Economics 16/05/2010: EU on the brink

Before I begin the post on Euro, let me bring you a piece of really good news I've learned about last night. Although it has been publicly released few weeks ago, I learned about this just last night. Ireland is ranked third in the world as a centre for research in immunology (details here). Interestingly, I was informed by an anonymous source close working in scientific R&D field that the DofF is putting loads of pressure on science funding organizations to provide 'commercial return'-linked 'Irish drugs' products backed by the above-mentioned research. In immunology, like in any other field linked to phrama or biopharma, it takes around 15 years on average and scores of millions of euros in funding before a drug can brought to the market. We are just at the beginning of what is now internationally recognized to be successful undertaking in immunology research. Sometimes, DofF needs to wait patiently for a payoff! Let's hope they do.


Ambrose Evans-Pritchard, in today's piece (link here) has a superb analysis as to why Euro is in the end game, with pat not an option for its fierce opponents. And, incidentally, why it's the markets that are getting things right in nailing Euro zone. Let me quote few passages (as usual, comments are mine):

"Geneva professor Charles Wyplosz said EU leaders made the error of overselling up their shock and awe package [€750 billion rescue package issued two weeks ago] before establishing any political mechanism to mobilise such sums. The fund is an empty shell, he wrote at Vox EU. Worse still, crucial principles have been sacrificed for the sake of unconvincing announcements."

Bingo: Wyplosz is 100% correct, as I wrote here, the package is a bizarre amalgamation of impossible, improbable and outright reckless:

• It contains guarantees that cannot be backed by resources
• It shoves more debt onto the shoulders of already insolvent sovereigns
• It turns Germany - a solvent nation - into an implicitly (as long as guarantees remain implicit) insolvent nation
• It contains no real mechanism for imposing any sort of discipline on Eurozone sovereigns who might continue engaging into reckless deficit financing
• It demolishes any credibility built up by the ECB over the last decade and with it tears the fabric of the Euro
• It represents a massive cost imposition on Eurozone's economies

"Brussels was unwise to talk of smashing the wolf pack speculators and defeat the worldwide organised attack on the Eurozone. As Napoleon said, if you set out to take Vienna, take Vienna. Besides, the language of the EU priesthood ex-ECB board member Tomasso Padoa-Schioppa talks of the advancing battalions of the anti-euro army frightens Chinese and Mid-East investors needed to soak up EU debt. These metaphors are a mental flight from the issue at hand, which is that vast imbalances masked by EMU, indeed made possible only by EMU have been decorked by the Greek crisis and now pose a danger to the entire world."

Bingo again! Since the foundation of the EU in its modern incarnation - in other words since the mid 1990s, Brussels did nothing in terms of economic policies other than issue lofty plans and guidance documents - which promptly went nowhere real, and blame 'others' for its own troubles. At times, this reminded me of the good old Sovietskies whose entire edifice of the state was supported - from the early 1970s through the late 1980s - solely by the threat of 'others' coming to take over the Motherland.

"One can only guess what Mr Trichet meant when he said we are living through the most difficult situation since the Second World War, and perhaps the First. ...was Mr Trichet alluding to something else after witnessing the Brussels tantrum by President Nicolas Sarkozy? According to El Pais, Mr Sarkozy threatened to pull France out of the euro and break the Franco-German axis at the heart of the EU project unless Germany capitulated. To utter such threats is to bring them about. You cannot treat Germany in that fashion."

And herein is where the trouble's brewing. One thing for people to say Germany should exit the troubled Euro to save itself. Another thing for the country like France, which never really bothered to comply with the budgetary restrictions of the Maastricht Criteria or SGP to threaten to pull out, leaving Germany to pick up the pieces...

"The German nation is moving on. I was struck by a piece in the Frankfurter Allgemeine proposing a new hard currency made up of Germany, Austria, Benelux, Finland, the Czech Republic, and Poland, but without France. The piece entitled The Alternative says deflation policies may push Greece to the brink of civil war and concludes that Europe would better off if it abandoned the attempt to hold together two incompatible halves. It can be done, the piece says."

