7/8/2013: Sunday Times, July 21, 2013: New Financial Order

Catching up on some of my past articles from the Sunday Times, here's an unedited version from July 21, 2013.

Five years into the Great Recession collapse of Irish domestic investment, underpinned by the unprecedented in history of the EU drop in lending to indigenous enterprises, continues to act as the main force holding back Irish recovery. Despite serious policy efforts to unlock banks lending, especially to the SMEs sector, expanded by the current Government and its predecessor there are many structural reasons as to why a return to the rampant lending and lending-backed investment in this economy remains elusive. After years of waiting for lending to return, we need to shift our policies focus away from attempting to refuel another SMEs credit bubble toward incentivising new forms of capital formation and accelerating the rate of existent debt restructuring in the real economy.

This week, research published by the Bruegel Institute reminded us about the horrors of the Irish credit system collapse. Looking at the outstanding credit to non-financial corporations from September 2008 through April 2013, the researchers found that Irish banking system experienced the largest decline in overall credit of all EU27 states. Ireland's outstanding credit to non-financial companies has fallen more than 50 percent over the period covered in the study, with the second-worst performing economy, Spain coming in with a more benign drop of 30 percent. Bankrupted Greece is in a distant fifth place, having posted a 'mere' 25 percent credit contraction.

Most recent Central Bank data, relating directly to the SMEs lending in Ireland, shows that new lending in Q1 2013 was 41 percent below the Q1 average for 2010-2012, despite the figures showing a slight rise quarter on quarter. Netting out new loans issued for financial intermediation and property, credit extended to SMEs in the first three months of this year was down 11 percent compared to the 2010-2012 average for the same period.

Strikingly, as Irish credit volumes shrunk faster than in any other EU state, interest rates for loans to Irish enterprises under EUR1 million in volume have declined in line with those for the lower credit risk economies. When it can be had, Irish SMEs credit is priced in line with such countries as Denmark, the Netherlands, Sweden and the UK.

On the other hand, SMEs’ demand for loans remains high. In Q2 2013, according to the latest ISME survey, demand for new credit rose to 41 percent from 38 percent a year ago. On average, 48 percent of all companies that applied for funding in the first six months of 2013 were refused credit by the bank, slightly down on 51 percent average rejection rate for 2012.

Good news: demand and refusal rates are starting to move in the opposite directions, just as credit supply is beginning to turn positive. Bad news: all improvements are shallow in nature and are yet to show sustainability over time.


All of this presents us with a paradox: while credit demand is high, both supply of loans and the cost is low. The reason for this is that Irish SMEs and banks are continuing to operate in a highly abnormal environment. Changing this will require reducing a severe debt overhang in the Irish SMEs sector, regulatory changes aimed at improving banks ability and incentives to restructure legacy loans, and a lengthy period of time to heal the overall collapse in SMEs willingness to undertake risky investment.

All indicators suggest that gradual improvements in the credit quality of SMEs are not keeping up with rising demand for loans.

Per ISME data, 12 percent of SMEs that do require bank finance abstain from applying for it; over half of them in fear that making an application can lead to the banks shutting down existent credit facilities. Of those SMEs that do apply, 28 percent saw demands for overdrafts reductions imposed onto them. Over half of the credit requests made but the SMEs were for overdrafts or invoice discounting/factoring.

This largely confirms the findings of our recent research based on the ECB data collected at enterprise level across the euro area. Applied to Ireland, our findings strongly suggested that significant contributor to the decline in credit was due to structural insolvency of SMEs’ balance sheets. These drivers are not being dealt with fast enough at the policy and banks levels to allow for the recovery in private sector investment.

