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INTELLIGENCITY Sustainable smart cities will be created in a grassroots fashion by ordinary citizens. Only then will governments and corporations become vital. p.30 The Queen’s Business Review

APRIL 2014

ISSUE NO. 2


EDITOR-IN-CHIEF.

David Kong INCOMING EDITOR-IN-CHIEF.

Tom Kewley CO-DIRECTORS.

Jonathan Claxton Paul De Sadeleer ART.

Emily Gong Sara MacLellan GRAPHICS.

Michael Chang Duncan O’Donnell Ashley Tse SPONSORSHIP.

Dominic Faoro Curtis Urbanowicz

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This magazine was printed on FSC-Certified Paper.


SENIOR ADVISER.

Lance Fraser LINGUISTICS.

Lauren Coles Sarah Fadel Vanessa Hung David Murray Riley Webb ONLINE.

Alex Lam Karan Khanna WRITERS.

Christine Bancroft Kyle Butler Robert Dolinar Chris Haliburton Tusaani Kumaravadivel James Lee Yingxi Liao Keenan Murray Jaclyn Sanscartier Duncan Seston William Upans Fraser Wells David Wilson Josh Wine

Please recycle this magazine when you are finished.

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April 2014, The Queen’s Business Review


TABLE OF CONTENTS Policy

Canada

World

Technology

6 12 22 30 A

hundred years ago, the guns of August sounded the start of The Great War. It began with a cavalry charge near the battlefield of Mons. Consider what it must have felt like to have been a charging cavalryman in the midst of artillery, fighter planes, tanks, and noman’s land. The world must have seemed to be moving too quickly. Four years later, the war had ended and a new world was born. Four empires had fallen and seven new countries were formed. Since then, the world was supercharged and never looked back. We reminisce about our place in this grand history. At what point will we be the charging cavalryman, lost in the world around us. The world moved too quickly for Heenan Blaikie, a bankrupted Canadian law firm; for Europe, where entrepreneurship is notably low; and for Canada, which can learn a lot from Kenya. We show how Google is poised to surpass Apple because of fundamentally different views on innovation. And from the cover, we look at how to create an environmental city of the future. The Great War introduced the U.S. as a world power. Today, we come to grips with another world power, poised to have the highest GDP by the end of the decade. Just as the twentieth century belonged to the U.S., we consider

whether the twenty-first century belongs to China. We discuss the financial markets, and the market for love. And we ask why not more students end up working there. As much as the Great War helped to establish democracy as the prevailing form of political organization in the world, it also created the first communist state. Our writers explore to what extent Marx’s doctrines will make a return in an increasingly automated world. Like Marx, we offer some ideas on how to prevent unchecked capitalism in the form of monopolies. Finally, we suggest how to deal with the former USSR state of Ukraine. Enjoras, the revolutionary in Victor Hugo’s Les Miserables, cried “Citizens, the nineteenth century is great, but the twentieth century will be happy.” Well, he was quite wrong about that. The future is not that easy to predict, and we do not see ourselves as fortune tellers. Instead, we look back into the wisdom of history to appreciate the present, and modestly peer from the present into the future. We ponder what may or may not make the 21st century happy, or make the 21st century great. On the 100th anniversary of the start of the modern world, The Queen’s Business Review asks, what will make tomorrow modern? David Kong, Editor-in-Chief

20

Legally Blind

China Finance

22

LETTER FROM

THE EDITOR

About QBR

LETTERS

SUBMISSIONS

By the Students

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The Queen’s Business Review is a collaborative effort between undergraduate students in the Queen’s School of Business and many other faculties at Queen’s University, Kingston, Ontario.

Please email comments and opinions on articles to letters@qbreview.org. They will be considered for publication.

Set your ideas in print. Send your article for publication in our next issue to submissions@qbreview.org.

26

Love for a Buck

34

Twitter -4-


6

The Return of Marx

7

Preventing Monopolies

12

Cashing Out: A Digital Currency

14

Brewing Change at Tim Hortons

8

Ukraine

Corporate Taxation

30

10 18

Interest Rates

Mr. Yu

28

Smart Cities

Tech 2.0: The Innovators

24

32

Entrepreneurship in Europe -5-

April 2014, The Queen’s Business Review


I

n 1848 a German-language London news- there overlook the undeniable impact that the Alongside the enormous benefits in productivpaper by the name of Deutsche Londoner rise of technology has had in expanding the gap ity and living standards that will come with the Zeitung published Karl Marx’s Communist between winners and losers in the 21st century ever-increasing capabilities of machines, there Manifesto for the first time. Its core assertion economy. A recent paper by Carl Frey and Mi- will also come a hollowing out of the role that was that capitalism was inherently rigged against chael Osborne of Oxford University concludes unskilled workers play in the new economy. the proletariat because it systematically enabled that 47 percent of U.S. jobs are at high risk of The gap between the “haves” and the “havethe owners of capital to prosper at the expense automation. This idea is not new – in 1933 nots” will become ever wider as the have-nots of the working class. Marx’s work would ulti- John Maynard Keynes predicted widespread find themselves no longer needed to produce mately have a greater impact goods and provide basic services on the shaping of the 19th and to the haves. What will follow is a ALUMNI CONTRIBUTOR 20th centuries than any other virtual disappearance of the middoctrine, inspiring revolutions dle class. in Russia and China (among How then, should society other countries) and laying the adapt to these impending transWhy an old, defunct idea may be poised for a comeback. ideological foundation for the formations? Those who worship great geopolitical struggles of at the altar of the free market will ROBBIE MITCHNICK, COMM 13. the post-WWII era. almost certainly continue to furRobbie Mitchnick works at the Canada Pension Plan Investment For all the Manifesto’s ther their ideology by claiming that Board in Relationship Investments. He is a former CEO of the apparent influence, the ecothose at the top have earned every Queen’s University Investment Counsel and the recipient of the nomic ideas underlying Marx’s bit of their wealth and that any shift Medal in Commerce for the Class of 2013. work have been, by and large, towards greater re-distribution of a spectacular failure. In the income will not be worth its cost absence of rewards to hard in inefficiency. This perspective work, risk-taking and innovaunemployment in the future, “due to our dis- has validity in so far as it is indeed true that a tion, communist economies stagnate. Beset covery of means of economising the use of la- certain degree of income inequality is desirable by inherently inefficient and corrupt central bour outrunning the pace at which we can find in society, as it justifiably rewards the industriplanning, they ultimate crumble under their new uses for labour.” Over the next century ous for their hard work and creates incentives own weight. Even China, history’s lone osten- this is a phenomenon that is likely to acceler- for those of lower economic status to improve sibly “communist” success story, is effectively ate at a staggering pace. Picture the world 50 their standing. However, to dismiss the need a capitalist economy, albeit one with a highly years from now – does anyone really believe we for greater re-distribution of income even in the influential state. will require human labourers to assemble our face of the transformative impact of technology It may seem odd then, that many of Marx’s goods, build our homes, or procure our food? would be foolhardy. 115 original ideas are likely to become increasingly relevant in the century to come. The reason for Gini Coefficient of Income Inequality, Indexed to 1985 Since 1985, income inequality has been rising worldwide this is simple: as technology and automation continue their march towards inevitably great110 er influence, the gains from this transformation will, in a purely free market, accrue disproportionately to a select few, at the expense of the unskilled and semi-skilled working classes. 105 The increase in income inequality in developed countries in recent decades has been well-documented. The relocation of manufacturing jobs to low-wage economies, rising 100 executive pay, and expansion of the financial 1985 1990 1995 2000 2005 2007 2010 sector have all been (rightfully) cited as causes Source: OECD of this trend. However, explanations that stop Gini Coefficient

On the Marx, After All

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In the interest of avoiding an ideological debate around what is “fair,” we will restrict our discussions to the pragmatic reasons why this is so. Firstly, with an overwhelming proportion of society’s wealth trapped at the top, even the businesses that produce the most desired goods will eventually lack for end-market demand. As Walter Reuther, head of the U.S. car workers’ union, quipped in 1955 after touring a refurbished Ford plant equipped with brand new robots, “these are impressive, but how are you going to get them to buy Fords?” Secondly, as the lower and middle classes become increasingly excluded from the rapid increase in prosperity enjoyed by the skilled classes, they will inevitably become a source of disruption. At a minimum, this will drive an increase in crime, imposing significant costs on the wealthy to safeguard their security and property. In the more distant future, if left unabated, it will eventually result in some form of revolution. This will not likely be the sort of militant revolution envisioned by Marx, because in developed economies with strong democracies and law enforcement systems, such movements are generally ineffectual. Instead, the swelling ranks of those at the bottom will eventually use their democratic weight to overcome the disproportionate “democratic” power wielded by the elite. Movements like the American Tea Party will be replaced by truly populous movements – only angrier and with greater support from the mainstream. Clearly these are undesirable outcomes from any perspective. If the gains from technology are to be enjoyed harmoniously, a bold and pragmatic re-engineering of policy will be required. This will have to be careful to respect the intellectual property rights necessary for creating incentives for innovation and avoid the sort of inefficient large-scale wealth transfers that allow the lower classes to freeload off the success of the wealthy, while still confronting the structural inequality problem. One example of such policy would be a large-scale enlargement of public sector support for university tuition, including postgraduate degrees and vocational training. This would give everyone, regardless of background, the opportunity to acquire the skills necessary to partake in the new economy. Funding for this and other required spending programs should come from measures such as the implementation of modest government royalties on intellectual property, such that the gains from new technology are shared by society at large. The course of humanity has reached an inflection point. The rise of intelligent machines has the potential to allow human beings to live far better lives than ever before. But with this great disruption comes the potential that the gains will accrue to a small minority of the population at the expense of a large majority. The wealthy elite would be well advised to accept a certain degree of income re-distribution, lest it be forced upon them. Somewhere, Karl Marx is smiling.

A

ntitrust regulators have been busy over characterized by a natural monopoly. Howevthe past year with mergers ranging er, what this analysis leaves out is that not all from airlines, to advertising, to cable. goods are created equally: consumers take into The question that they face in each case is account the quality of a good along with its price whether the market power gained in the pro- when deciding whether or not to purchase. For posed merger will adversely affect consumers. this reason, we split natural monopolies into Typically, regulators look at the possibility that two groups depending on the degree of differthe monopolist will raise prices significantly, but entiability of the good: homogenous goods and consumers can also be in a worse position if the heterogeneous goods. Homogenous goods have no difference market power means that the company will no longer need to invest and innovate to improve in quality that is perceivable by the consumthe quality of its goods. However, predicting er. Since consumers are unable to distinguish whether or not an industry is likely to slide high quality units from low quality units, they will make their coninto monopoly upon a sumption decisions merger is generally difbased purely on price. ficult to do in practice. In this situation, the Basic economic lowest cost producanalysis divides moers will dominate the nopolies into two market. If a homogegroups: legislative and nous good also has low natural. The first, legisRegulators should not be concerned marginal costs, then it lative, contains any corabout mergers when high-quality will be easy for a single poration that has marproducers can differentiate producer to establish ket power guaranteed themselves. and maintain a natural by government fiat, monopoly. Therefore, which includes both DAN MCGEE antitrust regulators direct provision by the should be concerned government itself and about proposed mergcompanies protected ers by producers of hounder legislation. Natmogenous goods. ural monopolies arise Conversely, heterogeneous goods can be in industries where marginal costs are low relative to fixed costs. As a result, the average total differentiated by customers on a spectrum of cost of production is decreasing over the entire quality. For these goods, the purchase decision range of production. Thus, a single company depends on the perceived value that the concan produce all of that industry’s goods at a sumer is getting from his purchase: the differlower average cost than two companies, each ence between the price and the value he place S serving half of the industry’s demand. The most on the quality of the good. Industries producing extreme natural monopoly sells non-rivalrous heterogeneous goods are not susceptible to natgoods, which are goods whose consumption by ural monopoly, even when their cost structures one individual does not prevent another from imply that they should be. This is because the consuming the same unit. These types of goods monopolist cannot defend its market position often have marginal costs that are almost zero through price alone. If a competitor enters the market with a good of significantly better and thus, enormous economies of scale. Since these companies have decreasing quality, it will take market share away from the average costs as they increase production, they monopolist, even if its price is higher. Thus the would be able to lower prices if a competitor process of “creative destruction,” described by attempted to enter the market, maintaining Joseph Schumpeter, will impose market discimarket dominance. Therefore, this basic pline without a regulator. With this framework, we can analyze acanalysis leads to the conclusion that in order to maintain competitiveness in a market, reg- tions made by antitrust regulators in past mergulators should prevent mergers in any industry ers to see if their decisions made economic

Not All Monopolies are Made Equal

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April 2014, The Queen’s Business Review


sense. First, consider the proposed merger of Publicis Groupe (sic) and Omnicom Group, which was approved by regulators in the U.S. and European Union, and is currently awaiting approval in China. In the short run, the majority of costs for these businesses are fixed because they represent employees’ salaries. However, the quality of the service provided can differ substantially from firm to firm and even from project to project. For this reason, advertising should be considered a heterogeneous good. Therefore, regulators made the correct choice in allowing this merger. Next, consider the mobile telephone market, where American regulators blocked a merger between AT&T and T-Mobile in 2011 and recently expressed opposition to a merger between T-Mobile and Sprint. Although these companies offer a wide variety of phones on an even wider array of plans, their product should be considered a homogenous good. First of all, few phones are proprietary to a single network so the providers are unable to gain differentiation based on which phones they sell. The actual product that the mobile providers sell is access to the mobile network for calls and use of data. Even though there are many different plans available, they differ based on the amount of the service that consumers want to purchase, not the quality of that service. Based on this analysis, regulators were right in opposing the AT&T merger and would also be justified in opposing the Sprint merger. Finally, consider the recently announced acquisition of Time Warner Cable by Comcast. Unlike the mobile telephone market, the quality of the service does differ between firms because consumers can purchase different Internet speeds. This would imply that Internet service should be treated as a heterogeneous good and that the regulators should not be concerned by this merger. However, before a company can provide broadband access to a particular household, they must first dig up the surrounding area and install the cables. In the U.S., these installations are tightly regulated and often forbidden entirely. Thus the cable incumbents’ monopoly power is actually from an indirect legislative monopoly. Therefore, allowing the merger without allowing new entrants to install cable networks will render consumers worse off. The way to ensure consumers are not harmed is to allow competitors to install cable networks underground in order to offer the many services that make Internet service a heterogeneous good and restrain the incumbents’ monopoly power. In summary, the degree of differentiability can serve as a proxy for the likelihood that innovation will break existing monopolies. Therefore, regulators should focus on the cases where a low-quality good is indistinguishable from a high-quality one as these are most susceptible to monopoly. However, they should also ensure that legislation is not inadvertently giving a company monopoly power before ruling that a merger can proceed.

