Bitcoin and blockchain. How does it work?

Blockchain is a chain of discrete blocks containing information and organized chronologically. Each block consists of a string of 0 and 1 (binary code). The string can be a number, an email address or a bank account. So, when you start adding these discrete blocs, you get a list. These blocks are interconnected with each other with what is called cryptographic hash. By design, block chain is “unhackable” because the data contained cannot be modified. Once the data has been recorded, it is not possible to change it retroactively without modifying the following blocks, making the network collapse. This makes blockchain suitable to track important data that cannot be temper450_1000ed with after it has been recorded like votes or money transfers.

In 2008 Satoshi Nakamoto presented his idea to create a currency that would not be physical, but digital, based on bits. Hence, Bitcoin.

When you pay digitally, in PayPal for example, your bank verifies that in your account there is the needed money to make the payment. Therefore, we depend 100% from these banks. Another concern with common payment method is privacy. When paying online with you credit card, you need to state your name to be able to make the payment, unlike with cash.

Bitcoin works peer to peer (P2P), like common torrents. When you download a movie from Pirate Bay (do not do that, it is illegal), the movie is not stored in a central server, but spread around different computers. When you have your torrenting program open, you allow other downloaders to get access to the movie and download it. This way, you do not depend on a single server but you rely on a group of computers. This increases the reliability of the system, as it is very unlikely that all of the computers will fall off the internet at the same time.

To keep track of the amount of Bitcoin that everybody has, there would be a need for a master record that intakes each transaction made by each person since the beginning. This record would be public, allowing users to track each bitcoin. Users could see through which accounts a bitcoin has gone through. The anonymity is kept intact as we do not know who the bitcoin belongs to. This universal record is called Blockchain.

Blockchain is a sequence of blocks that make reference to the last block and to the next. It is distributed globally, making it secure and public. It is nearly impossible to modify passed records and as long as there are users, the blockchain is kept safe. Each block contains transactions and they are created by the community. Each user can add blocks to the Blockchain, documenting each transaction. These members of the community are called miners. When a miner verifies a transaction, he sends it to the rest of the miners, so they can verify it and add it to the chain. This way, it gets decentralized.

Bitcoin is based in a number of rules.

  1. Blocks are made of text. The text consists of the information of the transaction. Party A sent X amount of money to Party C. Party A lost X. Party C won X.
  2. Each block is about 1MB in size and it will consist of as many transactions as fit in it. Approximately 2000 to 2200.
  3. Each 10 min a new block will be created, so the blockchain will increase by one block each minute. This will also put a cap in the amount of transactions per unit of time. 2000 to 2200 per 10min. 3-4 transactions per second. This is not even close to the amount needed to support a financial system, which is a bit cap limiting the potential of Blockchain.
  4. The miner who creates the block, will get a reward for doing so. The first block to be created rewarded 50 bitcoins to its miner, and every 210 thousand blocks, the number would divide itself by 2. Currently, you get rewarded 12 bitcoins for each block. This generates competition to mine blocks.
  5. From each block, a hash will be generated. A hash uses some data to create a unique identifier. You can generate one here. They have the curious property that if you know the algorithm that generated it, you can, knowing the initial text, generate the hash again. On the other hand, knowing the hash, it is very difficult to work backwards and find the text that generated it.
  6. Each block contains the hash from the previous block, the date and time of creation, the transaction of compensation to the miner that created it and all the transactions that fit in it to complete one megabyte. On top of this information, it will also contain a mysterious data that I will talk about later.

If we go to here we can see all the information about the block, with all the transactions that are included in it. On the right, we can also see the previous and next block. This little detail makes blockchain practically impossible to hack.

 Because of the characteristics of blockchain, each time a new block is created, it gets checked by other miners and added into the chain. In this case, if someone wanted to add a block with double spending for example, other miners would detect it and not accept the block into the chain. The only way to do this would require the hacker to get in control of more than 50% of the mining computers, in which case he would be able to add and delete blocks however he wanted to. A way of doing this would be spreading a virus around computers to make them mine in a fraudulent way. So, in theory, blockchains are hackable, but practically impossible. There have been reports of viruses spreading around the network that “steal” computing power from the infected computers. Then, hackers would use that power to mine more bitcoins.

