14/3/2016: Foreign Investors, Sovereign Risks & Regulatory Clowns

Over 2012-2013, sovereign and corporate bonds markets started showing sigs of QE-related fatigue within the system, most commonly associated with periodically volatile trading spreads, term premia and risk spreads. In 2013, following the onset of the Fed-related “taper tantrum” many emerging markets spreads on their sovereign bonds widen dramatically, especially in response to rapid devaluations of their domestic currencies.

“This prompted market analysts to identify five of the worst hit economies as the “fragile five,” attributing their vulnerability to economic fundamentals, particularly to current account deficits.” Which is fine - current account is a reasonably important signal of the overall external balance in the economy, but… the but bit is that current account alone means little. Take for example Russia: back in 2013, the economy enjoyed record current account surpluses - so was a picture of rude health by the analysts criteria. Yet, within the economy there was already an apparent and fully recognised on-going structural slowdown.

Bickering over indicators validity aside, however, it would be nice to know which indicators and which risk models do investors flow when they decide to buy or sell emerging market bonds?

Traditionally, we think about two types of factors: “push” and “pull” factors, determining whether the emerging economy experiences capital inflows or outflows.

- “The push factors often relate to economic or financial developments in the global economy as a whole or in the advanced economies, notably the United States.”
- “The pull factors often relate to country-specific economic fundamentals in emerging markets”

Both push and pull factors seem to be important.

In analyzing returns on sovereign CDS contracts, the BIS paper looks at CDS returns “for 18 emerging markets and 10 advanced countries over 11 years of monthly data from January 2004 to December 2014.”

Findings in a nutshell:

• “Statistical tests for breaks in the movements of CDS returns suggest a break at the time of the eruption of the global subprime crisis in October 2008. This leads us to consider two subperiods separately, an “old normal” before the outbreak of the crisis and a “new normal” afterwards.”
• “In both the old normal and new normal, we seek to explain the variation of these [principal factors] loadings [onto risk premia] in terms of such fundamentals as debt-to-GDP ratios, fiscal balances, current account balances, sovereign credit ratings, trade openness, GDP growth and depth of the domestic bond market.”
• “In the old normal, the first risk factor alone explains about half of the variation in CDS returns…” 
• “This factor becomes more dominant in the new normal, in which it explains over three-fifths of the variation in returns.”
• “When it comes to how the different countries load on this factor, we find that that the commonly cited economic fundamentals have little influence on the country-specific loadings on the factor. Instead the single most important explanatory variable for the differences in loadings is a dummy variable that identifies whether or not a country is an emerging market.”

To summarise the BIS findings: “In the end, we find that CDS returns in the new normal move over time largely to reflect the movements of a single global risk factor, with the variation across sovereigns for the most part reflecting the designation of “emerging market”. There seems to be no “fragile five”; there are only emerging markets. While the emerging markets designation may serve to summarize many relevant features of sovereign borrowers, it is a designation that lacks the kind of granularity that we would have expected for a fundamental on which investors’ risk assessments are based. The importance of the emerging markets designation in the new normal suggests that index tracking behaviour by investors has become a powerful force in global bond markets.”

And the cherry on top of the proverbial pie? Why, here it goes: “Haldane (2014) has argued that in the world of international finance, the global subprime crisis and the regulations that followed made asset managers more important than banks. Miyajima and Shim (2014) show that even actively managed emerging market bond funds follow their benchmarks portfolios  quite closely. For the most part, when global investors invest in emerging markets, instead of picking and choosing based on country-specific fundamentals, they appear to simply replicate their benchmark portfolios, the constituents of which hardly change over time.”

Wait, what? All regulators are running around the world chasing the bad bankers (for their pre-2008 shenanigans), all the while the new threat has already migrated to asset management. The regulators and enforcers are busy bee-buzzing around courts and regulatory hearings chasing the elusive ‘signalling value’ of enforcing old rules onto the heads of the bankers. With little real outcome to show, I must add. … But the future culprits are not to be found amongst those who care to watch the fate of bankers unfolding in front of them.

In short, having exposed the farce of bond / CDS markets pricing risks based on a vague and vacuous designation of a country, the BIS paper inadvertently also exposed the massive futility of the financial regulators chasing their own tails trying to get past crises culprits to prevent new crises from happening, even though the future culprits don;t give a toss about the past culprits.

Dogs, tails, everything wagging everyone, and vice versa…


Full paper here: Amstad, Marlene and Remolona, Eli M. and Shek, Jimmy, “How Do Global Investors Differentiate between Sovereign Risks? The New Normal versus the Old” (January 2016). BIS Working Paper No. 541: http://ssrn.com/abstract=2722580

6/3/2014: A 'New Normal' of Ireland's economy

This is an unedited version of my Sunday Times article from February 23, 2014.