Firstly, Irish SMEs remain heavily exposed to legacy loans secured against or for the purpose of property investment. Back in the early 2008, several investment banks have estimated that up to 90 percent of Irish business sector loans issued from 1998-1999 through 2006-2007 were exposed to the risk of collapse in property valuations. The main outcome of this is a wave of bankruptcies that is still consuming the sector. High debt levels tied to property loans mean that over one half of all Irish SMEs loans are currently in arrears, based on the Central Bank estimates. Referencing dynamics in residential buy-to-let markets (representing household side of the investment markets) and new lending data for SMEs, my own estimates suggest that closer to 70 percent of all SMEs loans still outstanding are either in arrears or at risk of failing.

However, even for the enterprises that survived the immediate drop in asset prices, property values decline has meant reduced borrowing capacity for years to come, greater propensity to avoid seeking new credit, and weakened existent production base. Behavioural studies suggest that SMEs hit by the property valuations declines, in contrast to newer enterprises formed after the property bust, will tend to reduce their future borrowings, even if they are given access to new finance. This applies also to companies that have completed successful debt restructuring. In addition, as SMEs lower their investment in new equipment, product R&D, and strategic and operational improvements, they reduce their future competitiveness and profit margins.

Secondly, Irish SMEs are operating in the environment of malfunctioning debt restructuring mechanism.

In a normal recession, banks hold sufficient capital to actively engage with SMEs in restructuring their debts. At the same time, short time span of a normal recession means that a bulk of businesses liquidations extend into the period of early economic recovery. Sales of distressed business assets, in normal recession, often take place in rising markets.

In a severe balance sheet recession, like that experienced today in Ireland, banks transfer costs of keeping the non-performing enterprises alive to other clients. One sign of this is that charges on short-term loans, often used to cover balance sheet pressures, tend to rise slower than charges on larger, capital investment-linked loans. From the bottom of the interest rate cycle through May 2013, cost of new credit for loans up to EUR1 million based on floating rate rose 33 percent. Cost of loans over EUR1 million with over 1 year fixation rose 87 percent. Such cost transfers harm better companies' ability to raise investment, while slowing down the rate at which the insolvency works through to weed out the unsustainable businesses. End game - delayed resolution of the debt crisis at the expense of suppressed capital investment and growth.


All of the above helps explain why less than a third of all Irish SMEs that do apply for credit from their bank end up drawing down any loans. But the above also suggests the policy direction that should be taken in trying to increase domestic capital formation while continuing to pursue system-wide deleveraging.

Unlocking investment requires, first and foremost, finding new sources for funding business expansion, distinct from bank lending. Such sources include equity financing and direct borrowing. The Government needs to develop incentives for equity investment in, and peer-to-peer and public-to-business lending to Irish SMEs.

To expand the pool of potential investors, we need to open these platforms and Irish investment services to international investors and institutions. Government re-insurance scheme for exports finance can be a good step forward in making Irish SMEs more attractive to foreign investors and freeing up some operating capital for growth. Another similar measure would involve more state co-investment in existent enterprises (as opposed to new ventures) based on their ability to generate intellectual property, associated with new products and services development.

While stimulating new forms of SME funding, Ireland also needs to accelerate the process of business insolvency resolution. This will require two major changes in the way our insolvency process is regulated.

We need to recognize the necessity for allowing banks to treat business equity as lower risk asset when restructuring legacy loans for sustainable enterprises. This can help increase debt-for-equity swaps between lenders and borrowers. In return, such swaps can allow banks to use their limited resources on deleveraging out of unsustainable loans. We also need to revise our targets for banks deleveraging, potentially extending the period over which the pillar banks are required to reduce their loans exposures and increase allowance for SMEs loans to be held by the banks. To reduce overall systemic risks, we can require banks to put their restructured SMEs loans through more rigorous stress-testing.

The second major change is to relax the constraints on entrepreneurship and professional standing for business owners going through bankruptcy proceedings. This will allow for a quicker return of past entrepreneurs to new ventures and will aid SME sector deleveraging.

