrutiny and they cannot easily extend loans to businesses, their traditional customers.

This creates a problem for companies, which have traditionally relied on bank loans for their operations. All of a sudden, a banker comes to the company and says, "Sorry, we need to close the credit line and you need to return the money to us as you are no longer bankable" (a new word they will invent to pull the money from otherwise a good company).

Japan has lost hundreds of companies, such as Daiei, its largest retailer, in phase three.

We know Japan could have come out of its mess much sooner had the government proactively, not reactively and unwillingly, faced the issues straight on. I am not sure if the Americans are addressing the right issues with the right priorities and sequence, and how long it will take to get back to "business as usual." It has taken Japan 15 years, and luckily, it is OK now as it has no further room to go down.

If you recognize that the three phases are like the law of physics (indeed it seems to me that what I have described is a general theorem of major financial catastrophe), then we should expect that the U.S. package should not be hastily worked out, but rather devised utilizing the wisdom of the rest of the world.

 

Asia's next crisis: 'Made in China'

Rapid evolution of Chinese economy threatens regional status quo

By KENICHI OHMAE 2001

Two seemingly separate events occurred this month: Beijing was awarded the right to host the 2008 summer Olympic games, and stock prices and currency rates in Singapore, Taiwan, and Hong Kong hit their lowest weekly marks since the 1997 Asian crisis.

Together, this says a great deal about the future of Asia -- and the immense challenges that the rest of the world faces from China.

Policymakers and industrialists will be paying a great deal more attention to China in the near future, but not because of human rights, the militarism of the central Communist government, or the opening of Chinese markets. The Chinese production economy is about to explode with accelerating vitality, and the rest of the world is unprepared for it.

I saw the implications of this recently on a visit to a 3-year-old manufacturing plant in the Pearl River Delta, one of the fastest-growing regions in China. This plant had 50,000 workers -- all young women, and none wearing eyeglasses.

"Don't you have any employees with bad eyesight?" I asked the manager.

He replied: "We fire them when their eyes go bad. They can find another job -- that's not my problem. There are plenty of people who want to work for us."

From the perspective of industrialized nations, practices like this are brutally cruel and would not exist in any other nation of China's stature due to labor laws. But in Shengzhen, Shanghai, Suzhou, Dalian and many more Chinese cities, where hundreds of millions of people eagerly flock to urban jobs from the hinterlands, such practices are taken for granted.

A situation with precedent

To find a comparable precedent, you would have to go back 40 years, to Japan's postwar economic surge. There are also echoes of Dickensian England -- the dawn of the industrial revolution -- or the "robber baron" era in America, when labor was inexpressibly cheap and technology was new.

One advertisement for a factory in Dalian, offering the equivalent of $ 100 per month, drew 2,000 girls from nearby farmlands. They literally surrounded the plant, seeking interviews.

Those who are hired work round the clock and live in company dormitories. They often study electronic circuitry or other high-tech skills on their lunch hours. Those laid off (for nearsightedness or other reasons), generally don't return to the peasant life; they become urban entrepreneurs in the burgeoning freelance and service businesses of China's new cities.

By itself, China's glut of low-wage and highly educable workers gives that country a remarkable competitive advantage. But there are three other engines fueling China's economic juggernaut as well.

One system, 10 nations

First, there is the political structure. In the last few years, because of a concerted policy of economic deregulation, the People's Republic has matured from "one nation, two systems" -- an empire with communist and capitalist components -- into "one system, 10 nations" -- a commonwealth of semiautonomous, self-governing economic regions. Some of these regions, such as Shengzhen, Shanghai, Dalian, Tianjin, Shenyang, Quindao and Suzhou, are already growing much faster than any the "Asian Tigers," such as Malaysia, Taiwan, Thailand and Korea.

The average population of these "region states" is 5-7 million. Although China is nominally Communist, businesses in these regions have far fewer regulations to deal with than their counterparts in Japan, France or Sweden. By comparison, China is a capitalist's paradise, so long as you remain within these regions and do not deal with the central government in Beijing.

Burning hunger to win

Second, Chinese industrialists are eager to learn and uninhibited by complacency.

I was a close adviser to several Japanese companies that cracked the U.S. market in the 1970s and 1980s. I vividly remember their executives confronting that formidable challenge by saying, "How can we do this?"

Today, their successors tend to enumerate all the reasons they can't act, and blame the economy and government for their troubles.

But Chinese companies have picked up where the Japanese left off. They are developing innovative, low-cost export businesses in apparels, vitamin supplements, foods (including shiitake mushrooms and vegetables popular in Japan), watches, consumer electronics and appliances, plywood, footwear, and precision electronic and mechanical components.

In the Pearl and Yangtze River deltas, there are more than 50,000 electronic component suppliers sophisticated enough to deliver their wares "just in time" to the local Japanese and Taiwanese manufacturers.