Satoshi also thought of this and based his solution in the proof of work protocol (POW) The original paper can be found here. This idea was developed to avoid spam. Let us see an example.

Sending mails is very cheap. You just need a sender, receiver and your content, which is text. It does not require lots of data, and so the temptation to send thousands and thousands of mails as spam is big. Therefore, in the 90´s, the POW was developed. This was a series of complicated mathematical calculations that the server asks the sending computer to solve, forcing the computer to consume more resources and making sending huge amounts of spam not viable. POW had some problems when being implemented in mail servers, but as an idea it was very interesting.

 Satoshi knew about POW and so, he decided to implement it in blockchain. By making a rule that the hashes have to have a certain and variable number of 0`s at the start, the only way left to guess the hash is to make multiple tryies until the hash has that needed ammount of 0’s at the start. This avoids the hashes from being completely random, and hard to create. As the blockchain develops, the amount of 0`s increase, making the process longer and more costy. Creating fraudulent hashes is so power and hardware consuming that it becomes inefficient. The amount of 0’s at the start of the hash is defined as “difficulty”. It has been statistically designed so that it takes 10min to create a block. Each 2016 blocks, the difficulty is checked to see if it needs to be increased or decreased. The process of finding a valid hash is referred as mining. Each miner, when he/she finds a valid hash, is rewarded with bitcoins. This is how new bitcoin are created.

Applications

 The use of bitcoin gives the seller and buyer complete anonymity. Thus, bitcoin started to be used in black markets like The Silk Road in the dark net (this site does not exist anymore, although there are someproxies). Even though the accounts where bitcoins and other cryptocurrencies are deposited are anonymous, the tracking of a bitcoin is very easy to do. At all times, each bitcoin can be traced back and see what accounts it has been deposited in. Therefore, a very logical application would be asset management. Traditionally, trade processes have been expensive, especially cross-border. With smart contracts, like the ones presented by the creator of Ethereum, would make the whole process easier and more transparent.

With these smart contracts, where property is defined digitally, smart loans can then be put in place. People with poor credit ratings could use these contracts to receive liquidity in form of a digital currency, and in exchange, post their property as collateral. There is not a big company that has yet found a big market share, but as the technology keeps developing, more news will follow.

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MBS, CDO…World economic meltdown?

Collateralized debt obligations (CDO) are a financial instrument used to spread risk and reward in the market. Using this financial instrument, belonging to the group of the asset backed securities, lenders are able to reach more people in need or want of a loan. This article is going to be very structured in short but abundant parts to ease the exercise of understanding it. We will explore the process of creation of a CDO, from the basic lendee through the financial institution until the final investor is reached. In the picture below, I made a graph that goes from left to right and shows the process of creating the CDO from the original debt.

 Captura de pantalla 2018-04-24 a las 13.51.48

 

The debt and the lending company

This part is easy to understand. No financial engineering has happened yet. There is a lending company (Ameriquest Mortgage is a case of a company that used to provide lending solutions for buying houses) that has (in this example) 6 loans to 6 different individuals. Inside the brackets in the graph there are a three-letter code, the amount lended, also called principal and the interest to be payed yearly. The three-letter code is called credit rating (click here for more information) and is assigned by a credit agency. We will talk about these in depth later. We need to know now that the credit rating is inversely proportional to the interest. The higher the rating, the lower the interest, because the theoretical risk of a default (the lendee stops paying their interests and principal) is lower. Thus, higher the risk, higher the reward. The problem faced by our model lending company is that if they only have 6000€ of cash, they cannot keep lending money and so they are left with 6 lending contracts and have to wait for the lendees to pay their interests and principal back before they can start the process again.

This is when the first work of financial engineering takes place. A loan is an illiquid asset, meaning that it cannot be transformed into money in a short span of time. You’re stuck with it until the person you lent your money to pays back. This can take up to 40 years in case of a mortgage.

