The $10 billion man

Face value
Feb 24th 2005
From The Economist print edition

Having turned round Nissan, Carlos Ghosn is about to run Renault as well

IT IS said that he could add $10 billion to the market value of Ford or General Motors with a stroke of his pen. But Carlos Ghosn is not about to sign up as chief executive of either firm. Instead, in May, he will become the boss of Renault, France's second-largest carmaker, while continuing to head Nissan, Japan's number two car firm. To ease the transition, this week he named Toshiyuki Shiga as Nissan's chief operating officer.

Although Renault and Nissan have cross-shareholdings and a deep alliance, their relationship deliberately stops well short of outright merger. Perhaps that is why it has been so successful, avoiding the integration pain that has marred, for instance, Daimler-Benz's takeover of Chrysler. In his book, “Shift: Inside Nissan's Historic Revival”, published in English last month, Mr Ghosn says that the strength of the alliance “can be found, on the one hand, in its respect for the identities of the two companies, and on the other, in the necessity of developing synergies.”
Certainly the benefit has flowed both ways since the Franco-Japanese deal was done in 1999.

First, Renault rescued Nissan, buying a stake (now 44%) and installing its Mr Ghosn as chief operating officer (and later chief executive). Mr Ghosn turned huge losses into a $7 billion profit and wiped out debts of about $23 billion. This has helped to prop up Renault's sagging profits in recent years. Nissan's latest operating profit margin is about 11%, making it the world's most profitable volume carmaker. Mr Ghosn's reputation soared as he set, then met, ambitious targets.

Now he is to be the first executive to try to run two big carmakers at once. No one has ever revived a carmaker as spectacularly as he has—much less attempted an encore. But then the industry has never seen anyone like the larger-than-life Mr Ghosn. Born in Brazil to a Lebanese immigrant family, he went to a French school in Lebanon before studying engineering at the Ecole Polytechnique in Paris. Few Frenchmen speak four European languages and get by in Japanese as well. He first made his name by turning around Michelin's business in Brazil, then America, before being hired by Renault. He was soon nicknamed “le cost killer” as he revived Renault in the mid-1990s.

In 1999, when Louis Schweitzer—Renault's now soon-to-depart chief executive—decided to link up with Nissan, he knew that Mr Ghosn, already his intended successor at Renault, was the man to put in charge of rescuing the Japanese firm. Mr Ghosn's “Nissan Revival Plan” involved shedding 20,000 jobs and closing five factories, a drastic move in conservative Japan. He also abandoned the cosy keiretsu family-of-firms system, a pillar of Japanese industry. Nissan's shares in keiretsu suppliers were sold to pay off debt. He slimmed down Nissan's product range, but accelerated development of new models.

A second plan, “Nissan 180”, launched in 2002, stands for reversing the company's decline by adding 1m in sales by October this year, achieving an operating margin of 8% and eliminating its debt. With sales in North America topping 1m, Nissan is on course to hit the last remaining target, before a new plan is unveiled in April. Then it will be up to Mr Shiga to hit those targets, under his boss's watchful eye. If he lives up to expectations, Mr Shiga could be in line to succeed Mr Ghosn as chief executive at Nissan within a few years.

Mr Ghosn attributes his success to the way that he works through cross-functional teams. He thinks that when people from different backgrounds work together under pressure they come up with more creative solutions. He proved the value of this technique when he successfully merged Michelin's American tyre business with another firm in the teeth of a recession. His personal style is brisk and direct, but not without warmth.

My other car firm's a Renault

And yet why risk everything by adding to his workload? Both Renault and Nissan have concluded that they have no choice but to share a boss for the next few years. To put a Japanese executive into Mr Ghosn's chief-executive shoes immediately might have signalled a return to the old days of consensual dithering and blind respect for seniority. To put a Frenchman in would have seemed too aggressive. Mr Ghosn's diverse international background made him more acceptable in Japan. He was not seen as an invading Frenchman. Indeed Ghosn-san has become a sort of national hero in his adopted country.

Mr Ghosn will devote the first few months in his new role to “re-discovering Renault”, mostly in Paris. Then, he says, he will spend 40% of his time in Paris, 35% in Tokyo, 15% in America and the other 10% in places such as China, Thailand, Brazil and Turkey. Needless to say, he has the use of a long-range executive jet. Over time, Mr Ghosn expects the executive teams of both Renault and Nissan to become more international.

America could prove his biggest challenge. First, he has to manage Nissan's headlong expansion there: the firm stumbled last year, with quality problems in vehicles made by inexperienced workers at a new factory in Canton, Mississippi. Mr Ghosn reacted by taking direct charge of the American business, which he will continue to run hands-on for another year, in addition to his many wider responsibilities. He drafted in 200 engineers from Japan to sort out the Canton factory and improve quality. It was a reminder that not everyone can keep up with Mr Ghosn's rapid pace.

Mr Ghosn's predecessor at Renault always dreamed that the alliance with Nissan would help the French brand to re-enter the huge American market, where some foreign car brands make huge profits. But Mr Ghosn seems more cautious. He thinks America poses huge risks. Renault has failed twice there before. But if he can make the transformational European-Japanese alliance a two-pronged success in America, Mr Ghosn will truly deserve to be called the $10 billion man.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

Screeching to the precipice

Feb 28th 2005
From The Economist Global Agenda

Argentina appears to have persuaded most of its bondholders to accept a deeply discounted debt-restructuring offer. But the country’s financing problems will continue unless it can coax back capital stashed abroad by its citizens

WHEN Argentina started restructuring its $81 billion-plus-interest in defaulted debt last month, it was billed as the biggest game of chicken in financial history: the government vowed not to improve its offer, worth broadly 30 cents on the dollar, and bondholders promised never to accept it. Now it seems that despite their threats of lawsuits, asset seizures and collective rejection of the Argentine ultimatum, the creditors swerved practically before they got into the car.

Not so long ago, most analysts were predicting that at best 70% of bondholders would accept the offer, which closed on Friday February 25th. Most now reckon that as many as 80% of creditors have participated. The Argentine Bond Restructuring Agency, which represents little guys in Germany and Austria, accepted the deal at the last minute. And a significant number of other retail investors, tired of the hassle, may have sold out to more sophisticated players who hope to take quick profits once Argentina is re-admitted into the emerging-market bond index. The official results may not be announced until Thursday. But if the acceptance rate is as high as reports now suggest, it should win the blessing of the International Monetary Fund (IMF), which must decide whether to roll over the $14 billion Argentina still owes it.

The success of the government’s negotiating strategy—which was not to negotiate at all but to offer a take-it-or-leave-it package instead—is a political triumph for Argentina’s president, Néstor Kirchner. As his Peronist party heads into legislative elections in the autumn, he can claim that he faced down the foreigners and won.

The foreigners have been chasing their claims since Argentina’s government stopped servicing its debt more than three years ago, on December 23rd 2001. It was the biggest sovereign default in history. Despite liberal help from the IMF, the government could not meet the punishing yields exacted by skittish investors or balance its books in the midst of a protracted recession. It devalued the peso, then decoupled it altogether from the dollar, dismantling the “convertibility system” that had killed hyperinflation a decade before. At its worst, the peso lost three-quarters of its value, wreaking havoc on the finances of banks, companies and households, which could no longer meet their dollar liabilities. But hyperinflation did not return, and after the economic meltdown of 2002, Argentina’s newly competitive exchange rate helped it grow once again.

Standard & Poor’s, a rating agency, has said that after the restructuring it will rate Argentina a B-minus debtor, a status that Ecuador did not attain for five years after its default. Foreigners will probably not want to lend to the Argentine government directly for a while after taking a 70% loss—twice the average haircut in recent sovereign defaults—and the government will still be left with a public debt equal to 80% or more of GDP. But the country’s new credit rating should increase access to capital for its best-behaved companies. Other immediate benefits include a smaller chance that lawsuits against the government will succeed and a better relationship with the IMF, which might allow Argentina more time to repay the Fund money it owes and soften the conditions that govern the debt.

Most important, greater confidence in Argentina (and its soaring equity markets) may bring home some of the $150 billion or so its citizens hold abroad. The return of flight capital is a practical necessity for the country to keep growing. Its galloping GDP growth, 8.8% in both 2003 and 2004, owes a lot to high soyabean prices and the use of capacity left idle by the economic collapse in 2001-02. Commodity prices have already declined from their peaks and capacity constraints are likely to be felt again this year, so fresh capital will be needed. Mr Kirchner has hardly wooed external direct investors: his government is yet to lift the freeze imposed during the crisis on rates charged by most foreign-owned utility firms. This has exacerbated worries that contracts in Argentina are not worth the paper they are printed on.
The president seems to be betting that a successful restructuring will increase domestic investment from its current level of 17% of GDP to more than 20%, enough to sustain impressive growth throughout the economic cycle. Only time will tell if the Argentines cheering his “patriotic” intransigence towards the international financial community are willing and able to shoulder the burden themselves.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

Collywobbles

Feb 25th 2005
From The Economist Global Agenda

This week, America’s financial markets saw a few ghosts, and shivered

THE markets were looking for an excuse to turn tail, and this week they got more than one. Spooked by fear of inflation, high oil prices and a revolt by Asia’s central banks, bonds, the dollar and shares all headed south, in that order. By the evening of Wednesday February 23rd, some poise had been regained. But the ease with which things went wrong—albeit just a bit—has left many wondering just how robust is the consensus view that all’s for the best in this best of all possible financial worlds.