I

n an old Jewish parable, “Water or Wine,” Whack-A-Mole the families of a town are instructed to Tax authorities have found themselves playcontribute a flask of their own wine into ing a game of Whack-a-Mole. When they do a communal barrel to celebrate the arrival of discover and remove one loophole, tax advitheir king. Over the course of the week, a mem- sors are already exploiting another one. The ber of every family reason for this is approached the barthat the tax code is rel and poured into highly complicated it the contents of a and grey-areas exist flask. On the day in many situations. of arrival, the king A good example took the first drink of this is the use of from the barrel and transfer pricing, in produced a face of which multinationals confusion. Instead overpay for goods of pouring a flask and services sourced Caught in between their voters and of wine, every famfrom lower-tax influence from multination corporations, ily had thought the countries. Although governments are finding it challenging to same thing: no one the use of “arm’s get corporate tax policy right. will notice one flask length” policies has of water in a barrel reduced the numRILEY WEBB full of wine. ber of infractions, Multinational corporations are still corporations have taking advantage of applied this mentality transfer prices on intowards paying cortangible services. porate taxes. Their More complex priority has been on maximizing shareholder tax arrangements are commonplace. Major value at the expense of paying their fair share. technology corporations such as Apple have They do this through base erosion and profit engaged in the “Double Irish”. Corporations in sharing (BEPS) schemes, which are aimed at Ireland are taxed based on country of control taking advantage of the different tax laws of var- rather than incorporation. Corporations avoid ious countries. Simply put, BEPS schemes re- taxes altogether by incorporating in Ireland, distribute profits into countries with lower cor- and hold control in a tax haven. Corporations porate tax rates. These tax avoidance schemes also use low-tax subsidiaries to levy above-marare created and implemented in a manner that ket interest rates as an alternative to transfer is consistent with the law by teams of highly-spe- pricing. In most circumstances, company profcialized tax accountants and lawyers. its remain offshore to avoid repatriation taxes.

Catch Me If You Can: Corporate Tax Avoidance

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Corporate Tax Rates Worldwide (2014)

Companies are consistenly allocating resources towards limiting their exposure to taxation 35% 30% 25% 20% 15% 10% 5%

Un ite dS

tat e Ca s na da Jap an Ch ina Sw ed en Fin lan d Ru Sin ssia g Ho apor e ng Ko Ge ng rm a Le ny ba no n Cy pr us Ir Sw elan d itz er Isl land eo fM an UA Br E itis Ber mu hV irg d a in Ca ym Islan ds an Is l an ds

0%

Source: Deloitte, Ernst & Young

An example is Australia’s detailed tax risk management framework that the government is encouraging socially responsible corporations to accept. The incentive is a lower frequency of audits, which will allow tax authorities to focus efforts on corporations who are more likely to be pursuing aggressive tax avoidance measures. The framework will also reduce the cost of monitoring suspect companies.

Governments would like to see these funds used for investment and jobs for their voters. Recently, tax authorities appear to be taking a different approach to their game of Whack-aMole. While governments are still implementing patchwork fixes, such as those in the OECD report on BEPS, they are also fighting corporations on another front: public opinion. The appropriate taxation of multinationals over the last year has changed from a legal battle into a moral debate. Governments are facilitating this debate by connecting taxes to social responsibility, involving consumers, and increasing tax management transparency. Social responsibility — a prominent buzzword in corporations’ financial statements over the past decade — is the act of benefiting society, not just the bottom line. The government has been quick to highlight that corporate taxes ultimately fund public goods and services. The absence of these revenues requires the government to either cut back on these services or raise money from other sources. This past year there has been a frenzied increase in media coverage on the issue. The U.S. government brought it to the forefront of public opinion when it put Tim Cook in front of the senate for Apple’s tax avoidance measures. It has yet to be seen whether consumers will react as strongly to media coverage on tax avoidance as they did to labour-standard abuse. Overall, it is doubtful that companies believe they will win over customers by adorning their products with testaments to their ethical tax management. Governments are putting in place incentives for corporations to be transparent with their tax strategies to account for this sentiment.

The Hand that Feeds Convincing corporations to abide by the spirit of tax law rather than the fine print is not a concrete solution in its own right. Many multinational corporations view their greatest responsibility as maximizing returns for shareholders. To solve the core problem, many governments are attempting a comprehensive reform to their tax laws with the intention of better accounting for the global and increasingly online world. On February 26th, U.S. Chairman David Camp released his proposal for tax reform. The three important broad strokes of this bill are its simplification of the tax code, reduction of the corporate tax rate, and reduction of taxes on foreign income. This is an important step towards encouraging multinational corporations to repatriate the profits held offshore. It also reduces the use of favourable tax treatments towards particular industries, which is a positive step towards increasing fairness and decreasing complexity. However, vested interests of lobbyist groups and politicians will shape this initial proposal into something very different. Politicians are too influenced by the interests of the multinational corporations who face the greatest potential loss from the tax reforms. Take for example the 2010 corporate tax reform implemented in the UK that encouraged tax avoidance. For the most part it has been touted as having a positive economic impact since its implementation — an Ernest & Young report expects 60 corporations to return headquarters to the UK by 2015, bringing with them jobs and growth. However, this was largely the result of concessions allowing corporations to implement tax avoidance strategies, lowering the effective tax rate for some multinationals to 8%. Effectively, the UK government is betting on lost tax revenue being offset by better future growth prospects. An alternative solution would have been to -9-

lower the corporate tax rate to near 8%, which would close these loopholes and be fairer to smaller domestic corporations. Unfortunately, governments would not be eager to do this for a number of reasons, the most important of which is that it would be unpopular. Governments face an inefficient tax system that is ripe for reform, but they are unable to make substantial changes. In an attempt to modernize the system, they inevitably face trade-offs between appeasing their voters and the corporations who provide jobs for their voters. The only way they could completely rid the world of these loopholes is to establish uniform international tax laws — an immensely improbable solution. As a result, the most welcomed approach will continue to be the public opinion campaign discussed earlier. For this to work, citizens need to speak out against corporations’ tax avoidance strategies - either through their purchasing decisions or through social media. Although this is an unlikely situation, governments can shift the odds in their favour by increasing tax transparency and by making information available to the public. When it comes to corporate tax revenues, it appears governments are beginning to favour watered down wine.

http://www.kpmg.com/Ca/en/topics/Managing-Risk-Driving-Performance/Pages/The-Rise-of-Tax-Risk%20.aspx http://www.kpmg.com/Ca/en/External%20Documents/ Tl0408-Tax-Transparency-Report-Final-Web.pdf http://www.forbes.com/sites/realspin/2014/02/27/dave-camps-tax-reform-plan-will-kickstart-a-sluggish-economy/ http://www.forbes.com/sites/anthonynitti/2014/02/26/analysis-of-chairman-camps-proposal-for-tax-reform-part-ii-the-business-tax-proposals/ http://www.theglobeandmail.com/report-on-business/international-business/us-business/republican-chairmans-simplified-tax-code-threatens-canadian-investment-advantage/article17124875/ http://oecdinsights.org/2013/07/19/what-is-beps-how-can-you-stop-it/ http://www.oecd-ilibrary.org/docserver/download/2313331e. pdf?expires=1393616851&id=id&accname=guest&checksum=4AECC32A97375B687CFA5465D5D89946 http://rt.com/usa/corporations-loophole-avoid-billions-taxes-761/ http://www.chabadofmv.com/templates/blog/post_cdo/AID/1086982/ PostID/17549 http://www.theguardian.com/politics/2010/nov/29/corporation-tax-8percent-exodus-multinationals https://www.gov.uk/government/uploads/system/uploads/attachment_ data/file/81286/corporate_tax_reform_part2a_cfc_reform.pdf http://www.sbs.ox.ac.uk/sites/default/files/Business_Taxation/Docs/ Publications/Reports/corporation-tax-in-the-uk-feb-2011.pdf http://www.ey.com/UK/en/Newsroom/News-releases/13-11-25---TheUK-is-flying-off-the-shelves%20 http://www.forbes.com/sites/realspin/2014/02/27/dave-camps-tax-reform-plan-will-kickstart-a-sluggish-economy/

April 2014, The Queen’s Business Review


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n response to the seizure of Crimea, some of 174 instances of sanctions since World War domestic political considerations force national policy-makers have urged the Western I, the use of sanctions was found to have had leaders to show that they are “taking action” world to hastily impose economic sanctions no more than a 40% success rate (Hufbauer, in response to the malfeasance of another on Russia. Their eager embrace of sanctions Schott, et al.). Furthermore, a majority of the state. Sanctions occupy the middle ground has exposed a dangerous public misconception successful cases were those where sanctions between mere diplomatic protest and costly of the efficacy of sanctions as a tool of foreign were applied to countries significantly weaker military action and provide leaders with a policy and of the practical risks involved in their than Russia or were accompanied by physically satisfying solution to foreign policy challenges use. Economic sanctions may be defined as the coercive actions. that have no vital effect on national interests deliberate, government-inspired but where complete inaction withdrawal or threat of withdrawwill be perceived as weakness. al of customary trade or financial From either a domestic or an relations. The most commonly international vantage point, a used forms of sanctions include resort to sanctions should more trade blocks, asset seizures, prooften than not be seen as a form hibition of banking transactions of political theatre, intended to and travel restrictions. An examproduce apparent rather than ination of the empirical evidence actual effects. We may thus safely indicates that sanctions generally disabuse ourselves of any notion Lacking any apparent grasp of realpolitik, Canada’s political leaders fail to achieve their stated goals. that the sanctions proposed are poised to entangle Canada and its allies in a sanctions regime External Affairs Minister by Mr. Baird are intended to that will subject Western economies to uncalculated risks while John Baird announced that, in have any actual effect upon the failing to deliver any concrete results that serve the Western world’s concert with the U.S. and the disposition of forces now on the collective security interests. European Union, Canada is ground in Crimea. actively considering imposing a WILLIAM UPANS Over Reach Dooms Sanctions range of currently unspecified The prospects of exerting ineconomic sanctions on Russia fluence through negotiation are to compel it to relinquish its generally improved by making control over Crimea. Mr. an effort to see the world through Baird has expressly ruled out the eyes of one’s adversary. In the absence of Primarily Instruments of Domestic Politics any form of military intervention. However, historical evidence strongly suggests that in the Despite their ineffectiveness at positively such an effort, one faces the risk of overreachabsence of supporting compulsive measures, influencing the behaviour of targeted nations, ing, of demanding more from the adversary economic sanctions are ineffective at positively sanctions continue to be a popular weapon in than he is able or prepared to concede. In influencing the behaviour of a highly motivated the international relations arsenal. They are Crimea’s case, this process mandates at least and powerful adversary. In a landmark study one means of demonstrating resolve when an acquaintance with Russian and Ukrainian

Economic Sanctions: Canada’s Dead-End Response to the Crimean Crisis

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history as well as some understanding of both nations’ security interests. Russia seized Crimea from the Ottomans under Catharine the Great and annexed it in 1783. A majority of Crimea’s population has consisted of ethnic Russians for most of the past two centuries. Its port of Sevastopol is the home base of Russia’s Black Sea Fleet, the primary mission of which is to safeguard Russian maritime access to the Mediterranean Sea. It is Russia’s only significant ice-free port. Assured access to Sevastopol is a vital Russian national security interest. It is safe to say that Russians would prefer to subsist by gnawing bark from trees rather than allow the Black Sea to become an American lake controlled by the U.S. Navy. By contrast, Ukraine has no comparable historical claim to Crimea and no remotely similar national security interest in its possession. It laid no claim at all to the peninsula before 1954, when Soviet Premier Khruschev transferred it from the Russian SSR to the Ukrainian SSR as a goodwill gesture on the 300th anniversary of Ukraine’s annexation by tsarist Russia. At the time, this transfer had little practical significance, since both republics were bedrock members of the Soviet Union. In the turbulent months during which the Soviet Union dissolved, the Yeltsin administration failed to take the obvious step of transferring Crimea back to Russia before Ukraine gained its formal independence in 1991. Viewed

HENRY KISSINGER CAUTIONED THAT “THE TEST OF POLICY IS HOW IT ENDS, NOT HOW IT BEGINS.”

through Russian eyes, the return of Crimea to Russian control is justified by history and is essential for national security reasons because of Ukraine’s drift towards membership in the EU and possibly even NATO. One finds little if any appreciation of these nuances in the public utterances of Western foreign ministers apparently bent on sanctioning Russia at any cost. Leading proponents of sanctioning Russia have also demonstrated little understanding of the mechanics of Russia’s power structure. It is popularly believed that the final straw which broke the back of the Yanukovych administration in Ukraine was the revolt of Ukrainian oligarchs who feared the freezing of their European assets and the revocation of their EU and U.S. travel visas. We may be encouraged by this precedent to believe that comparable threats of action against Russia’s oligarchs will cause them to pressure Mr. Putin to accede to Western demands for the withdrawal of Russian forces from Crimea. Any such hope fails to recog-

Ukraine

Crimea and the strategically important Sevastopol have often been areas of contention, most recently in a dispute involving Russia

