Economics 30/11/2009: Budget scope

For those of you who missed my yesterday's article in the Sunday Times, here it is in un-edited version. Note: updated below for estimated probabilities of default.

In their recent note, Fitch has singled out our massive public deficit and rising debt as the drivers for Irish sovereign bonds downgrade to a lowly AA- rating. This warning was in line with broader international markets concern about the mounting public debt liabilities around the world.

After days of falling prices on Chinese and Greek debts, this Tuesday it was Spain’s turn. October figures from Spain have revealed that the country deficit is now set reaching 9.5% of its GDP. The Spanish Government has gone out of its way to assure the markets that it plans to bring the deficit to 3% Euro zone limit by 2012. The plan involves raising VAT and capital gains tax. But the main measures will deal with public expenditure cut of 12-15%.

Spain, or course, is facing a public deficit that is some 3 percentage points shy of Ireland’s. But, unlike Ireland, Spain is planning to take its medicine in full and swiftly. Take another example. Denmark’s deficit is 7 percentage points below ours. In contrast to us, Danish government passed tax breaks and a major tax reform package encouraging more labour supply. The country also used its pension reserves to boost household income in this recession. To keep things under control – Danes cut public expenditure by up to 20% in some areas.

Latvia, Estonia, Iceland, and Hungary – all have implemented IMF-mandated cuts in public spending with some inflicting cuts up to 30% on public sector wages. All have seen subsequent rounds of upgrades from economic forecasters and bond markets.

But the signs are, after 27 months of severe crises, the Leinster House is still in the denial as to the full realities of our perilous fiscal position. Even after all the tough talk, Minister Lenihan is now appearing to accept Unions’ compromise for a temporary symbolically modest cut to public sector wages. Yet, the depth of our economic crisis requires nothing short of a drastic and permanent reductions in public spending.

Ireland’s promised €4bn cut in the Budget 2010 – contentious as it might seem to us – is pittance compared to what is needed to restore credibility in our economy.

Per latest set of accounts, we are in the need of raising almost a half of our current spending financing through borrowing. The latest forecasts from the EU Commission and the OECD state that Ireland's general government deficit is expected to be 12.2-12.5% of GDP in 2009 and 11.3-14.7% of GDP in 2010-2011. There is no snowball’s chance in hell that Ireland can reach the required 3% target by 2014 or, for that matter 2015, unless we deal with that share of the deficit that is known as structural deficit.

Any deficit arising in real life, therefore, can be decomposed into a cyclical deficit – that share of the deficit that arises due to a temporary recession – and structural deficit. The latter, of course, is the deficit that arises from structural overspending and cannot be expected to disappear when the economy reaches its long run growth potential.

Hence, the extent of our structural deficit is crucially dependent on the assumptions for the natural rate of growth in Irish GDP. So far this year, our Department of Finance forecasters have assumed that the natural rate of growth for Irish economy lies around the simple average for the 2000-2008 levels –close to 3.8% per annum. Their friends in the ESRI are slightly less optimism, predicting that the natural rate of growth is somewhere around 3% of GDP. All of this suggests that the structural component of our deficit is around 8-9% of GDP per annum or under €14bn. The cyclical component is in the region of 3-4% of GDP or up to €7bn. Hence, the current preferred adjustment path to fiscal solvency envisions cuts of €4bn in 2010 and 2011. Thereafter, reckon our mandarins, things will come back to ‘normal’ and Irish economy will miraculously churn out more tax revenue to cover the remaining hole.

But this bet assumes that Ireland is somehow an outsider to the entire Euro area club of smaller open economies. How else can our potential GDP growth be almost 300% above that of Denmark, 250% greater than Belgium’s, 60% above that for the Netherlands and for the Euro area as a whole? Or why should we assume that Irish economy will overshoot potential growth rate in the first year of recovery, when the majority of European economies are expected to reach theirs some 3-5 years after the end of a recession?

If our potential GDP growth is really in line with the small Euro area countries’ average, then our output gap (the difference between the potential and current GDP) is closer to 6% rather than 7.25% that the Department of Finance builds into its forecasts. This in turn implies that our cyclical deficit is around 2.5%, yielding a structural deficit of ca 9.5-10% of our GDP or €16-17bn in 2009 terms.

To get close to a realistically feasible path to solvency, Brian Lenihan should be aiming to cut some €8bn in public deficit in 2010 alone, followed by €3-4bn cuts in 2011 and 2012 each.

This is the real legacy of excessive exuberance with which Bertie Ahearn handed out cash to various Social Partners constituencies. And it is now manifested in purely toxic extent of deficits that cannot be corrected by any means other than savage cuts. The structure of our expenditure – manifested by the fact that some two thirds of it goes to finance wages, pension and social welfare payments – implies that the cuts must happen in exactly these areas.

Painful as this may be, there is simply no alternative. No productivity increases in the public sector will help deflate the actual costs of the sector. The costs that keep on rising. Per CSO’s latest data, 2009 was a bumper crop year for our servants of the state. Average public sector earnings are up 3.2% in a year to the end of Q2 2009, while average private sector wages are down 6.8% over the same time - a swing of 10 percentage points. Survivorship bias – the fact that earnings figures do not reflect the jobs losses and do not net out resulting redundancy payments in the private sector – suggests that the actual earnings growth differential is much wider than that.

Restoration of our economic health at this junction requires swift and significant cut – of the magnitude of 15-20% - in the total pay bill of the public sector. This can only be achieved through a combination of reduced employment and earnings cuts. It should be accompanied by a 10% cut in social welfare and a 30-40% cut in capital spending.

This is an urgent task that cannot be delayed for future Governments to tackle. Since May this year the Government has gone on a PR offensive arguing that the markets have treated Budgets 2009 as serious efforts to correct deficit.

Most of this is political sloganeering. As the chart clearly shows, although markets estimates of our probability of default on sovereign debt have declined in time from a historic peak in February 2009, this decline was far less significant than the overall market gains experienced by other countries with similar budgetary problems. Having peaked well ahead of all other Euro zone countries, Irish CDS spreads have stayed persistently at the top of the common currency area distribution. And there they remain with a significant risk to the upside.

Here are some index pics, all countries CDSs (5-year) set at 100 on 18/07/2008:

And here is an interesting chart for actual CDSs
The markets are now putting estimated probability of our default above that of Peru!

To put these into perspective, using OECD and EU Commission latest forecasts, taking €8bn in deficit financing out this year will save Irish taxpayers some €3-5bn in interest payments alone over the next 5 years.

The costs of our inaction are mounting.

Here are two charts on estimated probabilities of sovereign default for various CDSs, using a linear formula (not a more accurate PV of contingent claim =PV of fixed payment approach and no bootstrapping).

The above chart shows the cumulative probability of default over 5 year term of life of bonds... we are back in double digits and above Spain and Greece...

Economics 30/09/2009: Global Financial Stability Report

Update: There is an interesting note in one of today's stockbrokers' reports: "AIB is to review its selection process for a successor to Eugene Sheehy, according to reports this morning. The Government will not endorse an internal candidate based on renewed signals according to the article. Separately, Minister Brian Lenihan said it was "inevitable" that further public capital will be required by the country's banks after the NAMA transfers."

