12/9/2014: Irish Risk Ratings Comeback

Euromoney article on Ireland's improved risk ratings http://www.euromoney.com/Article/3379641/Category/14091/ChannelPage/8959/Irish-comeback-offers-a-safer-eurozone-bet.html

2/10/2013: Euro area sovereign crisis: predictable and reasonably priced?

• Can a model-based credit ratings system be used to predict future fiscal distress? Answer seems to be: yes.
• And have the fiscal downgrades of the euro area peripheral states been predictable in advance? Answer seems to be: yes.
• In other words, are the downgrades warranted by the actual pre-crisis dynamics in the economies? Answer seems to be: yes.
• Lastly, were there useful signals of stress build up that could have been considered by the policymakers prior to the onset of the crisis to alleviate or prevent the collapse of euro area peripherals? Answer seems to be: yes.

A new paper from CEPR (DP9665) titled "Sovereign credit ratings in the European Union: a model-based fiscal analysis" and authored by Vito Polito and Michael R. Wickens (September 2013: http://www.cepr.org/pubs/dps/DP9665) presents "a model-based measure of sovereign credit ratings derived solely from the fiscal position of a country: a forecast of its future debt liabilities, and its potential to use tax policy to repay these." [emphasis is mine]

The authors "use this measure to calculate credit ratings for fourteen European countries over the period 1995-2012. This measure identifies a European sovereign debt crisis almost two years before the official ratings of the credit rating agencies."

Ouch!

Now, the fourteen European (EU14) countries in the model-based calculations are Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Portugal, Spain, Sweden and the U.K.

So the main findings are: "…The model-based credit ratings:

1. Anticipate the downgrades of Ireland, Spain, Portugal and the U.K. that occurred from the end of the 2010s; 
2. Downgrade Greece to the lowest rating (coinciding with its highest default probability) from at least mid 2000; 
3. Suggest that the Italian sovereign credit rating has been overstated. 
4. For all other countries, the model-based credit ratings are similar, but not identical, to the credit ratings provided by the CRAs 

"An implication of these results is that the cross-section distribution of the model-based sovereign credit rating is no longer concentrated within the investment grade prior 2010 and it starts changing significantly from 2008. This suggests that a model-based credit rating would have identified and signalled to market participants signs of the impending European sovereign debt crisis well before 2010, when the CRAs first reacted to the crisis."

And the kicker: "A by-product of the methodology proposed in this paper is the quantification of a country's debt limit (measured as its maximum borrowing capacity) and how this changes over time. The numerical analysis suggests that for most EU14 countries the scope for increasing borrowing capacity by increasing taxation is limited as actual tax revenues are similar to tax revenues maximized with respect to tax rates."

In other words, we've run out of the road for taxing our way out of the crisis.

"Our findings suggest that EU14 countries are more likely to be able to raise debt limits and achieve fiscal consolidation by reducing their expenditures than by increasing taxes."

Any wonder? Ok, check out the first link here: http://trueeconomics.blogspot.ie/2013/10/2102013-low-tax-free-market-economy.html

21/12/2012: Slight upgrade for Ireland

Nice small present for the Day After (yep, that 'End of the World' thingy passed peacefully): Euromoney Credit Risk survey gave Ireland a small, but welcome upgrade:

Note that Ireland is just one of 3 countries receiving an upgrade.

Not a hugely significant development, but a nice step - 1 place up in the global rankings, now to 45th highest risk country (meaning there are 44 countries that rank less risky than Ireland). Do note, however, that our systemic risk scores in Structural Assessment has slipped, while Credit Ratings and Debt Indicators remained static.

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.

The cost of Ministerial chatter: Irish credit ratings

After a week of incomprehensible gibberish coming out of the Government statements on:

• borrowing restraints (here);
• receipts shortfalls (here and here);
• 'painful' solutions (aka destruction of private sector economy via fiscal policy - here);

and months of policy wobbles, two things came to their logical conclusion today.

The first one - reported (for now in very oblique terms - I will put more flesh on it when the embargo on the documents I received expires) here.

The second one - the S&P downgrade of Irish sovereign credit ratings.

Now, S&P is not known for being the quickest or the sharpest analysis provider on the block (I wrote about the need for a downgrade for some three months now), but at last they have moved, if only a notch, lowering Ireland's ratings from AAA to AA+ and retaining negative watch outlook (meaning more downgrades await).

I was neither surprised nor impressed by the S&P statement:

"March 30 - Standard & Poor's Ratings Services today said it had lowered its long-term sovereign credit rating on the Republic of Ireland to 'AA+' from 'AAA.' At the same time, the 'A-1+' short-term rating on the Republic was affirmed. The rating outlook is negative"

So far so good. Except in my view, a combination of the depth of our crisis, the severity of our economic policy failures and the lack of realism on behalf of this Government, pooled together with Cowen's unwavering determination to 'soak the rich' (middle and upper classes) to protect his cronies in the public sector - all warrant at the very least a downgrade to an A level. Given the structural nature of our deficits and Cowen's willingness to flip-flop on policy - an A- rating will be also justifiable.

Ok, back to S&P statement: "The downgrade reflects our view that the deterioration of Ireland's public finances will likely require a number of years of sustained effort to repair, on a scale greater than factored into the government's current plans," Standard & Poor's credit analyst David Beers said. As I said - lack of realism on behalf of the Government is costly. I have mentioned some recent evidence I got from the Partnership Talks (here). Telling... But what is also telling is the shade of realism that is being brought to the policy discussion table by the S&P, which is completely missed by the quasi-state ESRI (see here) who expect swift (2-3 year time horizon) action on closing structural deficits by increasing taxes.

The S&P is also referencing their belief that there will be further need for additional support for banking sector. I agree. And the Government has been boasting to the Partnership folks that it has resolved the banking crisis...

But here is a really good piece - bang on in line with what I've been warning about for a long time now. Despite our Government's senile belief that soon - a year or two from now - we are going to return to strong growth, S&P clearly states: "We expect that the Irish economy will materially under perform the Eurozone economy as a whole over the next five years, recording minimal growth in real and nominal GDP, on average, during the period. As a result, we believe that Ireland's net general government debt burden could peak at over 70% of GDP by 2013, a level we view as inconsistent with the prospective debt burdens of other small Eurozone sovereigns in the 'AAA' category."For comparison, here is the table from the DofF Junior Nostradamus's' January 2009 Update (below). This shows that our boffins are thinking we will be churning out 2.3% GDP growth in 2011, with 3.4% in 2012 and 3.0% in 2013...

Yeah, may be if we get Michael O'Leary to run this country...

"The medium-term prospects for the Irish economy are constrained by three interrelated factors: first, the impact on domestic demand as the private sector reduces its high debt burden, which stood at 280% of GDP in 2008; second, the scale of the deterioration of asset quality in the banking sector and possible need for additional capital; and, third, the support from external demand Ireland can expect as global economic conditions improve."

Ont the first point, I am again delighted that S&P decided to look beyond their naive insistence on focusing on public debt alone. Private debt mountains choking Ireland Inc (and soon to be added public taxation concrete weighing the economy down as we sink deeper into a recession) have been something I warned about for some time now.

On the second point, it is important to recognise that this Government has done virtually nothing to help repair the banks balance sheets and is not forcing households deeper into financial mess. Banking sector and real economy are linked.

• When a bank gets capital injection, but sees more mortgage holders defaulting because the Government has sucked their cash dry, what happens to banks assets?
  
• When a bank gets a deposits guarantee scheme at a cost to the system of €226mln since inception, but it costs the Exchequer twice as much due to higher cost of borrowing, what happens to the financial system's ability to provide credit finance?
  
