72 Hours to Decide the Fate of Cyprus: Will it Go Down Like Lehman Brothers?

The financial crisis in Cyprus is presently at a critical juncture. Having rejected a tax on bank deposits early this week, the government needs to come up with another option for financing, or face a liquidity crisis in the next 72 hours that renders the country effectively bankrupt.

From here there are several things that could happen, of which I list three in the order of relative likelihood that I would assign them.

     1.) The Russian government contributes to a bailout

The reason for proposing the bank levy initially was that the EU and IMF are unwilling to completely bailout Cyprus themselves. The EU and IMF funding is structured as loans. Despite the fact that the extra sum required is small compared to bailouts in other Eurozone countries, the Cypriot economy cannot support any greater level of debt than is currently being planned. What is needed is more 'equity' rather than debt, either from a direct fiscal transfer, or an internal source such as a bank levy. 

A fiscal transfer would be untenable to the EU, and Germany in particular, for two reasons. Firstly, this would set up a 'moral hazard' problem, such that other countries lose the incentive to be financially responsible. The impetus for austerity measures in Greece and elsewhere would be severely weakened. Secondly, a key beneficiary of the transfer would be Russian depositors, who were outspoken opponents of the bank levy as originally proposed. A bailout that transfers EU funds directly to wealthy Russians is rather unpalatable, both ethically and politically.

This leaves the Russians themselves the most likely participants in a bailout agreement. It is their own citizens that stand to lose out from default, and the Russian leaders have already shown their solidarity with the depositors, even if they are using Cyprus as a tax haven.

     2.) A bank levy is reinstated on large deposits

Having observed the outcry at taxing deposits universally, the Cypriot leaders probably wish they had limited it to large deposits in the first place. It is far more politically palatable to place a windfall tax on the wealthy than on the poor. They even amended the proposed bank levy before the vote in parliament, but by that time it was too late as it had already lost all support. However, since Cyprus is so low on outside options, a resurrection of a tax on larger deposits is a real possibility.

     3.) Default

There are many commentators arguing that default will not be allowed to occur, and EU authorities will relent and cave in to a larger bailout. In my view, default is a very real possibility. I outlined above why the EU is unlikely to provide a direct fiscal transfer; such a transfer is beyond the remit of the IMF and anything less than an equity injection will leave the Cypriot banks insolvent. This means the European Central Bank will cease providing them with cash, and they will be bankrupt.

In this case the likely consequence would be a Cypriot exit from the Euro. The mechanics of how this might be conducted were closely examined in case it were needed in Greece. The banking system would be put on hiatus while the currency is switched to Cypriot Pounds. Bank assets and liabilities, including customers' deposits, would be re-denominated. The new Pounds would instantly depreciate against all the major currencies. Simultaneously the government would probably default on its external debts, either directly (by ceasing payments) or indirectly (by denominating the debts in Pounds and printing money, leading to hyper-inflation.) In short a lot of people would lose a lot of money, and they would end up wishing they had accepted the bank tax originally proposed.

From the perspective of the rest of the Eurozone, the great big unknown in this situation is the knock-on effects. 

A very good parallel here is the Lehman Brothers bankruptcy at the peak of the credit crunch in 2008. This was allowed to happen by the US authorities on precisely the 'moral hazard' grounds that make the EU reluctant to completely bail out Cyprus. The Lehman bankruptcy had devastating consequences, which were unanticipated largely due to the opaqueness and intrinsic complexity of connections in the financial system. Small details, like where assets were parked overnight, went on to have major ramifications as it led to different bankruptcy laws being applied. With a national economy we are faced with a whole different set of opaque connections, complex dynamics and ambiguous legal territory.

The EU leaders know all this, and yet may still allow it to happen. If nothing else (and assuming the Euro survives the contagion), a Cypriot exit would provide a test case for how a bigger Eurozone nation might later conduct an exit.

My thoughts go out to the leaders currently negotiating the future of a nation. I hope you bring us back from the edge.

