Balance of Payments (II): internal and external structural adjustment

The BoP accounts should balance

In the long term, the balance of payments accounts for a given country is supposed to balance, that is, net out to zero.

a simple example

This is a common sense notion.  It’s easiest to see if we take a simple, theoretical example.  Assume a world where there are only two countries, A and B, where all exports are priced in the local currency and all imports are priced in the foreign currency. (Everyone knows the first assumption isn’t true, but in the real world the second one isn’t, either.)

Further, call the currency of A the $ and the currency of B the @.  Let’s take the initial exchange rate as $1 = @1.

a trade/current account deficit…

Let’s take the case where country A produces $1 billion of goods that it exports to B, but still has an annual trade deficit of $100 million.  It gets @1 billion for the goods and services it exports to B but it still has to get another @100 million from B to pay for the extra $100 million of imports it purchases.

Where does this extra @100 million come from?  Not from today’s income-earning activities in country A.  Looking at the other balance of payments accounts, the other @100 million might come from dividend or interest payments from abroad.  If it doesn’t–and this is the most likely case–country A has to sell things to B to get the extra @100 million.  This “selling” can come either in the form of promises to pay, i.e. bank loans or corporate/government bonds, or in physical assets like commercial or residential real estate or manufacturing plant and equipment.

…isn’t sustainable forever

This situation can’t go on forever.  If nothing else, at some point country A will run out of assets that country B will desire to buy.   In our simple world, country B will then be piling up loads of $ that it doesn’t particularly want.  Initially, it will “recycle” extra $ into country A’s bonds to get some interest income.   But there’s a limit to that, as well.  Sooner or later, the debt will reach a level where country B will get worried about the possibility that A may not be able to repay.

The level of country B’s concern will depend to some degree on its analysis of the character of A’s economy and of its imports.  If country A is importing, for example, machinery it will use to develop new export-oriented or import-competing businesses, B will be less worried.  So, too, if it sees that some purely domestic industry has immense potential to develop into an exporter.  But if the imports are mostly of consumer items that will generate no future income–like TVs or building materials for McMansions–concern will rise a lot faster.

In any event,  a persistent trade (and current account) deficit will sooner or later cause downward pressure on country A’s currency.  Country B will demand a premium for continuing to hold $.  What happens then?


One possibility is that country A intervenes in the currency market to buy up the “extra” $ that are sloshing around.  That is, the government of A takes action to defend the $1 = @1 exchange rate.  It may also have help from country B in doing so, since the government of B may be satisfied with the status quo.  In the real world, this is not a good solution, since the big international commercial banks, who would be the most worried about the present situation and who may well be leading a trading attack on the $, have far greater market power than any set of governments.

Two possibilities remain–external structural adjustment or internal structural adjustment.

Internal adjustment means slowing down the purchase of imports, particularly of imported consumer goods.  In practical terms, this means the government raising interest rates and inducing a recession.  How so?  The problem country A faces is typically that government economic policy is too stimulative.  As a result, the country is living beyond its means.  Most of the “extra” economy energy is going into consumption, and a disproportionately large share of that is going into consumption of imported goods.

The practical issue with internal adjustment is that politicians find this very difficult to do, since the change in economic policy is very visible.  It’s also very clear to voters exactly who has taken away the punchbowl.

External adjustment means standing aside and letting the currency markets achieve a new equilibrium.  In other words, in our example, country A allows the $ to devalue to what is, for now anyway, a new equilibrium level.

This is the solution almost all countries opt for, even though it leaves internal structural problems unaddressed.  Why this path?  It’s easier politically.  Local citizens will likely not realize the large loss of national wealth that devaluation entails–unless they travel abroad.  And to the degree that citizens do notice that the local price of imported goods has increased, anger can easily be directed against “greedy” currency speculators or foreign industrialists.

In academic theory, adjustment through currency devaluation is an illusory process.  The economy reverts to its prior state of disequilibrium, only with inflation at a higher level.  For smaller countries, I think that this is true in reality as well.  In the case of large countries like the US, the reality is more complicated.  More about this in later posts.

Tiffany’s fourth quarter 2009 results

I’ve just finishing listening to the TIF fourth quarter 2009 conference call.  There are a number of reasons for paying particular attention to what this company has to say, apart from possible interest in it as an investment:

–TIF has been a brilliantly successful marketer over many years, so it clearly has its finger on the pulse of its customers,

–TIF appeals to a broad array of consumers and sells the ultimate discretionary item, jewelry, so it is a good bellwether for consumer sentiment, and

–it’s an increasingly global company, with significant operations in the Pacific (35% of sales) and Europe (12%).

Here’s what the company had to say:

about the economy

There’s no “new frugality” or “new normal.” Consumers are behaving in this economic downturn the same way they have in the past.  They postpone purchases until they feel their jobs are safe and their personal balance sheets have stabilized.  Then it’s back to the stores!  This is what’s happening now.

