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IF THE deal over North Korea's nuclear-weapons programme holds, Kim Jong Il may be able to indulge his penchant for fine wines and Hollywood blockbusters again. Banks around the world had severed ties with North Korea after America last September blacklisted a Macau bank accused of doing business with the hermit kingdom, making foreign money tighter for the Great Leader. But a move towards more normal relations with America could help restore the flow.
The financial system is modern warfare's newest front. In a globalised economy money moves instantly and anonymously across borders. This can benefit terrorists, drug traffickers and rogue nations in need of cash. Keeping such customers out of the world's sprawling financial system is becoming ever harder.
Financial regulators have another big concern. Footloose capital transmits not just tainted money but financial crises too. The huge growth in the use of esoteric derivatives and the rise of hedge funds have made it increasingly difficult to understand where financial risk lies, partly because much of it is hidden away on islands with variable supervision.
But the most vexing problem that highly mobile financial flows pose for governments is that when they cross borders they may take tax revenues with them. This is particularly serious for rich Western countries with ageing populations that they will have to support in retirement. Such countries have launched a raft of initiatives to strengthen the international financial system against the undesirable side-effects of financial globalisation: financial crime, financial contagion and tax evasion. The idea is to prod financial centres worldwide to adopt international best practice on bank supervision, the collection of financial information and the enforcement of money-laundering rules.
One group has become the object of special scrutiny: offshore financial centres (OFCs). These are typically small jurisdictions, such as Macau, Bermuda, Liechtenstein or Guernsey, that make their living mainly by attracting overseas financial capital. What they offer foreign businesses and well-heeled individuals is low or no taxes, political stability, business-friendly regulation and laws, and above all discretion. Big, rich countries see OFCs as the weak link in the global financial chain.
In the past OFCs have indeed permitted various dodgy doings. Critics think their dependence on foreign capital encourages them to turn a blind eye to crime and corporate fraud within their borders. Sani Abacha of Nigeria, Mohammed Suharto of Indonesia and Ferdinand Marcos of the Philippines are just a few of the corrupt leaders who have looted their countries, helped by the secrecy offered not just by certain tax havens but also by some onshore financial centres, a point often ignored by the OFCs' critics. Some of the money used for the terrorist attacks of September 11th 2001 was funnelled through Dubai, which has recently set itself up as a financial centre. The accounting scams at Enron, Parmalat and Tyco were made easier by complicated financial structures based in OFCs (though, again, also in onshore centres such as Delaware).
But the most obvious use of OFCs is to avoid taxes. Many successful offshore jurisdictions keep on the right side of the law, and many of the world's richest people and its biggest and most reputable companies use them quite legally to minimise their tax liability. But the onshore world takes a hostile view of them. Offshore tax havens have “declared economic war on honest US taxpayers”, says Carl Levin, an American senator. He points to a study suggesting that America loses up to $70 billion a year to tax havens.
The Tax Justice Network, a not-for-profit group that is harshly critical of OFCs, reckons that global tax revenues lost to OFCs exceed $255 billion a year, although not everybody believes it. Canadians were alarmed by a government report showing that Canadian direct investment in OFCs increased eightfold between 1990 and 2003, to C$88 billion ($75 billion)—a fifth of all Canadian direct investment abroad. The bulk of this was in financial services, mostly in a few Caribbean countries.
Business in OFCs is booming, and as a group these jurisdictions no longer sit at the fringes of the global economy. Offshore holdings now run to $5 trillion-7 trillion, five times as much as two decades ago, and make up perhaps 6-8% of worldwide wealth under management, according to Jeffrey Owens, head of fiscal affairs at the OECD. Cayman, a trio of islands in the Caribbean, is the world's fifth-largest banking centre, with $1.4 trillion in assets. The British Virgin Islands (BVI) are home to almost 700,000 offshore companies.
All this has been very good for the OFCs' economies. Between 1982 and 2003 they grew at an annual average rate per person of 2.8%, over twice as fast as the world as a whole (1.2%), according to a study by James Hines of the University of Michigan. Individual OFCs have done even better. Bermuda is the richest country in the world, with a GDP per person estimated at almost $70,000, compared with $43,500 for America (see chart 1). On average, the citizens of Cayman, Jersey, Guernsey and the BVI are richer than those in most of Europe, Canada and Japan. This has encouraged other countries with small domestic markets to set up financial centres of their own to pull in offshore money—most spectacularly Dubai but also Kuwait, Saudi Arabia, Shanghai and even Sudan's Khartoum, not so far from war-ravaged Darfur.
Globalisation has vastly increased the opportunities for such business. As companies become ever more multinational, they find it easier to shift their activities and profits across borders and into OFCs. As the well-to-do lead increasingly peripatetic lives, with jobs far from home, mansions scattered across continents and investments around the world, they can keep and manage their wealth anywhere. Financial liberalisation—the elimination of capital controls and the like—has made all of this easier. So has the internet, which allows money to be shifted around the world quickly, cheaply and anonymously.
The growth in global financial services has helped too. Financial services are in essence the business of managing data. “It is zeros and ones,” says Urs Rohner, the chief operating officer of Credit Suisse, a Swiss bank, adding that “in no other industry do you see the impact of globalisation as enormously and dramatically as in finance.” This is because these zeros and ones can be traded, structured, lent and sold anywhere. Profits can be booked almost anywhere, too, and are increasingly being shifted toOFCs.
The growing importance of the financial-services industry in many economies means that a greater chunk of profits—and tax liabilities—are easily moved offshore. A paper published last year by Alan Auerbach of the University of California at Berkeley found that whereas in 1983 financial corporations accounted for only about 5% of all corporate-tax revenues in America, between 1991 and 2003 they made up roughly a quarter.
The taxman also has to worry about non-financial companies that are acting like financial ones. The main profit engine for General Electric, a large American conglomerate that makes everything from jet engines to plastics, is its finance division. Non-financial companies run pension funds and stock-option plans for their employees across the world, manage their corporate treasuries in myriad currencies and increasingly employ esoteric financial products such as derivatives to hedge risks and raise money. All of these activities can be set up inOFCs and often are, supported by an army of lawyers, accountants and investment bankers.
Parasites or pioneers?
OFCs are often portrayed as financial parasites that survive by diverting tax and other revenues from “real” economies, offering a haven for tax cheats and money-launderers. Some of this undoubtedly goes on—but it goes on in big onshore economies as well.
Businessmen and wealthy individuals insist that OFCs can play a legitimate role in reducing tax liabilities. The business community in particular argues that in a fiercely competitive global economy where national tax regimes can vary widely, minimising tax payments is a competitive necessity and OFCs are one solution. OFCs themselves insist that they are specialist financial centres and have far more to offer than just low taxes.
The main argument against OFCs is that by allowing companies and affluent individuals to avoid taxes, they sap tax revenues from “real” countries, limiting those countries' ability to pay for public services and forcing them to tax less mobile factors such as labour, housing and consumption. The big risk is that “globalisation is perceived to be rigged against the average citizen,” says David Rosenbloom, formerly the international tax counsel at the Treasury Department in America.
Critics also worry that OFCs do not supervise business within their borders tightly enough, which gives crooks an opportunity to enter the global financial system and could allow sloppy practices that might spark wider financial crises. Certainly, as many OFCs themselves will admit, only a couple of decades ago regulation in many offshore jurisdictions left much to be desired and bad money found its way in with the good. OFCs argue that this has changed and their supervision is now at least as good as onshore, sometimes better.
Libertarians say that tax, regulatory and other competition is healthy because it keeps bigger countries' governments from getting bloated. Others argue that OFCs may be an inevitable concomitant of globalisation. “Even if today's OFCs were somehow stamped out, something like them would pop up to take their place,” says Mihir Desai of Harvard Business School. Some academics have found signs that OFCs have unplanned positive effects, spurring growth and competitiveness in nearby onshore economies.
Should anything be done about OFCs? Countries try to discourage investment in tax havens through the tax code and pour resources into tracking down tax cheats. But this is a Sisyphean task—close one regulatory loophole and lawyers will open another; convince one OFC to co-operate in the fight against tax evasion or financial crime and another will take its place.
International organisations have launched various initiatives to try to get OFCs to tighten supervision, co-operate more with foreign governments to catch tax cheats and, at least in Europe, eliminate “harmful” tax practices. OFCs think such initiatives are designed to force them out of business. The countries that set these standards “are an oligopoly trying to keep out smaller competitors. They are both players and referees in the game. How can they be objective?”, asks Richard Hay, a lawyer in Britain who represents OFCs.
What is clear is that globalisation has changed the rules of the game. It has produced many benefits for rich countries, but has also provided more opportunities for tax leakage, which explains their anxiety over OFCs.
OFCs, for their part, have by and large done well out of globalisation. Two decades ago, they were mainly passive repositories of the cash of large companies, rich individuals and rogues. Some jurisdictions still ply this trade today and should be put out of business. But the best of them—for example, Jersey and Bermuda—have become sophisticated, well-run financial centres in their own right, with expertise in certain niches such as insurance or structured finance.
This special report will argue that although international initiatives aimed at reducing financial crime are welcome, the broader concern over OFCs is overblown. Well-run jurisdictions of all sorts, whether nominally on- or offshore, are good for the global financial system.
SOUTH of the great bend of the Yellow River a newly built four-lane expressway cuts through the scrub-covered semi-desert of the Ordos plateau. It is a bleak landscape. Overgrazing, intensive farming and the ravages of mining have taken their toll. Legend has it that Genghis Khan stopped to admire the area's lush grasslands and herds of deer as he and his warriors passed through on a mission of conquest eight centuries ago. If today he were to follow the signs to his mausoleum, just off the motorway, he would not be so impressed.
