22/7/2013: G20 Spells Out a Squeeze on Tax Arbitrage

Last week we saw the conclusion of the G20 Finance Ministers and Central Bank Governors meeting in Moscow. The meeting covered, in part, financial regulation and international taxation issues, aimed at addressing, as the IMF put it, "international spillovers of national tax policies".

Here's what the basic set of the proposals discussed implies for Ireland - a country at the centre of these spillovers in the euro area and largest per-capita beneficiary of the international tax arbitrage after Luxembourg.

The OECD-prepared, G20 discussed 'Action Plan' on Base Erosion and Profit Shifting (BEPS) covers loads of technical ground. The main points of relevance to Ireland's real economy are:

1. Tax issues relating to the Digital Economy - including coverage of tax application to services, geographic distribution of tax revenues etc. In the nutshell, the G20 will aim to adapt international direct and indirect taxation rules to the digital economy, including attribution of profit 'together with the character and source of income'. In simple terms, aggressive tax base shifting from, say the UK-sold advertising revenues to, say Ireland-based pro forma sales centre. In other words, the rules will challenge the system on which much of the Ireland's comparative advantage in ICT and financial services currently rests. The threat is more genuine in my view in the case of ICT services than in the case of financial services.
2. Tighter controls over Controlled Foreign Company rules - a relatively minor issue from the point of view of Irish real economy, but having a potential to impose small adjustment on our official GDP.
3. Reduce artificial avoidance of tax application, presumably including by schemes such as Double Irish. This has potentially strong adverse impact on Irish economy.
4. Intangibles transfers within the company group are to be tightened, to reduce effectiveness of transfer pricing. Once again, this suggests pressures on IP tax arbitrage and licenses arbitrage - a core competitive point for Ireland.
5. The Plan also aims to (explicitly) develop rules to align profits with value creation. Bad news for major MNCs operations here.
6. Beefing up of data, tax and transfer pricing documentation, and reporting compliance in line with BEPS proposals - an additional significant cost for Irish companies and MNCs, although this is symmetric for all other jurisdictions, so not an issue from comparative advantage of Ireland point of view.

In effect, many proposals link directly into CCCTB structure (see my analysis of this in the G8 context here):

• Reporting on tax matters re-aligned to cover business activities and capital bases
• Focusing on documentation of the location where key business risks and business processes are located
• A country-specific breakdown of group profits and revenues
• Common anti-avoidance regime
• Services delivered on-line will migrate toward effective tax rates based on location of end-user of services
• As KPMG analysis statesd: "Change in effective rate of tax on group profits where change in transfer pricing basis for profit attribution alters the mix of profits attributable to group members". Or in other words: kiss goodbye the key pillar of tax arbitrage in Ireland via consolidation of the tax base.
• Tax base will migrate to the locations "of key functions and management and oversight of key risks"

So good luck eating that 'breakfast of champions' of the claims that the G20 proposals present no threat to Ireland's economic model. They might not spell a full-scale closure of the tax 'haven' we run, but they do present a significant costs and risks threat to our model, where it is reliant heavily on tax arbitrage. Not a catastrophe, but...

18/2/2013: G20 & Currency Wars

Amidst continued rapid devaluation of the Yen, predictably, and per usual, the G20 summit in Moscow has ended with a useless and unenforceable statement. This time around, as was signalled in the days ahead of the meeting, the 'focus' of transnational vacuousness was on the topic de jour: the Currency Wars.

But the background to it was much less economic than political. G20's sole obsession is to drive forward the idea that to survive, the world needs more coordination of top-level policies. This invariably requires (a) finding a convenient newsflow-worthy boggy, (b) making a statement to the effect that greater coordination is needed and that cooperation can cure all ills, and © proceeding to do absolutely nothing about it post-statement. The latests communique went on to conclude that “ambitious reforms and coordinated policies” were the key to achieving strong sustainable growth. Just like that: coordinate and magic shall happen.

Thus, the meeting of G20 has issued a statement rallying against competitive currency devaluations - or in more common parlance, a “currency war”.

In reality, G20 has no power to abate, let alone reverse, the process of currencies debasement. Quantitative easing - in its now fully evolved multitude of forms will go on, with central banks and governments across the OECD continuing to print their ways out of the slump. If G20 communique were to achieve anything, it will be just to push the whole affair under the proverbial rug, with devaluations not explicitly targeted in public pronouncements.

The communique states that G20 states "will refrain from competitive devaluation. [and] will not target our exchange rates for competitive purposes, will resist all forms of protectionism and keep our markets open.” The devil, of course, is in the slight turn of phrase. The G20 committed to not drive down their currencies values for 'competitive purposes'. But as long as money printing is 'necessary' to sustain domestic financial stability or deliver a monetary stimulus or both - then all is ok.

