Booming Mongolia: Mine, all mine

“GOIN’ to OT?” drawls Andy, a burly tattooed man with that worldly air common to those who have done time in the American army. The gate at Incheon airport in South Korea is packed with travellers, mainly Mongolian expatriates on their way home, waiting to board a flight to Ulaanbaatar. Andy’s is a fair guess as to the destination of one of the few other Western passengers. “OT”—Oyu Tolgoi, or “Turquoise Hill”—is in the middle of nowhere, a desolate spot in the Gobi desert, another hour-and-a-half’s flight south of Ulaanbaatar (inevitably, “UB”). But it is the site of the biggest foreign-investment project in Mongolia, a copper-and-gold mine that is springing up at a remarkable speed and is expected, by 2020, to account for one-third of Mongolia’s GDP.

For Andy, who normally “does security” in places such as Afghanistan, Nigeria and Somalia, OT is a rest cure. Conditions are comfortable, the locals are a delight, and nobody tries to shoot him. And there are the transits through UB, a veritable Bangkok of the steppes—at least if your comparators are Kabul and Mogadishu. In the OT bus from UB airport into town, Andy is on tenterhooks waiting for the overnight hotel allocation. He is delighted with his billet—one where overnight guests are readily tolerated. The other news is less cheery: the airport bus will leave at four in the morning.

UB is a boom town on the frontier of global mining. Hotels are bursting; the Irish pubs, of which there are several, are heaving with foreign miners, investment bankers and young local women with very long legs and very short skirts. French bistros serve steaks the size of tabloid newspapers. Dozens of cranes punctuate the skyline. The streets, empty 20 years ago, are now clogged. It is hard to believe on the clear sunny mornings the city enjoys much of the year, but UB’s air is now as polluted as anywhere—second only to the Iranian city of Ahwaz, according to a recent study by the World Health Organisation. In the winter, when temperatures average from -10 to -30 centigrade, and often fall to -40 at night, UB burns a lot of coal.

Another sign of a boom is the effort to keep the city functioning through these crippling winters. When a Singaporean firm was building a joint-venture brewery to make Tiger beer, it was so anxious to finish in time for the summer-drinking high season that it hired patio heaters the size of jet engines for the construction site. Without such aids, building stops in the Mongolian winter. It is too cold to pour concrete.

A glitzy mall on the corner of the main Sukhbaatar Square houses the sort of establishments you come across in the better class of airport: chic boutiques, pricey restaurants, expensive-watch shops and, of course, an outlet of Louis Vuitton, which sells posh luggage. The shops usually look empty, which is reassuring for those nostalgic for the UB of the recent past—small, drab and poor, and offering its visitors, as one unhappily put it, a choice of “mutton, mutton and mutton”, but at least refreshingly different from other capitals.

Central Tower, as it is known, is a new ornament to downtown Ulaanbaatar. It is built next door to the lot where once stood the former headquarters of the former Mongolian People’s Revolutionary Party, the MPRP (it has since dropped the “R” word), which for seven decades until 1990 ruled Mongolia as a one-party state and rock-solid Soviet satellite. The building was burned down in rioting in 2008 after a disputed election. The use to which the site has now been put is as good a symbol as any of the new aspirations of Mongolia’s ruling class.

Dreams under your feet

To pay for these dreams, Mongolia is being dug up and sold to China. Already, more than 80% of its exports are minerals, a proportion expected to rise in a few years to 95%. Mongolia makes mining geologists salivate over its known riches and unexplored potential—for copper, coal, gold, silver, uranium, molybdenum, and on and on. Some 3,000 mining licences have been issued.

It is not just that Mongolia is a treasure-chest of geological wealth. It is slap-bang next to the world’s biggest and fastest-growing market for most minerals. Put together Mongolian supply and Chinese demand, and Mongolia will be rich beyond the wildest dreams of a population many of whom, a generation ago, saw themselves as nomadic herders. With just under 3m people, Mongolia has a chance of becoming a Qatar or a Brunei: a country that has only a small population but almost all of it, in global terms, loaded. Brian Fisher, an Australian economist who has conducted a study of the economic impact of OT, says Mongolia “sounds like Australia in 1930”.

In the third quarter of 2011 Mongolia’s economy grew by 21% compared with the same period in 2010. Even sober economists think the country is going to have to get used to this sort of thing. The IMF expects growth to average 14% a year between 2012 and 2016. In 2013, the year production is due to begin in earnest at OT, it is forecast to reach 22.9%. Others think it will be at least twice that.

Indeed, OT is the force driving many of these short-term projections towards the sky. Its construction is a big factor in this year’s boom. From 2013 its sales will start adding an average of about five percentage points a year to the national growth rate up to 2020, when its impact on the economy will peak. By November last year over $3 billion had already been spent on OT, a figure that will rise to $6 billion by 2013 and $10 billion by 2020. For Mongolia, a $6 billion economy, this is enormous.

So is the scale of the logistical challenge of building one of the world’s biggest copper mines in the middle of the desert. All supplies have to be brought in by road, from China to the south. Some 18,000 workers, including about 10,000 Mongolians and 6,000 Chinese, have to be housed and fed. Water had to be found, and is to be piped from an underground aquifer over 50km (32 miles) away. Electricity is to be provided first from China, then by a purpose-built power plant. And local people have to be compensated, coaxed and cajoled into believing that the mine is in their interests, not just those of the foreigners who are running it.

The project is a joint venture between the Mongolian government (34%) and Ivanhoe Mines of Canada (66%), which is in turn 49% owned by Rio Tinto, the mining giant that is managing OT and has put up most of the money. Already the Turquoise Hill, where the colour of the soil first betrayed the presence of copper to prospectors decades ago, has vanished. A huge pit is opening up for the first phase of the mine. Two shafts have been sunk for the second, underground, phase. On top of one, a tower is soaring. It will be the tallest structure in the Gobi, and perhaps in Mongolia. The workers are housed in long prefabricated buildings or, for the luckier ones, traditional gers, circular felt tents (equipped with untraditional en suite facilities, TV and Ethernet cables).

