European monetary union was a great experiment that made a lot of sense on paper. Europe, which had roughly the same size population and economy as the U.S., was at a competitive disadvantage, as dozens of currencies embedded extra transaction costs in cross-border trade and each currency separately had little chance to compete with the U.S. dollar for reserve currency status. Germany — the largest country in Europe and one of the world’s biggest exporters — was at a disadvantage too: The strong deutsche mark made its products more expensive and less competitive in the rest of Europe

There were also no-less-important noneconomic considerations. Germans were haunted by their past; they had started two world wars in the 20th century, and a united Europe was their way of lowering the chances of future European wars.
EMU sounded like a very logical marriage of all the significant powers of post–World War II Europe. But the arrangement was never really a marriage; it was more like a civil union. EMU members combined their currencies into one, the euro. They agreed to use the same central bank and thus implicitly guaranteed one another’s debts. They signed treaties that spelled out the rules of the union (the prenup), but unlike most prenups, in which the rules of divorce are spelled out, the EMU did not determine what would happen if a member fell upon financial hard times.

The grooms and brides never moved in together; their fiscal policies were never consolidated. Though treaties put limits on budget deficits (which, ironically, Germany was the first to break), each country went on spending its money as it wished. Some were relatively frugal (Germany); others (the PIIGS: Portugal, Ireland, Italy, Greece and Spain) went on spending binges like newly hitched college students who had just gotten their first credit card, with irresistibly low introductory rates and a free T-shirt.
Predictably, like many college students, the PIIGS went over their credit limit, but they had ceded control of their currency to the European Central Bank, so they could not arbitrarily increase their spending limits by printing more money. Governments that cannot afford to make their interest payments or roll over their debt and don’t have the key to the printing press are left with only one option: default.

EMU members were so eager to consummate the union that the issue of divorce was not addressed. To kick Greece out of the EMU, a new treaty has to be written and all the partner countries have to unanimously vote to approve it (which means Greece would have to vote for it too). For more on the economic and political costs of such a scenario, check out the terrific recent report by UBS Investment Research titled “Euro break-up — the consequences.”

It is very unlikely that Greece would leave the EMU of its own accord. All of its government and corporate obligations are in euros, and on the day it announced its departure from the European Union and a return to the drachma, its banking system would collapse. All depositors would run to their banks to withdraw their euro-denominated deposits. The drachma would trade at a steep discount to the euro, and while the government would be able to print drachmas at its leisure, the bulk of the corporate sector’s debts would be in steeply appreciated euros and its income in collapsed drachmas. The failure of the corporate sector would follow that of the banks.

Logically — though logic is a very significant assumption in this discussion, considering that politics is often emotional and illogical — Greece will not get out of the EMU on its own, and unless treaties are broken, which would set an enormous negative precedent for the rest of the EMU, Greece will not be kicked out of the union.

This brings us to a very probable solution: a full or partial bailout of Greece by the “strong” EMU countries (that is, Germany and France). It is in their best interest. Greece is a sovereign EMU nation, so German and French banks have not had to put up significant reserves (if any) against Greek debt, though they have more than $100 billion exposure to it. A disorderly (Lehman-like) collapse of Greece would send a profound shock through the European banking system, and instead of bailing out Greece, the German and French banks would need a bailout themselves. At the end of the day, someone will get bailed out. By bailing out Greece, Germany and France are indirectly bailing out their own banks, but with an added bonus: a preserved union.

A logical question comes to mind: Facing all these costs, not to mention a popular distaste for financing the exuberant, nontaxpaying Greek lifestyle, why wouldn’t Germany break treaties and get out of the EU itself? If Germany left the EMU, its economy would not be unscathed — the deutsche mark would likely skyrocket against an even-more-weakened euro. Germany’s exporters, which are vital to its economy, would lose competitiveness in European markets, and its economy would enter into a prolonged and very painful recession. The rest of the European economy would weaken, and Germany would have no one to sell its goods to. (This sounds a lot like the China-U.S. relationship.)

Yes, the pain the German economy would suffer would be a lot less than the pain that would be felt by Greece if it exited the EMU; however, schadenfreude would give the Germans little satisfaction. And although in today’s modern, civilized world, wars are not fought among developed Western countries, a broken Europe increases that probability.

Paraphrasing Rahm Emanuel, this is too good a crisis to waste, and over time it will bring the EMU closer and eventually push it toward the logical next step: marriage — a United Countries of Europe. Giving up one’s fiscal policy and sovereignty is very difficult, and national pride will require significant subjugation, but Europe will have little choice.

