Jeremy Warner's Outlook: Middle East comes riding to Citi's rescue

Capital gains tax reform up in the air; No capitulation in stock prices yet
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The Independent Online

First the banking crisis, now the inevitable call goes up for new capital. One of the things that was meant to distinguish the present credit crunch from previous banking implosions was that the banks were said to have made so much money during the good times and were as a consequence now so well capitalised that they were perfectly capable of weathering the storm without widespread need for rescue finance.

That particular myth has been shattered by news from Citigroup, the world's largest bank, that it is raising $7.5bn from the Gulf Arab emirate of Abu Dhabi. Whatever Win Bischoff, Citigroup's acting chief executive, says about the Abu Dhabi Investment Authority being "one of the world's most sophisticated equity investors", which though it is certainly large may or may not be true, it is hard to believe that America's premier bank would have chosen such an investor had it had any other options.

Only a couple of years ago, Congress passed legislation to prevent Dubai Ports from owning the US ports operation of P&O because of concerns over homeland security. This time around, Citi's need for the money seems to outweigh any squeamishness the US might have over its origins. The oil-rich states of the Middle East seem these days to be the only people with any money for propping up American banks.

As it is, the ADIA is forcing Citi to pay through the nose for its distress. For its $7.5bn outlay, the ADIA gets a convertible loan stock which could eventually translate into a 4.5 per cent stake but in the meantime pays a coupon of a jaw-dropping 11 per cent. That's a couple of notches above junk and a deeply humiliating rate to have to pay for such a top-drawer player.

Earlier this month, Citi committed itself to not cutting the dividend, despite massive writedowns on sub-prime and leveraged lending. Yet even though these losses, in combination with the acquisition binge the bank has been on for the past year, have eroded tier-one capital to below Citi's target level of 7.5 per cent, it is not immediately apparent why the bank should be forced to raise new capital on such usurious terms.

Unless, of course, Citi eventually has to bring the assets it finances through various Structured Investment Vehicles (SIVs) back on balance sheet. HSBC has already bitten the bullet on this issue by bringing some $35bn of SIV loans directly on to its own books. It is highly likely that Citi will have to do the same, with the result that all its capital ratios will end up shot to bits. Yesterday's capital raising has to be seen as preparation for this eventuality.

Still, it is a pretty pass indeed for America's largest bank to have to go cap in hand to the Middle East for money, and then be charged an arm and a leg for the privilege. Whatever next? Colonel Gaddafi to bail out Merrill Lynch?

Capital gains tax reform up in the air

The Chancellor, Alistair Darling, says he is in listening mode on business taxes and promises to announce concessions on capital gains tax reform in the next three weeks. Richard Lambert, director general of the CBI, warns that there will be a cry of rage from business if the changes fall short of expectations. Prepare to cry out with rage is my advice, for it is hard to see how Mr Darling is going to come up with anything meaningful.

This is because the capital gains tax reforms – billed as a tax "simplification" which would bring the much criticised rates of tax paid by private equity partners into line with everyone else – are actually just a tax-raising device designed to pay for the inheritance tax reforms announced by the Chancellor at the same time.

According to Treasury estimates, the capital gains tax changes will raise an extra £900m a year by 2010/11. The inheritance tax changes will, meanwhile, be costing at extra £1.4bn. The Chancellor is not lightly going to abandon his £900m, unless of course he does it by finding a different way of taxing the business pound. There are no published data on utilisation of taper relief, but judging by the Treasury estimate of the benefit to revenue of its abolition, it's a lot.

Ironically, it was this Government which originally introduced the very low rate of taper relief it now proposes to remove. It only goes to show that once a tax concession has been given, it is extremely difficult to remove without causing a stink.

Yet this is not just a case of tantrums after the sweeties are taken away. All the anecdotal evidence is that taper relief has genuinely helped to make Britain a more entrepreneurial country. To remove this obviously highly productive tax break for the sake of giving voters more generous, but entirely unproductive, inheritance tax reductions is not an obviously sensible thing to have done.

Whatever Mr Darling says to the contrary, it smacks of ill-considered, on-the-hoof, policy. The line of thought would have been: oh dear, we've got to do something to counter vote-winning Tory policies on inheritance tax, but where are we going to get the money from? How about capital gains tax, which we can pass off as an attack on public enemy number one – private equity? Never mind the collateral damage among hard-working entrepreneurs.

David Cameron, the leader of the Opposition, promised at yesterday's CBI conference to fight the capital gains tax reforms every step of the way, yet, perhaps significantly, he refused to commit himself to reversing them if elected. Again, this is because he knows he has to find the money for inheritance tax reform from somewhere.

Even he must now appreciate that taxing non-doms isn't going to cut the mustard. There may be votes to win in paying for inheritance tax reforms by making Britain a less competitive place, but in the long run it doesn't benefit anyone apart from the children and other beneficiaries of already wealthy householders.

No capitulation in stock prices yet

The phrase "stock market capitulation" is again coming into quite common usage in the City. Most often it is used in the context of the apparent resilience of equity prices to what's going on in the credit markets. Despite the widespread repricing of risk that is happening in debt markets, and the slowdown this is likely to cause in the world economy, share prices have remained relatively unaffected.

Some liken this phenomenon to the cartoon character who carries on running long after dashing over the edge of the cliff. The moment of capitulation is said to occur when, looking beneath him, he all of a sudden realises there is no ground and then plunges into the abyss. With the stock market again sinking into negative territory for the year, perhaps that moment is upon us.

Yet wherever the stock market is heading, it's not the right use of the expression. Rather, stock market capitulation occurs at the end of a bear market or major correction, not at the beginning. It is that moment when even the most diehard bull gives up hope of recovering his losses and sells. With the final sellers thereby flushed out, only buyers remain. Capitulation is therefore often seen as a buying opportunity.

As ever with stock market wisdom, the expression may not in practice be terribly helpful, as the point of capitulation is virtually impossible to determine with any certainty except with the benefit of hindsight. Yet it seems rather unlikely we are at it already. There's still a profound two-way split between the bulls and the bears, and it is not until we better understand what damage the credit crunch is going to do to the real economy that we can determine which view is the more insightful.

Valuations remain relatively undemanding, but they are based on earnings expectations which may now be unrealistic.

j.warner@independent.co.uk

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