19/02/2011: Paying down our debt out of Exports

Let's do a quick exercise. Suppose we take our current account - defined as the sum of the balance of trade (exports minus imports of goods and services), net factor income (such as interest and dividends) and net transfer payments (such as foreign aid and remitted profits). Suppose every year we use the current account balance solely for the purpose of repaying our Government debt. How long will it take us to do so.

Let us start with some notes on methodology.

Our current account is in deficit - since 2000, there was only one year - 2003 - when we had a surplus in the current account (charts below), which really means our external trade was not enough to generate a surplus to the economy. So let us assume that the we can reverse this 180 degrees and that the deficits posted in 2009-2010, plus those projected by the IMF to occur in 2011-2015 are all diverted to pay our Government debt.
Notice - this is impossibly optimistic, as our Government does not own current account, but suppose, for the sake of this exercise that it can fully capture net profits transfers abroad and cut the foreign aid to zero, plus divert all interest payments on own debt and private external debts to repayment of the principal on own debt.

Secondly, assume that only Government debt is taken into the account (in other words, we assume away Nama debt, some of the quasi-sovereign financing of the banks resolutions, and all and any potential future banks and spending demands in excess of the EU/IMF assumptions, as well as all future bonds redemptions - the latter assumed to have a zero net effect at roll-over, so no added costs, no higher interest rates, etc).

In other words, here is what we are paying down in this exercise:

Now, suppose we take current account balances for 2009-2015 (projected by IMF) as the starting point. The reason for this choice of years is that they omit fall-off in our exports in 2008 and also the bubble years of 2004-2007 when our current account imbalances were absurdly large due to excessive outward investment and consumption of imports.

Next, assume:

• We deal with present value of the debts
  
• We apply an average 3% annual growth rate to repayments we make (current account transfers grow 3% on average per annum)
  
• Currency effects are removed (so we use flat USD1.33/Euro FX rate throughout)

So here is the result:
And the conclusion is: if Ireland diverts ALL of its net current account (2009-2015 IMF projections taken at 3% average growth rate forward) to pay down Gov debt, it will take us until 2064 to reach 2007 level of official (ex-Nama+banks) Government debt.

Note: incidentally - the charts tell couple of interesting side-points based on our historical debt path:

The Government told us that we are not in the 1980s - as we had much higher levels of debt then. Ok, the figure above shows that as of 2010 - we ARE back in the 1980s: 2011 debt will equal as a share of GDP that attained in 1989. According to IMF database, our debt has peaked at 109.241% of GDP back in 1987. It is projected to be 104.7% in 2013. Not that much off the peak.

But, of course, in the 1980s there was no quasi-Governmental debt - the debt of Nama, some of the banks recapitalization measures and the debts that still might arise post-2013 from the Government banks Guarantees and resolution schemes. If we add Nama's 31bn worth of debt issued, this alone will push our 2011 debt levels to 121.8% of GDP and factoring in coupon rate on these, but 2015 our Official Gov Debt + Nama will stand (using IMF projections again) at 124.8% of GDP - well in excess of the peak 1980s levels of indebtedness.

Secondly, despite what any of us might think about the Celtic Tiger years, the Government never paid down the old debt, it simply was deflated by rising GDP. Which suggests that even during the Celtic Tiger boom years - our exporting economy was NOT capable of paying down actual debt levels.

Economics 31/10/10: Mortgages, relief and stimulus

David McWilliams' idea of deferring mortgage repayments for 2 years is continuing to generate some discussions in the 'new' media. Here are my thoughts on the topic.

David's idea starts from the right premise that households are currently suffering from mortgage/debt repayment burden that is non-sustainable in the current economic conditions and acts to depress consumption and household investment. But in my view, it is not going to yield any significant impact on the economy.

As expected incomes fall due to:

• continued recession in the economy (courtesy of the insolvency crisis we face across the entire economy);
• elevated risk of unemployment (ditto);
• rising tax burden on households (courtesy of the Government's perverse logic which puts the needs of financial services and Exchequer ahead of those of the real economy - households and firms);
  
• heightened risk of further tax increases in the future (ditto);
  
• behavioral implications of the severe and deepening negative equity (being further reinforced by the FR and Government denial of the problem and asymmetric treatment of development debts and household debt); and
• continued increases in the cost of mortgages finance and credit (courtesy of the Government approach to dealing with the banking crisis)
  

Irish households are indeed under a severe financial stress. This stress is amplified by the adverse selection of younger (and thus more heavily leveraged) households into the higher risk of unemployment. These very households are also more important contributors to future private investment side of the economy, as older households are dis-saving to consume.

