Irish credit II

Here are the facts in support of Irish credit ratings downgrade (for those impatient to get the actual downgrade forecast, see Table 2 at the bottom of this post) taken directly from the IMF’s latest Global Financial Stability Report published in October 2008.

These facts suggest that:
(a) the problem of Ireland’s high risk of sovereign and economic insolvency is not new –by the end of 2007 Ireland has emerged as the most financially exposed country in the developed world, to the total silence of Irish Government, Regulators and other domestic financial services authorities; and
(b) our sovereign ratings have are failing to reflect this risk, despite the fact that the data was available to all rating agencies for some time.

Our financial health ca January 2008...
Ireland ranks last out of the entire group of countries/ regions covered in the report in terms of its overall capital markets/financial stability (see table below). The countries/regions reported by the IMF include: the EU, Euro area, Canada, US, Japan, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, the UK, a general set of all emerging economies. Report parameters are given in IMF’s Table 3 in absolute terms.

Table 1 below ranks Ireland, and its two European competitors for the title of the worst-off (in terms of financial stability) Italy and Greece, across these same IMF-selected parameters.

Table 1: Ranking for Selected Indicators on the Size of the Capital Markets, 2007, expressed as % of country GDP/GNP
Sources: IMF GFS Report October 2008, and author own calculations.

Figures below plot the data that led to the above table results.

Figure 1: Total Reserves, % of GDP/GNPSources for Figures 1-7: IMF GFS Report October 2008, and author own calculations.

Figure 1 above shows total economies’ reserves (net of gold) as a percentage of GDP (and GNP for Ireland). Technically, ceteris paribus, higher levels of reserves relative to the economy size imply higher levels of solvency. Notice that this data is for 2007 – the year when Ireland was still in a relatively benign economic environment. In 2007 Ireland’s total reserves stood at a level almost 6 times below the EU27 average. Out of all main global financial centers selected by the IMF only Greece and Luxembourg showed weaker reserves base than Ireland.

Of course, we knew this already, as most of our wealth was trapped in the deteriorating housing markets. But the rating agencies failed to see this as a serious threat, preferring to focus disproportionately on the deceptively low public debt levels in this country. The irony that the state has managed to drive down its debt at the expense of economic stability (by taxing businesses and consumers to produce a ‘savings’ piggy bank for the public sector) and by imperiling our financial stability (by re-directing private financial flows and diverting investment into property and other state-incentivised schemes), was totally missed by the likes of S&P and Fitch.

Figure 2: Stock Market Capitalization, % of GDP/GNP
As the above figure shows, our stock market capitalization as the percentage of GDP/GNP ranked the second lowest in the world in 2007. Italy was the only country with a relative weight of the stock markets capitalization in its economy falling below that of Ireland. This parameter reflects, indirectly, the overall mammoth share of debt (as opposed to equity) on our corporate balance sheets and the effects of Irish economy’s dependence on leveraging and housing markets.

Figure 3: Debt securities as % of GDP
Figure 3 above shows how extreme were the levels of Irish debt liabilities in 2007, with the country leading the world in terms of private debt share of GDP. In the figure 4 below, the two sources of debt are combined to show that Ireland (as a share of GNP) has achieved a dubious distinction of becoming world’s most debt-ridden country by the end of 2007 – a point also missed by the rating agencies.

Figure 4: Total Debt Securities Outstanding, as % of GDP/GNP
Figure 5: Bank Assets as % of GDP/GNPWhen it comes to the financial system assets side of the balance sheet, Irish banking assets appeared to be relatively healthy in 2007 (Figure 5), although this does not include any correction for these assets quality. However two factors must be kept in mind:
(1) to date, Ireland has been leading the EU in terms of commercial bankruptcies (up 250% on 2007) and in terms of housing and commercial real estate crises, implying mid-term impairment charges for Irish banking system well in excess of those in other European countries;
(2) as the following two figures show, our assets cushion (non-bank assets as % of the total debt) and reserves cushion (total reserves as % of the total debt) were both thin, despite the fact that we are faced with an unprecedented (by global comparisons) total debt mountain.

