Friday, January 9, 2009

S&P's downgrade for Ireland

Here are my two cheers to S&P for today’s note on downgrading its outlook on Ireland –
One Cheer: for getting there late (although it is better than never), and
Another Cheer: for getting it so dramatically wrong, their ‘pessimism’ actually sounds like exuberant optimism when compared with reality.

Here are the details (all quotes are from S&P statement):

“Standard & Poor's Ratings Services said today it revised its outlook on the Republic of Ireland to negative from stable, on what we view as mounting fiscal pressures and deterioration of key economic sectors. At the same time, the 'AAA' long-term and 'A-1+' short-term sovereign credit ratings were affirmed. Standard & Poor's also affirmed its 'AAA/A-1+' ratings on the debt programs and instruments of those Irish banks where they are guaranteed until maturity by the Republic of Ireland.”

Hmm, let me get this right – Irish Government debt is ranked above junk level. Irish Government debt underwrites junk corporate debt of our banks, that in itself is over x2 times Irish GDP or over x5 times Government share of the entire Irish economy. So: 1:6 is AAA/A-1+, while 5:6 is something along the lines of B to CCC quality, absent guarantee. But the whole thing is AAA/A-1+... This does look to me like the logic of securitized mortgages ratings of the good old past – no weighted average can achieve this risk pricing. A BBB for Ireland Inc and B/CCC for the banks sounds to me like a better mark.

"The outlook revision reflects our opinion of the rising economic policy challenges stemming from the contraction of the key housing, construction, and financial sectors, which have spurred many years of strong economic growth and fiscal consolidation," said Standard & Poor's credit analyst Trevor Cullinan. …We have observed that general government debt levels also increased substantially between 2007 and 2008, by more than 16% of GDP, as a result of the widening deficit, although a substantial portion of the increased indebtedness (10% of GDP) remains in Exchequer cash balances as a liquidity buffer.”

This is fine, with a small caveat – all these trends were more than pronounced around the end of Q3 – the time by which the likes of our General Government Deficit has recorded expansion of 6% (Q1 2008 on Q1 2007), 10% (Q2 2008 on Q2 2007) and 12% (Q3 2008 on Q3 2007), the economy was in an official recession (2 quarters running) and the housing prices have been falling for some 11 months! S&P's ‘better late than never’ is hardly a useful time-line from the point of view of bonds investors who subscribed this week to another pile of Irish paper. Is S&P actually timing its notes after the issues are placed or was timing some pure coincidence?

“We note that the government has also extended guarantees to seven domestic credit institutions through Sept. 29, 2010, increasing general government guaranteed debt to an estimated 228% of GDP in 2009. Banking system exposure to the property and construction sector of about one-third of total loans (excluding interbank lending) suggests a high risk of asset deterioration at these institutions.”

Not a word on banks recapitalization scheme costs here - worth another 5-7% of GDP? Or the fact that the Government is planning to tap the markets for some €20bn in fresh debt in 2009 (possibly €30bn – should recapitalization scheme materialize and should the government redeem April 2009 bonds)? Or the fact that GDP is not something that should be used to peg our credit worthiness on, as GDP/GNP gap stands massive and rising?

As per 1/3 loan books exposure to property and construction sector… Anglo-Irish Bank’s annual results (December 2008) show 87% loan book exposure to Property & Construction. Bank of Ireland (as of July 2008) reported 26% exposure to Property & Construction, plus 44% to Residential Mortgages, so total BofI Property exposure was 70%, with some of the 'Other' loans secured against Property & Construction assets. AIB – also July 2008 figures – showed 37% exposure to Construction & Property, 23% to Residential Mortgages, giving it a grand total exposure to Property & Construction of 60%. Given that the rest of the sector (consider a relative banking minnow of IL&P - Construction & Property exposure of 6% of the banking book and 88% to Mortgages, yielding implicit exposure to Construction & Property sector of 94%) is even more entangled in Property & Construction lending, would the maths genius in S&P who did their sums please raise his hand?

“The ratings on the Republic of Ireland are supported by what we view as the flexibility of its economy, high per capita income, and a favorable demographic structure. The government's commitment to contribute 1% of GNP per annum to the National Pensions Reserve Fund (NPRF), in our opinion, reduces the fiscal burden of population aging more than in some other European countries. However, the government is expected to use NPRF assets to assist in funding an estimated EUR10 billion (5% of GDP) recapitalization of its domestic banking sector.”

Now, this is a pure hogwash.

Let’s start with NPRF. The Fund is hardly a credible buffer for pensions time bomb in Ireland for two major reasons: (1) the Fund was established to pay Public Sector pensions obligations and, as a residual, general government pensions (without stipulating the level of payment guarantees); (2) this year’s pension funds performance has wiped out at the very least 40-50% of the entire pensions provisions in the private sector. In other words, from the point of view of the private sector employees, NPRF is a tax on their output, providing no legal entitlement to a pension benefit. Full stop.

What about the perverse logic that in order to contribute to NPRF in 2008 and 2009, the state will have to borrow funds in the open markets! Is S&P implicitly promoting an equivalence of 'borrow expensively, to save cheaply' policy?

The hodge-podge about the ‘flexibility of Ireland’s economy’ is ridiculous. It was more than aptly illustrated by this week’s events in Limerick, where a quasi-closure of one multinational factory is likely to lead to a collapse of the regional economy. Our own National Competitiveness Council does not subscribe to the myth of some magic ‘resilience’ of our economic model. S&P would be better served to look at composition of our GDP and GNP to discover the fact that Ireland’s economy is severely restricted in its flexibility by: (1) excessive concentration of exports in the multinationals-controlled sectors, (2) atavistic and cost-inelastic structure of our labor markets, (3) one of the highest cost bases in business support public services in the EU27, (4) shortages of skills, and (5) over-reliance on personal consumption and construction in our domestic economy, and (6) excessive public sector waste.

One quick note on demographics: our 'demographic' benefit only works assuming static migration flows. Strong net emigration (in line with, say, 1980s and accounting for adverse selection bias in skills/ work experience) can easily shift our demographic pyramid to resemble EU average.

"The negative outlook reflects our view of the likelihood of a downgrade if ongoing fiscal measures to recapitalize the banks and boost the economy fail to improve competitiveness, diversity, and growth prospects, thereby leaving a more difficult-to-manage debt burden," said Mr. Cullinan. "Conversely, the negative outlook could revert to stable if the government's strategy is successful and allows public finances to return to the stronger position of recent years.”

Oh, mighty! What ‘ongoing fiscal …boost’? What Government strategy? This Government has not produced a single fiscal stimulus package to date! More than that, the Government is actually looking into cutting fiscal spending (something that it must do), without expressing any intent to roll public spending savings into fiscal stimulus (something that it should have pre-committed itself to doing long before it piled on expected debts through banks' guarantees and recapitalization measures).

Just read this from the Department of Finance:
"Investment in capital projects to enhance Ireland’s productive capacity has been retained at a very high level, of the order of 5 per cent of GNP... given the extraordinary economic and financial circumstances impacting on all countries, including Ireland, this level of investment, which is now being totally funded from borrowings, will provide a significant fiscal stimulus in these difficult times."

In other words, don't bet on any real fiscal stimulus - after all, recall that this 5% of GNP (not GDP) package is the same one we had since the passage of NDP two years ago - in late January 2007!

In short, S&P’s note is one of the most bizarre assessments of Ireland’s credit worthiness I’ve seen since the Building Ireland's Smart Economy flop (here). Can someone from their team actually get engaged with those of us who are on the ground next time?
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