Thursday, January 31, 2008

Understanding global competitiveness

The IMF recently projected 2008 global growth as 4.1 percent, lower than the 2007 estimated growth of 4.9 percent. Of note though is that Advanced Economies are projected to grow at 1.8 percent (2007 estimate of 2.6 percent) while Emerging Market and developing Economies are projected to grow at 6.9 percent (2007 estimate of 7.8 percent). This is ironic, as it shows that global growth is now being held up by the emerging and developing markets, which once depended heavily on the advanced economies, such as the US, for handouts. What we find now is that many US companies are in fact depending on economies such as China and India for year over year growth,

The world indeed changes. In fact the global slow down was in fact caused by irresponsible risk management practices in the US (an advanced economy) and perpetuated by other advanced economies such as the UK. Africa, for example, is expected to do better than the 2007 growth estimate of 6 percent by 1 percent, and the locomotive China will slow down from 11.4 percent to 10 percent, which is a plus for its overheated economy by calming further inflation concerns.

Poor risk management
But what is it that creates this disparity in global growth, and why do countries such as the mighty US see themselves going through this crisis, while developing countries such as China and Africa are able to defy the woes of a global slow down? It seems as if we are constantly being bombarded by bad news coming out of the US and the UK, while dismissing the bright spots globally, such as the Africa we love to sing about.

The main reason for the slow down in the advanced economies is because they failed to practice good risk management principles and went overboard in creating instruments related to the sub prime mortgage instruments, merely because of greed. The only major financial company that was not affected by this crisis seems to be Goldman Sachs, which has so far had no write downs. On the other hand, companies we look up to such as bear Stearns and Merrill Lynch, had massive write downs amounting to US$ billions.

The emerging and developing markets, however, did not get involved in too much fancy financial footwork. So while advanced economies are reeling from failed financial instruments, emerging and developing economies are benefiting from higher commodity prices and growth in consumer demand. China and India, for example, are the largest single markets in terms of numbers of people, which advanced economies drool at.

This contrast between economies tells us that it is not all about doom and gloom but a reminder that our fortune depends on how we handle our own affairs. Jamaica has always had competitive advantages in areas such as agriculture and tourism but has squandered it with poor leadership and management. There can be no doubting the facts that our agricultural products are among the highest quality and sought after in the world, and our natural beauty and culture are amongst the best in the world. If the basic ingredients for success exist then the reasons for our dismal failure to realize our potential over the years can only be because of the leadership.

Failure to understand global climate
What we have failed to understand is that within the global environment the requirements of competitive advantage have shifted. Prior to the 1990s, when globalization started to take hold, competitiveness could be garnered by unique products and services. With globalization, however, the nature of competitive advantage shifted with improved communication, information, and technology. Increasingly competitive advantage comes not from just the products and services but the knowledge base of the human resources behind the product and services. This happened because as technology and information became more available then products and services become more homogeneous. The only distinction therefore is the quality of human resources, and this is my greatest fear for Jamaica.

The fact is that Jamaica has developed into a country of talkers and profilers, and this is compounded by the fact that many of our leaders actually make choices based on profile or friendship (form) rather than substance. The result of this is that since the 1970s our productivity has been on average declining every year. But no sweat, when that started to happen we just continued to borrow to maintain our unproductive lives. This is the reason why even smaller states such as Trinidad and Barbados have done better than we have. Even with all their money they prefer to spend it on developing quality human resources (as evidenced by their high literacy rates) and productive infrastructure. This is the critical factor that will, with all our natural beauty and resources, make us suffer from the global slow down.

I do see where changes to this attitude are likely to take place, and this is no where more pronounced than in the announcements made by the police commissioner. Many have criticized Derrick Smith for not appearing to be in control of the crime situation, which as far as I am concerned is hypocritical. The high crime rates, and the deterioration in social conditions and break down in the crime fighting infrastructure, was well cemented by many years of neglect, and three months after coming to office he should solve the problem. I believe that he is doing the right thing by systematically putting in place the proper infrastructure to address the crime problem by first starting with the selection of a good police commissioner.

