This is currently happening in Europe. Capital is fleeing the already insolvent peripheral countries (Greece, Portugal, etc.) to the core countries (Germany, Switzerland, UK) in a flight to safety. In actuality, this trend is worsening their stance and banking systems. A hedge fund manager framed it nicely saying, “Greece is like a business whose revenue base is declining (GDP), who generates revenue through receivables (taxes), who collects only a fraction of those receivables, and who has a huge fixed expense base that it can’t cut without enraging customers (the voters). This is not sustainable, and definitely not a business you want to lend money to.”
At some point in history most countries have been overly optimistic, borrowed too much, got carried away, and weren’t ready when things deteriorated. However, there is one risk specifically unique to Europe scaring many investors, including myself: redenomination risk. What happens if the Euro falls apart? What if certain countries leave and not others? What currency will your investment be denominated in? What will that currency be worth relative to the dollar? Is there a way to hedge this?
Redenomination is scary, possible, and maybe even probable. So what's an investor to do? My best advice is to 1) study the language of each legal document to understand the ramifications of a currency change and 2) be careful when crafting new documents. As detailed in my previous post, Catalus is now actively seeking European investments. We are working to understand and mitigate redenomination risk, rather than letting it eliminate potential excellent opportunities. I’ve included some articles below on the topic.
Banks Prep for Life After Euro
Time to Think the Unthinkable on the Euro
Also, to review interesting investor letters like the one I refer to at the beginning of this post, visit the Neo-Alpha Blog.
