Tuesday, December 30, 2008

Lessons from the US Consumer Confidence data

US Consumer Confidence indicator (CCI) posted a new record low in the pivotal month of December. According to the Conference Board :
CCI, which had increased moderately in November, declined to a new all-time low in December. The Index now stands at 38.0 (1985=100), down from 44.7 in November. The Present Situation Index plummeted to 29.4 from 42.3 last month. The Expectations Index decreased to 43.8 from 46.2 in November.

Current conditions

“Those claiming business conditions are "bad" increased to 46.0% from 40.6%, while those claiming business conditions are "good" declined to 7.7% from 10.1% last month.”
This suggests that pessimism is taking a stronger hold amongst those who were previously either neutral or optimistic – a sign that this downturn is now being felt not only at the lower margin of earnings distribution, but also at the core middle and upper-middle classes.

Exactly the same dynamic – falling numbers of previously optimistic respondents, along with ‘marginal’ respondents – was evident in the assessment of the labor market:
“Consumers' assessment of the labor market was also considerably more negative than a month ago. Those saying jobs are "hard to get" rose to 42.0% from 37.1% in November, while those claiming jobs are "plentiful" decreased to 6.2% from 8.7%.”

Short-term expectations

Probably the worst piece of today's news relates to the future expectations. In a marked departure from the current conditions trend short-term expectations have shown greater polarization of US consumers away from the center, with marginal respondents migrating toward either greater optimism, or pessimism.

“Those anticipating business conditions to worsen over the next six months increased to 32.8% from 28.3%, while those expecting conditions to improve rose to 13.4% from 11.5%. The outlook for the labor market was also somewhat mixed. The percentage of consumers anticipating fewer jobs in the months ahead increased to 41.0% from 33.7%, while those expecting more jobs increased to 9.7% from 9.2%. The proportion of consumers anticipating an increase in their incomes decreased to 12.7% from 13.1%.”

Lessons for Ireland

In light of the US data, over the next two-three months we should expect:
  • Further deterioration in consumer confidence here, as to date, both the comparative dynamics of the Irish time-series and the underlying fundamentals for CCI in Ireland have been closely following those in the US;
  • Deeper declines in expectations component in Ireland than in the US, as underlying 'misery index' fundamentals for Ireland are showing much more negative future dynamics for Q1-Q2 2009;
  • Significantly stronger shift of previously marginal and optimistic consumers toward deeper pessimism (with respect to both their perceptions of current conditions and future expectations) as Irish downturn starts to feed through to the middle and upper-middle classes at an accelerating rate starting with January.

Monday, December 29, 2008

The price of uncertainty II: Anglo-Irish Bank shares

To continue with my last post's theme:

According to the latest annual results, Anglo-Irish Bank’s loan book carries construction and property sectors exposure of roughly 87% (details in Table 1 below). Given this, the bank is, in effect, a property investment play in the Irish, UK and US markets.
This implies that in the longer-term Anglo’s shares should follow market expectations concerning the ongoing property contraction in Ireland, US & UK. In other words, Anglo’s shares performance should reflect (with a possible lag to account for the differences in timing across the three markets) the fate of the specialty US real estate investors, e.g REITs.

The question is – does it?

Taking weekly closing data for the period of 2006-present for 6 REITs indices:
• SPDR DJ Wilshire REI,
• I-share DJ R EST INX,
• I-share FTSE NRT Residential ID,
• I-share FTSE NRT Industrial/office IDX,
• FTSE UK Industrial REIT and
normalized at 100% for January 1, 2008, I obtain time-series for changes in weekly prices of these indices and the Anglo’s shares. I then construct Blend 1 & Blend 2 synthetic portfolia with specialty REITs weights in each portfolio reflective of the relative share of these types of properties in the Anglo’s portfolio: 18.4% Residential REIT indices, 77% Commercial REIT Indices and 4.6% I-Wilshire Index (Blend 1) and 4.6% I-Share Index (Blend 2).