The problems started last week, when Alan Greenspan, the chairman of the Federal Reserve, professed himself puzzled by the “conundrum” presented by the flattening yield curve: the more he raised short-term rates (six times since June 2004, by 25 basis points on each occasion), the more already-low long-term rates fell. Markets don’t like it when the man who sets interest rates says he doesn’t understand them. The gloom deepened when new figures on February 18th showed that core producer-price inflation was at its highest in six years: could Mr Greenspan be behind the curve on inflation? Bond prices headed smartly down, as investors suspected that the Fed’s chairman might see a solution to both problems in lifting interest rates more smartly up.

The next blow fell on February 21st, when South Korea’s central bank, with most of its $200 billion of foreign reserves in dollars, said it planned to diversify away from the currency. Then, with Europe and America gripped by a cold wave, the price of a barrel of oil for April delivery rose back above $50. The scene was set for a sell-off, and on February 22nd the S&P 500 fell by 1.5%; the dollar lost 1.1% against the euro and the same against the yen; long-dated Treasuries continued to fall in price; oil futures rose still more and so did gold futures. Stockmarkets around the world, mostly in sympathy but with problems of their own, slid too.

The sweepers came in overnight to clear away the mess, and by the end of the week things looked better. South Korea’s central bank made it clear that it did not intend to sell dollar assets, just to buy fewer in future. Like other central banks, it has been quietly taking on fewer bonds from the American Treasury and more from other issuers for some time anyway. A mild increase, of 0.2%, in American core consumer prices (ie, not counting food and energy) in January calmed—perhaps temporarily—the previous week’s fears of renewed inflation. And a second take on last quarter's growth numbers—GDP grew by 3.8% at an annual pace, not 3.1% as first reported—confirmed that America's exports were doing rather better than earlier counts suggested. Share prices climbed part of the way back; the yield on Treasury long bonds dropped again; the dollar strengthened against both the euro and the yen; and oil and gold prices slipped back a bit.

How important was this week’s stumble? On the numbers, not very: this was no 1987-style rout. But there has been so little volatility in share prices in the past two years that any sharp change is unsettling. The VIX (or volatility index, alias the “investor fear gauge”) is a contract on the Chicago Board Options Exchange that tracks the implied volatility underlying the S&P 500. As the chart shows, volatility used to be high, touching 45 in August 2002 and then a lower peak of 34 early in 2003. Since then it has headed downwards. On February 22nd, the index jumped by 17.5%—and still only just cleared 13. Mark Hulbert, a columnist for MarketWatch, an online news service, points out that, if historical levels of volatility prevailed, we should expect the stockmarket to gain or lose 2% once a month or so. This week’s fall, though the largest in 21 months, was nothing to write home about.

Investment analysts have two theories on volatility and market performance, and unfortunately they contradict each other. One lot believes that low volatility suggests share prices will fall, as it means that investors are too complacent. They have been predicting a market meltdown for some time. The other group believes that low volatility suggests rising markets, as well-informed investors are rightly confident. The chart supports the latter: while the VIX has been having a near-death experience, share prices have headed up.

What matters most for share prices—or ought to—are the discounted value of companies’ future earnings and the relative attraction of other investments, both of which reflect the state of America’s and the world’s economy. The reason for this week’s wobble is that America’s two greatest vulnerabilities—its dependence on one set of foreigners to buy its bonds and on another to sell it oil—were exposed side by side. VIX or no VIX, not for the last time.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

In the eye of the investor

Buttonwood
Feb 22nd 2005
From The Economist Global Agenda

Efficient markets are producing boring returns these days. Is investing in one of the least efficient—art—a better bet?

NOT long ago, Buttonwood dropped in on the auction rooms at Sotheby’s, on London’s New Bond Street. The room was full, the bidding brisk. It brought back the heady days of the late 1980s, when it seemed that anything in a frame could be sold for a fortune and all the upwardly-mobile talk was of investing’s newest asset class. That was before the art market collapsed in 1991, of course, and the world’s two most prestigious auction houses found themselves in court explaining how they happened to have fixed prices between them.

Those heady days are back, it seems, and the price of art is once again making headlines. The London season kicked off earlier this month with sales at Christie’s and Sotheby’s that raised more than £110m ($205m), well up on takings a year earlier. They built on strongly recovering sales throughout 2004. One highlight last year was the $3m paid for Maurizio Cattelan’s life-sized wax image of Pope John Paul being felled by a meteorite. From the ridiculous to the sublime, another was the sale of Picasso’s “Boy with a Pipe”, which, at $104m, displaced Van Gogh’s “Portrait of Dr Gachet” as the world’s most expensive work of auctioned art.

Financial types have not been slow to note that art is hot again. At least half a dozen investment funds devoted to art have recently been set up or are being mooted, and another six or so may emerge this year.

What is new this time around is that a host of analytical tools is making it possible to approach the art market with a degree of financial dispassion. The other novelty is that the vehicles are being constructed specifically along the lines of hedge funds, private-equity funds and mutual funds, allowing investors to buy shares in a pool of art. As Bruce Taub, the former Merrill Lynch investment banker who set up Fernwood Art Investments, points out, this is another step down the long highway of democratising investment by securitising assets (bundling them up and selling shares in the resulting pool). Just as mutual funds made shares more accessible to average investors, so these art funds have the potential to open up the world of painting and sculpture to those who do not have generations of farmland or oil money behind them.

It is easy to see why investors might be interested: art seems to offer a way to ginger up returns on traditional financial assets. Art outperformed the S&P 500 stunningly over the five years from 1999 to 2004, according to the Mei/Moses art index created by two professors from New York University’s Stern School of Business (see chart below). That gap dwindles to nothing over half a century, but what matters, says Michael Moses, is that returns on art are not correlated with returns on shares. Owning both art and stocks can reduce the volatility of a portfolio by up to 20% while returning about the same amount, he reckons.

Britain’s Barclays Capital tests this theory in detail in the latest edition of its Equity Gilt Study, published on February 22nd. Barclays looks at how art and other assets performed over different phases of the business cycle and over different periods of time, using data from 1970 onwards. Art does best when the economy is growing, and it survives the ravages of inflation better than most, it transpires. Art prices rise when bond returns slump, and move broadly in tandem with property and (less so) commodities. Because its price bounces around so much, investors have to hold art for at least 35 years to be certain of real annual returns. All in all, and subject to tonnes of caveats, the best portfolio mix for a pension-fund investor, in particular, with a horizon of ten years or more would include a 10% weighting in art.

Those caveats, though, are important. The art market is hugely “inefficient”—ie, you lose your shirt if you don’t know your way around. Art is diverse, hard to value, expensive to trade and often impossible to unload at a profit. Even the best indices say only so much about art as an investment: they do not include private sales or, usually, works that fail to find a buyer at auction.

The new art funds think they have got round some of those drawbacks. Philip Hoffman, who used to work for Christie’s and last year founded the Fine Art Fund, says that more than 80% of its purchases are made directly from owners and attract no commission. Because the fund is closed-ended (investors have to leave their capital in for ten years), it can buy art on the spot for cash at good prices and cannot be forced to sell at a loss to meet redemptions. He says that it has already bought and sold some works with a profit of more than 45%.

Fernwood’s Mr Taub admits the drawbacks exist but sees virtue in necessity. The inefficiencies in the art market mean that knowledgeable investors can get the sort of performance that they could hardly hope for in the relentlessly analysed equities market. One of the two funds that Fernwood will launch this spring will reflect the skills of classic collectors, spreading risk by buying art over eight asset categories and permitting investors to come and go at fixed intervals. The other will reflect the practices of art-market professionals, amassing a war chest for opportunistic buying.

Buttonwood is all for diversifying portfolios, and thinks art is at least as jolly as pork bellies. But there are a few worries. One is that no matter how sophisticated the portfolio analysis used, it is simply not possible to discount mathematically the chances that Damien Hirst’s polka dots are going to appeal more in 20 years than Jeff Koons’s dinner plates. And this market, with more than $1 trillion in assets, is virtually unhedgeable.

Another concern is that most of the funds will be more lightly regulated than ordinary retail vehicles. Since they seem to be requiring a minimum investment of $250,000 from people with liquid assets of at least $5m, this may be fair enough. But there is talk that the ante could be as little as $50,000 through “feeder” banks, and that looks more questionable.

History prompts a third reflection. In the 1980s, Japanese buyers dominated the market for Impressionist and Modern art. Their bidding spree was backed by what turned out to be largely illusory wealth created by a bubble in share and property prices at home. The bubble burst, a lot of art was unloaded quickly and Japan has yet to emerge convincingly from the recession that followed. The Japan of two decades ago was very different from the America and Britain de nos jours, but the level of asset prices here nowadays does provide food for thought. Van Gogh’s “Portrait of Dr Gachet” made headlines when a Japanese businessman bought it for $82.5m in 1990. Fewer recall that it changed hands some years later for one-eighth as much.

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Read more Buttonwood columns at www.economist.com/buttonwood

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

Worries about weapons, contd

Feb 24th 2005
From The Economist Global Agenda

America is angry that the European Union plans to lift an embargo on sales of weaponry to China, which in turn is angry that Japan and America have identified Taiwan as a joint security concern

DESPITE all the fence-mending that has taken place during George Bush’s tour of Europe, some transatlantic disagreements could not be prevented from spilling into the open. The most awkwardly visible of these is the European Union’s planned lifting of its embargo on arms sales to China, which the United States opposes. On Tuesday February 22nd, Mr Bush said that: “There is deep concern in our country that a transfer of weapons would be a transfer of technology to China which would change the balance of relations between China and Taiwan.” If the EU went ahead with the lifting of the ban, he added, it would have to “sell it” to America’s Congress, which, he suggested, might retaliate with restrictions on technology transfers to Europe.

