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How Private Equity Could Rev Up the U.S. Economy
Two out of five private equity firms will disappear. The rest will feast off the financial wreckage
By Peter Carbonara and Jessica Silver-Greenberg
Business Week
Donald B. Marron, founder of the $3 billion private equity firm Lightyear Capital, has been eyeing financial wreckage for more than a year. In early 2008 Marron, the former chairman and chief executive of brokerage PaineWebber, sent teams of analysts to scout out more than 200 struggling U.S. financial firms. So far Marron has made only one deal, buying a stake in student lender Higher One last summer. But the 74-year-old art aficionado, whose starkly modern New York office brims with abstract paintings, says dealmaking will soon pick up dramatically. “We expect this trend to continue,” he says.
While some attention has been paid to the vultures now circling the troubled banking sector, private equity is beginning to venture out across the economy in search of deals big and small. Glen T. Matsumoto, a partner in Swedish buyout shop EQT Partners, is looking for more ways to spend the $1.5 billion his firm has amassed for infrastructure and energy plays, having picked up Michigan energy company Midland Cogeneration Venture in March. Brian A. Rich of Catalyst Investors, an upstart buyout shop with $300 million in assets, recently plowed $5.6 million into Mindbody, a California software company. He’s hoping to invest in more cash-starved technology and media outfits. “We think it’s a great time to put capital out,” says 48-year-old Rich, who ran Toronto Dominion’s (TD) U.S. merchant banking arm before starting Catalyst in 2000.
It’s been a rough two years for private equity firms, those freewheeling and much-vilified financiers who buy companies only to sell them later for a profit. The buyout boom that ended in 2007 wasn’t pretty; many of the deals made at the height of the frenzy have been disasters. Bankruptcy courts are littered with private equity blunders, including household names Chrysler, Tribune (TXA), and Linens ‘n Things. Such high-profile blowups heightened private equity’s reputation as a group of fast-buck artists who are better at destroying companies than running them.
But a strange thing has happened. While the experts were proclaiming—and maybe even celebrating—their death, private equity firms were quietly bulking up their war chests and readying themselves for a new wave of deals. By some measures they’re stronger than ever: Firms are sitting on a record $1 trillion with which to make new purchases, according to research firm Preqin. “They are showing up at the party with a wheelbarrow full of cash,” says Donna Hitscherich, a professor at Columbia Business School.
Slowly and deliberately, firms are mobilizing their forces to exploit huge opportunities being created by the recession. Some big buyout firms, filling the void created by the financial crisis, are acting like traditional investment banks, providing loans to troubled companies and even advising executives on mergers. Some firms are aggressively hiring and firing buyout specialists, turning the cold eye they usually train on companies onto themselves. Other firms are prowling bankruptcy courts in search of cheap assets or are capitalizing on government stimulus spending. “There is every reason to believe that private equity will have tremendous opportunity once we hit bottom,” says Colin Blaydon, director of the Center for Private Equity & Entrepreneurship at Dartmouth’s Tuck School of Business.
When private equity starts cranking up its dealmaking machine—and it will, eventually—the $1 trillion it has amassed could help revive the economy by pumping crucial capital into the markets. “Private equity will be an integral part of this country’s economic recovery,” says Gregg Slager, a senior partner at accounting firm Ernst & Young. Noted Stephen A. Schwarzman, founder of Blackstone Group (BX), in the private equity firm’s March annual report: “Getting the world economy moving again will take more than government intervention.”
STILL ATTRACTING INVESTORS
Private equity’s surprising resurgence is a study in managing through a downturn. With markets and businesses blowing up all around them, buyout firms calmly made their case to big investors that they were still worthy stewards of capital. In 2008 they attracted $554 billion from pension funds, university endowments, and other big investors, down only modestly from the record $625 billion the previous year. Even this year’s seemingly small tally thus far of $49 billion still puts private equity on track to match 2004’s total of $206 billion, the sixth-highest ever.
