Wednesday, May 27, 2009

Economics 28/05/2009: Two questions, US economy

Some months ago I was telling the readers of this blog and of my column in Business & Finance magazine to keep an eye on US Munis markets. Well, now is the time, especially California Munis... Good hunting...

I have two questions to ask our Brian 'Detouched-from-Reality' Lenihan and his lappy-Lassie Alan 'Tax-em-Brian' Ahearne:

1) If Ireland were to go to the markets with a bond placement of an odd Euro40-50bn, what chances do we have getting such an issue away without direct ECB help?
2) If ECB were to contemplate such a support scheme for Ireland, will it be willing to also underwrite our structural deficit - the deficit that is pure lard for Irish public sector pay and perks?

These are not some esoteric issues, they imply real risks to the systemic stability of Irish finances.

Question 1: in a recent IMF paper (here), the widening of CDS spreads for sovereign debt between Eurozone economies was explained by domestic 'vulnerabilities'. More specifically, the paper asserts that: "The sensitivity of countries to their domestic vulnerabilities appears to be conditioned by their loss of competitiveness over the upswing of the previous economic cycle. The countries with the largest decline in competitiveness display a particularly strong link between the prospects of the financial sector and sovereign spreads... The differentiation of countries by their debt levels is also stronger where the loss of competitiveness has been greater. The inference is that as external competitiveness has weakened, domestic vulnerabilities have acquired greater salience."

And further to the point: "another source of domestic vulnerability: public debt. ...think of loss of competitiveness as a proxy for weaker growth prospects, the question being posed is whether countries within particular competitiveness loss categories are differentiated by their debt ratios. The presumption is that with lower growth potential, a higher debt ratio will prove more onerous. This differentiation should, moreover, increase when the global growth prospects are substantially marked down, as after the fall of Lehman Brothers." And not surprisingly, the paper finds that it does matter - lower growth prospect means less sustainable debt at any given level.

So let us get back to Q1 above. What idiot in the market will be ready to take new Irish debt (Nama-related) with some Euro40-50bn in face value on anything even remotely close to the terms of our current bond offerings?

Which gets us to Q2 next. If no takers emerge, will the ECB cover Nama bonds? This is a question I have no answer to, but several divergent arguments can be made:
  1. ECB might take Nama bonds directly to rescue Ireland, halting altogether or severely restricting acceptance of further Irish bonds as collateral (so Brian Lenihan will be forced to do something about deficits, having been restricted from using banks borrowings from ECB to float his Government). This is the most likely scenario, but it hinges on stable markets for German bund.
  2. If German bund runs into thinner covers, the ECB will only part-finance Nama at the very best, holding its firepower for the potential need to cover some of the German issues. This will also restrict Brian Lenihan's ability to raid the ECB.
Either way, Irish Exchequer will feel some sort of a squeeze on its ability to support further borrowing. Which brings us to the potential response: a new mini-Budget in July. And either way, if you are holding Irish banks shares, give it a thought - do you really believe that ECB is going to print money for Nama on the back of a asset value discounts of 15-20%?

One interesting recent paper worth reading:
The role of the United States in the global economy and its evolution over time
, by Stephane Dees and Arthur Saint-Guilhem, ECB WP 1034/March 2009 (see here). Authors assess the role of the US in the global economy and its evolution over time.

The paper shows first that “the transmission of US cyclical developments to the rest of the world tends to fluctuate over time but remains large overall. Second, although the size of the spillovers might have decreased in the most recent periods, the effects of changes in US economic activity seem to have become more persistent. Actually, the increasing economic integration at the world level [including ‘China effect’] is likely to have fostered second-round and third-market effects, making US cyclical developments more global”. This, of course, simply means that the US is still the engine of global growth, to the chagrin of all those who believe in the decoupling or the European-century hypotheses.

In addition, the study shows that “the slightly decreasing role of the US has been accompanied by an increasing importance of third players. Regional integration might have played a significant role by giving more weights to non-US trade partners in the sensitivity of the various economies to their international environment.” So regional integration did seemingly push some of the economies slightly away from their link with the US, as expected. However, when third-parties (deeper trade cross-links) are accounted for, the regionalization actually deepened these economies link with the US business cycle in the long run.

A 1% increase in the US real GDP tends to be transmitted based on the extent of trade links between the US and other economies. This means that economies with closer ties to the US tend to experience stronger and quicker responses to the shock. For the Euro area, such shock will lead to an increase in real GDP of 0.2% on average (the range is 0.05% to 0.3%) as opposed to 0.4% for Canada and other developed economies. In the UK and Japan the increase in only 0.2%. In all of these economies, the shock is fully absorbed within 5 quarters, as opposed to 3 years for emerging economies. In other words, all the whingeing of EU leaders about the ‘bad Americans’ giving us a deadly flu in this business cycle is a case of a dog that bites the hand which feeds it. Next time you hear Brian Cowen whimpering about the crisis brought onto Ireland and Europe by Americans, remember the figure: every time America grows by 1%, we grow by 0.2%. Converse, of course, is also true.

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