The EU will lift its Chinese arms embargo, introduced after the 1989 Tiananmen Square massacre, later this year. This, the Union hopes, will open the door not only to profitable weapons sales but to closer trade relations in general with an emerging economic superpower. In an effort to assuage American concerns, the Europeans say they will limit the transfer of advanced technology by strengthening their “code of conduct” for arms sales; and that they will inform the Americans of any arms sales that would have been prohibited under the embargo. This week, France’s President Jacques Chirac said the embargo would be lifted under conditions that Europe and the United States “define together”.

That looks like wishful thinking. American opposition to lifting the ban runs deep. The Bush administration fears that it might enable the Chinese to develop the kind of sophisticated military systems used in Iraq by America and its closest allies. It also worries that these could be passed from China to rogue states or groups. Earlier this month, Congress voted overwhelmingly to condemn the EU’s planned lifting of the embargo. Some American politicians point out that the Chinese human-rights abuses that led to the embargo, such as the detention of dissidents, remain a serious worry. Others focus on regional security. Writing in the Wall Street Journal this week, Henry Hyde, chairman of the House of Representatives’ international-relations committee, said: “EU security policy toward China is on a collision course with America’s extensive security interests in Asia.”

At the centre of those interests lies Taiwan. Since the mid-1990s, China has been engaged in a rapid military build-up on the coast facing the island, which Beijing views as a rebellious province. This has increased tensions with America, which is legally committed (under the Taiwan Relations Act of 1979) to provide Taiwan with the means to defend itself. Although the Americans have recently appeared to play down this obligation, military confrontation with nuclear-armed China over Taiwan is all too possible. Some worry that all it would take is a miscalculation or misunderstanding.

In 1995 and 1996 China staged large-scale military manoeuvres in the Taiwan Strait, including firing unarmed missiles close to Taiwan's two main ports. China has fired no more missiles since, but has positioned large numbers of truck-mounted short-range ballistic missiles along the coast. It has also increased deployments of longer-range missiles that could target American bases in Japan or on the Pacific island of Guam, about 1,500 miles from Taiwan. And it is working to develop land-attack cruise missiles, which could be fired across the 100-mile strait and penetrate even the most sophisticated anti-missile defences that Taiwan is acquiring from America.

Under Bill Clinton, America stepped up contacts with the Taiwanese armed forces. In 2001, after Mr Bush became president, the Republican administration further strengthened these ties. Mr Bush also offered to sell Taiwan a huge package of advanced weaponry and help it buy submarines. Reports suggest that there are now more American military programmes in progress with Taiwan than with any other American ally.

Though Taiwan has run its own affairs for more than half a century, China continually threatens to retake it by force if it ever formally declares independence. Taiwan has enjoyed de facto independence since the end of the Chinese civil war in 1949, when Chiang Kai-shek’s Nationalist forces retreated to the island after being defeated on the mainland by Mao Zedong’s Communists. Nowadays, most western countries do not formally recognise Taiwan as an independent country, though in practice they deal with it as if it were.

A more assertive neighbour

Unlike America, Japan has stepped gingerly around the issue of Taiwan in recent years, which is why Beijing reacted so angrily to the new joint security arrangement between Japan and America that was announced on February 19th. The two called on China to be more open about its military affairs and, for the first time, Japan said it viewed Taiwan as a shared security concern with the United States—in the past they have preferred to waffle on about dealing with problems “in areas surrounding Japan”. China barked back that the statement violated its sovereignty. The kerfuffle has strained Beijing’s ties with Tokyo and Washington at a time when the three are supposed to be working together (along with South Korea and Russia) to curb North Korea’s nuclear ambitions.

Japan’s increased assertiveness is all the more unsettling for China because of Japan’s plans to reform its pacifist constitution and modernise the role of the Self-Defence Force (its de facto military). A relaxation of the constitution would make it easier in principle for Japan to participate in overseas military actions (it has already sent non-combat troops to Iraq). This could remove an obstacle to Japanese forces helping America protect Taiwan in the event of a Chinese attempt to invade the island.

China’s relations with Japan and America could deteriorate further in March when, at its next annual plenary meeting, China’s National People's Congress (the legislature) may enact an anti-secession law. This would give China, at least from its own perspective, a stronger legal basis for invading Taiwan. On Thursday, Taiwan's top policymaker on China, Joseph Wu, gave warning that enactment of the law could lead to the postponement of projects aimed at deepening economic integration with the mainland. China and Taiwan recently exchanged direct charter flights for the first time in 56 years, and Taiwan is considering easing barriers to investment in China by chipmakers, banks and chemicals firms. With this is mind, the Chinese might balk at implementing such provocative legislation. Reclaiming Taiwan by a process of slow economic assimilation is just as much a part of China’s long-term strategy as is military aggression.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

Candid words on Russia's drift from democracy

Feb 24th 2005
From The Economist Global Agenda

Vladimir Putin and George Bush have had a “candid” discussion about American fears that the Russian leader is sliding back into his country's old, authoritarian ways. Despite differences on this, the two leaders agreed on other important issues—and emerged from the summit still apparently friends

BEFORE meeting Vladimir Putin in the Slovakian capital, Bratislava, on Thursday February 24th, George Bush had urged European Union leaders to join him in pressing Mr Putin to recommit himself to “democratic reform”, following several recent moves in which the Russian leader has seemed to be taking Russia back towards its authoritarian past. After their summit, the American president used the word “candid” to describe their discussion on this matter. As Mr Bush breezily reiterated to the assembled reporters the concerns he had expressed about the rule of law, press freedom and other democratic institutions in Russia, Mr Putin stood beside him, stony-faced.

Mr Putin insisted Russia would not slide back towards totalitarianism and defended his much-criticised decision to abolish direct elections for Russia's regional governors—arguing that he was not simply installing placemen, as many suspect. Candidates for governor would have to be approved by the elected regional assemblies, said Mr Putin, arguing that this was no less democratic than the electoral-college system used to choose American presidents.

The public expressions of concern over Mr Putin's authoritarian drift that Mr Bush made during his European tour this week have encouraged a challenge to the Russian leader from Mikhail Kasyanov, whom the president sacked as prime minister a year ago. Shortly before the Bratislava summit, Mr Kasyanov called a news conference in Moscow to attack Mr Putin's record on basic rights and signal that he intended to challenge him for the presidency in the 2008 elections, at the head of a pro-democracy coalition.

Mr Putin can hardly have welcomed Mr Bush's interference in Russian politics, so it would be unsurprising if the word “candid” was diplomatic language for angry exchanges between the two summit leaders. Nevertheless, despite their differences, they did reach a number of important agreements, including pledges to continue co-operating in the fight against terrorism and in preventing the spread of nuclear weapons. Mr Bush also reiterated his strong backing for Russia's entry to the World Trade Organisation (WTO), which may happen as soon as this year.

Perhaps most importantly, the two leaders seemed to end the summit still friends and still in agreement that it is in their countries' common interest to be allies instead of adversaries.
There was a time when a meeting between the American and Russian leaders was a summit of the world’s two great, rival powers. Nowadays, it is a meeting between the world’s one main power and a medium-sized country whose global importance is still fading but which still has plenty of scope for troublemaking—and a huge nuclear arsenal. After meeting Mr Putin for the first time, in June 2001, Mr Bush seemed optimistic both about the direction Russia would take under its new leader and the prospects for good relations between their two countries. A few months later, Mr Bush’s confidence seemed justified, when, in the wake of the September 11th attacks, Mr Putin offered America his support in defeating global terrorism.

This initial confidence has taken several knocks in the intervening four years. Hopes that Mr Putin would be a liberaliser and moderniser have been belied by his crushing of opposition voices and independent media in Russia; by the disregard for the rule of law that he has shown in destroying Yukos, an energy giant; by his brutal military campaign to try to crush separatism in Chechnya; and by the scrapping of elections for regional governors.

It is not just Mr Putin’s illiberal actions at home that have upset Mr Bush but his foreign policies too. The Russian leader sided with France and Germany in opposing the American-led war in Iraq. He is also helping Iran to build its civilian nuclear capabilities (which, America fears, could aid the Islamic republic’s clandestine atomic-weapons programme). And he is negotiating to sell advanced military hardware to Syria.

At the time of the Iraq invasion, Condoleezza Rice—now Mr Bush’s secretary of state, and a specialist in Russian affairs—urged the American president to punish France and ignore Germany but to forgive Russia for its opposition to the war. Now, though, Mr Bush is under growing pressure to toughen his line with the Russian leader. In America’s Senate last week, two of its most senior members, John McCain and Joe Lieberman, proposed expelling Russia from the Group of Eight (G8) over its record on democracy and human rights. In the latest edition of the Weekly Standard, an influential voice of Mr Bush’s key “neo-conservative” constituency, James Goldgeier and Michael McFaul argue that Mr Putin’s authoritarianism may be the worst setback so far to the wave of democratisation that has swept the globe since the 1970s, from Latin America to Asia. Thus, they said, it was imperative for Mr Bush to make plain his concerns at the summit.

But what carrots and sticks can the American president offer his Russian counterpart? Despite the calls in Washington for some sort of sanctions, Mr Bush is still backing Russia's bid to join the WTO because he believes that having to live by its rules will strengthen the rule of law in Russia. He is also unlikely to contemplate anything so drastic as expelling Russia from the G8. There is no point even thinking of promoting “regime change” in Russia: whatever the flaws in the country’s electoral process, and despite recent protests by pensioners, there is no doubt that Mr Putin is still genuinely popular among Russians. They share his belief in the need for a strong, centralised leadership and his suspicion of westerners’ motives for peddling democracy.

Mr Putin is supposedly obliged to stand down in 2008 but he is quite likely to seek some more or less legitimate reason to stay in power after then—Mr Kasyanov would face an enormous challenge in trying to unseat him.

