21/6/2014: IMF 'Waived' Sustainability Requirement in Lending to Euro Area Countries

IMF paper, published yesterday now fully admits that the Fund has 'waived' its own core requirements for lending under the core programmes in euro area 'periphery'. More importantly, the criteria for lending that was violated by the Fund is… the requirement that "public debt be judged as sustainable with "high probability”" under new lending programme.

The paper is available here: http://www.imf.org/external/np/pp/eng/2014/052214a.pdf

Quoting from the IMF report: "In the sovereign debt crises of the 1980s, concerted financial support from the private sector was a standard feature of Fund-supported programs, most of which were within the normal access limits. By contrast, the spate of capital account crises that began in the mid 1990s occurred at a time when the creditor base had become much more diffuse, and the Fund’s strategy sought instead to entice a resumption of private flows through programs involving large-scale Fund and other official resources. While this strategy worked well in some circumstances, it failed to play its catalytic role in cases where, amongst other factors, the member's debt sustainability prospects were uncertain." 

Thus, the Fund clearly recognised that probabilistically, extended lending can only work where there is some confidence that the borrower debts post-lending by the IMF, are sustainable. In other words, the Fund agreed that there is the need for more extensive lending (in some cases), but that such lending should, by itself, not push beyond sustainability levels of debt. Were it to do so, the Fund would have required restructuring of the sovereign debt to reduce levels to within sustainability bounds.

This is how this 'bounded' lending beyond normal constraints was supposed to work: "In response to this varied experience, and to ensure effective use of its resources, the Fund concluded that decisions to grant access above normal limits should henceforth be guided by defined criteria. These were established in the 2002 Exceptional Access Policy, [EAP] which included a requirement that public debt be judged as sustainable with "high probability.” The framework applied initially only in capital account cases, but in 2009 became applicable to all exceptional access decisions."

Now, fast forward to the Fund entanglement in euro area debt/default politics: "When Greece requested exceptional access in May 2010, the policy would have required deep debt reduction to reach the high probability threshold for debt sustainability. Fearing that such an operation would be highly disruptive in the circumstances prevailing at the time, the Fund decided to create an exemption to the high probability requirement for cases where there was a high risk of international systemic spillovers—an exemption that has since been invoked repeatedly in programs for Greece, Portugal, and Ireland."

Elaborating on this, the paper states: "An important rigidity of the EAP came to the fore when Greece requested financial support in early 2010. When “significant uncertainties” surrounding the sustainability assessment prevented staff from affirming that debt was sustainable with high probability, the existing EAP framework would call for a debt reduction operation to deliver such high probability as a condition for the provision of exceptional access. In the case of Greece, where the high probability requirement was not met, however, there were fears that an upfront debt restructuring would have potentially systemic adverse consequences on the euro area. Given the inflexibility of the EAP, and the crisis at hand, the Fund decided to create an exemption to the requirement for achieving debt sustainability with a high probability when there was a “high risk of international systemic spillovers”. Since then, the systemic exemption has been invoked 34 times by end-May, 2014 in the three EA programs for Greece, Portugal, and Ireland."

Note that the systemic exemption has been invoked 34 times in just four years, in all cases in relation to euro 'periphery'. That is a lot of 'we can't confirm sustainability of debt levels post-programme, so we won't look there' invocations. More significantly, did anyone notice these invocations in IMF country reports that repeatedly assured us, since 2010 on, that things are sustainable in these countries?

Conclusion: the Fund now fully admits that its lending to Greece, Portugal and Ireland:

1) Required (under previous conditions) deep restructuring of sovereign debt; and

2) Was carried out in excess of the already stretched sustainability bounds.

The Fund loaded more debt onto these economies than could have been deemed sustainable even by its already stretched standards of 2002 EAP.

16/5/2014: Competitive Sports of Competitiveness Gains

Yesterday I posted my Sunday Times article on unemployment and skills: http://trueeconomics.blogspot.ie/2014/05/1552014-jobs-employment-lot-done-more.html

Here is an interesting chart via BBVA Research on labour costs competitiveness gains across the euro 'periphery' and other euro states:

BBVA Research chart above is plotting changes in unit labour costs 2009-2013 and decomposing these gains in 'competitiveness' into productivity growth and earnings/wages cuts. Here Ireland is a shining exemplar of improved competitiveness.

Alas, there are some problems with this. Wages/earnings destruction is hardly a good way for regaining competitiveness, especially when this process is associated with sticky prices (real value of income declines). In Ireland's case, we had on top of the said reductions of the purchasing power of income, also higher taxation and extraction of rents by the public sectors and by the banks. All of this 'improved competitiveness' is, therefore, a wee-bit of pyrrhic victory for Ireland. 

And then, of course we have our fabled increases in productivity. What happened here? Have we suddenly discovered major technological breakthrough that allow us to produce more using fewer resources? Err… not really. We took down construction and retail and domestic services sectors and reduced them to ashes. Highly labour-intensive, these sectors employed many producing lower value added than other sectors where few produce huge value added (much of it of course is superficial and accruing to the MNCs, but who cares in this land of magic competitiveness?). When we destroyed domestic sectors, we ended up with an economy producing less, but with even fewer people working. All the social welfare rolls swelling also fuelled our productivity. Of course, were we to fire everyone and just leave around one tax arbitrage P.O. Box in IFSC open, we will have miraculously higher productivity than anyone else in the world.

