The general assumption in the Greek crisis is that, in so far as there is one, plan B — Grexit — is the introduction of a new currency. I think that actually Greece using the euro outside of the Eurozone is more likely as plan B. It’s still very unlikely because it doesn’t make sense at all from the point of view of the Eurozone, but it’s fun to play with as a thought experiment, and discussing it may help understand why it won’t happen.

There are well known advantages to having your own currency, but in this case a new currency would have big problems,:

  • Risk of non-adoption by people on the street because they don’t trust it
  • Inflationary spiral caused by the economic situation, the sudden introduction and the above
  • Logistic issues (printing new banknotes, converting contracts) which is essentially impossible to do over the weekend, and impossible to announce in advance

The alternative is just to keep using the euro while being outside of the Eurozone. Like Kosovo does, or like Ecuador does with the US dollar.

Map of euro adoption

Going lilac? (source: Wikipedia)

How would it work out?

Paper money

According to the Greek central bank there are about €2000 of paper euros in ciculation for each person in Greece (the actual number may be more or less depending on net flows of notes and coins from other Eurozone countries, but you’d expect this to be a conservative estimate because of net incoming tourists presumably arriving with more euros banknotes than they leave with). These are not going anywhere in case of Greek exit from the Eurosystem, so Greeks have more than enough paper banknotes to go round for a long time, even if they can’t print their own new ones.

(Note that this abundance of paper euros also makes the risk that nobody is interested in new drachmas higher than it would otherwise be.)

No central bank

Grexit would happen through the suspension of the ELA, which would in turn push all Greek banks into bankruptcy (as a liquidity problem at the very minimum) which in turn would exclude them from the electronic payment systems (SEPA, etc). This would also make the Greek central bank insolvent. They could just close it down, which would allow them to default on €50-100 billion worth of Eurosystem liabilities. If you’re a unilateral adopter of the euro you don’t need a central bank, the ECB remains your central bank, at arm’s length.

Look ma, no debt!

While we’re defaulting, given a primary surplus the Greek government can operate with no debt at all, and will be better off than the status quo, even if they can’t borrow for the foreseeable future. So they can default on the whole debt stock from the Troika lenders, and why not the private sector as well given under a balanced budget they don’t need borrowing at all, so maintaining a good credit rating on the markets is pointless.

Having no central bank, the Greek treasury can operate their payments by opening commercial bank accounts (with no overdraft needed!) like any business, with Remnant Eurozone banks, e.g. Deutsche Bank. They can use online banking to manage it, no need for the banks to have branches in Greece. They can also use new Greek banks (see below).

Capital flight is good for you

With no central bank, the Greek banks would have no access to clearing accounts in the Eurosystem. But there are several options here. First, we can assume they would lose all their Eurozone assets (most being owned by the ECB as collateral, and Remnant Eurozone governments could enact special confiscation legislation for local law assets owned by Greek banks, fair game), as well as their liabilities (ECB funding, etc). What is left is basically the local Greek-law loan book, and local Greek euro deposits. As of late December this was approximately balanced. With capital flight it actually improves every day: the loan book can’t walk away, but the deposits (liabilities for banks!) shrink, and capital = loans – deposits, which gets more positive with every euro leaving. Assuming the impairments on the loans are not too far off fair value, and the Eurosystem exit doesn’t create too much new defaults (arguably a risk, but much less so in the Kosovo scenario than in the own currency one), we have solvent banks. If all else fail, a haircut on remaining large deposits should help rebalance.

Liquidity for non-Eurosystem euro banks

These Greek banks are illiquid outside the Eurosystem though, with no access to clearing accounts, but there are solutions:

  • Sell the solvent domestic loan books + domestic deposits to Remnant Eurozone bank(s) for €1. E.g. National Bank of Greece could become part of, say, Santander, who can get liquidity for their new Greek subsidiary operations from the Spanish central bank, still a Eurosystem member, and they have spare borrowing power there given their large balance sheet. Problem sorted. And Greek depositors get their €100k guarantee backed by Remnant Eurozone taxpayers as their deposits are fungible with domestic Eurozone deposits!
  • With the same solvent loans + deposits as above, perhaps less crap stuff sent into a bad bank type entity, reopen the (New) Greek banks as corporate entities which use Remnant Eurozone corporate accounts in lieu of central bank accounts for clearing. This needs a stop gap for liquidity, by either converting the deposits to term deposits (a soft form of capital controls arguably) or possibly finding bridge loans from external private entities. Given the entire deposit base is below €150 billion and may be much less by the time this scenario would unfold, and not all of it will move after an exit (too late), it should not be that hard to find hedgies to provide the financing.