The Greek crisis will soon be yesterday’s news and forgotten, but in the meantime it provides the EMU with a wake-up call that the prosperity-only setup is not a sustainable long-term model. The EU needs a default bailout (TARP-like) mechanism to deal with adversity. The good news is that while Greece is by far the most dysfunctional economy in the EMU, it is the smallest of the troubled PIIGS.

Germany is paranoid about inflation. It suffered through one of the worst-ever inflations in the early years of the last century, but a centralized bailout mechanism big enough to deal with the PIIGS will likely leave the ECB no choice but to rev up the printing presses. Given the alternatives, Germany will have little choice but to accept that reality. Inflation (unless it is hyperinflation) will be a more democratic and more politically acceptable solution than Germany and France’s underwriting the PIIGS’ debt.

Copyright Institutional Investor …

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here.

Investment Management Associates Inc. is a value investing firm based in Denver, Colorado.  Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.

In Russian there is an expression: The wise man learns from someone else’s mistakes, the smart man learns from his own, and the stupid one never learns.  You’d think I’d be putting the Chinese government in the latter category – obviously the Chinese have not learned from Dubai’s mistakes, and they don’t seem to want to learn from their own – empty shopping malls and cities which, based on these Google Earth images, are scattered all over China.

So erecting a $1.3 billion “seven-star hotel,” when Beijing’s office vacancy rate was over 20% just a year ago (I doubt it has changed much, considering how much they’ve built in a year) would appear to be less than smart. Wrong! It is brilliant!  The report also states, “The Saudi side was expected to foot the entire bill.”  The “Saudi side” will bear the eventual losses. The construction of Burj Khalifa 2.0 is brilliant on so many levels: the Chinese government gets the “Saudi side” to finance its objective of growth and full employment at any cost, the Guinness Book of Records gets another entry with a Chinese name, the Chinese communist propaganda machine has another news story for us all to digest, and a few years from now Burj Khalifa 2.0 will be bleeding money and the Chinese government will bail out the “Saudi side” at 20 cents on the dollar.  Brilliant! brilliant! brilliant!

I wrote about a year ago in Dubai’s Shot to The Moon, an article that is as relevant today as it was then.

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of  upcoming The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here.

Dubai, however, is like NASA; both have proven that anything is possible when you ignore economic costs. Many technological discoveries were made in the process of putting a man on the moon; but the project did have, and was expected to have, a negative return on capital.

Dubai has followed a similar path. The absolutely impossible category may not include building an underwater hotel, or the tallest building in the world, at a cost of $4.1 billion, or a covered ski resort in the middle of a desert, but these projects surely deserve a place in the category of economically impossible. Like putting men on the moon, Dubai’s projects were destined to have a negative return on capital. (At least NASA was up front about it).

Dubai’s construction wonders were made possible by high oil prices and, more importantly, unlimited (at the time) global liquidity – subprime global lending on steroids.

Today Dubai, a city/state that could do no wrong just a few years ago, is defaulting on the debt it issued to finance its building boom. However, what is happening in Dubai is just the most recent, most vivid example of what took place all over the world until the economic crisis. Economically impossible endeavors with negative returns on capital were everywhere and Dubai is just the latest to go bust.

Though everyone is talking about Dubai’s potential default, the scope of the problem is greater. Think about how much energy (oil, coal, natural gas), materials (steel, concrete), and industrial products (cranes, tractors) – in other words, stuff – it took to build these economically impossible wonders. China, the most populous country in the world, also masked its share of economically impossible projects through the guise of “stimulus” and at times outright censorship. China is the birthplace of the largest shopping mall in the world, which is empty, and a city built on spec for a million people that remains mostly vacant. These two just scratch the surface. The rest of the world, including the US (after all, we built a lot of now-empty houses and condos) is swarming with economically impossible projects.

How many houses (or in the case of Dubai, mansions), factories, hotels, skyscrapers, shopping malls, and railroads will not be built because there are too many already built? And if this is not convincing enough, funding economically impossible projects will be difficult for a while, as lack of liquidity and insurmountable losses suddenly turn bankers into … bankers. They find religion (at least for a little while) and start giving loans to folks who are expected to actually pay them back.

Dubai is the exemplar of economically impossible activities that have taken place everywhere, and why one can’t be optimistic that demand for stuff will return to levels even remotely close to what they were in the days when everything was economically possible and financeable.