So where are we, really, if we take out all these superficial and even potentially self-destructive 'efficiency gains'? Probably closer to Portugal - a net gain in competitiveness of around 3-4%. Not bad, but not as wonderful as our heroic 9.5% gain.

15/5/2014: Bad Habits Die Hard

A neat summary of the euro area revisions to targeted deficits for 2014-2016 period:

Per BBVA Research: "The relaxation in fiscal targets approved by ECOFIN in the first half of 2013 was an important factor in the European economy’s recovery in the second half of the year, as we pointed out in previous editions of this report. The panorama has not changed. Fiscal policy continues to be contractive, but less so than forecast at the time, thanks to the postponement of the 3% deficit target for several countries, including France, Italy and Spain. Deviations from the deficit targets in 2013 have been small, except in France (0.4pp off the May 2013 stability plan’s target) and plans presented to the Commission in April this year retain the targets forecast or modify them towards a somewhat slower consolidation path."

Here's a question: we have growth in underlying GDP (anaemic, but still growth). We have widening deficits compared to targets, and deficits reductions over time are penciled in at slower rates for 2014-2015. Oh, and we are still running deficits… so explain to me where is that amazing 'austerity' excluding the bizarre stretch of the imagination by which lowering deficits (not turning surpluses) is 'austerity'… [presumably in the same way as spending money we don't have is a stimulus, may be]…

Just a few pages down, BBVA gloriously declare: "Fiscal policy will continue to be restrictive in the forecast horizon, although fiscal efforts will be less rigorous than those of 2012 and 2013, since the rest of the adjustment has been postponed, in order to meet the target of structural balance in the public accounts beyond 2015. With all this, public consumption may go up by around 0.3% in 2014 and 0.7% in 2015."

Ah, European 'austerity' - where reducing the rate of spending growth represents unbearable economic pain and is yet consistent with a possible increase in the Government consumption...

It clearly looks like we are back to the good old 'bad' habits' on the side of the euro area periphery's largest sovereigns...

3/5/2014: Crisis Impact Comparatives: GDP changes 2007-2013

A very interesting map plotting changes in the GDP across various European countries since 2007:

My own calculations using IMF database and showing more up-to-date data and broader set of GDP metrics covering all advanced economies ex-Luxembourg, San-Marino, and Latvia (you can click on the image to enlarge):

One sample of just European economies:

And two sets of summary tables pooling together Euro area 'peripherals' plus Iceland:

We can't really say we are much better off than Iceland, and we are certainly to-date worse off than Portugal, although we are better off than Greece.

25/4/2014: A stretch of numbers here... a bond sale there... Greek Deficit in 2013

This week we had the data release by Eurostat showing the fiscal position of the euro area sovereigns for 2013, followed by the statement by the Troika (EU Commission, the ECB and the IMF) on Greece's fiscal position.

Based on data-driven Eurostat conclusions (see details here: http://trueeconomics.blogspot.ie/2014/04/2342014-some-scary-reading-from-eurostat.html) Greek fiscal deficit was 12.7% of GDP in 2013. Based on the Troika conclusions, Greece has managed to generate a budget surplus of 0.8% of GDP in 2013. The two numbers are so widely apart that the case of 'thou shalt not spin too much' comes to mind.

In reality, to arrive at 0.8% surplus, the Troika had to do some pretty extreme dancing around the real figures: they took out non-recurring spending out of the Greek deficits (all banks measures and all interest paid on gargantuan 175.1% of GDP Government debt). Just how on earth can debt interest payments be non-recurring is anyone's guess. But even removing that (to arrive at normal definition of primary deficits), the official primary deficit for Greece at the end of 2013 stands at 8.7% of GDP. The swing of 9.5% of GDP bringing this to a surplus of 0.8% is 'banks measures'.

The problem is that with 12.7% of GDOP deficit and 8.7% primary deficit in 2013 and with debt of 175.1% of GDP, Greece is plain simply and undeniably an insolvent state. This is precisely why exactly at the time of the above data publication and at the time when the Troika was extolling the virtues of the fiscal surplus in Greece, the very same European authorities praising Greek Government were announcing that they have engaged in a new round of debt relief negotiations with Greece (http://www.ft.com/intl/cms/s/0/9ec817d8-cadf-11e3-9c6a-00144feabdc0.html#axzz301XTTXyT).

Meanwhile, bust, bankrupted and in new default talks, Greek Government is hell-bent on buying votes into the upcoming European elections. Per FT account linked above:

"About 70 per cent of the [bogus Greek] primary surplus has already been allocated for current expenses rather than for writing down existing debt, according to the finance ministry. The government has set aside €524m as a one-off payment to low-income families and pensioners ahead of next month’s European elections. Another €320m will cover a projected deficit this year at IKA, the main social security organisation, following a decision agreed with international lenders to cut employers’ contributions."

This is truly epic: European authorities praising national Government for bogus surpluses that are explicitly being used to fund giveaways to vulnerable voters groups at the time of elections. This is 'reformed Europe'?

This is precisely the circus that is driving up valuations of peripheral bonds (http://mobile.bloomberg.com/news/2014-04-23/samaras-met-dimon-for-greek-bonds-on-way-to-a-400-return.html?alcmpid=markets) and that has an exactly negative correlation with the underlying strength / structural health of some of the peripheral economies (see my comment on this here: http://trueeconomics.blogspot.ie/2014/04/2542014-ecb-denmark-negative-rates.html).

