Month: February 2015

The funny world of Mr Katzarian

With the world focusing on the Greek debt tragedy, an article in the NY times about one Mr Kazarian, who claims that Greek debt in reality is only one tenth (!) the official size, caught my attention.

Mr Kazarian, founder of Hedge fund Japonica partners, is one of the largest private owners of Greek government debt. He has bought the bonds in 2012 and has made a (paper) killing so far, as they have appreciated in value. He says he is still holding on to his bonds believing they are still good value and – untypical for a creditor – argues for a debt write-off. According to him, the official debt figure (175 percent of GDP, ahem) is a meaningless number since it does not reflect “fair value” and is diverting attention from Greece’s true problems and “unnecessarily suffocating” the country.

My immediate reaction was that this is another version the “we owe it to ourselves” argument made by Keynesians to justify ignoring budget constraints. (For those of you who are unfamiliar with this argument: just remember that it is always helpful to be on the side of government if your goal in life are fat consultancy contracts or a tenured position).

Then I was prompted to ask Mr Kazarian how can the official debt be meaningless and “unnecessarily suffocating” at the same time? I mean, if something really doesn’t matter how can you be bothered with it? Isn’t that illogical?

But, Mr Kazarian is not another Nobel-prize winner without real world decision-making experience. Watching the video I learned he has a quite long and successful track record as a distressed debt investor. As a general rule, I tend to take arguments made by investors who are more experienced than me seriously even if they appear ludicrous. Therefore I decided to delve deeper into the matter.

I am not sure I have captured all of the arguments, but I think the following points summarize his view:

  1. Due to concessions made Greece’s debt burden is sustainable and lower than it appears
  2. Concessions (lower coupon, long maturities…) mean that the debt is worth less than par
  3. Writing of the debt to fair value leads to more realistic figures (“better accounting”)
  4. “Better accounting” leads to more confidence and “better decision making” by politicians

In the following paragraphs I will elaborate on each of these points.

Point 1: Due to concessions Greece’s debt burden is sustainable and lower than it appears

During the Greek debt restructuring 2012 part of the debt was written off, part of it was refinanced. This was a political decision/process, not a market based outcome. Due the fact that the write-off was not high enough (in order not to jeopardize banks who had foolishly lent the money encouraged by government-serving regulation) its debt debt-levels remained elevated and Greece remained shut-off from capital markets access. European tax-cows were forced to refinance the debt via various institutions (“Troika”) which are now the main Greek creditors.

However, at the time of the restructuring periphery debt was yielding upwards of five percent and at these levels Greece’s regular interest payments would have been overwhelming even after the write-off, with the result that Greece’s problems would have been in the news every second day. Now, NOBODY of the bureaucrats involved in the decision could need that. Therefore concessions were made: mostly below average coupon rates and maturity extensions. (The Austrian Finance minister at the time even said this would be a good deal for taxpayers. I don’t think she lied, I honestly think she was/is clueless – there is a lot of negative selection going on in bureaucracies).

So, yes, concessions were granted, but does this mean the debt level is lower than it appears?

Readers will remember the exchange I had with David Einhorn about the true size of Greece’s interest/GDP ratio. There was a material discrepancy between his bottom-up estimate and the official EU commission budget forecast numbers I used. I still have not resolved where difference comes from. Anyway, I have changed my mind and now think that interest/GDP does not matter much.

What matters much more is interest/tax revenue – and here Greece scores poorly. Below you find the tax revenue/GDP ratios for selected European countries.


As you can see, Greece’s tax revenue ratio is much lower than in other countries, even Cyprus’s ratio (39%) is significantly higher. And the difference is material.

Since I could not agree with David Einhorn on the correct interest expense/GDP ratio I have used another source. This post on FT-Alphaville features an IMF projection of Greece’s interest payments of about EUR 10 billion annually, i.e. about 4.75 percent of GDP. This is slightly lower than Portugal’s burden (5%) and close to Italy’s (4.7%) or Ireland’s (the latter figures taken from my post). If we forget for a moment that these countries have debt problems of their own, one could indeed conclude Greece is not extraordinary and wonder what the fuss is all about.

Adjusted for the lower tax base, however, the picture changes dramatically,


Now Greece looks considerably worse than the rest. For instance, it has to set aside double the tax revenue for interest payments than Spain, another crisis country. And these figures do not yet take into account the recent tax strike of Greece’s citizens.

