Economic Challenges and Priorities for Cyprus

The two-round Cypriot presidential election in February provided Nikos Anastasiades of the DISY Party with a convincing majority for his election as President. The election has widely been heralded as a success by domestic and international media, ending a period of instability brought about by the former President, Dimitris Christofias, whom many commentators blame both for the Mari disaster as well as for a less-than-optimal handling of Cyprus’ bail-out request to the European Union.

It is important to note amidst this euphoria that in concrete terms, little has changed with the election of the new President. An important issue is that the composition of Parliament has not changed, and that the new government will be forced to work with the Parliament that existed before the elections. This Parliament comprises 6 parties, which is a high number given the low population of Cyprus, and engenders a certain extent of political fragmentation.

The objective of this article is to examine the economic challenges and opportunities facing the new government in the first 12 months of its administration. It does so non-politically and non-ideologically, based on economic priorities and not political considerations.

There are four major economic challenges and opportunities facing the government:

1. Negotiating the bail-out package
2. Restructuring the public sector
3. Effective regulation and restructuring of the banking sector
4. Promoting sustainable foreign and domestic investment

Each priority is explored in further detail in an article by Philip Ammerman on Navigator Consulting Group.

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Yuan for the Money, Two for the Show

The Economist ran the latest of a series of interesting article on the increasing convertibility of the Chinese Yuan (“Yuan for the money”) in its February 9^th, 2013 edition. According to The Economist:

In the last three months of 2012 the amount of trade settled in China’s currency reached almost 900 billion yuan ($145 billion), or 14% of China’s trade, up from almost nothing three years earlier. China accounts for about 15% of the world’s money supply. 

Although the yuan accounts for a small currency share compared to the US dollar, Euro, Yen and British pound, the trajectory of future growth can readily be assumed.

Bloomberg ran an article on the growth of Chinese trade and the fact that in total imports and exports, China surpassed the United States to become the world’s largest trading nation (China Eclipses U.S. as Biggest Trading Nation, February 10^th, 2013).

“U.S. exports and imports of goods last year totalled $3.82 trillion, the U.S. Commerce Department said last week. China’s customs administration reported last month that the country’s trade in goods in 2012 amounted to $3.87 trillion. ... China’s growing influence in global commerce threatens to disrupt regional trading blocs as it becomes the most important commercial partner for some countries.”

The trade numbers are interesting for their impact on GDP. US GDP is just over $ 15 trillion, while China’s GDP is slightly less than half of this at $ 7 trillion. But remember that GDP is defined as the sum of:

GDP = private consumption + gross investment + government spending + net exports (exports – imports)

This raises a number of questions as to what happens to headline GDP and other factors in the “China model” if more transactions are denominated in yuan.  

Chinese GDP is a complex and often opaque creature, but a very large part of it is due to structure issues and government control.  

·       Chinese manufacture, despite its volume, retains a relatively low share of value in China. See for instance the share of value captured by Apple’s manufacturing operations in China. This results in lower relative net exports, and in turn feeds into lower private consumption due to low wages and dividends in China.

·       Low wage costs and a high labour supply. The Chinese growth model has been on attracting FDI to assure export-led growth, initially using low cost labours supply as a competitive advantage. This is beginning to change, as the Foxconn strikes and other data indicate. Should this continue, it will increase the net export and private consumption components of GDP.

·       Overinvestment in key manufacturing sectors, driven by the Chinese government’s stimulus spending focussing on export-led growth (but also domestic real estate). See for instance the glut in solar panel production. This depresses the net export component of GDP but raises gross investment. It is interesting that since much of the credit is from government-sponsored financial entities which are recycling hard currency earnings (via credit guarantees and credit lines from the central bank), government debt remains relatively low.

·       The availability of these hard currency reserves is precisely a result of exchange rate controls. It will therefore be interesting to see what effect denominating a higher volume of trade in yuan will have on China’s forex reserves, which numbered over $ 3 trillion in 2012.

