Wednesday, September 8, 2010

I am the Great Barazi! Dr. Omar.... you are getting sleepy.... very sleepy... I'm now going to snap my fingers and when I do, you will pay me.

So I know I’m kind of a block behind the parade on this but I just got done reading the latest broadside from the good ship DIFIC against the HMS Barazi off the coast of Dubai. It seems like fairly weak soup to me. Most of the DIFCI response is taken up with a lengthy chronology of the various memos that went back and forth between the various members of the DIFCI management team and tries to clear up who knew what when. In my last post I ignored this but now I have paid much closer attention. This is a little more complicated than I would like because the court makes the letter from DIFCI public but not the attached exhibits so it is not possible to follow the evidence trail directly. Having read it now I think my initial instinct to disregard it was correct.

DIFCI goes through the lengthy chronology in order to show that in the first two drafts of the investment bonus memo he makes reference to a net income of $200 million. Between the first and second drafts Bisher was sent the unaudited financials which showed that the net income was a loss of $87 million and the second draft was not amended to reflect that. This is the core of their argument that Barazi misrepresented the financial condition of DIFCI. They go on to claim that Barazi knew all along that the DIFCI was in serious financial shape and provide an email he sent to that effect.

This doesn’t make a lot of sense to me. At no point in any of the memos does Bisher suggest paying out bonuses on net income. Instead he suggests paying out bonuses based on realized gains. Considering the business that DIFCI was in this makes some sense. They were running an investment fund containing investments which were highly illiquid either because they were in private companies or else such massive stakes in public companies that they could not be disposed of. To pay yourself based on the performance of a investments that you may not actually be able to monetize might not be best. So I can see the reasoning behind paying themselves based on realized gains rather than net income.

The net income reference was made for the purpose of comparison with the realized gains and was made before the unaudited financials were available. It is true that the second draft was not amended to take into account the new information in a subsequent draft all reference to net income was dropped. Note that this would not have affected the thrust of the memos because they were being paid on realized gains. The relevance of the loss of $80 million has to be taken in context. This is on a multi-billion dollar investment portfolio and the loss was the result of an accounting change. While I think it had some relevance I think it would make as much sense to pay them zero based on the $80 million as it would to pay them $30 million on the $200 million. In any case they were paid on the realized gains of $60 million, a figure which is not disputed at all by the DIFCI. Also at no point did Bisher seek to conceal the $80 million loss, the DIFCI makes a point of saying he signed off on those numbers. Had he attempted to conceal that and paid himself on the basis of false returns that really would have been fraud but DIFCI does not allege this because it did not occur.

As to the allegation that Barazi knew the DIFCI was in hot water at the time of the bonus the evidence they provide is pretty slim. They show an email pleading for additional funds from mid-November 2008. The final memo on the 2007 bonus issue was in July of that year and the most relevant documents were finished by April. Of course everyone knows what happened in September of 2008, Lehman brothers defaulted and the markets went over a cliff. To say that the financial position of the DIFCI post-Lehman should have influenced the 2007 compensation decisions which were made in March seems to me be kind of a stretch. Something may well have been amiss in the finances of the DIFC in the spring of 2008 but the DIFCI response does not show it.

The DIFCI leads their response by denying that “the claimant can not absolve himself from the liabilities arising out of his conduct with respect to the procurement of the 2007 investment bonus on the basis that Dr. Omar authorized that bonus.” It then quotes the handbook saying that management cannot be indemnified against moral turpitude or other misconduct. In the following paragraph they say that “Barazi was not a passive recipient of the bonus” and point out that he played an active role in determining it. This is the weakest part of the case and also the most central.