Figure 1 compares changes in the valuations of these synthetic portoflia and Anglo-Irish Bank shares.
As shown above, US & UK REITs indices, blended to reflect actual Anglo-Irish Bank’s portfolio allocations of loans across various types of property have significantly outperformed Anglo’s shares since January 2008. While year-to-date decline in Anglo-Irish shares has been a dramatic 98.55%, the same period decline in US and UK REITs with exactly the same property markets and types exposure as Anglo’s was only 44.68%. Even at their lowest point (-63.9%), REITs performance was 54% better than that of the Anglo-Irish shares.

Using synthetic portfolio approach, REITs-based analysis predicts that the Anglo-Irish share prices should trade between €3.21 and €5.66 per share. Synthetic portfolio prices Anglo's shares at €3.75 at their global minimum in the first half of October, rising to €5.70 today.

However, the above does not account for the potential upward bias in Anglo-Irish Bank’s shares valuation prior to January 2008. In other words, we must address the argument that deep discounting in Bank’s shares reflects the fact that its peak valuations were more optimistic than the market average. To do this, I computed blended portfolia discounts from peak to January 1, 2008. Controlling for these, Figure 2 reconstructs the synthetic price share performance for Anglo-Irish Bank based on property markets fundamentals and accounting for the differences in timing in real estate contraction between the UK, US and Ireland.Thus, as shown in Figure 2, Anglo-Irish Bank shares have traded at a sector discount between late June and mid October 2008 and since the beginning of December 2008. Using full-sample simulation, Anglo-Irish shares are fundamentally valued at around €1.09 per share in the current market conditions as opposed to the actual share price of €0.15 today. Note the accuracy of the synthetic portfolio in tracking Anglo's shares since, roughly May 2008.

While the above exercise is not 100% accurate, it does suggest that the markets are currently discounting Anglo’s shares at a rate much greater (ca +13.7%) than warranted by the bank’s exposure to property markets.

There are two possible explanations for this excessive risk premium:
(1) the unexplained risk premium reflects lower quality lending by the bank than the average for REITs; and
(2) the unexplained risk premium accounts for the terms and conditions of re-capitalization scheme announced by the Irish Government.

While the first argument is impossible to assess, given the lack of data on Anglo-Irish Bank’s loans time structure, the second argument can be partially ‘priced’. The re-capitalization scheme will imply a dilution of existent shareholders’ equity to ca 20%. This suggests that the actual price target for the Anglo-Irish Bank shares should be around €0.22-0.25 per share. The associated regulatory risk-premium on the Anglo’s shares is, therefore, in the neighborhood of 69% of the share price.

No coincidence this estimate is so close to the 76% regulatory risk premium for the entire Irish Financials sector estimated in the preceding post…

Sunday, December 28, 2008

The price of uncertainty

Here is something that we have been discussing in my Investment Theory course in Trinity’s MSc in Finance: the role of LTCM bailout in creating a self-perpetuating culture of “We are too big to fail” amongst the US, UK and even Irish institutions.

“Today, … that ad hoc intervention by the government no longer looks so wise. With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed,” says Tyler Cowen.

How true this rings in the context of AIB and Bank of Ireland today! Indeed, their bizarre wobbling between “We don’t need capital injections” and “We’ll take some public money, please” speaks louder than Anglo’s surrender to the Exchequer. The message to the Government is clear – “Rescue us, but hold passing the costs – we are too big for you to let us fail”.

Tyler Cowen, however, puts this type of bluffing into perspective when he concludes that:
“John Maynard Keynes famously proclaimed that ‘in the long run we are all dead.’ …We’re not quite dead, but we are seriously ailing. ...we may be tempted again to put off the hard choices. But perhaps the next ‘long run,’ too, is no more than 10 years away. If we take the Keynesian maxim too seriously, and focus only on the short run, our prospects will be grim indeed.”

How? Well, those of you who were in my class last Fall would remember its core message: “Uncertainty and risk are all that matters in the financial markets”. In Tyler Cowen’s words:
“It has become increasingly apparent that the market doesn’t know what to expect and that many financial institutions are sitting on the sidelines, waiting to see what regulators will do next. Regulatory uncertainty is stifling the ability of financial markets to engineer at least a partial recovery.”

