WHEN THE MUSIC STOPPED
EXCERPT BY ALAN BLINDER
EVOLTUION AND OUTLOOK OF ENTREPRENEURSHIP BY SHAWN P. O’CONNOR
THE DEAL OF THE CENTURY BY JULIAN HE, CHRIS WU, AND RYAN AZARRAFIY
Spring 2013 issue
The Princeton
Financier SPRING 2013 Volume 2 | Issue 2
EDITOR-IN-CHIEF
LE T TER FROM THE EDITOR
Darwin Li ‘16
MANAGING EDITORS Hannah Rajeshwar ‘14 Seth Perlman ‘14
DESIGN & LAYOUT Michelle Molner ‘16 You-You Ma ‘16
CONTRIBUTORS Jonathan Ma ‘15 Hadley Chu ‘15 Julian He ‘14 Chris Wu ‘14 Ryan Azarrafiy ‘16 William Beacom ‘15 Christopher Huie ‘16
PCFC Board SPRING 2013
PRESIDENT Hannah Rajeshwar ‘14
CLUB MANAGEMENT Ambika Vora ‘15
EDUCATION Jonathan Hastings ‘15
MENTORSHIP Dalia Katan ‘15
MARKETING Michelle Molner ‘16
COMMUNICATION & TECHNOLOGY John Su ‘16
INDUSTRY INSIGHT Sunny Jeon ‘14 Julian He ‘14 Alex Seyferth ‘14
FINANCE Jason Nong ‘15 ALL CORRESPONDENCE MAY BE DIRECTED TO: The Princeton Financier 0666 Frist Center Princeton, NJ 08544 pcfc@princeton.edu www.princetoncfc.com
The improved economic conditions and financial metrics of the United States point toward continued growth in 2013, both in the financial industry and in the broader U.S. economy. For the first time in several years, the recovery of the real estate and housing sectors is creating optimism that is reflected in the equities and commodities markets. Yet despite these glimmers of hope and recovery, there are still reasons to worry. The nearly $17 trillion national debt and the large income disparities across classes have caused public concern and unrest. This issue of The Princeton Financier focuses on this theme—improvement tinged with uncertainty—on both a domestic and global level. This issue begins by addressing an issue pertinent to many current citizens and future generations of citizens: the recent events concerning our national debt and the legislation that has revolved around it. As this issue of The Princeton Financier progresses, we hope to instill in the reader both a sense of confidence as they learn about the growth prospects in different regions of the world and also a sense of caution as they understand the uncertainty in other areas. We hope to leave the reader not only more knowledgeable about current global affairs but also cautiously excited about the future prospects of the global economy. As has been the case for the past several issues, The Princeton Financier features work from the Princeton Corporate Finance Club’s Industry Insight Team, which publishes weekly newsletters that keep members of the Princeton community well-informed on prominent market activities around the world. Even a cursory perusal of the magazine clearly demonstrates their well-researched work, which has undoubtedly contributed significantly to the broader theme of global economics. Furthermore, for the second consecutive semester, dedicated staff writers have been instrumental in the magazine’s publication. Through their efforts, this issue is able to cover
the topic of Canadian energy investment policy and feature an interview with Scarlet Fu, a chief markets correspondent for Bloomberg, which provides a look into the journalism industry. Finally, this issue was also fortunate enough to include two professionally contributed pieces from Stratus Prep President Shawn O’Connor, a column writer for Forbes Magazine, and from renowned American economist Alan Blinder, author of After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead and a Gordon S. Rentschler Memorial Professor of Economics & Public Affairs at Princeton University. We are extremely grateful for the continued support from our undergraduate contributors and from leading industry professionals. In addition to the efforts of the magazine contributors and editors, the successful publication of the fourth issue of The Princeton Financier was made possible by the tenacity of many officers of its parent organization, the Princeton Corporate Finance Club (PCFC). From diligent design and layout planning to tireless fundraising and marketing campaigns, it took the hard work of many divisions of PCFC to create this final product. If you find this issue of The Princeton Financier to be fascinating, I recommend exploring many of the other exciting opportunities PCFC has to offer as well. On a final note, similar to a theme expressed in this issue, the young yet burgeoning PCFC sees a bright future ahead. With a growing student officer team and increased reach on campus, PCFC hopes to continue and improve upon its current operations for future semesters. With your support, the backing of committed corporate sponsors, and a creative team with big plans for the future, the continued growth and success of the PCFC is viewed with great optimism. Thank you. - Darwin Li
The Princeton
Financier INSIDE: 4 6 9 12 16 19 22 ABOUT PCFC
Kicking the Can Down the Road by Jonathan Ma An Inside Look at Financial Journalism: Interview with Bloomberg’s Scarlet Fu Interview by Hadley Chu BP & Rosneft: Deal of the Century by Julian He, Chris Wu, and Ryan Azarrafiy When the Music Stopped: An Excerpt From After the Music Stopped by Alan Blinder Entrepreneurship: Individual Accomplishments, National Impact by Shawn P. O’Connor The CNOOC-Nexen Deal and the Future of Foreign Direct Investment in Canada by William Beacom Southeast Asia: The End of the Ride? by Christopher Huie
The mission of the Princeton Corporate Finance Club is to provide an educational and networking platform for Princeton students interested in investment banking, private equity, venture capital, and the field of corporate finance at large. Established in March 2011, the Princeton Corporate Finance Club has quickly become a prominent club on the Princeton campus with over 400 student members and 30 officers working in seven divisions: Education, Mentorship, Industry Insight, Finance, Marketing, Communication & Technology, and The Princeton Financier. Our core values are fraternity, entrepreneurship, leadership, responsibility, integrity, professionalism, and mutual respect.
In order to understand the budget sequester of March 2013, it is necessary to understand the events that came before it. In 2007, the U.S. national debt was 34% of GDP. By March 2011, this figure had ballooned to 75%. This increase was primarily due to not only lower tax receipts produced by a recovering economy, but also major stimuli from the Federal Government. The national debt was and is predicted to grow due to the combination of an aging population with a higher demand for healthcare and social security and compounding interest payments on the current debt.
Erskine Bowles. This Bowles-Simpson Committee was tasked with identifying “policies to improve the fiscal situation in the medium term and to achieve fiscal sustainability over the long run.”
According to Harvard Economics Professor Martin Feldstein, the United States cannot afford to continue this trend. At some point, when a nation has too large of a ratio of debt to GDP, investors will suspect the nation’s ability to repay the debt and will demand higher interest rates to account for the added risk. Higher interest rates will not only add to the existing national debt but also affect consumers who would have to pay a higher interest rate for borrowing. There are two primary methods of lowering the debt: raising taxes and cutting expenditure. Both of these methods, however, slow economic growth.
The Committee proposed putting limits on discretionary spending and also proposed eliminating all tax expenditures, decreasing the current tax rates and then later deciding which deductions to add back on and then raising the tax rates accordingly. Furthermore, the committee proposed raising the scheduled retirement age in an effort to reform Social Security.
The Committee’s proposal would have cut $4 trillion in debt by 2020, which would reduce the ratio of national debt to GDP from its current level of 73% to 60% by 2023 and to 40% by 2035. BowlesSimpson took a balanced approach, by raising revenue and cutting entitlement against the wishes of Republicans and Democrats alike.
Although the proposal tackled the debt as diplomatically as possible, it ultimately failed in December 2010 as it received only 11 out of the 14 required votes to be considered by Congress. United States Debt Ceiling Crisis of 2011
Bowles-Simpson Committee In 2010, President Barack Obama created the National Commission on Fiscal Responsibility and Reform which was co-chaired by former Republican Senator Alan Simpson and former Democrat White House Chief of Staff THE PRINCETON FINANCIER | 4
In the middle of 2011, the Treasury needed Congress to raise the national debt ceiling because the United States’ debt obligations had increased from the previous year. To address the nation’s high level of debt, Republicans and some Democrats
tried to create a sustainable budget before raising the debt ceiling, but the ideological gulf between the sides proved too large to bridge. In the days directly prior to the Department of Treasury exhausting its borrowing ability, Congress passed the Budget Controls Act of 2011. The act raised the debt ceiling by $900 billion in exchange for $917 billion in cuts over 10 years. Furthermore, a Joint Select Committee of six Democrats and six Republicans was created to devise a plan that would decrease the deficit by $1.5 trillion over the next 10 years. The only caveat was that if the super committee could not reach a decision, then increasing the debt ceiling by $1.2 trillion would result in a $1.2 trillion sequester, or automatic spending cuts, which would be split between defense and nondefense. The sequestration was designed to be so painful that the super committee should be forced to find a compromise to avoid the horrid automatic cuts. The Super Committee Political commentator Fareed Zakaria described the super committee as “one more occasion where Congress...basically punted, kicked the can down the road.” Zakaria argues that the super committee was doomed to fail, as “the Democrats are saying no cuts to entitlements… The Republicans are saying no taxes… that’s great except we all know the only solution to our long-term debt problem
is cuts in entitlements and new taxes.” On November 21, 2011, the super committee announced it could not reach a solution. Without a plan from the super committee, America had to brace for the automatic budget cuts that were about to go into effect in January 2013 unless Congress and the President were able to find a way to put the nation on a sustainable path and to avert the cuts. United States Fiscal Cliff of 2012 Due to the budget sequestration, the Budget Controls Act of 2011, and the expiring Bush Tax cuts, Congress and the President were tasked with preventing a massive increase in taxes and sudden spending cuts. The Congressional Budget Office predicted that if Congress did not act, unemployment would rise from 7.9% to 9.1% and the U.S. economy would have a mild recession with -0.5% GDP growth in 2013. Once again, both sides clashed and a grand bargain did not materialize. President Obama, who had just been re-elected, pushed for and succeeded in passing the American Taxpayer Relief Act of 2012 (ATRA) which permanently extended the Bush Tax cuts for individuals earning less than $400,000 and raised the top marginal tax rate for those earning more than $400,000 from 35% to 39.6%, and raised capital gains tax from 15% to 20%. Furthermore, ATRA phased out certain tax deductions, raised estate taxes, allowed payroll tax cuts to expire, and extended federal unemployment benefits for a year. However, the act delayed the budget sequestration for two months to March 1, 2013 and did not address the issue of raising the debt ceiling. The American Taxpayer Relief Act is estimated to bring in $600 billion in revenue over 10 years. However, in the February 2013 Budget Outlook, the Congressional Budget Office projected that in 2023, the United States’ national debt would be 77% of its GDP and on an upward path, which suggests that futher work would need to be done.