Russian Federation Kiev

Ukraine

Crimean Region 0 0

200 Kilometers

Sevastopol

200 Miles

nize the vast differences between Ukraine and Russia in the ways in which economic power relates to political power. In Ukraine, the state exists in order to serve the oligarchs. In Russia, the oligarchs exist at the pleasure of the state. Early in his first term as President, Mr. Putin crushed the politically influential oligarchs who had emerged during the Yeltsin administration. With the state now all-powerful, the Russian oligarchs’ potential loss of travel and banking privileges in London is of little concern to Mr. Putin. Indeed, such a turn of events might even serve his purposes if it causes Russia’s oligarchs to invest more of their capital at home. The Costs of Retaliation Another failing of those urging sanctions is their slight regard for Russia’s capacity to retaliate and of the uneven distribution of the costs of such retaliation. The United States and Canada engage in little trade with Russia and would bear few of the costs of retaliation. On the other hand, a third of Europe’s natural gas comes from Russia. Most of that is delivered through Ukrainian pipelines. If a Russian response to sanctions were to include the turning off of its gas supply, Europe would experience significant and immediate economic loss. Moreover, Ukraine’s gas supply would also be cut off, conceivably forcing Europe to share already overstretched Norwegian gas supplies with its newly acquired Central European ward. In the face of these realities, Germany has signalled that it has little appetite for participating in a sanctions regime which would devastate German industry but which would have little chance of forcing a withdrawal of Russian forces from Crimea. Significant Russian owned financial assets are serviced in London. Britain has intimated that it would be reluctant to join in any system of financial sanctions which would damage this business. France has shown little willingness to jeopardize the flow of payments its shipbuilders receive from Russia for the vessels being built for the Russian Navy. If the fabric of Western unity were to be torn by internecine arguments over the uneven distribution of the costs of Russian retaliation, the effect of a failed sanctions regime would ironically be to weaken the West at the very moment when considerable Western financial resources and unity of purpose will be required to transform Ukraine’s econo- 11 -

my from Soviet to European Union norms. The Goal of Foreign Policy We would counsel the Canadian government to adopt a different approach to Crimea and more generally to Ukraine. In place of confrontation, a balanced and constructive approach would better serve Western interests. Canadian policy must be shaped by the goal of producing positive real world outcomes rather than satisfying the dictates of ideology. In practical terms, this means that Canada’s efforts should be devoted to assisting Ukraine in modernizing its economy, reforming its state institutions, fighting corruption and suppressing radicalization. Most Eastern European countries substantially achieved these objectives within a few years of breaking free of the Warsaw Pact and the Soviet Union at the end of the Cold War. It is Ukraine’s turn to join their ranks. A more mature and nuanced approach to Russia is also necessary. Support for a measured and unheralded enhancement in the strength of NATO forces in the Baltics would be one means of demonstrating our commitment to the security of Europe’s borders. This could be balanced by support for the proposition that Ukraine should not become a NATO member. Taken together, these measures would enhance stability by endorsing the current military status quo. In commenting on his own country’s policy towards the Crimean crisis, Henry Kissinger cautioned that “The test of policy is how it ends, not how it begins.” The subordination of strategy to domestic politics is pushing Canada towards an approach to Crimea that has no currently plausible positive outcome. We will see in the fullness of time how that policy ends.

van Bergeijk, Peter A.G. (2012, March 27). Failure and Success of Economic Sanctions. Retrieved from http://www.voxeu.org Kissinger, Henry A. (2014, March 5). How the Ukraine Crisis Ends. The Washington Post. Retrieved from http://www.washingtonpost. com Hufbauer Gary Clyde, Schott, Jeffrey J., Elliott, Kimberly Ann, Oegg, Barbara. (2009) Economic Sanctions Reconsidered (3rd Edition). Washington, D.C: Peterson Institute for International Economics Mead, Walter Russell. (2014, March 6). Russia Blows Past Obama’s “Off Ramp”. Retrieved fromhttp://www.the-american-interest.com McDonald, L. Col. Sean P. (2011, August 3). Efficacy of Economic Sanctions: North Korea and Iran Case Study. Retrieved from http:// www.dtic.mil/dtic/tr/fulltext/u2/a560335.pdf Schmitz, Gregor Peter (2014, March 5). Ukraine Crisis:EU Concerned about Cost of Sanctions on Russia. Retrieved from http://www. spiegel.de

April 2014, The Queen’s Business Review


A

t first glance, Canada and Kenya have transport, and limited security. As a result, only M-PESA transactions is equivalent to 25% of little in common. The former is an about fifteen million total bank accounts exist Kenya’s GNP. These numbers are mind bloweconomically vibrant and politically in Kenya, and only about four million Kenyans ing – $9 billion USD worth of transactions that stable member of the G7 whose national pas- have traditional bank accounts. This also means would have otherwise likely gone unrecorded time is ice hockey. The latter is a developing that cash is scarce; the average cash transaction are now legal, regulated, and taxed. More imnation whose gross domestic product per cap- in Kenya is equivalent to $1 USD. Images pressively, the added ease and convenience of ita is one-ninth of Canada’s rural low-income of farmers (75% of Kenyans are employed money exchange has led to income increases of cut off (LICO) and one-thirteenth of Canada’s in agriculture) trading cattle in exchange for between 5% and 30% for rural households who adopt the service. urban LICO. Tyrannical rule ended in Kenya services are easily conjured. In contrast, Canadians love in 2002, and since then the cash - consider the buzz and hyscountry’s politics have been teria surrounding the most recent muddled by corruption and bank note series introduction. Appost-election violence; the proximately 54% of all transactions current president, Uhuru are conducted using cash, repreKenyatta, is facing charges of senting 20% of total transaction valcrimes against humanity for Mobile banking is the next frontier for efficient monetary ue. Since its inception in 1934, the violence he instigated followexchange. Canada should adopt Kenyan style mobile money and Bank of Canada has issued eight seing a failed election bid in marginalize the wasteful physical currency. ries of bank notes. There are close 2007. Yet, Canada would do to two billion legal tender notes in JOSH WINE well to learn from Kenya’s circulation at any time. Cash cermobile banking system. tainly has its advantages: it is easy Traditional bricks-andto keep track of to assess spending, mortar banks are hard to it is costless to process and sellers find in Kenya. The country’s Where Kenya’s financial system reigns su- have no fear of bad debt. However, cash has population is largely tribal and therefore quite sparse – only 22% of Kenya’s forty-three preme (and where Canada can take note) is in its disadvantages: cash can be counterfeited and million citizens resides in urban settings. The advances made to mobile banking. In 2007, can change hands anonymously. Counterfeiting of Canadian bank notes is a country’s roads, bridges, and highway networks Kenya’s largest telecom provider, Safaricom, are in poor condition. 60% of the country’s launched a service called M-PESA, which bigger problem than one might expect. In 2004, population does not meet the monetary means mobile money in Swahili. Safaricom has the Bank of Canada (BOC) estimated that $13 threshold to open a traditional bank account. nineteen million Kenyan subscribers, seventeen million CAD worth of counterfeit money in Commercial banks have trouble sustaining million (67% of Kenya’s population aged 15 or 550,000 counterfeit notes passed through the operations outside of urban centers because older) of whom use M-PESA for nearly all of system. In 2012, after Canada rolled out two of limited client exposure, high costs of cash their daily transactions. Nowadays, the value of new bank note series and incurred massive an-

Cashing Out

- 12 -


ti-counterfeiting costs, only $1.6 million CAD worth of illegal tender passed through the system. Although the necessity of anti-counterfeiting measures is obvious (vast amounts of counterfeit notes tarnish a currency’s reputation and destabilize confidence in a central bank), the costs of these measures are astronomically high. The cost of the two-year roll out of the first new banknotes, the Journey Series, from 2004 to 2006, is estimated by the BOC to be between $25 and $35 million CAD. The ongoing cost of the new Polymer note roll out is estimated by the BOC to be between $75 and $100 million CAD, but the Globe and Mail puts actual costs much higher, at $300 million CAD. Given these figures, plus an unknown amount allocated to the RCMP (one strategic anti-counterfeiting task force received $21 million CAD of funding over four years), it is not far-fetched to peg Canadian anti-counterfeiting efforts at between $400 and $500 million CAD. As technological capabilities of counterfeiter improve, an ever-increasing amount of research and development dollars will be necessary to create safe and sham-proof bills. A traceable digital currency goes one step beyond fighting counterfeiting. Although privacy activists may call for resistance, the recording of every monetary exchange will work to the benefit of criminal justice departments and tax collection agencies. Drug dealers are known to horde loads of received cash to avoid piquing the suspicion of scrupulous investigators. Scores of people hide parts of their income or engage in under-the-counter cash transactions to avoid paying a tax. Most recent estimates

HOW WILL YOU SUCCEED?

state the size of the Canadian underground economy to be greater than $40 billion CAD, or 2.3% of GDP. The appeal of not declaring income is so obvious that it should be expected. This evasion may occur in the most innocent of settings: a soccer mom paying her landscaper with the underlying understanding that the price of services will be lower if she pays all or some portion in cash. In this simple example, the gar-

$9 BILLION USD OF TRANSACTIONS ARE NOW LEGAL, REGULATED AND TAXED dener is a sole proprietor of his business – he can go on to not declare this income and pay no income tax, or he can choose the safer scenario and under-declare his income so that he faces a lower tax rate. An underground, unregulated economy undermines the government’s regulatory authority and destabilizes the legitimate economy through temptation. Unrestricted use of electronic currencies, like Bitcoin, would undermine the ability of government institutions to set meaningful monetary policy. However, the continual printing of money is wasteful. The solution is something in between. Canadians should be encouraged to use their mobile devices to access banking ap-

plications and engage in everyday transactions. Venmo, a smartphone app already allows for encrypted transfers between Facebook friends by depositing and withdrawing funds from virtual accounts. Certain transactions cause users to incur fees, making them less desirable than cash exchange. The precedent should be set for banks and other application developers by working to pass legislation that approves direct banking operating systems like M-PESA for all types of phones. Ubiquity of mobile monetary exchange will sooner or later make printing notes obsolete. As computers become ever more reliable and security improves, instead of printing a bill, computer software could simply generate and trace a serial number for each dollar created. Although a purely digital but regulated currency sounds like science fiction, digital money is being adopted at a rapid rate. The Loonie should strive to keep up.

http://www.economist.com/news/finance-and-economics/21574520-safaricom-widens-its-banking-services-payments-savings-and-loans-it https://www.cia.gov/library/publications/the-world-factbook/geos/ ke.html http://www.economist.com/news/middle-east-and-africa/21573592-coalition-led-kikuyu-countrys-richest-and-biggest-ethnic-group-has?zid=309&ah=80dcf288b8561b012f603b9fd9577f0e http://www.statcan.gc.ca/pub/75f0002m/75f0002m2012002-eng.pdf http://www.lonelyplanet.com/kenya/weather http://www.centralbank.go.ke/index.php/news/243-banking-sector-registers-improved-performance http://www.cgap.org/blog/10-things-you-thought-you-knew-about-mpesa http://www.economist.com/blogs/economist-explains/2013/05/economist-explains-18 http://www.cbc.ca/news2/interactives/map-cdnbillscirculation/ http://www.bankofcanada.ca/wp-content/uploads/2012/02/dp2012-02. pdf http://www.rcmp-grc.gc.ca/count-contre/count-fals-eng.htm http://www.bankofcanada.ca/wp-content/uploads/2011/06/spencer.pdf http://www.statcan.gc.ca/pub/13-604-m/13-604-m2014073-eng.pdf

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BENEFIT S OF CFA SOCIETY TORONTO MEMBERSHIP CAREER CENTRE • access to exclusive online career centre • hundreds of job postings annually RAISE AWARENESS • promote the designation and the high ethical standard the charter embodies THE ANALYST • quarterly publication for industry professionals • a rich archive of research, trends, reading recommendations, and interviews with influential leaders in the investment industry MENTORSHIP PROGRAM • experienced mentors are assigned on a one-on-one basis to motivated protégés

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- 13 -

April 2014, The Queen’s Business Review


- 14 -


Brewing Change At age 50, Tim Hortons is among the most iconic of all Canadian brands. The evolving fast casual restaurant has amassed a cult-like following at home, and is now looking south of the border and overseas for new growth markets. On February 25th, the company unveiled its new five year strategic plan to mixed investor reviews. Jonathan Claxton explores how three strategic changes will ensure another half-decade of success. JONATHAN CLAXTON

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April 2014, The Queen’s Business Review


I

n Canada, few brands rival Tim Hortons, the restaurant chain started by a Hockey Hall of Fame-inductee and a maritime-born police officer in Hamilton, Ontario. In the half-century since its founding, Tim Hortons has grown to over 4,300 locations in all but one of the 13 Canadian provinces and territories (Tim Hortons, 2012). It has a cultlike following for whom a daily trip to “Tims”, as they affectionately refer to it, is a necessity rather than a luxury. More recently, the company has made inroads south of the border, amassing over 800 locations along the eastern seaboard from Florida to Maine. Tim Hortons has also whet the appetite of customers in the Middle East, opening 22 stores in Oman and the United Arab Emirates. On February 25th, the company unveiled its new five year strategic plan to mixed investor reviews. Tim Hortons is looking to open up 800 new locations, 500 of which are in Canada and the balance in the U.S. Also present were a range of new initiatives, from new menu options and improved supply chains to more technological integration and non-traditional store forms like “Tims Express” and self-serve

kiosks (Financial Post). Tim Hortons has been facing declining same-store sales, intensifying competition and concerns over whether the company will be able to maintain quality and consistency while meeting its ambitious growth targets. In order to overcome this, the iconic Canadian brand must carefully examine several strategic changes. Expanding geographically The first change is geographic expansion. Ontario and Eastern Canada have the most Tim Hortons stores per capita, with a store for every 11,400 and 8,100 people, respectively. In five years, the company plans to expand its presence in Western Canada and Quebec more rapidly, increasing the number of stores per person. This move reflects a desire to tap underpenetrated markets and increase sales. However, not all provinces are created equally with respect to growth and consumer purchasing profiles. On an absolute basis, Quebec has the second largest commercial foodservice sales after Ontario. However, on a per capita basis, the province lags behind the national average spend by 14%. Alberta and British Columbia

Tim Hortons Premium/Discount to Peer Median Price per Ounce South of the border, Tim Hortons sells products at a premium price 19%

20%

Canada

15%

11%

USA

9%

9%

10% 5% 0%

0%

-5%

-8%

-10% -15%

-12%

-20%

-20%

-25%

-28%

-30% -35%

-31%

Coffee

Iced Coffee

Specialty Coffee

Iced Specialty Coffee

All Coffee Products

Source: Miller Tabak & Co., LLC, Jonathan Claxton

- 16 -

have the highest annual per capita spend at $1,991 and $1,697, respectively (GE Capital). In other words, the average customer in Alberta spends 64% more at restaurants than his or her counterpart in Manitoba, the province with the lowest per capita spend. In light of this, a broadbased expansion into all of Western Canada would be a miscalculation.

