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The old order yields to the new

01 Nov 1997

For industrialists, investment bankers, institutional investors and individuals in Germany alike, the changes sweeping the country's financial markets are breathtaking in their scale and speed.

Internationalisation is the world on everyone's lips as Germany prepares for life without the Deutschmark and what it hopes will be a dominant role in a single currency Europe.

The country's leading companies brandish their commitment to shareholder value; debt issuers travel tirelessly around the world to broaden their investor base; and the increasing role of international investment banks in the German markets has introduced products, techniques and tactics that would have unthinkable just a few years ago.

All are driven by the same conviction: that the euro will change the face of financial markets in Europe, creating a competition for capital and a mobility of investment that will affect Germany -- and the rest of its European partners -- deeply.

And that, in turn, means that a country whose principle of mitbestimmung (co-determination) has served it well over the last 50 years, but which is still undergoing a painful restructuring as a result of re-unification, is embarking on a new era of wrenching change. Philip Moore reports.

FOR FRANKFURT-BASED investment bankers with memories stretching back a decade or more, the profound changes which are now sweeping through all corners of the German capital market are little short of astonishing.

At Goldman Sachs in Frankfurt, Stefan Jentzsch of the investment banking department echoes a number of his peers when he says: "I've been working in this market for 12 years -- 10 of them at Goldman Sachs -- and the changes we've seen in the last two or three years have been quite amazing."

For a snapshot of those changes -- on the equity as well as the debt side of the equation -- it is instructive to start not among the glittering skyscrapers of Frankfurt, but by the banks of the river Rhein in the more sedate setting of Wiesbaden, the state capital of Hessen.

The town's spas are reportedly an excellent palliative for rheumatism, and at least two of its companies are breathing new life into Germany's capital market and doing much to refresh its international appeal, albeit in very different ways.

The first of the two is SGL Carbon, which until the early 1990s was a loss-making unit named Sigri buried deep in the bowels of the chemicals giant, Hoechst.

Deriving its new name from a merger in 1992 with Great Lakes Carbon of the US, the company was floated first in Germany in 1995 and subsequently listed on the New York Stock Exchange (NYSE).

Since the company's IPO, which raised DM309m in September 1995, the original issue price of DM88.50 has more than quadrupled, touching a peak this year of DM262.

Earnings per share -- a modest DM7.6 in 1995 -- rose to DM9 in 1996 and will, according to estimates published recently by Credit Suisse First Boston, rise to DM10.9 in 1997 and to DM14 in 1998.

In spite of the stellar performance of the shares, this will mean that the SGL Carbon price/earnings ratio will have fallen from 32.6 in 1995 to a much more digestible 17.7 in 1998.

This is impressive stuff, although the two years since SGL Carbon celebrated its financial independence have been characterised not just by record profits and an outstanding share price performance.

Under the chairmanship of Robert Koehler, they have also represented the emergence of an entirely new corporate culture in Germany. It is a culture a million miles away from that which is embedded in older German monoliths such as Siemens, where -- as The Economist reminded its readers in August -- "an employee working more than a few hours overtime a week requires special permission from the works council."

SGL Carbon's workers do not need any such permission because the vast majority of its employees are, in effect, owner occupiers of the company.

In a country where the expression "shareholder value" is rapidly becoming hackneyed and in many cases misused -- with some companies reportedly spending a good deal more time talking about the concept than delivering it -- SGL Carbon recognised early that there was no better way of creating genuine shareholder value than to establish an environment in which the staff were owners whose performance could be correlated more or less exactly with that of the share price.

Perhaps the attitudes of SGL Carbon's chairman were shaped by his commercial background. Between 1975 and 1986, Koehler worked for Hoechst in the UK, where as he says he watched with interest the demise of the (old) Labour government and the transition of the UK economy into the entrepreneurial culture fostered by the Thatcher era.

Today, Koehler speaks like a confirmed Thatcherite. "The history of German corporate culture has been characterised by a cradle to grave mentality," he says.

"Employees at major companies expected the same type of security as civil servants. We want to move away from the model of an employed manager to an owner manager. And we want to encourage owner managers to have the confidence to challenge the chief executive if need be and to say 'Hold on a second, what are you doing here?'"

