Can Bono Save the World? (Again)

As growth slows and currencies depreciate, African countries which have borrowed in foreign currencies risk falling into the same debt traps they barely escaped. Bono, are you paying attention?

The turn of the millennium saw the Jubilee campaign, a massive effort to write off third-world debt. Bono was a leader of an admirable initiative to relieve highly indebted countries of financial burdens which were crippling their abilities to reduce poverty and grow. Much of the debt had been built up illegitimately in countries with weak institutions where the risk of borrowing was not understood; dictators such as Mabuto Sese Seko (Congo) and Idi Amin (Uganda) also amassed large debts which impoverished their respective countries.

The Jubilee campaign was largely successful, as it saw G7 countries pledge to cancel $50bn worth of debt. The true cost of the write-down is far less, given how little of the debt was actually being serviced. The Jubilee debt campaign has also worked against “vulture funds”, which buy the debt of defaulted countries and then attempt to bring judgements through legal systems in the developed world. Zambia faced an example of this when in 2007 one of its defaulted loans was bought for $3.3 million by a vulture fund, which then sued for $55 million — the full amount, plus interest and costs. Debt relief and campaigns like Jubilee are not a panacea, but they have reduced the debt burden of highly indebted countries and limited the ability of vulture funds to profit at the expense of poor countries.

As the quality of U2's songs declined into the new millennium, Africa's growth picked up on the back of the commodity boom. Unfortunately, debt relief and rising commodity prices were not sufficient to ensure sustainable growth, as institutions in Africa remain weak. With commodity prices declining since 2008, growth in Africa has slowed while government spending pressure has not abated. This has led to large deficits, which have to be financed with borrowing. With global yields at record lows, there has been a temptation to borrow in foreign currencies (specifically USD), as the issued interest rate is far lower than domestic borrowing. In recent years, we have seen USD bond issues by a broad range of countries including Ghana, Zambia, Ivory Coast, Kenya, Senegal, Ethiopia and Gabon. These enticing low-interest rates come at the expense of immense currency risk, which has now materialised with the depreciation of African currencies against the US dollar. The following chart shows the performance of the African universe against the USD since 2013.

How costly this depreciation is can be seen in the example of Zambia, where a $750m bond was issued in 2012 when the exchange rate was 5 kwacha to the dollar. Since the time of the bond issue, the exchange rate has weakened by 53% to 7,63 kwacha to the USD. The value of the debt has therefore ballooned from 3,75bn kwacha to 5,7bn kwacha. If the currency depreciates further, this debt burden will continue to rise.

The growth of foreign-currency debt in Africa since 2012 has increased the risk that certain countries find themselves once again in a debt trap. Weak institutions and a culture of patronage in Zambia have led to a mismanagement of the economy, as parties buy votes with populist policies in order to win elections. Michael Sata’s Patriotic Front (PF) made some impossible promises regarding employment, poverty and cost of living in order to get elected in 2011. A ruling party that campaigns with the slogan "More money in your pockets" will always be under pressure to deliver.

Once in power, the PF set about rewarding voters by ramping up spending. The total budget has grown by 45% between 2013 and 2015, which has caused a large increase in the fiscal deficit. Against a backdrop of falling commodity prices (copper is 85% of exports), the debt-to-GDP ratio increased from 26% to 40.5% between 2012 and 2015. The following chart from Barclays shows the past and present: a history of the fiscal deficit dating back to 2008 and the forecast looking to 2016. The fiscal deficit is projected to stay at high levels (8%+) in coming years, and Zambia has reached the point where it is difficult to finance its high level of spending.

These difficulties were emphasised last week when Zambia launched a bond that has the unwelcome distinction of being the most expensive dollar debt ever for an African government. They issued at a yield of 9,38%, which is far more expensive than the 2012 bond which was issued at a yield of 5,625%. The desperation of Zambia to borrow is highlighted by the $38,4m “costs” incurred for the bond issue. This is a phenomenal level of expenses for a bond issue, and is an astounding 27 times the $1,4m cost of the 2012 bond issue. The additional “costs” bring the effective cost of debt closer to 9,85%.

