20/6/16: Creating Fiscal Space. Or Money Growing on Trees

You might excuse an average punter for thinking things are going the beleaguered Irish Health Services ways with some EUR500 ml added to the spending bin (http://www.thetimes.co.uk/article/eu-ruling-means-extra-540m-for-health-fbpnqcqb8?shareToken=699206929a359223e8662e8ae88a18d2). After all, even the good folks of The Times bought into the positive story.

But, such a conjecture is wrong. What really is happening, thus? In simple terms, the Eurostat reclassification of the Government conversion of AIB preference shares into ordinary shares generates several implications:

1. Preference shares represent a preferred (or senior) claim on AIB assets in the case of default or dilution compared to ordinary shares. That is the basics corporate finance and as such implies that State conversion of shares adds new risk to the State holdings, as well as reduces the value of that holding. It does create a marginal improvement in the AIB’s outlook for selling shares in the markets, however.
2. The conversion also raises official State deficit and spending volume for 2015, which has no direct material impact on 2015 spending, except via two channels: Channel 1 is the impact that added spending has on future (2016) spending; and Channel 2 is the GDP effect - as AIB transaction added some EUR500 million to State official spending, that EUR500 million is now an addition to 2015 GDP.
3. Because State spending for 2015 is now EUR500 million higher, and because our 2015 deficit was still below the approved (by the EU) target, the State is allowed - by the EU rules - to spend extra cash this year.
4. Although Ireland has funds ‘available’ for such increased spending, the funding will come from borrowing. The reason for this is simple: Ireland is still running a general deficit. Not a general surplus. If the State were to spend EUR500 million of ‘added fiscal space’ on activities for which it is borrowing funds under pre-existent budgetary commitments, the deficit would have dropped - in 2016 - by, roughly, that amount. However, if Ireland were to spend it on a new spending line or to increase spending above previously planned, the funding will come via borrowing from some other activity, such as repaying Government debt.

In simple terms, there is no free lunch. Irish State does not have extra EUR500 million floating around that it did not have before. No matter what you classify things as, basic accounting means: unless you got paid by someone EUR500 million, you have to borrow EUR 500 million in order to spend it.

Simples. But not for Irish media that keeps confusing deficit financing via debt for resources.

18/2/16: Fiscal Space By Numbers: Village Magazine January 2016

This is an unedited version of my column for Village Magazine, December 2015.

Two recent events highlight the true nature of the ongoing Irish economic recovery.

Firstly, ahead of the infamous Ireland-Argentina Rugby World Cup match, the press office of the main Irish governing party, Fine Gael, produced a rather brash inforgraphic. Charting projected growth rates in real GDP for 2015 across all Rugby World Cup countries, the graph put Ireland at the top of the league with 6.2 percent forecast growth. “FACT: If the Rugby World Cup was based on economic growth, Ireland would win hands down,” shouted the headline.

Having put forward a valiant performance, Irish team went on to lose the game to Argentina, ending its tour of the competition.

Secondly, within weeks of publication, Budget 2016 – billed by the Government as a programme for the ‘New Ireland’ – has been discounted by a range of analysts, including those with close proximity to the State as representing the return of the fiscal policy of electioneering. Worse, judging by the public opinion polls, event the average punter out there has been left with a pesky aftertaste from the political wedding cake produced by the Merrion Street on October 13^th.

Tasteful or not, the public gloating about headline growth figures and the fiscal chest-thumping that accompanied the Budget 2016 did not stretch far from reality. Official growth is roaring, public finance are in rude health, and the Government is back in business of handing out candies to kids on every street corner. The air is so filled with the sunshine of recovery, the talk about the Celtic Tiger Redux is back on the chatter menu for South Dublin partygoers.

Ireland by the numbers

Irish Government is now projecting full year 2015 inflation-adjusted growth to come in at 6.2 percent followed by 4.3 percent in 2016. Less optimistic, the IMF puts 2015-2016 growth forecasts for the country at 4.9 percent and 3.8 percent, respectively. Still, this ranks Ireland at the top of the advanced economies growth league, with second place Iceland set to grow by 4.8 percent and 3.7 percent over 2015 and 2016, respectively. The only other advanced economy expected to post above 4 percent growth in 2015 is Luxembourg. Which is a telling bit: of all euro area member states, the two most exposed to tax optimization schemes are growing the fastest. Though only one has a Government gushing publicly about that fact. No medals for guessing which one.

The problem is: the headline official GDP growth for Ireland means preciously little as far as the real economy is concerned. The reason for this is the composition of that growth by source and, specifically, the role of the Multinational Corporations trading from Ireland. We all know this, but keep harping about the said ‘metric’ as if it mattered.

Based on the figures for the first half of 2015 (the latest available through the official national accounts), Irish economy grew by EUR6.4 billion or 6.9 percent in terms of real GDP compared to the first half of 2014. Gross National Product, or GDP accounting for the officially declared net profits of multinational companies, expanded by a more modest 6.6 percent over the same period.

Other distortions arising from this structural anomaly at the heart of Irish economic miracle are the effects of foreign investment funds and companies on capital side of the National Accounts. Back in 2014, the European Union reclassified R&D spending as investment, superficially inflating both GDP and GNP growth figures. Since then, our investment has been booming, outpacing both jobs creation and domestic public and private sectors’ demand. In more recent quarters, capital investment has been outperforming exports growth too. Which begs a question: what are these investments about if not a tail sign of corporate inversions past and the forewarning of the changes in the economic output composition in anticipation of our fabled ‘Knowledge Development Box’?