And so, at this point, the lending company takes its 6 loans, packs them together and makes a Mortgage Backed Security (MBS. The packing process is called “securitization”). This can be imagined as a bag with a certain number of contracts (the 6 original loans) that will yield each month a certain amount of interests (in our model 8,6% annually, taking the average of interest payed). These MBSs are sold to a financial institution like Goldman Sachs for example. Now that the MBS has been sold forward, the lending company gets back the original principal plus a small bonus and can start providing mortgages to new clients. Also, the risk of default has been transferred with the MBS to the new owner, in our case Goldman Sachs.

 

The Financial Institution and the CDO

The MBSs that the lending companies like Ameriquest sold forward did not get the interest of private investors like hedge funds or pension funds. Hedge funds considered MBSs not yielding enough. Instead, the pension funds found the MBS too risky (they are by law limited to invest in highest rating securities[AAA]). And so now the financial institution is the entity getting payed the interests of that debt but also carrying the risk.

To deal with this risk, they designed a way to pass the risk and the yield forward. This new method was called CDO. Each CDO was composed by different tranches each belonging to different credit ratings. When investing in a CDO, the investor could choose in which tranche to invest, so the pension funds could go for the highest quality tranches and the riskier hedge funds could go for the low-quality/high-yield tranches. Each year, the CDO would collect its interests and principal payments and share them through the investors according to their tranches.

At this point everybody is happy. The lending company sold their 6000€ in loans forward as an MBS to the financial institution, getting their small piece of the interests. The financial institution sold created the CDO and let the investors invest in it, getting their commission from the transaction. The investor money feeds a wheel that powers the lending machine.

 

But how do they really work?

The reader might ask him/herself what difference is there between having a tranche AAA or a tranche CCC more than the logical alpha difference? Well, the way the cashflow coming from the mortgage payments is spread gives preference to the owners of the triple A tranche, before paying then the second-best quality tranche and so progressively until reaching the worst quality graded tranche. Let’s see a mathematical example:

The total interests to be payed by our model CDO can be easily calculated with Matlab or a calculator:

Captura de pantalla 2018-04-24 a las 15.21.44

The code will return us the yield in euros and in form of percentage: 520€ (8,6667% of 6000€). This situation will allow each tranche to get paid the full amount of the interests owed to them. In case some client defaulted from the CCC tranche for example, the investors in the riskier portion of the CDO would not get paid in full.

Let’s say that instead of 520€, the CDO sees an inflow of 450€. Who gets paid? First, the investors who bought AAA tranche are paid. Their interests are 5% of 2000€ = 100€. Now there is only 350€ left. Second the BBB tranche gets paid. Their interests amount to 9% of 2000€ = 180€. Once they get paid there is only 170€ left and so it is turn to tranche CCC receive their fair share of the pie, but there is a problem. The interests of the tranche CCC are 12% of 2000€ = 240€, but they can only be paid 170€. Thus, will suffer the risk of the defaults in the greatest magnitude.

The best way to visualize a CDO is by imagining a skyscraper. Each floor of the building represents a tranche in our CDO. Now imagine there is a flood. The water represents the credit default. As the water keeps rising (more defaults), it will gradually affect a higher floor. Those floors under water will not receive any alpha.

 

History

The first CDO was issued in 1987 by Drexel Burnham Lambert Inc for Imperial Savings Association (none of the companies exist anymore). Until the end of the 90’s, the collateral of the CDO was generally corporate and emerging market bonds. In the 2000s the market for CDO skyrocketed from $69 billion in 2000 to $500 billion in 2006. Between 2004 and 2007, $1.4 trillion worth of CDOs were issued.

Early CDOs where very diversified, including corporate bonds from very different industries to student loans and credit card debt. This ensured that if one industry would have a downturn, the CDO would not suffer as greatly as the industry itself. This was used as a selling point. CDOs also returned sometimes 2-3 percentage points higher than corporate bonds with same credit rating.

CDO_-_FCIC_and_IMF_Diagram

 

Bad reputation. Where does it come from?