Poor protection buffers: still the ‘old’ news

Figure 6: Assets CushionFigure 7: Reserves Cushion
It is worth mentioning that our Assets cushion (Figure 6) is artificially inflated by the still high property valuations of 2007. Correcting for 2008 commercial and residential property contractions, Ireland's non-bank assets to GDP or GNP stand at the lowest level in the entire developed countries sub-sample. Of course, as far as our reserves to GDP ratio goes - the fact is that our banking sector reserves stood at a critically low levels even in 2007 invites two observations:
(1) reserve requirement ratios are the prerogative of Irish Central Bank and Financial Regulator - with domestic regulators having full access to the powerful policy lever of raising these requirements. Both did absolutely nothing;
(2) the IMF figure for reserves includes state own reserves (NPRF), implying that the real problem of the banking sector reserves crisis we are currently experiencing is even worse than the official figures suggest.

Given a precipitous fall in Irish shares, property and economic growth – all registering declines well in excess of other European countries – we are now facing the assets and reserves cushions that are critically low, warranting a significant downgrade on our credit ratings.

Ireland’s comparatives (2008-2009) and ratings forecast
Comparing our financial position to that of the peer countries, Table 2 below shows that our current credit fundamentals are woefully out of line with other AAA rated countries in Europe. In fact, even disregarding the realities of our economic slowdown and fiscal challenges facing the country in 2009, comparative analysis of financial stability fundamentals for Ireland suggest that our true ratings should be below those of Greece or Italy.

Table 2: Assets, Reserves and Ratings
Sources: Fitch, S&P and IMF data, author own forecasts

The above results show that Ireland is well over-due a downgrade on its sovereign debt to bring us in line with our relative peers – Italy, Greece and (correcting for Eurzone membership) Iceland. But Table 2 above (see forecasts for financial stability parameters marked in blue) also shows that taking into account our economic and fiscal prospects for 2009, the downgrade currently overdue can actually be much deeper than the one forecasted herein.

Current environment: even more room for downgrades
One cannot ignore the extent of the economic and fiscal deterioration in Ireland to-date. We are facing an officially projected deficit that is unprecedented in the entire EU27. And the official forecast, as I argued before (here) is by all means an underestimate of the fiscal black hole we are heading for.

Even with An Bord Snip delivering significant – ca 10% - cuts in pubic spending (at least half of which is already factored into the Department of Finance forecasts), and even assuming the Government has the guts to implement such changes, Ireland is likely to find itself in ca 10% deficit in 2009.

This alone should trigger our ratings to be downgraded below AA- and our bonds yields to head closer to 6-6.5% for a 10-year paper. Of course, Ireland cannot at this time issue 10-year paper, implying that our borrowings for the foreseeable future will be short-term. Should the downturn extend through 2013, or alternatively, should the post-downturn growth fail to reach above 3%, Ireland will be in a serious trouble when redemptions on 2008-2009 debt issues come knocking on the door.

But the fiscal challenge is not the only one. Ireland’s economic contraction is likely to reach 4.5-5% (GDP terms) in 2009, implying that we will continue to lead the EU in terms of recessionary pressures. Such a scenario also warrants a downgrade of our ratings to AA-/BBB+.

Last, but not least, the Irish Government has underwritten some €450bn worth of debts and obligations on the domestic banks’ books, plus an open-ended commitment to supply capital to the banks. The nationalization of Anglo alone is likely to add something to the tune of €7-10bn to 2009 liabilities of the Exchequer and some economists estimated last week that this liability can easily reach €15-30bn.

Now, do the math. The Government boasts of holding some €20bn in liquid reserves, including surplus 2008 borrowings. Of these, Anglo commitment will eat through, say €7bn, previous capital commitments alongside the underwriting of the equity placements for AIB and BofI – another €5bn, the Exchequer deficit, assuming An Board Snip delivers real savings, will take up the rest. This leaves Ireland Inc naked for 2009 – no stimulus, no cushion for error, no buffers for any bank or building society default and, even more crucially, no deficit financing for 2010 should the sovereign debt markets get tougher throughout the year.

In these conditions, it is highly likely Ireland will push 10-year yields well beyond 350-400bps spread on German bonds and despite Mr Cowen's protestations to the contrary, find itself begging for funds from external donors. IMF or ECB or both - the acronyms are semantic: either one will part with its money only on extremely strict conditions...