In downtown Wiesbaden, away from the banks of the river Rhein, DePfa Bank, which this year is celebrating its 75th anniversary, is a very different organisation from SGL Carbon.

It is much older, much bigger, much more conservative, and although it was privatised by the government in January 1990, its current shareholder structure is, as a JP Morgan credit research note explains, "designed to protect the company from takeover".

In a sense, however, this pedigree makes the transition in DePfa's attitudes towards its investors over the last few years still more remarkable.

Aside from the role it has played in improving the international visibility of the once-esoteric Pfandbrief, bankers acclaim DePfa for adopting an entirely new approach to the global investment community -- in part by leading the way when it comes to sacrificing one or two basis points in exchange for guaranteeing the success of broadly placed strategic bond issues.

As one Frankfurt banker says: "DePfa was probably the first mortgage bank really to think about broadening its investor base, and it worked very hard to do so by organising extensive roadshows and one-on-ones with investors. That means that DePfa has done a marvellous job not just for itself, but for all German banks looking for a wider investor base."

The most recent example of this commitment to what may be termed the creation of bondholder value has been DePfa's very un-German initiative of opening an office in Tokyo in November 1996. As the bank's latest annual report notes: "Our local, Japanese speaking staff are responsible, as investor relations managers, for maintaining links with institutional bond investors, local authorities and associations."

Investors clearly appreciated the effort DePfa was putting into cultivating its investor base long before this Japanese initiative, and long before they recognised the progress which other German borrowers (with the possible exception of the quasi-sovereign KfW) had made.

At the beginning of 1994, respondents to the top borrowers' poll in Euroweek's 1993 End of Year Review nominated DePfa as the most impressive new borrower of the year and as the third most impressive in terms of establishing its market profile.

While in subsequent years DePfa was joined (and even supplanted) by issuers such as L-Bank and DSL -- following what many commentators dubbed "the year of the Pfandbrief" last year -- DePfa returned to the top 10 (slightly ahead of DSL) of the most innovative borrowers, and came sixth -- and was the only German representative -- in the mini-league of borrowers most receptive to new ideas and structures.

Of course the iconoclasts of Wiesbaden are not alone. Companies such as Daimler-Benz, Veba, Hoechst and the computer group SAP may all have something to say about SGL Carbon being held up as the epitome of shareholder value in Germany.

Banks such as KfW, L-Bank, DSL and mortgage banks like Frankfurter Hypothekenbank and Rheinische Hypothekenbank (Rheinhyp) may also argue that they have been every bit as instrumental as DePfa in promoting bondholder value.

Like SGL Carbon and DePfa, all these could rightly be categorised as leaders in the promotion of the capital market, although they are the exception rather than the rule.

While it may appear patronising to label Germany as a nation of followers rather than leaders, this is very much what they are in the sphere of the capital market in particular and -- in many instances -- in that of the economy in general.

As one German banker working with a US investment bank in Frankfurt very frankly puts it: "What we have created in Germany today, unfortunately, is a country of Beamte -- or public servants -- with a public service mentality. There is still no entrepreneurial culture in this country, and one manifestation of that is to accept, almost unquestioningly, what politicians say."

Strong words, perhaps. But they are supported by harsh facts. It is small wonder, for instance, that a country with such ludicrously restrictive laws on retailing has in recent years created virtually no internationally recognised entrepreneur in the mould of the UK's Richard Branson.

At the core of the system which served Germany so well in the aftermath of the Second World War has been the concept of Mitbestimmung (or co-determination) -- in effect, economic management by consensus.

Demonstrably, from the performance of the German economy since the war, the system had strengths a-plenty -- best summed up in the single word, Wirtschaftswunder. In short, it produced world class exporters, an outstanding infrastructure and an equitable social framework.

But the system also had severe fault lines which left Germany surprisingly ill-equipped to compete within an increasingly integrated global economy.

The recognition over the last decade that the legacy of Mitbestimmung has included colossal and unsustainable social costs, a minuscule service sector and an underdeveloped financial services industry has led in recent years to a gradual but unmistakable erosion of German co-determination, which in the context of the capital market has been striking.

Repeatedly, the manifestation of the erosion of Mitbestimmung in the German capital market has involved high profile, controversial and sometimes widely unpopular initiatives taken by companies, associations or individuals.

These have typically been ice-breaking decisions, greeted at first with surprise and suspicion, but subsequently by imitation, and the process has happened in virtually every pocket of the capital market.

