Sunday, March 31, 2013

31/3/2013: Structural Reforms in Ireland: Far From Best-in-Class

Some interesting charts from the ECON review of the peripheral countries' structural reforms implementation during the crisis (full report is available here):

Note that by both measures, Ireland is not the 'best pupil in the class':

  • By unadjusted metric, we are second in the 'class' in terms of responsiveness rate, but
  • Once adjusting for the difference in reforms implemented and underlying conditions, we are only in the fifth (note: ECON chart is taken from the chart produced by the OECD, reproduced below which clearly shows our position to be worse than that of Italy)

In part, the above is driven by the fact that we have started our reforms earlier than other countries, hence, for example, in terms of labour market changes, we have most of the gains in the Gross Value Added per hour worked peaking in 2009-2010. Also, notice that our performance relative to other peripherals has deteriorated in 2011-2012 and is expected to remain there in 2013.

In part, however, the adjusted score is driven by structural differences in reforms adopted. And this implies that per OECD we are still ranked only fifth in the peripheral economies group when it comes to the adjusted scores over the broader period of 2009-2010 to 2011-2012:

31/3/2013: Are European Brahmins Cypriot crisis-free?

In an Orwelian Universe that is the EU, the rules are different for different castes... the Brahmins are, obviously, the top of the pile. Not surprisingly, amidst deposits outflows from Cyprus immediately prior to the EU sanctioned expropriations, there are strands of Cypriot Brahmins rushing out of their banks. Here's the report by Rossija 24 - Russian news agency on the topic:

 via a tweet:

Let's translate verbatim the above:

"Greek press has found compromising material on Cypriot President. According to the Greek media sources, few days before the Eurogroup decision to bail-in deposits, relatives of President Nicos Anastasiades took emergency steps to save their funds. The issue concerns the amount of EUR21 million in funds. A company, which belongs to the relatives of the President, transfered these funds from Laiki bank to London, as reported by the Rossija 24 TV channel. The Laiki Bank is currently undergoing restructuring, and haircuts on clients' funds can reach up to 80 percent."

We should note, of course, that this is just one report, albeit here is a Cypriot press report from just 30 minutes ago covering the same: and Greek reports: and and .

31/3/2013: Unique Ireland? Why not... per IMF working paper...

Here's an interesting case of Ireland's uniqueness:

Eyraud, Luc and Moreno Badia, Marialuz, "Too Small to Fail? Subnational Spending Pressures in Europe" [(February 2013). IMF Working Paper No. 13/46] paper looks at the re-distribution of spending between national and sub-national governments within the EU over time, covering the period of the crisis. Due to the size of the banking sector measures and their impact on the Government budgets in Ireland, the paper excludes Ireland from the dataset when running analysis.

In other words, we are so out of line with the rest of Europe in terms of resources we threw at the banks during the crisis, that our data is no longer meaningfully comprable to the rest of EU.

Here are two charts illustrating this 'uniqueness':

31/3/2013: Bank Leverage, Systemic Crises and Debt v Equity Funding: Tax Asymmetry

As the readers of this blog would know, I have been advocating more symmetric tax treatment of equity and debt, both in terms of public and private bonds and lending taxation. Here's a recent IMF paper on the topic that provides evidence that asymmetric taxation of debt and equity, with preferential treatment of debt over equity, generated internal instability in the system, making it more prone to crises.

Mooij, Ruud A., Keen, Michael and Orihara, Masanori paper "Taxation, Bank Leverage, and Financial Crises" (February 2013). IMF Working Paper No. 13/48 argues that "that most corporate tax systems favor debt over equity finance is now widely recognized as, potentially, amplifying risks to financial stability. This paper makes a first attempt to explore, empirically, the link between this tax bias and the probability of financial crisis."

The study "…finds that greater tax bias is associated with significantly higher aggregate bank leverage, and that this in turn is associated with a significantly greater chance of crisis. The implication is that tax bias makes crises much more likely, and, conversely, that the welfare gains from policies to alleviate it can be substantial far greater than previous studies, which have ignored financial stability considerations, suggest."

The paper "aims to provide a first attempt to establish and quantify an empirical link between the tax incentives that encourage financial institutions (more precisely, banks, the group for which we have data) to finance themselves by debt rather than equity and the likelihood of financial crises erupting; and then to try to quantify the welfare gains that policies to address this bias might consequently yield."

The paper combines two elements in a causal chain:

"The first is that between the statutory corporate tax rate and banks’ leverage. This has received substantial attention in relation to non-financial firms, but very little in relation to the financial sector. Keen and De Mooij (2011), however, show that for banks too a higher corporate tax rate, amplifying the tax advantage of debt over equity finance, should in principle lead to higher levels of leverage; the presence of capital regulations does not affect the usual tax bias applying, so long as it is privately optimal for banks to hold some buffer over regulatory requirements (as they generally do).

[In other words, capital requirements regulations are not sufficient to address the problem created by skewed incentives. The authors state that "Regulation, of course, has historically had the dominant role in addressing such problems of excess leverage in the financial sector, and the higher and tighter capital requirements of Basel III should to some degree reduce the welfare costs of debt bias."]

Empirically too, Keen and de Mooij (2012) find that, for a large cross-country panel of banks, tax effects on leverage are significant—and, on average, about as large as for non-financial institutions. These effects are very much smaller, they also find, for the largest banks, which generally account for the vast bulk of all bank assets. …Importantly, the finding that tax distortions to leverage are small for the larger banks, which are massively larger than the rest, does not mean that the welfare impact of tax distortions is in aggregate negligible: even small changes in the leverage of very large banks could have a large impact on the likelihood of their distress or failure, and hence on the likelihood of financial crisis."

The second link in the causal chain is the link "between the aggregate leverage of the financial sector and the probability of financial crisis. We estimate such a relationship for OECD countries, …capturing data on the recent financial crisis… The results suggest sizeable and highly nonlinear effects of aggregate bank leverage on the probability of financial crisis."

"… we consider three tax reforms that would reduce the tax incentive to debt finance:

  • a cut in the corporate tax rate; 
  • adoption of an Allowance for Corporate Equity form of corporate tax (which would in principle eliminate debt bias); and 
  • a ‘bank levy’ of broadly the kind that a dozen or so countries have introduced since the crisis."

"The implications of these reforms for aggregate leverage are readily estimated using the results above.

