27/7/15: IMF Euro Area Report: Debt's a Mean Bitch…

The IMF today released its Article IV assessment of the Euro area, so as usual, I will be blogging on the issues raised in the latest report throughout the day.

The first post looks at debt overhang.

Per IMF, low inflation environment in the Euro area is "pushing up real rates, more in countries with higher debt burdens"

And here's a handy chart from the Fund:

Note: Net debt is the total economy’s financial liabilities minus assets.

Broadly-speaking, with annual expected inflation at or below 1%, we have serious pressure on Portugal and Spain, where Government borrowing costs (and by some proximity, banks funding costs) have not declined as dramatically as in, say, Ireland. The second sub-group at risk are countries with lower debt ratios, but still high enough funding costs - Slovenia and Italy. Ireland is in a separate category, having enjoyed significant declines in cost of funding, without a corresponding improvement in debt ratios. In other words, for Ireland, so far, the challenge is less of day-to-day funding of debt, but the quantum of debt outstanding. Short-run sustainability is fine, but longer run sustainability is still problematic.

The problematic nature of debt carried across the euro area goes well beyond the sovereign cost of funding and into the structure of European banks balance sheets.

Per IMF: "A chronic lack of demand, impaired corporate and bank balance sheets, and deeply-rooted structural weaknesses are behind the subdued medium-term outlook:

• Insufficient demand. Business investment continues to lag the cycle, remaining well below pre-crisis levels, reflecting weak demand, as well as high corporate debt, policy uncertainty, and tight credit. While overall unemployment has begun to recede, it remains above 11 percent, with long-term and youth unemployment near historic highs. Fiscal policy is broadly neutral, but is not providing offsetting support.
• Weak balance sheets. The ECB’s comprehensive assessment (CA) found that banks had raised capital, but also saw NPLs continuing to rise, reaching systemic levels in some countries. High levels of NPLs and debt have held back bank lending and investment, limiting the pass-through of easier financial conditions. Europe’s experience contrasts sharply with that of the U.S. recently and Japan in the 2000s where, after their financial crises, aggressive NPL resolution helped support a faster recovery in credit.
• Low and divergent productivity. Progress on structural reforms has been piecemeal and uneven across countries, as highlighted by the slow implementation of Country-Specific Recommendation (CSR) reforms under the European Semester. Productivity remains well below pre-crisis levels and lags the U.S., especially in important sectors such as information technology and professional services."

Note, I wrote extensively on the three factors holding back credit cycle before and recently testified on the subject at the Joint Committee on Finance, Public Expenditure and Reform, the Houses of the Oireachtas: http://trueeconomics.blogspot.ie/2015/07/8715-ecb-qe-strong-monetary-weak-real.html

Here is a chart highlighting the state of NPLs across the Euro area, U.S. and Japan which shows just how dire are the conditions in European banking really are:

Even by provisions measure, Europe is a total laggard. Which means there is plenty more delve raging left in the system.

And here is the IMF chart on productivity:

Which really neatly highlights the debacle that is euro area productivity growth: we have a massive uplift in unemployment during the crisis. Normally, rising unemployment automatically induces higher labour productivity through two channels: by destroying more jobs in lower value-added sectors, and by destroying jobs of, on average, less productive workers. In Europe, of course, the former factor did took place, but there was no corresponding retainment of activity in the higher value-added sectors, and the latter factor did not take place because of inflexible labour markets (for example, unions rules preventing lay offs of less productive staff, basing any employment adjustments on superficial criteria of tenure and/or union membership/contracts structures). So net result: jobs destruction (bad) was not even contributive to improved productivity (bad). But things are actually even worse. Chart below shows the distribution of productivity growth by broader sector, comparing euro area and the U.S.:

This is truly abysmal, for the euro area, which managed to post negative growth in productivity in Professional Services, and undershoot U.S. productivity growth in everything, save agriculture (where U.S. already enjoyed significant pre-crisis advantage over the EU, which implies normally lower productivity growth for the U.S.) and Construction (where the U.S. has enjoyed more robust recovery since 2010 against continued decline of activity in the euro area).