Zambia is not alone amongst African countries which have ramped up spending in recent years through the build-up of foreign-currency debt. Ghana finds itself in a similar situation as it tries to launch another USD bond in order to meet it spending requirements, and it is likely to pay a significant price for this. There is a reason that foreign-currency debt is referred to as the “original sin”, since it has a history of triggering financial crisis.

Both Zambia and Ghana seemed to have reached the point where they are willing to borrow recklessly for political reasons. They need to satisfy the electorate in order to remain in power, and have used borrowed foreign money in a futile attempt to contain currency depreciation. While governments are thinking short term, the debts that they are building up in the present will not disappear after the next election, and citizens will suffer the consequences down the line. The extent of financial mismanagement means that both Zambia and Ghana are headed towards a financial collapse. They will soon find themselves in debt trap, beholden to their creditors and institutions like the IMF.

Bono’s services will be required shortly, and they should hope that U2 is done touring by then.

China Coverage

China's stock market crash continues to weigh on commodity prices. With the issue still topical Glacier (a Sanlam business) published my China article in their weekly newsletter.

http://www.glacier.co.za/mediacentre/GlacierMediaCentreArticles/funfonfrifay_glacier_20150717.pdf

Greece Coverage

With Greece being quite topical these days the Daily Vox and CNBC requested some commentary on the issue. Click on the links before for article and video.

http://www.thedailyvox.co.za/pay-back-the-money-greek-edition-can-the-referendum-end-the-crisis/

http://www.cnbcafrica.com/video/?bctid=4351572694001

The Significance of China's Stock Market Crash

1) These Chinese Stock market has crashed after a phenomenal bull run.
2) The Chinese equity bubble had the potential to boost growth, but now that the market has crashed this hope disappearing.
3) Growth has been driven by debt since 2007, which means an increased risk of financial crisis.
4) China has been the main driver of world  growth in recent years, but that growth will slow with knock on effects on global growth.

While the financial markets have been occupied with the turmoil in Greece, a potentially more serious development is the crash of the Chinese stock market after its  phenomenal run. Up to May 2015 the Chinese market had delivered 154% over a 12 month period and valuations of medium and small companies reached extremes. The market began selling off on the 15th of June and the crash continued despite measures by the central bank and government to prop up the market through the use of interest rate cuts and stock buying programs. The broad market has fallen 32% from its peak, a tremendous destruction of value given that the Chinese market is second only to the US in terms of size. Many companies have taken the strategic decision of suspending trading in their stock in order to prevent them falling further. Currently over 1000 stocks, out of a listed universe of around 3000, have suspended trading in recent days. This level of of suspension of trading is unprecedented as the action generally used for companies in Liquidation or Business rescue. As a comparison there have been 5 suspensions on the Johannesburg Stock Exchange for 2015 to date. While the market has fallen 32% in less than a month, the crash is actually understated due to the number of stock suspensions. 

China's economy slowed during the 2008 financial crisis, but then recovered strongly due to government stimulus and credit growth. Growth has slowed significantly in recent years, but at 7% it is still very high for an economy of its size. Expectations are that economic growth in China will remain strong (between 6% and 7% in coming years) and the equity bull market reinforced these beliefs.

The Chinese equity market crash is significant as the bull market had the potential to boost economic growth. New stock offerings (IPO’s) and stock issues by listed companies pull savings into businesses, which they can can then invest. High valuations lower the cost of equity and therefore the required return on prospective investments. This causes companies to ramp up investment and this in turn drives growth. There was some hope that the deluge of money being pumped into the equities would stem the decline in GDP growth, but with the market crash this hope has now disappeared. 

It is critical for China that their growth does not slow as since 2007 they have amassed a large amount of debt. In the 5 years leading up to the financial crisis, China grew at over 10% p.a. The economy began to slow in 2007 and growth dipped to 6% in 2009. China reacted to this by significantly increasing borrowing and investment in an attempt to maintain its high growth rates.  They succeeded in boosting growth, but at the expense of massive increase in the debt levels. A McKinsey report earlier this year highlighted the extent of the borrowing binge (http://www.mckinsey.com/insights/economic_studies/debt_and_not_much_deleveraging). The debt to GDP ratio has increased from 158% in 2007 to 282% in 2014, which means that debt levels in China now exceed those is developed markets such as the United States, Germany and Canada. 