  1. We suppose, as before, that a 1 percentage point reduction in the CIT rate reduces banks’ aggregate leverage by somewhere between 0.04 and 0.15. 
  2. This means, for instance, that the bank levy of 10 bp would reduce financial leverage by between 0.1 and 0.4 percentage points, for example from 93 percent to 92.9 or 92.6. 
  3. Eliminating debt bias altogether with an ACE would reduce leverage by 2.2 percentage points under what we shall take to be the central estimate of 0.08: say, from 93 to 90.8; with the upper bound estimate of 0.15, leverage would fall by 4.2 percentage points."

The above clearly suggests that ACE approach, basically removing disincentive to equity funding compared to other policy alternatives. It also shows that in impact terms, lower corporate tax rates are not sufficient to eliminate or reduce the adverse effects of the asymmetric treatment of debt against equity.

31/3/2013: German Hartz IV reforms - evidence

Another interesting paper, worth a read: Krebs, Tom and Scheffel, Martin, "Macroeconomic Evaluation of Labor Market Reform in Germany" (February 2013). IMF Working Paper No. 13/42.

Back in 2005 Germany undertook a massive reform of social welfare systems, known as Hartz IV reform. This "amounted to a complete overhaul of the German unemployment insurance system and resulted in a significant reduction in unemployment benefits for the long-term unemployed".

The IMF paper used "an incomplete-market model with search unemployment to evaluate the macroeconomic and welfare effects of the Hartz IV reform". The model was calibrated to German data before the reform followed by simulation of the calibrated model to identify the effects of Hartz IV.

"In our baseline calibration, we find that the reform has reduced the long-run (non-cyclical) unemployment rate in Germany by 1.4 percentage points. We also find that the welfare of employed households increases, but the welfare of unemployed households decreases even with moderate degree of risk aversion."

For all the debate about the merits of such reforms, it is pretty darn clear that Hartz IV-styled reforms - currently being advocated by the IMF and the EU for the peripheral states - cannot take place in the environment of protracted and structural Euro area-wide and national recessions and especially in the presence of other exacerbating factors, such as debt overhangs,  insolvency regime breaks, dysfunctional banking sector, monetary policy mismatch, etc.

Put simply, in 2005, German economy was into its second year of (anaemic at 0.7% in 2004 and 0.84% in 2005) growth with unemployment at an uncomfortable 11.2% still leagues below the current rates in the peripheral state. German government deficit in 2005 was at relatively benign 3.42% compared to the deficits in the peripheral states, with structural deficit at even lighter load of -2.6% of p-GDP and primary deficit at 1.0%. German debt/GDP ratio on Government side was at 68.5% of GDP. All of these parameters clearly indicate that Germany was in a much better starting position for consolidating social insurance systems than the peripheral states find themselves today.

31/3/2013: Draghi calling President Napolitano: a nasty precedent

Here's one of the best examples of the total departure of the EU institutions from the normal democratic constraints on their mandate vis-a-vis national affairs:

The story link is:

For a reply:

That is correct (assuming the reported call did take place): the ECB represents a sub-section of the executive pillar of power in the EU (and via the national central banks - in the member states), just as the US Fed. Neither the Fed nor the ECB have any business in influencing or restricting the legislative pillar (in the case of the above incident - the electoral process) or the entire executive pillar (in the above case - pertaining to the Presidency to which monetary policy institutions are accountable or co-accountable whenever oversight over monetary policy institutions co-rests with legislature) or the judiciary (presumably, Mr Draghi might call on European or national judges too, should their workings approach the issues related to OMT or other aspects of the monetary policy).

To see this, simply replace ECB's Draghi with, say, General X of the Common Security & Defence Policy calling President Napolitano to express concerns about Italian elections. How fast will 'military interference in political affairs' rise to media headlines?

Europe is now clearly on a dangerous path that can lead to subversion or manipulation of democratic institutions and processes. 

31/3/2013: Entrepreneurship and the Great Recession

Staying on the theme of 'catching up with my reading' today - a very interesting paper by Fairlie, Robert W., "Entrepreneurship, Economic Conditions, and the Great Recession" (February 28, 2013). CESifo Working Paper Series No. 4140.

From the abstract:

"The “Great Recession” resulted in many business closings and foreclosures, but what effect did it have on business formation?

On the one hand, recessions decrease potential business income and wealth, but on the other hand they restrict opportunities in the wage/salary sector leaving the net effect on entrepreneurship ambiguous.

The most up-to-date microdata available -- the 1996 to 2009 Current Population Survey (CPS) -- are used to conduct a detailed analysis of the determinants of entrepreneurship at the individual level to shed light on this question.

  • Regression estimates indicate that local labor market conditions are a major determinant of entrepreneurship. 
  • Higher local unemployment rates are found to increase the probability that individuals start businesses. [Note: authors do not control for quality of entrepreneurship, e.g. survivorship rates for entrepreneurial ventures founded by 'forced' entrepreneurs out of unemployment spells]
  • Home ownership and local home values for home owners are also found to have positive effects on business creation, but these effects are noticeably smaller. 
  • Additional regression estimates indicate that individuals who are initially not employed respond more to high local unemployment rates by starting businesses than wage/salary workers. The results point to a consistent picture – the positive influences of slack labor markets outweigh the negative influences resulting in higher levels of business creation. Using the regression estimates for the local unemployment rate effects, I find that the predicted trend in entrepreneurship rates tracks the actual upward trend in entrepreneurship extremely well in the Great Recession."

Wait, what was that about 'home ownership' and 'local home values'? Sure this is not suggesting that negative equity might have an effect on entrepreneurship? Irish Government & our 'Green Jerseys' say that it only matters when one decides to move...

See three posts from 2010 that I wrote on the topic of Negative Equity effects in Ireland: Post 1, Post 2 and Post 3) and another link from 2010 on the topic of Negative Equity and entrepreneurship (here).

31/3/2013: R&D and tax policy: income tax or targeted tax credits?

And while we are on innovation vs policy topic, here's another interesting study, looking into policy drivers for R&D. Ernst, Christof, Richter, Katharina and Riedel, Nadine, "Corporate Taxation and the Quality of Research and Development". CESifo Working Paper Series No. 4139, February 2013.

The paper "examines the impact of tax incentives on corporate research and development (R&D) activity. Traditionally, R&D tax incentives have been provided in the form of special tax allowances and tax credits. In recent years, several countries moreover reduced their income tax rates on R&D output.