The first variant brings a more generally interesting question: in a currency union, should financially weak regions have their own banks, or should they bank using the institutions from financially strong regions within the union? The answer is probably the latter, as happens in most centralised countries (e.g. most people in Cornwall do not bank with Cornish banks, but freeload on London banks, and quite rightly so; at an (ex-)country level the ex-GDR part of Germany has a weak indigenous banking sector and banks with West German banks, and quite rightly so).

What are the risks of Kosovoisation?

I may have missed something, but I don’t see many problems with this scenario, from Greece’s viewpoint. Long term, Greece would have no indigenous monetary policy, but they were never particularly good at it and monetary policy is of limited use anyway for a small country. They would loose access to EU structural funds, but then they save €400 billion of debt so net positive here surely. The main short term problem is if the Remnant Eurozone tries to cut private Greeks and private entities from their (non-overdraft) mainland Eurozone bank accounts. Possible but pretty hard, and mean. And hard to justify given all this would be triggered by the ECB pulling the plug in the first place.

Why this won’t happen

It should be obvious now that this won’t happen, precisely because it would probably be an okay deal for Greece, while costing the Eurosystem dearly both in nominal terms of treasury + ECB write-offs, in possibly collateral damage, and a very high risk of an associated cataclysm for the European project. The ECB will just not pull the plug unless Greeks do something really stupid (like printing their own unauthorised euros, they do have a print works I think).

One of collateral damage effects of the oil price crash of recent weeks has been that airlines who have aggressively hedged their jet fuel requirements face a loss on the hedge. Normally this is not a problem, as the point of hedging is to match anticipated revenues with anticipated costs, but here it may backfire if unsold inventory becomes uncompetitive (at the hedged price) compared to competitors who have not hedged (or hedged less).

This brings the question, how much should ideally an airline hedge its fuel costs?

Hedgie or airline operator?

The first thing is that the airline should resist the temptation to branch out as a macro hedge fund and hedge based on predictions of future oil prices, beyond its current need, e.g. for future flights it hasn’t irreversibly committed to fly yet.

Making macro predictions and running an airline are two very different problems and it is unlikely a single management would be equally good at both. If they’re good at macro prediction, they should close the distracting airline and become an oil trader on a much larger scale, and conversely. Arguably an airline operator will have some idea on the general dynamic of the airline sector, and its fuel requirements, in their geography, but that’s unlikely to be enough to justify making active bets on the broader markets.

Asset liabilities match

So a reasonable fuel is to match the hedge as close as possible to committed fuel liabilities.

The maximum hedge is thus all the fuel required for all the scheduled flights the airlines has to fly, that would be something like all flights with at least 1 passenger booked.

But, in an era of dynamic pricing, the price of seats unsold can be varied in response to supply and demand, and costs. So why hedge unsold tickets at all? This gives the minimum hedge: only hedge the fuel share corresponding to tickets already sold.

This inconveniently would be an exact match only if demand and supply don’t react to fuel costs being pushed to ticket prices, and are not variable for non-fuel factors. So the ideal match is somewhere between those 2 possibilities, without an exact answer being easily attainable.

The simplest for a shrewd airline may be safety in numbers: to hedge as much as (and no more than) their competitors (on comparable routes, etc). Then success remains a result of operational excellence or lack thereof.

Economic intelligence test

For investors in airline shares, there may be more to read in how management justifies their hedging policy — do they get the economics? — rather than how much. And run away from closet hedgies.

It’s now a commonly held view to say that Greece would have been better off exiting the euro, returning to their own currency in 2009, let it devalue and restart from scratch.

picture of Greek Europa face watermark on a euro 10 banknote

Greek Europa watermark on new series euro banknotes (credit: ECB website)

Devaluation is no panacea

GDP and real incomes are down about 30% since the beginning of the crisis. It’s a lot, but how much it would have been down in real terms (in hard currency) with an exit? Even if we assume no redenomination costs (untangling contracts denominated in euros, etc) and no adoption issues (Greeks keeping using the euro for some of their daily usage because they didn’t trust the new currency, see below) the typical fall in such cases would be likely at least 50%. Then you would get a bounce in nominal drachmas but where would they be now in real terms? -30% maybe? The historical experience of other countries doing devaluations, say Argentina, does not show it as a certain path to unbridled prosperity.