Yeah, remember those flamboyantly delightful days of denial, when everyone was keen on repeating the Krugmanite thesis that 'debt doesn't matter'? In reality, debt overhang is such a bitch… especially when it comes to messing up value-added investment and productivity growth. But never mind - Europe is not about these capitalist concepts, with its Knowledge Economy (as measured by IT and Professional Services and Manufacturing) shrinking in both metrics compared to the U.S.

Stay tuned for more excerpts and analysis from the IMF report.

10/1/2015: Where did Europe's EUR3 trillion worth of debt go?

You know the Krugmanite meme… Euro area is doing everything wrong by not running larger deficits. But here is an uncomfortable reality: since 2007, Euro area countries have managed to increase their debt in excess of 60% of GDP by a staggering EUR3 trillion.

So here's the crux of the problem: where did all this money go?

We know in terms of geographic distribution:

EUR1.6 trillion of this debt increase went to the 'peripheral' countries, and EUR39.2 billion went to the Easter European members of the Euro area. EUR517 billion went to the 'core' economies. And a whooping EUR759.9 billion to France. Now, across the 'periphery' some 20-25% of the debt increase is attributable to the banks measures directly, but the rest is a mix of automatic stabilisers (e.g. increases in unemployment benefits due to higher unemployment) and old-fashioned Keynesian policies.

It might be that Euro area is not spending enough in the right areas of fiscal policy. But to make an argument that it is not spending enough across the board is bonkers. We have allocated some EUR3 trillion in borrowed spending and we will continue to run the debt up in 2015. And still there is no sign of growth on the horizon.

So, again, where is all this money going?

23/8/2014: That Pesky Problem of Real Debt...

Again, revisiting IMF's Article 4 consultation paper for Euro Area, published in July 2014, here is a summary of the Euro area 'peripheral' countries debt overhang.

First real economic debt (debt of non-financial companies, households and public sector):

 Points of note:

1. Ireland's debt overhang is severe. More severe than of any other 'peripheral' country. Bet you forgot that little bit with all the 'best-in-class' growth performance droning in the media. Ah, and worse, remember, not the level alone, but the rate of debt increases over time, also matters. And by this metric, we too are the worst in the group, both for debt increases on 2003 levels and debt increases on 2008 levels.
2. Ireland's households' debt has declined over 2008-2013, more so than in Portugal and Spain. But it remains second highest after the Netherlands' and this decline masks true extent of debt problem because 2013 figure no longer counts household debts issued by banks that left Ireland and books of loans sold to investment funds. This also excludes some securitised debt.
3. Ireland's corporate debt problem is potentially overstating true extent of real debt in the economy, as it includes a small share of MNCs debt - debt issued by Irish institutions. This is likely to be relatively minor, in my view, as MNCs largely do not do debt intermediation via Irish domestic institutions. 

Now on to our household debt deleveraging in more detail:

Good news is, when it comes to our households, we are aggressively deleveraging compared to pre-crisis debt peak. As aggressively (in rate terms) as the U.S. Caveats mentioned above apply.

But there is a problem with all the debt legacy:

In the above 'PS' stands for private sector, not public sector. So private sector debt legacy is associated with negative subsequent economic growth, in general. But as above shows, for the peripheral countries, including the basket case outside Troika capture, Slovenia, and the rarely mentioned case of Finland (see chart below) it is also compounding structurally weak fundamentals other than debt alone.

So a timely reminder: that debt problem - it has not gone away. Not by any measure and most certainly not for Ireland.

Note: to see the problem in Finland consider the following chart:

4/4/2013: Real Debt: European Crisis in 4 charts

Some interesting charts from Liu, Yan and Rosenberg, Christoph B., World Economic Outlook, April 2013. IMF Working Paper No. 13/44. Available at SSRN: http://ssrn.com/abstract=2229653

Chart 1 below details the extent of the debt overhang in a number of countries:

Charts 2 and 3 outline the problem relative to financial assets available to offset the debt (theoretical offset, obviously):

Non-performing loans problem...

Quite telling, with no commentary needed, imo.

23/6/2012: Sunday Times 10/6/2012

This is an unedited version of my Sunday Times article from June 10, 2012.