So the rationale for a German exit is there. As it has been since the first day of the Euro creation and the massive pan-European euphoria (or call it chauvinism) that engendered the idea (no matter how absurd) that EU can absorb the entire Continent into its folds and stretch into Asia via 'acquisition' of Turkey, plus the grand delusion of the Euro becoming the reserve currency of the world. Only now, this rationale has real feet - the markets gave them these by exposing the weakness behind Europe's great experiment. The markets did exactly that with the USSR in the 1980s, with Asia in the second half of the 1990s, Russia in 1998, New York in the 1970s, Orange County in the 1990s, Latina America in the 1980s and then in 2002-2003. They will, once the European day-dreams are fully dealt with, do the same to China's economy on state steroids. After all, this is what the markets are designed to do - expose lies and support the true value.

But, says Evans-Pritchard, "What makes this crisis so dangerous is not just that Europe's banks are still reeling, with wafer-thin capital ratios. The new twist is that markets are no longer sure whether sovereign states are strong enough to shoulder rescue costs. The IMF warned in last weeks Fiscal Monitor that the tail risk of a widespread loss of confidence in fiscal solvency could no longer be ignored. By 2015 public debt will be 250pc in Japan, 125pc in Italy, 110pc in the US, 95pc in France, and 91pc in the UK."

Do I need to remind you what it will be like in Ireland? Check out here. And that's with only direct cost of Nama factored in. 122% of the national income by 2015! And our Minister for Finance dares to call us turning the corner.

Evans-Pritchard is right in his analysis of 'solutions' to the Euro crisis: "There is a way out of this crisis, but it is not the policy of wage deflation imposed on Ireland, Greece, Portugal, and Spain, with Italy now also mulling an austerity package. This can only lead to a debt-deflation spiral. ...The only viable policies short of breaking up EMU or imposing capital controls is to offset fiscal cuts with monetary stimulus for as long it takes. Will it happen, given the conflicting ideologies of Germany and Club Med? Probably not. The ECB denies that it is engaged in Fed-style quantitative easing, vowing to sterilise its bond purchases euro for euro. If they mean it, they must doom southern Europe to depression. No democracy will immolate itself on the altar of monetary union for long."

Note to all folks eagerly rubbing their hands in hope of getting their hands on Government 'stimulus' to offset deflationary effects of austerity in Ireland: Evans-Pritchard is talking about Euroarea-wide massive emission of liquidity. I called for that months ago in the Indo and in Mail articles. And on this blog as well. Back then, before the current sovereign bonds crisis hit, I thought an issuance of €1 trillion directly to citizens of Europe would do the trick. Now, we are more in the need of issuing €3 trillion. This should be split as follows:

• €2 trillion issued directly to each adult and child inhabiting Europe (EU27) and
• €1 trillion issued to the EU16 sovereigns on the basis of each sovereign share of the total Euroarea population.

Wait another month, and we'll need €4 trillion...

Of course, there's always an option of Germany leaving the Euro and setting up a separate, credible currency. It's the lower cost solution, for it requires no replay of the same crisis 10 years from now - which is, of course, an inevitability given the nature of the Euro area. No matter whether fiscally integrated or not.

Economics 16/05/2010: IMF on fiscal stability III

Continuing with IMF data on Fiscal Stability (see earlier posts here and here), tables below detail Irish public spending breakdown between payment to Public Sector employees, Social Welfare, Capital and Current expenditure heads.

Table 3a. Expenditure Structure: Advanced Economies, 2008 (as a share of GDP)
Table above shows primary fiscal expenditure breakdown by broad heads across 32 developed nations. Ireland GNP adjustments were added by me. The figures are for 2008 and reflect:

• The fact that Ireland had the second highest primary government expenditure as a share of economy of all countries. A burden of Government that is, frankly, unprecedented for a mature, competitive economy, especially when one considers the fact that we, Irish taxpayers, receive virtually nothing exceptional in return for our cash.
• We managed to have the fifth highest proportion of public spending that is being swallowed by pay to our grossly over-compensated public sector workers. Denmark, Iceland, Malta and Sweden were ahead of us in these terms. I can't vouch for Malta, but in all three other states, taxpayers get a lot more services for their money.
  