Following the Reagan strategy

Messrs Goldgeier and McFaul say in their Weekly Standard paper that Mr Bush should follow the twin-track strategy that Ronald Reagan adopted in relations with the Soviet Union in the 1980s: simultaneously offering serious co-operation on strategic matters of interest to the Russians (eg, reaching new agreements on dismantling nuclear weapons and liberalising American trade with Russia in advance of its joining the WTO) while wielding the stick, selectively, to prod Russia back towards democracy (eg, persuading other members of Community of Democracies to downgrade Russia’s status in the forum; or continuing to draw former Russian satellites, such as Ukraine and Georgia, into the democratic fold).

Mr Bush realises that such a strategy would be much more effective if the EU joined in. Pressure from the Union has helped to foster democracy in many of the former Russian satellites, a number of which have already joined the club. That said, EU membership for Russia is a very distant prospect indeed, so it would hardly be plausible to dangle it in front of Mr Putin. Furthermore, Mr Putin’s bargaining power in his relations with the EU is greatly strengthened by his having something Europe craves—plentiful oil and gas—and by his having things that terrorists and rogue states crave—nuclear know-how and materials.

However, what Mr Putin craves is a seat at the world’s top tables, and due respect for him and his country from the West’s main powers. Thus if America and Europe applied the right mix of incentives and pressures—and worked together in applying them, instead of letting Mr Putin play them off against each other, as he has often done—then there should be some scope for constraining his autocratic tendencies, if not converting him into a genuine born-again democrat.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

The best medicine?

Feb 22nd 2005
From The Economist Global Agenda

Novartis has made two acquisitions that propel it to the top position among the world's generic drugmakers. Has the Swiss pharmaceutical giant found the best way to hedge against the problems that beset makers of branded drugs? Or should it stick to making patented blockbusters?

THE world’s big pharmaceutical companies are not generally fans of generic drugmakers. These firms wait around for patents to expire on money-spinning blockbuster drugs and manufacture copies that sell at a fraction of the price of the originals, unburdened as they are with the huge costs of research and development (R&D) borne by the makers of branded drugs. Novartis, the world's sixth-largest drug company, is not so stand-offish. On Monday February 21st, the Swiss drug giant announced that it would pay $8.3 billion to acquire Germany's second-largest generic drug firm, Hexal, and a 67.7% stake in Eon Laboratories, an affiliate that is one of America's biggest generic suppliers. The deal moves Novartis above Teva Pharmaceutical Industries, an Israeli firm, to become the world's leading maker of generic drugs through its Sandoz division. Novartis hopes that its foray into generics will insulate it from the problems faced by the rest of the world's leading drug companies.

Recent results suggest that most big drug companies are in relatively good shape at the moment, though this disguises looming problems. Big Pharma relies on blockbuster drugs for its profits but the supply is dwindling. Drug pipelines everywhere are looking near-empty. In 2002, America's Food and Drug Administration approved just 18 new drugs, though in 2004 the number increased to 34. This compares with an average of 59 new drugs a year launched by big companies between 1998 and 2002. These firms spend up to 20% of their revenues on R&D but the time needed to develop drugs is getting longer—and 40% of products do not progress all the way through the development process. Moreover, less than a third of new drugs these days are first or second in their class and it is hard to charge blockbuster prices for the mediocre medications and line extensions that make up the rest of the new products.

Adding to the gloom is the risk that blockbuster drugs sometimes cause more harm than good to both patient and drug company. Merck, an American drug giant, suffered terribly after the withdrawal last September of Vioxx. It faces the prospect of billions of dollars of claims after studies concluded that taking the painkiller increased the risk of heart problems in some patients. In June, Eliot Spitzer, New York's business-bashing attorney-general, launched a lawsuit against GlaxoSmithKline (GSK) for allegedly suppressing data that linked one of its antidepressants to heightened suicide risks for children. Pfizer's Celebrex, which uses the same COX-2 inhibitors as Vioxx, was last week criticised by American regulators for increasing the risk of heart problems. But the drug will stay on the market as it was concluded that the product did more good than harm.

Since 1990, 14 drugs have been withdrawn from the American market, which accounts for 45% of the world’s $378 billion retail drug sales per year, according to Public Citizen, a consumer group. Of those, only Lotronex, a treatment for irritable-bowel syndrome in women, has been re-introduced.

As patents expire, pharmaceutical giants can find themselves in a vulnerable position. In August 2000, a ruling cut three years off the patent for Prozac, Eli Lilly's hugely successful antidepressant, causing the company's shares to drop by 30% in one day. Another patent ruling on Zyprexa, the firm's current bestseller with sales of over $4 billion last year, is expected shortly. Some drug companies have struck back through the courts. In America, the lapsing of patents can be delayed automatically if drugmakers sue rival generic firms. Patent rules can be bent in a variety of ways to delay generic drugmakers from bringing previously patent-protected products to market. Some big drug firms are also suspected of colluding with generic rivals—ie, paying them—to delay bringing non-branded products to market. A Department of Justice investigation is currently under way.

Novartis is embracing a generic-drug market that has ballooned in the past few years as health-care providers have sought to put a brake on the ever-rising costs of treatment. The generic market will be worth some $100 billion a year by 2010, according to Daniel Vasella, Novartis's chief executive, and he has said that he wants a 10% slice. Mr Vasella claims that big buyers, such as Wal-Mart in America and health-care providers in emerging markets, want to be able to buy a full range of patented and generic products from one supplier.

Novartis is not the only big firm making moves into generic drugmaking. Last year, Pfizer launched a generic version of one of its epilepsy medicines to take some sales from non-branded competition. Sanofi-Aventis has said that it will move further into the generic business, and GSK has licensed some products with expiring patents to generic companies for a share of the profits. On the other hand, Roche, a Swiss rival to Novartis, has said that it sees no future in entering the generics market.

The business is certainly a tough one. If several firms choose to copy a drug, prices soon tumble. The best-placed firms are those with the lowest costs, and at present these are mainly in India. After this week’s deal, some 15% of Novartis's revenues will come from generics but profits from that segment could be slender compared with those from blockbusters. Novartis may be wise to seek a measure of stability in an industry beset with ups and downs, but it could experience some unwelcome side-effects.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

On the trail

FINANCE & ECONOMICS

Banking for Native Americans

Feb 17th 2005 COMANCHE COUNTY, OKLAHOMA
From The Economist print edition

The market in financial services for Native Americans is growing, thanks not least to Indian-owned banks

THE heart of the Comanche Indian nation sits on a hilltop next to Interstate 44 in south-central Oklahoma. From here the 12,000-member tribe, self-proclaimed “Lords of the Plains”, oversees businesses that include four casinos, a funeral home, a housing authority, a water park and a museum. The tribal budget has ballooned to $11m this year, thanks largely to money from gambling. Now there are plans for a 5,000-seat convention hall and a hotel. Despite past discrimination from some local bankers, the Comanche leadership—its chairman has a graduate degree from Harvard and the chief financial officer ran a defence-contracting business—is talking with institutions including Merrill Lynch, Lehman Brothers, Bank of America and Bank of Oklahoma about finance for the project.

Changes are afoot in Indian country, and financial institutions are taking notice. Recently Wells Fargo and J.P. Morgan Chase were among the sponsors of “Res 2005” in Las Vegas, an annual trade fair focused on economic development for Native Americans. But despite the efforts of big banks such as Wells Fargo, which has approved commercial loans and credit lines of about $1.5 billion, as well as mortgages, and Washington Mutual, which is in the mortgage business, tribal leaders contend that most of the nation's 2.4m Native Americans remain underserved. Hence the trend toward native-owned banks.

Robert Williams, an expert on tribal law at the University of Arizona, says that Indian country is increasingly divided between the haves (the minority of tribes, like the Comanche, with successful gaming ventures) and have-nots (everyone else). Generally, Native Americans are much poorer and less familiar with banking services than the average American. They are more likely to be denied conventional home-purchase loans. Tribal banks are stepping in to plug the gaps.

The North American Native Bankers Association, a trade body, counts 19 banks nationwide that are owned by tribes or by individual Native Americans. Of these, 11 are in Oklahoma, a state with a rich mix of Indian groups but without huge reservations. Most of the banks are small, with average assets of only $79m, but several are growing fast, and serve not only Indians but other Americans too.

One tribal bank gaining national attention is Bank 2, based in Oklahoma City. Wholly owned by the 40,000-member Chickasaw tribe and with $62m in assets (on September 30th 2004), it is a growing player in the national market for mortgage lending to Indians, thanks in part to effective use of a federal home-loan guarantee programme known as Section 184 and a partnership with Fannie Mae, one of America's giant mortgage companies. About half of Bank 2's customers are Indians, and it does business with more than 80 tribes, including the Comanche. So far it has made no loans tied to casinos. Ross Hill, its president, and J.D. Colbert, who runs its Native American business, both former Federal Reserve officials, often criss-cross the country, speaking not only to prospective customers but also to other tribes about starting their own banks.

In Denver, a coalition of 18 Indian tribes, two Alaskan native groups and a tribal insurance consortium runs a venture called Native American Bank. The bank, which has assets of $52m, focuses on underserved Indian communities in remote places. Its president, John Beirise, a non-Indian formerly with Continental Bank in Chicago and Mercantile Bank in St Louis, says that one of his unexpected challenges has been “the pervasiveness of politics” in Native American communities and the way it slows change.

Indeed, some say that tribal politics and legal issues hinder Indians' economic advance more than a lack of banks does. “Banks are an effect, not a cause, of economic development,” argues Joe Kalt, co-director of a Harvard programme on Indian economies. Questions of land trust and sovereignty complicate business dealings with tribes, although a growing number of groups are adopting the uniform commercial code and granting waivers that allow banks and other businesses to recoup damages should things go wrong.