Jobs, domestic investment, exports-led recovery and sustainable long-term growth are the four meme that have captured the current Coalition, setting the early corner stones for the next election’s promises. Resembling the ages-old "Whatever you like, we’ll have it" approach to policymaking, this strategy is dictated by the PR and politics first, and economics last. For a good reason: no matter how much we all would like to have hundreds of thousands new jobs based on solid global demand for goods and services we produce, given the current structure of the Irish economy, these fine objectives are largely unattainable and mutually contradictory.

Firstly, restoring jobs lost in the crisis requires restarting the domestic economy and investment both of which call for an entirely different use of resources than the ones needed to sustain exports-led growth. Secondly, domestic and externally trading economies are currently undergoing long-term consolidation. Expansion or growth will have to wait until these processes are completed. Thirdly, replacing lost jobs with new ones will not lead to a significant decrease in our unemployment. Majority of current unemployed lack skills necessary to fill positions that can be created in a sustainable economy of the future.

Torn between these conflicting calls on our resources, Irish economy is now at a risk of slipping into a ‘new normal’. This long-term re-arrangement of the economy can be best described as splitting the society into the stagnant debt-ridden domestic core and slowly growing external sectors increasingly captured by the aggressively tax optimising multinationals. Only a major effort at reforming our policymaking and tax regimes can hold the promise of escaping such a predicament.


In simple terms, Ireland's main problem is that we lack new long-term sources for growth.

Let's face the uncomfortable truth: apart from a historically brief period of economic catching up with the rest of the advanced economies, known as the Celtic Tiger from 1992 through 1999, our modern economic history is littered with pursuits of economic fads. In the 1980s the belief was that funding elections purchases via state borrowing delivers income growth. The late 1990s were the age of dot.com ‘entrepreneurship', and property and public 'investment'. From the end of the 1990s through today, correlation between real GDP per capita growth and the growth rates in inflation-adjusted real exports of goods collapsed, compared to the levels recorded in the period from 1960 through 1989. In the early 2000s dot.coms fad faded and domestic lending bubble filled the void. Since the onset of the 2010s, the new promise of salvation came in the form of yet another fad - ICT services.

Decades of growth based on tax arbitrage and the lack of sustained indigenous comparative advantage and expertise left our economy in a vulnerable position. Ireland today has strong notional productivity and competitiveness in a handful of high value-added sectors dominated by multinationals. As past experience shows, these activities can be volatile. As the recent data attests, they are also starting to show strains.

Last week, the Central Statistics Office published the preliminary data on merchandise trade for 2013. The results were far from pretty. Year on year, total value of Irish goods exports fell to EUR86.9 billion from EUR91.7 billion in 2012, and trade surplus in goods shrunk by EUR5.25 billion. Overall, 2013 was the worst year for Irish goods exports since the crisis-peak 2009.

This poor performance is due to two core drivers: the pharmaceuticals patent cliff and stagnant growth in exports across other sectors, namely in traditional and modern manufacturing.

The data clearly shows that we are struggling to find a viable replacement for pharmaceuticals sector. If in 2012, trade balance in chemicals and related products category accounted for 105 percent of our trade surplus, in 2013 this figure rose to over 106 percent. Just as our exports in this category are falling, our trade balance becomes more dependent on them.

The strategy is to replace traditional pharma activity with biopharma and other sectors that are more research-intensive than traditional pharma. Alas, our latest data on patenting activity shows that Ireland remains stuck in the pattern of low R&D output with declining indigenous patent filings. Institutionally, we have some distance to travel before we can become a world-class competitor in R&D and innovation. The latest Global Intellectual Property Index published this week, ranks Ireland 12th in the world in Intellectual Property environment. Beyond this lies the problem that much of the innovation-linked revenues booked by the MNCs into Ireland relate to activity outside of this country and are channeled out of Ireland with little actual economic activity imprint left here.

From the point of view of our indigenous workforce, it is critical that Irish indigenous exporters aggressively grow in new markets. Yet, Irish exports to BRICS economies and to Asia-Pacific have fallen in 2013. Our trade deficit with these countries has widened by 87 percent to EUR858 million last year.

So far, the short-term support for falling goods exports has been provided by relatively rapidly rising exports of services. This process, however, is also showing signs of stress. While we do not have figures for trade in services for 2013, the IMF most recent assessment of the Irish economy shows that our share of the world exports of services remains stagnant. And the IMF projects growth in Irish trade balance on services side to slow down significantly after 2015.