Budget Sequester 2013 The automatic cuts from the Budget Control Act of 2011, which were delayed by two months by the American Taxpayer Relief Act of 2012 became a concern in March 2013. The sequestration was supposed to cut $85 billion for the Fiscal Year 2013, half in defense and half in non-defense. After weeks of discussion, once again no middle ground was found and on March 1, 2013, President Obama reluctantly signed an order putting the cuts into effect.
taxes. The optimal compromise is then the solution the United States had all along: the proposal by the Bowles-Simpson committee. In February 2013, Bowles and Simpson released a proposal similar to their 2010 version, except this time they included a means-test for the Medicare beneficiaries as well as the suggestion of raising Medicare eligibility age, which ultimately made the proposal highly unattractive to left wing Democrats. But equally unattractive is the removal of $1.1 trillion tax deductions. The new Bowles-Simpson proposal would reduce debt by $2.4 trillion in the next 10 years.
Moving Forward The debt limit is set to be breached on May 18, 2013, which both Congress and the President will again attempt to come together to find a compromise to reign in the United States’ national debt. There are a few possible solutions. The most pessimistic one is identified by Harvard History Professor Niall Ferguson, who laments, “is there a single
Two other possible solutions are evident in Senate and House budgets for fiscal year 2014. The largely Republicandriven House budget seeks to reduce the national debt by $4.6 trillion in the next decade, increasing reliance on spending cuts, capping government spending on Medicare, and lowering taxes, all of which are ideas that Democrats disagree with. The Senate budget that was largely spearheaded by Democrats seeks to
There are two primary methods of lowering the debt: raising taxes and cutting expenditure. Both of these methods, however, slow economic growth. member of Congress who is willing to cut entitlements or increase taxes in order to avert a crisis that will culminate only when today’s babies are retirees?” The span of time between when the crisis will come to a head and the present day may make compromise politically inexpedient. If this aversion continues for too long, the crisis will become unpreventable by the time action is taken. However, Princeton Economics Professor Paul Krugman suggests that in last year’s election, “American voters made it clear that they wanted to preserve the social safety net while raising taxes on the rich.” In this case, the solution may be to raise
reduce the debt by $1.85 trillion in the next decade. Of the $1.85 trillion in the Senate budget, $1 trillion will come from tax revenue, a solution that remains unpalatable to Republicans. Neither budget looks slated to receive wide support from both parties. The best hope is then to have a compromise that includes both increases in revenue and cuts to entitlement. Hopefully in 2013, Congress and the President will decide to take the House’s stance of reducing entitlement, the Senate’s plan for raising taxes, or reach another conclusion similar to the BowlesSimpson plan, rather than simply kicking the can further down the road. THE PRINCETON FINANCIER | 5
AN INSIDE LOOK AT FINANCIAL JOURNALISM: INTERVIEW WITH BLOOMBERG’S SCARLET FU
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Scarlet Fu is the chief markets correspondent for Bloomberg Television. She covers trading activity in Asia, Europe and the United States, contributes to “Bloomberg Surveillance”, and is featured on Bloomberg Television, Bloomberg Radio, and Bloomberg.com. Fu began her career at Bloomberg News covering Asian equities and worked as a U.S. stocks editor before switching to Bloomberg Television. Prior to working at Bloomberg, she worked at CNBC Asia in Hong Kong. She graduated from Cornell University with a bachelor’s degree in history and a concentration in Asian American Studies.
How do you choose your stories? We decide the day before which guests will be joining us. The show lasts from 6:00 to 8:00 AM, and then after it ends, I return to my desk and see what else is going on in the news, and then we have a meeting at 8:30 AM. You basically have half an hour to go from one day to the next and so we have to know all the headlines and news pegs. The segment producers will have booked around these stories and we will have suggestions, but sometimes there are holes to fill. We usually have a pretty good idea of what 80% of the show will be about but we won’t necessarily know what the top stories will actually be. Based on what is happening today, we can usually provide you with an idea but that idea will obviously be updated the next morning. After the meeting, I go back to my desk and then later, I contribute to the 10:00 AM to 12:00 PM show. What was your first job? I was a history major in college and after I graduated, I moved to Hong Kong because at the time, the economy was not doing very well which meant my options were ‘go to law school’ or ‘be a temp.’ Since neither of those options was very appealing, I went to Hong Kong to look for a job and got one at General Electric. They had a financial management training program, which sounded really good, but after about two weeks I realized that job was not the right fit for me. How did you get from there to Bloomberg? I did not want to be a mid-level finance manager, so I talked to the manager of the GE training program. At the time, GE owned NBC which owned CNBC, and CNBC was just launching. I told the manager that I wanted to switch to CNBC, and he helped me move over to the editorial and production side, where I started off as an intern. After that switch, I
had to prove myself indispensable so that they would hire me full-time. Why the switch from Hong Kong to New York? I stayed at CNBC Asia for slightly over two years and then I moved to Bloomberg after seeing a job advertisement in the newspaper. Back then, in Hong Kong, it was common to get jobs by reading advertisements in the newspapers. Since I was on the print/production side, and so I was ordering graphics, booking guests, writing scripts, and writing questions for the anchors to ask the guests, but I was never on camera. Television is one of those funny places where it takes a village to put together a show but there are only one or two people who actually get the credit. I moved to Bloomberg because I realized that as a television reporter, you are only re-writing wire copy instead of actually going out and doing the reporting yourself. I wondered ‘where do wire-copy people get their stuff? Why did they say Hong Kong stocks rose or fell? Where do they get this information from?’ Bloomberg was the place to do all of it because they have the information and wrote all those stories. I moved from CNBC to Bloomberg, started writing those stories, and after I returned home to the U.S., I eventually moved back to television. What have been the most interesting stories you’ve ever covered? In Hong Kong, I covered the handover which was certainly eventful but in the end turned out to be extremely orchestrated, so not a lot of news was generated from that. But the financial crisis afterwards really took everyone for a spin. That was really volatile—no one knew what was going on initially. I got trained to stare at the Bloomberg screen just to watch the index move. I remember watching it plunge, and then all of a sudden, it would go back up again. The government was buying stock
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because people were attacking the Hong Kong dollar and trying to break the peg. Basically, the Hong Kong government came in and defended the currency and bought up shares as a show of force which made a really great story. Of course, the financial crisis overall in 2008 and 2009 was also just stunning to watch unfold. Tell me about covering the recession from the inside. Unfortunately, bad news creates more interesting days for a news reporter. The boring days were those when the stock market was doing great in the summer of 2007. It was like ‘oh look it’s another buyout, it’s another M&A, another takeover, another quarter-record profits, and another record for the Dow.’ It lost its luster after a while, and even then, you would always get this unsettling feeling because you knew it couldn’t go on forever, but you didn’t know what was going to make the music stop. The financial crisis was fascinating, but thinking back, I feel like we missed a lot of the stories at the time because there was so much misinformation flying around. We knew what was going on with AIG and Lehman Brothers but we didn’t know the depth of the problems. Uncovering those problems took more investigative reporting by everyone. Do you think being at Bloomberg at this time gave you a different perspective on the recession? It’s possible—although when you fixate so much on the day-to-day, you often miss the bigger picture. I think what you are able to appreciate is how interconnected everything is and that there are a lot of warning signs here and there. There are always people who will be contrarians; when times are good you give them the opportunity to say it, but not everyone wants to believe it. The other thing about markets and Wall Street is that people might be convinced that the good times can’t last but that doesn’t mean that you
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sit it out either. You still have to make money and you don’t have to believe in something to make money off of it. Who are the most interesting people you’ve interviewed? Outside the world of finance? I interviewed Adrian Grenier from Entourage once. But what is really the most interesting is talking to people who head up companies and finding out how they navigate the waters in this extremely uncertain economy. It is always more interesting to hear people who have a lot of responsibilities; who have to take care of people in their company and who are really accountable for everything they do. I like that. Sometimes we spend a lot of time talking to economists and getting their GDP forecasts. But after a while that can sound the same, even though it’s not. When the Federal Reserve is so involved in the market, there is always a caveat that everyone has to give when making projections about the economy. What’s the hardest part of your job? The hardest part of my job is waking up at 3:00 AM! Being able to think clearly and quickly when you are sleep deprived is a huge challenge. But I think doing it day after day is the only way you get better at it because that’s the only way you build up the muscle memory and the institutional knowledge of everything since you can’t predict what kind of news is going to break at any given time. Just to give you an example, the other day there was breaking news on Fedex. Earnings reports were coming out, and they cut their forecasts for the full year, which was a surprise. You have to know the backstory to these delivery companies: what is going on with the economy, how leveraged they are to the economic cycle, etc. You also have to know that Fedex in particular is going through a big program of restructuring. If you don’t know any of that information, then the headline that comes out does not make sense. You have to know all of that information to be able to add context to the headline and thus make it a bigger story.