It has happened in the syndicated lending market. There were murmurs of amazement when Siemens appointed JP Morgan rather than a local Hausbank as the arranger of a jumbo syndicated loan facility at the start of 1995.

Today, such an initiative would barely cause a ripple.

It has happened in the equity market. There was widespread angst within corporate Germany a few years ago when a cluster of leading companies -- spearheaded by Daimler-Benz -- started making noises about listing their shares on the New York Stock Exchange and hence opening up their accounts to prying US regulators.

Today, one banker in Frankfurt reckons that up to 80% of Dax-listed companies are preparing to do the same.

It has happened in the securitisation market. Eyebrows were raised when the Commerzbank subsidiary, Rheinhyp, became the first German bank to launch a securitisation issue in 1995, risking incurring the wrath of the local banking authority which viewed such structures with deep suspicion.

Today, following a change of heart from the same authority, scores of German financial institutions are contemplating issuing similar transactions, according to some local bankers.

It has happened in the Pfandbrief market. There were profound misgivings in Germany when, just over two years ago, some of its more forward-looking mortgage banks cobbled together the idea of a "jumbo" Pfandbrief which would offer foreign investors liquidity but at the same time would possibly squeeze some of the smaller issuers out of the market altogether.

Today, for all intents and purposes, the jumbo sector is the Pfandbrief market.

It has happened in the bond market for Germany's Länder. There were whispers of discontent earlier this year, when Axel Gühl, treasurer at the east German Land of Sachsen-Anhalt, chose not to participate in the second pooled jumbo borrowing launched by a cluster of states in January -- and instead to launch individual bond issues aimed at international investors which, according to several local bankers, will soon involve the state breaking with tradition and soliciting a credit rating from one or more of the leading ratings agencies.

If and when this happens, other Länder looking to access the international capital market will have little choice but to do the same. The larger state of Hessen, home to Germany's financial centre, has already gone the same way.

And most striking of all, it has happened in the German mergers and acquisition (M&A) sector. There was widespread outrage in Germany this March when the steel and engineering group Krupp Hoesch launched a highly 'un-German' hostile takeover bid for its rival Thyssen -- outrage which was exacerbated when Deutsche Morgan Grenfell put the weight of its backing behind the aggressor, Krupp. Although it took political intervention to force a negotiated settlement, local bankers insist that it is only a matter of time before similar tussles emerge in Germany.

The result of all this is that investment bankers in Germany -- especially those foreign houses which only began to descend on Frankfurt in the mid to late 1980s -- can scarcely believe their luck. The extent to which the opportunities available to foreign banks in the market have proliferated over recent years (and even months) is neatly encapsulated by Werner Humpert, vice
president of Merrill Lynch Capital Markets in Frankfurt.

"The range of products we offer in the German market has dramatically broadened over the last one or two years," he says. "We've done some analysis of our business flows which have shown us that just two years ago we did three products in Deutschmarks. Today we have 10 including credit card backed deals, the high yield market and a range of equity-linked syndicated public deals which Germany had not previously seen."

Daniel Lee, chairman of Salomon Brothers in Frankfurt, puts the changes in the German market into an even longer historical perspective.

"I've been working in this market for 18 years," he says, in reference to the fact that he joined Salomon Brothers from Commerzbank in the mid-1980s.

"And when I think back 10 or 11 years ago to when we were setting up this office, the only way you could possibly win any business from a German client then was if for some reason or other you were offering a service which the German banks were unable to provide.

"In practice, that meant that the only product area open to foreign banks was in the derivatives markets, which is where most of the international players made their initial contacts with the German corporate base."

Today, he says, that has all changed. "The old Hausbank phenomenon really isn't a relevant issue any more, and I can't think of a single German borrower which feels it needs to channel all its business through one domestic bank," says Lee.

"And if you look at the M&A market the changes are amazing. Who's doing the advisory work for the Bavarian banks [Vereinsbank and Hypobank, which are in the process of merging]? JP Morgan. Who advised Krupp and Thyssen? Goldman Sachs, Morgan Stanley, SBC Warburg, Credit Suisse First Boston and JP Morgan, alongside the main German banks. In any large M&A or equity deal in Germany today you will find a foreign bank involved, and this has really only happened over the last seven years."

