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 CHAPTER 6

COUNTRY RISK ANALYSIS

I moved this chapter from the section on foreign investment analysis to this section because I have concluded that
the international economic environment is heavily dependent on the policies that individual countries pursue. Given
the close linkage between a country’s economic policies and the degree of exchange risk, inflation risk, and interest
rate risk that multinational companies and investors face, it is vital in studying and attempting to forecast those risks
to understand their causes. Simply put, attempts to forecast exchange rates, inflation rates, or interest rates are
helped immensely by a deeper understanding of how those economic parameters are affected by national policies. At
the same time, no one can intelligently assess a country’s risk profile without comprehending its economic and
political policies and how those policies are likely to affect the country’s prospects for economic growth.

I spend some time discussing the nature of property rights and their implications for political risk and economic
development. The chapter examines the experiences of Latin American countries and Eastern European countries
and addresses the question of what it takes to promote economic growth. A good discussion of property rights and
their effects on economic growth can be based on the end-of-chapter problems. This discussion serves to introduce
the topic of country risk analysis–the assessment of the potential risks and rewards associated with making
investments and doing business in a country. This is a vital task for multinational firms and international banks, who
must constantly assess the business environments of the countries they are already operating in as well as the ones
they are considering investing in. Similarly, private and public investors alike are interested in determining which
countries offer the best prospects for sound investments. Ultimately, investors are interested in whether sensible
economic policies are likely to be pursued because countries adopting such policies will generally have good
business environments in which enterprise can flourish. However, because political considerations often lead
countries to pursue economic policies that are detrimental to business and to their own economic health, the focus of
a country risk analysis cannot be exclusively economic in nature. By necessity, it must also study the political
factors that give rise to particular economic policies. This is the subject matter of political economy–the interaction
of politics and economics. Such interactions occur on a continuous basis and affect not just monetary and fiscal (tax
and spending) policies but also a host of other policies that impact the business environment, such as currency or
trade controls, changes in labor laws, regulatory restrictions, and requirements for additional local production.

SUGGESTED ANSWERS TO “ZIMBABWE DESCENDS INTO CHAOS”

1. What are key elements of country risk in Zimbabwe?

ANSWER. Zimbabwe has virtually all the key elements of country risk: fiscal irresponsibility, monetary instability,
the absence of property rights, a controlled exchange rate system, pervasive corruption, price controls, and the
absence of basic institutions of government–a well-functioning legal system, reliable regulation of financial markets
and institutions, and an honest civil service.

2. How has increased country risk affected Zimbabwe’s economy and living standards?

ANSWER. Zimbabwe’s economy has nosedived: per capita income has plummeted, inflation has skyrocketed, and
there are dire shortages of basic necessities such as food and fuel.

3. By how much is the Zim dollar at its official rate overvalued relative to its black market rate?

ANSWER. Zimbabwe’s official exchange rate of Z$824/U.S.$ is overvalued by a factor equal to 5,500/824, or 6.67,
relative to its black market rate of Z$5,500/U.S.$. This result can also be seen by expressing the official and black
2 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.
market rates in U.S. dollars and comparing them: an official rate of U.S.$0.001213592/Z$ (1/824) and a black
market rate of U.S.$0.000181818/Z$ (1/5,500).

4. What caused the Zim dollar to be so overvalued? What effect does an overvalued official rate have on
businesses and consumers in Zimbabwe?

ANSWER. The Zim dollar is overvalued because the government has persisted in printing money to finance huge
budget deficits, resulting in a high inflation rate, while attempting to fix the exchange rate. Both businesses and
consumers are hurting from the overvalued Zim dollar. Exporters find their costs rising because of high inflation
while they must convert their foreign currency revenues at an artificially low rate. The result is lower profit margins
or even losses. Meanwhile, owing to the overvalued Zim dollar, foreign exchange is in short supply, resulting in
shortages of foreign imports. These shortages hurt businesses that rely on foreign goods and services (which is
virtually all businesses in Zimbabwe) and consumers.

5. According to the Wall Street Journal (February 19, 2008, A10), “Mr. Mugabe has blamed his country’s
economic crisis on Western saboteurs hoping to return the country to white rule.” Comment on this statement.

ANSWER. As the answers to the previous questions indicate, Zimbabwe’s economy had all the help it needed from
Mr. Mugabe’s economic and political policies to go into a tailspin. These policies destroyed property rights, resulted
in high inflation and rapid currency depreciation, and led to massive underemployment of the country’s land, labor,
and capital resources. Obviously, Mr. Mugabe is just looking for a scapegoat to blame the country’s troubles on
rather than accepting responsibility himself.

SUGGESTED ANSWERS TO CHAPTER 6 QUESTIONS

1. What are some indicators of country risk? Of country health?

ANSWER. The chapter points to the following indicators of country risk:

-- A large government deficit relative to GNP

-- A high rate of money expansion, especially when combined with a relatively fixed exchange rate

-- Substantial government expenditures yielding low rates of return

-- Price controls, interest rate ceilings, trade restrictions, and other barriers to the smooth adjustment of the
economy to changing relative prices

-- Vast state-owned firms run for the benefit of their managers and workers
-- A citizenry that demands, and a political system that accepts, government responsibility for maintaining
and expanding the nation's standard of living through public sector spending and regulations

Here are key indicators of a nation's long-run economic health:

-- A structure of incentives that rewards risk taking in productive ventures --A legal structure that stimulates
the development of free markets

-- Minimal regulations and economic distortions

-- Clear incentives to save and invest

-- An open economy
CHAPTER 6: COUNTRY RISK ANALYSIS 3

2. What can we learn about economic development and political risk from the contrasting experiences of East and
West Germany, North and South Korea, and communist China and Taiwan, Hong Kong and Singapore?

ANSWER. These countries provide us with as close to a controlled economic experiment as we are ever going to find
in this world: same peoples, same language, same history, same culture, even members of the same families in many
instances, divided by an accident of history. And what we see is that those societies that respect the rights of
property and that subject their enterprises to the rigors of competition, particularly global competition, grow more
rapidly, create far more wealth, are more innovative, more willing to take risk, and are far more productive than
those nations with centrally planned economies. The lesson is as clear as possible: Incentives matter, and they matter
greatly.

3. What role do property rights and the price system play in national development and economic efficiency?

ANSWER. With property rights, people have a strong incentive to husband their assets and utilize them efficiently.
They also have a strong incentive to practice thrift, bear risk, and work hard to accumulate more assets. Soviet
communes founder on the question of "Who will stay up all night with the sick cow?" If the cow belongs to the
commune, no one wants to stay up. In other words, everyone has an incentive to be a free rider. But if it's Ivan's
cow, Ivan stays up. The mere formality of "owning in common" has nothing like the practical bite of actually
involving each participant in ownership. Property rights work in conjunction with the price system to ensure
economic growth and wealth creation. By signaling members of society as to the relative scarcity of goods and
resources, the price system ensures that society's assets are employed in their highest valued use. Market prices, in
conjunction with property rights, also motivate people to create more wealth by using appropriate combinations of
capital, labor, and other resources. The market price of risk, as reflected in the cost of capital signals people as to
which risks are worth taking and rewards them for taking those risks.

