– Neil Unmack is a Reuters columnist. The opinions expressed are his own —

The masters of the universe seem to be losing control of their own destiny.

Jon Moulton, founder of private equity firm Alchemy Partners, has walked out acrimoniously amid a succession and strategic spat with his partners, and Dominique Megret, chairman at PAI, has been ousted. Both cases could trigger so-called “key-man” clauses in the groups’ funds, a nuclear option that allows investors to halt new investment, or in extreme cases even liquidate the fund.

Both Alchemy and PAI’s bust-ups are unique, but we’re likely to see more like them as the private equity model comes under pressure in the aftermath of a global credit crisis.

Key-man risk has always been an issue in private equity. Because investors commit to tie up their capital for several years, they need some kind of fallback mechanism in case a key partner walks out. The clauses also typically have a “level 2″ layer, which is triggered if a certain number of senior managing directors leave. More than 90 percent of buy-out funds include some form of key-man clause, according to Preqin, an alternative assets research firm.

In the good years such clauses are less of a problem because managers are typically locked in by their share of the funds’ profits, or carry, which is paid out over time once a hurdle rate is reached.

The fact key-man risk is now emerging illustrates the precarious and bloated state of the private equity industry as it grapples with the post-crisis financial world. The logjam in the leveraged finance market makes deals harder to do, and defaults are climbing, forcing managers to write down investments. Valuations are depressed, exits are likely to be fewer and at lower multiples than originally expected.

That reduces transaction fees and hurts carry, putting strain on managers and bringing latent tensions to the surface.

The strain is both managerial — how to hold on to good staff who can no longer hope to receive the same payback for their hard work; and strategic — how and when to invest in a new era of tight credit and economic uncertainty.

Investors say it’s not easy to work out which firms will come under stress next. Groups that raised too much and invested too quickly during the boom years may be particularly exposed to writedowns and high overheads, but they could also have older funds that are performing better and still meeting their hurdle rates.

Managers will often try to sort out their differences behind closed doors, for example by reallocating more of the carry to other partners.

If they can’t, the key-man clause transfers power to investors, who must approve an alternative. However, their options are limited. Finding a new firm to manage the fund would be messy and complicated and nobody wants a fire sale.

Investors can press for lower fees, though sticking the knife into a struggling manager may only lead to worse performance. Their best bet may be to reduce future commitments and press for greater transparency over ancillary charges, such as transaction and consulting fees.

This doesn’t mean the private equity model is dead, but there is a certain irony here. After years of proselytizing private equity as a superior form of corporate ownership to the public equity markets, some managers are in danger of struggling to manage even themselves.

– Aron Cramer is president and CEO of BSR, a global business network and consultancy focused on sustainability. The opinions expressed are his own. –

The fall of Lehman Brothers last September triggered a collapse in financial markets, and then the real economy. It also signaled a further decline in the public’s trust in business. One year on, has anything changed?

At the start of 2009, only 36 percent of the U.S. public trusted business to “do what is right”—down dramatically from 59 percent one year before—according to surveys from the PR firm Edelman. But as of this July, trust levels in business had recovered somewhat, to 48 percent. Yet just as with the economic recovery overall, it is far too early to declare victory.

This is about more than winning a popularity contest. Without the public’s trust, business faces cynical consumers, unhappy employees, and public officials that tap into this mood with punitive legislation: hardly the conditions most companies want and need.

Before considering how to make further progress, it’s best to diagnose how this happened.

Inevitably, an economic decline brings a fall in trust. When large swaths of the public feel insecure economically, business suffers, too. We like the private sector a lot more when unemployment is at 5 percent than we do when it nears 10 percent.

Business is also represented by some rather unsavory figures in the public mind right now.  Bernie Madoff and John Thain symbolize this economic downturn, and for some, they symbolize the entire business community, regardless of whether their sins are widely practiced.

But the core of the problem is this: In the eyes of many, the objectives of the business sector are disconnected from broader social purposes. As UK Financial Services Secretary Lord Paul Myners said not long ago, too many in the financial services industry “had no sense of the broader society around them.”

That’s why so many people conclude that the economy is rigged against them. When business is viewed as consumed only with its own interests, and not wider public needs, the public is destined to be more cynical about its objectives. This is especially true as the debates over health care and climate change roll on.

The Edelman survey shows that there are some green shoots of trust beginning to develop. Just as with the overall economy, it is not guaranteed that these improvements will last. To make that happen, there are several steps business can take.

First is to restore the public’s sense that business exists to serve a larger purpose than producing quarterly profits. Business is, in fact, critical to our collective ability to make progress on our most pressing global challenges. We see companies from Nike to IKEA to GE making substantial investments in reducing climate change, and companies like Levi’s and Coca-Cola are exploring new ways to use water more efficiently. The shift to sustainable business is well underway, and is a core asset in the re-establishment of trust.

At key points in our history, business has earned the trust of the American public by embracing collective challenges, not by taking an “every company for itself” approach. That principle holds true today.

According to Edelman’s survey, nearly 90 percent of respondents said they would trust companies that drive better innovation by investing in research and development. We are again at a turning point when more companies should focus on building a different kind of future. Some are already: Starbucks is looking to support a fully functioning health care system, Clorox and SC Johnson are innovating to reduce the chemicals in all our households, and Procter & Gamble is developing water-purification products that meet the needs of people at the “base of the pyramid.”