Epilogue

My father lives a block away from my office. I stop by his house a few times a week on the way to work. We have breakfast (my stepmother makes a killer fake-egg omelet) and stimulating conversation. My father is a true renaissance man; he is a gifted teacher, a scientist, an inventor, he holds a PhD in electrical engineering, and to top all that he is a very accomplished artist. The bottom line; he is a very wise man. This morning we discussed this Dubai article.

He asked me, “But why would people in Dubai spend billions of dollars on buildings if they have little chance of earning a return on it?” He added, “I would think they’d have rational voices at the table pointing out obvious holes in these multi-billion projects.” At first I tried to explain that if things can get financed they’ll be built. I sensed skepticism. Then I explained how groupthink works, that under crowd pressure, especially after their predictions of the bubble bursting were proven “wrong,” as real estate prices kept climbing, skeptics were either turned into believers, got quiet, or got fired for being doomsayers and not being team players. My father started to see what I saw, and then I told him a joke that I heard from Warren Buffet years back.

A very successful oilman dies. He faces Saint Peter, who says, “You’ve been a good man and normally I’d send you to heaven, but heaven is full. We only have a place in hell.” The oilman says, “Any chance I could talk to other oilmen who are in heaven? Maybe I can convince someone to switch places with me?” Saint Peter says, “It’s never happened before, but sure, I don’t see any harm in it.” The oilman goes to heaven, finds an oilmen convention and yells, “They found a huge oil discovery in hell!” Oilmen are stampeding out of heaven to hell, and our oilman is running with them. Saint Peter asks him “Why are you going to hell with them? I have a spot in heaven, you can stay.” The oilman answers – “Are you kidding, what if it’s true?”

My father got it.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007). To receive Vitaliy’s future articles my email, click here.

My firm is looking to partner with financial planners / advisors to offer our unique portfolio management services to their clients. You may contact me here.

Copyright Vitaliy N. Katsenelson 2009.  All Rights Reserved.

Preparations included a visit to my doctor where I paid $285 for three vaccinations against hepatitis, tetanus and typhoid. My wife packed me antibacterial wipes and gave me clear instructions: “Wipe your hands every time you touch anything.”  

Images of dirt roads, AIDS, food-deprived kids, militants with AK-47s, and general lawlessness were circulating in my head, and on some very subconscious level I was saying final goodbyes to my wife and kids. I was going to South Africa. 

Ignorance is bliss. With hindsight, my expectations were so low that the presence of semi-paved roads would have elicited a positive surprise. The South Africa I found was not dominated by shades of brown, the color of sand and poverty that were imprinted in my head about Africa. The South Africa I found was bright green, blue and white. If it was not for the cars driven on the “wrong” (left) side of the street, a gift from the U.K., you’d confuse it with Southern California (Santa Barbara comes to mind especially).

The roads are in far better shape than in most cities in first world countries. Neatly manicured grass and palm trees and endless vineyards are responsible for the rich green colors. White is the color of waves bathing the coasts and the color of European-style buildings that are in perfect shape. Blue, the color of two oceans (Indian and Atlantic) surrounds the Cape, meeting at the Cape Point, and of course is the color of the bright blue sky.

 This is the view that you’ll get of Cape Town and the Cape if you only stay on the major roads and only visit the tourist areas. Until the early 1990s you’d see this side of the country only if you were white. If you were black, colored or Indian this paradise was off limits. The slums, poverty, humiliation, and treatment as a second class citizen were your domain. Whites controlled the country.

 Until the early 1990s, South Africa was governed under apartheid. Instituted in 1948, apartheid was a version of modern day slavery. Though individual black people were not per se owned by white folks, white people as a class dominated non-whites. People’s treatment and their rights were based solely on race. They were divided into four categories. Whites, about 15% of the country, had all the rights and ran and owned the country. Blacks, 80% of the population, involuntarily segregated to live in ghettos, also called townships, had no right to vote, were kept for the most part uneducated or were provided only vocational education, and were treated as sub humans. Blacks were not free to roam around the country; they needed a special travel document that allowed them to travel between ghettos and their place of work. Colored (mainly Indians) accounted for the remaining 5% of the population.

