Issues in microeconomics and macroeconomics studied through the prism of economies in transition.
This letter constitutes a permission to reprint or mirror any and all of the materials mentioned or linked to herein subject to appropriate credit and linkback.
Every article published MUST include the author bio, including the link to the author's Web site.
is the author of Malignant Self Love - Narcissism Revisited
and After the Rain - How the West Lost the East
. He served as a columnist for Central Europe Review
, and eBookWeb
, a United Press International
(UPI) Senior Business Correspondent, and the editor of mental health and Central East Europe categories in The Open Directory
, and Suite101
Until recently, he served as the Economic Advisor to the Government of Macedonia.
Visit Sam's Web site at http://samvak.tripod.com
Special - Hawala, the Bank that Never Was
Special - Money Laundering in a Changed World
I. The Myth of the Earnings Yield
II. Alice in Credit Card Land
III. The Revolt of the Poor - The Demise of Intellectual Property
IV. Financing Transport Projects
V. Is Our Money Safe?
VI. Workaholism, Leisure and Pleasure
VII. Financial Crises and Global Capital Flows
VIII. The Shadowy World of International Finance
IX. The Typology of Financial Scandals
The Myth of the Earnings Yield
By: Dr. Sam Vaknin
A very slim minority of firms distribute dividends. This truism has revolutionary implications. In the absence of dividends, the foundation of most - if not all - of the financial theories we employ in order to determine the value of shares, is falsified. These theories rely on a few implicit and explicit assumptions:
(a) That the (fundamental) "value" of a share is closely correlated (or even equal to) its market (stock exchange or transaction) price
(b) That price movements (and volatility) are mostly random, though correlated to the (fundamental) "value" of the share (will
always converge to that "value" in the long term)
(c) That this fundamental "value" responds to and reflects new information efficiently (old information is fully incorporated in it)
Investors are supposed to discount the stream of all future income from the share (using one of a myriad of possible rates - all hotly disputed). Only dividends constitute meaningful income and since few companies engage in the distribution of dividends, theoreticians were forced to deal with "expected" dividends rather than "paid out" ones. The best gauge of expected dividends is earnings. The higher the earnings - the more likely and the higher the dividends. Even retained earnings can be regarded as deferred dividends. Retained earnings are re-invested, the investments generate earnings and, again, the likelihood and expected size of the dividends increase. Thus, earnings - though not yet distributed - were misleadingly translated to a rate of return, a yield - using the earnings yield and other measures. It is as though these earnings WERE distributed and created a RETURN - in other words, an income - to the investor.
The reason for the perpetuation of this misnomer is that, according to all current theories of finance, in the absence of dividends - shares are worthless. If an investor is never likely to receive income from his holdings - then his holdings are worthless. Capital gains - the other form of income from shareholding - is also driven by earnings but it does not feature in financial equations.
Yet, these theories and equations stand in stark contrast to market realities.
People do not buy shares because they expect to receive a stream of future income in the form of dividends. Everyone knows that dividends are fast becoming a thing of the past. Rather, investors buy shares because they hope to sell them to other investors later at a higher price. In other words, investors do expect to realize income from their shareholdings but in the form of capital gains. The price of a share reflects its discounted expected capital gains (the discount rate being its volatility) - NOT its discounted future stream of income. The volatility of a share (and the distribution of its prices), in turn, are a measure of expectations regarding the availability of willing and able buyers (investors). Thus, the expected capital gains are comprised of a fundamental element (the expected discounted earnings) adjusted for volatility (the latter being a measure of expectations regarding the distribution of availability of willing and able buyers per given price range). Earnings come into the picture merely as a yardstick, a calibrator, a benchmark figure. Capital gains are created when the value of the firm whose shares are traded increases. Such an increase is more often than not correlated with the future stream of income to the FIRM (NOT to the shareholder!!!). This strong correlation is what binds earnings and capital gains together. It is a correlation - which might indicate causation and yet might not. But, in any case, that earnings are a good proxy to capital gains is not disputable.
And this is why investors are obsessed by earnings figures. Not because higher earnings mean higher dividends now or at any point in the future. But because earnings are an excellent predictor of the future value of the firm and, thus, of expected capital gains. Put more plainly: the higher the earnings, the higher the market valuation of the firm, the bigger the willingness of investors to purchase the shares at a higher price, the higher the capital gains. Again, this may not be a causal chain but the correlation is strong.
This is a philosophical shift from "rational" measures (such as fundamental analysis of future income) to "irrational" ones (the future value of share-ownership to various types of investors). It is a transition from an efficient market (all new information is immediately available to all rational investors and is incorporated in the price of the share instantaneously) to an inefficient one (the most important information is forever lacking or missing altogether: how many investors wish to buy the share at a given price at a given moment).
An income driven market is "open" in the sense that it depends on newly acquired information and reacts to it efficiently (it is highly liquid). But it is also "closed" because it is a zero sum game, even in the absence of mechanisms for selling it short. One investor's gain is another's loss and all investors are always hunting for bargains (because what is a bargain can be evaluated "objectively" and independent of the state of mind of the players). The distribution of gains and losses is pretty even. The general price level amplitudes around an anchor.
A capital gains driven market is "open" in the sense that it depends on new streams of capital (on new investors). As long as new money keeps pouring in, capital gains expectations will be maintained and realized. But the amount of such money is finite and, in this sense, the market is "closed". Upon the exhaustion of available sources of funding, the bubble tends to burst and the general price level implodes, without a floor. This is more commonly described as a "pyramid scheme" or, more politely, an "asset bubble". This is why portfolio models (CAPM and others) are unlikely to work. Diversification is useless when shares and markets move in tandem (contagion) and they move in tandem because they are all influenced by one critical factor - and only by one factor - the availability of future buyers at given prices.
Alice in Credit Card Land
By: Dr. Sam Vaknin
Your credit card is stolen. You place a phone call to the number provided in your tourist guide or in the local daily press. You provide your details and you cancel your card. You block it. In a few minutes, it should be transferred to the stop-list available to the authorization centres worldwide. From that moment on, no thief will be able to fraudulently use your card. You can sigh in relief. The danger is over.