We also need a greater link between these innovations and business’ lobbying efforts. For some time, there has been a concern that companies trumpet their green credentials on the one hand, while working to reduce public policy reforms on the other. With health care and climate change debates coming to a head this fall, there is a need for greater alignment between green messaging and lobbying—this will pay big dividends for the private sector and for public policy.

Business should look to remake the incentive structure to develop products and services we really need. Too often today’s markets create incentives that point in the opposite direction. Markets—including investors—prize short-term profits over long-term value. Compensation schemes cause executives to sacrifice innovations for the long haul. Had incentives for long-term thinking been in place sooner, rewarding leaders pushing for more fuel-efficient cars, rather than the SUVs that seemed like a good idea at the time, Detroit might be in a better position than it is now.

Business has a chance over the next few months to write a new chapter and align its interests with those of the public as we face the many global challenges ahead. Indeed, that is the only way for business to rebuild public trust and ensure a sustainable economic recovery.

The U.S. Treasury Department on Tuesday unveiled a revamped financial rescue plan to cleanse up to $500 billion in spoiled assets from banks’ books and support $1 trillion in new lending through an expanded Federal Reserve program. But initial market reaction reflected investors’ doubts about the plan, with stocks falling around 3 percent after the announcement by Treasury Secretary Timothy Geithner.

“For all the rhetoric that this is a new plan, they’ve done nothing but rehash and expand the old procedures,” said Steven Ricchiuto, chief economist at Mizuho Securities USA.

Carl Lantz, U.S. interest rate strategist at Credit Suisse in New York, said details of a proposed public-private investment fund for mopping up toxic bank assets were “very vague”.

“It sounds like for this public-private investment fund they are still exploring a range of different structures for the program or seeking input from market participants,” he said. “That’s the the kind of stuff we heard on TARP One and suggests that given all this time they still don’t have anything very specific nailed down.”

James Ellman, president of Seacliff Capital in San Francisco, criticized the proposals. “Investors want clarity, simplicity, and resolution. This plan is seen as convoluted, obfuscating, and clouded. We know that Geithner was able to overrule many other Obama administration people, and said we should not be tough on bank equity holders or bank management. So equity holders got a better deal, and it’s still not a good deal.”

Do you have confidence in Geithner’s plans? Debate the announcement below. We’ll update this post with fresh comments from analysts and other market participants as we get them.

– John Kemp is a Reuters columnist.  The views expressed are his own –

The last eighteen months have witnessed a revolution in financial regulation — if by that we mean a fundamental reconstruction, total change or turn round from the previous orthodoxy occurring in a relatively compressed time.

In particular, the sheer scale of recent policy interventions in the banking system is throwing up very uncomfortable questions about the government’s role in the economy, centered on its function as the ultimate re-insurer of risk and its function via the central bank as “lender of last resort” (LOLR) to the banking system.

The classic statement of LOLR operations set out in Walter Bagehot’s “Lombard Street” is to “lend freely, at penal rates, against good collateral”.

But in the aftermath of recent rescues, not much remains of the original doctrine. The Fed and other central banks are now lending freely, but to a wider range of institutions never envisaged before, against poor collateral, on increasingly generous terms, and providing support for solvency as well as liquidity.

Central banks and finance ministries are shouldering losses that properly belong to private shareholders and creditors. In the process they are protecting almost all depositors, and helping bail out shareholders. Walter Bagehot would be amazed at how far his doctrine has evolved.

The broadening of the lender of last resort guarantee was probably inevitable. But it makes explicit what was always implicit: in an integrated financial system the liabilities of the whole system are contingent liabilities of the central bank and ultimately the taxpayer.

In previous crises, the off-balance sheet liabilities of vehicles such as conduits have been consolidated back onto the balance sheet of the sponsoring commercial and investment banks. But in the current, system-wide crisis the liabilities of not just large banks but almost all financial institutions are being partially consolidated back onto the balance sheet of the central bank and the public treasury.

If system-wide liabilities are all, in some sense, contingent liabilities of the central bank and taxpayer, should the central bank and taxpayer regulate the quantity and type of these liabilities to limit the resulting fiscal and monetary risk?  Is there a maximum size of banking sector and financial system that economies such as the Iceland, Switzerland or even the United Kingdom can safely maintain in relation to their national output?

A NEW CREDIT POLICY?

The attached paper (https://customers.reuters.com/d/graphics/CRDTPOLICY.pdf) sketches out some of these issues in more detail and tries to frame the relevant questions for both policymakers and financial institutions trying to pick through the rubble of the global banking system.

For the time being, there are more questions than answers. But what is clear is that the current crisis marks a fundamental break with past practice. Modest adjustments or evolutions of existing theory and policy will not be sufficient. The theory has broken.

The twin framework of fiscal and monetary policy (in place since the 1930s); the central banking doctrine of lender of last resort (in place since the late nineteenth and early twentieth centuries); and the inflation-targeting framework for monetary policy (in place since the 1990s) have all been weighed in the balance and found wanting.

Only a fundamental rethink from first principles can equip the system to face the challenges posed by the current crisis and prevent a recurrence.