ANNUAL SAME-STORESALES GROWTH HAS BEEN DECLINING SINCE 2011 Further, commercial foodservice sales growth varies significantly from province to province. Compound annual growth rates (CAGR) for 2009 through 2012 ranged from 0.2% in British Columbia to 7.9% in Newfoundland and Labrador (GE Capital). On account of both their high average per capita spend and strong industry sales growth, Alberta and Saskatchewan are the most attractive candidates for Tim Hortons location expansion. Re-evaluating U.S. menu pricing The second change is a re-evaluation of its U.S. pricing strategy. The prices of a company affect everything from its profit margins to its customers’ perceived value of its products. Currently, Tim Hortons has conflicting price positioning north and south of the border. In Canada, relative to McDonald’s and Starbucks, Tim Hortons prices its products at an 8% to 31% discount to the peer median, depending on the product line. In the U.S., relative to McDonald’s, Starbucks, and Dunkin’ Donuts, Tim Hortons’ products are more expensive, selling at up to a 19% premium to the peer median (Miller Tabak). In order for Tim Hortons to become more


Tim Hortons Geographic Expansion

Over the next five years, Tim Hortons is prioritizing growth in Western Canada and Quebec

7.9%

West 2013 18,900 2018 17,100 Quebec 2013 17,600 2018 15,800

Ontario 2013 11,400 2018 11,300

0.2%

East 2013 8,100 2018 8,500

5.7%

3-yr. Industry CAGR

6.3%

3.5% 4.7% 3.3%

Capita per Standard Store competitive in the highly-crowded U.S. market, it must re-evaluate its menu pricing. The company has been building a foundation in the U.S. over the past few years, expanding brand recognition and establishing a foothold in several core markets in the Northeastern quadrant of the country. Over the coming years, Tim Hortons plans to reduce initial investments costs for its U.S. locations by 10% to 15%, as a result of decreased building costs and increased efficiencies with new equipment (Tim Hortons, 2014). Opportunities for improvements in the company’s U.S. supply chain and distribution channels also exist. As Tim Hortons realizes these economies of scale and transitions to a more aggressive U.S. strategy, it will be better able to bring down prices and align its price positioning north and south of the border. Intensifying competition A GE Capital survey of top industry CEOs asked for the top three opportunities and threats in the foodservice industry in 2013. Respondents listed acquisitions and consolidations, cost control, guest experience, and healthy options as the greatest opportunities; they listed operating costs, followed by competition and the economy as the greatest threats. Intensifying competition is particularly prevalent in the “fast casual” market that Tim Hortons competes in, with pressure from new entrants as well as limited sales and traffic growth. Companies like McDonald’s have made forays into a more sophisticated market with renovated stores and healthier menu options. Tim Hortons has also faced internal challenges at the store-level with more substantial, higher-priced menu items that take longer to prepare and contribute to the long, winding lineups that the chain is notorious for. Tims remains the clear market leader in the Canadian caffeinated beverage space, selling 74.5% of all quick service restaurant (QSR) servings. Mc-

4.4%

3.4%

Donald’s is second with 9.6% followed by Starbucks with 4.6%. Tim Hortons is also number one in the breakfast, morning snack, afternoon snack, and evening snack categories. However, the next and crucial ‘daypart’ that Tim Hortons must improve on is lunch. The company’s strategic plan calls for an “Ownable lunch proposition: Fresh, bolder flavours and significant moves in Health, Nutrition & Wellness”. In order to effectively capture the midday customer, Tim Hortons will have to do more than roll out health-conscious menu items. It will have to improve and streamline the total customer experience, from entrance to order to exit. Advanced point-of-sale (POS) technology and simplified menus will form the basis for this change The road ahead Industry headwinds at home and abroad abound for Tim Hortons. Annual same-storesales growth has been declining since 2011, and intensifying competition is pushing the need for change. The company’s strategic plan is prom-

1.5%

ising insofar as it touches on many necessary improvements at both the store and corporate level. However, there is still room for improvement. Geographic expansion in Canada must be more strategic, with accelerated location growth in provinces with the most attractive industry growth and consumer purchasing profiles. Price positioning north and south of the border must become more aligned to increase competitiveness in a saturated U.S. market. Finally, the store-level customer experience must be streamlined to present a more compelling value proposition to customers, particularly those outside of Tims’ breakfast stronghold.

Financial Post, Tim Hortons Inc to open 500 new stores in Canada, 300 in U.S. GE Capital, 2013 Canadian Chain Restaurant Industry Review Miller Tabak + Co., LLC, Tim Hortons (THI) Initiating Coverage Report (February 14, 2014) Tim Hortons, Annual Report (2012) Tim Hortons, Investor Conference 2014 Slide Presentation

Commercial Foodservice Sales by Province

On average, Alberta and British Columbia residents spend the most on restaurants National Average Spend Per Capita 2011 Commercial Foodservice Sales

$25,000

$2,500

2011 Commercial Foodservice Sales Per Capita

$20,000

$2,000

$15,000

$1,500

$10,000

$1,000

$5,000

$0

$500

NL

PE

NS

NB

QC

ON

MB

SK

AB

BC

$0

Source: GE Capital

- 17 -

April 2014, The Queen’s Business Review


R

ising interest rates in the Canadian real (Bank of Canada, CIBC Economic Research). potential growth of REITs and REOCs alike, estate markets have caused trepidation As interest rates represent one of the strongest stagnation in the real estate investment space among REIT and REOC investors. macroeconomic factors in determining future appears to be the only outcome. This logic is further amplified by the fact that the However, such concerns U.S. quantitative easing initiative has remain relatively unfounded declined in the past months by over as the real estate markets $10 billion to a level of $65 billion/ have proven to be semi-strong month, providing additional specuefficient in pricing in these With interest rates projected to rise over the next year, investors lation for fears of increasing mortrising rates. in the REIT market remain apprehensive of the real estate space. gage rates across North America Fears involving the prosHowever, given the effect of the efficient market hypothesis, this (Economic Times). Cumulatively, pect of rising interest rates in speculation is not a cause for concern as future rising interest rates these trends would suggest that inthe real estate market have have already been priced in. vestors are validated in withholding driven potential investors to investments from the real estate approach real estate operating ROBERT DOLINAR market. However, given the effects companies (REOCs) and real of the semi-efficient market hypothestate investment trusts (REesis and its ability to price in all curITs) with a bearish outlook. In rent public information, these fears just the last fiscal year, 10 Year Government of Canada (10Y GoC) bond yields value for real estate institutions, this heightened are unfounded. Following one of the primary concerns of saw a 58 bps increase, with a further upward level of caution is completely justified. As such, trend projected until at least the end of 2015 with the trend in interest rates undermining the the real estate market, the focus of this next

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Spread Between Implied REIT Cap Rate & 10Y Government of Canada Bond Yield Quarterly, 2006-2014

S&P/TSX Capped REIT Index Decline in the performance of Canadian REITs in the past year has stimulated discussion on their ability to generate consistent returns $185

6.0% Average Spread 5.0%

$180 $175 $170

4.0%

$165 $160

3.0%

$155 $150

2.0%

$145 1.0% 1/2/2006

$140 3/31/2007

6/30/2008

9/30/2009

12/31/2010

4/2/2012

3/5/2013

3/28/2013

8/1/2013

4/18/2013

10/30/2013

2/24/2014

Source: BMO Research, Government of Canada

discussion will apply specifically to REITs and their reactions to rising bond yields. After what has been described as the end of a “20-year era of exceptional returns,” the prospect of REITs in Canadian markets has been brought into question (CIBC REIT Monthly). In less than a year (since its peak on April 30, 2013), the S&P/TSX Capped REIT Index has declined by over 13.4%, lagging the S&P/TSX Composite Index by 27.6% for the same time period (Yahoo Finance). While emphasizing the difficulties that have been experienced by the real estate market of late, this example also illustrates the customary inverse relationship between rising interest rates (demonstrated in the GoC bonds) and declining REIT prices. More importantly, however, this example implies that rising interest rates have already been priced into the REIT market with a 13.4% correction. The semi-strong efficient market hypothesis states that any and all information found in the public domain is already inherently implied within the market price, making technical or fundamental analysis impossible (Encyclopedia of Economics). Essentially, in the case of Canadian REITs, the full decline demonstrat-

Source: Yahoo Finance

ed by the REIT Index is the direct product of investors anticipating the rise in interest rates and pricing in this publicly available information. This can be illustrated in an analysis of the spread between 10Y GoC bond yields and implied REIT cap rates. A cap rate (or capitalization rate) represents the unlevered return on investment for a single piece of real estate property. When evaluating real estate, the value of the property is derived from its ability to generate cash flows. If interest rates fall, the discount rate on the cash flows will also fall, raising the present value of the property. Thus, it can be said that cap rates have a direct relationship to bond yields, as declining interest rates increase property values and thereby decrease their unlevered return (or in this case, the cap rate). As such, if the REIT cap rates do not decline in a similar response to falling bond yields, it is likely to be a result of alternative public information. With that in mind, an analysis of the spread demonstrates that a downward trend occurred during the last months of 2013 as bond yields held a temporary decline (BMO Research, Bank of Canada). However, rather than dipping to its historical average, this trend

10 Year Government of Canada Bond Yields

ended with the spread remaining 43 bps above average, implying that investors are already pricing in future rising interest rates as they predict higher cap rates with lower property values. With valuations bottoming out and beginning a slow incline (despite the projected rise in yields), it is clear that the risks involved in rising interest rates have largely been eliminated through implicit pricing. Although it is true that the real estate market has experienced turbulent waters within the past year, rising interest rates are no longer a great cause for concern. As the volatility associated with interest rates inspires the most apprehension in real estate investors, the pricing-in of these rates can be seen as a positive step for real estate markets. With less exposure to risk, REITs and REOCs with high dividend yields will once again attract investors as a long-term growth investment. Although a recovery in the markets may never approach the valuation highs reached by the past 20 years of low interest rates, there is certainly further growth to be had.

Forecasted 10 Year Government of Canada Bond Yields Rising interest rates will cause stagnation in the real estate investment space

Rising interest rates have caused investors to approach firms in the real estate investment space cautiously 3.0%

4.0%

2.7%

3.5%

2.4% 3.0%

2.1% 2.5%

1.8%

1.5%

2.0%

3/1/2013

5/1/2013

7/1/2013

9/1/2013

11/1/2013

2/1/2014

6/1/2014

12/1/2014

Source: Bank of Canada

6/1/2015

12/1/2015

Source: CIBC Economic Research

AMS SUSTAINABILITY ACTION FUND (SAF)

The SAF is a commission of the Queen’s University Alma Mater Society (AMS) created to promote, and educate students on, environmental sustainability. We are pleased to announce that along with increased circulation, the use of certified environmentally friendly paper was made possible by the SAF. This issue’s cover story addresses the risks and opportunities present in sustainable business practices. - 19 -

April 2014, The Queen’s Business Review


Slow and Unsteady Many factors contributing to Heenan Blaikie’s collapse are apparent in the legal industry as a whole. First, law firms have been incredibly reluctant to innovate. On the operations front, they have only just begun applying lean management and six sigma practices when other industries have been embracing these tools for decades. On the marketing front, firms have just begun shifting to alternative pricing models. Even now, the billable hours model is the industry standard. This antiquated practice leaves clients entirely unable to predict legal expenses and incentivizes firms to decrease efficiency. How often firms actually inflate these hours is a matter of contention, but the incentive nonetheless causes suspicion. Additionally, law firms have been sluggish in differentiating. Speaking anonymously, a partner at a Toronto law firm with twenty years of experience discussed with your correspondent the actions firms need to take in order to differentiate. He explained that there are two significant considerations: first, the organization must alert the market of its core values, and second, the organization must advertise its leading talent. For the former, firms must clearly identify values that are important to its clients, create a culture that embraces those values, and intentionally structure the client experience and the firm’s work so that those values are exuded. For the latter consideration, firms must attract and retain top lawyers whose reputation and expertise can attract clients, continuously feeding business to the firm. The key, he explained, is to maintain a balance between the organization’s brand and the brands of these t was not simply misfortune that led and a 15% decrease in income per partner top lawyers. Indeed, many firms have failed to maintain Heenan Blaikie, a renowned Canadian law (Financial Post, Hasselback), Heenan Blaikie firm with over 500 lawyers, to abruptly dis- hired a consultant and began considering ‘stra- this balance. With a reluctance and possible solve its operations in early February. Although tegic options’ for its future. Although neither of inability to properly differentiate their organizathe organization had several unique managerial these declines was especially dramatic, the firm tional brands, Heenan Blaikie and others have challenges, the underlying causes of its failure was facing increased price competition from over-relied on a ‘rainmaker’ model. Hiring are representative of the legal industry’s defects. lower-level firms, breaking even on new To- highly connected, glamorous lawyers such as A mix of risk aversion and overregulation has ronto facilities and underperforming in Paris. former Prime Ministers (i.e. rainmakers), these caused the profession to face financial instabil- Altogether, the rumours of ‘strategic options’ firms have hoped to leverage previous political ity and fall behind others in innovation. Legal quickly became rumours of major downsizing. and business relationships to attract new work. firms, professional bodies and This model’s flaw, however, is other regulators must take off that although these exceptionaltheir blindfolds in order to avoid ly-paid rainmakers may bring in future Heenan Blaikie-like failnew clients, these clients rarely ures, and to improve the quality develop loyalty to the organizaand accessibility of legal services. tion. Rather, they remain loyal Educators and regulators must remove the impediments to progress only to the highly mobile rainBlaikie Breakdown in the legal industry. makers, following them as they Founded in 1973 in Montreal, move from one firm to the next. Heenan Blaikie grew to become ELLIOT SEETNER Even if the firm achieves some a notable, mid-tier law firm with differentiation from these superoffices across Canada and Parstars, it is for the short term and is, and a multi-service business at great financial expense. law practice (“mid-tier” refers Because of this lack of into large firms that are less ennovation and differentiation, many law firms This ominous news, along with continued trenched than the “Seven Sister” firms, which lead the Canadian legal industry). The firm leadership conflicts and management mishaps, are especially vulnerable to changes in market became recognized for hiring such well-known drove partners to exit the firm at an accelerat- dynamics. Without the ability to manage and individuals as Pierre Elliott Trudeau and Jean ed rate since December of 2013. As partners adapt operations, firms have significant chalChretien, and developing, among others, distin- left, equity stakes and clients followed, and a lenges in decreasing costs during economic guished labour and employment, and entertain- snowball effect began. On February 5th, the re- troughs. Without value-added pricing options maining partners voted to terminate the organi- or proper differentiation, firms have difficulties ment practices. when facing increased competition. The legal After a dip in Canadian M&A activity (a zation. Heenan Blaikie was no more. industry experienced both of these changes in major revenue source for corporate legal work)