It is true that Barazi was not a passive participant. This is because, as the DIFCI points out, there was no established methodology for compensating the managers of DIFCI for their performance. Barazi was asked by Dr. Omar to come up with one. They allege that his methodology constitutes moral turpitude and therefore a fraudulent attempt to compensate himself. As mentioned above the centrepiece of this argument is that a change in net income was not reflected in the memo until its third version. I argue that this is not relevant for two reasons. First the net income played no role in the calculation of the bonus and therefore failing to change the memo to reflect the change in net income until the third version does not constitute moral turpitude as the change would have had no effect on the calculation. Also the $87 million loss was never concealed from anyone including Dr. Omar.

Far and away the most important reason that it doesn’t matter is the point they themselves make that the DIFCI “lacked a clear cut methodology.” What that really means when combined with the fact that compensation was “at the sole discretion of the chairman” is that Dr. Omar did not need to refer to anything but his own fancy in order to compensate himself and Barazi. He could have rocked out of bed one day, walked into the office and said “Bisher, that’s a great haircut. I’m going to pay you $10 million.” Or “That was some fine singing at karaoke last night Bisher, here’s $5 million.” Heck, we should be happy that they made any effort to come up with a plausible methodology at all.

The DIFCI ties itself in a pretzel when it argues that Bisher established a questionable methodology and then further argues that he did not properly follow that methodology which it has already alleged was questionable. The fact of the matter is that because of the way DIFCI and the DIFC were set up there was no requirement for a methodology whatsoever. The mysterious workings of the mind of Dr. Omar were all that were needed to pay them out. As a result the only practical way for Barazi to have fraudulently acquired his bonus would have been for him to put Dr. Omar in a hypnotic trance and fraudulently induce him to write him a check. I wouldn’t put it past Bisher to do that but I think it would be really hard to prove in a DIFC court.

Speaking of Dr. Omar and due process what does the DIFCI say with regard to the unspoken allegation in the previous Barazi response that no legal proceedings were brought against Dr. Omar to compel him to disgorge his bonuses? In paragraph 41 the DIFCI says “the defendant notes that Dr. Omar has returned $13,600,000 in bonuses he received from DIFC.” Interesting, there seems to be no mention of legal proceedings. Presumably this would mean that the proceedings used to get Dr. Omar to disgorge this bonus were extra-legal. There’s another word for that, “extortion.” But I’m sure Barazi is really quite familiar with that term right now. This will indeed be a very interesting case if it goes to trial.

Personally I think the DIFC should drop the suit, pay Barazi him his severance conditional on the completion of the forensic audit. If they have real evidence of actual fraud they should charge him with that, not go back and forth with him over whether or not he is entitled to severance based on whether or not he used a proper methodology when no methodology was required.

Monday, September 6, 2010

There goes the Stimulus Package on it's way to China.... the beginning of the end of the WTO.

Whenever everybody in the US political sphere agrees on something my instinct is to oppose it simply so there is opposition. The one thing the Bush and Obama administrations have in common (aside from their fondness for massive deficit spending) is their assertion that the maintenance of the global free trade system is essential for American prosperity. One of my favourite mantras from my time at the University of Chicago was: “If someone asserts it, deny it. If someone denies it, assert it.” So, I am going to deny the assertion that free trade is currently the optimal policy for the United States.

First, let’s remember the origin of the free trade system. Its original motivation was political/military rather than economic. The Second World War was a massive human tragedy which killed something like 3 % of the human population in just under ten years. For the American economy, however, this tragedy had a silver or rather gold lining: it was a war of annihilation between America’s main economic competitors. The war destroyed the industrial capacity of the Axis Powers and severely disrupted that of Central Europe and Soviet Russia. At the end of the war the United States was the only power in the world with an unimpaired industrial plant and as a result in 1945 the US accounted for nearly 50% of world GDP.

Despite its economic supremacy, America faced a severe political/military challenge from the Soviet Union. The Red Army had just crushed the Wermacht and was positioned in the Center of Europe and invaded Northern China near the end of the war. Americas grand strategy was to contain the Soviet Union with a ring of alliances that stretched around the periphery of the Russian empire. Unfortunately the allies who composed this ring were the battered former Axis powers and the supine allied European states.