In particular, central banks and financial regulators may need to develop a far more explicit policy to control the quantity and distribution of credit, separate from, but complementing existing monetary and fiscal policies.

Rather than interest rates, which manipulate the cost of funds, this “credit policy” may need to operate through direct quantitative controls, including reserve requirements, volume quotas, or deposit to lending ratios, perhaps imposed in a contra-cyclical or contra-trend manner designed to limit credit growth during expansions.

This would mark a sharp break with the free-market principles which have informed bank regulation and government policy over the last three decades, but no more sharp than the wholesale rescue of bank depositors, shareholders and borrowers with public funds over the last eighteen months.

It is time to consider whether the volume and composition of credit should be an explicit target for government policy, alongside output, inflation, employment and income distribution.

For previous columns by John Kemp, click here.

– John Kemp is a Reuters columnist. The opinions expressed are his own –

Most successful elected leaders must disappoint their most ardent supporters at some point, as the bright hopes of an election campaign give way to the complex realities and constraints of governing, and need to occupy and retain the political center-ground to win re-election.

The trick of really successful leaders is to let supporters down gently to avoid turning disappointment into frustration and anger, retaining allegiance and support even when the maximum agenda goes unfulfilled and compromises must be made. Political supporters have to be given enough policy gains to be kept loyal, even as some cherished objectives fall by the wayside.

Despite the enormous outpouring of goodwill to the incoming president, or perhaps because of it, President-elect Barack Obama will be no exception to this iron rule.

The high hopes for the administration (cultural reconciliation between left and right, poverty alleviation, fairer distribution of economic rewards, renewed growth, financial reform, decisive action on climate change and “peace in our time”, to name but a few) have run far ahead of even the most successful president’s ability to deliver them in four or even eight years.

So the real question as the new administration prepares to take office is where will it dare and be able to be radical, and where will it be forced by circumstances to be more conservative.

Early indications suggest the administration may disappoint its progressive supporters with a cautious approach to foreign policy, the economy and finance, but its moves in climate change and energy efficiency could be far bolder.

CHOOSING BATTLES CAREFULLY

Like any president, Obama will have to decide which battles to fight and which to avoid, where to spend his political capital, and where to conserve it by hewing closer to the status quo. Presidents respond to the agenda forced upon them as much as they shape it.

Despite the “change” rhetoric, the new administration may find its options severely limited. Financial crisis at home leaves little room in the budget for new spending mandates beyond short-term stimulus.

While blaming the banks for causing the financial crisis is attractive, the system is probably not strong enough to withstand wholesale reform at the moment, so the administration may have to settle for more piecemeal changes.

Abroad, the administration also faces the familiar Gordian knot of intractable disputes: how to close the detention facilities at Guantanamo, deal with Iran’s suspected nuclear ambitions, engage European governments and become involved in the Middle East process.

Moreover, Obama’s commanding lead in electoral college votes (365-173) masks a narrower margin in the popular vote (53 percent to 46 percent). For all the enthusiasm about “change”, almost half the nation voted for Obama’s rival Senator John McCain. The president faces re-election in four years and cannot afford to stray too far from the political center.

The new president has two options. Try to enact a raft of radical reforms quickly in the hope of changing the whole political game by the time the next election is fought — the kind of “transformative” presidency with which scholars have credited Lincoln, Roosevelt, Truman and Reagan — though perhaps only in hindsight. Or pick a few carefully chosen battles and settle for competent administration and marginal improvements in other areas.

So far, Obama’s rhetoric implies the former, but his cabinet picks incline to the latter. His most enthusiastic supporters at home and abroad may be disappointed.

In many areas, circumstances may force the new president to be a gradualist rather than a great reformer, which risks disappointing core groups at home and foreign governments hoping for a more radical break with the past.

During the long campaign for the presidency, Obama showed himself to be one of the finest students of politics; despite the soaring oratory, he is well aware that politics remains the art of the possible.

The presidential transition has stressed bringing on board Washington insiders with previous governing and legislating experience (Clinton at State; Gates at Defense; Daschle at Health and Human Services; Blair and Panetta in intelligence; Geithner and Summers at the Treasury and on the White House National Economic Council) rather than innovative or iconoclastic visionaries from outside the Beltway.

Nevertheless, the administration needs to find at least some areas in which it can make a decisive break with the past and stress change rather than continuity, if only to maintain the enthusiasm of its core supporters among progressives and liberals.

Climate change and energy policy is shaping up to be the area where the incoming administration can make some bold gestures designed to reach out to domestic supporters and European governments while disappointing their hopes elsewhere.

THE NEW ENERGY TRINITY

Obama’s selection of Steven Chu to be secretary of energy last month was an indication of the importance he places on using science and technology, as well as a full range of fiscal incentives, to tackle climate change and reduce dependence on imported fossil fuels.

The Department of Energy (DOE)’s primary mission is stewardship of the nation’s nuclear stockpile, which absorbs more than half of the department’s $26 billion budget. DOE funds some research into alternative fuels. But until now the leading role on climate change and energy conservation programs has been taken by the Environmental Protection Agency (EPA) and the White House Council on Environmental Quality, with DOE playing only a minor supporting role.

So picking Chu, who has been one of the most prominent and outspoken advocates of using tax increases to force reductions in energy use, and a strong supporter of technological solutions to climate change in his role as director of the Lawrence Berkeley National Laboratory, sends a strong message about the incoming president’s priorities.