Members of a Mongolian tribe said to have been appointed by Genghis to take on the hereditary task of guarding his mementoes are certainly not pleased with what is happening on their ancestral land near Highway 210. The few hundred Darkhats, as they are known, are among some 4m Mongols living in Inner Mongolia, a province of China. The Mongols are vastly outnumbered by ethnic Han Chinese who, encouraged by the communist leadership, have migrated to Inner Mongolia in recent decades to work in factories and turn pastureland into farms. The Darkhats are happy enough that the new motorway brings more free-spending tourists to the mausoleum. What they resent is that much of their land has now been appropriated by the local government for the development of a Genghis Khan theme park next to it. To add insult to injury, they say, a Han Chinese businessman is running it.
China's economic boom is spreading wealth into parts of the country that until a few years ago were impoverished backwaters. Thanks to soaring demand for its natural resources, Inner Mongolia is notching up faster economic growth than any other region of China: nearly 22% in 2005 (albeit from a low base). The rush to exploit coal and natural gas reserves around Ordos City, about 60km (40 miles) north of the mausoleum, is turning it into a boomtown of lavish hotels and restaurants and grandiose new government buildings.
Where there is money in China, theme parks are often quick to follow. The Genghis Khan theme park is run by the Donglian Group, a privately owned conglomerate of construction, property and education businesses based in Ordos City. With the help of the city government it acquired 80 sq km (31 square miles) of land for its project. On this it has built a luxury hotel, including a vast banqueting hall in the shape of a round Mongolian felt tent, or ger, where visitors can watch a song-and-dance re-enactment of Genghis's life over a meal. The theme park itself includes what is described as the world's largest Genghis Khan museum (though with pitifully few exhibits), surrounded by hundreds of giant cast-iron figures of warriors on horseback and their camp-followers.
Local Darkhats complain they have been ill-compensated for the loss of their land. They are particularly incensed by tourists being diverted to the theme park, which obscures the mausoleum in a separate enclosure behind it. Many Darkhats earn their money as mausoleum guards or selling horse rides or trinkets to tourists. They say a road built by the Donglian Group linking up the two sites has covered a sacred spot where the mausoleum once stood before the communist government built a much grander one on the present site in 1956.
Across the border in Mongolia, the plight of the Darkhats is being noted. Mongolia itself was ruled by China for some 200 years until the early 20th century. After declaring its independence in 1921 it fell under the control of the Soviet Union. But despite the brutal purges that followed, Mongolians often quip that the Soviets' grip at least helped them preserve their independence from China and avoid the fate of Chinese-ruled Inner Mongolia or Tibet. Now, with the Soviets gone, many Mongolians watch China's growing economic might with concern. Though China brings badly needed money to their tattered economy, some are beginning to fear that Mongolia might eventually go the way of Inner Mongolia, the only difference being that instead of swallowing Mongolia, China will in effect rule it by controlling its economy.
The symbol of stirring nationalism in Mongolia is Genghis Khan. This year the impoverished country has poured millions of dollars into celebrating the 800th anniversary of Genghis's unification of the Mongol tribes into a single state which became the biggest empire the world has ever known, stretching from Beijing to the Balkans. Under the Soviets, commemoration of Genghis was taboo because it reminded Russians of the humiliation of living under the Mongol yoke. But now the government, led by Mongolia's former communist party, is sponsoring a cult of Genghis, elevating him to the near-divine.
From cigarette packets and vodka bottles to bank notes and the capital's recently named Chinggis Khaan (the usual spelling of his name in Mongolia) Airport, Genghis's benign-looking image is everywhere. An equestrian statue of him is being constructed in front of the parliament building in central Ulan Bator. His face in chalk looks down on the city from a hillside. He is rarely portrayed as the bloodthirsty slaughterer of Western imagination. Genghis, say Mongolians, was a bringer of peace who encouraged trade and the flow of wealth, technology and ideas across vastly different cultures. Indeed, he all but invented globalisation.
In a country of only 2.7m people scattered over an area four times the size of Germany, national heroes are few and far between. This makes it all the more galling that Genghis is claimed by China too. Unlike the Russians, the Chinese have got round their subjugation by the Mongols by insisting he was one of their own. Genghis's grandson, Kublai Khan, founded China's Yuan dynasty in the 13th century. That, in China's view, makes Genghis himself an honorary Chinese emperor. China's Mongols are one of the country's 56 officially recognised ethnic groups, which in theory at least makes them just as Chinese as the ethnic Hans who constitute 93% of the population.
Don't mention the bloody conquests
China has been feeling a little uneasy about Mongolia's anniversary celebrations. If Genghis Khan's bloody conquests have been somewhat sanitised for public consumption in Mongolia itself, they have been all but eradicated from Chinese histories. He is glorified for uniting China, but his armies' forays as far as the Rhine and his butchery of Muslims are never mentioned. The Chinese government worries that recalling such episodes might reinforce Western fears of a resurgent China and its military potential and undermine its cosy relations with the Islamic world.
For all China's professed admiration of Genghis, little official attention has been paid to this year's anniversary. Zhu Yaoting, a Beijing academic who wrote a biography of Genghis published in 2004, says his book was the first popular history in communist China to provide more than cursory details of Genghis's Western expeditions. But a screenplay he wrote for a television series about Genghis's life had trouble getting past the censors. The 30-episode production, which cost nearly $10m to make in 2001, was not cleared for broadcast on state television until three years later. The censors insisted on substantial cuts to avoid references to conquered regions with which modern countries might associate themselves. In Mongolia, however, an uncut Mongolian-language version of the series played this year to an enthusiastic audience.
With the approach of the Genghis Khan anniversary “deep historical animosities” were being exposed
In the city of Darkhan, a grim place next to Mongolia's north-south railway line some 220km north of Ulan Bator, a golden bust of Genghis peers from a cabinet in the quiet office of the deputy director of the Darkhan Metallurgical Plant. Things in Mongolia's only steel plant get busier at night-time when more power is available and the plant operates at full tilt. And if the deputy director's dreams come true, they should get much busier still when the plant starts making steel from iron ore instead of diminishing piles of rusting Soviet-era scrap.
Darkhan has been a battleground for the nationalists, who fret that foreigners are taking control of the country's mineral wealth and shipping it out of the country with little benefit to Mongolians themselves. In recent years multinationals have poured into Mongolia to extract everything from coal to gold, copper and iron ore. The mining business accounts for most of the country's reasonably healthy-looking annual growth rate of 6-7% in the past three years. The streets of Ulan Bator, desolate at the time when communism collapsed 15 years ago, are now clogged with cars, including many luxury four-wheel drives. A large settlement of squalid shanties and gers has sprung up on the city's edge as former herders flock to Ulan Bator in search of a share in this prosperity.
Worryingly for the nationalists, it is largely demand from China that is fuelling this boom. The Russian, Canadian, Australian and American companies digging up minerals in Mongolia see profits to be made not in their own markets but from selling to the Chinese. In April this year hundreds of nationalists staged a series of protests in Ulan Bator against the planned exploitation of large copper and gold deposits by Ivanhoe Mines, a Canadian company. The demonstrators attacked what they saw as foreign domination of Mongolia's resources.
To the horror of the multinationals, the government capitulated. A windfall tax was imposed in May on profits from gold and copper extraction when prices reach specified levels. Under a hastily introduced new law the government is entitled to own 34% of privately discovered deposits of “strategic” minerals (a vaguely defined term).
Whose ore is it?
Chinese companies are not yet big direct investors in Mongolia's mining business. Among the largest confirmed Chinese investments is a 51% stake in a zinc mine in south-eastern Mongolia, valued at $38m in 2004. But their interest is growing fast. Deep in the rolling hills north of Darkhan is a potentially much bigger project (though still much smaller than Ivanhoe's). At the Tumurtei iron-ore deposit, Chinese workers have been digging out rock and sending it to China in dozens of trucks a day for the past couple of years, say locals; mainly to Baogang, China's largest iron and steel company.
Tumurtei is thought to be one of Mongolia's biggest iron-ore deposits. But to the consternation of nationalist politicians, the state in the late 1990s granted exploitation rights to a consortium of Mongolian and Chinese companies, assisted by a $12.5m preferential loan from the Chinese government. Your correspondent was forbidden access to the mine. But a Chinese manager at the remote site says the Chinese employees get on well with the locals, despite language difficulties. “Mongolia used to be part of China, so they think a bit like us,” he says.
There has hardly been a meeting of minds on the Tumurtei deposit. Activists in Darkhan alleged the mining licence had been sold to the Chinese-Mongolian consortium illegally by an official at the metallurgical plant that had originally owned the exploitation rights. They accused the consortium of harming Mongolia's processing industry by sending the ore to China for refining. But then Mongolia has no facilities for processing iron ore. However, Darkhan's state-owned steel plant was trying to attract investment for a $1 billion upgrade to allow it to handle ore and end its dependence on dwindling scrap.
The Chinese had seen the trouble coming. An article on the Chinese commerce ministry's website—subsequently removed—noted that with the approach of the Genghis Khan anniversary “deep historical animosities” were being exposed. The potential fallout for the iron-ore mine was “not to be underestimated”. In late August, the Mongolian government agreed that the mining licence had been sold illegally and declared it owned the deposit. But it lacks the money to explore and exploit its minerals by itself.
The Mongolian government has already suffered the downsides of economic nationalism. By law, all gold output is supposed to be sold to the Bank of Mongolia, the central bank. This year the amount sold has fallen by half even though production has continued to rise, says the central bank's former governor, Ochirbat Chuluunbat. He blames a windfall tax that has encouraged small producers to sell gold on the black market rather than to the bank. Most black-market gold is smuggled across the 4,677km border with China. Taxes have also done little for Mongolia's cashmere industry, once one of the country's biggest export earners, which has been severely damaged by cheaper competition from China.