All this is justified commercially by the expectation that this mine will produce 450,000 tonnes of copper a year, making it one of the world’s five biggest mines, as well as being a big gold producer. And it will have a life of at least 50 years. The more they look, the more potential geologists find in the area. It will be what Rio calls a “first-quartile” mine in terms of costs—ie, among the cheapest. And its proximity to China means that the cost of transport should not be prohibitive. The price of copper is especially vulnerable to swings in market sentiment. But global supply is constrained, and barring global economic Armageddon, demand is not going to collapse.

Yurts revisited

OT, however, matters not just in itself, but as a test of Mongolia’s ability to work with foreign investors to pull off such mammoth undertakings. Next in line is Tavan Tolgoi (Five Hills), the world’s biggest untapped coal deposit, also in South Gobi province. Notional shares in this project have already been distributed (electronically) to every Mongolian born before March 31st 2011. With a general election due in 2012, this adds political urgency to an ambitious scheme to raise billions of dollars for the mine through an initial public offering of shares in Ulaanbaatar and London. This will double the market capitalisation of the sleepy UB stock exchange.

Mongolian coal production is expected to increase from about 16m tonnes a year now to 40m by 2020 and 240m by 2040. Again China provides a ready market, but the mining boom has exacerbated Mongolian fears of a Chinese takeover by commercial stealth. So feasibility studies are under way on the costly options of building railways to take coal to Russia, and thence out to Korea and Japan via Vladivostok, or to Dandong on the Chinese-North Korea border and thence by sea to South Korea.

A touch of Dutch on the steppes

Not everyone in Mongolia looks at the growth projections and goes giddy with delight. Many worry about the economic, environmental, social and strategic costs of becoming “Minegolia”. Economists fret about a “resource curse”, or “Dutch disease”. If even the Netherlands can be vulnerable to this—whereby wealth floods in as natural resources are exploited, pushes up the exchange rate, inflation, or both, and renders other industries uncompetitive—how is poor Mongolia to cope? And the Netherlands never had a year like the one Mongolia can expect in 2013, when the economy will grow by a quarter and the current-account balance will lurch from a deficit of 14% of GDP into surplus.

Furthermore, Mongolia, a 20-year-old democracy, is prone to populist policymaking. Even as the economy is booming, political parties are tempted to promise handouts. After pledges made at the previous election, every Mongolian, rich or poor, gets 21,000 togrogs ($16) on the 15th of every month. The big parties have declared a no-handout pact ahead of the next election, and the government has set up a “fiscal-stability fund” to smooth the commodity cycle. But the temptation to dip into the till will mount as voting nears.

For economists, the resource curse is a risk Mongolia has little option but to take. As Mr Fisher, the Australian economist, puts it, its comparative advantage is in commodities and mining services. There is no point in trying to compete in manufacturing with “the biggest factory on the planet” next door in China.

Mongolia is still a desperately poor country. It has just graduated, in development-bank speak, to “lower-middle-income” status, with a GDP of around $2,000 per head. The population of UB has expanded by 70% in the past few years, to about 1.2m now. Some poor people still spend the winter nights beneath the streets (open manholes are a pedestrian hazard), huddling near the pipes for warmth. The city is sprawling outward through valleys in all directions along dirt roads lined with clapboard fences, behind which former herders live in gers.

One such herder, given the name Igor by Russians he knew in his youth, describes a common life path. A few years ago, herding in Central province, he lost many of his sheep to a dzud, one of the periodic climatic disasters that hit Mongolia—a summer drought that results in too little pasture and too little hay for the winter, followed by heavy winter snow and colder-than-usual temperatures. Igor sold the rest of his livestock to pay for his children’s schooling, bought a pickup truck and moved to UB, where he makes a living hiring it out. He finds UB going from bad to worse, as more people come to town and scramble to earn money. All there is to look forward to is the summer pilgrimage home, to drink airag (fermented mare’s milk) with his friends in a ger.

It is not just the weather that drives herders into town. Some are mining refugees, fleeing environmental devastation. Besides the licence-holders Mongolia has tens of thousands of illegal gold prospectors, known as “ninja” miners because the green plastic bowls they carry on their backs to sift for specks of the metal make them look like mutant turtles. Their use of mercury and cyanide has poisoned rivers.

Mongolia’s most flamboyant environmental campaigner is a former herder called Tsetsegee Munkhbayar. He made his name helping clean up the Onggi river, and then for his extreme forms of protest, involving shooting at mining equipment or vehicles. In April 2011 he led a group of supporters into Sukhbaatar Square on horseback to demand talks with the government. Mr Munkhbayar, a grim-faced man looking out of place behind a desk in his UB office in knee-length boots and traditional jacket, believes that if Mongolians exploit the mines, “we will never develop.” He suggests an alternative future of herding, dairy-farming and tourism. As he talks he is interrupted by a loud blare of traditional Mongolian music. It is the ringtone on his mobile.

And not a drop to drink

One UB resident, visiting the OT site as an interpreter for a foreign journalist, cannot stop herself from weeping at what is being done to the area and to her country. For the outsider, the bleak brown desolation of the Gobi is not a landscape that evokes sympathy. And it needs an awful lot of Gobi to sustain a flock of goats and camels, so, vast though the OT project is, the number of herders directly affected is small. But the translator sees ruin: “You can’t drink copper; you can’t drink gold.”

In fact, the aquifer tapped for OT is too deep to affect surface water, too saline to pass human-consumption standards and so big it will be no more than one-third depleted after 50 years of the project. The big danger environmentalists see from its use is that even a future natural drought may be blamed on OT. It will be hard for the project to deny water to distressed local herders. That might lead to overgrazing.

Such a massive undertaking is bound to distort the local economy and disrupt the environment. Compared with the ninjas, the multinationals and the development banks that will help raise the largest-ever project financing for mining can at least claim to be part of the solution. They are conducting impact assessments and bio diversity studies. The project is also providing jobs, and creating more employment for locals through subcontracts.

But it will struggle to be popular. Oyun Sanjasuuren, an independent member of parliament, says mining is bound to be political because it is “the main thing in the country”. And the face of Mongolian mining over the past 15 years has been “mostly ugly”. Miss Oyun says she entered parliament as a centrist, but now finds herself on the right as the main parties have shifted steadily to the left. OT has not been helped by tactless remarks made in the past by Robert Friedland, Ivanhoe’s boss, about “the cash machine we intend to build”, and how nice it was to have so few people around and “no NGOs”.