Previous papers have shown that all three tax instruments are effective in raising the quantity of R&D related activity. We provide evidence that, beyond this quantity effect, corporate taxation also distorts the quality of R&D projects, i.e. their innovativeness and revenue potential.

Using rich data on corporate patent applications to the European patent office, we find that a low tax rate on patent income is instrumental in attracting innovative projects with a high earnings potential and innovation level. The effect is statistically significant and economically relevant and prevails in a number of sensitivity checks. R&D tax credits and tax allowances are in turn not found to exert a statistically significant impact on project quality."

All is fine, folks, but what does one do when the two countries compete for R&D projects allocations in the environment where both have already set zero tax on patent income?

31/3/2013: World Trade Drivers: policy or simple innovation?

A very important issue of logistics and transport innovation effect on trade flows is tackled in the study by Bernhofen, Daniel M., El-Sahli, Zouheir and Kneller, Richard, titled "Estimating the Effects of the Container Revolution on World Trade" CESifo Working Paper Series No. 4136, February 2013.

[Note: Italics are mine]

From the abstract: "The introduction of containerization triggered complementary technological and organizational changes that revolutionized global freight transport. Despite numerous claims about the importance of containerization in stimulating international trade, econometric estimates on the effects of containerization on trade appear to be missing. Our paper fills this gap in the literature. Our key idea is to exploit time and cross-sectional variation in countries’ adoption of port or railway container facilities to construct a time-varying bilateral technology variable and estimate its effect on explaining variations in bilateral product level trade flows in a large panel for the period 1962-1990."

Per findings: "Our estimates suggest that containerization did not only stimulate trade in containerizable products (like auto parts) but also had complementary effects on non-containerizables (like automobiles). As expected, we find larger effects on North-North trade than on North-South or South-South trade and much smaller effects when ignoring railway containerization. Regarding North-North trade, the cumulative average treatment effects of containerization over a 20 year time period amount to about 700%, can be interpreted as causal, and are much larger than the effects of free trade agreements or the GATT. In a nutshell, we provide the first econometric evidence for containerization to be a driver of 20th century economic globalization."

Now, 700% over 20 years is a massive uplift in what was already a much-advanced trade system (North-North). With South-South and North-South trade flows now rapidly converging in terms of volumes and type of goods traded to those of North-North, I would suspect we will see an equally massive positive impact on these trade flows as well, and as a result on global trade.

The evidence presented in the study is of huge importance. It shows just how impactful can a simple, non-formal-R&D driven innovation can be and it also puts into the context the scope for policy intervention vs organic business-led innovation intervention in delivering market outcomes.

Saturday, March 30, 2013

30/3/2013: A simple, yet revealing, exercise in house prices

Based on the latest reading for the Irish Residential Property Price Index, I computed three scenarios for recovery, based on 3 basic assumptions of:

  1. Steady state growth of 5% per annum in nominal terms (roughly inflation + 3% pa)
  2. Steady state growth at the average rate of annual growth clocked during 2005-2007 period, and
  3. Steady state growth at inflation + 1% pa
Note, Scenario 3 is the closest scenario consistent with the general evidence from around the world that over the long run, property returns are at or below inflation rates.

Table below summarises the dates by which we can expect to regain 2007 peak in nominal terms:

Yep, turning the corner (whenever we might do that) won't even be close to getting back into the 'game'...

30/3/2013: Retail Sales in February: Deadman Still Walking

With all the Cypriot Meltdown excitement as the newsflow, Irish data releases slipped into 'noise background' this week, so time to fix that.

March 28th we saw the release of the retail sales data for Ireland for February 2013. The headline from CSO read: "Retail Sales Volume increased 0.3% in February 2013" which obviously is the good news. Except, in reality, reading below headline we discover that:

"The volume of retail sales (i.e. excluding price effects) increased by 0.3% in February 2013 when compared with January 2013 while there was no change in the annual figure.  If Motor Trades are excluded, the volume of retail sales decreased by 0.2% in February 2013 when compared with January 2013 and there was an annual increase of 1.0%."

Wait a second, ex-motors, retail sales fell 0.2% in volume in m/m terms, but were still up 1.0% y/y. Oh, and durable goods (e.g. Electrical Goods) sales were down again.

And in value terms? The stuff that makes retail businesses actually hire or fire workers and pay or not pay taxes?.. Much the same:

"The volume of retail sales (i.e. excluding price effects) increased by 0.3% in February 2013 when compared with January 2013 while there was no change in the annual figure.  If Motor Trades are excluded, the volume of retail sales decreased by 0.2% in February 2013 when compared with January 2013 and there was an annual increase of 1.0%."

Let's see some dynamics:

  • Value of sales ex-motors averaged 96.6 in 3mo through February 2013 against 97.0 in previous 3mo period. 6mo average through February 2013 was 96.8 (virtually identical to 3mo average), implying effectively zero growth over 6 months period, although previous 6mo period average was 95.5.
  • Over longer horizons: 2006-2007 average of the index stands at 112.1, which was down to 2010-2011 average of 96.6 and 2012 full year average of 96.0, and January-February 2013 average of 96.5. You can tell the that whole volume 'activity' is just a flat trend since January 2011 with some volatility around it.
  • Volume of activity slipped on 3mo average through February 2013 to 100.1 from 100.6 in 3 months through November 2012. The rate of decline on 3mo averages basis in volume was more pronounced than for value index, which is a story consistent with pretty much the entire crisis - retailers are only able to shift volumes at the expense of revenues they get. Consumers are getting better deals, but this also means employment in the sector is unlikely to increase.
  • 2012 average of 99.6 is pretty much matched by january-February 2013 average of 99.7 - again, flat line growth trend. And as before that one runs from January 2011.

I keep tracking Consumer Confidence here, to show that the whole idea of 'confidence' when not underpinned by supportive fundamentals is not a reasonable concept for anchoring one's expectations about real economic performance.

