Technorati Profile
The chart below represents one of the most important charts for European financial markets in 2011, perhaps even for global financial markets*:
*Lou Basenese, Seeking Alpha
This chart may be broken into three phases:
In the pre-1999, pre-euro introduction phase, each country had its own interest rate on government bonds. Even before the euro became reality, interest rates began to decline and converge.
In the second phase, after introduction of the euro in 1999, it took just a year or two for interest rates to fully converge. For six or seven years, interest rates throughout the euro zone fluctuated together and were identical.
Finally, after Lehman went bankrupt in 2008, interest rates began diverging again and by 2011 had totally scattered. Notice that interest rates for countries like Germany went even lower, while Greece’s and Portugal’s interest rates jumped dramatically.
So what happened here? How does one explain the above chart?
In the first phase, rates converged because market participants believed that the advent of the euro would the risk of government debt for countries like Greece and Portugal. By the second phase, the complete concordance of interest rates (e.g. identical rates for Germany, Greece and Portugal) implied that market participants believed that the European Central Bank (ECB) would stand fully behind the debt of every country (e.g. even if there were a default in Greece or Portugal, the ECB would not permit investors to lose money).
After the Lehman debacle, interest rates diverged when it became increasingly evident that the European Central Bank did not have the monetary resources, and the German government did not have the political consensus or will, to save and hold harmless investors in bonds of all Euroland countries.
One might say that countries like Greece were “free riders” during the 2001-2008 period. Because their cost of debt was based on a false assumption, namely that the ECB and ultimately wealthier countries like Germany and Italy would come to the rescue, they could go on a borrowing binge, and not pay the full price of their profligacy. When their interest rates began to triple or quadruple, they entered a period of great financial distress, and wealthier EU countries had to come to the rescue.
The “scatter” effect has also been augmented by a diminution in interest rates in Germany, as investors in Europe and the world over have experienced a “flight to quality.” Demand for German government bonds increased, driving rates down.
The graph also underscores the importance of confidence of financial markets. The confidence of financial markets can make the difference between high interest rates or low interest rates on government debt, which in turn can make the difference between solvency or insolvency, where debt is denominated in a currency which a government cannot print (such as the euro).
So how do interest rates in Central Europe compare on 10-year bonds? The Czechs are doing very well at below 4% yields, the Poles are at approximately 6%, the Romanians at about 6.5%, and Hungarian yields have recently shot up to nearly 10%. (The above Central European yields are all in local currency).
A number of Central European governments would do well to reduce debt and otherwise restore a higher degree of confidence of financial markets. Take a hypothetical example: if reduction of national debt by 20% would allow a reduction of interest rate of 40%, the country would pay, over time, less than half of the interest it might otherwise need to before debt reduction and increasing confidence. (This is a gross oversimplification, because it neglects the effect of the maturity of loans – e.g. debt of governments is not at variable rates, but matures, and must be either paid off or refinanced).
You might ask, why are interest rates on government debt important for business owners? The answer is because government debt is typically the lowest interest rate applicable in that country – businesses usually borrow at a premium to government rates. There is also the possibility that government debt squeezes out private debt. In other words, the government absorbs so much capital from banks and other lenders, that there is little left for business. So every business owner has a vested interest in ensuring that government keeps their house in order.
Albert Einstein said that the greatest force in the universe is the power of compound interest. What we have seen over the past decades in US credit markets is compound, even exponential growth. In the chart below, the blue curve shows a perfect exponential curve, the red curve shows the actual level of US debt (in trillions of dollars).
A similar chart could be drawn for most of the developed world. Indeed, growth of money supply in many developed countries has also been exponential.
Note that from 1970 to 2008, there is an almost perfect match between US debt and an exponential growth curve. During this period, accumulating levels of debt acted like a steroid, powering the economy forward, contributing to rapid economic growth and rises in living standards.
Then in 2008, debt leveled off – see the squiggle at the end of the red line. You might say that the recession we are now feeling is caused by or correlated with cessation of credit growth (e.g. the removal of the steroid). We are experiencing withdrawal symptoms.
The trillion dollar question is: what happens to the squiggle at the end of the red curve? Let me present two scenarios moving forward:
(a) Governments hold debt under control (e.g. the red line might see dramatically reduced growth, level off, or decline). In this case, due to the cessation of credit growth, our economic growth (and hence consumption and standards of living) will stagnate or deteriorate.
(b) Debt returns to its old exponential growth pattern. This might happen if there is too much social resistance to deficit cutting, in which case governments may choose the less visible route of printing money and piling up debt through deficit spending. Steroids might make us temporarily feel better, but then we could be setting ourselves up for hyperinflation, possibly an eventual even bigger crash, as debt levels become even more unsustainable.
Is it possible for the debt binge of the past decades to end with a soft landing? If a narrow path between the two scenarios does exist, it would require consensus at the political level to find and walk that path. But political consensus seems to be giving way to polarization in the most important economies of the developed world.