It is hard not to talk about the CDO’s without talking about the economic crisis of 2007-09 in the US. After the tech bubble burst, amid concerns of a recession, interest rates were lowered by the Federal Reserve. This forced lenders to lend more to get the same amount of money they would make before (if you make 200€ from a 10% interest on a 2000€ principal, you need a 4000€ principal to make 200€ with a 5% interest rate).

Accumulating more debt was not financially intelligent from the risk management point of view and so the lending companies would sell the debt forward to financial institutions and those would create the CDOs. Thus, the CDOs would spread the risk through the financial system. There is a very interesting paper found here written by Raghuram G. Rajan for the National Bureau of Economic Research in 2005 that analyzes the increase in debt inside the financial sector and the risk it adds.

The influx of money into the mortgage business was driven because of banks entering the market, speculation by home buyers and US government policies aimed at expanding homeownership between the working class. I will try and show the different points and how they all collaborated to make the 2007 recession happen.

 

2007 crisis and the investors

Let’s start by analyzing first from the investors point of view. As the Federal Reserve decreased the interest rates previous to 2006, the investors were forced to lend more money to achieve same alpha in terms of euros or dollars as explained briefly before. To be able to lend more money to more people, credit requirements started to get lowered. Consequently, customer with worse credit ratings started getting loans for their houses. These mortgages became known as subprime mortgages.

united-states-interest-rate@2x

Another widely blame factor for the recession was the derogation of the Glass-Steagall act (Banking act). The Banking act was put in place in 1933 after the Wall Street Crash of 1929 to separate deposit banking from investment banking. This act was widely criticized and in 1999 President Clinton publicly declared that the law was no longer appropriate and so decided to derogate it. Since then, commercial banks were allowed to invest and deal in non-governmental and non-investment grade securities for themselves and customers stimulating the influx of capital into the mortgage market.

subprime_mortgage_originations_1996-2008.gif

Other policies by the US government like the creation of Freddie Mac and Fannie Mae (these banks were sponsored by the government but were built long before the crisis. In 1970 and 1938 respectively) also spurred the signing of subprime loans. With the excuse of facilitating house ownership to low and middle-income people, subprime loans were granted like there was no tomorrow, securitized and pushed into the financial system. Michael Lewis, writer of “The Big Short: Inside The Doomsday Machine” (can be found here) made famous the case of a strawberry collector in California that was making $14,000 a year and got a mortgage for approximately $750,000. If he spent 100% of his salary (before taxes) to pay for the house, it would have taken him 53 and a half years to pay it off. The society in general had the feeling that housing was a very solid investment and prices could never fall.

I can’t finish this part without mentioning the fault that credit rating companies had in the events of 2007. These companies get paid by banks and financial institutions to rate the products created by these same financial institutions, and thus face a high conflict of interest. They have to give an objective rating to the same people who are paying them, and we all know what kind of pressure it puts in the rating agencies. The shadow banking community would use the threat of not returning to certain agencies if their products where not generously rated, creating a false hope of security to investors. (Want to know what that shadow banking system is? Click here.

With this fear in mind, rating companies used the argument of great diversification to give high rating to bad loans and NINJA (No Income No Job or Assets) mortgages. Sometimes, even tranches of CDO A where put inside CDO B and then tranches of CDO B where put inside CDO A, and then both where put inside tranches of CDO C. This is an example of how complex and diversified these products are. This complexity and diversification does not make them more secure as the underlying assets are still of very low quality. In a scene of the movie “The Big Short” CDOs are defined as dog shit wrapped in cat shit. This helps understand that even though there are different assets underlying, they are both shit nevertheless (bad quality is not inside the definition of CDOs, but before the financial crisis, most CDOs had a high percentage of bad quality products).

 

2007 and the home-owners

If we look at the happenings from the home-owners point of view, we can see how the increase in housing prices allowed an orgy of over spending and debt to go on.