When the Music Stops: The Past, Present, and Future, of HMV

There are a two big myths circulating about HMV, the last-music-retailer standing on the British high street, which recently went into administration. Myth #1: HMV was killed by iTunes and downloaded music. Myth #2: HMV is, indeed, dead.

      1. HMV was killed by iTunes and downloaded music

This is a convincing narrative being propagated in much of the business press, but I don’t buy into it. There was, is, and will continue to be a market for hard-copy CDs and DVDs. Many people have not switched to downloading music, preferring the tangible feel of a disc in their hands.

No, from the product side, HMV’s competition comes from Amazon.com on the one hand, and from the supermarkets on the other. When it comes to buying the mass market, top charting movie release or pop record, it is simply easier to bung it in the trolley at Tescos instead of make a special trip to HMV. When it comes to buying niche, specialized albums and movies it was a safer bet that you would find it on Amazon. HMV has neither convenience nor range: it is stuck between a rock and a hard place.

      2. HMV is, indeed, dead

Reports of HMV's demise have been greatly exaggerated. As I write this, HMV has gone into administration, which means that it will be run as a going concern until a buyer can be found. Only if this proves impossible will it be wound down.
 
Most media commentators seem to miss the crucial point that on a going-concern basis HMV has still been reasonably profitable. It has been caught out because for years it relied on rising sales to support its working capital base. As I pointed out in this blog two years ago, its sales growth had halted, and it has been caught in a working capital trap. The administration process will wipe out its equity holders, allow a restructuring of debts and closure of unprofitable stores, but then the remaining assets should be able to continue running as a viable business.
 
One big risk factor here is the inexplicable decision of administrators to stop accepting HMV gift cards at the stores that remain open. This will have caused HMV’s credibility and brand value to plummet. In theory, as the last remaining record store on the high street it should have a reliable stream of customers. But the messy handling of the administration has caused much of its remaining value to evaporate. I would not be surprised if its future sale was accompanied by a complete re-branding to distance the firm from the current disarray.

*****
Update (21st Jan): Administrators have announced that HMV will accept gift cards. An eminently sensible decision, although much reputational damage has already been done.

Twenty-Twelve: A Year of Wake-up Calls

Every year has its share of good and bad events in world affairs. But looking back on this year it seems to have been filled with a mixture of unfortunate events and near misses which remind us of the failings in our current ways of doing things. However, many of these events seem to have triggered a real reevaluation of our policies, our political systems, and our social aspirations. Among the gloom there may be cause for optimism yet.

Extreme weather, Climate Change, and the end of the world

A few years ago, news reports would shy away from suggesting a link between extreme weather in the present day and long-run climate change. Any mention of such a link would be filled with hesitation and caveats. A turning point seems to have been reached this year, with news reports making this connection regularly and unashamedly. Indeed, the frequency and extremity of storms, droughts and flooding has undeniably been rising over the last decade. This year has seen Hurricane Sandy cause massive destruction in New York and its surroundings. Meanwhile much of the central US was hit by drought. In the UK, the rain from April to June was the heaviest on record, with more floods this winter making it possibly the wettest year on record.

The supposed Mayan prophecy of the end of the world did not come to pass. But the threat that climate change poses is very real, and this year saw a change in the tone of the debate about its effects.

American Political Deadlock, US National Debt and the Fiscal Cliff

As I write this, negotiations about raising the US debt ceiling are ongoing, and it seems likely that automatic spending cuts and tax rises will kick in. This in itself is a worrying prospect. But the fundamental factors causing it are even more cause for concern. On the one hand the US has an immense level of national debt, as well as a gaping budget deficit, which will doubtless be a source of global instability in years to come. On the other hand, the American political system is so highly polarized into two ideologically opposed parties it seems that meaningful political progress on any issue is almost impossible. 

A pessimistic analysis would conclude that the institutions of US politics are fundamentally broken, that gridlock is the new norm, policy will drift and the economy will stagnate. An optimist might attribute the slow resolution of problems to the election, and point to Obama’s new democratic mandate as a catalyst of further progress. We shall learn which (if either) is right by seeing how things play out in 2013.