23/4/2014: Some scary reading from the Eurostat...

Eurostat published full comparatives on key fiscal performance indicators across the EU and euro area for 2013. Here are three summary tables comparing euro 'periphery' states against each other and the EU18. You can click on images to enlarge:

First data summary:

Second: Ireland's share of the mess:

Third: Ireland's position within the 'periphery':

And key takeaways are:

1. In 2013, after years of austerity and pain, Irish Government deficit (7.2% of GDP) was the second worst in the euro 'periphery' group.
2. By relative comparative to EA18 (33% and 50% over EA18 levels), Ireland ranks worse than Italy, Cyprus and Portugal, and Spain (we have more 'red'/'green' cells).
3. In cumulative terms, 2010-2013 years were brutal to Ireland: we posted worst cumulated Government Deficits over this period and 2nd worst increases in Government debt.

Note: data is taken from http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-23042014-AP/EN/2-23042014-AP-EN.PDF

4/2/2014: Good at anything? Europe's broken monetary policy engine

Monetary policy is not a nuclear science. It is not even anatomy, for what it matters. Instead, it is more like a simple task in civil engineering. Bank of Japan can get the message, the Fed wrote books on it, Bank of England has discovered it, Canadians, Swedes, Danes, Swiss, everyone has figured it out by now... Meanwhile, in the euro area, there is a whole lot of mystery, mystique, halls of mirrors and corridors of contortions, when it comes to the monetary policy. And a simple, plain-sight visibility of its failure…

Take a look at this chart, plotting euro area real GDP growth against M1 money supply growth rate (via Pictet):

Spot anything of interest? Oh, simples.com: M1 growth declines predate GDP growth and levels declines. No, seriously, since 2006, euro area could not manage one policy - money supply. Forget the intricacies of fiscal policy (it is not an easy job to spend money on stimulating economic activity, when you are in debt up to your ears), the EU simply could not put enough money into the real economy to prevent cash in circulation from shrinking.

How on earth can such a feat be achieved? Simple: the ECB pumped trillion euros plus into the banks, instead of pumping the very same trillion (and more still would have been needed) into the real economy. Frankfurt opted for loading money into the banks balance sheets . It should have opted for using printed money to pay down real economy's debts (households' and non-financial companies' debts) which would have (1) repaired banks balance sheets, and (2) repaired the real economy, restarting consumption and investment. Instead, we have a bizarre, senile, idiotic situation where we print money and then, de facto, lock it up in the vaults.

It would half as bizarre if it was just locking the liquidity in the vaults, but the euro area monetary policy is currently all about the repayments by the banks of the LTROs, or in different terms - burning of cash out of the economy. This is cutting down on M1 growth rate. Just as the M1 growth should be rising, not falling. Forget about doing the right thing at the wrong time… we are doing the wrong thing at the wrong time… and doing so repeatedly.

And the latest? Annual growth rate of M3 money supply is again slowing, to 1.0% y-o-y in December 2013 from already low 1.5% y/y growth in November. The law of under fulfilled low aspirations clearly at work: expectation was for 1.7% y/y growth in M3, and ECB delivered 1.0% - the lowest rate since September 2010. Oops, predictably, lending to the private sector remained at -2.3% y/y in December 2013, an all-time low.

So for all its OMT, LTROs, BU 'policies activism', the ECB is now 5th year into mismanaging basic crisis-related monetary policy. Inventiveness and monetary engineering gushing out of Mario Draghi left, right and centre to the delight of the policy analysts and bonds salesmen, and the euro area is still where it was: below reference line on M3 growth.

23/1/2014: Funding Markets Spring Hits a Bump in the Euro Area: H2 2013 Repo Market Report

ICMA (International Capital Markets Association) report released yesterday showed massive 9.5% contraction in euro area repo markets, leading to lower availability of short-term funding to banks in the market over H2 2013 compared to H1. The core drivers of the decline are

• ECB's supply of funds met by lenders who are becoming more reliant on Central Bank's funding, and
• Cash hoarding by banks.

Here is a summary table showing H2 2013 repo market at the lowest point of any half-year period since H1 2009 and the third lowest reading since H1 2005.

At the same time, the share of anonymous electronic trading jumped unexpectedly to 25% from 19.8% a year ago. This came at the expense of domestic business (down to 26.1% from 29.7% a year ago) and less significantly at the expense of cross-border transactions within the euro area (down to 18% from 18.9% a year ago). The survey suggested that ECB's funding sources are the driver behind these trends in relation to domestic repos.

Summary table:

Net conclusion: things are not running smoothly in the funding markets, some five years since the crisis trough.

Full report here: http://www.icmagroup.org/media/Press-releases/

29/12/2013: Icelandic Model for Debt Crises Resolution?

A very comprehensive paper analysing the Icelandic approach to personal debt and corporate insolvency crises resolution:
http://hhi.hi.is/sites/hhi.hi.is/files/W-series/2013/WP1310.pdf

Latest comparatives between Icelandic and Irish economic performance: http://trueeconomics.blogspot.ie/2013/10/27102013-ireland-v-iceland-full-deck.html

11/12/2013: Will Europe Have Any Firepower for Banks Bail Outs?

