26/9/2013: Even with Hopium injections, we are not that far from Greece...

Irish Fiscal Council paper "The Government’s Balance Sheet after the Crisis: A Comprehensive Perspective" authored by Sebastian Barnes and Diarmaid Smyth is an interesting read.

The paper sets out a strong promise: "While discussion often focuses around the debt-to-GDP ratio as referenced by the EU Stability and Growth Pact, the reality is far more complex. This paper takes a comprehensive look at the Government’s balance sheet following the financial crisis. This involves assessing assets and liabilities of the General Government sector, off-balance sheet contingent and implicit liabilities as well as the wider public sector."

Alas, the side of the assets equation is a bit wanting...

While it is good to see the broader approach taken by the authors to the problem of fiscal sustainability of public finances in Ireland, too often, broadening of the coverage of the crisis-impacted sovereign balance sheet slips into the stream of extolling the riches of state-owned assets, whitewashing the liabilities using imaginary assets. The paper does not do this. Which is good. However, the paper is still creating loads of confusion because it provides no clear tabulation of the assets and the way they are accounted for in the analysis.

Instead of a concise tabulation, assets analysis is presented in two parts, both overlapping. This makes it nearly impossible to disentangle what the authors include where and to what specific value.

Let's start from the top:

Per authors: "General Government financial liabilities have increased four-fold since 2007, reaching €208 billion (127 per cent of GDP) in 2012. Over this period, Ireland experienced the largest increase in the debt-to-GDP ratio of any Euro Area country." Yep. Nothing controversial here.

"The Government has substantial holdings of financial assets. These increased modestly over the same period to reach €73 billion (45 per cent of GDP) in 2012. The main assets are cash balances, holdings of semi-state entities and investments in the banking sector."

Now, that's a bit of a statement, in my opinion, open to questions.

Firstly, it creates an impression that most of the assets Government has are liquid. Not so, in my view.

Secondly, it creates an impression that the Government has a functional power to seize these assets. Also a bit of stretch in my view.

Thirdly, is suggests that even if individually liquid and recoverable, these assets can be sold in the market or used as collateral in the case of distress. Again, not something I would agree with.

The authors conclude that "The Government’s net financial assets (NFA), subtracting financial liabilities from financial  assets, gives a broader measure of the financial position of government. NFA have  declined from a position of balance in 2007 to a net liability of €135 billion (82 per cent of GDP) in 2012. Using this broader measure, the Irish government was the third most indebted country in the Euro Area in 2012 (as a share of GDP)."

I am not so sure that EUR73 billion is the real number we should be using in computing Government net financial position. My gut feeling is that we are lucky if we can count EUR50 billion in somewhat liquid and accessible funds. And even then we are at a stretch. With that, our Government's net financial assets position rises to a  deficit of 95-96% of GDP and this means that we are now challenging Greece to the Euro area's title of the second most-indebted country. And that is before Greece Bailout 3.0 which will probably result in some sort of a debt write down for the Greeks (see here:http://english.capital.gr/News.asp?id=1877516) even if small.


Here are some details on my sceptical assessment. The paper lists the following Government 'assets' (comments outside quotation marks are obviously mine):

(A.) Shares and Other Equity. "This broad asset category was valued at €24 billion. It includes: (1) the value of semi-state assets, including the equity of General Government in the Central Bank; (2) a portion of the NPRF; and (3) other equity
holdings." (1) is at least in part imaginary. The valuations of semi state companies are 'hoped for' and are not tested in the market. They also do not account fully for the shortfalls in pension funds and the knock on effects to any purchaser of equity in these companies from the role these pension funds play in running the companies' strategies. They also ignore the fact that with transfer of ownership, the semi-states are unlikely to continue enjoy state protection of their dominant market positions. All in, (1) covers EUR12 billion of semi-states equity, plus EUR2 billion of balances in the Central Bank - of which, my guesstimate is, no more than EUR5-6 billion is recoverable. The authors state clearly that "Considerable uncertainty, however,surrounds the value of these assets." per CB reserves, these are euro system money and I wonder how much of this even technically belongs to the Irish state. (2) covers NPRF-held equities and banks shares. Equities component is small, with total EUR9 billion in NPRF 'assets' accounted for mostly by banks shares (excluding preference shares). National Accounts assign EUR11 billion to the total Government holdings of banks assets. These valuations are off the mark, in my view, as the only value of the banks (ex-Bank of Ireland) today is the value of capital injected into them, net the losses they will sustain on mortgages. The rest is awash on revenue side v cost side. At any rate, these assets are not exactly liquid and if released into the market in any appreciable quantity will cause severe dilution of their value. All-in, say EUR9-10 billion of this 'stuff' is a hoped-for value in any scenario of sovereign distress.