Partly that’s because returns haven’t been as awful as feared. Private equity funds lost an estimated 20% in 2008. That was on a par with hedge funds and handily beat U.S. stocks (-37%), real estate (-38%), and commodities (-47%). Big investors think private equity will perform better in the future, too. U.S. corporate pensions are assuming their private equity holdings will return 10.1% a year over the next five years, compared with an estimated 7.8% for hedge funds, according to research firm Greenwich Associates.
The nation’s largest pension fund, California Public Employees’ Retirement System, even boosted its target for private equity holdings in its portfolio by four percentage points last year. “We’re strongly committed to private equity, which helps diversify the portfolios of long-term investors,” says CalPERS’ spokesman Clark McKinley. Robert Hunkeler, who manages the $13.1 billion in International Paper’s (IP) pension funds, says he’s keeping his stake in private equity at 5% despite recent losses.
The next few years will be dismal for many firms, no question. Buyout shops may be sitting on piles of cash for new purchases, but their portfolios also are stuffed with companies at risk of folding unless they can refinance their debt. Boston Consulting Group estimates that 20% to 40% of private equity firms will disappear altogether in the next few years.
But the wiliest players have inoculated themselves from the worst of the pain. During the boom years, firms used a number of slick tricks to extract money from companies right away and ease potential losses. First they loaded the companies they bought with debt and kept the proceeds for themselves. Then they collected ongoing management fees from those same companies.
Often they did both. Kohlberg Kravis Roberts, founded in 1976 by Henry R. Kravis and George R. Roberts, pulled off the biggest buyout ever in October 2007 when it joined with another big firm, TPG, to buy Texas utility TXU for $45 billion. (KKR also pulled off the largest transaction during the last buyout boom with its $31 billion bid for RJR Nabisco in 1989, the controversial deal immortalized in the book Barbarians at the Gate.) After picking up TXU, KKR and its private equity partners immediately collected $300 million from TXU for “certain services” associated with the deal, according to filings with the Securities & Exchange Commission. Plus, the firms are “entitled to receive an aggregate annual management fee of $35 million,” which “will increase 2% annually.” TPG and KKR declined to comment.
Private equity firms also exploited the remarkably easy lending environment during the boom, negotiating financing terms with unprecedented flexibility. Firms often had to put up minimal capital to close a deal. The maneuvers are paying off now.
Consider the tale of Chrysler. Cerberus Capital Management—named after the mythical three-headed dog that guards the gate of Hades—bought the troubled carmaker in May 2007 for $7.4 billion. Founder Stephen A. Feinberg, a secretive financier with blue-collar roots, has, with hard-nosed dealmaking, transformed Cerberus over the years from a scrappy vulture into a private equity stalwart. In the case of Chrysler, Cerberus contributed only $1.2 billion in cash. And even though Chrysler has filed for Chapter 11, Cerberus isn’t likely to lose all of that money; it may be able to offset some of its losses with Chrysler Financial, the carmaker’s lending arm, which isn’t part of the bankruptcy. Cerberus could merge the lender with another Cerberus investment, GMAC Financial. “It is a big hit,” says one Cerberus executive of the bankruptcy. “But it won’t break the company.”
To be sure, the days of larger-than-life dealmaking are over. Banks are no longer providing the loans that fuel the biggest buyouts. Small purchases will replace megabuyouts, and firms will likely focus their energies on sprucing up operations rather than extracting fees and engineering financial gains. “It’s back to the future,” says William E. Ford, chief executive of General Atlantic, a private equity firm with $13 billion in assets.
Some firms have even begun to deemphasize buyouts, quietly transforming themselves into diversified financial players that provide a wide array of money management, trading, and advisory services. Schwarzman, the 62-year-old head of Blackstone Group, is aggressively filling the void left by the Lehmans of the world. Schwarzman’s ambitions are as grand as his New York City apartment, a 35-room triplex once owned by John D. Rockefeller. At the firm’s start in 1985, Schwarzman and co-founder Peter G. Peterson shared a secretary and oversaw a grubstake of just $400,000. Today Schwarzman, infamous for a lavish birthday party he threw himself in 2007, sits atop more than $90 billion in assets and employs more than 1,340 people. Blackstone collected $410 million last year—not from its bread-and-butter buyout business but from advising other companies on mergers, acquisitions, and restructurings. Said Schwarzman in the firm’s annual report: “Our financial advisory group delivered record fees last year by meeting the demand for a trusted, independent adviser.”