The Banking Union debate drags on and on and on and the further we travel in time into this debate, the more apparent is the pathetic nature of the undertaking, and with it, the pathetic state of leadership across Europe... Here's the latest instalment:
http://blogs.ft.com/brusselsblog/2013/12/eu-bank-bailout-fight-more-leaked-documents/

Key quotes in this latest instalment:

"Both the European Commission and the European Central Bank – along with most eurozone finance ministries – believe a “break in case of emergency” backstop needs to be in place to provide a safety net for the bank rescue fund since, even when it’s completely full, it will only have €55bn in it. Given the recent crisis experience, that might only be enough to bail out two or three mid-sized European banks."

Laugh! or Cry! or both. The entire circus is about EUR55 billion. Not enough to backstop another Ireland (based on the 2008-2010 crisis dimensions). Not enough to backstop the retail division of the Deutsche Bank alone (based on 5% loss over capital cushion). Not enough to backstop anything, really. Administration, compliance, enforcement and other bureaucratic functions associated with this backstop (and the necessary Banking Union spoking it to the ECB and the eurosystem) will be running at somewhere around 5-10 percent of the entire fund, annually. If this is a form of insurance, you might getter better quote on insuring Titanic in its current state for passenger traffic.

"In addition, the fund will take 10 years to completely fill through levees on European banks, meaning some kind of backstop needs to be in place in the interim. The “SRF Backstop” paper basically says: we need a backstop, but we’re still not sure what it should be or how it would work."

Two things. Unless euro area hopes to remain in the Great Stagnation for the next 10 years, we shall see growth in banks balancesheets. Over 10 years horizon (even if balancesheets grow at 1.5% = real GDP growth expectation for euro area + HICP target, so 3.5% nominal growth pa in balancesheets), the banking assets side (covered liabilities from the SRF perspective) will have expanded by 41 percent. In other words, to provide the same cover as today's EUR 55 billion the fund will require EUR 78 billion. Forget the idea that in its current vision SFR will only be sufficient to bailout two or three mid-sized European banks. We'll be lucky if it can bailout 1 or 2 of mid-sized European banks in 10 years time.

20/11/2013: Euro Area: the Zaporozhetz of Growth?..

"Ello... Ello... Stagnation calling... Is this Europe?"

Two snapshots from the recent ECB staff forecasts for the euro area performance: 2012-2014... Real GDP in the range of cumulative 3-years growth of... -0.0076%... 2014 rapid expansion of the forecast range of 0.9-1.2%... If this is the engine of growth, then this is the engine of mobility:

Update: The Zaporozhets of Growth is now spilling coolant (oil has drained already):

Via BBVA Research.

14/11/2013: With banks or without, things are heading for desperate in Italy...

The banks stress tests are coming up and the Euro periphery system is quickly attempting to patch up the massive cracks in the facade. The key one is the continued over-reliance of banks on sovereign-monetary-banking loop of cross-contagion. The banking system weakness is exemplified by Italy: Italian banks are the main buyers of Italian sovereign debt, which in turn means that Italian government stability rests on the banks ability to sustain purchasing, which implies that the ECB (with an interest of shoring up Italian economy) is tied into continuing to provide cheap funding necessary for the Italian banks to sustain purchasing of Italian Government debt… and so on.

Three key facts are clouding this 'stability in contagion' picture:

1. Banks in Italy and elsewhere are not deleveraging fast enough to allow them repay in full the LTROs coming due January and February 2015;
2. Banks in Italy are now fully saturated with italian Government debt, posing threats to future supply of Italian bonds and putting into question the robustness of the banking stress tests; and
3. Italian Government is running out of room to continue rolling over its massive debts.

If all 3 risks play out at the same time or close to each other, things will get testy for the Euro.


Point 1: Banks in the euro zone continue to carry assets that amount to three times the size of the euro area economy. This puts into question the core pillar of banking sector 'reforms' that the ECB needs to see before the banking union (BU) comes into being. The ECB needs to have clarity on quality of assets held by banks and, critically, needs to see robust deleveraging by the banks before th BU can be launched. If either one of these conditions is not fully met, the ECB will be taking over the banking system that is loaded with unknown and unpriced risks.

Per recent ECB data, Banks in the euro zone held EUR29.5 trillion in total assets by the end of 2012. That is down 12% on 2008. Too slow of a pace for a structural deleveraging. Worse, the bulk of the adjustments was back in 2009 and little was done since. Which makes the level of assets problem worse: on top of having too many assets, the system has virtually stopped the process of deleveraging. Knock on effect is that the firming of asset markets in Europe in recent two years was supported by a slowdown in assets disposals by the banks. In turn, this second order effect means that many banks assets on the books are superficially overvalued due to their withholding from the market. Nasty, pesky first and second order effects here.

Worse. Pressure on assets side is not limited to the 'periphery'. German banks held EUR7.6 trillion in total assets at the end of 2012, followed by the French banks with EUR6.8 trillion. Spain and Italy's banking sectors came in distant second and third, with EUR3.9 trillion and EUR2.9 trillion in total assets.

Capital ratios are up to the median Tier 1 ratio rising from 8% in 2008 to 12.7% in 2012. Quality of this capital is, however, subject to the above first and second order effects too - no one knows how much of the equity valuation uplift experienced by the euro area banks in recent months is due to banks reducing the pace of assets deleveraging…


Point 2: Assets quality in some large banking systems is too closely linked to the sovereign bonds markets. Italy is case in point. ECB tests are set to exclude sovereign debt risk exposures, explicitly continuing to price as risk-free sovereign bonds of the peripheral euro area states. But in return for this, the ECB might look into gradually forcing the banks to limit their holdings of sovereign bonds. This would be bad news for Italian banks and the Italian treasury.