• Crucially, none of our competitors - smaller open economies that actually do create jobs - had the size or the structure of public spending close to that of Ireland.
• Our generosity of the social benefits is significantly above average in absolute terms. When one realizes that the other countries we are being compared against all have older populations and higher unemployment (remember - these are 2008 figures), we can safely claim that Irish social benefits system is amongst the top two most generously funded in the entire developed world.
  

Now, consider how these expenditures are allocated relative to the total primary Government budget:
Table 3a. Expenditure Structure: Advanced Economies, 2008 (as a share of the total primary expenditure)
Table above shows that:

• Ireland had the second largest proportion of its primary expenditure allocated to the capital budget in 2008. Lest we forget, parts of the Irish Government's capital budget, under the NDP accrue to personnel spending as well - including NDP-specified expenditures on 'human capital', and other soft things.
• The above clearly distorts spending priorities reflected in employees compensation and social benefits shares of total primary spending.
• Despite this, our public sector employees have still manged to capture a greater share of the total primary spending that average.
• It is also worth noting that some countries with greater share of public expenditure accruing to the employees' compensation include countries with functions defense forces, such as Israel and members of NATO.

Stay tuned for more revelations from the IMF database...

Economics 15/05/2010: IMF on fiscal stability II

Continuing with IMF Fiscal Outlook update released yesterday (see the first post here) - I have compiled IMF data on Ireland's fiscal position, and added some GDP/GNP gap and Nama analytics. As usual, the table below should be self-explanatory:
So quick conclusions:

• For all the talk about Government doing the right things, our deficit is record busting for 29 leading advanced economies in 2010 and 2011 in terms of share of GDP. It is expected by the IMF to decline only marginally to 28th and 27th ranks in 2014-2015.
• Despite repeated assurances to the markets and the EU, Ireland is not expected to reach 3% deficit limit by 2015, with IMF expecting our deficit to be -5.3% of GDP in the end of 2015.
• When converted to a more realistic measure of our income - GNP - our deficit is jaw-dropping 16% in 2010. It is forecast to be at -6.9% in 2015.
• Iceland, Portugal and Greece are expected to significantly outperform Ireland in terms of deficit in 2010-2015.
• For all the talk about 'small Government', Irish Government spending as a percentage of our economy (GDP) has increased dramatically between 2000 and 2009, rising by over 50%.
  
• In 2009 our Government's share of the economy measured by GDP was in excess of the average for the advanced economies.
  
• In terms of GNP, our Government's share of economy was over 34% higher than the average for the advanced economies.
• In 2010, Irish Government's share in the economy is expanding, despite the chorus of voices from the Left that we are not having a public sector expansion. It is forecast to rise to 46.6% of the entire economy relative to GDP and 61% in terms of GNP. Average for advanced economies is expected to be 43.2% (a decline on 2009).
• Last year, we ranked as the economy with second largest share of GNP accruing to the State. In 2010 we will be the first economy.
• Irish Government's graft on Irish economy was heavier than that of Sweden in 2009 and will remain such through 2015.
• Despite having none of the superior public services supplied by the Swiss Government, Irish economy is paying its Government a toll (in terms of economic income captured by the State) that was 6.4% greater than in Switzerland in 2005, rising to 41% in 2008, to over 61% in 2009. This is the true measure of the rip-off-Ireland carried out by the Public Sector here.
• The same rip-off is expected to grow over 2010-2015, rising to 66% in 2010 before declining to 53.5% in 2015.
• Low government debt has been paraded by the State officials and politicians as a crowning achievement of this economy. Back in 2000-2007 that might have been warranted, despite the fact that, when measured relative to GNP, our debt was not really that much lower than that of some of our peers.
• The debt situation has changed dramatically since then. This year, despite all the talk about the Government's corrective actions on deficit, our debt is going to put us as 24th-ranked country in the advanced countries. In 2011 we will slip down to 25th.
  
• By 2015, factoring Nama our debt to GDP ratio will stand at 122% - ranking us 3rd worst performing advanced economy in the world by debt/GDP metric. Ex-Nama, we will hit 122% of debt/GNP.
  