Even more disturbing was that people’s rights varied based on skin color–the more white blood you had in you the more rights you had. Black people had no rights at all, colored and Indian had slightly more rights. The definition of colored in South Africa is someone of mixed race between white and black. There was even a special commission in South Africa that determined a person’s official color (race). In one year, thousands of people would change their color in their official documents through that commission. None went from black to white or white to black, most of the changes were (“upgrades”) from black to colored or colored to white.

 In the early 1990s the country was ready to explode; modern day slaves got fed up with apartheid. They started demonstrations which spilled into violent confrontations with the government. They demanded equal rights and the release of their leader, Nelson Mandela, who at the time had been in prison since the 1960s. The government resisted at first, blood was spilled, but out of fear of a nationwide uprising Nelson Mandela was released. Negotiations between him and F. W. de Klerk, South Africa’s newly elected president, began as result. Apartheid was dismantled, equal rights for all races were established and black people voted for the first time in the 1994 elections. Nelson Mandela was elected president.

 Then amazing transformations began in South Africa.

 Nelson Mandela’s actions after he became president are fascinating to me. This is a person wrongly imprisoned for 27 years by white people, who now had effective control of the country, as his party controlled over 65% of the votes. He did not seek revenge. He did the unthinkable–he united the country. It would have been easy for him to go after his oppressors and try to socialize wealth. After all, a small minority of the population controlled all the wealth of the country. What is easier than taking wealth from the rich oppressors who had gotten rich on the backs of slaves, and distributing this wealth to the poor? Though it would have been the easier decision, it would have been the worst decision for the country and for all races. This type of thinking sent Zimbabwe (South Africa’s northern neighbor) back to the proverbial Stone Age. White people would have fled the country and the new owners of businesses and land) would not have known what to do with it, lacking the skills and experience to manage it.

 Mandela and de Klerk received Nobel peace prizes for their roles in the transition. Mandela united a country that was deeply divided, prevented bloodshed in a time of great risk for civil revolt, and put South Africa on the right course to strengthening democracy and capitalism.

 With that historical backdrop, let’s get back to the trip. At first I was touched by the beauty of South Africa, especially the pulchritude of Cape Town; at least the parts visible to a tourist. But as I learned more about the country, I was deeply touched by its transformation from modern day slavery to a capitalistic democracy where everyone enjoys equal rights. Now, people of all races are an equal part of the country that used to be controlled by a relatively small minority.

 South Africa has the most robust economy on the continent, which is kind of like being the best baseball player on a minor league team. After all, the majority of its neighbors are embattled in civil war or suffering from the last one. A peaceful transition from one of the worst civil rights abusers on the continent to a model for other nations, spiked with a healthy dose of capitalism and democracy, has given this country a chance to be a formidable competitor in a more serious league.

 Don’t assume that South Africa doesn’t have problems; it has plenty. Official unemployment is running at 25% or so, and the unofficial number is a lot higher, closer to 40%. The country still has to make up for the hole in education created by apartheid, but the situation is improving dramatically for blacks. People with means, still predominantly white, have access to better private education, but government sponsored programs have made huge leaps since the 1990s.

 While in Johannesburg, I visited the infamous slum of SOWETO, which stands for South Western Township. It is probably the most well known township, as guided tours go there twice a day, and it was the residence for the most famous person on the continent, Nelson Mandela. His house has been turned into a museum.

SOWETO, just like other ghettos created by apartheid, is still around but the contrast in its transformation is very observable. The shacks and matchbox houses (the size of a two car garage) are gradually being torn down and replaced by government built housing. That did not impress me much, as this new housing reminded me of socialist Soviet Union government built houses. You could call them “architectural terrorism.” They were probably designed by Stalin’s or Khruschev’s favorite architect. They were identical ugly ducklings and made all cities look blandly the same.

 What amazed me about SOWETO were the beautiful, privately owned houses that are being erected in the township. The contrast of shacks, government built houses and beautiful new little mansions located side by side is quite a view. Though a lot of non-whites still live in townships, they do it by choice and can buy or build a house in any neighborhood, including previously white-only areas.

Crime is high in South Africa, as poverty is still much, much higher than in developed world countries. I was told not to walk on empty streets at night even in safe neighborhoods. But as long as the country remains on the road of democratic capitalism, the poverty will decline and the crime rate will follow. Most of the houses in semi-wealthy (non-township) neighborhoods have fences topped by electric wire. While crime is an issue, I did not see a single electric fence in SOWETO. Of course, there is little to steal from the shacks of poor people, but the electric fences were even missing around the wealthy houses. I was told that if you try to rob folks in SOWETO they don’t call the police, they just shoot you.