Collapse of consumption and household investment we are witnessing today is the direct outcome of the above forces and it will continue to worsen as long as households' disposable after tax incomes continue to decline and remain at risk of further pressure. In addition, non-discretionary segment of consumption (energy, education, transportation and health) show no signs of price deflation, implying that discretionary disposable after tax income - the stuff we get to spend in the shops or invest - is even more distressed.

The problem here is not that we face a temporary shock to our income. The problem is of debt overhang - basically, the insolvent nature of our households' balancesheets.

Thus, any solution to this problem will require a permanent debt writedown. It cannot be resolved by temporarily suspending mortgages repayments for several reasons:

1. Temporary suspension of mortgages repayments will not draw down the overall debt burden, as banks will reload increases in mortgage finance costs into the future to offset for losses incurred during the holiday even if there is no roll up of interest during the holiday. In other words - suspending mortgage repayment for 2 years will likely lead to banks pushing even higher cost of mortgages interest into years 3 and on for all households concerned;
2. Any rational household will anticipate (1) above to take place and will ramp up precautionary savings to compensate for expected cost increases in their mortgages, withdrawing even more cash from today's consumption. A mortgage holiday in these conditions will lead to zombie banks turning into zombie households;
3. Any rational household will, also in anticipation of (1) withhold any purchases of property until the full realisation of true future mortgage finance costs takes place post holiday;
   
4. If any suspension of mortgages finance involves rolling up of the interest for 2 years, the burden of future mortgage liabilities will increase dramatically, which, once again will be anticipated by the rational households. As a result, households will take 2 years worth of 'free' rent and then default at the point of interest roll up kicking in. We can expect a wall of mortgages defaults in 2013;
   
5. In order for the repayment holiday to have any real effect, the long term growth rate in personal disposable income will have to exceed: increase in the cost of mortgage finance post-holiday + inflation - tax increases expected. This, using current growth estimates etc suggests that in order for a 2 year holiday on repayment of mortgages to have any positive effect, our aggregate expected growth rate in personal income should be in excess of 50% in years 2013-2018. This is clearly not anywhere near being realistic.
   

Once again, the problem we face is the size of leverage taken on by the Irish households. Whether reckless lending or borrowing or both caused this problem is irrelevant. Households become long-term insolvent when their total debt liability rises above 4-5 times their earnings even in the moderate growth in income environment.

We have - on aggregate - households facing:

• current long and short term debt burden of ca 145% of GNP, and
  
• expected (2014) sovereign debt burden of ~140% of GDP or ca 165% of GNP (under rather optimistic assumptions on GDP/GNP gap) - at least 80% of this will have to be repaid out of the pockets of our households.
  

The problem is that these headline figures conceal imbalances in distribution of debt.

While on per-capita basis the overall household debt liabilities amount to ca 310% of our national income, in real terms what matters is the incidence of the debt on productive households. We currently have ca 41.3% of population in employment (or 1,859,000). Of these, 552,900 are in the age group of 25-34 years of age, 469,600 are in 35-44 years of age and 393,900 are in the age group 45-54 years of age. Assume that the demographic pyramid does not change (for better or worse) in the next 10 years. Total employment pool of those that can be expected to carry the debt burden is actually closer to 1.42 million or 31.5% of the total population of the country.

This raises public and household debt leverage ratio on population that can be expected to repay it to a whooping x10 times household income. This, folks, is a bankruptcy territory for roughly speaking 1/3 of our entire population or for nearly 100% of our productive population.

A 2 year holiday from mortgages repayment will simply not solve this problem. Only significant debt write-off of household debts or full restructuring of our sovereign debt and deficit (to eliminate the need for future tax increases and reverse recent tax increases) or a combination of both will be able to correct for this severe debt overhang.

Economics 1/10/10: External Debt

Yesterday, CSO published Q2 2010 data on our International Investment Position.

