Papadopoulos and Sons: Debt versus Equity
by George Hatjoullis
The film ‘Papadopoulos and Sons’ (http://bit.ly/142nAB0) is a good little film which I enjoyed very much and can wholeheartedly recommend, especially to Cypriots. This is not, however, a film review. It is about one message in the film.
Harry Papadopoulos arrived in London as a baby, a refugee from the 1974 Turkish invasion. From Fish and Chip shop beginnings he builds a Cypriot food products empire. He then overextends himself with debt going into property development and loses all except a half-share in the chip shop. There is a chance he can salvage a part of the property deal with another slug of debt. While waiting for the salvage operation to come to fruition he goes to live in and revives the chippy with his estranged brother, the larger than life but reformed Zorba character, Spiros. The experience resolves unfinished business with his brother (quite a moving scene), resurrects Harry and re-integrates his dysfunctional family. The important message however is that he rejects the salvage operation (which would make him a half a billionaire) and opts for the chip shop. His reason is that he owns it and has no debt. He likes to wake up to that feeling.
The debt versus equity theme is a recurring one in these blogs. The discussion of the Merchant of Venice in an earlier blog illustrates the issue rather well. In finance theory it is normally discussed in terms of which is the cheaper form of financing but this misses the fundamental point. Equity can destroy your present but debt can destroy your future. The reason is that debt inevitably involves leverage and a commitment that lives with you. If you start a business with money you have and never borrow, you can only lose what you had and make. If you start a business and also borrow you can lose what you had and get left with the debt. The debt does not necessarily go away and there is a price to be paid for writing down debt. Of course if you borrow you can expand, make more profit and keep all the profit minus the interest and this is the main attraction. You can more easily keep control of your enterprise but only if successful. Governments encourage you to borrow by giving tax breaks for interest. If you fail you could lose your future.
The intoxicating allure and destructive nature of debt has been understood over time as is witnessed by religious restrictions on debt financing. Today only Islam still actively disapproves and Islamic banking seems devoted to applying Sharia Law. Christianity used to have widely enforced usury laws and the law often handed down harsh penalties to defaulters. Debtors’ prison was not uncommon and, though somewhat self-defeating, a severe discouragement. The world has only to lift its head and see that many of the problems besetting it today originate in the practice of debt financing.
Of course, the remarkable global material economic growth achieved may also be attributed to the leverage afforded by debt. Debt offers people a chance to ‘make it’. However, if they get it wrong it may be a while before they get another chance. For the borrower debt is leveraged risk. However, for the lender debt is also risk. The claim of the debtor may be unextinguishable but if the debtor has no assets the creditor cannot get anything of the loan back. The creditor effectively risks all on a contract and a claim, for a limited return. Basically the only people it is worth lending to are those that do not need the capital, just the liquidity. Debt for liquidity makes sense but not as capital. It is the increasing use of debt as capital that has caused the problems. This is only made possible by leverage and leverage is only possible through debt.
The problems of Cyprus today originate in debt. The previous government borrowed too much. The Bank of Cyprus and Laiki bank invested the bank’s capital in ‘safe’ Greek government debt. Many people borrowed to buy land, build houses, educate their children and fund speculative business ventures. How will they service the debt if they lose their employment? The solution, we are told, is to borrow 10 billion euro, about 60% of GDP. Of this, 1.2 billion may be used to recapitalize the cooperative movement (http://bit.ly/17kiP4x). Debt as capital again. Why am I not reassured?
The security for all this debt is the gas reserve. So the solution is to mortgage the future of the Republic of Cyprus. Nick Butler of the FT has some interesting observations to make on this subject and I recommend all read this article (http://on.ft.com/10swy5F). In essence, do not count your chickens. As I have repeatedly asserted, the 10 billion will not be the last loan. There will need to be more ‘rescues’ for the Republic to remain a eurozone member. The reason is the destructive nature of the bank bail-in on GDP and hence tax revenue. The economic forecasts amount to blowing smoke. So debt caused the problem. Debt will solve the problem and more debt is inevitably going to be necessary to keep the original ‘rescue’ on track. Even less reassured now.
What options does the Republic of Cyprus have? Not many, indeed only one. It can exit the eurozone and the EU. This is not an easy option and one that may be as destructive to GDP as the present option, at least in the short-term. However, exit offers some new degrees of freedom. It can devalue the Cyprus pound. Not only will this provide an economic boost it may also eliminate the real cost of some outstanding debt. Of course, it will lose access to international debt markets, at least for a while. This may not be entirely bad as it means it cannot borrow and will have to look to equity solutions. Foreign direct investment on a profit share basis might be attractive to some sovereign wealth funds and private equity operations. Cyprus can then make a virtue of being small as it will not take much to make a big difference. The development of the gas reserves can also proceed on a sharing basis. It is an option worth considering. I refute the words of Mario Draghi ,that the problems of the Republic are the same in the eurozone as out. There may be less problems out of the eurozone, Mario.