Klaus Meyer's Blog
On Business and Economics in Volatile Times
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Next week Europe is electing its parliament. It is a peculiar election because so little is talked about it in the Media, or on the streets, yet it is for one of the most influential political bodies in the world, and the election is (after India) probably be largest election in the world. Yet, why were Indian recently all excited about their election, and Europeans seem so numb? Probably it is because this parliament has most of the usual powers in shaping laws and monitoring a governmental bureaucracy - yet it lacks the pivotal power to elect or dismiss a government. In other words, the European parliament is shaping the rules, but not selecting the people.
The governance structure of the European Union is most peculiar indeed. At first sight, it looks like a national government: there is bureaucracy headed by someone resembling a prime minister, there is a parliament, there are various institutions such as a Central Bank and an independent judiciary, and there is another chamber representing the member states. Yet, this 'other chamber' holds most of the power - it is the Council of Ministers, which aren't the ministers of the EU, but the representatives of the member states, each coming to meetings with a veto in their bag. Imagine a group of 27 quite diverse people trying to make decisions on something substantial ... I'd rather call them the horse-trading club.
The parliament, in contrast, run much more like a normal parliament, organized along political parties, and discussing subtleties of legislation. Especially for businesses, most of the relevant rules are decided in the European Parliament - when legislation comes down to national parliaments, they are constrained by what has been decided already in Strasbourg and Brussels. Equally crucial, the European Parliament scrutinizes the budget of the EU, and thus the the Commission (i.e. the bureaucracy). Hence, it does its best to minimize money wasted. National politicians loath to admit it, but for many areas of politics, true power has slipped away from national parliaments long time ago. But they won't tell you - except when they need a scapegoat.
Looking at the candidates presenting themselves on TV and on the streets these days, many come across as country bumpkins with a grievance. They may have a point on whatever special issue they stand for, but some of them would get lost in the town hall of a medium sized city. Reading, interpreting and monitoring the budget of a city a quite a challenge - a lot of the country bumpkins on the election trail do not seems to be up to that task. Would you entrust them to monitor the European Union, and to negotiate their way through Brussels and Strasbourg? Sending inexperienced folks and fringe parties would weaken parliament's monitoring role, and make for a lousy representation of your country.
For most voters, probably the best choice is the mainstream party they are closest to ideologically. But check out your local candidates - are they really up to such a challenging job, or are they just good at playing the media? And don't forget to vote - else the parties you least like will end up much stronger than your worst nightmare!
Medium-size, privately held firms have long been a backbone of the German economy, often misunderstood by Anglo-Saxon observers more accustomed to outside shareholders and strict focus on quarterly profit numbers. Yet, these firms, often labeled 'Hidden Champions' have survived and prospered for decades, often pursuing very long-term oriented strategies in very specific niche markets, yet with a global reach. My co-author Bernd Venohr has been recording and analyzing these firms, and jointly we wrote two papers about them.
When the financial crisis hit, I was concerned whether this model would be robust to the challenges of the global downturn. Three characteristics would be expected to work against them: Firstly, they tend to be highly leveraged and thus dependent on bank finance because their owners like to retain control and thus do not wish to dilute their equity stake. With tightening credit markets, these bank loans have become harder to come by. Secondly, many of these firm operate in sectors that are disproportionately affected by the recession, broadly speaking investment goods and consumer durables - sectors in which buyers postpone purchases when budgets get tight. Thirdly, many of these firms are highly export-oriented and thus contributed to Germany's huge trade surplus, which makes them vulnerable to economic fluctuations elsewhere.
Indications are, however, that, generally speaking, these medium size firms are doing rather well. For example, The Economist reports this week, German and French medium size firms are doing much better than their respective economies overall. While liquidations jumped up in Britain, the 'corporate death-toll' in Germany 'was little changed from a year earlier'. The Economist goes on to cite INSEAD professor Ludo Van Der Hyden, who offers explanations for the good prospects for entrepreneurs very much in line with earlier comments in this blog , namely their ability to operate more efficiently and to react more flexibly to changing circumstances. In particular, these smaller firms tend "not to make the kinds of stupid responses that big companies make, such as cutting costs deeply and indiscriminately, so they recover faster". In other words, their strategic leadership is focused on the next upswing rather than on short-run financial performance indicators - as illustrated in my blog on May 20.
Germans thought themselves and their banks to be rather safe back in 2007 when the first sub-prime mortgages surfaced in the U.S and a bank-run brought down the British mortgage lender turned bank Northern Rock. Germany didn't experience a housing bubble like Anglo-Saxon countries, and their mortgages tend to be financed differently - far more long term. Mortgage backed long-run obligations called Pfandbriefe are backed directly by mortgages, subject to very conservative evaluation criteria and caps on the percentage of the purchase value that may be financed in this way. While Anglo-Saxon economists may berate this system for its inflexibility, it should have protected German banks against the kinds of financial meltdown that plagues London, Dublin and New York these days.
