Sunday, January 24, 2010

Economics 24/01/2010: Consumer side of the economy equation

Before posting my Sunday Times article, couple of interesting links from elsewhere:

Myles Duffy on Revenue's 2009 figures - here. Good and concise view.

Excellent essay on Google v Apple battle and why Google just might be losing it - here.

Now to my article, as usual, unedited version:

The latest retail sales figures show continued weakness in consumer demand through November 2009 with core sales (ex-motors) up a poultry 0.3% in volume and down 0.3% in value on October. In twelve months to December, Irish retail sector has recorded a massive 8.2% drop in the volume of sales, while the value of good and services sold collapsed 12.9%.

This weakness in retail sales is important for three reasons – both overlooked by the analysts. First, this was a month usually characterised by higher spending in anticipation of Christmas holidays. Second, this was the beginning of the Christmas season that concluded the decade and came after extremely poor 2008 holidays shopping. Penned up demand was great, going into November, but consumers opted to stay away from the shops. Third, even November retail sales were out of synch with forward looking consumer confidence indicators.

Combined, these facts suggest that the retail sector is suffering from a structural change that is here to stay, even if the broader economic activity and consumer confidence were to bounces into positive growth.

This observation is far from trivial. Despite all of our hopes for a recovery based on exports, any growth momentum in the economy can be sustained only on the back of improving private consumption and investment. In Q3 2009, the latest for which data is available, personal consumption of goods and services accounted for 63.5% of our GNP and over 50% of GDP. During the crisis, due to a much deeper collapse in investment, the importance of consumer spending has increased. At the peak of the bubble in 2007, consumption spending amounted to 57% of our national output.

Retail sales form a significant component of the overall consumer expenditure and it is also strongly correlated with other components, especially communications and professional services. These links are highlighted by the anaemic revenues generated by mobile and fixed line service providers, and dramatic declines in demand for insurance.

Thus, overall, retail sales offer some insight into what is going on at the aggregate personal consumption level.

Earlier this week, PwC released an in-depth analysis of emerging trends in Irish retail sector that sound a warning for the future of our consumer economy. The report found that in response to the crisis, some 55% consumers are now reporting lower spending on goods and services, while 65% are saying they are spending more time shopping for value.

Over the last year, only aggressive price cuts kept the volume of sales from reaching the levels of 1999-2000 in real terms. 71% of Irish retailers have increased their promotional activities, while 67% have offered aggressive discounts (63% of retailers plan further realignments of costs in 2010).

In other words, the impact of the current economic crisis on consumer behaviour has been deeper than a normal recessionary dynamic would support. PwC survey has found that 53% of all retailers believed the changes in consumer attitudes to shopping we are witnessing today are long term or permanent in nature.

This permanent nature of change is due to what in a 2004 theoretical paper on household consumption I called ‘learning-by-consuming’ effect. While searching aggressively for better value, the households simultaneously improve their expenditure efficiency and discover that buying cheaper does not always mean sacrificing quality. PwC research confirms my theoretical model by showing that 86% of consumers who shopped for value perceived cheaper goods to be of the same quality as higher priced goods.

The permanence of change in consumer behaviour is worrisome. Barring dramatic improvements in consumer willingness to spend, two negative developments will persist in our economy.

First, any return to growth will be short-lived and prone to sudden reversals with the risk of a double-dip recession.

Second, any recovery absent robust growth in private expenditure will imply further widening of our GDP/GNP gap as MNCs tear away from the lagging domestic economy. Over the long run, this gap will have to be closed either through a massive downsizing of the foreign investment sector (as costs bear down on companies operating here), or via a return of another credit bubble. Neither development would be welcomed.

In the nutshell, we can expect retail price deflation to continue in 2010. According to NCB Stockbroker’s economist Brian Devine, further deflation in 2010 can lead to a statistical bounce in overall retail sales. “With prices declining, consumer confidence stabilizing and consumer attitudes shifting towards value expect the volume of retail sales to grow in 2010,” says Devine. But, “job losses and emigration will weigh on overall consumption and as such we can expect consumption to contract marginally in 2010."

In other words, the prognosis for improved consumer confidence carrying sustained recovery in 2010 is not good.
Should the changes in consumer behaviour be permanent, we can expect consumption to grow at 1.5-3% per annum as wages stabilize and the savings rate begins to decline from its 2009 high of over 11%. And even from this low growth scenario, the risks are firmly to the downside.

Given the expected impact of Nama on mortgage interest rates, credit and deposit rates, it is highly likely that our savings will remain elevated well through the first half of this decade. The ESRI forecasts personal savings rates to stay above 10% through 2013 and close to 8% thereafter. In contrast, over 2000-2007 our savings rates averaged just above 6%. Higher savings, of course, will mean lower consumer spending and private investment. Rising cost of borrowing and credit will add to our woes.