The problem starts with a realisation that Italian banks are now primarily a vehicle for rolling over Government debt. Italy's Government debt is over EUR2 trillion. EUR397 billion of that is held by Italian banks. Another EUR200-250 billion can be safely assumed to be held by Italian banks customers who also have borrowings from these banks. Any pressure on the Italian sovereign and the ca EUR600 billion of Italian debt sloshing within the banking system of Italy is at risk.  That puts 20.7 percent of Italian banks assets at a risk play. [Note: by some estimates, Italian banks directly hold around 22% of the total Italian Government debt - close to the above figure of EUR397 billion, but way off compared to Spanish banks which are estimated to be holding 39% of the Spanish Government debt, hence all of the arguments raised in respect of Italy herein also apply to Spain. A mitigating issue for Spain is that it's debt levels are roughly half those of Italy. An exacerbating issue for Spain is that its deficit is second highest in Europe, well ahead of Italain deficit which is relatively benign).

Worse, pressure cooker is now full and been on a boiler for some time. In the wake of LTROs, Italy's banks loaded up on higher-yielding Italian Government debt funded by cheap LTRO funds - Italian banks took EUR255 billion in LTROs funds. In August 2013, Italian banks exposure to Italian Government debt hit EUR397 billion, just shy of the record EUR402 billion in June and double on 2011 levels. I

Either way, with or without explicit ECB pressure, Italian banks have run out of the road to keep purchasing Italian Government debt. Which presents a wee-bit of a problem: Italy needs to raise EUR65 billion in new debt in 2014. Italy is now in the grip of the worst recession since WWII and its debts are rising once again.

Chart below shows that:
1) Italian Sovereign exposures to external lenders declined in the wake of the LTROs, but are back to rising in recent quarters;
2) Italian banks reliance on foreign funding rose during the LTROs period, declined thereafter and is now again rising; while
3) Other (non-financial and non-state) sectors remain leveraged at the levels consistent with late 2006.

Point 3: Overall, Italian Treasury is now competing head on with the banks for foreign lenders cash and Italian corporate sector is being forced to borrow abroad in absence of domestic credit supply. Foreign investors bought almost 2/3rds of the last issue of Italian bonds, but how much of this appetite can be sustained into the future is an open question. Foreign investors currently hold slightly over a third of Italy's debt, or EUR690 billion, down from more than EUR800 billion back in 2011. The Italian Government is now turning to Italian households to mop up the rising supply. Italy issued EUR44 billion worth of inflation-linked BTP Italia bonds with 4 year maturity. As long as inflation stays low, the Government is in the money on these.

Next in line - desperate measures to raise revenues. Per recent reports, there is a proposal working its way through legislative corridors of power to raise tax on multinational on-line companies trading in Italy. The likes of Google, Amazon and Yahoo will be hit with a restriction on advertisers to transact only with on-line companies tax-resident in Italy, per bill tabled by the center-left Democratic Party (PD). The authors estimate EUR1 billion annual yield to the state - a tiny drop in the ocean of Italian government finances, but also a sign of desperation.

11/11/2013: A Great Tech Future for Ireland… or a Bubble? Sunday Times, November 10

This is an unedited version of my Sunday Times column from November 10, 2013.

Depending on which measure one uses Ireland slipped into the Great Recession as far back as in the mid-2007. Since then and through the first half of this year, our nominal Gross Domestic Product is down 15.3 percent or EUR14.55 billion. Despite the claims about the return of growth, played repeatedly from early 2010, our economy posted 19 quarters of negative growth and only 7 quarters of expansion.

These numbers reveal the unprecedented collapse of the domestic economy, ameliorated solely by continued growth in exports, primarily driven by the multinationals. At the end of last year, total exports of goods and services from Ireland were up 16 percent on 2007 levels. However, the latest global and domestic trends suggest that this growth is at risk from a number of factors. These include both the well-known headwinds that are currently already at play, as well as the newly emerging signs of distress. 

The former cover the adverse impact of the ongoing patent cliff in pharmaceutical sector and the continued migration of manufacturing to Eastern and Central Europe and Asia-Pacific. Added pressures are building up from our competitors for FDI, such as the Netherlands, Belgium, Sweden, Finland and, more recently, Austria.

The risks that are yet to fully materialise, however, pose a threat to the biggest post-2007 success story Ireland has had - the Information and Communications Technology (ICT) services. This sector, most often exemplified by the tech giants, such as Google and blue chip firms such as Microsoft. More trendy and smaller players include the games developers, cloud computing and data analytics enterprises, as well as on-line marketing and advertising companies.

While easy to discount as being only potential, these threats are worrying. 

Since 2007, goods exports from Ireland grew by a cumulative 2.1 percent, against 33 percent growth in exports of services. If in 1998-2004 goods exports averaged over 67 percent of our GDP, today this share has declined to 51 percent. Meanwhile, share of services exports rose from an average of 23.3 percent of GDP in 1998-2004 period to 58.4 percent projected for this year. More than half of this growth came from ICT services.