• When a bank gets a promise to be rescued in some time in the future, but sees corporate deposits dry out today because the Government actually taxes companies (and sole traders) in advance of their receiving payments on overdue invoices, what happens to bank's capital?

Has Mr Lenihan bothered to take Level I CFA exams, he would have probably understood these brutal A-B-Cs of macrofinance. Alas, he didn't.

Now, next, the S&P avoids falling back into its comfort zone: "The government has already taken steps to contain the budgetary impact of these pressures, and further adjustments in taxation and spending, amounting to 2%-2.5% of GDP, are expected to be announced in next month's supplementary budget. At best, however, these measures will contain this year's general budget deficit to around 10% of GDP and lay the basis for a slow reduction in nominal budget deficits in future years. We are concerned, however, that a credible multi-year fiscal consolidation strategy will not emerge until after the next general elections, due by 2012. Accordingly, on current trends, we believe Irish net general government debt will likely exceed 70% of GDP by 2013 before beginning to trend downwards."

True that, as they say in the USofA. True that. Can you close your eyes and imagine Brian Cowen telling public sector unions that he is going to cut numbers of paper pushers employed in the public sector? or to trim their pay? or to eliminate our overseas aid budget? or to cut our defense spending by half to reflect the real might of our armed forces? or to privatize health care delivery (not access to services - delivery)? or to introduce efficient system of education fees? or that he will switch all public sector employees of age 45 and less into defined contribution private pension schemes? or that he will no longer automatically index pensions to already retired public sector workers to future wage increases in the sector? or that the corporatist model of centralized wage bargaining is done and over for ever? or that he will impose restrictions on striking activities in the public sector and will end job-for-life conditions of employment in the sector?

No? Neither do I. And neither does the S&P - at last.

Irish credit III

NTMA is brewing up a plan again (here). This time around, reportedly for a 5-year bond to be launched next Tuesday at 4.5%. Which would be a wishful thinking - the current bid yield is 60bps above that - if not for the possible caveat.

Oh no, the caveat is not about launching the bonds into the outter space from Baikonur Launching Station in Kazakhstan (although potentially only Martians would willingly take Irish paper on these terms and only Borat-land would underwrite such a launch). The caveat - speculative at this junction - is that the 'launch' will aim to place the bond in Irish banks and some into the eurozone CBs. The banks will then go to the ECB and get, ugh, 85c on a euro. A helicopter drop of money with Mr Trichet in the driving seat.

Now, don't take me wrong - NTMA has done some seriously competent job to date and, in my view, represents pretty much the second half of the two functioning financial organizations in this state (the Revenue Commissioners being another). But they are facing an increasingly impossible task of feeding the Brian-Brian-Mary T-Rex of fiscal excesses.

Last time around (see here) only 21% of the bond issue has gone to the willing private buyers. That issue was priced to the market median. This time, 4.50% implies only a 75bps premium over German 10-year bund placed earlier this week. Today's YTM on 10 Plus Bond Index was at 5.90% and no outstanding bond with maturity beyond 2014 was priced at YTM below 5%. So where does it leave the newest issue? My guess - at the ECB via a primary orbit of the Irish banks.

So let's speculate together:

Take 4.5% at 15% ECB discount on, say 79% of bonds placed via banks (and with CBs), 2018 10-year bond and March 16th closing (clean) price of 91.35. You have YTM of 4.64-4.89% - darn close to 4.5% NTMA dangling about, except it is priced off the February issue (extending the maturity horizon).

Now, move forward to 2019-2020 and take the same 4.5% bond at 15% discount, 85% placement with ECB and get 5.6% YTM at today's opening price. What is the YTM consistent with 100% placement at ECB? 6.4%, which in March 16th market corresponds to 11.5 cents discount on a Euro. Also nicely close to today's 15 cents discount at ECB window.

It all adds up iff we are setting up a sale to ECB. At ECB's discounts on near-junk paper (here)...

Housekeeping and S&P

You can see a quick snippet of my contribution to the Bloomberg report on Ireland today here.


But for now, the main piece of news of the week so far is the S&P downgrade of Irish Banks.

The downgrade is the second in just 4 months - took Ireland's Banking Industry Country Risk Assessment from Group 1 (prior to December), to Group 2 in December and now to Group 3. We are now in the sick puppies crate with Portugal, Austria and Japan. The first (December 2008) downgrade was based on S&P's negative assessment of banks loan books exposures to housing and construction. The latest downgrade is based on an all-but-silly argument that Anglo Irish Bank loans scandal has undermined reputation of Irish Banking, as if a litany of bad loans did nothing of the sort, or as if unethical manipulation of the banks books via cross deposits between IL&P and Anglo did nothing of the sorts.

More importantly, S&P has also threatened a further downgrade due shortly - this time on the back of "significantly weaker long-term prospects for the Irish economy". Such a downgrade will place us in a banking ICU with Greece, Israel, the Czech Republic, Slovakia and Slovenia in the neighboring beds.

But the real unspoken issue remain unaddressed.

• The Irish taxpayers have guaranteed the banking system's liabilities, nationalized one of the big 3 banks and committed to injecting capital into other.
  
• Yet, the ability of the Exchequer to cover these commitments has been deteriorating at a speed that would make Einstein's theory of relativity go bonkers.
  
• In the mean time, not-too-often remembered smaller banks, building societies and credit unions are getting their closets opened up by scandal-seeking media. And rich pickings these parish-pump financial institutions present under the inspecting lens of public attention.
• All along, housing markets are still falling, commercial property is heading South like a flock of geese sensing a winter chill and the economy is shrinking like ceran wrap on a fireplace mantle.

So here is a question that S&P is trying to avoid so desperately and our Government is bent on denying with the trustworthiness and passion of the banker telling the markets "Our books are sound and we need no new capital": Given Irish Exchequer decision to blend public debt with banks' liabilities and capital exposures, why should Ireland's General Government bonds be rated AAA?


Rome or Reykjavik?
In the mean time, economic silliness (I am avoiding here a much stronger word) continues to grip the Government, as the latest statements by Minister for Finance (see here), attest.

“A lot of political pundits say the choice next time for Ireland will be Rome or Reykjavik,” Lenihan said on Bloomberg TV today. “Most people will vote for Rome."

Yes, Minister, we get the historical pun. But do you actually mean what you are saying?

Ireland is already in the company of Rome in many senses. Being a part of the APIIGS countries we are in a club of the sickliest countries in Europe (and OECD) alongside Italy. We have surpassed Italian levels of unemployment and, should we adopt Minister Lenihan's suggestion and chose Rome, we will be settling into a trend (long-term) growth rate of 0.5% annually over the next 30 odd years. But then again, we have already surpassed Italy as a more corrupt society (according to the World Bank) and as our economy shrinks by 7+% this year and 16% between 2008-2010, we are well on track to be the Mezzogiorno of the North Atlantic (minus weather, food, wine and beaches of Sicily). And, of course we are heading for the glorious 100%+ public debt to GDP ratio should Brian Cowen, have his way with the economy. So, Mr Lenihan, is Irish Government really bent on getting Ireland to join Rome? Is this what you will be telling the international investors?

In reality, what this comment illustrates is that Mr Lenihan is much better fit to be a Minister for Justice than a Minister for Finance, for even his European references set is so limited to the legalities of European treaties that he forgets that the brief he has is in finance!

But there was more to Lenihan's comments than Rome v Reykjavik blunder. “The ECB stands behind the entire Irish banking system, just as the Bank of England will stand behind the banks in the U.K.,” said Lenihan. “So there’s no default issue in relation to the banking system.”