Steve Stallings, Wells Fargo's senior executive for native banking, says on the other hand that dealing with tribes is “no different from doing business with certain kinds of regulated industries, doing international business.” Even so, the lending system gets clogged. Mr Stallings estimates he could double his bank's volume of Indian mortgage lending if trust issues were resolved more easily.

Even non-casino tribes are getting more sophisticated about the political and legal reforms needed to get business and finance moving. “They're like little developing countries,” says Mr Kalt. Apparently, some people may even see them as models: he was recently invited to Poland, a country undergoing an economic transition of its own, to lecture on American Indian constitutions.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

A martyr for the Amazon

LATIN AMERICA

Dorothy Stang

Feb 17th 2005 SÃO PAULO
From The Economist print edition

The land battles behind a murder

“DO YOU know what a sobbing monkey sounds like?” Dorothy Stang once demanded of a group of state legislators. She knew, because she had heard monkeys screaming as their habitat was being burnt down. Sister Dorothy, an American nun, had befriended the forest, its wildlife and, especially, poor migrants eking out a living in the Brazilian Amazon. She thus made enemies of loggers and land grabbers, for whom nature and the poor are obstacles. On February 12th she was murdered in Anapu, a district along the Trans-Amazon highway in Pará state where she had worked for 20 years.

Her death has provoked as much shock and grief as the slaying in 1988 of Chico Mendes, who led a struggle by rubber tappers to be able to harvest the forest without destroying it. Yet the Amazon produces an incessant flow of martyrs, most quickly forgotten. Of the 1,349 deaths in land conflicts in Brazil between 1985 and 2003, more than a third were in Pará, according to the Comissão Pastoral da Terra, a group linked to the Catholic Church.

Behind the violence is a toxic mixture: land is cheap but potentially valuable, its ownership uncertain and the state impotent. In Anapu, for example, in the 1970s the then-military government, eager to develop the Amazon, doled out land-use rights. Most did nothing productive, so the government reclaimed the land. In the 1990s Anapu attracted poor migrants, some fleeing land wars in southern Pará. These became Sister Dorothy's flock. She campaigned to obtain land for them and preached that earning a livelihood and conserving the forest could be reconciled.

They were making progress. Some 400 families had settled on land that INCRA, the federal land-reform agency, has earmarked for “sustainable development projects”, in which 80% of the land would stay as forest. But the former beneficiaries, or people who thought they had bought the rights from them, continued to covet an area that is flat, stocked with high-value timber and close to a main road. There were at least ten disputes over land ownership in the settlement where two men shot Sister Dorothy.

Stung by accusations that it had ignored death threats against her, the federal government promised to punish the killers (a rare event) and sent 2,000 troops to the area. But that does not amount to the steady rule of law needed to curb violence and rampant deforestation. Federal and state governments lack both the determination and the resources to supply this. Roberto Smeraldi, of the Brazilian branch of Friends of the Earth, detects “a lot of goodwill” but “very little” action in the two years since Luiz Inácio Lula da Silva became Brazil's president.
The government roused itself late last year, suspending logging licences and demanding that landholders prove their title, an attempt to bring order to the Amazon's Wild-West property market. Loggers and land-grabbers mobilised, blocking a main road and threatening to poison rivers. This month the government retreated, reinstating the licences and lifting the deadline for re-registering property.

But Sister Dorothy's murder may have been, in part, a backlash against progress. Two “extractive reserves” of the sort championed by Chico Mendes were recently created near Anapu, one of them the “largest area of sustainable use on the planet”, says Nilo D'Avila of Greenpeace, an NGO. And land reform is at last taking hold in Anapu. Land-grabbers “were feeling cornered,” thinks Ana Paula Santos Souza of Fundação Viver, Produzir e Preservar, an NGO in Pará. Sister Dorothy's work may yet outlive her.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

The new money men

BUSINESS SPECIAL

Hedge funds

Feb 17th 2005 NEW YORK
From The Economist print edition

Investors have made a trillion-dollar bet that hedge funds will bring them rich returns. But will they?

IT SEEMS an unlikely trend. In recent years the fund-management industry has been mauled for its excessive and opaque fees, deceptive marketing and rampant conflicts of interest. At the same time, however, not only has the industry flourished, but it has done so in its costliest, highest-leveraged and least transparent segment: hedge funds. Instead of shunning such unregulated funds, investors have been falling over themselves to grab a piece of the action.

Whereas the size of the mutual-fund industry in terms of assets and offerings has merely returned to its level of 2000, hedge funds have doubled in size and number, according to Hedge Fund Research, a consultancy (see chart 1). In 2004 alone around 400 new hedge funds were created, bringing the known total (many others escape scrutiny) of 7,000 into rough parity with the number of mutual funds.

The start-up fever is especially acute in the many hedge-villes dotting Greenwich, Darien, Rowayton and other lovely, affluent towns in southern Connecticut. New funds begin daily, some in spare rooms in someone's home, others in waterfront offices with parking for yachts. In Manhattan, midtown office towers serve as hedge-fund warehouses. Tiny windowless offices house unknown operators trying to build a track record. Full-floor suites filled with lavish artwork, gyms and kitchens that bubble over with superb (and healthy) food are the domain of successful funds. The same is true in Boston, San Francisco and London.

While there have been numerous pronouncements that the tide will soon turn, nothing suggests this is imminent. Quite the opposite. Initially sold only to wealthy individuals, then the family offices of wealthy individuals, increasingly hedge funds are now being sought out by large institutions. Foundations and endowments, the least regulated component of the institutional world, came first; company and public pensions are now piling in. The State of New York announced in January that it might put some of its $88 billion pension fund into hedge funds, joining those managing the pension funds of teachers in Texas and Ohio as well as public employees in Chicago and California. If institutions merely meet the amount they currently intend to invest in hedge funds, another $250 billion will be flowing into the industry, according to Greenwich Associates, a consultancy.

What might hold them back is not desire, but capacity. Such is the popularity of hedge funds that many of the largest are closed or, as they say in the trade, “soft-closed”, meaning that entry requires special pleading—and many plead. Caxton Associates, Moore Capital, Renaissance Technologies, SAC Capital Advisors, Maverick Capital, and Highbridge Capital Management, all carrying excellent records and managing billions of dollars, are considered too inaccessible to be included in a Standard & Poor's index of investible funds. Unable to get into established winners, investors are pouring money into managers with no track record but good pedigrees. Last November, Eric Mindich, formerly of Goldman Sachs, raised $3 billion for a new fund. His old partner, Dinakar Singh, will open an equally big fund this month. It is widely believed that either one could have raised two or three times as much money.

Given the enthusiasm, at the very least it should be clear what all these customers are buying. In fact, that is a surprisingly hard question. Unlike mutual funds, which are strictly defined under America's 1940 Investment Act, hedge funds operate under exemptions to the law. Theoretically that limits their audience to sophisticated and affluent investors. In reality, clever lawyers, lots of money and astute marketing have expanded the exemption so that they can be sold to anyone, do almost anything and keep whatever they do, and who they do it for, a secret.

Some hedge funds actually hedge, meaning they attempt to invest in a manner that offsets adverse market movements. But since they also want to capture returns, the hedge is never complete and many funds do not even bother (see chart 2). Responding to institutional demand, notes Greenwich Associates, some new hedge funds restrict themselves to holding long positions in common stocks, just like ordinary mutual funds or, for that matter, traditional accounts managed by brokers on behalf of clients.

Hedge funds have some common characteristics. They are usually pooled investments (like mutual funds) structured as private partnerships (unlike mutual funds). Many carry substantial leverage and are quite rigid about the flow of money from clients. Initial “lock-ups” for as long as four or five years are not uncommon; rarely is money allowed to come in or go out more than monthly. This restriction allows hedge funds to take positions in the most illiquid corners of the market including options, futures, derivatives, and unusually structured securities.

Where's the money?

Increasingly, the large funds that have succeeded flit from one area to another. Last year and the year before, when lots of companies were coming out of bankruptcy and the economy was improving, successful funds dominated the market for distressed debt. Since hedge funds can account for more than half the daily volume on the New York Stock Exchange and can have an equally large presence in every other financial market, where they might be today is anyone's guess.

Investors value this ability to embrace opportunities, magnify returns through leverage, and take difficult positions because of a stable base of assets. But they have not always been so keen. Mutual funds, if structured correctly, can have the same characteristics (though there are some liquidity restrictions). A big reason why mutual funds approach investing differently is that when they tried to take a flexible approach in the mid-1990s they were torn apart by consultants and customers for so-called “style drift”. Complaints reached a crescendo in 1996 when Jeffrey Vinik was hounded out of running what was then the single largest fund, Fidelity's Magellan, for moving from stock to bonds just a bit before the investment cycle turned.

Under pressure from the press and pension consultants, most (but not all) mutual funds began to follow narrow pre-designated benchmarks that were tightly limited to a class of investing, such as shares of companies included in the S&P 500 index, or an even narrower subset, for example a mid-cap benchmark. That helped performance in the soaring equity markets at the end of the last decade, but also contributed to their wretched results during the bear market of 2000 to 2002. It also undermined mutual-fund fee structures. Customers realised that much of the funds' performance simply mimicked the relevant index. Many chose to invest in index funds instead, because these charge far smaller management fees. (Perhaps appropriately, Mr Vinik, who has been something of a genius in identifying trends, reincarnated himself as an outstanding hedge-fund manager.)