As more people were given mortgages, the demand for housing increased, increasing prices. With the revaluation of the owned house, a person would get a second mortgage to buy a second house for speculation or refinance their current mortgage to include their credit card debt or a new car. This refinancing was based in the idea of the house always increasing in value, giving a false sense of wealth. A good example of this is shown in the movie based on the same book by Michael Lewis, when one of the main characters goes to a stripper club to ask the dancer about her finances (found here). The stripper confesses in the scene that she has 5 houses and a condo, and when loan companies ask her about her job, she just writes she is a “therapist”. No further research done in her back-payment capabilities. All this over indebtedness led to people consuming over their possibilities and so it stimulated the economy.

 

What started the recession?

When the mortgages had been signed, a technique called predatory lending was used. The name is quite self-explanatory. This consisted in unfair, deception and fraudulent practices during the loan origination process. These practices where done by a wide number of lending companies. The most common “trick” done on the lendees consisted in presenting them a contract with an Adjustable-Rate mortgage. This meant that for the first few years, they would pay as an example 5%, and after the 3rd or 4th year, the interest would raise to 14%, increasing monthly payments. Thus, the number of defaults started to raise when the higher rates would start. This was by the end of 2006, start of 2007. The graph does not require further explanation.

Captura de pantalla 2018-04-24 a las 18.26.02

With the increase of defaults, more houses entered the market making the supply surpass the demand and consequently home prices decreased very abruptly. Here is another graph showing the evolution of housing prices developed by JP. With the further decrease of price, lendees found themselves without opportunity to refinance their debts and had to return the keys to the banks. As you can see, a domino effect swept across the economy bringing the country into a recession. If you want to see an explanation in video format, I recommend a scene from “The Big Short” movie (found here).

Captura de pantalla 2018-04-25 a las 14.36.47

 

Credit Default Swaps (CDS)

I did not want to finish this article without stopping a second to talk about Credit Default Swaps. This product belongs to the group of derivative products. They are related to CDOs. They can be considered as insurance on the CDO’s payments. Let’s take the case that you buy participations in CDO A sold to you by JP Morgan. For a small yearly fee, you can buy a contract by which you get the guarantee that JP Morgan will pay the money that the CDO has to deliver in case it does not. With the past behind our backs, it is easy to look back and say that it was a stupid idea from JP Morgan (and all other banks) to provide these insurances on products based in bad quality loans. But, as mentioned previously, nobody could imagine that housing prices would go burst and there would be such high default rates around the country. These contracts (CDS) nearly dragged down several banks and insurance companies, being the most famous case AIG. AIG had CDS covering more than $440 billion and they had nowhere close to that amount of money. More information on AIG and their CDS problem here.

 

So, is it good or bad?

Our economy is based in credit. If every person had to wait until they had saved money to start a company, very few people would do that. With credit for a new factory, for example, we are being advanced future cashflows that the factory will create. We will pay back the credit with the profit generated with the company. We definitely need credit. They present a risk for the lender and lendee, but both parties are able to bear with it.

By the end of the 80’s, lenders found the way to pass that risk allowing them to provide more credit. This is not bad per se. As long as it is used to buy something useful at a reasonable price, credit represent a great advantage to our economy.

The problem arises when lenders and lendees lack the responsibility to evaluate the consequences of their acts. Lenders started spreading risk everywhere that infected the system. On the other hand, lendees went into spending madness stimulated by the increasing prices of their owned homes. This gave a false hope of wealth to the economy that started growing based in debt. I wanted to write the verb own in cursive as the feeling of having a house was quite surreal. The house was ultimately owned by the owner of the CDO in which the debt had been packed into. The years previous to the recession were dominated by a fake feeling of ownership and safety that we have to try and prevent from happening again to the best of our ability.

 

Djibouti, the African Singapore?

Since 1977, Djibouti enjoys independence from France in one of the most important territories of the Horn of Africa. In 1994, the country broke into a civil war that lasted 2 years between the People’s Progress Assembly (in government) and the Front for the Restoration of Unity and Democracy (FRUD). The conflict reached an end when the main faction of FRUD signed an agreement to share power, even though the more radical factions of FRUD continued fighting until 2000 when a final agreement is reached. Some ministerial posts were assigned amid this agreement.