4. What indicators would you look for in assessing the political riskiness of an investment in Eastern Europe?

ANSWER. Here are some key indicators to look for in assessing the political riskiness of investing in Eastern Europe:

a) Do they free prices quickly or continue the old system of administered prices that are based heavily on state
subsidies? Although a free economy will need free prices, the public still expects the state to protect it against
unexpected events. So the working public expects its wages to rise precisely in line with rising prices. If the
governments give in on this point and index wages to inflation, they will institutionalize inflation.

b) Do they dismantle and sell state-owned monopolies quickly?

c) Will Eastern Europeans be willing to see successful businessmen grow rich? Unfortunately, most of Eastern
European society doesn't understand business and the concept of making money. There are no role models or
business traditions as there are in the West. Two generations in Eastern Europe have never experienced private
contracts, free markets, or inventive enterprise. Instead, Communism mandated lethal doses of envy in
everyone. They were taught to despise those who got ahead, and to pull them down. To avoid social self-
destruction, Eastern Europeans need to learn to tame envy. They need to encourage one another to succeed, and
to praise and honor those who do. Unfortunately, it might take a generation for negative attitudes concerning
hard work and wealth to fade from the Eastern European psyche and be replaced with respect for honesty and
enterprise.

d) Do they establish all the paraphernalia of capitalism--including capital markets, tax regimes, and contract law--
to go along with their new-found enthusiasm for free markets? These are not mere details. Completing such
tasks will embroil the region in all the wrangles about wealth distribution and the size and role of the state
which Western countries have spent generations trying to resolve.
4 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

Another key indicator of political risk would be seeing governments give in to the temptation to fine-tune their
economies in order to reduce the costs of making the transition to a market economy. The constant changes of policy
involved in fine-tuning will reduce government credibility--just when it is crucial--and increase the likelihood and
costs of policy mistakes. The only hope for success is to devise a complete reform program and implement it as
quickly as possible. Governments must convey that their commitment to the program is absolute. Some setbacks
along the way are inevitable, but they must do the best they can. Milton Friedman has often said, "Don't let the best
be the enemy of the good."

Perhaps most important of all, the reform program should include a set of simple rules to govern how policy makers
and the public are to operate. This will boost credibility, reduce investor uncertainty, and discourage any efforts by
special interest groups, who will be hurt by some of the reforms, to forestall the reform program.

5. Exhibit 6.8 describes some economic changes that have been instituted by Mexico in recent years.

a. What are the consequences of those changes?

ANSWER. During the past few years, the Mexican government has changed its development policy from one that
sought growth that subsidizing domestic production and import substitution to one that encourages exports and
competition in the global market. By opening up its economy, Mexicans should be able to buy a larger variety of
higher quality goods at lower prices. Imports will force Mexican companies to either improve their products and
make them at lower prices or else go out of business. At the same time, foreign investment in Mexico should
introduce new product and process technologies and train workers in modern manufacturing techniques. Foreign
companies that invest in Mexico and source locally will help their Mexican suppliers improve their quality and
efficiency, much as Japanese auto manufacturers in the U.S. are forcing American auto parts suppliers to master new
standards of product quality and production efficiency. Privatization will improve the efficiency of the Mexican
economy, as will a reduction in the government red tape that strangles entrepreneurs. Lowering tax rates will boost
incentives and lead to more economic growth and less tax evasion. Cutting government spending will reduce
government deficits, thereby lowering the need to keep to printing money and reducing the rate of inflation. Lower
inflation, in turn, will make Mexico a more attractive place for investors, leading to an inflow of capital and a
reduction in capital outflows. It will also help stabilize the value of the peso, reducing currency risk and making it
easier for companies to plan for the future, further stimulating investment. These wide economic reforms have
gained credibility for the Mexican government and renewed confidence in the future of Mexico. Salinas has
convinced many in the Mexican and foreign business communities that he has a clear economic policy that will
likely survive his presidency. It will be extremely difficult-and hence unlikely--for a future government to reverse
what he has already done. The result should be more investment, more economic growth, less political risk, a more
competitive Mexican economy, and better-off citizens.

b. Who are the winners and the losers from these economic changes?

ANSWER. Clear gainers from these reforms include Mexican consumers, who will gain access to higher-quality, less
expensive goods, and most workers, who will become more productive and better paid. Foreign firms and their
workers who now have access to the Mexican market for their goods and services are also winners. Losers include
government bureaucrats whose functions have been scaled down or eliminated (which also ends their ability to
demand bribes), protected companies and their workers who are now subject to foreign competition, and the workers
and managers at newly-privatized state companies who will now face a much tougher business environment without
subsidies.

6. Many anti-poverty activists in the developing world believe that what keeps incomes and living standards from
rising as fast as they have in the developed world is an international conspiracy of bankers, corporations,
governments, and other institutions allegedly bent on oppressing the masses in order to enrich themselves.
Comment on this view.
CHAPTER 6: COUNTRY RISK ANALYSIS 5

ANSWER. The true culprit is neither a conspiracy nor a deficit of capital goods, labor, or other inputs necessary to
spur economic progress. Instead, the problem is the cumulative weight of dozens of manmade obstacles that prevent
economic resources from being used efficiently. Writing about Latin America, but applicable to all nations, Vargas
Llosa said, "The crucial element is the complex web of barriers that hurt Latin America’s ability to compete,
creating all sorts of disincentives for making more efficient use of technology and increasing productivity. Some of
these barriers relate to the outside world–tariffs, quotas, multiple exchange rates and excessive regulations against
foreign producers. Other obstacles are domestic–government-owned enterprises, barriers to entry into certain
industries, and inefficient financial systems. There have been many times in the last 130 years, for instance, in which
Latin America’s trade barriers were almost four times higher than Asia’s. To give another example, since the
nationalization of oil in Venezuela, that country’s oil productivity has remained at half its previous level."

7. For decades, efforts to end world poverty have focused on redistributing wealth, rather than creating it. How
successful has this approach been in fostering long-term economic progress.?

ANSWER. Such policies have been totally unsuccessful. In Africa, for example, average gross domestic product fell
by more than 16 percent from 1975 to 2000, despite billions of dollars in foreign aid. Critics charge that government
development assistance suppresses local enterprises and markets and is too often squandered by oppressive regimes.
As the chapter explains, what is needed to boost incomes is a good dose of economic freedom.

ADDITIONAL CHAPTER 6 QUESTIONS AND ANSWERS

1. How might a government budget deficit lead to inflation?

ANSWER. Instead of financing the deficit by raising taxes (unpopular) or issuing debt (expensive), the government
may choose to print money (a noninterest bearing liability that need never be redeemed). The expansion in the
supply of money without a corresponding increase in the demand for money will cause inflation.

2. What political realities underlie a government budget deficit?

ANSWER. Generally speaking, government spending is popular and taxation is unpopular. So governments tend to be
quick to spend money, but reluctant to tax their citizens to finance these expenditures. As government promises
expand more rapidly than its ability to generate taxes through economic growth, the government faces a choice: Cut
the growth in spending, raise taxes, or do neither. The Soviet Union is facing this choice now. And it is doing what
governments often do: Take the easy way out and do neither.

