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.

Mea Culpa

First mea culpa, this blogging on a regular basis is a lot harder than it first appears. How Leo Kolivakis at Pension Pulse can do it every day is beyond me. As it used to say on my old school report – “Must try harder”

Second mea culpa, I also got the Ukraine situation badly wrong – the worst I foresaw was what euphemistically gets called “Collateral Damage” and we are certainly beyond that now.

Despite the situation having deteriorated farther than I anticipated, it hasn’t driven the markets down any farther. The attached chart of the Gazprom GDR shows that following the initial drop on the  invasion of Crimea it has mainly ignored recent events, although volatility has picked up. 

We have hung on to our basic positions in Russia, but more recently we have been “renting” stocks to take advantage of the volatility – buying small positions on down days they selling them out when they bounce; ideally we would be doing this as part of our option overlays, but there aren’t enough listed options on the GDRs.

Few precise details have emerged about the recent gas deal signed between Russia and China, but a couple of analysts who have run their slide-rules over what little we do know have suggested that it is at best a breakeven deal for Russia. Given that Putin was very keen to show the West that he has other choices of “friends”, it would not be surprising if China were able to drive such a hard bargain; in short, Gazprom remains a continuation of State policy by other means and as such will remain very “cheap”.

Some commentators have tried to use the deal to paint President Obama in a bad light – weak, ineffective, etc – the Realpolitik is that there is very little more he could do without Europe taking a stronger stand and there certainly doesn’t appear to be much appetite for that currently. Ironically, President Reagan warned of this kind of impasse when Western Europe first started negotiating to import Russian gas back in the 80’s

Now that Sunday’s Presidential Elections have returned the pro-European Petro Poreshenko things should calm down for a while. The forced closing of poling stations in several of the pro-Russian strongholds, such as Donetsk and Lugansk, only serve to legitimize a government that will probably be just as corrupt as the last one. It doesn’t make Russian stocks a screaming buy, but they should move slowly higher as things “normalize”

In recent weeks we have observed the Brazilian market get a bounce every time Dilma’s approval ratings drops, or word leaks out that preparations for either the World Cup or the Olympics are going badly; FIFA has said publically that the preparations for the World Cup are the worst they have ever seen, whilst the IOC has apparently informally approached the UK to see how quickly they could bring back on-line the facilities used last time around.

Congress has opened an investigation into the purchase of a refinery in Pasadena TX when Dilma was the Minister for Mines and Energy and Chairperson of Petrobras. The company was forced to acquire 100% of an operation they only wanted to acquire 50% of, paying out $1.25BN instead of their expected $360M, for an asset that was possibly only worth $42M. As a long-term follower of Petrobras, none of this surprises me.

Expectations of a first round win for Dilma have faded, although she is still currently expected to win in the second round. IF the Government is forced to introduce any kind of electricity rationing because of the poor rains, the October race will be wide open. Dilma, again in her previous role as Minister for Mines and Energy, intervened in the market to ensure that returns on investment were below those required to bring in new capital, so now the country faces a shortage of back up capacity and a $20Bn subsidy bill.

I remain confident that the World Cup will be a success, in the sense that it will happen, someone will win, and that people will have fun. Should Brazil get to lift the trophy again, they will probably deem it to be the greatest series ever.

I am happy to see the election of Narendra Modi as the new Prime minister of India. To call the Gandhi clan that has been at the core of India’s mismanagement for so long “tired and corrupt” would be an understatement. India needs someone who is not permanently trying to hold the poor back, but is actively trying to give them opportunities. Modi comes with baggage that is for sure, but he deserves the benefit of the doubt at this stage.

I used the bounce in many of the Indian names in my portfolio to cut back exposure, not because I doubt Modi’s abilities, but because I recognize that he has a herculean task ahead of him. Despite all the good wishes, we won’t know if he is actually going to be successful for quite a while as the vested interests fight to maintain their privileges.

Finally, I am surprised it took the Thai military so long to intervene in the dispute between the Government and their opponents. Given how the country has become increasingly polarized whilst the economy has slowly stagnated  - the State Planning Agency recently announced that the economy has slipped back into recession – it was only a matter of time before they stepped in. 