Just how feeble the whole statement is was illustrated immediately, with the worst offender - the Japanese Yen, down 7% in value already in 2013 - posting a slide against major currencies. In many ways, the communique makes it even more likely that sustained devaluation of the yen will be even more damaging now. Prior to G20 statement, the Japanese Government could have simply continued pushing down yen values by focusing on aggressive statements about the need for monetary stimulus and forex rate targeting. Now, it will have to print hard cash silently.

And the Fed is still sitting on a massive bonds purchasing programme that so far has been running at ca USD80bn per month. At G20 meeting this programme has been squarely defended by Bernanke.

Senior Bank of England, Martin Weale went on, during the G20 summit, to praise Sterling debasement, saying that a 25% devaluation of the pound over 2007-2008 period was not enough to boost exports and that more devaluation should be targeted.

In short, the entire G20 summit was a joke. It neither signaled any real policy shift, nor mapped a single tangible policy response to the crises still impacting advanced economies. If anything, via reducing potential rhetorical impact of monetary policy stance, it pushed the G7 countries into a more aggressive real monetary policies responses space. This promises to accelerate the currencies wars, while reducing overall ability of the monetary authorities to quickly unwind the decisions taken in years to come.

16/2/2013: Minister Noonan Talks International Finance, briefly

This week, Calgary Herald reported some fascinating remarks made by Irish Minister for Finance, Michael Noonan at the EU Finance Ministers meeting. Quoting from the paper (full link here), with mine emphasis added:

"Arriving Tuesday for a meeting of the 27 EU finance ministers, Irish Finance Minister Michael Noonan said: "I think all this debate about the relative value of currencies is going to be an issue at the G-20 but we're coming through a period where the concern was the volatility of the euro". "It's a bit soon to argue that it's too strong." Noonan said he wouldn't support any proposals that the ECB should intervene in the markets to get the value of the euro down."

This statement bound to raise eyebrows of anyone even remotely familiar with economics and / or international finance.

Minister Noonan - in charge of the Finance portfolio in a Euro area country - seemingly has trouble formulating exactly what the Euro crisis is / was about. Volatility of the euro he cites was never a problem during the crisis. In fact, in major exchange pairs, Euro has not been the driver of the volatility, but the subject to periodically, short-term elevated volatility induced by the changes in policies and fundamentals in non-Euro area countries. And volatility of the EUR relative to any other major currency was actually lower than for exchange rates ex-EUR.

The confusion in his mind seems to arise from the lack of basic grasp of the currency markets.

1. Minister Noonan seems to have no idea that "volatility of the Euro" as a phrase is fundamentally imprecise. Euro (and any other currency) can be volatile only in terms of a bilateral (or in more complicated setting - triangular) exchange rate. He mentions no such pairs. We can talk about EUR/USD exchange rate volatility, or EUR/JPY volatility, etc, but not about 'Euro volatility' in pure terms, unless we want to say that EUR is the driver of volatility in the bilateral exchange rates vis-a-vis all major currencies.
2. Minister Noonan seems to be confusing 'volatility' (definable by a number of statistically objective metrics) and 'uncertainty' (definable only imperfectly by a risk transform approximation). This is more than an innocent failure to understand philosophical differences between risk and uncertainty. By confusing 'volatility' for 'uncertainty', Minister Noonan anchors his analysis of potential and preferred solutions to the crisis solely to policies that can reduce volatility of the exchange rate. By this metric, the crisis was not even worth a footnote in a newspaper.

But then comes a logical step that defies any comprehension. Having stated that the crisis was 'volatility of the Euro', Minister Noonan goes on to say that he opposes ECB intervention to alter the value of the euro. Surely, intervention would be consistent with policy management to reduce the exchange rate volatility that Minister Noonan is so concerned about?

Let's set aside the apparent lack of logic in the statements above. And let's focus on Minister Noonan's longer-term position vis-a-vis the Euro. 

Minister Noonan and his Government have actively pursued policies of extending Irish Government debt maturity. The latest instalment of this strategy was the 'deal' on the IBRC Promissory Notes. In other words, Irish Government entire economic policy (with exception of 'exports-led recovery') can be summed up as a hope for future inflation wiping out real value of Irish Government debt. Forget the fact that such an outcome will destroy the other side of our economy where debt overhang is also present: the households (higher inflation = higher interest rates = higher burden of debt). But what on earth is Minister Noonan doing talking against his own Government policy?

This bizarre combination of 'swinging' focus in policy goes deeper. Irish Government second (and last) pillar for economic policy - other than inflation - is 'exports-led recovery'. 2010-2012 data on Irish exports shows rapidly contracting rate of growth in exports. Monthly and quarterly data show even more reasons for concern. Foreign demand weaknesses and structural issues in the Irish exporting sectors are clearly major drivers. But higher valuation of the Euro are not helping. Yet, Minister Noonan is concerned with preventing devaluation!