Here are some highlights:

"At 30 June 2010, the gross external debt of all resident sectors (i.e. general government, the monetary authority, financial and non-financial corporations and households) amounted to €1,737bn." So Irish total gross external debt rose €63bn qoq.

Our total foreign liabilities stood at €2,643bn and are offset by €2,500bn of foreign assets.

The liabilities also include €1,218bn of equity and derivative liabilities that do not form part of external debt.

Liabilities of the Monetary Authority (to ECB) that consist almost entirely of short term loans and deposits, amounted to €66bn, an increase of €28bn on Q1 2010, but down €38bn on Q2 2009.

General government foreign borrowing decreased by over €3bn to €80bn between end-March and end-June 2010.

The liabilities of other sectors (financial intermediaries and non-financial corporates) increased by €17bn from Q1 and at €657bn represented 38% of the total debt, a similar share to the
previous quarter.

Direct investment liabilities increased by €17bn to €262bn in Q2

Liabilities of monetary financial institutions (credit institutions and money market funds) consisting mostly of loans and debt securities were €672bn, an increase of over €5bn on Q1, but down €18bn on Q2 2009.

Few charts. Starting with levels of assets and liabilities:
Next, balance:
Notice declining surplus in Other Sectors.

Combining assets and liabilities:
Lastly, removing Government from the equation:
Clearly, a sign of expanding liabilities and rising assets, with net balance on the negative side slightly worse than in Q1.

Summarizing these in tables:

Economics 19/8/10: Irish bonds & our fndamentals

This is an unedited version of my article in the Irish Examiner from August 18, 2010.

The latest Irish bonds auction was perhaps the most eagerly anticipated event in the NTMA’s history. Its outcome was a small victory for NTMA, but a Pyrrhic victory for Ireland.

A quick guide to the results first. Facing svere headwinds from the markets, NTMA managed to sell 4 and 10 year bonds at average yields of 3.627% and 5.386% respectively.

This means that NTMA improved on July auction of 10 year bonds, but is still locked into what amounts to the third highest cost of borrowing over the last three years. A year ago the same bonds were placed at an average yield of 4.55% - which means that borrowing €1 billion today is now €8.4 million costlier than a year ago.

However, the NTMA results are hardly a reason to cheer, from the economy wide perspective.

Three events have triggered the extraordinary global attention to Irish bonds over the last few weeks. Firstly, there was a public relations flop when the ECB had to step in provide support for Irish bonds by directly buying the surplus paper out of the market. Second by Monday this week, Irish bond spreads over the benchmark German bunds rose to a stratospheric 300 basis points. At the same time, our CDS spreads hovering above 310 basis points benchmarks, were
signaling that markets anticipated a significant probability of Irish Government default on its sovereign debt.

All of these developments, especially set against much calmer changes in yields and CDS spreads in other Eurozone economies have indicated that the markets are changing not just in terms of the overall willingness of bond investors to underwrite risk in general, but in their attitudes to Irish debt in particular.

You see, during the first quarter of this year, sovereign debt crisis has engulfed the peripheral economies of Europe, collectively know as PIIGS (Portugal, Greece, Ireland, Italy and Spain). The crisis, of course, was triggered by the markets belated realisation that these countries economies cannot sustain massive debt and deficit financing liabilities they have taken on before and during the current Great Recession. That was the moment when Ireland was lumped together with the rest of the Eurozone’s sickest economies.

This time around, we are on our own. Over recent months, all of the PIIGS countries have unveiled a series of aggressive deficit reduction and austerity programmes aimed at significantly reducing their future borrowing requirements. All, that is, except for Ireland. Instead, Irish Government has spent the last 9 months waiting for the Trade Unions to vote on the Croke Park deal that actually limited our future ability to address deficits. On top of that, we staunchly resisted markets, the IMF and the EU Commission repeated calls for clarity on specific budgetary measures planned for the period of 2011-2014. Currently, the IMF forecasts Irish deficit to remain at over 5% of GDP in 2015.

In May 2010, before factoring in the latest funding allocations to banks, IMF Fiscal Monitor provided an estimate for Ireland’s borrowing requirements for 2010. These figures are strikingly different from the deficit numbers presented by our official framework. IMF forecast that Ireland will need to borrow at least 19.9% of its GDP in order to finance debt roll overs from previous years maturing in 2010, plus the deficit of -12.2% of GDP. In approximate terms, Ireland’s Government borrowing this year would amount to roughly €33bn before Anglo Irish Bank and INBS latest projections for new funding.