But is it ?
It is definitely not. To understand why, we should first review the intricate procedure involved.
In principle, the best and safest thing to do is call the authorization centre of the bank that issued your card (the issuer bank). Calling the number published in the media is second best because it connects the cardholder to a “volunteer” bank, which caters for the needs of all the issuers of a given card. Some service organizations (such as IAPA – the International Air Passengers Association) provide a similar service.
The “catering bank” accepts the call, notes down the details of the cardholder and prepares a fax containing the instruction to cancel the card. The cancellation fax is then sent on to the issuing bank. The details of all the issuing banks are found in special manuals published by the clearing and payments associations of all the banks that issue a specific card. All the financial institutions that issue Mastercards, Eurocards and a few other more minor cards in Europe are members of Europay International (EPI). Here lies the first snag : the catering bank often mistakes the identity of the issuer. Many banks share the same name or are branches of a network. Banks with identical names can exist in Prague, Budapest and Frankfurt, or Vienna, for instance. Should a fax cancelling the card be sent to the wrong bank – the card will simply not be cancelled until it is too late. By the time the mistake is discovered, the card is usually thoroughly abused and the financial means of the cardholder are exhausted.
Additionally, going the indirect route (calling an intermediary bank instead of the issuing bank) translates into a delay which could prove monetarily crucial. By the time the fax is sent, it might be no longer necessary.
If the card has been abused and fraudulent purchases or money withdrawals have been debited to the unfortunate cardholders’ bank or credit card account – the cardholder can reclaim these charges. He has to clearly identify them and state in writing that they were not effected by him. A process called “chargeback” thus is set in motion.
A chargeback is a transaction disputed within the payment system. A dispute can be initiated by the cardholder when he receives his statement and rejects one or more items on it or when an issuing financial institution disputes a transaction for a technical reason (usually at the behest of the cardholder or if his account is overdrawn). A technical reason could be the wrong or no signature, wrong or no date, important details missing in the sales vouchers and so on. Despite the warnings carried on many a sales voucher (“No Refund – No Cancellation”) both refunds and cancellations are daily occurrences.
To be considered a chargeback, the card issuer must initiate a well-defined dispute procedure. This it can do only after it has determined the reasons invalidating the transaction. A chrageback can only be initiated by the issuing financial institution. The cardholder himself has no standing in this matter and the chargeback rules and regulations are not accessible to him. He is confined to lodging a complaint with the issuer. This is an abnormal situation whereby rules affecting the balances and mandating operations resulting in debits and credits in the bank account are not available to the account name (owner). The issuer, at its discretion, may decide that issuing a chargeback is the best way to rectify the complaint.
The following sequence of events is, thus, fairly common :
The cardholder presents his card to a merchant (aka : an acceptor of payment system cards).
. The merchant may request an authorization for the transaction, either by electronic means (a Point
of Sale / Electronic Fund Transfer apparatus) or by phone (voice authorization). A merchant is
obliged to do so if the value of the transaction exceeds predefined thresholds. But there are other
cases in which this might be either a required or a recommended policy.
3. If the transaction is authorized, the merchant notes down the authorization reference number and
gives the goods and services to the cardholder. In a face-to-face transaction (as opposed to a phone
or internet/electronic transaction), the merchant must request the cardholder to sign the sale slip. He
must then compare the signature provided by the cardholder to the signature specimen at the back
of the card. A mismatch of the signatures (or their absence either on the card or on the slip)
invalidate the transaction. The merchant will then provide the cardholder with a receipt, normally
with a copy of the signed voucher.
. Periodically, the merchant collects all the transaction vouchers and sends them to his bank (the
. The acquiring bank pays the merchant on foot of the transaction vouchers minus the commission
payable to the credit card company. Some banks pre-finance or re-finance credit card sales
vouchers in the form of credit lines (cash flow or receivables financing).
acquiring bank sends the transaction to the payments system (VISA International or Europay
International) through its connection to the relevant network (VisaNet, in the case of Visa, for
credit card company (Visa, Mastercard, Diners Club) credits the acquirer bank.
credit card company sends the transaction to the issuing bank and automatically debits the
issuing bank debits the cardholder’s account. It issues monthly or transaction related statements
to the cardholder.
cardholder pays the issuing bank on foot of the statement (this is automatic, involuntary
debiting of the cardholders account with the bank).
Some credit card companies in some territories prefer to work directly with the cardholders. In such a case, they issue a monthly statement, which the cardholder has to pay directly to them by money order or by bank transfer. The cardholder will be required to provide a security to the credit card company and his spending limits will be tightly related to the level and quality of the security provided by him. The very issuance of the card is almost always subject to credit history and to an approval process in Europe. Unfortunately, the same cannot be said about credit card issuers in the USA. This lackadaisical vigilance, the monpolistic practices of certain credit card companies, the Kafkaesque procedures and the arbitrariness of the results - put both merchants and credit card holders at risk. Whatever it is that credit card companies provide - it is not guaranteed payment or secure refunds.
The Revolt of the Poor - The Demise of Intellectual Property
By: Dr. Sam Vaknin
Three years ago I published a book of short stories in Israel. The publishing house belongs to Israel's leading (and exceedingly wealthy) newspaper. I signed a contract which stated that I am entitled to receive 8% of the income from the sales of the book after commissions payable to distributors, shops, etc. A few months later (1997), I won the coveted Prize of the Ministry of Education (for short prose). The prize money (a few thousand DMs) was snatched by the publishing house on the legal grounds that all the money generated by the book belongs to them because they own the copyright.
In the mythology generated by capitalism to pacify the masses, the myth of intellectual property stands out. It goes like this : if the rights to intellectual property were not defined and enforced, commercial entrepreneurs would not have taken on the risks associated with publishing books, recording records, and preparing multimedia products. As a result, creative people will have suffered because they will have found no way to make their works accessible to the public. Ultimately, it is the public which pays the price of piracy, goes the refrain.