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Quite simply, how much finance do you have to know to be a financial journalist? You know a little bit about a lot of different things, but you pick up a lot of it on the job. Part of it just is reading every day—constantly reading other news stories, reading Bloomberg stories, reading the Op Eds, reading the research reports that people send us when they come on as guests, and reading research reports people send us because they were guests. You have to read constantly. Who are your competitors and how do you differentiate yourselves from them? Anyone and everyone who covers business and financial news are our competitors, from the Wall Street Journal and the Financial Times to various blogs. In comparison to other TV networks, I feel we’re less solely focused on the markets. We also compete for the same guests, but we try to ask smarter questions, and I think we usually succeed.We try to avoid the pattern of a CEO giving us the standard patent answer, us letting it go, and then moving on to the next topic. We will really challenge them. The way I see it, you’re both a mirror and a catalyst for Wall Street. What role does Bloomberg play in the industry today? Perhaps more generally, what do you think the role of financial journalism is today? I think it’s interesting how a lot of people in the financial world will use media as a means to their own ends. Take the battle between Bill Ackman and Carl Icahn—they’re playing it out in the media and we’re covering it. We like the angle of ‘here’s Carl Icahn—this big corporate raider guy who’s inspired Gordon Gekko—he’s got a personality larger than life, and they’re battling each other.’ They both have billions of dollars at stake, and we contribute to that, so we don’t help matters either. You have to sift through a lot of information to get to what it is they really believe in. They use the media to push their agendas and we allow it to happen fairly often.
But on the other hand, the media has done an incredible service to everyone by explaining what happened with the financial crisis. Were we responsible for helping drive stock prices up the way they were? Maybe, or maybe we were a mirror of what was actually going on too. We try to be as hype-free as possible but even as a financial news channel, we are still part of the entertainment business. We need to give people a reason to watch. I’m sure you’ve heard about the whole Lululemon story right now about the see-through yoga pants. People are joking ‘who’s going to do the bend-over test?’ So even though the problem resulted in a $20 million hit for the company, but it was still entertaining. What keeps you going every day? The fact that I’m accumulating knowledge and that I’m always trying to learn something new. That motivation is probably the best part of the job. In two hours, I could be interviewing someone on a topic I know nothing about but I have an hour beforehand to figure it out. You probably won’t ask the best questions in the world but all you can do is make the best of what you have at the moment and fly by the seat of your pants knowing that you have built up enough knowledge about the business world and the economic world to be able to ask an intelligent question. Best advice you’ve ever been given? While the tiger mom didn’t personally give me this advice, there is a certain truth to it: you don’t enjoy something until you’re good at it. The only way to get better at something is to do it over and over again and then it becomes fun. You start to feel like you’re in control of the material and so you can have a higher-level discussion about it than you were capable of having before.
Russian oil giant Rosneft has completed a deal with British Petroleum (BP) that has an expected worth of over $55 billion. The Daily Telegraph has dubbed this deal the “deal of the century” as it will make Rosneft the world’s third largest oil producer after ExxonMobil and Chevron and also secures BP a foothold in one of the world’s largest and richest oil regions. Rosneft reached agreements with not only BP but also Alfa-Access Renova (AAR) in order to secure their ownership stakes in the Russian oil firm TNK-BP—which is currently the third largest oil firm in Russia and one of top ten largest oil firms in the world. The deal is expected to have wide-ranging consequences for not only the Russian oil sector, but for the Kremlin and future foreign investment activity as well. Background The firm at the center of this deal is TNK-BP, a vertically integrated corporation that operates primarily in Russia and the Ukraine. Formed in 2003 as a “strategic partnership” between BP and Russian business consortium AAR, TNK-BP now produces nearly 1.7 million barrels of crude per day and currently has a market value of $37 billion. In 2003 TNK-BP acquired natural gas firm Rospan, and in 2004 began to pursue international interests by purchasing 50% of Slavneft, a Russian-Belorussian firm. Ownership of TNK-BP is currently divided in an equal 50-50 split between BP and AAR.
Rosneft is an even larger firm. It is the largest oil producer in Russia, both in terms of extraction and refinement, and is valued at nearly $85 billion. Similar to TNK-BP, Rosneft is vertically integrated and owns production facilities from Chechnya to Siberia as well as shipping and pipeline systems and refineries near the Black Sea and the Pacific Ocean. The firm’s first major expansion occurred in 2003 via its acquisition of facilities from the now-defunct Yukos Group, a Russian firm whose former owner was convicted of fraud and tax evasion. Much of Rosneft’s complex organizational
subsequent protégés have not been shy about protecting their interests in both Rosneft and other domestic firms. As a “supermajor”, or one of the world’s six largest public owned oil and gas companies, BP is also accustomed to governmental intervention. In 2008, AAR leaders forced a power play by spreading allegations that TNK-BP British executives had violated Russian visa laws. The threat of litigation led to the removal of BP-backed CEO Bob Dudley, an American national who was subsequently replaced by Mikhail
Although BP is relinquishing its stake in TNKBP, the British oil giant views the planned sale as an opportunity to secure a much stronger foothold in the rich Russian oil sector. structure is indebted to its origins as a state-run enterprise from the early days of post-Soviet Russia. At this time, policy makers had appointed the executive leadership of the firm and provided oil fields originally run by the Soviet energy department in an attempt to ultimately push the fledgling corporation into the private sector. Even after a 2006 IPO that raised an impressive $10.7 billion, over 75% of the firm is still owned by the Russian government—and the Kremlin regimes under both Putin and his
Fridman, the president of AAR. Since the Russian courts were favoring AAR’s claims, and 25% of BP’s revenue originates from its Russian venture, the British chose to acquiesce to AAR to avoid losing part of their investment. BP was once again impeded by the Russians in 2011 amidst the planning of a joint venture with Rosneft for the development of oil fields in the Arctic shelf. In addition to expanding into new sources, the two firms had hoped to test cold-weather drilling technologies THE PRINCETON FINANCIER | 9
developed exclusively for the Russian Arctic. However, this undertaking was blocked in Russian courts by AAR due to claims that the partnership would violate previous exclusivity contracts that were signed during the creation of TNKBP. The case languished in court until ExxonMobil offered Rosneft a cut in its Texas and Gulf operations in exchange for BP’s spot in the partnership. This proposition was accepted because it was favorable to both firms. The ExxonRosneft deal was ultimately worth $3.2 billion and is thus seen by many as a huge loss for BP. The Deal In 2012 Rosneft announced its plans to acquire TNK-BP in a deal that could quite possibly make Rosneft the largest publicly traded energy company in the world. The deal is worth $61 billion and requires Rosneft to pay BP $17 billion in cash and provide12.84% of its own shares in return for the British’s 50% stake in TNK-BP. As part of the deal, Rosneft will assume control of AAR’s share as well in what will become the largest global M&A transaction in the past three years and the largest oil deal in the past decade. In addition, BP will gain two seats on Rosneft’s Board of Directors. In order to finance the deal, Rosneft has been massively borrowing from multiple lenders.