It is likely that the numbers would have looked better at PPP (purchasing power parity) as all local services and goods go down in price in a devaluation. Greece is though a small country which is far from self-sufficiency and imports many goods, including energy, that are not produced locally, thus ensuring the impact of a devaluation would be felt by all.

So, while it’s not impossible that real GDP would have done a bit better with a devaluation, it’s certainly not a given.

Distributional impact of devaluation and Kosovo-isation risk

Perhaps the one advantage of the devaluation route is that it makes everyone with nominal incomes in the national currency poorer. This is sort of good for social equality — we’re all down together — although in the case of Greece it wouldn’t apply to shipping magnates or owners of tourist-oriented businesses (whose products are world-priced in competition with alternative destinations) so the one percent (or a section thereof) would have done okay either way.

For recipients of social transfers, it’s also not obvious which way is best. A pension halved but still in hard currency may buy more than a devalued one. The distribution is different (cheaper haircuts, higher cost energy) so who knows which is better.

One case where it would be worse for the poorest is the “Kosovo-isation” scenario, where people in employment or with any form of foreign income keep using the euro despite the introduction of a new currency, so the currency is only used by state employees and benefit recipients, who spend or exchange it as soon as they can to avoid it losing value. Some say the state collecting taxes in its own currency gives it value, but not necessarily: people can just convert from euros, or whatever the street currency is, to the tax currency the day before a tax payment is due. In this case the new currency may just go into a death spiral which is combining the disadvantage of a hard currency with those of a local one.

Tsipras is the Troika’s child

Creative destruction has a bad name, but it does, to an extent, work. A problem with everybody getting poorer together in a devaluation is that there are fewer reasons to change bad habits and people can just plod along in their mediocrity until the next round.

Greece had and may still have a dysfunctional state with poor tax collection and poor value for money when delivering services, that is not providing a well working framework for a modern economy. For example, clientelism is central to Greek politics which means people are given jobs they may not be qualified for or productive in as a reward for political support. This is not only a direct net cost to the Greek taxpayer (compared to employing productive people at market rates), but also an opportunity cost as these people may have otherwise found more productive use for their time. Even for the beneficiaries of state largesse, being stuck in dead end careers in comfy but meaningless jobs may not be that fulfilling.

The crisis has allowed Greece to make some progress on this, no doubt with some collateral damage. To know if the devaluation solution would have been better, we would need to know whether there are net benefits to the shock therapy, and how they compare with reforms possible, or not, under a devaluation scenario.

There may be more progress to come as Tspiras, being an outsider can break lots of allegiances that were untouchable for the incumbent. It is quite plausible that his government makes some progress that would have been impossible, or taken decades more, in a sleepy repeated devaluation cycle where a newcomer like Tsipras would have remained permanently unelectable. If Tsipras is the Greek Lula, and the euro crisis made him possible, it may not be a bad thing for Greece.

What now?

In any case, whether the benefits of devaluation then would have been real or imaginary, it’s a bit too late. Exit at this stage would probably be the worst of both worlds, by creating a real term depression at a moment where there are not many benefits left from it. Both Tsipras and the Greek electorate seem to be wise to that.

The main remaining open question is whether they obtain a satisfactory compromise on the large debt stock. Tsipras has new reforming powers to bring to the table. Many of his proposed reforms are compatible with fiscal responsibility (anything that attacks clientelism, or the economic privileges of the Orthodox church, or effective tax collection from the rich). Besides it seems they understand they need to keep the nominal debt untouched, which allows Northern governments to sell a deal to their own electorate more easily. What they need is lower outgoing cash flow for the next couple of years, which any combination of rescheduling, lower interest, or interest capitalisation can do. The situation further ahead can be dealt with later on. A partial (or total) conversion to GDP bonds would also be a good compromise: Greece pays if it does well (as it would with the current setup) and doesn’t if it doesn’t manage (in which case the current setup produces sooner or later a hard default).

The tricky point for the negotiation is perhaps whether they manage to isolate Greek banks from the Greek treasury. If Greek banks were either self standing, or taken over by a eurozone body (EFSB or whatever) then the Greek treasury could suspend, or threaten to suspend, official sector repayments without as such causing a disaster. They could be kicked out from the eurozone for that reason, though that would probably, ironically, require a treaty change and unanimity, that is it would be practically impossible unless they behave really really badly. And if everyone knows that, they’ll do a deal before we get there.