PROFITING FROM THE PAIN
Blackstone’s advisory clients range from troubled insurer AIG (AIG) to the Ukrainian government. In December Tim Coleman, who co-heads Blackstone’s reorganization and restructuring group, flew to Detroit to meet with Ford Motor’s (F) CEO, Alan Mullaly, and other top executives. Coleman’s recommendation: Rework the debt. After that initial meeting, Mullaly hired Blackstone and Goldman Sachs (GS) to dispense advice. The three companies spent the next few months brainstorming and hashing out strategies at Ford’s headquarters. “We worked ‘round the clock,” says Coleman. “There wasn’t room for anyone’s ego to get involved.” They brought their plan to bondholders in April, offering to exchange $1.8 billion in debt for $1.3 billion in equity. The investors agreed.
Like all tough-minded investors, private equity firms are busy looking for ways to profit from rivals’ pain—and even their own. College friends Rodger R. Krouse and Marc J. Leder are among the most aggressive. The two left Lehman Brothers (LEHMQ) in 1995 to forge their own firm, Sun Capital Partners, in Boca Raton, Fla. They had a tough time muscling into the clubby world of private equity, but since 2002 Sun Capital has bought more than 200 small and midsize companies and earned 20% a year. Among its holdings: restaurant chain Friendly Ice Cream and bagel chain Bruegger’s Enterprises. More than 10 of Sun Capital’s companies have filed for Chapter 11, including retailer Big 10 Tires, auto parts supplier Fluid Routing Solutions, and department store Mervyns. But Krouse and Leder, both 47, are capitalizing on the trouble by doling out high-interest, short-term loans to some of its bankruptcy victims. Sun Capital declined to comment.
Few private equity portfolios are as troubled as that of New York’s Apollo Management—but even its list of losers is presenting opportunities. The $45 billion Apollo owns bankrupt retailer Linens ‘n Things, along with struggling casino chain Harrah’s Entertainment and real estate firm Realogy. But Apollo recently raised $15 billion for new investments and plans to use a quarter of that stash to buy distressed debt, including the debt of some of its own holdings.
Junk bonds are familiar territory for Apollo founder Leon Black. The 57-year-old started Apollo in 1990 after leaving Drexel Burnham Lambert, the notorious investment bank that collapsed that year. Black’s interest in his own distressed debt is partly defensive and partly speculative. By buying back bonds aggressively, Black can try to prevent other vultures from picking up the debt and wresting control of his investments. He’s also likely betting that the bond prices will rise in value and that he’ll be able to sell them at a profit later. Apollo declined to comment.
FRENCH CONNECTION
Many private equity firms are taking a sharp pencil to their own books as well. Even as the giants are laying off staff and closing offices, they’re recruiting specialists in fields where they see opportunities. Apollo, for example, added former Morgan Stanley (MS) banker Neil Shear to its new commodities group. In a burst of recent hiring, Blackstone picked up infrastructure specialists Trent Vichie and Michael Dorrell from the New York branch of Australia’s Macquarie, among other recruits.
Carlyle Group, one of the largest and most secretive private equity firms, started preparing for a flood of bank deals last year. The 22-year-old firm, whose ranks have included such well-connected advisers as former President George H.W. Bush and former British Prime Minister John Major, has been expanding aggressively into real estate, venture capital, and other alternative assets—and has bagged some high-profile talent. Last year, Carlyle lured UBS (UBS) investment banker P. Olivier Sarkozy, half brother of the French President. Sarkozy has advised on a number of bank deals, including ABN Amro’s sale of LaSalle Bank to Bank of America (BAC) for $21 billion, part of a breakup of the Dutch bank.
