The prospect of a resurgence in world growth has been beneficial to the Australian dollar as the market focused on the traditional relationship between the currency and commodity prices. From a low of 71 cents to the US dollar at the beginning of July 1995, the currency ended the year at 79 cents, a gain of over 10%. Against formerly "hard" currencies such as the yen and Deutsche mark block, the Australian dollar was even stronger. The effect of our strong currency is to reduce the underlying gains from international investment. In Australian dollar terms, the Morgan Stanley Capital International (MSCI) World Index rose a mere 7.2%. Fortunately the fund's portfolio was well positioned in anticipation of a rise in the US and Australian dollar and the adverse impact was minimal, hence the portfolio outperformed the index by 5%, at 12.2% before tax.

This result was achieved despite the decision to hedge our US shareholdings by selling S&P 500 futures contracts. In retrospect, this was a poor decision and reduced the portfolio return by nearly 6%. This cautious view was predicated on the belief that investment markets were facing potential dislocation from currency turmoil and that the market which had seemingly been unaffected by these events would come under pressure as its currency appreciated. Moreover we believed (and still do) that in a low inflation environment companies will struggle to raise earnings because of pressure on selling prices. As it transpired, companies produced surprisingly good earnings (because of lower interest rates and high productivity) which together with bountiful liquidity resulted in an uninterrupted surge in share prices. Exacerbating our position was the market's emphasis on immediate earnings visibility which is generally not a characteristic found in value stocks. This was the year of big popular so-called blue chips. Many of these companies have seen their price earnings ratios rise to levels not seen since the days of the "nifty fifty" back in the early 1970's. It is our experience that in very strong liquidity-driven markets, less visible stocks tend to lag the general indices. As you are aware, our speciality is to fossick around in less well trodden ground.

Disposition of Assets

Region	30 June 1996	30 June 1995
Japan	31.0%	10.0%
Western Europe	25.7%	19.1%
North America	14.5%	30.7%
Other Asia	9.5%	10.7%
South America	5.2%	9.5%
Australia	3.4%	4.4%
Eastern Europe and Russia	- *	2.8%
Africa	0.5%	1.0%
Total Invested	89.8%	88.2%

* The profit attached to the Russian investment were realised in June 1996. This realisation assists in obviating the need for expensive tax administration with regard to foreign investment funds (FIF's). We have since reinvested in Russia.

Portfolio Changes
You will know from the quarterly reports that we have been building up our investments in both Japan and Europe and reducing our investments in the USA. We categorise our holdings in Japan in two classes; those benefiting from a weaker yen and those that will gain from a recovery/restructuring of the domestic economy. The former includes names of well known companies such as Canon, Fuji Photo Film, Citizen Watch and Matsushita (maker of National Panasonic, JVC and Technics). The other group includes the local Coca-Cola bottlers, Sekisui House (the premier house builder) and some leading pharmaceutical companies.

The Korean holdings have been reoriented towards banks and stockbrokers, with the sale of Hyundai Marine & Fire and LG Insurance. The share price of these insurance companies had doubled on the back of strong premium growth and an improved regulatory environment.

In Europe, we added Olivetti and ENI in Italy, Lyonnaise des Eaux, Lagardère and Banque Nationale de Paris (BNP) in France and Deutsche Bank and Daimler Benz in Germany. The later two investments are described more fully on page __.

The reduced exposure to North America came from a significant unwinding of the position in the Airlines, the sale of Dow Jones, Apple, Masco and Quno, and the trimming of IBM. The significant addition has been Novell.

In South America we took our profits on Brahma, Petrobras and Telebras, while adding to Souza Cruz and the bank/insurance companies.

The composition of the Australian portfolio has changed with the sale of Burswood Property Trust and Hills Motorway. Mobile Communications had a successful listing in June at $2.50 per share versus the initial subscription price of $1.00.

Top Ten Holdings (as at 30 June 1996)

Stock	Country	Industry	% Holding
Fuji Photo Film	Japan	Photographic Products	5.5%
IBM	USA	Information Technology	4.0%
Canon	Japan	Office Equipment	3.2%
Matsushita Electric	Japan	Consumer Electronics	3.2%
Sekisui House	Japan	Housing	3.2%
Tabacalera	Spain	Tobacco	3.2%
Olivetti	Italy	Computers/Telecoms	3.2%
Yamanouchi Pharm.	Japan	Pharmaceutical	3.0%
Mobile Comm.	Australia	Telecoms	2.5%
Novell	USA	Networking Technology	2.4%
TOTAL			33.4%

Current Investment Themes
The case for the Japanese companies was described in some detail in earlier correspondence so you will not be burdened with further detail here.

As for Europe, there are many obvious obstacles in the way of restructuring but we believe sight should not be lost of the inherent strengths of the companies. These range from their already established global presence, their large market shares, widespread brand recognition and so on. There is also clear evidence of change. Government spending is being re-evaluated, with many long cherished and often abused schemes being curtailed. At the company level, apart from re-engineering processes, firms are adopting concepts such as performance related pay and stock options for the first time.

There is no ready formula to identify the winners in this process of change. Most Continental companies started to reappraise their structures as they entered the nineties - goaded by persistent strengths of their currencies and the removal of barriers to free trade. The companies we favour tend to be among the larger multi-nationals on account of their entrenched positions, depth of management and resilient balance sheets. These qualities can of course impede change and we run the risk of underestimating the difficulties involved and misreading the magnitude and duration of the adjustment period.