Here, per usual, updated charts linking (or rather showing the lack of links) confidence to retail sales indices:

Lastly, recall that I run my own index of Retail Sector Activity (RSAI) that is a much stronger correlative for retail sector indices:

Two things jump out from the chart above:
  1. The overall flat-line trend in activity in the retail sector over January 2009-present period, showing that, in principle, there is no recovery and there is no sustained signal of one coming so far in the short term future.
  2. Forward-looking RSAI has slipped (on 3mo average basis) from 107.9 in 3 months through November 2012 to 106.0 in 3 months through February 2013. M/m RSAI is down 1.83% and y/y it is up 1.84%, tracking correctly the overall dynamics in the CSO indices.
Hence, my expectation is for more of the same in the next 3 months, with retail sales slipping slightly in volume and value, posting closer to zero growth in y/y terms over Q2 2013. The deadman is still walking, for now... and the 'turning point' is still some corridors away...

30/3/2013: Irish Debt Deleveraging 2012: Not much happening

Over the recent years we have been told ad nausea that all the economic suffering and pain inflicted upon us was about 'deleveraging' our debt overhang, 'paying down our debts', 'repairing balancesheet of the economy' and so on. Well, surely, that should mean reduction in our total economic debt levels, right?

Wrong! Our debt levels, vis-a-vis the rest of the world are up on the crisis trough and on pre-crisis peak (EUR580bn in 2007 to EUR651.2bn in 2012), and our net position (foreign assets less foreign liabilities) is down from EUR119.4bn deficit in 2007 to EUR153.7bn deficit in 2012:

 The above exclude IFSC.

Meanwhile, IFSC continues to grow in size, both in absolute and relative terms:

  • Foreign assets up from EUR1,810bn in 2007 to EUR2,319bn in 2012
  • Foreign liabilities up from EUR1,727bn in 2007 to EUR2,322bn in 2012
  • Proportionally to our total foreign assets and liabilities the IFSC has grown from 79.7% in 2007 to 82.3% in 2012 on assets side and from 74.9% in 2007 to 78.1% in 2012 on liabilities side.

Back to non-IFSC balancesheet (as our policy makers and civil servants love treating ISFC as some sort of a pariah when it comes to counting its liabilities, and as some sort of a hero when it comes to referencing it in terms of employment, tax generation etc):

Chart above shows frightening trends in terms of our foreign liabilities as a share of GDP and GNP. Put simply, in 2007, non-IFSC foreign liabilities stood at a massive 357.5% of our GNP. Last year, they reached a n even more dizzying 488.1%.

You might be tempted to start shouting - as common with our officials and 'green jerseys' - that the above are gross figures and that indeed we have vast assets that are worth just so much... Setting aside the delirium of actually thinking someone can sell these 'assets' to their full accounting / book value etc, err... things are not looking too bright on the net investment position (assets less liabilities) side:

In 2007, Irish net investment position vis-a-vis the rest of the world was a deficit of 63.3% of GDP and 73.6% of GNP. In 2012 the net position was in deficit of 93.9% of GDP and 115.2% of GNP. Put differently, even were the Irish state to expropriate all corporate, financial and household assets held abroad and sell them at their book value, Ireland would still be in a deficit in excess of 115% of our real economy.

But back to that question about 'deleveraging' our debt overhang, 'paying down our debts', 'repairing balancesheet of the economy' and so on... the answer to that one is that Ireland continues to increase the levels of its indebtedness. The composition of the debt might be changing, but that, folks, is irrelevant from the point of view that all debts - government, banking, household, corporate, etc - will have to be repaid and/or serviced out of our real economic activity, aka you & me working...

30/3/2013: Euro area sovereign risk rises in March 2013

Here's an interesting bit of data (pertaining to analysts' survey): per Euromoney Country Risk survey:

"As of late March 2013, the survey indicates that 13 of the 17 single currency nations have succumbed to increased transfer risk [risk of government non-payment or non-repatriation of funds] since... two-and-a-half years ago." And the worst offenders are?.. Take a look at two charts (lower scores, higher risk):

Per definition of the transfer risk: "The risk of government non-payment/non-repatriation – a measure of the risk government policies and actions pose to financial transfers – is one of 15 indicators economists and other country risk experts are asked to evaluate each quarter. It is used to compile the country’s overall sovereign risk score, in combination with data concerning access to capital, credit ratings and debt indicators."

Friday, March 29, 2013

29/3/2013: Eurocoin signals 18th consecutive month of recession

Eurocoin leading indicator for euro area growth was out today. Key highlights:

  • Eurocoin rose to -0.12 in March 2013 from -0.2 in February 2013. 
  • Eurocoin remains below -0.03 reading attained in March 2012 and +0.57 reading for March 2011.
  • 3mo MA is now at -0.183 which gives Q1 2013 growth forecast (q/q) or 0.18% for euro area GDP.
  • This means that Eurocoin is now below zero in every month since September 2011, marking a massive 18 months in a row.
  • In previous recession of 2008-2009 Eurocoin duration below zero was 13 months, which means that the current bout of economic contraction is longer in duration than the so-called Great Recession.
  • In March 2013 Eurocoin gained some upside support solely from buoyant stock markets. 
Here are some charts:

And as usual, monetary policy charts for which analysis remains as postulated in my February post (here):

Thursday, March 28, 2013

28/3/2013: Cyprus: too-small-to-fail, too-small-to-bail

This is an unedited version of my article for Sunday Times, March 24.

This week, euro area leaders have added yet another term to the already rich vocabulary engendered by the financial crisis. If only a few days ago the world was divided into too-big-to-fail (e.g. Irish pillar banks and Spain) and too-big-to-bail (e.g. Italy) institutions and economies, today we also have too-small-to-fail and too-small-to-bail economy, Cyprus.

Worth just 0.2% of the euro area GDP, with the insolvent banking sector and the liquidity strained sovereign, Cyprus is a tiny minnow in terms of both the required external assistance and its direct impact on the euro area economy. The country overall GDP amounts to about ½ of the cost of bailing out Anglo Irish Bank, and its banking and fiscal troubles need just EUR15.8 billion of funding to plug the gap left by the EU mishandling of the Greek bailout back in 2011-2012. With the reputational costs to the euro area of letting this nation go into an unassisted default, Cyprus is simply too-small-to-fail.

Despite this, the end game now being played in Nicosia, Moscow, Frankfurt and Berlin shows that Cyprus, perhaps, is also too-small-to-bail. The problem is that granting sufficient funding to Cyprus via Troika loans risks pushing the Cypriot Government debt/GDP ratio to 170% even with the haircut on depositors. Were the EU adhere to the conditions of the bailout that also envision Cypriot banking and financial services sectors shrinking to euro area average in size, the government debt to GDP ratio can reach above 210 percent. Yet, altering the terms of the bailout to provide funds that are not debt-based, such as directly funding the banks writedowns of Greek Government bonds, risks triggering calls for similar actions across the rest of the euro area periphery. Pretty quickly, Cypriot EUR10 billion bill can swell to EUR200-250 billion call on the ECB.