Nationalists may worry about China, but it helps to keep many Mongolians in work. South of Darkhan some of the country's many thousands of unlicensed prospectors tunnel for gold (for sale through black-market middlemen to China) in the hills. They are called ninja miners, after the green plastic bowls they carry on their backs in which they sift crushed rock for specks of the metal. Dozens of them live in gers next to the narrow shafts they have dug deep into the hillside. They stoically deny that anyone has been hurt while digging, or that anyone has fallen sick from the mercury-laden chemicals used to separate gold from ore in a makeshift processor nearby. But the Mongolian media report frequent deaths and injuries, suggesting that this is dangerous work. Still, even Mr Chuluunbat says the government “should be thankful” for the employment created by the ninja mining. Despite its various drawbacks, trying to ban it would be “a very bad solution”.
Close to the Tumurtei iron mine, some locals complain that the facility has provided few job opportunities. Just as Ulan Bator's construction boom has provided employment for many labourers from China (who are said to be less costly and more disciplined than Mongolians), many of the workers in the mine are Chinese. But in the county capital, Huder, residents are grateful for any jobs available. Communist-era buildings that used to house workers at an animal-feed factory, now abandoned, lie ruined and gutted. A Chinese entrepreneur who last year set up a small factory in Huder to turn the local birch trees into chopsticks (for export via China to Japan) provides welcome employment. The county chief says he is sad about the loss of the trees for the chopsticks, but they may get a reprieve. The businessman, Lan Taochang, says making a profit in Mongolia is so tough that he may pull out soon.
For all Mongolia's nationalism, the government remains acutely aware of the dangers of upsetting its powerful southern neighbour. Officials studiously avoid criticism of China, which provides vital port facilities for Mongolia's exports.
This year Mongolia allowed the Dalai Lama to visit for the first time in four years. (Mongolia's main religion before the Soviet-backed government all but stamped it out was Tibetan Buddhism, which is now making a tentative recovery.) But in deference to the feelings of the Chinese government, which objects to any overseas trips by the Dalai Lama, the invitation was issued by Ulan Bator's main Buddhist monastery, and news of the impending visit was kept secret until shortly before the eminent guest arrived.
Genghis, say Mongolians, all but invented globalisation
In order to avoid falling under the sway of either Russia or, particularly, China, Mongolia pursues what it calls a “third neighbour” policy. This involves remaining on good terms with its giant neighbours but also reaching out to countries such as America and Japan (Mongolia's biggest aid donor). America has been delighted by Mongolia's support for its military operations in Iraq, including the dispatch of some 200 support troops. This is the first time Mongolian troops have been stationed in Iraq since Genghis's grandson, Hulagu, conquered Baghdad.
That engagement, too, has provided some Mongolians with a frisson of national pride. A Mongolian general, given warning by an American counterpart of the dangers of operating in Baghdad, is said to have quipped: “I know. We've been here before.” When it comes to their country's relations with a resurgent China, however, Mongolians have no interest in seeing history repeated.
THERE is nothing new about companies wanting to secure the best talent. The East India Company, founded in 1600, used competitive examinations to recruit alpha minds. The company's employees included James and John Stuart Mill, two of Britain's greatest intellectuals, and Thomas Love Peacock, one of its wittier writers. General Electric (GE) carefully ranks its employees, with the best groomed for leading positions and the weakest eased out. In the mid-1950s it launched its corporate university at Crotonville near New York, often dubbed Harvard-on-the-Hudson. Jack Welch, the company's legendary boss, spent half his time on “people development” and visited Crotonville every two weeks. As for investment banks and consultancies, they have to be obsessive about talent: what else are they selling?
But now something new is in the air. Thanks to a hyper-competitive labour market, professional-service firms have become more preoccupied with talent than ever; and even companies in more mundane businesses have begun to think that they cannot manage without it.
The 1990s were a time of galloping growth for professional-service firms. Jay Lorsch, of Harvard Business School, and Thomas Tierney, head of the Bridgespan Group, have produced some striking figures, showing that global revenue across the industry leapt from $390 billion in 1990 to $911 billion in 2000. Companies became both much bigger and much more global: by 2000 PricewaterhouseCoopers had over 9,000 partners, and McKinsey had 81 offices worldwide. There was a frenzy of mergers and acquisitions: America alone saw 7,638 of them in 1995-2000, worth a total of $471 billion. And lots of newcomers entered the market in the 1990s—2,300 advertising firms, 2,600 accounting firms and nearly 50,000 freelance consultants. This rapid growth faltered a bit when the dotcom bubble burst, but is now resuming.
Headlong expansion has created serious problems for professional-service firms. They have to work harder to woo potential recruits, particularly potential stars, not just from each other but also from high-tech companies. And they have to turn their recruits into company men in double-quick time. This has led them to pay even more attention to talent.
Goldman Sachs, for example, underwent a wide-ranging internal review in 1999, complete with benchmarking against industry leaders. It increased its emphasis on formal training, setting up a Goldman Sachs University, and encouraged senior partners to put more effort into developing talent. McKinsey's People Committee has spent the past two years fine-tuning its talent machine. It has boosted its training budget to $100m, diversified its sources of recruitment and rejigged its internal organisation to appeal to well-qualified young people.
The triumph of the HR department
Managing talent has become more important to a much wider range of companies than it used to be. One result has been that human-resources departments, which used to be quiet backwaters, have gained in status. A survey by Aon, a consultancy, identified 172 HRexecutives who were among the five best-paid managers in their companies. That would have been unheard of a few years ago. The biggest earners among them worked for some surprising companies, such as Black & Decker, Home Depot, Pulte Homes, Viacom and Timberland. Companies are also trying to give their people-managers better tools. The Yankee Group estimates that last year over 2,300 companies worldwide adopted some form of talent-management technology and predicts that the market for such technology will nearly double by 2009.
Talent-intensive companies have provided both a model and a training school for the corporate world. GE is America's CEO factory: when Mr Welch chose Jeffrey Immelt to succeed him in 2001, two of his disappointed rivals, Bob Nardelli and Jim McNerney, were immediately snapped up by Home Depot and 3M respectively. It is also an inspiration: there are now 1,600 corporate universities loosely modelled on Crotonville. Consultancies and investment banks have become finishing schools for future corporate leaders: Lou Gerstner at IBM, Ken Chenault at American Express, Meg Whitman at eBay and Chuck Conaway at K-Mart all started out in consultancies (as do 65% of the products of top business schools).
Capital One, a credit-card company, shows what a difference the application of talent can make to a sleepy market. The company's headquarters, in McLean, Virginia, looks more like a consultancy than a bank. The atmosphere is informal. The staff is young and “data-centric”. The formula seems to work: founded in 1995, Capital One is now number four in the American credit-card market. Last year it doubled its number of employees to 20,000.
The company's success is due to the deployment of lots of brainpower in a business generally seen as unexciting. The founders, Rich Fairbank and Nigel Morris, were both products of MBAprogrammes and consultancies. They decided that they could use mass customisation to compete with financial giants such as American Express, recruited a high-powered team of former consultants and used sophisticated statistical techniques to slice the credit-card market into tiny segments.
Companies are now beginning to gain insights into managing talent that should allow them to tackle the problem in a more organised way. The first rule is to think more carefully about their critical talent. Deloitte, a consultancy, offers a useful example of how UPS reduced the turnover rate among the people who drive its trucks and deliver its packages. Big Brown had found that even though it selected its drivers with great care, turnover was uncomfortably high, mainly because drivers hated the back-breaking work of loading the trucks in the morning. So the company contracted out this job to part-timers who are much easier to find than drivers.
Second, it is essential to plan ahead. EDS, a giant technology company, has built a global skills inventory of its 100,000-strong workforce. The company compared the workforce's current skills with its future needs and set about filling the gaps by encouraging workers to acquire the relevant skills. Schlumberger, a Franco-American oil-services group, is preparing for an expected skills shortage in the next few years by asking its managers to cultivate successors, and holding rigorous inquests when a high-flyer jumps ship.
Third, companies need to be more imaginative about recruiting and retaining talent. That includes paying more attention to “passive candidates”—those who are not actively looking for a job but might be open to seduction (see chart 2). Popular techniques include going through lists of people attending conferences in order to buttonhole stars, buying information about competing firms (including names of key workers) and searching the web for people who have created new patents.
High attrition rates in the first few months have also persuaded companies to pay more attention to keeping new recruits on board. In the late 1990s American Express found that far too many of its new managers were leaving within the first two years. It now gives them a chance to work on projects that are overseen by the CEO, as well as providing them with “assimilation coaches”. Companies are also cultivating relations with former alumni. Ernst & Young, a consultancy, fills about a quarter of its vacancies from this source.
The fourth rule is to create internal markets for talent. Many HR departments instinctively look outside. Deloitte calculates that the typical American company spends nearly 50 times more to recruit a professional on $100,000 than it spends on his or her further training every year. Moreover, new recruits can take more than a year to learn a job. One solution is to establish an internal market, encouraging workers to apply for jobs across the company. Schlumberger encourages its employees to post detailed CVs on the company intranet; McKinsey allows consultants from all over the world to apply for any project within the company.
One difficulty with implementing these ideas is that there is no consensus about who is responsible for managing talent. If the CEO is in charge, he may well be distracted by too many other responsibilities; if it is the head of HR, he may lack the institutional heft to get much done.
Nor, indeed, is there a consensus on the best way to manage talent. Part of the problem is that HR as a discipline has not achieved anything like the level of sophistication of, say, finance. But more importantly, the more valuable the talent, the more difficult it is to manage. In business, as everywhere else, world-class talent sometimes comes in unexpected guises. Ray Kroc sold milkshake machines to restaurants before starting to build McDonald's at the age of 52. David Ogilvy was a chef, a farmer and a spy before becoming an advertising genius.
And solutions that have proved successful in one place do not necessarily work in another. On arriving at Home Depot in 2000, Mr Nardelli was determined to apply the lessons he had learned at GE to reinvigorate the DIY giant. He appointed a colleague from GE, Dennis Donovan, to run the HR side, and boosted his credentials by paying him the second-highest salary in the company. He replaced the company's ad hoc talent-management system with a much more formal one, creating a leadership development institute, employing more human-resource managers and imposing an elaborate system of performance measurement. But the results have been mixed. Home Depot's share price is now somewhat lower than it was when Mr Nardelli took over. Wal-Mart and Lowe's are providing stiff competition. And there is widespread disgruntlement about Mr Nardelli's giant pay package. Demoralised employees have taken to calling the company “Home Despot”.