The risk with some of the smaller companies is that they have relatively narrow business bases and many are seeing some of their historic advantages starting to fade. For example, several of the specialist engineers that we have visited in Germany and Switzerland are finding new competitors emerging in Asia who are undercutting their prices by 30% or more. Some of this may be transient as it relates to recent currency strength, but in a way these companies carry all the burdens of breaking technical barriers only to find their new competitors hitching a ride on their endeavours. Although many of these companies have share prices at 10 year lows, we are inclined to avoid them for the moment. We would rather concentrate on companies with some pricing power derived from brands with international spread.

Another 20% of our assets are evenly dispersed between Korea, Indonesia, Brazil and Russia. Starting with Russia, shareholders will be aware that we regard this as one of the few remaining emerging markets with all the attendant volatility. We have seen this investment rise 50% within three months of purchase and then fall back two-thirds. At present it is well above our initial entry price and with Yeltsin's re-election to the Presidency, Russian economic resuscitation looks promising. However, we would be surprised if there were no further power struggles in the Kremlin with temporary adverse consequences for our investment. The gradual progress being made on tax and company law reform is encouraging.

Like Russia, Brazil's reforms face the perverse headaches of a resource rich, large country. Fortunately the process is past stalling point, though reforms to the social security system and administration have lost momentum. As the economy gradually expands, we can see enormous potential in credit growth in the private sector which is virtually debt free.

Our Indonesian stocks have put in a motley performance. Astra, the country's largest car and truck assembler, was harmed by the government's edict to launch an "Indonesian car", initially to be built in Korea! This latter enterprise is part owned by the family of the President. However, there has been much consternation expressed by the US and Japanese trade officials and the proposal has now been diluted. Jaya Real Property and Smart continue to benefit from the fast growth in consumer spending.

The Korean market is suffering from the deterioration in the competitiveness of its exports in the face of a weakening yen. As was noted last quarter, we believe that the financial sector will be the principal beneficiary of the transformation of this economy. The banks have been through a torrid time of bad loans following the Government-directed lending of the previous boom but these loans are now provided for and interest spreads are widening as these companies are free to allocate greater resources to the consumer market. Our research suggests that the banks are on the cusp of a major boom in consumer lending, similar to that witnessed by Japan in the early eighties. This should result in extraordinary earnings growth over the next five years.

The recent rise in volatility of Wall Street, the change in leadership away from the technology stocks and some evidence of earnings disappointment - all in the face of high real interest rates, encourages us to maintain our hedge against the US holdings of the portfolio. Should the US market sell off, we would expect other markets to experience some weakness in sympathy. Nevertheless, we derive comfort from the fact that many of the companies we own are priced modestly in relation to their historic valuations and hold the prospect of strong earnings growth over the next three years.

Currencies
The portfolio is hedged out of the yen and hard European currencies. Half of the company's assets are denominated in Australian dollars by currency hedges.

For readers who follow our regular stock stories, below is a list of the stocks we have featured since our first quarterly report and their subsequent price action.

STOCK	INDUSTRY	COUNTRY	ENTRY PRICE EXIT * OR CURRENT PRICE	% CHANGE
American Airlines	Airlines	US	54.17 $US 89.92 *	66%
Apple	Computers	US	28.16 $US 34.45 *	22%
Brahma	Brewery	Brazil	0.2236 BR 0.4824 *	116%
Delta Airlines	Airlines	US	50.29 $US 83.00	65%
Dow Jones	Information Technology	US	37.99 $US 39.56 *	4%
Fuji Photo Film	Photographic Products	Japan	2070 ¥ 3460	67%
IBM	Computers	US	57.26 $US 99.00	73%
Jinro	Spirits	Korea	25000 W 17300	(31%)
Olivetti	Computers/Telecoms	Italy	1117 IL 823	(26%)
Pharmacia	Pharmaceuticals	Sweden	117 SK 197 *	68%
Schlumberger	Oil Production	US	65.97 $US 79.00 *	20%
Smart	Commodities	Indonesia	1791 RP 1650	(8%)
Tabacalera	Tobacco	Spain	3147 SP 6450	105%
Western Atlas	Oil Production	US	46.56 $US 58.25	25%

PLATINUM CAPITAL LIMITED ANNUAL REPORT

CHAIRMAN'S REPORT - 30 JUNE 1996

Investment Performance
Platinum Capital Limited, as an investment company, is to be judged by its investment performance. By this I mean the change in the Net Asset Value per share over time. In the year ended 30 June 1996, the NAV rose to $1.1155 per share, from $1.0385 at the beginning of the year, an increase of 7.42%. The NAV figure is calculated after providing for all tax liabilities; both realised and unrealised.

Before allowing for tax, the increase was 12.21%. By way of comparison, the Morgan Stanley Capital Index (MSCI) which is often used as a benchmark for performance of international investment funds, was up 7.25% for the same period. (The MSCI is a pre-tax measure).

Looking at the two year performance of the company since its inception, the Platinum NAV is up 26.84% on a pre-tax basis, the MSCI Accumulation index up 22.27%. The relative performance of these two measures over time is shown in Chart 1 below.

In judging this performance, we rate it as not bad, but below our aspirations. International markets were again volatile, with trends that were often contradictory - the kind of situation that sorts out the better managers from the others. This environment resulted in the relatively low absolute gain in the MSCI (7.25%) and Platinum has done well to substantially out-perform that result. On the other hand, Platinum suffered during the year from a short position in the US market intended to give some protection to the portfolio. This position cost the portfolio about six percentage points in pre-tax performance.