3. What obstacles do Third World countries like Argentina, Brazil, and Ghana face in becoming developed nations
with strong economies?

ANSWER. These countries have not established and enforced the property rights that give their peoples the incentive
to make the investments and take the risks that lead to economic growth. They have also not shed their statist
dogma--economic nationalism, state ownership, protectionism, price controls, subsidies, and monopolies--in favor
of market economics. At the same time, their cultures tend not to value those traits necessary for economic
development--an emphasis on education, a willingness to break with tradition, and entrepreneurship.

4. What is the link between a controlled exchange rate system and political risk?

ANSWER. A controlled exchange rate system, used to protect an overvalued currency, presents the risk of tighter
currency controls, the likelihood of a large devaluation, and various economic distortions that lead to increasing
government control of the rest of the economy.
6 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

5. Milton Friedman has suggested that public sector firms in Latin American countries should simply be given
away, possibly to their employees. How do you think workers would feel about being given (for free)
ownership of the public sector firms that employ them? Why?

ANSWER. Workers would most likely oppose such arrangements. Under state ownership, a firm's survival depends
on its access to the national treasury, not on its economic efficiency. Thus state-owned firms can--and often do--pay
exorbitant wages and tolerate enormous overstaffing, with the excess costs covered by government subsidies.
Private- sector companies cannot tolerate such labor practices. If a private-sector company's costs exceed its
revenues that company will die. Thus, workers who benefit from high pay and low effort at state-owned companies
will--and do--oppose privatization.

6. How did capital flight contribute to the international debt crisis?

ANSWER. Capital flight–the flow of capital from debtor developing countries–occurs for several reasons, most of
which have to do with inappropriate economic policies. These reasons include government regulations, controls, and
taxes that lower the return on domestic investments. Perhaps the most powerful motive for capital flight is political
risk. In unstable political regimes (and in some stable ones) wealth is not secure from government seizure, especially
when changes in regime occur. It exacerbated the international debt crisis by reducing the foreign currency assets
available to service developing country debts.

SUGGESTED SOLUTIONS TO CHAPTER 6 PROBLEMS

1. Comment on the following statement discussing Mexico's recent privatization. "Mexican state companies are
owned in the name of the people, but are run and now privatized to benefit Mexico's ruling class."

ANSWER. Historically, Mexican state companies have been run to benefit politicians as well as their bureaucrats and
workers rather than consumers and taxpayers (who wound up subsidizing these firms). Whether privatization
benefits Mexico's ruling class depends on how prices are set and the terms of the sale. Even if privatization takes
places at unrealistically low prices, it will benefit all Mexicans, provided that (a) no laws restrict the ability of
domestic or foreign firms to compete with privatized firms and (b) the government ends its subsidies to them.
Competition will force privatized firms to be more efficient and lower their prices to consumers, while cutting
subsidies will end a major drain on the Mexican treasury.

2. Between 1981 and 1987, direct foreign investment in the Third World plunged by more than 50%. The World
Bank is concerned about this decline and wants to correct it by improving the investment climate in Third
World countries. Its solution: Create a Multilateral Investment Guarantee Agency (MIGA) that will guarantee
foreign investments against expropriation at rates to be subsidized by Western governments.

a. Assess the likely consequences of MIGA on both the volume of Western capital flows to Third World nations
and the efficiency of international capital allocation.

ANSWER. By lowering the risk-adjusted return required by investors, MIGA will increase the flow of Western
capital to Third World nations. At the same time, however, subsidizing investment insurance will tend to produce
less efficient capital allocation; more money will be channeled to those countries that have the greatest risk of
expropriation (since these are the countries that will receive the greater implicit subsidy from MIGA). Because
respect for property rights is critical for economic growth, these are also the nations with the poorest economic
prospects. Under MIGA, American taxpayers will wind up subsidizing the expropriation of American property.
Thus, MIGA becomes another welfare scheme, not a business venture.

b. How will MIGA affect the probability of expropriation and respect for property rights in Third World
countries? Consider this question from an option pricing perspective.
CHAPTER 6: COUNTRY RISK ANALYSIS 7

ANSWER. Governments always have the option of expropriating foreign property in their nations. The decision of
whether to expropriate this property depends on the cost of exercising this option. By lowering the cost of
expropriation, MIGA would make expropriation more advantageous for Third World governments and, hence, more
likely. Instead of Third World governments compensating MIGA-insured investors, Western governments would
provide this compensation.

c. Is MIGA likely to improve the investment climate in Third World nations?

ANSWER. Quite the contrary. MIGA would counter the decline in private investment not by making foreign
investment safer, but by having Western governments pay for the costs of Third World expropriations. If the World
Bank really wants to improve the investment climate in the Third World, it could simply stop giving money to Third
World governments that subvert their own development by expropriating foreign investors.

d. According to a senior World Bank official (Wall Street Journal, December 22, 1987, p. 20), "There is vastly
more demand for political risk coverage than the sum total available." Is this a valid economic argument for
setting up MIGA?

ANSWER. In general, a shortage of a good or service reflects underpricing. This situation is no exception. The
problem is not that private insurance is not available--several private entities such as Lloyd's of London offer
insurance for foreign investments--but that its costs accurately reflect the true risk of placing one's money in
countries where property rights are routinely violated. In other words, the demand for low priced political risk
insurance exceeds its supply. At the right price, enough insurance would be available to exactly satisfy the market's
demand. The purpose of MIGA is to boost FDI in Third World countries, most of which suffer from capital flight.
The fact that the countries' own citizens don't trust the government is a clue that investment there is unsafe.

e. Assess the following argument made on behalf of MIGA by a State Department memo: "We should avoid
penalizing a good project [by not providing subsidized insurance] for bad government policies over which they
have limited influence... Restrictions on eligible countries [receiving insurance subsidies because of their
doubtful investment policies] will decrease MIGA's volume of business and spread of risk, making it harder to
be self-sustaining." (Quoted in the Wall Street Journal, December 22, 1987, p. 20.)

ANSWER. MIGA's approach to foreign investments seems to be based more on a protection of greedy governments
than on a respect for property rights. The World Bank seems to see expropriations as events that involve no human
responsibility or blame. The World Bank refuses to loudly condemn Third World governments for seizing Western
property. Countries throughout Africa that have nationalized foreign corporations have afterward received World
Bank loans at subsidized rates to help run the new state-owned industries. A question that the MIGA official failed
to ask is, "Why should taxpayers of developed countries subsidize the self-destructive behavior of Third World
countries?"

Some countries, like South Korea, Taiwan, and Hong Kong, have done very well at attracting foreign investment.
MIGA would play down the differences in how governments treat investors, thus penalizing nations that honor
property rights and rewarding nations that violate them. Given the crucial role that property rights play in economic
development, this is a perverse set of incentives.