Of course, you could say that Greece could raise taxes and the problem will go away. This is exactly what the creditors want and we hear lot’s about how Greece needs to improve tax collection these days. Economic ignorance wherever you look! As if increasing taxes has ever solved any problem or led to economic growth (The causality runs exactly the other way: higher wealth allows the political class to extract a larger share before people revolt).

It is absolutely certain that this will not work. The reason being, of course, that higher taxes will stifle what (legal) economic activity is left in Greece. Just think about it: Greece would have to increase average taxes by 30 percent in order to reach Cyprus’s or Portugal’s tax level – impossible!

To sum up: No, Greece’s debt load doesn’t look sustainable WITHOUT new concessions. Even if you ignore the stock and just look at the flows it remains too high.

Ad 2.) The concessions (lower coupon, long maturities…) mean that the debt is worth less than par

This is obviously correct. Without concessions made the bureaucrats could not even pretend that Greece is solvent.

Ad. 3) Writing of the debt to fair value leads to more realistic figures (“better accounting”)

Now, I am not exactly sure what he means by that.

It is certainly true that a write-off would bring much-needed transparency. For instance, tax-payers in the rest of Europe would finally be confronted with holes in their governments’ budget. So far most of the “educated” citizens of Europe have believed their governments’ assurances that all is well. The politicians can get away with this because government accounting doesn’t know about provisions for expected losses and they will be acknowledged only when finally written-off. This is indeed a huge flaw in public accounting and Mr Katzarian is absolutely right to criticise that.

Or take the ECB. A write-off would finally make it clear that it has engaged in government financing, although explicitly forbidden by EU contracts. This certainly would mean the end of the fiscal union debate. As someone who is tired to see government economists and “quality” newspapers argue for that nonsense, I would highly welcome such a development – even if I am aware that it would lead to a big economic and political crisis. (I confess that am a fan of the German proverb: “Besser ein Ende mit Schrecken, als Schrecken ohne Ende!”)

And this is exactly the reason why a write-off will never happen, as long as extend and pretend works. The accounting of government is opaque for a purpose. It has never been otherwise. If you do not believe me, read this book, it will cure you of any illusions you might have.

But, I feel that Mr Kazarian labours under another misconception as regards debt accounting. Warning: this is a bit technical!

He claims that EU accounting is arcane and does not reflect reality, i.e. the “fair value” of Greece’s debt, with the consequence that the parties involved (Troika, IMF, the Greek government) discuss about the wrong figures. Using proper accounting (fair values, not nominal values) the parties would realize that the Greek problem is much smaller. Happy end!

First possibility: Mr Katzarian confuses debtor vs. creditor accounting.

If you are a creditor of someone who is likely to default, the “fair value” of the loan will be below its par value. Now, a conservative management would provision against a likely default and write down the loan to fair value. They would still keep the nominal value on their books, however, for that’s what was lent in the past, but they would book a provision against this claim until the problem is resolved in bankruptcy. For the reasons mentioned before, Greece’s lenders (Troika) are not interested in conservative accounting practices. Heck, this is why they try to avoid technical bankruptcy and continue to pour money into the hole.

As a debtor, however, you are NOT allowed to write down the loan. And this is not arcane, but good and honest accounting. For, when it comes to bankruptcy the creditors’ nominal value represents the legal claim against the debtor’s assets. They form the basis for negotiations and the ultimate court decision.

Now, I would be shocked, if Mr Katzarian did not know all this. I mean that’s the bread and butter of distressed debt investing and he has a 20+ year track record in that field.

Which brings me to the second possibility: he thinks that due to the fact that a lot of the refinanced debt has a negligible coupon, it should be booked like a zero bond.

How does that work?

If you issue a zero bond at, say 50 percent of par, with a maturity of 30 years, it is not the par value that appears on your balance sheet. That would be insane, as it implies the creditors have a pledge on your assets twice as high as the amount they lent you. Instead, the liability rises in line with the interest accrued over time. The more time passes, the higher the creditor’s pledge becomes. It is this sum, i.e. the sum of price paid + interest accrued, which constitutes the claim in bankruptcy.

So is Mr Katzarian right, after all?