Still, Mr Nardelli's record is unlikely to discourage other companies from trying to find ways to get on top of the problem. They are motivated by a powerful combination of fear and hope: fear of talent shortages and hope that they can be turned into a source of competitive advantage. Those hopes often involve shopping for talent in the developing world.
FOR a society so given to miniaturism, Japan is powerfully attached to gigantism in banking. In a study of the banking crisis and economic slump that gutted Japan in the 1990s, Akihiro Kanaya and David Woo, economists with the International Monetary Fund, say that part of the cause was the “persistent focus of banks on market share”. The banks pursued growth for growth's sake, making new loans at the peak of property and stockmarket bubbles in 1989-90 when that meant taking on riskier and riskier customers at lower and lower margins.
When those loans went bad, the weakest banks collapsed, but only after they had made another lot of bad loans in the hope of growing their way out of trouble, postponing a banking recovery by another half-decade. From a high point in 1986, when they accounted for a quarter of the Japanese stockmarket's capitalisation, to a low point in 2003, when they spoke for less than 3% of it, the banks have had a gruelling ride. Their lending contracted by one-third, and familiar names disappeared in a wave of mergers and bail-outs. Eleven of the country's biggest commercial and development banks, some of them among the largest in the world, consolidated into three “megabanks”.
Industrial Bank of Japan, Dai-Ichi Kangyo Bank and Fuji Bank were among the big names subsumed into Mizuho in 2000; Sumitomo Bank and Sakura Bank fused into Sumitomo Mitsui in 2001; and in January this year Bank of Tokyo-Mitsubishi and UFJ, both the product of earlier mergers, completed a merger which once again gave Japan the biggest bank in the world by total assets: Mitsubishi-UFJ Financial Group, or MUFG, with a balance-sheet total of $1.7 trillion, slightly more than that of America's Citigroup.
That has made MUFG cock of the walk, ahead of Mizuho with $1.46 trillion in total assets and Sumitomo Mitsui Financial Group with $900 billion. These banks are even bigger than the biggest banks of the pre-crisis days. But are they any better?
The stockmarket certainly seems pretty keen on them. Bank shares have multiplied in value since the low point struck three years ago. But the big banks' profitability remains low by international standards, and their strategic direction is unclear. They are run by a generation of managers who got where they are today by managing shrinkage, not growth.
Not only do the banks have to grow again, they have to grow in new directions if they want to boost their profits to international standards. They now have to do well as retail banks, a line of business in which they have been relatively weak but which is the least volatile and most profitable area of banking in most rich countries. Whereas HSBC gets more than 60% of its profits from retail banking and Citigroup more than 70%, the figure for Mizuho is about 42%, for SMFG 15% and for MUFG 16%, says Naoko Nemoto, an analyst with Standard & Poor's.
The blockage in Japan looks like one of supply, not demand. David Atkinson, an analyst with Goldman Sachs in Tokyo, calculates that the big banks have only 2,700 branches between them in the whole of Japan. One carmaker alone, Toyota, has almost twice as many dealerships. Divide the sales staff of Japan's major banks by the customer base, says Mr Atkinson, and there are only enough staff for at most 55 minutes of personal contact with each customer each year, allowing for about two transactions of modest complexity. By contrast, the average customer of an American retail bank expects to conduct two or three branch transactions per month.
Newer, nimbler banks have been seizing the opportunity. They include Shinsei Bank, re-born from the Long Term Credit Bank of Japan, which collapsed in 1998 and was bought two years later by foreign investors. Its retail banking business has attracted 1.6m customers from a standing start in 2001. A survey by the Nihon Keizai Shimbun newspaper ranked Shinsei the best bank in Japan for customer service last year, followed by Sony Bank, an internet bank launched by the Sony group five years ago.
The biggest network of them all
The big Japanese banks had even less incentive to develop retail networks while the state-owned post office savings bank offered a cheap alternative. But the savings bank, by some measures the biggest financial institution in the world, is now due to be privatised. Its long-term future is not yet clear (see article). It scarcely matters, however, whether Japan's big banks expect the privatised postal savings bank to be a Godzilla-sized competitor in 12 years' time, or whether they foresee its dwindling from a major to a minor competitor. Either possibility ought to be focusing their minds on the need to strengthen their own retail business. So too should the prospect of rising short-term interest rates, after years of zero rates. Even allowing for a rise in deposit rates as well, banks should be able to get a better return from loans than they have been doing in recent years.
There are signs that the big Japanese banks have indeed been looking ahead to such things. Moving, as often, in convoy, they have been buying into finance companies which operate credit cards and which lend money at high interest rates to people with poor credit histories. This may yield some short-term profits, but the banks would be eccentric to put too much long-term emphasis on this limited market when they have so many better-heeled customers of their own to whom they could be selling loans. Very probably they have that in mind, and they are buying finance companies to help them understand better how the process works. Fine, though they might acquire the same knowledge more cheaply by hiring a consulting firm or buying a book.
Building up a branch network can be an expensive and time-consuming process. Mr Atkinson thinks that in the long term MUFG could reasonably aim for 1,500 branches, or two-thirds more than it has at present. It sounds a lot, but what other option does MUFG have? It has huge assets but relatively low profits. If it wants to be valued in the stockmarket at anything like the size of its global rivals, retail expansion is the only large-scale option readily available to it, and to its rivals too.
And perhaps then, with more proven retail expertise at home, Japanese banks will become a touch more visible abroad, where after the retrenchment of the past decade they are at present hardly visible at all. Which is not to say they are entirely absent, but that their business is mainly in financing Japanese investments and Japan-related trade. As India's economy boomed last year, lending there by Japanese banks tripled to $4.3 billion. But China in particular must present a frustrating spectacle. Its banking system has opened to foreign investment, the potential is immense, Western banks are piling in—yet Japanese banks are standing on the sidelines.
The timing has been bad for them, because they mostly still need to repay money which the government lent them during the banking crisis. Until they have finished doing that, they can hardly start throwing money around elsewhere. The politics are touchy, too. Japan's pre-1945 empire casts a long shadow. Relations with China have become more fractious during Junichiro Koizumi's term as prime minister, partly because his visits to the Yasukuni war shrine in Tokyo have caused angry protests in China, and partly because Japan is seen as an ally of China's great new rival, America.
Even if the political climate improves and when Japan's banks have paid off the government, they need to have a banking model worth exporting, whether to China or anywhere else. Such things can be built from unlikely beginnings. Think how useless British banks were at retail in the 1960s, and how much better they are now. Japan has formidable traditions of mass production and of personal service. Put them together, and a great retail banking system could be built on that foundation—equal to the corporate banking system of which the Japanese were justly proud for most of the 20th century.
“WE ARE facing our own extinction,” the 14th Dalai Lama, spiritual leader of the Tibetan people, warns an audience of 450 of his compatriots, before cheering them up with his habitual, chuckling, hopefulness. Most of the listeners have newly arrived in his seat in exile in Dharamsala in northern India, on the other side of the Himalayas from his homeland. Almost ever since he fled Tibet with some 80,000 followers, after China put down an uprising in 1959, he has been worrying about the threat to the existence of Tibetan civilisation. Every year it looms larger.
Out of a population of some 6m, 130,000 Tibetans are in exile, three-quarters of them in India. They have done well at keeping alive their traditions and their dreams of returning home. Two prospects are now making those dreams fade. The first is the imminent completion of a railway linking central Tibet with China. When it opens for passengers in 2007, the pace of immigration of Han Chinese will pick up. Tibetans, already a minority in cities, may simply be swamped.
Second, as the Dalai Lama himself puts it in an interview with your correspondent, is the fact that “my death would be a serious setback.” This sounds odd from an incarnation of Avalokiteshwara, the Buddha of Compassion. It is also an understatement. Lobsang Nyandak Zayul, a minister in the exile government the Dalai Lama heads in Dharamsala, is starker: “There will be chaos. We really are scared.”
The Dalai Lama, 70 last July, seems in rude health. But he will not live forever. His supporters argue that it is China that should worry, and seize the opportunity he is offering to reach an understanding with its Tibetan minority. Karma Gelek Yuthok, a monk who is the top civil servant in the education ministry, lists three reasons: no future leader will enjoy the Dalai Lama's command over Tibetan loyalties; he is asking not for independence, but merely “genuine autonomy” for Tibet; and he prohibits violence.
Since 2002, there have been four rounds of talks between the Dalai Lama's representatives and Chinese officials. Optimists see this as evidence that these arguments are beginning to work. But many Tibetans fear China just wants to placate international opinion and is playing for time. In this analysis, China sees the Dalai Lama not as the solution to its Tibet problem, but as the problem itself, which death will fix.
China knows that the deaths of Dalai Lamas, and the discovery of the next incarnation, have often involved intrigue, turmoil and division. There would be a search for the new incarnation—a gifted boy identified through oracles, portents, clues left by his predecessor, and the intervention of senior lamas. During the interregnum, regional, religious and other tensions among Tibetans that the Dalai Lama's authority helps to conceal might resurface. The Dalai Lama has said that he will be reincarnated only if Tibetans still need the institution. It is hard to find a Tibetan, however, who does not think he will come back. The Dalai Lama expects the infant 15th to be found outside Tibet. After all, “the very purpose of reincarnation is to carry my task forward.”
This prediction makes it harder for China to meddle in the reincarnation process. It does not, however, make it impossible. The senior lama traditionally most involved in identifying and tutoring a young Dalai Lama is the Panchen Lama. The tenth Panchen Lama died in 1989 and two young men—one recognised by the Dalai Lama and most Tibetans and another by the Chinese—carry the title of the 11th. The “Tibetan” panchen has been in custody since 1995 (for his own protection, says China). “Our Chinese brothers and sisters,” explains the Dalai Lama, “have created complications.” China might use both panchens to endorse a pretender to the Dalai Lama's succession.