·       This last point also inevitably concerns the US dollar. Besides the obvious issues of how the USD will continue as the reserve currency and the value of the USD, there is another question as to how much longer China will continue to invest in US Treasuries, both as a hedge against devaluation as well as a political lever.

Will yuan-denominated transactions incur lower transaction costs? Theoretically, yes, although if we measure total transaction costs, including potentially higher yuan inflation rates, regional currency valuation issues, and the costs of converting yuan holdings to parent currencies when repatriating or declaring annual profits or dividends, this is not a foregone conclusion if set over a 5-year time period. On the other hand, if we assume a well-managed currency and an appreciating yuan, the conversion effect will provide a significant upside to such transactions.

This last point notwithstanding, we anticipate a major growth in yuan transactions over the next five years. The momentum pointing to this is undeniable, and is magnified by semi-governmental investments in African infrastructure projects or commodity trading.

This will inevitably lead to a struggle to manage the yuan’s appreciation by the Chinese central bank, which already finds itself having to manage a short-term Japanese yen and a longer-term US dollar devaluation. It is no coincidence that China is doubling down on gold purchases.

An increase in yuan transactions is a clever short-term method of taking some of the pressure off the rising Chinese currency. Yet this pressure is only likely to accelerate, both given national policy among key trading partners (Japan and the US in particular) as well as the likely demand for yuan transactions among companies, semi-governmental organisations, and private citizens and small entrepreneurs.

The next step will almost certainly be a move to denominate oil and commodity prices in yuan, which would lead to a real issue in the future of the US dollar. And while an appreciating yuan will flatter USD-denominated GDP, the current structural imbalances in an over-supplied, mercantilist model remain to be resolved.  

© Philip Ammerman, 2013

An abbreviated tale of two banks

Recent decisions on the Icelandic and Irish banking work-outs and the impact of Eurozone decisions call into question fundamental issues of moral hazard, shareholder risk and common sense. This is seen in recent decisions concerning Landeskanki of Iceland and Allied Irish Bank of Ireland.

On January 28^th, the Financial Times reported (Iceland triumphs in Icesave court battle) that the court of the European Free Trade Association (EFTA) ruled that the Icelandic government’s decision not to reimburse Dutch and British Landesbanki Icesave depositors using national resources, but with the liquidated resources of Landesbanki, was upheld.

In part, this was due to the fact that the liquidation process has paid back over 90% of the minimum deposit guarantee:

In any case British and Dutch governments are still likely to get most, if not all, of their money back. Landsbanki’s estate has already paid back IKr585bn ($4.6bn) of the IKr1,166bn claims from Icesave, equivalent to more than 90 per cent of the minimum deposit guarantee that the two governments were obliged to pay. … It intends to repay the full amount but will only pay interest for about six months, because of an Icelandic supreme court ruling, rather than the full length of time that the two governments demanded.

It is instructive to contrast this with the recent European Central Bank decision on the cost of bailing out Anglo-Irish Bank to the Irish government as reported by Reuters on the same day (Insight: Irish banks at mercy of international paymasters).

The Irish government had made a very modest proposal of converting a promissory note issued at the height of the crisis for underwriting Anglo-Irish with the issue of long-term government bonds. This restructuring would improve the loan term, reducing the EUR 3.1 billion the government is currently spending per year on the note. Ireland’s 2012 GDP is estimated by Eurostat at EUR 162.3 billion, so this promissory note amounts to 1.9% of 2012 GDP.

As reported by Reuters, the ECB rejected Ireland's preferred solution for restructuring the cost of propping up Anglo Irish because it amounted to "monetary financing" of the government.

This is extremely ironic, given that the ECB’s EUR 1 trillion Long Term Financing Operation (LTRO) to private banks was extended with the precise objective of monetary easing.

As reporting previously (Navigator, Eurointelligence, FT Alphaville), the low-cost LTRO funds (1%) was re-invested in higher-yield sovereign bonds, resulting in indirect  “monetary easing” as well as a significant carry trade interest for the banks.

This contrasting approach, which is currently being implemented in Cyprus, calls into question a number of issues:

·       When and under what conditions should a government, and by extension the citizens of a country, be made responsible for the mistakes of a private bank?

