8/5/16: Leverage and Management: Twin Risks or Separate Risks?

A new paper “How Management Risk Affects Corporate Debt” by Yihui Pan, Tracy Yue Wang, and Michael S. Weisbach (NBER Working Paper No. 22091 March 2016) looks at the role management risk (uncertainty about future managerial decisions) plays in increasing overall firm-wide default risk.

Specifically, the paper argues that “management risk is an important yet unexplored determinant of a firm’s default risk and the pricing of its debt. CDS spreads, loan spreads and bond yield spreads all increase at the time of CEO turnover, when management risk is highest, and decline over the first three years of CEO tenure, regardless of the reason for the turnover.”

The authors also show that a “similar pattern but of smaller magnitude occurs around CFO turnovers.”

Overall, “the increase in the CDS spread at the time of the CEO departure announcement, the change in the spread when the incoming CEO takes office, as well as the sensitivity of the spread to the new CEO’s tenure, all depend on the amount of prior uncertainty about the new management.”

Which means that leverage risk and management turnover risk can be paired.


In some detail, as authors note, “firm’s default risk reflects not only the likelihood that it will have bad luck, but also the risk that the firm’s managerial decisions will lead the firm to default”. In other words, while leverage risk matters on its own (co-determining overall firm risk), it also runs coincident and is possibly correlated with management turnover risk. “Management risk occurs when the impact of management on firm value is uncertain, and, in principle, could meaningfully affect the firm’s overall risk.”

This is not new. Empirically, we know that management risk is “an important factor affecting a firm’s risk. However, the academic literature on corporate default risk and the pricing of corporate debt has largely ignored management risk. This paper evaluates the extent to which uncertainty about management is a factor that affects a firm’s default risk and the pricing of its debt.”

Using a sample of primarily S&P 1500 firms between 1987 and 2012, the authors “characterize the way that the risk of a firm’s corporate debt varies with the uncertainty the market likely has about its management. The basic pattern is depicted in [the chart above]… The announcement of a CEO’s departure is associated with an increase in the firm’s CDS spread, reflecting an increased market assessment of the firm’s default risk. The CDS spread declines at the announcement of the successor, and further declines during the new CEO’s time in office, approximately back to the pre-turnover level after about three years.”

Quantitatively, the effect is sizeable: “the 5-year CDS spread is about 35 basis points (22% relative to the sample mean) higher when a new CEO takes office than three years into his tenure. Spreads on shorter-term CDS contracts exhibit an even larger sensitivity to CEO turnover and tenure. Spreads on loans and bond yield spreads also decline following CEO turnovers. These patterns occur regardless of the reason for the turnover; changes in spreads following turnovers that occur because of the death or illness of the outgoing CEO are not economically or statistically significantly different from changes in spreads in the entire sample.”

Dynamically, the results are also interesting: the process of risk pricing post-CEO exits is consistent with information updating / learning by markets. “The observed decline in default risk over tenure potentially reflects the resolution of uncertainty about management and hence a decline in management risk. …Bayesian learning models imply that if the changes in spreads around CEO turnover occur because of changes in management risk, then when ex ante uncertainty about management is higher, spreads should increase more around management turnover and decline faster subsequently. Consistent with this prediction, our estimates suggest that the increase in the CDS spread at the time of the CEO departure announcement, the change in the spread when the incoming CEO takes office, as well as the sensitivity of the spread to the new CEO’s tenure, all depend on the amount of uncertainty there is about the new management. For example, the increase in CDS spreads at the announcement of a CEO departure when the firm does not have a presumptive replacement is almost three times as high as when there is such an “heir apparent.” The revelation of the new CEO’s identity leads to smaller declines in spreads prior to the time when he takes over if the new CEO is younger than if he is older; presumably less is known about the young CEOs ex ante so less uncertainty is resolved when they are appointed. But once a younger CEO does take over, the market learns more about his ability from observing his performance, so the spreads decline faster.”

Fundamentals that may signal CEO quality ex ante also matter: “…when the CEO has an existing relationship with a lender before he takes his current job, the lender is likely to know more about the CEO’s ability and future actions, leading to lower management risk. Consistent with this argument, we find that the sensitivity of interest rates to the CEO’s time in office is 39-57% lower for loans in which the CEO has a prior relationship with the lender compared to those without such a relationship. This relation holds even if the CEO is an outsider and the relationship was built while he worked at a different firm, so the existence of the relationship is exogenous to the credit condition of the current firm.”

What about cost of debt and risk pricing? Some nice result here too: “Since uncertainty about management is likely to be idiosyncratic rather than systematic, it theoretically should not affect a firm’s cost of debt (i.e., the expected return on debt). Accordingly, firms should not adjust the cost of capital they use for capital budgeting purposes because of management-related uncertainty. In addition, since variation in management risk appears to be relatively short-term, it is unlikely to affect firms’ long-term capital structure targets. However, since management risk increases the volatility of cash flows, it should increase the demand for precautionary savings. Consistent with this idea, we find that firms facing higher management risk tend to have higher cash holdings. In particular, cash holdings decline with executive tenure, but only for firms for which management risk is likely to be high.”


Overall, an interesting set of results - highly intuitive and empirically novel. One thing that is missing is control for quality of governance within the firms, e.g.
- CSR
- ERM
- Board and C-level quality metrics
Avenue for future extension of the study…

14/3/2016: Foreign Investors, Sovereign Risks & Regulatory Clowns

Over 2012-2013, sovereign and corporate bonds markets started showing sigs of QE-related fatigue within the system, most commonly associated with periodically volatile trading spreads, term premia and risk spreads. In 2013, following the onset of the Fed-related “taper tantrum” many emerging markets spreads on their sovereign bonds widen dramatically, especially in response to rapid devaluations of their domestic currencies.