America needed to revive the economies of the Western Alliance if the containment strategy were to succeed so it came up with a global economic plan with several features. The first was a massive influx of aid in the form of the now famous Marshall Plan. The second was the establishment of a stable foreign exchange regime which would simplify trade through the Bretton Woods agreements. Finally was the establishment of a trade liberalization regime under the General Agreement on Tariffs and Trade or GATT which became what we now know as the WTO. The first round held in Geneva in 1947 eliminated or reduced 45,000 tariffs. Subsequent rounds made great strides in bringing down tariff barriers all over the world. While the GATT was a multilateral organization, the fact that America was the only intact market on the planet meant that it’s most salient feature was granting more or less open access to the American consumer for our allies in the struggle against the Soviet Union.

The plan worked like a charm. Between 1948 and 1953 world trade grew by 40%. By 1963 the total volume of world trade was three times what it was before the war and twice its previous all time high. By 1971 it was six times what it had been in 1935. This is an extremely important point, the creation of the GATT system ended the generally mercantilist regime that predated the World Wars and international trade exploded as never before in human history. This channelled massive amounts of wealth to the various trading partners that would not have been possible without it and enabled a rapid recovery from the devastation of the war. By the end of the Cold War in 1989 Germany had the same share of world GDP that it had before the war and Japan had twice as large a share. America and its allies presented an economic, military, and political challenge to the Soviet Union that it could not overcome and it collapsed after a failed coup attempt in 1991. Mission accomplished, well and truly.

After its victory America, confident in its permanent supremacy, kept the global free trade regime open. Indeed it expanded it, bringing in its erstwhile opponents Russia in 1993 and China in 2001. The maintenance of this free trade regime after the end of the cold war has arguably had an even greater effect on the world than it did during the cold war itself. By enabling China and India to access the US consumer on a level playing field the global free trade system has helped to bring 400 million people out of poverty in the last 20 years. This is a reduction of human misery that has been without precedent. It has made the world economy as a whole more efficient and raised world GDP by a substantial amount. The huge American trade deficits have been a massive subsidy to the rest of the world particularly China.

To get a sense of how important this is to China you have to look through the numbers a little. In 2006 the Chinese trade surplus with the US was around $250 billion and Chinese nominal GDP was around $3 trillion (I use nominal rather than PPP because we are talking about international trade rather than domestic consumption.) So the Chinese trade surplus with the US in 2006 was 12% of the entire Chinese economy. This overstates the case somewhat because China has trade deficits with countries which supply it with raw materials but in turn those deficits are driven by and more than financed by the surplus with America. Considering that an additional 40% of the Chinese economy is investment which is largely export oriented the impact of the global free trade regime accounts for nearly half of the Chinese economy. These are just numbers, what this has meant in the quality of life for hundreds of millions of people cannot be overstated or really understood unless you go to China and see if for yourself. It is truly mind boggling.

So how has it been working out for the country at the center of the system? This is a complicated question and it comes with a complicated answer. From the perspective of the American consumer this has been awesome. The global economy is much more efficient and the increasing globalization and the addition of hundreds of millions of new workers to the global trading system has kept down the prices of labor intensive products. In the immediate post-war era Americans got used to consuming at a level commensurate with a country which was producing 50% of the worlds GDP. As America’s share of GDP has declined the American people have been reluctant to reduce their consumption. And they haven’t had to because America’s trading partners have been willing to lend their surpluses back to America in order to finance yet more consumption. Yep, from the perspective of the consumer it seems like a good deal all around.

So how is it working out for the American worker? This is kind of a mixed bag. From the perspective of the American knowledge worker it’s working out quite nicely. People in the intellectual capital intensive businesses can farm out of the labor intensive aspects of their business to China for manufacturing or to India for services where the labor costs are much lower. For unskilled and semi-skilled Americans this has been a disaster. They are now forced to compete with the 400 million other semi-skilled workers in the global trading system and this has been pushing wages down. Here in the future the global market clearing price for a year of work in a factory as a semi-skilled worker is somewhere in the neighbourhood of $8,000 per year. Naturally this is not enough to sustain an American lifestyle which is why, as mentioned above, the American lifestyle is increasingly debt financed.