The bear market prompted many investors to think it might be good to have money with an investment manager who knows when to invest and, ideally, where to invest, and works within a format that allows him to do so. Relatively good returns, meaning better performance than the market, has become a bit less important than absolute returns (ie, not losing money, especially when the market falls). Mr Vinik's move into bonds would now be considered within the context of astute risk control. Institutions aspire to hire managers who can provide high “alpha”, meaning risk-adjusted returns. But it may amount to much the same thing—making money and not losing it.

A clever mutual-fund manager could, of course, pursue this approach in the new environment. But it has become much more sensible to start a hedge fund. Why? Because, to cite a phrase of the moment, a hedge fund is “a compensation scheme masquerading as an asset class”. Whereas the average mutual fund charges 1% or 2% of assets, and smart buyers can pay a fraction of that, hedge funds charge 1% or 2% plus a big slug of profits, typically 20%, but often more. One well-known, but secretive, fund based on Long Island is reputed to charge 5% of assets plus 44% of profits. Another leading fund charges no maintenance fee but 50% of profits. An industry consultant says he has seen a new fund that will receive 80% of any excess above a guaranteed return linked to a well-known index. Even these huge costs do not really reflect what investors pay, since most hedge funds agree to conduct business through a prime broker, which extracts fees through stock- and bond-lending charges, as well as trading costs based on the fund's net asset value.

The benefits of this kind of relationship for a manager and for the Wall Street firms are obvious. In a report published in 2003, Bernstein Research reckoned that the size of the hedge-fund industry was one-sixth that of the mutual-fund industry, but already provided more revenues. If true, the situation is now even more dramatic. People attracted to the idea of working in the investment world for the money (a sizeable percentage) cannot shift into hedge funds fast enough. Nor can the investment banks, which are losing good employees but enjoy the solace that many become exceedingly good customers.

To bank or to hedge?

Institutional Investor's obsessively read list of most-highly-paid hedge-fund managers starts with familiar names (George Soros: $750m), but 16 others made at least $100m in 2003. As impressive as the earnings are at the top, they are even more striking viewed from the bottom. Business-school graduates note that a job at investment banks often lasts only until the first bump in the market. Salaries are high, but pressure from those above you is higher still and there is constant carping about costs. A bad year at a hedge fund may result in unemployment, but a good year means good compensation amid excellent resources: costly data terminals and abundant creature comforts, such as fresh fruit, flowers and parties.

Banks might gripe about these comparisons were they not battling so hard for hedge-fund business. At a time when mutual and pension funds have become ever more reluctant to pay the traditional five cents a share for trades, hedge funds pay up to four times that amount if in the process they can receive good ideas or particularly effective execution. This makes sense because the hedge fund's compensation is tied to outperformance, not efficiency.

And trading is just the beginning for banks. Hedge funds want hot issues, structured derivatives, margin, stock-lending for short sales and the equivalent for fixed-income, clearing and settlement, customer support and marketing. The money coming from all these transactions and fees is enormous. Svilen Ivanov of the Boston Consulting Group reckons hedge funds received $45 billion in revenues last year, of which one-third to half was profits. Although there is some overlap in the numbers, investment banks collected $15 billion either directly from hedge funds or because of them, producing $6 billion in profits. For individual firms, hedge funds were critical to last year's performance. They produced one-quarter of Goldman Sachs's profits, estimates Guy Moszkowski of Merrill Lynch, and only a slightly smaller slug of Morgan Stanley's returns.

Performing for whom?

Oddly, given the spectacular wealth that hedge funds produce for their own managers and for investment firms, they do not, overall, seem to produce much wealth for clients. Certainly the highest-performing funds have produced breathtaking returns. Renaissance has earned almost 40% annually for more than a decade, SAC in excess of 30%. There are many others with excellent records. But there are good reasons to believe that these are rare exceptions.
Whatever the merits of high fees—the ability to attract talent, a performance-oriented incentive structure that discourages bloat—they are almost certainly exceeded by the problems.

The most evident is the drag which high fees put on performance. Historically, an investor able to outperform the broad market by two percentage points annually has been considered something of a genius. But that barely covers the maintenance of the average hedge fund. High fees tied to performance also encourage hedge funds to take big risks. Winners might just be lucky and their luck may be offset by the losses of others. A third problem caused by high fees is attrition. Successful managers become rich, possibly too rich to care about work, in just a few years. Managers that disappoint are quickly put out of business by angry clients, or they may shut down voluntarily because earning a performance bonus will require catching up to a prior “high-water mark” first. Last year around 270 funds closed. The available information on hedge funds suggests they typically last only a few years.

That adds complexity to the task of selecting a fund that will do well in the future. It also plays havoc with any indices used to track hedge-fund performance. A paper* published last November by Burton Malkiel, a professor at Princeton, and Atanu Saha, of the Analysis Group, a consultancy, presents a frightening picture of what is left out of the most commonly cited benchmarks. Hedge funds report their performance only when they want to, and consequently stop reporting in the months that they are collapsing. Unsuccessful hedge funds may never report. Clever hedge-fund organisers may seed many funds, operate them for a few years, then announce in public only the most successful ones, “backfilling” the performance data from prior periods—ie, projecting what the fund might have earned before it existed if it had pursued the same strategy. Worst of all, bad funds tend to disappear along with their records. Only one-quarter of the 600 funds that reported data in 1996 still exist. Recalculating results, Mr Malkiel concludes that for all their vaunted talent, hedge funds perform less well than cheaper mutual funds.

A second paper, in the Journal of Investment Management**, concludes that, because of their double fee structure, hedge funds of funds (ie, funds that buy into dozens of other hedge funds, following the “fund of funds” approach that has become common in the private-equity market) perform worse than individual hedge funds. Yet such funds have become popular, especially with investment consultants, because they are seen as diversifying risk.

And even this somewhat patchy record may overstate the potential for hedge-fund success. Hedge-fund returns, relative to market returns, have been fading. This may be true for a number of reasons, including low interest rates (hedge funds often hold big cash balances while they wait for bright ideas); the result of so many hedge funds getting into the business and, often, pursuing the same strategies; the possibility that the supply of hedge funds has outstripped the talent to run them; or simple chance. “Why should the appeal of rich fees be limited to smart managers?” asks Howard Marks of Oaktree Management, a hedge-fund adviser in Los Angeles.

Nor do hedge funds represent a fresh start for their scandal-tainted industry. A small fund named Canary Capital was at the heart of the late-trading, market-timing scandal. Other funds have been prosecuted for allocating fees to brokers who never executed trades; violating fiduciary obligations by shifting good investments to personal accounts; and using funds for personal expenses. All of these are hard for outsiders to detect.

Dog for sale, $10m

The largest area of transgression, and one that is almost certain to arise more in the future, is the incorrect valuation of securities held in funds. All securities are, to some degree, hard to price. The less liquid they are, the harder this becomes and hedge funds specialise in illiquid securities. Even if a hedge fund wants to value its portfolio correctly, it could make mistakes. If it had other motives—and because compensation is a multiple of returns this cannot be ruled out—disaster could follow.

The SEC has brought 51 cases (11% of all its enforcement actions) against hedge funds, claiming damages in excess of $1 billion. Known prosecutions, as well as others that have yet to be disclosed, encompass around 400 funds. In only three of these cases were investors made whole, a result the SEC blames in part on the fact that it is able to investigate a fund only in response to receipt of a complaint.

That is due to change next year. Last December, William Donaldson, chairman of the SEC, pushed through new regulations for hedge funds. Funds will have to register, meaning they will have to acknowledge their existence and submit to inspection by the SEC of their books and records. It would be no surprise if a series of announcements were to follow about hedge funds repricing their assets downwards and also, perhaps, reviewing how much they charge for compensation (the details of performance bonuses are complex and there is an assumption that they are mostly resolved in favour of managers).

Whether the new rules will act as a deterrent to abuses by managers or, more importantly, whether they will do anything to slow the industry's momentum remains to be seen. The bigger it grows, the more the boundaries between hedge funds and traditional asset management are blurring. But on current trends, hedge funds' second trillion dollars of assets will arrive even faster than the first.

* “Hedge funds: Risk and Return”. Working paper.
** “Fees on Fees in Funds of Funds” by Stephen J. Brown, William N. Goetzmann and Bing Liang.
Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

Finding something to crow about

FINANCE & ECONOMICS

Asian equities

Feb 17th 2005 HONG KONG
From The Economist print edition

Usually, investors look to Asia for growth. Time to think of income

FOR investors in Asian shares, the stars have been aligned auspiciously in the past two years. Traditionally regarded as a play on world economic growth, the region's equities have benefited from strong global expansion, rapid corporate restructuring after the technology bubble and, latterly, recovery from the SARS outbreak. As profits have soared, so have stockmarkets. The MSCI Asia (ex-Japan) index rose by over 40% in 2003 and by 14% last year.

February 11th, however, was the first day of the year of the rooster—a bird that can jump but not fly, as CLSA, a Hong Kong broker, notes. Stockmarket forecasts have lost altitude, not without reason. With global growth softening and interest rates rising, notably in America, investors' appetite for risk may at last be fading. Asian exporters face slower growth abroad, high raw-material prices, growing competition from China and diminishing returns from cost cutting. “Asia is the manufacturing centre of the world and manufacturers enjoy almost no pricing power at all,” says Eddie Wong, chief Asian equity strategist at ABN Amro, a Dutch bank.

According to Markus Rösgen, Citigroup's regional head of strategy research, this means that Asian companies' earnings will grow by less than 3% this year, after 45% in 2004. Expecting weaker profits at technology companies in particular, he would not be surprised if earnings fell by 10-15%. He is not the only pessimist. Institutional funds have already grown warier. A survey by Merrill Lynch of regional money managers, published on February 15th, found that the percentage who think the case for owning Asian equities is strengthening fell from 39% in December to 33% in January and 29% in February.