I

Blind Justice, Blind Industry

- 20 -


2013, and although Heenan Blaikie was the only major firm to collapse in Canada, numerous others were forced to restructure (Financial Post, Tedesco). But why is the industry so bad at adapting? Firm Beliefs One reason is likely that “lawyers as a group differ significantly from the general population in what has been called ‘resilience’ — the ability to recover after failure, to bounce back” (Lexpert). Psychological tests have shown that lawyers score low in this dimension and are generally risk-averse individuals. Those that have difficulty recovering from failure actively take steps to avoid chances of failure. Intuitively this makes sense as a large portion of legal work involves minimizing risk for clients. Risk-averse individuals are thus attracted to the profession and much of the professional training focuses on risk mitigation. Unfortunately, this has resulted in an industry greatly afraid of change. Few lawyers are willing to deviate from the status quo and few individuals with decision-making power in firms have business backgrounds. The result is that most firms continue to rely on antiquated business models. This dynamic is only exacerbated when larger firms require fifty plus partners signing off on each organizational decision made. Although the nature of the profession almost necessitates this characteristic, the legal education system can be improved to at least lessen its negative effects. For example, the case-study approach loved by business schools could be adapted and applied to law school classes. This could teach students how to solve not just technical legal issues, but also those experienced by legal firms, which often require some risk-taking and creativity. Bar on Capital A second root cause of the industry’s defects, and one which can be completely removed, is the regulation on raising capital. In Canada, the US, and several other common-law countries, non-lawyers are not legally allowed to have an ownership interest in law firms (The Globe and Mail). This prohibits firms from raising finances through private equity or public markets, and leads to a number of worrisome issues. First, this regulation leaves firms financial-

ly vulnerable to partner exits. Although equity stakes in public corporations can be easily sold to external investors, equity stakes in law firms must be sold back to the organization. As Heenan Blaikie experienced, a slight dip in revenues can lead to a ‘run-on-the-bank’ effect in which numerous partners exit the firm in a short period of time. In such a situation, exiting partners demand payment for their equity stake in cash, usually equivalent to a year’s salary, and place the firm under huge financial stress. Furthermore, such situations diminish clients’ confidence in the firm’s continued existence, which is essential for the long-term nature of legal work. Many clients move their accounts to other providers, perpetuating the downhill snowball effect. Second, this regulation prevents the industry from gaining well-needed discipline to innovate and differentiate. Law firms with external interests would be placed under the same financial pressures by investors as other businesses, incentivizing change and improvements to enhance short and long-term profitability. As well, such firms would benefit from the managerial expertise that their new organizational structure could provide; nonlawyer owners and boards of directors would be able to impart business knowledge and advocate less risk-averse approaches. Third, this regulation impedes law firms from gaining valuable diversification. Similar to ad agencies, much of corporate legal revenues fluctuate differently in different markets and being part of international holding companies can aid with this financial challenge. Removing the capital regulation will allow parent companies to hold ownership interests in multiple law firms (and possibly other organizations) in multiple markets. Aside from the provided benefits of synergy, economies of scale, and greater expansion abilities, such parent companies will be able to absorb variances in profits and shift capital around as needed. Slater & Gordon, the first law firm to ever go public, has benefited tremendously from these and other factors, driving its share price over 250% since its 2007 IPO (Reuters). Although the Australian firm led other domestic and UK firms to follow suit, much of the common-law world has cited conflict-of-interest concerns as the reason for not passing this bar.

Annual Canadian M&A by value and volume, 2008-2013

Deal Volume

$250,000

3,500

Aggregate Deal Value

3,000

$200,000

Honest Lawyers Imagine Company A has a large ownership interest in a law firm and is a direct competitor with Company B. Now imagine Company A launches a lawsuit against Company B, and Company B hires this law firm to represent its interests (Company B has been a regular client of this law firm). Critics of deregulation argue that the firm’s interests in satisfying its owner and its client are directly conflicting; they argue that even if this conflict occurs quite infrequently, the mere possibility for these opposing incentives would degrade lawyer-client relations in the legal system as a whole (Bloomberg BusinessWeek). This argument is invalid for several reasons. Firstly, regulators can minimize conflicts of interest when they adjust policies. While non-lawyers would be allowed to have ownership stakes in law firms, new policies could restrict how large those stakes could be and would be able to necessitate firms to publicly disclose potential conflicts of interest upon taking new clients and new cases. Upon such announcements, clients could decide whether or not to continue using their services. Secondly, if such conflicts still remained, providing low-quality legal services in the interest of satisfying owners would not be a sustainable strategy. Although the quality of legal work may be initially unintelligible, clients would be able to recognize sub-par performance in the mid-to-long term and would be quick to transfer their work to competing firms; in an industry with large, repeat accounts, and therefore high levels of buyer power, risking client relationships would be detrimental to firm profitability. Furthermore, such sub-par performances would rapidly spread through word-ofmouth, further damaging firm profitability and also attracting the eyes of watchful professional bodies, such as the Law Society of Upper Canada. Indeed, the Law Society would most definitely develop a whole new string of regulations for public law firms. All in all, lifting ownership regulations would eliminate a critical obstacle to the legal industry’s progress. The significant benefits of such deregulation are apparent, while the risks are either entirely unlikely or can be protected against. By having non-lawyer ownership interests in firms, legal services could become increasingly innovative and differentiated, and gain a greater ability to manage fluctuations in demand. Ultimately, legal work will improve in quality and accessibility, and fewer firms will collapse like Heenan Blaikie. The lawyers involved in regulation must overcome their low resilience and take off their blindfolds to see the true justice of this solution.

Millions (USD)

2,500 $150,000

2,000 1,500

$100,000

1,000 $50,000

$0

500

2008

2009

2010

2011

2012

2013

- 21 -

0

Source: PWC

Bloomberg BusinessWeek. Weber, Robert C. “Law Firms Should Spurn Outside Investments.” 20 Sep. 2011. Financial Post. Hasselback, Drew. “Heenan Blaikie’s Lesson for Bay Street: Change or Die.” National Post, 8 Feb. 2014. Financial Post. Tedesco, Theresa. “Heenan Blaikie’s Stable of Politically Connected ‘rainmakers’ Not Enough to Stem Troubled Law Firm’s Losses.” National Post, 4 Feb. 2014. The Globe and Mail. Gray, Jeff. “Canadian Law Firms: Time to Take Stock?” 18 Oct. 2011. Lexpert Magazine. Wannop, Donna C. “Bounce Back.” July 2013 Reuters. “Slater & Gordon Ltd (SGH.AX).”

April 2014, The Queen’s Business Review


I

n July 2011, Quantum Fund announced its shadow banks have grown to be nearly 70% utility maximization through consumption closure. Founded by George Soros and Jim of China’s GDP in size as of 2012. Ironically, smoothing, given underlying societal Rogers in 1973, the fund was infamously re- shadow banking’s remarkable growth is a prod- conditions. Indeed, prior to the reforms of sponsible for breaking the Bank of England in uct of the same system that has propelled Chi- 1978, China’s household savings rate was only 1992 and sparking the 1997 Asian Financial Cri- na’s economic growth – a state-owned financial 5% of disposable income but has skyrocketed sis. Rogers has now set his eyes on China. Born sector that lends out most of China’s enormous to ~40% by 2009. The Chinese, with limited and raised in America, he is a self-professed savings to state-owned enterprises. Private en- children for financial support and no social believer in China’s growth story, publishing a trepreneurs and business owners without politi- safety net, have turned into scrupulous savers. book in 2008 entitled A Bull in With heavy capital controls, China: Investing Profitably in Chinese households on average the World’s Greatest Market. hold more than two-thirds of An unavoidable challenge that their wealth in bank deposits. now faces the largest creditor naThe Chinese Communist tion in the world is the prospect Party has been reluctant to of financial liberalization, which undergo a major, planned Set to become the largest economy in the world, China must will allow opportunists like Jim democratization of the markets. push forward significant financial reforms to contain off-theRogers to participate in China’s It had rebuilt a war-torn country books debt risks and ensure the sustainability of the economy. growth. China has like clockthrough a “gradualism” approach work churned out impressive – a slow and steady transition to TONY XING growth rates year after year, gainavoid disorganized overhauls and ing a slew of critics along the way. social unrest. The government They warn investors of China’s remains a five-tier “tiao-kuai” shadow banking system along administrative hierarchy in which with the misleading data and off-the-books risks cal connections cannot easily secure funds from each level appoints and determines targets for it creates, which, together, represent the greatstate-owned banks and so turn to shadow bank- the level below it. Reluctance to change is est impediment to China’s financial maturity. ing. Even local governments often circumvent understandable. First, there are concerns of The only solution is a planned, large-scale fiborrowing constraints through loosely regulat- a premature liberalization. When Southeast nancial reformation that substantially decentraled “local financing platforms” for their funding Asian economies tried in 1997, Quantum Fund izes China’s financial markets. needs. Furthermore, shadow banking has ben- shorted the Thai baht, ultimately throwing the efited from China’s unusually high savings rate region into deep financial turmoil. Second, Creating the shadow banking system unregulated wealth management products have Shadow banks are a diverse set of non-tradi- and reluctance to reform. Modigliani and Brumberg’s Life Cycle been largely successful. However, the benefits tional institutions that are similar to banks in function and beyond the monitoring and con- Theory offers one way of thinking about of reformation outweigh the fears. Oversight trol of the regulators. JP Morgan estimated that China’s savings rate – it is a model of lifetime and investor protection must be put in place

Financial Liberalization: Is Shanghai the next Hong Kong?

- 22 -


ECONOMISTS SPECULATE THAT CAPITAL ACCOUNT REFORM IS UNDERWAY to contain risk and check the growth of debt. Shanghai is far from a dominant financial center like Hong Kong or Singapore, at least until financial liberalization materializes. Moving towards marketization Financial liberalization refers to (in a plausible order of execution) domestic interest rate deregulation, opening up of the capital account, and the increased international use of the Renminbi (RMB). Execution of interest rate deregulation will be in an order of decreasing complexity, beginning with institutional rates such as the interbank rate and following with consumer rates such as lending and deposit rates. There has already been considerable progress. Money and bond market interest rates have been set free and limits on lending and deposit rates have been reduced. However, households still earn low to negative real interest rates on their savings because of capped deposit rates, giving banks easy profits on interest rate margin. The stepped approach here is justified. A model built by Hellman, Murdock and Stiglitz asserts that a full liberalization leads to intensified competition amongst banks due to lowered net interest margins, and therefore lower franchise values. As a result, banks would be inclined to take bigger risks on their loans. Despite the moral hazard, China announced this month that further freeing of bank deposit rates

may come as early as next year. A full liberalization is only a matter of time. In an unprecedented move in 2009 China allowed banks in Hong Kong to offer RMB-denominated deposit accounts, thereby creating a market for the issuance of RMB-denominated bonds in key financial centers including Hong Kong, Singapore and London. The government intends to position the RMB to eventually become an alternative to the U.S. Dollar, which would help to stabilize domestic trade in the event of another USD-related crisis like

THE CCP REBUILT A WAR-TORN COUNTRY THROUGH A “GRADUALISM” APPROACH – A SLOW AND STEADY TRANSITION TO AVOID DISORGANIZED OVERHAULS AND SOCIAL UNREST

that of 2008. However, internationalization of the RMB is flawed without an open capital account as the arbitrageurs would be able to profit from the interest rate differences between market-driven offshore RMB and regulated onshore RMB. Thus, economists speculate that capital account reform is underway. China’s savings conundrum has translated to an investment-based economy that inarguably generated remarkable wealth. However, as

long as loans are dominated by the state, shadow banking can only grow in size. But Rogers remains bullish in the China story, moving his entire family to Singapore in 2007 with the desire for his two daughters to speak Mandarin fluently. The attention of an investor like Rogers is a double edged sword: should China’s financial liberalization go awry, investors like Rogers can spark a financial crisis like that of 1997. Ironically, it is often fears of sophisticated financiers like Rogers and the short-term capital they bring that impede financial liberalization. No doubt, top investors will embrace a reformed China. So China should embrace them. As Rogers put it, “if you were smart in 1807 you moved to London, if you were smart in 1907 you moved to New York City, and if you are smart in 2007 you move to Asia.”

Allen Franklin, Jun Qian and Meijun Qian (2005), “Law, finance, and economic growth in China,” Journal of Financial Economics, 77, 55-116. Badkar, Mamta. “The Difference Between The Confusing Onshore And Offshore Renminbi Market.” Business Insider. N.p., 27 Feb 2013. Web. 18 Mar 2014. F. Modigliani and S. L. Cao (2004), “The Chinese saving puzzle and the life-cycle hypothesis,” Journal of Economic Literature, XLII, pp. 145-170. FS Mishkin (2009), “Globalization and Financial Development,” Journal of Development Economics, 89, 164-169. Gough, Neil. “China Details Plans to Liberalize Interest Rates and Encourage Private Banks.” The New York Times. The New York Times Company, 11 Mar 2014. Web. 15 Mar 2014. H. Mehran and B. Laurens (1997), “Interest Rates: an approach to liberalization,” www.worldbank.org. Kroeber, Arthur. “A Chinese Trilemma: Renminbi Internationalization, Capital Account Opening, and Domestic Financial Liberalization.” (2013): n. page. Print. N. Lardy (2008), “Financial repression in China,” Peterson Institute Policy Brief, September, 2008, 1-6. Schuman, Michael. “Why You Need to Worry about China’s Shadow Banking.” Time. N.p., 19 Feb 2014. Web. 15 Mar 2014. Thomas F. Hellman, Kevin C. Murdock and J.E. Stiglitz (2000), “Liberalization, Moral Hazard in Banking,and Prudential Regulation: Are Capital Requirements Enough,” American Economic Review, March, 147-165. Wang, Yanlin. “Per capita income grows 8.1% in 2013.”Shanghai Daily. N.p., 25 Feb 2014. Web. 15 Mar 2014. Lectures by Economics Professor Tsui Kai Yuen of Chinese University of Hong Kong

Global Gross Domestic Savings (1975-2012)

Over the past two decades savings in China have strongly increased compared to the rest of the world World

60%

Gross Domestic Savings (% of GDP)

OECD members

50%

China

Korea, Rep.