The tyranny of the exponential curve – when applied to debt – is that as overall levels of indebtedness double every few years – it becomes increasingly difficult to escape the curve. If we do not escape the curve, and debt continues to double every few years, there are two basic scenarios: (a) if loans are denominated in foreign currency there is a default and collapse; (b) if loans are denominated in local currency, governments can print money and inflate themselves out of a debt problem, resulting in hyperinflation.
If we do bring our exponential debt growth under control, the removal of the constant stimulus of debt growth will result in a very different economic environment in the coming decades – certainly compared to the previous steroid-driven credit growth decades. Growth in the developed world would be much more moderate and standards of living would rise much more slowly, if at all – still better than default or hyperinflation.
Running a small or medium-sized
enterprise (SME) can be compared to piloting an aircraft. In the
achievement of your objectives, you keep your eye on certain
controls. As velocity and altitude are typically the two most
important gauges for a pilot, for the owner of an SME, it is usually
profitability and cash flow. Too often, SME owners will neglect cash
flow. This may result in the business equivalent of crashing an
aircraft into a mountainside.
So why is cash flow so
important?
First, cash is like the gasoline in an aircraft or
automobile. You run out, you crash. New companies, particularly in
the hi-tech business, talk of a “burn rate”: the higher your
overheads, the faster your gasoline is being depleted, the faster you
must either reach cash break-even or get a cash infusion, failing
which, you crash.
Second, many businesses are seasonal. Even
though they may be highly profitable, they may require huge amounts
of cash at certain times of year (like when inventories and
receivables are building up), and throw off huge amounts of cash at
other times of the year, (like when inventory and receivables might
be declining). The cash flow in seasonally positive months may easily
give a false sense of security. Like a predator in the jungle that
must ensure it has enough energy to make it to the next “kill,”
the SME owner must ensure that there is enough cash even in the good
months to make it through the entire cycle.
Third, cash is
also a buffer that protects a business in any down cycle. If the
bottom falls out of the economy – and your company’s sales –
your cash buffer will determine how long you can survive and whether
you will survive until your sales pick up again. Deceptively, many
businesses with cyclically declining sales are cash-flow positive; as
receivables diminish, they are turned into cash. Such businesses
survive downturns very well, only to hit a wall when they are
recovering, where receivables once again begin to accumulate.
Fourth, cash flow may be strained whenever there is a capital
investment program. Will your business have enough gasoline to take
it not only through the capital investment program, but also the
increase in sales required to pay off any bank loans, etc.,
associated with the investment? One of my clients entered into a €10
million investment and expansion program, only to find out that the
expected revenues from the expansion did not materialize due to the
recent recession. It helps to do the analysis beforehand.
Finally,
banks usually monitor cash flow, and will often prescribe cash flow
coverage ratios (such as cash flow during any given period must be a
minimum of X times interest, or Y times principal and interest).
One of the most important exercises that the CFO or financial
manager should do is a Profit & Loss / Cash Flow Statement. This
is vastly superior to the “back of the envelope” liquidity
calculations that most SME’s employ. Generally, an excel
spreadsheet will suffice, and it is generally not difficult to create
a spreadsheet that will give you both P&L and cash flow
statements. Make the statement as “granular” as you require the
information—weekly, monthly, or quarterly, and for as far out as
you need it: a minimum of one year, but could be for multiple years.
This type of forecast should not be performed annually and
then forgotten until the following year. Rather, it should be a
“living” document, updated periodically to reflect up-to-date
information. It may also be used for sensitivity analysis: “what
if” decisions. What if the company were to engage in a new
investment? What if the company were to open a new office? What if
the company were to take on a new product line? Or open a new
warehouse? All of these “what if” decisions may be quantified.
And not only will the owners and management of the business be able
to ascertain whether or not such decisions will crash the business
from a cash flow perspective, if one uses the cash flow forecast to
calculate Net Present Value, one may also ascertain whether the
decision is accretive to the value of the business, or diminishes its
value.
Performing this type of analysis regularly is an
important step forward in the corporate governance of a company. The
vast majority of investors will require this type of information. You
might say that it is the business equivalent of moving from Visual
Flight Rules to Instrument Flight Rules, which allows pilots to fly
also through fog or through the night. It may be an important step in
leaving behind “crisis management,” to building a real company.
The cover of
The Economist portrays a euro coin falling from the sky in flames. The
Daily Telegraph newspaper recently reported that the UK Treasury is already making contingency plans for the demise of the euro, and British embassies in euro-zone countries are making contingency plans for saving British nationals, given the expected riots: “
A senior minister has now revealed the extent of the Government’s concern, saying that Britain is now planning on the basis that a euro collapse is now just a matter of time.”
Bond auctions across Europe indicate that interest rates on Italian and Spanish bonds are rising to unsustainable levels, and even German bonds (Bunds) are experiencing hiccups … (This is no longer just about Greece). A month ago, the demise of the euro was considered a long shot. Now it’s more a question of what can be done to save it.
Where is decisive leadership in Europe?
So far, the silence is deafening.
Much of the action taken by European authorities has been counter-productive. By making the Greek haircut to banks consensual (e.g. so that the haircut would not technically qualify as a “default”), so that owners of Greek Credit Default Swaps could not collect any insurance with respect to the Greek default, future investors in euro-denominated bonds (e.g. Spanish or Italian debt) would rather not take their chances (with or without CDS’s). If a 50 percent haircut is not a default, then what is?