agreed to ship up to 67 million tons of oil over five years. As the deal nears completion, Rosneft has since borrowed another $6 billion from Gazprombank. After the deal, Rosneft will become the world’s largest energy company in terms of liquid hydrocarbon extraction and the third largest by estimated net profit ($21.46 billion). This deal will enable Rosneft to extract half as much oil as that of Saudi Arabia. The merger will also initiate a powerful alliance between Rosneft and BP and most notably, mark the end of TNK-BP, Russia’s third largest oil supplier that while profitable, was often harmed by boardroom disagreements. Rosneft’s acquisition of TNK-BP has garnered widespread approval since the deal was announced. Former Russian President Vladimir Putin has demonstrated strong support for the merger, since it will make Rosneft’s Chief Executive Officer, Igor Sechin, one of Russia’s most powerful individuals, thus increasing Rosneft’s and therefore, the Russian government’s power. According to Putin, “this is a good, large deal that is necessary not only for the Russian energy sector but also the entire economy.” In early March, the European Union also approved the merger, though according to the EU anti-trust authority, “the merged entity would continue to face constraints
Historically, state-run behemoths HYL KVVTLK [V PULMÄJPLUJ` ILJH\ZL not only are they prone to develop excessive internal bureaucracy, they are also susceptible to external political PUÅ\LUJL Since December 2012, Rosneft has borrowed more than $30 billion from multiple banks across countries including the U.S. and China. Rosneft also secured $10 billion in advance payments from commodity trading companies Vitol and Glencore and in return, THE PRINCETON FINANCIER | 10
Russian oil sector. The British stand to gain a significant stake in Rosneft which will become one of the largest oil firms in the world at the conclusion of the merger. The move also allows BP to protect its financial interests in the area while removing it from direct involvement, which should lessen Russian political interference. Yet the underlying question is which firm got the better end of the bargain: BP or Rosneft? Winners and Losers BP looks to gain the most from this deal, since it will likely catalyze the end of its difficult marriage to AAR. The four oligarchs of AAR who collectively own the other half of TNK-BP (Len Blavatnik, Mikhail Fridman, German Khan, and Viktor Vekselberg) have had historically testy relations with BP. An argument between AAR and the CEO Bob Dudley concerning the relative merits of dividend payments versus retention of earnings led to Dudley’s removal in 2008. During this time, Dudley claimed to be under “constant harassment” from both his business partners and the Russian government. Furthermore, AAR was responsible for blocking the previous $7.8 billion Arctic development deal between BP and Rosneft which led to BP’s rival ExxonMobil cashing in on the opportunity and further souring relations between BP and AAR. This deal will dissolve the toxic relationship between BP and AAR while also smoothing relations with the Russian government. Thus this deal seems to secure BP’s future in the oil-rich nation. In past years, Russian authorities have raided BP’s offices in Moscow, and at one point even sought to detain Dudley, who was the CEO of BP at the time. With BP’s 10% stake in Rosneft, the deal provides an alliance with Russia’s stateowned oil giant and opens a gateway to Russia’s immense oil riches.
from a number of strong competitors.” Although BP is relinquishing its stake in TNK-BP, the British oil giant views the planned sale as an opportunity to secure a much stronger foothold in the rich
However, there are reasons to be skeptical of BP’s future in Russia. Combined with Rosneft’s continual underperformance, the power struggle in the Kremlin only adds increasing amounts of uncertainty to
the potential benefits of the deal. A 10% stake is not insignificant in a venture filled with uncertainties. Obviously, supporters of the deal argue that BP will bring better management and expertise to Rosneft and revive the Russian oil giant. But that logic is built upon an uncertainty. In fact, many BP shareholders would rather walk away from the TNK-BP venture after many profitable years with a cash settlement. However, a cash-only deal is not being offered by Rosneft. The lesson of the day is that there is no free lunch. BP’s alliance with Rosneft, though full of promises, is also full of uncertainties and risks. That being said, Rosneft’s gains are accompanied by fewer downsides. After the deal, Rosneft will become the world’s largest listed oil producer, with 4.5 million barrels of oil production per day, which is equivalent to 45% of Russia’s oil output. Rosneft will most likely not dominate the oil industry to the degree that Gazprom dominates the gas industry, but the deal will create a
comfortable margin between Rosneft and its closest rivals, Lukoil and Surgutneftegaz. On the other hand, the AAR oligarchs seem to be in the sole losers of this deal. They stand to lose their very profitable alliance with TNK-BP, and even worse, Rosneft has held the upper hand in negotiations since the beginning, since Rosneft already had a firm agreement with BP to buy its half of the company. Therefore, if the oligarchs had decided to end the negotiation because they did not approve of the terms, they would find themselves in a 50-50 partnership with Rosneft, and thus the Russian government as well. The oligarchs will do everything to avoid this situation as the government would undoubtedly move to remove whoever controls the other half. Even though the deal helps Putin in achieving his goal of state dominance in key sectors, it does not necessarily guarantee Russia’s success in the long run. In the short term, the deal helps Russia improve its image as a foreign investment
THE PRINCETON FINANCIER | 11
destination by ending BP’s troublesome relationship with AAR, but in the long term, inefficiency and capital flights could present enormous difficulties for Russia. Historically, state-run behemoths are doomed to inefficiency because not only are they prone to develop excessive internal bureaucracy, they are also susceptible to external political influence. Capital flight is also another potential byproduct of staterun behemoths. Net capital outflows from Russia have been continually increasing and reached $80 billion in 2011. The reemergence of state-run behemoths might serve to further aggravate the problem. Whether BP, with its newfound access to the promised land of Arctic riches, and Rosneft, with its fresh dominance in the Russian oil industry, can be successful in the future remains to be seen. Thus the BP-Rosneft “deal of the century,” as one of the biggest mergers in history and the largest oil deal since the Exxon-Mobil merger, might just prove to be more than hype and could permanently change the landscape of the oil industry.
WHEN THE MUSIC STOPPED: AN EXCERPT FROM
AFTER THE MUSIC STOPPED By Alan Blinder (REPRINTED BY PERMISSION OF THE AUTHOR AND THE PENGUIN PRESS)
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Alan S. Blinder is the Gordon S. Rentschler memorial professor of economics and public affairs at Princeton University, vice chairman of the Promontory Interfinancial Network, and a regular columnist for The Wall Street Journal. Dr. Blinder earned his A.B. from Princeton University, his M.Sc. from the London School of Economics, and his Ph.D. from the Massachusetts Institute of Technology—all in economics. He has taught at Princeton since 1971, and was founder of the university’s Center for Economic Policy Studies, where he served alternately as director and co-director from 1989 to 2011. He also served as vice chairman of the board of governors of the Federal Reserve System from June 1994 to January 1996. Before that, he served as a member of President Clinton's original Council of Economic Advisers, from January 1993 to June 1994. He served as economic advisor to the Democratic presidential candidates in 2000 and 2004, and he continues to advise numerous members of Congress and elected officials. He also served briefly as deputy assistant director of the Congressional Budget Office when that agency was founded in 1975, and testifies frequently before Congress on a wide variety of public policy issues. Dr. Blinder is the author or coauthor of 20 books, including the textbook Economics: Principles and Policy (with William J. Baumol), now in its 12th edition, from which well over two and a half million college students have learned introductory economics. His latest book, After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead, was published in January 2013 (Penguin Press). He is based in Princeton, NJ.
By 2006 the United States had built an intricate financial house of cards—a concoction of great complexity, but also of great fragility. Like most houses of cards, this one was constructed slowly and painstakingly. The sheer ingenuity was impressive. But when it fell, it tumbled suddenly and chaotically. All that was necessary
to trigger the collapse was the removal of one of its main supporting props. The jig was up when house prices ended their long ascent; after that, the rest of the crumbling followed logically. Unfortunately, not many people had penetrated the tortured logic beforehand; so few were prepared for the devastation that ensued.
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The end of the house-price bubble itself could hardly have come as a surprise. By 2006 the “is there a bubble” debate was just about over, and seemingly everyone was wondering how much longer the levitation act could last. The disagreement—and it was a serious one—was over how far house prices would fall. Optimists thought prices would just level off, ending their unsustainable climb,
or perhaps decline only a little. Pessimists were talking about price declines of 20 percent, 30 percent, or even more. What about the market? Futures traded on the Chicago Mercantile Exchange on September 16, 2006 indicated that investors expected a 6.4 percent decline in the Case-Shiller ten-city composite index. That proved to be way too small. In the end, the more pessimistic you were, the more prescient you were.
anticipated this virtually unprecedented collapse. (True confession: I was not one of them.) For decades, Americans had witnessed periodic housing bubbles, which blew up and popped in particular parts of the country. But when home prices fell in, say, Boston, they kept rising in, say, Los Angeles—and vice versa. The period after 2006 was different. House prices fell all over the map, undermining the trumpeted gains from geographical diversification.
The Cards Tumble
That was a forgivable error. The proverbial hundred-year flood actually happened. But when the housing market began to crater, we also learned that many of the MBS were not nearly as well diversified geographically as had been claimed. In fact, it turned out that a distressingly large share of the bad mortgages came from a single state: California. Many of the rest came from Florida, Arizona, and Nevada—collectively known as the “sand states.” For these and other reasons, the MBS turned out to be much riskier than advertised.
The bond bubble was far less visible to most people, vastly more complicated, and appreciated by few. It also burst with devastating effect. But the bursting came in stages. Once house prices stopped rising, subprime mortgages that had been designed to default started doing precisely that. At first, many of us wrongly believed that subprime constituted too small a corner of the financial market to do much damage to the overall economy. We soon learned better. To pick two nonrandom examples, Treasury Secretary Hank Paulson said in an April 2007 speech that the subprime mortgage problems were “largely contained.” A month later, Federal Reserve Chairman Ben Bernanke told a Fed conference that “we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.” Unfortunately, the huge amounts of leverage multiplied the damages many-fold, and the untoward degree of complexity helped spread the ruin far and wide. Financial industry executives—allegedly the smartest guys in the room—had every incentive to keep the party going for as long as they could, and they certainly tried. The regulators, still asleep at their various posts, allowed them to go on for far too long. The day of reckoning was delayed but not avoided. Why did the house of cards tumble so hard and so fast? First, when the national housing bubble burst, home prices fell almost everywhere—an “impossible” event that had not occurred since the Great Depression. In fairness, few observers
Second, the securities were not as widely distributed as had been thought. Yes, there were holders all over the world—from hamlets in Norway to Italian pension funds to billionaires in Singapore. But when the crash came, we learned that many leading financial institutions had apparently found mortgage-related assets so attractive that they still owned large concentrations of them when the bottom fell out. One reason was that there was so much profit in selling the other tranches of MBS, CDOs, and the like that investment banks were willing to hold the lowest-rated (“toxic waste”) tranches themselves. The failures and near failures of such venerable firms as Bear Stearns, Lehman Brothers, Merrill Lynch, Wachovia, Citigroup, Bank of America, and others were all traceable, directly or indirectly, to excessive concentrations of mortgage-related risks.