The commissioner has indicated that he will do what should have been done in the first place, and what I have always been saying. That is attack the problems that shape the break down of law and order, namely “night noise”, indiscipline on the roads, and providing an avenue for citizens to air their concerns of the police force. We will not be able to solve murders if we do not start with shaping social behaviour. The attempts in the past have been to form police squads and report “one day’ crime reductions as successes.

If we are going to do better during the global slow down then the first thing we need to do is rethink how we employ human resources. We must adapt the concept of value added, and employ persons not on the basis of who they were or know but what they can bring to the table. It is the use of the best human resources that will drive this country forward, as human resources have become maybe the most important factor of production. Many still believe it is capital but with the easier access to capital globally this in my opinion is secondary to human resources. Financial innovation can create money in a short period of time, but it is very difficult to develop a person that thinks “outside the box”.

The inability to use the best human resources will not only be the downfall of companies but also countries, and will determine which countries survive in the global slow down.

Thursday, January 17, 2008

The power of prophesy

Prophesy has always been a central theme of most religions. At the heart of many religions is a messiah type figure, but the supporting cast always includes many prophets. The ability to see the future has always been the desire of not only religious prophets but people in business and their personal lives. We remember a few years ago a lady called Ms. Cleo, who used to televise psychic abilities on “expensive” television ads, indicating that there was a demand for that type of service.

Investing is no different, as investors pay investment managers to predict what will happen in the markets and consequently make successful investments on their behalf. We have seen also recently in Jamaica where prophesy has played a big part in our politics, as Prophet Phinn was a greater discussion point than the economic issues, and when that prophesy did not work out many reasons were given why it did not come true.

Such is the power of prophesy, and we all hold on to the desire to predict the future for financial and other gain. When making an investment, or predicting elections, the odds of success are 50-50, as the investment, or election, can go one way or the other. So in many instances a prophesy is nothing more than a gamble that something will happen one way or the other, and the reward for success is usually great, while the risk of loss can usually be tempered. For example when trading currency one can makes an informed bet that the market will move one way or the other, and if the prediction is successful then the reward can be exceptional.

Importance of data
The more successful prophets, however, usually base their predictions on sound data or trends. For example in Prophet Phinn’s case he was betting against the hard data (the polls) and a desire of the people to see change. The odds were therefore definitely not in his favour and anyone who bet on his success would have lost big, as the risk was always greater than the reward. The fact though is that usually if one properly analyzes the data then fairly accurate predictions can be made about what will happen in the future.

This ability to predict, based on data, is a feature that seems to be lacking in the Jamaican landscape. This I believe is one reason why we always seem to be caught by surprise with economic surprises, and seem to have been continuously in a state of economic decline. It seems as if we manage more based on emotions, and what we believe will happen, rather than taking a practical look at the data and interpreting what will happen. This is at the heart of the financial statement analysis that accountants are taught. But even many that are taught this art do not seem to have come to terms with it as yet.

Similarly I can’t understand why we have not been able to predict what is happening in the global market today. From as early as March 2007, I remember speaking with Ralston Hyman, and discussing the increasing probability of a US recession and increase in oil prices. There were many of course who were saying that the sub prime crisis would be contained, and there would be no spillover into the US economy, much less globally, just because the great (or not so great today) Ben Bernanke was saying so. I remember having the conversation with a young economist and he was adamant that Bernanke was correct, and we would not see any negative effects on the wider economy. Well my argument to him is that as an accountant we are trained to analyze data, and predict based on data, rather than just listen to the emotions of the market. In the short run it is emotions that move markets, but over the longer term all markets are influenced by fundamentals (data).