These dilemmas, yet to be fully articulated by the policymakers publicly, are nonetheless informing the mess behind the recent events. In the view of euro area leadership, dealing with Cyprus either requires bankrupting its economy and its people, or risking destroying the monetary system infrastructure that rests on the ECB’s pursuit of singular, deeply flawed, yet legally unalterable mandate. A familiar conundrum that has been played out in Ireland, Greece, Portugal and Spain by the incompetent crisis management from Brussels, Frankfurt and Berlin.

Alas, what is still missing in the Cypriot Dilemma debates is the consideration of the longer-term impact of this latest iteration in the euro area crisis on broader European economy.

In this context, Cyprus is neither too-small-to-bail, nor too-small-to-fail. Instead, it is a systemically important focal point of the euro area financial crisis.

The Cypriot crisis orderly resolution requires funding from some non-debt sources to plug the gap between EUR17 billion in funds needed and EUR10 billion that can be committed in the form of loans. The EU has opted to bridge this gap with a levy on the deposits, thus triggering a wholesale expropriation of private property without any legal basis for doing so.  This expropriation, termed in the language resembling Orwell’s “1984” “an upfront one-off stability levy”, also cuts through the allegedly inviolable State Guarantee on all deposits under EUR100,000.

As the result, since last weekend all European and foreign depositors in the EU banks are no longer treated either pari passu or senior to risk investors, such as bondholders, but subordinated to them. Safety of deposits is no longer assured by the banking system or by the Sovereign guarantees. One of the cornerstones of the yet-to-be-established European Banking Union - the joint system of deposits insurance protection – is no more a credible mechanism of protection of ordinary savers.

In the short run, as highlighted in the media during the week, this means potential for bank runs in Greece (where depositors are already facing substantial potential losses through their savings in Cypriot banks and the state finances are in a much worse state than they are in Cyprus), Spain (with the Government desperate to fund its fiscal adjustments amidst rising tide of discontent with austerity measures) or even Italy (where savings in form of bank deposits are the main pillar of pensions provision for the aging population). In Cyprus itself, the debacle of the European leadership crisis management approach is now leading to the growing risk of the country being forced to exit the euro area.

In my view, these are low probability, but high impact risks that must be considered simply for the devastating effect they would have on the rest of the euro system.

Even if the above short-term nightmare scenarios do not play out, the Cypriot Dilemma is not going away.

Throughout the crisis, the EU has adopted a ‘muddle-through’ approach to dealing with the problems. This has meant that instead of using aggressive monetary policy, as the US and the UK, in addressing the crisis, the EU used debt tools to plug the financing gaps in the banking and fiscal sectors. The result of this was a dramatic uplift in overall debt burdens.  While euro area General Government deficit is expected to reach a relatively benign 2.56% in 2013 with a primary balance (excluding debt financing costs) forecast to post a surplus of 0.25%, close to the pre-crisis 2008 levels, euro area government debt is expected to rise from 70% of GDP in 2008 to 95% this year. Deficits are down, debt is up, public and private investment and deleveraging running at negative or zero rates. These dynamics clearly show the true cost of the EU leadership crisis.

In the long run, Cyprus blunder is going to yield dramatic economic and social costs.

Firstly, any resolution of the Cypriot crisis will involve unsustainable debt for the Government and the wholesale destruction of the Cypriot economy. With EU-demanded scaling back of the banking sector on the island to the ‘euro area average’, Nicosia is facing an outright contraction in the nation GDP of some 15-17% on pre-crisis levels. Second-order effects of this measure and the increase in the island corporation tax rate also demanded by Brussels will take economic losses closer to a quarter of the national income. There are no potential sources for plugging this economic hole. Even the promises of the off-shore gas reserves will not deliver economic recovery to the society with effectively no oil and gas expertise, skills or firms present in the economy.

The EU is de facto sealing the fate of one of its members as the second-class state within the Union just as it did with the rest of the ‘periphery’.

Long-term impact of debt accumulation as the sole mechanism for dealing with the crisis will also hit the entire euro area.  Per IMF relatively benign projections, euro area combined debt to GDP ratio will now exceed or equal 90% bound for at least six years in a row. This means that the euro area is facing a debt overhang crisis of the size where Government debt levels impose a long-term drag on overall economic growth. Any adverse headwinds to economic growth and fiscal performance in years to come will have to be faced without a cushion allowing for fiscal policy accommodation.

Undermining of the sovereign guarantees and depositors’ protection principles in the Cypriot case, even if reversed in the final agreement, will also have a long-term effect on euro area growth potential. With savings no longer secured from expropriation, euro area is facing long-term realignment of the household investment portfolios. This realignment will reduce bank deposits, especially the more stable termed deposits, and lower euro area assets held by the households. The end result will be higher cost of bank credit and equity in Europe, smaller supply of loanable and investable funds and, thus, lower long-term investment activity.

Violation of the property rights and trampling upon the principles of the common market in structuring of the original Cyprus ‘rescue’ plan means that overall risk-return valuations by investors will be re-adjusted to reflect the state of policymaking in Europe that puts bondholders over all other financial system participants, including, now, the depositors.

Currently, euro area economic activity and investment are funded primarily via bank credit, reliant on deposits and bank capital. Shares and equity account for around 14.3% of the total household portoflios in Europe as contrasted by 32.9% in the US. In order to rebalance the euro area investment markets away from reliance on more expensive and risk-prone bank lending, the EU must incentivize equity holdings over debt and shift more of the banks funding activity toward more stable deposits, reducing the amount of leverage allowed within the system.  Cypriot precedent makes structural change away from debt financing much harder to achieve.

Lastly, the Cypriot crisis has contributed to the continued process of deligitimisation of the EU authorities in the eyes of European people who witnessed an entirely new and ever more egregious level of the first-tier Europe (the so-called ‘core’) diktat over the social and economic policies in the peripheral state.

Prior to last week, Cyprus might have been too-small-to-fail or too-small-to-bail from Frankfurt’s or Berlin’s perspective, however the way the EU has dealt with this crisis exposes systemic flaws in the political economy of the euro area that cannot be easily repaired and will end up costing dearly to the entire EU economy.