The real wake-up call didn’t come until August 9, 2007, when BNP Paribas, a huge French bank, halted withdrawals on three of its subprime mortgage funds—citing as its reason that “the complete evaporation of liquidity in certain market segments of the US securitization market has made it impossible to value certain assets fairly.” Loose translation: Dear Customer, you can’t get access to the money you thought was yours, and we have no idea how much money that is. To people acquainted with American history, Paribas’ announcement brought to mind the periodic “suspensions of specie payments” in the nineteenth century—times when some prominent bank precipitated bank runs by refusing to exchange its notes for gold or silver. The big French bank had just refused to exchange its fund shares for cash. Whether you were French or American, the signal was clear: It was time to panic. And markets dutifully did so, all over the world. At some point, and in this case it didn’t take long, the interplay of falling asset values with high leverage starts calling into question the solvency of heavily exposed financial firms like Bear and Paribas. Thus, market-price risk, which is already acute and getting worse, conjures up visions of counterparty risk: worries that firms that owe you money might not be able to pay up. Once such seeds of doubt are sown, the scramble for liquidity begins in earnest, because, like it or not, markets are fundamentally built on trust— in particular, on trust that the other guy will pay what he owes you in full and on time. In worst cases, markets seize up. In less severe cases, enormous “flights to quality” are triggered, typically to U.S. Treasury bills. In any case, the bond bubble, which was predicated on blissfully ignoring risk, ended with a bang on August 9, 2007. Fear was taking over. At the Fed’s Annual Watering Hole
The system began to crack in July 2007, when Bear Stearns told investors in one of its mortgagerelated funds that there was “effectively no value left.” The music was stopping. A variety of financial markets started twitching nervously, which should have been taken as an omen. But wishful thinking dies hard.
In late August of each year, most members of the Federal Open Market Committee (FOMC) doff their gray suits, don their cowboy boots (if they own any), and head off to Jackson Hole, Wyoming. There they meet with a select group of
THE PRINCETON FINANCIER | 13
academic economists and a highly select group of bankers and Wall Streeters, for an invitation to the Jackson Hole conference is the hottest ticket in Lower Manhattan. While plenty of time is set aside for hiking and whitewater rafting, the dominant activity at Jackson Hole is shoptalk. It was in great abundance in August 2007. The annual conclave, which is the Fed’s premier event, is hosted by the Federal Reserve Bank of Kansas City, and its conference planners hit the jackpot in selecting the topic for the 2007 edition: “Housing, Housing Finance, and Monetary Policy.” When the group convened on the evening of August 30, housing was going to the dogs, housing finance was cratering, and a monetary policy response to all this was growing increasingly urgent. Few people wanted to talk about the weather—which, as usual, was gorgeous. Too bad the conference didn’t take place four weeks earlier. At its August 7, 2007, meeting, the FOMC had concluded that “although the downside risks to growth have increased somewhat, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected.” How’s that again?, many of us thought when we read the statement. The predominant concern is inflation? Many Fed watchers blinked in disbelief. What were those guys thinking? Two days later in Paris, the financial world started coming apart at the seams. The next day, the FOMC held a hurriedly arranged telephonic meeting. This time their statement assured the financial world that the Fed was “providing liquidity to facilitate the orderly functioning of financial markets.” (Translation: We are pumping out cash like mad.) But the federal funds rate was kept right where it had been since June 2006, at 5.25 percent. Was the Fed still seeing inflation as the “predominant policy concern”? Okay, give them a break. Only three days had passed since their August 7 meeting. The Fed would fix things soon. Right? Wrong. The committee met telephonically again six days later, noting correctly
that “the downside risks to growth have increased.” That was a healthy step; they demoted inflation from its singular status as the predominant risk. But the FOMC still refused to cut the funds rate. (It did reduce the less-important discount rate.) Looking back, it’s hard to see how this could have been a close call on August 16, and many Fed critics said so at the time. But thirteen days later, as FOMC members from Washington and around the country boarded planes to head to the beautiful Grand Tetons, the funds rate was still stuck at 5.25 percent.
unlimited amounts—is the central bank. Both the Federal Reserve and the European Central Bank (ECB) did so massively, starting on Paribas Day, August 9, 2007. In so doing, they were performing a function that central banks have performed for centuries: serving as the “lender of last resort” in order to get their financial systems through liquidity crises. The volume of new dollars and new euros spewing forth from the world’s two largest central banks was unprecedented. But the actions themselves were time-tested and routine, part of every central banker’s DNA.
We learned later that Bernanke took the opportunity to cloister away several FOMC members in a small upstairs conference room to figure out what to do next—as their initial efforts were clearly inadequate. There must have been many other interesting sidebar conversations. But still, rates weren’t touched until the FOMC’s next regularly scheduled meeting, which was on September 18—a full forty days after Paribas Day. Yes, a lot of rain can fall in forty days and nights— and it did. The Fed cut the funds rate by 50 basis points on September 18, observing that “the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally.”
Back in 1873, Walter Bagehot, the sage of central banking, had instructed central banks on what to do in a liquidity crisis. His triad was lend freely, against good collateral, but at a penalty rate. Why? Because the acute shortage of liquidity in a panic can push even solvent institutions over the edge. Customers come in demanding their money. If the banks don’t have enough cash on hand, word gets around, and bank runs start sprouting up everywhere. The disease is highly contagious.
That last thought was important. Before the cataclysmic failure of Lehman Brothers a year later, there were two competing views of what the crisis was all about. In the narrower, technical view, the financial world was experiencing a liquidity crisis— an acute one, to be sure, but still a liquidity crisis. In plain English, that meant that frightened investors and institutions wanted to get their hands on more cash than was available—partly because of the heightened counterparty risk just mentioned, partly because assets formerly deemed safe now looked risky, and partly because banks and investment funds feared that their customers might show up at the electronic door one day, seeking to make hefty withdrawals. The Paribas approach—just say no—was not an appealing way to cope with such a problem. The dash for cash was on. The one institution in any country that can provide more cash in a hurry—in principle, in
THE PRINCETON FINANCIER | 14
By serving as the lender of last resort, the central bank is supposed to stop all that from happening. And every central banker in the world knew Bagehot’s catechism. So that’s basically what most of them did in August 2007. In fact, one can argue that the ECB stuck with the Bagehot script until late 2011. The ECB refused to cut its interest rates until October 2008 (yes, that’s 2008, not 2007), and even then it gave ground grudgingly. The 4 percent European overnight rate that prevailed in August 2007 did not fall to 3.25 percent until November 2008 and did not get as low as 2 percent until January 2009. By contrast, the Fed had virtually hit zero by December 2008. Was this mess nothing more than a big liquidity event, as the ECB’s actions suggested? Perhaps not. An alternative, and darker, view of the crisis conceptualized what was happening as a serious impairment of the economy’s normal credit-granting mechanisms. On this broader view, the scarcity of liquidity
was just the tip of the iceberg. The real problems lurked down the road—in gigantic losses of wealth; in massive deleveraging and possible insolvencies of major institutions; and, as just mentioned, in severe damage to the banking system, the shadow banking system, and other credit-granting mechanisms. If all that happened—and in August 2007, it hadn’t happened yet—the whole economy would be in big trouble. Economies that are starved of credit fall into recessions, or worse. Businesses decline and fail. Workers lose their jobs. The Fed Springs into Action Well, maybe not exactly “springs.” Bernanke, who was a noted scholar of the Great Depression, was slowly bringing his rather hawkish committee around to the view that this was something big— not just a major liquidity event, but potentially the cause for a big recession. But old habits die hard, and while the Fed was way ahead of the ECB, it was not quite there yet. At its September 18 meeting, the FOMC qualified its view that “the tightening of credit conditions has the potential to . . . restrain economic growth” by adding that “some inflation risks remain.” It was a finely balanced assessment of risks—far too balanced, given the emerging realities. Just five days earlier, the Bank of England had intervened massively to save Northern Rock, a huge savings institution, from the first bank run in Britain since 1866. Things were coming unglued in England. Our problems here were strikingly similar. Could we be far behind? While the Fed’s speed made the ECB look like the proverbial tortoise watching the hare, this particular hare wasn’t actually running that fast. After its 50-basis-point rate cut on September 18, 2007, the Fed waited another six weeks—until its next regularly scheduled meeting—to move again. By that time, many mortgage-lending companies had failed, and Citigroup and others had announced major writedowns on subprime mortgages. But the Fed chipped in with only another 25 basis points on October 31—a baby