The changes in the German capital market are being driven by several factors, although three stand out most prominently. In simple terms, these are the ghosts of Germany past, Germany present and Germany still to come.

The ghost of Germany's past is reunification in 1990 and the massive costs which were associated with it. The after-effects are most concisely summed up by one syndicate manager in Frankfurt who says that "before 1990 people in Germany lived in a sheltered environment. That shelter has now gone."

But others argue that even by 1990, the sheltered environment in which Germany lived was looking increasingly fragile, and that the collapse of the Berlin Wall merely acted as a catalyst.

The ghost of Germany present is the painful restructuring of the economy as it battles against the twin imperatives of cutting its unemployment rate (at its highest level since the 1930s) and pinning down its deficit in accordance with the straightjacket of the Maastricht criteria for monetary union.

The ghost of Germany still to come, meanwhile, is the anticipation of Emu on January 1 1999, the disappearance soon thereafter of Germany's beloved Deutschmark and the level playing field within Europe's capital market which will take shape as a result.

Speak to any continental European banker (especially within the core European block) and they will tell you that the introduction of the euro on January 1 1999 -- with the probable participation of 11 economies -- is a racing certainty.

It is not difficult to foretell the calamitous consequences for the German economy which would arise in the event of Emu suffering a lengthy delay or being abandoned altogether.

In the short term, it is probable that there would be an unprecedented flight to perceived quality -- in other words, a massive influx of funds to the Deutschmark, be it through the currency or bond market.

That would lead very rapidly to a colossal appreciation in the Deutschmark's value and, more slowly, to a giant upheaval within German industry with exporters bearing the brunt of the effects of a soaring Deutschmark -- with very obvious implications for the outlook for German unemployment.

But for all this, and for all chancellor Kohl's apparent obsession with the timely launch of the euro, German opinion is clearly very sharply divided about the merits of a single European currency.

One notable thorn in chancellor Kohl's flesh is the Bavarian premier Edmund Stoiber, who has demanded that Germany's participation in Emu be delayed if the 3% deficit target cannot be met.

Another is Wilhelm Nölling, former SPD finance minister and one time Bundesbank central council member, who wrote to the Frankfurter Allgemeine newspaper in March saying, as a Morgan Stanley update translated it, "that he is prepared to file a lawsuit against the government with the constitutional court if the government puts the euro timetable above the criteria".

Other dissidents include former finance minister Stoltenberg who has publicly declared that job creation must come before the Maastricht criteria -- while the present Bundesbank supremo, Hans Tietmeyer, caused embarrassment late this summer when he told a newspaper that the heavens would not necessarily cave in should Emu be delayed.

Last but not least there is the small matter of the German on the street: opinion polls have repeatedly suggested that the majority of German citizens (albeit a small majority) do not want to see their precious Deutschmark washed down the Emu drain.

One local banker -- while insisting that the project will go ahead on time whatever individuals such as Stoiber or Stoltenberg may have to say on the subject -- is very frank about the national resistance to Emu.

"We certainly wouldn't want to see a referendum on Emu in Germany," he says. "Quite obviously the German people don't want to give up the Deutschmark. Why should they, when the strength of the currency has traditionally dictated that their holidays in Spain get cheaper year after year? But remember also that the Deutschmark is an important symbol of national identity in Germany."

For economists and analysts responsible for advising their clients on the likely economic environment in Europe after 1999, Emu has been something of a moving target.

For example, Morgan Stanley noted in its June edition of EMU Insights that "recent developments make it increasingly unlikely that the German general government deficit (under the Maastricht definition) can be reduced from 3.8% of GDP in 1996 to 3% or less this year", and that "with Germany likely to exceed the 3% deficit threshold, the outlook for Emu has changed: the chances of a wide Emu including Italy, and the chances of no Emu at all, are rising."

The pendulum has since swung back, with most commentators now quoting Germany as an odds-on certainty to be in the first wave of Emu.

By early September, for example, Morgan Stanley was noting that "national accounts data released on September 10 show a surprisingly low general government deficit of 3.1% in the first half of 1997, which induces us to lower our forecast for the deficit for the full year from 3.3% to 3%."

It adds: "The key conclusion must be that this will help silence the domestic Emu critics and, hence, makes the 1999 start date for Emu more likely than ever."