3. In the early 1990s, China decided that by 2000 it would boost its electricity-generating capacity by more than
half. To do that, it is planning on foreigners' investing at least $20 billion of the roughly $100 billion tab.
However, Beijing has informed investors that, contrary to their expectations, they will not be permitted to hold
majority stakes in large power-plant or equipment-manufacturing ventures. In addition, Beijing has insisted on
limiting the rate of return that foreign investors can earn on power projects. Moreover, this rate of return will be
in local currency without official guarantees that the local currency can be converted into dollars and it will not
be permitted to rise with the rate of inflation. Beijing says that if foreign investors fail to invest in these projects,
8 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

it will raise the necessary capital by issuing bonds overseas. However, these bonds will not carry the "full faith
and credit of the Chinese government."

a. What problems do you foresee for foreign investors in China's power industry?

ANSWER. Since the return is set in nominal yuan terms, high inflation--a perennial Chinese problem--will reduce the
real value of this return. This high inflation, in turn, will put pressure on the yuan to devalue, lowering the dollar
value of the return. Finally, the local currency returns may be blocked. In other words, the dollar return is likely to
be lower than the yuan return and the dollar return may never be realized because of inconvertibility.

b. What options do potential foreign investors have to cope with these problems?
ANSWER. Don't invest under these terms. If they do invest, they can buy political risk insurance against currency
inconvertibility. They should also negotiate for higher yuan returns to compensate for the anticipated yuan
devaluation and the cost of political risk insurance.

c. How credible is the Chinese government's fallback position of issuing bonds overseas to raise capital in lieu of
foreign direct investment?

ANSWER. Not very credible. If the bonds don't carry the "full faith and credit of the Chinese government," then
investors will either not buy them or, if they do, they will demand an interest rate that will compensate them for the
political risks associated with the absence of the guarantee. The bonds will have to be dollar denominated and the
interest rate will have to be as high as the dollar yield that investors would expect if they invested directly in the
power plants themselves. In other words, the Chinese government will realize no benefit by financing the power
projects through issuing bonds as opposed to enticing investors to provide equity financing for the projects.

4. You have been asked to head up a special presidential commission on the Russian economy. Your first
assignment is to assess the economic consequences of the following seven policies and suggest alternative
policies that may have more favorable consequences. Note: Since this set of questions was first written there
have been massive changes in Russia. Yet many of the policies discussed here still persist and the consequences
are as predicted.

a. Under the current Russian system, any profits realized by a state enterprise are turned over to the state to be
used as the state sees fit. At the same time, shortfalls of money do not constrain enterprises from consuming
resources. Instead, the state bank automatically advances needy enterprises credit, at a zero interest rate, to buy
the inputs they need to fulfill the state plan and to make any necessary investments.

ANSWER. The system as described completely destroys all incentive to be efficient and profitable. In effect, it
penalizes success and rewards failure. At the same time, the ability to borrow unlimited amounts of money at a zero
interest rate encourages firms to squander capital without penalty and reduces the incentive to cut costs. Moreover,
the absence of any constraints on the ability of state banks to print money to cover shortfalls guarantees rapid
expansion of the money supply and inflation.

Short of an immediate and complete overhaul of the current system, the government should quit printing rubles and
allocate the available supply of capital by auctioning it off to firms. To ensure that firms are realistic in the price
they are willing to pay for capital, the state would have to allow enterprises that can't service their debts to go
bankrupt. Managers of profitable enterprises should be allowed to keep, say, 70% of their profits to reinvest or pay
bonuses (equivalent to a 30% corporate tax rate). Enterprises that show losses should be forced to borrow at the
auction-determined interest rate to cover their shortfalls or go out of business. At the same time, bankers should be
similarly incentivized to make money, thereby forcing them to assess the creditworthiness of potential borrowers.

b. The Russian fiscal deficit had risen from 2.5% of GNP when Mikhail Gorbachev assumed power in 1985 to an
estimated 13.1% of GNP in 1989. This deficit has been financed almost exclusively by printing rubles. At the
same time, prices are controlled for most goods and services.
CHAPTER 6: COUNTRY RISK ANALYSIS 9

ANSWER. By printing money while controlling prices, the government guarantees that there will be massive
shortages of goods and services throughout the Soviet Union. At the same time, black markets will arise in
controlled products while prices of uncontrolled products will skyrocket. Shutting down the printing presses will end
suppressed inflation. Decontrolling prices will end shortages. Gorbachev can eliminate the deficit by raising taxes or
cutting spending. Alternatively, he can finance the deficit by borrowing from the public. This latter approach,
however, will require the government to pay an interest rate that yields a positive real return to savers.

c. Russian enterprises are allocated foreign exchange to buy goods and services necessary to accomplish the state
plan. Any foreign exchange earned must be turned over to the state bank.

ANSWER. This system of foreign exchange allocation destroys any incentive to conserve on foreign exchange, and
allows bureaucrats to decide what amount of foreign exchange is needed to accomplish the state plan. It also
discourages Soviet exports since the government imposes what is, in effect, a 100% tax on foreign exchange
earnings.

A partial solution to this problem is to free up the market for foreign exchange. By allowing enterprises to buy or
sell foreign exchange as they see fit, they will have a stronger incentive to earn foreign exchange and to conserve on
its use.

d. In an effort to introduce a more market-oriented system, some Russian enterprises have been allowed to set their
own prices on goods and services. However, other features of the system have not been changed: Each
enterprise is still held accountable for meeting a certain profit target; only one state enterprise can produce each
type of good or service; and individuals are not permitted to compete against state enterprises.

ANSWER. The basic problem with this system is that without the possibility of competition, the state enterprises
become unregulated monopolies. Since their goods are already underpriced, deregulated enterprises can reach their
profit target by raising their prices rather than by cutting costs or producing higher quality goods. In fact, they
appear to have not only raised prices but also cut production, thereby simplifying their lives. In other words, freeing
prices for goods produced by monopoly factories just enables producers to reap monopoly profits.

The answer here is to permit competition, from individuals, other state enterprises, and foreign companies. At the
same time, producers must be able to keep most of their profits. Otherwise, they will have no incentive to produce
more and better goods.

e. Given the disastrous state of Russian agriculture, the Russian government has permitted some private plots on
which anything grown can be sold at unregulated prices in open-air markets. Because of their success, the
government has recently expanded this program, giving Russian farmers access to much more acreage. At the
same time, a number of Western nations are organizing massive food shipments to the Russia to cope with the
current food shortages.