While exports engine is still running, albeit in a lower gear, domestic side of the economy remains comatose under the huge weight of our combined public and private debt overhang.  Total government and domestically-held private sectors debts stood at 189 percent of our GDP in 2007. At the end of 2013 it was 252 percent. This does not include debts held outside our official domestic banking system or loans extended to Irish companies abroad. The good news is the cost of funding this debt is relatively low. The bad news is – it will rise in the longer term.

And, in the long run, the wealth distribution in Ireland is skewed in favour of the older generations. This leaves more indebted working age households out in the cold when it comes to saving for future retirement and funding current investment in entrepreneurship and business development.

Irish economy is heading for a major split. Across the demographic divide the generation of current 30-45 year-olds will go on struggling to sustain debts accumulated during the period of the Celtic Tiger. They will continue facing high unemployment rates for those who used to work in the domestic economy. A stark choice for these workers will be either re-skilling for MNCs-dominated exports-focused services sectors, emigrating or facing permanently reduced incomes. Even those, likely to gain a foothold in the new ICT-led economy will have to stay alert hoping that the footloose sector does not generate significant jobs volatility.

All in, the unemployment rates in the economy are likely to remain stuck at the ‘new normal’ of around 8-8.5 percent through the beginning of the next decade, contrasting the 5 percent full employment rate of joblessness in the first decade of the century.


At this point in time, it is hard to see the sources of growth that can propel Ireland to the growth rates recorded over the two decades prior to the crisis. Back then, Irish real GDP per capita grew at an annualised rate of some 4.7 percent. The latest trends suggest that our income is likely to grow at around 1 percent per annum over 2010-2025 period - the rate of growth that has more in common with Belgium and below that expected for Germany. Aptly, the IMF puts our current output gap – the distance to full-employment level of economic activity – at around 1.2 percent of GDP, which ranks our growth potential as only thirteenth in the euro area. This clearly shows the shallow growth potential for this economy even in current conditions.

Slow recovery in employment and continued deleveraging of the households mean that Ireland will be staying just below the Euro area average in terms of income and consumption, and above the EU average in terms of unemployment. In that sense, the economic mismanagement of the naughties will be reversed by not one, but two or more lost decades.

Ireland has some serious potential in a handful of domestic sectors, namely food and drink, and agrifood, as well as in the areas where our ability to create and attract high quality human capital can offer future opportunities for growth. We have a handful of truly excellent, globally competitive enterprises, such as CRH, Ryanair and Glanbia. But beyond this, we are not a serious player in the high value-added game of modern economic production. In sectors where we allegedly have strong expertise: pharma, biotech, ICT, and finance, Ireland has no globally recognised large-scale indigenous players.

Ending the lost decades on a note of rebirth of the Celtic Tiger will take much more than setting political agendas for ‘kitchen sink’ growth agendas. It will take big-ticket reforms of the domestic economy, tax system, and political governance. Good news is that we can deliver such reforms. Bad news is that they are yet to be formulated by our leaders.

Box-out: 

Recent research note from Kamakura Corporation provided yet more evidence of the damaging effects of the EU's knee-jerk reaction policies in the wake of the global financial crisis. Specifically, Kamakura study published last week focused on the July 2012-issued blanket ban on short selling in the European Credit Default Swaps (CDS) markets. CDS are de facto insurance contracts on sovereign bonds, actively used by professional and institutional investors for risk management and hedging. The study found that as the result of the EU ban, trading activity declined for eighteen out of 26 EU member states' CDS. Put in more simple terms, as the result of the EU decision, risk hedging in the sovereign debt markets for the majority of the EU member states' bonds was significantly undermined, leading to increased risk exposures for investors. At the same time, liquidity in the CDS markets fell, implying further shifting of risk onto investors in sovereign bonds. Kamakura analysis strongly suggests that investors holding sovereign debts of euro area ‘peripheral’ countries like Spain and Italy are currently forced to pay an excessive liquidity risk premium in CDS markets. At the same time, the EU regulators, having banned short selling can claim a Pyrrhic victory in public by asserting that they have reacted to the crisis by introducing tougher new regulations. In Europe, every political capital gain made has an associated financial, social or economic cost. This is true for economic decisions and financial markets regulations alike. Too bad that those who benefit from the former gains rarely face any of the latter costs.

17/7/2013: Sunday Times, July 14: The New Normal for Ireland

This is an unedited version of my Sunday Times article from July 14, 2013.



