|Risky Business: Investing in Cuba Is More Than Just a Financial Gamble|
By Justin Rohrlich JUN 20, 2012 1:45 PM
"It's hard to argue against weeding out corruption. Sometimes, in the process, you break a couple of eggs."
The regime’s distaste for markets is easy to understand. Because of the markets, people who had been brought up to depend on the state to provide everything had developed some economic independence. Customers had learned the importance of price and had learned to choose their purchases, while market traders had emerged who had learned the subversive skills of bargaining, procurement, and logistics. People had also learned the usefulness of markets as sources of news and gossip outside official control. The results of decades of ideological work were at risk.
Sometimes, the bribes are blatant, like the “free trips abroad, computers, flat-screen TVs or large deposits of cash in foreign bank accounts for senior officials” reported by a South American importer doing business in Cuba before he was accused of corruption and expelled in 2009. Other times, they may be inadvertent (a few dollars for gas) or perfectly acceptable in market societies (paying commissions).
"The forms of persuasion -- let's call it that -- are nearly infinite," said the importer.
And illegal. As one Facebook commenter who appears to be acquainted with Stephen Purvis, writes: “Steve has meant well by ‘subsidising’ the marginal salaries of Cuban management staff -- but we all know that ANY payments of foreign currency to Cubans is strictly prohibited and is regarded as paying bribes.”
Some have suggested that the Cuban leadership simply looked at its runaway accounts-payable column and decided to have the intelligence services “buy out” the government’s foreign partners at an extremely favorable price.
Foreign investors in Cuba have dealt with this before. A backgrounder from the UK Trade & Investment office describes the events of early 2009, when the global financial crisis “sparked a shortage of hard currency on the island and led Castro to freeze the bank accounts of joint ventures operating there.” Castro has been slowly paying out the money, estimated at more than $800 million, since then.”
Sometimes, this is what doing business in a Communist country entails. And, in fact, it’s something a certain type of investor needs to expect.
Why Cuba? What's Wrong With a Mutual Fund?
Investors in emerging markets -- and emerging emerging markets, commonly known as “frontier markets” -- tend to be attracted to accordingly outsized returns. For them, the potential rewards of frontier markets means parking their money far -- both literally and figuratively -- from Wall Street or Canary Wharf. (The countries currently included in the MSCI Frontier Market Index are: Argentina, Bahrain, Bangladesh, Bulgaria, Croatia, Estonia, Jordan, Kenya, Kuwait, Lebanon, Lithuania, Kazakhstan, Mauritius, Nigeria, Oman, Pakistan, Qatar, Romania, Serbia, Slovenia, Sri Lanka, Tunisia, Ukraine, United Arab Emirates, and Vietnam.)
Once a country goes from being a frontier market to an emerging market -- and in the case of China, all the way on to a developed market, it can “start to focus on sustaining its own wealth within its own economy,” says Michael St. Germain, a research analyst at Brighton House Associates. And that’s when new frontier markets like Kenya, and yes, Cuba, replace them.
“If you go back 12 years, most emerging markets were essentially frontiers in one way or another,” Stuart Culverhouse, chief economist of frontier market investment banking boutique Exotix Ltd., tells me. "As people have become more comfortable with the idea of emerging markets, as the Malaysias, the Turkeys, the Brazils of the world all become more mainstream, it has made investors look beyond those countries” to find opportunity.
Naturally, for every reward, there exists a risk. Here’s St. Germain, writing in the BHA Investor Monitor:
There’s no doubt that frontier-market investing has its risks. Geopolitical risk is the most inherent issue. These burgeoning nations are susceptible to political and social instability, which causes their stock markets to be highly volatile. Additionally, investors can find themselves victims of nationalization. Although frontier governments are opening their markets to outsiders, they often remain apprehensive of foreign investment. As companies grow, therefore, and foreign investment and control increases, they are susceptible to nationalization by the government.
Frontier markets also lack infrastructure. Safeguards such as regulatory oversight that are provided by developed and many emerging markets simply do not exist in frontier markets. As a result, investors are exposed to currency corruption and other risks.
Perhaps the largest risk, though, is illiquidity. Being small in terms of capitalization and trading volume, frontier markets are by nature illiquid meaning it can be difficult for an investor to extract himself from a position, if not impossible. Although you can buy your way in to these markets, you may never be able to cash out of your position.
In addition, frontier markets, for the most part, do not have many ETFs or index funds, and for those that do exist, the lack of investor demand decreases liquidity further as well as poses the threat of traders selling at a discount. Generally, the main reward for taking such risk is larger returns, albeit significant ones.
Overall, the sheer scale of the frontier market combined with its demographic trend paint a rather positive picture.
“Twenty-three percent of the world’s population lives in these frontier markets,” St. Germain tells me. “That number in itself is staggering. Plus, the available working population is over 10 years younger than those in developed markets. Over the past decade or so, the effects of technology and globalization have given these markets the ability to cheaply educate their people, and such a ready workforce makes frontiers a logical place to invest long-term.”
That can mean any one of a number of places. Stuart Culverhouse likes Sub-Saharan Africa. Michael St. Germain likes Nigeria and Sri Lanka. Regarding Cuba, the law doesn’t apply to Exotix, which is headquartered in London, doesn’t do business in the US, and is off-limits to US residents (and, in turn, US regulators). Culverhouse is “optimistic over a longer time horizon.”