EU Bureaucracy, public sector finances and the Grexit

In 2012 it seems we came very close to seeing the break-up of the Eurozone. While disaster was, apparently, narrowly avoided, the budgetary problems of the periphery countries are far from resolved and the political union is more fragile than it has been in years. In the mean-time the degree of bureaucratic waste in the European political system has become ever more apparent. The backlash in the UK against surrendering power to Brussels has grown to record levels; so much that the anti-EU UK Independence Party is now the third most popular party, having overtaken the Liberal Democrats in the opinion polls.

An image has emerged of an EU parliament and commission disconnected from the people they represent. European bureaucrats are seen as a sinister elite, bound together by the sacred mission of European integration, a mission so important that trivialities such as democracy and national sovereignty can be ignored.

The chaos caused by public spending cuts in Greece has changed the people’s tolerance level for wasteful publicly funded institutions. After the failure of leaders to agree on the next EU budget in 2012, the stage is set for a showdown in 2013. This could well lead to turmoil, both in Brussels and further periphery countries, if it is not handled with finesse.

Some other alarm bells

• The Arab Spring has stumbled. The jubilation at the toppling of several dictators is over, as the situation in Syria has crumbled to all-out civil war, and an Islamist-backed strongman has risen to the leadership of Egypt. The freedom and democracy that many in the region hoped for may yet be realized, but is proving more elusive than most hoped for.

• The Sandy Hook shooting seems to have caused a change in the US debate on gun control. The stark contrast between the two attacks on primary schools that occurred on December 14th is especially poignant. In China, a man with a knife attacked 20 children, and none died; in the US, a man with a gun attacked 20 children all of whom died. It looks like in 2013 we may see new legislation curbing sale of the most powerful weapons to the public.

• The Libor scandal has shaken up the banking sector and to skeptics is proof that the financial sector is rotten. When the metrics (i.e. interest rates) taken as the fundamental building blocks of the financial system are so easily corrupted, what does this say about the rest of the system?

• The dispute between China and Japan over island territory has raised tension in East Asia, and contributed to the election of a hawkish leader in Japan’s election. The search for a diplomatic solution must be a top priority, as the crisis is already damaging the regional economy and threatens something much worse.

Have we woken up yet?

This remains to be seen. While I have noted a change in the tone of many important debates, this needs to be followed by action if real progress is to be made. I will be watching closely in 2013 to see if these seeds of change will flourish.

The Perils of Relying on GDP in the Information Age

“What gets measured gets managed” is one of the fundamental principles of management. What would a business do if they realised that their one critical measurement tool was broken? If their primary performance indicator was found to be unfit for purpose?

What about a country? When it comes to measuring the health of an economy, the received wisdom is that Gross Domestic Product is the best measure we’ve got. It’s widely acknowledged to be imperfect, but is measured anyway, and used as a yard-stick for government competence almost everywhere.

There are two flaws with GDP that are usually cited in economics textbooks.

Firstly, GDP leaves out certain things that have economic value. It leaves out value-creating work that is unpaid, such as volunteer work and domestic care that parents provide to children or relatives to relatives. It leaves out the value of leisure time spent doing nothing but relaxing.

Secondly, GDP includes certain things that have no economic value (or negative value). Products that are bought then never used are one example. ‘White Elephant’ vanity projects, like the ones described here by the BBC’s Paul Mason, fall into this category.

Industrial activity that creates pollution and products that are harmful to health are often put in the second category: they add to GDP but have negative ‘externality’ effects for society. I would suggest treat these differently. They reveal another, deeper, flaw with GDP, which is that it ignores the ‘balance sheet’ effects of economic activity.  This is a major area of interest to environmental economists, but it has yet to make it into the mainstream of policy creation and debate.