“This prompted market analysts to identify five of the worst hit economies as the “fragile five,” attributing their vulnerability to economic fundamentals, particularly to current account deficits.” Which is fine - current account is a reasonably important signal of the overall external balance in the economy, but… the but bit is that current account alone means little. Take for example Russia: back in 2013, the economy enjoyed record current account surpluses - so was a picture of rude health by the analysts criteria. Yet, within the economy there was already an apparent and fully recognised on-going structural slowdown.

Bickering over indicators validity aside, however, it would be nice to know which indicators and which risk models do investors flow when they decide to buy or sell emerging market bonds?

Traditionally, we think about two types of factors: “push” and “pull” factors, determining whether the emerging economy experiences capital inflows or outflows.

- “The push factors often relate to economic or financial developments in the global economy as a whole or in the advanced economies, notably the United States.”
- “The pull factors often relate to country-specific economic fundamentals in emerging markets”

Both push and pull factors seem to be important.

In analyzing returns on sovereign CDS contracts, the BIS paper looks at CDS returns “for 18 emerging markets and 10 advanced countries over 11 years of monthly data from January 2004 to December 2014.”

Findings in a nutshell:

• “Statistical tests for breaks in the movements of CDS returns suggest a break at the time of the eruption of the global subprime crisis in October 2008. This leads us to consider two subperiods separately, an “old normal” before the outbreak of the crisis and a “new normal” afterwards.”
• “In both the old normal and new normal, we seek to explain the variation of these [principal factors] loadings [onto risk premia] in terms of such fundamentals as debt-to-GDP ratios, fiscal balances, current account balances, sovereign credit ratings, trade openness, GDP growth and depth of the domestic bond market.”
• “In the old normal, the first risk factor alone explains about half of the variation in CDS returns…” 
• “This factor becomes more dominant in the new normal, in which it explains over three-fifths of the variation in returns.”
• “When it comes to how the different countries load on this factor, we find that that the commonly cited economic fundamentals have little influence on the country-specific loadings on the factor. Instead the single most important explanatory variable for the differences in loadings is a dummy variable that identifies whether or not a country is an emerging market.”

To summarise the BIS findings: “In the end, we find that CDS returns in the new normal move over time largely to reflect the movements of a single global risk factor, with the variation across sovereigns for the most part reflecting the designation of “emerging market”. There seems to be no “fragile five”; there are only emerging markets. While the emerging markets designation may serve to summarize many relevant features of sovereign borrowers, it is a designation that lacks the kind of granularity that we would have expected for a fundamental on which investors’ risk assessments are based. The importance of the emerging markets designation in the new normal suggests that index tracking behaviour by investors has become a powerful force in global bond markets.”

And the cherry on top of the proverbial pie? Why, here it goes: “Haldane (2014) has argued that in the world of international finance, the global subprime crisis and the regulations that followed made asset managers more important than banks. Miyajima and Shim (2014) show that even actively managed emerging market bond funds follow their benchmarks portfolios  quite closely. For the most part, when global investors invest in emerging markets, instead of picking and choosing based on country-specific fundamentals, they appear to simply replicate their benchmark portfolios, the constituents of which hardly change over time.”

Wait, what? All regulators are running around the world chasing the bad bankers (for their pre-2008 shenanigans), all the while the new threat has already migrated to asset management. The regulators and enforcers are busy bee-buzzing around courts and regulatory hearings chasing the elusive ‘signalling value’ of enforcing old rules onto the heads of the bankers. With little real outcome to show, I must add. … But the future culprits are not to be found amongst those who care to watch the fate of bankers unfolding in front of them.

In short, having exposed the farce of bond / CDS markets pricing risks based on a vague and vacuous designation of a country, the BIS paper inadvertently also exposed the massive futility of the financial regulators chasing their own tails trying to get past crises culprits to prevent new crises from happening, even though the future culprits don;t give a toss about the past culprits.

Dogs, tails, everything wagging everyone, and vice versa…


Full paper here: Amstad, Marlene and Remolona, Eli M. and Shek, Jimmy, “How Do Global Investors Differentiate between Sovereign Risks? The New Normal versus the Old” (January 2016). BIS Working Paper No. 541: http://ssrn.com/abstract=2722580

17/12/15: Re-aligning Ruble with Oil: Fed Hiccup...

Two casualties of the Fed's rate jitter: Oil & Ruble

Source: @Schuldensuehner 

Ruble is now nearing August 2015 lows on a continued trend that realigned with oil prices.

And while we are at it, another pairing:

Source: @Schuldensuehner 

Note: as of yesterday's closing Russian CDS 5 year spread was at 308.91 with implied probability of default of 19.15%. A week ago, same stood at 291.64 with implied probability of default at 18.26% and at the end of Tuesday, at 305.91 with implied probability of default at 18.99%.

But as a reminder, watch not only Brent, but also Urals-Brent spread. Hawkish dove of the Fed has less to say on that than Russian energy substitution ongoing in Europe and Turkey via Saudi's and Iranian contracts.

