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Serving Sri Lanka

This web log is a news and views blog. The primary aim is to provide an avenue for the expression and collection of ideas on sustainable, fair, and just, grassroot level development. Some of the topics that the blog will specifically address are: poverty reduction, rural development, educational issues, social empowerment, post-Tsunami relief and reconstruction, livelihood development, environmental conservation and bio-diversity. 

Tuesday, February 07, 2006

Budget, Trade Deficits, Interest and Exchange Rates - Lessons to learn

Daily Mirror: 02/02/2006" “The Thought Leadership Forum” By Ranel T Wijesinha

During the time of the Mexican Currency crisis, which was discussed in this “Thought Leadership Forum” two weeks ago, Canada was often referred to as the Western Hemisphere’s equivalent of Sweden. Sweden, a well-known welfare state, experienced a long recession in the early 1990s, with unemployment rising to unprecedented levels. Canada earned this accolade as it were, since the public sector controlled over half of the economy. Public sector costs were increasing. However, the economic base could no longer support these costs. This in turn led to large budget deficits, government borrowing and a significant national debt. The national debt in Canada soared even higher than that of Sweden.

Canadian National Debt
By 1995 close to 50 percent of every dollar spent by the Canadian government serviced interest payments. 40 percent of that national debt was falling due by 1996. A key concern was that the Canadian government’s borrowings were not restricted to domestic capital markets. As debt mounted, Canada had raised needed funds abroad. By early 1995, 30% of Canada’s huge national debt was in foreign hands. Of course “foreign” meant mostly American. When the media surfaced this in February 1995, comparing the Canadian situation with that of Mexico, people naturally became insecure about anything in Canadian dollars.

The question in the minds of banking and financial circles then was that, if Canada went the way of Mexico, the United States will bail it out as well. If Mexico had cost America $20 billion, how much would Canada cost? If Canada went, how far behind could Brazil and Argentina be? What would their bailouts cost the United States?

United States and the Reagan Presidency
During the eight years of the two-term presidency of Ronald Reagan America’s national debt tripled, from under $1 trillion before he assumed the presidency to well over $3 trillion when he left. They say Ronald Reagan accumulated far more national debt than all of his predecessors, starting with George Washington combined. By February 1995, the grand total was $4.5 trillion dollars. The issue was not only budgetary deficits of hundreds of billions of dollars each year. Over 13 years the USA had international trade deficits, which by the mid 1990’s was in excess of $150 billion. Foreigners had been accumulating dollar holdings, which were then invested back in the United States. The “recycling process” apparently seemed to work well. The Japanese, who had the world’s largest trade surplus, were the biggest accumulators of dollars and thus the biggest exporters of capital to the United States.

The dollar Yen Crisis
When the US economy was believed to have recovered and reached a GDP growth rate of 7% Alan Greenspan, the Chairman of Federal Reserve, not wanting the economy to heat up increased the Federal funds rate by ¼ percent. During the next twelve months, Greenspan raised rates six times. There was a large-scale sell off of bonds. The Japanese, the Swiss, and Germans began to move out of US investments. By 1995, foreigners had invested over a trillion dollars in the US. By February 1995, triggered by the Mexican crisis; concerns about Canada and the related implications, there was an unprecedented run on the dollar. The Dollar/Yen crisis had begun.

Japanese investments in the USA
A few examples of Japanese investments in the United States particularly in real estate, and in major direct investments, such as Mitsubishi’s purchase of the Bank of California, or the purchase of the Hollywood studio MCA by Matsushita are useful real life situations. These will prompt us to learn that a foreign investor does not always profit in even developed nations, unless there is sound macro economic management of these nations.

In December 1990, Matsushita paid $6.1 billion for MCA. In 1995, it sold 80 percent of its stake in the studio to Seagram’s a Canadian company for $5.7 billion. On the face of it, we may think it made a small profit. However when Matsushita repatriated the sale proceeds, it realized a foreign exchange loss of $ 1 .9 billion (Y 165 billion).

Mitsubishi Bank - Mitsubishi Bank bought the Bank of California in 1984 for $800 million, when the rate of exchange was approximately 250 yen to the dollar. Post acquisition it found out that it had to write off large amounts of bad loans, bulk of it relating to California real estate. To offset the impact of these write offs it invested a further half billion dollars.

Thus their total investment was now $1 .3 billion. The exchange rate sank below 100 yen to the dollar in 1995 and Mitsubishi had a reported loss equivalent to over half of its original investment.

Rockefeller Centre
Mitsubishi Real Estate in 1989 had achieved an 80 percent stake in the company that owned this New York landmark for a cumulative cost of $ 1 .4 billion. The dollar exchanged for 150 yen at this time. When this sale to “foreigners” as it were was revealed, there was an enormous public outcry. The question was-How can the USA allow Japanese to acquire American landmarks? The protestors were unaware that Mitsubishi had also acquired the $ 1 .3 billion mortgage that had been outstanding against Rockefeller Centre. With surplus office space in New York, Mitsubishi’s mortgage payments exceeded its rental income. By 1995, Rockefeller Centre had drawn in a further $500 million of cash. With the change in the yen/dollar exchange rate, the loss was $1 billion. In May 1995, Mitsubishi Real Estate declared bankruptcy.

There are several thoughts here. At a time when we are endeavouring to introduce many desirable and long outstanding pro-poor strategies, coupled with populist and some-times only politically motivated welfare measures and subsidies, simultaneously with investment in much needed rural infrastructure, we must be cautious in achieving the right balance. Macro-economic management requires deep thinking, sound science and experience. Innovation is essential but learning from the lessons of economic heavyweights would be nothing less than a prudent and responsible way forward.

It is also useful for key political players, to recognize (as it turned out in the recently kick started “peace process” which I think requires blessings rather than a premature “standing ovation” given that it has only just re-started) that inciting sentiment, which is anti-multinational, anti- multilateral, anti foreign investor, anti USA (our largest market for the apparel sector-our major employer) or anti western or European, is simply out of style and out of tune.

President Clinton bailed out Mexico by contributing US $ 20 billion by dipping into a Fund meant to stabilize the US dollar (not the Peso- even though we are not naïve to the relationship between these currencies, more so since NAFTA was in place then) even without referring to Congress, and the IMF and the Bank for International Settlements contributed US$ 32 billion. Quite simply, politicians, rather than only being vocal and critical, must add value to the thinking of the poor and sunshine into their innocent lives. That, then, would be a pro-poor strategy.

Ranel Wijesinha., FCA (Sri Lanka), MBA (USA), is a Past President of the Institute of Chartered Accountants of Sri Lanka and Past President of the Confederation of Asian and Pacific Accountants. He has served as Director, Business Development for the John Keells Holdings Group and has worked overseas with Deloitte Touche Thomatsu International. Until 2001, he was Partner and Head of Consulting of PricewaterhouseCoopers, Sri Lanka and is currently in Independent Consulting, serving overseas and local clients.

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