Same store sales improved significantly around the world, ex Japan, in 4Q. Strength is across all price points.  The gains are almost completely due to increase in the number of transactions, not to customers buying higher-priced items.  In the US at least, the traffic in the stores is not up, either.  Rather, people who were just window-shopping in prior quarters are buying now.  Also,

1Q2010 sales so far are running ahead of the “high teens” year on year sales gains TIF expected. The company guidance is for earnings of $.245-$2.50 a share for 2010, up from $2.09 in 2009 and $2.39 in 2008 (before the worst of the financial crisis hit sales).

The New York region was a bit stronger than the norm for the US.  But of the five best-performing domestic branch stores, three were in (beleagered) California:  Orange County, San Francisco and Beverley Hills.

the economy, sort of

TIF took over $100 million out of its cost base in 2009 by laying off 10% of its staff, saving $60 million annually, and reducing marketing expense by $44 million.  The marketing spending is beginning to increase, and over time TIF plans to add back some of the salespeople it eliminated.

Interestingly, however–and I think indicative of the experience of business as a whole in the US–taking a hard look at itself during the downturn, TIF discovered that it had more “fat” in its operations than it realized.  Some of those lost jobs are simply not going to return.

TIF’s expansion plans

The company’s sales per square foot break out regionally as follows:


Americas (53% of sales)         $1900                 $2200

Japan (19%)                               $3300                $3400

Pacific, ex Japan (16%)           $3800               $3800

Europe (12%)                               $2700              $2500

Given these numbers, it should come as no surprise that TIF will focus on the Pacific ex Japan for its expansion this year.  The company plans to open eight new stores there.

There will be no expansion in Japan, a country whose decades-long infatuation with Western luxury goods seems to have come to an end.  Instead, operations there seem to me to be destined to become a cash cow that will fund growth elsewhere.

The situation in the US, which showed by far the largest drop in sales per square foot, is interesting.  TIF has been experimenting with half-size (2500 sq ft instead of its traditional 5000), limited range stores recently–indicating it believes the domestic market for full-size stores is very close to saturated.  It has come to the conclusion, however, that its best choice is to build a hybrid of the two–locations with the “look and feel” of a traditional Tiffany store, but with only 3750 sq ft of space.  TIF will open five of them this year.

Europe, where sales are booming for TIF, will get three new locations.   It’s hard for me to tell whether this success is coming in spite of slow economic activity there or because of it.  European analysts tend to lump TIF together with COH as “affordable” (read: not real) luxury.  And some European luxury purists tend to turn up their noses at non-local brand names.  Still, it’s well worth trying to figure out how big this market can potentially be for TIF.

TIF as a stock

This is one I’m not going to be much help on. TIF has been a very strong relative performer since the market turned up a year ago.  Yet it’s trading at just under 20x earnings guidance for 2010, which is a low price earnings multiple for it historically.  I suspect it’s going to continue to do well vs. the S&P 500 during the year ahead.

The problem for me is that TIF–which I owned for many years–has performed much better than I had expected over the past twelve months.  That’s annoying.  Worse, I find it hard to jump on the bandwagon now.  That’s probably good for you if you own the stock.  In situations like this, my change of heart and subsequent purchase without exception mark the relative performance peak.  So maybe I am doing something useful for TIF just by sitting on my hands.

Disney’s Alice in Wonderland: how important?

Despite tepid reviews (52% from Rotten Tomatoes) and questions about how well integrated the 3-D is into the plot, Disney’s Alice in Wonderland has turned out to be a big box office hit.  Out about two and a half weeks, Alice has been the #1 film in the US for the past three weekends.  It has grossed $265 million in the US so far and another $300 million abroad, according to Box Office Mojo.  This compares with estimated production costs of $200 million.  (This contrasts sharply with DIS’s previous major release last November of The Princess and the Frog, which grossed $104 million in the US and $160 million abroad vs. production costs of $105 million.  It’s now in DVD sales.)

There’s no easy way to go from movie revenues to movie profits, for two reasons:

–the division of profits among the various parties–producers, stars, distributors–can differ widely from film to film, and

–the studios use project accounting for films.  This means at the outset they estimate total revenue and total costs, and allocate each proportionately as the money comes in.  Marketing, for example, is a major expense that comes mostly during the theatrical release period.  If the studio estimates half the revenue will come from DVD sales (that would be very high in today’s world), then only half the total marketing expense would be allocated against box office.  If, in contrast, the studio said DVD revenues would be zero (another unrealistic assumption), then all the marketing costs would be allocated against box office.

It seems to me that the contribution to operating profits of Alice will be north of $200 million for this quarter.  It will be interesting to see what the actual number is.

Alice will be followed by Ironman 2, the most anticipated movie release of 2010, which will debut during the June quarter.  IM2 will likely creating another blockbuster operating profit result.

The big issue for the just-revamped Disney movie business is, of course, that neither film has much to do with the new film management.  Alice was put in the pipeline by the old regime, and IM2 was bought with Marvel Entertainment.

Nevertheless, I think some of the positive glow from these films will rub off on the rest of DIS.  Investors will be somewhat more willing to believe that Disney’s movie business is back on the right track.  And they’ll probably be willing to extrapolate any nascent signs of recovery in the theme park business more quickly than they would otherwise.