The revenue commissioners annual statistics data for 2011 throws some interesting comparisons. Back in 2010, prior to the more recent increases in income-related levies and charges, gross taxable personal income in Ireland amounted to EUR77.7 billion against the taxable corporate income of EUR70.8 billion. The amounts of income and corporate taxes paid on these were, respectively EUR9.82 billion and EUR4.25 billion, yielding effective economy-wide rates of tax of 12.6% for personal income and 6.0% for corporate tax. Thus, excluding USC, PRSI, most of Vat, and a host of other taxes and charges applicable uniquely to households, Irish Government policy is explicitly to tax personal income at an effective rate of more than twice the rate of corporate income. Of course, this disparity in taxation is inversely correlated with the disparity in representation: when was the last time you heard our leaders talk about not increasing tax burden on people as a sacrosanct principle of the state in the same way they talk about protecting our corporation tax regime?

Monday, March 25, 2013

25/3/2013: Cyprus is unique in its problem... oh, wait...

So you'd think Cyprus is the 'bad boy' in grossly-overweight-financial-services club? Oh... right:


Now, wait, I am sure the Department of Spin is going to come after me pointing that 'Ireland's figures include IFSC'... my reply... so what? Cypriot figures include Sberbank & VTB... and, unlike the-best-in-the-class Ireland, Cyprus is just starting to deleverage its financial services sector.

25/3/2013: Cyprus 'deal' - notes from the impact crater

What are the true 'innovations' of the Cypriot 'bailout' deal?
  1. At this junction one must face the realisation that European 'leadership' vacuum has reached alarming proportions. Cyprus was pushed to the brink, literally hours away from ELA cut-off, with a deliberate and mechanical precision. This is hardly consistent with any spirit of subsidiarity and/or cooperation that the EU was allegedly built on. In a further affirmation of the mess that is EU policy-making, the markets must now be aware that the EU has no defined approach to dealing with debtors and creditors, nor with issues of assets or liabilities. In other words, five years into the crisis and numerous 'white papers' later, with acronym soup of various 'solutions' and new 'institutions' thicker than pasta fagioli - there is still no clarity, no legal or institutional commitment, no formula, no predictability, but rather politically-motivated swinging from one extreme (no bail-ins in Ireland) to the other (all bailed-in in Cyprus).
  2. We now have bailed in uninsured bank deposits within the so-called 'open' economy with 'common currency' and 'common market' based on rules and laws. In other words, unlike in Ireland, Portugal and Greece, the EU has crossed another line.
  3. We now have bailed in senior bank bondholders (and the sky did not fall)
  4. We now have capital controls within 'common currency' area and within the 'common market' - kind of equivalent to Louisiana declaring its dollars purely domestic to Louisiana. 
  5. Bail-ins under the Cypriot deal are non-transparent and not defined, showing that the entire package was put together is a half-brained fashion at the last minute. Surely this, if not the first but very much the most exemplary indicator of the complete mess in policymaking. It further reinforces the view of PSI measures - both in Greece and in Cyprus - as being politically motivated, rather than systemically and legally structured.
  6. The fact that the Cypriot banking system will now be completely shut out of the funding markets reinforces my view that unwinding the 'emergency' measures deployed by the ECB during the crisis will be: a) risky, b) costly and c) protracted. As the result, the monetary policy risks missing the window for optimal interest rates reaction and either over-reaching on the inflationary side or over-tightening to the detriment to future growth. either way, peripheral countries will be the likely victims.

Overall, from the EU-wide point of view, Cypriot 'deal':
  • Does not reduce the risk of contagion or re-amplification of the crisis in other peripheral states;
  • Does not create or even enable a break between sovereign and bank crises; 
  • Adds to the overall quantum of policy uncertainty; 
  • Raises even more doubts as to the functionality of the cornerstone crisis-related institutions (ESM and OMT); and
  • Acts to strengthen the hand of eurosceptic, nationalist and populist political movements and parties in the Euro area 'periphery'.

25/3/2013: Debt, Demand & Deposits: Cyprus 2013

Der Spiegel has a handy graphic detailing the extent and the depth of the Financial Services sector in Cyprus...


The above lumps together couple of things that should, really, be addressed:

  1. Cyprus' financing needs only cover banks recapitalisations to the deposits base as provided by the end-of-January 2013 figures. Since then at least EUR3-5 billion and more likely even more fled the country. And selection bias suggests that larger depositors (potentially with more political connections) were more likely to avail of 'systemic' exemptions to withdrawals in recent days.
  2. As termed deposits mature, more will leave, unless the Government imposes involuntary lock-in for depositors with termed contracts.
  3. Cyprus' financing needs above do not include non-CB and non-deposit funding for the banks that is going to mature in months to come and has to be replaced by some other source of funds (presumably we can assume that ECB / ELA will step in, but I don't see how that arrangement in the medium term can be pleasing to the ECB).
  4. The deposits above do not break out MFI deposits, corporate deposits and personal deposits. It is one thing to bail-in personal accounts and yet altogether another matter to bail-in corporations and other banks (the former are subject to more strict capital controls than the latter two).
These are material risks to the sustainability of the Cypriot 'bailout' programme.

25/3/2013: The False Vacuum of the EU: a must-read essay

On rare occasions does one come across an essay so brilliantly argued and provocative in its depth. A must-read: Nucleating the False Vacuum of the European Union

25/3/2013: Bankrupted Cyprus, aka 'The Rescue'

While European 'leaders' celebrate the breakthrough 'bailout' agreement with Cyprus, let's get back to Planet Reality, folks. The 'deal' is based on a EUR10bn loan to the Cypriot Government for which the taxpayers will be on the hook.

EUR10bn = 56.2% of the country 2013 forecast GDP.

