Cyclopedia Of Economics

"Slush funds are obtained from a joint stock company's finances, carefully managed so that the amounts involved do not appear on the balance sheet. They do not necessarily have to consist of money, but can also take the form of stocks and shares or other economically valuable goods (works of art, jewels, yachts, etc.) It is enough that they can be used without any particular difficulty or that they can be transferred to a third party.

If a fund is in the form of money, it is not even necessary to refer to it outside the company accounts, since it can appear in them in disguised form (the 'accruals and deferrals' heads are often resorted to for the purpose of hiding slush money). In light of this, it is not always correct to regard it as a reserve fund that is not accounted for in the books. Deception, trickery or forgery of various kinds are often resorted to for the purpose of setting up a slush fund."

He mentions padded invoices, sham contracts, fictitious loans, interest accruing on holding accounts, back to back transactions with related entities (Enron) - all used to funnel money to the slush funds. Such funds are often set up to cover for illicit and illegal self-enrichment, embezzlement, or tax evasion.

Less known is the role of these furtive vehicles in financing unfair competitive practices, such as dumping. Clients, suppliers, and partners receive hidden rebates and subsidies that much increase the - unreported - real cost of production.

BBVA's payments to ETA may have been a typical payment of protection fees. Both terrorists and organized crime put slush funds to bad use. They get paid from such funds - and maintain their own. Ransom payments to kidnappers often flow through these channels.

But slush funds are overwhelmingly used to bribe corrupt politicians. The fight against corruption has been titled against the recipients of illicit corporate largesse. But to succeed, well-meaning international bodies, such as the OECD's FATF, must attack with equal zeal those who bribe. Every corrupt transaction is between a venal politician and an avaricious businessman. Pursuing the one while ignoring the other is self-defeating.

Note - The Psychology of Corruption

Most politicians bend the laws of the land and steal money or solicit bribes because they need the funds to support networks of patronage. Others do it in order to reward their nearest and dearest or to maintain a lavish lifestyle when their political lives are over.

But these mundane reasons fail to explain why some officeholders go on a rampage and binge on endless quantities of lucre. All rationales crumble in the face of a Mobutu Sese Seko or a Saddam Hussein or a Ferdinand Marcos who absconded with billions of US dollars from the coffers of Zaire, Iraq, and the Philippines, respectively.

These inconceivable dollops of hard cash and valuables often remain stashed and untouched, moldering in bank accounts and safes in Western banks. They serve no purpose, either political or economic. But they do fulfill a psychological need. These hoards are not the megalomaniacal equivalents of savings accounts. Rather they are of the nature of compulsive collections.

Erstwhile president of Sierra Leone, Momoh, amassed hundreds of video players and other consumer goods in vast rooms in his mansion. As electricity supply was intermittent at best, his was a curious choice. He used to sit among these relics of his cupidity, fondling and counting them insatiably.

While Momoh relished things with shiny buttons, people like Sese Seko, Hussein, and Marcos drooled over money. The ever-heightening mountains of greenbacks in their vaults soothed them, filled them with confidence, regulated their sense of self-worth, and served as a love substitute. The balances in their bulging bank accounts were of no practical import or intent. They merely catered to their psychopathology.

These politicos were not only crooks but also kleptomaniacs. They could no more stop thieving than Hitler could stop murdering. Venality was an integral part of their psychological makeup.

Kleptomania is about acting out. It is a compensatory act. Politics is a drab, uninspiring, unintelligent, and, often humiliating business. It is also risky and rather arbitrary. It involves enormous stress and unceasing conflict. Politicians with mental health disorders (for instance, narcissists or psychopaths) react by decompensation. They rob the state and coerce businessmen to grease their palms because it makes them feel better, it helps them to repress their mounting fears and frustrations, and to restore their psychodynamic equilibrium. These politicians and bureaucrats "let off steam" by looting.

Kleptomaniacs fail to resist or control the impulse to steal, even if they have no use for the booty. According to the Diagnostic and Statistical Manual IV-TR (2000), the bible of psychiatry, kleptomaniacs feel "pleasure, gratification, or relief when committing the theft." The good book proceeds to say that " ... (T)he individual may hoard the stolen objects ...".