All of the research on SME credit in the Euro area and Ireland shows that both supply and demand drivers are responsible for the collapse of investment during the current crisis. Instead of attempting to rebuild the legacy systems based on unsustainable lending, we need to think outside the box to identify new ways for funding productive investment. Both banking and the SME sector will require significant changes to deliver on this.
                                                                                                   

Box-out:

Largely ignored by the Irish media headlines, there is a new longer-term threat to our economy emerging from the EU's penchant for policies harmonisation. This week, at the talks in Vilnius, Lithuania, EU officials were discussing the need for pan-European regulation of data protection. In part, these talks were driven by the EU-US Free Trade Agreement negotiations and the recent scandal relating to e-spying. However, the main impetus for harmonising European regulations is the emerging imbalances in the ICT services investment across the EU. Ireland’s EU partners, especially Germany and France, are unhappy that our, allegedly, light-touch regulations act as a major attractor for foreign direct investment in ICT sector, ‘stealing’ jobs from Germany and tax revenues from France. The risks implied by harmonisation of EU regulations in this area are of significant economic concern. It is, perhaps, ironic that data protection regulations or their potential harmonisation did not make it into the ESRI's latest paper on ICT-related FDI, titled "Boosting Foreign Direct Investment in the Information and Communication Technologies Sector: What Works?" published this week. Foreign providers of ICT services in Ireland dominate the sub-sector which acts as the sole source of growth in Ireland from 2008 through today. Between Q1 2008 through Q1 2013, Irish ICT services credit to the current account rose from EUR5.86 billion to EUR9.35 billion. In Q1 2013, ICT services trade surplus exceeded our economy’s total external balance by 37 percent. Squeeze this sector through regulatory harmonisation and Ireland’s latest recession will look like a walk in a park, while our debt sustainability risks will go back to 2011 levels.

6/6/2013: Domestic Economy v MNCs: Sunday Times 26/5/2013

This is an unedited version of my Sunday Times column from May 26, 2013



Over recent months, one side of the Irish economy – the side of aggressive tax optimization and avoidance by the Ireland-based multinational corporations – has provided a steady news-flow across the global and even domestic media. While important in its own right, the debate as to whether Ireland is a corporate tax haven de facto or de jure is missing a major point. That point is the complete and total disconnection between Ireland’s two economies: economy we all inhabit in our daily lives and economy that exists on paper, servers and in the IT clouds. The latter has a mostly intangible connection to our everyday reality, but is a key driver of Ireland’s macroeconomic performance and the Government PR machine.

Take a look at two simple sets of facts.

According to our national accounts, Ireland’s economy, measured in terms of GDP per capita, has been growing for two consecutive years expressed in both nominal terms and inflation-adjusted terms. Real GDP per capita in Ireland grew over 2010-2012 period by a cumulative 2.38% according to the IMF. Accounting for differences across the countries in price levels and exchange rates (using what economists refer to as purchasing power parity adjustment), Ireland’s GDP per capita has risen 5.7% over the two years through the end of 2012. Over the same period of time, Ireland’s GNP per capita, controlling for exchange rates and prices differentials, has grown by 3.3%.

Sounds like the party is rolling back into town? Not so fast. The aggregate figures above provide only a partial view of what is happening at the households’ level in the Irish economy. Stripping out most of the transfer pricing activity by the multinationals, domestic economy in Ireland is down, not up, by 5.2% between 2010 and 2012, once we adjust for inflation and it is down 2.7% when we take nominal values. With net emigration claiming around six percent of our population, per capita private domestic economic activity has fallen 4.2% over the last two years.

All in, Irish domestic economy is the second worst performer in the group of all peripheral euro area states, plus Iceland. Sixth year into the crisis, we are now in worse shape than Argentina was at the same junction of its 1998-2004 crisis.


What the above numbers indicate is that the Irish domestic economy, taken at the household level, has been experiencing two simultaneous pressures.