Irony has it, I predicted after the last issue of Government bonds in February that in effect Ireland is already being rescued by the ECB. Now, we have a confirmation. Mr Lenihan's reckless actions on Irish banks have been preconditioned upon his belief that the ECB is going to back him up!

Here are two follow up questions to this statement:
1) If this is true, when did you negotiate with the ECB actual arrangements for emergency financing for Irish banks?
2) Do Germans and French know about this ECB commitment to Ireland?

Lenihan said nothing on this, other than claim that Ireland will be "in a position to fund ourselves as a state this year and the European Central Bank stands behind our banking system... So we’re a solvent state and we’re well able to do our business.” This is eerily reminiscent of Eugene Sheehy's infamous battle cry that AIB will not take any public money last Autumn. We know how that one turned out in the end...

Setting aside the arguments as to whether or not Mr Lenihan can actually finance our Exchequer deficit this year, can we please see the actual contract that commits the ECB to underpinning the Irish Government guarantees to the Irish banks and provide capital to these banks?

New Credit Markets Acrobats: Brian, Brian & Mary

The media is now ‘seriously’ talking about the Government setting up a ‘shamrock’ SFEF-styled bond (named after Societe de Financement de l'Economie Francaise guaranteed bonds issued by the French) for Ireland (see here).

The bonds peddlers – primary and secondary alike – have been enthused. The idea is that an already nearly-insolvent state will issue strong-guarantee senior, cash-redeemable only bonds covered by Ireland’s AAA rating for a large volume issuance, blah-blah-blah…

In reality there are serious and insurmountable problems with the idea of Ireland Inc issuing a SFEF to be disbursed across Irish banks in order to aid their capitalization and re-start lending.

First problem is that this state can hardly convince the markets to buy its own bonds, let alone a stand-alone, ring-fenced ‘aid’ bonds. The General Government Guarantee for such bond will either have to take priority over the Government guarantees on its own direct debt in order to fly, or it will have to take a second seat to these in order to flop.

In the former case, you can throw away any hope of top tier ratings for Government bonds out of the window, and assign risk weightings to public debt on par or even in excess of those currently allocated to our banks. Hmmm… an appetizing prospect.

In the latter case, the SFEF will be subordinate to the Government Banks Guarantee Scheme (GBGS) – a measure that had spectacularly failed to deliver for the banks and for the Exchequer. Even more to the point here, Ireland’s €440bn bank guarantee scheme has in effect converted Irish banks debts and deposits into a SFEF-styled vehicle already. According to both the European Commission and the ECB – this was a bad deal for the country credit position.

In February 2009, the Commission said the GBGS could have a “potential negative impact on the long-term sustainability of public finances”. The ECB’s assessment of such schemes across the EU also reads like a wholesale condemnation of the overly-optimistic packages, with Irish GBGS being a front-runner for the title of the most reckless of all. “…Together with weakening fiscal positions in the wake of the economic crisis, the bank rescue packages seem to have contributed to a sharp widening of intra-euro area government bond spreads, in particular for member countries with weaker fiscal positions. Looking ahead, it is important that governments return to sound fiscal positions as soon as possible in order to maintain the public’s trust in the sustainability of public finances”.

Expanding the scope of GBGS to cover not only the existent debt and deposits, but also the future lending (under the SFEF), while pushing the Guarantees quality even below the already low stuff that the original Scheme delivered is not an appetizing prospect, either.

Now, another problem with SFEF is that it is restricted by the EU rules to a 2-3 year maturity window (with only a small portion allowed to be issued with a 4-5 year horizon). This means that any SFEF written in 2009 will mature in 2011-2012. The Government latest bond placement shows that from now on, we are likely to see most of the standard new Government debt hitting the 2012 maturity date (for 2009 issues) and 2013 date (for 2010 issues). There is absolutely not a snowball’s chance in Hell that we can frontload so much debt (once our own Exchequer borrowing requirements are factored in) into the economy for 2011-2013 horizon.

In my view, the Government is completely missing the point by pursuing this idiotically frantic search for new cash to throw at the problem of banks balance sheets. As I have proposed in this blog before (here) and in numerous articles in the press, the solution to the problem of stalled lending must begin at the coal face of the credit demand and supply imbalances. These are driven as much by a lack of funding as by a lack of demand for funding. The problem is therefore a twin collapse in fundamentals and it requires address both sides of equation simultaneously.

Side 1: collapsed supply of funding is driven by deterioration in banks balance sheets. Solution: help banks to unload bad loans off the books by doing equity-for-loans swaps under the capitalization scheme.

Side 2: collapsed demand for funding is driven by the excessive leverage of the households and corporates. Solution: take their bad loans and restructure them via a combination of a partial write-down (to the amount equal to the recapitalization funding given to the banks) and restructuring.

This is, really, the only way we can get out of this mess!

Buffet's Lesson from Ireland

Buffett Can't Find Green in Ireland, says Barron's (here)

"IT'S RARE FOR WARREN BUFFETT to suffer a near-total loss on an investment, but he did so with the purchase of shares of two Irish banks last year.

As he admitted in his annual shareholder letter, Buffett, the CEO of Berkshire Hathaway, invested $244 million in shares of two unnamed Irish banks. "At year-end, we wrote these holdings down to market: $27 million, for an 89% loss. Since then the stocks have declined even further. The tennis crowd would call my mistakes "unforced errors."

What were those two Irish bank stocks? We suspect that one of them is Allied Irish Banks (AIB), whose U.S.-listed shares are down to just $1 from a high of $45 last April...

What might have attracted Buffett to Allied Irish? Assuming he bought the stock, we suspect that he was motivated by the same reasoning that attracted Michael Price, a former mutual-fund star who runs MFP Investments.

At the Ira Sohn investment conference last May, Price recommended Allied Irish Banks, then trading around $41. Price said the stock looked cheap because it held a valuable stake in Buffalo-based M&T Bank (MTB). Excluding the M&T stake and another investment, Allied Irish was trading for just five times annual profits, Price asserted.

One reason we think that Buffett bought Allied Irish Banks is that Berkshire is the second-largest holder of M&T Bank at 6.7 million shares, behind Allied Irish Banks at 26.7 million shares. Buffett may have known about the Allied Irish holding in M&T, a bank that Buffett has praised in the past..."

Buffett's losses were small for Berkshire, but they are material for Ireland Inc.

Berkshire's mistake in buying into AIB had nothing to do with M&T share, which fell by only a third, as opposed to a 90%+ loss on AIB and BofI ("The other Irish bank whose shares were purchased by Berkshire could have been Bank of Ireland" says Barron's).

The real mistake was to buy into the banks run by the likes of Eugene Sheehy - a man who just last summer had a nerve to raise AIB's dividend in a clear case of mad macho bravado. And of course, his mistake was to buy into Ireland Inc regulatory circus - ran by a gang of financially inept political appointees of a regime that itself had one economic policy for all problems: throw more money at its cronies.

Now that Mr Buffett has learned his lesson, he will share it with the rest of the investment world. Who would bother putting any institutional money into this economy ever again? And who would bother buying Irish Government bonds backed by a claim on economy that is built on AIB-BofI-Anglo-IL&P-Nationwide & Co sand and issues bonds to keep this sand from liquefying under our feet?

Some housekeeping: a handful of updates

A cleaning up of some of my emails provided for a digest of interesting updates on the topics already covered in other posts. Here is an attempt to combine these...

To the QNHS (here) and Live Register data (here):

Per Davy note: "The worst affected areas [of unemployment] are building and those service sectors related to construction and the global financial crisis. Construction employment slid 7.6% quarter-on-quarter, followed by hotels and restaurants (- 3.2%), retail/wholesale (-2.3%) and financial/business services (-1.9%). No pain-sharing is evident in the data: private sector employment dropped 97,400 over the last 12 months while public employment increased by 10,000."