Should Enda, perhaps have a chat with Minister Noonan, rather than send troops out after his party backbenchers whenever they are slightly critical about the Government position? Afterall, in the above few words, Minister Noonan has managed to mis-state the source of the Euro problem, derive an implicit but deeply flawed policy conclusion out of this mis-statement, and contradict his Government's two cornerstone policies. 

21/6/2012: Few thoughts on G20 report on Euro Area

Joint G20 assessment of the euro area (emphasis and comments are mine):

"Efforts on several fronts  are still needed to build a stronger monetary union. Specifically: 

1. moving toward a pan-euro-area financial stability framework, which inter alia implies centralized powers in banking supervision and resolution, and common deposit insurance; [banking union, consistent with my view of what is required to shore banking sector, but absent a pan-European insolvency resolution regime, not sufficient condition for sustainable crisis resolution]
2. stronger fiscal integration, including national fiscal rules, as envisaged by the Fiscal Compact, complemented by fiscal risk sharing to ensure that economic dislocation in one country does not develop into a costly fiscal and financial crisis for the entire region; [Naive, or rather politically correct, statement. The Fiscal Compact can be expected to have any real effect on fiscal performance in the medium-long term. Precisely the time scale over which it will be most likely non-enforceable.]
3. structural reform to strengthen competitiveness and improve the  ability to adjust to shocks, including by a wage-setting mechanism that is more responsive to firm-level economic conditions, reducing labor market duality and in general barriers to hiring and firing, and lowering barriers to domestic and foreign competitions in product markets. [This is another weak policy orientation. Structural reforms are needed, beyond any argument, but these must start not from altering cost competitiveness but from creating institutional and operational platforms for entrepreneurship and investment. Europe lacks growth dynamics not because its labour costs are too high or there is a difficulty with hiring and laying off workers. These are important factors, but they are not primary ones. Europe lacks growth because the Governments take up 50% of the economy, because taxes are prohibitive to investment and jobs creation, consumption and saving, because the structure of European institutions favors incumbents over newcomers and thus retards fully social mobility and renewal.]

There is growing awareness among European policy makers to move along these lines and
active efforts are underway to build the necessary consensus."

Overall, G20 is still held hostage to:

1. Consensus policies represented by the IMF-think - of micro-fixing sub-structures of specific politically correct markets for inputs (labour) instead of focusing on the larger scale imbalances that lead to unsustainable expansion of the state over private sector opportunities and returns.
2. Politically correct 'non-interference' in specific solutions designed by the euro area - most visible in the acceptance of the Fiscal Compact framework as a 'sustainable' solution to the fiscal crisis.

I find it amazing that the G20 (or rather it is IMF who authored the document) is treating recent adjustments in the economic imbalances in the euro area as if it is something that is consistent with a functional adjustment.

"The global financial crisis has triggered a noticeable narrowing of external imbalances. As world trade collapsed, current account balances of deficit economies improved substantially—well in excess of what would have been expected given the fall in output based on standard trade elasticities (i.e., “residual” changes are large), despite a significant increase in interest costs on their external debt. Substantial demand compression following the collapse of credit, asset and housing booms and a decline in confidence in periphery economies, reinforced by fiscal consolidation, played an  important role in this wrenching adjustment. Many of the factors identified below as contributing to the imbalances—such as excessive optimism and easy financial conditions begetting consumption and construction booms—are out of the picture now. Hence, much of the adjustment observed so far is likely to be lasting."

Firstly, I agree that much of the adjustment outlined above is now engrained into consumer and investor behavior. Secondly, I disagree that the fiscal adjustments have been either significant or sustainable in the long run. Let us keep in mind that there is no decrease in government spending in 2011-2012. There is an increase. But what worries me most in the above is that the adjustments described would be consistent with the rates of growth into the future that are hardly sustainable given debt overhang. In other words, the environment of depressed consumer credit, consumer spending, high interest cost of capital, etc warrants growth expectation for euro area of 1-1.5 percent annually in real terms, if not lower. Working out debt of 90% to GDP (fiscal debt alone) and well in excess of 250% for the total debt at the above rates of growth, in my view, is simply not going to happen. Unless we are talking about double-digit inflation.

An interesting related chart: 

The above clearly shows how deep collapse of economy has driven 'improvements' in Irish external balance (purple area representing collapse in growth) and how our automatic fiscal policy destabilizers (income & transfers) have been a 'break' on the external balance improvements. (Note: I am not suggesting there is a positive value in driving income & transfers down, just observing the fact). As per my term of automatic fiscal destabilizers, here's the quote from the report:

"In some booming economies (e.g., Ireland and Spain), debt ratios declined, but given the extent to which ample fiscal revenues had been linked to unsustainable asset market developments, structural balances remained fundamentally weak. That weakness was unmasked by the crisis."

I'll blog on specific risk assessment report tomorrow, so stay tuned.