This fiddling with rules has only served to increase the reluctance of investors or banks to lend to any European government, helping to increase borrowing costs across the European Union, at the worst possible time. A perfect example of how fiddling with the rules for self-serving advantage only serves to dig a deeper hole.
Now to translate the uncertainty surrounding the euro to the level of the man-in-the-street.
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Will the euro cease to exist as a currency? If so, what will happen to contracts denominated in euro?
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Will one or more economically weaker countries resign or be dropped from the euro zone, in which case there might be an even stronger “core” of euro zone countries? in such a scenario the Euro might even emerge as a stronger currency than today.
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Unless dramatic action is taken to rescue the euro, if it does not cease to exist as a currency, it may become substantially weaker. This may create windfall profits and losses among parties to euro-denominated contracts. I, for example, have entered into a lease agreement with option to sell a house in euros. If the euro collapses, my lessee will only be too delighted to purchase the house in vastly depreciated euros. There are most likely millions of such contracts, both inside and outside the euro zone, which would create grief for the contracting party suffering from devaluation.
Bottom line: if the euro were to collapse in value, this is likely to create massive and unintended wealth transfers, creating windfall profits for some, and great difficulties for others.
In Central Europe, Slovenia and Slovakia were very fast to join the euro zone. Poland, Hungary and other Central European countries may be thankful that they did not immediately rush into the Euro. Under the above scenarios, having a local currency may provide degree of insulation from the Eurozone difficulties. Wouldn’t it be ironic if the zloty and the forint would become safe havens from euro-zone fallout?
The world waits with baited breath to see whether Germany and the wealthy members of the euro zone have enough at stake to depart from their strategy over the past few years of providing “too little, too late” in defence of the euro, and carry out a definitive last minute rescue of the euro, and to see what form such a rescue might take.
My last column argued that financial
markets over the next five to ten years will be characterized by
volatility. For those who accept this conclusion, this article now
describes what a business owner or manager might do about it.
Volatility does not necessarily mean
that all news is bad: the recent appointment of a technocratic
government in Italy headed by Mario Monti triggered a dramatic fall
in interest rates on 10-year Italian treasuries from approximately
7.3 percent to approximately 6.5 percent – whopping potential
savings on trillions of dollars of debt! It dramatically illustrates
how confidence is at the cornerstone of our financial system.
Yet the dragons of massive indebtedness
(in countries like Greece, Italy, US and UK) and of lack of
competitiveness (and Greece, Spain, Portugal) are far from slain.
There will be many more battles before the European Union truly
operates like a union – especially in the financial sense. So
volatility will persist as we lurch from crisis to crisis – the
gyrations may even increase in intensity.
So for those who run businesses, if you
accept a scenario of volatility moving forward, how might that affect
your actions?
1. Increase the equity available in
your business. Most businesses are financed by a combination of debt
and equity. Lowering your debt/equity ratio increases the stability
of your business, and allows you to weather storms more easily. This
can be done by infusing fresh equity, paying down debt, or a
combination of the two.
2. Be more cautious with your
investment and expansion plans. Perform sensitivity analysis as to
how your new projects or expansions will perform under more
pessimistic scenarios. Is the project robust enough to perform
adequately even under negative scenarios?
3. Reduce your “burn rate”.
What are your monthly overhead expenses? To the extent that you
reduce such fixed expenses, you improve the ability of your business
to survive a possible diminution of revenues. Sometimes this can be
done by cutting only fat, not muscle, from your operations. Cutting
fat is a “no-brainer” – it simply needs to be done. Cutting
muscle must be done much more carefully, fully weighing costs and
benefits.
4. Restructure short-term debt to
long-term debt. To the extent that you hold short-term debt, you may
be at the mercy of financial institutions who may refuse to extend or
renew your debt. Switching to long-term debt diminishes this
vulnerability, as long as loan covenants are observed.
5. Allocate your portfolio. If you
are holding large volumes of cash or securities over the longer term,
consider balancing and hedging your portfolio. Gold and other
precious metals, for example, may be a useful hedge or insurance
policy should the world economy become seriously destabilized, and
fiat currencies lose their value.
While inflation has been generally
low in developed economies, due to the large amount of free capacity
in the economy (high unemployment, etc.), the alarming increase in
money supply in most developed countries may eventually trigger
significant inflation. So in conjunction with point four above, to
the extent you are able to obtain long-term indebtedness, under an
inflation scenario you would do better with fixed rather than
variable rate financing.
As Larry Summers wrote: “It’s
the central irony of financial crises that they are caused by too
much confidence, too much borrowing and lending, and too much
spending – and they are only resolved with more confidence, more
borrowing and lending and more spending.” As we lurch from crisis
to crisis, governments will have little option but to rev up the
printing presses and print even more money. It has been remarkable
how little inflation has resulted from past exercises of Quantitative
Easing. One cannot discount the possibility that eventually inflation
– or worse, stagflation – will rear its ugly head. And inflation
is one of the more unpleasant manifestations of volatility.