 Politically, South Africa is only slightly more dysfunctional than the rest of the world, even the good old U.S. of A. All corruption charges against Jacob Zuma, a leader of the majority party and likely to become the next president, were withdrawn by a high court (before the case went to trial), and he was acquitted of rape charges in 2006. Most people in South Africa believe that he was guilty, but they’ll never find out, as the case never went to trial. This sounds horrible, but then our senator from Alaska was almost reelected in November after he was convicted of bribery, and then all the charges were dropped in April by the U.S. Attorney General.

 Today, South Africa is still battling with discrimination, but a different one–reverse discrimination. Its version of affirmative action is called black economic empowerment (BEE). Blacks, colored and Indian candidates must be given preferential treatment when hiring decisions are made. As my white South African friend put it, this is a small price to pay for a bloodless revolution that has taken place in the last two decades. I agree that neither BEE, nor affirmative action, is good for the economy or the race they try to promote. I had a very pleasant two-hour conversation on the plane from Cape Town to Johannesburg with a very bright (I mean smart here) black woman who is online marketing manager for LG. She resented BEE because it created a perception that she was hired not based on merit but on color.

 BEE is not good for South Africa, though it was a sacrifice needed to appease population that has been oppressed for a long time. It is by far not the worst that could have happened, but it does produce a “brain drain,” as well-educated, skilled workers are leaving the country.

 I’ll be watching them with great interest to see if South Africans still vote in this election along racial lines. The African National Congress, the party of Nelson Mandela, has been ruling the country since 1994. Absolute power corrupts absolutely and thus many perceive this party as being corrupt. Though ANC and its current leader Zuma are expected to win, this year ANC has a new challenger, the Congress of the People (COPE), a party that was started by ex-ANC members who are respected by non-whites. The emergence of COPE provides a hope (I know it rhymes) that presents a formidable opposition force that might prompt ANC to clean up its act.

South Africa’s success in the future will be determined by several factors:

• The country’s ability to remain a capitalist, free market economy. It has a long history of this, along with a Roman-Dutch-English legal system and property laws. 
• Maintaining democracy and equal rights. This is the country’s biggest test. If it maintains equal rights for all races, in this case especially for minority whites, it will stop the “brain drain” and people who left may actually return. 
• Educational achievement. Apartheid has kept 85% of the country intentionally uneducated. Education will solve a lot of the problems in South Africa. Unfortunately, it is a slow process that requires substantial upfront investment and a long-term payoff period.

The history of the continent doesn’t bode well for South Africa’s future. It is full of starts and failures, riddled with examples of what not to do. So far, South Africa has defied the continent’s history. Hope is the word that describes South Africa and its transformation from what appeared like a hopeless situation in 1990s to by far the most progressive political and economic force in Africa. It gives me the feeling that almost anything is possible.  

Click here to see pictures from this trip (opens PDF).

Vitaliy N. Katsenelson, CFA, is director of research at Investment Management Associates in Denver, Colo. He teaches a graduate investment class at the University of Colorado at Denver and is the author of Active Value Investing: Making Money in Range-Bound Markets (Wiley 2007).

The contraction was led by plunging sales of Japanese cars and trucks in a weak US automobile market. Exports to Europe also declined while growth in shipments to China and other Asian countries – including sales of Japanese factory equipment used in those countries’ own export industries – slowed sharply.

Note that deceleration in growth in demand from “unstoppable” China. As you can see from this FT article – a demand for steel started to decline in China – a second sign.

Indian iron ore exporters on Monday warned that demand from steel mills in China had fallen sharply over the past month and that Chinese buyers were defaulting on contracts with suppliers.

Could the Japanese slowdown in sales of cars be driven solely by high oil prices? Could Chinese decline in demand for steel be driven by post Olympian (short-term) slump? I suppose. But in the past neither country had to make an excuse. The probabilities have just increased that we are facing worldwide economic slowdown. That may not be a bad thing. We need things to cool down and normalize. But if you think the “stuff” stocks (energy, materials and industrials) are “growth” stocks that are just taking a breather before they embark on a continuation of the run we saw over last four years, think again.

I hope the following two articles will explain why I think that may not be the case.

Look to the margins when using the price/earnings ratio

Chinese and Starbucks Late Stage Growth Obesity

If you would like to receive my articles by email (usually couple days before I post them to this website), drop me a line (clicke here).