Finally, subdued consumer spending means lower Exchequer revenue through VAT and Excise duties. This is likely to lead to higher tax burden in Budget 2011 and a further downward pressure on consumer spending.
In this environment, the Government simply cannot afford inducing more uncertainty and pressure on already over-stretched households’ balance sheets. Restoration of consumer confidence requires an early and committed signal from the Exchequer that Budget 2011 will not see new increases in taxation. From here on through 2014, all and any fiscal adjustments should take the form of permanent cuts to public expenditure and elimination of tax loopholes, not a series of raids on taxpayers’ incomes.

The Government should also reverse its decision to limit Banks Guarantee coverage of ordinary deposits to Euro100,000 that is scheduled to come into force later this year. Lower guarantee protection will act to increase precautionary savings as well as deplete the already razor thin deposits base in Irish banks. The twin effects of such an eventuality will be greater demand for public capital from our financial institutions, plus lower consumer spending. Does Irish economy need another twin shock just as the recession begins to bottom out?

It appears that despite all pressures, the Government is staunchly refusing to carry out a public inquiry into the causes of our banking sector crisis. Instead of confronting with decisiveness this matter of overarching public interest, our Taoiseach has resorted to deflecting all queries with his favourite catch phrase: “We are where we are”. One wonders whether the Government would be as willing to use this phrase if the subject of the proposed inquiry was a series of major transport accidents, or a systemic failure in our health sector. Institutions responsible for over 80 percent of the entire banking sector in the country came close to a collapse and have to be rescued by the taxpayers at a total cost (including Nama) of Euro72-89 billion or 46-57 percent of our annual national output. What else but a fully public inquiry with live television coverage of all hearings can one expect in a democratic society? An inquiry into the systemic failure of our financial system must be not only public, but comprehensive. It should cover all the lending institutions in receipt of state assistance as well all policy-setting, regulatory and supervisory bodies – from the Financial Regulator to the Department of Finance – responsible for ensuring stability of our financial system. This inquiry should have powers to fine those who failed in fulfilling their contractual and/or statutory duties. And it must be conducted by people who have no past (since at least the year 2000) or present connections with the any of institutions called in for questioning. Anything less than that will be an affront to all hard working men and women of this country who are expected to pay for the mess caused by the systemic failures in our banking sector.


Mai said...

Hi Dr. Constantin

I couldn't agree more with you about having a fully open banking enquiry - considering we as taxpayers are paying for this whole NAMA mess I think it is the least we are entitled to. I think it is quite arrogant of Mr. Cowen to suggest otherwise.

However I disagree with you on the following:

"The Government should also reverse its decision to limit Banks Guarantee coverage of ordinary deposits to Euro100,000 that is scheduled to come into force later this year. Lower guarantee protection will act to increase precautionary savings as well as deplete the already razor thin deposits base in Irish banks".

1) The UK only guarantees deposits up to £50,000.
2) How does lowering the deposit protection guarantee increase savings?
3) The last I read the deposit base in Irish banks was somewhere in the region of €85 billon plus - hardly razor thin.

Am I missing something here? If I have misunderstood I apologise.



TrueEconomics said...

Dear Mai,

Limiting the guarantee to 100K for depositors implies that uncertainty about ones' deposit over that limit will increase. Thus, risk of suffering a loss will rise as well. This will create an added incentive to beef up savings as well as to 'spread' savings across border to the UK banks. The end result - savings rate might rise (or at the very least it will not decline by as much as in the environment of fully secured savings), while banks' deposits base will migrate (partially, of course).

The Government is fooling itself into believing that if incentives to save are reduced, people will start spending money once again. This is not true in the case of precautionary savings. People are saving out of fear, not because interest yields are high. Government actions to increase this fear through talking about new taxation, removal of the guarantee and the clandestine process of Nama are only going to feed the fire of precautionary savings.

Now, 6 lending institutions had something to the tune of 400 billion in loans outstanding on their books. Their 229 billion deposits base means loans to deposits ratio of 173%. Conservative book would require a deposit base of between 85-90 percent, depending on reserves. So optimal deposit base should have been around 445-470 billion.

229 billion is less than 1/2 of this. And at the times like these - with uncertain funding prospects, rising demand for capital cover and rising bad loans provisions - this is razor thin.

For the two main banks in question, loans to customer deposits ratios, last time I checked, stood at 150-160%. Slightly better than for 6 guaranteed institutions taken together, yet still, very thin.

Hope this explains my view.

Best, Constantin

Mai said...

Dear Constantin,

Thank you for clarifing. I understand now your point of view. I hadn't thought of it from that perspective.