Not what it was

Feb 8th 2007

From The Economist print edition

Howard Read

European business has improved out of recognition

WHAT with accounting scandals at Ahold and Parmalat, bribery allegations against Siemens, corruption at Mercedes, Brazilian prostitutes laid on for a Volkswagen board member and a legal challenge to a pay-off bonus at Mannesmann, European business has been having a torrid time lately. Now a criminal investigation has been launched into alleged insider share dealing at a sensitive time at EADS last spring. Meanwhile protectionism has blocked cross-border takeovers, and labour-market reforms in France and Germany have stalled.

But at the same time European business and finance has seen huge changes for the better. Europe's strength in financial services is evident not just in the City of London, which since the Big Bang liberalisation of British finance 20 years ago has expanded into the old docklands area of Canary Wharf to accommodate the flood of foreign banks that have poured into London. Strong contenders are beginning to emerge in continental Europe too. Retail banking is still too fragmented along national lines, but rationalisation in insurance has created global outfits such as France's AXA, Germany's Allianz and Italy's Generali.

Compared with America, Europe is doing very well in many service industries. Nokia, Sony Ericsson, Vodafone and Telefonica are global forces in mobile telephony. Europe's airlines make money whereas America's stagger in and out of bankruptcy. At least two failing European flag-carriers, Sabena and Swissair, were allowed to go irrevocably bust, and Air France and KLM have successfully merged. British Airways, one of the world's most profitable airlines, has a market capitalisation one and a half times that of American Airlines, the world's biggest carrier by number of passengers. EasyJet and Ryanair, two lowcost airlines, took an American business model and made it fly, and about 50 start-ups are trying to do the same. European logistics and freight giants such as DHL, TNT and Kuehne + Nagel are challenging America's Fedex and UPS.

At the same time Europe is becoming ever more integrated into the global economy, with emerging countries such as Brazil and India adding to the inward investment into the continent that has traditionally come from America and Japan. Next it will be the Chinese investing in Europe as they set up distribution and marketing networks for their own products.

European manufacturing companies too have begun to overhaul themselves. In addition to the radical reshaping at companies such as Philips and Siemens, the car industry has recast itself from a regional into a global mould, led by BMW, Mercedes and Audi. Renault became global through its partnership with Nissan and might yet be the saviour of Ford. Volkswagen is a leader in the Chinese market. Japanese and

South Korean investment in Europe is forcing local firms to match the incomers' productivity and quality. Katsuaki Watanabe, chief executive of Toyota, the world's best car company, has acknowledged that even his firm has to try harder to keep up with these new rivals. It is globalisation in action.

It's all coming together

But the renaissance of European business also owes much to a change of climate in Germany, where many firms are now striking local deals with trade unions to get round inflexible labour practices. Workers at Volkswagen, fearful of losing their jobs, have in effect accepted pay cuts by agreeing to work longer hours for the same money. German firms are investing again after a long pause, profits as a share of national income are rising and business confidence is higher than it has been for years. Some of the reasons behind Germany's recent revival have implications for the whole continent.

The resilience of German business has allowed it to survive a dismal period for the German economy when the bills for unification came in. Germany has always had a rigorous tradition of technical education, which has suited companies concentrating on capital-intensive advanced engineering industries. The country also has a long tradition of exporting advanced products, and not just luxury cars and power stations. The world's biggest industrial-gases company is Germany's Linde; its biggest chemical company is BASF, which has defied the trend for such firms to fragment, as Britain's ICI did. There are other examples in specialist areas, such as Munich's Knorr-Bremse, the world's leading maker of railway brakes.

The struggle in the 1990s to overcome the disadvantages of a strong D-mark sharpened the competitive edge of many German exporters, whereas the Italians relied on devaluation. Since the arrival of the euro German companies have been much more disciplined than British or Italian firms about holding down wages, so they have sustained their advantage. For instance, at Opel, the German arm of General Motors, German workers have sacrificed pay and increased their productivity to hold on to their jobs, whereas the company's British factory on Merseyside has shrunk and may face closure in a couple of years. Ordinary Germans may have found the going tough in recent years, but German business has managed to retain its global competitiveness.

One reason for that may be changes in the financial sector as the country has started to move from a conservative, bank-based capitalism to a more entrepreneurial capital-markets system. The old model served German business well until the 1990s because it meant that companies had stable shareholders willing to stick around for the long term. Companies could plan and invest for the future without worrying too much about short-term ups and downs, which helped many leading German companies to develop and grow. But it has outlived its usefulness.