Two points:

1. If Government is so aggressive in staking its control over AIB's selection of a CEO, why can't the same Government commit to firing the entire boards upon initiation of Nama? Governments change overnight, so why banks' boards are so different?
2. I must confess, I like Minister Lenihan's belated (this blog and other analysts have said months ago that there will be second round demand for funding post-Nama due to RWA changes triggered by Nama, and then due to second wave of defaults within mortgage and corporate loans portfolia) recognition of a simple financial / accounting reality. Strangely enough, the brokers themselves never factored this eventuality in their projections of Nama effect on banks balance sheets.
   

Oh, another little point: Minister Lenihan was last night explaining on RTE that BofI and IAB both raised circa Euro1bn bonds each with the issues oversubscribed by a healthy margin and that these were 3-3.5 year bonds. we should be impressed, then? Au contraire: those foreign investors (in the case of BofI 92% of the bond issue gone to foreign institutionals and banks) are making a rational bet that Ireland will continue to guarantee depositors through 2014 if not even longer, and that the Exchequer will rather destroy the households than see banks go under. In other words, the markets priced Irish banks now as being effectively fully guaranteed by the state - bondholders, shareholders, unsecured debt holders, furniture and office suppliers, staff - you name a counterparty working with Irish banking sector... they are all now implicitly guaranteed by you, me, ordinary taxpayers in Tallaght and elsewhere across the nation. Some success, then.

News: IMF's Global Financial Stability Report Chapter 1 is out today. This is the main section of the report and it focuses on two themes:

1. Continuation of the crisis in financial markets - the next wave of (shallower, but nonetheless present) risks to credit supply in globally over-stretched lending institutions; and
2. Future exist strategies from the virtually self-sustaining cycle of new debt issuance by the sovereigns that goes on to mop up scarce liquidity in the private sector, thus triggering a new round of debt issuance by the sovereigns (irony has it, I wrote about the threat of this merry-go-round link between public finances and private credit supply back in my days at NCB - in August 2008).

The report is a good read, even though it is a voluminous exercise - check it out on IMF's main website (at this hour I am still working with press access copy).

Ireland-specific stuff:
Nice chart above - Ireland was pretty heavy into ECB cash window back in 2007, but by 2009 we became number one junkies of cheap funding. Like an addict hanging about the corner shop in hope of a fix, our banks are now borrowing a whooping 7% of their total loans volumes through ECB. This is a sign of balance sheet weakness, but it is also a sign that the banks are doing virtually nothing to aggressively repair their balance sheets themselves. Why? Because Nama looms as a large rescue exercise on the horizon.
But, denial of a problem is not a new trait. Per chart above, through 2006, Irish banks were third from the bottom in providing for bad loans despite a massive rate of expansion in lending and concentration of this lending in few high risk areas (buy-to-rent UK markets, speculative land markets in Ireland, UK and US and so on). Now, taking the path the Eurozone average has taken since then, adjusting for the decline in underlying property markets in Ireland relative to the Eurozone, and for the shortfall on provisions prior to 2007, just to match current risk-pricing in the Eurozone banks, Irish banks would have to hike their bad loans provisions to 3-3.75%. And this is before we factor in the extremely high degree of loans concentrations in property markets in Ireland. Again, why are we not seeing such dramatic increases? One word: Nama.
Lastly, table above shows the spreads on bonds in the US and Eurozone. Two note worthy features here:

1. The rates of decline in all grades of bonds and across sovereign and corporate bonds shows that they are comparable to those experienced by Ireland. This debunks the myth that Irish bonds pricing improved on the back of something that Irish Government has done ('correcting' deficit or 'setting a right policy' for our economy). Instead, Irish bond prices moved in-line with global trends, being driven by improved appetite for risk in financial markets and not by our leaders' policies;
2. Current spreads on Irish bonds over German bunds suggest market pricing of Irish sovereign bonds that is comparable to US and European corporates. In effect, Ireland Inc is not being afforded by the markets the same level of credibility as our major European counterparts. One wonders why...
   

Economics 18/09/2009: An Illustration to the Idiot's Guide to Economics

Per chart below, average monthly bond spreads for Irish Government 10-years paper for the last 8 months.We've read Brian Lenihan's lips and here is what he said:

August 2009 (here): "The proposal to establish a National Asset Management Agency has been widely supported internationally by bodies such as the IMF and the OECD and tellingly since
the announcement of the establishment of Nama in April, bond spreads above the German benchmark for Irish sovereign debt have halved, from almost 3 per cent over 10 year German Bonds to now just 1.5 per cent. Irish 10 year bond yields are now 4.8 per cent."

August 2009 (here): "Indeed, during May I had to undertake a tour of EU financial centres to correct misinformation that existed about Ireland. This tour had a positive impact and there has been a significant reduction in the spreads on the State’s borrowing."

Plenty more to be found in the same vein. So per chart above, we've read your lips, Minister and... they produce gibberish so far. As I have remarked on many occasions, Irish bond spreads decline was

• in line with other countries (and in particular - with APIIGS);
• had more to do with the global change in appetite for risk and little-to-nothing to do with Minister Lenihan's decisions or policies;
• lastly, per chart above, while Minister Lenihan was trying to sell his disastrous policies to the nation on the back of declining bond spreads, Ireland has moved from the already dubiously distinctive position of being the second most screwed up economy in the Eurozone after Greece prior to May 2009 to being the worst economy in the Eurozone in terms of its bonds spreads over German bund since Minister Lenihan (per above quote) undertook his courageous road show to Europe.
  

Per one observer comment on this: "we are now the largest pig in the APIIGS pen" - welcome to Lenihanomics?

And on a funny note (credit here)and courtesy of bocktherobber :

Economics 15/07/2009: Bonds Spreads: ECB Model

As promised earlier (here), I have re-done the ECB model estimated for Belgium, Ireland, Greece, Spain, France, Italy, the Netherlands, Austria, Portugal and Finland for the specific parameterisation for Ireland. Taking the path for our debt, deficit and bond issuances through 2013 under three different assumptions:
Assumption 1: NAMA bonds are off the public balance sheet and have no adverse impact on pricing, plus our liquidity conditions are in line with those of Germany (this corresponds to the dream scenario);
Assumption 2: NAMA bonds are on the public balance sheet, implying some adverse pricing effects, but out liquidity remains in line with German (this corresponds to 'markets are asleep' scenario); and
Assumption 3: NAMA bonds impact our balance sheet and yield shut down of the international borrowing markets for NAMA bonds (this is ECB buys NAMA scenario).

Chart below shows the resulting spreads over German 10y Bund:
One quick explanation is also due: 2009 levels are the fundamentals-implied levels of spreads under the ECB model. This is what the spread should be, were the markets pricing our bonds in line with what ECB says they are doing. ECB Monthly Bulletin does not report residuals, so I can't tell the accuracy of the pricing model.

Nonetheless, three things stand out:

1. We are facing potential upward pressure on yield in 2009, should we go to the markets instead of the ECB;
2. NAMA is posing serious risk of destroying our balance sheet in years to come as the cost of debt financing can soar not only for NAMA-own bonds, but also for all the bonds rolled over by the Government.
3. It is relatively clear that any auction since January 2009 below 6.2% yield would have flopped, were it not for the ECB lending window circus.
   

And notice the term structure emerging in the chart below... Someone is not quite ready to buy Brian Lenihan (or for that matter ESRI's) story that we are getting serious about controlling our spending into the medium term future...