For now, that probably doesn’t translate into outperformance when the market is going up.  But it will likely mean some protection on the downside, therefore outperformance when the market is weak.

another SEC problem: first Madoff, now the Lehman case

Madoff vs. Lehman


By now, everyone is at least somewhat familiar with the extent of the SEC’s failure in not detecting the Bernie Madoff ponzi scheme, even after being handed damning evidence on a silver platter by whistleblower Harry Markopolos.

Probably just like any other present or past Wall Streeter, I find two aspects of the Madoff case particularly striking:

–Markopolos’ account of how little the SEC knows  (basically, nothing, in his view) about how the finance industry works, and how disinterested it was in either learning about the industry it is mandated to regulate or in doing its job of enforcing the rules

–Madoff’s comments on how easy it was to fool the SEC.  Auditors came in, asked a few questions and left without bothering to actually audit–that is, to verify the truth of Madoff’s answers.

From hearing Markopolos on Bloomberg radio during his book (No One Would Listen) tour, I came away with the impression that Markopolos is a very obsessive, prickly man with a more-than-healthy respect for his own intelligence.  Whether he was that way before his pursuit of Madoff, or because of it, is an open question.  But, if you wanted to be extra-generous to the SEC, you might think that he gave off a weirdness vibe when he (repeatedly) visited them, that worked against the case he was making.


Now comes Lehman, which is shaping up to be a carbon copy of the Madoff case.

I’ve already written about the bare bones of the Lehman case a few days ago.  Basically, SEC examiners were sent into the offices of the major investment banks, including Lehman, as the financial crisis was unfolding.  Their job was to monitor trading activities and identify liquidity or leverage problems.  According the the just-released report of the Lehman bankruptcy court, however, Lehman was, in effect, falsifying its financial accounts right under the SEC’s noses.

See my earlier post for more details, but in the simplest terms what Lehman did during the last year of its existence was to:

— borrow tens of billions of dollars right before its quarter ended,

–use the money to repay other debt,

but not show the new borrowings anywhere in its financials.

The result was that the company substantially understated its financial leverage in its reporting to shareholders and the SEC.

New information

1.  Initial reports indicated this accounting sleight of hand was being accomplished by shunting highly questionable transactions through Lehman’s London office.  This activity, and the associated “funny” accounting, was presumed to have the blessing of the British Financial Services Authority, the UK equivalent of the SEC.

To me at least, this seemed like another bad consequence of the UK’s “regulation lite” policies, which were aimed at building up the country’s financial services industry by  supervising companies’ activities less rigorously than was customary elsewhere.

It turns out, however, that this isn’t right.  The Financial Times reports that Lehman rendered a full and accurate account of these transactions to the FSA, using conventional accounting standards.  It reported both the cash received and the new borrowings.  It was only when Lehman gave its worldwide financials to shareholders and the SEC that it eliminated the new debt.

This sounds just like the Madoff ponzi scheme, where Madoff told the SEC one thing and foreign regulators another, in the hope no one would make a simple phone call to compare notes.  And, of course, no one did.

2.  It also turns out that Lehman used its dubious financials to bad-mouth other brokers, including Merrill Lynch, to the commercial banks who were lenders to both.  Merrill believed itself at a disadvantage.  It briefly considered mimicking the Lehman accounting technique but rejected the idea.  So Merrill called up the SEC–and the Federal Reserve–and reported what Lehman was doing. Apparently, both the Fed and the SEC–again, a lá Madoff–ignored what Merrill was saying.

3.  In what appears to me to be twisting the knife a little bit, JP Morgan Chase announced that it had at one time used an accounting treatment similar to Lehman’s for a small number of low-dollar-value transactions.

Morgan makes two points, in an implicit criticism of Lehman, the SEC and the auditors, Ernst & Young:

(1) it stopped doing so when Jamie Dimon, one of the few heroes of the financial meltdown, took over (read:  this was at best a dubious way to do business); and

(2) it disclosed the new borrowings in footnotes, as it believed accounting rules required it to do (read:  JPM thinks Lehman should have disclosed the new borrowings someplace, even with the accounting dodge it was using).

Where is the SEC?  When did it stop regulating the markets?

The SEC response

The SEC response to the newspaper accounts is reportedly that all the senior people assigned to Lehman have since left the agency–and, I guess, by implication they have nothing that they can investigate.

I don’t think this is a good enough answer.  Although the investigatory wheels are grinding extremely slowly, they do seem to be moving.  The Lehman bankruptcy report could easily, I imagine, lead to prosecution of Lehman’s top management.  This is something that I think the American public wants, given the enormity of the damage to the economy the financial crisis has done.

Given instances like Madoff and Lehman, investigation of the regulators can’t be far behind.  If the press depiction of the SEC inaction turns out to be substantially accurate–and the evidence seems very strong that it is–the most benign finding I can imagine is one of incompetence and negligence on a level that defies belief.

Of course, logically speaking, it may turn out that the situation with the SEC is not so benign–and is in fact far worse than that.  There’s no evidence of a darker side to the SEC as yet, however.  And in any event, the strength of Wall Street lies less in the SEC than in the basic honesty of the very large majority of market participants.