You can hear the echo of the global free trade system whenever Americans bemoan the problems with the economy. “Wages for working Americans have been stagnant for 20 years;” this is because American workers are competing with another 400 million people that were not in the system 20 years ago. “The divide between the rich and the poor is getting wider,” the rich benefit from lower prices and the ability to tap cheaper foreign labor which increases their earnings, the unskilled now have to compete with that foreign labor which decreases their earnings. “The post housing bubble unemployment seems to be structural not cyclical,” many semi-skilled workers who’s manufacturing jobs moved abroad went into construction, now that the housing boom is over there is not much manufacturing for them to return to so they are structurally unemployed. “The stimulus package is not working,” the stimulus package was designed to generate consumption; much of what we consume is produced abroad so much of the stimulus money was ultimately siphoned off by our trading partners. “This recovery is anaemic and not creating enough jobs,” Q2 GDP was revised down from 2.4% to 1.6% because of the trade deficit was larger than expected. 0.8% of American GDP is $110 billion or about as much GDP as would employ 1.1 million people. The recovery is creating jobs, but in our trading partners, not here. Yep, there it is beneath the surface, the global free trading system the US built up is causing serious problems for the US worker.

So given that so many of the problems which confront policymakers are linked directly or indirectly to American support for the free trade system why is protectionism not gaining more supporters. I think I know. It’s a unique psychosis that I will call “Smoot-o-phobia.” In 1930 partially as an attempt to raise revenue and partially in an effort to shield American workers from foreign competition Congress passed the Smoot-Hawley Tariff Act. This raised tariffs on imports to the highest level ever and touched off a trade war as our trading partners retaliated with tariffs of their own. World trade collapsed fell 40% from 1930-1933. The Smoot-o-phobes believe that the Smoot Hawley tariff caused this collapse in world trade and which deepened and lengthened the great depression and therefore they believe that the last thing we should do in the middle of a recession is tamper with the global trading system.

I think this argument is nonsense for two reasons. First, though I have a degree in economics I will be the first to agree with my friends from the physical sciences who called economics a social “science.” That is to say, it is not exact. It is very hard to separate causal and coincident factors in explaining a phenomenon. It may well be that the Smoot-o-phobes are onto something with their theory but I would argue that the collapse of the global banking system was a much more powerful factor. As evidence of this I point to the recent credit crisis. Between 1930 and 1931 in the immediate aftermath of Smoot world trade fell by about 28%, between 2008 and 2009 world trade fell by 24% without any additional trade restrictions. Could it be that the greater factor was the collapse of credit rather than the imposition of tariffs?

The second reason is that the position of America in the global trading system in 2010 is completely the opposite of what it was in 1930. The American position in 1930 was analogous to the position of China today, it was the source of most of the worlds spare industrial capacity and a net exporter both of finished goods and raw materials. As such it had a lot to fear from a trade war because its trade balance was a positive contributor to GDP so it really was a Congressional miscalculation (one of many I’m afraid) to pass the Smoot Hawley bill. Here in the future the US is not only not a net exporter, it is running the largest and most persistent trade deficit in the history of the world. If world trade were set to zero tomorrow the GDP would INCREASE, we LOSE money to world trade. I think the Smoot-o-phobia which infects American policymakers is purely psycho-somatic.

Now that I have made my argument I think it is equally important for me to point out what I am not arguing. I am not arguing that limiting the global free trade system is the globally optimal solution. It is not. But it does not matter what is globally optimal, it matters what is optimal for the people who are in control of the largest consumption based economy in the world, namely: Americans. The only way for another country to limit American power over the trading system or to mitigate the effects of American protectism would be for that country to create a similarly consumption oriented economy, something which no one seems willing to do.