But this is factually untrue . In the USA there is a very limited group of authors who actually live by their pen. Only select musicians eke out a living from their noisy vocation (most of them rock stars who own their labels - George Michael had to fight Sony to do just that) and very few actors come close to deriving subsistence level income from their profession. All these can no longer be thought of as mostly creative people. Forced to defend their intellectual property rights and the interests of Big Money, Madonna, Michael Jackson, Schwarzenegger and Grisham are businessmen at least as much as they are artists.
Economically and rationally, we should expect that the costlier a work of art is to produce and the narrower its market - the more emphasized its intellectual property rights.
Consider a publishing house.
A book which costs 50,000 DM to produce with a potential audience of 1000 purchasers (certain academic texts are like this) - would have to be priced at a a minimum of 100 DM to recoup only the direct costs. If illegally copied (thereby shrinking the potential market as some people will prefer to buy the cheaper illegal copies) - its price would have to go up prohibitively to recoup costs, thus driving out potential buyers. The story is different if a book costs 10,000 DM to produce and is priced at 20 DM a copy with a potential readership of 1,000,000 readers. Piracy (illegal copying) should in this case be more readily tolerated as a marginal phenomenon.
This is the theory. But the facts are tellingly different. The less the cost of production (brought down by digital technologies) - the fiercer the battle against piracy. The bigger the market - the more pressure is applied to clamp down on samizdat entrepreneurs.
Governments, from China to Macedonia, are introducing intellectual property laws (under pressure from rich world countries) and enforcing them belatedly. But where one factory is closed on shore (as has been the case in mainland China) - two sprout off shore (as is the case in Hong Kong and in Bulgaria).
But this defies logic : the market today is global, the costs of production are lower (with the exception of the music and film industries), the marketing channels more numerous (half of the income of movie studios emanates from video cassette sales), the speedy recouping of the investment virtually guaranteed. Moreover, piracy thrives in very poor markets in which the population would anyhow not have paid the legal price. The illegal product is inferior to the legal copy (it comes with no literature, warranties or support). So why should the big manufacturers, publishing houses, record companies, software companies and fashion houses worry?
The answer lurks in history. Intellectual property is a relatively new notion. In the near past, no one considered knowledge or the fruits of creativity (art, design) as 'patentable', or as someone's 'property'. The artist was but a mere channel through which divine grace flowed. Texts, discoveries, inventions, works of art and music, designs - all belonged to the community and could be replicated freely. True, the chosen ones, the conduits, were honoured but were rarely financially rewarded. They were commissioned to produce their works of art and were salaried, in most cases. Only with the advent of the Industrial Revolution were the embryonic precursors of intellectual property introduced but they were still limited to industrial designs and processes, mainly as embedded in machinery. The patent was born. The more massive the market, the more sophisticated the sales and marketing techniques, the bigger the financial stakes - the larger loomed the issue of intellectual property. It spread from machinery to designs, processes, books, newspapers, any printed matter, works of art and music, films (which, at their beginning were not considered art), software, software embedded in hardware, processes, business methods, and even unto genetic material.
Intellectual property rights - despite their noble title - are less about the intellect and more about property. This is Big Money : the markets in intellectual property outweigh the total industrial production in the world. The aim is to secure a monopoly on a specific work. This is an especially grave matter in academic publishing where small- circulation magazines do not allow their content to be quoted or published even for non-commercial purposes. The monopolists of knowledge and intellectual products cannot allow competition anywhere in the world - because theirs is a world market. A pirate in Skopje is in direct competition with Bill Gates. When he sells a pirated Microsoft product - he is depriving Microsoft not only of its income, but of a client (=future income), of its monopolistic status (cheap copies can be smuggled into other markets), and of its competition-deterring image (a major monopoly preserving asset). This is a threat which Microsoft cannot tolerate. Hence its efforts to eradicate piracy - successful in China and an utter failure in legally-relaxed Russia.
But what Microsoft fails to understand is that the problem lies with its pricing policy - not with the pirates. When faced with a global marketplace, a company can adopt one of two policies: either to adjust the price of its products to a world average of purchasing power - or to use discretionary differential pricing (as pharmaceutical companies were forced to do in Brazil and South Africa). A Macedonian with an average monthly income of 160 USD clearly cannot afford to buy the Encyclopaedia Encarta Deluxe. In America, 50 USD is the income generated in 4 hours of an average job. In Macedonian terms, therefore, the Encarta is 20 times more expensive. Either the price should be lowered in the Macedonian market - or an average world price should be fixed which will reflect an average global purchasing power.
Something must be done about it not only from the economic point of view. Intellectual products are very price sensitive and highly elastic. Lower prices will be more than compensated for by a much higher sales volume. There is no other way to explain the pirate industries : evidently, at the right price a lot of people are willing to buy these products. High prices are an implicit trade-off favouring small, elite, select, rich world clientele. This raises a moral issue : are the children of Macedonia less worthy of education and access to the latest in human knowledge and creation ?
Two developments threaten the future of intellectual property rights. One is the Internet. Academics, fed up with the monopolistic practices of professional publications - already publish on the web in big numbers. I published a few book on the Internet and they can be freely downloaded by anyone who has a computer or a modem. The full text of electronic magazines, trade journals, billboards, professional publications, and thousands of books is available online. Hackers even made sites available from which it is possible to download whole software and multimedia products. It is very easy and cheap to publish on the Internet, the barriers to entry are virtually nil. Web pages are hosted free of charge, and authoring and publishing software tools are incorporated in most word processors and browser applications. As the Internet acquires more impressive sound and video capabilities it will proceed to threaten the monopoly of the record companies, the movie studios and so on.