If there is a need for any proof of this – watch Anglo’s ADRs melting away in the US while the Irish market and the Government remain shut for the holidays: $0.12 on December 26.

Or here is the evidence in two charts and on a slightly more macro scale, plotting ISE Financials index performance against main policy shift dates and ISE Financials relative to S&P Banks index (both normalized to 100 at June 3, 2008). The trend is clear – every new round of Irish Government policy announcements has been greeted by the markets as a sign of a rising risk premium on Irish shares. This macro-trend has been about as clear as the fact that a long put on Irish banks on any date just prior to a new Government policy announcement would be in the money.

And this poor record has far less to do with the Anglo's or AIB's or BofI's fundamentals than with the short-termist and unconvincing policy performance by the Government. For all would-be-Keynesians out there, the gap between December 20th price (Anglo’s de facto nationalization announcement) and current price – a loss of 76% or $-0.38 per ADR – is, in effect, the latest revealed price of regulatory & policy uncertainty in Ireland. Steep!

Friday, December 26, 2008

Euro Area GDP forecast

Using Euro COIN data released last week, I constructed two trend points (short-run trend consistent with contraction from Q3 2006, and long-term trend consistent with entire time series from January 1999). These provide forecast for January-February 2009 Euro area GDP growth based on the trends and predictive power of the Euro COIN model. The series, including forecasts, plotted in the graph below, point to a continued and deepening contraction in the Eurozone economy through February 2009.

Wednesday, December 24, 2008

What if? - When the IMF knocks on neighbours' doors

In light of the IMF rescue packages for Latvia, Iceland and Hungary, it is worth looking at the conditions imposed under these loan contracts. While Ireland has not requested IMF assistance, yet, as probability of such a request rises (due to the deepening mismatch between Exchequer receipts and outlays), what austerity measures can the Irish Government count on should our rescue be structured along the lines similar to the above three states?

In answering this question (table below), I use the following comparatives:
(1) Current and forecast GDP and GDP per capita levels and growth rates;
(2) 2008 and 2009 budget deficits; and
(3) Relative extent of committed liabilities under various national rescue plans.

The estimates are presented under two scenarios for Ireland:
  • 'Benign' scenario implying IMF/external funding of 10% of the 2008 GDP which will cover ca 30% of committed state liabilities for 2009; and
  • 'Average' scenario consistent with 25% of GDP borrowing covering ca 75% of liabilities).
A third scenario - consistent with relative liabilities in line with those in Iceland would imply an improbable, but not an impossible demand for external funding of up to 58% of GDP. To err on the conservative side, I omit this scenario in the current post.

Finally, it is worth noting that I do not 'price-in'
  • the effect of deeper economic contraction in Ireland than in some of the reference countries;
  • the effects of higher public spending as a share of the domestic economy in this country relative to the reference countries; and
  • factors relating to inflation differentials and currency adjustments (note that all countries in receipt of IMF loans have had significant currency devaluations, while Ireland had a significant currency appreciation).
Thus, these estimates should be viewed as lower bounds.

To date, the only sign of any 'austerity' measures coming from the Department of Finance is a vague rumor that Brian Cowen is looking for a 5% wage bill cut in the public sector. Whether or not this figure is gross of the wage increases granted in the latest Partnership agreement is a moot point, given the austerity measures of 15-20% estimated above.

Tuesday, December 23, 2008

How (not) to spin data

The latest press-release from CSO’s QNHS-based analysis of Q2 2002 – Q2 2008 data on educational attainment sounds self-congratulatory:

“In the second quarter of 2008, 29% of all persons aged 15-64 had attained a third level qualification. The proportion of people with a third level qualification increased steadily over the years since Q2 2002 when the comparable level was just over one fifth (22%). Excluding 15-24 year olds (the age group most likely to be still in education), just over one third (34%) of 25-64 year olds had a third level qualification, and this had also increased gradually annually since 2002 when the level was 25%. … The latest available figures for all EU member states showed that, in the second quarter of 2007, 30% of all 25-34 year olds had a third level qualification. The equivalent figure for Ireland was 44%, ranking the country second in the EU only to Cyprus (47%). The lowest levels of third level attainment were reported in Czech Republic (16%), Slovakia (18%), Italy (19%) and Austria (19%).”

