Don’t know how many of you caught the recent news, but a new Nano (Tata’s ultra-cheap car) spontaneously burst into flames last week soon after its owner drove it off the lot (see Car Fire Raises Safety Concerns for details and a FIERY photo).

When it was launched less than a year ago, the $2,500 Tata Nano was promoted as a safe, ultra-cheap car for poor Indians, an alternative to the motorbikes that zoom precariously around the country.

New questions about the safety of the pint-sized auto are being raised, however, after one of them burst into flames Sunday as it was being driven home from the showroom.

I have no doubt that Tata is trying its level best to develop a car that’s at once affordable and reliable. However, in light of this incident, I can’t help but be reminded of the folly that was the Yugo. The Yugo debuted in the U.S. in the 1980′s with great fanfare, only to disappoint in just about every imaginable way. In fact, a recent book details its ignominious history and goes so far as to label it the worst car in history (see Yugo: The Rise and Fall of the Worst Car in History).

If Tata plans to sell the Nano in developed markets (it has stated that it will), it best make sure that it overcome the quality issues that currently dog it – not only the perceptions, but now, the reality. In fact, after digging a bit deeper into the Nano, I discovered that this was not the first problem of its kind. There have been four similar occurrences. That may not sound like many, but when you’ve only sold 30,000 units, it is more than a minor issue.

Let’s not also forget that Tata is the owner of Jaguar and Rover (see Buyer’s Remorse). Although I am not privy to financial performance data for Jaguar or Rover, my understanding is that the two brands have been underperforming (see Jaguar/Rover Revisited or Indian Firms’ Foreign Purchases). Of additional concern for Tata is that the fallout from Nano spillover to consumer perceptions of Jaguar and Rover.

Add that to Tata’s growing list of headaches…

I am currently out of the country, spending time visiting Tilburg University in the Netherlands. I am working with co-authors on faculty at the School of Economics and Business Administration, and giving a research seminar. My schedule keeps me in Holland for a total of 10 days, moving on to Paris from here. I will be making a brief visit to HEC Paris for a seminar and some meetings, followed by a few days of vacation with my family.

A couple of thoughts/observations about the Netherlands in the few days that I’ve been here:

1. civilized
2. modern
3. architecture
4. bicycles
5. bicycles
6. bicycles
7. rain

OK, I’ll leave you with that.

In the meantime, until I post more regularly,  I’ll share a few things that I’ve been reading of late:

• How will and RMB Revaluation affect China, the U.S., and the World? – Michael Pettis nails this one, going further than many of the analyses that I’ve read about revaluation of the Yuan. His post echoes many of the sentiments that I expressed in previous posts about a sudden revaluation of the Yuan (see China and the Yuan Again and China and the Revaluation of the Yuan). He, like I, advocates for a measured revaluation of the Yuan, but he cautions against inciting a trade war with China. It’s quite a long read, but well worth it.
• Is China the Next Building Bubble? – An interesting compilation of arguments on both sides of the China Bubble debate. Although I was not so much interested in the investment advice (although some might be), I thought the review of existing arguments was very well done. The article is similar to a recent post that appeared on this blog (see Is China a Bubble Economy?), but goes further by providing more detailed data.
• America’s Real Dream Team – Exactly why I see that China (and by extension, developing countries) is still years away from closing the technological capability gap with the United States (see my comments in China Attracting High-Tech Research). I should, however, also point out one thing that struck me about Friedman’s Op-Ed. For those of you who have read Thomas Friedman’s book, The World is Flat: If Friedman is correct in the Op Ed that immigrants help drive America’s relative innovativeness vis-a-vis the rest of the world, then he may be refuting the same convergence effects for which he advocates in his book.
• Enormous Adviser Fees Spark Warning – An article from the Financial Times about how interested parties to M&A deals (namely, investment banks) and their fee structures can create perverse outcomes. The article suggests that “[bankers] fees [are] a “deadweight cost” on shareholders that could swallow a significant part of savings derived from mergers and acquisitions.” Well worth the read. I’ve written a bit about this myself (see A Great Shareholder Ripoff and Why M&A Deals Go Bad).

