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Hell and high water
Europe�s Stability and Growth Pact appears to be staggering towards an early death. The steadfast refusal of the French Government to live within the pact�s 3% budget deficit limit, plus the inability of Germany to do so, has pitched the eurozone�s two largest economies against both the European Commission and smaller member states which are complying with the rules.
As accounting & business went to press, it was unclear whether the Commission would impose its permitted multi-million euro fine on France. But moves to do so would undoubtedly create one of the European Union�s most severe crises.
In the meantime, key politicians were retreating into opposing corners. French President Chirac and prime minister Jean-Pierre Raffarin appeared as committed as ever to their strategy of stimulating their lagging economy through tax cuts. �This is not about modifying the stability pact,� said Chirac. �It�s a case of getting the representatives of eurozone nations to examine together the terms of a temporary softening.�
France and Germany are calling for acceptance that sanctions should not be used against them in recognition of the urgent steps needed to boost their economies. This, they say, conforms to the �special circumstances� conditions under which the Commission can waive punishment. Some cynics suggested that the real special circumstances were that it was the eurozone�s two largest economies that were affected, rather than the small member states.
Irish finance minister, Charlie McCreevy, said: �We have gone through hell and high water to agree with the stability pact.� Austria�s finance minister, Karl-Heinz Grasser, told the press: �If France were to go over 3% for a third year, then sanctions must be the consequence.�
The Commission�s economic and monetary affairs commissioner, Pedro Solbes, sided with the small nations. �I think the �special circumstances� regulation is not a way to avoid the 3% limit,� he said. �We are not suspending the pact. We have to apply the pact.�
Outgoing president of the European Central Bank, Wim Duisenberg, echoed this when he asserted that slow growth within the eurozone was attributable to the failure of some members to comply with budget deficit rules. And his replacement, Jean-Claude Trichet, added that the stimulus impact of the deficits was outweighed by damage to investor confidence, once deficits exceeded a certain level.
Despite the surprise news that Italy has stayed comfortably inside the 3% deficit limit, the pressure on the pact now seems unbearable. Not only has European President, Romano Prodi, referred to it as the �stupidity pact�, but a team of experts concluded in July that it had to be reformed. The advisory panel appointed by Prodi said that the pact rules should operate more flexibly, with the deficit ceiling lifted as soon as a member country�s economy stopped growing. Their call is backed by many economists.
John Hawksworth, chief economist at PricewaterhouseCoopers, said: �I would say the problem with the 3% limit is that it is not linked to the position in the economic cycle. What we have suggested, and they might do this, is some sort of target over an economic cycle - perhaps a 1% deficit. There is potential for reform along these lines. That would not produce bad effects.�
But Hawksworth warned that failure to take a grip on the situation could harm the European economy. �If they don�t, you could have damage in two respects,� he said. �If Germany is persuaded to take action [to comply with the deficit limit] - and it is unlikely that they or France would do so - it would push them further into recession. The other possibility is that they just say they won�t play by the rules. Then everyone else would say the same. You would see a big increase in deficits, pushing up interest rates, damaging investment and, in the longer term, countries would face pressures with an ageing population and even bigger government deficits, which would create the need for very radical surgery to put things right. They need to find a political solution to reform the pact.�
Martin Essex, senior economist at Capital Economics, was more relaxed about the crisis. �Broadly, the Stability and Growth Pact is a big mistake,� he said. �Therefore, France and Germany are right to ignore it. In times of economic downturn you need looser economic and fiscal policies and tighten the belt when things get better. The problem is that countries never want to do the latter.�
Loosening the deficit rules would have little economic impact, Essex suggested. He predicted that the euro would continue to strengthen against the dollar because the size of the United States deficit is so much larger than that in Europe. This would reduce overseas demand for eurozone goods, leaving manufacturers to rely on domestic demand. He added that while British companies may need to adjust their export focus, there would not be much effect on them.
�Almost by definition, whatever happens to the United States� currency, people there will buy British goods,� explained Essex. �And whatever happens in the European economy, they won�t be buying British goods.�
Initially, the in-fighting over the future of the pact was a matter of little concern to anyone other than economists and politicians. It now appears to have become a real political issue to the voting public and has been described as one of the reasons why the Swedish electorate voted so strongly against the adoption of the euro.
The phoenix of corporate governance
A symbol of the corporate greed and weak governance that destroyed the reputation of giant American businesses, MCI, is set to emerge phoenix-like from the ashes of Chapter 11 protection as a model of good governance practice. MCI has announced a programme of 78 reforms to convert the telecoms giant previously known as WorldCom into a structure that will be the envy of shareholders and non-executive directors around the world. The old WorldCom committed the world�s largest ever fraud, assessed at $11bn.
The reform programme was drawn up by Richard Breeden, a former chairman of the US Securities and Exchange Commission, who was appointed �corporate monitor� by the corporation. It forms part of MCI�s settlement with the SEC and has been approved by the MCI board.
Breeden endorsed prior moves by MCI to move beyond its recent heritage, through the appointment from outside of new chief executive, president, chief operating officer, general counsel and director of internal controls. All the former directors have left. The company has also recruited over 400 new accounting and finance staff, closing its existing operations in Clinton where most of what the company describes as �fraudulent activities� took place. KPMG has been appointed the new auditor in place of Andersen and will conduct a re-audit of the period 1999 to 2002.