The wealth generated by the miners is an obvious target. And the militant Mr Munkhbayar has many fans even among young urban Mongolians who moan that development is arriving too slowly. Like him, they wish it could come from some other industry. Every herder, says one environmentalist, hopes that at least one person in his family will carry on the life. But that may be changing. Twenty years ago it was hard to meet anyone in UB who identified with the city. Even if they were born there, they saw “home” as the “aimag”, or province, from which their parents came. Now a new generation of city-dwellers feels less attached to the countryside and to nomadic herding traditions. Their numbers are swollen by young people returning from an overseas education to chase the new opportunities the mining boom is throwing up.

One such, a young man called Damdin, is finding life difficult. After 15 years in Fairfax, Virginia, he has forgotten most of his Mongolian. He left Mongolia with his mother, who was fleeing his alcoholic father. At school in America the other Asian students were scared of him, despite his short stature; Mongolians, he says, have the reputation of being psychos. Now back in UB, living in a ger with his father who spends his time playing games on Facebook, his ambition is to open UB’s first skateboard shop.

When The Economist encountered him, outside a derelict Buddhist temple in a ger district in the middle of the afternoon, and later at the nearby police station, he had just been punched and robbed of his phone by friends of the friend he had lent it to (“It was 4G, man!”). He was drunk, despite saying he is always teased as a wuss for sticking to beer when real men drink vodka. He was cradling a little street-puppy he had rescued from his muggers, knowing his grandmother would not let him take it home. He presented as forlorn a picture as could be imagined of the pain and dislocation of being caught between two worlds. But he said he had no intention of going back to Virginia.

Source: http://www.economist.com/node/21543113

Australian Dollar on Sturdier Ground

Don't bet that a slowdown in the global economy will drag the Australian dollar down like it did in 2008.

Back then, Australia's currency fell off a cliff as the resources boom that fueled it sputtered.

But Australia's commodity sector is more firmly dug-in these days. In liquefied-natural-gas alone, more than $140 billion worth of projects are already under construction, compared with $15 billion in 2008. Significant committed investment in infrastructure to support massive coal and iron ore operations can't be quickly reversed either.



Record inbound merger-and-acquisition deals last year—worth $65.7 billion—also support the Australian currency as acquirers buy Aussie dollars to fund their investments. This year might not hit another record, but strong interest in resources should support continued dealmaking.

There are risks, especially slowing growth in China and India. But a hard-landing for Asia seems less likely than it did a few months ago. A more muted downturn won't pull the ground from underneath Australia's currency.

Further interest rate cuts from Australia's central bank are possible—dark clouds persist over retail and manufacturing. That could see yield-starved investors look elsewhere. Still, the Reserve Bank of Australia cut the cash rate twice late last year, with more or less no lasting impact on the exchange rate.

A seize-up in global credit markets would also weigh on the Aussie. When the markets shut in 2008, Australian banks were forced to sell local currency and buy greenbacks to meet short-term funding needs in U.S. dollars, Royal Bank of Canada strategist Michael Turner says. But the Australian banks, which have some of the highest credit ratings in the world, are less reliant on short-term funding than they were four years ago.

The Australian dollar has traded in a fairly tight range around parity with its U.S. counterpart for most of the past 12 months, compared with an average of around 75 cents for the past three decades. A deep shock to the global economy that decimates commodity prices could see a return to historical norms. A strong recovery in the U.S. that leads to higher interest rates there could be a game-changer too.

Absent such dramatic events though, the dollar's more likely to stay closer to parity this year than it is to fall back into its old ways.

Source: http://online.wsj.com/article/SB10001424052970204555904577164080084233546.html?mod=WSJ_Heard_LEFTTopNews

For Europe, Few Options in a Vicious Cycle of Debt

Europe has a $1 trillion problem.

As difficult as the last two years have been for Europe, 2012 could be even tougher. Each week, countries will need to sell billions of dollars’ worth of bonds — a staggering $1 trillion in total — to replace existing debt and cover their current budget deficits.

At any point, should banks, pensions and other big investors balk, anxiety could course through the markets, making government officials feel like they are stuck in a scary financial remake of “Groundhog Day.”

Even if governments attract investors at reasonable interest rates one month, they will have to repeat the process again the next month — and signs of skittish buyers could make each sale harder to manage than the previous one.

“The headline risk is enormous,” said Nick Firoozye, chief European rates strategist at Nomura International in London.

Given this vicious cycle, policy makers and investors are closely watching the debt auctions for potential weakness. On Thursday, Spain is set to sell as much as 5 billion euros ($6.3 billion) of government bonds. Italy follows on Friday with an auction of more than $9 billion.

The current challenge for Europe is to keep Italy and Spain from ending up like Greece and Portugal, whose borrowing costs rose so high last year that it signaled real likelihood of default, making it impossible for the governments to find buyers for their debt. Since then, Greece and Portugal have been reliant on the financial backing of the European Union and the International Monetary Fund.

The intense focus on the sovereign debt auctions — and their importance to the broader economy — starkly underscores the difference between European and American responses to their crises.

Since 2008, there has been almost no private sector interest to buy new United States residential mortgage loans, the financial asset at the root of the country’s crisis. To make up for that lack of investor demand, the federal government has bought and guaranteed hundreds of billions of dollars of new mortgages.

In Europe, policy makers are still expecting private sector buyers to acquire the majority of government debt. Last month, in perhaps the boldest move of the crisis, the European Central Bank lent $620 billion to banks for up to three years at a rate of 1 percent.

Some officials had hoped that these cheap loans would spur demand for government debt. The idea is that financial institutions would be able to make a tidy profit by borrowing from the central bank at 1 percent and using the money to buy government bonds that have a higher yield, like Spain’s 10-year bond at 5.5 percent.

But the sovereign debt markets continue to show signs of stress. Italy’s 10-year government bond has fallen in price, lifting its yield to more than 7 percent, a level that shows investors remain worried about the financial strength of Italy’s government.

And European banks appear to be hoarding much of the money they borrowed from the central bank, rather than lending it to governments. Money deposited by banks at the European Central Bank, where it remains idle, stands at $617 billion, up from $425 billion just a month ago.