40%

Japan

30% France

Canada

20%

United States

10%

1970 1975 Source: World Bank

1980

1985

1990

1995

- 23 -

2000

2005

2010

Hong Kong SAR, China

April 2014, The Queen’s Business Review


O

ver the past three years, the European to two thirds of all employment in the European this image, there are significant institutional reldebt crisis has been one of the most Union. There are many tools in Europe which ics that continue to perpetuate existing biases prolifically analyzed events in global can enable entrepreneurs to succeed, including against risk-taking, creativity, and optimism, all economics. Its crippling effects on the popula- an educated population and a relatively stable of which are qualities that are fundamental to tions of most European countries have forced political and business environment. However, the innovation process. For example, the Eugovernments and businesses to evolve as well some crucial factors are holding entrepreneurs ropean education system is designed to sepaas rethink their fiscal strategies. Although much back including structural factors (such as access rate and screen students into rigid disciplines of the blame for the crisis can be attributed to a to financing, and taxation) and cultural factors as early as grade school. Level of educational lack of political cohesion and ineffective Euro- (such as the innate lack of risk-taking found attainment is often based on family class which zone monetary policy, some of the blame can across Europe). If these factors are overcome, can create an underlying attitude of cynicism. be placed on the prolonged lack of innovation the resulting business creation in Europe would The European school system fails to create the in a remarkably well-educated region of the provide the continent the chance it needs to re- thirst for knowledge necessary to enable creativity. It is not possible to receive a well-rounded world. European history provides deep insights gain the economic power it has slowly lost. education because students are segregated so into the underlying problem of the sovereign early. There are also few identidebt crisis. Since the Industrial fiable success stories from which Revolution, the strength of the aspiring entrepreneurs can find manufacturing sector has been a inspiration. The isolated examcrucial force enabling economic ples of Richard Branson from growth. Over the past fifty years, Virgin, Hasso Plattner from SAP however, other countries have and Ingvar Kamrad of IKEA are strengthened their manufacturfar outweighed by the publicity ing capabilities, and Europe no and prominence of their non-Eulonger enjoys the proprietary Europe has a weak innovational culture in comparison to the rest ropean counterparts, such as advantage it once did. Although of world. It must further promote the entrepreneurial mindset if it Steve Jobs, Oprah, and Mark this trend can also be seen in hopes to regain its competitiveness Zuckerberg. Although class inethe U.S., most European counquality alone does not have a ditries have not met the innovaDAVID WILSON rect effect on entrepreneurship, tion standards set by the North it does contribute to a culture American giant and have failed that ultimately dispels potential to solve the problems associated innovators. Ironically, class and with the decline of manufacturincome inequality is more prevaing. The recent crisis has further Cultural Barriers Preventing Business Creation lent in the U.S. than Europe but the American exposed and enhanced the global perception In the U.S, the concept of the “American belief in upward mobility has remained potent that Europe has an outdated model. Despite Dream� constructs a national ethos of hope while there is no equivalent in Europe. that the nations most affected by the crisis, eswith the idea that anyone with a decent work A second contributing factor to consider pecially the PIGS (Portugal, Ireland, Greece, ethic, no matter his or her background or deis the risk-averse nature of Europeans. Both Spain), are home to a highly educated youth, mography, can be successful. This kind of World Wars dampened the European appetite high youth unemployment continues to be a ideology fuels a culture that promotes idea for risk. Although independent restaurants and persisting problem. One less explored solution generation and entrepreneurship. Without a shops are scattered throughout Europe, there is to the endemic unemployment in youth is prosimilar story to tell, Europe’s culture is tainted little desire for scale and growth. Risk aversion moting entrepreneurship. Greater investment by a backdrop of centuries of class segregation, explains this preference well. The European in innovation has the potential to increase emwhich creates the perception that only a very tradition of pragmatic conservatism was born ployment as well as productivity. Currently, unselect few are destined to prosper. Although out of the extensive infrastructural and ecoderestimating small to medium size enterprises there is some evidence of attempts to reform nomic damages that resulted from hosting both (SMEs) is an oversight as they contribute close

Rising from the Ashes: The State of Innovation and Entrepreneurship in Europe

- 24 -


Structural Discouragers The tendency to shun risk can also be explained by identifiable structural causes, which must be addressed. First, all entrepreneurs experience a financially motivated fear of failure; however the financial repercussions of entrepreneurial failure drastically differ in Europe and North America. It is much easier for American entrepreneurs to recover from bankruptcy than their European peers. According to the European Commission, in most European countries it takes several years to be free of debts. For example, French bankruptcy law forces declarants of bankruptcy to undergo a process that lasts close to 9 years from the filing date. In comparison, the same process is usually complete in less than 1 year in the U.S. The punitive nature of European bankruptcy laws goes even further: some countries have laws that prevent the formerly bankrupt from holding senior executive positions. With this type of framework in place, it is no surprise that many people shun the idea of building their own businesses. Second, entrepreneurs face obstacles financing early stage and growing ventures. Since the dotcom bubble burst and now the debt crisis, venture financing has been weak in Europe. European ventures tend not to be as desirable as international alternatives. European venture capital firms have been seeing investible capital rapidly diminish and move away from their funds as, in general, their returns have been subpar at best. The dryness of capital for entrepreneurs means that a disproportionately small number of businesses will be able to grow even beyond the initial stages. The alternative is to go abroad for financing. Many European

The Weakening State of European Venture Capital

Decreased deal funding and total investment capital correlate with the poor state of European entrepreneurship Number of Deal Fundings

$30

200

Amount Raised

$25

150 $20

Billions

World Wars. While China and America were rapidly investing in growth after the Second World War, Europe was stuck with the necessary task rebuilding the continent, which distracted it from developing global powerhouse businesses. Of the Fortune Global 500 companies that have been founded since 1950, just 12 of them are European, whereas 52 of them are American. In essence, Europe is producing less ‘Big Business’. Europe’s global power is rapidly disintegrating as a result. Overcoming cultural factors discouraging entrepreneurs is one of the most important steps towards promoting innovation as a means of economic stimulus. To plant a desire for success within entrepreneurs, any remnants of ‘class conflict’ must be extinguished. The best way to do this is through educational reform. This reform involves promoting innovation and entrepreneurial thinking. Perceptions about potential for success as an entrepreneur are still low across the European Union. The effect of these cultural factors is shown by the low rates of entrepreneurs across European countries. Just 2.3% of Italy’s population and 4.2% of Germany’s adult population are fulltime entrepreneurs compared to 14% in China, 7.6% in the U.S. and 17% in Brazil. If European governments and companies work together on targeted efforts, this perception can be shifted and an increase in entrepreneurship as well as an economic boost could be on the horizon.

$15

100

$10 50 $5 $0

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

0

Source: Ernst & Young

entrepreneurs are based in Silicon Valley and other hotbeds of innovation. Difficulties of financing and the heavy penalty for failure mean that unless reform is enacted, entrepreneurship will continue to be discouraged. Overcoming the Hurdles Promoting entrepreneurship as a key catalyst in the European economic recovery is becoming an increasingly popular strategy. Many governments have started to take a step in right direction. In France, the national government has developed a plan, called “Brand France”, whose goal is to promote foreign investment into French research, patents and assets. Similarly, Spain is attempting to reinvent itself as the capital of European high technology. With a significant portion of its well-educated population unemployed, it has refocused its attention on the job creation benefits that come from entrepreneurship. The Spanish government is providing funding for early stage companies as well as changing some legislation to ease business development. Another measure Spain has taken is to promote entrepreneurship within universities. Both IESE and ESADE have developed programs to support students and alumni who are starting their own firms. Increased funding continues to be a problem but there are other issues that also require attention. Many European nations, especially the PIGS, are cash-strapped and are simply investing in new businesses as a means of stimulus. This may not be to most efficient way of address the problem. Moreover, structural changes are necessary to promote a long-term culture of innovation. Procedures should be changed for entrepreneurs who fail during their first attempt at building a business. The current system of severely penalizing those who have failed is ineffective and only discourages further attempts. The European Commission has spearheaded efforts to improve conditions in most countries. In January of 2013, the Entrepreneurship 2020 Action Plan was passed and one of the most important sections included provisions for second chances after declaring bankruptcy. Though the plan is not as comprehensive as it needs to be, it covers several important areas and so far seems to be successful. European governments must make - 25 -

a commitment to direct investment as well as adjusting tax policies and other legislation to make venture capital financing more attractive for investors. The benefits from these should be twofold: first, there would be financing available for more ideas and more businesses would stay ‘local’ because of tax benefits and second, as the European business environment continues to become more conducive to promoting innovation, economic recovery will be accelerated. Will the Increased Emphasis help Europe Rise from the Ashes? In recent years, modernized European governments have begun realizing the need for greater promotion of business creation. With rampant unemployment, increased attention to entrepreneurship will help people work in value-adding roles. If existing limits are eased, an entire landscape shift could be seen as Europe turns into an innovation hub. Past small-scale attempts of encouraging business creation, such as the one in pre-debt crisis Germany, have not always been successful. One fundamental problem is that the unit of government promoting entrepreneurship has not had enough political clout to make substantial reform. Still, it is very possible that an increase in entrepreneurship and innovation will help boost the European economy by decreasing unemployment as well as increasing exports and domestic consumption. Yet, achieving this is contingent on a cohesive effort by European governments. It must be recognized that increased business growth and creation could very well be one of the most crucial means of stimulus for long-term European economic recovery.

Bloomberg Businessweek. (2013, October). Entrepreneurs are key to Europe’s Success. Retrieved January 04, 2014, from Bloomberg Businessweek: http://www.businessweek.com/articles/2013-10-08/ esade-entrepreneurs-are-key-to-spains-future Bloomberg Businessweek. (2013, June). France wants the Profits from French Innovation. Retrieved January 4, 2013, from Bloomberg Businessweek: http://www.businessweek.com/articles/2013-06-13/ france-wants-the-profits-from-french-innovation CNN Money. (2013). Fortune Global 500. Retrieved January 4, 2014, from CNN Money: http://money.cnn.com/magazines/fortune/ global500/2012/full_list/ Economist. (2013, July). European Entrepreneurs: Les Miserables. Retrieved January 15, 2013, from Economist: http://www.economist. com/node/21559618 European Commission. (2013, May). Promoting Entrepreneurship. Retrieved January 4, 2014, from European Commission: http:// ec.europa.eu/enterprise/policies/sme/promoting-entrepreneurship/ index_en.htm

April 2014, The Queen’s Business Review


Demographic Shifts China has experienced unique and significant demographic changes, which contribute to the success of its online dating industry. In pursuit of higher education and ultimately successful careers, young marriageable Chinese, who range in age from 19 to 25, are devoting less time to their personal lives and to finding their significant other. High-speed life styles and demanding workloads leave this demographic with little time for other engagements. In 2011, the number of Chinese singles reached over 30%. When asked about this, 48% of these singles attribute their relationship status to their narrow social circle while 42.5% say it is because they lack time and face tremendous ca-

DIVORCE REMAINS A TABOO IN CHINESE SOCIETY, WHICH MAKES THE QUEST FOR LOVE ARDUOUS AND IN NEED OF CAREFUL PLANNING. reer-related pressure. The online matchmaking industry’s value lies in its ability to provide Chinese singles with exposure to a larger candidate pool, with filters for personality and physical attributes built in for efficiency. A larger candidate pool allows Chinese singles to leverage the plethora of new opportunities that inevitably arise with more candidate choice. The larger candidate pool also lowers the opportunity cost of incompatibility; should candidates find each other unsuitable, there are many other “fish in the sea” within the Chinese dating community. orn out of the rapid development and can dating industry lags at a meagre 4.9%, while Access to a large dating pool is especially imporadoption of the Internet, the Chinese that of the Chinese dating industry is at an im- tant because the One-Child Policy, introduced dating industry has flourished, simpli- pressive 40%. The phenomenon of the robust in 1979, led to a rise in sex-selective abortive fying a complex human need. As recently as Chinese dating market and its stale counterpart practices and exacerbated the population gap 2012, three of China’s most popbetween men and women. As of ular dating websites – Baihe.com, 2005, there were approximately Zhenai.com, and the NASDAQ 32M more males than females listed Shijijiayuan.com – were under the age of 20, at a ratio of boasting a user-base of approx13 to 1, and the chasm is growimately 142M users. This was ing. With increasing exposure to In a nation where tradition burdens men and women with the filial more than double the amount Western ideologies of individualobligation of marriage and production of offspring, an increasing from the previous year. Accordism and freedom, many females number of Chinese singles is faced with an urgent need to find their ing to Analysis International, a now vie for the same high-level life partners. Naturally, then, the commercialization of love has leading provider of information positions that males traditionally become the next lucrative market waiting to be tapped. product in China’s Internet mardominated. As a result of this ket, revenue for the Chinese onparadigm shift, women are no JANE SHUI line dating industry is expected to longer willing to settle for ordibreak $318M by 2014. Interestnary men, even though the supingly, geography appears to play ply of extraordinary men cannot a significant role in the industry’s satisfy the demand. Consequenprofitability; North American online dating in the U.S. can be decomposed intro three, tially, a two-pronged problem arises: on the websites have not experienced similar success. equally influential, factors: the sweeping demo- one hand, there are a huge number of males Whereas Chinese dating sites reached 142M graphic shift in China, the important role Chi- who are unable to find a partner, while on the users by 2012, websites such as eHarmony and nese culture plays in marriage, and the superior other, a significant number of highly educated Match.com maintained only 37M users by the Chinese business model. females are dissatisfied with remaining market end of 2013. The growth rate for the Amerisupply. The online dating industry operates on

B

Love for a Buck

- 26 -


Internet User Base in China year-over-year growth in millions, 2004-2010 250%

200%

150%

100%

50%

2004

2005

2006

2007

2008

2009

2010

Source: Chinese Internet Network Information Centre

Growth in the Online Dating Industry

The Chinese dating industry has rapidly expanded its customer base US

2.5%

EU 2.0% China 1.5%

1.0%

0.5%

0.0%

2004

2006

2008

2010

Source: Synovate Business Consulting, 2006

Culture The Chinese dating industry is able to sustain revenue growth better than its American counterparts because of the unique role traditional Chinese culture plays. Historically, marriage was viewed as a necessity and reaching a certain age without having a life partner meant failing to accomplish a fundamental life stage. Parents would often match their daughters or sons to those of another family, and the newly-weds would never have met prior to their marriage. This approach illustrates why the traditional Chinese marriage is better understood as the amalgamation of two families rather than two individuals. The two individuals are expected to have similar levels of education, height, salary, and family backgrounds. Men preparing to marry must own real estate or property, since it represents stability and the ability to provide for his wife and family. Spending on housing is not discretionary, but mandatory, which further pushes housing prices up in spite of government regulation. Chinese singles continue to bear the burden of marriage; 80% of Chinese adults have married compared to just 68% of American adults. Divorce remains a taboo in Chinese society, which makes the quest for love arduous and in need of careful planning. Therefore, in such an environment, the average customer lifetime value is expected to be much longer and the revenue generated from

each customer much greater. The industry is especially affected by this mindset since children are constantly pressured by their parents to find a partner, which means that there will be sustainable market demand for the services that it offers. Superior Business Model The Chinese dating industry is able to maintain a competitive edge against its rival American one because of its superior business model. Through online services, companies are able to make profits from membership registration fees, charges for sending and reading messages, and using online chatting and virtual gifting. Customers are also segregated into different tiers based on the amount of membership fees

http://www.google.com/hostednews/afp/article/ALeqM5gsKfSQD9W9nnnYWH8XK7WI_qkl6g?docId=CNG.1df2c5b1933c0f9bb31bbc4840b42737.2e1 http://www.skadate.com/blog/skadate-dating-software-presents-datingin-asia.html http://www.statisticbrain.com/online-dating-statistics/ http://clients1.ibisworld.com/reports/us/industry/ataglance.aspx?entid=1723 http://daxueconsulting.com/china-dating-industry/ http://knowledge.wharton.upenn.edu/article/dating-in-a-digital-worldtrends-in-21st-century-china/ http://howvc.com/Html/economy/industryresearch/49593138307.html http://paper.people.com.cn/rmwz/html/2013-01/01/content_1188944. htm?div=-1 http://news.sina.com.cn/pl/2014-01-10/074429204845.shtml http://www.economist.com/news/china/21581759-are-high-house-prices-hurting-women-more-men-married-mortgage

Chinese Gender Ratio To Housing Affordability

Rising gender disparity and increased housing costs have created a successful business environment for the Chinese dating industry 130

120 Gender Ratio

low initial registration and service fees, which has made the online dating realm an accessible platform for lonely hearts.

that they pay, where each tier receives different levels of personalized or premium services. Online dating websites also employ a variety of methods to advertise and reach potential customers. For example, numerous dating shows in China provide an excellent opportunity for both implicit and explicit advertising. Female and male contestants that participate in the shows are supplied from the three major dating websites in China: Shijijiayuan, Baihe, and Zhenai. American dating businesses simply do not have exposure to these kinds of tools. These dating shows serve as a form of product placement for the dating companies, and this form of advertisement has proven to be hugely successful and effective. The dating shows illustrate, to the customers, the need for a publicized platform where greater number of young males and females can meet each other at the convenience of their fingertips. The sophistication of the Chinese online dating industry business model is incomparable, and it is one of the major reasons contributing to the success of the Chinese dating industry. The combination of a significant demographic shift and unique traditional culture in China has given rise to the world’s fastest growing online dating industry. Chinese businesses are able to seize the opportunity and monetize the fundamental human need for love. The success of this industry, though impressive, is also troubling. It is reflective of many problems the current generation of young Chinese adults are facing, such as income disparities and gender gaps. If you’re in need of love, Paris might still be a better bet.