These numbers put into perspective my arguments that the Government is not doing its job of controlling public spending. Three 'tough' Budgets behind us, we are still rolling down the slippery slope of fiscal insolvency.

The latest talks about finding €3 billion in fresh cuts is yet another plaster on a gaping shark bite of our fiscal policy wreck. We need to find €15 billion in cuts, NOW, folks, and we need to abandon Nama, before we can call in the press and tell them that Ireland is on the mend.

There will be more analysis based on IMF data coming in days to come. So stay tuned.

Economics 14/05/2010: IMF on fiscal stability I

So the IMF analysis of changes in global fiscal positions is out today and makes an interesting reading. Here are some high level observations, pertaining to Ireland.

In relation to the EU and Irish Government consistent attacks on so called ‘bond speculators’, IMF states: “Net CDS positions amount to only about 5 percent of outstanding government debt in Portugal (the country with the highest share), 4 percent in Ireland, and 2 percent in Greece and Spain. In other countries, including Italy, the ratio is even lower, and it is extremely small for Japan, the United Kingdom, and the United States.”

In other words, CDS markets are shallow and cannot be expected to have a significant effect on sovereign bond spreads or yields.

However, per IMF: “The analysis uses 5-year CDS and 10-year bonds, as they are the most liquid maturities. Granger causality tests over the period January 2008–April 2010 show that the CDS spreads anticipated bond spreads (measured by the Relative Asset Swap spreads), while the reverse is not true.” In other words, as I’ve stated on many occasions before – CDS markets are a good predictor of sovereign yields.

Another interesting analysis from the IMF. I am adding to it adjustment for Ireland to GNP figures, per usual argument that GDP is largely irrelevant for our country real income metrics. I also added rankings columns for two main parameters of fiscal sustainability.
One should be concerned with the figures provided above. While international comparisons call for GDP as a benchmark for national income, in Irish case, this metric is best captured by GNP. And of course, GDP/GNP gap is growing rather dramatically...

I will be posting more on IMF analysis over the next couple of days, so stay tuned.

Economics 12/05/2010: Irish Nationwide - an expensive delay

I have gone through the Irish Nationwide balance sheet, as summarized in the table below (all values are in millions of euro):
All scenarios are explained above and all assumptions are in there as well.

So the conclusions are:

• If we continue injecting cash into INBS, the total cost of winding down the bank will be the loss of all cash already put into it, plus the expected post-Nama injection of ca €1,148 million. The grand total bill for shutting INBS via Minister Lenihan's preferred option will be €7,234 million;
• Shutting down INBS back in 2009 would have cost between €2,030 million and €3,078 million, were the Government to listen to people like Peter Mathews, Brian Lucey, Karl Whelan and myself. The bond holders (senior ones) would have been paid 50 cents on the euro.
• Shutting it down now, without going Nama route will cost €1,575-2,659 million, plus the money we already dumped into it to date, i.e €2,700 million. Which is still cheaper than what Minister Lenihan's plan would deliver.
  

Either way, the DofF and Minister Lenihan really must come clean on the issue of bondholders at this stage. How much more can this economy carry on throwing good money after bad?

Economics 13/05/2010: AIB's IMS blues

AIB released its Q1 2010 IMS statement:

• It will issue 198m shares to the Government in lieu of a €280m preference coupon it will not be paying (remember the stockbrokers and the Government argued that this coupon payment will be a handsome return on our ‘investment’ in AIB?).
• AIB, subsequently will be in for an 18.6% Government stake in the bank.
• Some analysts are saying that the lack of dividend is due to AIB being precluded from paying cash dividends on debt instruments while its business case was under review at the EU.
• I would say that this represents a convenient excuse. In reality, AIB simply cannot afford a €280 million pay out, given its funding conditions and given its capital requirements.
  

There is more farcical stuff in the IMS. AIB claims that while trading conditions remain challenging in Ireland, its UK (ex Northern Ireland), Polish and Capital Markets operations are booming. Ooops, the very family silver that AIB is going to sell to cover its bad loans in the Republic is still the only set of assets that have any positive value in AIB.