Combined with the selection of other strong climate change advocates to head the EPA and Council on Environmental Quality, Chu’s forthcoming nomination suggests the administration is preparing to be quite radical in this area.

Given the multiplying problems for the incoming administration’s climate and energy agenda, it may need to be.

For previous columns by John Kemp, click here.

– Preston Keat is director of research at Eurasia Group, a global political risk consultancy, and author of the forthcoming book “The Fat Tail: The Power of Political Knowledge for Strategic Investors” (with Ian Bremmer). Any views expressed are his own. For the related story, click here.

There are a number of macro risks that will continue to grab headlines in 2009, including the conflicts in Afghanistan and Iraq, cross-border tensions and state instability in Pakistan, and Iran’s 
ongoing quest to develop advanced nuclear technologies.

These risks are real, and will not be resolved easily or quickly. But there are two other general groups of political risks that could be defining both for investors and policy makers: first, the prospect of a number of interrelated market risks in developed and emerging Europe, and second, the challenges faced by the United States regarding multilateral leadership (particularly in the area of financial regulatory reform).

Political risks have historically mattered much more in emerging markets, but political risk in the developed, industrial democracies is rising more quickly than anyone would have predicted a year ago.

Europe

Political-market risk in emerging Europe is significantly higher now than any time in the past decade. Russia and Ukraine, and even recent star “emerging Europe” performers such as Turkey, Hungary, and Romania face serious vulnerabilities in the coming 
year. In addition, western financial institutions based in countries
 like Germany, Italy and Austria are particularly vulnerable to a credit 
crisis in Eastern Europe, where they have large loan exposures. Russia’s growing anti-westernism, its state intervention in strategic
 economic sectors, and its assertive posture regarding Georgia have been widely discussed, and will remain concerns in
 2009.

This also plays into one of the most problematic country risk 
stories right now: Ukraine. Its steel-centric economy is in free
 fall due to dramatically reduced global demand, many of its companies
 have large foreign debt financing needs that they will struggle to meet, 
 and its domestic politics are gridlocked and bordering on 
dysfunctional.

Add serious ongoing tensions with Russia to the list, and 
the situation looks bad from almost every angle. The year has
 already started badly, with Gazprom cutting gas supplies 
to Ukraine, and the
 standoff highlights the growing animosity between Moscow and Kiev.

The global financial and credit crises, combined with recession in
 Western Europe, have exposed several other countries in emerging Europe 
to serious financial market risks. In Hungary, the IMF and the 
EU needed to step in with a dramatic aid package in order to head off a potential currency and bond market collapse. And in Romania, there are
 growing concerns about a real estate bubble, rapidly declining economic
 growth, and the evaporation of repatriation cash flows from Romanians 
living in Italy and Spain.

Both the Hungary and Romania stories highlight the increasing 
interconnectedness of political and market risk in the EU. The newer
 member states can no longer be considered in relative isolation from the
 core, Western European countries.

The most notable example is the 
exposure of Western banks to credit risk in Eastern Europe. In recent
 years western banks have made substantial home mortgage, consumer, and
 business loans to eastern Europeans that were denominated in western 
currencies. The borrowers were
 exposed to local currency risks that the often did not fully understand
.

Italy, 
 Austria, and Germany had the largest exposures. Now these western
 governments may need to step in to assist with the solution. In fact, if
 the EU and European Central Bank had not intervened in dramatic fashion 
in Hungary, a number of western-European banks and pension funds would
 have been in very serious trouble. The problem is that this may only be 
the beginning of a crisis that could involve dozens of countries in both 
the East and the West.

The U.S. and Multilateralism

In the past several years the dynamics of “multilateralism” have evolved 
fairly dramatically. Two central developments this year:

1.  A number of
 additional players such as India, China, and Brazil are actively
 seeking to play a larger role in multilateral negotiations and 
institutions.

2.  The U.S. is in the process of a presidential 
leadership transition, with an expectation that the new administration
 will address these issues differently than its predecessor.

This new environment presents both challenges and opportunities. A 
larger number of “key” players at the table means that policy 
coordination could be much more difficult - a classic collective action
 problem. At the same time, engaging newer, emerging-market countries may 
make sustainable “breakthrough” outcomes more plausible, as these 
countries will be central to tackling complex issues such as climate 
change and global trade.

Prior to September of 2008, the central challenges of 
multilateral cooperation were in areas such as energy/climate change, 
 trade, and security. Then the global financial and credit crisis offered 
an almost perfect experiment. How would the world’s leading 
countries, along with those who aspired to positions of greater 
leadership (e.g. China, India, Brazil) manage this systemic crisis?

When it comes to a new financial regulatory architecture, the U.S. is 
likely to find support for its agenda in the UK and China, who will
 share the its general aversion to giving meaningful regulatory authority 
to multilateral institutions such as the IMF. As long as these three key
 players can agree on general principles for market regulation, power 
will remain in the hands of national governments rather than any
 multilateral organization.

But this 
is where a key, lurking political risk comes into play - can the U.S.
 actually take the lead in developing a coherent approach to new 
regulation of capital markets?