And now, let's begin counting the proverbial chickens:

  1. IMF forecast for GDP - used above - is based on nominal GDP growth over the fiscal year 2013 of 0.33%. Even by IMF 'rosy' standards this is way off the mark, as other (EU Commission and Cypriot own) forecasts envisioned GDP contracting between 0.5% and 1.3% in 2013.
  2. IMF forecast is based on pre-bailout assumptions with the banking sector returns to the economy being at the levels consistent with full functioning of the Cypriot financial services sector.
  3. Even outside the above points, IMF forecast through 2017 saw Government debt/GDP ratio in Cyprus rising to 106.11%, prior to the current 'deal' on foot of forecast GDP growth of 2.87% per annum on average between 2013 and 2017.
Now, with the deal:
  1. Shrinkage of the financial services sector will be immediate and deep;
  2. Deficit financing of any capital investment by the Cypriot Government will cease;
  3. New debt is going to be loaded onto the country;
  4. Reduced savings and exits by larger depositors will mean reduced revenues for the economy, etc
Much of this was outlined in my previous post on debt sustainability in Cyprus (

Now, let's do simple exercise. Add EUR10bn to Cypriot debt pile and get scenario of Cyprus (post-crisis with no growth effects).

Then, adjust GDP growth from 2013 through 2017 to yield average rate of economic growth of -0.18% annually (note, this is much more benign than Greek forecasts for the first 5 years of the crisis which are equal to -2.94% annually on average). This yields scenario of Cyprus (post-crisis with growth effects).

The above two scenarios are compared in the chart below against Greek forecasts by the IMF and the pre-'bailout' forecast by the IMF for Cyprus:

This is what the EU leadership is currently celebrating - a wholesale, outright bankrupting of the entire country. Well done, lads!

Sunday, March 24, 2013

24/3/2013: Few Cypriot Myths & Few Billions in Losses

Ever wondered why would the IMF (and reportedly the EU Commission) reject the proposed (Plan B) Cypriot Government raid on state pensions funds? Oh... ok... IMF review from November 2011:
Naughty, naughty little Cyprus...

And the very same IMF note also sheds some light on those 'oligarchs' deposits that are so vast, the entire EU is apparently chocking on chicken breasts at Herman von Frompuy's dinners:

"First, non-resident deposits (NRD) in Cypriot banks (excluding deposits raised  abroad by foreign affiliates) are €23 billion (125 percent of GDP), most of which are  short-term at low interest rates [note: ECB official data does not exclude foreign affiliates deposits, which are normally out of touch in levy imposition. Also note: much of bulls**t about Russian oligarchs deposits was about high interest rates allegedly collected by them on Cyprus deposits. Guess that wasn't really the case as chart below confirms: deposit rates decline sharply by nationality grouping for both corporates and individuals... so who was exactly earning 'high returns' on Cypriot deposits? oh, well... Cypriots...].

"These could prove unstable in the event of  further confidence shocks. [In other words, Cyprus requires very stringent capital controls if it is to avoid instantaneous bankruptcy even with ELA continuing]

"This risk is partly mitigated by the 70 percent liquid asset requirement against the €12 billion in NRD in foreign currency), and the 20 percent requirement for the €11 billion in euro-denominated NRD). [Wow, so apparently 'oligarchs' deposits carry massive safety cushions, whilst 'ordinary' depositors are not...]

"Second, €17 billion in deposits collected in the Greek branches of the three largest Cypriot-owned banks could be subject to outflows in response to difficult conditions in Greece. Outflows in the first half of 2011 were close to €3 billion (nearly 15 percent of the total), although a portion of these returned to the Cypriot parents as NRD. [Now, there was more of Greek money than 'oligarchs'?]

Now, couple more revealing charts:

Clearly, structuring PSI the EU authorities & IMF knew the above factoid, right? Just as they knew the following (which clearly highlights the fact that any substantial hit on Cypriot banks would have immediately spelled insolvency of the entire economy):

24/3/2013: Irish GDP & GNP Growth 2007-2012

Five charts summarising Irish GDP and GNP dynamics in 2007-2012 period. The first set is of 4 charts plotting various measures of GDP and GNP in constant and current prices in terms of year-on-year changes:

In all of the above, I show two 'trend' figures: the 2% annual real growth trend as a long-term sustainability level of growth and the within-crisis (period of contracting GDP or GNP) and out-of-crisis (period of sustained positive growth) averages. These two sets of lines provide a marker for assessing as to whether or not the economy is currently running at the growth rates above or below trend.

And to summarise the state of play today:

Thus, after almost two years of 'turned corners' and 'recoveries'

  • Ireland's GDP and GNP are still massively below the pre-crisis levels of 2007. 
  • Ireland's GDP growth in constant and current prices is running below trend levels in Q3 and Q4 2012
  • Ireland's GDP growth shorter-term trend (post-crisis) is below the long-term trend levels, which is simply not consistent with normal U-shaped recovery
  • Ireland's GNP growth is running at above trend levels for 3 quarters now in constant prices terms, and close to the trend levels for current prices terms
  • By all measures (across current and constant prices) both GDP and GNP are posting markedly slower rates of growth in Q4 2012 compared to previous quarters.

24/3/2013: Are Cypriot Debt Dynamics Worse than Greek?

A nice chart via Pictet (link) on the size of the banking sector in Cyprus and its dynamics since 2006:

Now, do notice, reducing the above to 300-330% of GDP as required by the Troika in Plan A (and so far not disputed by the Cypriot Government) will imply lowering liabilities by EUR66.6 billion. Overall, banking margins in Cyprus are running at around 1.2% net of funding costs, we can roughly raise that to double to include wages and other costs spillovers, which implies that EUR66.6bn deleveraging of liabilities should take out of the Cypriot GDP somewhere around EUR1.5bn annually or 9% of GDP. Auxilliary services, e.g. legal, accounting and associated expatriate community benefits that arise in relation to international banking services being offered from Cyprus will also have to be scaled back. Assuming that these account for 50% of the margin returns to the economy, overall hit on Cypriot economy from deleveraging can be closer to EUR2.2bn annually or 12.7% of GDP.

Now, consider the loans package of EUR10 billion that Cyprus is set to receive if it manages to close the EUR5.8 billion gap. Absent banking sector deleveraging, this will push Cypriot Government debt/GDP ratio to over 140% of GDP. However, with reduction in GDP, the debt/GDP ratio (assuming to avoid timing considerations assumptions a one-off hit to GDP) will rise to 161%.

Now, recall that IMF and Troika 'sustainability' bound for debt/GDP ratio used to be 120%. We are now clearly beyond that absolutely abstract number even without the banking sector deleveraging. And let's take the path of debt/GDP ratio forecast by the IMF which would have seen - absent the 'rescue' package - debt/GDP ratio in Cyprus rising 106.1% of GDP by 2017. With the 'rescue' package and banking sector deleveraging, this can now be expected to rise to 174% of GDP in 2017 against Greek debt of 153% of GDP.