At Carlyle, Sarkozy spends much of his day poring over balance sheets and scouring troubled mortgage portfolios. He has been traversing the U.S. for the past few months, visiting local banks in tiny towns and regional players in urban areas. Now Sarkozy, along with Blackstone, Centerbridge, and W.L. Ross, are in discussions with management at BankUnited (BKUNA), a struggling lender in South Florida. “Private equity will be a prime catalyst in the necessary recapitalization of banks, both here and globally,” says Sarkozy, 39. “The time is ripe.”
BARGAINS IN THE `CANDY STORE’
Perhaps the most combative arena for private equity these days is the bankruptcy courts. Buyout firms are swarming, making bids on busted businesses and in some cases entering into bidding wars. Lynn Tilton, the pugnacious founder of Patriarch Partners, spends much of her time in court fighting over cheap assets. The 49-year-old Tilton, known for her flamboyance in stiletto heels, recently lost a contentious 16-day auction for instant photography pioneer Polaroid to rivals Hilco Consumer Capital and Gordon Brothers Brands. She’s appealing the decision. On Apr. 20 Tilton bought Stila Cosmetics, filling out a portfolio of troubled brand names that include mapmaker Rand McNally. Stila had fallen behind on its debt payments, and lenders took control of the makeup manufacturer. They called Tilton on a Friday night to make a deal. She talked with management on Sunday and by the following weekend owned the company. “I haven’t seen anything like this in 35 years,” Tilton says of the opportunities before her. “This is like a candy store for us.”
The value in Patriarch’s distressed plays isn’t always obvious. Last summer Tilton bought a paper mill in Maine, since renamed Old Town Fuel & Fiber. But she didn’t buy it just to make pulp. A main attraction for Tilton is the mill’s $30 million grant from the Energy Dept. for a research program studying how to make biofuels from wood chips. Tilton wants to produce a biofuel called butanol at the plant, which can be used as aircraft fuel. That would create another potential opportunity, because Patriarch also owns a helicopter maker and an aircraft parts manufacturer.
Few investments look as appealing as those blessed by government dollars. As part of the $787 billion federal stimulus package signed into law in February, the government has earmarked $29 billion to patch crumbling roads, bridges, and schools. Thanks to Uncle Sam, the infrastructure investing trend is picking up. The states’ cash crisis is also sparking interest. “With states facing real economic trouble, you will see further pressure on them to hand over infrastructure to private firms,” says Ben Heap, co-head of infrastructure in UBS’s (UBS) private equity group. There were 127 infrastructure funds in 2008, up from 91 in 2006, according to research firm Probitas Partners.
When Sadek Wahba, investment chief at Morgan Stanley’s (MS) $4 billion infrastructure fund, goes shopping for deals, he follows two main principles. First, invest only in public necessities. Second, make sure the concerns of local citizens are heard—to minimize political problems later. In December, Morgan Stanley and a group of investors paid $1.15 billion for 36,000 parking meters in Chicago. Wahba is converting the old coin-operated devices to electronic pay machines. “These assets are a good hedge against inflation, because you are providing a basic service,” says 43-year-old Wahba.
But the best example of private equity’s shrewdness in the downturn may be its ability to spiff up its sullied image. In Pittsburgh, Robert B. Fay and his brother Pat feared selling their 62-year-old construction business, Joseph B. Fay Co., to private equity, worried that a buyer would dismember the company and lay off staff. The family’s lawyer called New York’s FdG Associates after reading that the $300 million buyout firm had experience working with family-run businesses. In all, the Fay brothers met with six private equity firms. FdG’s team wore casual khakis to its meeting to underscore its anti-Wall Street image, while rivals sent representatives in designer suits. The Fays identified with the FdG team instantly and agreed to sell to the firm in February. Says Bob Fay: “These guys came to us as partners, not vultures.”
with Tara Kalwarski in New York and David Welch in Detroit
BUSINESS EXCHANGE: READ, SAVE, AND ADD CONTENT ON BW’S NEW WEB 2.0 TOPIC NETWORK
Old Stakes, New Value
Amid the ongoing cash crunch, some university endowments, insurers, and other big investors are looking to sell their investments in private equity funds. An Apr. 13 piece on Deal.com reports that Goldman Sachs recently launched a $5.5 billion fund to buy up those stakes on what’s known as the secondary market. “Things may be tougher than usual in the world of private equity but it just means more opportunities for Goldman,” the author writes.
