Jeremy Warner's Outlook: BAE needs to clear the air over Saudi arms deal. Future will be clouded until it does

Rates: markets may be in for nasty shock; Reuters deal: not all over yet
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The shares just flew off the shelf yesterday when Hoare Govett placed £750m of stock on behalf of BAE Systems, apparently oblivious to the continued controversy that surrounds Britain's premier arms manufacturer. Protesters meeting under the auspices of the Campaign Against Arms Trade will be out in force for today's BAE annual meeting, and it won't be just the fact of BAE's business that they will be shouting about.

The demonstration will also be calling for the reopening of a corruption inquiry into BAE's arms deal with Saudi Arabia. An SFO investigation into bribery claims was abandoned last December on grounds of national security after the Saudi royal family threatened to break off diplomatic ties if Britain continued with the probe.

Washington has already issued a formal protest and several Congressmen have demanded that a full explanation of US concerns be given before any more BAE-related arms deals are approved. That would presumably include the proposed $4.1bn purchase of Armor Holdings which yesterday's share placing is intended partially to fund.

This places a degree of regulatory risk over the deal that wouldn't otherwise exist. Armor, a manufacturer of armoured vehicles including the famous Humvee, looks to be an excellent acquisition for BAE which further consolidates the company's position in the world's largest arms market. The present strength of the pound against the dollar makes it especially good value for BAE.

However, it is plainly going to be a bit of a problem if the US takes the view that BAE broke the law in winning the Al Yamamah arms contract, and that the Brits are trying to hush it up in their own perceived commercial interest. BAE could find itself blacklisted not just from buying Armor, but potentially from all US arms deals.

BAE insists that there is as yet no evidence of this occurring. Even so, if Mike Turner, the BAE chief executive, thought the issue would subside and eventually go away post the SFO's decision, he's had another think coming. In fact, ending the inquiry has in some respects made the situation a great deal worse. By arguably flouting the OECD convention on bribery and corruption, Britain has found itself an international pariah in danger of being ostracised by the US and others.

The hypocrisy of this position from states and companies which have in the past routinely practised corruption on a much grander scale than Britain is certainly worthy of debate, but it doesn't necessarily help BAE's position. Failure to pursue the SFO investigation to its conclusion may have protected the Al Yamamah contract and the flow of anti-terrorist intelligence from Saudi Arabia, but it may not in the long run end up being in BAE's best interests.

BAE has always insisted that it did nothing wrong, and there is in any case a perfectly valid line of argument to the effect that, if you want to win large orders in that part of the world, something has to be compromised to oil the cogs. I doubt there is any international defence contractor active in the Middle East which hasn't resorted to these practices in the past.

With BAE, however, the key question is exactly when the alleged payments into obscure offshore bank accounts took place. Some of these payments took place before Britain's new bribery law came into force and are therefore not covered by it.

But there are other suspect payments that took place afterwards. BAE's broad-brush assurance that it did nothing wrong is frankly not good enough in the circumstances the company now finds itself in. Neither the public and now, more worryingly from the point of view of the shareholders, the US authorities, are likely to be convinced by it.

If BAE is so confident of its innocence, why doesn't it order an independent inquiry, similar to what James Baker did for BP over the Texas City oil refinery blast, chaired by someone of unimpeachable integrity, whose findings would be published.

This may indeed by the only way of clearing the air once and for all. BAE would no doubt argue that anything it did would be seen as a whitewash and in any case would only further inflame tempers against its interests. Maybe, but the test will be this deal. If BAE finds itself blocked, it will have no option but to proceed to a more public airing of this particular piece of dirty linen.

Rates: markets may be in for nasty shock

Virtually nobody in the City believes interest rates will be left on hold after the Bank of England's Monetary Policy Committee concludes its monthly meeting tomorrow. The only question is whether it will be just the quarter point, or the full half.

Few are betting on the latter, not least because Mervyn King, the Governor, has gone out of his way to stress that inflation should soon be on its way back to target. None the less, it shouldn't be altogether discounted, and my guess is British bank rate will eventually peak at a rather higher level than the markets currently expect - maybe 6 per cent.

As judged by the Retail Prices Index - still the measure most commonly used for wage-bargaining purposes - inflation is already at nearly 5 per cent. In order to anchor inflationary expectations at the 2 per cent target for the CPI, Mr King may need to remove the punch bowl rather more swiftly than he would like.

In any case, it can be argued that underlying inflation is a good deal higher than that observed by the official figures, as these are flattered by the current strength of the pound. A more normalised exchange rate against the dollar would mean higher import prices. If I'm right about bank rate reaching 6 per cent, what will that do to the markets?

Not a great deal judging by what's happened in the US. High short-term interest rates in the US have caused large parts of the housing market to come unstuck, particularly those parts backed by sub-prime lending, but, as evidenced by the present merger boom, they have done nothing to undermine stock market confidence or to reduce the propensity for deal-making. There appears to be still a huge amount of liquidity out there looking for a home, and that's driving both equity prices and deals.

Of course, this could quite quickly dry up if afflicted by higher interest rates than expected. Signs of exaggerated exuberance are everywhere to be seen. One of the wilder ones is in the London market for contemporary art, where speculators are buying everything that moves in the expectation of flipping these largely vacuous works for a big profit a few months down the line.

The phenomenon is driven by City bonuses, which can, presumably, afford to be lost, but it is still real money that is being gambled in this way, and someone will in time get seriously burnt. In any case, the madness of the contemporary art market can be seen as symptomatic of a much wider misallocation of capital.

Can the world economy really have created wealth on the scale that now seems to be slopping around global money, equity, property and art markets, or is it just a function of unrestrained credit growth? There is no easy answer to this question, but, if it is the latter, then there will eventually be a heavy price to pay.

Reuters deal: not all over yet

A done deal? Not yet by the look yesterday of the Reuters share price, which trails the see-through value of the offer mooted by Thomson Corp by some distance. This reflects not so much concerns about the Reuters Share Foundation Company, which could theoretically block the deal on grounds of protecting editorial integrity, as the potential for anti-trust interference.

Depending on whose numbers you believe, the deal would enable Thomson/Reuters to leapfrog Bloomberg to become the number one provider of financial data with approximately 35 per cent of the market. In certain areas, they would be more dominant still. No wonder Thomson is able to offer investors a mouthwatering $500m of synergies.