Share Price
The share price movement over the year has been most disappointing. It was $1.14 in August last year and is now $0.92. In the last analysis we cannot do a lot to influence the share price. Theoretically it should be close to NAV per share and move with it but, in practice, it does not. The movement in these two measures over the last two years is recorded in Chart 2 below, which shows fairly wide swings in the share price from a premium over NAV at some moments in the past to a fairly substantial discount at the present.

Options
On 1 July 1996 the right to exercise options on shares at $1.20 per share fell due. As the share price at that time was well below the price at which the options could be exercised, the company advised option holders not to exercise, and none were.

Dividends
Last year Directors told shareholders that their dividend policy would be to start with a relatively modest dividend payment that could be built up over time. In addition, dividend policy would take account of franking credits and distribute them over time.

This year, the company recorded an operating profit after tax of $13.04 million. While this figure is not really relevant to the company's performance (profits or losses are a function of what investments were sold in the year and are, in that sense, arbitrary), it is relevant to the company's capacity to pay dividends.

Directors are recommending two dividend payments. The first is an ordinary dividend of 2 cents per share, fully-franked. The second is a special dividend of 4 cents per share, also fully-franked, to pass on some of the accumulated franking credits. The balance of the franking account after these dividends stands at about 13 cents per share.

Share Buyback Powers
The Platinum share price is currently selling at a fairly substantial discount to NAV. Directors have determined that there may be times when it is in the interest of all shareholders for the company to be able to buy back its own shares at the prevailing market price. Typically, this would occur when the market price represented a substantial discount to NAV.

Currently, the Articles of Association and the Corporations Law permit the purchase of 10% of the company's issued shares in any one year. We are seeking your approval to be able to buy back up to 20% of issued shares in any one year.

We hope that the exercise of this power from time to time will have two positive results. Firstly, it may minimise the times when the share price trades at a meaningful discount to NAV and, secondly, purchases at a substantial discount will raise the NAV itself.

Outlook for 1996/97
The year ahead will not be an easy one in which to achieve strong investment returns. In many markets around the world, most importantly in the United States, good value is hard to find. Apart from lack of opportunities, this creates an element of vulnerability in these and other markets. Our investment approach will reflect this view.

Articles Preface
Last year we tried to give readers some insight into our investment process. We described the desk activity of gathering information, analysing it and preparing ourselves for field trips. This was followed by some light treatment of our experiences on the road, visiting various companies.

To develop this theme further, we decided to incorporate some pieces that we digest in the process of formulating investment ideas. While much of our time is spent on assessment of individual companies, there is also a need for us to keep abreast of broader issues, be they political, economic or technological.

Over the last 10-15 years there has been a discernible increase in the quantity and sophistication of services provided to global fund managers. In earlier times, an international fund manager would use the services of an economist together with his own understandings of the market in formulating views about the prospects for investment in a global sense. The information was relatively scarce and rudimentary. This has changed with the emergence of investment strategists. Generally working in teams, they brew up a concoction of economics, history back-tested models and measures of market sentiment. Thus we find large broking houses employing not only regional but also global investment strategists who produce intensive studies in their attempts to predict the future. The real value to investment managers from these writings is the triggering of ideas rather than necessarily the conclusions.

To elucidate this aspect of our work, we have included three pieces from prominent strategists. Each of these writers is highly regarded and each writes from a slightly different perspective. The first piece by Jonathan Wilmot of brokers, CS First Boston, reminds us of some of the similarities between now and the turn of the last century. Alexander Kinmont's piece on Japan and Soviet Russia: Ideological Twins is an abridged version of a scholarly article that will help readers understand many of the supposed contradictions within the Japanese economy. Alexander is the Japanese market strategist with Morgan Stanley. The last article is produced by David Roche of Investment Strategy and deals with the controversial issues of European Monetary Union. (David was formerly with Morgan Stanley and now operates his own consultancy).

Though these writings may seem laborious, I think the insights you will derive will be worth your time.

JAPAN AND SOVIET RUSSIA, IDEOLOGICAL TWINS

Soviet Russia: An Appealing Model In The 20s
Japan was fighting Russia in North Manchuria up to 1934. From 1928 to 1938 Russia was the fastest growing major economy in the world - not a comforting prospect for a Japan which "mindlessly extrapolated" such growth into the future, just as did later observers in the 1950s. It did not escape Japanese notice that 1928 was the year in which Stalin promulgated the first five-year plan - creating the first control economy in the world. Moreover, the domestic situation was fertile ground for economic theories that appeared to surpass cold-hearted capitalism. The 1927 stock and property market collapse left around 3 million unemployed.

1940 - The End Of Liberal Capitalism In Japan
Manchuria was an offshore laboratory - experience acquired there had still to be transferred back to Japan. During the late 1930s control economy measures seeped into the legal system under cover of the war effort. Nevertheless each new element of control seemed inadequate to the Manchurian returnees. The final battle over economic development came in 1940, as the fight was joined over a new commercial code. Kishi Nobusuke - post-war Prime Minister, but then jimujikan or chief bureaucrat at the MCI, MITI's (The Ministry of International Trade and Industry) forerunner - clashed with his minister at MCI, Kobayashi Ichizo. Kobayashi was a serious capitalist, responsible for the foundation and expansion of the Hankyu group. Kishi on the other hand was a pragmatic ideologue - a characteristically hard Choshu man who had been the chief economic bureaucrat of Manchuria.