Economics 10/07/2009: Don't panic, ECB is... errr... backing down

On a light-hearted side of the blog:As they say in one famous commercial: for serious press, there's Mastercard, for BJs, there's Mayo Advertiser. (Hat tip: JH)



As the Bank of New York Mellon, one of the world’s largest and, in my view lowest counterparty risk custodian banks says the markets are now seriously disenchanted with European financials.

Per FT report today, concerns about the European banking sector are at their highest level since March. Euro might be sliding.BoNYM said its data showed net outflows from German bunds for the first time since mid-March. This is at the time when our own clowns are claiming that there is now a clarity in the borrowing markets for Irish debt. Hmmm... Clarity about what? An impeding disaster that is named NAMA?

BoNY Mellon also tracks outflows from Italian, Spanish, Portuguese, Belgian and Greek bonds. Emerging European markets lead, with APIIGS, plus France, Belgium, Germany and Sweden are at the forefront of the new pressure. By the end of this round - the acronym of 'troubled' or 'exposed' states will have 27 letters in it. Per FT report, Austria, Italy, France, Belgium, Germany and Sweden, which together accounted for 84% of the exposure to Eastern Europe. FT quotes BoNYM head of currency research saying that the euro area has lost its safe haven status, and is increasingly seen as a high-risk region among international investors. Thank god someone is being realistic...

But not in the marbled halls of the ECB. Those guys are simply out to lunch. Per their latest assessment (here): "Despite the financial turmoil, the global landscape of international currencies and - within that - the share of the euro remained steady. Specifically, between end-2007 and end-2008, the share of euro-denominated instruments increased by around 1 percentage point for outstanding debt securities, around 2 percentage points for outstanding cross-border loans and deposits, and around 1 percentage point for global foreign exchange reserve holdings... The review also shows that the international role of the euro maintains a strong regional pattern. Its international use continues to be most pronounced in countries with close geographical and institutional links with the euro area."

But the ECB's rosy take on the Euro is only half a problem. ECB's Monthly Bulletin (see here: scroll to 09/07/2009) is already on the path of plotting 'exit strategies' from the current active support policies - despite giving a rather gloomy outlook for the Euro zone for 2009-2010... Go figure. A companion paper to the bulletin has another re-print of the already trite table that was first floated by the OECD back in January 2009 and then slightly updated by the Article IV paper by the IMF last month. This is:
Enjoy - our Government's contingent liabilities relating to the banking crisis are ten times greater than those of the second most-screwed up banking sector in the euro area - Belgium. Oh, we are having some fun...

But not enough, I hear you say? Here is another good one from the ECB:
Now, California is considered to be bunkrupt, given its state deficit is only $24bn through next 12-18 months (depending on the budgetary framework taken), relative to a GDP of $1.8trillion a year - less than 0.008-0.013% of GDP. Ireland? Well - depends on whether you count NAMA or not, we are pushing for some 12-30% of GDP... Spot the difference? Ok, another chart then:We are facing worse deficit than Greece, but our spreads are lower... What gives? The market is not pricing in NAMA as a state liability. Not yet.

Here is what ECB used to assess the bond spreads:
"The following empirical model is used to explain the ten-year government bond yield spreads of
ten euro area countries (inc Ireland) over Germany (spread):
spreadit=α+ρ spreadit-1+β1 ANNit+β2FISCit+β3IntlRiskt+β4LIQit+εit

In this model, ANN denotes the announcements of bank rescue packages made by individual euro area governments (this variable takes the value 1 after the date of the announcement and the value 0 before); FISC denotes the expected general government budget balance and/or gross debt as a share of GDP, relative to Germany, over the next two years, as released biannually by the European Commission; IntlRisk is a proxy for international investor risk aversion, as measured by the difference between the ten-year AAA-rated corporate bond yield in the United States and the US ten-year Treasury bond yield; LIQ is a proxy for the degree of liquidity of euro area government bond markets, measured by the size of a government’s gross debt issuance relative to Germany; εit is the unexplained residual."

For the lack of time right now, I can't re-parameterize the model to derive the values of the fundamentals-justified spread for Ireland. I shall do this over the weekend, but here are the main results for the group of 10 countries:
Good luck.

Economics 02/07/2009: Downgrade on Irish debt

Moody's downgraded Ireland from top Aaa government-bond ratings one notch to Aa1 (hat tip to PMD) saying that Ireland's policy response to the economic downturn had been decisive and the government had a strong balance sheet before the crisis struck, so there was only a need for a moderate downgrade. The ratings were on watch for possible reduction since April. So the move was widely expected.

"The review process focused on the nature of the policy response and the extent to which the Irish economic model was durably affected by a sudden and brutal economic and financial adjustment," said Moody's Sovereign Risk Group analyst.

Despite politically correct chatter about ‘decisive response’ etc, Moody's still has a negative outlook on Irish ratings. Why? Risk of further deterioration in terms of debt affordability (as measured by the share of government revenue used for interest payments) and financeability (the cost at which the country can raise more debt).

Per WSJ report, the ratings agency said debt dynamics will remain unfavorable for the country for several years, and that downside risks outweigh upside risks in the near to medium term.

Economics 12/06/2009: NTMA gamble

My apologies for staying off the blog posts for some time now - travel and compressed number of commitments this week have kept me with no time for blogging. Hopefully, this brief interlude is now over.

Per NTMA release:
"Irish Government Bond Auction on Tuesday 16 June 2009
The Irish National Treasury Management Agency (NTMA) announces that it will hold an auction of Irish Government bonds on Tuesday next 16 June, closing at 10.00 a.m.
Two bonds will be offered in the auction –
3.9% Treasury Bond 2012
4.6% Treasury Bond 2016
The overall total amount of the two bonds to be auctioned will be in the range of €750 million to €1 billion."

This is clearly a gamble on the 2016 bond and another tranche of medium term borrowing for 2012 issues.

Two problems continue to plague NTMA in my view:

Problem 1: issuance of bonds maturing prior to the magic 2013 deadline is threatening to derail the fiscal adjustments promised to the EU Commission, as these bonds will have to be rolled over into new issues and, potentially, at a higher yield. This also relates to the problem faced by the buyers of these bonds, as prices are likely to be depressed further should interest rates environment change.

Problem 2: signaling via maturity suggests that we are in trouble. If the state cannot issue credible 10+ year bonds, what does this say about the markets perception of the quality of our finances?

The bet NTMA are entering with the 7-year bond is that healthy results in the latest US Treasuries auction for 30-year paper yesterday will translate into a general bond markets demand improving.

Here are the combined results for the entire H1 2009 to date in issuance of bonds... not that NTMA would bother to put these in an Excel file for all to use...

First long-term:
Telling us that longer term bonds cover is at risk of being thin again (2.7 in March, down to 1.1 in April and up to 1.8 in May). Effective yields are rising: March issue at 4.5 coupon yields 5.81%, then down to April issue at 4.5 coupon yielding 5.08%, and up to May issue at 4.40 coupon and 5.19% yield. Next one will have 4.60 coupon and at what effective yield?

Plus notice how, with exception of one bond placement, all issues have gone past 2013. This means that offering another 2012 maturity bond next week is a sign of growing concerns for NTMA.