In such an environment, what might coax investors into parting with their money? Malaysia might: a revaluation of the ringgit, which some think possible, would boost the foreign-currency value of domestic assets. In Indonesia, there are high hopes that the new president, Susilo Bambang Yudhoyono, will crack down on corruption and encourage foreign direct investment. The Thai stockmarket, last year's laggard, should benefit from the overwhelming re-election of free-spending, business-friendly Thaksin Shinawatra. By contrast, China may be best avoided while it struggles to control its runaway growth; Taiwan is too exposed to a faltering technology industry; and South Korea remains mired in credit-card debt.

For industries rather than countries, manufacturers, particularly exporters, are likely to stay squeezed between slowing revenues and rising costs. Energy and mining stocks are exposed to China's appetite for commodities, which may slow as the economy cools. For technology firms, the overproduction of semiconductors, flat screens and computers does not bode well. However, industries focused on domestic consumers, such as banks, utilities, telecoms and retailers should fare better. And Asian shares still look cheap: using prospective 2005 earnings, CSFB's Stewart Paterson puts their price-earnings ratio at 12, against a consensus of 16 for Japan and America and 15 for Europe.

Although Asia may not offer investors supercharged earnings growth, it can certainly provide income. Since the 1997-98 financial crisis, companies have slashed debt and cut reckless overinvestment. Average gearing has fallen sharply, to a 25-year low, notes Mr Rösgen, while the ratio of capital spending to sales has fallen by half, to 8%. Nor are managers blowing the cash on mergers, on which only $10 billion was spent last year. Instead, they are paying it to shareholders. CLSA calculates that dividends grew by 25% a year between 1998 and 2004 (see chart). Indeed, Asian equities now boast a higher yield, 3.3%, than European shares (3.2%) or American ones (2.1%). “This is further proof of the transformation of Asian attitudes to shareholders. Asia is a lot less risky than it used to be,” says Percival Stanion, head of asset allocation at Baring Asset Management in London.

Tighter capital discipline should make Asia a safer, more stable place for investors and, in the short run, a more rewarding one. In the longer run, Asia ought to regain some of its appetite for risk. Its growth prospects, after all, are still remarkable—even if the rooster stays earthbound.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

A wise investment?

LEADERS

Hedge funds

Feb 17th 2005
From The Economist print edition

Investors need to become much more sceptical about hedge funds

WHEN an opaque investment fund that does no hedging (in other words, it takes no positions designed to offset other bets) calls itself a hedge fund, charges the sky-high fees of a typical hedge fund and has wannabe customers banging on its door, it is time to ask: what is going on?

The rise of hedge funds is not new. But the funds continue to grow strongly, attracting billions in new money and piquing the interest of investors who, until recently, would never have considered them. Among the new customers are some of America's biggest public pension funds, whose beneficiaries almost certainly have no idea that some of their savings are about to be poured into such murky investments.

As more and more hedge funds are created across a widening range of investment styles, so they are having an ever greater impact on the structure and efficiency of capital markets. With little outside scrutiny, hedge funds can move vast sums at speed as they seek out opportunities.

That can be useful. Authoritative observers, including Alan Greenspan, chairman of the Federal Reserve, credit hedge funds with adding a layer of robustness to the financial system. It is true that hedge funds' willingness to take on risk means that they have been a helpful influence on some bankruptcy proceedings and emergency refinancings. They have also brought much-needed liquidity to neglected corners of financial markets. And their habit of selling against unwarranted price rises can act as a restraint on bouts of irrational exuberance.

But hedge funds can also be risky. The imminent collapse in 1998 of Long-Term Capital Management, a big hedge fund, compelled the New York Fed to step in (perhaps wrongly) with a rescue plan to stop a cascade of other failures. Since then, the hedge-fund industry has mushroomed and become more controversial. Are the high fees which hedge funds charge really justified by performance better than that offered by conventional funds? Can they really protect customers from losing money when markets are falling, as some claim? And, perhaps most pressing, is it right that hedge funds, once sold only to the very wealthy and financially aware, are increasingly being touted as safe for relatively unsophisticated investors?

The answers to these questions are respectively: no; mostly no; and a definite no. Hedge funds have lately been receiving more attention from regulators, and rightly so. Beginning next year, America's Securities Exchange Commission (SEC) will require the management companies of all hedge funds with American customers to register their existence—although not yet details about the actual funds themselves. This newspaper was against the idea of registration when it was first mooted last year. Given how the industry has developed, however, this relatively light-touch form of regulation now seems appropriate. Knowing how many funds there are and who owns them is useful information that is currently impossible to obtain.

But should regulators go much further? Although there is a stronger case today than there was a year ago for more regulatory intervention, on balance it is not strong enough to justify reams of new rules. Tie hedge funds up in too much red tape and they will lose the very characteristics that have made them useful as well as popular. And it is not as if the funds are entirely unobserved. They are subject to anti-fraud law. Moreover, the banks that lend to them and the brokers that allow them to leverage their trading positions all have a keen interest in knowing their customers.

Keeping watch

Such a hands-off approach will look awfully complacent when a big hedge fund blows up, or when some hedge-fund scandal hurts small investors. But strict regulation gives no assurance that those things will not happen. More onerous rules could lull investors to the risks of hedge funds rather than keep them wide awake. Nevertheless, the industry should be watched with special care. It is a cliché to say that the best form of investor protection is caveat emptor; it is also true. In the case of hedge funds the maxim applies with special force. If they took the trouble to inform themselves, many investors would conclude that hedge funds are not for them.

Investors of all sorts, you have been warned. If you want to take your chances with hedge funds, understand what you are doing—and, if you are a pension-fund trustee, do it with liability insurance tucked into your back pocket. All investments need to be watched. Right now, it seems, hedge funds need to be watched more carefully than most.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

The gatekeeper

FINANCE & ECONOMICS

Italian banks and the EU

Feb 17th 2005 PARIS
From The Economist print edition

The European Commission tells Italy to open its banking market

EUROPE'S much-promised single market in financial services is taking a long time to create. It might never be finished, indeed, without a fight or two. So it may be a good sign that, after only a couple of months in his job, Charlie McCreevy, the European Union's commissioner for the internal market, is squabbling with Antonio Fazio, governor of the Bank of Italy.

On February 8th Mr McCreevy wrote to Mr Fazio, asking him “to correct the impression” that he is trying to stop foreigners buying their way into Italy's banking market. Several newspapers had reported an unofficial deal between Mr Fazio and the Italian government to block foreign takeovers. Before his official reply was acknowledged on February 17th, the governor had responded indirectly, in a speech last weekend. Foreigners, he said, own on average 17% of the capital of Italy's four largest banks, compared with 7% of Germany's top four and 3% of France's.

That's not the point, says Oliver Drewes, a spokesman for Mr McCreevy: “We are talking about foreigners taking a controlling stake in Italian banks.” According to Italian banking law, the purchase of any more than 5% requires Mr Fazio's nod. On his watch, which began in 1993, no foreign institution has bought a majority stake, although a few have grumbled that they would have but for Mr Fazio's opposition. So far Banco Bilbao Vizcaya Argentaria, Spain's second-biggest bank, has acquired 15% of Banca Nazionale del Lavoro; Santander Central Hispano, Spain's number one, has 8.6% of Sanpaolo IMI. ABN Amro, a big Dutch bank, owns slices of Capitalia and Banca Antonveneta.

Mr Fazio is over-protective because his country's banks are likely to be on several shopping lists should cross-border European bank mergers begin in earnest. Italy's banking market is fragmented and its banks are small. UniCredit, the largest by market capitalisation, ranks only 15th in Europe. It could be bought for a fraction of the price of a top German or French bank.

The governor might be trying to protect the banks' corporate customers too. Loans to large companies such as Parmalat, a dairy group that went spectacularly bust in 2003, and Fiat, a struggling carmaker, are not priced on an economic basis, says Alessandro Roccati, of Fox-Pitt, Kelton, an investment bank; a foreign buyer would surely reprice them, making the companies' restructuring harder than it already is. Small and medium-sized firms might also find credit tighter were their banks bought by unsympathetic foreigners.

As long as Mr Fazio is in charge, Italy's big banks will stay in domestic hands. Parliament is discussing a proposal to limit his term (remarkably, the central-bank governor enjoys life tenure) and to transfer the approval of bank mergers to the antitrust authority, but Italian lawmaking is notoriously slow. The commissioner could take Italy to the European Court of Justice, but Mr McCreevy's people say that is still miles off. The banks' foreign suitors may simply have to wait, and hope that Mr Fazio's successor is more amenable.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

Small country, big ambitions

BUSINESS

Icelandic businessmen abroad

Feb 17th 2005
From The Economist print edition

Icelandic businesses are making big acquisitions across Europe

THEY are well-heeled, these Icelanders. Brave, too. Last year's flow of Icelandic takeovers in Europe looks ready to become a flood—not all of it into companies much fancied by other investors.

Bravest of Iceland's brave is the Baugur Group, run by Jon Asgeir Johannesson. Born as a supermarket but now an investment house in retailing of many sorts, last autumn it bought Magasin du Nord, a Danish department-store group which, after three years of losses, expects to lose $30m more in 2004-05, on turnover of about $350m. Last week, a Baugur-led consortium completed the $1.25 billion takeover of Britain's Big Food Group, which had begun losing money on sales of some $9 billion. On February 9th, another struggling British supermarket chain, Somerfield, revealed it was a target. A bid is only a possibility, but could exceed $1.9 billion. Baugur had already bought British real estate, besides clothing and jewellery stores, and London's famous toy-shop, Hamleys.