There is more spin in these remarks than truth about the quality of our labour force. Here is why.

Based on the set of three main international rankings, Ireland’s third level education system ranks 22nd out of 38 countries, or 15th within EU27. Less than 20% of our entire crop of third level attendees and graduates come from the universities and institutes that make it into top 500 in the world rankings. Furthermore, CSO own data shows that only 18% of our 15-64 year olds have managed to actually complete a third year degree - a real measure of the ‘third-level qualification’ attainment.

This suggests that only ca 3.6% of our labour force had a real, internationally competitive educational qualification - i.e a Bachelor's degree or above. For comparison, the figure is closer to 9% in the US and 10% in the UK.

Figure 3 in the CSO report shows that Cyprus leads EU27 in the proportion of the labour force with third level qualification. Cyprus actually fails to rank amongst top 50 countries around the world for quality of its 3rd level education. Apart from Cyprus hardly constituting a worthy competitor for the 'knowledge' economy-bound Ireland Inc, virtually all of the countries named by CSO as being laggards to Ireland score better than Ireland in the university league tables. May it be the case that the CSO's (and EU's) methodology for measuring success in education is confusing quantity with quality?

A regression of the proportion of the 3rd level education attainment for 25-34 year olds on the proportion of early school dropouts shows a strongly negative relation between two variables:
For the entire set of countries (EU27): y = -0.2051x + 33.649 R2 = 0.0079
For small EU countries sub-sample: y = -0.2966x + 35.017 R2 = 0.0648
This is logical, as more drop outs should, in theory, imply fewer potential graduates. In both cases, Ireland and Cyprus come up as strong and influential outliers. Exactly the same happens when we look at the positive relationship between the proportion of the graduates with completed secondary education and those with third level qualification.

Now, considering the two equations above, two additional facts, not considered by the CSO, emerge as being of interest to the case of Ireland's education success. First note the difference in the intercepts between the two groups of countries. This suggests that an average small EU state has a higher share of the labour force with thrid level education. Second, the adverse impact of early school drop outs on educational attainment is stronger for smaller countries than for the larger states. In some ways, this again points to some problems with the CSO data, because, as it turns out, Ireland scores almost exactly the average for the smaller EU15 states in terms of the share of the population who failed to complete secondary education. So by both of these facts, Ireland is an outlier - an exception to the rule.

Hmmm… something is not quite right.

One possible explanation of this puzzle is that somehow Irish society is so polarized across the social demarcation lines that a substantial share of population has extremely poor graduation rates for secondary education, while another substantial sub-group has extremely high graduation rates for third level education. But this would not explain the case of Cyprus where income inequality is different in composition and magnitude from Ireland.

Another explanation is that Ireland, and possibly Cyprus, suffer from quality dillution in education at the third level, also known as 'dumbing down' of our universities. Much has been written and said in public about this matter, but the latest CSO numbers may be providing an indirect hint at the extent of the problem. If the vast majority of Irish Universities and third level institutions cannot reach top 500 in the world league tables, an army of the graduates (and, given the CSO methodology, an even bigger army of the 'near' graduates) they produce might just deliver the equivalent of the Chariman Mao's Great Leap Forward in education - massive boost in quantity, at a cost to quality.

The latest plan is a 'white elephant'

The latest Government plan for crises-ridden Irish economy is, letter for letter, a rehashing of past clichés and a pandering to the minority interest groups in politics and business.

