Wednesday, March 30, 2011

Preparing For Perestroika

CUBA: Preparing For Perestroika
The Daily Reckoning | Mar. 29, 2011, 3:30 PM

Dividing Old Havana from Chinatown is Cuba's Capitolio Nacional, a
monumental edifice with a fateful past. El Capitolio was conceived
during the Roaring '20s, when the island led the world in sugar exports
and the future seemed sky blue.

President Gerardo Machado dreamed of turning Cuba into the Switzerland
of the Americas. He decided that his 4 million countrymen needed a domed
capitol building even taller and more ornate than the one he toured in
Washington. So Cuba's Congress dutifully poured 3% of the country's GDP
into their new home. (This would be akin to the US Congress spending
$420 billion for a new office today, but let's not give them any ideas…)

It took 8,000 skilled Cuban laborers just three years to complete El
Capitolio, which featured gilt ceilings, a giant diamond embedded into
the pristine marble floor and the world's third-largest indoor statue.
However, the showy project couldn't have been more poorly timed. Work
completed in 1929, just as America's stock market crashed and the Great
Depression unfolded.

The Smoot-Hawley tariffs crushed Cuban sugar prices by 74%. When El
Capitolio's ribbon was cut in 1931, Cuba's economy lay in tatters.
Machado was forced out of office, and his dream building would perform
congressional service for only 28 years before Fidel Castro's
revolutionaries swept into Havana and opted for more austere premises. I
don't need to recite the history from here, which you probably well know.

The winds of change are gathering in Cuba, though. Since Fidel Castro's
health nearly failed in 2006, power has passed to his younger brother,
Raul Castro. Raul has quietly reshuffled more than 30 cabinet members to
prepare his party and people for a sweeping economic policy overhaul –
Perestroika al Cubano. Even the semi-retired Fidel seems to have glumly
accepted that change is inevitable, candidly admitting to a visiting US
journalist that "the Cuban model doesn't even work for us anymore."

The global economic crisis whacked Cuba hard. Venezuela cut back on its
largesse as its own economy worsened. Tourism and remittances softened,
while nickel export prices tanked. Furthermore, three severe hurricanes
left a wake of destruction in 2008. Unable to service Cuba's estimated
$21 billion foreign debt, and running out of generous leftist patrons to
hit up, Raul Castro has, apparently, decided he has little choice but to
pry open Cuba's economy.

Castro's wild card is Cuba's oil and gas reserves. The island currently
produces 60,000 bbl a day. But its US-facing northern waters hold an
estimated 5-20 billion barrels of oil and 20 trillion cubic feet of
natural gas. (Note: This compares with 29 billion barrels of oil
reserves in the entire US.) Accessing this undersea oil requires the
sophisticated drilling technology the US excels in. But as long as
sanctions remain in place, the US oil majors are excluded from that
bonanza. Amidst the applause of oil industry lobbyists, the dance for
reengagement has begun, with both partners taking some unprecedented steps.

Raul Castro has issued a far-reaching five-year road map for Cuba's
future economic reform. The proposed changes would put Cuba on a very
similar path to that taken by China in the 1980s and Vietnam in the
1990s. Here are some of the ideas: permit real estate transactions
amongst Cubans, merge the two-tier currency system, close down
inefficient state enterprises, decentralize state ownership, facilitate
private ownership of businesses, distribute idle land to farmers, open
state-owned wholesale markets and further encourage foreign investment –
particularly in tourism.

In recent months, some planned reforms have already been implemented in
an effort to delay Cuba's impending insolvency. Costly subsidies on
sugar and personal care products are being scaled back. The government
announced plans to shed 500,000 state workers (that's 10% of the
country's government work force in a country where 85% of workers work
for the state) and guide them somehow into the private sector.

Cubans are being encouraged to grow and sell their own fruits and
vegetables. The government is inviting foreign investors to develop 10
golf course estates in Cuba, with a new law allowing 99-year land leases
to foreign buyers of plots in such projects. In the old days of Fidel's
revolution, such policies were unthinkable.

So what is the potential for a liberalized Cuban economy?

Just look 90 miles across the straits to Florida. A million
Cuban-Americans call Miami home. Cuba has 60% of Florida's population
and 80% of its landmass, but greater natural resources and a much longer
coastline, so one might conclude that the two are of comparable overall

Perhaps to underscore their similarities, remember the fact that England
and Spain cleanly swapped the two in 1763. Today, Florida's economy is
12 times larger than Cuba's. One reason is that Florida gets 20 times as
many tourists as Cuba, plus an inflow of affluent retirees.

When the US government stops restricting its citizens from traveling to
Cuba, the island will become an instant tourist magnet. Offering short
flights, sunny beaches, cool music, "old world" architecture and cheap
surgery, Cuba should have no problem drawing several million American
tourists a year, as further-away destinations like Costa Rica have done.

Should reforms become comprehensive enough, agriculture seems an obvious
investment play: Half the land is arable, labor is cheap and rain is
plentiful. Cuba's once-vaunted sugar industry stands in disarray, with
80% of the old mills shut down. However, today's high sugar prices
provide ample incentive to revive the sector, along with other
traditional crops such as cigar tobacco.

Despite its long coastline, fisheries and aquaculture remain largely
overlooked. Cuba is a world-class producer of nickel, but other mineral
deposits remain underexploited. And then there's the oil. The entire
power system needs to be updated, financial services developed,
retailing expanded – the opportunities seem endless.

Beyond the subsidized basics, most consumer goods have to be imported,
and imports draw heavy duties. Telecom services are costly due to
government monopolization and inefficiency. The list goes on. In this
environment, it is tough for most Cubans to get by unless they receive
remittances, tourist gratuities or tea money.

All in all, we eagerly await the implementation of Cuba's economic
reforms. As this process unfolds, Cuba could transform into one of the
world's most attractive frontier investment destinations. America has a
long track record of turning bitter rivals into productive partners (a
recent example being Vietnam), and re-engagement with Cuba could be one
of Obama's most notable foreign policy legacies.

Some frontier investors are not waiting for that and are already
investing in Cuba. While 100% foreign ownership is permitted, most
investors enter joint ventures with Cuban state enterprises, which
typically contribute land, labor and sometimes capital. Over 250 such
joint ventures exist, mostly for specific sectors or projects.
Investments are made in foreign currency, eliminating exchange rate
issues, and there are no restrictions on capital repatriation. Corporate
income tax is 30% for joint ventures and 35% for wholly owned foreign
companies, but tax holidays of five-seven years are available.

A few Cuba-focused investment groups have been established that non-US
investors can access. Canada-listed Sherritt Group is a major player in
Cuban nickel mining and, formerly, telecoms. A private investment group
backed by European investors, Coral Capital has restored Havana's
historic Saratoga Hotel, which was recently ranked by Conde Nast as the
16th best hotel in the world. Coral is now planning a number of golf
course, marina, housing and hotel projects, as is Leisure Canada, a
Canada-listed investment vehicle.


Douglas Clayton
for The Daily Reckoning

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