Last night I was a guest on a Late Debate (RTE Radio 1) alongside a SIPTU rep who was clearly traveling in some parallel reality claiming that:

• public sector took all the pain of adjustment to-date;
• those on higher incomes took no pain to date; and
• layoffs in public sector would be equivalent to layoffs in private sector.

Per point 1 - Davy note says it all, but an update on Exchequer results below also highlights the same.
Per point 2 - October Budget 2009 and its update, November Finance Bill II, both imposed progressively increasing Income Tax Levy on higher earners.
Per point 3 - two facts: (1) wage to value added ratio in Public Sectors (average) is ca 30% lower than in the Private Sector and some 1/3 lower than in the Financial and Business Services, and (2) wage to value added ratio in majority of public sector categories is close to or less than 1, so cutting 1 person out of the public sector would cost economy nothing (for ratio of 1) or would save economy some resources (for ratio is <1).
One caveat - of course, within Public Sector there are people who are highly contributive to the economy. For example: both IDA & Enterprise Ireland are aggregated into the above averages. These agencies have been significant contributors to the economic welfare in this country. Similarly, within each category, there is little understanding as to the variance of wage/ productivity ratios. E.g, do higher salaries in our flagship Universities relative to the second-tier third level institutions correspond to the productivity differentials? Knowing internal operations of Trinity, not exactly, but fairly closely. Thus, raising taxes in a 'proportionate' way as the Unions insist will hurt disproportionately more those who earn higher wages because of their higher productivity, even in the public sector.
Per Unions' 'Alternative Universe' - I got a general sense that our Unionists simply do not understand that in all instances, public sector workers depend for their wages on private sector earnings. Somehow, the Bearded Men of SIPTU/ICTU/CPSU/TGWU and the rest of the alphabet soup do not get the concept of who pays for what in this economy.

Per Exchequer Returns, February 2009 (here): there is significant evidence of deep wage cuts in private sector as income tax revenue continued to slide in January and February, despite the introduction of the income tax levy. In addition, current (non-capital) spending was up 3% y-o-y in February 2009. 2009 current spending is now on track to reach over 38% of Irish GNP - matching the record high achieved in 1983. Pure waste!

Financials and Other Stocks: as Davy puts it in a recent note: at the end of February 2009, the entire Irish Financial Sector accounted for only 3.5% of the Irish Stock Exchange capitalization as compared to 37.5% a year ago. This is diversification through attrition. The ISEQ dropped 10.3% in February - its sixth successive monthly decline. This was "the worst February performance in its 25-year history. It underperformed the FTSE Eurofirst 300 index, which also experienced its worst February performance, by 0.6%." A picture is worth a 1,000 words (all courtesy of Davy):
The last chart of course shows that Ireland is a absolute under-performer in its peer group. Davy do not analyse earnings in this context, but the above valuations are hardly making the shares cheaper. Earnings declines are now precipitous for all companies and my suspicion is that P/E ratios are falling. In other words, there is a question to be asked if there are any bargains out there given the earnings projections?Lastly, Davy provide a good snapshot of the bond markets dynamics in the chart reproduced above. Spot the odd-one-out? Note the timing of our departure to the Club Med of Near-Insolvent States - bang on coincident with Mr Lenihan's Budget... This should be a warning to everyone who is desperate for this Government to do something about the crisis: doing 'something', as opposed to doing the right thing, will make matters worse. Clearly, the markets are not seeing higher taxes and a lack of spending cuts (Budget 2009) as 'doing the right thing'.

Mansergh Calls for 'Celtic Tiger' Fat Cubs to pay their share in the downturn: Mr Mansergh - Bertie's pet in the Dail and a Junior Minister in the Cabinet - called yesterday for the tax measures in the mini-budget to focus on making sure that those who benefited most during the Celtic Tiger era pay more in taxes. Great idea from the Grand Weasel of Irish Politics. How about we start with Mr Mansergh himself - a person whose ministerial salary is out of touch with reality, and whose pension benefits are so lavish, that some bankers would envy the returns on so few years of such a non-demanding work as that of a Junior Minister for State with responsibility for the Arts. Mansergh serves in the cabinet which, with exception of 3-5 Ministers, is remarkable for its inability to do its job at a basic level. Yet the cabinet is being paid more than its counterparts in the US, UK, EU15 or indeed anywhere else in the developed/ democratic world. So, be my guest, Mr Mansergh - pony up, say 50% of your own income - you and your colleagues and their senior public service underlings are the Fat Celtic Tiger Cubs.

The Latest Exchequer Figures: can Biffo turn Gruffalo?

Gruffalo is a marvelously hideous and not-so-bright character in my son's favorite books. Today's Exchequer figures and the talk about the need for higher taxes and courageous Government policies remind me of this imaginary animal.

The preliminary Exchequer receipts show that we are on track to deliver on my forecast from February 8 (here) that estimated a tax revenue this year between €33.3bn (moderate case) and €34.5bn (benign scenario). Ulster Bank's Pat McArdle - an excellent economist with good knowledge of the budgetary nitty-gritty - agrees (his forecast produced today is €34bn). Of course, to remind you, DofF official forecast revenue is €37.7bn. Ya wish, baby!

It feels good (even in these sad circumstances) to be the first to deliver a correct prediction. The post - linked above - and the precedent ones (Update I and the original post) were bang on the money. The mini-budget is now inevitable by the end of March - spot on my prediction for tax increases before April made in December issue of Business&Finance and here.

Ulster Bank note (full credit to Pat McArdle) shows the rate of DofF's descent into forecasters' hell:

Forecast date: 6 Dec 2006 - €56.3 billion

Forecast date: 5 Dec 2007 - €51.8 billion

Forecast date: 14 Oct 2008 - €42.8 billion

Forecast date: 9 Jan 2009 - €37.0 billion

Current figures: Ulster Bank - €34.0 billion, my - €33.3-34.5 billion

As of today, we are some €22-23bn ahead of DofF-forecast for the shortfall. This, as McArdle rightly points out (I produced the same figure back in February) is approximately what we have to find to plug the hole in the side of our public spending Titanic.

Think about it: the hole is almost 70% of the entire revenue projected for this year. Can we plug the hole with a Gruffalian (draconian) 50% income tax increase?

Here is the breakdown of the revenue figures (again from Ulster Bank note):

I've said time and again that the Laffer Curve and tax minimization will imply that the revenue will fall as taxes rise or at the very least it will not rise in 1-to-1 relationship to tax rates increases. We have evidence of this. VAT receipts have fallen at more than 4 times the rate of fall in national income and in line with retail sales. Income tax receipts are down at ca 1.5 times of income contraction (and this is before self-assessment returns come in).

And as far as tax minimization goes - many of those on both high and low incomes are sole traders or business proprietors. These categories of workers do not pay income tax on a regular basis, bunching much of their payments into October. They do pay more regular VAT and this smooths quarterly VAT returns. Comes October, they will do everything legally possible to make sure Biffo-the-Gruffalo, Bromidic-Brian and Mary-the-Lottery-Winner don't get their paws on hard earned cash. In addition, the sole-traders on lower earnings will never be brought into the tax net, no matter how much the Government widens it, because they will 'adjust' their income to just below any feasible new threshold.

I did some crude maths on the two effects and here are my estimates.

First the assumptions. I assume that both Laffer Curve and Tax Minimization effects will reduce 1% increase in the rate of:

• Income tax to a 0.68% increase in underlying revenue (with Laffer effect reducing tax rate increase contribution by 20% and a Tax Minimization effect reducing it by further 15%),
  

• Corporate tax to a 0.6% increase in underlying revenue and
• Excise taxes to a 0.4% increase in underlying revenue.