More importantly, as the Budgets 2012-2014 have clearly shown, the Government has no coherent plan for supporting the growth capacity of the domestic economy. This means that the entire economic strategy forward remains focused on the ICT services to deliver growth in 2014-2015. 

And herein lies a major problem. Increasingly, international markets and global developments are signaling the emergence of an asset bubble within the ICT services sector. These signs can be grouped into three broad categories.

Firstly, we are witnessing the development of a bubble in investors' valuations of the ICT companies. Controlling blue chips, tech valuations have grown over the last decade at a pace roughly double that found in other sectors. Many tech stocks are currently trading in the range of 25-50 times their sales, dangerously close to the levels last seen at the height of the dot.com bubble. Last 18 to 24 months have also seen a series of tech IPOs with post-listing annual returns in 50 percent-plus ranges - another sign that investors are rushing head-in into the sector. Meanwhile, blue chip technology companies are trading near or below their multi-annual averages, suggesting that hype, not real performance is the driver of the market for younger firms. MSCI ACW/Information Technology benchmark tech stocks index is up ca 90 percent over the last 5 years. Recent research from PWC shows that IT sector M&A deals in Q3 2013 were up 34 percent year on year.

Secondly, costs inflation is now driving profitability down across the sector. Take for example Ireland. In 4 years through June 2013, average weekly earnings in the economy fell 1 percent. In the ICT sector these rose 11 percent. Back in Q2 2009, ICT sector posted the third highest average weekly earnings of all sectors in the Irish economy. This year, it was the highest. Other costs are inflating as well. Specialist property funds with a focus on the tech sector, such as Digital Realty Trust, are awash with cash from their massive rent rolls.

CSO publishes a labour market indicator, known as PLS4. This combines all unemployed persons plus others who want a job but are not seeking one for reasons other than being in education or training and those who are underemployed. In Q2 2013 this indicator stood at nearly one quarter of our total potential workforce. Yet, the ICT services sector has some 4,500-5,500 unfilled vacancies. With tight labour supply, stripping out transfer pricing in the sector, value-added is stagnating in the sector, implying lagging productivity growth.

Thirdly, as in any financial bubble, we are nearing the stage where the smart money is about to head for the doors. In recent months, seasoned investors, ranging from Art Cashin, to Tim Draper to Andressen Horowitz announced that they cutting back their funds allocations to the sector. 

To see how close we are getting to forming a bubble, look no further than the recent fund raising by Supercell - a games company - which raised USD1.5 billion in funding in October. The firm has gone from zero value to USD3 billion in just three years on last year profit of just USD40 million. The investor who financed the Sueprcell deal, Japan's Masayoshi Son is now declaring that he is investing based on a 300-year vision for the future. Expectations and egos are rapidly spinning out of synch with reality. In tandem with this, Irish politicians are vying for any photo-ops with the ICT leaders and industry awards, summits and self-promotional gala events are musrooming. In short, the sector is becoming a new property boom for Ireland's elites.

Global ICT services sector hype is pushing up companies valuations across the sector and delivering more and more FDI into Ireland. This is the good news. The same hype, however, also brings with it an ever-increasing international exposure of Ireland's tax regime, the main driving reason for the MNCs locating into this country. This, alongside with rampant wages inflation and skills shortages, is one of the top domestic reasons for the tech-sector vulnerability. 

Overall, risks to the ICT services sector are material for Ireland. Our economy's reliance on the tech sector FDI has grown over time, and even a small contraction in the sector exports booked via Ireland can lead to us sliding dangerously close to once again posting negative current account balance. 

Our capacity to offset any possible downturn in the sector with other sources of growth has been diminished. Post-2001 dot.com bust we compensated for the collapse in ICT and dot.com companies activities by inflating property and Government spending bubbles. This time around all three safety valves are no longer feasible. Between Q1 2001 and Q2 2003, ECB benchmark repo rate declined from 4.75 percent to 2.0 percent. Today, the ECB rates are at 0.5 percent and cannot drop by much into the foreseeable future. 

Besides credit supply, there is a pesky problem of credit demand. The evidence of this was revealed to us last week, when we learned that the Government Seed and Venture Capital Scheme (SVCS) and the Micro-enterprise Loan Fund turned out to be a flop. Both schemes are having trouble finding suitable enterprises to invest in. May we wish better luck to yet another ‘state investment vehicle’ launched this week, the ‘equity gap’ fund for medium-sized companies.

Ireland's policymakers today have little to offer in terms of hope that we can weather the next storm as well as we did ten years ago. 

Based on numerous multi-annual initiatives by the Government and business lobbies, Ireland’s 'new school' of economic thinking post-crisis is solidly focused on tax incentives to rekindle a new property and construction boom and on advocating more Government involvement in the economy. The latter includes such initiatives as more state investment and lending schemes for SMEs, a state bank, state-run agencies to sell services to foreign state agencies, state-supported access to exports markets, and state-funded R&D and innovation. 

This reality is compounded by the fact that in recent years, much of our development agencies attention has focused on attracting smaller and less-established firms and entrepreneurs from abroad to locate into Ireland. Both IDA and Enterprise Ireland have active campaigns courting these types of ventures. Of course, such efforts are both good and necessary, as Ireland needs to continue diversifying the core base of MNCs trading from here. Alas, it is a strategy that not only brings new rewards, but also entails new and higher risks. Should the tech sector suffer significant market correction, in-line with dot.com bubble bursting or banking sector crisis, majority of the younger firms that came to Ireland to set up their first overseas operations here will be downsizing fast. Unlike traditional blue-chip firms, these companies have no tangible fixed assets. They own no buildings, employ few Irish workers and have no technology domiciled here. For them, leaving  these shores is only a matter of booking their flights.