Short-term: a sea of borrowings here:
Covers are getting healthier, spreads on yields are shrinking and maximum allocated yields are starting to notch up again. What does it mean? Short-term money is relatively abundant and so covers should not be a problem for any non-junk paper, but the markets pricing spreads are getting tighter, more compressed to the higher yield range.
One more comment - both OECD and IMF have warned the governments not to succumb to a temptation to issue short term paper as refinancing it will bear a risk of higher yields. Guess what - based on the evidence above - is our Exchequer doing? H1 2009 issues to date:

• paper maturing in or before 2013: €12,157mln
• paper maturing after 2013: €2,978mln

Nothing more to say...

Economics 04/06/2009: Exchequer returns for May

First order of business today is to say "Happy Birthday, Jen" to my (much) better half - "I miss you here in Moscow!"

Second order of business is the Exchequer release from yesterday. As my access to data and software is somewhat more restricted here, it is a short analysis:

January-May 2009 tax receipts are in and they are down €3.6bn y-o-y – 21%, slightly better than –24% decline in January-April. Uncork that vintage Dom, Brian? Not yet…

Budget expectations are for 15.6% decline in the entire 2009. Not likely at the current rate. So far we have: 5 months receipts accounting for 39% of the total of projected annual intake of €34.4bn. Annual projection from here suggests that we are going to see around €32-33bn assuming all goes as planned.

Good news, in 2007 we also had 39% collected by the end of May. Bad news is – we had a very robust flow of business for SMEs and self-employed – all of whom force tax payments into the end of the year. Now, recall that we are going to see two things around October-November: (1) tax returns reconciled for 2008, (2) tax returns estimates for 2009. On (1) we can assume that estimates made, say in October 2008 did not fully take in the carnage of November-December, so estimated payments back in October 2008 will be erring on higher side, implying that the actual returns filed in autumn 2009 might be much weaker. On (2), given the current tax measures in place, businesses and self-employed will do everything possible to reduce and delay payments, so estimates will be erring on a lower side and tax deductions will be used to the max. I am not sure that a combination of (1) and (2) will not provide for relatively poor showing in autumn returns.

Current moderating is most likely reflective of the fact that the first half of 2008 was relatively buoyant, so the corresponding period in 2009 is going to register steeper declines. This will moderate into the second half of 2009, naturally, but it will mean preciously little, because any decline on the debacle that we witnessed in H2 2009 is going to be a disaster reinforced.

Another issue to keep in mind: current figures include two rounds of tax increases – Budget 2009 and, partially, Supplementary Budget 2009 – some €230mln added in 5 months. So one can expect further push on tax receipts side. The fact that it is not very impressive is telling me that tax measures are not working and tax substitution and minimization are now working their way through the economy.

To see how bad the new tax measures are at raising revenue – consider the fact that tax receipts in April were 1.7% below the tax profile published on April 28. In other words, within days, the receipts have already slowed down 1.7% relative to what DofF expected. May figures were 1.9% ahead of the profile: Corpo Taxes came in €155mln ahead of profile, Excise and Income taxes were ahead by €48mln and €39mln, respectively. VAT was down €139 million on profile in the month. So, ok – we are now bang on the target when it comes to profile.
Note: the source for the above table is Ulster Bank, with minor adjsutments by me.

But Income tax receipts were driven by new taxes, as are Excise duties, and the two will see some new pressure per optimising households and businesses. Corpo tax can surprise on the upside, assuming the US MNCs continue to book profits here – that is the big unknown in my view. CGT is also a candidate for downgrades as investors are shifting out of Ireland, booking losses here. In general, apart from income tax, other revenues were down 27% in May – a moderation of sorts on 32% decline in April, but the flattening out of the tax decreases curve is not anything to cheer about – it is simply the nature of any asymptotic dynamics: the closer you get to absolute zero, the slower the pace.

So back to income tax measures: €48mln monthly gains in May suggest that the income tax measures to date are yielding: 48mln*5/0.39=615mln in revenue, assuming that income tax follows the same path over the year as total tax receipts. A far cry from €1.5-2bn envisioned and very much close to what myself and other observers were expecting back in April.

In the mean time, spending races ahead: current expenditure was up 4.3% (in April it was up 4.5% but the latest ‘moderation’ is still placing current spending at an insolvency levels and the decrease was due to factors other than demand for social welfare and public sector wages). Capital spend continues to fall - down 6.3% year-on-year. Some suggested that there are timing issues delaying capital spending boost, but we are now 5 months into the year and this leaves me wondering – what sort of timing are we talking about?

On the net, therefore, May figures are no real improvement: receipts are flattening at a very slow rate, we might be closer to target here than before, but this only means a difference of €1-2bn on revenue side – a chop-change for our public sector wasters. On expenditure side, we are now 10 months past the July 2008 promises by the Government to introduce real savings, and… zilch, nada, none, nyet, can’t find any no matter how hard I am looking… If a rapidly decaying alcoholic were to be the allegory for the Exchequer balance sheet, we are past the gulp stage and into a burp moment. The hand with a bottle is rising once again, drawing closer and closer to the mouth. How long can this last? Your guess is as good as mine, but a friend today suggested that 6 weeks from now the Government will say, “Whoops, due to international economic conditions (WHICH HAVE NOTHING TO DO WITH THE LAST 12 YEARS OF FIANNA FAIL RULE) our readiness for rebound which was most certainly there when we said so has now disappeared. Not our fault, mate.”

Sounds about right…

Economics 28/05/2009: Two questions, US economy

Some months ago I was telling the readers of this blog and of my column in Business & Finance magazine to keep an eye on US Munis markets. Well, now is the time, especially California Munis... Good hunting...


I have two questions to ask our Brian 'Detouched-from-Reality' Lenihan and his lappy-Lassie Alan 'Tax-em-Brian' Ahearne:

1) If Ireland were to go to the markets with a bond placement of an odd Euro40-50bn, what chances do we have getting such an issue away without direct ECB help?
and
2) If ECB were to contemplate such a support scheme for Ireland, will it be willing to also underwrite our structural deficit - the deficit that is pure lard for Irish public sector pay and perks?

These are not some esoteric issues, they imply real risks to the systemic stability of Irish finances.

Question 1: in a recent IMF paper (here), the widening of CDS spreads for sovereign debt between Eurozone economies was explained by domestic 'vulnerabilities'. More specifically, the paper asserts that: "The sensitivity of countries to their domestic vulnerabilities appears to be conditioned by their loss of competitiveness over the upswing of the previous economic cycle. The countries with the largest decline in competitiveness display a particularly strong link between the prospects of the financial sector and sovereign spreads... The differentiation of countries by their debt levels is also stronger where the loss of competitiveness has been greater. The inference is that as external competitiveness has weakened, domestic vulnerabilities have acquired greater salience."

And further to the point: "another source of domestic vulnerability: public debt. ...think of loss of competitiveness as a proxy for weaker growth prospects, the question being posed is whether countries within particular competitiveness loss categories are differentiated by their debt ratios. The presumption is that with lower growth potential, a higher debt ratio will prove more onerous. This differentiation should, moreover, increase when the global growth prospects are substantially marked down, as after the fall of Lehman Brothers." And not surprisingly, the paper finds that it does matter - lower growth prospect means less sustainable debt at any given level.

So let us get back to Q1 above. What idiot in the market will be ready to take new Irish debt (Nama-related) with some Euro40-50bn in face value on anything even remotely close to the terms of our current bond offerings?