The only person who might perhaps, in the short term, enjoy a little of the Dalai Lama's prestige among both Tibetans and foreigners, is Ogyen Trinley. He is claimant to the title of 17th Karmapa, the head of one of the main sects of the Kagyud, or “Black Hat” school of Tibetan Buddhism, which in the 17th century lost state power to the dalai lamas' own Gelugpa school.
ReutersFamiliar but unrecognised
Ogyen Trinley, recognised by both the Chinese government and the Dalai Lama as the incarnate Karmapa, was born in Tibet, but in 1999 fled to India. Now still only 20, the Karmapa lives in a Dharamsala monastery. On an October morning, his waiting room is crowded with a tour group from Hong Kong. The karmapas' international following has helped their sect grow rich, and fuelled a power struggle.
A promised “interview” with the Karmapa requires a permit from a sleepy Indian police station. It turns out to be a couple of questions squeezed into the end of a busy morning spent granting audiences to devotees, and draping khataks, white silken scarves, round their necks. Two panicky monks say that “political” questions are not allowed, and rush off to fetch a breathless official from the exiled government to reinforce the message.
The Karmapa, whose smile can light up the neighbourhood, seems tired and rather dour. After a few minutes, his interpreter snaps his notebook shut with authoritative finality. The Karmapa has just answered a question about whether he was right to leave Tibet: “I pray it was the proper decision.”
It would not be surprising if he is having doubts. He seems to have traded one form of captivity for another. The Indian security around him is heavy. His travel is restricted. He is not allowed to visit his predecessor's seat in Sikkim, a Himalayan kingdom annexed by India in 1975. Nor, it appears, does he have the freedom others in India take for granted, to speak his mind. The Karmapa is in a delicate position. There is in India a rival claimant to the incarnation, with some influential backers. With much treasure at stake, the dispute has already involved fistfights in monasteries and courtroom battles, and could turn nastier still.
Some Tibetans think there are other factors, too, behind India's sensitivity about the Karmapa. His flight provoked some suspicions of Chinese connivance, and raised questions about his motives. If he is a Chinese agent, it is hard to imagine better cover. In exile, he is both living embarrassment to China and a threat to its hopes that, with the passing of the 14th Dalai Lama, its Tibet troubles will be over. India, intent on closer ties with China, probably does not want the Karmapa to antagonise Beijing.
Not just Hollywood
The fear that the Dalai Lama's death will be a disaster for the Tibetan cause looks justified. His fame as a Nobel-prize-winning guru and friend of the stars has produced little concrete benefit: no government recognises his. But top politicians as well as private citizens are drawn to him. Because of him, Tibet is sand in the wheels of China's drive to become a respected international citizen. And, under him, India has given Tibetans a home big enough to encompass the dream of cultural survival.
Even critics of Tibetan culture—with, for example, its mass monasticism, often starting in childhood—do not want its destruction. China has apologised for the ravages of the Cultural Revolution of 1966-76 and stresses its new-found respect for Tibetan tradition. In India, the idea of Tibet as a distinct culture with a vibrant future is kept alive in schools and monasteries. In Dharamsala, one of several “Tibetan Children's Villages” (TCVs) teaches—and houses—more than 1,900 children. Most were born in Tibet. Their parents sent them on the dangerous trek through high passes in the Himalayas, to receive a decent education in India.
One 12-year-old girl arrived just a couple of months ago with her seven-year-old sister, after an arduous month-long journey. Her mother brought them, and then risked arrest again to return to Tibet. Mother and daughters may never meet again. On arrival, the girl, who came from eastern Tibet, near what Tibetans regard as the border with China, spoke almost no Tibetan, although she was fluent in Chinese.
Dickensian in DharamsalaAFP
Most travel in the winter months, when the bitter cold and snow make it easier to escape detection (as well as to die of frostbite and hypothermia). The reasons for coming are economic as well as political. Some Tibetans cannot afford to put a child through a Chinese school. Some of their richer compatriots send children to school in China. Phuntsog Namgyal of the TCV says its “prime aim” is to inculcate a sense of Tibetan identity and culture. To his regret, because of a lack of Tibetan-language materials, and because the children have to sit Indian exams, the medium of instruction from age 11 is English.
For many, a Tibetan education will not disguise the growing realisation that they will probably die in India. There must be a strong temptation to abandon Tibet as a lost dream and do as well as they can in the outside world. Dolma, a young Tibetan political-science student in Delhi, reckons that, if they had the chance to go back to a free Tibet tomorrow, half the young Tibetans in India would prefer to stay put.
The Dalai Lama, however, thinks only “a very small minority” are losing their Tibetan identity. Karma Gelek Yuthok, of the education ministry, is a self-confessed pessimist. He frets that the Tibetan schools in India have failed both in equipping children to win scholarships at the best Indian colleges, and in providing a grounding in Tibetan language and culture. This he feels especially keenly. Preserving the culture was, after all, “the core purpose of our coming into exile”. Worse, he is worried about the “quality of human beings” the schools are turning out.
Young Tibetans abroad might become assimilated into exile, just as there are fears that those at home may grow up assimilated into China. Between 2,500 and 3,000 Tibetans still escape to India each year, mostly through Nepal. More than one-third are under 14 years old. Among adults, the largest groups are monks and nuns. India has branches of the most famous Tibetan monasteries. But at the audience in Dharamsala, there were lay-people of all ages, including the very old and infirm.
The journey to India is getting harder. Nepal is racked by insurrection, and in January King Gyanendra, to curry favour with China, ordered the shutting of the Dalai Lama's representative office, and of a Tibetan welfare centre, though the United Nations High Commissioner for Refugees and a transit centre still function. At a reception centre in Dharamsala, a handwritten poster from a newcomer tells of the rape of three Tibetan women in Nepal. It advises readers to tell their friends to travel in large groups.
The Tibet Transit School (TTS) near Dharamsala was founded in 1993 for arrivals from Tibet aged 18-30. A group of students give the usual three explanations for the decision to come to India: to see the Dalai Lama, to get an education and to flee the lack of opportunities at home. (The Dalai Lama himself, a pragmatic sort of idealist, adds a fourth: the belief that from India it is easy to secure entry to America.)
In some places, particularly in the eastern parts of historic Tibet now incorporated in the Chinese province of Sichuan, there is virtually no education available. TTS's director, Chhoeze Jampa, says three-quarters of his students have to start from scratch, learning to read and write. When he inaugurated the school, the Dalai Lama encouraged its students to return to Tibet later on. Mr Jampa says that 60% of his graduates have returned home, or tried to.
Two new arrivals, still at the reception centre, strapping young men in their 20s, were among just three out of a group of 51 who reached Nepal and India. They had each paid guides 4,000 yuan. That is nearly $500, a huge sum, which they made by selling caterpillar fungus, a prized Chinese medicine. Their parents had brought them up not to get into trouble with the Chinese authorities, and they had not told them their plans.
The group walked by night from Lhasa to the border. After 17 days' hiking, they were resting on a mountaintop when they were ambushed by Chinese police, who opened fire. The two escaped by ditching their luggage and hiding in the hollow of a riverbank. They finished the journey to the border with a seven-day walk without food or money, and sick from the cold.
Life back in their village, of settled nomads and farmers, was not so bad. There is even a school now, though it does not use Tibetan beyond the primary years, and it came too late for them. They endured this ordeal simply to see the Dalai Lama. This they achieved, at the audience. Given the chance to call their village to leave a message for their parents that they are safe, the first, tearful, news one tells the friend who answers the phone is that they have seen His Holiness. (“He looks just 40!”)
When they left home, they meant simply to make their pilgrimage and return, smuggling tapes and pictures of the Dalai Lama for the friends they left behind. Having heard, however, that they could attend TTS, they made plans to stay five years. This resolution was already wavering after the phone call home.
No direction home
Most exiles in India, however—some 100,000 of them—are there for the long haul. Tsultrim Dorgee Chunang, general secretary of the Tibetan Youth Congress (TYC), loyally puts the Dalai Lama's lifespan at 110. Even so, he argues, Tibetans should be preparing for life without him, but are not. The Dalai Lama himself has, in his way, done his bit to prepare them. He has imposed a sort of democracy. There is a largely elected, 46-member, parliament and, since 2001, a directly elected prime minister.
However, there is something in Mr Chunang's charge that many exiled Tibetans refuse to take responsibility for their own futures because they rely on the Dalai Lama. The Tibetan Women's Association, for example, went through a protracted debate over its stand on the Dalai Lama's proposal of a “middle way” short of full independence. The conclusion was to follow the Dalai Lama, whatever his position may be.
The TYC has not dropped the demand for independence, but does not criticise the Dalai Lama. Mr Chunang says it would see autonomy only as a stepping-stone to independence, and that the TYC's commitment to non-violence might weaken when the Dalai Lama dies. The railway will make an obvious terrorist target.
This sort of talk allows China, which professes not to understand such differences of opinion, to accuse the Dalai Lama of insincerity. But it is also why so many Tibetans fear the Dalai Lama's death and urge China to make the most of his willingness to compromise. The Dalai Lama himself takes encouragement from stirrings of sympathetic interest in Tibet within China, and from his conviction that China's “totalitarian system” will change.
“If you look locally,” he concedes, “it is almost hopeless.”“But from a broader perspective, there's hope.” China's continued vilification of the Dalai Lama personally, however, gives little hint of a readiness to treat with him. Rather, it speaks of an aggressive rising power determined the Dalai Lama will die on the wrong side of the mountains, and the wrong side of history.