As most kleptomaniac politicians are also psychopaths, they rarely feel remorse or fear the consequences of their misdeeds. But this only makes them more culpable and dangerous.

Small Business

Everyone is talking about small businesses. In 1993, when it was allowed in Macedonia, more than 90,000 new firms were registered by individuals. Now, less than three years later, official figures show that only 40,000 of them still pay their dues and present annual financial statements. These firms are called "active" - but this is a misrepresentation. Only a very small fraction really does business and produces income.

Why this reversal? Why were people so enthusiastic to register companies - and then became too desperate to operate them?

Small business is more than a fashion or a buzzword. In the USA, only small businesses create new jobs. The big dinosaur firms (the "blue-chips") create negative employment - they fire people. This trend has a glitzy name: downsizing.

In Israel many small businesses became world class exporters and big companies in world terms. The same goes, to a lesser extent, in Britain and in Germany.

Virtually every Western country has a "Small Business Administration" (SBA).

These agencies provide many valuable services to small businesses:

They help them organize funding for all their needs: infrastructure, capital goods (machinery and equipment), land, working capital, licence and patent fees and charges, etc.

The SBAs have access to government funds, to local venture capital funds, to international and multilateral investment sources, to the local banking community and to private investors. They act as capital brokers at a fraction of the costs that private brokers and organized markets charge.

They assist the entrepreneur in the preparation of business plans, feasibility studies, application forms, questionnaires - and any other thing which the new start-up venture might need to raise funds to finance its operations.

This saves the new business a lot of money. The costs of preparing such documents in the private sector amount to thousands of DM per document.

They reduce bureaucracy. They mediate between the small business and the various tentacles of the government. They become the ONLY address which the new business should approach, a "One Stop Shop".

But why do new (usually small) businesses need special treatment and encouragement at all? And if they do need it - what are the best ways to provide them with this help?

A new business goes through phases in the business cycle (very similar to the stages of human life).

The first phase - is the formation of an idea. A person - or a group of people join forces, centred around one exciting invention, process or service.

These crystallizing ideas have a few hallmarks:

They are oriented to fill the needs of a market niche (a small group of select consumers or customers), or to provide an innovative solution to a problem which bothers many, or to create a market for a totally new product or service, or to provide a better solution to a problem which is solved in a  less efficient manner.

At this stage what the entrepreneurs need most is expertise. They need a marketing expert to tell them if their idea is marketable and viable. They need a financial expert to tell them if they can get funds in each phase of the business cycle - and wherefrom and also if the product or service can produce enough income to support the business, pay back debts and yield a profit to the investors. They need technical experts to tell them if the idea can or cannot be realized and what it requires by way of technology transfers, engineering skills, know-how, etc.

Once the idea has been shaped to its final form by the team of entrepreneurs and experts - the proper legal entity should be formed. A bewildering array of possibilities arises:

A partnership? A corporation - and if so, a stock or a non-stock company? A research and development (RND) entity? A foreign company or a local entity? And so on.

This decision is of cardinal importance. It has enormous tax implications and in the near future of the firm it greatly influences the firm's ability to raise funds in foreign capital markets. Thus, a lawyer must be consulted who knows both the local applicable laws and the foreign legislation in markets which could be relevant to the firm.

This costs a lot of money, one thing that entrepreneurs are in short supply of. Free legal advice is likely to be highly appreciated by them.

When the firm is properly legally established, registered with all the relevant authorities and has appointed an accounting firm - it can go on to tackle its main business: developing new products and services. At this stage the firm should adopt Western accounting standards and methodology. Accounting systems in many countries leave too much room for creative playing with reserves and with amortization. No one in the West will give the firm credits or invest in it based on domestic financial statements.

A whole host of problems faces the new firm immediately upon its formation.

Good entrepreneurs do not necessarily make good managers. Management techniques are not a genetic heritage.

They must be learnt and assimilated. Today's modern management includes many elements: manpower, finances, marketing, investing in the firm's future through the development of new products, services, or even whole new business lines. That is quite a lot and very few people are properly trained to do the job successfully.

On top of that, markets do not always react the way entrepreneurs expect them to react. Markets are evolving creatures: they change, they develop, disappear and re-appear. They are exceedingly hard to predict. The sales projections of the firm could prove to be unfounded. Its contingency funds can evaporate.