Last week, the Irish voters approved the new Euro area Fiscal Compact in a referendum. This week, the Exchequer results coupled with Manufacturing and Services sectors Purchasing Manager Indices have largely confirmed that the ongoing fiscal consolidation has forced the economy into to stall. Irish economy’s gross national product shrunk by over 24% on the pre-crisis levels and unemployment now at 14.8%. The most recent data on manufacturing activity shows a small uptick in volumes of production offset by significant declines in values, with profit margins continuing to shrink. Deflation at the factory gates is continuing to coincide with elevated inflation in input prices. In Services – accounting for 48 percent of our private sector activity – both activity and profitability have tanked in May. The Exchequer performance tracking budgetary targets is fully attributable to declines in capital investment and massive taxation hikes, with current cumulative net voted expenditure up 3.3% year on year in May.

On the domestic front, the hope for any deal on bank debts assumed by the Irish taxpayers, one of the core reasons to vote Yes advocated by the Government in the Referendum, has been dented both by the German officials and by the ECB. Furthermore, on the domestic front, the newsflow has firmly shifted onto highlighting the gargantuan task relating to cutting our deficits in 2013-2015 and the problem of future funding for Ireland.

Per April 2012 Stability Programme Update, Ireland’s fiscal consolidation path will require additional cuts of €5.55 billion over the next three years and tax increases of at least €3.05 billion. Combined, this implies an annual loss of €4,757 per each currently employed worker, equivalent to almost seven weeks of average earnings. This comes on top of €24.5 billion of consolidations delivered from the beginning of the crisis through this year. The total bill for fiscal and banking mess, excluding accumulated debt, to be footed by the working Ireland will be somewhere in the region of €18,309 per annum in lost income.

This has more than a tangential relation to the Government’s main headache – weaselling out of the rhetorical corner they put themselves into when they solemnly promised Ireland’s ‘return to the markets’ in 2013 as the sole indicator for our ‘regained economic sovereignty’.

Even assuming the Exchequer performance remains on-target (a tall assumption, given the headwinds of economic slowdown and lack of real internal reforms), Ireland will need to raise some €36 billion over 2013 and 2014 to finance its 2014-2015 bonds rollovers and day-to-day spending. In January 2014 alone, the state will have to write a cheque for €8.3 billion worth of maturing bonds. The rest of 2014 will require another €7.2 billion of financing. Of €36.5 billion total, €19.3 billion will go to fund re-financing of maturing government bonds and notes, plus €6.9 billion redemptions to Troika. Rest will go to fund government deficits.

At this stage, there is not a snowball’s chance in hell this level of funding can be secured from the markets, given the losses in economy’s capacity to pay for the Government debts. Which means Ireland will require a second bailout. And herein lies the second dilemma for the Government. Having secured the Yes vote in the Referendum of the back of scaring the electorate with a prospect of Ireland being left out in the cold without access to the ESM, the Government is now facing a rather real risk that the ESM might not be there to draw upon. In fact, the entire Euro project is now facing the end game, which will either end in a complete surrender of Ireland’s economic and political sovereignty, or in an unhappy collapse of the common currency.

The average cumulative probability of default for the euro area, ex-Greece, has moved from 24% in April to 27.5% by the end of this week. For the peripheral states, again ex-Greece, average cumulative probability of default has risen from 45% to 52%.

Euro peripherals, ex-Greece: 5-year Credit Default Swaps (CDS) and cumulative probability of default (CPD), April 1-June 1

Source: CMA and author own calculations

These realities are now playing out not only in Ireland and Portugal, but also in Spain and Cyprus.

Spain has been at the doorsteps of the Intensive Care Unit of the euro area for some years now. Yet, nothing is being done to foster either the resolution of its banking crisis, nor to alleviate the immense pressures of it jaw-dropping 24.3% official unemployment rate. Deleveraging of the banks overloaded with bad loans has been repeatedly pushed into the indefinite future, while losses continue to accumulate due to on-going collapse of its property markets. At this stage, it is apparent to everyone save the Eurocrats and the ECB, that Spain, just as Greece, Ireland and Portugal, needs not loans from the EFSF/ESM funds, but a direct write-off of some of its debts.