Among other Icelandic buys, in December SIF, a seafood group, bought Labeyrie, a French food firm, for $675m (debt included); Bakkavor, a supplier of chilled meals, has bought 20% of Geest, a large British firm in that line, and is now studying a full bid; Icelandair holds 10% of Britain's low-cost airline easyJet. Actavis, a maker of generic drugs chaired by Thor Bjorgolfsson, who made his first pile in Russian brewing, has bought drugmakers in Bulgaria, Serbia and Turkey, and is now buying into India, as a road into the American market. Only 4% of its $500m-or-so turnover today comes from Iceland.

The Icelandic banks helping to finance these acquisitions are themselves buyers. The biggest purchase so far came last year from Kaupthing Bank, Iceland's largest. After earlier lesser but sizeable buys in Finland, Norway, Sweden and Switzerland, it paid $1.25 billion for FI-Holding, a Danish bank strong in corporate lending. In Britain, by early 2004 it held 19.5% of Singer & Friedlander, an investment bank. Burdaras, an Icelandic investment company, later bought a 9.5% stake, and many expect a full Icelandic bid for the London bank, now valued in the market at $950m.

Burdaras itself is 50.2%-owned by three arms of Landsbanki, Iceland's number two, which has overseas ambitions of its own. Formerly state-owned, Landsbanki was privatised in 1998-2003. In 2000 it bought Heritable Bank, a small British housing-finance bank, and in 2003 a private-banking operation in Luxembourg. It has just agreed to buy one of Britain's few surviving independent stockbrokers.

All this from an island of only 300,000 people. Not all the money is Icelandic: SIF, for instance, paid for Labeyrie partly via a syndicated loan in London. Yet it raised $300m, mainly from local sources, in a later share issue; and this soon after a Kaupthing issue had raised $550m. What is the source of Iceland's financial muscle?

A broad answer is almost 14 years of deregulating and privatising government. Specifically, Iceland, like Luxembourg or Ireland, has become a friendly place for financiers and, like Switzerland, is not subject to EU tax-prying: Burdaras's biggest shareholder is Landsbanki's Luxembourg private bank. And corporate profits, taxed at 50% in 1991, and, after cuts, still at 30% in 2001, now pay 18%, the lowest tax-rate in the OECD after Ireland and Hungary.

Few as they are, Icelanders are also feeling richer. After a slide in 2001-02, the economy is back to 4-6% growth. And, with inflation and interest rates mostly low, house prices, bonds and equities have soared in recent years, encouraging a sharp rise in household borrowing. Some of this has gone, indirectly, into investment overseas. Local banks meanwhile have borrowed heavily abroad; an OECD estimate out this week suggests that the country's external debt may have risen by some $6 billion in 2004. A chunk of this has flowed out again into the overseas-investment spree. After all, there are not a lot of attractive opportunities for Iceland's ambitious businessmen at home.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

Bargain of the century

BUSINESS

Italian business

Feb 17th 2005
From The Economist print edition

How to double your money in Italian retailing

THERE are many ways of making money quickly in retailing. Philip Green, a British entrepreneur, took just two years to make a paper profit of £1 billion ($1.9 billion) by reviving BHS, a once-struggling British high-street chain. Another lucrative strategy is illustrated by the joint-venture between IFIL, a listed Italian investment company controlled by the Agnelli family (which also controls Fiat, Italy's largest industrial group), and Auchan, a private firm that is France's third-largest supermarket operator.

IFIL and Auchan are jointly breaking up La Rinascente, until two years ago a listed Italian retail firm. The process is nearly complete. This week, Lazards, an investment bank, opened bids for Grandi Magazzini and UPIM, La Rinascente's department-store chains. Analysts anticipate that the bids for the stores, whose value lies mainly in their property, will exceed €800m ($1.04 billion).

This money will be split between the two partners in the joint-venture that began in 1997. On completion of the sale of the department stores, IFIL will have turned its share of the joint-venture into cash—some €1.75 billion in total when other sales are also counted. Auchan has taken its share in a mixture of cash and assets. In March 2003, when IFIL and Auchan completed an offer for the 41% of La Rinascente's shares that they did not own, thereby delisting it, the implied value of the whole group was €1.77 billion. So IFIL and Auchan have doubled their money since taking La Rinascente private.

In 2003, La Rinascente's operating profit improved only modestly amid stiff competition. So how did IFIL and Auchan do it? The timing of their offer to La Rinascente's minority shareholders was certainly opportune: the price of the ordinary shares had slumped from an average of €5.90 in 2000 to €3.34 just before they made their offer which, at a 33% premium to that price, was accepted by most minority shareholders.

Offer documents sent to shareholders are supposed to contain sufficient information to allow a proper evaluation of the offer. In those sent to La Rinascente's shareholders, which were approved by Consob, Italy's stockmarket regulator, IFIL and Auchan did not hint at a break-up of the group. On the contrary, they talked of their own “implementation of medium-to long-term strategies” and of plans for La Rinascente to continue “in the various sectors in which [it] operates”. The joint-venture agreement would run until 2022 (though, from 2012, IFIL could force Auchan to buy it out).

Astonishingly, the offer documents contained no information about the market value of La Rinascente's extensive property portfolio. This portfolio, whose book value at historic cost was €1.27 billion, included plums such as 38 shopping centres (most with an Auchan hypermarket), shops in prime city-centre sites, and the valuable Rinascente building in the heart of Milan.

Yet just months after the offer was completed, the market value of the 38 shopping centres (alone) was established at €861m, following competitive bidding. An American property group was selected to buy 49% of a new La Rinascente subsidiary, Gallerie Commerciali Italia (GCI), to which the centres were sold. Following this deal La Rinascente in effect paid a special dividend worth nearly €300m each to IFIL and Auchan.

Late last year, Auchan agreed to pay €1.06 billion to IFIL to buy it out of La Rinascente's supermarket chains and of the controlling stake in GCI. This deal thus valued La Rinascente's food-retailing arm at €2.12 billion. Curiously, IFIL did not seek expert opinion on the appropriateness of the price for this, the most valuable part of the joint-venture. Nor did it invite competitive tenders—which might also have yielded a significantly higher price.

IFIL says that as La Rinascente is still pursuing its medium-term to long-term strategy, statements in the offer documents are consistent with the subsequent break-up. It adds that no valuation of the property assets was included in the offer documents because these contained public information only; and that there was no third-party involvement in the sale of the food business to Auchan because IFIL's board members felt confident about the terms of the deal. Consob, one of whose jobs is to ensure that investors are provided with meaningful information in offer documents, said that the relevant officials were too busy to respond to The Economist's questions.

Just under 1% of La Rinascente's shares remain in the hands of minority shareholders, who declined the opportunity to sell to IFIL and Auchan. These shareholders, too, have doubled their money. Asked who these shareholders are, IFIL replied: “We do not know.”

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

Telecomglomerate

BUSINESS

Communications

Feb 17th 2005
From The Economist print edition

A new breed of telecoms firm emerges

THE telecoms business in America, as well as being built with wires and switches, has been based on imaginary divisions: between local and long-distance calls; wireless and wire-line; regional and national service; voice and internet. But recent deals by America's two biggest “Baby Bells” to buy long-distance operators have laid to rest this old, fictional industry structure. A new corporate beast is emerging: the telecomglomerate, competing across all categories of communications.

On February 14th, Verizon, a large regional telecoms operator, said that it would acquire MCI, a long-distance provider, for $6.7 billion. Provided the deal goes through—some MCI shareholders still prefer a higher bid by Qwest—the combined firm will have annual revenues of over $90 billion and 250,000 employees. Along with the agreement two weeks ago by SBC, another regional Bell company, to buy AT&T, it brings to a close America's long-distance phone industry.
The logic behind both deals is to enable the regional operators, which have near-monopolies on local calls in their area, to move into supplying communications services to businesses, a lucrative market. Yet the deals will ultimately mean much more. They will end the old non-aggression pact among regional operators to avoid competing in each other's territory. Competition will come—first for business and, later, for residential customers—not across copper wires, but from wireless and fibre lines for internet access.

Both Verizon and SBC will be new “oligopolies” able to offer the full gamut of communications services, says Raul Katz of Adventis, a telecoms consultancy. Eli Noam, the director of Columbia University's Institute for Tele-Information, calls the consolidation a natural evolution to achieve scale and diversify risk. “The telecom industry has moved from utility to volatility, and it is difficult to survive in the commodity part of the business,” he says.

Ironically, MCI was devoured by the very competition it instigated. Founded in 1963 as Microwave Communications Inc, it set up wireless towers for radio dispatchers, and eventually took on AT&T's monopoly in 1968. In its first years, the joke was that it had more lawyers than linemen; the firm even placed its headquarters one block from America's telecoms regulator. Its 1974 antitrust suit against AT&T culminated in the 1984 break-up of “Ma Bell”. MCI was bought by WorldCom in 1998 and disappeared, until its name was resurrected after WorldCom emerged from bankruptcy protection in 2004 following an $11 billion accounting scandal.

The sudden removal of America's long-distance companies by the regional operators poses new regulatory questions, just as America's politicians debate revising the nation's telecoms laws and a new chairman of the Federal Communications Commission (FCC) has to be appointed to replace the current boss, Michael Powell, who steps down in March. Together, it heralds a massive overhaul of America's telecoms regulatory landscape.

“The new FCC chairman either has a big eraser or a new pen—one or the other,” says Reed Hundt, the FCC chairman from 1993 to 1997. Whether there are fewer rules or more, however, the mergers are expected to be approved by regulators with conditions, such as to ensure transparency for internet pricing for businesses.

But the new telecoms war will be not just between the telecomglomerates, Verizon and SBC, and the remaining Baby Bells, but among cable firms, too. They are now offering phone and internet service, just as telecom firms are now vying to offer TV service. Battle lines are being drawn.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.