“It’s hard to see why a banker would want to tie up money in a European sovereign for, say, three years,” said Phillip L. Swagel at the University of Maryland’s School of Public Policy, who served as assistant secretary for economic policy under Treasury Secretary Henry M. Paulson Jr.

Italy’s troubles highlight how hard it is to generate demand for a deluge of new debt from a dwindling pool of investors. The country needs to issue as much as $305 billion of debt this year, the highest in the euro zone. By comparison, France, with the second highest total, needs to auction $243 billion of new debt, according to estimates by Nomura.

Governments like Italy’s are at the mercy of markets because they simply don’t have the cash to pay off even some of their bonds that come due. They must issue new bonds to cover their old debts, as well as their budget deficits, at a time when investors are growing scarce.

Banks, traditionally big holders of government bonds, have been selling Italian debt. “We’ve seen a lot of liquidation by non-European investors,” said Laurent Fransolet, head of European interest rate strategy at Barclays Capital in London. For instance, Nomura Holdings in Japan slashed its Italian debt holdings, mostly government bonds, to $467 million on Nov. 24, from $2.8 billion at the end of Sept.

European banks have also been dumping the debt. BNP Paribas, a French bank, cut its exposure to Italian government bonds to $15.5 billion at the end of October, from $26 billion at the end of June.

Italian banks, though large owners of their government’s obligations, may not want to take on too much more, to keep their investors happy. Shares in UniCredit have fallen more than 40 percent since last week as the Italian firm has tried to raise capital to comply with new regulations.

There are ways to avoid spectacularly bad debt auctions, at least in the short term.

The central bank can help by buying a country’s bonds in the market ahead of a new debt sale. That would help bolster prices at the auction, or at least keep them stable.

There is also some evidence that banks’ government-bond selling may have abated at the end of last year, according to Mr. Fransolet. Central bank figures show European financial firms acquired $2.4 billion of Spanish government bonds in November, after selling a monthly average of $4.8 billion in the preceding three months.

Governments may also be able to attract new buyers to their bond markets. Belgium sold $7.2 billion of government bonds to local retail investors last month, in part appealing to their patriotism.

Opportunistic hedge funds, betting the market is too pessimistic about certain European countries, may also bite. Saba Capital Management, a New York-based hedge fund headed by the former Deutsche Bank trader Boaz Weinstein, owns Italian government bonds, though it does so as part of a wider trading strategy that includes bets that could pay off if Europe’s problems worsen.

But it is doubtful that Italy and Spain can find enough new buyers this year to bring their bond yields down to sustainable levels. Instead, if their economies slow — and if their governments become unpopular — debt auctions could fail and their cost of borrowing could rise even more.

All eyes would then turn to the central bank for drastic action. It could lend more cheap money to banks, in the hope that some of it might find its way into government bonds. Or it could become a big buyer of government bonds itself, printing euros to finance the purchases.

But that may not be a lasting solution, since the central bank’s actions could scare off private investors. Typically, when government-backed organizations like the central bank hold a country’s debt, their claims on the debtor rank higher than those of other creditors. For that reason, private investors might think their holdings would fall in value if the central bank became a big owner of Italian debt — and they might retreat.

At the same time, the crisis response in the United States did not depend solely on government-backed entities like the Federal Reserve to buy housing loans. Professor Swagel of the University of Maryland points out that banks and investors also took large losses on existing housing debt. While painful, the mortgage debt proved less of a drag on the financial system.

So far, Europe has been averse to taking permanent losses on government bonds. Except in the case of Greek debt, European policy makers have shied away from any plan that could mean private holders of government debt get hurt.

However, Nouriel Roubini, a professor of economics at the Stern School of Business at New York University, recently argued in a Financial Times editorial that Italy’s debt should be reduced to 90 percent of the gross domestic product from 120 percent. In such a situation, investors might suffer a 25 percent hit on the value of their Italian bonds, he said.

Such haircuts might seem like the recipe for more instability right now. But if Europe struggles to find buyers for its debt, more radical options are likely to be considered. Europe’s debt problem is huge, and the experience in the United States suggests dealing with it may take several, more drastic approaches.

“If you go halfway, you’ll never get to the end,” Professor Swagel said. “And that describes European policy-making.”

Source: http://dealbook.nytimes.com/2012/01/11/for-europe-few-options-in-a-vicious-cycle-of-debt/

China’s property market: Marriages and mergers

COULD the arrival of the year of the dragon rescue the country’s beleaguered property developers? As Chinese new year approaches later this month, tens of thousands of couples are preparing to marry under what is considered an auspicious sign. To win over a bride in a country undersupplied with women, it helps a lot if the aspiring groom first proves his worth by buying a home.

China’s developers need all the help they can get. Keen to cool overheating residential-property markets, the central government has restricted purchases of multiple homes, demanded larger down-payments and curtailed opportunities for speculators to “flip”, or quickly sell on, properties. It has curbed developers’ access to bank lending and cut off credit from new trust companies. It is also encouraging the use of property taxes like those introduced in Shanghai and Chongqing last year. The government remains committed to policies of this ilk.

Taken together, these measures have splashed cold water on the market. Price growth has been slowing since early 2010 (see chart). Analysis by Soufun Holdings, the country’s largest property website, suggests that prices fell during December 2011 in 60 of the 100 cities it monitors. Land prices are falling fast, too. A recent survey of leading developers by Standard Chartered indicates that land prices are a third off their peaks of late 2010. There are also reports of land auctions run by local governments—a prime source of assets for developers and of funding for local exchequers—failing across the country. All of which presages an overdue consolidation of the industry.

One harbinger of the bloodshed to come is a row that erupted in Shanghai just after Christmas. SOHO China, a big developer, announced that it would buy a 50% stake in prime property near the city’s Bund promenade. It agreed to pay roughly 1 billion yuan ($158m) to Greentown China Holdings and nearly 3 billion yuan to Shanghai Zendai Property, two smaller developers. This outraged Fosun International, a conglomerate that owns the other half of the property, which claimed it had the right of first refusal and is now threatening legal action.