Which gets us to Q2 next. If no takers emerge, will the ECB cover Nama bonds? This is a question I have no answer to, but several divergent arguments can be made:

1. ECB might take Nama bonds directly to rescue Ireland, halting altogether or severely restricting acceptance of further Irish bonds as collateral (so Brian Lenihan will be forced to do something about deficits, having been restricted from using banks borrowings from ECB to float his Government). This is the most likely scenario, but it hinges on stable markets for German bund.
2. If German bund runs into thinner covers, the ECB will only part-finance Nama at the very best, holding its firepower for the potential need to cover some of the German issues. This will also restrict Brian Lenihan's ability to raid the ECB.

Either way, Irish Exchequer will feel some sort of a squeeze on its ability to support further borrowing. Which brings us to the potential response: a new mini-Budget in July. And either way, if you are holding Irish banks shares, give it a thought - do you really believe that ECB is going to print money for Nama on the back of a asset value discounts of 15-20%?


One interesting recent paper worth reading:
The role of the United States in the global economy and its evolution over time, by Stephane Dees and Arthur Saint-Guilhem, ECB WP 1034/March 2009 (see here). Authors assess the role of the US in the global economy and its evolution over time.

The paper shows first that “the transmission of US cyclical developments to the rest of the world tends to fluctuate over time but remains large overall. Second, although the size of the spillovers might have decreased in the most recent periods, the effects of changes in US economic activity seem to have become more persistent. Actually, the increasing economic integration at the world level [including ‘China effect’] is likely to have fostered second-round and third-market effects, making US cyclical developments more global”. This, of course, simply means that the US is still the engine of global growth, to the chagrin of all those who believe in the decoupling or the European-century hypotheses.

In addition, the study shows that “the slightly decreasing role of the US has been accompanied by an increasing importance of third players. Regional integration might have played a significant role by giving more weights to non-US trade partners in the sensitivity of the various economies to their international environment.” So regional integration did seemingly push some of the economies slightly away from their link with the US, as expected. However, when third-parties (deeper trade cross-links) are accounted for, the regionalization actually deepened these economies link with the US business cycle in the long run.

A 1% increase in the US real GDP tends to be transmitted based on the extent of trade links between the US and other economies. This means that economies with closer ties to the US tend to experience stronger and quicker responses to the shock. For the Euro area, such shock will lead to an increase in real GDP of 0.2% on average (the range is 0.05% to 0.3%) as opposed to 0.4% for Canada and other developed economies. In the UK and Japan the increase in only 0.2%. In all of these economies, the shock is fully absorbed within 5 quarters, as opposed to 3 years for emerging economies. In other words, all the whingeing of EU leaders about the ‘bad Americans’ giving us a deadly flu in this business cycle is a case of a dog that bites the hand which feeds it. Next time you hear Brian Cowen whimpering about the crisis brought onto Ireland and Europe by Americans, remember the figure: every time America grows by 1%, we grow by 0.2%. Converse, of course, is also true.

NTMA - a problem foretold

For months now I have been saying that soon, very soon, there will come a moment when the markets are not going to take any more of the Irish Government IOUs. At least not at the yields consistent with AAA, AA+, AA or even AA- ratings. The Government, its eager-to-please economic advisers and its boffins in the CBFSAI and DofF were not listening and continued to pile on debt commitments as if they were running a San Fran Fed, not an economy with 4.5mln people in it.

Today's NTMA results show that I was (and am) on the right track. I can't stress the fact that, in my view, NTMA are doing a good job in the current conditions, so whatever is to yet to come - it will be the fault of their masters in DofF and the Government.

In a quick summary, NTMA issued €1bn worth of bonds today in 5 and 9-year paper, with the markets willing to bid only €1.24bn on the offer - a 124% coverage overall. This compares with x3 times cover (300%+) for the previous auction. And, this time around, there was plenty of cash in the sovereign debt markets (not the case with the previous auction) with estimated €19bn worth of funds available for 'fishing'.

So what's at play? The 'bait' was off and the fish were too smart to line up for the Irish cast.

Last point first: Ireland to date has raised €12bn in its annual borrowing requirement (per DofF rosy estimate) of €25bn. This is just the stuff to finance the current deficit with. Again, per my projections we would need another €2-4bn in additional borrowings this year. How this can be achieved is unclear, as markets are getting thinner by the day and at €1bn per month, we are not getting there at any rate. But investors are bound to start getting even less welcoming when they realise that with NAMA, Ireland will have to open the flood gates for bonds issues - even at a hefty 40% discount, €90bn-strong NAMA will require €54bn in bond financing. That is the amount needed before we consider re-issuance of maturing paper...

Now to the wrong bait issue - the pricing of the bonds was very ambitious in my view - at 4% for €300mln worth 5-year paper (cover of 160%) and at 4.5% for a 9-year issue (cover at 110%). In March 24 auction, cover ratios achieved were 380% and 270%.

The next to watch is Thursday auction of short-term paper: 1-mo (€400-500mln), 3-mo (€500-600mln) and 6-mo (€400-500mln) T-Bills. If successful in finding a solid market, these might push Irish Government to switch into more aggressive financing through short-term debt - effectively creating a credit card system of financing for Irish deficits.

But even if the Government keeps short-term paper issuance at the going rate, it does appear to me that a part of the Government strategy is to use short-term bonds to finance spending in a hope that either:
(A) the economy improves dramatically (good luck to you chaps), or
(B) Brian Lenihan will raid the taxpayers in an even more massive robbery, comes Budget, or
(C) The ECB will take the balance off Brian's hands (in effect, we are borrowing recklessly short-term in a hope that a rich uncle rides into town with a wallet full of cash).
Otherwise, issuing 1-9mo debt when your problem is a structural deficit of ca €15bn (roughly 45% of your revenue) per annum is as close to playing a Russian Roulette as one can come.

But either way - (A) implies we can't deal with our mess ourselves (an embarrassing line of policy to take), (B) implies that the Government has no moral right to rule, while (C) implies that the Government is willing to go hat-in-hand to the world only to avoid threatening the Trade Unions. Take your pick.

Nationalize or else?..

I just received a good comment to an earlier post (here) that warrants a separate attention.

"Regarding NAMA, it seems to me that the one big advantage to this scheme is that it means someone will lend us enough money to cover the bank's bad debts, via the sleight of hand of issuing government bonds to the banks and then them redeeming this in hard cash from the ECB. I strongly suspect the Irish government would be hard pressed to borrow this kind of money from anywhere else.

What I don't understand is why we don't first just nationalize the banks. The question of proper pricing then becomes less of an issue. We'd be just moving money between different arms of the state.

One thing I've wondered about: can this device for swapping government bonds for euros only be done by a commercial entity? If we first nationalized the banks would such a move then be precluded? If so, maybe the government do secretly intend to largely nationalize them at a later stage after the cash has already been received from the ECB. I do hope there's some technical reason like this for not first nationalizing the banks, that the reasons are not purely political, because I've no confidence that the taxpayers will end up paying a fair price for these assets. Finbar."

There are several arguments in favour of nationalizing first, then deleveraging bad assets, recapitalizing and re-floating the banks. And there are several arguments against such an approach. I will first deal with arguments in favor of nationalization...

