Tuesday, November 10, 2009

Economics 10/11/2009: Our Unique Path to Solvency

Updated: FX outlook (below)

And so two things come to pass in the last few days that will have a significant bearing on Ireland in years to come.

Issue 1: the ECB has firmly set its sight on exiting from money printing business sooner rather than later. Per ECB's statement last week, the bank will close off its 1 year discount window, cutting maturity of the loans available to the banking sector in the euro area from 1 year long term maturity to 3 months traditional maturity. This will mean two things for Irish banks who are the heaviest borrowers from the ECB by all possible measures (see here):
  1. Irish banks will face much faster transmission of any rates increases into their cost of borrowing increases;
  2. Irish banks will see higher cost of borrowing directly due to them being unable to access 3-12 months maturity instruments outside the interbank lending markets (currently they are collecting a handsome subsidy from the ECB’s discount window by borrowing at rates well below those offered in euribor).

And all of this will mean that our banks will once again see their margins squeezed by the credit markets, implying an even greater incentive for them to go after their paying customers with higher mortgage rates, credit cards rates and banking fees and costs.

Issue 2: earlier this week, the EU produced an estimate that the Union members’ total public debt could reach 100% of GDP by 2014 up from 66% in 2007. Last month, the Commission forecast that EU debt levels will rise to 84% in 2010 and 88.2% in 2011. Now, it says that not only the debt will top 100% of GDP in 2014, but that it will keep on rising after that. And the Commission named the row of culprits most responsible for fiscal debacle: Greece, Ireland, Latvia, Spain and the UK. This is linked to the earlier paper from the Commission that looked at long-term demographic challenges to deficit financing, where Ireland and other countries were presented as basket cases in terms of pensions liabilities and expected healthcare costs associated with ageing population.

This, of course means the following two things for Irish economy:
  1. Despite all extension for 2013 deadline for Mr Cowen to deliver SGP-compliant budget for Ireland, the EU is going to put more pressure on Ireland to bring its house in order. Not doing so will risk derailing of stimulus exits and deficits rollbacks by the likes of Italy, followed by Austria, Spain, Portugal and France. This simply cannot be allowed for the fear of undermining euro’s credibility and with it any plans Brussels might have for the tidy earnings from reserve currency seignorage in the future;
  2. Brussels will be pushing harder and harder for own tax revenue source – some sort of a unified federal tax – in order to divorce itself from the precarious and uncertain (i.e volatile) sources of state-level revenues.

The net effect of all of this – taxes will go up. To put this into perspective, should the EU allow us the deadline of 2014 to sort out our deficit, this will mean our debt will be up by another €20-22bn and our cumulative interest bill will rise (by the end of 2014) by another €5.5-7bn.

Alternatively, consider the annual bill for this debt – at 4.7-6% per annum (a reasonable range starting from today’s low rates and reaching into rates consistent with ca 1.75-2.0% base ECB rate), the new, shall we call it ‘delay the pain SIPTU’-debt, will cost us every year something to the tune of €940-1,320 million, or just about what Mr Cowen is now promising to shave off the public sector pay bill.

So do the math – accumulation of liabilities (interest only) of up to €1.3bn per annum and political process delivering promises of savings of €1.3bn after two years of the crisis… Path to solvency indeed.

Now, per one reader's request, here is my view on what this means for the euro:

Macro side: unwinding of deficits will mean a steep fall off in Government consumption and investment, so both - short term and longer term demand for euro will fall. This will be offset by the simultaneous unwinding of quantitative easing, so supply of euro will also decline. Three scenarios and paths are possible from there:

  1. If the two offset each other, we are down to interest rate differences to drive currency pairs against the euro (more on this below);
  2. If monetary tightening will be lagging fiscal constraints, then euro will be heading south vis-a-vis dollar but not by much as it is highly unlikely that Obama Administration will be able to sustain its own deficits for much longer;
  3. If monetary tightening leads fiscal tightening, then euro might head further north vis-a-vis the dollar.
  4. Interest rates effects are most likely to drive euro up for several reasons: the US Fed is likely to continue easing as fiscal stimulus runs out; the ECB has reputation building (re-building?) to do; US has higher tolerance for inflation.
  5. Last issue to watch over is the financial sectors demand for liquidity. Here, the US is more likely to face smaller demand for liquidity than euro area and this will imply a net positive to the dollar upside.