The second development is also technological. The oft-vindicated Moore's law predicts the doubling of computer memory capacity every 18 months. But memory is only one aspect of computing power. Another is the rapid simultaneous advance on all technological fronts. Miniaturization and concurrent empowerment by software tools have made it possible for individuals to emulate much larger scale organizations successfully. A single person, sitting at home with 5000 USD worth of equipment can fully compete with the best products of the best printing houses anywhere. CD-ROMs can be written on, stamped and copied in house. A complete music studio with the latest in digital technology has been condensed to the dimensions of a single chip. This will lead to personal publishing, personal music recording, and the to the digitization of plastic art. But this is only one side of the story.
The relative advantage of the intellectual property corporation does not consist exclusively in its technological prowess. Rather it lies in its vast pool of capital, its marketing clout, market positioning, sales organization, and distribution network.
Nowadays, anyone can print a visually impressive book, using the above-mentioned cheap equipment. But in an age of information glut, it is the marketing, the media campaign, the distribution, and the sales that determine the economic outcome.
This advantage, however, is also being eroded.
First, there is a psychological shift, a reaction to the commercialization of intellect and spirit. Creative people are repelled by what they regard as an oligarchic establishment of institutionalized, lowest common denominator art and they are fighting back.
Secondly, the Internet is a huge (200 million people), truly cosmopolitan market, with its own marketing channels freely available to all. Even by default, with a minimum investment, the likelihood of being seen by surprisingly large numbers of consumers is high.
I published one book
the traditional way - and another on the Internet
. In 50 months, I have received 6500 written responses regarding my electronic book
. Well over 500,000 people read it (my Link Exchange meter registered c. 2,000,000 impressions since November 1998). It is a textbook (in psychopathology)
- and 500,000 readers is a lot for this kind of publication. I am so satisfied that I am not sure that I will ever consider a traditional publisher again. Indeed, my last book
was published in the very same way.
The demise of intellectual property has lately become abundantly clear. The old intellectual property industries are fighting tooth and nail to preserve their monopolies (patents, trademarks, copyright) and their cost advantages in manufacturing and marketing.
But they are faced with three inexorable processes which are likely to render their efforts vain:
The Newspaper Packaging
Print newspapers offer package deals of cheap content subsidized by advertising. In other words, the advertisers pay for content formation and generation and the reader has no choice but be exposed to commercial messages as he or she studies the content.
This model - adopted earlier by radio and television - rules the internet now and will rule the wireless internet in the future. Content will be made available free of all pecuniary charges. The consumer will pay by providing his personal data (demographic data, consumption patterns and preferences and so on) and by being exposed to advertising. Subscription based models are bound to fail.
Thus, content creators will benefit only by sharing in the advertising cake. They will find it increasingly difficult to implement the old models of royalties paid for access or of ownership of intellectual property.
A lot of ink has been spilt regarding this important trend. The removal of layers of brokering and intermediation - mainly on the manufacturing and marketing levels - is a historic development (though the continuation of a long term trend).
Consider music for instance. Streaming audio on the internet or downloadable MP3 files will render the CD obsolete. The internet also provides a venue for the marketing of niche products and reduces the barriers to entry previously imposed by the need to engage in costly marketing ("branding") campaigns and manufacturing activities.
This trend is also likely to restore the balance between artist and the commercial exploiters of his product. The very definition of "artist" will expand to include all creative people. One will seek to distinguish oneself, to "brand" oneself and to auction off one's services, ideas, products, designs, experience, etc. This is a return to pre-industrial times when artisans ruled the economic scene. Work stability will vanish and work mobility will increase in a landscape of shifting allegiances, head hunting, remote collaboration and similar labour market trends.
In a fragmented market with a myriad of mutually exclusive market niches, consumer preferences and marketing and sales channels - economies of scale in manufacturing and distribution are meaningless. Narrowcasting replaces broadcasting, mass customization replaces mass production, a network of shifting affiliations replaces the rigid owned-branch system. The decentralized, intrapreneurship-based corporation is a late response to these trends. The mega-corporation of the future is more likely to act as a collective of start-ups than as a homogeneous, uniform (and, to conspiracy theorists, sinister) juggernaut it once was.
Financing Transport Projects
By: Dr. Sam Vaknin
The role of government in facilitating transport projects is inevitable. But governments are monopolists and largely cannot be trusted with the efficient allocation of resources, not to mention the problem of corruption. So, the less the state is involved the better off everyone is.
Transport has gone a full circle. Until the beginning of the 17th century it was largely privately financed. The state took over until the last two decades of the twentieth century. And now there is a revival of the involvement of the private sector in financing infrastructure. Additionally, transport has become a commodity and is securitized, as we shall see.
All social (or public) goods carry social costs and bring on negative externalities (such as environmental damage). Embedded in every public good there is a moral hazard - others bear a disproportionate part of the costs while the perpetrators go "free". This is why accurate statistics, forecasting and cost benefit analysis systems are a must. I am not talking only about cost coverage calculations but also about finding ways to impose on the users of transport infrastructure the real costs of their actions. This is known today as "user pays" charging schemes. But to do so, the state needs to know what ARE these costs. This is one way of forcing the private sector to participate in the financing of infrastructure.
But we are digressing. Allow me to return to more conventional methods.
Transport infrastructure is financed today mostly by the state. Governments usually assume bilateral or multilateral debt from commercial banks, through the international bond markets - but, most often, from institutions such as the World Bank and regional development banks through the EBRD. I have already indicated my aversion to this method of financing. The money is sure to be spent either inefficiently or corruptly or both. Yet hitherto both the financial scope of most of these projects, their regional and international repercussions and the need to adhere to statal planning - inhibited most forms of alternative financing.
Recent developments in private sector financing allow for reasonable solutions to this age-old dilemma. These solutions are widely experimented with in dozens of countries, many of them poorer and less stable than Macedonia.
The most widespread and accepted private sector financing method is the Build-Operate-Transfer (BOT) system. The state grants a 15-35 years concession to a private construction and engineering consortium of firms backed by ample financial resources (the contractors). The private firms build the infrastructure project, operate it for the concession period at the end of which they transfer it to the state without compensation. All the income during the operating period goes to the contractors. If the period of concession is sufficiently long - the contractors have an interest to observe high standards of quality in order to minimize maintenance costs. The state (sometimes through "golden shares") maintains a say in certain operational aspects (such as tariffs of usage).