If you believe everything you read in the New York Times, you’d think that China is about to wrestle away the technological leadership position from Western firms (see China Drawing High-Tech Research from U.S.). There is no doubt that foreign firms are increasingly conducting research in China. But that stylized fact does not tell us anything about the kind of research activities that Western firms are undertaking in China, or its likely impact on the technological dominance of Western firms.

According the Times article:

For years, many of China’s best and brightest left for the United States, where high-tech industry was more cutting-edge. But Mark R. Pinto is moving in the opposite direction.

Mr. Pinto is the first chief technology officer of a major American tech company to move to China. The company, Applied Materials, is one of Silicon Valley’s most prominent firms. It supplied equipment used to perfect the first computer chips. Today, it is the world’s biggest supplier of the equipment used to make semiconductors, solar panels and flat-panel displays.

In addition to moving Mr. Pinto and his family to Beijing in January, Applied Materials, whose headquarters are in Santa Clara, Calif., has just built its newest and largest research labs here.

OK, solid reporting of the facts. The article then continues:

It is hardly alone. Companies — and their engineers — are being drawn here more and more as China develops a high-tech economy that increasingly competes directly with the United States.

Competes with the United States in what exactly?

Jobs? OK, I get that. These are research jobs that might otherwise be located in the U.S. But the fact remains that they could just as easily be located in other countries if not China – Malaysia, Indonesia, or India for example. So just because the facility is located in China doesn’t mean that it’s a zero-sum job competition with the U.S. This is acknowledged in the article:

Mr. Pinto said that the company was readjusting its work force as manufacturing shifted to Asia, but that the Xi’an facility involved a new approach to researching the design of an entire assembly line and was not replacing laboratories elsewhere.

So if it not a direct competition for U.S. jobs, is the article then suggesting that China is increasingly competing with the U.S. in the technological knowledge race? I think that is part of the implication. However, I am likewise skeptical about this conclusion, …and several key nuggets from the article itself discredit such an inference. Allow me to elaborate:

1. The fact remains, an American firm (Applied Materials, Nasdaq: AMAT) is making the investment. The shareholders of AMAT own the rights to the residuals of the local subsidiary. So the profits belong to the American investor. Not only that, but theoretically (although I realize it does not always work this way in practice), any productive knowledge that is developed at that facility likewise belongs to the American parent. AMAT has the right to use that knowledge however it wants and wherever it wishes. The counter-argument has been that knowledge invariably spills over to local firms, the local economy, and even AMAT’s Chinese employees. However, research is increasingly calling those knowledge transmission mechanisms into question. The host country does not benefit nearly as much as some have suggested, precisely because foreign firms are very careful about the types of knowledge they are willing to bring to the foreign country and are keen to protect their most valuable knowledge (not allowing it to leak).
2. Speaking of the types of activities (even if R&D activities) that foreign firms conduct in host countries like China, Western firms often bring low value-added activities to their foreign research facilities. The most valuable knowledge remains in the domestic research facilities (see Globalization Discontents and Globalization Revisited). Even the author of the New York Times article recognizes this: “Applied Materials continues to develop the electronic guts of its complex machines at laboratories in the United States and Europe. But putting all the machines together and figuring out processes to make them work in unison will be done in Xi’an.” So the assembly (low value-added activity) will be performed and researched in China. The design (high value-added activity) will be done in the West. This is consistent with the theory of comparative advantage.
3. The Chinese government is subsidizing the investment. According to the Times, “Locally, the Xi’an city government sold a 75-year land lease to Applied Materials at a deep discount and is reimbursing the company for roughly a quarter of the lab complex’s operating costs for five years, said Gang Zou, the site’s general manager.” You certainly can cry foul and argue that buying (artificially subsidizing) foreign investment is tantamount to unfair competition; but  again, at the end of the day, who is appropriating the value of the investment, China or AMAT (and by extension, it’s mostly U.S. shareholders)? I vote for the latter, as research is increasingly demonstrating that countries that buy foreign investment often do not receive the hoped-for benefits.