Why do balance sheet effects matter? Because there are a range of economic activities that deplete our ‘stocks’ of natural capital (e.g. mining, oil extraction, fishing and some farming) and there are a range of activities that generate future economic liabilities (e.g. pollution, health deterioration). When economics was born hundreds of years ago, humanity’s impact on the environment was sufficiently small that balance sheet effects could be ignored. Now that the human race has grown to over 7 billion we are having a profound effect on our environment, and we can no longer ignore these effects. Just as it would be inconceivable to manage a business based solely on its profit and loss account, it is a fallacy for governments to concentrate so much on GDP, which measures only flows.

If this is not enough to convince you that GDP is a fatally flawed metric, consider another sort of good that it ignores: Free goods. GDP was developed in an age when most goods produced by businesses were products you could hold in your hand or services delivered face to face. Computing, software and the internet has changed all that. If I consider the most important services I use, most of them are information services, and most of them are provided to me for free by companies such as Google, Facebook and Skype, NFPs such as Wikipedia and the BBC, and individuals who share their thoughts through blogs. Advertising aside, none of this activity is captured by GDP, and yet lives all over the world have been made much richer by the easy availability of information and social contact for free.

GDP has been used consistently since WW2 because it has been a reasonable proxy for quality of life. But in the Information Age, the fundamental linkage between GDP and quality of life is broken (see also this HBR article). Infinitely scalable services with no marginal cost, given away for free, have changed the ball game and now we need a better stick with which to measure economic success.

Does this Apple look rotten to you? The World’s Largest Company and a $1bn Pyrrhic Victory

Apple, the world’s largest company by market capitalisation, reached two milestones last month. On 20th August, it became the most valuable company in history, in nominal terms, after surpassing the previous record set by Microsoft in 1999. And it was declared the victor in a long-running court case with Samsung over patent rights, in which it was awarded a cool $1 billion in damages.

Apple is a lot of people’s darling company. It has done incredible things: it has revolutionised many industries from computing to music through to mobile telecommunications. But its relentless pursuit of court cases based on intellectual property is a bad omen. It hints at a company that is paranoid, aggressive and insecure, not one that is cool, calm, and confident as Apple always used to seem.

Superficially the lawsuit is a rational manoeuvre: by disarming your competitors you can maintain your dominance in the market.

But that is precisely the problem. Not only does Apple come across as petty and bullying by pursuing its court cases, it appears to be aiming for a monopolistic position from which it can exploit its market power and dictate smartphone prices. This has been astutely ridiculed by Samsung which points out, “[it is] unfortunate that patent law can be manipulated to give one company a monopoly over rectangles with rounded corners.”

Courts around the world have refused to side with Apple. A judge in the UK dismissed Apple’s suit against Samsung, saying “[Samsung products] are not as cool. The overall impression produced is different.” In Germany, the Netherlands, Japan and Korea courts have found in Samsung’s favour. It is perhaps unsurprising that Apple’s only major victory was on its home turf in California – and the figure awarded in damages is absurd, like a number Dr Evil might pull out of the air.

What is also quite shocking is the fact that Samsung is one of Apple’s biggest suppliers. Plenty of management research shows that cooperative relationships across value chains contribute to long-run success – exemplified best by Toyota’s rise and longevity. Innovative technologies are shared, supply chain management can be optimised, best practices spread. Samsung is dangerously conflicted, acting as both supplier and competitor to Apple, and a long-running feud will do neither company any favours.

With regard to Apple’s new record market capitalisation this is only a nominal record. Accounting for inflation, Microsoft still holds the real record (peak valuation in $850bn 2012 dollars). Microsoft achieved that milestone in the late nineties, shortly before the tech bubble burst.  Apple is beginning to look like Microsoft in other respects. For starters it has transitioned from a rapid growth phase to the ‘mature company’ phase that stock analysts seem to dread (its first dividends, paid in July, are a key indicator of this). Microsoft adopted bullying tactics with its competitors (Netscape, BeInc…). And Microsoft did its utmost to maintain its monopolies over various software classes. It very quickly became an uncool company, its valuation flatlined, and right now it seems to be destined for decline.