110

100

90 1.5

1.6

1.7

1.8

1.9

2.0

2.1

Housing Affordability

- 27 -

2.2

2.3

2.4

2.5

Source: S-J Wei et. al

April 2014, The Queen’s Business Review


QSB’s China Connection It is surprising that in a business world where China is increasingly relevant, few students of the undergraduate program actually end up working there. A QSB alumnus tries to change that with a new model for philanthropy. GARRET GEROW

- 28 -


W

illiam Yu never fails to respond to an email from one of his students. His students are not of the classroom, and Mr. Yu is not their professor – Mr. Yu’s students are the 50+ alumni and participants in the Queen’s School of Business Cansbridge Capital Asia Internship Program, an educational program run by Queen’s University which sponsors Queen’s students to complete internships that they find in Asia. The Queen’s Business Review sat down with Mr. Yu to learn more about the man behind the program. Born and raised in Taiwan, Mr. Yu graduated from Queen’s in Mechanical Engineering (’84) and Business (MBA ’87). Throughout his career, Mr. Yu has worked in Canada, the San Francisco Bay Area, China, and Taiwan, which he now calls home. Beginning his career in finance, Mr. Yu, a self-described “entrepreneur at heart,” went on to cofound Intrinsyc Software (TSE:ICS) and AutoChina International (NASDAQ:AUTCF), among others. Throughout our discussion, he frequently draws on his entrepreneurial spirit and risk-taking temperament as key drivers in his decision to establish the Cansbridge program. The inspiration for the Cansbridge program came to Mr. Yu in 2009 during a conversation with a fellow Queen’s alumnus, Stuart Beck, the former Consulate General to the San Francisco office and current High Commissioner to India. They were discussing, or as Mr. Yu laughs, “lamenting” over the insular nature of Canadian universities, Queen’s in particular. Ever the entrepreneur, Mr. Yu saw an opportunity to create a program that would achieve three objectives: first, to help Queen’s students break out of their insular mindsets; second, to connect Queen’s with the unrelenting ascent of Asia’s economy; and third, to fulfill a deep-seeded personal desire to give back to the Queen’s community. Mr. Yu speaks passionately about giving back to Queen’s, “It’s always been in the back of my mind,” says Yu, “I just didn’t know how I wanted to do it.” The Cansbridge program, through its financial subsidies and travel reimbursements for students, has a present value that would land Mr. Yu easily in the ‘Tricolour Lifetime Circle of Distinction,’ although this type of notability is of little appeal to Mr. Yu. “I have always been an active rather than a passive investor, so never a ‘fire and forget’ type of person,” says Yu, “I want to create value above and beyond a monetary contribution.” Yu’s hands-on, active approach comes through in his managing of the program; beyond simply being the program’s financial and strategic backbone, Mr. Yu individually engages with each and every alumni and participant of the program. What Yu emphasizes is the fellowship that develops among alumni of the program and his interest in creating personal interactions with the students. Fellows of the program are invited throughout the year to

events that Mr. Yu holds with his wife, Diana, in Taipei, San Francisco, and Kingston. For Yu, the most rewarding part of the program is the personal interactions he has with its members. “Mentorship is important to me,” says Yu, “I take the time to get to know the students as much as I can.” Yu comments often on the enjoyment and personal satisfaction that he derives from seeing the changes that occur when students participate in the program. To Yu, “the best way to break out of the comfort zone and explore the world is to be embedded in a foreign environment, to meet the day to

day challenges of a different culture and learn to fit in.” Mr. Yu’s vision and generosity have allowed over four-dozen students to do just that. Yu’s hope for the program is that it will be a highly-sought after experience in which only the best students will be selected to participate. At the end of the program, Yu’s goal is to help students realize their entrepreneurial and risk-taking potential. Ross Kelley (BComm. ’13), a first year management consultant with Deloitte in Calgary attributes his success throughout recruiting largely to the rare opportunities and unique experiences that he gained as a participant of the program. Kelley, who (following his exchange in Barcelona) interned at a petrochemical engineering company in Shanghai, has - 29 -

become a fervent supporter and spokesman of the program. “What students need to realize,” says Kelley, “is that the Cansbridge Program is not exchange; it’s beyond exchange. Living and studying in Asia is entirely different than living and working in Asia. Working there is a whole new level of introduction to the culture.” Like most of the program’s alumni, Kelley recalls the often precarious cultural situations and difficulties that he drew on throughout his recruiting interviews. “Few people will be able to compete with the types of experiences that you’ll get while working in Asia.” For participants of the program, these experiences range from inevitable cultural and language differences (unavoidable for foreigners working in Asia), to the downright strange. Having participated in the program myself, I can recall a day of internet fame (or perhaps infamy), when I was mistaken for the fugitive at-large Edward Snowden while riding the Shanghai Metro on my way home from my first day of work. As it turns out, a fellow commuter that day mistook me for Snowden and sparked a heated debate on the front-page of Weibo, China’s state-censored version of Twitter with over 500 million users, over the validity and authenticity of the picture. Whatever their experiences, participants of the program return to Queen’s, without fail, with a handful of unique stories to share with colleagues. It seems as though the program has already had an impact among students at the Queen’s Schools of Business by increasing students’ awareness and interest in Asia, and in China in particular. More commerce students are currently enrolled in Introductory Mandarin Chinese than the program’s head, Xuelin Bai, can recall in her over 20 years of teaching Mandarin at Queen’s. Every year, there is an increasing amount of applications to QSB’s exchange partner schools in Mainland China, especially among students with non-Chinese backgrounds. Building the Queen’sChina connection also occurs further up the education hierarchy. This past September, the Ministry of Education of China officially approved The Queen’s Master of Finance program, taught in partnership with the Hanqing Advanced Institute of Economics and Finance at Renmin University. However, more still can be done. It is surprising that in a business world where China is increasingly relevant, few students of the undergraduate program actually end up working in China. Even sinophiles are systematically steered away from taking a full-time position in China, simply because of the range of choices available for on-campus recruiting. Perhaps what students need is a lesson in Mr. Yu’s brand of risk taking. Says he, “The biggest risk one can take is not to take any risk.” It does not take the astuteness of a Cansbridge alum to notice prescience of such advice.

April 2014, The Queen’s Business Review


C

ities gained prominence as the dreary, resources, namely energy, can be optimized. Observers may argue that there are already overpopulated and unsanitary by-products of the industrial revolution. Their a number of cities that self-identify as ‘smart.’ dark days gave rise to tuberculosis, child labour Unfortunately, for the vast majority of cities, and the proletariat. Environmentalists have crit- this is a great exaggeration. Although some citicized cities for displacing habitats and forests ies (particularly in Eastern Asia) demonstrate and polluting the air. Smog in major Chinese great technological capabilities, it is a stretch to cities have become so terrible that the pre- consider them a model of the future. Data inmier “declared war” on it. Yet the benefits of frastructure and management is a highly costly urbanization are unstoppable. Larger cities are endeavor. Without a direct, measurable revgenerally wealthier and more productive. Cities also lead innovation by connecting people from all walks of life. From Florence arose the Renaissance and from Birmingham, the Industrial Revolution (Economist, 2013). Today, the city itself is being revThe current approach to building smart cities is olutionized, as innovators focus flawed – for a city to become smart and sustainable, on creating a smart and sustainstandalone infrastructure and applications must be able city. developed while municipal and corporate involvement The word ‘census’ origiremains minimal. nates from Rome, whereby the administration of the time was TUSAANI KUMARAVADIVEL able to take advantage of the

A Smart Approach to Cities

large amounts of data produced by cities. Modern municipalities, in a similar fashion, are eager to collect, process, and use data to create “smart-cities” that will provide a higher quality of life for their citizens. Although a “smart city” has yet been defined, the general belief is that such municipalities would feature self-managing systems and services. Advocates for such a city imagine a world where forces can be immediately responsive - emergency services will know where a gas leak or fire is located. The transit system is self-managed, scheduled to respond to citizen needs. Analysis of common events such as traffic collisions can be analyzed to build better transport networks and the management of key

enue model, it is unlikely that municipalities themselves will be involved in the initial construction of such infrastructure. Therefore, the smart city revolution will be driven by entrepreneurs and private organizations, which will have to prove the usefulness of their technologies before receiving buy-in. Companies such as IBM and Microsoft are eager to provide services that would undoubtedly serve as infrastructure for the overall “smart city” model. For such firms, these con- 30 -

tracts are a winning revenue source. Providing the infrastructure to collect data generates revenues beyond the initial implementation cost – maintenance, analysis, and upgrades are likely to follow, thus providing these firms with a handle on the city’s information. However, sinking their teeth into these cities will prove quite challenging given the grandiose ambitions outlined by these firms. For example, Siemen’s “Infrastructure and Cities” division is its lowest performing division because few municipalities can justify investment. Moreover, throwing IT infrastructure at a complex goal is hardly a solution – smart cities will benefit from a human component. Therefore, smart cities, as society will know them in a few decades from now, will start with the individual, followed by small startups and larger corporate firms. Already, individual persons have grasped the basic building blocks of a smart city. Collisions and minor incidents are self-reported by Twitter users and provide up-to-date information faster than any city website. Smartphones from which users regularly check-in, and applications that mine data posted to public feeds will provide some of the lower-level infrastructure necessary. Small mobile applications provide a wide berth of information in a way that is far more convenient than ever before. Some applications will be built purely for the sake of curiosity, but will provide inspiration or a basis for bigger, more integrated applications. Much of the data necessary for these applications is already freely available or available upon request thanks to freedom of information acts. But


when several applications exist, one can link data to provide information that is integrated and useful to city management. An application which links peak energy usage to the management of non-time sensitive utilities can help cities save money by working off the grid and decreasing the total stress on the system. Although a disconnected architectural approach may appear counter intuitive, it protects the city from having to rely on a single platform or vendor in the future. Organizations, whether they are publically run or outsourced to firms, will also recognize and respect the importance of managing and applying data to make decisions. They will build their own databases from which future technologies will draw from. Modern cities are global powerhouses requiring large energy and resource inputs to run successfully. Ideally, cities will be able to minimize their energy inputs while providing the same (or greater) quality of life they provide today. Linear energy approaches use electricity and resources as they are demanded. This is the method with which energy today is managed. However, energy centers of cities need to become circular. Smart cities will manage energy centers by reducing use during peak hours and recycling resources through an integrated system. Smart metering, already a part of most buildings in Europe and North America, should be applied at the wider, community level. The European Initiative on Smart Cities has vowed to decrease greenhouse emissions by 40% (Strategic Energy Technologies Information System, 2012). The commission is currently off target but these projects prove an interest in smart city measures to drive sustainability. Other countries will soon see that these measures will prove necessary not just for the sake of environmental sustainability but to continue providing the same level of services in a cost-manageable manner. Municipalities will display apprehension in working with larger companies to make use of a unified system given implementation difficulties. New York City implemented a $500 million public-safety network in 2008, but was unable to make use of it in any practical manner because of logistical challenges (New York Daily News, 2012). Given that governments often demonstrate great difficulty in implementing IT systems, corporations will

City Databases In Seoul

Seoul has invested in the collection and accessibility of data in recent years

150

100% Publically Accessible Proportion

120

80%

90

60%

60

40%

30

20% 0%

0 2011

2012

2013

IT Firms Producing Smart City Products

Technology firms are fast developing infrastructure solutions and products for the upcoming smart city age

Company

Ambitions/Key Points

IBM

Smarter Cities and Smarter Planet. Coordinated data collection and analysis system

GE

Sustainable Cities. Sustainable energy, water, transportation, and utilities system

Microsoft

CityNext. Building an integrated info center based on phone data

Accenture

Intelligent City Network to bring together multiple municipalities SmartGrid. Power conservation/management system

Cisco

Smart Connected Communities. System integration and energy management

need to lead and build the implementation process before selling cities on the project. This may be a risky endeavor on the part of firms who would prefer to secure a client before spending money on a project. However, the growing size and interconnectedness of cities will present this data as a cost saver rather than a cost center. Furthermore, a built system can be tailored to several cities ensuring that technology firms are able to approach and fulfill the needs of multiple prospects. Perhaps the closest example of this system in action is Seoul, South Korea. Its current initiatives build upon a number of existing systems and technologies. u-Seoul Net, a three-pronged system providing citizens with city information, a CCTV network, and internet services for government use, began in 2003 and was finally completed in 2011. The city also makes use

As populations migrate from rural areas to urban centres, cities that invest in smart technology can realize cost savings

7

Urban Population Rural Population

6

Billions

2014

Source: Seoul Municipal Government

Urban vs. Rural Population Disribution 8

Municipal Databases

5

of community mapping, which relies on citizen-built road information. Similarly, an app called iTour links users to notable attractions across Seoul. Over the past few years, the city has increased the number of databases available to the public. As of 2012, there are 37 regularly-used city-based applications in Seoul. While its many advanced services may not yet be classified as “smart� because they are currently unintegrated, the administration is now courting a number of companies who boast that they will be able to integrate the plethora of available services in order to make Seoul a smart city. Most envision the path to smarter cities as glamorously innovative with one or two key players in the implementation process. The reality is comparatively subdued. Ordinary citizens will play a major part in the development of the information needed to build resource and citizen conscious cities of the future. Larger firms and municipal governments will play a decidedly less high-profile role as a merger and user of these datasets. Whoever makes it happen, there is no better place to create meaningful societal and environmental change than the city. Indeed, by 2008, the average human was urban.