So while this article provided a nice read and some interesting factual nuggets about Western firms making R&D investments in China, I am not so sure I agree with the conclusion that, “Of course, China will lead everything.” No doubt, China is a country with a tremendous amount of potential and an increasingly skilled labor force; however, the fact remains that it is many, many years away from closing the technological capability gap with the West.

Paul Krugman echoed the sentiment expressed by Simon Johnson in arguing that the U.S. needs to quit pussyfooting around and finally label China a currency manipulator (see Taking on China).

Tensions are rising over Chinese economic policy, and rightly so: China’s policy of keeping its currency, the renminbi, undervalued has become a significant drag on global economic recovery. Something must be done.

Today, China is adding more than $30 billion a month to its $2.4 trillion hoard of reserves. The International Monetary Fund expects China to have a 2010 current surplus of more than $450 billion — 10 times the 2003 figure. This is the most distortionary exchange rate policy any major nation has ever followed.

And it’s a policy that seriously damages the rest of the world. Most of the world’s large economies are stuck in a liquidity trap — deeply depressed, but unable to generate a recovery by cutting interest rates because the relevant rates are already near zero. China, by engineering an unwarranted trade surplus, is in effect imposing an anti-stimulus on these economies, which they can’t offset.

So how should we respond? First of all, the U.S. Treasury Department must stop fudging and obfuscating.

Twice a year, by law, Treasury must issue a report identifying nations that “manipulate the rate of exchange between their currency and the United States dollar for purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade.” The law’s intent is clear: the report should be a factual determination, not a policy statement. In practice, however, Treasury has been both unwilling to take action on the renminbi and unwilling to do what the law requires, namely explain to Congress why it isn’t taking action. Instead, it has spent the past six or seven years pretending not to see the obvious.

I agree with Krugman and with Johnson (see China and the Revaluation of the Yuan) that labeling China a currency manipulator is likely without repercussion. There is little that China can do but continue to purchase dollar-denominated assets. Dumping its dollar-denominated holdings seems far-fetched, and runs counter to its own self interest.

That said however, and as I’ve argued on this blog before, we must be careful what we wish for when it comes to a yuan revaluation.

Think about the short-term shock to the Chinese economy, which depends upon exports for a good portion of its GDP. By many accounts, exports make up some 25% of Chinese GDP. A revaluation of the yuan makes Chinese exports relatively more expensive thereby decreasing foreign demand for Chinese-made goods. This negatively impacts local production and creates a feedback loop through to domestic employment and wages. In the extreme, this threatens social stability, and China is certainly not the poster-child for social stability.

Not only that, but given the foreign interests and investments in China, it is not entirely clear to me that a yuan revaluation that catapults China into recession would not result in a global contagion effect. Supply chains are so interconnected around the globe that an upward price movement for intermediate and finished goods coming out of China could have dire consequences for Western companies that rely on Chinese-sourced goods (just ask Wal*Mart).

I certainly agree that it is in the long-term interests of the U.S. for China to address its imbalances via some kind of yuan remediation. It is also in China’s best interest. However, the near term economic adjustments associated with a significant rise in the value of the yuan could be painful, not just for China, but for the rest of the world as well. In addition, a sudden rise of the Yuan could be socially destabilizing for China. Given China’s already tenuous political and social situation, it is therefore difficult from a policy standpoint for Chinese politicians to justify decisions that might not be in their own near-term interests (and swallow the pill so to speak), …even though they recognize the problem.

But I agree that it likely won’t hurt to call China out.

Nevertheless, when China does finally revalue their currency, my recommendation is that it proceed with caution. A gradual revaluation to competitive levels over a number of years is probably the best outcome for the global economy.

The answer, obviously, is yes. The question now is what form those increased rights will take, and what the consequences will be for publicly-traded companies and their management. Tara Siegel Bernard at the New York Times penned an interesting article about Shareholder Democracy in which she addressed some of the salient issues (see Voting Your Shares May Start to Matter).