Will Apple go the same way? It seems to be well on the way. Its products have been revolutionary – but its improvements with each new product generation are now more and more incremental. The release of a new iPhone (the 5th generation) will be a great test. The sales are likely to be strong, but sales numbers will be less important than the quality and originality of design when considering Apple’s long-run competitive advantage. Near field control, mobile wallet, or 4G technology cannot be considered revolutionary developments – they are already available so widely. On the other hand, soft-SIM technology, femtocells or something entirely novel could demonstrate that Apple still has what it takes to innovate.

The Good, The Bad, and The Ugly: Corporate Marketing during the London 2012 Olympics

Alongside the fantastic sport and athletics, I have been both impressed and irritated by the corporate marketing associated with the London 2012 Olympics. In the run up to the games the overall corporate involvement was excessive, in particular the corporate floats that preceded the torch procession all around the country. But at the venues themselves it was heartening that the presence of logos was limited and the focus was entirely on the athletes.

Some companies, both Olympic sponsors and non-sponsors, ran clever advertising campaigns based around the Games. For others, the campaigns were so bland, dull or ‘in-your-face’ that they served only to annoy. And worst of all some sponsors used the Olympics as a licensed monopoly for their products, which has backfired in ironic style for some! Here is a summary of the best and worst corporate Olympic associations, based on both my opinion of their adverts and on the newspaper and social media views on the campaigns.

Gold Medals (Sponsors)

British Airways

BA’s witty, self-deprecating tagline ‘Don’t Fly. Support Team GB’ is probably the most memorable piece of advertising I’ve seen associated with these Olympics. It shows a very British sense of humour, and resonates Virgin Atlantic’s famous ‘fly BA,’ campaign of 1986*. What’s more, BA's ads used the #homeadvantage hashtag, which perhaps helped psyche-out foreign athletes as they arrived. It was risky at the time, but has been vindicated by Team GB’s epic performance.

Cadbury

Not necessarily the most prominent of the sponsors, but Cadbury punched above its weight with its poster campaign on London buses and Tube stations, with some humorous comparisons between athletics and chocolate bars. I, for one, was amazed to learn that cycles in a slipstream are ‘only one Twirl bar apart.’ These ads raised a smile – and Cadbury seems to have avoided being tainted by the ‘junk food’ brush that harmed McDonalds and Coca Cola (see below)

Gold Medal (Non-sponsor)

Nike

Nike has had such a phenomenally successful campaign that more people think Nike is an Olympic sponsor than Adidas**. Nike’s campaign, based on the theme of ‘greatness’ and the places called London that aren’t London,UK, cleverly side-stepped the prohibition on mentioning London 2012 and the Olympics in ads, while capturing the spirit of globalism and inspiration The Games represent.

Silver and Bronze Medals (Sponsors)

Samsung

Samsung’s campaign was solid, but not exceptional, and avoided leaving a bitter feeling in the mouth as some other sponsors did. It was certainly more prominent than Panasonic, the other electronics-supplying sponsor!

Adidas

Lots of sponsors tried to associate themselves with Team GB’s athletes, but non more successfully than Adidas, which helped make several up-and-coming competitors household names before the Games even began.

Silver and Bronze Medals (Non-sponsors)

Jack Daniels

Mainly for its cheekiness, I really liked Jack Daniel’s adverts which focused on its history of winning Gold Medals at international spirits expositions. It included interesting trivia (JD has won seven golds, then stopped entering competitions as seven is its lucky number) and associated itself cleverly with The Games at relatively low cost.

Wooden Spoon (Sponsors)

Visa

Lots of things were wrong with Visa’s campaign, but above all its insistence that everything Olympic can only be paid for by Visa really took the biscuit. You knew it was going too far when it switched off regular cash machines from Olympic venues, and replaced them with just a handful of Visa-only cash machines. Hilariously, its payment systems actually broke down at Wembley stadium early on in the Games. It managed to get blamed in ‘empty-seatgate,’ its adverts were boring and in-your-face, and it is pretty-much lacking in consumer credibility anyway. We do not, in general, get to choose to have Visa or MasterCard, we just take whichever is issued by our bank!