Sometimes it is better to create a product mix: well-recognized brands which sell well - side by side with innovative products.

I gave you a brief - and by no way comprehensive - taste of what awaits the new business and its initiator, the entrepreneur. You see that a lot of money and effort are needed even in the first phases of creating a business.

How can the Government help?

It could set up an "Entrepreneur's One Stop Shop".

A person wishing to establish a new business will go to a government agency.

In one office, he will find the representatives of all the relevant government offices, authorities, agencies and municipalities.

He will present his case and the business that he wishes to develop. In a matter of few weeks he will receive all the necessary permits and licences without having to go to each office separately.

Having obtained the requisite licences and permits and having registered with all the appropriate authorities - the entrepreneur will move on to the next room in the same building. Here he will receive a list of all the sources of capital available to him both locally and from foreign sources. The terms and conditions of the financing will be specified for each and every source. Example: EBRD - loans of up to 10 years - interest between 6.5% to 8% - grace period of up to 3 years - finances mainly industry, financial services, environmental projects, infrastructure and public services.

The entrepreneur will select the sources of funds most suitable for his needs - and proceed to the next room.

The next room will contain all the experts necessary to establish the business, get it going - and, most important, raise funds from both local and international institutions. For a symbolic sum they will prepare all the documents required by the financing institutions as per their instructions.

But entrepreneurs in many developing countries are still fearful and uninformed. They are intimidated by the complexity of the task facing them.

The solution is simple: a tutor or a mentor will be attached to each and every entrepreneur. This tutor will escort the entrepreneur from the first phase to the last.

He will be employed by the "One Stop Shop" and his role will be to ease life for the novice businessman. He will transform the person to a businessman.

And then they will wish the entrepreneur: "Bon Voyage" - and may the best ones win.

Sovereign Debt

In a little noticed speech, given in January 2003 at an IMF conference in Washington, Glenn Hubbard, then Chairman of President Bush's Council of Economic Advisers, delineated a compromise between the United States and the International Monetary Fund regarding a much mooted proposal to allow countries to go bankrupt.

In a rehash of ideas put forth by John Taylor, then Treasury Undersecretary for International Affairs, Hubbard proposed to modify all sovereign debt contracts pertaining to all forms of debt to allow for majority decision making, the pro-rata sharing of disproportionate payments received by one creditor among all others and structured, compulsory discussions led by creditor committees. The substitution of old debt instruments by new ones, replete with "exit consents"  (the removal of certain non-payment clauses) will render old debt unattractive and thus encourage restructuring.

In a sop to the IMF, he offered to establish a voluntary sovereign debt resolution forum. If it were to fail, the IMF articles can be amended to transform it into a statutory arbiter and enforcer of decisions of creditor committees. Borrowing countries will be given incentives to restructure their obligations rather than resort to an IMF-led bailout.

In conformity with the spirit of proposals put forth by the Bank of England and the Bank of Canada, Hubbard insisted that multilateral financing should be stringently conditioned on improvements in public sector governance and the legal and regulatory frameworks, especially the protection of investor and creditor rights. He rejected, though, suggestions to strictly limit official financing by international financing institutions.

Yet, these regurgitated schemes suffer from serious flaws.

It is not clear why would creditors voluntarily forgo their ability to extort from other lenders and from the debtor an advantageous deal by threatening to withhold their consent to a laboriously negotiated restructuring package. Nor would a contractual solution tackle the thorny issues of encompassing different debt instruments and classes of creditors and of coordinating action across jurisdictions. Taylor's belated proviso that such clauses be a condition for receiving IMF funds would automatically brand as credit risks countries which were to introduce them.

The IMF is, effectively, a lender of last resort. When a country seeks IMF financing, its balance of payments is already ominously stretched, its debt shunned by investors, and its currency under pressure. The IMF's clients are illiquid (though never insolvent in the strict sense of the word).

The IMF's First Deputy Managing Director, Anne Krueger, proposed in November 2001 to allow countries to go bankrupt within a Sovereign Debt Restructuring Mechanism (SDRM). Legal action by creditors will be "stayed" while the country gets its financial affairs in order and obtains supplemental funding. Such an approach makes eminent sense.