The focus of MCI�s new corporate governance regime will be the antithesis of the most spectacular weakness in the old WorldCom, with strong non-executive directors and shareholder links to counterbalance the power of executive directors. The chief executive and chairman posts will be separated, directors must demonstrate their independence and qualification for office, while they will draw a salary of $150,000 - more than four times that paid to WorldCom�s directors. A quarter of net profits are to be paid out annually as shareholder dividends to prove directorial faith in the accuracy of the company�s accounts.
�Breeden�s report not only sets new standards for good corporate governance but also establishes a road map that helps us build our foundation for the future,� said Michael Capellas, currently MCI chairman and chief executive. �The company has already implemented many of the proposed corporate reforms, but we know we have to do even more to regain public trust.�
MCI has attracted a strong new board. Members include former Financial Accounting Standards Board chairman, Dennis Beresford, former US attorney-general and under-secretary of state, Nicholas Katzenbach, former US deputy attorney-general, Eric Holder, and former Touche Ross chairman, W Grant Gregory, as well as retired executives of several major corporations. MCI has meanwhile moved forward to remove itself from Chapter 11 bankruptcy protection. The US Bankruptcy Court has approved MCI�s settlement with the Securities and Exchange Commission, involving a civil penalty of $2.25bn.
Breeden�s new code contains a further raft of reforms and commitment to best practice. MCI will establish a �governance constitution�, which can only be changed by shareholders. Other additional powers held by shareholders will include their right to nominate directors and their election of one new director each year, with an on-line �town hall� developed to improve shareholder links with MCI. Directors and auditors will be limited to a maximum 10-year period of office, a quarter of directors� fees will be invested in company stocks, all directors other than the chief executive must be independent and the chief executive will be banned from sitting on audit, governance, compensation and risk management committees.
Similar far-reaching corporate governance changes are likely at other businesses accused of serious accounting malpractices. The Dutch retailer Ahold has appointed a respected lawyer, Peter Wakkie, to propose a restructuring of the company to introduce strong and progressive corporate governance practices.
However, restrospective legal reform proposed by President Bush�s administration stands accused of attempting to whitewash past corporate governance misdeeds in the US. The so-called �Enron Escape Clause� legislation is opposed by many of the country�s leading lawyers and judges.
�Retroactive legislation moving rapidly through Congress would make it easier for corporate wrongdoers to escape responsibility for defrauding investors, harming the environment and otherwise maximising profits at the expense of the health and financial well-being of ordinary citizens,� alleged Nan Aron, President of lobbying group Alliance For Justice. �In the wake of the worst corporate scandals in 50 years, rather than acting to deter wrongdoing, Congress is poised to encourage more white collar misconduct with the passage of a so-called class action reform bill which actually retroactively helps several of our most notorious corporate miscreants escape accountability.�
�Basel faulty�, say banks
Even the apparent recognition by the European Central Bank that the Basel II rules on bank capital will not, after all, be implemented until 2007 has done little to quiet the row that is rocking the banking industry.
While the Basel II argument has been staggering on for months, it has generated little publicity simply because the proposals are so complicated. The essence of the proposed new rules is to provide a better match between banks� capital and risks, with the intention that banks� financial positions are more transparent and their risk positions capped.
However, Basel II has proved dramatically unpopular with many banks, and even with domestic regulators. Not only is the United States unhappy with Basel II, but banking regulators in the US intend to ignore it for the vast majority of the country�s banks which will be allowed to continue to operate under the less onerous Basel I provisions.
The position of US regulators has infuriated European banks, which still expect to have Basel II rules imposed upon them by legislation. Similarly, European SMEs are arguing that the higher cost for banks of implementing Basel II will be passed onto customers as more expensive loans, thereby reducing firms� international competitiveness.
Standard & Poor�s, the credit rating agency, has made the Basel debate even fiercer by advising banks that those which most comprehensively implement the Basel II rules are likely to have their status downgraded. S&P echoed the criticisms of some politicians in warning that the closer matching of held capital with risk would make loans more difficult to obtain during recessions and consequently worsen the impact of economic downturns.
Concerns in the United States are particularly focused on the impact on banks� highest margin activities, �sub-prime loans�, through which the poorest households borrow money, credit card lending and loans to low status small firms. Banks and regulators in the US fear that the full application of Basel II would force them to reduce their exposure in markets where they believe their risks are fully recognised and fully recompensed by the interest rates charged.
Bruce Aitken, senior manager in KPMG�s financial services advisory practice, says that Basel II will change banks� working practices. �It could lead to a certain amount of higher risk activities which have not attracted adequate capital in the past, requiring more capital and some release of capital on lower risk activities,� he predicted. Building societies in the UK might benefit from this because mortgages are a low risk product. There might even be more price differentiation between mortgage customers, according to risk profile. Meanwhile, it is possible that higher risk loans, such as sub-prime consumer lending and loans to younger small firms, might become more expensive, said Aitken. Banks may also find that their capital requirements vary according to the rating of their corporate borrowers.
Basel II could seriously affect banks� corporate governance practice, Aitken predicted. �I think there will be an impact on banks� corporate governance, which is coming anyway,� he said. �The onus is on senior management to demonstrate they are running a tight ship.� But despite resistance to Basel II by many in the banking industry, Aitken believes the new rules will be adopted. �My view is that it will happen, but there could well be a few more twists and turns to go before we get something that can be implemented. There will be some compromises to be made.� | 