ANSWER. Although the Western nations are well-intentioned (we think; they may be using this as a means of
dumping the agricultural surpluses they have accumulated by subsidizing their domestic farmers), the effect of food
aid will be to drive down the price of food in the Russia, thereby reducing the incentive of Russian farmers to
produce food. If Western nations wish to aid the Russia, they can provide it with advice and money tied to the
implementation--not just the promise--of genuine economic and political reforms. After all, food shortages reflect a
combination of price controls and lack of incentive faced by farmers; it is not an act of nature.

f. The United States and other Western nations are considering instituting a Marshall Plan for Eastern Europe that
would involve massive loans to Russia and other Eastern Bloc nations in order to prop up Gorbachev and the
reform governments.
10 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

ANSWER. The key here is to recognize that we are dealing with a political problem, not an economic problem, and
political problems cannot be solved with money alone. The basic problem with massive loans to these nations is that
by alleviating their economic crisis, it would reduce the governments' incentive to institute real economic and
political reform. It also boosts the power of the bureaucrats at the expense of the private sector. Thus, any loans
should be tied to the implementation of genuine reforms. Better still, money should be provided directly to private
companies on close-to-market terms, thereby building up the private--not the public--sector. As Mr. Gorbachev has
already proved to the world's satisfaction, no matter how many Harvard economists he puts to work, he will not be
able to restructure the Soviet economy and still preserve the power of the Communist Party. The two things are
antithetical. You can't have a free-market economy and an economy run by and for a Communist Party elite. The
contradictions inherent in this attempt ultimately led to the downfall of communism in the Soviet Union, as it also
will in China.

5. The president of Mexico has asked you to advise him on the likely economic consequences of the following five
policies designed to improve Mexico's economic environment. Describe the consequences of each policy, and
evaluate the extent to which these proposed policies will achieve their intended objective.

a. Expand the money supply to drive down interest rates and stimulate economic activity.

ANSWER. Rapid expansion of the money supply will lead to higher inflation and higher nominal interest rates. It will
also raise real interest rates to the extent that savers demand a bigger inflation risk premium for the higher inflation
risk that they must now bear. Higher inflation will make it more difficult for business to plan and lead to a reduction
in business investment. It will also reduce the reliability of price signals, thereby reducing the efficiency with which
the Mexican economy operates. The net effect will be higher interest rates and slower economic growth, exactly the
opposite of what is desired.

b. Increase the minimum wage to raise the incomes of poor workers.

ANSWER. Those workers covered by the higher minimum wage and who keep their jobs will see their incomes rise.
However, many workers will lose their jobs since the new wages will exceed the value of their work (low wages
typically signal low productivity and few salable worker skills, not exploitation). The most seriously affected
companies will be those facing foreign competition, since they will be unable to raise their prices much. Such
companies will attempt to lower their costs by substituting capital for labor, moving offshore, or just reducing their
workforce. Moreover, those workers who are not covered will find more competition for their jobs, leading to a fall
in wages in the uncovered sector of the economy. The net effect will be higher unemployment and a workforce that
is worse off overall. To the extent that companies can offset their higher labor costs by raising prices, their
customers will be worse off.

c. Impose import restrictions on most products to preserve the domestic market for local manufacturers and,
thereby, increase national income.

ANSWER. Import restrictions will lead to higher domestic prices for lower quality products. It will also stifle
innovation and make domestic firms less competitive. The evidence is that countries that follow an export-oriented
growth strategy grow much more rapidly than those that seek to grow through import substitution. Thus, this policy
will reduce Mexico's national income, not increase it.

d. Raise corporate and personal tax rates from 50% to 70% to boost tax revenues and reduce the Mexican
government deficit.

ANSWER. The odds are that the Mexican government will collect less tax revenue at a 70% tax rate than at a 50%
rate. People will have greater incentive to cheat on their taxes and less incentive to work if 70% of what they earn
goes to the government. Thus, both actual and reported income will probably be sufficiently lower at a 70% tax rate
than at a 50% rate that the rise in the tax rate will be more than offset by the decline in taxable income. At the same
CHAPTER 6: COUNTRY RISK ANALYSIS 11

time, economic growth will be reduced and there will be more demands on the government to "do something,"
which usually means spending more money. The net result will be a higher deficit.

e. Fix the nominal exchange rate at its current level in order to hold down the cost to Mexican consumers of
imported necessities (assume that inflation is currently 100% annually in Mexico).

ANSWER. Mexico and many other Latin American countries already tried this during the 1970s and early 1980s. To
summarize the conclusions in the Mexican Peso case, the resulting jump in the real exchange rate boosted imports,
cut exports, and led to capital flight and huge and unsustainable trade and government budget deficits. Sorting out
the mess cost Latin America a decade of economic misery and lost economic growth. Fixing the exchange rate with
inflation running at 100% annually, as proposed here, will double the real value of the peso in a year. This will bring
on the troubles just described even faster than in the 1980s.

ADDITIONAL CHAPTER 6 PROBLEMS AND SOLUTIONS

1. The president of Brazil has just appointed you to work with the country's cabinet ministers to launch a radical
restructuring of the Brazilian economy. Inflation is running at over 1,000% annually, and the federal
government is running a deficit in excess of 10% of GNP (the U.S. deficit is about 3% of GNP). To finance the
deficit, the government has incurred huge debts, both internally and externally. In your initial discussions with
the cabinet ministers, you realize that there is considerable disagreement about a number of specific program
proposals. Your job is to assess the issues and the relative merits of the proposed policies.

a. The Governor of the Banco do Brasil, Brazil's central bank, wants to cease its purchases of government bonds
issued by the Ministry of Finance to fund the ongoing federal budget deficit. The Banco do Brasil has acquired
50% to 60% of all government bonds issued in the past several years with money expressly created for that
purpose. In other words, it has been monetizing the deficit. Other cabinet ministers are afraid that this policy
will lead to higher interest rates and wonder how the deficit can be financed otherwise.

ANSWER. Ending monetization of the deficit will reduce the growth in the money supply. This change in policy will
actually lower nominal interest rates by reducing inflation, which is the primary cause of high rates. Ending the
threat of inflation would lead to lower nominal rates and--as the inflation risk premium imbedded in nominal rates
shrinks--to lower real rates as well. The government can reduce the deficit by cutting spending, leading to a healthier
economy and stronger growth, or by increasing taxes, which will likely weaken the economy. Alternatively, the
government can sell bonds to the market. This will probably boost real interest rates, but the nominal interest rate
will still be lower than it was before. Borrowing from the private sector to finance large deficits, however, is not a
sustainable policy. Sooner or later, the government will have to face the issue once again of whether to raise taxes,
monetize the deficit, or cut spending. The latter can be done by selling off money-losing state enterprises. An
alternative, and less traumatic way to reduce the deficit is to reduce the rate of increase in government spending and
then allow the natural rise in tax revenues from a growing economy to eventually narrow the gap between tax
revenues and spending.

b. The Minister of Infrastructure has proposed that his ministry begin privatizing the hundreds of state-owned
enterprises under his administration. These enterprises include virtually all of Brazil's steel industry, mining
industry, electric utilities, the telephone company, national oil company, chemical companies, and a wide range
of manufacturing companies. Opponents claim that this move will lead to massive unemployment and the
bankruptcy of vital national industries.

ANSWER. Privatization is probably the single most valuable step that Brazil can take to deal with its economic crisis.
Privatization will lead to efficiency gains for the whole economy by forcing the privatized companies to earn their
keep in a competitive market. At the same time, the government will convert what has traditionally been a series of
deficit-plagued companies into both a one-time source of revenue through the sell-off as well as an continuing
12 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

stream of tax revenue from now-profitable companies. Consumers will likely receive higher-quality service at lower
prices (assuming that the government permits competition in what have historically been run as government
monopolies).