12/6/15: Ukraine Debt Haircuts

Important article today in the FT on the issue of write downs on Ukrainian debt: http://www.ft.com/intl/cms/s/0/949628a4-102a-11e5-bd70-00144feabdc0.html#axzz3cg6nwFC9

In my view, the write down should take into the account discounts at which current debt holders have taken their long positions, so that vulture funds and distressed debt speculators take a larger haircut than someone who held debt over longer term and bought it at lower discounts. This will put heavier penalty onto distressed debt speculators and reduce penalty on investors who acquired Ukrainian debt before the crisis started.

Meanwhile, Ukraine's probability of default is climbing. Here are two sources: implied bonds probability of default at >95% and Credit Default Swaps implied probability of default at almost 82%.

Source: @Schuldensuehner

Source: CMA

The latest spike in default probabilities took place following IMF comments (see:  http://www.imf.org/external/np/tr/2015/tr061115.htm) that effectively altered markets expectation as to whether or not the IMF will allow Kiev to default on private debt. It now appears that the IMF has little problem with Kiev using strong-arm tactic of threatening (and enacting) a default on private sector debt. Prior to this week, the understanding was that the IMF will not lend to Ukraine if it goes into a default - a position that allowed private debt holders to argue that their intransigence is supported by the pressure from the IMF on Kiev to conclude a deal. Now, that pressure is gone and IMF seemingly is giving green light to Kiev to default, as long as such a default does not take place after any deal conclusion.

Update: The strategy deployed by IMF in the case of Ukraine - the strategy of actively forcing a default as a credible threat to private sector holders of debt - is not new. It was outlined in this document from 2002 (see page 28 of http://www.imf.org/external/pubs/ft/exrp/sdrm/eng/sdrm.pdf): "There may be a risk that creditors would withhold an extension of the stay in the hope that the IMF would provide more financing or call on the member to make additional adjustment efforts. For example, even in circumstances where the member is implementing good policies and negotiating in good faith, creditors may refuse to extend the period of the stay as a means of persuading the member to turn to the IMF for financing that could enhance the terms of any restructuring. The creditors could threaten to lift the stay to force the debtor to agree to more adjustment than contemplated under the IMF-supported program. Such risks could be reduced, however, by the resolute application of the IMF’s policy of lending into arrears, under which it signals its willingness to continue to support a program, even if the member has interrupted payments to its creditors."

15/5/15: Greece on a Wild Rollercoaster Ride

Greece has become a BitCoin of Europe in terms of volatility, and, man, things are soaring and crashing on a daily basis now. Here are three snapshots of Greek Credit Default Swaps:

End of last week:

Mid-week this week:

Closing yesterday:

Meanwhile, the entire financial system of Greece is now on a weekly timeline courtesy of the ECB approvals of ELA:

One move by ECB down on ELA or laterally on collateral requirements, and the house of cards can come crashing.

Note: Sources: CMA and @Schuldensuehner.

26/1/15: Markets v Greece: Too Cool for School... for now

There is much talk about the impact (or rather lack thereof) of Greek elections on the markets.

In fact, the euro continued to price in the effects of a much larger factor - the QE announcement by the ECB, the stock markets did the same. Only bonds and CDS markets reacted to the Greek elections, and even here the re-pricing of Greek risks was moderate so far (see chart below and the day summary for CDS - both courtesy of CMA).

The reason for this reaction is two-fold.

Firstly, Greece is a small blip on the overall radar map of Euro area's problems. Even in terms of Government debt. Here is the summary of the Government debt overhang levels (over and above 60% of debt/GDP benchmark) across the Euro area:

In simple terms, real problems for the euro, in terms of risk pricing, are in Italy, France and Spain.

Secondly, Greece is a political risk, not a financial risk to the Euro area. And it is a risk in so far, only, as yesterday's election increases the probability of a Grexit. But increasing probability of a Grexit does not mean that this increase is worth re-pricing. It is only worth worrying about if (1) increase in probability is significant enough, and (2) if elections changed the timing of the possible event, bringing it closer to today compared to previous markets expectations.

Now, here is the problem: neither (1) nor (2) have been materially changed by the Syriza victory last night. My comments to two publications yesterday and today, summarised below, explain.


Greek elections came as a watershed for both the markets analysts and the European elites, both of which expected a much weaker majority for the Syriza-led so-called 'extreme left' coalition. The final outcome of yesterday's vote, however, is far from certain, and this has been now fully realised by the markets participants.

The confrontation with the EU, ECB and the IMF, promised by Zyriza, is but one part of the dimension of the policy course that Greece will take from here on. Another part, less talked about today in the wake of the vote is accommodation.

Let me explain first why accommodation is a necessary condition for both sides in the conflict to proceed.

Greece is systemically important to the euro area, despite all claims by various European politicians to the contrary. Greece is carrying a huge burden of debt, accumulated, in part due to its own profligacy, in part due to the botched crisis resolution measures developed and deployed by the EU. It's debt is no longer held by the German, French and Italian banks, so much is true. German and French banks held some EUR27 billion worth of Greek Government debt at the end of 2010. This has now been reduced to less than EUR100 million. There is no direct contagion route from Greek official default to the euro area banking sector worth talking about. But Greek private sector debts still amount to roughly EUR10 billion in German and French banking systems (with more than EUR8 billion of this in German banks alone). Greek default will trigger defaults on these debts too, blowing pretty sizeable hole in the euro area banks.

However, lion's share of Greek public debt is now held in various European institutions. As the result, German taxpayers are on the hook for countless tens of billions in Greek liabilities via the likes of the EFSF and Eurosystem.

And then there is the reputational costs: letting Greece slip out into a default and out of the euro area will mark the beginning of an end for the euro, especially if, post-Grexit, Greece proves to be a success.