In 2003 the People’s Rally for Progress* (RPP in French) joined forces with FRUD under a coalition called Union for the Presidential Majority. UMP elecCaptura de pantalla 2018-04-10 a las 16.07.24ted as their leader Ismaïl Omar Guelleh (previous leader of the RPP) for the parliamentary elections of 2003 and 2005 presidential elections. Not so surprisingly, they won all the parliamentary seats and Guellehwon the presidentialelections with 100% of votes in favor (the opposition did not present any candidate as a boycott). Guelleh had served as president from 1999 on. The Djiboutian constitution limits each president to 2 terms so a change in the constitution was implemented to abolish the limitation. In April 2016, Guelleh started his fourth term as the president of Djibouti.

In general Djibouti can be spoken of as a certainly calm country, especially when compared to its neighbors. In the south it has Somalia, in the west it shares its border with Ethiopia and in the north the Al-Qaeda supporting Eritrea is located. Djibouti is home to Camp Lemonnier (the only permanent U.S. military base in Africa) as well as French, Japanese, Italian and Chinese troops. Saudi Arabia and UAE have also been showing interest in positioning their troops in the third smallest country on the continent’s mainland. This great presence of foreign military forces in its territory has helped the local economy immensely providing safety to commerce as well as need for local services.

Djibouti owes its existence to three big causes. Due to its strategic place, nearly all the cargo shipments that wish to sail through the Suez Canal need to pass by Djibouti, converting it into an international hub.

Due to the first reason, the political situation in the Horn of Africa and the attacks of 9/11 in New York City, a second source of growth arrived. After the twin towers fell, United States created a special Task Force meant to be deployed in the Horn of Africa, in Camp Lemonnier. Other countries followed. Djibouti is the base from where drone and manned operations are conducted against pirates and Al-Qaeda factions present in the area and close countries likeYemen.

As a third catalyst of change in the small country was war. When in 1998 conflict between the independence seeking Eritrea and Ethiopia broke, the latter channeled all its trade through Djibouti instead of Eritrea, which would have been a more logical hub to go to. This brought a large economic impact. In the year 98, the pass of Ethiopian cargo through Djibouti quadrupled. The Ethiopian economy has also been enjoying a steady 10% increase of gross domestic product annually[1] in the last few years, further helping Djibouti. Despite the growth of the neighboring country, Djibouti has relied more on the gulf countries to expand its harbors and other infrastructures to meet demands from new and more important clients like China. Specially Dubai, through the state-own company called Dubai Ports World (DPW, owned by the holding company Dubai World and chaired by Sultan Ahmed bin Sulayem). DPW entered a $400 million harbor upgrade[2]  in Doraleh in 2009. Dubai sought with this move to confront the competition posed by Oman’s renewal of their main harbor in 1998. Djibouti Free Zones and Port Authority (DFZPA) owns two thirds of the endeavor. The remaining part belongs to DPW.

Despite all the different countries involved in Djibouti, Ethiopia remains the single most important user of Doraleh’s and other close cities’ harbors. Thus, in 2011, Djibouti and Ethiopia engaged in a project to modernize the railway connections between the two neighboring countries. The project was given to China Railway Group and China Civil Engineering Construction Corporation (CCECC). The total investment was $4 billion[3]. The lines in the Ethiopian side of the border would take 85% of the total costs, partially financed by the China Exim Bank (70%) and the local government (30%). This project would connect Addis Abeba (capital of the western country) with the smaller Djibouti and make connections between the coast and the capital faster.

Together with this railroad venture, Djibouti connected to the Ethiopian electrical grid** to import energy that same year. The transfer of electricity summed up to approximately 60MW. This lowered costs to businesses and private users.

Opportunities in Energy

Energy production and distribution in Djibouti is very poor. With transmission losses as high as 16%, there is a great deal of opportunities to increase performance in such an essential part of the economy. With the construction of a morereliable and efficient grid there would also be an increase in other fields of the economy, such as the manufacturing sector (it only accounts around 20% of the GDP. In 2013, the World Bank’s Djibouti Enterprise Survey showed that approximately half of companies in Djibouti claim access to electricity to be their main obstacle. This study also showed that 25% of the costs of a business comes from the electricity bill).