Maybe in 20 years time historians will see that the euro, somewhat inadvertently — or perhaps by design if we consider the euro as a federalist pre-commitment device — helped Greece extricate itself from its own failings. And perhaps save the EU from it own failings in the process too.

First trade of the year on the main Obliquity Portfolio has been to exit Dignity, the undertaker consolidation firm, and double down on Tesco.

Too shady in the cemetery

Dignity is a business that is natural fit for the obliquity strategy: stable, boring, hard to like. But, and it’s something I had not understood well enough when I took the position, it’s designed more as a financial derivative than a business. Heavily leveraged and constantly adding to debt to maintain the high leverage, via copious dividends and capital returns (which produce an administratively annoying share split every year). With ever decreasing interest rates this works well, but could become a bit risky in any credit contraction cycle. Besides the management seems more interested in financial trickery than the underlying business. As they buy stable small/family firms that do something pretty predictable, it’s hard to cock up in the short term, but I expect long term neglect to lead to loss of market share and customers. Investment bankers just rarely make good businessmen. The position has been quite profitable (more than doubled) so seems a good time to exit, and it also now doesn’t pass the obliquity criteria any longer, via 4 criteria fails: management (I don’t trust them), balance sheet (too leveraged), diversification (none) and price action (too much momentum).

Tesco

Tesco woes are well known, and to some extent it was an error to buy in when they had fraudulent management and the wrong priorities in customer service (trying to outwit people with clubcard tricks), though it’s also a natural match for the portfolio and even with imperfect product and a fail for management it would pass. I believe that they’ve now got the right management and understand what they got wrong. It will take a while.

I doubled the position which takes it back to a full large cap position (it had almost halved since inception).

Loews: quirky conglomerate

An earlier acquisition, funded by accumulated dividends, during the autumn was Loews, a baroque US family conglomerate doing hotels, insurance, and energy exploration, that is managed in a Buffett-style kind of way. Not the best timing just before the energy prices crash but I trust they will survive it. It’s sort of a miniature obliquity portfolio on its own, and should make a fair long term holding that is structurally unglamorous and thus discounted.

Russia’s troubles are now well documented. From a monetary viewpoint they’ve been reasonably restrained, they could have done lots of silly things, like blowing all their foreign reserves, which probably would have just been given away to speculative traders. Capital controls may be another possibly bad idea, though it’s somewhat surprising it hasn’t, so far, been the natural instinct of such an authoritarian regime.

Russia clearly would have a hard time maintaining a dollar peg (not enough dollars), or say a gold peg (not enough gold). But they’ve got a lot of oil. And the Rouble, like most commodity country currencies, is strongly correlated with the flagship export — incidentally I’m not convinced this should be the case as often as it seems to be in practice, there may a self-fulfilling prophecy element in these correlations.

Revenue from oil sales are a large part of the Russian government’s income. So if they peg the Rouble to oil, they get constant income from this (assuming constant pumping volume) matching constant(ish) nominal liabilities (pensions, civil service salaries set in sticky nominal roubles). Remarkably this to an extent naturally happened: the oil price chart in roubles is much flatter than in dollars.

In normal times, the oil price might be considered too volatile to be used as a mean of payment but in crisis times, it may be less volatile than a free floating lame duck currency. And a peg can be undone in quieter times.

So I suggest that the Central Bank of Russia declares the Rouble convertible to a fixed quantity of oil.

Petrol Station with Cental Bank of Russia logo

Putative petrol station operated by Central Bank of Russia (credits: CBR logo from website, petrol station from Flickr user minaletattersfield, CC by-sa licence, collage commentisglee on same.)

They don’t even need to actually deliver oil for people wishing to redeem roubles directly — or only as a last resort. Delivering internationally traded oil futures would do fine. Indeed the rouble could become a well regarded, highly liquid, oil derivative in its own right, that just happens to also buy you a cocktail in Moscow.

Looking back at my short tipping exercise from February this year, the results are remarkable:

Stock Symbol Performance Feb 2 to Dec 12
Globo GBO -27%
Quindell QPP -91%
Wandisco GBL -69%
Naibu NBU -79%
Judge Scientific JDG -48%
Mean -63%

So that’s a full hit, every stock in the set declined markedly and £100 invested equal weighted in this short portfolio would have returned £63 profit in less than a year. Unfortunately shorting is a pain due to the unlimited downside if you get it wrong, and I haven’t actually shorted anything. I did get the time frame wrong, given that we didn’t have to wait for 2016 to see results. In a real portfolio I would have probably exited all the positions by now, except perhaps Globo which may have some more downwards potential.