Thus, in the last two weeks, the bond markets have finally began to re-price Irish sovereign debt as if the country is no longer the leader in the PIIGS pack in terms of expected future deficit
corrections.

In the end, the markets are right. Ireland is facing a massive debt and deficit overhang that is well in excess of any other advanced economy in the world. And contrary to official statements uttered on the matter this week, this twin problem is not a matter of one-off recapitalization of the Anglo Irish Bank. Instead, it is a long-term structural one.

Take first the banks. The recapitalization and balance sheets repair approach undertaken by the Government so far means that Nama alone can be expected to lose around €12 billion over the next 10 years. These losses will have to be underwritten by the Irish economy.

In addition, total losses by the Irish banks are likely to add up to between €49 and €53 billion over the next three-four years. These can be broken down to €33-36 billion that will be needed in the end for the zombie Anglo, €6bn for equally gravely sick INBS, at least €8 billion for AIB and up to €2 billion for the healthiest of all – Bank of Ireland.

These numbers are based on my own analysis and are confirmed by slightly more pessimistic estimates by the independent banking sector analyst Peter Mathews. Once again, Irish economy – or in other words all of us – can be expected to underwrite these. Thus, total bill for ‘repairing’ Irish banks via Government preferred approach of Nama, plus recapitalizations is likely to be €61-65 billion over the next decade.

Now, consider our current spending. Having slashed capital expenditure down to the bone, the Government has committed itself to preserving public sector pay and employment through 2014. Transfers – including welfare and subsidies – are pretty much a no-go area for serious
savings, given continued rises in unemployment, long term nature of new joblessness and political dynamics in the country. Between them, these two spending headlines account for over 1/3 of the entire deterioration in our public spending from 2008 to-date.

Budget 2010 forecasted that our debt to GDP ratio will peak at around 84% in 2012 and will slowly decline thereafter. This, of course, is clearly an underestimate, but even by that metric, we are looking at a debt mountain of over €152 billion.

All of this means that at the very least, Irish state debt will be well in excess of €210 billion by 2014-2015. Given yesterday’s auction results, the interest bill on this debt alone will total €11.3 billion annually – more than 1/3 of all tax revenue collected in 2009.

Let’s put this into more easily understood perspective. If Ireland were a household and its debt constituted its mortgage taken over 30 years, the ‘family’ will be spending more than half of its total gross income on interest and principal repayments.

Or put differently, the legacy of this crisis and systemically mistaken approach taken to repairing the banking sector will amount to over €111,000 in new debt dumped on the shoulders of every currently employed person in the country. To say, as our policymakers and official analysts do, that this figure doesn’t really matter because it is a ‘one-off measure’ is adding insult to the injury.

Economics 28/05/2010: Spain's downgrade is a warning for Ireland

In a significant development today, Fitch cut Spain’s credit ratings to AA+ from AAA. This was expected.

What was unexpected and new in this development is the expressed reason for the cut.

Per reports, "Fitch said Spain’s deleveraging of record-high levels of household and corporate debt and growing levels of government debt would drag on economic growth." (Globe & Mail)

This puts pressure not only on the euro and European equities, but also on the rest of the PIIGS' sovereign bonds. Ireland clearly stands out in this crowd.

As I have shown here and more importantly - here, Ireland is by far the most indebted economy in the developed world. While it is true that a large proportion of our total external debt accrues to IFSC, even adjusting for that

• Our General Government Debt held externally is the fifth highest in the developed world;
• Our External Banks Debt is the highest in the world;
• Our Private Sector Debt (Total Debt ex Banks & Government) is the highest in the world; and
• Our Total External Debt is the highest in the world.

In addition, per IMF (see here) our budgetary position is one of the weakest in the world, including for the horizon through 2015 (here).

“The downgrade reflects Fitch’s assessment that the process of adjustment to a lower level of private sector and external indebtedness will materially reduce the rate of growth of the Spanish economy over the medium-term,” Fitch’s analyst Brian Coulton said in a statement.