While aggregate inflation across the economy has been relatively benign, stripping out the effects of the interest rates reduction on the cost of housing, Irish households are facing significant price pressures in a number of sectors, reducing their real household incomes just at the time when the Government is increasing direct and indirect tax burdens. At the same time, rampant unemployment and underemployment have been responsible for lifting precautionary savings amongst the households with any surplus disposable income. By broader unemployment metrics that include unemployed, officially underemployed, and state-training programmes participants, Irish unemployment is currently running at 28% of the potential labour force. Adding in those who emigrated from Ireland since 2008 pushes the above broad measure of unemployment to close to 33%.

Lastly, the households are facing tremendous pressures to deleverage out of debt, pressures exacerbated by the Government-supported efforts of the banks to increase rates of recovery on stressed mortgages.

In this environment, real disposable incomes of households net of tax and housing costs are continuing to fall despite the increases recorded in GDP and GNP. The Irish Government, so keen on promoting our improved cost competitiveness when it comes to the foreign investors is presiding over the ever-escalating costs of living at home.

In 2012 consumer prices excluding mortgages interest costs stood the highest level in history and 1.2% ahead of pre-crisis peak of inflation recorded in 2008. Much of this is accounted for by the heavily taxed and regulated energy prices.

Sectoral data reveals the story of rampant annual inflation in state-controlled parts of the economy. Of ten broader categories of goods and services, ex-housing, reported by CSO, all but one private sectors posted virtually no inflation over 2012 compared to the average levels of prices in 2006-2008 period. Food and non-alcoholic beverages prices declined 1.4%, clothing and footware prices are now a quarter lower, costs of furnishings, household equipment and routine household maintenance are down 13%, and recreation and culture services charges are down more than 2.7%. Restaurants and hotels costs are statistically-speaking flat with price increases of just 0.4% on 2006-2008 average. The only private sector that did post statistically significant levels of inflation was communications where prices rose 3.5% by the end of 2012 compared to pre-crisis average. But even here postal services charges lead overall inflationary pressures.

In contrast, every state-controlled and heavily taxed sub-sector is posting rampant inflation. Alcoholic beverages and tobacco prices are up 12.3%, health up 13.4%, transport up 11.4%, and education costs are up 30.4%. Energy costs are up 32.5% and utilities and local charges are up 14.9%. While energy costs rose virtually in line with increases in global energy price indices, the state still reaped a windfall gain from this inflation via higher tax revenues, and higher returns to state-owned dominant energy market companies: ESB, Bord Gais and Bord na Mona.

The state extraction of funds through controlled charges and taxation linked to these charges is rampant. Over 2009-2012 period, indirect taxes, state revenues from sales of services and investment income – all linked to the cost base in the underlying economy rose from EUR 24.8 billion in 2009 (44.3% of total state revenues) to EUR 25.2 billion in 2012 (44.5% of total state revenues). This was despite significant declines in imports and consumption of goods in the domestic economy and declines in government own consumption of goods from EUR 10.4 billion in 2009 to EUR 8.56 billion in 2012. For those who think this extraction is nearly over now, let me remind you that IMF forecast increases in Government revenues for Ireland over 2014-2018 are set to exceed revenues increases passed in all budgets since 2008.


The price and tax hikes on Irish households leave them exposed to the risk of future increases in mortgages costs. Government controlled prices are sticky to the downside, which means that the once prices are raised, the state regulators and policymakers are unwilling to adjust prices downward in the future, no matter how bad households budgets can get. The reason for this is that semi-state companies reliant on regulated charges have significant market and political powers, especially as they act as prime vehicles for big bang ‘jobs creation’ and ‘investment’ announcements that fuel Irish political fortunes. At the same time, the state uses revenues obtained directly via dividends payouts and indirectly via taxes on goods and services supplied by the semi-state companies as substitutes for direct taxation. Absent deflation in state-controlled sectors, there is very little room left in the private sectors to compensate households for any potential future hikes in mortgages by reducing costs of goods and services elsewhere.