The speed and quantum of the debt increase has only a few precedents in history, with no nation in a comparable position able to escape an an economic slowdown and most experiencing a credit crisis. (http://on.ft.com/1aYv5KM). A country with a high level of debt is very dependent on growth as any slowdown can impact the ability to service the debt load, which would precipitate a financial crisis.

While China’s debt fueled boom has been under scrutiny for several years, investors have generally believe that the government will be able to deal with any fallout due to the low level of government debt (55% of GDP), the current account surplus (more exports than imports) and the size of their foreign exchange reserves ($3,7 Trillion) . Despite these fundamental positives and the fact that the economy and credit growth has continued to grow at a rapid pace this year, I believe that a slowdown is now inevitable and there is a meaningful risk of a hard landing brought about by a financial crisis. Over the last 5 years China has contributed 30-40% of the world’s economic growth and the consensus among economists and market participants is that this is likely to continue. A significant slowdown will be quite unexpected with massive knock effects for the global economy.

Yanis Varoufakis on Bloomberg: A Great Political Interview

Yanis Varoufakis is not a politician. He is an academic who has published several books on game theory and global economics. In January 2015 he moved from teaching at the University of Texas to being the Finance minister of Greece, a country that has been in a debt crisis since 2010. Prime Minister Alexis Tsipras appointed him despite Varoufakis not even being a member of Syriza, the party that won the election. Not being a politician means that he has not built up years of experience in obfuscation, but is able to speak clearly and incisively on the economic crisis and the upcoming referendum.

With Greece going to a referendum on Sunday the 4th of July 2015, the government is aiming to convince the people to vote "No" to the current debt-restructuring proposal. Varoufakis gave an interview to Bloomberg this week where he dismantled many of the arguments made by the Eurogroup, the financial industry and the media. He made the important point Greece will never be able to recover as long as they have an unsustainable debt load. The IMF belatedly confirmed this when they said they would not put another bailout proposal to the board unless it contained debt relief. http://www.theguardian.com/business/2015/jul/02/imf-greece-needs-extra-50bn-euros

Varoufakis had the financial world on hold for 20 minutes as he gave this interview. I am sure that that his straightforward approach would have changed the minds of many in the financial industry that view him as a left wing pariah. He is critical of the approach to the crisis since 2010, which has been one of denial and short term fixes ("Extend and Pretend"). IMF, Euro commission and the ECB have imposed a program that is one of the great failures of economic history. Greece has been insolvent since 2010, but the programs to bailout out private sector banks while barely altering Greece’s debt burden have caused a great depression in Greece. Five years later and Greece is still not growing, as no one is willing to invest in productive capacity in Greece while they are insolvent. The IMF, the United States and Global Investors all do not believe that the Greek debt is sustainable, but the Eurozone institutions, fearing a knock on effect in other indebted nations such as Italy and Spain, refuse to acknowledge this or propose a deal that will solve the problems.

Greece has to say "NO" to the status quo and seek deal that will set them on a sustainable path, either inside or out of the Euro.

A Greek Holiday or: How I learned to stop worrying and love the Grexit

A weeklong holiday in Greece last week cemented my view that the country would be far better off it were to default on its debt, leave the Eurozone and revert back to its own currency. A few days in Santorini highlighted the tourism assets (20% of GDP) that Greece has in its islands. I was also positively surprised with the quality of the infrastructure in Athens. The financial press continues to favour a compromise and debt restructuring due to the systemic financial risks of an exit. However, Greece has very little to lose as its economy has ceased to function effectively due to its debt burden and continuing uncertainty regarding its future. If an exit is managed well then they have much to gain in that exiting the Euro as devaluing will improve economic competitiveness and put back to work unutilized resources.

3 Thoughts from my trip:

1) Greece has the potential for a quick economic recovery

Greece's economy is currently clogged by uncertainty regarding its future. No country can function properly while living in a suspended state where its currency, banking system and political institutions may cease to exist at any point. Under these circumstances it is no surprise that there has been no progress on the economy since 2008.  Even if there is another bailout agreement, the uncertainty will continue because a debt burden of 180% of GDP is unpayable. This is understood by Greek citizens and private institutions, even as officials within the Eurozone try to deny it. While a default will be a shock to the system, it will remove the uncertainty overhang that has made the economy dysfunctional. The country will get a massive boost by the elimination of its debt, while the devaluation of the currency will boost its competitiveness and cheapen assets thereby enticing investors.