I am also not arguing that the limitation should be total. It should be just enough to mitigate or negate the labor cost advantage of the lower cost countries. Ordinarily this would happen over time with exchange rate adjustments but some of our trading partners are committed to maintaining a fixed exchange rate with the US dollar.

I am also not arguing that this would be costless. There would be increased inefficency in the US economy. The evaporation of our trading partners surpluses would also limit the avaliabilty of credit to the American consumer and the American government. I don't think this is bad thing because I think that is coming sooner or later. I simply think that the US would rather be in control of the timing and duration of that credit contraction rather than the bond vigilantes. Taking advance action like this would give the government the initiative.

What’s the cure for Smoot-o-phobia? That’s a complicated question but it comes with a simple answer: elections. The American consumer who benefits from the global free trade system and the American worker who is getting his head caved in by it are the same guys. At this stage of the game Americans need to do a lot more working and a lot less consuming in order to pay back all the money they borrowed over the past 30 years. In order to do this more effectively they need to negate the labor cost advantages of low cost countries which have enjoyed unfettered access to the American market for the past 20 years. To do that they need to place limits on the international trading system.

Lucky for them in addition to being the American consumer/workers these folks are also the American electorate and as such they are in control of the government most responsible for the maintenance of the international trading system. They can therefore vote in people who are in favour of limiting it. As the recession goes on and employment does not recover because the international trading system is limiting the capacity of traditional measures to revive the economy the Smoot-o-phobic arguments are going to fall on increasingly deaf ears and protectionist candidates will begin to win elections. You heard it here first.

Wednesday, September 1, 2010

Congratulations gentlemen on surpassing Bahrain. Beneath your chairs are some boxing gloves in case any pregnant women try to sit down at your table.

So I’m back from the break now and ready to go for September. A lot has happened in the interim so I have a lot of writing to do. But before I get into the bigger issues I want to write about some of the smaller, less noticed ones.

Speaking of small, Bahrain was downgraded by Moody’s last week. I found this out by reading an article in The National that was positively dripping in schadenfreude. My favourite part of the article was where they called the downgrade the first fora GCC government. Well, I suppose that’s true if you don’t count the total obliteration of the various Dubai government related entities and the restructuring of Dubai World. Personally I think those things do count but I’ll not quibble with the national. The GCC has now seen its first sovereign downgrade of the financial crisis.

Though this is not big news in the way that the downgrades on the Eurozone periphery have been, it was only one notch and is still investment grade, the report is still interesting. They point out that Bahrain has a 7% of GDP budget deficit and has relatively little in the way of foreign exchange reserves or sovereign wealth funds in contrast to Saudi Arabia or Abu Dhabi. This means that should the world economy slo significantly and drive down oil prices Bahrain will be in a bind without much room to manoeuvre. Interestingly they also make the point that political tensions between the Shia and Sunni on the island are a source of potential instability. Most interesting are the points they make about the financial sector.

Bahrain has long been a financial center for the Gulf and Moody’s seems to argue that the banking sector in Bahrain is a liability both because it is too large and because it is too small. It is too large because with bank balance sheets three times the size of GDP any serious deterioration of asset quality might require government intervention which would be beyond the capacity of the government to intervene given its already stretched fiscal position. At the same time Moody’s says that the banking sector is not large enough to diversify the economy away from its dependence on hydrocarbons. So the Bahrainis seem to have sought to diversify their sources of revenue but instead have simply added another liability, at least according to Moody’s.

Well I can tell you why the banking sector in Bahrain is not big enough, it’s because Dubai has totally stolen its mantle as the financial center of the GCC. Sure there are still a lot of bank assets in Bahrain but virtually all the growth in financial employment in the GCC has taken place in Dubai over the past five years. Some have even consolidated their operations in Dubai and closed their Bahraini operations, or rather left a skeleton crew in Bahrain to appease the government but functionally consolidated in Dubai.