To read the full article, go to http://bx.businessweek.com/private-equity/reference
Carbonara is a senior writer for BusinessWeek. Silver-Greenberg is a reporter for BusinessWeek.com.

01

maio

2009

Bretton Woods III ?

Bretton Woods III ?
Nouriel Roubini
A few years back, before this crisis erupted, several economists were concerned about the sustainability of the large global imbalances fueled by the so-called Bretton Woods II system. These economists recognized, in the tendency of export-led economies to manage their exchange-rate systems, the origin of large trade and current account surpluses that, via large foreign reserve accumulation, were financing the mirror image of those surpluses, namely the large U.S. trade and current account deficits.
These surpluses, primarily in several export-led Asian economies and also in oil-producing countries, ballooned to extensive proportions in 2007 and 2008. The purchases of U.S. government bonds by these investors helped keep long-term interest rates low and led many investors to seek high-yielding investments, especially in some emerging markets.
Although we are not (yet) witnessing a U.S. dollar crisis, the Bretton Woods II system is still at the center of the debates on the origins of this crisis. Understanding the nature of this crisis is fundamental in order to understand what reforms need to be undertaken for this not to happen again–and to understand what the global economy will look like after this crisis.
Although other factors have played a part, it is hard to argue that the large global imbalances that arose a few years ago had no role whatsoever in the current, synchronized global recession. However, so far, global imbalances do not seem to be on even the long-term agenda of most of those trying to remake the global financial system.
Global imbalances are now starting to narrow, though, and the current crisis is likely playing a role. As saving rates rise in the U.S., trade volumes fall on lower demand, expensive credit and weak commodity prices. The current U.S. account deficit has fallen from 6.6% at the end of 2005 to 3.7% at the end of 2008, and the IMF estimates it will fall further, to 2.8% of GDP, in 2009.
Many of the emerging economies that easily financed wide deficits are now being forced into consuming less, given the lack of credit and, in some cases, currency devaluation that boosts the costs of imports. Meanwhile, the fall in the price of oil and other commodities is shifting many oil exporters–some of the larger surplus nations–into deficit territory.
Is this the death of Bretton Woods II? Can export-led growth countries increase consumption, or are we going to see large imbalances in the global economy return when the recovery will be in full swing? And would a permanent correction of global imbalances be contractionary? If surplus economies continue along a business-as-usual path, trying to stoke export demand rather than increasing domestic spending to boost consumption, it could increase deflationary pressures.
Fiscal and current account surpluses and foreign exchange reserves can be used to increase government spending on infrastructure and public services and boost consumption and investment, which might help unwind the global imbalances. In fact, fiscal stimulus spending underway during the current downturn by surplus countries like China and the Middle East will help increase their own domestic demand and also boost the exports of deficit countries.
Governments with comfortable fiscal/external surpluses, commodity revenues or foreign exchange reserves, such Asia-Pacific, the Gulf Cooperation Council, Canada, Norway, Germany and Russia, have rightly increased stimulus spending in spite of easing exports and commodity prices recently. However, there are criticisms that such spending still falls short and is steered toward export firms rather than domestic demand, which will only exacerbate global deflationary pressures. On the other hand, stimulus spending by deficit countries such as the U.S. and U.K. will only accentuate pressure on global fiscal deficits and imbalances.
Some are still concerned that the unwinding of imbalances might be disorderly, leading to swift exchange-rate moves. However, it is also possible that this might be a gradual process, aided by a beefed-up IMF and other multilateral institutions which will avert balance of payments crises–if not sharp contractions–in many emerging economies, especially in Eastern Europe.