Pro-nationalization arguments:

1. Clarity of valuations: banks are not going to willingly reveal all pertinent information concerning loans quality to NAMA, so nationalizing them and then opening their books will provide much needed clarity concerning fundamentals relevant to valuations and pricing;
2. One-shot recapitalization: whatever price NAMA sets for impaired and stressed assets, such a price will either be too low to allow the banks to continue operating without further recapitalization injections, or too high to allow the Exchequer to recoup significant share of losses. Nationalizing the banks will resolve the problem, as capital requirements can be dropped significantly under a public guarantee on publicly-owned banks. The upside here is significant (see below);
   
3. Ownership-liability symmetry: under nationalization, ownership of banks assets will be fully coincident with the holder of liabilities - the State. This prevents a situation where taxpayers money is being used to underwrite private shareholders and bondsholders objectives;
4. Bond holders can get a haircut: under nationalization scheme, the Government can impose a stamp duty on bondholders in Irish banks, allowing for a partial recovery of funding and imposing a haircut on banks bondholders (currently covered by a blanket taxpayers'-financed guarantee);
5. Maximizing recovery for the taxpayers: if the objective of NAMA is to deliver value to the taxpayers, while deleveraging the banks balance sheets, nationalization, with a clear pre-commitment by the state to disburse banks equity via a voucher-based privatization within say 3-5 years will deliver both (see below for an outline of the scheme);
   
6. Avoiding discriminatory treatment of individual loans: Under NAMA arrangement, some developers / business owners that have performing loans against them might not want to face an arbitrary transfer of their loans to NAMA. This might be a litigious issue that can be fully resolved by an outright nationalization of the banks;
7. Change of the guard: Under nationalization, the Government will have a full right to change the executive structure of the banks and their boards to bring in new blood to run these institutions, breaking away with legacy issues in management.

Voucher scheme
To pre-commit to such a scheme, the Government can issue 3 or 5 year options on shares of the banks. For example, a part of existent equity in AIB can be converted into options at a price on the day of nationalization. Suppose, for the sake of illustration, that nationalization takes place on May 4, 2009.

Suppose that the Government commits to voucher-privatizzing 50% of the value of shares, retaining 50% shares in own account. April 30 closing price for AIB is €X. The European-style call options are issued on May 4, 2009 at an exercise price of €X with maturity date of, say, May 4, 2012.

The Government re-floats a part of its share holding in AIB on May 4, 2012 (Swedish Government retained ca25% of the banks shares on own account after re-privatization, so Irish Exchequer might want to do something similar). This sets the expiration price on AIB shares at S. If S>X, households holding options will exercise them, collecting S-X in profit. If not, they will forefeit any gains with no loss.

Two questions arise concerning such transaction:

• How the vouchers should be disbursed? My preference is to issue vouchers on a flat-rate basis to all households in Ireland in order to achieve a voucher-distribution that is reflective of the economic stimulus in line with an across-the-board tax cut;
• What will happen to AIB shares when vouchers are exercised? Nothing: markets at IPO will be pricing in an inflow of shares from the households as it will be pre-announced in advance.
  

The Government can collect a special rate CGT on such profit realization at, say, 30%, so that in effect there will be a 0.3*(S-X) payout to the Exchequer in addition to the retained shares value.

The upside to capitalization savings

Banks equity capital (BEC) = assets net of liabilities must legally not fall below 8% of the Risk-Weighted Assets (crudely for any given asset - e.g a loan or a bond - held by the bank, RWA =risk weight*asset value=RW*AV).

At the end of 2008 both banks hold ca €80bn in property loans of various quality. Not all of these loans will be earmarked for NAMA, so, having no better guidance from the NAMA itself, assume that the banks would want to off-load ca 3/5ths of this amount or €48bn.

(How do I get to this number? AIB has total assets of €182bn, RWA of €116bn, RW of 116/182= 63.7%, BEC €9.28bn and the actual Tier 1 capital of €9.9bn. BofI has assets of €204bn, RWA of €134bn, RW of 65.7%, BEC requirement of €10.72bn against the actual T1 capital of €10.1bn. Note that RW(BofI)>RW(AIB) implies lower quality of the BofI book. Prior to the first round of recapitalization, combined RWA €250bn, BEC Tiers 1&2 requirement of €20bn (0.08*250bn) just covered by the actual Teir 1 held. Any change in the NAV of underlying assets would have triggered a rise in RW thus driving the banking system below the 8% requirement, so the Government injected €7bn, thereby providing for the €87bn RWA cushion and raising Tier 1 capital to 10.8%. While sounding like a high number, this is pittance compared to the US and UK trend toward raising T1 ratios to 12-14% that would require a further injection of €3-8bn in cash, assuming there has been no deterioration in the assets quality since the end of 2008. Further note that total 6-banks property exposure ex Poland for AIB is €165bn. So far, we do not know how much NAMA will take on, but in the case of Securum - Sweden's bad bank - only took on non-performing loans. Now, AIB assumes max 25% non-performing loans on total development & property investment loan book, with current running non-performing loans at 3.5%, so our €48bn assumption is about coincident with the ca 25% non-performing loans assumption on property exposure across the 6 banks).

As Government bonds carry a RW=0, the value of NAMA bonds replacing specific assets will be excluded from RWA calcualtions. If NAMA buys €Xbn in loans at discount d%, then banks will get to write off €Xbn of assets, get €(1-d)*Xbn in state bonds in return and face a net cost of €dXbn to their capital, so that the combined banks RWA becomes €(250-(1-d)X)bn against Tier 1 capital of €27bn post re-capitalization. Writing off €dXbn of the value of the loans will hit the banks straight into their book value, thus cutting their equity capital - and directly hit their Tier 1 capital as well.

So Tier 1=27bn-dX=8% of RWA=250-(1-d)X. In other words, 0.08*[250-(1-d)X]=27-dX. Now, solving for discount factor:
d=[7+0.08X]/(1.08X).

If the Government wants to buy 3/5ths of the property-related loans, X=€48bn and d=20.9% - a scenario that would see the state issuing €38bn in new bonds - over 1/2 of the entire current Government debt.

Analysts estimate that the total loans impairments across BofI and AIB can run between €19-25bn. Adverse selection under the voluntary NAMA scheme imply that the banks will dump the lowest quality assets first. This means that under the scheme of 60% of loans being purchased by NAMA, the cost of the scheme - €38bn will be underwriting the asset base with expected recovery of just €48bn-19 or 25bn = 23-29bn, making an immediate loss to the taxpayers of €9-15bn.

Under nationalization scheme, the Government can blend assets at its own choosing, spreading the loss-implying assets across the books and it can drive T1 capital to 6% if it wants to. This would imply that, under an unbiased weighting scheme, NAMA will get €11.4-15bn in loss-inducing assets against the book that has
d=[14.9+0.06X]/(1.06X)=[14.9+0.06*48]/(1.06*48)=35%
costing the Exchequer €31.2bn in new bonds for an asset base with underlying recovery of €33-36.4bn - a nice expected profit of €1.8-5.2bn.

And this is the exact value of nationalization...

Arguments against nationalization will be dealt with in the follow up... (I need a smoke break!)

Daily Economics 08/04/09: Toxic Fumes from Toxic Bank

First a bit of news
A birdie in front of my window has just chirped (hat tip to the birdie) that the ECB has tentatively signaled to the Irish Government that it will finance (largely? or in full?) the 'bad bank'. Under such an arrangement, the state will issue a sea of bonds - say €30-60bn to cover €50-90bn of impaired loans floating out there - and swap these for freshly printed cash from the ECB. Taxpayers get debt. Government gets pile of assets with default rates of, ughh say 20-25% (?). Banks get cash.