What would happen if all the small investors banded together and cast their ballots during proxy season, the time of year when all shareholders get to vote on corporate issues? How much of an impact would they have?

Until recently, the votes of small investors — the ones who didn’t just throw their ballots in the trash — were largely meaningless. Even if they were angry about soaring executive pay and risky business practices, there was little they could do.

Sure, in theory, investors could vote for the people who serve on the board, many of whom are paid handsomely to oversee management and set executive pay. But investors don’t have any say on the nominees. Nor do they have much of a real choice even if they do vote. Say you withhold a vote for a candidate running uncontested. It doesn’t matter, since directors can win without a majority.

And if you chose not to vote? Your broker is allowed to cast your ballot without your permission, and brokers typically vote in line with management.

So much for shareholder democracy.

But the tide is beginning to turn, albeit slightly. In recent years, more companies have adopted a “majority rules” requirement…And starting this year, brokers can no longer vote shares held in their customers’ accounts without permission.

Investors would also stand to benefit from the so-called Shareholder Bill of Rights, legislation proposed by Senator Charles Schumer of New York and Senator Maria Cantwell of Washington…

One provision…would make it easier for certain investors to nominate independent directors to corporate boards, or what is known as proxy access.

The Senate proposal would [also] require that candidates for director receive at least half the vote in an uncontested election and require all directors to face re-election annually (unless shareholders approve otherwise). It would also give shareholders a so-called say on pay, which is a nonbinding vote on executive compensation practices.

More companies are beginning to do this voluntarily, and corporate governance experts say these votes can actually help curb excessive pay.

I am generally supportive of increasing shareholder rights. After all, shareholders are the rightful owners of the corporation, and as such, deserve to have a say in its direction.

That said however, and as I have argued before, we have to be careful what kinds of rights we bestow to what kinds of shareholders, …especially those we are willing to grant to shareholders of the short-term “trader” variety (see Different Stock Classes). As I pointed out in that post, there is an increasing wedge developing between investor/owners and investor/traders.

Historically, shareholders were individual company owners (often dispersed) who held stock for long periods of time. Today, the picture is quite different. Shareholders are represented less and less by individuals holding stocks for the long-term, but by institutions looking to make a quick buck – buying and selling with incredible frequency. The rise of such “traders” (those who seek to profit from near-term volatility in stock prices) has changed the nature of the system. Whether they be institutional or individual, it seems that there is a large class of traders (not investors) today who are looking to profit from the tiniest movement in share price. These traders are inconsistent with the spirit of the view of the shareholder as owner. They are not really “owners”, and often do not even necessarily care about the survival of the firm. They only care about micro-movements in share price.

To the extent that we end up granting increasing rights to investors of the institutional “trader” variety, we might end up with a system that wreaks havoc for corporations and their management. In the extreme, it could create an environment in which management spends too much time and attention fending off proxy attacks and not enough on the tasks with which “owners” have entrusted them in the first place – running a sound business so as to maximize profit over the long-term.

The Economist ran an interesting article that proposed a solution to short-termism, a serious problem afflicting capitalism (see A Different Class). According to the Economist:

The spectacular collapse of so many big financial firms during the crisis of 2008 has provided new evidence for the belief that stockmarket capitalism is dangerously short-termist. After all, shareholders in publicly traded financial institutions cheered them on as they boosted their short-term profits and share prices by taking risky bets with enormous amounts of borrowed money. Those bets, it turns out, did terrible damage in the longer term, to the firms and their shareholders as well as to the economy as a whole. Shareholders can no longer with a straight face cite the efficient-market hypothesis as evidence that rising share prices are always evidence of better prospects, rather than of an unsustainable bubble.

I guess what the author is suggesting is that if equity market participants could have anticipated the long-term consequences of managerial action of this sort, they would have punished those engaging in such behavior, but they cheered them on by bidding up share prices instead. OK. Fair enough. A lot of ink (pixels?) has been spilled criticizing the efficient market hypothesis on this count.