step that it repeated at its next regular meeting on December 11. A number of FOMC members were less than convinced of the need for easier money. After that, however, the Fed seemed to step it up a notch. The next day it announced two new liquidity-providing facilities. The first was a series of currency swap lines with foreign central banks, which were finding themselves seriously short of dollars. In a currency swap, the Fed, say, lends dollars to the ECB in return for euros. When the dollar liquidity crisis in Europe passes, the ECB pays back the dollars and gets back the euros. The initial announcement was for just $24 billion, which was considered sizable at the time. But the swap lines eventually topped out at a whopping $583 billion in December 2008. The second facility was the Term Auction Facility (TAF), designed to do Bagehottype lending to banks, though for periods longer than normal—up to four weeks. The Fed’s earlier attempts to lend to banks had been stymied by bankers’ fears of being stigmatized by asking the central bank for a loan. Didn’t that mean you were on the ropes? The TAF sought to overcome the stigma problem in two ways: It was set up as an auction in which any bank could show up to bid; the bank didn’t need to be in bad shape. And since the bank wouldn’t receive the cash for a few days, a TAF loan would not save a bank that was on the brink of disaster. TAF was important—at its peak in March 2009, it was lending $493 billion. It was shut down in March 2010--no longer needed. But the Fed was just warming up. Over the Christmas–New Year holidays, Bernanke must have got to thinking—or to having nightmares— about the 1930s. On January 9, 2008, he convened an FOMC conference call—ostensibly to review recent developments but perhaps actually to shake the committee out of its lethargy. The minutes of that meeting noted that “the downside risks to growth had increased significantly since the time of the December FOMC meeting,”
but the committee was not yet ready to cut interest rates. Undaunted, Bernanke got them all on the phone again on January 21. The minutes of that call observed that “incoming information since the conference call on January 9 had reinforced the view that the outlook for economic activity was weakening.” Only twelve days had elapsed between the two calls. How much could have changed? What had changed was that the FOMC was now ready to act—dramatically. With just one dissenter, the members agreed to announce an almostunprecedented 75-basis-point cut in the federal funds rate early the next morning. In the entire eighteen and a half years of the Greenspan Fed, the FOMC had moved the funds rate by 75 basis points only once—and that was an increase. Furthermore, federal funds rate announcements always come at exactly 2:15 p.m. This one came at 8:30 a.m. The Fed clearly wanted to be heard on January 22—and it was. Eight days later, at its regularly scheduled meeting, and again with one dissenter, the FOMC dropped the funds rate another 50 basis points, down to 3 percent, leaving federal funds trading 125 basis points lower than they were only nine days previously. The Fed was on DEFCON 1. The FOMC majority now clearly saw the task ahead of them as a two-front war, and it was gearing up for battle on both fronts. It needed to provide massive amounts of liquidity, for well-known reasons that Bagehot had articulated 135 years earlier. But it also needed to cut interest rates to fight an imminent recession, as Keynes had prescribed 72 years earlier. Chairman Bernanke did not want to preside over another episode like the 1930s. In Europe, however, overnight rates were going nowhere. The ECB was fighting the shortage of liquidity hard, maybe even harder than the Fed. But it was far from convinced that recession was in its future. At the ECB’s headquarters in Frankfurt, there was lots of Bagehot but not much Keynes.
THE PRINCETON FINANCIER | 15
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Shawn P. O’Connor is an honors graduate from Harvard Law School and Harvard Business School, where he was recognized as a Baker, Ford, and Thayer Scholar for his academic accomplishments. Mr. O’Connor is a summa cum laude, Phi Beta Kappa graduate of Georgetown University’s School of Foreign Service where he was valedictorian. Mr. O’Connor currently serves as the Founder and CEO of Stratus Prep (a global test preparation and admissions counseling firm), Stratus Careers (a career counseling and corporate training organization), The Stratus Foundation (an educational non-profit) and The Startup Stand (an entrepreneurship non-profit). He has published more than 50 articles in publications such as Fortune and The Financial Times and is a weekly contributor to Forbes and US News and World Report.
The concept of “the office,” aside from conjuring up images of Steve Carell, often makes Americans think of cubicles, sticky notes, 9-to-5 hours, a steady yet modest salary, and most of all, safety and security for their families. Today, however, “the office” is changing—indeed, empirical evidence suggests that for more and more Americans, home and office are one and the same. Many individuals today freelance, take on contract positions, and/or work from home, options which used to inspire a fear of insecurity due to the lack of a consistent paycheck and ancillary benefits. Work is not only changing in physical space, but also in expectations, responsibilities, and the replacement of the concept
of an employee with that of what I will call a “Value creator.” Given the state of the macroeconomy and the political intransience in Washington, Americans are beginning to solve this country’s financial crisis themselves through the often lauded American ingenuity; through innovation and with incredible determination, Americans are beginning to reinforce the nation’s future through small business creation, intrapreneurship, and community development efforts that are not dependent on the government. Indeed, the individual accomplishments of intrepid entre- and intrapreneurs are permitting us to envision a solution to the funding crisis in Social Security and Medicare: economic growth.
THE PRINCETON FINANCIER | 16
First, let’s take a historical look at traditional employment in the United States. Beginning in the years after World War II, after obtaining a college degree, many new graduates secured their first job and established a long-duration (often decades) career within that firm. Loyalty and commitment were the prerequisites for advancement within a company even for relatively inefficient workers who might only create dubious value. We see the costs of such a system in the 20+ year economic morass in Japan which continues to preserve such an employment structure. Recently, the realities of work in America have changed dramatically. According to recent data from The Bureau for Labor Statistics, the median
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number of years that workers have been with their current employers is just 4.6 (“Employee Tenure Summary, 2012”). Employees are always seeking new opportunities, facilitated by LinkedIn and online job sites, like Monster and The Ladders, which have significantly reduced the investment required to seek out a new position and enhanced the efficiency of recruiters. However, in this more transparent employment environment, workers must differentiate themselves through their demonstrated value creation. According to Seth Godin’s “The Last Days of Cubicle Life” in Time, “The job of the future will have very little to do with processing words or numbers (the Internet can do that now). Nor will we need many people to act as placeholders, errand runners or receptionists. Instead, there’s going to be a huge focus on finding the essential people and outsourcing the rest” (Godin, 2009). In other words, especially for relatively low-skilled office workers, it will no longer be enough to show up at the office and meet expectations; the successful employees of tomorrow will be creative problem solvers with differentiated skill sets, innovative ideas, and a commitment to “getting the job done.” In other words, they will need to be entrepreneurs (or at least intrapreneurs, the term given to those who perform as entrepreneurs within a broader corporate context). The need for workers to be entrepreneurial has been increasing for at least the last decade and thereby changing “the office” as we and our parents and grandparents once knew it. Entrepreneurs, rather than financiers, are now revered by society. But the majority of entrepreneurs look very little like Mark Zuckerberg. Many are not twenty-something technologists but middleaged Americans starting a small business after losing their job at a large corporation and being unable to find similar work as companies demand more from current employees and contractors rather than hiring new permanent employees, as exemplified by the rising productivity levels but the still relatively anemic economic picture. To support this thesis, Godin postulates that in the future,
“Work will mean managing a tribe, creating a movement and operating in teams to change the world. Anything less is going to be outsourced to someone a lot cheaper and a lot less privileged than you or me” (Godin, 2009). There will be a lot less “busy work” in small and large companies alike, requiring all workers to be entrepreneurial and innovative if they hope to survive in relatively well-paid positions in the developed world. Such entrepreneurship is critical to the success of the United States and other developed economies. The United States has a long history of government support for entrepreneurship, perhaps most evident in its bankruptcy laws, some of the world’s most forgiving. Furthermore, in 1953 with the passage of the Small Business Act, the Small Business Administration (SBA) was established to promote the growth of small ventures, particularly those founded by minorities and other traditionally disadvantaged populations, by helping such companies secure loans and develop management skills. The government recognized the importance of small business to economic growth, and
(Clark & Saade, 2010). While given today’s fiscal realities, the next generation of entrepreneurs cannot count on the government for similar support, they are again leading the nation’s recovery and collectively, if unintentionally, suggesting a growth path out of our economic woes. Data from the SBA strongly supports my hypothesis regarding the impact of small businesses on the U.S. economy. According to the SBA, “Small businesses currently represent 98 percent of all businesses in the United States and they generate nearly 64 percent of all net new jobs in this country” (Clark & Saade, 2010). Because of the power of small businesses and the continued economic stagnation and political paralysis in Washington, Americans do, can, and indeed must, continue striking out on their own not only to ensure their own economic future but also that of the nation. Americans clearly have the power and determination to address our vast fiscal challenges through the free market. When I observe debates between our two major political parties’ budget
Because of the power of small businesses and the continued economic stagnation and political paralysis in Washington, Americans do, can, and indeed must, continue striking out on their own not only to ensure their own economic future but also that of the nation. therefore set policies to incentivize entrepreneurs to turn their ideas into lucrative business. Later, during the last prolonged period of economic malaise, the Small Business Economic Policy of 1979 was enacted, which required Congress to “establish a national policy to implement and coordinate the policies, programs, and activities of all Federal departments, agencies, and instrumentalities in order to provide an economic climate conducive to the development, growth, and expansion of small and medium-sized business”
proposals, I am distressed by the lack of a long-term, sustainable method to controlling our country’s national debt and funding Social Security and Medicare. But because of the fundamental shifts in the definition of “work” outlined above and the demonstrated power of entrepreneurship as a driver of economic development, I am confident that growing out of this crisis through ingenuity is not only possible, but likely.