Well, I am afraid he is not. First, the refinancing by the Troika was not a zero coupon bond transaction – they really refinanced the whole nominal amount, not some fraction of it. The fact that the “fair value” at the time was significantly below the price paid doesn’t affect the accounting. The correct way would have been to provision part of the exposure immediately on the creditors’ books, but the nominal amount should stay there nevertheless. For comparison, in a real zero coupon transaction there is no need to provision immediately, since only a fraction of par is paid in.

But even if we pretended, it was a zero coupon bond transaction, not much would change for Greece WITHOUT further concessions. Yes, debt/GDP would be lower, but the interest expense would remain the same, with the difference that instead of a coupon payment, the (higher) interest accrual on the zero would need to be budgeted for. I see no way around it: Greece’s debt load is simply unsustainable without significant further concessions.

 Ad. 4) “Better accounting” leads to more confidence and “better decision making” by politicians

Politicians do not want to make good decisions. They want to stay in power, not maximize welfare, or what have you. Arcane accounting is a tool to achieve that (by misleading the public).

But let us pretend for a moment that “better accounting” is indeed achievable. How would it look like?

Clearly the debt would have to be written-off to sustainable levels, whatever that means. If we define the German level as sustainable (defined by interest/tax payments) one would have to cut Greece’s debt load by roughly 65 percent, ceteris paribus, and Greece would be AAA credit according to current rating agency logic.

But is this logic correct? If we talk about “true accounting” would not we also have to record the debts of off-balance sheet liabilities into account? For example, would not we have to account for demographic changes and associated welfare liabilities as well? After all, something similar happens in life insurance/pension accounting.

And Greece’s demographic “off-balance” liabilities are indeed huge, as this article in Handelsblatt argues (unfortunately only in German). The main points:

  • Greece is expected to be the third oldest nation on earth by 2030 (average age 50 years)
  • Greece ranks 55 in innovation (out of 142), behind Uruguay, Serbia and Mauritius (!)
  • Greece’s Math-PISA Rankings show a worrying trend (2006: 28; 2009:39; 2012: 42)
  • International patents (PCT) in 2012: Greece 628 vs. Germany’s 46620
  • Last but not least: with 1.4 births per woman Greece’s population is shrinking

We can safely assume that nobody in Greece’s political class (and the rest of Europe) is interested in honest accounting…


I think that Mr Katzarian gravely misunderstands the situation. He seems to think that by working hard and persuading politicians he can work on a turnaround of the country. He strikes me as somebody completely unfamiliar with bureaucratic logic and political processes. I seriously hope that I am wrong and he succeeds, although I think the chances of this are close to nil. I congratulate him on his paper profit and advise him to sell as much as he can as quickly as possible.

That’s the “nice guy” version.

The “bad guy” version is that Mr Katzarian has realized that he cannot turn his paper profit into cash due to a lack of market depth. There are probably not many people willing to risk large sums of money on Greece staying afloat. In this case, his only chance to get out at close to current levels is a write off of Greece’s debt ratio, such that sustainability is achieved and market liquidity in the bonds increased. The plan is good, there is certainly enough dumb money out there willing to lend money to a serial defaulter (see Ecuador, Argentina, Ivory Coast…). However, this requires that his claim is treated pari-passu with public creditors such as the ECB and the IMF for write-off purposes. I know, I know, that’s what the bond prospectus says. But what’s a contract worth to Mrs Lagarde or Mr Draghi? Not much, I am afraid…


Is this worse than 2000? The case of Tesla Motors

A few months back, this post by made me sceptical about Tesla (Nasdaq: TSLA) and alternative fuel vehicles in general. Since fuel efficiency is constantly improving, the argument goes, the marginal benefit of switching to a fuel-efficient car decreases exponentially. Put differently, as traditional cars are getting more efficient by the day, it pays less and less to incur the switching costs (higher price, inconvenience…) of alternative fuel vehicles.

From this I deduced that Tesla might never become as mass market as implied by its valuation (USD 35 billion at its peak). Lower oil prices in the meantime are another headwind.

Tesla and Tobin’s Q

And Tesla’s valuation is indeed demanding, as was laid out nicely last week in article on FT-Alphaville. The author uses Tesla’s historic R&D and capex in order to estimate its “replacement” value, i.e. what it would cost somebody to replicate what Elon Musk has done so far. The answer: USD 3.1 billion! Honestly, I was surprised by the low number. For comparison: that’s 50 percent of Apple’s annual R&D. Dividing the current business value (approx. USD 27bn) by the replacement value gives you a Tobin’s Q of 9!