Now, note I am not assuming that the Laffer effect will result in a fall off in revenue, but that it will only undermine the rate of revenue expansion. I then computed two scenarios:

Scenario 1: 'Biffo gets upset' - increasing excise tax rates by 20%, income tax rates by 25% and corporate tax rate by 10% across all possible bands. Under this scenario, gross annual revenue rises to €33.5bn assuming January-February slaughter of the Exchequer continues. To assure that budgetary deficit does not exceed DofF estimate of 9.5% of GDP, promised by Biffo to Brussels in January, and allowing for a 5% decline in GDP, Brian-Brian-and-Mary must come up with €6bn in fresh public sector cuts on top of the above tax increases and the pensions levy!

Scenario 2: 'Biffo goes Gruffalo' - increasing excise tax rates by 25%, income tax rates by 50% and corporate tax rate by 25% across all possible bands. The Gruffalo-Biffolo must come up with €3.1bn in fresh public sector cuts!

And that's before any second order effects of tax increases (dynamic Laffer Curve) and no spillover from higher taxes into weaker economy.

Pat McArdle estimates the required additional cuts to be around €4bn this year. Ok, close enough... An impossible task for Mr Cowen's gang of public sector appeaseniks.

Kranty - the end of the road? Updated

Updated below

"Kranty" is a Russian slang for German "Kaput", Italian "Finita la Comedia", or in plain English "The end of the road". You get the wind... So is the latest 3-year Irish bond issue of €4bn at 170bp over mid-swaps the end of the road for Irish Exchequer borrowing? The FT's Alphaville blog seems rather pessimistic (here). FT's blog musings aside, for a country which has seen CDS levels in excess of those paid on the senior debt of an embattled English retailer just a couple of weeks ago, the question is no longer of the extent of markets pessimism, but of fiscal survival.

And the latest bond offer is puzzling.

Borrow short to lend long?
First the 3-year term. It is equivalent to borrowing short to lend long, for even the DofF forecasts (rosy as they may be) imply that in 2012 - the bond will mature in the environment of a deficit of 4.75% of GDP and a General Gov Balance absent serial €16.5bn savings between now and then) of 12.25% of GDP. In other words, no one can seriously expect the Government to pay down the bond.

So why is this 3-year term? Is it because the NTMA could not place any new bonds on these terms with a longer maturity? Is it because the market pricing for a new 5-year bond would have implied an admission of a junk-level risk on Irish Government debt? The indications that an answer to these questions might be, sadly, a 'Yes' is in the details of the bond offer itself.

Costly, but small
This time around we are raising only 2/3rds of the volume of funds raised in January's €6bn placement. Given that the Government, post January issue, was in the need to somehow raise ca €19bn of new funds to plug its deficit this year alone, €4bn today is peanuts. Why not go to the markets early and raise, say €10bn? We know we'll have to do this at some time later in the year, by when many other countries would have gone to the markets and the spreads would have widened for all, including the Germans? In short, a miniscule placement today also suggests that quite possibly, NTMA could not place a sizable issue into the market.

Lastly, there are questions about the pricing of the bond. The FT blog outlines this problem perfectly: the latest bond "spread is almost five-times that of Barclays’ UK guaranteed 3-yr £3bn deal this week, which priced at 35bp over mid-swaps and Roche’s huge €5.25bn 4-yr deal at 225bp over". Yes, it is pricey, but it is not priced to sell.

Getting under the radar?
What is even more dodgy is that the NTMA claimed that the bond was over-subscribed to the tune of €1.2bn over the placed €4bn amount. In other words, the NTMA decided not to take more money today under the present bond issue despite knowing that it will have to tap markets for much more than that in the near future (here). Why? I have nagging suspicion - and this is speculative at this moment in time - that the bonds were issued to be placed primarily with the banks who can now roll them over to the ECB's lending window. Clearly, as a test case for the future, such a 'roll-over' had to be modest enough for the ECB (or other European states) not to smell a rat. Hence the €4bn ceiling.

Of course, there can be other possible explanations for the bizarre nature of the issue, but these are equally unflattering (see the update below). However a mere suspicion that something as problematic as the state issuing bonds for placement via the banks at the ECB would be a sign of desperation...

ECB's blind eye to Ireland?
From ECB's point of view, this might fly for only a short period of time. Here is why. The ECB is fully aware that the Irish Exchequer is bound to come knocking at its doors sooner, rather later. Yet, a publicly open and transparent loan from the ECB would have to carry serious policy prescriptions with it that would be matching those impose by the IMF on other countries: a 15-25% pay cut for the public sector, a 10-15% contraction in public expenditure across the board, a reform of public sector pensions and a significant divestment by the state out of its industrial shareholdings. These policies - necessary to keep cool other would be borrowers from ECB - will cost Brian-Brian-Mary their jobs and can potentially derail the Lisbon II ratification.

Hell, they might spell the end to the Euro itself, as a transparent rescue loan to Ireland will be followed by the demands for the similar lending from Italy, Greece, Spain, Portugal and possibly Austria.

So the ECB is absolutely desperately trying to find some face-saving formula to allow Ireland access to funds without opening the door for other Eurozone states and without imposing punishing conditions on our incompetent Government and overweight public sector.

Hmmmm... has anyone gave it a thought how are we going to squeeze out the remaining €15bn without anyone noticing, then?

Update I
It is now being rumored (hat tip to BL) that the NTMA was originally in the market for placing €6bn worth of bonds, got interest in €5.2bn, but due to extremely low offers (high yields) was forced to claw the issue back to €4bn. It correct, this implies that we have issued a bond with subscription rate of only 67% - by any reasonable measure constituting a failure by the state to finance less than 1/4 of its annual budgetary requirement. In other words - a failure of borrowing on a 3-year basis. Things can't get much more embarrassing than this, folks. And yet, to this moment, I have not seen a single media article, actually recognizing this reality. Is our media going 'soft'? or have we, engulfed in a rediculous charade of the Anglo Irish Banks scandals forgot about the reality of having to tap the markets for at least €15bn more in cash, having in effect failed to raise the mere €6bn last night?..

Germany to the Rescue! - Update I

Now a peak at the CDS spreads again (hat tip to BL). To my earlier post (here) see the chart below: Gheez - we have Irish CDS reaching toward Philippines around mid February...
Of course, per Davy (here) there is no need to panic. “The risk of Ireland not being able to meet ongoing debt payments over the next few years is very low.”

Low? Hmmm.

Ireland government bond CDS at 3.4% and a recovery rate of 40-50% is equivalent to a risk-neutral (frictionless markets etc) default probability of CDS/(1-RR)=3.4%/0.6 = 5.67 pa or (1- (1-0.0567)^5)=25.3% cumulative default probability over 5 years. For 50% recovery rate, the latter figure is 29.7%.

Now, investors are risk averse, not risk neutral, and the Irish bond market is not exactly frictionless which can push the above probabilities down, although we do not know by how much.

What is, however, not accounted for here is the potential downside to the recovery rate - the amount that can be expected to be recovered should a sovereign actually default. For now, the markets price in a 40% recovery, implying that in the case of a default investors can expect to get 40c on each Euro back. But how realistic is this?