“THE time when we could count on cheap oil and even cheaper natural gas is clearly ending.” That was the gloomy forecast delivered in February by Dave O'Reilly, the chairman of Chevron Texaco, to hundreds of oilmen gathered for a conference in Houston. The following month, Venezuela's President Hugo Chavez gleefully echoed the sentiment: “The world should forget about cheap oil.”
The surge in oil prices, from $10 a barrel in 1998 to above $50 in early 2005, has prompted talk of a new era of sustained higher prices. But whenever a “new era” in oil is hailed, scepticism is in order. After all, this is essentially a cyclical business in which prices habitually yo-yo. Even so, an unusually loud chorus is now joining Messrs O'Reilly and Chavez, pointing to intriguing evidence of a new “price floor” of $30 or perhaps even $40. Confusingly, though, there are also signs that high oil prices may be caused by a speculative bubble that could burst quite suddenly. To see which camp is right, two questions need answering: why did the oil price soar? And what could keep it high?
To make matters more complicated, there is in fact no such thing as a single “oil price”: rather, there are dozens of varieties of crude trading at different prices. When newspapers write about oil prices, they usually mean one of two reference crudes: Brent from the North Sea, or West Texas Intermediate (WTI). But when ministers from the Organisation of the Petroleum Exporting Countries (OPEC) discuss prices, they usually refer to a basket of heavier cartel crudes, which trade at a discount to WTI and Brent. All oil prices mentioned in this survey are per barrel of WTI.
The recent volatility in prices is only one of several challenges facing the oil industry. Although at first sight Big Oil seems to be in rude health, posting record profits, this survey will argue that the western oil majors will have their work cut out to cope with the rise of resource nationalism, which threatens to choke off access to new oil reserves. This is essential to replace their existing reserves, which are rapidly declining. They will also have to respond to efforts by governments to deal with oil's serious environmental and geopolitical side-effects. Together, these challenges could yet wipe out the oil majors.
The ghost of Jakarta
But back to the question of why prices shot up in the first place. The short explanation is that oil markets have seen an unprecedented combination of tight supply, surging demand and financial speculation. One supply-side factor is OPEC's clever manipulation of output quotas. Back in 1997, at a ministerial meeting in Jakarta, the cartel decided to raise output just as the South-East Asian economies were hit by crisis, sending prices plunging to $10. Desperate to engineer a price rebound, Saudi Arabia targeted inventory levels: whenever oil stocks in the rich countries of the OECD started rising, OPEC would reduce oil quotas to stop prices softening. It worked like a charm.
Another supply-related factor has been the shortage of petrol in the American market. Over the past year or two, prices have spiked as refineries have been unable to meet local demand surges.
Supply concerns have also played a part in the so-called fear premium. The nerve-wracking uncertainty before the invasion of Iraq, and the terrible terrorist attacks in Iraq and Saudi Arabia afterwards, have pushed up prices to a higher level than the fundamentals would seem to justify. Other supply worries arose from the crackdown by the Russian president, Vladimir Putin, on the oil company Yukos, and from civil strife in Venezuela and Nigeria. Some pundits think the fear premium may have added $7 to $15 to the cost of oil on futures markets in New York and London.
Adding to the froth has been the sudden influx of new kinds of financial investors into the oil market. Some are merely chasing the huge returns recently offered by oil. Big equity funds, fearful of what $100 oil could do to their holdings, might invest in oil futures at $40 or $50 as a cheap insurance policy. OPEC ministers love to blame hedge funds for high oil prices, but they are only partly correct. The “net long” positions (that is, their speculative bets on higher prices) held by such funds peaked in March last year and dropped through 2004, but oil prices kept rising regardless.
Phil Verleger, an energy economist associated with the Institute for International Economics in Washington, DC, reckons that the cartel itself may be to blame for the speculation: by declaring its intention to prop up prices, first at $30 and now at $40, “OPEC has given Wall Street a free put option” (because investors believe the cartel will cut output to stop prices falling).
Supply constraints coincided with a huge boom in oil demand. Global oil consumption last year increased by 3.4% instead of the usual 1-2%. Nearly a third of that growth came from China, where oil consumption rocketed by perhaps 16%. One senior European oil executive claims that, in contrast with the embargoes and supply-driven price rises of the past, “This is the first demand-led oil shock.”
And it was not just China that used a lot more oil. India's oil consumption too leapt last year, and America's was quite robust. In fact, despite $50 oil, global oil demand in 2004 grew at the fastest rate in over 25 years. The global economy also grew at a scorching pace. That appeared to defy the conventional wisdom that high oil prices drag down demand, and prompted the question whether oil prices even matter any more (see article).
No safety net
So was it supply or demand that pushed prices above $50? Both matter, of course, but neither provides a complete explanation. What is new, and what has set the market alight, is the lack of spare production capacity.
In a normal commodity market, no producer in his right mind would keep lots of idle capacity. But that is precisely what several OPEC countries have been doing with their oil wells for years. Saudi Arabia, in particular, has maintained a generous buffer that it has used to prevent the market from overheating during unexpected supply interruptions. For example, during the Iran-Iraq war, the first and second Gulf wars and Venezuela's political crisis of 2003, oil exports from the countries concerned were disrupted, but the Saudis immediately started pumping more oil from their idle fields and single-handedly prevented a price surge and possibly an oil shock. This vital buffer, argues Robin West of PFC Energy, a consultancy, helps Saudi Arabia to act as the “central bank of oil”.
Alas, the buffer has been in decline for some years, because OPEC has not been investing sufficiently to keep pace with growing demand. As a result, global spare capacity last year dropped to around 1m barrels per day (bpd), close to a 20-year low. Almost all of this was in Saudi Arabia. In short, the market for the world's most essential commodity now has no safety net to speak of.
In such a tight market, argues Edward Morse ofHETCO, an energy-trading company, even relatively minor changes in supply and demand can get magnified into unnerving price spikes. In the past, there has often been an inverse relationship between spare capacity and oil prices (see chart 1). The IMF has recently told OPECthat it must increase global spare capacity to 3m-5m bpd in order to ensure “the stability of the world economy.”
More worryingly, Mr Morse believes the problem extends well beyond just spare production capacity. He points to the tightness in markets for oil rigs, tankers, petroleum engineers, refinery capacity and various other bits of the oil value chain, and concludes that the problem is systemic: “The illusion that oil is in perennial oversupply has led to two decades of underinvestment in the oil industry. The world has been living off the legacy spare capacity built up many years ago.”
Given today's high prices, surely the market will soon enough provide the necessary new infrastructure? Probably not, for two reasons. The first is that the world seems to be coping rather well with today's shockingly high prices, so perhaps they have to persist for longer or rise higher still before investors are stirred into action. The second reason is the bitter memory of oil at $10 a barrel.
OPEC countries are unlikely to rush to build lots of spare capacity because they are worried that another price collapse may follow. PFC Energy observes that when the oil price hit $55 late last year, spare capacity was less than 15% of the 8.7m bpd peak reached in 1985, and notes: “OPEC national interests do not lie in creating large capacity surpluses that have existed for most of the history of oil.”
The western oil majors are even more terrified of another price collapse, and are keeping a tight rein on their capital expenditure. Projects are typically “stress-tested” for profitability at $20 a barrel or below. Some argue that Big Oil is being too cautious. But nobody thinks that spare capacity will ever return to the gold-plated levels of the mid-1980s.
Still, the crunch may ease if the Saudis rebuild their buffer. It may be in their interest to do so. For most of the OPEC countries, it makes sense to try to maximise prices in the short term because their reserves of oil are relatively small. The Saudis, by contrast, are sitting atop at least 260 billion barrels of proven oil reserves, far more than Libya, Venezuela, Indonesia and Nigeria combined. Even at current production levels of around 10m bpd, which make them the world's top exporters, they have enough oil to pump for most of this century. They will not want prices to stay too high for too long, or else investors will put money into non-OPEC oil or alternative fuels.
The desert kingdom's rulers also remember the lessons of the 1970s oil shocks, when the biggest losers were not consuming economies (which eventually adapted to higher prices) but the petro-economies of OPEC. Ali Naimi, the Saudi oil minister, rejects the idea that his country wants prices to rise ever higher: “We are misunderstood: we thrive on the economic growth of others, which is concomitant with energy demand.” That is why the Saudis have long acted as the voice of moderation withinOPEC, resisting calls from price hawks such as Libya, Iran and, since the rise of Mr Chavez, Venezuela to squeeze consumers.
Indeed, at the most recent formal OPEC meeting, held in Iran on March 16th, the Saudis in effect bullied reluctant cartel members into trying to calm prices down. They won agreement for a rise in oil production quotas to boost global oil inventories that looked like a reversal of the cartel's established policy of keeping OECD inventories tight and prices high.
Developments within Saudi Arabia seem to confirm that the buffer is being rebuilt. Saudi Aramco, the state-run oil giant (and the world's largest oil company), has recently launched its biggest expansion programme in many years. Outside contractors report a surge in rig counts and drilling activity as the country increases spare capacity to its stated goal of 1.5m-2m bpd. But even if Saudi Arabia is willing to re-establish an adequate buffer, this could take years. Will prices stay high until then?
For much of the late 1980s and 1990s, the world enjoyed low and stable oil prices between $20 and $30. Now oil prices have shifted to double that level, apparently without causing much pain. OPEC ministers and Wall Street analysts talk of a new “price paradigm”. At first sight, there seems to be something in that. In the past, contracts for delivery of crude months or years ahead (what Alan Greenspan, the chairman of the Federal Reserve, has poetically called “distant futures”) usually stayed low and stable even if the spot price shot up because of some short-term disruption. But for the past couple of years the distant futures have tended to shoot up too. The markets clearly expect that higher prices are here to stay.
Political scientists point to the bloated welfare states in most OPEC countries which will require higher oil prices to balance budgets and avoid social unrest. Some industry analysts see a new “floor” price of $30-40, if only to persuade oil firms to splash out on necessary investments upstream. Matt Simmons, a prominent energy investment banker, thinks that in view of rising input costs (for such things as oil rigs, steel pipes, tankers and so on) the oil price “needs to go way, way up”.