The BOT approach has spawned off a host of variants. There is BOO - the Build, Own and Operate (classic) version. Then there is Build, sell to a financial institution or an investor, Lease it back from the new owner and Operate (BLO). There is also BLOT - like BLO but with a transfer of the asset to the state at the end of a long, pre-determined period. The Sopang Airport in Malaysia was constructed on a Build-Sell (to a group of banks)-Lease-Operate basis.
Lately, private entrepreneurs have begun to tap the international equity and debt markets to raise financing for transport projects. A case in point is the financing of the M2 Motorway in Australia. Both shares representing ownership in the assets and bonds representing an interest in its future stream of income are sold to investors through investment banks, portfolio managers and then through the international stock and bond markets.
This approach is a remote off-shoot of MUNIS. These are municipal bonds issued by local authorities to finances specific transport infrastructure, such as a toll-way. The income from the project goes to cover the interest and principal payments of the bonds. Such bonds are issued either directly to investors and portfolio managers or through the stock exchange were they are freely traded. The interests of the investors are (supposed to be) protected by custodian banks and trustees. Most of these bonds are backed by long term letters of credit and the interest income is tax free. State Route 91, the Riverside Freeway in California, was fully financed by municipal bonds. Munis have caught on with many countries, including countries in transition.
Last but not least, private enterprises are allowed to own their own infrastructure. Firms can own a railway section and even trains ("Own Your Wagons" schemes) providing they finance them. In many countries, construction licences are conditioned on participation in infrastructure costs.
Transport infrastructure all over the world is decrepit. Maintenance is bad. Planning is absent. Corruption is rampant. The only hope is to remove as much as we can from the process of planning and constructing transport infrastructure from the hands of the state. Maybe this will even attract the billions dollars under mattresses and carpets in the informal economy.
Is Our Money Safe?
By: Sam Vaknin
Banks are institutions wherein miracles happen regularly. We rarely entrust our money to anyone but ourselves – and our banks. Despite a very chequered history of mismanagement, corruption, false promises and representations, delusions and behavioural inconsistency – banks still succeed to motivate us to give them our money. Partly it is the feeling that there is safety in numbers. The fashionable term today is “moral hazard”. The implicit guarantees of the state and of other financial institutions moves us to take risks which we would, otherwise, have avoided. Partly it is the sophistication of the banks in marketing and promoting themselves and their products. Glossy brochures, professional computer and video presentations and vast, shrine-like, real estate complexes all serve to enhance the image of the banks as the temples of the new religion of money.
But what is behind all this ? How can we judge the soundness of our banks ? In other words, how can we tell if our money is safely tucked away in a safe haven ?
The reflex is to go to the bank’s balance sheets. Banks and balance sheets have been both invented in their modern form in the 15th century. A balance sheet, coupled with other financial statements is supposed to provide us with a true and full picture of the health of the bank, its past and its long-term prospects. The surprising thing is that – despite common opinion – it does. The less surprising element is that it is rather useless unless you know how to read it.
Financial Statements (Income – aka Profit and Loss - Statement, Cash Flow Statement and Balance Sheet) come in many forms. Sometimes they conform to Western accounting standards (the Generally Accepted Accounting Principles, GAAP, or the less rigorous and more fuzzily worded International Accounting Standards, IAS). Otherwise, they conform to local accounting standards, which often leave a lot to be desired. Still, you should look for banks, which make their updated financial reports available to you. The best choice would be a bank that is audited by one of the Big Six Western accounting firms and makes its audit reports publicly available. Such audited financial statements should consolidate the financial results of the bank with the financial results of its subsidiaries or associated companies. A lot often hides in those corners of corporate ownership.
Banks are rated by independent agencies. The most famous and most reliable of the lot is Fitch-IBCA. Another one is Thomson BankWatch-BREE. These agencies assign letter and number combinations to the banks, that reflect their stability. Most agencies differentiate the short term from the long term prospects of the banking institution rated. Some of them even study (and rate) issues, such as the legality of the operations of the bank (legal rating). Ostensibly, all a concerned person has to do, therefore, is to step up to the bank manager, muster courage and ask for the bank’s rating. Unfortunately, life is more complicated than rating agencies would like us to believe. They base themselves mostly on the financial results of the bank rated, as a reliable gauge of its financial strength or financial profile. Nothing is further from the truth.
Admittedly, the financial results do contain a few important facts. But one has to look beyond the naked figures to get the real – often much less encouraging – picture.
Consider the thorny issue of exchange rates. Financial statements are calculated (sometimes stated in USD in addition to the local currency) using the exchange rate prevailing on the 31st of December of the fiscal year (to which the statements refer). In a country with a volatile domestic currency this would tend to completely distort the true picture. This is especially true if a big chunk of the activity preceded this arbitrary date. The same applies to financial statements, which were not inflation-adjusted in high inflation countries. The statements will look inflated and even reflect profits where heavy losses were incurred. “Average amounts” accounting (which makes use of average exchange rates throughout the year) is even more misleading. The only way to truly reflect reality is if the bank were to keep two sets of accounts : one in the local currency and one in USD (or in some other currency of reference). Otherwise, fictitious growth in the asset base (due to inflation or currency fluctuations) could result.
Another example : in many countries, changes in regulations can greatly effect the financial statements of a bank. In 1996, in Russia, to take an example, the Bank of Russia changed the algorithm for calculating an important banking ratio (the capital to risk weighted assets ratio). Unless a Russian bank restated its previous financial statements accordingly, a sharp change in profitability appeared from nowhere.