And mortgages costs are bound to rise over time. In 2008, new mortgages interest rates averaged around 5.2% against the ECB repo rate average of 3.85%, implying a lending margin of around 135 basis points. Since January 2013, ECB rates have averaged 0.7% while Irish mortgages rates averaged around 3.4%, implying a margin of 270 basis points. At this stage, we can expect ECB rates to revert to their historical average of around 3.1% in the medium-term future. At the same time, according to the Troika, Government and Central Bank’s plans, Irish banks will have to increase their lending margins. Put simply, current average new mortgages rates of 3.4% can pretty quickly double. Ditto for existent mortgages rates.

Based on CSO data, end of 2012 mortgages interest costs stood at the levels some 14.5% below those in 2007-2009 period and 29.6% below pre-crisis peak levels.  Reversion of the mortgages interest rates to historical averages and adjusting for increased lending margins over ECB rate would mean that mortgages interest costs can rise to well above their 2008 levels, with inflation in mortgages interest payments hitting 50%-plus over the next few years.


The dual structure of the Irish economy, splitting the country into an MNCs-dominated competitiveness haven and domestic overpriced and overtaxed nightmare, is going to hit Ireland hard in years to come. The only solution to the incoming crisis of rampant state-fuelled inflation in the cost of living compounding the households insolvency already present on the foot of the debt crisis is to reform our domestic economy. However, the necessary reforms must be concentrated in the areas dominated by the state-owned enterprises and quangos. These reforms will also threaten the state revenue extraction racket that is milking Irish consumers for every last penny they got. With this in mind, it is hardly surprising that to-date, six years into the crisis, Irish governments have done nothing to transform state-sponsored unproductive sectors of the domestic economy into consumers-serving competitively priced ones.

Chart with Argentina: GDP per capita adjusted for PPP differences (prices and exchange rates)

Box-out: 

Remember Ireland’s ‘exports-led recovery’ fairytale? The premise that an economy can grow out of its banking, debt and growth crises by expanding its exports has been firmly debunked by years of rapid growth in exports of goods and services, widening current account surpluses and lack of real growth in the underlying economy. Recent data, however, shows that the thesis of ‘exports-led recovery’ for the euro area is as dodgy as it is for Ireland. In 2010-2012, gross exports out of the euro area expanded by a massive 21.4%. Over the same period GDP grew by only 2.8%. Stripping out positive contributions from the private economy side (Government and household consumption, plus domestic investment), net exports growth effectively had no impact on shallow GDP expansion recorded in 2010 and 2011. The latest euro area economy forecasts for 2013 across 21 major research and financial services firms and five international economic and monetary policy organizations show a 100% consensus that while exports out of the euro area will continue to post positive growth this year, the euro area recession will continue on foot of contracting private domestic consumption and investment. Median consensus forecast is now for the euro area GDP to fall 0.4% in 2013 on foot of 2.1% drop in investment, 0.8% contraction in private consumption and a relatively benign 0.3% decline in Government consumption. The same picture – of near zero effect of exports on expected growth – is replayed in 2014 forecasts, with expectations for investment followed by private consumption expansion being the core drivers for the euro area return to positive GDP growth of ca 1.0%. Sadly, no one in Europe’s corridors of power seem to have any idea on how to move from fairytale policies pronouncements to real pro-growth ideas.

12/1/2013: Banks lending to private sector - Nov 2012

For much of the discussion about "Ireland is not [insert a euro 'peripheral' country name here]", here are comparatives in terms of banks lending to private sector in November. Predictably and as mentioned earlier on the blog, our lending is still contracting. On the 'positive' side, it is contracting less in Greece, Spain and Portugal for non-financial corporates, and less than in Greece, but more than in Spain and Portugal for households.

For the sake of my own physical and mental health, I am not going to give you a judgement of what this means. Draw your own conclusions.

Note: I just realised I forgot to link to the source on this.

Economics 02/11/2009: Central Bank Credit Data - Renewed Crisis Dynamics

So Irish Central Bank monthly data – out last Friday – provides some more fodder for thought about what is going on with credit flows in the country most dependent on ECB repo window (see here).