Beyond this, the legacy of the financial crisis adds to artificial growth statistics. Irish ‘bad bank’, Nama, and its vulture funds’ clients are aggressively disposing of real estate loans and other assets bought at a cost to the taxpayers. Any profits booked by these entities are counted as new investment here. Once again, GDP and GNP go up even if there is virtually nothing happening to buildings and sites being flipped by these investors.

And while we are on the subject of the old ways, last month Ireland became a domicile of choice for an upcoming merger between Pfizer and Allergan – two giants of the global pharma world. Despite numerous claims that Ireland no longer tolerates so-called ‘tax-driven corporate inversions’ (a practice whereby U.S. multinationals domicile themselves in Ireland for tax purposes), it appears that  we are back in the same game. Just as we are apparently back into the game of revenue shifting (another corporate tax practice that sets Ireland as a centre for booking global sales revenues despite no underlying activity taking place here), as exemplified by the Spanish Grifols announcement earlier in October.

All of these growth sources also benefit from weaker euro relative to the dollar and sterling, courtesy of the ECB printing presses.

Looking at the national accounts for January-June 2015, Gross Fixed Capital Formation accounted for EUR3.8 billion or almost 60 percent of total GDP growth over the last 12 months, or nearly 3/4 of all growth in GNP.

In simple terms, the real economy in Ireland has been growing at closer to 3.5 or 4 percent annual rate in 2015 – still significant, but less impressive than the 6 percent-plus figures suggest.

Kindness for the Exchequer

Still, the above growth has been kind for the Irish Government. In the nine months though September 2015, Irish Exchequer total tax receipts rose strong EUR2.75 billion, or 9.5 percent year-on-year. Just over 45 percent of this increase was due to unexpectedly high corporate tax receipts that rose 45.7 percent year-on-year. Vat receipts increased EUR742 million or 8.3 percent year-on-year, while income tax posted a more modest rise of EUR677 million up 5.7 percent. While both VAT and Income Tax receipts came in within 1-2 percentage points of the Budgetary targets, Corporation Tax receipts over-shot the target by a massive EUR1.21 billion or 44.2 percent.

As chart below shows, in the first nine months of 2015, Corporation Tax receipts have not only outperformed the previous period trend for 2007-2014 and the historical average for 2000-2014, but posted a massive jump on the entire post-crisis ‘recovery’ period.  Both the levels of tax receipts and the rate of annual growth appear to be out of line with the underlying economic performance, even when measured by official GDP growth.

CHART: Corporation Tax: Cumulative Outrun, January-September, Euro Millions

Source: Data from Department of Finance

                              

This prompted the by-now-famous letter from the outgoing Governor of the Central Bank, Professor Patrick Honohan to the Minister for Finance in which Professor Honohan politely, almost academically, warned the Government that a large share of the current growth in the economy is accounted for by the “distorting features” – a euphemism for tax optimising accounting. Per letter, “Neglecting these measurement issues has led some commentators to think that the economy is back to pre-crisis performance”.

Professor Honohan’s warning reflects the breakdown in sources of growth noted earlier, with booming multinationals’ activity outpacing domestic economic expansion. The same is confirmed by the recent data from labour markets. For example, whilst official unemployment in Ireland has been declining over the recent years, labour force participation rates have remained well below pre-crisis averages and are currently stuck at the crisis period lows.  In simple terms, until very recently, jobs creation in Ireland has been heavily concentrated in a handful of sectors and professional categories.

Of course, this column has been saying the same for months now, but for Irish official media, the voice of titled authority is always worth waiting for.

The Revenue attempted to explain the Exchequer trends through October, but the effort was half-hearted. Per Revenue, the UER800 million breakdown of Corporation Tax receipts outperformance relative to target can be broken into EUR350 million of the “unexpected” payments; EUR200 million to “early” payments; and EUR200 million to ‘delayed’ repayments. Which prompted a conclusion that the surge in tax receipts was “sustainable”.

Turning back to fiscal management side of accounts, Irish debt servicing costs at end of 3Q 2015 fell EUR296 million or 5.9 percent compared to January-September 2014. The key driver of this improvement was refinancing of the IMF loans via market borrowings and, of course, the ECB-driven decline in bond yields. Neither are linked to anything the Government did.

Spurred by improving revenue side, however, the Government did open up its purse. Spending on current goods and services (excluding capital investment and interest on debt) has managed to account for just under one tenth of the overall official economic growth in the first half of 2015. In other words, even before the Budget 2016 was penned and the print of improved revenues was visible on the horizon, Irish austerity has turned into business-as-usual.

Talking up the future

As the result of the tangible – albeit more modest than official GDP figures suggest – economic recovery, Budget 2016 unveiled this month marked a large scale U-turn on years of spending cuts and tax hikes.  Even though the Government deficit is still running at 2.1 percent of GDP and is forecast to be 1.2 percent of GDP in 2016, the Government has approved a package of tax cuts and current spending increases worth at least EUR3 billion next year. The old formula of ‘If I have it I spend it’ is now replaced by the formula of ‘If I can borrow it I spend it’.

Which means that in 2016, Ireland will run pro-cyclical fiscal policy for the second year in a row, breaking a short period of  more sustainable approach to fiscal management. Another point of concern is the fact that this time around, just as in 2004-2007, expansionary budgeting is coming on foot of what appears to be one-off or short-term boost to Exchequer revenues. Finally, looking at the composition of Irish Government spending plans, both capital and current spending sides of the Budget and the multi-annual public investment framework include steep increases in spending allocations of questionable quality, including projects that potentially constitute political white elephants and electioneering.

In short, the Celtic Tiger is coming back. Both – the better side of it and the worst.