Monday, November 7, 2011

07/11/2011: Sunday Times, Nov 06, 2011

This an unedited version of my article for Sunday Times, Nov 06, 2011 edition.

In a recent research paper titled “The real effects of debt” Bank for International Settlements researchers, S. Cecchetti, M. Mohanty and F. Zampolli provide analysis of the long-term effects of debt on future growth. The authors use a sample of 18 OECD countries, not including Ireland, for the period of 1980-2010 and conclude that “for government debt, the threshold [beyond which public debt becomes damaging to the economy] is in the range of 80 to 100% of GDP”. The implication is that “countries with high debt must act quickly and decisively to address their fiscal problems.” Furthermore, “when corporate debt goes beyond 90% of GDP, [the] results suggest that it becomes a drag on growth. And for household debt, … a threshold [is] around 85% of GDP.”

Thus, combined private non-financial and public debt in excess of ca 255% of GDP exerts a long-term drag on future growth even in the benign environment of the Age of Great Moderation, the period from the mid-1990s through 2007, when low inflation and cost of capital have spurred above-average global growth.

The period under consideration in the study, was also the period when Baby Boom generation was at its prime productive age, when rapid expansion of ICT drove productivity in manufacturing and services, and innovations in logistics revolutionized retailing (the so-called Wal-Mart effects).

And yet, despite all the positive push forces lifting the growth rates the negative pull force of building debt overhang was still visible. Euro area economies have posted average growth rates of 2.0% per annum in 1991-2007, well below less indebted group of smaller advanced economies that posted average annual growth of over 4.2%.

From the Irish perspective, these impacts of debt overhang on long-term growth present a clear warning. Ireland’s robust growth in the 1990s and through 2007 represent not a long-term norm, but a delayed catching up with the rest of the advanced economies. In other words, even disregarding the negative effects of the severe debt overhang we experience today, Ireland’s average growth rates in the foreseeable future will be close to the average growth for smaller open economies in the euro area. That rate, according to the IMF latest forecasts, is unlikely to be significantly above 2.0%.

But Ireland’s debt overhang, when it comes to debt that matters – i.e. debt analyzed by Cecchetti, Mohanty and Zampolli – is beyond severe. It is outright extreme. Across the 18 advanced economies, average real economic debts weighted by the economies’ size stood at 307% of GDP at the end of 2010 and are expected to rise to ca 310-312% of GDP or GNP. Ireland’s real economy debt to GDP ratio is likely to reach above 415% of GDP and, more importantly, 490% of GNP. (Chart below)

According to the Bank for International Settlements econometric model, the above overhang can be expected to reduce Irish GDP growth by ca 0.7 percentage points over the long run, implying that our long term potential growth rate rests somewhere closer to 1.3-1.4% per annum on average.

At these rates of growth, our Government debt repayments, even if the entire pool of Irish bonds were financed at the lowest currently available rates – the EFSF 3.3% – Ireland nation debt financing will be consuming the entire surplus generated by economic growth.

This issue frames the entire discourse about the ‘green shoots’ allegedly emerging on Ireland’s economy landscape.

In October, according to the NCB Purchasing Index Irish manufacturing sector moved back into growth territory. The headline index, however, came in at an anaemic 50.1 (index above 50 mark signaling growth). Crucially, jobs prospects continued to deteriorate with sub-index for employment standing at 47.1. New exports orders – the leading indicator of our exports-led ‘recovery’ still underwater at 49.8. Profit margins for Irish manufacturing firms continued to contract for the 32nd consecutive month.

Even our much celebrated trade data is starting to flash warning signs. In August – the latest period for which trade statistics are available – seasonally-adjusted trade surplus was a hefty €3,699 million. This figure represents a year-on-year decrease of 1.3%. Given this trend, in annual terms, for eight months through August 2011, Irish trade surplus is running at 0.5% below 2010 result.

Per latest IMF projections, in 2012-2016, Irish current account surpluses are expected to average 1.38% of GDP per annum. Despite unprecedented collapse in imports, fuelling trade growth does require new debt financing and imports of inputs. Small open economies’ average forecast for the euro area is 1.94% over the same period. In other words, less indebted countries of the euro area are expected to generate greater current external surpluses than more indebted Ireland. Get the point? Debt overhang can hold back even exports-led recoveries.

The debt overhang is now also exposing the underlying weaknesses in the Exchequer fiscal adjustments. Lack of consumer demand, investment, and the resultant implosion of domestic economy are now driving the state finances deeper into the red despite massive capital spending cuts and sizeable tax increases over the last three years. The latest tax receipts show that in 10 months through October 2011, income tax receipts are behind the budgetary target by 1.2%, VAT -4.5%, corporation tax -4.2%. Adjusting for the hit-and-run pensions levy, year on year tax Exchequer deficit is down just €155 million. Fuelled by stubbornly high unemployment and lack of any real reforms in public finances, voted current exchequer expenditure is up from €33,662 million in 10 months to October 2010 to €34,450 million for the same period this year.

All indications so far are that the second half 2011 growth will once again post a nominal GNP contraction and quite possibly the same for nominal GDP.

Courtesy of overburdened households and companies, Irish economy is now stuck in a quick sand of a balance sheet recession, which risks becoming a full-blown decades-long stagnation. Even our greatest hope – improving competitiveness – is being threatened by debt. Again, referring to the latest data, despite the past gains, Ireland remains the least competitive 'old' euro area economy. Ireland has competitiveness gap of 34.7% compared to Germany and 14.7% compared to euro area as measured by differences between our harmonized competitiveness indicators. This gap will be virtually impossible to close, as the gains in competitiveness to-date have been driven primarily by jobs destruction and earnings declines. Cutting even deeper into earnings by raising taxes and/or reducing employment costs will either risk destabilizing even more our sick banking sector or will require cuts in taxes to compensate for disposable income losses.

To summarize, there is no hope of growing out of the debt crisis we face when the expected growth this economy can achieve in the next decade or so is roughly ten times smaller than the debt repayments we have to finance for the combined public and private non-financial debt. Once we rule out sovereign debt restructuring, the only solution to our crisis will require reducing the private sector debt overhang.


This week, European Financial Stabilization Fund postponed placement of €3 billion new bonds that were earmarked to provide new funding for Ireland under the Troika agreement. The funds are critical to our repayment of the €4.39 billion in Government bonds maturing November 11. While no one expects the Government to fall short on bonds redemption, the delay in raising EFSF funds is worrisome from the broader Euro area perspective. The hopes of leveraging the EFSF from its current €440 billion lending capacity to €1 trillion or more have hit a number of snags in recent days with all BRIC countries, the G20, the UK and Japan all suggesting that they will be unwilling to invest in EFSF leveraging on the basis of the terms implied by the current arrangements. The suspension of the latest issue, coming on foot of the original plans for 3.3% coupon pricing of the new and much smaller debt further extends concerns about the EFSF ability to leverage up. The EFSF leveraging is designed to provide cover for sovereign bonds of Italy and Spain, as well as for some limited capital supports to the euro area banking sector. If the EFSF cannot issue unlevered bonds at 3.3%, the implied commercial rates for levered EFSF issuance can be somewhere North of 5.25%. Costs and even the shallowest of the margins will push the effective lending rate to the member states to above 5.5%. Yet, at these rates, Italy’s sovereign financial imbalances cannot be sustained, regardless of whether the country deficit is 5% or 2%. Ditto for Portugal, and Greece, and Ireland. In other words, there’s not a snowball’s chance in hell the latest EU proposal for leveraging EFSF will work, given this week’s fiasco.
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