In other words: the market is valuing Tesla at nine times of what it cost to build! This valuation makes only sense if the company enjoys a “moat” resulting in outsized returns down the road  – so far Tesla has been loss making.

But, does Tesla’s have a moat?

Let me confess that I am no auto industry expert, but here are my thoughts for what they are worth.

First, Tesla is still unprofitable despite charging Porsche-like prices which leads me to conclude that good, old “economies of scale” is still the name of the game for manufacturing businesses – you need a critical mass of units to cover the fixed costs. Tesla is no exception.

I also hear that Tesla is an amazing vehicle, quite cutting-edge technologically. A lot of bulls make this argument and I suppose they equate superior technology with “moat” in their head.

In order to assess whether Tesla’s technology indeed constitutes a “moat” we have to answer the question of how easy it is to build a top-notch car, i.e. we have to judge the results so far. For comparison, just look at the story of Austrian Formula-1 team Red Bull Racing:

Red bull, an energy drink producer (!), decided a few years back to enter Formula one for marketing reasons. It hired the right people, has spent a meaningful amount of money and competes successfully with the likes of Ferrari and Mercedes ever since. No question, Red Bull’s execution was excellent, and good execution is rare. But, I reason that if Red Bull can dominate the most competitive racing series, building a single good car is doable. Certainly for the likes of Toyota, Mercedes and, maybe, Coca Cola 🙂

To sum up: it seems to me that building a cool and fast car can be done in short time – at least, if you are willing to throw some money at the problem. So, the fact that Tesla can build expensive, technologically advanced cars does not necessarily mean there are barriers to entry – no indication of a “moat” to see here, if you ask me.

Wait a minute! Does this mean car manufacturing is easy?

Of course it is not. After all, we know that there is huge dispersion in profitability between the Toyota’s, the Volkswagens, Porsches on the one hand and the GMs, the Peugeots and the Fiats on the other. And the profitability patterns have been persistent for quite some time suggesting that there indeed is some kind of “moat”. What is it?

It appears, while it is possible to build an excellent car in limited numbers, the challenge is to deliver high quality in mass production AND be profitable at the same time. This is difficult as success depends on a host of factors, such as production processes, reliable supplier networks, logistics and a large and skilled workforce. These are not easy to replicate, take time to perfect (60+ years in the case of Toyota) and therefore constitute a legitimate “moat”.

On the other hand, most tech companies’ “moats” come in the form of network effects. Microsoft Office, Google or Facebook are all about the network and high switching costs. Indeed one could say, efficient production processes and economies of scale are to the car industry what the network is to Silicon Valley. While Elon Musk, Tesla’s founder, no doubt is a marketing genius and a skilled lobbyist and networker, he still has to prove it can deliver on that one. Count me sceptical.


I have long asked myself why established car brands do not already compete with Tesla since they already have electric, or hybrid car series. Especially, because Tesla partially relies on technology from established manufacturers (just as Red Bull does for its Formula-1 car). Now, I have got the feeling they are using Tesla as a canary in the coal mine. Think about it: it is like free market research for them. Should electric cars really take off, they are in a much better position to quickly seize the opportunity capture market share with their capacities already in place. In the opposite, they do not loose any money.

I am reluctant to short Tesla as it is a fashion stock. Given easy money and the ongoing M&A wave, it is indeed possible that Tesla will be taken over at an absurd valuation. The same goes for many other start-ups. I do think, however, that the optimistic valuations we are witnessing in the start-up sphere are reminiscent of the dotcom bubble and are accompanied with a general overvaluation of the market (the only difference between now and then, is that back in 2000 stocks outside tech were at least fairly priced). I usually do not buy index puts and prefer to hold cash instead, but at these market levels they could even have a positive expected value. I am really thinking about setting myself an index target of, say 2250 in the S&P, where I commit myself to buy an out of the money put.

Let’s wait and see.




More evidence that Russia’s external debt problem is overstated

This article from “The Moscow Times” (MT) confirms my previous analysis: it is very likely that Russia’s external debt load is overstated. This is because many oligarchs fund their Russian operating entities via offshore holdings that are treated as foreign investors/creditors from a national account perspective.