In short, one side of the equation - the Troika - has all the incentives to deal with Syriza.

One the other side, we can expect the fighting rhetoric of Syriza to be moderated as well. The reason for this is also simple: the EU-IMF-ECB Troika contains the Lender of Desperate Resort (the ECB) and the Lender of Last Resort (the IMF). Beyond these two, there is no funding available to Greece and Syriza elections promises make it painfully clear that it cannot entertain the possibility of a sharp exit from the euro, because such an exit would require the Government to run a full-blown budgetary surplus, not just a primary surplus. For anyone offering an end to austerity, this is a no-go territory.

So we can expect Syriza to present, in its first round of talks with the Troika, some proposals on dealing with the Greek debt overhang (currently this stands at around EUR 210 billion in excess debt over the 60% debt/GDP limit), backed by a list of reforms that the Syriza government can put forward in return for EU concessions on debt.

These reforms are the critical point to any future negotiations with the EU and the IMF. If Syriza can offer the EU deep institutional reforms, especially in the areas so far failed by the previous Government: improving the efficiency and accountability of the Greek public services, robust weeding out of political and financial corruption, and developing a functional system of tax collections, we are likely to see EU counter-offers on debt, including debt restructuring.

So far, Syriza has promised to respect the IMF loans and conditions. But its rhetoric about the end of Troika surveillance is not helping this cause of keeping the IMF calm - IMF too, like the ECB and the EU Commission, requires monitoring and surveillance of its programme countries. Syriza also promised to balance the budget, while simultaneously alleviating the negative effects of austerity. In simple, brutally financial terms, these sets of objectives are mutually exclusive.

With contradictory objectives in place, perhaps the only certainty coming on foot of the latest Greek elections is that political risks in Greece and the euro area have amplified once again and are unlikely to abate any time soon. Expect the Greek Crisis 4.0 to be rolling in any time in the next 6 months.

So in the nutshell, don't expect much of fireworks now - we all know two deadlines faced by Greece over the next month:

• The IMF review, to start as soon as the new Government is in place;
• February Euro Group meeting (tomorrow one will not be of much substance) with Greek bailout expiring February 28th, although the EU is already signaling, less than 24 hours after Greek election, willingness to extend maturity of the programme (http://uk.reuters.com/article/2015/01/26/uk-greece-election-eu-idUKKBN0KZ0ZB20150126)

These are the markers for the markets to worry about and these are the timings that will start revealing to us more information about Syriza policy stance too. Until then, ride the wave of QE and sip that kool-aid lads... too cool to worry about that history lesson, for now...

16/1/2015: S&P Capital IQ Global Sovereign Debt Report: Q4 2014

S&P Capital IQ’s Global Sovereign Debt Report is out for Q4 2014, with some interesting, albeit already known trends. Still, a good summary.

Per S&P Capital IQ: "The dramatic fall in oil prices dominated the news in Q4 2014, affecting the credit default swaps (CDS) and bond spreads of major oil producing sovereigns which have a dependence on oil revenues. Venezuela, Russia, Ukraine, Kazakhstan and Nigeria all widened as the price of oil plummeted over 40%. Separately, Greece also saw a major deterioration in CDS levels as it faces a possible early election."

And "Globally, CDS spreads widened 16%."

No surprises, as I said, but the 16% rise globally is quite telling, especially given CDS and bond swaps for the advanced economies have been largely on a downward trend. The result is: commodities slump and dollar appreciation are hitting emerging markets hard. Not just Russia and Ukraine, but across the board.

Some big moves on the upside of risks:

• "Venezuela remains at the top of the table of the most risky sovereign credits following Argentina’s default in Q3 2014, resulting in its removal from the report, with spreads widening 169% and the 5Y CDS implied cumulative default probability (CPD) moving from 66% to 89%." 
• The only major risk source, unrelated to commodities prices is Greece where CDS spreads "widened to 1281bps - an election as early as January could see a change of government and fears over a possible exit from the Eurozone have affected CDS prices." 
• "Russia enters the top 10 most risky table as CDS spreads widened around 90% following the fall in oil price which is adding more pressure to an economy already subject to continued economic sanctions." 
• "Ukraine CDS spreads also widened by 90%." 
• "CDS quoting for Nigeria remained extremely low throughout the last quarter of 2014. Bond Z-Spreads widened 150bps for the Bonds maturing in January 2021 and July 2023 but remained very active." 

Venezuela and Ukraine are clear 'leaders' in terms of risks - two candidates for default next.

Other top-10 are charted over time below:

Again, per S&P Capital IQ:

• "The CDS market now implies an 11% probability (down from 34% in Q3 2014) that Venezuela will meet all its debt obligations over the next 5 years, as oil prices dropped 40% in Q4 2014." 
• "Russia and Ukraine CDS spreads widened 90% during Q4 2014. The Russia CDS curve also inverted this quarter with the 1Y CDS level higher than the 5Y. Curve inversion occurs when investors become concerned about a potential ‘jump to default’ and buy short dated as opposed to 5Y protection." This, of course, is tied to the risks relating to bonds redemptions due in H1 2015, which are peaking in the first 6 months of the year, followed by still substantial call on redemptions in H2 (some details here: http://trueeconomics.blogspot.ie/2014/11/24112014-external-debt-maturity-profile.html). As readers of the blog know, I have been tracking Russian and Ukrainian CDS for some time, especially during the peak of the Ruble crisis last month - you can see some comparatives in a more dynamic setting here: http://trueeconomics.blogspot.ie/2014/12/16122014-surreal-takes-hold-of-kiev-and.html and in precedent links, by searching the blog for "CDS".
• "Greece, which restructured debt in March 2012, returned to the debt markets this year. CDS spreads widened to 1281bps and the 4.75Y April 2019 Bonds, which were issued with a yield of 4.95%, now trade with a yield of over 10%, according to S&P Capital IQ Bond Quotes." 