THE PRINCETON FINANCIER | 17
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While publications as varied as The Economist and GQ have called Fort McMurray, Alberta (a small town brimming with oil rents) a tough epicenter with the potential to change the global geopolitical map, it has yet to do so. The Canadian federal government has made numerous poor decisions, leaving its energy policy in disarray. Observers both in and out of Canada are watching anxiously as energy markets take shape with no clear signaling from the Canadian government. The investment climate in the Canadian natural resource sector remains uncertain. The generous endowment of natural resources and relatively relaxed controls on foreign investment have historically made Canadian oil sands a generally sound investment choice. A diversified economy that weathered the economic crisis relatively well allows Canada to open its doors to foreign investment without public outcries of “neocolonialism” or fear of losing national sovereignty. With Venezuela and Saudi Arabia (the two countries with the largest quantity of known oil reserves) closely protecting their national treasures through state-owned enterprises, the oil reserves available for private ownership in Canada are the largest in the world. Remarkably, they represent a massive 50% of global market share. This opportunity has been left available for foreign investment in part because Canada recognizes that its domestic capital is insufficient to
further catalyze development of its export-led economy. The opportunity that investment into Canada presents to the world is clear: a stable political economy with relatively free access to foreign investors, but recent developments have put this favorable investment position into question. Canada suffers severe price differentials between its own crude and its global counterparts. For Canadians, this practice seems unjust, especially since Canada, in contrast to the Middle East, represents the United States’ most secure energy supplier, so political stability in Canada should represent a premium not a discount. Although this idea lacks common economic sense, the wedge between West Texas
As the Royal Bank of Canada pointed out in a recent report, unfavorable terms of trade “would ultimately first manifest themselves in the form of reduced business investment.” This loss affects the average Canadian. Current losses in real domestic income are valued at about $1,200 per Canadian per year. Although the Canadian economy is outwardly oriented, its inaccessibility to the global market only worsens price differentials. Rectifying these price differentials is the first step in improving market efficiency and the investment climate. The pipelines solution to market access has also been the focus of intense controversy. Although the price differentials are in part due to difference
This development might at least be imagined to offer some certainty to the investment climate, but that view seems too charitable. The Canadian government is without a clear strategy. Intermediate (WTI) and Western Canada Select (WCS) prices of crude oil, which is as large as $20 a barrel, is starting to spook investors. Oil extraction from sand is costly, and even slight price differentials are more than enough to turn investments sour and undermine Canada’s terms of trade.
in quality, a surplus in supply is the main culprit. Pipelines would bridge the distance between high global demand and high Canadian supply. Americans are familiar with Keystone XL, which would transport Canadian crude to American buyers and export the remainder along
THE PRINCETON FINANCIER | 19
the Texan coast. The proposal, while well publicized, was rejected for the time being on environmental grounds. However, oil is fungible and its high demand tends to overcome supply interventions. Tar sand oil continues to travel south by tanker and train. Unfortunately for environmentalists, this is even more carbon-costly than building Keystone. Unfortunately for investors, the price differential remains. The rejection of Keystone sparked a reactionary turn by Prime Minister Harper towards Asia. Since the Enbridge
fill in the gaps and so the decision was somewhat influenced by the federal government. With CNOOC providing the necessary capital, it was difficult for Harper to reject a deal for which he had so earnestly supported, but the acquisition of Nexen would surrender Canada’s control of some of its most important assets. To much public surprise and dissent, the government approved the deal and Nexen was acquired for $15.1 billion. Canadian commenters have argued that Investment Canada should have rejected the deal and opted for a joint venture agreement instead. Canada did not outright reject
From a qualitative perspective, natural resources are not just the fuel but the engine to Canada’s economy. Northern Gateway pipeline set to export oil to Asia through ports in Vancouver already in the works, he established a plan for diversification. Harper has felt emboldened to softly push against Canada’s given position as unequivocally aligned with the U.S. As expected, this option predicates entirely on China’s eagerness to invest in Canada. With the Trans-Pacific Partnership coming into the foreground, Harper could be seen as a chief strategist leveraging himself between the United States and China. This development might at least be imagined to offer some certainty to the investment climate, but that view seems too charitable. The Canadian government is without a clear strategy. Lobbying in China by the Canadian government for closer economic ties after the Keystone rejection was eventually reciprocated by an equally aggressive bid by CNOOC (China National Offshore Oil Company) for Nexen, a major Canadian oil and gas company. Investment Canada, the governmental body tasked with regulating large foreign investment into Canada, has very flexible criteria for making its decisions. It is generally believed in Canada that politics
the CNOOC bid as a “national security threat” like U.S. bureaucrats did when CNOOC bid for Unocal for $18.5 billion, but Harper cautioned publically that any forthcoming investment would not enjoy such favorable treatment. A bid by Petronas, Malaysia’s state energy company, faced unexpected resistance from Investment Canada. Nothing undermines investor confidence like unsystematic application of government intervention, and Harper has given no clear signals to potential investors or concerned Canadians about how Canada’s investment policy is shaping up. Harper has faced even more drama over the recent renegotiation of Canada’s FIPA, or Foreign Investment Promotion and Protection Agreement, with China. Although FIPAs are common-place, few are negotiated in private in Vladivostok, ratified with minimal parliamentary debate, and made legally binding for decades to come. The rash turn, which would grant Chinese companies the right to sue the Canadian government in private international courts for protectionism, has provoked public outcry. To Canadian observers, it appears that Harper turned to China after being slighted by Obama
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over Keystone, but he discovered that this direction was unpalatable to the Canadian public. In the long run, reacting, and not leading, will not serve Canada, its investors, or Harper well. If Harper is simply responding to events rather than driving them, it is worth evaluating the different currents in this moment of transition. Under Canadian investment policy, will Canada favor the American investment, the Chinese investment, or will both enjoy equal treatment? The fact that the Canadian public has taken great notice of this ongoing debate, is undoubtedly a factor. Although the Canadian press likes to pretend emotionalist and alarmist fears about foreign encroachment never factor into the country’s decision-making, the control of “national assets” by a state-owned enterprise tied up with a Communist regime does not sit well with the majority of Canadians. Even the overwhelmingly centrist Canadian public has been suspicious of surrendering control of its “national” assets to China. Does this translate into greater access to American investors? American investment in Canada has been a longstanding tradition. The Canadian public seems indifferent to American ownership of most iconic Canadian conglomerates from Molson Canadian, which runs by the slogan “I am Canadian!” to Tim Hortons, a fast food restaurant named after a Canadian hockey player. Capital-rich Europe and the United States have both enjoyed a favorable investment position in Canada, and there has been no outcry from the Canadian public. There is a certain partiality in Canada towards Canada’s traditional partners, which suggests doors will remain open to their investors. There are, however, also more rational reasons for the national politic to be wary of this new China-based investment. From a qualitative perspective, natural resources are not just the fuel but the engine to Canada’s economy. As Canada’s expertise is resource extraction, its quaternary sector is inextricably linked to the primary natural resource sector. CNOOC’s strategy is also more concerning. As argued in The
ownership of its own resources. As a result, PetroCanada was privatized and became a retail subsidiary of Suncor Energy in 2009. The rise of investment from abroad, which threatens Canada’s foreign and domestic capital positions, is enough to revive protectionist sentiments.