Even more compelling evidence came in early October when the Bundesbank led Europe's central banks in a concerted interest rate rise that gave a strong signal of their commitment to a co-ordinated monetary policy ahead of Emu.

The Bundesbank triggered the rate rises by announcing an increase in its repo rate from 3% to 3.3%. The Bank of France immediately raised its intervention rate to 3.3% after consultation with the Bundesbank, while the central banks of the Netherlands, Belgium and Denmark also raised short term rates by 25bp.

The move was a classical pre-emptive strike by the Bundesbank, catching financial markets off-guard in the manner that has been its hallmark in recent years.

But it combined elegantly the Bundesbank's traditional domestic role as the slayer of inflation with its new emerging European role as the guardian of monetary rectitude.

The rate rise was justified on domestic grounds, with inflationary pressures building up in the German economy as a result of growing economic activity and the weakness of the Deutschmark against the dollar this year.

In addition, German monetary policy has been in an expansionary phase since 1992 -- and has been instrumental in underpinning Europe's economic recovery and enabling the achievement of the Emu cri-teria.

The possibilities of interest rate increases had in any case been sketched out even prior to the weakening of the Deutschmark, with the Bundesbank noting in its 1996 annual report that "it would be premature, if not downright wrong, to assert that inflation has been permanently contained or -- as some claim -- that it is 'dead'."

But the October rate rise carried a wider European resonance. By demonstrating that its anti-inflationary zeal is still alive, the Bundesbank demonstrated two key points.

First, it was able to reassure Euro-sceptical members of the domestic population that the drive towards Emu would not involve any weakening of Germany's disinflationary policy.

Second, it was able to show the international community that Europe's central banks -- led, naturally, by Germany -- are determined to ensure that the euro begins life as a low inflation, strong currency.

That said, to start a cycle of raising rates in a country where unemployment is at its highest level since the 1930s is a policy that is unlikely to win too many friends politi-cally.

Although the Bonn government welcomed the move as a sign of Germany's anti-inflationary commitment ahead of Emu, it will add to the pressures facing the Kohl administration. While rising rates are scarcely likely to be welcomed by German industry, nor has the failure of Kohl's government to push through fiscal reform which had been hailed by the chancellor as the "tax reform of the century" and which is seen by industrialists as vital if Germany is to restore its competitiveness.

"Tax reform in this country is so crucial if we are to attract money, attract intellectual property and give sufficient incentives to keep good German management in this country," says Koehler at SGL Carbon.

Another dark cloud on the German economic horizon is the grim prospect of little change for the better in terms of unemployment, which is maintaining its apparently relentless upward momentum in spite of signs of a pick-up in the economy as a whole.

Local analysts dismiss Kohl's promises of halving unemployment by the year 2000 as almost meaningless election-speak -- largely because the entire structure of the economy was changed by the recession of the early 1990s, with companies emerging leaner, meaner and more aware of the need to restrict wasteful overheads and excessive staffing levels. "The German economy has become fundamentally much stronger over the last five years," says Ralph Süppel, vice president and senior economist at JP Morgan in Frankfurt.

"The problems of a strong currency, reunification and recession all helped to put in place a very healthy restructuring of German industry, and the result is that it is pointless to compare the German economy of the 1970s and 1980s with that of the 1990s. In the last decade productivity growth averaged less than 1.5% per year. Now it's growing at 4%. In the 1980s unit labour costs were rising at between 2.5% and 3% per year. Now the increase is zero."

If corporate Germany is to maintain these encouragingly strong microeconomic fundamentals, the suggestion is that companies will not be rushing to sign up new recruits even in the event of a prolonged upturn in the economy.

However, some hope for Germany's swelling masses of unemployed is held out in a July report on the economy published by Credit Suisse First Boston which noted that "our central view is that continuing export and investment strength will force companies to reverse their job cuts, implying a significant acceleration in private consumption and GDP growth" and adding that "a persistent recovery may even lead to re-hiring next year".

Less encouraging was a note released earlier this year by Goldman Sachs which reflected that "if there are no changes in the institutional arrangements that prevent the labour market from equilibriating supply and demand, future historians will conclude that rising unemployment turned both German and European monetary union into a failure."

That would indeed be a gloomy postscript on the Kohl era. EW

01 Nov 1997