With Kobayashi out of the country in 1940 - incidentally trying to break the oil embargo of Japan - Prime Minister Prince Konoe, Mr Hosokawa's ancestor, slyly demanded that ministries present their plans for reform. Kishi had fortuitously at hand precisely such a blueprint, based on solid Manchuria/Soviet economics, in the September 13, 1940, Cabinet Planning Board's "General Plan for the Establishment of the New Economic Structure". As can be imagined, capitalists rebelled at proposals which gave complete control of investment and profitability to the state, arguing that the CPB was full of "Reds". Though this incident ultimately led to the resignation of Kishi - who later admitted that he always was "a little red", and the interests of private capital were able to secure a purge of the most obviously "red" CPB officials, the defeat of western-style capitalism in Japan was quickly encompassed.

No Change In 1945
It was the outright incompetence of the Occupation, which closed off, perhaps for ever, Japan's way back to a more obviously recognisable form of capitalism. By dissolving the zaibatsu and purging 210,000 Japanese, mainly business and military men, from public life, the Occupation destroyed the possibility of any cohesive representation of the interest of private capital against the state. By contrast, only nine Ministry of Finance (MOF) officials were purged. In an unusually elegant essay in Chuo Koron in 1977, Sakakibara Eisuke and Noguchi Yukio argued that "the preservation of the wartime financial controls, together with the failure of the Occupation authorities to reform the financial sector extensively, proved to be of decisive importance in determining the pattern of Japan's economic expansion". They noted then - and it is still true today - that there had been no significant change in either the number of banks or the structure of the banking industry. It still retains its wartime form. If the banking system retains its wartime form, though there have been changes on the periphery, it is hardly surprising that the overall orientation of the economy is unchanged. The overall orientation of the economy is to acquire production capabilities, not to generate profits.

The ideological foundations of the economy remain unchanged. Let us go back again to 1940. The key propositions of the New Economic Order were as follows: the separation of the ownership of capital form the exercise of management in order to co-ordinate the aims of business and the aims of the state; revision of the Bank of Japan (BOJ) articles in order to increase the power of the BOJ to direct bank credit; mobilisation of the public in order to raise the savings rate; low interest rates in order to help capital-intensive industry; and overall revision of labour relations.

The separation of the ownership of capital from the exercise of management was rendered absolute by the destruction of the pre-war equity primary market and the corporate bond market. This was the aim of the revision of the BOJ law - still in force today - which gives the bank's objective as "the appropriate application of the state's total economic power".

Equity - Anathema In Japan
The system reached its apotheosis post-War - the fragmentation of the zaibatsu increased the power of the group bank relative to the corporation. Whereas stock issues had contributed 68% of external corporate financing in 1935, they contributed only 10% in 1963, when rapid post-war growth should have suggested much greater reliance, and never more than 14% ever since. Direct bank finance accounted for only 31% of industrial fund raising in 1931 - it peaked at 96% in 1984. Not only was equity issuance destroyed, but that of bonds, too, by the simple devices of establishing the Public Bond Issuance Committee (chaired by the Industrial Bank of Japan), which decided who could issue - on grounds not related to credit-worthiness - and requiring collateral for each issue. Banks had the right to collect fees for monitoring the collateral, which rendered bonds uncomfortably expensive compared with rate-controlled bank debt.

Yet a proper equity capital market could have been developed in the early 1950s if the BOJ had not in the "high" period of post-war controlled finance followed the policy of "overloan" in order both the jump-start growth and to gain almost complete bureaucratic control over the allocation of capital within the economy.

By allowing banks to borrow more than is rationally defensible at undifferentiated rates from the central bank, which allows the banks to lend at undifferentiated rates to business, the need for equity funding is so diminished as to eradicate the need for the stock market to become a capital market.

Even now, when the pure form of the system has been superseded, its shadow still hangs over banks because they have no experience with credit rating or differential loan pricing according to credit worthiness. This leaves the BOJ with a problem. The banking system is designed to act without restraint.

Labour - Premeditated Not Ordained by Culture
Labour practices are the other key element of the modern economy. The totality of the transformation is impressive. Though in 1927 exactly the same proportion of the workforce changed jobs annually in the United States and Japan (4.3%), in 1993 only 1.5% of the workforce changed jobs in Japan versus 4.4% in America. Whereas in 1935 only 36% of company employees were employed directly from university and had never worked anywhere else, by 1993 the "salariman" ratio had risen to 93%.

Peter Drucker argues that the maximisation of volume is an entirely rational reaction to the realities of Japan's labour situation. He starts by noting the high proportion of Japanese workers recruited straight from university or school. The productivity per man hour of such recruits may be lower than that of a person who has been on the job for 25 years, but their productivity per unit of wages is far - in his estimate three times - higher than their older colleagues because of pay based on seniority. The business that can expand faster therefore has an in-built, "almost unbeatable", labour productivity advantage. Conversely, "the business that cannot increase its volume quite rapidly finds itself losing productivity".

He continues, "Under the Japanese system, labour is, in effect, a capital expenditure, and one in which, contrary to all other capital expenses, the fixed charge increases as the 'investment' gets older". This reminds one that labour costs are a more important fraction of sales for listed companies than depreciation. Drucker concludes with the frightening observation that "the much-vaunted increase of Japanese productivity since the 1950s represents in substantial part, perhaps as much as half, non-recurrent shifts in the labour force rather than genuine productivity increases". The push towards volume growth engendered by the reorganisation of labour relations, therefore, remains an important factor in the successful operation of the system.

No Proper Private Sector Means Low, or No, Returns
By these developments, the divorce of shareholders and managements could be perfected. Put very simply, the overall architecture of the system has relegated the making of money to irrelevance or sometime worse - actual illegality - and that notion overhangs current management. The whole tone of pre-war economics is recognisable to anyone who has visited Japanese companies - all the same words keep recurring; seisan noryoku (production capacity), zosan keikaku (plan to increase capacity), gokanen keikaku (the ubiquitous five-year plan) - all focused on the expansion of production potential rather than the identification of profit opportunities.