The release of the Irish quarterly national accounts for Q1 2013 two weeks ago should have been a watershed moment for Ireland. Aside from confirming the fact that Irish economy is back in a recession, the new figures reinforce the case for the New Normal – a longer-term slowdown in trend growth and continued volatility of economic performance along this trend. The former revelation warrants a change in the short-term policies direction. The latter requires a more structural policies shift.


Months ago, based on the preliminary data for the last quarter of 2012, it was painfully clear that Irish economy has entered another period of economic recession. This point was made on these very pages back in early March although it was, at the time, vigorously denied by the official Ireland.

Irish economy is currently in its fourth recession in GDP terms since 2007. Q1 2013 marked the third consecutive quarter in the latest recessionary episode. Since the onset of the crisis, Ireland had 17 quarters of negative growth in private and public domestic investment and expenditure, and counting.

For the Government that spent a good part of the last 2 years telling everyone willing to listen about our returning fortunes, things are looking pretty grim. Since settling into the office by the end of H1 2011, through the first quarter 2013, Coalition-steered economy has contracted by EUR1.52 billion or 3.75%.

The fabled exports-led recovery, first declared in Q1 2010, is not translating into real economic expansion. Neither do scores of strategic policies documents launched with promises of tens of thousands of new jobs.

With the national accounts officially in the red, the bubble of claimed policies successes is bursting. What is emerging from behind this bubble is the New Normal. Whether we like it or not, in years to come we will continue facing high risks to growth and a lower long-term growth trend. Traditional Keynesianism and Parish Pump Gombeenism - the two, largely complementary policy options normally promoted in Ireland - cannot sustain us in the future.

Prior to the crisis, Irish economy experienced three periods of economic growth, all driven by different internal and external forces, none of which are likely to materialize once again any time soon.

The first period of 1991-1997 witnessed rapid convergence in physical and financial capital, as well as in human capital utilization to the standards, observed in other small open economies of the EU.

From 1998 through 2003, Irish economy experienced a combination of rising share of economic activity generated in the domestic economy and rapid expansion of the financial services. This period is characterised by two short-lived, but significant booms and busts: the dot.com expansion and the subsequent dramatic acceleration in public spending.

From the late 1990s, Ireland also experienced accelerating property boom, which culminated in an unsustainable investment bubble. All three periods of economic expansion in recent past were underpinned by favourable external demand for MNCs exports out of Ireland, low or falling cost of capital and accommodative tax environments, in which tax competition was an accepted norm.

These drivers are now history.

Since the onset of the second stage of the domestic economy’s recession in H2 2010, Ireland has entered an entirely new period of development that will shape our long-term growth performance.

Externally, our capacity to extract rents and growth out of tax arbitrage is coming under severe pressures, best highlighted by the recent G8 decisions, the CCCTB proposals tabled in Europe and by accelerated tax policies gains in countries capable of serving big growth regions outside the EU. The financial repression that commonly follows credit busts is also denting our tax-driven growth engine by raising competition for tax revenues, and lowering our real cost competitiveness vis-à-vis Europe and North America.

Internally, since 2002, MNCs-led manufacturing in Ireland has suffered what appears to be an irreversible decline. Goods exports are down from EUR90.4bn in 2002 to EUR78.7bn in 2012 before we take account for inflation. Meanwhile, exports of services are up from EUR32.2bn to EUR93.3bn. Problem is: over the same time, services exports net contribution to the economy has expanded by only EUR18 billion. More worryingly, services exports growth is now falling precipitously.

Data from the Purchasing Managers Indices confirms the long-term nature of our economic slowdown. Average rates of growth in GDP are now closer to 1.5% per annum based on Services sectors contribution and closer to 1.0% for Manufacturing. Prior to the crisis these were 7.0% and 2.6%, respectively. In 1990-2007, all sectors included, Ireland experienced average annual growth of 6.6%. Now, we are looking at ca 1.5-1.7% average growth rates through 2020.

Lower growth rates for Ireland will be further reinforced by the lack of access to credit flows previously abundantly available from the global funding markets. This will impact our banks lending, direct debt issuance by companies, and securitised or asset-backed credit.

The retrenchment of the global financial flows away from the euro area, coupled with regulatory changes in European banking suggest that investment in the New Normal will become inseparably linked to the internal economy and significantly more expensive than the decade preceding the 2008 crisis. Much of this change will be driven by the same financial repression that will act to reduce our tax regime advantages.