One recent experience with sovereign default shows that in the case of Argentina in 2000-2002 (see Andritsky, J (2005) Default and Recovery Rates of Sovereign Bonds, The Journal of Fixed Income, September 2005)
" Uncertainty about the expected recovery value is a main caveat when pricing credit-contingent claims in reduced-form models...The resulting recovery value estimated from Argentine global bonds starts out above 50% and falls to 25% after default."
So back-track from the above to today's Ireland Inc scenario and, suppose the recovery rate of 60% today implies a recovery rate of 30-40% at default and the current probability of default over 5 years of (1-[100-CDS/(1-RR)/100]^5)=36%... Nothing to worry about, folks, then - in plain English the above means that if Ireland Inc is any better than Argentina (the country that routinely and with frightening regularity takes foreign investors to the cleaners), our CDS levels today might be consistent with an equilibrium cumulative default odds of over 1 chance in 3.

But hold on, if the CDS rates are not a decent measure of implied default probability and a purely speculative tool instead (as our Nobel-prize contesting gurus from Davy, the DofF and CB keep telling us), why should the CDS data track closely the yield spreads? Maybe because they 'kinda feel so, man!' or maybe because the speculators in both markets are all in some global conspiracy club (wearing Venitian Canvivale masks and speaking in secret signs), or maybe, just maybe, both markets are really not buying the DofF-led and Davy-repeated story of 'no risk of default for Ireland Inc'.

Either both, the markets for CDS and Irish bonds are wrong, or Davy and the Government are. Take your pick.

Germany to the Rescue!

And so it comes to pass that my comment yesterday on the German need for a rescue package for Ireland (see WSJ blog here) is today's FT Deutschland topic du jour:

FT Deutschland reports that Germany's Finance Minister, Peer Steinbruck said that the euro area will find a way to 'circumvent the legal no-bailout clause'. Steinbruck was talking specifically about the potential need to rescue Ireland on the back of a dramatic increase in our CDS spreads - those pesky 'speculative' things that our DofF dismissed as being irrelevant minority instruments (see here).

Oh, yes. Brian Cowen can start making the rounds - cap in hand. Just don't send that embarassment-in-a-Ministerial-Merc Mary to do the job, please, and don't tell Germans that we too share their fondness for a pint... We are no longer in a polite-visit-to-Japan territory. We are in a begging mood.

Steinbruck's comment is worrisome in terms of three issues:

1. Last night, the dollar rallied and the US Treasuries yeilds compressed on the back of a flight to safety, including the outflows from European bonds. Should Ireland tap into German funds for a rescue loan, Eurozone's golden standard German Bunds will suffer. If the rest of PIIGS were to follow Irish suit, there will be a wholesale downgrade in the Bund - a calamity for the Eurozone stability. So in the end, there is an argument that a rescue of Ireland might be forthcoming, if and only if that rescue is small enough - €2-3bn would work, €10bn probably won't. But of course Ireland's need for cash is nothing close to €2-3bn. Can Germany afford sacrificing its own bonds stability to plug Mr Cowen's budget deficit? Will Germany stand by and lend money to Ireland with no strings attached? Will German loans be better termed than those of the IMF?
2. No one in the media has mentioned the turn of the phrase used by Steinbruck: that 'circumvent the legal no-bailout clause' thingy. Even in better days of global growth, international markets did not look kindly on Eurozone's penchant for arbitrarilly re-writing its own rules of fiscla and monetary stability, as was done with the Maastricht criteria earlier this decade. Now, the appetite for reckless decisions is even lower. This presents a serious problem for the Euro - young currency's credibility is based on the rules underpinning its existence. Should these rules be 'circumvented', we may kiss good-by the idea of a stable Euro.
3. Steinbruck's comments on Ireland did nothing to explain his view of the risks facing the Eurozone in the context of reckless Irish spending and economic management. This might be signaling that instead of economic stability concerns, Steinbruck was thinking about political issues. Will German rescue of Ireand come at the expense of forcing this country to ratify the Lisbon Treaty? Quite possibly so. Blackmail has been used by the EU before - most notably in the agreements with Norway and Switzerland and in the case of Nice Treaty vote in Ireland, as well as in the case of the Danish rejection of the Maastricht Treaty.

Oh, dear...

Back from the snow

I am back in Dublin after a few days of snow-capped Italian Alps, great food, great wine, sunshine, crisp and clean mountains air. Friuli was, as it always is, a marvel!

What did I miss while away?

First, the recapitalization announced last week is not working. The magic, if a promise of the state taking a large chunk out of any future profitability, growth strategies and competitiveness of the Irish banks has had any magic in the first place, is now all gone. Gone because of the terms of this senile arrangement for all sides involved.
Here is how:
(1) The state is borrowing money at ca 5.5-5.7% in the market and injects money into the banks at 8%, earning risk unadjusted 2.5% return implying a risk-adjusted return (assuming our banks CDS spreads for last week) of ca -2-2.5%,
(2) The banks get money at 8%. Hostage to Government's demands on boards composition and lending, their profitability is shot for the foreseeable future,
(3) The banks are required to lend money out to businesses at... 8% (cost of funds) + admin cost (1.5%) so, say, ca 10% to repay the state,
(4) Businesses will stay away from this latest Government-engineered rip-off, while Ireland Inc's corporate and household balance sheets will still carry excessive levels of risk and debt and the economy will continue to spiral downward.
So, Minister Lenihan, the scheme cannot work even in theory. Forget about trying to make it work in practice.

Second, my favourite charts are updated to show that the things I missed while away were duly priced into Irish shares valuations by the market. Hey, at least the market still functions...

Third, I've missed some lively debates on certain 'academic' blogs about the pesky foreign commentators 'talking down' Irish Miracle Economy (and Government credit ratings). Needless to say, I am not amused:
(1) Some of those who made these comments themselves are keen on offering consultancy services advising foreign governments and commenting on their policies. Do their comments suggest that they claim a privilege to do what others should not be allowed?
(2) A part of this debate has finally exposed the undemocratic, technocratic nature of some of the members of the Irish intellectual elite. One commentator went as far as state that any publicly open debate exposes Ireland to the irrationality of the masses and that openness and freedom of expression thus are best reserved exclusively for discussions involving only 'informed' policymakers and analysts.

Which brings us to today's news: Irish 5-year CDS spreads have hit 378bps today, with a recovery rate of 40%, implying (assuming frictionless markets and no arbitrage) a lower bound of the Ireland Inc's default rate of 22%. Adding thinness of the markets (Irish bonds being traded in relatively small volumes, plus the half-day trading yesterday in the US) our implied sovereign default rate stands probably closer to 25%.

These are the resignable-level figures for our Brian-Brian-Mary Triumvirate of the Incompetents.

Paul De Grauwe View: Credit Trouble Ireland

"Spreads of sovereign debt within the eurozone have increased dramatically during the last few months, largely as a result of panic in the financial markets. When it engages in quantitative easing, the ECB should privilege the buying of Irish, Greek, Spanish and Italian government bonds to eliminate the distortions and the externalities that these spreads create,"
says Paul De Grauwe in his yesterday's post on Vox - a worthy reading.

What this means is that, as predicted in my earlier posts, Ireland is now a prime candidate for an ECB-led rescue. De facto, De Grauwe's proposition implies Irish Government issuing (near-)worthless bonds and placing these with ECB in return for loans - a scenario that is indistinguisheable from an actual lender-of-last-resort rescue or equivalent to IMF lending money to Ukraine, Latvia, Hungary and Iceland.

De Grauwe offers a rather conventional - but not necessarilly wrong - view of the bond markets as being gripped by a speculative panic:
"My hypothesis is that the widening bond spreads within the eurozone are the result of panic in the financial markets. The panic that followed the banking crises has led investors into a stampede away from private debt into assets that are deemed safe. These are mainly government bonds of a few countries. The US, Germany, and possibly France are a few of these countries that, for some strange reason, have been singled out as supplying safety. Other countries do not profit from the same 'panic flight to safety'."