Currently, heavy reliance on fossil-fuel production, mostly imported from the gulf countries, keeps Djibouti exposed to price volatility. In 2014, Djibouti launched its long-term plan, called “Vision 2035”. This plan aims to direct the country towards renewable resources. By 2020 they want to have moved from 100% fossil sourced to 100% renewable. The sources would be mainly solar, geothermal and wind, but also imported energy from Ethiopia, whose production is based on hydropower.

Captura de pantalla 2018-04-10 a las 19.43.13

Djibouti has tremendous solar energy potential. Areas of the world famous for their solar energy production like Germany or Phoenix, Arizona have a Global Horizontal Irradiance (GHI) of 3.5kWh/m2/day and 5.7 kWh/m2/day respectively. In Djibouti it varies depending of the area between 4.5-7.3kWh/m2/day.

Studies show that Djibouti has also great opportunities for wind energy to be transformed into electricity. There are no on-grid wind power plants. However, studies show that there are areas of the national territory with potential. In the area of Goubet, analysis show that a grid-connected production plant could be installed. In the study a hypothetical plant was used that had a reference capacity of 20MW and a cost of $2500/kW. The project would have a payback period of approximately 10,7 years and an operation time of 20 years. Of course, the feed in price would ultimately determine the viability of the project. Here is a graph developed by the International Renewable Energy Agency (IRENA) showing the selling price, payback period and the revenue:

 

Captura de pantalla 2018-04-10 a las 20.16.41

 

Once the energy producing industry reaches a certain level of development, new opportunities will appear in the transmission sector. Djibouti is located in Africa and very close to the Arabian Peninsula. With a modern and efficient grid, energy produced from renewable resources could help Djibouti become a place from which to transmit energy towards the members of the Gulf Cooperation Council (GCC is formed by: Bahrein, Kuwait, Oman, Qatar, Saudi Arabia and UAE). CO2 emissions in countries members of this coalition are of increasing concern and so both parties would be interested in the deal (GCC to reduce CO2 emissions and Djibouti as an energy exporter).

Renewable energy present a lack of reliability. You cannot make the sun shine or the wind blow on demand. In the case of Djibouti this can be solved with a good connection infrastructure to the Ethiopian grid. The neighbor country has a network of production plants much larger than Djibouti, based in hydropower, which is a constant source. Djibouti energy consumption would represent 4,6% of the Ethiopian consumption. Each country consumes 0.376 billion kWh and 8.14 billion kWh[4] respectively so there would not be a problem to incorporate Djibouti into the Ethiopian grid.

The main challenges facing investments in the energy sector in Djibouti are the import tariffs (There is no local manufacturing industry, so all the technology needs to be imported) and the 33% VAT. Also, the lack of regulation and the levels of judicial security have been of great concern to international investors. (This fear was increased by the conflict between DPW and DFZPA. The dispute was over a deal in which allegedly DPW had not respected the sovereignty of Djibouti[5]). To promote private investments, authorities (Electricité de Djibouti,EDD, http://www.edd.dj/) liberalized the sector in May 2015. EDD kept distribution and transport, but the new law allowed private enterprises to generate power. This law included some tax exemptions for renewable energy producers. The strong will showed by politicians and a stronger legal framework can lure international capital to invest in the small countries. Work has been done, but there is still lots to be done.

Manufacturing and international Hub

Currently there are a few investment projects going on together with “Vision 2035” aiming to make Djibouti a world business center. Currently the economy is based on providing services for the transport industry. There is no local agriculture and most of the food is imported from neighbor countries.

On average, each day 45 cargo ships cross the Suez Canal. These ships connect Europe, Far East, the Horn of Africa and the Persian Gulf together. 60% of the port usage consists in cargo vessels, and fossil fuels amount to 16% of the usage[6]. This strategical position has given Djibouti the reputation as the bunkering and transshipment service hub. Djibouti is currently building new Liquid Natural Gas (LNG) and oil terminals to further increase their role as a refueling center for both commercial and military vessels.

