Sunday, August 22, 2010

Economics 22/8/10: Fundamentals of investing in IRL Inc - I

Few months ago, while speaking as a guest on RTE's Frontline, I confronted two of our 'surrender to Brussels' politicians with a suggestion that a country can do just fine outside the 'Yes, Commissioner' world of European convergence consensus. In return, one politician - from the opposition side of the Dail - rushed to conclude that when advocating greater sovereignty on economic policies I was talking about the UK. My reply was that I had in mind more the path of the country like Switzerland.

In the light of the ongoing sovereign crisis, and with all the talk about bond markets unwillingness to underwrite our economy, I decided to return to the same issue. Here are major comparatives in investment (bonds-related) fundamentals in Ireland vis-a-vis Switzerland and Luxembourg.

I do this in a series of 4 posts. The first one deals with current account dynamics, the second one will deal with Government finances, the third one will show comparatives for GDP, and the fourth one will conclude by making comparisons across other variables, such as inflation, population growth and labour markets.

All data is based on IMF's World Economic Outlook, updates for April and July 2010, which covers period from 1980-2015. Some additional forecasts (beyond 2015) were performed by myself, alongside some additional variables computations.

I chose the two countries for several reasons:
  1. Both are core European countries;
  2. One of these is outside the EU, another is inside the same tent as Ireland;
  3. With a caveat concerning some of aggregate accounting issues with Luxembourg's data, all three have roughly similar economies characterized by: (a) no significant natural resources of their own, (b) small size of population and land mass, (c) heavy reliance on exports, (d) open nature of economies, (e) 'more Boston than Berlin' aspirations in tax policies, (f) being a bit of a thorn in the softer side of Brussels, and so on
So here are few charts and comments. In most cases, I take on the position of a rational investor in sovereign bonds, willing to hold these to maturity. In other words, what matters to me in most of these charts is the answer to the following question: "Given country A fundamentals compared to countries B and C, what is the likelihood that country A can generate sufficient net income to cover its debt obligations?"

Chart 1:
If our expected current account surplus of 2010 were to be used to pay down our debt, how long would it take? The answer to it is 'forever'. Our net surplus from trade and investments from the entire world was negative €4.03bn throughout the 2000s. In the 1990s, our average current account surplus was just €1.108bn, in 2010 our expected surplus in the only year when current account was positive in the 200s - the year 2010 - will be only €849mln. At the same time, our debt currently stands at €86.83bn and rising with interest bill on this well in excess of €4.56bn annually at latest 10 year bond auction yields. In other words, exporting our way out of the recession will not even cover our entire interest bill.

Here's an interesting observation. Irish Government thinks that exports will carry Ireland out of the recession. However, there is an argument to be made that value added in our exports is not really that impressive once the inputs costs are taken out.

Chart 2:
If you were an investor thinking about Ireland's fundamentals, you wouldn't have much hope of getting a positive return on your investment, if net exports were your underlying security, except in the period 1992-2000.

This, one can argue, might be true of our manufacturing exports, where we import often expensive inputs and where transfer
pricing (on inter-company sales) further contributes to lower net value added. But what about our services trade? Well, the current account data shows that during the last decade, when services trade really started to take off in Ireland, our net external balance was negative. So something is not adding up and I will take a look at this in the forthcoming posts.

But for now, we do have impressive exporters, yet our current account performance has been exceptionally weak, compared to
Switzerland and Luxembourg - two countries that are equally as reliant on imported inputs as Ireland.

It is worth noting also that in the case of Switzerland, their exports composition includes significant pharma and high tech
manufacturing exports as well. It just appears that they manage to do trade better...

n fact, a bet made on Ireland Inc based on its external economic performance back in 1980 would have been a disastrous one as Chart 3 below illustrates. An investor betting on our external balance would have 48.1 cents on every euro invested. Based on IMF forecasts, by 2015 this loss can be expected to widen to 48.9 cents. At the same time, identical bet on Luxembourg would have netted a gross return of over €5.11 by now, and a projected gain of €9.20 by 2015: a spread in return relative to Ireland of €5.59 by 2010 and €9.69 by 2015.

Chart 3:
The differences are even more dramatic when we look at comparison to Switzerland: a bet of €1.00 on Swiss external balance made in 1980 would have netted investor €8.145 by 2010 and is expected to yield €13.434 by 2015, implying the spread between investment in Ireland and Switzerland of €8.626 in 2010 and €13.923 in 2015.

bviously, the earlier analysis is sensitive to the time frame for investment chosen (Chart 4).

Chart 4:
Suppose a bet €1.00 was made on Ireland Inc based on its external economic performance back in 1995. An investor betting on our external balance would have grossed 0.393 cents on every euro invested by today and can be expected to gross a loss of 1 cent by 2015. An identical bet on Luxembourg would have netted a gross return of 11.23 cents by now, and a projected gain of 13.305 cents by 2015. The differences are slightly less dramatic when we look at comparison to Switzerland: a bet of €1.00 on Swiss external balance made in 1995 would have netted investor 9.54 cents by 2010 and is expected to yield 11.88 cents by 2015. Oh, and there wouldn't be any risk of getting these returns expropriated by the Government tax policy changes.

(Second post to follow)

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