Some imbalances seem to be persistent though. China’s surplus does not seem to be shrinking very much, largely because the import contraction, including goods for re-export and cheaper commodities, is more severe than that of exports. And those of Germany and Japan are expected to continue to be quite large also.
The consumption share of China’s GDP has fallen since the year 2000, although Chinese government investment could provide a boost in 2009. The IMF suggests China’s current account surplus will continue to rise, albeit at a slower pace, in 2009, nearing $500 billion from almost $430 billion in 2008. Such a large current account surplus implies still large reciprocal deficits in some of China’s trading partners, likely the U.S. and several European countries.
There is a risk that China’s fiscal stimulus might exacerbate production overcapacities, creating further deflationary pressures, unless China is able to stimulate domestic demand, especially private consumption. Moreover, there is related risk that China’s extension of investment and credit expansion could defer China’s transition to a global economy in which the U.S. consumer consumes less.
As it currently stands, China’s almost $600 billion fiscal stimulus has less than 10% dedicated to social welfare programs. Expanding this expenditure through increasing government outlay on health care, pension payments and unemployment benefits, could have a significant effect on boosting consumption, particularly as it could reduce some of the households’ structural pressures to save.
In the longer term, some tax policy changes, including the requirement of state-owned enterprises to pay dividends and the introduction of a value-added tax, might also be supportive of consumption-based growth. Chinese leaders are cognizant of the need to rebalance growth, meaning China may be better placed to do so than some of the export- and investment-led advanced economies, or the Asian tigers whose growth models are in question amid of the global export collapse.
So far, despite several months of hot money capital outflows, China seems to have increased its share of the safest U.S. assets, especially Treasury bills. Given the global export weakness, China may be forced to maintain its quasi dollar peg, which will likely involve a resumption of U.S. dollar asset purchases. Yet Chinese concerns about the long-term value of its U.S. assets have increased. China has been diversifying its assets on the margins, increasing the share of gold (from a very low share of total assets) and loaning its foreign exchange to resource exporters. The Chinese Central Bank governor has suggested that, over time, the IMF’s SDR has a certain attraction as a reserve currency, given the instabilities that have stemmed from the U.S. dollar’s reserve currency role.
The severe effects of the global recession and export contraction on Asia’s growth, manufacturing output and employment loss might pave way for Asia to rethink its export-led growth model and move its source of growth away from exports and toward domestic consumption. However, this might require a lot more political will, since the existing growth model has helped Asia attain higher per-capita income and significant poverty reduction.
Moreover, the structural changes required to change the growth model–to move production from low-end manufacturing to high-end labor-intensive manufacturing and services to boost employment and incomes; improve the social safety net, and pension and health care systems; invest in skills training and R&D; and enhance intermediation of savings and credit access for firms by developing financial markets–all involve short-term costs with results only in the long term, something that political leaders might be unwilling to trade.
On the other hand, it could be argued that Asia might continue to follow an export-led model even in the future to sustain growth and poverty reduction, and at the same time use the presently available vast resources to boost safety nets and cushion the economy and workers from any future global export downturn.
While policies to increase domestic demand might boost Asian imports and reduce current account surpluses, shrinking exports recently have, in fact, led imports to shrink at a faster pace than exports (given the high import content of exports), thus keeping up the trade and current account surpluses in many Asian countries. Letting the exchange rate appreciate will also be challenging for Asia and will largely depend on China’s currency stance. In fact, many Asian countries started favoring an undervalued currency recently–or at least have stopped allowing appreciation–given weakened exports and a need to maintain competitiveness with China.
Asia’s stance will also be governed by the losses that the central banks will have to realize on their U.S. Treasury holdings by letting their currencies appreciate. Moreover, any change in Asia’s growth model will be governed by the mid- to long-term factors such as the pace of rise in the U.S. savings rate and whether it’s structural or cyclical in nature, and also the trends in global commodity, shipping and Asian labor costs going forward.