·       What special interests have been served (primarily by European banks over-exposed to bad loans in other countries) in the current Eurozone bailout and LTRO approach?

·       Who has paid more in the European banking crisis: bank shareholders and bank management? Or citizens and taxpayers?

·       At what point does European monetary policy and European competition policy contradict common sense in financial restructuring? (And how many years ago was this point passed by?)

These recent decisions illustrate more than the technical issues such as bank deposit insurance or bank regulation in the Eurozone or European Union. They illustrate a very real problem of regulatory capture and embedded moral hazard, as well as the total immunity of bank managers and government officials responsible for regulating banking as well as sovereign debt.

It should come as no surprise if popular anger and dissatisfaction at the “democratic deficit” of Brussels and Frankfurt continue to rise, and increasing numbers of European citizens and voters become fundamentally disillusioned with the idea of sharing national sovereignty any further.

© Philip Ammerman, 2013

Philip Ammerman is Managing Partner of Navigator Consulting Group and ECN Business Intelligence.

Financially Decoding the Athens Metro

The news in Greece has been dominated this past week by the Attiko Metro strike, which lasted for 8 days. Attiko Metro runs the Athens Metro: disruption caused to millions of commuters during the five working days of the strike’s duration cannot be underestimated.

The main reason for the strike is the Greek government’s decision to implement a single wage policy for all Greek public sector workers, including those of state-owned companies (DEKO). The government claims that this will have the effect of reducing wages by 20% on average.

One of the inexplicable issues here is the lack of basic economic reporting available to the public. A review of the Attiko Metro’s website (http://www.ametro.gr/) or that of the operating company Stasy (http://www.stasy.gr/) shows a total lack of financial data.

The Attiko Metro site does not have a single section on financial reporting, although it has extensive reporting on its history, technical issues, “the Metro and Culture” and other worthy issues. The Stasy site has a single reference to financial information: the 2011 financial summary, as published in press according to law, without any kind of detailed financial report.

Compare this to Transport for London, which has already published its 2012 Financial Report as well as its 10 Year Business Plan as well as a detailed review of all Commercial Contracts and expenditure.  

Compare this to RATP, which runs the French public transport system, and provides detailed operational and financial information and the complete 2011 annual report (the RATP financial year ends on December 31^st; Transport for London’s financial year ends 31 March)

Compare this to the Washington Metro, which publishes its detailed Financial Statements, including contract, its Strategic Plan, its Operating Scorecard, and even the meeting agenda its Board of Directors.

One has to wonder why, in 2013, a company of this size does not make detailed financial or operational reporting available to the public. The Athens Metro is a Greek development project which was financed by EUR 1.2 billion of European taxpayer money via the EU Structural Funds. The Metro’s current operations are financed by passenger tariffs, while its deficit is financed by the Greek taxpayer, via Greek government subsidies. The Metro is a public sector monopoly. Why should its reporting requirements be held to a lower standard than any other public company’s?

The answer, of course, is precisely because it is a public sector monopoly. The standard of Greek public sector management in financial and strategic matters has been disastrous. The necessary skills, competencies and procedures are simply not in place, and are possibly not even accepted as being a necessary aspect of management.

There is also no doubt that for years, the Athens Metro has been used as a source of political patronage. As Nikos Malkoutzis writes in the Kathimerini article An Underground Resistance in Athens (ekathimerini.com, Thursday Jan 24, 2013):

Decision makers are also paying the price for treating the civil service as a private club to which they could bring new members whenever they wanted. It has been well documented that the metro experienced a surge in its employee numbers, often in nontransparent circumstances, under the 2004-09 New Democracy government. The current administration is now trying to slash costs that were in some cases unnecessarily created by its predecessors.