The row is revealing for several reasons, and not only because such public brawls are unusual in China. It serves as a good example of past excess: the property in dispute became the city’s most expensive when, in 2010, Shanghai Zendai paid 9.2 billion yuan for it in an auction. That the two smaller firms agreed to sell their crown jewel hints at the liquidity squeeze now facing weaker developers. And the squabble between the bigger players shows that there are cash-rich developers primed to take advantage of the tumult.

The scope for consolidation is huge. There are over 30,000 property developers in China. Many of these are small local firms that cannot command the access to credit, economies of scale or geographic diversification that big firms can. Analysts at Citibank estimate that the biggest 100 or so firms control only a quarter of the sector, with the next 500 firms commanding perhaps 10% to 15% more. But consolidation is gathering pace (see chart).

The obvious losers from this process will be firms that are heavily leveraged. HSBC estimates that the average gearing for leading listed developers rose from 47% in 2010 to 56% last year (before tightening measures hit home). That average masks wide variations, however: China Overseas Land & Investment (COLI), a state-run goliath, has a leverage ratio of only 36%, whereas Shimao, a smaller rival, has one of 77%. Analysts from Standard & Poor’s, a ratings agency, have run stress tests on the balance-sheets of leading developers and conclude that a 30% drop in contract sales from 2011 levels could push many weaker firms to the brink.

What about the winners? Conventional wisdom maintains that the big listed developers will best the unlisted developers, which are seen as having murky accounts and weak access to capital markets. Not necessarily, argues Andrew Lawrence of Barclays Capital. He sees an analogy with Britain’s frothy property market in the 1960s, when it was the flashy listed firms that overloaded their balance-sheets with debt, whereas the unlisted firms stayed trim and came out on top. He thinks much the same may happen in China.

Another bit of conventional wisdom holds that property developers focused on booming provincial cities will do much better than those with eyes on the biggest “Tier-1” markets like Beijing and Shanghai. One reason to think so is that the edicts issued by the federal government to curb market fervour are enforced with vigour only in the largest cities.

But it is just possible that the downturn could lead to a reversal of fortunes. Markets outside the big cities are often very thin, with few secondary buyers and little investment from other parts of the country. A sharp drop in prices and confidence could lead to a frightening freefall. Privately built housing in peripheral markets is also more vulnerable to cannibalisation by the vast amount of subsidised “social housing” being built by the government.

Pointing to Beijing’s speedy rebound from an earlier property downturn in 2008, analysts at Citibank argue that the leading markets may have a natural floor for prices even in the worst environment. If so, firms like China Resources, Longfor and COLI, which are well positioned in the big cities, may weather the storm better. This is especially true if there is a flight to quality. As the number of defaults and failed projects increases, buyers (who typically pay for homes before they are built) may well favour bigger developers with strong brands and stronger balance-sheets.

In any contraction, big and diversified firms that have little debt and access to cheap capital will come out on top. On that basis, the biggest winners of the coming shake-out are likely to be firms that are state-owned or that have strong links to the government. The likes of COLI and Poly Real Estate Group enjoy official patronage and access to subsidised credit. Of the 20 biggest developers, as measured by yuan sales, ten are wholly or partially controlled by state entities. That share will rise.

Source: http://www.economist.com/node/21542777

Carrefour: Bread, cheese, new boss?

LAST summer, amid rumours that he was about to be sacked, Lars Olofsson was given another six months to revive Carrefour, the world’s second-biggest retailer. His time is up.

Carrefour’s performance has grown mouldier since then—and not in a good way, like Roquefort cheese. In November 2011 it lost market share in France, its home market, which accounts for 42% of sales. This came after several profit warnings, a string of U-turns and a Brazilian merger plan that ended in failure. Carrefour’s shares fell by 45% between January and December last year. Another profit warning may come on January 19th, when the firm will announce its quarterly results—and possibly Mr Olofsson’s future.

Carrefour’s woes are not all the chief executive’s fault. Mr Olofsson took over a struggling firm with a passé business model that mainly operates in a stagnant part of the world. However, he compounded these problems with inept management. A gifted marketer, he can make unrealistic goals sound reachable; but he cannot make them so. His plans for Carrefour have had to be revised more than once.

Mr Olofsson is under pressure from Bernard Arnault, the boss of LVMH, a luxury-goods group, and Colony Capital, a property-investment firm. The two jointly own 16% of Carrefour’s shares and 22% of the company’s voting rights through Blue Capital, an investment vehicle. The stake they bought in 2007 has halved in value, so they are urging Mr Olofsson to pep up the stock price quickly. This makes it harder for him to devise a long-term strategy to turn around the sausage-laden supertanker.

In the past, Carrefour had three strengths: low prices, a vast range of food, clothes and white goods, and the convenience of having all those things in one place. Today shoppers can find low prices and infinite choice online, so fewer bother to drive to an out-of-town hypermarket.

European demography hurts Carrefour, too. Populations are ageing. More people live on their own. And whereas big families buy in bulk, singles tend to shop locally, frequently and in small quantities. “Hypermarkets are not dead, but they are outdated,” says Natalie Berg at Planet Retail, a research firm.

Mr Olofsson has invested hundreds of millions of euros in a revamp called “Carrefour planet”. The new stores boast “beauty areas” with gleaming cosmetics counters and “organic areas” with mountains of organic food. Alas, building a “planet” shop costs twice as much as an ordinary hypermarket. And cash-strapped European shoppers want bargains, not overpriced vegetables. “This is not a good time to refit and renovate the stores,” says Jérôme Samuel of HSBC, a bank.

Carrefour depends too much on products that are in long-term decline, says John Kershaw at Bank of America Merrill Lynch. Its sales of white goods, books, DVDs and electrical gadgets shrank by 20% over the past four years. It needs to offer cheap food, which never goes out of fashion. But its hypermarkets are 8.8% more expensive that the cheapest rival, according to J.P.Morgan Cazenove. As the biggest retailer in France, Carrefour has the clout to cut prices by more and for longer than its rivals. But it hasn’t done so.

The next boss of Carrefour is likely to be French. Thierry Breton, a former economics minister, could be a candidate. Georges Plassat, a former boss of Casino, another supermarket chain, has indicated that he wants to stay in his current job as boss of Vivarte, a retail group. Noël Prioux, the head of Carrefour France, is another possibility, though he started his current job only in June.