However, Paul Krugman notes in his article "The Myth of Asia's Miracle", "Japan, unlike the Asian 'tigers', seems to have grown both through high rates of input growth and through high rates of efficiency growth". Yet he also suggests that Japanese growth has been "achieved only through a very high rate of investment, nearly twice as high a share of GDP as in the United States". Krugman's view is that "one ends up with the probable conclusion that Japanese efficiency is gaining on that of the United States at snail's pace, if at all ....".

Taking the figures provided by Alwyn Young of MIT (on whose work the thrust of Paul Krugman's article is based), themselves drawn from Summers and Heston, it is clear that Japan has performed exceedingly well in terms of annual growth of output per capita. Over the period 1960-85, Japan's per-capita output grew at an annual rate of 5.5%, only fractionally behind that of the main Asian "tigers". Considering the different scale of Japan, this is indeed a major achievement. However, just as the total factor productivity calculations performed by Young expose the entirely unexceptional nature of growth in Asia, so they relegate Japan from a top-10 placing among the 66 countries surveyed, to a less glamorous 32nd spot, sandwiched between Greece and Luxembourg.

It is worth speculating on the origin of the difference between Japan and, say, Singapore, which studies show to have experienced negligible gains in efficiency. Since in large part, defeat was attributed to inadequate technology, Japan has become voraciously, some would say indiscriminately, acquisitive of technological developments. In addition, from the early post-war period onwards, Japan was granted open access to both US technology and preferential access to the US market - both factors that may explain some of the efficiency gains secured during that period.

But in a changed world, Japan will probably have to pay the full economic price of what it buys from now on. It is perhaps also a comment on the relative paucity of important new technology developed wholly in Japan that the example of Toray's carbon fibre is always used - it's the exception that proves the rule.

In one of Alwyn Young's articles, I was particularly drawn to the notion, that the sort of force-feeding of industry indulged in by Japan probably involves increased inefficiency if it moves too far about beyond the boundaries of "learning by doing", or the limits of the existing accumulated technical expertise of the populace. The endless shifting into "higher value-added areas", which is held out by, for instance, Mieno Yasushi (former BOJ Governor), as the only salvation of the economy may in fact be counterproductive.

Is This System Itself Unsustainable?
The conservative supremacy of the 1980s in both Britain and America and the abiding hold of modern conservatism's ideas on investors and stock brokers, together with the collapse of the Soviet Union and China's apparent embrace of capitalism, make it peculiarly difficult to accord correct assessments to control economies. After all, we know these systems don't work.

Japan is therefore a challenge, a control economy which has gone on working long after it should, according to our preconceptions, have failed. The overall design of the Japanese economy has but one aim - the rapid expansion of capacity. It was realised as early as the 1930s that the free functioning of private capital markets was inherently opposed to this project. Consequently, both the equity market and the corporate bond market were excluded from an active part in financing post-war reconstruction - and to all intends and purposes remain excluded.

The result of this unusual system of corporate finance has been to leave corporate Japan without a consciousness that capital has a cost. During the high-growth era, factors such as technological catch up and relative labour costs combined to allow higher growth - though as can be seen from the figure below, even in the great period of high growth only around a quarter of overall growth could be ascribed to technological progress per se.

With the end of the high-growth era investing at above the cost of capital might have become important, but did not because of the growing existence of unrevalued assets. The period of high growth had, of course, vastly inflated asset values, quite apart from the twin bubbles of 1961-63 and 1970-73. With this cushion available, capital could still be put to work in ignorance of its cost. In due course, the very manner in which capital was (inefficiently) used - buying stock holdings and property - led to a rise in the cushion of "hidden assets". The rise in the most recent bubble was merely the most extreme stage in a long-run process.

Great effort has been expended in trying to prove whether control of capital markets has resulted in a lower cost of capital for Japanese companies compared with their competitors, or that the bureaucracy has variously been "good" (Chalmers Johnson) or "bad" (Kent Calder and the Economist magazine) at directing the economy. Both these positions have missed the point. If private capital markets have been excluded from any role in allocating capital, there can be no true consciousness of capital having a cost, and if there are no restraints placed on management by capital markets, then managers become essentially indistinguishable from bureaucrats - all are equally functionaries.

The real threat to and the real weakness of control systems, however is in their inability to mark to market. No land in Japan is marked to market, neither are whole categories of stock holdings, or most debt. The economy is unable to bear the dislocation that would be caused by general revaluation - and so loses efficiency again by becoming unable to reallocate unproductive capital with any vigour.

We must, I think, identify the erosion of hidden assets as the eventual trigger for either failure or reorganisation. The system has been in a sense dysfunctional probably since the end of the high-growth era in 1969. Only accumulated hidden assets and their periodic replenishment by bubbles have allowed the continuation of the habits of the high-growth era. Now the scale of the bubble losses threatens even them, and at the core of the system, the banks, too.

It is entirely justified for us to ask whether or not the whole thing is destined to go the way of its main ideological mentor, the Soviet system, when the hidden assets run out. For equity investors this suggests that, contrary to popular perception, the Japanese market does exhibit serious downside risks. Stalinist impulses and stock markets rarely cohabit happily. It also means that we are not dealing with an "ordinary cycle". Japan has come so far down the road of diminishing returns that full scale reorientation is now necessary - and will remain so even when the coming cyclical upturn makes people forget the underlying difficulties.

As investors we often ask the wrong category of question. Taking the chart below, the proper question is not, "How far can ROE (return on equity) bounce in the coming cycle?", but "Will the slope of the trend-line change?"