Fitch said "Spain’s current government debt would likely reach 78 per cent of gross domestic product by 2013 from under 40 per cent before the start of the global financial crisis in 2007." Irish debt is projected to reach 94% of GDP by 2015 (IMF) or 122% of GNP - the real measure of our income. If we factor in the cost of Nama and banks, Irish Government debt will reach 122% of GDP by 2015.

This puts into perspective the real scope for public spending cuts we must enact in this and next year's Budgets. The Government aim to reduce spending by a miserly €3 billion in each year through 2012 will not do the job here. We will have to do at least 2.5 times that much to get our house in order.

Economics 29/04/2010: Debt crisis is spreading

Another credit downgrade from S&P, this time for Spain, from AA+ to AA with negative outlook, based on the outlook for years of private sector deleveraging and low growth. Spain, as you can see, is severely in red in terms of debt, ranking 14th in the world. Spain's external liabilities stand at 186.1% or $2.55 trillion (as of 2009 Q3) against estimated 2009 GDP of $1.37 trillion.

The country is actually worse off in terms of debt than Greece which has ranks 16th at debt at 170.5% of GDP or $581.68 billion, with 2009 GDP of $341 billion.

Of course, Ireland is world's number 1 debtor nation with external debt of 1,312% of GDP (IFSC-inclusive) of $2.32 trillion in Q3 2009 against the GDP of $176.9 billion. Of course, part of this debt is IFSC, but then, again, we really do not have a claim on our GDP either, with GNP being a more real measure of our income. So on the net, our debts - the actual Irish economy's debts - are somewhere in the neighborhood of 740%. This is still leagues above the UK - the second most indebted nation in the world - which has the debt to GDP ratio of 'only' 426%!

The S&P also provided estimate for expected recovery rate on Greek bonds, which the agency put at 30-50%. In other words, S&P expects investors in Greek bonds to be paid no more than 30-50 cents on the euro. Yesterday on twitter I suggested that "Greek debt should be renegotiated @ 50cents on the euro - severe default. Portugal's @ 80 cents - mild default, Irish @ 70-75 cents". Looks like someone (S&P) agrees. Before it is too late, before German and other European taxpayers have poured hundreds of billions of euro into the PIIGS black hole of delinquent public finances, Europe should cut losses and force Greece and Portugal to renegotiate their liabilities. If Ireland and Spain were to elect to follow, so be it. Of course, in Irish case, the debt re-negotiations should cover private debts, not public debt.

Just how many billions of euros are EU taxpayers in for for the folly of admitting Greece - a country that spent 90 years of the last 180 (since 1829) in defaults on its debts - into the common currency area? Well, Greek 2-year bonds were traded at yields of 26% yesterday at one point in time. This is pricing that's in excess of pretty much every developing country, save for basket cases which practically cannot issue bonds at all.

IMF's Dominique Strauss Kahn has told Bundestag yesterday that Greek package will be

• €100-120bn for three years;
• Which means German taxpayers are on the hook for €67 billion over 3 years, not €25 billion that Germany ‘s economics minister was signing for in the original deal;
• Ireland's contribution will also have to rise to €4 billion over 3 years, not €500 million we originally were told we will have to contribute;
• Greece will not be forced to restructure or reschedule debt
• The loans to Greece will be subordinated to existent bondholders, which means that if in the end Greece does pay 30-50 cents on the euro to the latter, European taxpayers will be lucky to get 10 cents on the euro.

The whole deal is now looking like a massive subsidy for Greece and entails absolutely no protection to European taxpayers.

But internationally, EU news are getting darker and darker by the minute. Last night Bloomberg reported that EU countries are in for estimated €600 billion bill for the fiscal crises that have spread across the block. That's the cost, in the end, of all the tacky policy follies that Brussels endorsed and pushed through over the last 10 years -

• from the Lisbon Agenda, which was supposed to deliver EU to the position of economic superiority over the US by 2010,
  
• to the Social Economy, which was supposed to deliver... well, who knows what...
  
• to the Knowledge Economy, which was aiming to turn us all into brains in a Petri Dish
• to the absolutely outlandish HIPCI and HIPCII agendas wholeheartedly embraced by the EU, which were supposed to deliver debt relief to the world's real basket cases (before Greece and other PIIGS took the spotlight away from them), and the rest of the international white elephants.