Congress will probably feel that it needs to act in a dramatic
 fashion and enact new legislation. The Treasury and the Federal Reserve 
will also have serious, and potentially conflicting agendas. So even if
 the multilateral dimension looks manageable, the domestic and
 bureaucratic politics of new regulation present a substantial new risk.

– John Kemp is a Reuters columnist. The views expressed are his own –

After six decades of uninterrupted credit creation and an unprecedented era of consumption and prosperity, the credit process has come to an abrupt halt. If credit has been the locomotive of the modern economy, the third quarter of 2008 marked the point when the engine stalled and the economy began to roll back down the hill.

For decades, financial activities have grown much faster than the real economy. Between 1952 and 2007, U.S. nominal GDP grew by a factor of 39 times, while total credit market debt outstanding surged 101 times.

Finance has become even more dominant in the last 25 years, as subdued business cycles, improvements in technology and communications, deregulation and pension privatization have fueled a massive increase in the issuance of debt and other financial assets.

In 1952, the U.S. economy had just $1.28 of debt for every dollar of GDP, and as late as 1980 this figure was still as low as $1.61. But beginning in the 1980s, financial services underwent a revolution that saw credit instruments per dollar of GDP rise to $2.28 in 1990, $2.67 in 2000 and a staggering $3.55 by the end of 2007.

Increasing debt, much of it bought in recent years by China and oil-producing countries of the Middle East, has allowed the United States to have both guns and butter. It financed a huge expansion of consumption, home-building and business investment, while allowing the federal government to cut taxes and still fight two major wars in the Middle East.

But in the three months between July and September, the miracle of modern finance came crashing down.

Despite the turbulence, total debt rose another $585 billion, according to the Federal Reserve’s “Flow of Funds” report issued yesterday. But almost all the increase was government borrowing ($527 billion) to backstop the Federal Reserve and other rescue programs. The private sector borrowed just $58 billion.

Once seasonal adjustments are made, the total volume of debt owed by U.S. households fell for the first time since records began in 1952. While the shrinkage was marginal, at an annualized rate of just 0.8 percent, it stands in stark contract to the double-digit increases reported between 2002 and 2006.

For corporations, debt growth has slowed from almost 14 percent per year to 3.7 percent in the last twelve months.

Only the federal government remained an active borrower, with debt growing at rate of almost 40 percent in the three months ending in September.

THE VAPORIZATION OF WEALTH

Respected commentators, including the former chairman of the Federal Reserve, Alan Greenspan, have minimized the importance of the growing debt mountain by pointing out that household and corporate assets have grown even faster, and balance sheets are stronger than the debt figure alone implies.
Not any more.

Household wealth is evaporating as falling home prices and a plunging stock market wipe out a sizeable chunk of assets.

Households’ net worth (assets minus liabilities) has shrunk in each of the last four quarters. From a peak of $63.6 trillion at the end of Q3 2007, households’ net worth has fallen by a massive $7 trillion (11 percent) in the last twelve months to just $56.5 trillion.

The wealth that has vanished is equivalent to half the country’s annual output, and larger than the entire annual production of any other country on the planet.

In what is probably the largest disappearance of wealth in history outside war, falling home values have vaporized $4 trillion worth of homeowners’ net equity since the start of 2006. Net equity is down by a third from $12.5 trillion to $8.5 trillion.

In the past twelve months, there have been further losses from falling equity prices ($2.73 trillion), mutual fund valuations ($890 billion) and pension fund reserves ($1.65 trillion).

Until recently, corporations have been spared. But the net worth of nonfinancial businesses seems to have peaked at $16.2 trillion in Q2 and fell $52 billion during Q3. Further losses are inevitable as commercial real estate values go into freefall.

CAPITAL REPATRIATION

Perhaps the most significant changes, however, have come in transactions with foreigners. Desperate for cash, U.S. corporations, banks and investors and liquidated their overseas asset portfolio at a record rate during Q3.

U.S. residents liquidated their overseas portfolio at an annualized rate of almost $770 billion. There were record sales of bonds ($291 billion) and commercial paper ($273 billion), and a smaller but significant fall in overseas equities ($57 billion) and other miscellaneous assets ($277 billion).

On the other side of the ledger, foreigners continued to support the U.S. currency and balance of payments, despite the implosion of the U.S. banking system, making net purchases of U.S. assets at the surprisingly fast rate of $815 billion per year during the three months between July and September.

But the net purchases were entirely accounted for by ultra-safe U.S. Treasury bonds ($819 billion) and more than half of those purchases were by foreign governments and central banks ($464 billion).

Private investors also bought $355 billion worth of safe Treasuries. Both the private sector and governments shunned the agency market, selling at a rate of $240 billion per year, and corporate bonds, where holdings fell at a rate of $126 billion.

DOLLAR REVALUATION SUSTAINED

Capital repatriation explains much of the dollar’s recent surge against all the other major currencies except the yen.

Some commentators have suggested the dollar’s slide will resume once repatriation has run its course, and that a weak economy and damaged banking system will see a renewed substantial decline in the dollar’s value from early next year.

But as I noted in a recent column, the dollar’s behavior this decade has been inversely linked to the strength of the economy and the massive expansion of the financial system between 2002 and 2007.

Earlier in the decade, rapid U.S. growth sucked in imports faster than U.S. manufacturers could raise their exports, while some of the balance-sheet expansion leaked abroad in the form of net purchases of overseas assets by U.S. residents.