Why is this? I’d say it’s for two reasons. One is that when Bisher and Dr. O were not too busy lighting Sheikh Mohammed’s money on fire with various investment schemes or paying themselves substantial bonuses for managing those fires, they were luring the wide world of finance to the DIFC. The DIFC legal system has turned out to be kind of a bait and switch but when choosing a location once you have taken the bait, it’s hard to switch. The other reason is that it is a lot easier to attract expat knowledge workers to Dubai than it is to attract them to Bahrain.

There are many reasons for this. Some people will point to the infrastructure, which is impressive. Personally I think Dubai is likely to be the red headed stepchild of the capital markets for some time to come so I doubt that they will be adding to this but the silver lining to the collapse of the real estate market is that there is still a lot of spare housing capacity in Dubai so they actually don’t need to add to it. Others might point to the relatively permissive moral environment of Dubai. This is a factor as well, bankers and traders like a martini now and again. Their girlfriends like to be able to weak little bathing suits on the beach and occasionally kiss their significant others in gratitude for rescuing them from the rain of London. To be sure the atmosphere is a bit chillier now than it was a few years back but it’s still not Saudi Arabia.

While the liberality and infrastructure of Dubai are impressive I don’t think they are the primary reason why it is easier to move people to Dubai than elsewhere in the Gulf. I think the reason for that is the human infrastructure. Over the past ten years Dubai has achieved a critical mass of expat human capital. People want to live there because everyone else does. It has become the regional headquarters for so many multinationals that the expat social milieu is not dominated by a particular industry. Finance is prominent to be sure but there are foreigners there in the media, pharmaceuticals, infrastructure, consulting, you name it. It’s a much more interesting place to live than any other city. Dubai has created this environment through massively leveraging itself to build the physical infrastructure and marketing the hell out of itself in the West. Those two things are not sustainable now that the good ship Dubai has struck the restructuring iceberg but the human architecture that it has build should be able to outlast either one of those two things.

If Dubai is ever to recover it ABSOLUTELY must retain its preeminent position as the place for international expats to live and work. Thus I was shocked to read a recent news article about an assault on expats in Dubai by three Emirati men. At the IKEA cafeteria a Canadian investor man and his marketing manager wife sat down at a table for twelve which was partially occupied by Emiratis. The Emiratis claimed the entire table and demanded the couple depart. The woman, who was seven months pregnant and has doubtless been walking endlessly around the IKEA which is designed to be walked around endlessly demurred the Emirati brothers proceeded to beat her and her husband senseless. A Syrian man came to the rescue when the Emiratis began beating the unconscious husband with a chair and they beat him senseless as well. They broke the jaw of the pregnant woman and there is some ambiguity as to whether or not her pregnancy was compromised. The last thing her husband saw before being knocked unconscious was one of the Emiratis beating his wife and blood rushing down her legs. My guess is that if her pregnancy had not been compromised the courts would have made a point of noting it as a mitigating factor.

Obviously an attack on a pregnant woman by three Emirati men in the middle of an IKEA cafeteria is horrific in its’ own right and pretty hard to understand. What’s more, Dubai is completely dependent on foreigners to do most of the work, to move there, buy apartments and set up businesses in order to dig Dubai out of its deep dark hole. You would think that the authorities would deal harshly with the culprits. Besmirching the reputation of Dubai as a tolerant multicultural hub poses an existential threat to Dubai itself. Alas, it is not so. The assault occurred in June of 2009, the first hearing was in August 2010. All three assailants are free men in a city where hundreds are in prison for bounced checks. Two of them failed to even show up for the hearing, the judge questioned this but was not given an explanation and no action was taken. It would seem that the Emiratis don't think this is a big deal or that they will suffer any consequences. They may well be right.

It’s their country, they can do what they want, but if you ask me this is no way to run a country completely dependent on its reputation among foreigners. As sad as the article itself is the comment at the bottom from an Emirati: “they should have moved.” They probably will, and not to the next table but rather to the next country and if enough foreigners decide to follow them the creditors will beat the hell out of Dubai.