By percentage widening, the picture is much the same:

So all together - a rather unhappy picture in the emerging markets - a knock on effect of oil prices collapse, decline across all major commodities prices, dollar appreciation and the risk of higher US interest rates (the last two factors weighing heavily on the risk of USD carry trades unwinding) - all are having significant adverse effect across all EMs. Russia is facing added pressures from the sanctions, but even absent these things would be pretty tough.


Note 1: latest pressure on Ukraine is from the risk of Russia potentially calling in USD3 billion loan extended in December 2013. Kiev has now breached loan covenants and as it expects to receive EUR1.8 billion worth of EU loans next, Moscow can call in the loans. The added driver here (in addition to Moscow actually needing all cash it can get) is the risk that George Soros is trying to get his own holdings of Ukrainian debt prioritised for repayment. These holdings have been a persistent rumour in the media as Soros engaged in a massive, active and quite open campaign to convince Western governments of the need to pump billions into the Ukrainian economy. Still, all major media outlets are providing Soros with a ready platform to advance his views, without questioning or reporting his potential conflicts of interest. 

Note 2: Not being George Soros, I should probably disclose that I hold zero exposures (short or long) to either Ukrainian or Russian debt. My currency exposure to Hrivna is nil, to Ruble is RUB3,550 (to cover taxi fare from airport to the city centre on my next trip). Despite all these differences with Mr Soros, I agree that Ukraine needs much more significant aid for rebuilding and investment. Only I would restrict its terms of use not to repay billionaires' and oligarchs' debts but to provide real investment in competitive and non-corrupt enterprises.

16/12/2014: The Surreal Takes Hold of Kiev and Moscow...

While all of us are watching the Ruble crash, there is an ongoing collapse in Ukraine: http://www.nakedcapitalism.com/2014/12/imf-world-bank-halt-lending-ukraine-franklin-templeton-4-billion-ukraine-bet-goes-bad.html.

I posted IMF 'note' on the emergency visit to Kiev last week http://trueeconomics.blogspot.ie/2014/12/14122014-imf-emergency-mission-to-kiev.html which, in simple terms, amounted to nothing... as in nada... or no new lending.

And to note a simple fact: yesterday's Moscow dramas were nothing compared to Kiev dramas: http://trueeconomics.blogspot.ie/2014/12/15122014-russia-ukraine-cds-hitting.html and

Note: Russia's CDS rose, but didn't even make it into top under-performers group, while Ukraine did... and at an eye watering 77.36% probability of default (cumulative at 5 years). In other words, unless the IMF stamps out some USD15+ billion in new 'loans', Ukraine is done for.

The Russia/Ukrainian 'Arc':

It shows that Ukraine is getting worse faster than Russia is getting worse...

But back to Russia for now, as West's newest 'ally' East of Dniper is out of criticism or questioning... Ruble is tanking, still, as predicted in the first link above:

Credit to: @Schuldensuehner 

The reason is that when you have a 1am Governing Council meeting, you signal to the domestic economy that things are out of control (and they are), which prompts:

• Companies facing upcoming debt redemptions or holding Ruble deposits to run for FX cover and demand dollars or euros or pounds or Mongolian tugriks; and
• Households facing actual inflation (in PPP terms, not CPI) to run for FX deposits and demand same dollars or euros, less so unfashionable pounds and certainly not Mongolian tugriks...

The only way to stop this is... capital controls. All of which has little to do with the actual economy as a cause of the malaise, but all of which will cause actual economy to contract.

Oh, Happy Birthday, Wassily Kandinsky... your Composition VII aptly illustrates the whole mess:

15/12/2014: Russia & Ukraine CDS Hitting Major Highs

Both Russian and Ukrainian CDS are going hyperbolic:

10/12/2014: Ukraine & Greece CDS Flash Red... again...

It's another 'Oh dear' moment for Greece as the country slides into another political mess:

And still, with CDS widening by a massive 5.63% in one day, Greece is still performing better than Ukraine, which is facing a report from the IMF estimating fiscal shortfall of USD15 billion on top of what the Fund already previously estimated to be USD17 billion (http://www.cnbc.com/id/102254994#).  Now, the total expected cost of underwriting Ukraine is at USD42 billion and counting.

I estimated before that Ukraine will require around USD55-60 billion in supports and the number still stands. As I suggested on numerous occasions over the year, Ukraine needs a Marshall Plan, not a short-term lending facility.

Here is the summary of changes in Ukraine's (and Russian) CDS:

29/6/2014: What a Difference a Year of ECB Activism Makes...

Mapping decline in CDS and implied probabilities of default for Euro area 'peripherals' over the last 12 months:

Largest declines: Greece, followed by Portugal, Spain, Italy and lastly Ireland. Timing of declines and divergent macrofundamentals of these countries suggest that drop in CDS has little to do with internal policies and performance of individual states - the 'periphery' is still being priced jointly. The decline in risk assessments of the 'peripherals' is primarily down to common policy, aka: the ECB.