My basis for saying that the sub prime effects would spill over into the wider economy was based on logical reasoning, as I had discussed with Ralston at the time. The fact is that the US economy is 70% consumer spending. The fact also is that at the time we knew that many of the financial institutions had created derivatives (CDOs) from the sub prime mortgage instruments and sold them into the market, thus multiplying the effect into the financial system. Now if we accept these two facts, then wouldn’t it be obvious then that if the consumer and financial markets are affected then it would have a spill over effect in the wider economy. What was driving the US economy also was the boom in the housing market, so if this sector is affected then wouldn’t the growth in the economy be affected. It seemed logical to me but I am also trying to logically consider the argument on the other side without much success.

Oil warnings
The data, at that time, also showed that demand for oil was increasing and there was growing turmoil in the Middle East. At the time oil was below $60 per barrel, and the year before we saw a significant percentage increase in the price of oil. There was no indication that it was a short term bubble, as the growth in Asia, particularly China, was consuming everything in sight and there was no evidence of let up. Still we refused as a country to come to grips with what was happening and ignored the call for action. Even China was able to adapt, with all their strength, and today 60% of their energy generation is from coal. In Jamaica’s case though we have painted ourselves into the corner of an additional US$300 Million import bill, when we should have started to prepare for preventing this from 2006.

What I have found though is that if one makes an assessment that a negative is coming then you are not really taken seriously, as we do not like to hear bad news, even if it is logical. If one predicts, using emotion, that something positive will happen then everyone will accept it, as people love to hear good news. So it is a natural part of human nature. This was the case in the recent downturn in the US market also, where there were some commentators on CNBC who were saying for a while that the US is going into recession, and that a significant rate cut is needed. But most of the persons were saying that the decline in the stock market was just a healthy correction, and that the mortgage write offs last year was the last of it, even though the financial institutions admitted that they did not have a handle on the value.

So here we are today. As a country we have failed to take advantage of the record global growth levels over the past three years, and we are suffering because we have failed to prepare for the inevitable slow down in global growth (because economies move in cycles). So our inability to predict properly has caused us to have the worst of both worlds. What we must focus on though is going forward and stop this long term down trend in our economic fortunes.

With a globalized economy we must understand that the competitive edge comes not from just the natural advantages we have but the ability to stay one step ahead of the competition. What it means is that we have to develop the ability to predict what will happen, and take both the good and bad news, as not doing so will continue to be to our detriment. In making projections though it must be based on proper analysis, and not just the meaning, of the numbers.

Thursday, January 10, 2008

Unregulated lives

“The law should not be a shackle”. This is a statement attributed to a former Prime Minister, which I do not think he meant that people should ignore the law, but it really is representational of the way we approach our lives in Jamaica. It also is one reason why an investor will look on at Jamaica and see it as an undisciplined society where crime and unfettered behaviour rules. Why invest in an economy that does not subject itself to strict rules and regulations.

Nowhere is this type of behaviour more obvious today than in the area of the unregulated investments. There are many countries, developed and otherwise, that have been subjected to the effects of similar events. The more famous recently being Albania but certainly in the United States (US) they see their fair share of “unregulated investments”. The National Futures Association (NFA) reported in February 2007, in an investor alert on the “Risks of trading in the Retail….Foreign Currency Market”, that since 2001 25,000 customers lost US$395 Million in foreign currency (Forex) schemes. What is important to understand though is that the major Forex brokers do register with the Commodity Futures Trading Commission and are subject to reporting requirements such as capital adequacy ratios, which is similar to the indicators tracked by the FSC.

The US has also more recently seen the effects of the sub prime mortgage crisis, which one of the main issues is that these instruments were not subject to proper interrogation by the regulators. The result as we all know is that the whole global economy is slowing.

Unsupported regulators
The difference between Jamaica and the US, however, is that when the US regulators try to deal with such a situation to prevent a greater crisis, they are supported with constructive criticisms by the public. In our cases we do not just criticize but blame the regulators for what is happening, even though the regulators have been warning the public about the dangers for a long time. So how does the regulators have an impact on whether a company makes money or not? I just cannot understand the logic. I can only conclude, as I have been saying for a while, that the problem with Jamaica is mainly one of a breakdown of law and order.