4 3 2

City to contractor: Pretty please, could you take back this great $549 million wireless network? New York Daily News http://www.economist.com/blogs/babbage/2013/06/urbanisation

1 0

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

Source: United Nations

- 31 -

April 2014, The Queen’s Business Review


S

uccessful technology companies must Microsoft has perfected this stage and built an navigate both short and long cycles. Firms empire in the industry. Stage 2, Expansion, entails introducing that introduce and then improve popular products at scale can own entire decades; since product line extensions to drive the core brand the 1960s, IBM, Hewlett Packard, Microsoft, into profitable new areas. Apple���s products, Apple, Samsung and others have all had their iPod, iPhone, and iPad, demonstrate successful taste of the top in hardware or software. In their product line extensions. Although Apple refers early days, these were all young ‘TechCo 1.0’ to its family of portable screen-based products companies driven by innovation: they intro- as examples of its “innovative” tradition, this duced a new product, their customers respond- kind of self-congratulation, made public at ed, and profits accrued. This is a seductive stage. Many companies have a difficult time leaving it and so are slow to recognize warning signs. A natural part of the technology sector is that competitors are quickly born with hopes of undermining companies’ ability As Apple reflects on its past successes, Google is to maintain a monopoly on the dreaming about the future. new and popular product. New players in the same space entice TOM KEWLEY customers and as underlying market conditions change, companies are rendered vulnerable to competitors with fresh eyes on the future. Evolving into a successful next-stage Tech- reverential tech industry trade shows, can Co 2.0 company that is capable of shaping lead to complacency. Clayton Christensen, our century requires redefining “innovation”. a professor at Harvard Business School, Today’s tech “big players” and the strategies describes this dangerous perception as the they use to address innovation reflect this need. “Innovator’s Dilemma”: companies fixated on Whereas Google, Amazon and Facebook are satisfying existing customers risk failing to do making smart bets on big ideas that enable po- the same thing for future customers, and will tential market-dominance for the next 10 or 20 Google’s Recent Investments years, Apple and Microsoft are not extending in millions (USD) their ambitions nearly as far, and seem content to sit on their cash and “innovate” by tweaking DeepMind $400 existing products or introducing new products within arm’s reach.

High-Beam Headlights or

Rearview Mirror?

The Three Stages of TechCo 2.0 Companies TechCo 2.0 companies build on the stable platform of success they have achieved as TechCo 1.0 companies. To become dominant, they must move through three evolutionary stages. Stage 1 is Re-Innovation, characterized by ameliorating the original innovative TechCo 1.0 launch product with refinements that can spur new rounds of revenue growth. By refreshing the Windows operating system over decades,

Waze

inevitably fall behind. Standing in a stationary boxing ring, stuck in the present, and continuing to fight for market share, is not an easy task. To ensure long-term financial health, companies must be willing to enter another, deeper, realm of innovation. The third stage of the TechCo 2.0 lifecycle is known as Transformation. Long-term viability is contingent upon investing in R&D. Many large technology companies have entered this stage, which can be further deconstructed into 3 sub-stages. In Stage 3A, Iteration, a company “looks into the rearview mirror” for inspiration and is consumed with its past glories. Companies lost in their own product development can literally iterate themselves out of existence; BlackBerry is the most cogent example in recent memory. When it launched a series of indistinguishable new products with names so arcane they ran into four digits (like “8700c”), satisfying current customers became a faint hope, let alone future ones. In Stage 3B, Acquisition, a company uses its cash aggressively to purchase small, innovative companies closely related to its core business, sometimes at exorbitant costs, in an attempt to sustain relevance with customers. Judicious acquisitions can be an effective way to “innovate by osmosis”. The third and final stage, 3C or Moonshots, describes when a company makes significant bets on risky ‘moonshots’, which can be either acquired or launched in-house. Several companies are now making headlines with multimillionor multi-billion dollar Stage 3C investments in other companies capable of radically transforming the mother brand. Google is perhaps the best example. In combination with non-obvious acquisitions (Stage 3B), Google has leveraged substantial R&D (Stage 3C) to launch entities that were previously only conceived in the realm of science fiction. Since the ‘moonshot’ tech investment du jour is robotics, it is no surprise that Google purchased Boston Dynamics, known for its military-grade humanoid robots and Amazon picked up Kiva Systems to help power its vast fulfillment centers with pick-and-pack machines. Amazon

$966

YouTube

$1,650

Nest

$3,200

Motorola Mobility

$12,500

0

3,000

- 32 -

6,000

9,000

12,000

15,000


CEO Jeff Bezos even went as far as teasing us with futuristic drones that could one day drop packages at your door. Facebook, too, has dipped its toes in lofty but innovative waters; it has reportedly made an offer to acquire Titan Aerospace, whose drones would support Mark Zuckerberg’s ambitious Internet.org project that aims to provide aerial Internet coverage in Africa. Google’s activities in Stage 3C might appear riskier than Apple’s popular Stage 3A successes with iterative screen-based product evolution or Microsoft’s lucrative upgrades to its Windows operating system software. But risk must be assessed on a spectrum of continual time. Operating within a near-term, limited opportunity set with fewer unknowns provides a steady stream of profits for a time, even a long time, but does not necessarily insulate a firm from ‘future risk’. The greater risk resides in failing to reach beyond what is comfortable. Building an Operating System for the World Google was the prototypical TechCo 1.0: it created a universal verb, as in “I Googled it”, then evolved into TechCo 2.0 by adding an email client in Gmail, a web browser in Chrome, a mobile operating system in Android, a video repository in YouTube, and more. In 2004, CEO Larry Page said, “Imagine your brain being augmented by Google. For example, you think about something and your cell phone could whisper the answer into your ear.” Google has become the boldest player at Stage 3C and is adroitly positioning itself to shape our future. Its secretive product development division, Google X, has kick-started wearable computing (Google Glass) and is aiming to connect the world to the Internet using balloons (Project Loon). The company hired a futurist who believes ultimately in machine learning (Ray Kurzweil). It is working to replace traditional cars with safer, self-driving vehicles (making a venture investment in Uber; pouring resources into its own self-driving technology). Google also bought a thermostat maker (Nest), and a cellphone manufacturer (bought and sold Motorola Mobility). Google Calico is a health and well-being initiative with a grand goal of extending human life, perhaps to immortality. In a Google-optimized future, we are asked to imagine motoring along in driverless cars at the age of 150 while using the Internet with our minds. A far cry from Apple’s excitement over its design of iOS 7’s flat screen icons, to be sure.

TechCo 2.0 - Stage 3 Descriptions 3A: Iteration

3B: Acquisition

3C: Moonshots

Description

Increasingly small design changes on original product line.

Aggressive purchases of smaller companies to renew relevance with consumers.

Devote significant R&D and M&A budget to sometimes fanciful long-term initiatives.

Characterized By

Minimal M&A investment, instead focusing on already-successful products.

Making headlines by acquiring competitors or a number of startups.

Making headlines by acquiring or launching companies not related to current business operations.

Example

Microsoft launching Windows 95 with the Rolling Stones song, “Start Me Up" or Apple launching iOS 7.

Yahoo's Marissa Mayer buying Tumblr or Facebook buying WhatsApp.

Amazon's drones, Google buying Boston Dynamics or starting Google Calico or Google Glass.

Has Apple Peaked? Meanwhile, Apple is enduring an uneasy drumbeat of criticism about its failure to break free of its screen-based product cocoon and develop lucrative pathways into the future. Steve Jobs’ fixation on design was his strength, but also sowed the seeds of Apple’s eventual decline, which may have already begun. Its stock has run into a volatile stretch and the Economist, Venture Beat and New Yorker are all asking if Apple has peaked.

APPLE IS ENSCONCED INSIDE A KING’S CASTLE WITH THE ENEMY SCALING ITS WALLS

[Jobs] once took the team to see an exhibit of Tiffany glass at the Metropolitan Museum in Manhattan because he believed they could learn from Louis Tiffany’s example of creating great art that could be mass-produced. Recalled Bud Tribble, “We said to ourselves, ‘Hey, if we’re going to make things in our lives, we might as well make them beautiful’.” (“Steve Jobs” by Walter Isaacson) In a 1983 International Design Conference in Aspen, Colorado, Jobs alluded to a number

The Three Stages of TechCo 2.0 Companies

of future innovations such as the iPad and Siri in an event with the theme, “The Future Isn’t What It Used to Be – Or Is It?” Yet its fixation on design has left observers wondering else what Apple might be working on. Google has consistently reinvested its cash hoard, while Apple remains in an accumulating phase with over $100 billion in its coffers, much of it buried safely overseas out of reach of American corporate tax regulations. In 2013, Apple acquired PrimeSense, a 3D sensor company, and announced in March 2014 its plans to partner with automotive companies to power CarPlay, an in-car operating system. Still, these product enhancements fall within its original product purview – devices with screens. Venture Beat put it this way: “if Apple wants to continue to be the leader — or, should I say, recapture the title — it will need to do something crazy. Something against its current corporate DNA. Something that it has never done in the past.” Apple is ensconced inside a king’s castle with the enemy scaling its walls. Its problems not only lie in the form of nimble competitors, but also in the guise of untapped future revenue brought about by unwillingness to reach beyond its comfort zone. Its resources are still plentiful but are not being deployed for the long-term, at least so far. Google, on the other hand, has its hand in so many future-forward industries that if even one proves to be a scalable success, the company can continue to insulate itself from the ‘future risk’ that swallowed BlackBerry, Hewlett Packard, Palm, AOL, and others who grew enamored with merely iterating ever-smaller enhancements of past successes. The contrast is stark: Apple has its eyes in the rearview mirror, admiring the reflection of its past successes. Google is powering along with its high-beam headlights blazing, illuminating possibilities, dreaming of what could be, future on fast-forward.

TechCo 2.0 firms must move through the three stages to establish dominance in their respective fields

3A. Iteration

1. Re-Innovation

2. Expansion

3. Transformation

3B. Acquisition

http://www.wired.com/business/2013/01/ff-qa-larry-page/ http://www.newyorker.com/online/blogs/currency/2014/02/why-is-apple-being-so-nostalgic.html http://venturebeat.com/2012/12/18/if-apple-really-wants-to-win-something-crazy-needs-to-happen-in-2013/ http://www.economist.com/news/business/21570751-worlds-most-valuable-firm-may-be-past-its-prime-has-apple-peaked http://www.fastcodesign.com/3027052/infographic-of-the-day/googleapple-and-facebooks-biggest-acquisitions-over-the-last-15-year

3C. Moonshots

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April 2014, The Queen’s Business Review


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ince Facebook and Twitter have become merce products. If it had been able to shift its If someone tweets about going to see the new mainstream internet utilities, there has revenue stream toward this medium, then the movie American Hustle and also frequently visbeen debate over whether the business company would have left its site and apps un- its Flixster.com (which is a MoPub client), then platform of Twitter will be more sustainable cluttered with ads and could have maximized MoPub can permit Twitter to show promotions than that of Facebook. To answer this question, user enjoyment. An off-site network would related to that movie on Flixster.com. Two factors explain how the acquisition of analysts have attempted to compare the under- have partnered with a third party network, uslying frameworks of both companies: Twitter’s ing social information to tailor advertisements MoPub has given Twitter a competitive edge Interest Graph and Facebook’s Social Graph. to users of other websites who were clients of over Facebook: off-site margins and insurance. Firstly, Twitter, unlike Facebook, can However, analysts have missed an important that third party network. However, shortly after piece of analysis. How will each respective firm Facebook started to develop this off-site net- achieve high margins on off-site ad revenue because it does not need to partuse this data? ner with third party networks in What enables Twitter to be order to maintain the external a superior communication platad network. The development form for real-time information, of Twitter’s off-site network will self-expression, and content enable it to profitably generate creation is its ability to exploit revenue on a large scale without human curiosity. By using an Twitter’s recent acquisition of MoPub has enabled it to use the cluttering its site with ads. Furasymmetric follow model, where data obtained through its “interest” platform more effectively thermore, new web applications a user can have many followers than Facebook has been able to use the information gathered such as “Facebook AdBlock” without having to reciprocate through its “social” platform in the long-run. completely neutralize Faceby following back, an “Interest book’s current revenue model. Graph” is created. People can Secondly, the insurance arconnect to each other based MICHAEL KARP gument relates to the effect that purely on their shared interests. MoPub has on reducing TwitWith massive amounts of interter’s dependence on its internal est data from the website, the ad network. In the future, if its graph can consolidate this inforgrowth is not able to meet anamation based on popular trends lysts’ unrealistic expectations, and terms, allowing advertisers to work, the effort was shelved. Margins had been Twitter can still make MoPub’s ad business effectively target Twitter users. This can be contrasted with Facebook’s too low after paying partnered networks their more valuable, independent of its own internal ad network. “Social Graph.” Instead of connecting us- share revenue. Fans of Twitter believe that the service has On the other hand, Twitter just recently ers based on shared interests, “Friends” are brought together based on their affinity to one purchased MoPub, a company with access to a become not only an internet utility, but an esanother. Facebook is able to analyze this data large network of digital clients, including Word- sential service for consumers, businesses, and for marketers using the EdgeRank algorithm, Press, Flixster, Ngmoco, and OpenTable. This the media alongside companies like Google. which generates data based on friends’ affini- mobile-focused advertising exchange firm was Whether or not these fans are right, Twitter has ty to one another (through interaction within purchased for $350 million just before its IPO. certainly only begun to show its potential as a The purchase enables Twitter to use cross-de- meaningful global advertising medium. events, profile views, and likes). In 2012, Facebook started to branch out vice layering and off-site targeting to provide from its current internal ad network to a new advertisements to users related to who and off-site network, including the sale of e-com- what they follow and which words they tweet.

Twitter vs. Facebook

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April 2014, The Queen’s Business Review


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The Queen's Business Review Apr 2014