Bit (3) above: 'Other equity holdings' "valued at approximately €3 billion. This includes the value of direct holdings of bank equity by the Exchequer, investments in the insurance sector and capital contributions to the European Stability Mechanism." Seriously? We'd get a rebate on ESM contributions? Insurance sector 'investments'? Shave off some EUR1 billion here for a dose of realism.

(B.) Currency and deposits. "The Government holds a substantial amount of relatively liquid  assets, which are managed by the NTMA. These were valued at €24 billion at end-2012. This figure includes cash balances held by the Exchequer (€18 billion), local government (€1.4 billion) and cash balances held by other Government bodies(such as the NPRF)." Can the Government expropriate the funds belonging to local authorities? Legally and actually? Can the Government capture all balances held by the Government bodies? May be. May be not. Surely it depends on contractual obligations of these bodies and the nature of assets? So suppose that EUR2.4 billion of the above is not subject to capture/recovery.

(C.) Amongst gloriously liquid Irish Government 'assets' the paper (and it is accepted methodology, I must say, which of course doesn't mean it makes any sense beyond purely theoretical exercise) list: "Loans and Other Assets(such as Accounts Receivable). This category was valued at €15 billion and includes a broad range of assets, namely loans from the Housing Finance Authority (HFA)(€4 billion), other Government loans,tax accrual adjustments (mainly VAT and PAYE (€3 billion) and a range of smaller assets such as collaterals, EU transfers and mobile spectrum receipts." Good luck, as one might say, selling these or pledging them as a collateral. The entire notion that all of these assets have the stated face value in the market is questionable. That they might have a stated value in an environment of distress sufficient enough to warrant their seizure is plain bonkers.

And so on… The point is that a claim that EUR73 billion represents assets that can be used to fund any shortfall in Irish Government funding or that they provide any yield that is NOT accounted for on the balance sheet already (remember, current debt is driven by deficits and these are driven by operating costs and revenues of the Government, which in turn are accounting for all asset yields that currently accrue from all of the above assets) is a bit of a stretch and double-counting.

In light of this 'net liabilities' discussion, we need to see some serious, detailed, models-based liquidity and legal title risks analysis of the assets that (a) in total amount to EUR73 billion and (b) amount to EUR45 billion that remains unaccountable in the paper in any appreciable details.


But never mind - on the net, the paper is very useful and worth a read. Here are two little gems (I will blog on rest later):

Ouch! You don't need to be a nuclear scientist to spot the problem above…

The true value of the above is that it shows clearly that even on the 'net liabilities' basis, with all the hopium injected into valuations of assets, Ireland is not that much different from Greece... Have a nice day, ya all...

10/08/2011: Was US markets panic behind Irish banks shares crash?

I've just crunched through some interesting data on VIX and Irish Financials index IFIN and there are some interesting results.

To remind you - VIX is in effect a market-based metric of risk in the US markets.

The main premise advanced by the proponents of the argument that US financial crisis drove Irish financial crisis is that panics in the US have caused irrationally pessimistic revaluations of the Irish financial equities and thus led to the collapse of the banks shares in H2 2007- H2 2009.

To assess this, I divided daily data from VIX and IFIN into three periods. Pre-crisis period covers data from January 2000 through July 2007. Financial crisis period covers data from August 2007 through December 2009, while Sovereign crisis period runs from January 2010 through today.

Given the nature of data, VIX data for intraday spreads is only available since September 2003.

Table below summarizes core stats on the data:
Several features worth highlighting in the above:

• IFIN data shows declining positive skew over the evolution of the crises, while VIX shows growing positive skew. This suggests that rising US risk aversion (VIX) was becoming structural over time as crises progressed from financials to sovereigns, while Irish financials were moving from positively skewed distribution in the pre-crisis period (positive non-risk premium to Irish financials) to progressively smaller positive skew in the crises periods. This is not consistent with the risk spillover from the US to Ireland story.
• Intraday variation in Irish financials remains smaller than in VIX, but shows qualitatively similar dynamics to VIX. However, increase in intraday variation during the crises is much stronger in the Irish financials than in VIX, which again suggests that risk pricing in the US markets had little to do with Irish financials risk-pricing. Notice that intraday spreads are highly non-normal in their distribution with third and fourth moments off the charts.
  