About the likely dimension of these flows, I wrote the following,

Obviously, we can only guess about the true size of this phenomenon, but I think it is safe to assume that these types of flows are material. Moreover, if the proportion of these types of flows really amount 50 percent of external debt, as some analysts suggest, then it is reasonable to assume that the proportion is even higher for the direct equity flows. For instance, retained earnings of a Russian commodity producer held via a Cypriot holding would show up here. In order to put a figure on my thoughts, I will simply postulate that 50% of the direct investment flows mentioned above, i.e. about USD 235 billion, are not truly foreign claims on Russia, but claims by Russians disguised as foreign claims. Obviously, this is not very scientific, but it helps puts things into perspective.

And now the MT provides some recent figures on debt redemptions,

According to Central Bank data, Russian companies and banks need to repay $109 billion in foreign debt in 2015, a heavy burden at a time when low oil prices have sunk export earnings and Western sanctions have stemmed capital inflows. These sanctions are widely believed to prevent companies from refinancing foreign debts by taking out new foreign loans. But official figures tell a surprisingly different story. Last year, net private sector debt repayments amounted to around $40 billion, or less than half of the $100 billion that the Central Bank said fell due, implying the rest was refinanced or rescheduled. Even in the fourth quarter, after Western sanctions were tightened, the size of net redemptions was only around half of debts falling due.

That suggests that many “foreign” debts are really debts to fellow Russians operating from offshore.

Aha, actual repayments were 40 percent of the CBRs estimate. And I would like to emphasize that the ratio held up even during the last quarter when sanctions were already biting.

Clearly, the fact that not all redemptions had to be met could also be due to the fact that Russian banks, i.e. not the owners themselves, decided to roll over USD funding. This would be a feasible strategy, given that we know many Russians converted RUB deposits into USD deposits during Q4 thereby improving FX-funding for the banking sector (and lowering the RUB).


It is my opinion that Russia’s economy could even handle the entire official external debt load (USD 600bn-700bn), since most debtors earn in USD anyway and margins are likely to remain stable due to the RUB fall. Most corporates I’ve looked at so far, with the exception of Rosneft, are not overly levered and have wisely chosen to fund themselves at medium term maturities. This should give them enough time to earn the USD they need without resorting to refinancing.

However, I think the “true” debt load is far lower, since there is compelling evidence that a sizeable chunk of this external debt represents in effect equity financing, mitigating the refinancing problem.

(Disclosure: long RUB and select Russian bonds and stocks)

Is this worse than 2000? The case of Rocket Internet

I read this interesting article about Rocket Internet (RI), the famous German start-up operator. RI has surprised analysts with a quick EUR 600 million equity raise. This comes only months after the IPO in October 2014 where it managed to raise EUR 1.4 billion (valued @ EUR 5bn) from Investors despite annual losses of EUR 150 million.

Now, that’s what I call a cash burn rate!

What happened to the money?

From the FT,

Its biggest recent investments have been in food delivery, including €496m for a 30 per cent stake in Delivery Hero, a Berlin-based online food takeaway service, and €150m on Kuwait-based food takeaway portal Talabat.

Rocket is spending an additional €110m to acquire a majority interest in HelloFresh, a grocery delivery business, also based in Berlin.

Acquisitions – what an innovative company!

They paid 500 million Euros for a 30 percent stake in a company I have never heard of. This is why I had a look at the Homepage of Delivery Hero. They are in food delivery, a famous high margin business ripe for innovation, and have about 12 million orders a month. Oh, and the have invested only USD 1 billion so far.

How did they achieve 12 million meals per month?

Operational excellence, maybe?

From Wikipedia:

Under the leadership of Niklas Östberg and Fabian Siegel, Delivery Hero first expanded to Australia, Russia and Mexico in 2011. In early 2012 the enterprise then acquired Lieferheld in Germany and in the UK.[4]

Delivery Hero then raised €25 million in new funding to finance acquisitions in four European countries: Sweden, Finland, Austria and Poland. In August 2012 Delivery Hero started expanding in both South Korea and China[5] and the Asian expansion continued in 2013 when Delivery Hero increased investment in TastyKhana following a successful cooperation period.[6]

In 2014 Delivery Hero acquired a controlling stake in Latin American market leader PedidosYa [7] and in August 2014 the group acquired German market leader and rival,[8]

According to TNW Tech5 2014, Delivery Hero is one of Germany’s top 3 fastest growing start-ups [9] and Delivery Hero is now the world’s largest online food ordering network with over 75,000 global restaurant partners and 1,000 staff in 23 countries worldwide.[

Aha, Delivery Hero mainly grew through acquisitions. The company was founded in 2011 and immediately went on an acquisition spree. It seems boring, slow organic growth doesn’t get “investors” exited anymore.