Today, sovereign debt defaults lead to years of haggling among bankers and bondholders. It is a costly process, injurious to the distressed country's future ability to borrow. The terms agreed are often onerous and, in many cases, lead to a second event of default. The experiences of Ukraine and Ecuador in the 1990s are instructive. Russia - another serial debt restructurer, lastly in 1998 - was saved from a recurrent default by the fortuitous surge in oil prices. Argentina and its emasculated debtors were not as lucky.

Moreover, as Hubbard observed in his speech, both creditors and debtors have a perverse incentive to aggravate the situation. The more calamitous the outlook, the more likely are governments and international financial institutions to step in with a bailout package, replete with soft loans, debt forgiveness and generous terms of rescheduling. This encourages the much-decried "moral hazard" and results in reckless borrowing and lending.

A carefully thought-out international sovereign bankruptcy procedure is likely to yield at least two important improvements over the current mayhem. Troubles now tackled by a politically-compromised and bloated IMF will be relegated to the marketplace. Bailouts will become rarer and far more justified. Moreover, the "last man syndrome", the ability of a single creditor to blackmail all others - and the debtor - into an awkward deal, will be eliminated.

By streamlining and elucidating the outcomes of financial crises, an international bankruptcy court, or arbitration mechanism, will, probably, enhance the willingness of veteran creditors to lend to developing countries and even help attract new funding. The creditworthiness of lenders increases as procedures related to collateral, default and collection are clarified. It is the murkiness and arm-twisting of the current non-system that deter capital flows to emerging economies.

Still, the analogy is partly misleading. What if a developing country abuses the bankruptcy procedures? As The Economist noted wryly "an international arbiter can hardly threaten to strip a country of its assets, or forcibly change its 'management'".

Yet, this is precisely where market discipline comes in. A rogue debtor can get away with legal shenanigans once - but it is likely to be spurned by lenders henceforth. Good macroeconomic policies are bound to be part and parcel of any package of debt rescheduling and restructuring in the framework of a sovereign bankruptcy process.

Addendum - Vulture Funds

Vulture funds are financial firms that purchase sovereign debt at a considerable disaggio and then demand full payment from the issuing country. A single transaction with a solitary series of heavily discounted promissory notes can wipe out the entire benefit afforded by much-touted international debt relief schemes and obstruct debt rescheduling efforts.

Addendum - Nationalizing Risk

During the months of September-October 2008, governments throughout the world took a series of unprecedented steps to buttress tottering banks. In the USA, the Federal Reserve and the Treasury Department have flooded the financial system with liquidity; granted commercial banking licenses to the few investment banks left standing; lent funds against financial instruments turned toxic; and purchased non-voting equity and senior debt in a host of firms and banks. Several European countries have guaranteed all bank deposits and short-term interbank loans.

These steps served to halt the panic at least temporarily and have thus prevented runs on banks and the seizing up of the credit markets. Still, these were mere palliatives. They did not tackle the roots of the crisis, though they averted it.

Instead of eliminating risky, ill-considered investments and bad loans by allowing defaults and bankruptcies, governments have shifted debts and risks from financial institutions to taxpayers and sovereigns. The question was thus no longer: will this or that bank survive, but: will this or that country remain solvent. Iceland, for instance, essentially went belly up. Other countries, including the USA, are liable to pay for this largesse with a bout of pernicious inflation.

And even as the United States begins its long recovery, Europe and Asia are left to bear the brunt of American profligacy, avarice, regulatory dysfunction, and shortsightedness. According to a research note published by Credit Suisse, the Baltics, Bulgaria, Ukraine, Romania and Hungary "face many of the same macro-economic strains as Iceland, with deep balance of payments deficits and a high ratio of private sector credit to GDP". To these one can add South Africa.

Shifting risk from the private sector to the public one and from one locale (the USA) to others (Europe, Asia) are not long-term solutions. They only postpone the inevitable. The imbalances in the international financial system are such that unwinding them requires a prolonged and painful global recession. In economics, there is no free lunch.

Martin Schubert and his New-York (now Miami) based investment boutique, European Inter-American Finance, in joint venture with Merrill Lynch and Aetna, pioneered the private trading of sovereign obligations of emerging market economies, including those in default. In conjunction with private merchant banks, such as Singer Friedlander in the United Kingdom, he conjured up liquidity where there was none and captured the imagination of businesses on both sides of the Atlantic.