• 1-month dynamic correlations between VIX and IFIN remained negative across all periods (implying that rising US risk was associated with falling IFIN valuations), but relatively weak (at maximum mode of 0.35 on average). median correlations show a bit more dynamism during the crisis, rising from -0.41 in pre-crisis period to -0.51 during the Financial crisis period and declining to -0.45 in Sovereign crisis period. However, these are not dramatic either. In fact, positive skewness was reinforced during the Financial crisis period, while negative kurtosis declined in absolute value.

Chart above summarises the entire series of data, showing historically relatively weak, but negative (as expected) correlation between the values of Irish financial shares and the risk levels in the US markets.

Chart below breaks this down into three periods:
What's interesting in the above chart is that:

1. Correlation remains negative but explanatory power significantly declines in the period of Financial Crisis (so the picture is the opposite of the claim that the US 'panic' spilled over into Irish markets), while the slope remains relatively stable.
2. More interestingly, the relationship completely disappears since the onset of the Sovereign crisis. basically, once the IFIN hit 4,000 levels, there is no longer any meaningful connection between Irish financial shares prices and risk attitudes or perceptions in the US markets. Guess what - that magic number was reached around 29/09/2008.

Chart below plots 1mo dynamic correlations between VIX and IFIN
While correlations tend to stay, on average, in the negative territory, as the table above shows, they are not significantly large. In fact, overall during the Financial crisis period there were 318 instances of the correlation equal to or exceeding (in mode) 0.5 - or 51% of the time. In pre-crisis period this number was 42% and during the Sovereign crisis so far - 45%. But there is a slight problem in interpreting this 51% as the spillover effect from the US. During the Financial crisis period, pre-Lehman collapse, higher correlations took place 58% of the time, while post-Lehman collapse they took place 45% of the time. So overall, it appears that US risk attitudes (aka 'panics') were more related to adverse movements in IFIN before the Big Panic took place than during and after the Big Lehman's Panic set on.

Interestingly, there is also no evidence that changes/volatility in the US attitudes to risk had any significant serious impact (adverse or not) on volatlity Irish financial shares valuations, as shown in the chart below:
In no period in our data is there a strong relationship between changes (volatility) in US risk attitudes and the Irish financial shares valuations volatility.

A note of caution - these are simple tests. The data shows a number of problems that require serious econometric modeling, but overall, so far, there is no strong evidence to support the proposition that Irish banks shares or financial shares have been significantly and systematically adversely impacted by the US 'panic' or by 'Lehman collapse'. Our banks problems seem to be largely... our banks own problems...

18/07/2011: Some thoughts on Irish stocks bubble

There is a classic defined relationship between the various stages of bubble formation and markets responses, as illustrated in the chart from (source here) below.

Of course, there is an argument to be made that ‘normal’ bubbles are driven by either information asymmetries or behavioural ‘exuberance’ or both, and are, therefore, significant but temporary departures from the steady state ‘mean’ growth trend. The return to the mean, thus implies the end of the correction phase, as also shown in the chart below.


Of course, one can make an argument that what we have experienced in the case of Ireland is more than a simple bubble, but a structural break underwritten by underlying fundamentals, such as lower permanent rate of growth.

Irish GDP grew 8.82% cumulative in the period 2003-2010 in terms of constant prices or annualized rate of growth of 1.215%. In per capita terms current prices it grew by 14.85% cumulatively and at an annualized rate of 1.998%. Taken from these rates, from 2003 on through today, the average expected value of IFIN should be around 8,898 (mid-point between 8,659 and 9,139 implied by above rates from the ‘Smart Money’ period mid-point valuation). Note that, crucially, the new mean post-bubble bursting should be at least at or above the ‘Smart Money’ end-of-period valuations.

This is certainly not the case with Irish financials as shown in figure below:
Note that three forecasts (my own calculations, so treat as indicative, rather than absolute) provided assume that the average annual growth rate of 1.998% (upper forecast from the starting point at 2003-2004 average), mean forecast (based on 1.215% annualized average growth, starting from 2003-2004 average) and lower forecast (based on 1.215% annualized growth, starting from 2000-2003 average). All three are well above the post-Despair peak.

What about other signs of a classic bubble?
In the run up to the Public Money phase, it is clear that IFIN shows a number of sell-offs and shallow bear traps, but these can be linked to higher overall volatility of the index.