The net assets themselves are always misstated : the figure refers to the situation on 31/12. A 48-hour loan given to a collaborating firm can inflate the asset base on the crucial date. This misrepresentation is only mildly ameliorated by the introduction of an “average assets” calculus. Moreover, some of the assets can be interest earning and performing – others, non-performing. The maturity distribution of the assets is also of prime importance. If most of the bank’s assets can be withdrawn by its clients on a very short notice (on demand) – it can swiftly find itself in trouble with a run on its assets leading to insolvency.
Another oft-used figure is the net income of the bank. It is important to distinguish interest income from non-interest income. In an open, sophisticated credit market, the income from interest differentials should be minimal and reflect the risk plus a reasonable component of income to the bank. But in many countries (Japan, Russia) the government subsidizes banks by lending to them money cheaply (through the Central Bank or through bonds). The banks then proceed to lend the cheap funds at exorbitant rates to their customers, thus reaping enormous interest income. In many countries the income from government securities is tax free, which represents another form of subsidy. A high income from interest is a sign of weakness, not of health, here today, there tomorrow. The preferred indicator should be income from operations (fees, commissions and other charges).
There are a few key ratios to observe. A relevant question is whether the bank is accredited with international banking agencies. The latter issue regulatory capital requirements and other defined ratios. Compliance with these demands is a minimum in the absence of which, the bank should be regarded as positively dangerous.
The return on the bank’s equity (ROE) is the net income divided by its average equity. The return on the bank’s assets (ROA) is its net income divided by its average assets. The (tier 1 or total) capital divided by the bank’s risk weighted assets – a measure of the bank’s capital adequacy. Most banks follow the provisions of the Basle Convention as set by the Bank of International Settlements. This could be misleading because the Convention is ill equipped to deal with risks associated with emerging markets, where default rates of 33% and more are the norm. Finally, there is the common stock to total assets ratio. But ratios are not cure-alls. Inasmuch as the quantities that comprise them can be toyed with – they can be subject to manipulation and distortion. It is true that it is better to have high ratios than low ones. High ratios are indicative of a bank’s underlying strength of reserves and provisions and, thereby, of its ability to expand its business. A strong bank can also participate in various programs, offerings and auctions of the Central Bank or of the Ministry of Finance. The more of the bank’s earnings are retained in the bank and not distributed as profits to its shareholders – the better these ratios and the bank’s resilience to credit risks. Still, these ratios should be taken with more than a grain of salt. Not even the bank’s profit margin (the ratio of net income to total income) or its asset utilization coefficient (the ratio of income to average assets) should be relied upon. They could be the result of hidden subsidies by the government and management misjudgement or understatement of credit risks.
To elaborate on the last two points : a bank can borrow cheap money from the Central Bank (or pay low interest to its depositors and savers) and invest it in secure government bonds, earning a much higher interest income from the bonds’ coupon payments. The end result : a rise in the bank’s income and profitability due to a non-productive, non-lasting arbitrage operation. Otherwise, the bank’s management can understate the amounts of bad loans carried on the bank’s books, thus decreasing the necessary set-asides and increasing profitability. The financial statements of banks largely reflect the management's appraisal of the business. This is a poor guide to go by.
In the main financial results’ page of a bank’s books, special attention should be paid to provisions for the devaluation of securities and to the unrealized difference in the currency position. This is especially true if the bank is holding a major part of the assets (in the form of financial investments or of loans) and the equity is invested in securities or in foreign exchange denominated instruments. Separately, a bank can be trading for its own position (the Nostro), either as a market maker or as a trader. The profit (or loss) on securities trading has to be discounted because it is conjectural and incidental to the bank’s main activities : deposit taking and loan making.
Most banks deposit some of their assets with other banks. This is normally considered to be a way of spreading the risk. But in highly volatile economies with sickly, underdeveloped financial sectors, all the institutions in the sector are likely to move in tandem (a highly correlated market). Cross deposits among banks only serve to increase the risk of the depositing bank (as the recent affair with Toko Bank in Russia and the banking crisis in South Korea have demonstrated).
Further closer to the bottom line are the bank’s operating expenses : salaries, depreciation, fixed or capital assets (real estate and equipment) and administrative expenses. The rule of thumb is : the higher these expenses, the worse. The great historian Toynbee once said that great civilizations collapse immediately after they bequeath to us the most impressive buildings. This is doubly true with banks. If you see a bank fervently engaged in the construction of palatial branches – stay away from it.
All considered, banks are risk traders. They live off the mismatch between assets and liabilities. To the best of their ability, they try to second guess the markets and reduce such a mismatch by assuming part of the risks and by engaging in proper portfolio management. For this they charge fees and commissions, interest and profits – which constitute their sources of income. If any expertise is attributed to the banking system, it is risk management. Banks are supposed to adequately assess, control and minimize credit risks. They are required to implement credit rating mechanisms (credit analysis), efficient and exclusive information-gathering systems, and to put in place the right lending policies and procedures. Just in case they misread the market risks and these turned into credit risks (which happens only too often), banks are supposed to put aside amounts of money which could realistically offset loans gone sour or non-performing in the future. These are the loan loss reserves and provisions. Loans are supposed to be constantly monitored, reclassified and charges must be made against them as applicable. If you see a bank with zero reclassifications, charge off and recoveries – either the bank is lying through its teeth, or it is not taking the business of banking too seriously, or its management is no less than divine in its prescience. What is important to look at is the rate of provision for loan losses as a percentage of the loans outstanding. Then it should be compared to the percentage of non-performing loans out of the loans outstanding. If the two figures are out of kilter, either someone is pulling your leg – or the management is incompetent or lying to you. The first thing new owners of a bank do is, usually, improve the placed asset quality (a polite way of saying that they get rid of bad, non-performing loans, whether declared as such or not). They do this by classifying the loans. Most central banks in the world have in place regulations for loan classification and if acted upon, these yield rather more reliable results than any management’s “appraisal”, no matter how well intentioned. In some countries in the world, the Central Bank (or the Supervision of the Banks) forces banks to set aside provisions against loans of the highest risk categories, even if they are performing. This, by far, should be the preferable method.