Malkoutzis’ article is also worth looking at for the basic financial and operating information it contains about the Athens Metro:

·       Used by about 650,000 passengers a day; more than 400 million rides a year

·       Approximately 15% of all users do not pay fares, translating an estimated EUR 30 million in lost revenue per year

Let’s do a very quick calculation on fare losses using this data. If we assume an average ticket price of 0.85 cents (taking into account reduced fares and common fares), and a total of 400 million rides per year (and assuming 1 ride = 1 ticket), then the total turnover should be at least EUR 340 million. If we assume this figure is 25% off, then the turnover should be EUR 255 million.

Stasy, which consolidates the financial operations of the Attiko Metro, the Tram, and the Athens-Piraeus Railway, reports total income of EUR 126.911.848, and a net loss (after tax) of EUR 123,172,584. Comparing this to the theoretical sales of the Athens Metro alone indicates the magnitude of financial mismanagement in the Greek public transport system.

If we assume 15% of all passengers are fare dodgers, then the lost income amounts to EUR 51 million, not the EUR 30 million quoted in the article.

Rides / Year	400,000,000
Average Fare (cents)	0.85
Sales (EUR)	340,000,000
Share of Fare Dodgers	15%
Lost Income (EUR)	51,000,000

In all the times I have ridden the Athens Metro, I have never seen a ticket inspector at work. Access to the platforms is free entry: there are no turnstiles or gates anywhere.

It should therefore come as no surprise that the Metro is losing money:

·       The Metro is a public sector monopoly. There are no competing metros, surface tram lines or surface bus lines: the only competitors are private taxis. Nearly all staff are public servants employed under what amounts to permanent employment contracts and in practise cannot be fired except for criminal behaviour.

·       The Metro is regulated solely by the Greek government without any other form of oversight by other stakeholders. The Greek government provides 100% of the funding to cover the Metro’s losses. No steps are taken to replace non-performing management or staff: the only management replacements occur when a new government makes political appointments.   

·       There is no financial transparency over basic operations. Basic information such as staff count, wages, income, expenditure, procurement and strategic planning is unavailable to public scrutiny.

·       There is no attempt to control fare-dodging. There are no ticket inspectors; access to the platforms is free, without barriers.

·       There is no attempt to generate additional revenue using the platforms and stations for additional services, such as catering, parking, or advertising.

·       There is a high investment programme for line maintenance and expansion, which brings with it the risk of corruption via bribes on over-priced procurement contracts.

None of these issues are being addressed in an effective and satisfactory manner. There has been no attribution of responsibility or accountability at any level of the system, whether in the Greek Parliament, at the Ministries of Transport or Finance, or in the Attiko Metro company itself.

Rather than solving the systemic issues, the government (and the Troika) are tinkering with the symptoms--a theoretically high wage cost—in an immediate attempt to reduce costs.

Yet we live in a European Union of 2013, with legal regulations on financial reporting, and numerous examples of best practise (and common sense) available.

The failure to act on this is yet another testament to the sheer incompetence and duplicity of the public sector in Greece, led by the political parties and the patronage system that control it.  The only surprise, perhaps, is the willingness of Greek and European taxpayers (and the IMF) to pay for it.

Given this record, the privatisation of the Athens Metro appears to be a valid solution. The Greek state should focus on regulation of issues such as customer satisfaction, fares and timelines, cleanliness and safety and track expansion agreements. A private operator should take over operations within a clearly-defined operating framework.

This privatisation would best be structured as an operating lease and revenue-sharing agreement, based on specific review dates and performance indicators. The operator would pay a mandatory annual fee to the Greek State, with additional revenue share based on performance.

Any privatisation should include the clause that the operator has successful experience in managing a mass transit system in a comparable capital city.

The main risks to such an arrangement would most likely be the future political risk of a Greek government intent on changing the terms of the agreement, or a Greek political party seeking political gains by exploiting the unionised workforce. Yet as the example of Athens International Airport shows, it is possible to combine excellent service under a private operator, despite the operating risks in the political environment.

The Attiko Metro is not on the list of Greek privatisations published by the Hellenic Republic Asset Development Fund. The events of these past two weeks may convince decision-makers that it should be.

(c) Philip Ammerman, 2013

27 January 2013

Philip Ammerman is Managing Partner of Navigator Consulting Group and European Consulting Network.