For any period we can take, IFIN exhibits more volatility than either S&P or FTSE bank shares sub-indices. Historically, across indices (to assure comparable scale), IFIN standard deviation stands at 65.40 against S&P’s BIX at 36.84 and FTSE A350 Banks at 32.70. January 2003 through June 2006, IFIN standard deviation was 25.16 against that for BIX of 10.29 and FTSE A350B at 12.07. For the run up to the crisis period between June 2006 and June 2007, IFIN standard deviation was 15.66 against S&P’s BIX of 4.64 and FTSE A350B of 5.22. Lastly, during the crisis – from July 2007 through today, IFIN standard deviation was 56.40 against 28.07 for S&P BIX and 27.83 for FTSE A350B.

To see the relationship, or the lack there of between the volatilities, consider the following chart.
Even from the simple consideration of the rates of change, week on week, IFIN has the lowest correlation with the S&P Banking BIX index – with relatively low explanatory power. Things are even worse if we are to look at the downside risks. Chart below plots downside weekly movements for the three indices that correspond to market declines of 2% or more week-on-week. Again, you can see that both before and during the crisis, there is little relationship between downside risk to Irish financials and to S&P measure.
And the same story is formally confirmed by the Chart below which plots the pair-wise relationships between S&P BIX and FTSE A350 and IFIN.
So overall, IFIN data strongly suggests that we are not in a “normal” financial bubble scenario.

But what about that claim that Lehman's Bros collapse had influence on our banks shares? Recall, Lehman was in trouble since Spring 2008 and went to the wall on September 15, 2008. Also recall that the issues started with Bear Sterns troubles in March 2008 and JPMorgan Chase completed its acquisition of Bear Stearns on May 30, 2008. So let's take the data subset on extreme downward volatility for the period from May 2008 through September 2009. If Lehmans and/or Bear had much of an effect on Irish financials we should expect either one of the following two or both to hold:

1. Correlation between IFIN and S&P BIX to be large and significant
2. Correlation between IFIN and BIX to be larger in the period considered than over the history from 2003 through today.

Overall, evidence suggests that actually the opposite of both (1) and (2) above holds. In fact, based on data for weekly market declines greater than 2% (relatively significant events, but not really too dramatic by far), the period between Bear & Lehman collapse and the next 12 months, Irish financials were less impacted by the US financial shares movements than in the period of 2003-present overall. The impact of Lehmans & Bear on UK financials was stronger, although not dramatically strong, however.

Economics 19/9/10: Irish banks - Government intervention still has no effect

Returning to my old theme - let's take a fresh look at the Government and its policy cheerleaders success rate with repairing our banking sector. Here is a quick snapshot of history and numbers as told through the lens of Irish Financials index.
So clearly, we have some really powerful analysts out there and keen commentariat (actually one and the same in this case) on the future prognosis for our banks.

But what about recent moves in the index itself?
Take a look at the chart above, which maps the Financials Index for two subperiods:
Period 1: from Guarantee to March announcement of the 'final' recapitalization of our banks,
Period 2: from Guarantee to today.
Now notice the difference between two equations. That's right, things are not getting any better, they are getting worse.

Next, let's put some historical markers on the map:
Surely, our financials are getting better, the Government will say, by... err... not getting much, much worse. The reality, of course is, any index has a natural lower bound of zero. In the case of Irish Financials Index, this bound is above zero, as the index contains companies that are not banks. As far as the banks go, there is a natural lower limit for their share values of zero. Our IFIN index is now at 80% loss relative not to its peak, but to its value on the day of Guarantee!

Having pledged banks supports to the tune of 1/3 of our GDP already, the Government policy still has not achieved any appreciable improvement in the index.

Forget longer term stuff - even relative to Q4 2009, Government policies cannot correct the strategic switchback away from Irish banks shares that took hold:
A picture, is worth a 1000 words. Unless you belong to the upbeat cheerleaders group of the very same analysts who missed the largest market collapse in history, that is.

Economics 17/10/2009: WalMart/IKEA Effect, Bull Markets in Stocks

Scroll for IKEA Effect discussion and Retail Sales Data below...

A superb note on the current markets from Robert Lenzner on the links between the Bull run we are experiencing and economic fundamentals is available from Forbes (here). To sum it up: that which can't go on usually doesn't.

What are the implications for Ireland?