In short, the EU 'rescue' is going to simply wipe Cyprus off the map in economic terms. All debt 'sustainability' consideration are now out of the window.

Here's the chart:

Of course, the above analysis is crude as it ignores:

  1. Potential positive effects of replacement activity and the fabled 'gas revenues' etc - which presumably were already reflected in GDP growth figures in the IMF forecasts
  2. Potential negative effects of tourism, real estate sales and other services declines due to the reduced activity in the banking sector, which can raise the above adverse impact of the banking sector deleveraging to 15% of GDP. Corporation tax increases can yield further losses.
  3. Timing issues for the deleveraging which is not expected to happen overnight.
Nonetheless, all in, there have to be some severe doubts as to viability of the Cypriot debt path under the Troika Plan A, let alone under the Cypriot Plan B.

Saturday, March 23, 2013

23/3/2013: And the Strong Are Yet to Become Strong: German Debt Sustainability

A very interesting paper by Burret, Heiko T, Feld, Lars P. and Koehler, Ekkehard A., titled "Sustainability of German Fiscal Policy and Public Debt: Historical and Time Series Evidence for the Period 1850-2010" (February 28, 2013). CESifo Working Paper Series No. 4135. Available at SSRN:

Here's from the abstract:

"In the last decades, the majority of OECD countries has experienced a continuous increase in public debt. The European debt crisis has prompted a fundamental re‐evaluation of public debt sustainability and the looming threat of sovereign debt default. Due to a multitude of large scale events in its past, Germany is far from being an exception: In fact, Germany’s peacetime debt‐to‐GDP (Gross Domestic Product) ratio has never been higher."

And a chart:
[Click on the chart to enlarge]

On methodology: "In this paper, we analyse the sustainability of Germany’s public finances against the standard theoretical back‐ground using a unique database, retrieved from multiple sources covering the period from 1850 to 2010. Multiple currency crises and external events offer anecdotal evidence, contradicting the historical perception of Germany as the poster child of European public finance. Given these corresponding breaks in time series, the empirical analysis is conducted for the sub‐periods 1872‐1913 and 1950‐2010. In addition to an anecdotal historical analysis, we conduct formal tests on fiscal sustainability, including tests on stationarity and cointegration and the estimation of Vector Autoregression (VAR) and Vector Error Correction Models (VECM)."

And the punchline: "While we cannot reject the hypothesis that fiscal policy was sustainable in the period before the First World War, the tests allow for a rejection of the hypothesis of fiscal sustainability for the period from 1950 to 2010. This evidence leads to the conclusion that Germany’s public debt is in dire need of consolidation. Albeit a much needed reform, the incompleteness of the German debt brake will have to be addressed in the coming years, in order to ensure that fiscal consolidation actually takes place"

[Skip below to see the more extensive summary of conclusions]

And the recent experience? Here are the economic fundamentals pertaining to the cost of capital and growth:

A descriptive table of stats summarising the overall performance:

And public expenditure levels (alongside revenue and balances)

So the results after skipping through loads of rigorous tests are:

"After the experience of the two World Wars, the German population is quickly alarmed when debt levels appear to be rising to unsustainable levels. This holds particularly for recent years, as Germany’s debt‐to‐GDP ratio has never been higher in peacetime than today...

In this paper, we analyse sustainability of German public finances from 1872 to 2010. Given the breaks in the data series, in particular those induced by the two World Wars, the main analysis is conducted for the sub‐periods 1872‐1913 and 1950‐2010. …While we cannot reject the hypothesis that fiscal policy was sustainable in the period before the First World War, this only holds if we do not allow for trends in the cointegration relation. The hypothesis of fiscal sustainability for the years 1950 to 2010, on the other hand, must be rejected. After the Second World War, German public finances have become unsustainable.

This evidence leads to the conclusion that public finances in Germany are in dire need of consolidation. In fact, the introduction of the debt brake in the year 2009 is a much needed reaction to this development. Although such fiscal rules always have their loopholes and are necessarily incomplete, they usually have some success in restricting public deficits and debt (Feld and Kirchgässner 2008, Feld and Baskaran 2010). The incompleteness of the German debt brake will have to be addressed in the coming years in order to ensure that fiscal consolidation actually takes place. One shortcoming of the new debt rule requires wider ranging reform, however: The Länder (including their local jurisdic‐tions) not only have huge consolidation requirements, they also do not have the tax autonomy to balance the spending demands on their budgets. The next major reform of the German fiscal constitution should thus allow for more tax autonomy at the sub‐federal level."

23/3/2013: IMF 9th Review of Ireland's Programme

IMF Completed 9th Review with Ireland:

"Ireland’s strong policy implementation has continued and positive signs are emerging. Real GDP growth was 0.9 percent in 2012, and employment rose slightly over the year, although unemployment remains high at 14.2 percent. Further deepening its market access, Ireland issued €5 billion of 10 year bonds at 4.15 percent in March."

"The 2012 fiscal deficit of 7¾ percent of GDP was well within the 8.6 percent target. In 2013, the fiscal deficit is projected at 6¾ percent of GDP, moving toward the target of below 3 percent by 2015.  Public debt is expected to peak at 122½  percent of GDP this year and decline in later years provided growth picks up from the 1 percent rate projected in 2013."

"Financial sector reforms have continued to advance, but banks remain weighed down by nonperforming loans at about 25 percent of total loans." Per Mr. David Lipton, First Deputy Managing Director and Acting Chair:

"…problem loans remain high and accelerating their resolution is a key to economic recovery. The recent establishment of mortgage loan restructuring targets for banks is therefore welcome, and it will be supported by reforms announced by authorities that facilitate constructive engagement between banks and borrowers, promote the efficiency of repossession procedures as a last resort, provide banks with the right incentives through provisioning rules, and by sound implementation of the personal insolvency reform. Progress with resolution efforts for SME loans is also a priority.

“Building on the strong budget outturn for 2012, sound budget execution remains critical in 2013, including continued vigilance on health spending and a successful introduction of the property tax...

“Prospects for Ireland’s exit from official support have improved, yet continued strong policy implementation remains paramount given risks to medium-term growth and debt sustainability. Timely and forceful delivery on European pledges to improve program sustainability, especially by breaking the vicious circle between the banks and the Irish sovereign, would go a long way toward Ireland’s durable exit from drawing on official support.”