Since the United States could not fund all its imports, let alone asset purchases, from export earnings, the result was a steadily increasing net offer of U.S. financial assets to the rest of the world and persistent downward pressure on the currency.

Now the devaluation process has gone into reverse. Slower growth, and the liquidation rather than accumulation of overseas assets, have sharply reduced the U.S. external borrowing requirement during the last four quarters and resulted in strong dollar appreciation. (https://customers.reuters.com/d/graphics/US_EXTFIN1208.gif).

Currencies are potent symbols of national identity, and it is a common mistake to conflate the strength of a country’s currency with the performance of its economy.

In fact, exchange rates have never been directly linked to economic performance. Japan’s lost decade in the 1990s coincided with, and was partly caused by, the strength of the yen. Much the same could be said of the underperformance of the British economy in the early 1990s and the French economy in the 1930s.

So there is no reason to expect next year’s forecast U.S. weakness to be expressed in a falling exchange rate.

Assuming activity and imports remain depressed throughout 2009, growth switches to Asia, and U.S. investors and corporations stabilize or continue to liquidate their overseas asset portfolios, rather than trying to add to them, the U.S. currency could remain surprisingly steady.

But that would be a sign of weakness, not strength.

For previous columns by John Kemp, click here.

– James Saft is a Reuters columnist. The opinions expressed are his own. –

Trade finance, a basic lubricant for the global economy, is becoming much more expensive and tougher to get, accelerating an already harrowing downturn.

Banks are reluctant to allocate scarce capital to trade finance, which funds cross-border buying and selling, and are very wary about being caught short by defaults by other banks which write letters of credit or by the importers and exporters themselves.

While not the prime cause of a slowdown in global trade, which is being buffeted by declining consumption and tighter finance to households and businesses, tough conditions for the obscure but crucial corner of finance that funds goods and commodities between dispatch and delivery is sand in the wheels.

Stunningly bad trade figures from China underlined the problem. China had been expected to show double digit growth in trade last month as compared to November 2007, but the data showed exports falling 2.2 percent from a year ago and imports down 17.9 percent.

“Global demand for Chinese products is vanishing,” said Gene Ma, an economist at China Economic Monitor, a Beijing consultancy. “Secondly, the credit freeze in importing countries has made it hard for Chinese exporters to sell abroad. I heard some Chinese exporters had to cancel shipments as they were worried about getting paid by their buyers.”

Chinese banks have been very nervous about accepting letters of credit from abroad, making it tougher for imports to China to get the needed financing. China and the U.S. pledged $20 billion to fund trade with developing countries last week, but that is a tiny balm for a huge market.

The rule of thumb is that 90 percent of global trade requires financing. Karl Alomar, chief executive of China Export Finance, estimates that letters of credit which had accounted for about 70 percent of Chinese trade finance in 2007 might now only have 30-40 percent of the market, in part due to concerns about international banks.

Many deals that would otherwise go through will inevitably be scrapped, while many more will be less profitable. The World Trade Organization Director-General Pascal Lamy said in November that some transactions that charged a “spread” of 80 basis points over bank benchmark rates a few months ago were now charging 500 basis points.

It may well take concerted international action by central banks and governments to bring trade finance back to life. But this is far from an easy ask; there are many calls on governments for capital and guarantees already and it could  prove politically easier to prioritize “purely domestic” issues like automaker bailouts over trade.

DEATH SPIRAL

For the weakest importers like British high-street retailer Woolworths, denial of trade finance can hasten a death spiral. “Woolworths is one of the better examples of that,” said Panmure Gordon banking analyst Sandy Chen.

“Because they couldn’t get the credit insurance to effectively fund their pre-Christmas inventory stocking they couldn’t put orders into shippers in the Far East. Because shippers couldn’t get the assurances on whether or not Woollies could pay they wouldn’t ship.”

Woolworths Group was forced to put its retail and distribution business in administration.

Even putting counterparty risks aside, trade finance is vulnerable in the current situation. Banks, and crucially many non-bank finance companies, are having their own difficulties raising funds and are being forced to pay more. They are also under considerable commercial and political pressure to channel what resources they have to areas that either have a big payoff or, like mortgage lending, win points with their government regulators and shareholders.

Trade finance, though it is vital in aggregate, doesn’t tick too many of those boxes. It is also fairly easy to pull back from without enormous immediate repercussions for the banks as it is short-term.
Difficulties with trade finance have also contributed to a 94 percent decline in the price for dry commodities space on large ships.

The Baltic Exchange’s chief sea freight index, which tracks prices to ship resources like coal and iron, is close to a 21-year low. Importers and exporters of commodities and their banks are simply worse risks than they used to be, making finance more expensive and scarcer.

The chilling thing about the trade finance situation is not its impact in isolation but the way in which it illustrates how easy it is to send a very highly integrated global economy into reverse.

“If there are significant increases in perceived counterparty default risks leading to a shut-down of one part of the supply chain it rapidly moves on to the rest of the chain,” Chen of Panmure Gordon said.

“It’s a cycle that feeds on itself.”

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on here. –

For full coverage of the crisis in credit, click here.

I recently visited one of the most frightening sites on the Web—the place where I look at my shrinking retirement account.