The reason that state-owned enterprises are money losers is that most of them are way overmanned and very
inefficient. Privatization will force them to cut their workforces. But to argue that this will result in massive
unemployment ignores the fact that these enterprises are squandering vast resources that could be used more
efficiently elsewhere in the economy and lead to higher economic growth. The laid-off workers will have to find
jobs in the private sector of the economy. This leads to further gains in efficiency, as unproductive workers from the
privatized firms become productive members of society. The surest guarantee of getting and keeping a job in the
private sector is to be worth more than your compensation. The argument that giving people jobs, regardless of their
productivity, helps the nation brings to mind the old solution to eliminate unemployment: Put half the population to
work digging holes and let the other half fill them in. Everyone will be working, but to what end?

Simply put, taxpayers and consumers subsidize the inefficiency of state-owned enterprises. If taxpayers and
consumers decide they want to pay the redundant workers to do nothing, they should do so directly. Transparency is
the key to allowing taxpayers and consumers to make informed decisions as to how they want to spend their money-
-on goods and services they value or on overpaid, underworked state employees.
The bankruptcy argument ignores the fact that bankruptcy doesn't destroy assets; it simply transfers them to those
who are able to use them more efficiently. It also ends the possibility of cross-subsidization by the private sector
through the tax collection mechanism.

c. The Minister of Political Economy has proposed that Brazil enter into free trade agreements with its Latin
American neighbors. This would involve eliminating all tariffs, duties, and fees on imports. A number of other
government leaders oppose this move, because the Brazilian market is larger and generally more protected than
those of its neighbors. They feel that opening the border would expose Brazil to rapid growth in imports that
exceed any incremental export activity.

ANSWER. The more protected an economy is, the greater the disruption when it opens its borders, but also the
greater the economic benefit that it reaps. Consumers will benefit because free trade will expand the quality and
variety of goods and services available to them--and at better prices too. Opening the economy to imports will also
force inefficient protected Brazilian firms to become more efficient to survive. Brazilian exporters will gain as well
by being able to substitute higher quality, lower priced imports for domestic supplies. To the extent that the opening
of free trade does lead to a net increase in Brazilian imports, that net increase will be financed by additional,
voluntary inflows of foreign capital; that is, Brazil can run a deficit only if other nations are willing to finance it.
Such a situation will not boost unemployment or slow down economic growth, the fear underlying resistance to free
trade. If Brazilians demand more imports than foreigners demand Brazilian exports, the real's value will fall until
equilibrium is again established in trade. The net result from free trade, therefore, will be a more competitive Brazil
and happier Brazilian consumers.

d. The Minister of Finance has proposed creating a new tax on consumption and lowering income tax rates. His
concern is that Brazil's personal savings rate has been close to zero over the past several years. He believes that
increased savings will help to dampen inflation, lower interest rates on the federal debt, and promote exports.
Critics of this proposal argue that the vast majority of Brazil's population are living very near the poverty line
and that a consumption tax would be highly regressive (hit the poor relatively harder than the rich). It also
would tend to dampen domestic demand, the principal engine of economic growth in Brazil.

ANSWER. The shift from an income tax to a consumption tax will increase the incentive to save while at the same
time increasing the incentive to engage in productive activity (income, after all, is the return to productive activity),
thereby stimulating economic activity. The problem facing Brazil is not a lack of consumption. Indeed Brazil is
consuming too much relative to its income; otherwise, it could not have run such huge trade deficits. The main effect
of higher savings will be to lower imports and free up resources to service the export market, thereby cutting the
current-account deficit. It should also lead to lower interest rates and more investment. But increased savings will
CHAPTER 6: COUNTRY RISK ANALYSIS 13

not lead to less inflation, unless the government uses those savings to substitute for newly-printed money as a means
of financing its deficit.

Only from a static standpoint could one be concerned about the poor being hurt by the new tax system. From a
dynamic standpoint, the increase in investment brought about by the additional savings will increase worker
productivity and raise their wages. At the same time, the regressivity of the consumption tax can be reduced or
eliminated by providing generous allowances to lower-income residents. Specifically, the consumption tax will tax
workers on the difference between what they earn and what they save. By providing generous dependent deductions,
the consumption tax can do away with taxes on the poor. Although a consumption tax will stifle consumption
initially, by making Brazilians wealthier over time (by increasing their productivity), it will eventually lead to higher
consumption and a higher standard of living. At the same time, even though consumption will fall at first,
investment will rise since the increased saving will lower the cost of capital faced by companies, leading to more
positive NPV projects. In other words, there is no necessary reason to expect that a nation with a high savings rate
will have a low growth rate. Japan is a good example of a nation with a high savings rate and a (historically) high
growth rate. Any excess domestic savings (that is, savings not invested domestically) are exported abroad as capital
by running a current account surplus.

e. The Minister of Labor has proposed raising the minimum wage to raise the income of poor workers and,
thereby, offset the effects of restructuring on them. Other cabinet members are concerned about the effects this
policy will have on employment and competitiveness.

ANSWER. Raising the minimum wage will boost incomes for those workers who retain their jobs. However, it will
also cause higher unemployment among unskilled workers and make Brazilian industry less competitive. The most
seriously affected Brazilian companies will be those facing foreign competition, since they will be unable to raise
their prices much. Such companies will attempt to lower their costs by substituting capital for labor, moving
offshore, or just reducing their workforce.

f. The Central Bank has proposed that it replace the current fixed exchange rate system with a freely floating
exchange rate system. Critics of this proposal argue that floating the real will devalue the currency and raise the
cost of living (by boosting the price of imported necessities) for Brazilians.

ANSWER. The argument that floating the real will lead to currency devaluation implies that the real is currently
overvalued. Although devaluation will raise the cost of imported goods, it will also end the subsidies used to
maintain real overvaluation. These subsidies can be given directly to Brazilians instead of only to those who buy
imported products. At the same time, devaluation will make Brazilian industry more competitive internationally and
boost Brazil's GNP, benefitting all. Finally, Brazil will be unable to maintain an overvalued currency forever.
Hence, the only question is whether the real is devalued today or tomorrow. The longer Brazil waits, the more
foreign exchange it will squander trying to preserve an overvalued currency.

g. In order to reduce the money supply and, thereby, suppress inflation, the Minister of Finance has proposed
freezing all bank accounts. Depositors will be able to withdraw only the real equivalent of about $1,000.
However, other cabinet ministers are concerned about possible adverse consequences of such a freeze.