When the cornerstone crumbles

Perhaps the most frustrating in the entire document is its centre piece – the so-called €500mln venture capital fund which, according to the reports represents:
“…the key element in Building Ireland's Smart Economy... is the establishment of venture capital funds worth €500 million designed to lure innovative industries and boost research and development.” The Irish Times, December 19, 2008.

The fund will allow three US-based VC companies to invest in start-up Irish and foreign-owned IT and environmental "green tech" companies setting up here. The Government will provide up €25 million a year for 10 years and take a 49 per cent share in the investment companies. Investors will avail of a 15% tax rate on profits.

As quoted in the aforementioned article Taoiseach Brian Cowen said that:
"The aim is that Ireland becomes the world's leading location for business innovation, a country where there will be a critical mass of companies - both Irish and international - at the forefront of innovation, creating the products and services of tomorrow and well-paid quality employment."

It will do nothing of the sorts.

Poor record

This plan represents a clear lack of learning from the past mistakes. Our State’s record in acting as a venture capital investor is thin in experience and disastrous in quality.

Media Lab Europe
(MLE) is one example that springs to mind. Some 8 years ago, the State decided to ride the IT bubble hysteria by dumping in excess of €35 million into an early-stage investment in a belief that government-paid provider of services to the various government agencies is the way to enhancing Ireland’s knowledge economy. Five years later it became apparent that the organization was incapable of delivering either commercial or academic value. MLE produced just 15 refereed papers (only 3 were published in the first-tier journals) between 2000 and 2005, signed up virtually no non-governmental business and clocked a mind-boggling loss on public investment.

Other high-tech state-run ‘investments’, inclusive of the public sector own IT programmes, fared equally poorly.

... and poor thinking

But last week’s plan is a true ‘white elephant’ of our economic development even if the record of this State in picking economic ‘winners’ is omitted. The plan fails on the basis of the Venture Capital sector own data across the following parameters:
(1) Timing – 10 year horizon;
(2) Sectors targeted for investment – IT and ‘green’ technologies;
(3) Type of investment – seed and early stage capital; and
(4) Size – €500 mln spread over 3 funds.

According to the European Commission DG for Enterprise and Industry (DGEI) analysis of seed capital funding, for the period of 1994-2003, 5-10 year seed and early-stage development capital funds average internal rates of return were -1.8% and 1.3% respectively. Almost exactly the same returns were recorded for the period of 1983-2003. This included better-performing US-based funds and covered the era of the IT bubble, when tech valuations reached stratospheric proportions.

European Private Equity and Venture Capital Association (EVCA) confirms the above results for more current data. As shown in Table 1, 10-year returns averaged -1.1% for the early stage investments – the same type of investment envisioned in our State plan. In contrast, development finance might have been a safer bet for taxpayers money, but considering the dire shortage of high-quality early-stage domestic firms, this would require us to “pay” established foreign firms to locate here – something that is not kosher under the EU regulations.

Table 1: Funds Formed since 1980, top quarter returns as of 31 December 2006

Figure 1 illustrates two major EU-wide market trends in VC investments:
(1) Fewer and fewer private funds invest in high-tech start ups (due to higher risk, lower returns to these investments); and
(2) Both the seed and start-up capital shares of total VC allocations have been falling precipitously over time.
The Irish Government plan runs precisely against these two trends.

Figure 1: Allocation of funds raised 2002-2006, €bn
Sources: EVCA and PEREP Analytics for 2002-2007 figures

Another report compiled in March 2006 by DG for Economic and Financial Affairs (DG EFA) concluded, among other things:
“As a whole, the returns produced by European venture capital funds specialising in early stage (seed capital and start-up) investment have been disappointing. …taking into account the relatively high risk of this type of investing, the IRRs recorded do not appear competitive when compared to the more predictable buyout investing. …The difference in performance between venture capital and private equity may well be the main explanation for the recent trend for European investment activity to focus on less risky buyout investment rather than venture capital.” As Table 2 shows, even accounting for distributions to investors, early stage financing simply does not pay off when compared to development stage investments.