On the other hand, if we are to distinguish within the 'peripherals', we can identify 3 sub-groups of countries:

• Weakest and stand-alone: Greece
• Mid-range weakness, also stand-alone: Portugal
• Stronger 'peripherals': Ireland, Spain and Italy

29/6/2014: Mid-Summer CDS Dreams: Ukraine v Russia

One of these countries has a brand new Association Agreement with the EU... and a fresh probability of sovereign default of 41%... another one (with probability of default at 11.9%) does not...

In two years from June 2012 through June 2014, Ukraine's probability of default declined 1.47% as the country received massive injections of funds from the IMF, US and EU. Russia's probability of default fell 3.89% over the same time. For comparatives: Ukraine's June probability of default is running at around 41%, Serbia's at 17.6%. Ukraine is currently the worst rated sovereign (by CDS-based probability of default) of any state with an Association Agreement with EU.

6/3/2014: A 'New Normal' of Ireland's economy

This is an unedited version of my Sunday Times article from February 23, 2014.


Jobs, domestic investment, exports-led recovery and sustainable long-term growth are the four meme that have captured the current Coalition, setting the early corner stones for the next election’s promises. Resembling the ages-old "Whatever you like, we’ll have it" approach to policymaking, this strategy is dictated by the PR and politics first, and economics last. For a good reason: no matter how much we all would like to have hundreds of thousands new jobs based on solid global demand for goods and services we produce, given the current structure of the Irish economy, these fine objectives are largely unattainable and mutually contradictory.

Firstly, restoring jobs lost in the crisis requires restarting the domestic economy and investment both of which call for an entirely different use of resources than the ones needed to sustain exports-led growth. Secondly, domestic and externally trading economies are currently undergoing long-term consolidation. Expansion or growth will have to wait until these processes are completed. Thirdly, replacing lost jobs with new ones will not lead to a significant decrease in our unemployment. Majority of current unemployed lack skills necessary to fill positions that can be created in a sustainable economy of the future.

Torn between these conflicting calls on our resources, Irish economy is now at a risk of slipping into a ‘new normal’. This long-term re-arrangement of the economy can be best described as splitting the society into the stagnant debt-ridden domestic core and slowly growing external sectors increasingly captured by the aggressively tax optimising multinationals. Only a major effort at reforming our policymaking and tax regimes can hold the promise of escaping such a predicament.


In simple terms, Ireland's main problem is that we lack new long-term sources for growth.

Let's face the uncomfortable truth: apart from a historically brief period of economic catching up with the rest of the advanced economies, known as the Celtic Tiger from 1992 through 1999, our modern economic history is littered with pursuits of economic fads. In the 1980s the belief was that funding elections purchases via state borrowing delivers income growth. The late 1990s were the age of dot.com ‘entrepreneurship', and property and public 'investment'. From the end of the 1990s through today, correlation between real GDP per capita growth and the growth rates in inflation-adjusted real exports of goods collapsed, compared to the levels recorded in the period from 1960 through 1989. In the early 2000s dot.coms fad faded and domestic lending bubble filled the void. Since the onset of the 2010s, the new promise of salvation came in the form of yet another fad - ICT services.

Decades of growth based on tax arbitrage and the lack of sustained indigenous comparative advantage and expertise left our economy in a vulnerable position. Ireland today has strong notional productivity and competitiveness in a handful of high value-added sectors dominated by multinationals. As past experience shows, these activities can be volatile. As the recent data attests, they are also starting to show strains.

Last week, the Central Statistics Office published the preliminary data on merchandise trade for 2013. The results were far from pretty. Year on year, total value of Irish goods exports fell to EUR86.9 billion from EUR91.7 billion in 2012, and trade surplus in goods shrunk by EUR5.25 billion. Overall, 2013 was the worst year for Irish goods exports since the crisis-peak 2009.

This poor performance is due to two core drivers: the pharmaceuticals patent cliff and stagnant growth in exports across other sectors, namely in traditional and modern manufacturing.

The data clearly shows that we are struggling to find a viable replacement for pharmaceuticals sector. If in 2012, trade balance in chemicals and related products category accounted for 105 percent of our trade surplus, in 2013 this figure rose to over 106 percent. Just as our exports in this category are falling, our trade balance becomes more dependent on them.

The strategy is to replace traditional pharma activity with biopharma and other sectors that are more research-intensive than traditional pharma. Alas, our latest data on patenting activity shows that Ireland remains stuck in the pattern of low R&D output with declining indigenous patent filings. Institutionally, we have some distance to travel before we can become a world-class competitor in R&D and innovation. The latest Global Intellectual Property Index published this week, ranks Ireland 12th in the world in Intellectual Property environment. Beyond this lies the problem that much of the innovation-linked revenues booked by the MNCs into Ireland relate to activity outside of this country and are channeled out of Ireland with little actual economic activity imprint left here.

From the point of view of our indigenous workforce, it is critical that Irish indigenous exporters aggressively grow in new markets. Yet, Irish exports to BRICS economies and to Asia-Pacific have fallen in 2013. Our trade deficit with these countries has widened by 87 percent to EUR858 million last year.

So far, the short-term support for falling goods exports has been provided by relatively rapidly rising exports of services. This process, however, is also showing signs of stress. While we do not have figures for trade in services for 2013, the IMF most recent assessment of the Irish economy shows that our share of the world exports of services remains stagnant. And the IMF projects growth in Irish trade balance on services side to slow down significantly after 2015.