ANSWER. This policy smacks of lunacy. It destroys faith in the monetary system and discourages savings and the
work that leads to those savings. Nonetheless, Brazil tried this in early 1990. The result, as predicted, was economic
chaos. The message such an action sent is that work and saving aren't the ways to get ahead. Citizens figured that
such an action was likely to reoccur and responded with capital flight, increased consumption, and less investment.
Another random document with
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The Project Gutenberg eBook of The island of
stone money
This ebook is for the use of anyone anywhere in the United States
and most other parts of the world at no cost and with almost no
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Title: The island of stone money

Uap of the Carolines

Author: William Henry Furness

Release date: January 30, 2024 [eBook #72830]

Language: English

Original publication: Philadelphia: J.B. Lippincott Company, 1910

Credits: Peter Becker, Karin Spence and the Online Distributed

Proofreading Team at https://www.pgdp.net (This file was
produced from images generously made available by The
Internet Archive)

*** START OF THE PROJECT GUTENBERG EBOOK THE ISLAND

OF STONE MONEY ***
THE ISLAND OF STONE MONEY
UAP OF THE CAROLINES

A RECORD, IN THE MAKING

 THE
ISLAND OF STONE MONEY
UAP
OF

THE CAROLINES

By
WILLIAM HENRY FURNESS, 3rd, M.D., F.R.G.S.
AUTHOR OF
“HOME-LIFE OF THE BORNEO HEAD-HUNTERS”

WITH ILLUSTRATIONS FROM PHOTOGRAPHS

BY THE AUTHOR

PHILADELPHIA & LONDON

J. B. LIPPINCOTT COMPANY
1910
 Copyright, 1910
By J. B. Lippincott Company

Published September, 1910

Printed by J. B. Lippincott Company

The Washington Square Press, Philadelphia, U. S. A.
IN MEMORIAM
23 JUNE, 1909
 CONTENTS
CHAPTER PAGE
I Introductory 11
II Native Houses 21
III Bachelors’ Houses 36
IV Costume and Adornments 56
V Songs and Incantations 69
VI Dance and Posture Songs 82
VII Money and Currency 92
VIII Uap Friendships 107
IX Religion 142
X Perception of Colour 155
XI Tattooing 157
XII Burial Rites 162
Uap Grammar 180
Vocabulary 199
 ILLUSTRATIONS
PAGE
A Record, in the Making Frontispiece
A Native Residence 22
A Rich Man’s House 24
House of a Copra Trader 26
A Native-Made Path 30
A “Pabai,” or Men’s Club-House 36
Return From a Fishing Cruise on the Open Sea 40
A “Failu” 44
Man and Wife of “Pimlingai,” or Slave Class 48
Lemet, a Mispil 52
Waigong, a Boy of Sixteen or Seventeen 56
Full Dress of a High-Class Damsel 60
Inifel, a Turbulent Chief 64
A Phonographic Matinée 72
Four Damsels Who Sang into the Phonograph 74
Lian, Chief of Dulukan 76
The Largest “Fei” on the Island 92
Stone Money Belonging to the “Failu” 96
“Gagai,” or Cat’s Cradle 108
Kakofel, the Daughter of Lian 110
Coconut Grove 114
Migiul, a Mispil 124
Fatumak 126
Fatumak’s Account for Coconuts Rendered 138
The Mode of Carrying Babies 154
The Tattooing of the Men of Fashion 158
Tattooing 159
Usual Tattoo Marks of a Mispil 160
Funeral Gifts of Stone Money and Pearl Shells 166
Gyeiga Placing Two Pearl Shells on Her Father’s Corpse 168
Map 273
 THE
ISLAND OF STONE MONEY
 CHAPTER I
INTRODUCTORY

A
lthough old-time Pacific whalers and missionaries, both of them,
let us hope, from kindly motives of rendering the islanders
happy, introduced two unfortunate attendants of western
civilization—alcohol and diversity of faiths—nevertheless the natives
of The Caroline Islands have retained the greater part of their
original primitive beliefs, and recently, under admirable German rule,
have perforce abandoned alcohol. Wherefore they are become an
exceedingly pleasant and gentle folk to visit; this is especially true of
the natives of the island of Uap or Yap, the most westerly of the
group. Like all other primitive people (it hurts one’s feelings to call
them savages or even uncivilized,—one is too broad and the other
too narrow) they are shy at first, either through mistrust or awe, but,
let acquaintance and confidence be once established, and they are
good company and benignantly ready to tolerate, even to foster
condescendingly, the incomprehensible peculiarities and demented
foibles of the white-faced visitor.

When I visited The Caroline Islands in 1903, there was but one
small steamer, of a German trading company, which, about five
times a year, links these little worlds with our great one, and the
people which it brings from the uttermost horizon must seem to the
natives quite as wonderful as beings from Mars might seem to us;
we at least can discern the little point of light from which our Martian
visitors might come, and can appreciate the size and distance of
another world, but to the man of Uap, whose whole world in length
and breadth is but a day’s walk, the little steamboat emerges from an
invisible spot, out of the very ocean.
After a whole month of tossing and rolling and endless pitching
on the tiny, 500-ton steamer, Oceana, plying between Sydney and
The Marshall and Caroline Islands and Hong-Kong, we were within
one night’s sail of the little island of Uap,—a mere dot on our school
maps. Here I intended to remain for nearly two months and await the
return trip of the steamer. The five short stops which the steamer had
made at other enchanting, alluring islands had been veritable hors-
d’œuvres to whet the appetite, and while drinking in the beauty of my
last sunset from the deck of the copra-laden little steamer, with the
sea the colour of liquid rose leaves and the sky shaded off in all tints
of yellow, orange, green, blue, mauve, and rose-color, I was thrilled
by the thought that I was soon to enjoy again the earthy perfume of
damp groves of palm, the pungent odor of rancid coconut oil, and the
scent of fires of sappy wood, whereof all combined compose the
peculiar atmosphere of the palm-thatched houses of Pacific
Islanders. I expected to be awakened on the following morning by
the sudden change from tossing on the open sea to the smooth
gliding of the vessel through the waters of the calm lagoon, and with
that delicious smell of land and of lush vegetation. Instead of this,
however, in the gray of dawn, I was instantly aroused by the clang of
the captain’s signal to the engine room, ringing first “stop” and then
“full speed astern.” I jumped from my berth to the deck and looked
into a thick, impenetrable fog that utterly hemmed us in. From every
side an ominous roar of breakers rose above the thump of the
engines. The fog lifted; there were the reefs and breakers distant not
a hundred and fifty feet dead ahead of us; then down came the fog
and off we backed, only to find that the reefs encircled us completely.
Even before the glow on the light and fleecy clouds which formed the
ineffable beauty of the sunset had faded, heavy clouds had arisen;
by midnight the sky was inky black with no star to guide our course.
The captain thus fell a victim to the strong, variable currents,
characteristic of these waters, which are indeed but one of the many
varieties of thorns which hedge these Sleeping Beauties of the
ocean; these had been responsible for our being hurried on much
faster than the log could show, and here we were almost on top of
the reef, two hours ahead of time, with the land hidden behind an
impenetrable veil.
Our situation was like a fever-dream, wherein vague but fatal
dangers threaten, and, strain as we may, we are unable to open our
eyes. The fog had been like a great eyelid, raised and lowered just
long enough to give us one fleeting glimpse, and no more, of fatal
peril, while the thunder and hissing swish of the breakers were like
the deadly warnings of a rattlesnake before it strikes. Then, of a
sudden, again the dense fog lifted completely, and the land seemed
verily to rise out of the sea, and we found ourselves directly in front
of the very entrance to the harbour with the channel of deep-blue
water almost running out to meet us. Five minutes more of fog and
we should have been pounding helplessly on the reefs with the
garden gates impenetrably closed.
I mention this only to give the hint that were the gates wider open
and less dangerously ajar, “trade’s unfeeling train” would have long
ago wholly overrun these imprisoned little lands and dispossessed
the aboriginal “swain.”
Yap, or rather Uāāp, with a prolonged broad ā, the pronunciation
invariably used by the natives, means, in their old language, I was
told, “the Land,” which, I suppose, exactly meant to the aborigines—
the whole world. Uap is, as I have said before, the westernmost of
The Caroline group, and lies about nine degrees north of the
equator. It is not an atoll, but the result of volcanic upheaval; it is
encircled, nevertheless, by coral reefs from three to five miles wide,
and has, at about the middle of the southwestern coast, a good
harbour in Tomil Bay.
To recall very briefly the general history of this group of islands:
They have been known to the civilized world since 1527, when they
were discovered by the Portuguese; a hundred and fifty years later
they were annexed by Spain and named in honour of Carolus II. At
the close of the Spanish-American war the whole group was
purchased from Spain by Germany for the sum of $3,300,000, and
since then under judicious and enlightened government has steadily
improved in productiveness.
The natives of Uap, in number from five to six thousand, are of
that perplexing type known generally as Micronesian, which covers a
multitude of conjectures. The natives of each island have certain
characteristics of form and features which make relationship to
natives of other islands or groups of islands a possibility; but, on the
other hand, there are such differences in language, in customs, in
manner of living, that it is well-nigh impossible to state, with any
degree of certainty, what or whence is the parent stock or
predominant race. By way of generalization merely, and not as
deciding the question, let me say that the people of Uap are of the
Malayan type,—a light coffee-coloured skin; hair black and inclined
to wave or curl, not crinkly, like the Melanesian and African; eyes
very dark brown, almost black; cheek bones rather high and noses
inclined to be hooked, but not prominent. In this last feature they
resemble other Polynesians and the Melanesians of New Guinea
and The Solomon Islands. They are not as tall nor, on an average,
as strongly built as the natives of Samoa, Fiji, or Tahiti. Since the
sale of intoxicants and gunpowder has been prohibited, except to the
trustworthy chiefs, they are gentle, docile, and lazy; formerly, under
the very lax rule of Spain they were exceedingly troublesome and
frequently made raids upon the Spanish and German traders, and
were continuously at internecine war.