First consider the aggregates on money supply side:
This clearly shows that whilst M1 money supply has expanded by just under €3bn (or 3.4%) between August and September 2009, M2 money supply has contracted by over €4.1bn or 2.11%. The contraction is primarily driven by the decline in deposits with set maturity of up to 2 years which have fallen by a whooping €7.43bn or 7.9%. Part of this was probably used to deleverage shorter-term debt securities (up to 2 years in maturity) – which have declined by €2.66bn or just under 5.5%. But whatever happened with the rest of deposits is hard to explain out of the CB data. Deposits with medium term maturity constitute the most stable measure of future lending capacity in the credit sector and this decline does not signal much needed stabilization in future lending conditions.

Now to more detailed data on consolidated balance sheet. First, liabilities side:

The above chart clearly shows that all liabilities, save for Non-Government Deposits and Government Deposits with the Central Bank, are still trending up. Net external liabilities are certainly in reversion after June local trough and are now dangerously reaching for February 2009 crisis levels. Bad news?

Well, aggregates are showing something very similar:
Total liabilities are now in excess of the non-Government credit volumes once again for the second time this year. First this condition was observed in January-February 2009. Next, we have crossed once again to the situation of private sector credit falling below total liabilities in August 2009. September 2009 re-affirmed the trend as the gap between two time series widened to the second highest level in 2009 so far with January gap of €27.7bn and September gap of €22.0bn. So non-Government credit flows are no longer covering total liabilities… Bad stuff? Wait…
On the assets side, the above shows that save for Government debt which is converted through accountancy double-entry into Government Credit (up 77.9% year to date in September), not much else is rising, with fixed assets down 14% year to date, interest earnings on non-government credit down 49.6%, official external reserves up 11.35%.

On private sector credit decomposition:
Total private sector credit (PSC) has declined from the peak achieved back in November last year to current €378.1bn or 6.4%. This is dire and the decline is actually accelerating since beginning of September. Table summarizes:
The same is true for non-mortgage credit and mortgage credit. Importantly, the data on mortgage credit and non-mortgage borrowing shows that there is no deleveraging in sight for Irish households. Residential mortgage lending today continues to remain at well above the peak markets level for house prices. In 2007, average monthly level of mortgage debt in Ireland stood at €131.1bn. In September 2007, the level was €136bn or 8.83% below the latest level recorded in September 2009. Thus, as negative equity pressures continue to increase due to falling house prices and as rents continue to destroy yields on property, Irish mortgage holders are simply prevented from deleveraging in the credit cycle by falling incomes and rising taxes.

This does not bode well for the short-term prognosis for the Irish financial system (reliant heavily on low default on mortgages assumptions amidst a full blown meltdown of the development loans) and for the Irish construction sector and property markets (reliant on some sort of a return of the buyers to the collapsed market for properties). It also does not support any hope of the stabilization in the property-related tax revenues.
Hence, although credit contraction has set in firmly back in June (with credit to private sector posting negative growth in yoy terms since then), mortgages credit is lagging (implying that we are yet to witness true crunch on mortgages – something that is likely to happen once the banks set out in earnest to rebuild their margins by hiking mortgages rates post-Nama) and non-mortgage credit is back on the rise (potentially reflecting accumulation of credit arrears by financially stretched households).

The same picture, of building pressure on the arrears side can be glimpsed from the changes in trends for credit cards spending. New purchasing using credit cards has lagged repayments in January-August 2009. In September, more charges were incurred than paid down. The same (albeit on a vastly smaller scale) took place in business cards. Hence, balances are now rising across all credit card debts, as shown in the chart below.

Net result of all of this: outstanding indebtedness of Irish private sectors is no longer declining. The rate of growth in overall debt levels has hit 0 in May 2009, bounced back to positive territory in June-July 2009 and failed to hit negative (deleveraging territory) since then.