• Our exports are likely to suffer significant downward pressure in years to come - a combination of Obama Administration Healthcare Reform (driving down long-term returns to pharma sector and re-orienting US purchasing to more centralized and, more likely, heavily domestic-industry oriented purchasing will undermine majour pharma players - the dominant force in Irish exports) plus cyclical effects of patents expiration (Pfizer - Ireland's largest singular exporter - is facing tough times in coming up with new blockbusters as its existent ones are running out of patent protection) will act to depress future exports growth in the pharma and bio-phrama sector.
• Our indigenous exports will remain uncompetitive for years to come as a combination of strong euro (especially if the ECB continues to move toward 'exit strategies' and higher interest rates) and the legacy of the crisis (high debt levels and severe maturity mismatch in Irish sectors) will continue to weigh on future growth.
• Our domestic consumption will remain in doldrums for years to come under combined weight of higher taxation and stronger euro, with a resultant shift to imported substitutes (see IKEA effect below).
• Our trading and investment block - the EEC - will remain anaemic growth partner.
• Our internal investment will stay flat at low levels as a combination of higher investment costs (banks raising margins and engaging in wholesale capital destruction by re-drawing terms and conditions of existent loans to companies and households post-Nama) and precautionary savings (our households and corporates holding excessive cash reserves with demand-style access covenants on these holdings) will imply low returns to domestic investment, high cost of such investment all in the environment of subdued growth.

Can you see Bank of Ireland or AIB shares trading at Euro4.00-5.00 range with these prospects? I don't...


Ikea Effect: I wrote before on many occasions about the WalMart effect: give consumers better value for money (through more efficient purchasing, logistics, distribution, marketing and retailing) and they will vote for you in tens of thousands. Now we have a small glimpse at it in the form of IKEA.

Here it is - in this week's CSO data on retail sales: August retail sales down a massive 1.0% overall, after six months of shallow increases. Worse than that - core retail sales (ex-motors) down 1.8% on July breaking three months improvements pattern. Food sales were down 2.8% despite decent weather and more families staying at home instead of leaving for a vacation. But, Furniture & Lighting was up 26% - thanks to IKEA.

Few charts to illustrate trends.
So broader trends are dire. But look at what's happening in Furniture Sector (IKEA Effect):
Self-explanatory.

Now, per CSO CPI data: Furniture and Furnishings, plus Carpets & Floor Covering account for 1.0812% of total Household Expenditure in 2006, Household Textiles - for additional 0.2424%, Glassware, tableware & household utensils 0.2577%, so roughly 1.6% of household spending goes to items sold by IKEA. Per CSO data, 2008 personal consumption expenditure in Ireland was €93,863bn, so roughly speaking €1,500mln of this went to goods of the types sold by IKEA. If IKEA offers average savings on Irish-domestics in the sector of some 25-40% (and my own experience suggests it is actually greater than that, but let us be conservative), the savings potential due to IKEA Effect add up to some €375-600mln or some €133 per every person in this country.

Now, IKEA has been trying to get a store into Ireland since at least 2000, which implies that an average Irish household has lost up to €4,000 in savings that could have been achieved were the IKEA (or WalMart) effect present in this economy. All due to the corporatist and politicised nature of our planning and retail regulations. Some price to pay!

Of course, these savings would have been even greater as:

• IKEA (WalMart) effect could have had spillover effects to other sectors of Irish economy were our policymakers not engaged in actively restricting competition in retail sector;
• IKEA (WalMart) effect would have coincided with heavier purchasing of durable goods during the boom years of 2003-2007, thus offering greater level savings on more expensive items.

But let us not count 'small change' - after all, preserving a 'small town' character of retailing (with convenience shops littering every corner of our towns and gas-station shopping outside of Dublin instead of proper multiples retailing) is worth €4,000 per family. Isn't it?

A quick note on the WalMart effect in broader terms. Ireland is aiming to get its R&D spending (public and private) contribution up to 3% of GDP or in 2009 terms - roughly €5.1bn per annum. Now, assuming WalMart-type retail efficiencies can deliver a 10-15% savings on our retail spending, the gains from the WalMart effect will mean an addition to our GDP to the tune of €9-14bn per annum. Of these, some 30% will be accruing to the Exchequer in form of various taxes, so the second order increase in GDP will be €2.7-4.2bn. Total increase in GDP will, therefore exceed €11-18bn or 6.5-10.5% of GDP. (These are back of the envelope calculations, but you can see where it is going)...