In short, our policy and business elites seem to be flat out of fresh ideas and are ignorant of the potential threat that our over-concentration in ICT sector investment is posing to the economy. Let’s hope the new bubble has years to inflate still, and the new bear won’t be charging any time soon. 

Update: new article on the topic from the BusinessInsider: http://www.businessinsider.com/4-billion-is-the-new-1-billion-in-startups-2013-11

Box-out:

Just when you thought the Euro crisis is nearing its conclusion, here comes a new candidate state to join the fabled periphery.  Last week, the IMF concluded its Article IV consultation assessment of Slovenia. The Fund was more than straightforward on risks and problems faced by the country bordering other ‘peripheral’ state – Italy. Per IMF: “Slovenia is facing a deep recession resulting from a vicious circle of strained corporate and bank balance sheets, weak domestic demand, and needed fiscal consolidation. Cleaning up and recapitalizing banks is an immediate priority to break this cycle.“ Some 17.5 percent of all assets held by the Slovenian banks were non-performing back in June 2013. Worse, over one third of all non-performing loans were issued to 40 largest companies in the country, putting strain on the entire economy. Corporate debt is so high in Slovenia, interest payments account for 90 percent of all corporate earnings. If that is a ‘cycle’ one might wonder what constitutes a full-blow crisis? Spooked by the Cypriot crisis ‘resolution’, Slovenian Government has so far rejected the use of international assistance (re: Troika funding) in addressing the crisis. However, the country fiscal deficit is running at 4.25 percent of GDP, net of banks’ restructuring and recapitalisation costs. In other words, Slovenia today is Ireland back in 2010. Brace yourselves for another Euro domino falling.

9/11/2013: Stress testing zombie banks: Sunday Times, November 3

This is an unedited version of my Sunday Times article from November 3, 2013.


In the marble and mahogany halls of European high finance HQs, the next few months will be filled with the suspense of the preparation for the banks audits.

Much of this excitement will be focused on matters distant to the real economy. Truth is, saddled with zombie banks, and public and private sectors’ debt overhangs, euro area is incapable of generating the growth momentum sufficient to wrestle itself free from the structural crisis it faced since 2008. The latest ECB forecasts for the Euro area economy, released this week, predicted real GDP contraction of 0.4 percent for 2013 and growth of 1 percent in 2014. With these numbers, the end game is the same today as it was two years ago, when previous stress tests were carried out. The system can only be repaired when banks absorb huge losses on unsustainable loans.

New stress tests are unlikely change this. However, the tests are important within the context of the weaker banking systems, such as the Irish one. The reason for this is that the ECB needs to contain the sector risks as it goes about building the European Banking Union, or EBU.

The good news is – there are low- and high-cost options for achieving this containment in Ireland’s case. The bad news is – neither involves any relief on the legacy banks debts necessary to aid our stalled economy. The worse news is – the Government appears to be pushing for exiting the bailout without securing the low cost option, leaving us exposed to the risk of being saddled with the costlier one.


The IMF data suggests that Euro area-wide banks’ losses can be as high as EUR350-400 billion - or just under one third of the total deleveraging that still has to take place in the banks. The ECB needs to have an accurate picture of how much of the above can arise in the countries where banks and Government finances are already strained beyond their ability to cover such losses. The ECB also needs to deliver such estimates without raising public alarms as to the levels of losses still forthcoming.

Taken together, the above two points strongly suggest that in the case of Ireland, the banks will come out of the stress tests with a relatively clean bill of health shaded somewhat by risk-related warnings. Pointing to the latter, the ECB will implicitly or explicitly ask the Irish Government to secure funding sources for dealing with any realization of such risks. Such precautionary funding can only come from either a stand-by credit line with the IMF and/or European stabilization funds, or a commitment to set aside some of the NTMA cash. An NTMA set-aside will cost us the price of issuing new Government debt. This is potentially more than ten times the price of IMF credit line.

In short, Ireland should be using ECB’s concerns over our banking system health to secure a cheaper precautionary line of credit. Judging by this week’s comments from the Government, we are not. One way or the other, it is hard to see how continued uncertainty build up within Irish banks can help our cause in obtaining both a precautionary line of credit and a relief on legacy banks debts.


The ECB concerns about Irish banks are not purely academic. Our banking crisis is far from over.

Consider the latest data on three Pillar Banks: AIB, Bank of Ireland and Permanent tsb, covering the period through H1 2013 courtesy of the IMF and the EU Commission reviews published over recent weeks. On the surface, the three banks are relatively well capitalised with Core Tier 1 capital ratio of 14.1 percent, down on 16.3 percent a year ago. Meanwhile, the deleveraging of the system is proceeding at a reasonable pace, with total average assets declining EUR30.5 billion year on year.

The problem is that little of this deleveraging is down to writedowns of bad loans. This means that high levels of capital on banks balance sheets are primarily due to the extend-and-pretend approach to dealing with nonperforming loans adopted by the banks to-date. All members of the Troika have repeatedly pointed out that Irish banks continue to avoid putting forward long-term sustainable solutions to mortgages arrears and that this approach can eventually lead to amplification of risks over time.