Carrefour has a good business in emerging markets and owns property worth an estimated €17 billion. Having decided to pull out of markets where it is not in the top two, it has a hefty market share in 32 countries. Yet Carrefour is still concentrated in Europe, especially France. Growth in Asia cannot make up for flops at home. Indeed, if the company does not perk up soon, investors may demand that its fizzy emerging-market business be spun off from its flat European one.

Source: http://www.economist.com/node/21542804

The semiconductor industry: Space invaders

LAS VEGAS is a city of fast bucks, fast food and fast marriages. It could also be the place where a long war was declared. On January 10th Paul Otellini, the boss of Intel, will address the International Consumer Electronics Show (CES), a vast gathering of gadget-makers, sellers and aficionados in Sin City. He will introduce a phalanx of products showcasing the chips the world’s largest semiconductor company most wants to hype.

Up on the stage with Mr Otellini will be not just PCs of the sort that the company has powered for decades, but also new slimline PCs known as “ultrabooks”, which are being made by the likes of Toshiba and Hewlett-Packard (HP), and even a couple of smartphones. They represent the front-line of an army of Intel-powered kit going into battle against smartphones and tablets which use processors based on designs from ARM, a British firm.

Intel and ARM, pretty much as different in size and approach as competitors can be, have carved up most of the world of microprocessors—the most lucrative bit of the $313 billion global semiconductor market—between them. Each has a well defined patch in which it is pre-eminent. Intel bestrides the market for the microprocessors at the heart of PCs and servers like a colossus; ARM’s legions hold sway in the wide open spaces of the mobile market, having expanded without hindrance from their home turf in mobile phones to the booming world of tablets. Neither side has shown the stomach for more than the occasional raid into the other’s domain.

The wares on show at CES provide the clearest indication yet that Intel is escalating hostilities. It is trying to break into the rapidly growing smartphone market (it already makes chips for some tablets). ARM, meanwhile, has set its sights on the server business, where its low-energy chips should appeal to customers worried about high electricity bills. And more of its processors are likely to find their way into PCs in the coming years too.

The battle is not just about dividing up territories already occupied; it is also about finding new lands to conquer. Both firms are keen to stake claims on the largely uncolonised and still somewhat notional terrain known as the “internet of things”: the myriad processors in industrial machinery, consumer goods and infrastructure, ever more of which will communicate with each other and with distant computers. Cisco, a giant American maker of networking gear, estimates that by 2015 there may be almost 15 billion internet-connected devices, up from 7.5 billion in 2010. Whereas the market for more phones and other personal computing devices is limited by the number of persons the planet has to offer, things, being more numerous than people, provide a lot more long-term room for growth.

Intel, founded in Silicon Valley in 1968, is responsible for many of the advances that have made today’s semiconductors possible. It employs almost 100,000 people and mints money. In the first nine months of last year, the company generated $40.1 billion in revenue and $13.2 billion in pre-tax profit. Admittedly, in December it cut its revenue forecast for the fourth quarter of 2011 by 7%, to $13.4 billion-14 billion, because floods in Thailand had disrupted the production of hard-disk drives and hence demand for its chips. But that was a hiccup; Intel has no real rival in the market for chips that power PCs and servers. Advanced Micro Devices (AMD), the distant second in both, has been struggling. It replaced its chief executive in August after a seven-month search and laid off 1,400 workers in November.

Empire and foundry-nation

Intel’s business has been inextricably entwined with the steady fall in the cost of processing-power known as Moore’s Law, which is named after one of the company’s founders. Ever better chips mean ever increasing sales, which mean ever more money with which to build ever better factories for ever better chips.

The firm’s top brass attributes much of the company’s success in harnessing this virtuous circle to the fact that it both designs and makes its chips, with ten chip factories (“fabs” in industry argot) operating and two more under construction. Brian Krzanich, Intel’s manufacturing head, says this means it can bring chips to market faster and with fewer faults than rivals who use external firms, known as “foundries”, to make their chips. This helps explain why it dominates the market for high-performance processors in PCs and servers.

ARM’s chips are, by contrast, designed to economise on energy rather than to maximise processing power. And it makes none itself, instead selling licences for its semiconductor designs or its “architecture” (a recipe from which licensees make their own designs). Licensees pay a fee and a royalty of 1-2% per chip.

In essence, ARM provides a development base on which others build. The costs are shared, as are the resulting revenues and profits. ARM expects to recoup a chip’s development costs from the sale of the first ten licences. Royalties, which flow later, make up just over half its revenues.

Next to Intel’s leviathan, ARM is a shrimp. It employs just 2,000 people. It reported revenues in the first nine months of last year of £354m, or $568m, on which it made a pre-tax profit of £107.3m (see table). But it lies at the heart of a huge “ecosystem” of companies: a federation, perhaps, as opposed to Intel’s integrated empire. It has 270-odd licensees with 830 licences. Between them they shifted perhaps 8 billion ARM-based semiconductors in 2011, half of them in mobile phones and mobile computers, the other half embedded in consumer items and elsewhere. According to IDC, a research firm, the market for PC-powering chips that use Intel’s x86 processor architecture, which Intel dominates, was about 400m last year.

The ARM federation comprises not only chipmakers but also designers of chipmaking tools, devicemakers and software companies. ARM uses collective insights to design chips it thinks its partners will need; and they in turn shape their products with ARM’s processors in mind.

The dead past

There are intense rivalries within the federation, for example between NVIDIA and Qualcomm, leading makers of graphics chips. And the dividing line between federation and empire is not always clear. Design-tool firms such as Cadence Design Systems and Synopsys work with both ARM and Intel. So do Microsoft, HP, Apple and others. Intel itself is an ARM licensee. But that is for the most part because those businesses straddle the divide, not because the divide is not there.

ARM’s impressive position in the mobile-device market was born out of what seemed at the time like a string of failures. In the 1980s, when the trend in chip design was to make the hardware on processors capable of ever more varied and subtle types of calculation, Acorn, a then-marginal and now-defunct British computer-maker, had a niche in designing chips good at carrying out only a few types of calculation, but which did so very quickly. This reduced-instruction-set computing (RISC) approach requires software that can make up for the limitations of the chips, but uses less power than other approaches.