By Alexander Kinmont

Morgan Stanley

MARKET FOCUS: LAISSEZ-FAIRE ABOUT GROWTH
The late 19th century is often called the golden age of laissez-faire. Today's global economic structure more nearly approaches that period than any time before or since. Internationally mobile savings oscillating between the safe core and the risky periphery; a revolutionary cluster of new technologies; new markets and sources of cheap supply (food then, manufactures now); the spread of improved management techniques; an ideological bias in favour of sound money and free markets; excess savings in the leading (but declining) industrial power (the UK then, Japan now); grand projects of unification and monetary union: these are some of the striking parallels.

Even some of the obvious differences turn out to be disguised similarities. There is no classical gold standard today, but even under that regime it was the bond and currency market vigilantes who most effectively policed the system. Today, government has a much larger role in the economy but, even in the 19th century, leading countries sometimes had very high government debt-to-GDP ratios, (usually the legacy of war) which had to be periodically rolled back by running primary budget surpluses during peacetime growth. And, while it is true that the state now cushions the impact on individuals of ill health, unemployment, and old age, the actual and contingent cost of doing so makes activist fiscal policy practically impossible.

More impressive still, is the fact that one can observe so many similar trends in the late 19th and 20th centuries: historically low and less volatile inflation; downward pressure on real wages and job security in the high wage economies; a tendency to outright deflation in the hard money countries; creeping protectionism and rising inequality; capital's dominance of labour; frequent bubbles and crashes in financial markets; periodic banking crises; episodes of protracted slump - caused as much by a previous period of over optimistic investment in industrial capacity as by the collapse of a massive financial bubble. It is worth noting that the long decline in world interest rates that accompanied all this lasted about 30 years (1867 to 1897 in the UK). That there was also an underlying tendency for international bond yield convergence, with occasional sharp interruptions. And that real bond yields were, as far as the data allow us to tell, about the same as we have experienced over the last decade.

But it is also worth remembering that the golden age of laissez-faire ended rather badly for capitalists, bondholders and international relations. The growth of very large firms eventually produced the logical and in some ways necessary antidote: larger and more powerful unions. (To quote from a recent academic paper "Wage, price an output indices ... show a decrease in nominal wage flexibility - the change in wage inflation associated with output fluctuations - after the 1880s, following an increase in strike frequency linked to the spread of large scale manufacturing.") World inflation started to pick up, though at first very slowly, in the mid-1890s and world interest rates started to trend gently higher shortly thereafter. The political consensus in favour of laissez-faire came under increasing threat in the early 20th century, and there are many who argue that the inexorable competition and social strains of laissez-faire contributed directly to more strident nationalism and to the outbreak of the First World War.

This ancient history may be surprisingly relevant to the performance of global markets over the next few months. It is already possible to discern a creeping political reaction against the harsher aspects of late 20th century laissez-faire. The best and only antidote is a period of growth, rising employment and spreading prosperity. In our modern democracies it is neither feasible nor desirable that policy be geared to the immediate gratification of bond and shareholders, even if most workers are stakeholders via their pension and insurance policies. In any case, global competition, budget discipline, industrial restructuring and rapid technological advance are supposed to be a formula for improving the trade-off between growth and inflation. Central banks need to allow this proposition to be tested, without taking cavalier risks.

The point can be made even more simply: in Europe sustained convergence and the achievement of EMU depends on a return to growth; in Japan a sustainable upturn in private demand is essential if public finances and bank balance sheets are to be slowly repaired; in Latin America recovery has started but needs to continue to buttress reform and justify earlier austerity; in Russia too. Even in the US, a healthy economy (and stock market) through November will help the cause of free trade and fiscal responsibility in the next presidency. That is why none of the G3 central banks are prepared to take an aggressive posture towards the current pick-up in world growth. And rightly so. As this idea sinks, in core real yields will ease back, and markets will celebrate. Even, and perhaps especially, the apparently overvalued US equity market.

By Jonathan Wilmot

CS First Boston

EMU: IF IT WERE DONE ... T'WERE WELL IT WERE DONE QUICKLY

Investment Conclusion
The consensus is dead set against us. Few among our clients think that EMU will do economic good. But all think EMU will happen, and only a very few think it will be postponed - and then for a short, immaterial time. That's because the political will to achieve EMU is awesome.

We maintain our 60% conviction that EMU won't happen on time. If we're right, the key investment strategy is to be short the French franc and French bonds versus the DM and bunds. But at the request of our clients, this report looks at what to do if EMU happens (40% probability). We conclude that if EMU happens, it will have to be a broad church that rapidly includes the high public debt and deficit Southern Comfort Countries (SCC).

Then SCC bonds would be the investment to go for, because EMU wipes out their devaluation and default risks. That's not yet fully reflected in current SCC bond yields. SCC currencies are now fairly valued, so there's nothing to be made there.

EMU would destroy one of Europe's key shock absorbers for joblessness and misguided policies - the currency markets. Social pressures will be increased by the deflationary impact of EMU, particularly the SCCs and France. Instead of relieving these pressures through currency volatility, the result will be political instability. That means EMU will eventually blow up (members will leave) and Europe's politics will fragment. That would make nearly all European financial assets and currencies (bar the UK) a short into US and Asian equivalents.

Our EMU Scenario
There's an attraction in being the last to say, as we do, that there's a 60% probability EMU won't happen on time and an 80% chance of it blowing up if it does. But is our conviction based on science, or a love of being at an angle to the world?