Table 2: Cumulative investment multiples for EU funds formed in 1980-2003
Source: DG EFA 2007

What about the risks associated with the plan? Again, using the DG EFA data, as Table 3 states, European VC investments underperformed the equity indices in all instances, with exception for the period of post-bubble recession in the US.

Table 3: Public markets returns vs. VC investment
Source: DG EFA 2007

Suppose that the Irish Government fund performance matches the peak past returns for EU VC funds. This implies that at the end of 10 years period we attain a cumulative total value per €1 invested multiple (inclusive of disbursements, etc) of ca x2.9 (as consistent with vintage 1995 funds). This delivers an annualized rate of return of 6.6% or risk-adjusted annualized return of only 3.7-4.8%. This is worse than putting the taxpayers money into a termed deposit with the Anglo Irish Bank. Now, considering the business cycle dynamics, the current investment, assuming 2009 will be the last year of economic contraction in Ireland, implies a historical valuation coincident with the VC funds of vintage 2000-2001. In this vintage, the EU funds yielded a cumulative total value multiples of ca x0.8 and x0.65 respectively, giving a compounded rate of return on the planned state fund of -35% to -20%. Risk-adjusted, this implies a range of -58.3-87%.

Destroying the market

In 2006, a DGEI workshop on seed finance has concluded that “Public intervention needs to take place in a way that avoids the risk of crowding out the private sector.”

To date, Irish VC markets have been characterized by monopolistic competition with Enterprise Ireland (EI) capturing a lions’ share of total investment and private VC firms acting as a competitive minority fringe. Thus, even at the times of plenty the Irish market can hardly be described as that with sufficient demand/supply clearance. In other words, during the time of the robust entrepreneurial activity, Irish start-ups have shown only minor ability to attract private VC capital. Of course, the presence of a state lender with soft budget constraints (EI) helped to undermine domestic VC services.

This structure of the market has hardly changed to warrant a new intervention by the Irish Government. Indeed, if capitalized as planned, the new plan will deliver a re-enforcement of the already unhealthy degree of state monopoly power over the VC market in this country. In the end, there is very little difference between the Irish Department of Finance boffins picking the ‘winning’ start-ups or appointing three US VC funds to do this for them. After all, the rules of the game are fixed (remember those IT and green-tech ideals?) and the losers are known in advance (Ireland’s taxpayers and entrepreneurs).

It would have been simply better for the Government to drop the CGT to match the 12.5% corporate tax. At least this would have assured that private gains yield returns to the Exchequer, without socializing private losses.

Friday, December 19, 2008

Ireland's Debt Mountain(s)

The latest CSO data merely confirms what we have known all along: Ireland is now by far the leading country when it comes to overall external debt held by its corporates, consumers and the Government. Our gross external debt has risen precipitously since the onset of the latest crisis from €1.537 trillion on January 1, 2008 to €1.671 trillion as of September 30, 2008. Some €21bn of this increase is accounted for by the State borrowing its way out of the need to reduce the runaway train of public spending. Roughly €25.3 bn came from the Monetary Authority.

Most worrisome were the increases of roughly €45 bn in the liabilities of the Other Sectors. This line of liabilities (up 4.13% between Q2 and Q3 2008) should have been rising at a much slower pace than the Gross External Debt (up 3.16%) if the households and firms were actually de-leveraging. Alas, this is not the case, suggesting that declines in households' incomes and corporate revenues are forcing the real side of Irish economy deeper into debt-dependency. This will have two implications on 2009 economic environment in Ireland:
(1) 2008 consumers' strike - leading to a precipitous collapse in retail sales - will continue as Irish households attempt to play catching up with de-leveraging that is well underway in the US and UK;
(2) Income tax hikes and VAT rates increases passed in the Budget 2009 will further exacerbate excessive debt burden problems, leading to slower, more painful de-leveraging of corporate and household balancesheets and prolonging the current crisis.

Thursday, December 18, 2008

A train wreck of Irish economic policy

In managing the ongoing economic crisis, observing Irish Government policy can only be compared to watching a train wreck in slow motion. The banks re-capitalization scheme announced this week is just another example. By ignoring Ireland's impoverished and debt-overloaded consumers and companies, the latest plan will not deliver any real benefits to growth, credit flows or consumer/producer confidence.