As I calculated the investment loss since the steep decline in the markets began, and particularly since the collapse of Lehman Brothers in mid-September, some questions arose (in addition to: Will I ever be able to retire?).

--Did we in the media do our job in reporting on the run-up to the crisis?

--Now that an “official” recession has been declared in the U.S. and the depth of the crisis is becoming clearer around the world, are we in the media keeping things in perspective? Should we even be using words like “crisis” or “meltdown?”

On the first question, I can’t help thinking of Claude Rains’ “Casablanca” character Captain Renault, who was “shocked, shocked to find that gambling is going on” in Rick’s club. In hindsight, given the current state of the financial markets, wasn’t it obvious a problem was brewing?

Not necessarily. And it probably wouldn’t have been obvious to anyone reading online or print coverage or watching television news in the United States.

A look at a study by the Pew Center’s Project for Excellence in Journalism indicates that, in the United States, coverage of the economy was pretty much drowned out by coverage of the presidential election—at least until the two stories converged in mid-September. Indeed, as the Pew material shows, in the month preceding the week of Sept. 15, which saw the Lehman bankruptcy, the Merrill Lynch sale, the AIG bailout and large drops in share prices, the proportion of the news hole devoted to the economy reached a low for the year, filling only 4.8 percent of the time on television and radio and space in the print and online media. Since then, that focus has shifted, as the presidential campaign narrative became, again, “it’s the economy, stupid,” and as the presidential transition has focused on U.S. economic problems.

Reuters News Editor-in-Chief David Schlesinger is skeptical that financial journalists could have done much more to predict the depth of the crisis.

“Journalists do best when reporting what's happening and giving the news context and analysis,” he said. “We also do well when we look backwards and discuss past events from the perspective of the present. We do least well when we prognosticate. While our reporting and commentary did discuss potential weak points in the economy, we did not -- and nor frankly could we -- accurately predict the calamitous events of this year.”

Schlesinger worries, though, that there was a certain inevitability to the crisis and that the media played a role.

“I do worry about the narrative lines of reporting that contributed to the crisis,” he said. “To take just one example, much of the crisis was caused by banks taking on excess risks in the pursuit of higher profits. Yet had a major bank president stepped back from that fray and declined to participate, the ‘grammar’ of our results reporting would surely have compared that bank's results negatively against expectations and against its peers.

“That brave bank president would surely have lost at least his bonus and probably his job. The very fear of that kind of negative comparison helped spur things on -- as Citibank's ex-CEO Charles Prince said (while still in his job), ‘As long as the music is playing, you’ve got to get up and dance.’

“We in the media help play that music, probably exacerbating the highs on the way up and the lows on the way down.”

So did our reporting help change the tune that was being played? Did it raise questions about the factors that contributed to the crisis, including complex financial instruments, subprime mortgage lending and excessive risk?

To fully answer that would require a deeper analysis than we have room for in this space, but there is evidence that questioning notes were sounded.

As early as Aug. 18, 2003, a Reuters story quoted Fed governor Edward Gramlich citing the dangers of “predatory lending” in extending subprime credit. By 2006, the pace had accelerated. A Factiva search of Reuters News found 128 stories that mentioned the phrase “subprime mortgage” that year, including a number in which analysts predicted a deterioration in credit quality. The crescendo came in 2007, when there were more than 10,000 stories that referenced subprime mortgages and when Reuters.com built a special section to house material on the issue. That section developed into the current Crisis in Credit and Housing Market sections.

Still, the overall “music” was loud and infectious and it’s easy to understand why so many couldn’t stay off the dance floor.

Now that the crisis is here, some are accusing the media of deepening the problems. Richard Lambert, director general of the CBI, a U.K. employers group and a former editor of the Financial Times, said “careless headlines or injudicious reporting risk becoming self-fulfilling prophecies of a very serious nature.” He urged journalists to be especially vigilant in their fact-checking and called on the press to avoid such words as “panic,” “fear” and “chaos.”

He also suggested that journalists should cut bankers, regulators and politicians a little slack, since “precious few journalists gave any hint at all of what was about to come.”

The FT’s Lex column (Note: subscription required) accused Lambert of shooting the messenger and lamented that some would “seek to clamp down on the fourth estate…, hoping regulation will recreate a golden age when the business press was a tamer, more deferential beast” that “could be hushed up in times of financial turbulence.”

But those days are gone, as Lex put it. “The digital revolution, by lowering entry barriers and intensifying competition, has put paid to all that. It will not return.”

And good riddance. As a card-carrying lover of the First Amendment and the digital revolution, I’m happy those days are gone. But with our freedom comes a sometimes frightening responsibility, especially in troubled economic waters.

As Schlesinger says, “We have a responsibility to be careful, and most of our reporting has been very careful. But we too have played some discordant notes and we need to learn from that.”

What do you think? Did we in the media do our job in reporting on the financial crisis, both before the market collapse in September and since? Are we being careful enough not to sow panic and make things worse? How can our reporting help you weather the storm?

Please post your comments here.

I’ll be using this space regularly to explore issues arising from Reuters and other media coverage of the world and to have a discussion with you. Among the topics I plan to look at: the dangers and rewards of covering religion; the use of anonymous sources; the debate over shield laws for journalists, and much more. I’ll also be providing lots of space for you to have your say.