Economist, CNOOC has discovered that ownership of oil wells (upstream investment) alone does not translate into control of oil markets. CNOOC, in the recent spate of acquisitions which included Nexen, aims to seize managerial talent. It attempts to buy out not only Canadian resources but also Canadian expertise—acquiring the whole Canadian competitive package in one sitting. Moreover, Canadians would become the lower workforce under foreign managers extracting their own resources. The U.S.-China dichotomy has consumed the Canadian press, but the more troubling and long-term global trend that could threaten Canada’s investment position vis-à-vis many of its partners has been ignored. As Asian tigers rise, Canada becomes a net recipient of foreign direct investment (FDI). Capital dependency is often associated with a mercantile or developing economy. In the past, the mutual benefit of free trade was more apparent. Canada enjoyed the capital flows it needed to support its export industries and develop its native businesses, while labor-rich, capital-poor
manufacturing companies were able to use Canadian capital to help them develop at breakneck speeds. On this framework, Canada vastly improved its national real income and improved its terms of trade by negotiating a series of FIPAs. As countries like China transition out of the manufacturing-dependent, capital-poor phase, the reciprocity is less clear. Canada could be the relatively capital-poor, labor-poor partner in some of its trade agreements. The graph above depicts Canada’s net investment position has deteriorated rapidly with respect to the Asian tigers and Brazil. The capital deficit with the U.S. may be greater in absolute terms, but the relative imbalance with China is much greater. Despite Canada’s current affinity for free trade, the country has a history of protectionism. In the 1970s, the nationalization of Fina to create PetroCanada was largely a response to public fears that Canada’s natural resources would be exploited. However, as Canadian expertise accumulated and its private companies developed, Canada had no reason to worry about competing for
Generally speaking, Harper is left with two main options. The first is to continue bandwagoning the United States and accept the severe price differentials or wait for Keystone approval. The second option is to accept Chinese capital, but, in order to placate the public, investment policy will have to restrict large market share ownership while welcoming in capital. The first option does not necessarily signal an unequivocally good investment climate for American investors. Price differentials will continue to disadvantage any company that invests in Canada. The second option would reflect a growing trend away from American dependency. American investors will have to compete with companies both around the world and in Canada to secure ownership. Preferably for Canada, Harper could forge a path between the two. By relying on the United States as a traditional partner, but also taking advantage of Asian investment for leverage and to resolve the price differentials, Harper could forge Canada’s new economic position in an evolving global order. Harper is in an unenviable position of knowing that while Canada needs capital, he also needs to satisfy the more protectionist demands of some of his constituents. A viable way forward is to craft an energy policy that controls not the level, but the kind of investment into Canada so that Canada’s favorable position is maintained while capitalizing on a changing global market. We should expect Investment Canada to restrict its approval to only mergers and joint ventures, not outright acquisitions, as they pose less of a threat to Canadian control. Most importantly, such a policy must be conveyed clearly and transparently to Canadians and foreign investors. In the meantime, investment into Canada will be uncertain. CNOOC closed the door behind it and there are uncertainties as to how to reopen it.
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Even throughout the recent financial crisis, investors in Southeast Asia have enjoyed a great ride over the past decade with stocks in Indonesia, Thailand, and the Philippines rising over 220% since 2008. Moreover, in the past year alone, Indonesia’s and the Philippines’ GDP grew by 6.2% and 6.6% respectively. Over the same period of time, the MSCI Emerging Markets Index, an index designed by Morgan Stanley Capital International to assess the performance of global emerging markets, has increased by 88%. This growth can be viewed in contrast to the MSCI ACWI Index, another Morgan Stanley developed index that provides a broad measure of equity-market performance around the world, which only increased by 52%. The disparity represents the stark difference between the rates at which these emerging regions are growing relative to those of the rest of the world. However, after this exciting ride, investors are beginning to wonder whether the growth in these markets has plateaued, as countries in the region have shown signs of both mixed growth and instability. An analysis of various economic factors across the Philippines, Vietnam, and Indonesia will help us better comprehend the reasons for Southeast Asia’s market performances, which will ultimately help us understand how investors are responding to these recent developments.
Southeast Asia’s enormous growth in the past decade can be attributed to a number of factors. As quantitative easing and weak growth prospects in the West pushed investors towards emerging markets, the region experienced and benefited from a substantial flow of foreign investments. The combination of its optimal central location, economic relationships with other Asian countries, and low costs spurred tremendous growth rates in Southeast Asia. The region is the center of Asia’s economic boom due to the young population of over 600 million people, abundant natural resources, and growing trade connections between both China and India. Additionally, local governments have been able to exploit record-low funding costs while wages in China have been increasing which is helping to bring export and manufacturing businesses to the region. The substantial growth and the markets’ strong performances, however, have left equities trading at unstable valuations. The Philippines index currently trades at a price-to-book ratio of 2.6 and a priceto-earnings ratio of 20.8. Similarly, the Indonesian index is trading at a price-tobook ratio of 2.7 and a price-to-earnings ratio of 18. These statistics are highly contrasted with the emerging markets average price-to-book ratio of 1.6 and price-to-earnings ratio of 12.3. These noticeably higher ratios for the markets in the Philippines and Indonesia indicate
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that although the trading fundamentals in these countries are healthy, the cost to trade is extremely high, which is a hindrance to the rapid growth of the Southeast Asian markets. Also, despite having extreme growth potential, there exist inherent risks in the Southeast Asian markets. Previous periods of strong investment inflows and the resulting currency appreciation have prompted government actions in the form of capital controls. As a result, interest rates remain at historic lows, raising fears that inflation problems may return and distort investment relationships. In particular, Vietnam’s growth has been perpetually impeded. Prior to the financial crisis, many foreign banks, including those from North Asia, Australia, and New Zealand, eagerly bought into Vietnam’s banks. Today, however, Vietnamese banks are less inviting. According to HSBC, the economy has slowed from an average of 7% annual growth since the early 1990s to 5% last year. Moreover, decreasing property prices and increasing bad loans have made banks reluctant to lend, thereby further obstructing economic growth. Furthermore, other challenges have led to rampant inflation, which averaged approximately 8.9% annually for the past few years, and annual credit growth, which exceeded 20% from 2006 to 2010. The lack of transparency and weak accounting practices have also
generated great uncertainty concerning the quality of loans in the system. The State Bank of Vietnam (the country’s central bank) reported in November 2012 that the ratio of bad debt to total loans was 8.82%, but Moody’s Investors Service estimated this ratio to be at least 10%. Thus, Vietnam is a prime example of why foreign investors express caution in investing in Southeast Asia. Foreign investors are concerned with the region’s unstable banking system and would rather look towards other areas with less risk and more growth. The Philippines represents a slightly different case, as its stable, long-term growth has only recently been hampered by a variety of factors. The primary concern is the difficulty in sustaining strong economic fundamentals, such as stock prices and GDP values. Analysts believe the market is trading at values that leave little room for further upside. According to Bill Maldonado, CIO of Asia Pacific at HSBC Global Asset Management, the Philippines has become “relatively expensive compared to its North Asian peers.” Stocks deliver return on equity of about 15%, but in turn, investors must pay more than three times book value. In contrast, according to a report by Duncan Mavin of The Wall Street Journal, Chinese shares offer a similar return on equity for only about 1.5 times book value, and South Korea offers a return on equity of 12% for only 1 times book value. Another aspect about the Philippines that could hinder its growth is its weak infrastructure. Although the government has extensive plans for investment in infrastructure, the Philippines has the worst infrastructure quality among major Southeast Asian countries according to the 2012 World Economic Forum’s Global Competitiveness report. This low quality points to increasing instability of the economy. While both Vietnam and the Philippines have demonstrated reasons for foreign investors to be concerned, Indonesia shows certain signs of promise. Its stocks and GDP have both risen by enormous proportions, and foreign investors are still attracted because of its relatively
stable statistics in the past decade. Interestingly enough, Indonesia’s trade and current account deficits are factors that are contributing to its economic stability. In the beginning of the first fiscal quarter of 2013, Indonesia recorded its second consecutive trade and current account deficit, which is estimated to be between $1.5 and $2 billion. Analysts from The Wall Street Journal believe that this figure is due to its strong growth in recent years that has attracted many imports even while global demand and export prices slide. These imports are used to upgrade the country’s factories and infrastructure, which eventually lead to more value-added exports. However, though Indonesia may be performing relatively well, there are still certain aspects of its economy, much like those of Vietnam and the Philippines, that raise doubts for outside investors.
to boost the infrastructure and the natural resources sectors, both of which need foreign investment. Thus, a prolonged investment slowdown could generate severe strains later on. While certain countries of Southeast Asia are falling out of favor for investors, other parts of Asia have become more attractive, particularly China and Japan. Despite the general increase in wages in China, since the end of the last fiscal quarter of 2012, Chinese equities have risen over 30% on average. This substantial increase can be attributed to the country’s efforts to improve economic data reports, various financial reforms, and a successful transition of political power. The relative and recent stability of China has renewed investors’ interest. Likewise, reforms have also made Japanese markets appealing. The Nikkei 225 has risen over 30% since the last
However, though Indonesia may be performing relatively well, there are still certain aspects of its economy, much like those of Vietnam and the Philippines, that raises doubts for outside investors. According to a Barclays report, investment in the economy in the last fiscal quarter of 2012 was 7.3%, which was the lowest in five quarters. One factor is that weak global risk sentiment and unfavorable domestic developments have been putting pressure on Indonesian assets. The moderation in investment is consistent with high frequency indicators such as capital goods imports and lending for investments. By contrast, household consumption, the main driver of the expansion of the Indonesian economy, increased by 5.4%. With GDP growth averaging 5.7% over the last decade, Indonesian markets look to be a safer investment and are clearly an exception to the larger trend within Southeast Asia. It is important to note, however, that continued investment is required to keep the momentum going, both in the private and public sectors. Indonesia is still looking
fiscal quarter of 2012 due to the change in consumer and investor expectations that the election of Prime Minister Shinzo Abe will herald the start of a far more aggressive monetary stimulus. This change has consequently lead to the weakening of the yen from 80 to 94 per United States dollar in December 2012, which has actually benefitted the country with regards to exports. As a result of these developments, many investors are switching their focus away from Southeast Asia towards the larger, more liquid markets of China and Japan. The journey for investors in Southeast Asia has proven fruitful over the past decade. However, various factors have caused this ride to decelerate—a momentum that we should continue to carefully follow and analyze in the upcoming years. THE PRINCETON FINANCIER | 23
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