So my view is that dollar-euro pair will remain volatile over some time, with some limited upside to the dollar in the medium term. Carry trades in dollar will be continuing especially as the BRICs and the rest of the world launch into a new investment cycle in early 2010. Depending on whether this will coincide with monetary/ fiscal tightening in the euro area, we might see temporary testing of $/€1.65 barrier.

Euro-sterling story is a different story. The UK will be unwinding fiscal stimulus, while continuing monetary easing (banks are still in need of capital and writedowns will remain pronounced), which means we shall see plenty excess supply of sterling. The pressure is to the downside here and parity can be approached once again (remember that 0.98 moment in December 2008?).


Anonymous said...

Dollar euro $1.50.
Carry trade in dollars is creating a new massive bubble in commodities.
Foreign holders of dollars are suffering depreciation because of the tanking dollar.
How far behind are interest rate rises in the U.S. inducing a similar rise in rates in Europe?.

Given as you state the total EU debt will exceed 100 billion euros can you comment on the effects of the above on the euro exchange rates,interest rates and how it will affect us here in Ireland?.


There are many paths open to Ireland at present, unfortunately our government is oblivious to everything except the bailing out bankrupt financial institutions at incredible risk to the rest of the economy.
Ireland must tap into 'the next big thing': GREEN POWER.

Financiers, economists and leaders of industry have all tipped green technology as the next big thing for the world economy. They see it as being on the scale of information technology, the internet and mobile communications — the kind of economic breakthrough that builds industries, generates jobs and creates fortunes. The internet was largely built by Silicon Valley start-ups, not by telecom giants. The green tech industry could be a similar story, making it an ideal sector for innovative Irish companies.

Irish entrepreneurs and their financial backers should now be positioning themselves to tap into a new wave of clean technologies. To assist them, one key development is required: a smart-grid electricity network. Basically, this is a software overlay on the existing electricity power lines. It would allow us to apply IT to improve the efficiency of energy consumption.

Cisco, whose technology helps run the internet, is building a two-way link into electricity grids. John Chambers, its chief executive, has described the smart grid as “an instant replay of the internet; instead of moving zeros and ones, we’re moving electricity”.

A smart grid could be a big driver of wealth and jobs over the next decade. Christian Feisst, the head of business development at Cisco’s smart-grid subsidiary, has said: “The change in energy will be the greatest infrastructure project of the next decade.”

Michael Walsh, the chief executive of the Irish Wind Energy Association, says many wind firms face delays of up to 10 years for a connection to the national grid.

EirGrid, the state-owned electric power transmission operator, has said Ireland needs 1,150km of new electricity circuits and the upgrading of a further 2,300km if we are to meet our 2020 goal. A spokeswoman said that this was “a massive task” but that they were on target to achieve it.

According to its latest annual report, EirGrid has the best-paid staff in the public sector — with its 225 employees receiving an average of €110,000 each — and giving it a target of 2020 is not acceptable. Firms such as IBM and Cisco are introducing smart grids in Miami, Amsterdam and Malta over a much shorter period.

Despite this year’s 10% reduction in electricity prices, Ireland’s remain among the highest in Europe and they are being blamed for our continuing lack of export competitiveness. The Small Firms Association has called for a review of the regulation of the entire energy market.

We also need action on the feed-in rate, the price the ESB pays micro-generators for the power they sell to the grid. Our rates are dismal by international standards, and this should be rectified immediately, otherwise it will stunt the growth of this promising sector.

Cearbhall Ó Dálaigh.

Brian Nolan said...

What do you think of the idea to dam a few western valleys, pump sea water into them using wind power, and then generate electricity on demand using hydro power from the filled dams? Works for me, but you seem to have a better handle. Myles