Rocket Internet spent one-third of IPO proceeds for a company which itself only grows through acquisitions and has required ever-increasing outside funding. While not strictly a Ponzi scheme (since I assume no one has received its money back so far, although the increasing valuations must make the original investors equally happy, if not happier), this thing certainly feels like one.

The chances of RI being successful in the long run are close to zero, unless you get out in time. Not only because acquisitions are the most challenging capital allocation decision within any company that even experienced CEOs get wrong more often than not, it is also almost impossible to successfully integrate different businesses at this speed. Also some of the jurisdictions in which RI operates are, ahem, exotic. In any case: expect more dilutive capital raises down the road.

If this can happen in Germany, I wonder what the madness in Silicon Valley must look like…



more on capital flight – china edition

I have written two posts about capital flight in Russia (here and here). I argued that the official figures way overstate capital flight and that the “net errors and omissions (NEE)” – that classic capital flight indicator – amounted to a paltry USD 3 billion in 2014.

With the rumours about Chinese capital flight increasing, I thought it might be helpful to repeat my analysis for China. China’s currency peg is unlikely to reflect the true market value which, in the case of an overvaluation, provides an incentive for capital to flee the country. Thankfully, I have come across this chart that neatly summarizes the relevant flows.


The chart confirms the observations made in my last post: reserves are indeed falling (red line). But more interestingly, NEE (yellow) was negative for the last three quarters and unexplained outflows totalled approximately USD 100 billion for 2014. That’s way higher than the Russian figure even adjusting for GDP. An outflow of that size means a pretty significant reduction in the monetary base (capital flight traditionally takes place in the form of cash) and leads to a contraction in credit outstanding. If you assume a money multiplier of 10, it means that USD 1 trillion of potential credit could not be granted. One can see how this matters even in the context of China’s huge reserves.

NEE trends can be a very useful predictor of currency peg breakdowns as shown in the following chart (chart via the IIF here). It shows the historic NEE for Russia and Argentina.


As you can see, watching Argentina’s NEE could have warned you about things to come. The same holds for Russia, where capital flight was a huge problem, especially during the period of a managed FX-rate regime.

Of course, China is not Argentina. It has a positive current account and a positive external investment position. Still, I will be watching this data coming out from China and if this state of affairs persists, the peg might come under pressure soon.

(Disclosure: short CNY and AUD, long RUB)


Will the devaluation of the Chinese Yuan be the World’s next Lehman moment?

Interesting developments are taking place in the Chinese Yuan market. Talk about an impending devaluation is increasing and my out of the money CNY put option that was already completely written off only a few months ago, has come back to life as implied volatility is rising. I have written about my bearish stance on all things China related repeatedly on this blog.

Pressure has only intensified in January as the appreciation of the USD has sent China’s real effective exchange (via David Stockman, read the whole article) rate to a record high. USD strength comes at the most inopportune moment thereby hitting exports and margins at the same time that its insane fixed spending spree is coming to a halt.


There is more to it, however. As the following chart shows (via FT-Alphaville) the Chinese Yuan has been trading at the upper end of its trading band for the better part of 2014.


What’s going on here?

After all, it’s well known that China has the world’s largest FX-currency reserves as a result of running persistent current account surpluses helped by a currency that has been kept deliberately undervalued. This “war chest” virtually assures that there cannot be a currency crisis as the Chinese authorities have more than sufficient means to defend the peg. Therefore it doesn’t make sense to bet against the Yuan – you cannot break the Chinese central bank (PBOC). This is the familiar narrative.

Turns out, the story is only half-true. I have always doubted whether China’s capital account has been that closed after all. It is difficult to square all those rumours about the CNY carry-trade, Chinese real estate “investment” in Vancouver and Manhattan as well as Macau’s gambling revenues (5x Vegas!) with a truly closed capital account or a Chinese fondness for gambling.

Is there a way to access the dimension of those capital flows?