But the situation we face today is not one that was unpredictable. Anyone who has been listening to my commentaries will know that for over a year I have been pleading with the companies involved and the regulators to ensure the unregulated investors were brought into regulation as soon as possible because I had foreseen that it would create social difficulties for many, as there will be some that enter the market that are not legitimate. Anyone who knows me will know also that I have always supported alternative investments such as Forex trading and hedge funds, but what I am not in support of is any investment offered to the public that is not transparent through registration and regulation. The risks to the less vulnerable are too great.

But like many other things we tend to ignore them, not having the foresight to prevent them. One such case in point is the FINSAC era. At that time I was not as much involved as I am today, but I remember clearly listening to Charles Ross saying every time he was on the Breakfast Club that prolonged high interest rates would damage the economy. But of course no one listened to him, as no one listens to me, because it was not in the interest of anyone to do so.

Similarly on July 29th 2006 my column was entitled “Oil: Jamaica’s main external threat”, where I wrote “Since 2000 fuel imports as a percentage of total imports has increased from 18.67% to 29.94%, an 85.6% increase…” and “The ever increasing oil price is a huge risk to Jamaica’s economic viability. For this reason it is very important that we develop and implement a plan to reduce our dependency on oil as a fuel source.” Eighteen months later we are looking at a serious threat to the economy from oil, which over that time all we have done is to write an energy policy. What can I say, I am just an accountant, and who am I to challenge the great intellects we have had leading us.

Government response
The government’s response to the unregulated investments is appropriate. Nothing more can be done than to ensure that the proper legislative framework is in place to accommodate these investments and have a proper definition of investment clubs. The US Securities and Exchange Commission (SEC) define an investment club as “a group of people who pool their money to make investment decisions.”

The SEC also addresses when an investment club has to register under the Securities Act of 1933, and that is when the membership interests are “securities”. It further states that generally a membership interest is a security “if it is an “investment contract” ” and “Generally, a membership interest is an investment contract if members invest and expect to make a profit from the entrepreneurial and managerial efforts of others”. But if everyone meets and participates in each investment decision then it would be precluded and under the current schemes with thousands of investors (across countries) it is a little difficult to do so.

The SEC further states that an investment club must register with them as an investment company under the Investment Company Act of 1940 if all of the following three conditions apply – (1) the club invests in securities; (2) the club issues membership interests that are securities; and (3) the club is not able to rely on an exclusion from the definition of an investment company. A private investment company does not need to register with the SEC if (1) if does not make, nor propose to make, a public offering of its securities, and (2) it does not have more than 100 members.

In addition to the above the advisor needs to register with the SEC if they are compensated for providing advice regarding the club’s investments. Also if one person selects investments for the club, that person may have to register. In general, however, a person who has US$25 million or more under management is required to register under the Investment Advisers Act of 1940.

Looking at the structure in the US it is clear that our own unregulated schemes would fall under the requirement to register with the FSC, not only by virtue of the number of investors and funds involved but also because in many cases the investors have contracts with the companies and are not directly involved in the investment decisions. So within this context the government’s response to these unregulated investments could not have been any different as at the heart of it all is the responsibility of the regulators to protect the investing public and how can they conceivably do that without having the proper information? How can the public make proper investment decisions without having proper independent information?

The lack of information is the problem and to be fair to the FSC they have never said that they are against alternative investments. What they have said is that these companies should come in and get regulated.

I have always agreed that the traditional financial institutions are suffering from the “fat cat syndrome’ and seems to lack the ability to create new products that give risk seekers a proper alternative to high interest bearing government paper, and this has helped to prevent the proper development of our capital markets and economy. But the real problem we continue to suffer from as a society is resistance to any structure and regulations in our lives, while trying to compete with markets that recognize how important it is.