Why would the state go for this? Because if we price this junk at a fair market value, taking it off the banks will still leave us exposed to the need to recapitalize the banks. As they write down their assets after the transfer, the value of an asset will drop - from its current risk-adjusted (if only bogus) valuation of, say €0.90 per €1 in face value, to a fair value of, say €0.50, implying a loss of €0.40 per €1 in face value. This will chip into banks' capital reserves, driving down their core capital.

So the state will pay over the odds for the default-ridden paper to avoid the follow-up recapitalization call. This will sound like a right thing to do, but given that the taxpayers will be holding highly risky debt for which they have overpaid, it is not.

Second source of added liability comes from the nature of assets transferred to the bad bank. Banks have an incentive to transfer impaired consumer loans - the loans on which they have hard time collecting. So the state impaired assets pool will be saddled with near-default mortgages and credit cards debt. This is political dynamite, for no state organization will enforce collection on these voters-sensitive assets.

So the taxpayers will end up banking with the state. The fat cats of the public sector will end up banking with BofI and AIB.

Why would the banks go for this? While getting rid of the troublesome assets, the banks will get capital injections and no equity dilution. The bondholders will be happy too - lower risk base, higher risk cushion imply lower spreads and thus higher prices. The taxpayers will have to get a second round of squeezing as repayment to the state will be required to compensate for losses generated by the overly-generous original pricing scheme. These will take form of 'Guarantee' dividends to the Exchequer which, alongside with existent preference shares, will lead to a widening in lending spreads and banking fees. Customers will have to pay the Government via the banks.

Why would the ECB go for this? Ah, the birdie told me that the ECB, desperate to find some solutions to similar banking problems elsewhere, is keen on using Ireland as a sort of policy lab. Given it's newly acquired mandate to print cash in quantitative easing exercise, this means the price of such Social Laboratory Ireland is low enough for them to deal on Irish 'bad' bank.

All happy, save the soon-to-be-stuffed-again taxpayers...


A follow up on the Budget
Following the Budget last night, Irish media has gone into an overdrive. The simplistic terminology and naive analysis dominate the space between print, radio and TV with commentators heralding the Budget as:

• 'tough' - nothing tough about slicing off an odd €3bn off a deficit that is so vast. We will have to borrow half of our annual spending requirement this year - primarily, to pay welfare rates and public sector wages. In family economics, such budgeting is known as 'reckless' or 'subprime'. In Lenihanomics it is known as 'making hard choices' (at the expense of others);
• 'fair' - there is nothing fair about the budget that has taken the pain of adjustments required by the serial failure of this Government (in its various past incarnations) to reign in its own cronies' spending and dumping it all onto the population at large. Nothing can be further away from being fair than an idea that you soak the private sector to insulate and even gold-plate more the lives of the true Irish elite - the public sector dons;
• 'timely' - there is nothing timely about the Budget that delivers in April 2009 the corrections promissed in July 2008;
• 'far-reaching' - aside from 'deep-reaching' into yours and my pockets, the Budget failed to deal with the most pressing issues at hand. The actual deficit problem remains unaddressed. Reform of public sector - unaddressed. Economic stimulus - unaddressed. Banks financing - unaddressed. You name the topic.

For anyone who still needs a more down-to-earth explanation of the budget, here is an illustration
The media reaction to the Budget is hardly surprising.

Irish intellectual milieu is based on a vicious pursuit of any independent analysis and thought with a goal of eliminating any possibility of serious dissent. Anyone with a point of view departing from the consensus is left jobless and/or branded as a hack or a generally diseased mind.

How many dissenters are ever asked to advise or brief the policymakers? None. How many non-consensus economists work for the Government? None. In our Universities? A handful and then only on junior posts. How many differing opinions does the Irish Times feature in its main pages? Virtually none, unless they can be comfortably pigeonholed into some agenda slot.

Hence today's reaction. But also the continuous drift of consensus opinion to the La-La land of pseudo intellectualism of some of our left-of-centre pontificates. This is not reflective of any public opinion in the streets, but it is reflective of the incestuous nature of our public policy discourse.

At least in the Soviet Union they respected dissidents enough to physically hunt them. Here, we are simply growing immune to independent thinking.


And the best non-economist analysis of the state of our affairs

The piers are pummelled by the waves;
In a lonely field the rain
Lashes an abandoned train;
Outlaws fill the mountain caves.

Fantastic grow the evening gowns;
Agents of the Fisc pursue
Absconding tax-defaulters through
The sewers of provincial towns.

Private rites of magic send
The temple prostitutes to sleep;
All the literati keep
An imaginary friend.

Cerebrotonic Cato may
Extol the Ancient Disciplines,
But the muscle-bound Marines
Mutiny for food and pay.

Caesar's double-bed is warm
As an unimportant clerk
Writes I DO NOT LIKE MY WORK
On a pink official form.

Unendowed with wealth or pity,
Little birds with scarlet legs,
Sitting on their speckled eggs,
Eye each flu-infected city.

Altogether elsewhere, vast
Herds of reindeer move across
Miles and miles of golden moss,
Silently and very fast.

W.H. Auden 'The Fall of Rome'

Mini-Budget 2009: A 'Fail' Grade

To summarize, mini-Budget failed to deliver the substantial public expenditure savings promised. As a result of destroying private wealth and failing to cut public sector waste, instead of reducing the Gen Government Deficit to 10.75% of GDP as claimed in the Budget (Table 5), Minister Lenihan has left a Deficit of -12.5% to -13.0% of GDP in 2009. Details below.

The mini-Budget 2009 Part 1 is in and the Government has done exactly what I've expected it to do - soaked the 'rich'. This time around, the 'rich' are no longer those with incomes in excess of €100K pa, but those with a pay of €30K pa. We are now in the 1980s economic management mode, full stop.

Microeconomic Impact: Households

• The heaviest hit are the ordinary income earners and savers: Income levies up, thresholds down. Impact: reduce incentives for work at the lower end of wage spectrum and generate more unemployment through adverse consumption and investment effects. Before this budget, it would have taken a person on welfare living in Dublin ca €35-37,000 in annual pre-tax wages to induce a move into job market. Now, the figure has risen to over €40,000. PRSI ceiling is up a whooping 44.2% to €75K pa. This is jobs creation Lenihan-style;
• DIRT is up from 23% to 25% and levies on non-life and life insurance are up. CGT and CAT are up from 22% to 25%. The CGT is a tax stripping off the savers/investors protection against past inflation, so Mr Lenihan is simply clawing back what was left to the investors after his predecessors generated a rampant inflation. This is savings and investment incentives Lenihan-style;
• Mortgage interest relief is cut and will be eliminated going forward (Budget 2010) - I hope people in negative equity losing their jobs will simply send their mortgage bills to Mr Lenihan. Let him pay it;
  
• Interest reliefs on investment properties and land development are down. The rich folks who bought a small apartment to rent it out in place of their pension (yes, those filthy-rich Celtic Tiger cubs who saved and worked hard to afford such 'luxury' as a pension investment) are getting Lenihan-styled treatment too.These measures, adopted amidst a wholesale collapse in the housing sector, are equivalent to applying heavy blood-letting to a patient with already dangerously low blood pressure.