In Japan, apparel companies like Fast Retailing (known for the Uniqlo brand) have taken advantage of large-scale production in China and halved consumer prices of high-quality clothing. In the otherwise very depressed Japanese market, Uniqlo has been doubling its sales for three consecutive years, with an awesome operating margin of 25 percent. The direct approach, in which Japanese-designed products mass-produced in China are sold in company-owned stores, is now being called "Uniqloization."

Many companies are following suit in such industries as glasses and stationery.

In short, China is rapidly supplanting industries that took other Asian countries 15 years or more to build.

Currency system strong

The third and most influential factor behind the scenes has been the stability of China's currency. This represents either an accident of history or a supreme example of cunning foresight.

In 1997, when Hong Kong was returned to China, the United Kingdom agreed to leave about $ 38 billion of reserve capital in the territory -- but only if the Chinese promised to keep the currency intact. It was stipulated that for every new Hong Kong dollar that its three central banks minted, they would hold in reserve the equivalent of about 13 U.S. cents -- a very high amount.

The Chinese not only accepted this, but pegged their mainland currency, the renminbi (RMB), against the Hong Kong dollar as well. They also prohibited exchange of renminbi outside of China, limiting speculators to the H.K. dollar. In effect, by embracing a restriction against minting money to relieve economic pain, China has made itself immune from the currency fluctuations that have bedeviled Mexico, Indonesia, Russia, Brazil and Argentina. As a dollar-based economy, China enjoys the same protection against inflation the United States does.

The world has never seen an economy with these qualities before. And because it is so new, the effects are just now being felt.

Already, China is doing to the rest of the Asian economy what Japan did to the West 20 years ago. The currencies of and the stock prices in Korea, Thailand and Malaysia have declined precipitously since 2000. Some countries, like Japan, Singapore and Taiwan, are being hit much harder by this new competition than they were by the economic crises in 1997.

Time to wake up

What should politicians and industrialists outside China make out of all this?

We must shake ourselves out of complacency.

For decades, economists and investors have waited for China to wake up, fearing its overwhelming population but lusting after its enormous market. Finally, the awakening has begun, and it will expand much more quickly than most of us expect. If Hong Kong's trading volume is added to the export and import volumes of China, it becomes the third largest trading nation in the world, trailing the U.S. and Germany but surpassing Japan.

There is reason to believe that China's central government will rapidly evolve into a "United States of Chunghua," with most economic decisions made at the regional or provincial level. Chunghua, which translates into English as "China," actually means "the prosperous center of the universe."

China's regional autonomy is far stronger than Japan's and Germany's. Chinese states compete against each other for foreign investment and markets. In a strange way, the federal governance structure of China is the closest, among all large nations, to that of the United States.

This regional competition will further accelerate China's economic expansion far beyond anything we have seen in Asia to date. Americans (and others) will be forced to trade with China, as consumers will demand China's inexpensive products and producers will require inexpensive components. Like the U.S. in first half of the 20th century, and Japan in the second half, Chinese industries will overcome protectionist efforts to resist. Other nations will be challenged to match China's unfair advantages with innovation and other forms of competitiveness.

And it won't be easy. Each time a Chinese industry has competed directly with a foreign industry, China has won.

That doesn't mean that China should get blanket political approval from the West. On the contrary, it has never been so dangerous.

Wither democracy?

China is not a democracy, and the human rights and totalitarian abuses of the Chinese government will continue. But they will occur in the context of one of the most highly capitalist societies on the planet.

This, in itself, will test many prevailing assumptions about economic development.

For example, Western nations have traditionally preached that democracy is a prerequisite for economic prosperity. But Democracy at this stage of China would lead the majority of its population to demand greater distribution of wealth, as they have in India. But there are still 900 million farmers in China with an average annual income of $ 500. Distribution of wealth would lead, as it has in India, to the distribution of poverty. So it will be a long time before China adopts democracy and the central government gives up its unchallenged power.

Constructing a new view

American politicians and businesspeople seem to oscillate between viewing China as a James Bond villain and a market to be exploited. Both of these views are now obsolete. Many of China's consumers, for instance, will be cunningly reserved for its own domestic industries.

China is a fierce new economic competitor, perhaps the fiercest since the U.S. itself came on the scene at the turn of the last century.

In the short run, China's emergence is triggering a second Asian economic crisis more severe than the first. But unlike the currency speculators who triggered the 1997 crisis, China won't go away.

In the long run, the ability of a company to thrive in this new world will depend on how well it can figure out how to "internalize" China's advantage to increase its own competitiveness.

Unlike what the newspaper headlines indicate, competition is not a fight between China and the U.S. or Japan, but a race in each market in which the victor will be the company that best internalizes China's competitiveness to beat its domestic competitors. The rest of us will have to temper our opposition to China with the fact that, as consumers, we will never have had it so good. People around the world will soon come to depend on the quality and price of goods that China can provide better than any other nation. When we finally meet the enemy, over in Beijing, we will find out it is us.

Kenichi Ohmae is managing director of Ohmae & Associates and author of "The Invisible Continent -- Four Strategic Imperatives of the New Economy (Harper Collins)."

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