Fireworks

Fireworks (credit: Maciej Lewandowski on Flickr)

The small cap markets are missing an instrument for limited risk shorting, for instance put options, perhaps with fewer strikes than normal options  — e.g. a logarithmic ladder —  and fewer expiries — quarterlies would be more than frequent enough. It could be either something tradable like certificates or spread bets, or as an OTC keep-to-maturity product. The market for this is small but a niche operator could do well. They could hedge by selling discounted call spreads (calls with truncated upside at the put strike) to bulls to match their put portfolio with a small amount of capital needed to market make the inventory. With the right risk management this is a low risk business that can be operated with no price risk, and it would offer a more useful service than open ended spread betting. Shorting is essential to functional markets.

That said there are some mitigating factors: it has been a bear market for small caps, during which basket cases often don’t do well. They can conversely do spectacularly, for a while, during bull markets, which can be quite testing for shorters. That said the iShares MSCI UK Small Cap ETF, as a proxy for the market, is flat on that same period so a hedged long/short portfolio would have returned about the same. That hedge may not work fully in case of a short squeeze or bullish market where the basket cases race far ahead.

Having not made divination posts for a while, let’s make a new prediction, that the price of Bitcoin will go down markedly in classic currency terms in the next 3 to 6 months.

Transaction acceptance means net bitcoin selling

The reasoning is pretty simple: one of the main happenings in the Bitcoin world recently has been increased acceptance at legitimate vendors like Dell, Overstock, Expedia (for hotels) and others. Bitcoiners see that as a success and, ironically, some Bitcoin holders see it as doing something of civic value to buy at vendors that accept Bitcoin.

But what happens when someone buys a laptop from Dell with Bitcoin? There is no sign of Bitcoin becoming used in the business supply chain, where it doesn’t really solve any material interesting problem, so Dell will immediately convert the Bitcoins to dollars to pay their employees and suppliers. Indeed one of the reason vendors are accepting Bitcoin is that payment processing intermediaries make that easy by doing it for them and “removing the Bitcoin risk” from the vendor: they price in dollars (or another classic currency) with the payment gateway, and get dollars paid by classic wire transfer.

What happens on the buyers’ side: will people buy Bitcoins to buy Dell laptops? It seems unlikely. Dell is probably more trustworthy than most operators in the Bitcoin ecosystem, and you don’t want anonymity or pseudonymity when buying a laptop: you want them to know your address and deliver the laptop there. So there’s basically no reason to pay using a classic method to get Bitcoin and then use those shortly at a legitimate vendor. So who’s gonna buy Dell laptops with Bitcoins? My guess is mostly people who for some reason or other had accumulated Bitcoins, legitimately or not, and now have an opportunity to spend it on something more useful than Bitcoin t-shirts, and also see it as a “good” thing for the ecosystem.

And then came momentum

As it happens Bitcoin has been on a downward trend since its peak for several months, and has also seen a further boom in “mining” activity. Bitcoin mining, like its real world namesake, is one of those activities which tends to be structurally loss-making as it’s very hard for rational investors not to be outnumbered by innumerate optimists. Volatility and a downward trend may accelerate some of these past optimists giving up on accumulating mining proceeds, and exiting through transactions, which might provide some comfort (product + civic value) even if nursing a net loss.

Raw momentum regardless of mining (“it’s going down because it’s going down”) will also tend to put a further downward pressure, so basically we have a fundamental trend towards sale of Bitcoin created by transaction acceptance, amplified by momentum and mining dynamics.

Absent any new net buyers of Bitcoin, it’s hard to see how it could go anywhere but down on a simple demand and supply basis. It’s hard to think of a source of new net buyers. Most people who may be interested in Bitcoin at this stage — where it has acquired some maturity but is still an emerging underground tech — have probably already jumped in and are sustaining steady-state flows. I just don’t see any new major demand source coming in to offset transaction-driven sales.

Show me the money

So to quantify the prediction for verification, let’s say that BTC/USD will touch US$ 250 (approximately halve in value from now) for at least one day at reputable exchanges before April 1, 2015.

(Disclosure: I have a few pennies on downward Bitcoin bets at shady blockchain betting operator bitbet.us — not a recommended counterparty or investment. Note that if I win I get my payoff in devalued Bitcoins, which, if my fellow gamblers don’t discount that effect correctly, as I expect them not to, will be a pyrrhic victory.)

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