Under an “open current account” /”closed capital account” – type of policy, changes in FX reserves over time are a function of current account surpluses/deficits since only trade related flows are allowed. China has officially had just such a regime augmented by the possibility of foreign direct investment (FDI) flows. In order to see whether China’s reserve development corresponds to theory, I have compared China’s actual FX Reserves to what would have happened if indeed only trade and FDI flows had occurred. For the purpose of illustration I have charted the development below (the yellow line stops after 2013 as I could not find FDI data for 2014).


I find the result quite telling. As you see, theory and practice matched quite well in the beginning as current account surpluses and FDI flows almost entirely explain the FX-reserve development. But at the end of 2009, in the aftermath of the financial crisis and the beginning of fed QEs, this relationship breaks down somewhat and FX-reserves swell even more than what could be expected by FDI and trade flows. The difference looks small in the chart, but it is material: at the end of 2013 it amounted to more than USD 650 billion (it might have fallen somewhat during 2014, but due to a lack of FDI data, it is difficult to tell). This is strange and should not be the case and I am not aware of any policy shift that took place. (Add to this the fact that a lot of capital flows are hidden in the trade data due to over- and underinvoicing of export/import receipts and the speculative flows could be even larger).

“Fine, so they have even more FX reserves they can use to defend the peg – what’s the point?” you may ask.

Well, first, if those USD 650 billion have been able to enter the country circumventing capital controls they also might leave the same way, suggesting that the PBoC might not be entirely in control of its capital account. This might already have started. Note that FX reserves (blue) have been falling slightly since mid- 2014, which could explain the recent pressure on the currency

Second – and many observers forget this – FX reserves are mirrored by liabilities. In the case of central bank reserves, the liabilities go under the name of monetary base. The increased monetary base has underpinned China’s reckless debt growth (again, read David Stockman’s article on that). In other words, a sustained outflow of reserves might trigger a deflationary contraction in the monetary base and result in a credit deflation, unless accompanied by an increase in monetary velocity. Unfortunately, velocity is very difficult to control – just ask the Fed. Should this unfold, Lehman would ineed look like child’s play.


The CNY has been underpinned by huge monetary inflows over the past fifteen years. Whereas it is difficult to forecast how China’s current account will evolve, I think it is a safe bet to assume that FDI flows will slow. For one, the increase in the real effective exchange rate has harmed China’s status as a low-cost producer. But more importantly, the new government seems determined to reduce foreign company’s profit margins thereby rendering the country unattractive to invest. However, the biggest danger lurks in those hidden capital flows that might reverse course and put the Chinese authorities in front of an unpleasant choice: either risk debt deflation, or scrap the peg and devalue. I have crudely estimated those cumulative flows at about USD 600 billion. If memory serves me well, that’s equal in size to Lehman’s balance sheet before it defaulted…

(Disclosure: short the CNY)

Note to Paul Krugman: Russia is Not a debtor country

As I stressed in my last post, understanding capital flight is essential in assessing Russia’s fundamental economic position. Apart from political risk, which to some extent is unquantifiable, most observers agree that capital flight is the biggest challenge facing the Russian central bank (CRB).

Therefore, I was delighted when I recently discovered this NYT article by Paul Krugman in which he ponders about Russian capital flight. He basically starts with this graph that charts Russia’s current account surpluses over the past 20 years.


To quote Krugman’s view of the matter,

It has been in consistent large surplus, with a cumulative surplus of more than $900 billion. Russia should not be a debtor country. It has managed this nonetheless, presumably because corporations and banks have borrowed abroad, and somehow that money has ended up invested in luxury London real estate and other things. It would be nice to have a good picture of how the flow of funds worked.

He is puzzled by the fact that Russia, despite its huge cumulative external surpluses is a creditor country. Although he doesn’t explain his reasoning, I suspect that he was mentally referring to Russia’s external debt load (USD 650 billion) which featured prominently in the financial press during the December Ruble crash (see my post on this topic).

So, what’s wrong with that view?