Threats of being "locked out of financial markets" will prove to be empty. In an environment of surplus global savings and ample liquidity, Greece will not struggle to find alternative creditors. Their funding requirement is not onerous as they are running a primary budget surplus, while their current account deficit is currently 1,5%, having narrowed from 10% since 2012.

The risk to a rapid recovery is a possible descent into populist policies by the left wing government, which will waste the opportunity for a fresh start.


2) 21st Century Politics and Norms makes sovereign debt virtually unenforceable

While Merkel, Draghi and the European political elite have been painting a nightmare outlook for Greece if it defaults and leaves the Eurozone, it is the lenders who are really scared. Greece has around EUR 320bn worth of debt, the majority of it owed to external parties such as the ECB, IMF and the EFSF (European Financial Stability Fund). (http://www.theguardian.com/world/datablog/2015/jun/19/the-greek-debt-what-creditors-may-stand-to-lose)  There is a further EUR 80bn borrowed by the Greek banking system via the Target 2 payment systems. This is the means by which Greeks have been able to withdraw Euros even as their banks have run out of money. The European banking system would need to make up this amount and it would have to be done with state assistance. (http://www.yardeni.com/Pub/target2.pdf)

Costs to the Eurozone

For the Eurozone, the cost to Greece defaulting is high, both in monetary terms and in the additional fragility it will add to the Eurozone. It would highlight the fact that countries can exit the Euro, making the currency more fragile. If Greece successfully manages to walk away from its debt burden it will add to the risk that other highly indebted such as Spain and Italy may choose to do the same.

Costs to Greece

Since 2008 Greek debt has migrated from private sector balanced sheets (banks, investors, pension funds) to taxpayer backed institutions like the Eurozone/IMF/ECB investors. (http://money.cnn.com/2015/01/28/investing/greek-debt-who-has-most-to-lose/). With the debt now held largely by foreigners, the cost to Greeks in the case of a government default is relatively low. This is in contrast to South Africa where 65% of the government bonds are held locally by Pensions Funds, Banks and other investors.

While the Eurozone has an incentive to make life as difficult as possible for Greece once they default, there is very little that can be done to enforce sovereign debt payment in the modern world. The Greek state does not hold significant offshore assets, and it would not be easy to attach the assets of Greek citizens. Throughout history war has been used as a means to enforce sovereign debt payments but that would be difficult in today's political environment. While the European creditors would like the Greek government to sell assets (like its islands) in order pay them back, there is little they can do to force them.


3) Sovereign Debt needs to be Legitimate

Credit quality is defined as the capacity and willingness of an entity to meet its financial obligations. Greece has neither the capacity to pay (given size of the debt burden) nor the willingness (given the electoral victory of Syriza on a debt repudiation platform). The Greek electorate understands that a debt load of 180% of GDP is impossible to recover from without severe sacrifices, no matter how the debt is restructured and how low the interest rate. In the mid 90's South Africa's debt burden crept towards the 60% of GDP level, a breach of which risked sending the country into a debt trap. While the 60% level is no longer considered the “Red Line” and interest rates are very low at this point in time, it is difficult to believe that an external debt load 3 times the "debt trap" level is in any way sustainable.

I believe that the Eurozone powers erred in not legitimising the debt restructuring through a democratic process like a referendum. (http://rashaadtayob.blogspot.com/2011/11/referendums-are-solution-to-european.html) In November 2011 then Greek president George Papandreou suggested a referendum on the bailout package. Four days later he was forced to backtrack under pressure from Merkel and Sarkozy and 10 days later he had to resign. Had they gone ahead with the referendum, it would have granted legitimacy to the bailout package and the debt that the people of Greece assumed. Without legitimacy the people of Greece feel no need to continue for further sacrifice in order to pay back the debt, which is why they elected Syriza on the promise of a new deal. Without legitimacy private entities were not willing to hold the debt and it continued to migrate on to Euro/IMF/ECB balance sheets, which means that taxpayers in the Eurozone and globally are now on the hook for the debt.