The new openness in the financial sector has three main causes. First, the introduction of the euro made it easier to compare the performance of different banks, exposing the German ones' low margins. Second, the Basel II accord on banks' reserve assets, due to come into effect next year, is already forcing German banks to pay more attention to the quality of their loan books. And third, the scrapping of the state guarantees enjoyed by Germany's state-owned Landesbanken and Sparkassen, at the insistence of the European Union, has acted as an incentive to banks to improve their profitability.

According to Paul Achleitner, chief financial officer in charge of investment at Allianz, German unification meant that for the first time in decades Germany needed to import capital rather than having enough to spare to export it. “Local banks stopped lending money at subsidised rates and companies needed to raise funds on the international markets. This meant they had to adapt to international norms in everything from accounting to managing for value and concentrating capital in core businesses. Slowly but surely we are seeing the dismantling of Fortress Germany; German companies are now among the most competitive in the world.”

The era of the stolid, traditional Deutschland AG (Germany Inc) is drawing to a close. According to Dirk Schumacher of Goldman Sachs, the collapse of the tech bubble and Germany's tax reform in 2000 were contributory factors. The bubble showed up the weakness in the core lending business of German banks, and the tax reform at last enabled banks to sell their long-standing shareholdings in German companies without incurring huge capital-gains tax bills.

But some observers think Germany has got it only half-right; it still

Howard Read

needs to reform its labour market and its welfare system. According to Hans-Werner Sinn, head of the Ifo Institute, an economic-research centre in Munich, Germany needs “more wage negotiation on the level of the firm. The majority of workers in a firm must have the right to override union decisions if they do not like them.” He also thinks welfare should concentrate on topping up low wages rather than providing a substitute income for those not prepared to work at lower rates.

A new way of doing business

Another financial factor that has made a difference is private equity, which from tiny beginnings only a few years ago has grown into an important force. In 2005 about €72 billion was raised in new capital in Europe, well over double the amount in 2004, according to PricewaterhouseCoopers and Thomson Financial. Most of that, €57 billion, was for buy-outs of existing firms. Of the rest, €10.9 billion was for new ventures and €3.6 billion for high-tech investment.

Different countries had different preferences: in Sweden and Britain 93% of the funds went into buyouts, whereas in Germany only 43% was used for such transactions and 26% went to high-tech firms. In Switzerland the share of high-tech investment was as much as 87%. Most of this money comes from Britain (29%) and America (24%). Pension funds are now overtaking banks as the main source of finance because they are under pressure to invest some of their funds in something other than bonds and quoted equities.

The total invested by these funds was also a record, at €47 billion, spread over more than 7,000 separate companies. About two-thirds of the money was spent on buy-outs. Venture capital aimed at business start-ups accounted for just over a quarter of total investment, but accounted for three-quarters of the deals.

Critics think that private equity can be dangerous, burdening firms with debt and stripping out cash to pay the new owners a disproportionate return. Private-equity firms are inclined to move uneconomic production offshore, breeding strong resentment about job losses. And although they will probably have a great year in 2007, those critics argue, they may not be able to maintain that performance.

Others are more sanguine, pointing to the improvements in governance and management private equity usually brings with it. It is not afraid to take difficult decisions that family-owned and listed companies often shy away from. For Dominique Senequier, the boss of AXA Private Equity in Paris, it has an important role to play in making European business more competitive. For example, this might be done by “several companies in private-equity ownership getting together and then returning to the stockmarket”, she says.

Europe's politicians may still be talking of fostering champions, but European companies are streets ahead of them. They were already beginning to reform themselves to meet global competition; now the new financial-market capitalism is giving them a further boost. That new financial underpinning will dispense with the need for the old protectionism.

Some analysts think that changes in Europe have not gone far enough and that America will always lead because its open economy provides the best example of what the (European) economist Joseph Schumpeter famously called “creative destruction”. Last year's Nobel prize-winner for economics, Edmund Phelps of Columbia University, thinks that Europe will continue to lag in productivity and innovation because it has stuck to a corporate model of capitalism that takes the wishes of government and workers into consideration. But much of European business already operates outside its home country, far from the constraints of the old corporatism—which is anyway beginning to wane. The

changes may not be as dramatic as in America, but they are reforming European industry and producing returns for shareholders to rival America's.

Although Europe will continue to lose old jobs in basic manufacturing, it will gain new ones in high- added-value industries and in services. Germany and France need labour-market reforms to introduce more flexibility, not to save old manufacturing industries but to foster new service ones. Now that global free trade is a reality and the rigid old financial structures are being swept away, things will change for the better. European business is on the move again.

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