Loans loss provisions are up 11 percent to EUR28.2 billion and non-performing loans are up to EUR56.8 billion. Still, while in H1 2012 non-performing loans accounted for 22.2 percent of all loans held by the banks, at the end of June this year, the figure was 26.6 percent. Non-performing loans are now 35.5 percent in excess of banks’ equity, up from just 4.7 percent a year ago. As a reminder, Irish Exchequer holds 99.8 percent stake in AIB, 99.2 percent share in Ptsb and 15.1 percent stake in Bank of Ireland. This means that should capital buffers fall to regulatory-set limits, further writedowns of loans will mean nullifying the Exchequer stakes in the banks and crystalising full losses carried by the taxpayers.

Continued weaknesses in the solvency positions of the banks are driven primarily by three factors. Firstly, as banks sell or collateralise their better loans their future returns on assets are diminished. The second factor is poor operational performance of the banks. Net losses in the system fell between H1 2012 and H1 2013. However, this still leaves banks reliant on capital drawdowns to fund their non-performing assets. The third factor is the weak performance of banks’ non-core financial assets. Over the last 12 months, Irish banks holdings of securities grew in value at a rate that was about 12-15 times slower than the growth rate in valuations of assets in the international financial markets.

In short, the IMF review presented the picture of the banking sector here that retains all the signs of remaining comatose. This was further confirmed by the EU Commission report this week, and spells trouble for the Irish banks stress tests.

In 2011 recapitalisation of Irish banks, the Central Bank assumed that banks operating profits will total EUR3.9 billion over the 2011-2013. So far the banks are some EUR4.5 billion shy of matching the Central Bank’s rosy projection.

This shortfall comes despite dramatic hikes in interest margins on existent and new loans, decreases in deposit rates, and reductions in operating costs. Compared to H1 2011 when the PCARs were completed, lending rates margins over the ECB base rate have shot up by up to 138 basis points for households and 59 basis points for non-financial companies. Rates paid out on termed deposit have fallen some 103 basis points. As the result, banks net interest margins rose.

On top of that, the funding side of the banks remains problematic. The NTMA is now holding almost half of its cash in the Pillar Banks, superficially boosting their deposits. Private sector deposits continue to trend flat and are declining in some categories. This is before the adverse impacts of Budget 2014 measures, including the Banks levy and higher DIRT rates start to bite.

Behind these balance sheet considerations, the economy and the Government are continuing to put strains on households' ability to repay their loans. This week, AA published analysis of the cost of mortgages carry (the annual cost of financing average family home and associated expenses). According to the report, the direct cost of maintaining an average Irish home purchased prior to the crisis is now running at around EUR 21,940 per annum. Under Budget 2014 provisions, a married couple with two children and combined income of EUR 100,000 will spend one third of their after-tax earnings on funding an average house. In such a setting, any major financial shock, such as birth of another child, loss of employment, extended illness etc., can send the average Celtic Tiger household into arrears.


All of this, means that any honest capital adequacy assessment of the Irish banking system will be an exercise in measuring a litany of risks and uncertainties that define our banks’ operating conditions today and into the foreseeable future. Disclosing such weaknesses in the system will risk exposing Irish banks to renewed markets pressures, including possible failures to roll over maturing debts coming due. It can also impair their ability to continue deleveraging, and fund assets writedowns. On the other hand, leaving these stresses undisclosed risks delaying recognition of losses and exposing us to pressure from the ECB down the line.

Not surprisingly, as the ECB goes into stress tests exercise, it is exerting pressure on Ireland to arrange a stand-alone precautionary line of credit. While it is being presented as a prudential exercise in light of our exit from the bailout, in reality the credit will be there to cushion against any potential losses in the banking system over 2014-2018, before the actual EBU comes into force. Should such losses materialise, the Exchequer will be faced with an unpalatable choice: hit depositors with a bail-in or pony up some more cash for the banks. Having a stand by loans facility arranged prior to exiting the Bailout will help avoid the latter and possibly the former. The cost, however, will be an increase in overall interest charges paid by the State, plus continued strict oversight of our fiscal position by the Troika.

A rock of interest charges and Troika supervision, a hard place of zombiefied banking, and a rising tide of risks are still beckoning Ireland from the other side of the stress tests.

Box-out: 

The latest data from the retail sector released by the CSO this week painted a rather mixed picture of the domestic economy’s fortunes. Controlling for some volatility in the monthly series, Q3 2013 data shows that despite very favourable weather conditions over the July-September 2013, Irish core retail sales (excluding motors sales) fell in volume by some 0.3 percent compared to Q3 2012. On the other hand, there was a 0.6 percent increase in the value of sales over the same period. Currently, the volume of total core retail sales in Ireland sits 4.3 percent below 2005 levels. Non-food sales, excluding motor trades, fuel and bars sales, fell 2.1 percent on 2012 in volume and is up 1.2 percent in value. The inflation effects imply that when it comes to core non-food sales, the volumes of retail trade are now down 22 percent on 2005 levels, while the value of sales is up almost 2 percent. Consumers are still on strike, while retailers are getting only a slight prices relief in the unrelenting crisis.

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.

27/10/2013: Ireland v Iceland: Full Deck

Here's the deck for comparatives between Iceland and Ireland. You can click on every slide to enlarge. Enjoy!