This statement prompted, yesterday, a rushed welcoming from a member of the officialdom of Irish ecnomics (see here). And yet, had Irish econocrats read through De Grauwe's article in full, they would have arrived at the following statement:
"Only Greece and Ireland saw their bond rates increase significantly over the last year, suggesting that the increased spreads of these countries are not only due to panic."

Needless to say - I agree with De Grauwe. Irish (and PIIGS in general) spreads are fundamentally linked not to those of the other Eurozone states but to the lack of national competitiveness (see De Grauwe's chart on unit labour costs reproduced below), economic diversification, cumulative wealth of society, infrastructural and human capital and indeed many other economic fundamentals which determine the resilience of economy in a downturn. In short - not a panic, but a low productivity of the PIIGS economies drives the crisis.

Relative unit labour costs in Eurozone
Source: http://www.voxeu.org/index.php?q=node/3009

In short, our econocrats, so keen on pumping public sector investment into building up Ireland's capital base, infrastructure, education etc somehow managed to convince themselves that our deficit in these areas, alongside our vast and widening Exchequer shortfall, uncontrollable public spending growth, massive banks guarantees and recapitalization commitments by the state and macroeconomic management that requires raising taxes during a severe recession, all matter little to the bonds markets. Instead, the panic - that deus ex machina of economics - is the answer.

No need to panic then...

Falling from disgrace

Ah, another day, another screw up in the Biffoland – the veritable emporium of economic policy oddities and quaint Boggerista collectibles. So much drama, RTE’s / ESRI’s tax-everyone-to-death crowd is getting all excited. In reality, if 2008 was the year Biffo & Co have fallen from grace, 2009 is shaping up to be the year when they will fall through the bottom of hell itself.

The 'savage cuts' were announced at last – ‘adding to just under €2.1bn’ in RTE’s official interpretation. In the mean time, the Exchequer results get sidelined by David Begg’s and Jack O’Connor’s pleading poverty for the public sector workers.

Let’s cut through the fog, shall we?

In the entire ‘package’ announced by Cowen the only hard budgetary measure was the pension levy. But even here, Mr Cowen fails the reality test. If the pensions levy is tax deductible – and all indications are that it is – the alleged €1.4bn in savings will shrink to ca €800mln.

The only announced economic rescue measure – some two-years old capital spending programme slightly neutered by the second-largest ‘cut’ of the day. But give it a second to take the perverse 'logic' of this Government's thinking in. If capital spending programme under the NDP is a stimulus package today - in the recession - what on earth was it enacted for some two years ago? To boost rabid inflation to Zimbabwean levels?

The rest of this 'new' package is pure hot air.

Cuts in professional fees and administrative savings?.. This beggars a question why these were not cut by Biffo when he was the Minister for Finance? So, either Biffo was an inept Minister for Finance (in which case he has some room to cut these lines of spending today) or he is an inept Taoiseach (in which case he has no room to cut these). Take your pick.

Child benefit restriction – aiming to save €75mln – is another hit at the same soft target. Remember Budget 2009 – children already got some whacking from our Biffo ‘The Gruffalo’. How much more can he milk out of them, should more ‘adjustments’ be needed in the near future (see below)? Lots! He can tax the un-born off-springs of the rich (income in excess, of oughh, say €150K pa) household.


But all of this pales in comparison with what should have been done by the Government in today’s announcement. As my earlier posts (here and here) estimate, in 2009 we are going to face “a shortfall of up to €7,080mln on 2008 revenue, not €3,898mln as DofF forecast in January. My previous post forecast €7,698mnl shortfall, so January figure appears to be generally supportive of this.”

The latest Exchequer results have just run over my correction – given the latest figures and the dynamic of different tax lines deterioration, we are now facing at the very least a ca €8bn shortfall on 2008 figures. Belatedly, some economists are coming to a realization that this indeed is the case (see here and scroll to Niall Says: February 3rd, 2009 at 7:50 pm comment). We are back to that original estimate of mine and things are likely to get even worse from here on, implying today's cuts should have been in the neigbourhood of €4-5bn!

In the end, Brian Cowen has loudly and publicly declared tonight that anyone expecting him to govern this economy out of the recession is a fool. He hasn’t got the balls, he hasn’t got the ideas and he hasn’t got the Cabinet to do the job. Full stop.

Someone, dial Trichet’s private secretary. We will need his money very soon!

P.S. Here is a problem no one noticed for now. If the basket cases Ireland, Greece and Italy are weighing heavily on the reputation of the Euro, then the lack of an immediate adverse reaction to today’s announcement by the bond markets might suggest that the Magnificent Three are now creating a drag on German bunds. In other words, Irish, Greek and Italian mess is now costing real money to German taxpayers through elevated spreads on the bund. I’d venture to say that Mrs Merkel might be a bit concerned about Brian’s economic flops.

S&P's visit: Pints!

S&P gang is in town (hat tip to P.O.) making rounds, sniffing out the need to slam the book on Irish bonds AAA rating. Better late than never, I'd say.

This blog has argued on numerous occasions (here and here) that Irish credit ratings should fall from their current AAA rating to at least AA-/A- levels. In fact, I called for S&P to climb down from its ivory tower of 'Ireland's low public debt...' myth and produce a more realistic assessment of the risks inherent in our borrowings (here).

This, of course, was predicated on:

• Irish Government's exposure to toxic banks debt (here);
• Irish Government's exposure to its own reckless spending (here);
• Irish Government's inability to carry out necessary economic policy adjustments to address the real crises in this economy: corporate and household debt (here), and public sector excessive cost to the rest of the economy (here and here);
• Irish Government's lack of realistic understanding of how economy works (here and here);
• Irish Government's wobbling on various aspects of economic policy (see all the Mushroom Cloud posts in January 2008 archive)...

...and so on. I can go on listing more reasons as to why this is no longer an economy warranting a gold-standard AAA rating, but let me put three facts in front of you:

Fact 1: Despite having (belatedly) recognized the need for some sort of crisis management solutions in July 2008, the Government has yet to produce any realistic plan for dealing with the above problems.

Fact 2: Courtesy of FT (hat tip to B.) there is a self-explanatory chart below (corrected per Anonymous update, the number for Irish bank liabilities should be at 396% of GDP). Of course, those of you who are regular readers would recognize this as something I have written about ages ago (here), but FT's authority helps.
Fact 3: Finally, another chart illustrates the fact that no one in the market actually believes that our bonds offer AAA protection from default.
Pretty conclusive, then? So what's the point of sending a team over to Dubs, S&P? To have a few pints with our BB&M Trio and listen to their assurances that our 'greenish knowledge innovation' errr... economy-thingy is steaming ahead?

To the icebergs, then, Captain Brian!

PS: I am currently working on preparing a comprehensive compendium of comparisons per our debts (across various sectors and maturities) to the rest of the Eurozone, so keep watching the blog...

DofF Forecast: does it hold any water?

I have a serious question to ask of our Government: Do budgetary projections by the DofF in (e.g those contained in their January 2009 Addendum covered here) hold any water?

In particular, no one has yet taken the DofF forecasters to a task of explaining how on earth, with projected:

• shrinking GDP (-€7.6bn in 2009 in nominal terms relative to 2008) and GNP,
• negative inflation (-1%),
  
• rising unemployment (+2.9 percentage points on 2008) and falling employment (-4%), and
• rising, not falling, Net Current Expenditure (+4.3bn in 2009),
  

does DofF come up with a revenue fall-off of just €3.9bn for 2009 relative to 2008 and total revenue as a percentage of GDP actually rising from 33.6% in 2008 to 33.7% in 2009? (Those of you who are impatient enough, see one potential answer at the end of this post)...