While exports engine is still running, albeit in a lower gear, domestic side of the economy remains comatose under the huge weight of our combined public and private debt overhang.  Total government and domestically-held private sectors debts stood at 189 percent of our GDP in 2007. At the end of 2013 it was 252 percent. This does not include debts held outside our official domestic banking system or loans extended to Irish companies abroad. The good news is the cost of funding this debt is relatively low. The bad news is – it will rise in the longer term.

And, in the long run, the wealth distribution in Ireland is skewed in favour of the older generations. This leaves more indebted working age households out in the cold when it comes to saving for future retirement and funding current investment in entrepreneurship and business development.

Irish economy is heading for a major split. Across the demographic divide the generation of current 30-45 year-olds will go on struggling to sustain debts accumulated during the period of the Celtic Tiger. They will continue facing high unemployment rates for those who used to work in the domestic economy. A stark choice for these workers will be either re-skilling for MNCs-dominated exports-focused services sectors, emigrating or facing permanently reduced incomes. Even those, likely to gain a foothold in the new ICT-led economy will have to stay alert hoping that the footloose sector does not generate significant jobs volatility.

All in, the unemployment rates in the economy are likely to remain stuck at the ‘new normal’ of around 8-8.5 percent through the beginning of the next decade, contrasting the 5 percent full employment rate of joblessness in the first decade of the century.


At this point in time, it is hard to see the sources of growth that can propel Ireland to the growth rates recorded over the two decades prior to the crisis. Back then, Irish real GDP per capita grew at an annualised rate of some 4.7 percent. The latest trends suggest that our income is likely to grow at around 1 percent per annum over 2010-2025 period - the rate of growth that has more in common with Belgium and below that expected for Germany. Aptly, the IMF puts our current output gap – the distance to full-employment level of economic activity – at around 1.2 percent of GDP, which ranks our growth potential as only thirteenth in the euro area. This clearly shows the shallow growth potential for this economy even in current conditions.

Slow recovery in employment and continued deleveraging of the households mean that Ireland will be staying just below the Euro area average in terms of income and consumption, and above the EU average in terms of unemployment. In that sense, the economic mismanagement of the naughties will be reversed by not one, but two or more lost decades.

Ireland has some serious potential in a handful of domestic sectors, namely food and drink, and agrifood, as well as in the areas where our ability to create and attract high quality human capital can offer future opportunities for growth. We have a handful of truly excellent, globally competitive enterprises, such as CRH, Ryanair and Glanbia. But beyond this, we are not a serious player in the high value-added game of modern economic production. In sectors where we allegedly have strong expertise: pharma, biotech, ICT, and finance, Ireland has no globally recognised large-scale indigenous players.

Ending the lost decades on a note of rebirth of the Celtic Tiger will take much more than setting political agendas for ‘kitchen sink’ growth agendas. It will take big-ticket reforms of the domestic economy, tax system, and political governance. Good news is that we can deliver such reforms. Bad news is that they are yet to be formulated by our leaders.

Box-out: 

Recent research note from Kamakura Corporation provided yet more evidence of the damaging effects of the EU's knee-jerk reaction policies in the wake of the global financial crisis. Specifically, Kamakura study published last week focused on the July 2012-issued blanket ban on short selling in the European Credit Default Swaps (CDS) markets. CDS are de facto insurance contracts on sovereign bonds, actively used by professional and institutional investors for risk management and hedging. The study found that as the result of the EU ban, trading activity declined for eighteen out of 26 EU member states' CDS. Put in more simple terms, as the result of the EU decision, risk hedging in the sovereign debt markets for the majority of the EU member states' bonds was significantly undermined, leading to increased risk exposures for investors. At the same time, liquidity in the CDS markets fell, implying further shifting of risk onto investors in sovereign bonds. Kamakura analysis strongly suggests that investors holding sovereign debts of euro area ‘peripheral’ countries like Spain and Italy are currently forced to pay an excessive liquidity risk premium in CDS markets. At the same time, the EU regulators, having banned short selling can claim a Pyrrhic victory in public by asserting that they have reacted to the crisis by introducing tougher new regulations. In Europe, every political capital gain made has an associated financial, social or economic cost. This is true for economic decisions and financial markets regulations alike. Too bad that those who benefit from the former gains rarely face any of the latter costs.

22/1/2014: 2013 - A Kinder Year for Peripheral CDS...

2013 was a kind year for Irish CDS... but it was an even kinder one for CDS of the countries from which, allegedly, Ireland decoupled, e.g. Italy and Spain...

Oddly enough (for those claiming Ireland's 'uniqueness' in terms of positive performance) the year was even kinder for Slovenia - a country that is only starting to move into a crisis mode:

And even lots-of-pain-for-little-gain Greece and Cyprus managed to pick up some positive momentum:

So the entire thesis for the 2013 CDS markets in euro area 'periphery' is really about global chase for yield squeezing more and more funds into 'peripheral' bonds and bidding down risk valuations of the said paper. This re-assessment of risks has little to do with underlying reforms or fundamentals on the ground in the countries and more to do with the exuberance of investors pushing cheaper funds into every corner of financial universe.

The good news is - this has a positive effect of lowering longer-term borrowing costs. The bad news is - this presents a threat of reforms fatigue. But we know this much already. After all, the sovereigns are not immune from the effects of QE...

5/1/2013: Euro periphery in CDS markets: 2013

One of the core improvements in the Irish economic conditions over 2012-2013 period relates to the decline in Government bonds yields and associated reduction in the Credit Default Swaps spreads (CDS spreads). In particular, bonds and CDS spreads have been referenced often enough as showing Ireland's 'divergence' from the euro area peripherals.