One frame…

First, the rails buckle underneath as the Exchequer balance snaps under the weight of reckless public spending. Pop, pop – the fastenings fly off as tax line after tax line comes short. “No worries, we have a plan”, calls out the engineer. Enter the emergency budget – empty of any ideas as to how to mend the path or to lighten the load.

Then, the engine slumps oil-less. Banks hit the friction of bad corporate and household loans. The sparks of private unemployment fly. “All’s fine,” shouts the engineer, “we have insurance”. Emergency banks guarantee follows, but panic engulfs the carriages.

For what seems like an eternity the train pushes on. Dust, gravel and engine parts are shooting in all directions. Business insolvencies double year on year under the weight of the heaviest corporate debt load in the EU. Consumers crumble under the largest debt mountain in the OECD. Homes repossessions are on the rise and retail sales crash. The policy engine spins out of control: income, savings and consumption taxes go up and business rates increase. “The fundamentals are sound,” shout engineers. The rest of the world is selling off Irish shares and assets.

By the end of last week, the index of Irish financial companies shares has fallen 67% relative to the Black Monday of September 29th – the point that triggered the banks guarantee. “This will all end happily,” chirp engineers, “We’ll commission new reports, appoint new committees and issue more emergency responses.”

… to another

Enter this Sunday’s desperate ‘capitalization’ package. This promises to deliver some €10 billion to the banks in a swap for equity. The details, predictably, are sparse. Everyone expects the capital injections to be a copy-cat of those instituted by Germany and the UK – the countries hardly facing the same problems as Ireland. This implies a mixture of private and public funds to be made available to the banks with some token conditions, e.g dividends and management bonuses caps.

In a statement the Department of Finance said the plan will underpin the availability of loans to individuals and businesses.

Ooops. By-passing Ireland’s impoverished consumers and companies, the plan will not deliver any such benefits.

Elsewhere in Europe and the US, similar capitalization schemes have failed to reduce the cost of corporate borrowing or to restart lending to the households. In the UK, a £43 billion capital injection scheme has been in place for almost two months and the supply of consumer and business credit continues to fall - whether due to demand slowdown, lenders withdrawal from the market or both. In the US, massive banks’ capital supports have lowered the mortgage rates, but there is no meaningful increase in new mortgages uptake.

Three reasons for State-to-Banks recapitalization in-effectiveness

First, heavily indebted households are unlikely to take up new credit regardless of the cost. Short of the Government scheme to reduce the household debt or to increase after-tax incomes, no policy will shift consumers out of precautionary savings and into credit markets. So the retail sales will continue falling, businesses will suffer and consumers will keep on heading North for shopping. Our engineers, who two months ago raised VAT and now stubbornly refuse to back-down will see even less VAT revenue in 2009.

Second, heavily indebted Irish businesses can use new credit to either roll-over existent debts, or to finance short-term operational expenses, e.g export transactions. With exception of export credits, any new lending will simply re-arrange the deck chairs on the sinking Titanic of corporate Ireland. None of the new loans will go into capital acquisition, investment or hiring. These activities have stopped not because credit got dear, but because economic demand for goods and services has collapsed.

Third, for the banks, turning recapitalization proceeds into business loans will defeat the entire purpose of the scheme. Assuming re-capitalization is needed because bank’s capital is running too low relative to the size of the impaired or threatened loans, recapitalization must drive up the capital-to-loans ratio. Taking the money and using it to issue more loans will do exactly the opposite.

And this brings us to the issue of costs. The scheme will use the last of the remaining taxpayers’ money – the National Pensions Reserve Fund – to increase capital reserves of the banks. This means the state will no longer have any remaining capacity to inject a meaningful stimulus into the real economy. The consumers will go on cutting spending, business will go on laying off workers and the Exchequer will go on issuing new emergency responses. The more things change…

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