In 1990 Apple, struggling itself, needed a chip for its Newton, a personal digital assistant that was to restore the company’s fortunes. It liked Acorn’s chip designs: the two formed Advanced RISC Machines as a joint venture with a chipmaker. The Newton was a flop, and Acorn was wound up in 1999—the year that ARM floated. Apple, which today has a cash pile of $81 billion, sold its 43% stake because it needed the money.

When the mobile-phone market took off, ARM’s parsimonious processors were ideal for products in which battery life is at a premium and high-power chips and the fans that cool them are therefore not an option. Today more than 95% of the world’s mobile phones contain an ARM-based chip. Tudor Brown, ARM’s president and one of its founders, adds that the shift to “systems on a chip”—single bits of silicon that package together not just one or more central-processing cores but also graphics processors and other accoutrements—also helped ARM. Its stripped-down processing cores play well with others.

As mobile phones have become cleverer as well as commoner, ARM has gained again. Cleverer phones use more and pricier processors. The average number of ARM-based chips in a phone went up from 1.5 in 2006 to 2.5 in 2010. NVIDIA’s new Tegra 3 system on a chip for smartphones and tablets contains five ARM cores as well as NVIDIA’s own graphics-processing unit. And more, dearer cores mean more royalties. A smartphone can in the best case bring the company eight times as much in royalties as a basic phone, a tablet computer 11 times as much. This shift is far from over (see chart).

There is no such growth in the market for new PCs, which increasingly depends on the replacement of old computers by new ones with better, but not more numerous, processors, and makes up ever less of the total market for microprocessors. No wonder Intel is desperate for new territory, and willing to fight for it.

It is bringing two powerful siege engines to the field. One is its low-power Atom line of chips. The latest of these, code-named Medfield, is already in production and will almost certainly feature in the phones Mr Otellini shows off at CES. A study by Jefferies, an investment bank, says that Medfield is on a par with several popular ARM chips when it comes to processing bang for the energy buck. And Intel is working with Google to ensure that the search firm’s Android mobile operating system runs smoothly on Atom chips.

The company does not intend to stop there. The width of the circuitry on a Medfield chip is a mere 32 nanometres (nm), or millionths of a millimetre. Using a three-dimensional chip design Intel plans to shrink that even further over the next couple of years, to 22nm and then 14nm, and sell chips that beat the competition on both energy-efficiency and performance.

The wedge

The other thing Intel is counting on to help it succeed is new leadership. In December it put Mike Bell and Hermann Eul in charge of a streamlined internal unit focused on cracking the mobile-device market. Mr Bell, who joined Intel in July 2010 after working at Palm and Apple, says the firm has hired more people with a telecoms background and assembled a team to develop software to help phonemakers get the most out of its chips. Intel has also acquired businesses such as the wireless operation of Germany’s Infineon Technologies to help with systems-on-chips. Mr Bell is confident that combining all this with the company’s manufacturing might will make it a force to be reckoned with. “We can move this army en masse over to our mobile effort,” he says.

But even if the chips prove effective, Intel will be hard put to build a phone business out from its beachhead. Getting processors on a technical par with ARM’s, says Michael Rayfield of NVIDIA, is “the easier of the two hurdles. The software hurdle is staggering.” Firms that have invested in ARM’s silicon-and-software combination will be reluctant to give Intel’s chips a chance until they are sure they can handle all kinds of software applications as smoothly as ARM’s. Intel will also struggle to match the extensive and deep relationships its rivals have in the phone arena. The complex reciprocal relationships that make up ARM’s ecosystem, says Mr Brown, the company’s president, are “probably our biggest barrier to entry”.

The fragmented mobile-device market also requires lots of different system-on-chip configurations, which Intel will find a challenge to match. And makers of tablets and smartphones may be reluctant to commit themselves to an architecture dominated by a single company that makes its own processors. “With ARM, when you are tired of Qualcomm you can go to NVIDIA or another company,” says Linley Gwennap, the boss of the Linley Group, a research firm. “But in Intel’s case, there’s nobody else on its team.”

Birth of a notion

While Intel is mustering its forces to attack the mobile-device business, it also faces an assault on its own redoubts. For years the firm has had an iron grip on the PC arena thanks to Microsoft’s decision to design successive versions of its Windows operating system specifically to run on the x86 architecture. But last year Microsoft said that the next version of Windows, which it wants to look and feel the same on mobile devices as on desktops, will work with ARM chips too—one of a number of cracks in the “Wintel alliance”. This could encourage more firms in the ARM federation to try their luck in the PC market, though Intel’s extensive product lines and deep relationships with PC makers make it very difficult to beat.

ARM itself spies a bigger opportunity in another of Intel’s dominions: servers. The server market is hitching a ride on the spread of smartphones, tablets and other devices. The more data is sent to and from the cloud by them, the more social sites they need endlessly to update, the more servers are required. And the data farms in which these servers sit have a prodigious thirst for electricity, a problem that ARM’s chips were created to solve.

In November HP announced a project ambitiously named Moonshot to develop servers using ARM-architecture chips made by Calxeda, a Texan company of which ARM owns 25%. The chips are less powerful than their Intel equivalents. But they are less thirsty and need less cooling, so whereas a standard rack (a man-high cabinet with about a cubic metre of volume) in a data centre can only house a few hundred Intel server chips, Calxeda thinks it can cram in almost 3,000. With 100 racks in a hall, “you’re talking megawatts” with normal servers, says David Chalmers of HP. Moonshot is designed to use a tenth of the power of current server systems and cost 60% less.

Moonshot and other low-energy servers could appeal to, say, social media companies and other web-based firms which do not need to carry out very complicated processing—which benefits from the architectures of more complex chips—or to do it very fast. But Reuben Miller of IDC thinks this segment is likely to be no more than 10-12% of the overall server market by 2015. And ARM’s share of even that smallish slice may be modest to begin with. Just as phonemakers are used to things working in an ARM-ish way, most server software is written for Intel’s chips, and reaps the benefits of its 64-bit architecture, which makes accessing lots of memory, among other things, much easier. ARM’s architecture uses a 32-bit standard, and though the company recently unveiled a 64-bit version, no chips making use of it are yet available. Until they are, says Warren East, the firm’s chief executive, “we can’t even address probably 75% of the server market.”