Surprisingly though, German banks are in trouble too. First a few smaller state-backed institutions went to the wall and were quickly taken over. Yet, even larger institutions faced major problems with HRE Bank needing a major bailout. How could that happen to conservative German Bankers? There are two reasons for this, one reasonable, the other not. Firstly, German (and Austrian) banks heavily invested in Eastern Europe, both by lending to private and state borrowers, and by taking over local banks. It seemed to be a good strategy at the time, but now that Eastern Europe faces a deeper economic slump than most, these investments face major write-offs.
Secondly, German banks have heavily invested in U.S. mortgage-backed financial assets, which turned out to be toxic. A friend of mine who is a banker in Frankfurt told me that Germany held more toxic U.S. assets than any other country! How could this be? On the one hand, Germany generated a persistent trade surplus for many years, which led to an inflow of money that had to be re-invested. So did the Chinese, though it seems the Chinese have been more cautious in the choice of investments: U.S. government bonds (and, recently, private equity). Somehow, German bankers more than others trusted 'AAA' ratings on financial instruments that they failed to fully comprehend, pursuing higher interest rates on supposedly low risk assets. A higher interest rate on supposedly the same level of risk should always raise alarm bells - certainly among trained bankers. It seems that risk management failed in a lot of banks, curiously in particular among the state-backed Landesbanken. Financial regulation putting too much emphasis on "ratings" thus can create systemic risks that need to be addressed.
Sinn, H.W. (2009): Bei Bad Banks zahlt der Steuerzahler drauf, Wirtschaftswoche, May 23.
Handelsblatt (2009): Deutschen Banken drohen neue Turbulenzen, May 19.
Handelsblatt (2009): HRE-Desaster: Kein Land in Sicht, May 6.
The Economist (2009): Germany's bail-out: Too little, and late, April 19.
Sometimes the business news can be as exciting as a crime novel, eagerly you await the next act. Two such dramas are currently playing out in Germany, both with the same theme: If you try to bite off more than you can chew, you get eaten alive.
Case 1. The megalomaniac: Maria Elisabeth Schaeffler, heir and CEO of Schaeffler Group, a medium size automotive supplier. The target: Continental, one of Europe's largest manufacturers of tires and a major supplier to the German car industry. In an unprecedented move (at least in Germany), in 2008, Ms Schaeffler made a hostile take-over move bid for Continental, a company several times the size of her own - with the enthusiastic backing of her financiers. Continental's board resisted, and so did various employee representations and interest groups. Then the financial crisis hit, and, while she managed to drag out the inevitable, her bid eventually collapsed like a house of cards. The Schaeffler group called for state-aid, which it didn't get. The latest rumours are that Continental would take over Schaeffler - achieving consolidation of the automotive supplier industry, but not quite the way Ms Schaeffler had imagined it.
Case 2: The megalomaniacs: Wendelin Wedeking, CEO, and Wolfgang Porsche, major shareholder, of Porsche AG . The target: VW, one of Europe's largest car manufacturers. In a family battle that has all the trappings of a Hollywood movie, the Porsche family tried to take over VW, the company that made the probably most famous design of Ferdinand Porsche - founder of Porsche - a world hit: the VW Beetle. VW was led most recently by Ferdinand Piëch another descendent of Ferdinand Porsche, and also a shareholder in Porsche AG. Yet the Porsche and Piëch families have been doing battle for years. At the end of 2008, it looked like Porsche was to pull through the unthinkable, taking over VW despite VW's minority state ownership and traditionally strong trade unions. Yet, Porsche made enemies with some of the banks that initially supported its bid, and securing finance has become a lot more difficult in tightening credit markets. Porsche AG asked for state-aid, which it didn't get. The latest rumours are that VW would take over Porsche - achieving consolidation of the car industry, yet not quite the ways Messrs Porsche and Wiedekind had imagined it.
So, what are the lessons from these stories? Do you recall the section on managerial hubris in the textbook chapter on mergers and acquisition? If not, read it again - managers sometimes think they can do the undoable. Only sometimes they are right. An ambitious take-over that depends on banks providing the bulk of the finance is a very high risk transaction - only do that if you are sure not to live in a bubble economy.
The current economic situation is challenging, yet at same time creating many opportunities. The newspapers – even business oriented publications – focus a lot of the challenges and the costs. Entrepreneurs, in contrast, convey much more upbeat perspectives, for instance in a panel of practitioners and academics at the University of Bath. Richard Elliot, Michael Mayer and myself were joined by Andrew Payne, Strategic Relations Development Director of Halcrow Group Ltd, and entrepreneur Margaret Heffernan, who has been involved in running multiple businesses.