This means that at the times of adverse shocks - such as, for example, a fall in revenues from exports or an increase in foreign companies extraction of profits from Ireland – our economy will be experiencing more severe credit and income contractions. This will put more pressure on investment and lower the velocity of money in the economy. Longer-term capital financing will become more difficult as domestic investors will face more uncertain returns and higher liquidity risk. A bust and severely restricted in competitiveness banking sector - legacy of the misguided post-2008 reforms - will not be helpful.

Thus, in the future, switch to services exports away from manufacturing and domestic investment, and reduced access to credit will mean higher volatility in growth, and lower predictability of our economic environment.

The New Normal requires more agile, more responsive and better-diversified economic systems, alongside a more conservative risk management in fiscal policies and less centralisation and harmonisation of policies at super-national level. It also calls for more aggressive incentivising of domestic investment and savings.

In terms of the fiscal policy stance, this means adopting a more cautious approach advocated, in part, by the ESRI this week. Irish Government should aim to continue reducing public spending, but do so in a structural way, not in a simplified framework of pursuing slash-and-burn targets. In addition, the Government needs to re-focus on identifying lines of expenditure that can be re-directed toward more productive use. In the short run, this can take the form of switching some of the current expenditure into capital investment programmes.

Reforms of social welfare, public education, health and state pensions systems will have to make these lines of spending more effective in helping people in real need, while slimmer in terms of total spend allocations. This can be achieved by direct means-testing and capping some of the benefits. But majority of these changes will have to wait until after the immediate unemployment and growth crises have passed.

In the longer run, going beyond the ESRI proposals, the Government should permanently reallocate some of the spending (such as, for example, overseas aid or poorly performing enterprise supports) to areas where it can increase value-added in public services (e.g. water supply or public transport) and create new exports platforms (e.g. e-health and higher quality internationally marketable education). Additionally, new revenues should be raised from severely undertaxed sectors and assets, such as agriculture and land, to be used to lower tax burden on both, ordinary and highly skilled workers.

Beyond a short-term stimulus, rather than directing tax- and debt-funded new investment, public sector should help generate new opportunities for more intensive growth. Increasing value added in existent activities, not simply scaling these activities up in terms of quantity of services deployed or employment levels involved should become the priority for future public sector growth.

Adding further to the ESRI analysis, the objective of using fiscal policy to drive enterprise creation requires simultaneously freeing more resources in the private sector to invest in new technologies acquisition and adoption, and development of indigenous R&D. We need to increase, not shrink, disposable incomes of the middle- and upper-middle classes and improve incentives for these segments of the population to invest. IBEC's suggestion this week that the Government should abandon any future tax increases makes sense in this context. The key, however, is that direct and indirect income tax increases of recent years must be reversed.

We need to recognise, support and scale up clustering initiatives in the tech and R&D sectors that deliver partnerships between the existent MNCs and larger domestic enterprises and start ups. To do this, we should create direct links between the existent clusters, such as for example IT@Cork initiative and public procurement systems. To re-orient public procurement toward supporting younger enterprises, larger procurement tenders should explicitly target new opportunities for partnerships between MNCs and SMEs or start-ups.

To address structural decline in debt financing available in the economy, we should exempt from taxation capital gains accruing to any real investment in Irish enterprises, including the IPOs and new rights issues, where such investments are held for at least 5 years. To qualify for this scheme, an enterprise should have at least a quarter of its worldwide employees based in Ireland.

The New Normal of lower trend growth and higher uncertainty about the economic environment is here. Addressing the challenges it presents requires robust policy reforms. The least painful and the most productive way of implementing these would be to start as early as possible.

Box-out:

Recent report from CBRE on office market in Dublin for Q2 2013 provides an interesting insight into the commercial real estate markets dynamics in Ireland. Despite the cheerful headlines and some marginally encouraging news, the market remains in deep slump and so far, hard data shows no signs of a major revival. Good news: vacancy rate in Dublin office space has declined by 4% on Q1 2013, to 17.2% in Q2 2013. The vacancy rate was 19.32% in Q2 2012. Bad news: at this rate, it will take us good part of 10 years to catch up with the EU-average rates. More bad news: office investment spend fell from EUR79.6mln in Q2 2012 to EUR72.6mln in Q2 2013. Adding an insult to the injury, prime yields fell from 7.0% to 6.25% in the year through June 2013. The office market in Dublin is firmly reflective of what is happening in the economy. Only 37% of offices take ups in Q2 2013 were by Irish companies. Massive 65-66% of the city and suburban office space was taken up by the ICT and Financial services providers in a clear sign that outside these sectors, economic activity remains largely stagnant. Overall, on a quarterly basis, offices take up in Dublin has fallen for the second quarter in a row while there was the first annual decline since Q3 2012.