Unfortunately the coup isn’t likely to solve much of the underlying problem as they are too closely aligned with the “Blue Shirt” opposition of the urban elite. Perhaps they would have had more credibility if they had forced Suthep’s supporters NOT to have boycotted the Februa

Does size matter?

Last week Nigeria rebased its GDP to become the largest economy in Africa. It went from $264Bn to $509Bn, an increase of 89%, overtaking South Africa’s $384bn and just ahead of fellow Petro-state Norway’s $499Bn.

Kenya is undergoing a similar exercise, and preliminary estimates suggest their economy is 20% bigger at around $50Bn.

10 years ago, China carried out a major review of GDP that added 16.8% to its GDP, and many commentators at the time “guessed” that they were still underestimating GDP by at least 10%.

It will be interesting to see the effects of Purchasing Power Parity adjustments on these new numbers.

It’s not that these countries have previously been dishonest about their GDP, but that economies change over time and that changes to Government statistics always lag the economy.

When I was a medical student, I was taught “you can’t find a fever without taking a temperature”; you can’t estimate a sector’s growth without first identifying that sector. The census that increased China’s GDP had found $284Bn worth of companies that the central Government did not know existed, mainly in the service sector.

Prior to 1985, China didn’t even calculate but used the system that completely disregarded service industries. Even after they started to calculate it, China didn’t fully adopt GDP until 1993. Incidentally, the former Soviet States didn’t abandon the measure until 1991.

Telecoms, and especially mobile telecoms, are common areas Governments have underestimated GDP. Many countries, of which India is possible the most well known, decided NOT to regulate mobile telecoms in the same way they regulated fixed-line; since the poor would never be able to afford mobile phones, they would never require the same degree of protection!

As we now know, freed from Government protection, consumers were able to get a plethora of “value added” services from their mobile providers – not least actual working lines. In the African context, Kenya’s Safaricom introduced M-Pesa that is often regarded as the world’s most successful mobile payment system. I suspect the upcoming revisions will show a dramatic increase in this category.

The recent revision in Nigeria took Telecoms and IT from 0.9% of GDP to 8.7%! My Nigerian friends tell me that the networks are still highly congested – to put up a cell tower you often need to provide a generator to ensure uninterrupted power and a guard to make sure the generator does not get removed, then fuel for the generator, etc, so the roll out continues to be slower than possible. The dead hand of Government still manages to hold things back.

There were several sectors that were going completely unmeasured. The previously unmeasured entertainment industry that includes Nigeria’s famous Nollywood film industry added an estimated 1% to GDP.

Ironically, the increased size of the economy only goes to show how totally inept the Government sector is. Taxes/ GDP, already low in Nigeria, are now half as much, likewise the power generation deficit is twice what it was!

But let’s focus on the positive.

This “hidden” growth explains why firms like Dangote and the various banks have done so well. They have not been taking inordinate risks, but merely responding to market growth. Some of the revised indicators I am looking to see broken out are various types of loans to GDP as they would show how much more growth the banks can finance without excessive credit risk.

Each of these increases slowly but surely rebalances the global economy towards where the majority of the people live. This slow process is the raison d’être of Emerging Markets investing.

As countries move into Middle Income status, they tend to attract more Foreign Direct Investment as Multinationals firms seek out new markets, particularly in the consumer discretionary sector. The sheer size of the market becomes too big to ignore. Consumers in these countries may not have money to burn, but they certainly have increasing amounts to be spent on branded products. Indeed the consumption of internationally branded goods can become status symbols.

As the markets grow, local entrepreneurs rather than rent seekers tend to take a larger share of the economy, meaning that regulations become less about protecting insiders and more about the fair functioning of markets. Meanwhile the rent seekers themselves focus less on hiding their wealth abroad and actually start reinvesting it domestically.

For stock market investors, despite these GDP adjustments, Nigeria will remain a Frontier Market for quite a few more years. Liquidity will remain low, access limited, and too many fund trustees have received pleading letters from the bereaved relatives of recently deceased ex-Ministers.

20 years ago, no one would take Brazil seriously, whilst today it is firmly on everyone’s radar and they have to have a genuine reason for not investing there. Today it is acceptable to dismiss investing in Nigeria, but give it a few years.