Meanwhile Intel isn’t standing still: its investment in more energy-efficient processors, such as those of the Atom line, can reap benefits in servers as it does elsewhere. HP’s Mr Chalmers, happy to work with both sides if it gets his clients the servers they need, expects to announce servers based on Atom chips and something similar from AMD this year.

Each side, then, seems to have defences against the incursions of the other. But that does not mean the war will end in stalemate. Intel is more vulnerable than it looks, for several reasons. One is that despite demand from emerging markets such as China, the PC market is unlikely to grow anywhere near as fast as it has done in the past. Intel’s aggressive promotion of ultrabooks seems like a somewhat desperate attempt to inject excitement into a category that has lost momentum.

What is more, the well-fortified world of Wintel provided the PC market with relatively juicy margins. In smartphones and tablets Intel will find itself in a much more brutal competitive environment in which the advantages of its integrated approach to design and manufacturing may well be outweighed by those of agile competitors used to servicing a wide range of companies with lots of different products.

The chips, like dust

Another big test for Intel will be the small but fast-growing market for embedded chips—the sensors and microcontrollers which will, as they become able to talk to each other, make up the “internet of things”. Renesas Electronics, a Japanese company, holds the largest fief in this fragmented terrain. ARM also has a worthwhile chunk of it. But it is a lawless and fragmented territory, largely served by in-house designs and software that both Intel and ARM see as ripe for replacement.

In 2009 Intel splashed out $884m on Wind River, a firm that specialises in software for things that you might not expect to need any, in order to give its efforts in the embedded-chip market a fillip. It has since been able to ink deals with car companies, makers of digital signage and other firms that put chips into their various wares. The company says that annual revenues from embedded-chip sales are now running at $1.5 billion, and it expects these to grow by 25% in each of the next three years.

Yet ARM’s flexible business model, allowing for lots of different chips for different applications, and its happiness in lower-margin businesses, may well give its federation an edge in this business too. Its long experience of producing low-energy chips should be another advantage. Tiny embedded processors “will not use huge amounts of processing power, but power consumption will become more and more critical,” says Ganesh Ramamoorthy of Gartner, a research and consulting firm. ARM already makes a quarter of its revenue from embedded chips. And for the newer embedded processors in what the company calls the Cortex-M family, nine-tenths of the licences so far sold have yet to lead to products, and thus royalties. Having your own fabs can be handy. But when it comes to invading virgin territory quickly, having lots of allies to help you is absolutely fabulous.

Source: http://www.economist.com/node/21542402

Rich managers, poor clients: A devastating analysis of hedge-fund returns

HEDGE-fund managers are the smartest investors around. With keen eyes and sharp brains, they spot and exploit inefficiencies in the markets. Or at least that is what the industry tells its clients.

There is no doubt that hedge-fund managers have been good at making money for themselves. Many of America’s recently minted billionaires grew rich from hedge clippings. But as a new book* by Simon Lack, who spent many years studying hedge funds at JPMorgan, points out, it is hard to think of any clients that have become rich by investing in hedge funds (whereas Warren Buffett has made millionaires of many of his original investors). Indeed, since 1998, the effective return to hedge-fund clients has only been 2.1% a year, half the return they could have achieved by investing in boring old Treasury bills.

How can that be, when traditional performance measures for the industry show average returns of 7% or so? The problem is a familiar one in fund management and is the equivalent of the “winner’s curse” that occurs with auctions (the successful bidder is doomed to overpay). Take a whole bunch of fund managers and give them an equal amount of money to invest. The managers that perform best initially will tend to attract more investors, and so will gradually become bigger than the moderate or poor performers (who will eventually go out of business).

But the manager will not perform well indefinitely. By the time a bad year occurs, the manager will be running a much larger fund. In cash terms, the loss on the expanded fund may easily outweigh the gains made when the fund was smaller. The return of the average investor will be lower than the average return of the fund.

What is true for individual funds also turns out to be true for the industry as a whole. Between 1998 and 2003 the average hedge fund earned positive returns every year, ranging from 5% in 2002 to 27% in 1999. Back then, however, the industry was quite small: overall assets only passed $200 billion in 2000.

That strong performance attracted the attention of pension funds, charities and university endowments at a time when their portfolios had been clobbered by the bursting of the dotcom bubble. They duly piled into “alternative assets” like hedge funds and private equity. By early 2008 the hedge-fund industry had around $2 trillion under management.

But that year turned out to be the annus horribilis for the hedge-fund sector. The average performance was a loss of 23%. In cash terms the loss for that single year was more than double the industry’s total assets under management in 2000, when it was still doing well. Mr Lack reckons that the industry may have lost enough money in 2008 to cancel out all the profits it made in the previous ten years.

At this point, hedge-fund managers might cry foul. The losses suffered in 2008 make a huge impact on the way Mr Lack calculates his figures. If you use the same methodology on stockmarkets, hedge funds outperformed the S&P 500 between 2001 and the end of 2010.

But private-equity managers are judged on a similar basis (the internal rate of return) to Mr Lack’s calculations. And his numbers probably flatter the hedge-fund industry. Indices of hedge-fund returns overstate the numbers because of factors such as “survivor bias” (poor performers stop reporting their numbers) and “backfill bias” (only successful newcomers start to report). These effects could add 3-5 percentage points a year to average returns. Many investors invest in the sector through funds of funds, which charge an additional layer of fees.

Even if you allow for the rebound in markets (and hedge-fund returns) in 2009 and 2010, investors have still got the short end of the stick. They have yet to recover the losses suffered in 2008. But hedge-fund managers took home almost $100 billion in fees between 2008 and 2010 (and an aggregate haul of $379 billion between 1998 and 2010).

Mr Lack’s book suggests the blind faith displayed by many institutional investors in hedge funds needs to be reconsidered. Individual managers may be brilliant but it is hard to spot them in advance. John Paulson was not particularly well-regarded before he made a fortune betting against subprime bonds—and his performance has slumped since. Investing in hedge funds will enable some lucky managers to enjoy an early retirement on their yachts. It will not enable pension funds to eliminate their deficits.

Source: http://www.economist.com/node/21542452