In the meantime, I’ll be watching that retirement account.

Dean Wright, Global Editor, Ethics, Innovation and News Standards

– Paul Taylor is a Reuters columnist. The opinions expressed are his own –

The global financial crisis has been a stark reality check for the European Union, exposing divergences over economic policy and highlighting the European Commission’s growing difficulty in enforcing common rules.

The European response to the turmoil shows that most real power still resides with member states, not in Brussels. Even after 50 years of integration, governments instinctively reach for national solutions at the risk of harming EU partners.

The 27 EU leaders, especially the big three of Germany, France and Britain, need to take a deep breath before next week’s summit and measure how much damage they could inflict on future prosperity and on Europe’s credibility in the world if they continue down this path.

The EU united briefly in October behind a plan to avert a meltdown of the financial system and a call for a global summit to reform financial supervision, incorporating the emerging economies of Asia, Africa and Latin America.

But since then, forces pushing towards a re-nationalization of EU economic, fiscal and competition policy seem to have gained the upper hand over forces working to unite and coordinate Europe’s response to the crisis.

“It may be that measures taken nationally will break community rules and we will not recover,” said Tommaso Padoa-Schioppa, former Italian finance minister and president of the Notre Europe foundation.

“What we observe now is that both forces are at work — an extraordinary effort at coordination and a strong diversity of measures taken at national level.”

SMOKE AND MIRRORS

In two months, countries such as Ireland, Britain and now France, have cast aside the EU’s budget discipline rules in favor of massive deficit spending.

Who seriously believes that the deficits which those countries will run next year, way in excess of the EU’s limit of 3 percent of Gross Domestic Product, will be brought back into line within a year or two, as Brussels says it expects?

Likewise, the 200 billion euro ($252.8 billion) economic recovery program proposed by the executive European Commission last week was largely an exercise in smoke and mirrors, aimed at creating at least a facade of unity.

It totted up money already spent, or about to be spent, by national governments, with just 30 billion euros in proposed EU funds, some of which finance ministers blocked this week.

That may be inevitable since the EU budget is a mere 1 percent of the bloc’s combined GDP, while national budgets average about 40 percent of GDP.

The Commission hoisted a European flag of convenience over often divergent measures that member states were taking anyway, in the hope of dissuading them from making more unorthodox, protectionist or beggar-thy-neighbor moves.

But it cannot mask the fact that the three biggest EU economies are heading in separate directions.
Britain has thrown fiscal caution to the wind and cut sales taxes, France is on the brink of announcing a big boost in public spending but orthodox Germany, Europe’s biggest economy, is holding out against a bigger stimulus for now.

EACH FOR HIMSELF

EU restrictions on state aid to banks have been eased, with a further softening in the pipeline as Brussels faces pressure to be ever more indulgent. Even pro-market Sweden’s finance minister this week urged the Commission “to call off these legions of state aid bureaucrats”.

The single market at the heart of Europe’s economic success is starting to fray as a result.
“Each country is acting for itself, also in the impact of bank rescues,” said Daniel Gros, director of the Center for European Policy Studies.

“There are different conditions on help to the banks, different interest rates on state loans to banks, different governance arrangements, different conditions on lending.”

An earlier free-for-all over guaranteeing bank deposits led some savers to withdraw money from solvent institutions and place it in troubled ones such as Britain’s Northern Rock or Irish banks that had an unlimited state guarantee.

Now France is fighting Brussels to be allowed to pump money into healthy banks in return for commitments to lend more to the “real economy”, while the Commission demands that ailing banks reduce their activity as a condition for state aid.

EU officials are worried that the each-for-himself mentality will weaken the European position in global climate change negotiations, the latest round of which began this week.

EU leaders are due to adopt ambitious plans next week to make good on their pledge to cut greenhouse gas emissions by 20 percent by 2020, reduce energy consumption by 20 percent and draw 20 percent of energy from renewable sources.

But a fierce battle is under way to water down or delay implementing measures because of the financial crisis. That would weaken the EU’s green leadership ambition just as a more climate-conscious U.S. president takes office.

GOLF CART BLUES

Historically, European integration advances through crises. The 1970s oil price shock led to the creation of the European Monetary System. The 1989 fall of the Berlin Wall made possible the establishment of the euro single currency.

And the Sept. 11, 2001 attacks on the United States hastened the adoption of a European arrest warrant, replacing centuries of cumbersome extradition proceedings for criminal suspects.

The financial crisis may yet spur another leap forward for the EU, perhaps convincing Irish voters next year to reverse their rejection of the Lisbon Treaty and allow a reform of the bloc’s creaking institutions.

But this crisis could also deal Europe an enduring setback. If budget discipline and competition rules fray further, it will be hard to get the toothpaste back into the tube when it’s over.

One image from the last few weeks summed up the EU’s uncertain state as it struggles to find a common path.

At crisis talks in Camp David with U.S. President George W. Bush in late October, French President Nicolas Sarkozy, the rotating president of the EU member states, rode in the front of a golf cart with Bush, while European Commission President Jose Manuel Barroso sat glumly in the back, facing the wrong way.

Diplomats said Barroso was offered a seat in the second cart alongside Secretary of State Condoleezza Rice, but he was determined to stay in the front cart, even if that meant taking a back seat.

For more columns by Paul Taylor, click here.

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