Reforming China

There have been a couple of minor reforms in China that could prove to be the start of something bigger.

The Government has proposed restricting the amount mobile phone companies can spend on marketing, at the same time they have announced a plan to create an infrastructure company to take ownership of the cell towers.

China’s State Owned Asset Supervision and Administration Commission (SASAC) that “owns” all the State Owned Enterprises has told the three cell phone companies to reduce their marketing and subsidy costs by 20% for each of the next 3 years, shifting the focus away from attracting new customers to retaining existing one. Merrill Lynch recently issued a report where they expect the profits of the whole system to rise by 12% because of this one change.

In the early stages of mobile rollout, acquiring sufficient sites to install transmitters is a major strategic imperative; market coverage, not only by area but also reliability, is a vital marketing tool to attract and retain clients.

At some point, coverage stops being a tool to differentiate between established firms as they all cover the same area – look at the coverage of the three major Canadian cell phone companies, and you see that they all provide essentially identical service in identical places, whilst they all fail to provide coverage in the same places as each other.

Depending on the exact business model chosen, an infrastructure company can free up capital for the cell phone operators as it buys up their existing infrastructure. It can reduce total capital expenditure, as the operators are able to lease capacity, resulting in less duplication of equipment. Again, using Canada as an example, our major Celcos are each building near identical LTE/ 4G systems nationwide. Capex would be greatly reduced if they leased capacity from an infrastructure company, only adding their own capacity where lease capacity was inadequate.

Under such a model, new entrants and discount brands would also find it much easier to break into the market.

The same Merrill Lynch report estimates the value of the infrastructure changes to the three Celcos to be around $30bn.

The two announced changes amount to about $50bn in today’s money. If we assume ½ that $50bn makes its way back to the Government in higher taxes and dividends from the 3 telephone companies that is an extra $25bn in Government revenues.

We are seeing similar “small” scale initiatives in other SOEs; PetroChina is preparing to sell two large gas transport pipelines. As the old Government adage goes, with a billion here and a billion there, pretty soon you are talking real money!

If this improved capital management is sustained, and don’t forget that there are a lot of insiders who will lose out if it is sustained, not only will the GDP growth rate decline at a slower pace, but Government revenues will also see a meaningful improvement, allowing them to better tackle several of the key issues, such as the shadow banking system.

These changes are small, and are certainly not the “Big Bang” approach some people are demanding, but every journey starts with a single step.

So Argentina defaults again.

So Argentina defaults again.

Despite the headlines this is generating, the sun will continue to rise, the inhabitants of Buenos Aires will continue to enjoy the world’s best steaks, and tourists will still flock to Evita's tomb.

Countries don’t have a “right” to default, but sometimes it is the only option. In an ideal world, they swiftly reach an agreement with their creditors, who recognize the reality of the situation, everyone learns their lessons, and move slowly forwards, chalking it all up to “experience”

Unfortunately we don’t live in an ideal world. As we saw with the Euro Crisis, Governments leave it far too late to publically admit that they need bailing out even when it is perfectly obvious that they need to.

As I have mentioned before, I remember some of the roadshows for Argentine bond issues during the run-up to the crisis, and private meetings I had with the Ministry of Finance in Argentina, where the economic projections were a work of fiction. Following the Russian default of ’98 and the Brazilian devaluation of ’99, Argentina’s de-pegging was a matter of when not if.

What made the situation worse was the attitude the Argentine Government took to the restructuring. After years of posturing and nationalistic chest thumping, the late President Nestor Kirchner announced on Primetime TV, “this is the deal, take it of leave it”. To underline the point, he included a law prohibiting any reopening of negotiations with any party who didn’t participate in the restructuring. Argentina is now paying the price for his hostility.

The public faces of the dispute are the Vulture Funds, such as Elliot Capital. It is a very apt term, even though it is supposed to be an insult, as no one else is really going to get involved until the vultures have given the body a good picking over; they reassure the rest of us that some kind of bottom has been reached. Indeed, the papers on Friday were full of stories of hedge funds buying the Argentine stock market directly, now that all the bad news is in the price. My clients own some Argentina through the Frontier Markets ETF (FM.N)

The Vulture Funds, however, are not the only interested parties in the court case. A lot of bonds were originally sold in Europe, where people often buy such bonds as part of their retirement planning. As you can see from the two charts below, in the early 90’s the spread of Argentine bonds over US treasuries was narrower than the spread of Italian Government bonds over German Bunds, suggesting they were considered a less speculative investment. It was only the prospect of Euro inclusion that brought Italian yields down. As a result approximately 2/3 of the holdout investors, by value, are small time investors, mainly from Italy.

To all intent and purposes, the Bond markets closed to Argentina after their take-it-or-leave-it restructuring. A more reconciliatory attitude would have kept them open, but that wasn’t the Kirchners’ problem. They have tried to dress it up in terms of nationalist chest thumping, but the reality is they themselves were not inconvenienced by the problems of the ordinary people as they became even wealthier. They happily “lead the people” against the depredations of Foreign Creditors and the IMF without worrying about spiraling unemployment or 30% inflation.  The Government squandered huge windfalls from higher agricultural commodity prices, and stole all the assets from the private Pension Fund system just to keep afloat.

In about 2006 the late President Kirchner fell for the charms of Hugo Chavez, borrowing dollars from him at about 15%. This at a time when the markets were charging Brazil 5.5%, and the IMF was charging 2-3%. Unfortunately for Argentina, Chavez immediately dumped the bonds into favoured Venezuelan banks, which in turn promptly dumped them onto the market to earn precious dollars. The Argentine treasury found itself having to intervene in the market to buy back the bonds with the money Chavez had “leant” them in order to stop their remaining debt spiraling downwards.

I was building a bond portfolio for some clients using ETFs recently. In anticipation of this “default”, I double-checked the Argentina content of the major EM Bond ETFs, and got a number of around 1%. Even I was surprised how irrelevant Argentina had become.

That is the bottom line now Argentina doesn’t matter. They have so ostracized themselves, that no one has the level of investments there that is going to require any significant attention. Whether Inflation is 25% or 30% isn’t going to be changed by this week’s events, GDP growth will be relatively unaffected; meanwhile, over in Nigeria …

What of the future? Is there any kind of solution to this charade?

According to the papers, approximately $1BN in credit default payments have been triggered, versus about $4BN in debt holdouts. Is that enough to push the holdouts to accept the original offer? Obviously that depends on who holds what, but one of the better conspiracy theories I have heard recently is that the whole negotiation is a giant Kabuki Play to justify the triggering of those CDS, and that the Holdouts can now accept a lower offer once the no-renegotiating clause expires at the end of this year.

So my feeling is Argentina is moving into the end game here. Christina Fernandez’s time as President runs out next. Rampant double-digit inflation is giving the population more pressing concerns to worry about than the holdouts from 2001, whilst the new President will have less emotional attachment to “punishing” Argentina’s creditors

So this little spat is going to rumble on a little bit longer. It may create some headlines, but the reality is no one really cares any more.