Nevertheless, I agree that short-termism is a real problem. I’ve written a bit about too, but mostly with respect to how it impacts executive pay (see Revisiting Executive Pay, The Credit Crunch and Executive Pay, or A New Approach to Executive Compensation). I have made the following point, or something closely related, in each these posts:

…let’s not forget about the accounting assumptions about the firm. The standard assumption in accounting is that firms have an infinite lifespan. They are assumed to be around forever. Moreover, in finance we assume that firms should maximize the net present value of all future cash flows. However, there is a fundamental disconnect between some of these assumptions and the state of the world. Although the firm is supposed to be around forever, human beings are not. The average lifespan of the homo sapien is around 70 years. And if you consider the lifespan/tenure of a typical CEO (now less than 4 years), the picture looks even bleaker. This creates a severe incentive problem. If I’m a typical CEO, what incentive do I have to look out for the best long-term interests of my firm? After all, I’ll probably only be around here for a few years. In this sense then, CEO’s have an incentive to increase near-term performance sometimes at the expense of long-term performance.

But I also recognize that the investment environment around the CEO has changed quite drastically, and that the CEO is often making seemingly rational decisions given the structural environment he or she faces coupled with his or her pecuniary incentives. For example, I wrote in Revisiting Executive Pay and echoed in an Op-Ed at the IB Times (see Executive Pay: The Problem is Systemic):

…we need to ask ourselves, “Who are shareholders?” Although seemingly a silly question, the answer has important implications for corporate governance and executive pay. Historically, shareholders were individual company owners (often dispersed) who held stock for long periods of time. Today, the picture is quite different. Shareholders are represented less and less by individuals holding stocks for the long-term, but by institutions looking to make a quick buck – buying and selling with incredible frequency. The rise of such “traders” (those who seek to profit from near-term volatility in stock prices) has changed the nature of the system. Whether they be institutional or individual, it seems that there is a large class of traders (not investors) today who are looking to profit from the tiniest movement in share price. These traders are inconsistent with the spirit of the view of the shareholder as owner. They are not really “owners”, and often do not even necessarily care about the survival of the firm. They only care about micro-movements in share price.

What’s more, with institutions [more] interested in trading than in ownership, the incentives of the institutions align with those of the CEO’s. That is, with institutions looking to make a quick profit, short-termism on the part of the CEO is not only condoned, but sometimes encouraged.

The Economist not only echoes that sentiment, but provides supporting evidence for the changing investor landscape:

In the early 1980s shares traded on the New York Stock Exchange changed hands every three years on average. Nowadays the average tenure [holding shares] is down to about ten months. That helps to explain the growing concern about short-termism.

In the past I offered some ideas for how to deal with the short-termist problem via executive compensation – restricted shares instead of options, board mandates, say on pay, etc. The author of the Economist article proposes an alternative that attacks the problem from the equity-market side via dual-class shares (one set of shares for investor/owners and one set of shares for trader/owners).

If the stockmarket can get wildly out of whack in the short run, companies and investors that base their decisions solely on passing movements in share prices should not be surprised if they pay a penalty over the long term. But what can be done to encourage a longer-term perspective? One idea that is increasingly touted as a solution is to give those investors who keep hold of their shares for a decent length of time more say over the management of a company than mere interlopers hoping to make a quick buck. Shareholders of longer tenure could get extra voting rights, say, or new ones could be barred from voting for a spell.

Dual-class shares are nothing new. Neither are shares with uneven voting rights. However, the evidence thus far is inconclusive with respect to the effectiveness of dual-class and/or vote-differentiated shares on firm performance. If anything, the academic literature suggests that they don’t always work in practice as they are intended in principle. It has been well documented that the holders of shares with greater control (ownership) rights can take advantage of the holders of shares with fewer control rights. Research demonstrates that firms with dual-class shares make decisions that are often not in the best interests of minority shareholders, especially when it comes to private perquisites, compensation, and investments.

That said however, I don’t think this is a reason to dismiss the idea of dual-class shares offhand. I think that the principle underlying the idea is a good one. If we can find some way to build in protections for minority shareholders, or to implement executive compensation plans that provide managers greater incentives to maximize for the long run, there just might be something to it…