Here are some stats and charts based on CDS data and implied cumulative (5-year) probability of default (CPD) for the euro area peripheral states:

Summary table first, showing changes in CDSs and CPDs over 2013

The table above shows that Irish CDS performed well, but not as strongly as those of all other peripheral states, save Portugal and Italy. In fact, Ireland CDS decline over 2013 at -81.8 was slightly slower than the average for Italy, Portugal and Spain (-87.3), while our CPD decline of -5.16 percentage points was slightly faster than the average CPD decline for Italy, Portugal and Spain (-5.02 percentage points). The reason for the latter outperformance is made clear in the last bullet point of this post.

In absolute terms, however, Irish CDS are signalling stronger sovereign performance when it comes to risk of default:

But Spain is catching up in terms of CPD and in terms of CDS spreads.

Here is Ireland's progression in 2012-2013 showing that most of the improvement was priced in 2012, rather than over the last year:

And looking at the year-end position puts forward several core points about our sovereign debt risks:

• Irish CDS have shown strong declines since the beginning of 2012
• Irish CDS declines do not warrant a conclusion that we are distinct from other peripheral countries. Instead, the conclusion should be that we (alongside Spain and Italy) are distinct from Portugal and Greece. This is intuitive, given that Italy did not have to raise bailout funding, while Spain raised bailout funding solely for banks recapitalisations. Recall that Ireland was tipped into the bailout by the banking crisis and that absent banking crisis, we could have, potentially, sustained Exchequer funding without the need to resort to a bailout. This is not to downplay very substantial deficit pressures that we had ex-banks. But it is to point out that we are different from Portugal and Greece, both of which had to raise funds to shore up almost exclusively sovereign funding.
• Irish CDS since the beginning of 2012 are carrying heavier weighting on probability of default estimates: in the last two charts, our CPD is priced along the mid envelope of (CDS, CPD) quotes, while Greece implies underpricing of the probability of default (along the lower envelope). Our probability of default is slightly over-estimated compared to Portugal and Spain, but is in line with Italy. This potentially relates to the point raised above in relation to speed of our CPD declines over 2013: we might be experiencing an over-due repricing (very slight) in the relationship between the CDS levels and implied estimates of the probability of default.

Less drama-prone interpretation of data than what the thesis of 'Ireland has decoupled from the peripherals' suggests...

27/10/2013: Irish CDS spreads: a reason to smile for a change...

It might be disheartening sometimes (often) to read the newsflow involving Irish economy. But occasionally, there are some really worthy decent news... Here's an example: 12 months difference in CDS spreads:

First Q3 2012:

Now, Q3 2013:

That's a huge change... even though we are still far from where we want to be, the change is impressive.

24/7/2013: Q2 2013 CDS report: spotlight on Irish CDS performance

CMA published Q2 2013 report on CDS markets. Here's the top 30 table of riskiest sovereigns (ranked by probability of default over 5 years):

Note Ireland's significant improvement from Q1 2013, moving from 20th most risky (5 year CPD of 15.7% and mid-point CDS  at 188.64) to 27th most risky (5 year CPD down to 14.0% and CDS at 165.22).

18/7/2013: One table, four entries, wealth of irony...

One cannot contain a sense of deep irony when looking at today's mid-day CDS markets snapshot from CMA:

In one table we have:

• Euro area CDS spread from Finland (implied cumulative 5 year probability of default of 2.02% - which is asymptotically zero), Greece (implied CPD of 50.85% after two previous defaults), and Cyprus (implied CPD of 65.39% after previous default). 
• Egypt (implied CPD of 41.22% after a coup d'etat) 

That's, as Mario Draghi put it on June 25th, "reflect[s] on the importance of a stable euro and a strong Europe" or perhaps, as he put it "the euro area is a more stable and resilient place to invest in than it was a year ago" or may be "I am confident that the project for Europe will continue to evolve towards renewed economic strength and social cohesion based on mutual trust, both within and across national borders, and above all stability". Take your pick... (link)

20/6/2013: China Volcano Blowing Up at Last?

Good title to a research note, as I tell my students in MSc in Finance, does the following things:

1. Captures attention of the reader for the right reason
2. Conveys enough information for the reader to continue reading, but not enough to end up with a feeling that all that needs to be known is already expressed in the title
3. 'Sells' the story without over-exaggeration
4. Commits the story to memory.

Today's 'good title' award is for the folks from Markit, for the note titled "Perfect Storm" - a simple, run of the mill account of the day when Asian CDS markets got bashed on China's end of things:

And while on China, excellent article in the FT today on Chinese steel giant Wisco: http://www.ft.com/intl/cms/s/0/fa98c4e2-d830-11e2-9495-00144feab7de.html

Read and weep... China has managed to perfectly waste a USD586 billion stimulus from 2008. That's a lot of burning of cash, if you ask me.

Here's mid-day CDS wideners by order of magnitude:

And here's yesterday's:

That's 40bps in two days. Whacking-cracking... 

On June 6th, China's CDS were at 91.61 with CPD of 7.71%. Chinatastic...

And with that China is heading for a classic sugar crunch just as the punch run out. Over the last three weeks, China's interbank loans rates jumped from about 3% to over 7%, having hit last week 9.6%.

Someone, dial Bank of Japan, quickly!

13/5/2013: Cyprus CDS

It doesn't look like anyone (save for Olli Rehn) is betting on Cyprus' 'vast gas wealth' to be anywhere near its current account anytime within the next 5 years...