McDonalds, Coca-Cola

These two companies were mentioned in the press a lot, but mostly as part of commentary / incredulity at how two of the unhealthiest foodstuffs around feature so prominently in a festival of sporting prowess. Their products taste nice – but are so calorific they are fuelling an epidemic of obesity, which is what sport and athletics should be trying to fight, not cosy up to. What’s more, McDonald’s insistence on a monopoly over serving chips in Olympic venues (with the notable exception of Fish’n’chips) seemed petty, and Coca-Cola unwittingly brought its ownership of Innocent Smoothies to greater attention by making Innocent ‘the official smoothie of London 2012-’ not so Innocent after all, eh?

Do you agree or disagree? Share your thoughts in the comments box below!

______________________________

*Richard Branson describes the episode in his book Screw It Let’s Do It: “On 10 June 1986, BA ran a promotion to give away 5,200 seats for travel from New York to London. Immediately, we ran an advertisement that said, ‘It has always been Virgin’s policy to encourage you to fly to London for as little as possible. So on June 10 we encourage you to fly British Airways.’”

**Thanks to Ad Age Global / Toluna for the research, and thanks to Private Eye magazine where I first read about this amusing survey!

Oversupply, Collusion, or Petrodollars: What drives London's property market?

As a renter in London, I have a natural interest in the capital’s unusual property market. Rents in London seem decoupled from the rest of the country, 3 or 4 or 5 times as high, due to the demand created by London’s proximity to well-paid jobs. I don’t have much insight on which way the residential property market is going to go, but this fascinating article from Buttonwood at the Economist suggests UK house prices and rental rates are out of step and may be due for a correction.

One thing that has puzzled me is the resilient prices for commercial property. I haven’t found a good source of data on office rents but piecing together a few datapoints suggests rents have risen gradually and are apparently just 15% off their peak in 2008.

My insight on this comes from two simple observations. Firstly, there is a vast amount of vacant space in the City of London. Near my office in the Monument area there is a sparkling new development, The Walbrook Building, that has been vacant since it was completed in 2010. Streets near where I work and where I used to live in the East London area have a proliferation of empty space and ‘To Let’ signs.

Secondly, there is huge amount of new office space coming on to the market based on new completions. The Heron Tower in Bishopsgate, and St Botolph’s in Aldgate are ‘prime’ examples. The Shard, which opened this month in an impressive ceremony is the epitomy of this, with some reports suggesting barely any space in it is let. The Cheesegrater, the Pinnacle and the Walkie Talkie are all still under construction.

Sooner or later economics ought to catch up with this glut of new capacity and cause a crash in the commercial property market. One apt question, then, is why have prices remained resilient so far?

With respect to rents, I think this may be a case of weak competition. Most of the properties are owned and/or managed by a handful of developers (Land Securities, Canary Wharf Group, British Land) and property brokers (Knight Frank, CBRE, Cushman Wakefield, JLL, DJD). They each have such a large exposure to rental rates overall that they would rather let properties go vacant than let them at lower rates (the natural course of events in a competitive market).

With respect to capital prices, it is no secret that London property has become a magnet for foreign cash. Two of the highest profile developments (The Shard, Battersea Power Station) have backers from Qatar and Malaysia respectively (indeed, Qatar has also recently bought the Olympic Village, Credit Suisse HQ and Harrods.) These buyers are able make high bids for these assets because they have petrodollars which they need to recycle, on which they are willing to accept lower rates of return than other investors. It’s an interesting reversal of 20th century neocolonialism. While all this investment is superficially good for the UK economy, it has the effect of inflating property prices when arguably the economy would benefit from a correction. It also leaves prices vulnerable to capital flight, with the possibility of a full on crash (akin to the 1997 Asian Financial Crisis).

Having made all these bold predictions I shall eagerly wait and see how things play out. In the meantime, I shall not be investing in commercial property in London any time soon!