IMS confirmed that AIB will need €7.4bn in new capital, and that this based on Nama discount expected to average 45%. As AIB is shifting €23bn of the bad and the outright ugly loans to Nama, this discount might change. So no speculation here…

Aside from speculation, if AIB is hoping to get some dosh for its 22% stake in the US M&T, worth estimated $2.3bn. If this target is achieved (a big if, given that large placements like these would probably attract some discount) the sale can deliver new capital of €900mln. The target for capital raising then moves to €6.5bn. Selling Polish holdings will provide maximum of €2.4-2.6bn, assuming euro holds against zloty and assuming a discount of no more of 10% on block sales, inclusive of commissions. Of course, this means that AIB will have to write down its book value on the asset side, so that the net gain is likely to be around €1.2-1.4bn to capital side.

Which leaves us with a hole of €5.1-5.4bn to plug. The UK side of business is a sick puppy, unlikely to yield any net gain on risk-weighted assets side, but let’s be generous and give it €500mln of value. On the other hand, AIB investors are raking the dosh in… well, not really. I would expect the bank to be able to sell something to the tune of €1.2bn worth of equity at the most (its current market cap is €1.22bn as of yesterday close price). Suppose this is the net (although discounts might imply much shallower rate of capital raising). Will the Exchequer be required to pump in another €3.4-3.7bn into AIB?

But wait, this is hardly a final number. Remember, so far AIB has been assuming (in its impairments provisions) that the 2009 performance will continue into 2010. It sounds conservative, until you actually pause and think. There are serious lags on some assets deterioration and on recognition of impairments. These lags are driven by two major factors:

1. On households and corporate loans side, impairments take time to build up. For example, an average unemployed person with job tenure of 6 years would have gotten around 36-42 weeks of redundancy (factoring in tax relief) when they lost their jobs back in the H1 2009. They might have had savings. At an average rate of saving of 5% of annual income over 6 years, that would add up to 30% annual income or another 16 weeks worth of income cushion. Again, net of tax the cushion rises to ca 19 weeks. This means that any serious distress on their mortgages will show up around 55-61 weeks after the layoffs. Guess that pushes the dateline for major stress on mortgages only starting to manifest itself to around May-July 2010.
2. Much of the non-Nama book of commercial and development lending that will remain with AIB has been rolled up, redrawn across covenants and so on. How long will it take for these to come up for another appraisal? I’d say on average 12-24 months. So look back at 2008-2009 loans that were non-performing then and were rolled over for 12-24 months. These will start flashing red once again sometime around 2010-2011.
   

Neither (1) nor (2) is provided for (as far as risk capital goes) under the current €7.4bn new capital requirement. By the time the demand on these hits, AIB will have no assets left to sell. Then what?

How I know that AIB is once again has its head stuck in the sand on future impairments? Well, this morning’s IMS tells me as much. For its non-NAMA loans, AIB is expecting bad debt charges to be matching 2009 rates. IMS says that bank’s €27bn residential loans book is continuing to perform “better” than the sector averages (as if there is any meaningful average here to be had). And significantly it says that residential bad debt charges are currently not significantly different from 2009. The non-NAMA exposure to property in Ireland will be €12bn of which €9 is investment and €3bn land and development. These are still material at this stage, as any further writedowns on this part of the book are going to hit capital base again.

On the macro side of its balancesheet, AIB is still going to be a sick bank with loan to deposit ratio declining from a severely unhealthy 146% to a still unhealthy 124% post-Nama. And this is really rosy, folks. And the cost base and margins are unlikely to improve. Take for example deposits costs – AIB’s IMS highlighted the reality of high cost of attracting new deposits. Wait till Government starts hovering dosh from the punters through the new Post Office bonds. Supply of deposits will drop. And then, wait for the ECB to cut its discount window operations again, should things improve in the euro area funding markets. AIB, alongside BofI, is heavily dependent on being able to roll the collateralized borrowings from ECB. AIB’s term funding as a percentage of wholesale funding is massively up from 30% in December 2009 to 41% by end Q1 2010, reflecting a €6bn of issuance.

So can anyone explain just how on earth can AIB escape a de facto nationalization?