It is a different story with commodity exporters who, as a whole, are set to shift from surplus to deficit territory in 2009, given robust spending and much lower revenues. Unlike China, oil exporters were already contributing more to rebalancing in the last few years, with much of the incremental increase in revenues being spent–or rather, absorbed–at home by massive projects and increased consumption. In fact, rather than generating surpluses, the current risks are that the economies of many oil exporters in the CIS, Africa and even some in the GCC could contract in 2009, given the weaker hydrocarbon and non-hydrocarbon sector outlook.
Facilitated by past savings, many of these countries, including Saudi Arabia, the United Arab Emirates and Russia, are conducting expansionary fiscal policies this year and will run significant fiscal deficits at an oil price below $50 a barrel. Moreover, countries like the UAE, Saudi Arabia and others are expected to run current account deficits, financed by the sale of past savings. Meanwhile, with many sovereign wealth funds and other government capital being deployed domestically, there may be fewer foreign purchases.
The eurozone’s largely balanced external position covers ample intra-EMU imbalances among eurozone countries. Current account dispersion reached from 8.4% in the Netherlands and 7% in Germany to -13.4% in Cyprus as of 2008. The European Commission notes that, while large current account balances by themselves could merely be the expression of rational private sector choices, a comparison of real exchange rates with their benchmark “equilibrium” current accounts shows the existence of sizable real exchange rate misalignments.
Decompositions of this kind gave rise to claims that Germany in particular, in its role as EMU’s “center” economy, is engaging in beggar-thy-neighbor behavior by setting in motion a real competitive devaluation of its currency through falling unit labor costs. This makes a rebalancing of high-deficit countries all the more challenging. Since a nominal devaluation is not an option within the EMU, high-deficit countries have no option but to deflate in real terms, either through relatively higher productivity or consumption restraint against an already ambitious German benchmark.
Germany is not exposed to overindebted households and non-financial corporates to the extent that Spain, Ireland or France are. However, as the current downturn makes painfully clear, balanced financial accounts provide no shield against an over-reliance on external conditions or undiversified specialization patterns. Bundesbank President Axel Weber recently made clear that Germany should try to break its dependence on exports as the mainstay of its economic growth, whereas Chancellor Angela Merkel argues a strong industrial base and external competitiveness are valuable assets, especially for an aging and shrinking population: In fact, Merkel says, “[export reliance] is not something we even want to change.”
Ultimately, the Bretton Woods II system of global imbalances has had effects reaching far beyond the U.S. and Asia. Like the U.S., emerging markets in Eastern Europe were able to fund large current-account deficits in the recent era of cheap financing. In May 2007, I wrote: “The currency and economic policies of China and East Asia have contributed–among many other factors–to unsustainable global current account imbalances whose rebalancing now risks becoming disorderly rather than orderly.” This is certainly the case in Central and Eastern Europe, where current account deficits have been the norm and where the unwinding of such imbalances is raising concern that it could contribute to a regional financial crisis along the lines of 1997 in Asia.
The drying up of capital inflows amid the global financial turmoil is necessitating a sharp adjustment in Eastern Europe’s external imbalances. These imbalances rival, and in some cases exceed, those in pre-crisis Asia: Current-account deficits in Southeast Asia from 1995 to 1997 fell within the range of 3% to 8.5% of GDP, while those in Central and Eastern Europe were well over 10% of GDP in Romania, Bulgaria and the Baltics in 2008.
A correction in the region’s imbalances is already underway via currency depreciation (in countries with flexible exchange rates) and via a sharp drop in domestic demand. Thus far, the IMF has stepped in with financial assistance for three E.U. newcomers–Hungary, Latvia and Romania–to smooth the sharp drop-off in capital inflows and to avert a disorderly unwinding of external imbalances. These countries are unlikely to be the last to knock on the IMF’s door.
Nouriel Roubini, a professor at New York University’s Stern Business School and chairman of Roubini Global Economics, is a weekly columnist for Forbes. Analysts at Roubini Global Economics assisted in the research and writing of this piece.

Forbes – April 30, 2009