Microeconomic Impact: Businesses

• Providing no measures to support jobs creation or entrepreneurship, Lenihan managed to mention only his Government's already discredited programme for 'knowledge and green' economy creation from December 2008 as a road map for what the Government intends to do to stimulate growth;
• No banks measures announced or budgeted for, implying that an expected budgetary cost of ca €4-5bn in 2009 due to potential demand for new banks funds is simply not factored into our expenditures. Neither are there any costings or provisions for the 'bad' bank;
• No credit finance resolutions, PRSI cuts for employers, minimum wage reductions etc;
• CAT and CGT taxes up, income of consumers down, insurance levies up... Lenihan-styled treatment for business support is so dramatic that it is clear we have a Government that only knows how to introduce pro-business and pro-growth policies for their own cronies.

Microeconomic Impact: Public Sector
The only clear winners in the Budget were public sector workers. They face no unemployment prospect, no imposition of any new levies or charges, no cuts in salaries or indeed no changes to their atavistic, inherently unproductive, working practices.

Yet, they can retire earlier with a tax-free lumps sum guaranteed. And no actuarial reduction for shorter work-life, implying that the cost of the Rolls-Royce pensions to all of us has just risen by a factor of at least 1/3! Happy times skinning the taxpayers to pay the fat cats of the public sector elites? Lenihan-styled sharing of pain.

Pat McArdle of the Ulster Bank in an excellent late-night note on the Budget said: "Our main quibble with the Budget is with the split of the burden between tax and spending. ...contrary to the recommendation of practically every economist in the country, they opted for a 55% to 45% split in favour of taxes".

This is correct. On the morning of the Budget day, Mr Lenihan told the nation that not a single economic adviser was suggesting that the Budget impact should fall onto expenditure side. Clearly, he was either incapable of listening or simpy arrogantly ignorant.

Adding insult to the injury, Lenihan also ensured that majority of cuts were to befall the already heavily hit middle classes. Microecnomically speaking, Minister Lenihan has just dug the private sector grave a few feet deeper. It was at 6ft before he walked into the Dail chamber. It was at 10ft once he finished his speech.

Macroeconomic Impact: When Figures Don't Add Up
In Macroeconomic terms, we are no longer living in Ireland. We are living in Cuba where numbers are fudged, forecasts are semi-transparent and the state knows better than the workers as to what we deserve to keep in terms of the fruits of our labour. Mr Lenihan has torn up any sort of social contract that could have existed between the vast majority of Irish people and this Government.

All data is from DofF Macroeconomic & Fiscal Framework 2009-2013 document.
More realistic assessment of the GDP collapse in 2009 is being met with a relatively optimistic assumption that GDP contraction will be only 2.9% in 2010. Even more lunatic is the assumption that Ireland will return to a trend growth of ca 4% in 2012-2013. So my assumptions are: -8-8.5% fall in GDP in 2009, -3.5-4% fall in 2010, +1% growth in 2011, +2% in 2012 and +2.2% in 2013. This will be reflected in my estimate of the balance sheet below.

Another thing clearly not understood by the Government is the relationship between income, excise and import duties. Imagine a person putting together a party for few friends. She had before the Budget €100 to spend on, say, booze. Now she has €90. Her VAT, excise, import duties on €100 of spend would have been ca €66. Now she goes off to Northern Ireland with her €90. Does the Government lose €66? No. It also looses other (complimentary) goods shopping revenue. Say that the cost of party-related goods is €250 worth of purchases at 21% VAT, 10% duties. Total cost of a €10 generated by Lenihan in income tax levies is a loss of over €140 in revenue. Good job, Brian. Your overpaid economic policy advisers couldn't see this coming?

Notice investment figures in the table above? Other sources of GDP growth? Well, DofF did apply a haircut on its projections in January 2009 update, but these corrections are seriously optimistic on 2011-2013 tail of the estimates. This again warrants more conservative estimates.
Judging by the inflation figures estimates, the DofF believes that the era of today's low interest rates is simply a permanent feature of the next 5-year horizon. Again, this is too optimistic and should it change will imply much deeper economic slowdown in 2010-2013 period.

Now to the estimates Table below summarizes the estimated impact of the measures.
Per DofF estimates, the Exchequer deficit drops, post mini-Budget-1, by ca €2.7bn in 2009 or 2% of GDP. This is rather optimistic. In reality, this estimation is done on a simple linear basis, assuming no further deterioration in receipts and a linear 1-to-1 response in tax revenue to tax measures. This also assumes the macro-fundamentals as outlined in the Table 2 discussed earlier.

Now, building in some of my outlook on the budget side and GDP growth side, Table below reproduces DofF Table 5 and adds two scenarios (with assumptions listed): From the above table, we compute the General Government Deficit (the figure that is the main benchmark for fiscal performance) as in the following Table:
This speaks volumes. The Government promised in January 2009 the EU Commission to deliver 9.5% deficit in 2009. It has subsequently reneged on this commitment, producing an estimated Gen Gov Deficit of 10.75% today. However, stress-testing the DofF often unrealistic assumptions provides for the potential deficit of 12.5-13.0% for this year.

But there is a tricky question to be asked. Has Lenihan actually gone too far on the tax increases side? Note that the estimated gross impact of the overall budgetary measures is €3.3bn for the remaining 8 months of 2009, implying an annual effect of €4.95bn in fiscal re-balancing. This is ca 2.9% of GDP - a sizable chunk of the economy. From that figure, per Table 5 above, the implied net loss to the economy from the Government measure (estimated originally at -1% of GDP) should be closer to 1.5-1.7%. This in turn implies that instead of an 7.7% contraction in GDP, the DofF should have been using a 9.2-9.4% contraction. In today's note, Ulster Bank economics team provides a revised estimate of GDP fall for 2009 at 9.5% for exactly this reason.
Mr Lenihan and his advisers simply missed the point that if you take money out of people's pockets, you are cutting growth in the economy. Of course, our Ministers, their senior civil servants and advisers would not be expected to know this, given they lead such sheltered life of privilege.

If the above estimates were to reflect this adjustment, we have: 2009 GDP of €168.2bn;General Government Deficit of 11% for DofF estimates, and 12.7-13.25% for my scenarios. I will do more detailed analysis for 2010-2013 horizon in a separate post, but it is now clear that the Government has not achieved its main objective of an orderly fiscal consolidation to 9.25% deficit. Neither has it achieved an objective of supporting the economy through the downturn.

Conclusions
Today's Budget delivered a nuclear strike to the heart of the private sector economy in Ireland. It furthermore underscored the Government commitment to providing jobs and pay protection for public sector workers regardless of the cost to the rest of this economy. We are in the 1980s scenario facing years of run-away, unsustainably high public spending and no improvements in public sector productivity amidst severe contraction in demand and investment at home and from abroad.

Minister Lenihan has promised to go on a road show selling Ireland Inc. I wish him good luck and I wish his audiences a keen eye to see through the fog of demagoguery this Government has produced in place of sensible economic policies. If they do, their response to Mr Lenihan's approaches is likely to be "Thank you, Minister. We don't need to invest in the economy that taxes producers, savers and consumers to protect public sector waste. Thank you and good by."
From an investment case point of view - they will be right.

PS: As the first fall-out from the Budget, Moody's downgraded Irish banks (here)... More to come.