Andrew Payne outlined the response of Halcrow, an internationally-oriented engineering consultancy. While they faced contraction in some business sectors, other activities were actually booming due to (at least temporarily) increased spending in infrastructure development – not necessarily in the U.K. To handle immediate pressures, Halcrow is implementing a programme around their three C’s “client care, cost control and cash collection.” In Payne's experience with the crisis, Halcrow did get a few things right, including keeping long term goals in mind, have visible internal communications from the CEO, and scenario planning in one team. He concluded that the most important focus at this time would be that everyone in the organization keeps "a clear line of sight of the customer".
Margaret Heffernan emphasized the crisis as an opportunity for entrepreneurs to make their mark: "the really smart people will come out a lot stronger". It is likely that the next upswing will be driven by new business ideas. Entrepreneurs are in a good position to come up with such new ideas, and to implement them. They have several factors potentially in their favour. Firstly, they may be able to attract human capital that normally would work for big firms offering stable jobs. Secondly, many big businesses are struggling with inertia and debt, and (inadvisably) cut their product development, leaving opportunities to grab for entrepreneurs. Third, the current tough environment allows entrepreneurs to find out quickly what works, and what does not work - and to readjust accordingly.
On a different level, Margaret as well as other speakers emphasized that the external crisis provides a 'air cover' for implementing change, and to focus on long term objectives while others are distracted by the external 'noise'. Internally, people may be 'too frightened to challenge the boss', and thus allow change that might otherwise be opposed. For example, Apple developed its IPod during an earlier recession, and stuck to its invention while commentators lost faith in, until it eventually took off. However, despite the opportunities, the crisis is a tough test of entrepreneurs' "values, stamina and competences". It's like a real world "Dragons' Den".
The audience was generally less optimistic and challenged the panel accordingly in the discussion. However, the panelists encouraged businesses and graduates to look for entrepreneurial opportunity rather than being overwhelmed by widespread fatalism.
The word of the month seems to be 'green shoots', yet interpreting them is becoming a full time job for business journalists. I have been complaining about the excessively pessimistic attitude of the tabloids; fortunately that is gradually shifting, good news is no longer hidden away. Yet, what do those green shoots really mean?
Optimism about the global economy come from a number of different indicators:
Does this mean the world economy is on the way to recovery? Probably not. A lot of these adjustment seem to be corrections for excessive budget cuts or overly pessimistic valuations. A good part of the drop in manufacturing has been caused by reductions in inventories - now that inventories have reached lower levels corresponding to current demand, the manufacturers are producing again. Also, governmental incentives such as car scarpage schemes appear to come through to consumers. All this seems to suggest that we may have reached the bottom of the recession, and markets are correcting for over-reactions.
Yet, so far the green shoots look like the recovery of last years' greens. I don't yet see new varieties emerging that may provide new bloom to devastated landscapes. In other words, I am looking out for new products, services, and business models that may be driving the next upswing - and so far I see very little. Thus, we may have reached the bottom, but the recovery is likely to be slow.
I do not normally read books written by politicians, nor would I recommend them. Yet, there is always an exception to a rule. The Exception is Vince Cable's "The Strom" on the world economic crisis. Vince Cable is a respected politicians (a rare feat nowadays) in the British parliament, representing a party that regularly get 15 to 20% of the votes in elections, but is considered unlikely to ever get in government due to the archaic nature by which parliamentary seats are allocated in this country. Yet, perhaps it is this distance from actual power that relieves him from the pressures of daily politics and thus enabled him to provide a thoughtful and analytical reflection of where we (the UK & global economy) are, and how we got there.
Vince Cable provides a very knowledgeable overview, backed by economic analysis (he used to be Chief Economist of Shell) and a good understanding of economic history. He explains the emergence of the mortgage bubble and subsequent credit crunch in the U.K., its interrelationships with the global economy, and with wider issues such as the recent surge and collapse of the oil price. Throughout he is analytical without being overly academic. In fact, as an academic reader, I would sometimes have preferred a few graphs depicting the data trends or analysis he was talking about. However, the less academic writing style makes this book very accessible for lay persons not used to analyzing economics issues. Moreover, he largely separates his analysis from his own policy suggestions in the final chapter, which means readers can benefit from his insights without being put off by political views they may disagree with. Overall, thus, a good book to pass on to a friend confused about what is happening around us.
I have set my MBA students the following exam assignment:
"Choose a company with global operations in an industry that you are familiar with...
Do you think this is a challenging assignment? Well, yes. But then, an doing MBA is about achieving things you never thought you could achieve, isn't it?
More generally, every business has to go through this sort of analysis - and if you are on the job market this summer you have to be able to engage in a meaningful conversation on these sorts of issues with whoever will be interviewing you!
The deadline was May 1. So next week, I shall be receiving the analysis of some 25 different companies. Let's see what creative ideas my students come up with!
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