Today, his vision is vindicated by the proliferation of ventures similar to his and by the institutionalization of the emerging economies sovereign debt market. Even obligations of countries such as Serbia and Iraq are traded, though sporadically. Recently, according to Dow Jones, Iraqi debt doubled itself and is now changing hands at about 15 to 20 cents to the dollar.

The demand is so overwhelming that Geneva-based brokerage firm Trigone Capital Finance created a special fund to provide interested investors with exposure to Iraqi paper. Nor is the enthusiasm confined to this former member of the axis of evil. Yugoslav debt is firm at 50 cents, despite recent political upheavals, including the assassination of the reformist and pro-Western prime minister.

Emerging market sovereign debts are irresistible. Some of them now yield 1000 basis points above comparable US Treasuries. The mean spread, according to JP Morgan's Emerging Markets Bond Index Plus is c. 600 points. Corporate securities are even further in the stratosphere.

But with frenzied buying all around, returns have been declining precipitously in the last few weeks. Investors in emerging market bonds saw average profits of 10 percent this year - masking a surge of 30 percent in Brazilian and Ecuadorian paper, for instance. JP Morgan Chase's EMBI Global index is up 19 percent since September 2002.

Nor is this a new trend. The EMBI Global Index has witnessed in each of the last four years an average gain of 14 percent. According to Bloomberg, the assets of emerging market debt funds surged by one tenth since the beginning of the year, or $948 million - compared to $648 received during throughout last year.

The party is on. Emerging market debt is either traded on various exchanges or brokered privately to wealthy or institutional clientele. The obligations fall into categories too numerous to mention: insured and uninsured credits, defaulted or performing, corporate against municipal or sovereign and so on.

A dominant class of obligations is called "Brady bonds" after the former U.S. Treasury Secretary Nicholas Brady. These securities are the outcomes of the rescheduling pf commercial bank loans (sometimes defaulted) to developing nations. The principal of the rescheduled debt - guaranteed by U.S. zero coupon Treasuries deposited by the original issuer in the Federal Reserve or some other credible institution - remains to be fully paid. The interest accrued on the principal until the moment of rescheduling is reduced and the term of payment is prolonged.

Brady countries include Venezuela, Brazil, Argentina, Ecuador and Mexico, to name just a few. The bonds have been trading since 1989. Only one Brady bond has ever defaulted (Ecuador). No interest payment was ever missed or skipped.

As Nazibrola Lordkipanidze and Glenn C. W. Ames observe in their paper, "Hedging Emerging Market Debt", the terms of individual Brady packages vary. Individual countries have issued as few as one, and as many as eight different bonds, each of which can vary with respect to maturity, fixed or floating coupons, amortization schedules, and the degree to which principal and interest payments are collateralized.

The market is besieged by - mostly offshore - mutual funds managed by the likes of Pacific Investment Management Company (PIMCO), AllianceBernstein, Scudder Investments, MFS Investment Management and Mainstay Investment Management.

Emerging market debt attracted entrepreneurial fund managers who set up nimble and agile shop. Ashmore Investment Management was divested to its current owners by Australia & New Zealand Banking Group. Despite the obvious shortcomings of its size - limited access to information and research - it runs a successful Russian fund, among others.

When the United Kingdom based firms, Garban Securities and Intercapital Securities, merged late in 1999, they transferred their illiquid emerging market securities businesses into a common vehicle, Exotix. The new outfit's team was poached from the trading side of emerging markets divisions of various investment banks. Exotix brokers the purchase and sale of fixed income products from risky countries.

Maxcor Financial, a broker-dealer subsidiary of Maxcor Financial Group, is an inter-dealer broker of various securities products, including emerging market debt. It also conducts institutional sales and trading operations in high yield and distressed debt. AIG Trading, of the AIG group, maintains a full-fledged emerging markets team. It boasts of "senior level contacts within many central banks, allowing us to provide rare insight".

Other outfits stay out of the limelight and offer discrete services, custom-tailored to the needs of particular clients. The Weston Group, in operation since 1988, is active in the Mexican market. It does underwriting, private placements and structured finance.