It turns out, quite a lot. Obviously, the mere fact that there are external debts doesn’t mean the country is a NET external debtor. As with any corporation, the balance sheet of the economy as a whole also has TWO sides. You surely have to account for the foreign assets of Russian’s and the Russian state before determining its overall financial position. Only after taking into account Russia’s external assets can we determine its Net International Investment Position (NIIP). Fortunately we do not have to guess, as the CRB calculates this figure on a quarterly basis according to standard IMF methodology. There we see that at the end of Q3 2014, Russia’s NIIP stood at a positive USD 232 billion (see Excel at the bottom of this page here). Conclusion: not only is Russia NOT a creditor, but it is a net (external) creditor to the tune of 12 percent of GDP, according to official figures.

Furthermore, I will argue that the IMF methodology overstates Russia’s external liabilities in the NIIP calculation (and hence underestimates its NIIP), due to a specific feature of Russian business life: offshore holding companies.

Let’s have a look.

According to the NIIP accounts Russian residents had international liabilities of about USD 1178 billion as of 30.9.2014. In case you are confused, this is higher than the external debt figure (about 650 billion) touted in the media and used in my original post. Don’t worry, there is nothing wrong here. It is just that the liability definition, as used for NIIP calculations, also includes equity stakes that are owned by foreign residents. This is because NIIP is calculated using national accounts whose purpose is to measure money flows between economies. From the perspective of flows, it is irrelevant whether the flow is debt or equity. A liability in this case just means a financial claim – any kind of claim – of a foreign entity towards a Russian entity.

I want to focus on the direct investment figure (USD 476.5 billion) which includes direct, i.e. non securitized, equity investments (USD 325 billion) as well as direct debt financings (USD 151 billion). (The latter figure is part of the external debt of USD 650 billion). These are transactions that typically arise as a result of foreign direct investment (FDI). These are not portfolio flows, or “hot money” as it is often called in the literature.

Now, you have certainly heard of Russian oligarchs’ Cypriot, Caribbean etc. holdings with the help of which they steer their businesses. Yukos is a case in point. Although, everybody knew that its ultimate owner was M. Khodorkovsky, its official owner was a holding incorporated in Gibraltar (Menatep). Yukos is by no means an exception – virtually every large Russian businessman operates this way (for reasons that do not only have to do with property rights). In this case, every capital increase or earnings used for the upgrading of plants and not distributed would be treated as an investment by a foreigner for NIIP purposes. And this is matters for the discussion at hand. For instance, some analysts suggest that up to 50% of the external debt of Russian corporations is quasi-equity provided by such offshore holding companies.

What do we make of that?

Obviously, we can only guess about the true size of this phenomenon, but I think it is safe to assume that these types of flows are material. Moreover, if the proportion of these types of flows really amount 50 percent of external debt, as some analysts suggest, then it is reasonable to assume that the proportion is even higher for the direct equity flows. For instance, retained earnings of a Russian commodity producer held via a Cypriot holding would show up here. In order to put a figure on my thoughts, I will simply postulate that 50% of the direct investment flows mentioned above, i.e. about USD 235 billion, are not truly foreign claims on Russia, but claims by Russians disguised as foreign claims. Obviously, this is not very scientific, but it helps puts things into perspective.

So what’s the point of this exercise?

Reducing the USD 1178 billion in external claims by USD 235 billion doubles Russia’s NIIP to around USD 470 billion, or more than 20 percent of GDP, or about the same size as China’s NIIP! China is hardly the country that is usually associated with external debt issues. Further, it is this figure that needs to be compared to the cumulative USD 900 billion in current account surpluses mentioned by Krugman. If you accept my reasoning and subtract 470 from 900, one gets a rough USD 430 billion. This would be my estimate for the cumulative capital flight from Russia over the past 20 years – makes USD 20 billion/year. I think most people would be surprised by the rather low figure. I was surprised too.


Krugman is flat wrong to state that Russia is a debtor nation when in fact is a substantial net creditor. This is probably not intentional. After all, I have seen too many mainstream economists struggle with simple accounting principles. This is also shown time and again by Keynesians’ exclusive focus on flow measures like GDP and never differentiating between debt driven growth and pure economic growth. As an old hand in analyzing currency crisis, however, he should know the difference between a positive and a negative NIIP.

The article nevertheless was inspiring. Reading it, I immediately recognized the flaw in his thinking and it made me want to research this topic. Honestly, what I found surpassed my expectations. I certainly need to dig deeper into this, but I think there is a high probability that Russian capital flight is much less than commonly believed. I am convinced that the main risk to my long Russia thesis is political – not fundamental.

(Disclosure: long RUB as well as select Russian bonds and stocks)