“There is a significant scope in the country essentially untapped,” he says. “It requires moves both on the Cuban side and the American side; the transition from Fidel to Raul introduced a more pragmatic and commercial agenda and there has been some indication from the US in recent years about a reform agenda, and we have some optimism about where that might lead.”
Is This for Real?
Such endeavors as extralegal payments to staff may be an attempt to speed the change that Kirby Jones, a Washington, DC, consultant described by the New York Times as the “man to see about business in Cuba,” maintains is coming -- only at the Cuban government’s own pace.
“In America, we like immediate change, overnight success,” Jones tells me. “I have been struck by the speed at which Cuba has been changing, though by ‘speed,’ I mean in a Cuban context, not a US one.”
Jones, who has advised companies including Abbott Labs (ABT), General Electric (GE), and Caterpillar (CAT) on Cuba issues, says Cuba’s reserve stems from their determination not to mimic the Soviet Union’s wobbly transition to capitalism.
“I remember walking through Moscow with a World Bank official way back when,” Jones recalls. “He pointed out a McDonald’s (MCD) and said, ‘Look at that -- that’s real progress.’ To him, it was a victory; a symbol of the defeat of Communism.”
But Jones explains that symbols don’t necessarily represent true change.
“It worked well for some -- the oligarchs, the mafia,” he says. “In terms of building a base for fundamental, long-term change, I think the jury is still out. Cuba sees what happened in Russia and is saying, ‘We don’t want that.’ Corruption is a disease that strikes even the most sophisticated countries, including ours -- look at Enron.”
Jones says those doing business in Cuba need to be aware of what has occurred in recent months, though how the corruption crackdown will affect future investment can be a matter of perspective.
“As far as the arrests are concerned, you can spin that negatively or positively,” he says. “It’s hard to argue against weeding out corruption. Sometimes, in the process, you break a couple of eggs.”
Hal Klepak, a Canadian military historian and author of two recent books on the Cuban military and Raul Castro, sees the crackdown as a bullish sign.
"In a country where small-scale but widespread corruption is the rule, if the government is to be seen to be serious about rooting out the scourge, it must show it is doing so at the very top and doing so in a dramatic way," Klepak told Reuters after Amado Fakhre’s arrest last year.
"I do not see it as bad at all for foreign business in Cuba, probably just the opposite in the mid- to long-term," he explained. "But there is also little doubt that it does make many jittery when the problem is such a generalized one."
At the same time, there is a case to be made for not providing a crucial source of hard currency to a regime described by the 2012 Human Rights Watch World Report as “the only country in Latin America that represses virtually all forms of political dissent.”
“The government increasingly relied on arbitrary arrests and short-term detentions to restrict the basic rights of its critics,” the report says, “including the right to assemble and move about freely. Cuba’s government also pressured dissidents to choose between exile and continued repression or even imprisonment, leading scores to leave the country with their families during 2011.”
Further, Cuba hasn’t done much to burnish its FICO score over the years. It has been called a “debt-market pariah,” in an exclusive club that briefly welcomed Argentina in 2001 as it defaulted and devalued its currency and admitted Pakistan as a member in 1998, when it was isolated internationally for conducting nuclear tests. Cuba is the veritable chairman of the board, having served continuously since 1999.
Cuba's Caa1 sovereign ratings reflect a debt moratorium, in place for more than 20 years, which has led to the accumulation of principal and interest arrears. Cuba's ratings incorporate very low economic strength largely on account of the small size of its economy and low GDP per-capita.
Very weak institutional strength reflecting governance problems are factored into Cuba's ratings, along with considerations related to limited availability of information and a lack of transparency.
In addition to weak government financial strength, Cuba's ratings incorporate: (i) the economy's extreme dependence on imported goods, (ii) restricted access to external financing, and (iii ) ongoing political uncertainties.
Which means, in so many words, “good luck.”
Yankee, Stay Home
Though the State Department describes Cuba as having “a hostile investment climate, characterized by inefficient and overpriced labor, dense regulations, and an impenetrable bureaucracy,” there are strict rules to further dissuade stateside investment. Under US law, Americans doing business in Cuba face swift, severe (and constitutional) penalties. From the website of SGR LLP:
The man behind the transformation of Cuba's Fuerzas Armadas Revolucionarias (FAR) into a major economic force is Gen. Raul Castro, Cuba's defense minister and designated successor to elder brother Fidel. Beginning in the late 1980s, as materiel and subsidies from Moscow progressively dwindled, Raul Castro introduced the "Sistema de perfeccionamiento empresarial (SPE)," or enterprise management improvement system, that streamlined the Cuban military's operations. With the disappearance of the Soviet bloc by 1991 and the ensuing severe economic crisis that threatened the regime's survival, the younger Castro went further and established state corporations like the Gaviota tourism group for joint ventures with foreign capital. Today, the military is not only a largely self-financing institution but a major player in the overall Cuban economy.
Raul Castro entrusts a military managerial elite for the day-to-day oversight of the FAR's business empire. Vice minister of defense, General Julio Casas Regueiro, and Maj. Luis Alberto Rodriguez Lopez-Callejas, son-in-law to Raul Castro, serve as GAESA's chairman and CEO, respectively. Key money-making enterprises are also headed by high-ranking officers, as in the case of Gaviota whose CEO is Brig. Gen. Luis Perez Rospide.