We think the probability is against EMU happening on time. It all depends on the German and French economies. Germany's public spending cuts will get implemented quickly and are likely to be worth 2% of GDP. France has no equivalent package. Indeed, its attempts to plug budget deficits with increased charges and taxes simply create bigger deficits down the road, by hitting demand.

The German economy is now recovering. The recovery is led by export orders, principally for capital goods. But domestic orders will revive too under the impetus of rising labour income (despite falling government handouts). France cannot recover in the same way. It has no capital goods industry to plug into global restructuring and industrial relocation. Furthermore, its car industry, after years of Calvet-style ignorance masquerading as management, is now on the ropes, and it accounts for 10% of manufacturing output.

Therefore, French growth will lag. Germany will meet the Maastricht criteria for public deficits and France will fail. The arrogance of European politicians is that they think politics can win out over economics and that the German people will, in an election year, willingly give up the DM for what will inevitably be a poor quality alternative, the Euro. By the time the matter comes before the Bundestag and Bundserat in spring 1998, the argument of abandoning the DM to save German jobs won't wash. The economy will have recovered. And the vast majority of those working won't buy the connection between jobs and abandoning the DM.

So we are now at the zenith of political (and market) optimism about EMU and at the nadir of economic realism. Things only have to change a little bit for our convictions to pay off. The swap will happen when markets cop on that France is in deep trouble on public finances and jobs, despite the protestations of the politicians (who will never admit it). The timing of that is when signs of German economic recovery and the French lack of it become clearer. That could be when the Juppé government presents an unrealistic 1997 budget in the autumn.

Being short the French franc and bonds and long the DM and bunds will pay handsomely. This will happen as the yield spread on French ten-year bonds over German bunds goes from zero to 100bp, mirroring the fiscal quality gap between the two. There's an argument for holding equity positions the other way round (long France and short Germany) based on the thesis of an ultimate devaluation of the French franc. But, given the quality of German corporate restructuring, we are long both French and German equity markets.

And market realisation that EMU could fail also makes it attractive to go short SCC bonds, particularly in Italy where optimism is well overdone.

If EMU falls to bits, UK financial assets would also do well. It's a reasonably well-run country, with a globalised, investor-friendly, and relatively cheap corporate sector. UK financial assets currently incur a big risk premium because of their likely exclusion from the EMU zone. But no EMU would mean no risk premium.

Thinking The Unthinkable - If EMU Happens
The consensus is that political determination will make EMU happen, more or less on time. Then the DM would remain weak and so would bunds. Who wants to own something that will cease to exist and where you get your money back in debased silver?

In contrast, you should own the bonds of the high debt, high deficit SCCs. Once in the EMU zone, SCC bond holders will get paid back in better quality assets than what they paid out, and they get a higher yield in the meantime.

SCC bond yield differentials to German bunds are what investors get paid for the higher risks of default and devaluation. But if SCCs are in EMU, the devaluation risk goes. And most of the default risk goes too. That's because most governments default on their debts by printing money to create inflation, which devalues their debts. Inside EMU, currency risk, and therefore relative inflation risk, is gone.

The residual risk is "can't pay, won't pay". But that risks is minimal for political and financial reasons. Default by any EMU member state cannot be countenanced as it would destroy EMU and the EU. France and Germany would have to bail out any potential SCC defaulter. But maters would never get that far, because the liabilities of all EMU governments would be in the same currency. The European Central Bank (ECB) would have to refuse to discount a member state's paper in order for the country to default, but it would have no power to do so.

The practical consequence of all this is demonstrated by the Belgian bond market. The Belgian yield spread to Germany has fallen to 20bp for ten-year paper. Everyone knows that either Belgium will be in EMU or it'll move to a Hong Kong-style currency peg with the DM. If Belgium is in EMU, the devaluation risk inherent in owning a slug of Europe's most indebted currency is gone. Similarly, under a currency peg with the DM, all Belgian public debt would be convertible into, and serviced in, either DM or BFr at the investor's choice and at the fixed-peg exchange rate.

So the market has concluded that the only risk in Belgian bonds is the default risk, which is marginal. Consequently, Belgium enjoys (and Belgians do very much enjoy) virtually the same interest rates as Germany, without having anything like the same quality of economic structure or public finances. No wonder highly-indebted SCCs are desperate to join EMU, while low-indebted, free market-oriented Britain abhors the idea. European integration is all about costs and benefits, not irreconcilable cultures, football yobbos and xenophobia.

Of course, interest-rate spreads between SCCs and Germany are influenced by each individual economy's policy risks, debts and deficits. Inside or outside EMU, Greece is not Sweden. But the default risk will ultimately be reduced by almost as much as the devaluation risk for all SCCs, provided the market thinks SCCs are EMU-bound within the life span of their bonds.

More Haste, Less Speed
But will SCCs get into EMU immediately, if ever? If you believe in EMU, there's a strong argument for some SCCs (Italy, Spain, Portugal and Sweden) getting in smartly. That's because leaving them out carries a big political risk for those who do go in.

First, exclusion would increase SCC interest rates well above today's levels (some considerable measure of optimism about SCC membership is already reflected in current interest rates). Higher interest rates would skittle SCC budget arithmetic. And that would mean permanent exclusion from EMU, leaving the excluded SCCs with no alternative but to go for growth through periodic competitive devaluations. That policy could also be allied with a return to devaluing SCC debt burdens by tolerating somewhat higher inflation.

The victims of these policies would be the core EMU countries. They would be transformed into a cosmic centre of deflation. Therefore, if EMU is to work, not only to the SCCs have to be included in EMU, they have to be included fast.