The problem, of course, is that €600 billion price tag for fiscal excesses has generated preciously little in returns (despite what folks at Tasc keep telling us about the fiscal stimulus) which means we will have to pay for it out of our long term wealth. The same wealth that has been demolished by the recession and the financial markets collapse!

Economics 11/03/2010: Debt figures confusion reigns at RTE?

Per RTE report yesterday (emphasis is mine, see original here)

“New figures from the Central Bank show that at the end of January Irish residents - mostly companies and institutions - had an outstanding debt of €1.1 trillion. Figures for issued debt securities indicate that €790 billion worth of this debt is denominated in euro, while the remaining €270 billion is denominated in foreign currencies."

This, indeed, is misleading enough for the non-economist. While RTE choice of words ‘outstanding debt’ might imply ‘total debt’, in reality, of course, the Central Bank note (available here) is dealing only with securitized debt: bonds, notes and debt securities issued, plus equity issued. But it does not include non-securitized loans, mortgages, corporate loans, over drafts, credit cards, corporate invoice-discounting, and even massive volumes of investment fund shares/units.

This, if course, explains how the figures issued today differ from our real total debt measure: the Gross External Debt of all resident sectors, published quarterly (with one quarter delay) by CSO. Q4 2009 is still due for release later this month, but per latest CSO data, in Q3 2009, the gross external debt of all resident sectors in Ireland stood at €1,637bn or €51bn down on the Q2 2009 level – some €537 billion more than what RTE’s note mistakenly labelled to be Ireland’s outstanding debt.

The liabilities of Ireland-based monetary financial institutions (aka our financial system inclusive of IFSC) were virtually unchanged quarter on quarter at €691bn with their share of total debt rising from 41% in Q2 2009 to 42% in Q3.

Similar dynamic took place in Other Sectors – comprising insurance companies and other financial enterprises, plus non-financial companies – where debt as of Q3 2009 stood at €618 billion or 38% of the total, up from 37% in Q2 2009.

Virtually all of the quarterly decrease in our indebtedness came from the Central Bank funds changes. This is why excluding the Central Bank and Government liabilities, total economy debt rose from €1.513 trillion in Q2 2009 to €1.508 trillion in Q3 2009.

Since Q3 2007, the overall debt levels in Other Sectors rose by a cumulative of 15.6%, in Direct Investment sector by 9.3%, and our total debt rose by 8.33%. At the same time, our wealth - or assets side - have collapsed by over 60%.

Only banks have so far managed to de-leverage in Ireland (down 9.8% on Q3 2007) thanks to the taxpayers’s cash. Which brings us to a sad but inevitable conclusion – while banks use our money to write down their bad debts, is it any surprise that the real debt burden in the Irish economy is not declining?

Now, paired with Central Bank information note, if we subtract from the total debt figure in Q3 2009 the approximate IFSC-related debt of €850-900 billion (reflecting both securitized and non-securitized debt held, keeping in mind that most of the IFSC debt is securitized), this leaves Irish resident companies, households, banks, financial services providers and the public sector in the hole for roughly €730-790 billion.

Take this into a perspective: this number is equivalent to

• €165,273-176,485 debt per every man, woman and child in this country – resident and citizen (per latest CSO population data, here)
• Assuming paydown in the amount of our annual public deficit projected for 2010, this debt mountain will take us 41-44 years to pay down without any interest accruing on it (just think of 44 years of austerity and you get the picture)
• At the current interest rate charged on Government borrowing, the annual interest bill relating to our economy’s debt mountain adds up to €36.85-39.35 billion or more than 50% of the total annual Exchequer expenditure (just a reminder, we are being offered a plan to borrow more by the Letter of 28 - here - because, apparently, we have not borrowed yet enough)
  
• Given the average family size in Ireland (2.82 persons per household) and the latest average house price (€242,000 per Q4 2009 daft.ie report), this level of indebtedness is equivalent to 2 houses per every family in the Republic

Shall I go on? Sadly, reading RTE report one might conclude that things are ok: most of our outstanding debt is owed by the IFSC, so no need to worry, folks. Alas, that would be as wrong as calling today’s data release from the Central Bank a true reflection of our debt mountain.