These numbers - the backbone of Irish Government plans for the year - are suspiciously incongruous. Not only because they do not seem to add up. But also because we have no reason to trust DofF forecasts on the basis of their historical accuracy.

Do Government numbers hold up to scrutiny?
This week, it came to media attention that the entire Department of Finance employs only one PhD-level economist. As far as I am aware, we do not know:

1. Where and when did this person obtain her/his degree?
2. Was her/his degree in the field of macroeconomic modeling?
3. Has he/she ever published peer-reviewed research in the areas of taxation and/or macroeconomic forecasting?

In other words, we have no idea how qualified this economist is to carry out macroeconomic forecasting, policy evaluations and risk analysis.

Furthermore, per my knowledge, no one knows who exactly is responsible for supervision and execution of forecasting in DofF and what model is being used. Searching DofF website for Chief Economist reveals no such person. We do not know whether forecasting function is, indeed, an established and managerially resourced function of the Department. Ditto on the Risk Analysis side, which requires both an expert in microeconomic risk modeling and macroeconomic risk specialist.

It is simply not sufficient to say that accountancy or previous budgetary experience, potentially possessed by some DofF employees (how many?) qualifies the Department to deliver any sort of economic analysis or projections. Certainly not the ones which can used by the Government to argue about the need for one reform or another.

In fact, to see the absolute poverty of economic policy research output produced by DofF one should go straight to the source: here. They might as well publish these reports in Gaelic only, for no serious economist would recognize this as proper economics.

One example: in the sole document relating to economic reviews and outlook for 2008, titled Irealnd's Contribution to the Public Consultation Process on the Review of the EU Budget (I am not kidding - they couldn't even spell Ireland correctly). Here, DofF's 'Research' team devotes only 4 pages to the entire analysis of a vital fiscal policy process. The issue of EU-wide tax - something that was a hot topic of debate in Ireland throughout 2007-2008 is given 148 words! Of course, DofF gives five times this much to the discussion of CAP - suggesting, perhaps, our Finance boffins are more comfortable in the cow sheds than in the world of macro-finance and macroeconomics.

Getting basic research wrong - something that is being done by virtually all Irish Government departments on a routine basis - is a serious issue. Brandishing as a major reform a promise to get policies onto an 'evidence-driven' platform, as our Government did last week (see here: 3rd bullet point under Taxation heading), while having no capability to prepare proper economic analysis is hardly a responsible way of governing.

When even the mighty fail by poor research
Few months back, I was sent a research note from PIMCO's cult giant, Bill Gross. Gross is an archetypal salesman, in my view, who has fantastic intuitive understanding of the market (which is way more than our public sector mandarins and politicians have). This is, in most instances, sufficient to earn high rates of return and to contain downside risks.

But, it is not enough to do two things -
(a) provide rigorous analysis of your position in the market at any point in time - past, present, or future; and
(b) explain to others why your intuitive searchlight is capable of picking the right opportunities out of the mass of potential investment strategies.

Published in June 2008 (see here: those of you who attended my class last Fall in TCD's MSc in Finance would recognize it) the note contained a rant about US inflation indices. Specifically, Gross expended some 4 pages of small print arguing that

1. US inflation has been historically higher than measured by the CPI;
2. True US inflation should be much closer to the 'global' average (including such economically stable and developed countries like Venezuela, Indonesia, Brazil, Philippines, Thailand, Columbia, Turkey, Ecuador and Vietnam - out of a sample of 24 countries chosen, seemingly, to deliver Gross' point).
   

All of this led to the following conclusion:
"What are the investment ramifications [of the 'fact' that U.S. inflation is closer to worldwide levels than previously thought]? With global headline inflation now at 7% there is a need for new global investment solutions, a role that PIMCO is more than willing (and able) to provide. In this role we would suggest: 1) Treasury bonds are obviously not to be favored because of their negative (unreal) real yields. 2) U.S. TIPS, while affording headline CPI protection, risk the delusion of an artificially low inflation number as well. 3) On the other hand, commodity-based assets as well as foreign equities whose P/Es are better grounded with local CPI and nominal bond yield comparisons should be excellent candidates. 4) These assets should in turn be denominated in currencies that demonstrate authentic real growth and inflation rates, that while high, at least are credible. 5) Developing, BRIC-like economies are obvious choices for investment dollars."

Lacking:

• serious analysis - Gross tweaked the evidence to support his own premise;
• proper investigation of academic and practitioner research - Gross ignored the fact that several Congressional and academic investigations since the early 1990s have concluded that CPI actually overestimates the true extent of inflation in the US by between 0.5% and 1% pa,

he produced a call to arms for investors that cost PIMCO and those who follow its strategy an arm and a leg. How? Gross' advice - issued in June 2008 -

• has missed a significant H2 2008 rally in Treasuries, Munis and TIPS;
• calling for heavier weighting for commodities-linked economies came at the time of extreme valuations of these economies (e.g Russia and Brazil both have peaked in June-August 2008), before they fell off the cliff in H2 2008;
• led to an unprecedented cancellation of dividends by several PIMCO munis funds - the first time in known history any fund suspended payouts for what is, in effect, a monthly yield-generating securities class.

I do enjoy the fact that, being criticised at the time for arguing against Gross' June note, I did turn out to be right about both his call on inflation (he was concerned with hyper-inflation as the world was teetering on the verge of deflation) and on emerging markets.

Back to DofF numbers
But I am not telling this story with some malice towards Gross or PIMCO in mind. At the very least, the man can spell Ireland better than our DofF boffins can. Instead, I am using it as an illustration as to the importance of proper research in backing any strategy - investment and/or policy-related. PIMCO's operations are much more superior to what is going on in our DofF and the rest of civil service when it comes to the quality of research and analysis. This implies that if people like Gross can get things spectacularly wrong, people that occupy our DofF - quipped with one token PhD level economist - simply have no chance at getting anything right.

Remember their latest numbers:

• shrinking GDP (-€7.6bn relative to 2008),
• negative inflation (-1%),
  
• rising unemployment (+2.9 percentage points on 2008) and falling employment (-4%),
• a revenue fall-off for the Exchequer of just €3.9bn for 2009 relative to 2008, and
  
• a total revenue as a percentage of GDP actually rising from 33.6% in 2008 to 33.7% in 2009

Well, of course to get these things to add up, one has to assume that tax increases passed in the Budget 2009 will not reduce tax revenue. In other words, that the Laffer Curve does not work. We shall see, of course, but empirical studies provide little comfort that such an assumption is a reasonable one. Ditto the numbers on retail spending in the NI and South of the border, SuperQuinn's plan to shut down supermarket located near Newry and loads of anecdotal evidence showing that Irish shoppers are fleeing the Republic for that VAT heaven of NI.

This spells serious trouble for the Government. Suppose that due to increases in the income tax, VAT and other taxes, the revenue were to decline by, say, 2.1% of GDP - as it did in less recessionary 2008. This would imply that tax increases will still be contributing positive revenue growth for the Exchequer, although on a much smaller scale. In such a scenario,

• the net Exchequer borrowing will jump from 6.3% of GDP to 8.4% of GDP,
• the General Government Deficit will rise by €3.8bn in 2009 - from 9.1% of GDP projected by DofF assuming €2bn in savings goes through, to over 12%.

Now, suppose tax increases wipe out any revenue gains by 2010 - the deficit will then rise to above 13% of GDP in 2009 and 15% in 2010.

Add to this the fact that while DofF was basing its numbers on -4% growth rate in GDP for 2009, the economy quite probably will contract by at least 5% - balooning potential deficit to 15-16% this year.

A scary thought, indeed, because even the IMF will not lend Mr Cowen a penny with such financial performance on the plans. So much for Brian, Brian&Mary's 'evidence-based' policies...