But some of this may be wishful thinking. In reality, oil companies have little control over prices.OPEC ministers are better placed, but even they cannot reliably control the oil market, as the industry's history of booms and busts clearly shows. Saudi Arabia's Mr Naimi seems to be arguing for moderation when he says that working out a fair price for oil is “a moving target: it needs to be comfortable for both consumers and producers, and at a level where investors will put money in to grow this industry.” But it is quite possible that prices could drop lower even than Mr Naimi would wish.
One factor is potential weakness in demand. There is much talk about Chinese demand changing all the rules, but that is just plain wrong. China's share of world oil consumption is still under 8%, far smaller than America's at 25%. Goldman Sachs, an investment bank, estimates that even assuming robust growth, China will remain a smaller oil consumer than America for decades to come.
And the growth in China's oil demand of nearly 16% last year is unsustainable. For one thing, there are simply not enough cars in all of China to guzzle that much oil. Much of the 2004 rise was related to the country's overheating economy and is unlikely to be repeated. For example, shortages of cheap coal led to the use of pricey fuel oil or dirty diesel for electricity generation; as bottlenecks in the coal system ease, that oil use will disappear. Over the past two years, as the country has developed its oil infrastructure, it has needed to fill pipelines, storage tanks and the like, but these were one-off purchases. The International Energy Agency (IEA) says that in January and February 2005, Chinese oil demand rose by only 5.4% on the same period in 2004, less than a quarter of the rate a year earlier. And if China's banking sector or its overall economy takes a knock, oil consumption is bound to be hit too.
Follow that oil priceKatz
On the supply side, too, things may ease up. Julian West of CERA, an energy consultancy, has compiled a list of all of the oil projects, led by both government companies and by private firms, that are due to come on stream over the next few years, “all found, all commercial, and all economic at half today's price.” He calculates that this “river of supply” could lead to a dramatic net increase in global oil production, with 2007 perhaps seeing the largest rise in production capacity in history. By 2010, this might add 13m bpd to the 2004 total of 83m bpd. Not everyone agrees with his assessment, and Mr West himself cautions that geopolitics could choke off this pending supply, but otherwise “the supply problem in two to four years will be too much oil.”
The financial markets offer another possible route to a sharp fall in oil prices. Pension funds have usually shunned commodities in the past, but in the past year or two they have poured tens of billions of dollars into securitised investments in oil, hoping for returns above those they can get on the anaemic stockmarkets. Mr Verleger worries that they have now developed a herd mentality reminiscent of the internet boom. As returns inevitably decline over time, the herd may turn tail and prompt a price collapse. In short, despite China's undeniable thirst and the shortage of global spare capacity, the oil-price boom may yet prove a bubble.
Aramco's boss, Abdallah Jumah, sums it up: “Where the oil price goes, nobody knows.” He wishes it were otherwise. “The key is stability so we can plan. Oil investments take a long time to come to fruition.” His boss, Mr Naimi, argues that “oil is simply too vital a commodity to be left to the vagaries of the marketplace.” But even Saudi Arabia cannot guarantee oil-market stability, especially with its buffer so depleted. Indeed, the only sensible thing anyone can say about oil prices today is that they are unlikely to remain stable. A terrorist attack on Saudi oil infrastructure could send them past $100; a financial-market crash could push them below $10.
That uncertainty creates enormous problems for the western oil majors. Big Oil has never been much loved, but since OPEC's rise in the 1970s the majors have actually been the consumer's best friend, because their success at developing non-OPEC oil has restrained the cartel's market power. So it is worrying that their economic health is not as robust as it appears.
IN THE smoke-and-mirrors statistics for foreign investment in China, Hong Kong appears as the biggest investor, followed, oddly, by the Virgin Islands. Trailing in sixth place, behind Japan, South Korea and America, is Taiwan. But if investments were traced back to their true origins, Taiwan might well turn out to be the largest.
The capital flow from Taiwan to China is turning the mainland into a global leader in information-technology (IT) equipment, albeit one that still relies mainly on imports for the more advanced components. In 2002, China overtook Japan and Taiwan to become the world's second-largest IT hardware producer after America. The steep upward curve of China's ITexports is almost exactly matched by its imports of IT components from Taiwan. China is now the world's biggest IT hardware exporter to America. Yet more than 60% of these exports are made in China by Taiwanese companies.
China's latest list of its top 200 export companies is headed by subsidiaries of Taiwanese ITfirms: Hon Hai Precision Industry (whose exports from China in 2003 were worth $6.4 billion), Quanta ($5.3 billion) and Asustek ($3.2 billion). Altogether Taiwan has 28 entries on the list, all of them high-tech companies. Far from being undermined by competition from China, Taiwanese IT businesses are benefiting from their production on the mainland, increasing their global market share across a broad range of products, says Nicholas Lardy of the Institute for International Economics in Washington.
Thanks to a huge trade surplus with mainland China, Taiwan has built up the world's third-biggest holding of foreign-currency reserves: a record $239 billion at end-November 2004. Taiwan is second only to Japan as a source of Chinese imports. And for Taiwan, China is the biggest export market. Taiwanese companies employ some 10m people on the mainland. For China, worried as it is about growing unemployment, this is an enormous contribution to stability. In just a few years, a strong economic symbiosis has developed across the Taiwan Strait.
Take the city of Dongguan in Guangdong province (which borders on Hong Kong). The municipality is a vast sprawl of factories, many of them Taiwanese, stretching mile after mile through what were tiny villages a few years ago. Dongguan is awash with Taiwanese money, much of which has been there for a decade or so. Dongguan was an obvious choice for the first wave of Taiwanese investors who flocked to the mainland after the Taiwan government began to ease investment restrictions in the early 1990s. It is close to Hong Kong, which together with nearby Macao offers the only direct flights from Chinese cities to Taiwan.
To start with, Dongguan was a magnet for low technology, labour-intensive industries. But since the late 1990s, Taiwanese investment in the mainland has moved rapidly up the technological ladder. Dongguan is still booming, but the investment hotspot has shifted north to the Yangzi River valley, particularly in the area around Shanghai, an area with good access to skilled workers and potentially better placed for China's domestic market. The town of Kunshan, an hour's drive from Shanghai, has become almost a replica of Taiwan's high-tech industrial zones. Some 300,000 Taiwanese businessmen and their dependants now live in the greater Shanghai area, causing property prices to soar.
Taiwan is rife with stories of kidnappings, robbings and murders of Taiwanese businessmen on the mainland. There is also speculation about how many really make money; Tsai Ing-wen, a former head of Taiwan's mainland-affairs office under President Chen, estimates that only half of them do. Even so, more than 70,000 Taiwanese firms have set up on the mainland, notwithstanding political tensions, Taiwan's restrictions on some investment and the absence of direct flights. “This is a time of global competition,” says Preston Chen, chairman of the Ho Tung Group, which has invested over $100m on the mainland. “If you don't go [to China], others will, and the first to suffer will be you.”
In Dongguan, some Taiwanese businessmen in low-value-added industries are getting restless as the stampede of Taiwanese capital shifts to the north. Some have begun to move elsewhere, including neighbouring Vietnam. “If you come back in ten years it's hard to say whether you'll find any Taiwanese business here,” says Juei Chen Wong, the boss of a Taiwanese electric-wire factory in Dongguan.
He is exaggerating: more likely, other Taiwanese businesses less dependent on cheap labour will move in. For labour-intensive manufacturers geared to the export market, China may be losing some of its shine. But the new wave of Taiwanese investment is looking for skilled labour, and is setting its sights not only on markets abroad but also on a fast-growing group of affluent consumers in China itself. This investment is helping to transform China's trade, now fuelled increasingly by higher-value-added production. In 2003, China exported some $130 billion-worth of electronic and IT products, up 41% on the previous year. Such products accounted for nearly one-third of total exports. Chinese officials say that output of IT products will triple by 2010.
To achieve this, China needs Taiwanese businesses, even if they support independence. In May 2004, the Communist Party's mouthpiece, the People's Daily newspaper, accused Hsu Wen-lung, the founder of Taiwan's Chi Mei Group, which has a large chemical plant on the mainland, of using his profits for pro-independence causes. But China has not taken any direct action against the company. “There are a very small number whom we do not welcome,” says Mr Zhang, the Chinese government spokesman. “But as long as they uphold the law, we let them invest. We have not said we will expel them.”
So near and yet so far
At government level, the two sides still bicker over what they call the “three direct links”: communication, trade and transportation, which have been disrupted since the end of the civil war. But barriers have been quietly dismantled. Mail is channelled through Hong Kong; direct telephone calls have been possible since the 1980s; cross-strait cargo shipping can be routed through a third area, but can go directly if not carrying local freight.
The absence of direct flights except to Hong Kong and Macao is the biggest nuisance, though it really is no more than that. If you set off an hour before dawn from downtown Taipei, you can reach most of the big cities on the mainland by the afternoon. But direct flights would certainly help. Getting to Shanghai currently takes six or seven hours. Flying direct would take 90 minutes.
The Taiwan government estimates that direct air and sea links would reduce shipping costs by 15-30%. Sea transport would be twice as quick, and air travellers would save $390m a year. But direct flights are fraught with symbolism, so both sides are determined to extract maximum political advantage from any move they make.
For Taiwan, direct flights are part of a bigger question: how much economic integration with the mainland it should allow. Should it stop trying to curb investment in certain technologies; open its doors wider to trade with the mainland; and allow mainlanders to work, invest and holiday in Taiwan? The economic arguments are compellingly in favour, particularly in information technology.
UNTIL recently, China was widely accused of exporting deflation to the rest of the world. Massive overcapacity in China, it was argued, was depressing the prices of manufactured goods. This year, however, the charge against China has been turned on its head. It is now being blamed for exporting inflation to the rest of the world as its insatiable demand for raw materials pushes up the price of oil and other commodities. Amidst this confusion, one thing is clear: the entry of China and other emerging economies into the global economy may affect monetary policy in ways that central banks do not yet fully understand.