As a transshipment provider, the coastal country is in charge of receiving cargo from one ship, storing it until another ship with the right destination arrives and gets the cargo. This is the kind of service the Singapore harbor also provides.

The strategical position has attracted foreign investment to develop further the current infrastructure to make it more modern and efficient, even though great inefficiencies are still present.

As an example of the inefficiencies happening in the port, the case of Ethiopia in July 2016 can be shown. During that time, the landlocked country was suffering one of its biggest drought in decades and was forced to seek international cooperation for the import of wheat (Ethiopia is the biggest wheat consumer of Africa). All this help was sent to Djibouti, meaning that extra ships where coming to the already busy port. By the middle of July, 33 ships were waiting at anchorage and 12 were expected to unload 470 thousand tons of wheat.  Some ships that arrived in February, were not released until May according to African Business Magazine. On top of this problem, a bottleneck is created because just under half of the roads in Djibouti are paved, making the transportation of goods and foreign aid to Ethiopia slower.

To deal with the infrastructure shortage, the local authorities have struck deals with different private and state-owned companies from other countries like China or UAE.

The widely talked “Belt and Road Initiative” developed by China arrived in Djibouti in 2016. The Djibouti Silk Road Station is part of the “One Belt and One Road” initiative launched by President Xi in 2013. This project will connect the small country with the main industrial cities in China. The agreement signed between the DFZPA and the Silk Road E-Merchant Information Technology Co. Ltd stipulates the setting of a currency clearing system using Gobebill Payment’s services, establishing a transit trade center, export processing zone, free trade zone and a commodity collecting and distributing center. Not agreed but envisioned projects also include building an extensive data cloud computing platform and congress center. In 2015, Djibutian port authorities signed an agreement with China Merchant Group to build the Free Trade Zone (aprox 48km2).

This new Free Trade Zone is expected to create 340,000 people indirect and indirect jobs in the next 10 years according to the Oxford Business Group and is expected to handle $7 billion in trade within two years. The area will feature manufacturing, transport, electronic trade and regional distribution businesses. This will help to industrialize the country.

After analyzing the country and its future I reach two conclusions. First of all, this small country has lots of potential. It has the capability to become a trade and financial hub, like for example Singapore. It is not unknown the story of success that surrounds the Asian country and how it transformed itself from a fishing town into one of the main financial and commerce capitals of the world. Thanks to free trade, easiness to invest, its strategic position and the strong legal framework, outside money flowed into Singapore to make it into what it is known for now a day. Djibouti needs to strengthen its regulatory system and its implementation to reach a similar growth like Singapore enjoyed.

Nevertheless, Djibouti still presents a very low proportion of skilled labor and so it will present a liability into the development of local businesses. Only the Free Trade Zone is going to demand approximately 34000 skilled labor a year, and the local government has not been taking big action to solve this deficiency. The dependency of the country from Chinese money is also worrying, as the Asian giant’s account are not known for their transparency. Nobody knows what the numbers really look like. Their economy is based in a huge bubble of debt, and its uncertain if it is going to go burst. In case the projects were left without finishing them because of a recession in China, this would real affect the local economy. Despite this fact, the commitment of the investors looks serious and the amount of completed projects is already important.

In the end, the destiny of the Djibouti lays on the hands of the territorial government and their attitude to push forward the needed political agenda and reforms to reach this goal and become the African Singapore. The country is in an embryonic state for investment and even though the outlook is good, without the political will all this potential can be lost.

Hugo Casao

@CasaoHugo

 

[1] https://tradingeconomics.com/ethiopia/gdp-growth-annual

[2]  Djibouti: Changing Influence in the Horn’s Strategic Hub, Chatham House, April 2013

[3] https://www.railway-technology.com/projects/ethiopia-djibouti-railway-line-modernisation/

[4] https://www.worlddata.info

[5] More information found in https://www.fairobserver.com/region/africa/djibouti-china-us-investment-development-africa-news-54311/

[6] https://www.fleetmon.com/ports/djibouti_djjib_1278/