Companies such as Omni Whittington have specialized in "debt recovery" - the placement and conversion of defaulted bank and trade debt from political risk countries. They buy bad debt through a dedicated investment fund, collect on non-performing credits (on a "no cure, no pay" basis) and manage portfolios of loans gone sour, including the negotiation of their rescheduling.

One sure sign of this niche's growing importance is the proliferation of conferences, consultancies, seminars, trade publications and books. Banks and law and accounting firms have set up dedicated departments to tackle the juridical and commercial intricacies of defaulted debt, both corporate and sovereign. International law is adapting itself through a growing body of legislation and precedents. Moody's Investors Service, Standard & Poor's and Fitch regularly rate emerging market issues.

RBC Investment Services (Asia), a business unit of the Royal Bank Financial Group, a Canadian investment bank, advises its clients in their investments in Bradys. Union des Banques Arabes et Francaises, 44 percent owned by Credit Lyonnais and the rest by Arab banks, including the Iraqi Rafidain, is an aggressive buyer of Iraqi and other Middle Eastern debt.

But the market is still immature and inefficient. In an address to the Sovereign Debt Restructuring Mechanism Conference earlier this year, Kenneth Rogoff, Research Director of the International Monetary Fund surveyed the scorched landscape:

"Private debt flows to emerging markets (produce) wild booms, spectacular crashes, over indebtedness, excessive reliance on short-term and foreign-currency denominated debt, and protracted stagnation following a debt crisis. Emerging economies' governments ... sometimes borrow more than is good for their citizens (and are) ... sometimes willing to take on excessive risk to save on interest costs. On the investor side, there is often a reluctance to hold instruments that would provide for more flexibility and risk sharing, such as GDP-indexed bonds, domestic equity, and local currency debt—in part, because of poor policy credibility and weak domestic institutions. The result is an excessive reliance on 'dangerous' forms of debt, such as foreign-currency denominated debt and short-term debt, which aggravate the pain of crises when they occur."

Weak property rights, uncertain debt recovery mechanisms, political risks, excessive borrowing, collective action problems among creditors and moral hazard are often associated with credit-insatiable emerging economies, failed states, erstwhile empires, developing countries and polities in transition.

Signs of trouble abound from Turkey to Bolivia and from Paraguay to Africa. Nigerian President Olusegun Obasanjo said last July that paying civil servants was more important than avoiding default on the country's $30 billion debt. Its Supreme Court ruled in April 2002 that it is unconstitutional to pay down the external debt before all other government expenses. Nor would that be the first time Nigeria reneges. The Paris Club of creditor countries has been rescheduling its debts repeatedly.

This is not to mention Argentina. Its corporate sector missed $4.6 billion in payments in the last six months alone and the country defaulted on a whopping $95 billion in obligations. The conduct of debtors, transparency and accountability are not improving either. Russia all but withheld information regarding a French lawsuit in a  plan to swap $3.1 billion in new Eurobonds for about $6 billion of defaulted Soviet-era debt.

The status of creditors is under further strains by the repeated floating of schemes to put in place some kind of sovereign bankruptcy mechanism. The Bush administration proposed to modify all sovereign debt contracts pertaining to all forms of debt to allow for majority decision making, the pro-rata sharing of disproportionate payments received by one creditor among all others and structured, compulsory discussions led by creditor committees.

The IMF's First Deputy Managing Director, Anne Krueger, countered, in November 2001, with the idea to allow countries to go bankrupt within a Sovereign Debt Restructuring Mechanism (SDRM). Legal action by creditors will be "stayed" while the country gets its financial affairs in order and obtains supplemental funding. Such an approach makes eminent sense.

In opening remarks to the Council of the Americas in November 2001, Martin Schubert offered these observations:

"Talk of adopting bankruptcy procedure protection for governments ... similar to that employed by private companies, could be the match that lights the fire, due to the conflicts such a standstill would create. Moreover, what government debtor would be willing or able to assign assets to a trustee or assignee in bankruptcy, for the benefit of creditors?"

But investors never learn. In a world devoid of attractive investment options, they keep ploughing their money into the high-yield scenes of financial crimes committed against them. This self-defeating tendency is reinforced by the general stampede from equities to bonds and by the slow-motion implosion of the US dollar, partly as a result. Until the next major default, that is.