Personal details are generally uninteresting; it therefore suffices

to say that I was received most kindly by the little colony of white
people who live upon the island, consisting of the resident doctor,
then acting as Governor; the postmaster; the manager—an
American—of The Jaluit Trading Company; and four Spanish and
German copra traders.
I was most hospitably entertained by Herr Friedlander, one of
these copra traders, and, in point of residence, the oldest white
trader on the island. With a courteous friendliness for which I shall be
always grateful, he invited me to lodge with him at his little copra
station in Dulukan, where I could be all the time in close touch with
the natives; not only was he always ready to act as my interpreter,
but was also at every turn unwearied in his kindness and devotion. I
had expected and hoped to share the home life in the houses of the
natives, as I had done in Borneo, but the village life and the home
life of the people of Uap differ so widely from those of the Borneans
that I found it would be better by far to stay in Herr Friedlander’s
comfortable little pile-built house and visit the natives, or get them to
visit me.
As soon as the Oceana had discharged her cargo and departed
on her way to Hong-Kong, we set our sail of matting in Friedlander’s
native-built copra barge, which was fairly loaded to the gunwales
with my luggage and photographic outfit, and glided through green
aisles of mangrove and over the glassy blue and green water of the
lagoon to the southern end of the island where lies the delightful,
scattered little village of Dulukan.
 CHAPTER II
NATIVE HOUSES

T
he island is divided into districts, more or less defined, which are
the remnants of former days when these districts marked the
division into hostile tribes; but now, under one government,
these separate districts are but little regarded as tribal divisions, and
within them the houses are scattered indiscriminately in small
groups. Such a thing as a village street or even a road between rows
of dwellings nowhere exists; there is, therefore, nothing of what we
would call village life, when
“all the village train, from labour free,
Led up their sports beneath the spreading tree.”

The large “bachelor houses,” to be sure, are adequate meeting

places for the men, but the poor neglected women have no common
ground where the heart-easing and nutritious gossip of the day may
be exchanged. In the coconut groves, which form a broad band
along the coast all round the island, each house is surrounded by a
neatly-swept clearing, and this little lawn, if that can be called a lawn
which is devoid of grass, is brightened here and there by variegated
crotons, suggestive of the neatness of the Uap housewife, and
affording an attractive playground of chequered shade under the
lofty palms. The houses are always built upon a platform, about two
and a half to three feet high, of masses of coralline rock, which look
like huge pieces of pumice stone; when first taken from the water
this soft lime-like rock lends itself admirably to being smoothed and
fashioned with the primitive implements of the natives. The platform
is made level on top by filling in with rubble and earth or with a
covering of large flat stones. This loosely built foundation is, I
suppose, to serve the same purpose as the high piles whereon
tropical houses are usually built, namely, to keep the floor, which is
also the domestic bed, as high and dry as possible above the level of
the ground, which at times is deluged with rain in the usual tropical
abundance. Well constructed houses have a broad and long
foundation platform, whereon is built a second stage just large
enough to be covered by the house; the lower and larger then serves
as a broad uncovered veranda round at least three sides of the
building. The cornerposts for the framework are embedded in the
upper dais of stone so that the occasional typhoons which sweep the
island and level even the coconut palms may not carry away the
whole structure. Every beam and stanchion is mortised to its fellow
and bound with innumerable lashings of twine made from the fibre of
coconut husks; not a nail is used and scarcely a peg.

A NATIVE RESIDENCE

In the little yards or clearings about the houses and on the larger
broad platform of stones whereon the houses are built, all that there
is of village life goes on; here guests are received and entertained,
councils of the wise held, and news passed round. It is decidedly
bad manners for any visitor to enter a house, except by special
invitation, no matter how intimate a friend he may be. Very often, to
add to comfort, upright stones are imbedded in the lower platform to
serve as back rests when sessions of the councils happen to be
prolonged or the orator prosy. A matting of bamboo grass, or else
panels of interwoven fronds of the coconut palm form the side walls
of the house; security and secrecy, it must be remembered, are
hardly necessary in such small communities, where all are
acquaintances, and every article of household use or of luxury is
almost as well known to everybody as to the actual owner; stolen
goods are not marketable and thefts are quite rare, except, of
course, of coconuts that happen to fall unexpectedly and temptingly
from a neighbour’s tree.
The interior of the house is neither bright nor cheerful; it is not
strange, therefore, that there is but little indoor life. The eaves of the
palm-thatched roof overhang so far that they almost touch the level
of the floor and all the light and air come through the doorway, or
through one or two panels in the wall which are occasionally raised
like shutters and held by a wooden hook suspended from the rafters.