Of the two sides of the balance sheet, the assets side should earn the most attention. Within it, the interest earning assets deserve the greatest dedication of time. What percentage of the loans is commercial and what percentage given to individuals ? How many lenders are there (risk diversification is inversely proportional to exposure to single borrowers) ? How many of the transactions are with “related parties” ? How much is in local currency and how much in foreign currencies (and in which) ? A large exposure to foreign currency lending is not necessarily healthy. A sharp, unexpected devaluation could move a lot of the borrowers into non-performance and default and, thus, adversely affect the quality of the asset base. In which financial vehicles and instruments is the bank invested ? How risky are they ? And so on.
No less important is the maturity structure of the assets. It is an integral part of the liquidity (risk) management of the bank. The crucial question is : what are the cash flows projected from the maturity dates of the different assets and liabilities – and how likely are they to materialize. A rough matching has to exist between the various maturities of the assets and the liabilities. The cash flows generated by the assets of the bank must be used to finance the cash flows resulting from the banks’ liabilities. A distinction has to be made between stable and hot funds (the latter in constant pursuit of higher yields). Liquidity indicators and alerts have to be set in place and calculated a few times daily. Gaps (especially in the short term category) between the bank’s assets and its liabilities are a very worrisome sign.
But the bank’s macroeconomic environment is as important to the determination of its financial health and of its creditworthiness as any ratio or micro-analysis. The state of the financial markets sometimes has a larger bearing on the bank’s soundness than other factors. A fine example is the effect that interest rates or a devaluation have on a bank’s profitability and capitalization. The implied (not to mention the explicit) support of the authorities, of other banks and of investors (domestic as well as international) sets the psychological background to any future developments. This is only too logical. In an unstable financial environment, knock-on effects are more likely. Banks deposit money with other banks on a security basis. Still, the value of securities and collaterals is as good as their liquidity and as the market itself. The very ability to do business (for instance, in the syndicated loan market) is influenced by the larger picture. Falling equity markets herald trading losses and loss of income from trading operations and so on.
Perhaps the single most important factor is the general level of interest rates in the economy. It determines the present value of foreign exchange and local currency denominated government debt. It influences the balance between realized and unrealized losses on longer-term (commercial or other) paper. One of the most important liquidity generation instruments is the repurchase agreement (repo). Banks sell their portfolios of government debt with an obligation to buy it back at a later date. If interest rates shoot up – the losses on these repos can trigger margin calls (demands to immediately pay the losses or else materialize them by buying the securities back). Margin calls are a drain on liquidity. Thus, in an environment of rising interest rates, repos could absorb liquidity from the banks, deflate rather than inflate. The same principle applies to leverage investment vehicles used by the bank to improve the returns of its securities trading operations. High interest rates here can have an even more painful outcome. As liquidity is crunched, the banks are forced to materialize their trading losses. This is bound to put added pressure on the prices of financial assets, trigger more margin calls and squeeze liquidity further. It is a vicious circle of a monstrous momentum once commenced.
But high interest rates, as we mentioned, also strain the asset side of the balance sheet by applying pressure to borrowers. The same goes for a devaluation. Liabilities connected to foreign exchange grow with a devaluation with no (immediate) corresponding increase in local prices to compensate the borrower. Market risk is thus rapidly transformed to credit risk. Borrowers default on their obligations. Loan loss provisions need to be increased, eating into the bank’s liquidity (and profitability) even further. Banks are then tempted to play with their reserve coverage levels in order to increase their reported profits and this, in turn, raises a real concern regarding the adequacy of the levels of loan loss reserves. Only an increase in the equity base can then assuage the (justified) fears of the market but such an increase can come only through foreign investment, in most cases. And foreign investment is usually a last resort, pariah, solution (see Southeast Asia and the Czech Republic for fresh examples in an endless supply of them. Japan and China are, probably, next).
In the past, the thinking was that some of the risk could be ameliorated by hedging in forward markets (=by selling it to willing risk buyers). But a hedge is only as good as the counterparty that provides it and in a market besieged by knock-on insolvencies, the comfort is dubious. In most emerging markets, for instance, there are no natural sellers of foreign exchange (companies prefer to hoard the stuff). So forwards are considered to be a variety of gambling with a default in case of substantial losses a very plausible way out.
Banks depend on lending for their survival. The lending base, in turn, depends on the quality of lending opportunities. In high-risk markets, this depends on the possibility of connected lending and on the quality of the collaterals offered by the borrowers. Whether the borrowers have qualitative collaterals to offer is a direct outcome of the liquidity of the market and on how they use the proceeds of the lending. These two elements are intimately linked with the banking system. Hence the penultimate vicious circle : where no functioning and professional banking system exists – no good borrowers will emerge.
Workaholism, Leisure and Pleasure
By: Dr. Sam Vaknin
The official working week is being reduced to 35 hours a week. In most countries in the world, it is limited to 45 hours a week. The trend during the last century seems to be unequivocal : less work, more play.
Yet, what may be true for blue collar workers or state employees – is not necessarily so for white collar members of the liberal professions. It is not rare for these people – lawyers, accountants, consultants, managers, academics – to put in 80 hour weeks. The phenomenon is so widespread and its social consequences so damaging that it acquired the unflattering nickname workaholism, a combination of the words “work” and “alcoholism”. Family life is disrupted, intellectual horizons narrow, the consequences to the workaholic’s health are severe : fat, lack of exercise, stress take their toll. Classified as “alpha” types, workaholics suffer three times as many heart attacks as their peers.
But what are the social and economic roots of this phenomenon ?
Put succinctly, it is the result of the blurring borders and differences between work and leisure. The distinction between these two types of time – the one dedicated to labour and the one spent in the pursuit of one’s interests – was so clear for thousands of years that its gradual disappearance is one of the most important and profound social changes in human history.
A host of other shifts in the character of the work and domestic environments of humans converged to produce this momentous change.