To the extent that China adds to the world's productive capacity and strengthens competition, it should, on balance, help to reduce inflation for a period. A purist would argue that in the long run, inflation is determined entirely by monetary policy, but in the short to medium run cheaper imports from China will reduce inflation. A study by economists at America's Federal Reserve estimates that cheaper imports from China have lowered inflation in America by an annual average of 0.1-0.3 percentage points in recent years. Another study by Dresdner Kleinwort Wasserstein, which allows for the price-reducing effects of Chinese competition on all producers, reckons that China may have brought down America's inflation rate by almost a full percentage point. So what should central bankers do?
Last year, prompted by fears about deflation, America's Federal Reserve reduced short-term interest rates to a 45-year low of 1%. America's underlying rate of consumer-price inflation fell to only 1% at the end of last year, a bit too low for comfort. The experience of America in the 1930s and Japan over the past decade shows that deflation can be much more harmful than inflation: falling prices increase real debt burdens, depress demand and so push prices even lower. Deflation also emasculates monetary policy, because interest rates cannot fall below zero.
The right sort of deflation
The Fed is now celebrating its success in avoiding deflation. But Stephen King, chief economist at HSBC, argues that with hindsight some of the deflation that the Fed was fretting about last year was in fact “good deflation”, caused by structural changes in the global economy. Historically, benign deflation, of the sort experienced in the late 19th century at a time of rapid growth, has actually been more common than malign deflation, when prices and output spiral downwards. In recent years, cheaper imports from China and other emerging economies, along with the IT revolution (which has boosted productivity growth), have cut the prices of many goods and so, for a period, brought down inflation.
Mr King suggests that last year the Fed and some other central banks, fearing the bad sort of deflation, may have cut interest rates by too much and then left them low for too long. Instead, he says, they should have accepted this “good” deflation.
This is an echo of a lively debate in the 1920s, when some economists suggested that when rapid productivity growth is bringing down the cost of production, overall price stability may be the wrong goal. Instead, average prices should be allowed to fall to pass productivity gains on to workers in the form of higher real incomes. But just like today, monetary policy prevented prices from falling. Because nominal wage rises lagged behind productivity growth, profits surged. The mistaken belief that profits could continue to grow at this pace helped to inflate the late-1920s stockmarket bubble.
In retrospect, it is clear that the risk of deflation in America last year was exaggerated. Even so, it is hard to criticise the Fed's rate cuts in 2001-03. Even if some of the threatened deflation was of the good sort, there was a high risk of bad deflation after the bursting of the stockmarket bubble. At a time of weak growth, it was understandable that the Fed did not want to run the risk of any sort of deflation; it was desperate not to repeat the mistakes of the Bank of Japan in the 1990s.
This does not mean that the Fed is blameless. The best concept for understanding the forces at work is the “natural rate of interest”, which goes back to Knut Wicksell, a Swedish economist working at the start of the 20th century. The idea was developed further by Austrian economists such as Friedrich Hayek. The natural rate of interest is the rate at which the supply of saving from households equals the demand for investment funds by firms. If the rate set by the central bank (the cost of capital) is lower than the natural rate, there will be excessive investment and borrowing, and households will not save enough. At the natural rate of interest, policy neither stimulates nor reins in the economy.
To make life tricky for central bankers, the natural rate can vary over time, in line with changes in the return on capital or households' desire to save. And there is good reason to think that the natural rate has risen in recent years. The entry of China's army of cheap, unskilled labour into the global economy has increased the ratio of labour to capital, which in turn lifts the worldwide return on capital. The spurt in productivity growth from IT has also increased expectations about future profits and investment opportunities, further lifting the natural interest rate. In other words, the very same forces that have caused central banks to cut interest rates to prevent inflation falling have actually increased the required equilibrium real rate of interest.
Meanwhile, households in many countries have decided that they need to save less than they used to, because they think rising share or house prices are likely to provide the assets to finance their retirement. In the economic jargon, the supply curve for saving has shifted backwards, whereas the demand curve for investment funds has shifted outwards. This implies a higher natural rate of interest.
Capital on the cheap
China has also caused the cost of capital to fall below its natural rate in another way. China and other Asian countries have been big buyers of American Treasury bonds, through heavy foreign-exchange intervention to hold down their currencies against the dollar. According to some estimates, that may have reduced bond yields by anything from half a percentage point to a full point. This “subsidy” has artificially lowered the cost of capital for homebuyers and companies, at precisely the time when the return on capital and hence the natural rate of interest has increased.
In theory, if central banks hold interest rates below the natural rate, credit and investment will rise too rapidly and households will save less and spend more. This is what has happened in America in recent years. Austrian-school economists would say that in the late 1990s interest rates were held too low in relation to the higher expected return on capital, which caused excessive investment, falling saving and the biggest stockmarket bubble in American history. Since the bubble burst, the expected return on capital may have fallen, but real interest rates have been cut by more, leaving them even further below their natural rate.
Holding interest rates too low for a prolonged period has created a whole series of excesses: a global housing bubble (of which more in the next article), rampant consumer borrowing and spending, and an unhealthy amount of investment in highly risky assets, such as emerging-market bonds, as investors searched for higher yield amid falling interest rates.
The exceptionally low cost of capital may also have distorted economies by encouraging firms to invest in labour-saving machinery rather than hire new workers. Thus, ironically, China may be indirectly to blame for America's jobless recovery. Workers are being priced out not by cheap Chinese labour, but by low-cost capital investment subsidised by the Fed's incorrect response to the downward pressure on inflation exerted by China.
As inflation has started to edge up, the Fed and other central banks have started to lift interest rates. But the risk now is that pushing real rates back to where they should have been in the first place will reveal the fragility of the recent economic recovery. Decisions taken on the basis of unsustainably low interest rates, such as borrowing to the hilt to buy an overpriced house, will suddenly look unwise. Aware of this risk, the Fed is lifting interest rates gradually. But a gentle rise may fail to halt the borrowing binge if expectations of future gains in house prices are entrenched, so the bubble may continue to inflate.
On the other hand, bigger rate increases (which may be unavoidable if inflation continues to rise) could cause a hard landing, triggering the bad deflation that central bankers have been so keen to avoid. Awkwardly, there would then be much less room for interest-rate cuts or fiscal stimuli than after the stockmarket bubble burst, because most of the ammunition has been spent already.
A pinch of Basel
In its latest annual report, the Bank for International Settlements (BIS), the central bankers' central bank based in Basel, Switzerland, also expresses concern that monetary policy around the world has been too loose in recent years. The BIS frets that even if inflation is subdued in the short term, very low interest rates could either increase the risk of higher inflation in future or feed into financial imbalances such as excessive growth in credit and rising asset prices. Competition from China, deregulation and faster productivity growth have helped to hold down inflation, says the BIS, at the same time as financial liberalisation has increased the risk of booms and busts in asset prices.
Not only are structural forces such as globalisation helping to hold down prices, but central banks' success in the battle against inflation has also enhanced their credibility and reduced inflationary expectations. This has meant that they need not tighten policy by as much as previously in response to rapid growth in demand. Conversely, so long as inflation is subdued, they can afford to ease policy more freely to deal with economic downturns or during bouts of financial instability. The Fed has been doing exactly that in recent years, which has resulted in record low interest rates. This has reduced economic volatility in the short term (America's recession after the stockmarket bubble burst was the mildest in history), but the asymmetric policy could cause long-term problems by allowing bigger financial imbalances to build up. Rescuing investors each time a bubble bursts also encourages even more risk-taking.
The bottom line is that the extra liquidity created by lower interest rates is now more likely to spill over into asset prices and excess credit growth than into old-fashioned inflation. Liquidity has certainly been flowing freely in recent years. Monetary policy in the big developed economies has been looser than at any time for three decades. The Fed not only reduced short-term interest rates to a 45-year low, but it also made huge efforts to convince the bond market that rates would be kept low for a considerable period, thereby bringing down bond yields. Real short-term rates have been negative for the first sustained period since the 1970s (see chart 10). If the Fed sticks to its current slow tightening, real interest rates will remain negative well into next year.
The European Central Bank has been much criticised for running an overly tight monetary policy and thereby cramping growth in the euro area. Yet in fact, although interest rates in the euro area did not come down by as much as in America in 2001-03, real rates are also negative, and are at their lowest for over 25 years.
Another useful gauge of monetary policy is to look at the gap between interest rates and growth in nominal GDP. Nominal GDP growth can be seen as a proxy for the average rate of return on investment in America Inc, so this is a very crude estimate of the gap between actual interest rates and the natural rate. In both America and the G7 economies as a whole, the negative gap between interest rates and nominal GDP growth is currently at its widest since the 1970s (see chart 11).
America's lax monetary policy has spilled over beyond its borders. Low American interest rates have encouraged capital to flood into emerging economies. For those countries that try to peg their currencies against the dollar, notably China and the rest of Asia, this has caused a large build-up in foreign-exchange reserves and excessive domestic liquidity. When central banks buy dollars to hold down their currencies, they amplify the Fed's loose monetary policy. All this means that, arguably, the Fed has not only caused the Americans to save too little, but also the Chinese to invest too much. Ed Yardeni, an economist until recently at Prudential Equity Group, tracks the growth of what he calls “supermoney” (the sum of America's cash and banks' reserve holdings at the Fed, plus foreign reserves held by central banks around the world). He found that earlier this year supermoney was expanding at an annual rate of almost 25%.
In August 1977 The Economist published a signed article by Alan Greenspan, then a private-sector economist, which contained a list of five economic “don'ts”. One of them was: “Don't allow money-supply growth to spiral out of hand.” In recent years, Mr Greenspan seems to have inadvertently broken his own rule. As a result, America's economic recovery is built on wobbly foundations.