June 20, 2017 higherground

Letter from William White and Richard Wood re Trump’s Cuban Announcement.

Dear investors and friends,

You will have noticed that President Trump gave a fiery speech on Friday in which he outlined what he described as a new policy towards Cuba. We write to give our views on (a) what the changes will in reality consist of, and (b) how these are likely to affect future gains of the Higher Ground Antillean Fund.

The changes: perception versus substance. Despite Friday’s sound and fury, it is notable how little of importance will change. Diplomatic relations and the embassies continue, the liberalised OFAC rules on Cuban access to USD payments are unchanged, the regular dialogue on such key bilateral issues as migration, narcotics control, environmental protection, overflights are maintained, and agricultural and telecom sales, direct air travel and ferries and cruise liners are all unaffected.

Only two modest facets will be tweaked: Some tightening of travel and tourism rules for US persons have been announced. But note that there is a 30 day period for “comments” from interested parties, one assumes US airlines, credit card companies and hotels. The actual regulations will not be amended until ” some” time thereafter. Second, there are new prohibitions on US persons doing business with entities owned or controlled by the military, whose civilian businesses are extensive (and have excellent payment records).

In what is becoming a familiar feature of the Trump presidency, this dichotomy between the media impact and actual policy enables Trump to fulfil his campaign promises to elements of his base, whilst in fact furthering traditional U.S. and corporate interests. In this case, the medium term outcome for the U.S.-Cuba relationship, inevitably driven by geography and economics, will be a neighbourly one of gradual economic integration, with Cuba; a natural destination for U.S. travellers and market for U.S. exports.

Impact on Antillean. U.S. laws have an important, although second order effect on us. It will be obvious to you that the U.S. cannot affect the legality of what we do as Canadians and Europeans vis-a-vis Cuba. Our countries have similar trading and financing relations with Cuba, as they would with any other frontier economy. The ‘plumbing’ of the fund was designed to work with or without the easing of restrictions that Obama brought about. So our operations are unaffected.

However, secondary effects can impact the Fund. For instance, there may be a modest fall-off in revenues from US tourists to Cuba, who will probably suffer more form-filling upon their departure and return. This may have some negative effect on the amount of USD coming into Cuba, and flowing to the obligors in our portfolio.

So how much fewer U.S. travellers will come? Nearly 285,000 Americans visited Cuba between January and May this year, surpassing the total number of U.S. visitors during all of 2016 (284,900), according to data from Cuba’s National Office of Statistics, EFE reports. The numbers, originally posted on Twitter by José Cabañas, Cuba’s Ambassador to the U.S., and Josefina Vidal, Director of North American Affairs in Cuba’s Ministry of Foreign Relations, represent a 145 percent increase over the 116,000 U.S. travelers who visited Cuba in the first five months of 2016.

Join us in some back-of-the-envelope calculations. If the 145% increase seen in Jan-May this year were applied to the 2016 full year tourist numbers, we could expect 700,000 US visitors in the whole of 2017, of whom 400,000 are yet to arrive (June through December). Let’s assume that the new strictures cut that number by a quarter, so 100,000 fewer US tourists than expected. And that each of those tourists spends $2,000 with Cuba making a gross margin (USD brought in minus USD needed to be paid out to support each tourist) of 30%. Gain to the island’s FX reserves of $600 per US visitor. Under those rough assumptions, these regulations might cost Cuba $60million p.a. Cuba’s total imports of goods are $11.063 billion, (Economist Intelligence Unit). So this drop in FX revenue is worth 0.6% of what Cuba needs to pay for her imports, (that’s payments to us inter alia). That is manageable, we think.

Equally, there may be upside for the Fund. The restrictions on U.S. persons doing business with well-managed, strongly cash-generative civilian businesses owned by the military, may add to the often self-inflicted compliance difficulties faced by some of our bank competitors, such as Republic Bank and National Bank of Canada. They may be forced to decline discounts of obligations issued by these businesses, which will diminish competition and over time, raise rates.

We are fixed income, not equity investors in Cuba. We hope that Cuba flourishes in the long term. But in the short and medium term, all we need is for each of our instruments to be repaid on time. At the same time, our returns on this strategy are boosted by irrational U.S. policy towards Cuba. TELMEX, the incumbent Mexican fixed and mobile operator pays 2% on its 1 year USD debt. We earn 15% on one year USD obligations of ETECSA, the Cuban fixed/mobile operator. How much of that difference in yield is accounted for by credit quality and how much by capital constraints resulting from the U.S. embargo? We believe that we are being paid far more than we deserve for the credit risk. That surplus is a direct result of the paucity of players and capital available to Cuban trade finance.

Only 6% of our current portfolio is made up of ETECSA. We would like it to be more. If this U.S. action enables us to take on more of this strong issuer’s paper at higher yields, we will do that.

As always, please contact us if you have concerns.

William White                                   Richard Wood