Spain’s problems are immense. On the upper side of estimated demand for European funds, UBS forecasts the need for €370-450 billion to sustain Spanish banking sector and underwrite sovereign financing and bonds roll-overs. Mid-point of the various estimates is within the range of my own forecast that Spanish bailout will require €200-250 billion in funds, a move that would increase country debt/GDP ratio to 109.9% in 2014 from current forecast of 87.4%, were it to be financed out of public debt, as was done in Ireland or via ESM.

Overall, based on CDS-implied cumulative probabilities of default, expected losses on sovereign bonds of the entire EA17 ex-Greece amount to over €800 billion, or well in excess of 160% of the ESM initial lending capacity.

Europe is facing three coincident crises that are identical to those faced by Ireland and reinforce each other: fiscal imbalances, growth collapse, and a banking sector crisis.

Logic demands that Europe first breaks the contagion cycle that is seeing banking sector deleveraging exerting severe pressures and costs onto the real economy. Such a break can be created only by establishing a fully funded and credible EU-wide deposits insurance scheme, plus imposing an EU-wide system of banks debts drawdowns and debt-for-equity swaps, including resolution of liabilities held against national central banks and the ECB.

Alongside the above two measures, the EU must put forward a credible Marshall Plan Fund, to the tune of €1.75-2 trillion capacity spread over 7-10 years, with 2013 allocation of at least €500 billion. This can only be funded by the newly created money, not loans. The Fund should disburse direct monetary aid to finance private sector deleveraging in Spain, Ireland and to a smaller extent, Portugal. It should also provide structural investment funds to Greece, Italy and Spain, as well as to a much lesser extent Ireland and Portugal.

The funds cannot be allocated on the basis of debt issuance – neither in the form of national debts, nor in the form of euro bonds or ESM borrowings. Using debt financing to deal with the current crises is likely to push euro area’s expected 2013 debt to GDP ratio from 91% as projected by the IMF currently, to 115% - well above the sustainability threshold.

The euro area Marshall Plan funding will require severe conditionalities linked to long-term structural reforms. Such reforms should not be focused on delivering policies harmonization, but on addressing countries-specific bottlenecks. In the case of Ireland, the conditionalities should relate to reforming fiscal policy formation and public sector operational and strategic capabilities. Instead of quick-fix cuts and tax increases, the economy must be rebalanced to provide more growth in the private sectors, improved competitiveness in provision of core public services and systemic rebalancing of the overall economy away from dependency on MNCs for investment and exports.

Chart: Euro Area: debt crisis still raging

Source: IMF WEO, April 2012 and author own calculations

The core problem with Europe today is structural policies psychosis that offers no framework to resolving any of the three crises faced by the common currency area. Breaking this requires neither harmonization nor more debt issuance, but conditional aid to growth coupled with robust resolution mechanism for banking sector restructuring.

Box-out:

This week’s decision by the ECB to retain key rate at 1% - the level that represents historical low for Frankfurt.  However, two significant developments in recent weeks suggest that the ECB is likely to move toward a much lower rate of 0.5% in the near future. Firstly, as signalled by the euro area PMIs, the Eurozone is now facing a strong possibility of posting a recession in the first half of 2012 and for the year as a whole. Secondly, within the ECB governing council there have been clear signs of divergence in voting, with Mario Draghi clearly indicating that whilst previous rates decisions were based on a unanimous vote, this time, decision to stay put on rate reductions was a majority vote. A number of national central banks heads have dissented from previous unanimity and called for aggressive intervention with rate cuts. In addition, monetary dynamics continue to show continued declines in M3 multiplier (which has fallen by approximately 40 percent year on year in May) and the velocity of money (down to just under 1.2 as opposed to the US 1.6). All in, the ECB should engage in a drastic loosening of the monetary policy via unsterilized purchases of sovereign debt and cutting the rates to 0.25-0.5%, with a similar reduction in deposit rate to 0.25% to ease the liquidity trap currently created by the banks’ deposits with Frankfurt. The ECB concerns that lower rates will have adverse impact on tracker mortgages and other central bank rate-linked lending products held by the commercial lenders is misguided. Lower rate will increase banks’ carry trade returns on LTROs funds, compensating, partially, for deeper losses on their household loans.