Arguably the most important was the increase in labour mobility and the fluid nature of the very concept of work and the workplace. The transitions from agricultural to industrial, then to the services and now to the information and knowledge societies, each, in turn, increased the mobility of the workforce. A farmer is the least mobile. His means of production are fixed, his produce was mostly consumed locally because of lack of proper refrigeration, preservation and transportation methods. A marginal group of people became nomad-traders. This group exploded in size with the advent of the industrial revolution. True, the bulk of the workforce was still immobile and affixed to the production floor. But raw materials and the finished products travelled long distances to faraway markets. Professional services were needed and the professional manager, the lawyer, the accountant, the consultant, the trader, the broker – all emerged as both the parasites of the production processes and the indispensable oil on its cogs.
Then came the services industry. Its protagonists were no longer geographically dependent. They rendered their services to a host of “employers” in a variety of ways and geographically spread. This trend accelerated today, at the beginning of the information and knowledge revolution. Knowledge is not locale-bound. It is easily transferable across boundaries. Its ephemeral quality gives it a-temporal and non-spatial qualities. The location of the participants in the economic interactions of this new age are geographically transparent.
These trends converged with an increase of mobility of people, goods and data (voice, visual, textual and other). The twin revolutions of transportation and of telecommunications really reduced the world to a global village. Phenomena like commuting to work and multinationals were first made possible. Facsimile messages, electronic mail, other modem data transfers, the Internet broke not only physical barriers – but also temporal ones. Today, virtual offices are not only spatially virtual – but also temporally so. This means that workers can collaborate not only across continents but also across time zones. They can leave their work for someone else to continue in an electronic mailbox, for instance.
These last technological advances precipitated the fragmentation of the very concepts of “work” and “workplace”. No longer the three Aristotelian dramatic unities. Work could be carried out in different places, not simultaneously, by workers who worked part time whenever it suited them best, Flexitime and work from home replaced commuting as the preferred venue (much moreso in the Anglo-Saxon countries, but they have always been the pioneering harbingers of change). This fitted squarely into the social fragmentation which characterizes today’s world : the disintegration of previously cohesive social structures, such as the nuclear (not to mention the extended) family. This was all neatly wrapped in the ideology of individualism which was presented as a private case of capitalism and liberalism. People were encouraged to feel and behave as distinct, autonomous units. The perception of individuals as islands replaced the former perception of humans as cells in an organism.
This trend was coupled with – and enhanced by – the unprecedented successive annual rises in productivity and increases in world trade. These trends were brought about by new management techniques, new production technology, innovative inventory control methods, automatization, robotization, plant modernization, telecommunications (which facilitates more efficient transfers of information), even new design concepts. But productivity gains made humans redundant. No amount of retraining could cope with the incredible rate of technological change. The more technologically advanced the country – the higher its structural unemployment (attributable to changes in the very structure of the market) went.
In Western Europe, it shot up from 5-6% of the workforce to 9% in one decade. One way to manage this flood of ejected humans was to cut the workweek. Another was to support a large population of unemployed. The third, more tacit, way was to legitimize leisure time. Whereas the Jewish and Protestant work ethics condemned idleness in the past – they now started encouraging people to “self fulfil”, pursue habits and non-work related interests and express the whole of their personality.
This served to blur the historical differences between work and leisure. They were both commended now by the mores of our time. Work became less and less structured and rigid – formerly, the main feature of leisure time. Work could be pursued – and to an ever growing extent, was pursued – from home. The territorial separation between “work-place” and “home turf” was essentially eliminated. The emotional leap was only a question of time. Historically, people went to work because they had to – and all the rest was designated “pleasure”. Now, both were pleasure – or torture – or mixture. Some people began to enjoy their work so much that it fulfilled for them the functions normally reserved to leisure time. They are the workaholics. Others continued to hate work – but felt disoriented in the new, leisure enriched environment. They were not qualified or trained to deal with excess time, lack of framework, no clear instructions what to do, when, with whom and to what.
Socialization processes and socialization agents (the State, parents, educators, employers) were not geared – nor did they regard it as being their responsibility – to train the populace to cope with free time and with the baffling and dazzling variety of options.
Economies and markets can be classified using many criteria. Not the least of them is the work-leisure axis. Those societies and economies that maintain the old distinction between (hated) work and (liberating) leisure – are doomed to perish or, at best, radically lag behind. This is because they will not have developed a class of workaholics big enough to move the economy ahead.
And this is the Big Lesson : it takes workaholics to create, maintain and expand capitalism. As opposed to common beliefs (held by the uninitiated) – people, mostly, do not engage in business because they are looking for money (the classic profit motive). They do what they do because they like the Game of Business, its twists and turns, the brainstorming, the battle of brains, subjugating markets, the ups and downs, the excitement. All this has nothing to do with pure money. It has everything to do with psychology. True, the meter by which success is measured in the world of money is money – but very fast it is transformed into an abstract meter, akin to the monopoly money. It is a symbol of shrewdness, wit, foresight and insight.
Workaholics identify business with pleasure. They are the embodiment of the pleasure principle. They make up the class of the entrepreneurs, the managers, the businessmen. They are the movers, the shakers, the pushers, the energy. Without them, we have socialist economies, where everything belongs to everyone and, actually to none. In these economies of “collective ownership” people go to work because they have to, they try to avoid it, to sabotage the workplace, they harbour negative feelings. Slowly, they wither and die (professionally) – because no one can live long in hatred and deceit. Joy is an essential ingredient.
And this is the true meaning of capitalism : the abolition of work and leisure and the pursuit of both with the same zeal and satisfaction. Above all, the (increasing) liberty to do it whenever, wherever, with whomever you choose. Unless and until the Homo East Europeansis changes his set of mind – there will be no real transition. Because transition happens in the human mind much before it takes form in reality. It is no use to dictate, to legislate, to finance, to cajole, to offer – the human being must change first. It was Marx (a devout non-capitalist) who said : it is consciousness that determines reality. How right was he. Witness the USA and witness the miserable failure of communism.