Diabolically, this is also a self-fulfilling prophesy. If the market perceives that SCCs must be included quickly, the DM and bunds will be weaker, because the greater will be the debasement relative to the DM of the DM's successor, the Euro. The corollary is also true. The greater the number of lousy quality SCCs that are included in EMU, the greater the mark-up will be for owning their currency and bonds, because investors will be paid back in something alloyed to the DM.

The weaker the DM is, the stronger the SCC currencies will be, and the lower SCC interest rates will go relative to German rates. That matters to SCC governments a lot. Stronger SCC currencies spell lower interest rates. And the interest expense on public debt is the major determinant of SCC budget arithmetic (with the exception of Sweden).

So if the markets believe that the SCCs are going into EMU, they go to work to make it easier for them to get in. And the shorter the time that the markets hypothesise it'll take to include SCC countries in EMU, the bigger the positive effect on SCC budge arithmetic and the more likely the SCCs are to make it into EMU. The beauty of the model is undeniable?

Assuming that we're dead wrong on EMU, and it happens more or less on time, then we believe EMU will be a broad rather than a narrow church by the year 2000. Certainly, Sweden, Italy and Spain would have to be inside by then. Our forecasts of SCC bond yields under an "EMU happens" scenario are conservatively provocative. The lessor for investors who buy the EMU story is to be long SCC bond markets and short FFr bonds (in case EMU doesn't happen after all).

The EMU Blow-Up
There's a 60% probability of EMU not happening on time. But if it does, it has an 80% chance of blowing up afterwards. And the blow-up will be a lot more conclusive than an exchange-rate crisis.

There are three structural reasons why EMU could fail. First, there is no mechanism for fiscal transfers within the EU to offset the pain of adjustment of peripheral economies to the core. Second, the labour markets of Europe are not standardised or liberalised. So structural unemployment is the adjustment mechanism for the harmonisation of inflation and growth, as well as of monetary and fiscal policies. France's 25% youth unemployment already shows the way. But that's just the trailer to the main feature when the tide of EMU deflation sweeps along the Mediterranean shore. Third, the integration of Central Europe into the EU will provide a whole new source of cheap labour and imports, as well as competitive devaluations, for EMU members to contend with.

The most likely way in which failure will show is in a severe post-EMU recession with its locus in France. If EMU happens, it will do so despite France failing to meet the Masstricht budget deficit criteria (and not by a little, whatever the fudged pre-EMU budge arithmetic is cooked up to show).

The Germans would have to get the French to agree to further fiscal stringency post-EMU, if EMU was to find muster in Germany. But the French would continue to try and preserve le Grand État, while covering costs with higher taxes and contributions sociales. That would put the French economy back into recession.

That France would flip and become a deregulated country of small government is highly unlikely. France is the birth place of centralised "mind over market" philosophy, which has done more to wreck Europe economically than even communism. And the pain of changing course could hardly be envisaged by France's political elite, even if they were all sent for re-education to some anti-ENA institution.

The country's character is writ deep in its financial arithmetic. France spends more, as a proportion of GDP, than any other European country on handouts to its transfer-addicted citizenry, making French government primary expenditure the highest in the G7 bloc. That's because of France's rigid labour markets. Public sector employment is the highest in Europe, while the private sector fails to create jobs. Don't fool yourself that you can change this without changing an entire political class. The bottom line is that under EMU French jobs will migrate to Germany.

Sooner or later, the same fate would befall other SCC EMU members. That's because EMU-land is likely to be a pretty chilly, deflationary place. It will remain so as long as its policy makers continue to marry three economically fatal elements in their thinking: big government, fiscal stringency based on high taxes, and "mind over market" micro-economic policies (thou shalt not fire anybody, or open your shop at ungodly hours, etc).

History will judge Europe's mediocre leaders in this decade against policies that shrink demand with fiscal charges, that kill individual motivation and responsibility through taxes, handouts and anti-market social laws, and hamper private sector dynamism by failing to liberalise their economies. All common economic sense has been sacrificed in pursuit of a chimeric political goal: European integration. The globalising world economy would have achieved integration in Europe anyway, as it is doing in Asia, without our beloved leaders' mediocre presence ever gracing superfluous European summits.

In an ERM world of exchange rate bands, where stupid economic policies create unacceptable levels of unemployment, they get attacked through financial markets, whose volatility is a relatively harmless kind of tooting that prevents worse, and usually produces the desired change in policy (devaluation). Investors would sense the unsustainability of idiotic economic policies and tilt at incompetent governments in currency and bond market jousts. But in the awful, silent spring of early EMU, there will be no currency markets left to upset. The flat world that Europe's political "control freaks" will have designed for themselves will no longer have any acceptable economic or financial safety valves. So the pressure is exerted on society at large. And the politicians are in for a shock.

Europe on the road to integration is much like a car equipped with shock absorbers to iron out the bumps. Abolish the shock absorbers and the bumps don't go away. Indeed, the chassis now takes the bashing instead and finishes by falling to bits. That's exactly what will happen to Europe post-EMU. The body politic will have to absorb all the shocks in terms of regional disparities and unacceptable levels of unemployment. Dissatisfaction will out, but no longer through volatility in financial markets. It will erupt in political life instead.

Our guess is that EMU, far from creating a sexless, tasteless, supra-national Europe, would give us excitement aplenty. It would be a Europe where the balance of power in parliaments is held by the populist parties of economic nonsense and the balance of power in the streets of riot-torn capitals is held by jobless, crypto-fascist yobs. That may not seem much different to London after England loses a European championship match. But, given the scale, it means shorting all the EU!

By David Roche

Independent Strategy

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