Irish credit I

The prevailing feature of last year’s end is a growing tide of anger at the impotence of our Government to come to grips with the bleak reality of a severe downturn that is facing the rest of us. But the latest developments in global markets are suggesting that our Exchequer will have to deal with more than domestic pressure to reform in 2009.

Three events since the beginning of the New Year show the extent of the deepening global economic crisis with potentially dramatic implications for Ireland.

Sovereign debt financing
First, last week’s German 10-year bund auction, a golden standard of financial security for European markets, turned into an unmitigated disaster. The auction failed to sell 13pct of a relatively modest €6bn issue – second worst result in history that follows on the heels of seven auctions that failed to secure full placements in 2008. The latest US auction of 90-day T-bills – considered to be risk-free by the markets – was subscribed up to 50pct, while the UK’s 10-year bond issue had to be placed at 5pct.

Second, Greece has moved one step closer to a sovereign debt default and a deeper political crisis when banks bailout package triggered a wave of discontent from the crisis-impoverished consumers. To date, this has led to the firing of the Finance Minister in a Government that was, similarly to Ireland’s, elected just 16 months ago. Greek 10-year bonds are now yielding 5.31pct – dangerously close to the junk bond levels. This week’s Irish 5-year bonds being priced at 4.14pct implies that (a) adjusted for their term structure, Irish bonds would be priced to yield around 5.47pct for a 10-year bond – well ahead of Greece, and (b) the global appetite for long-term sovereign debt is in a steep decline. It is doubtful if Ireland will be capable of placing a 10-year note even in theory at anything below 5.6-6pct mark, suggesting that whatever debt we do raise in 2009 might come not only at a high price today, but at an even higher price in the future refinancing markets.

Our borrowing plans
Last, but not least, our Exchequer results for December have shown an unprecedented rate of collapse, with Q4 2008 receipts down a whooping 22pct on Q4 2007. The timeline of deterioration, highlighted in the box-out is frightening. Despite the Department of Finance forecast for 6.5pct General Government Deficit for 2009, it is likely that our GGD will exceed 9pct – three times the Stability and Growth Pact limit for the Eurozone member states by this year end.

The Government has acknowledged that Ireland will have to borrow ca €20bn in 2009 – a level of new bonds issuance that is unprecedented in Europe. And don’t forget that Ireland Inc is also likely to face the need for extra €5bn for the expected cost of banks recapitalization and guarantees and another €5bn in redemption cover for April bond.

Such borrowing, relative to the domestic economy, would imply bonds issuance of ca €450bn for the UK (well above the €160bn debt placement planned by the UK Exchequer) and €470bn for Germany. Put into perspective, the US is planning some $950bn in new bonds issuance, inclusive of some quasi corporate bonds by the likes of Fannie Mae & Freddie Mac, for an unprecedented 2009 economic stimulus. Were the country to use Irish Government fund raising plans it would have to issue over $1.8 trillion in new bonds. And while the rest of the world is using borrowings to finance economic growth, our Government is plugging the Exchequer imbalances.

The cost of digging ourselves out
All three events have one theme in common – they suggests that our economy is now firmly set on track to higher taxes and more pain for the ordinary households. For thousands of Irish businesses toiling under pressure to maintain revenue and employment this is a far more ominous threat than all external shocks combined.

The structure of pricing in the sovereign debt markets is now poised to change, with a renewed buyers’ focus on the underlying economic fundamentals. These include:
• Traditional fundamentals: fiscal deficits, inflation and economic growth prospects; and
• New fundamentals: the quality of macroeconomic management and the reasons for debt placement.
On both, Ireland offers a poor prospect. But it is in the second set that our Government’s failure to deliver leadership will be felt most, both by the NTMA trying to place our bonds and by the ordinary businesses and consumers, trying to cope with the cost of the public sector burden.

For traditional fundamentals, last year’s record unemployment claims growth (up 66pct), EU’s largest economic contraction (-2.5pct of GDP), widening of GDP/GNP gap, above EU-average inflation (especially in the state-controlled sectors), and extreme housing and construction crisis are all set to continue in 2009.

Irish property prices can decline by ca 25pct in real terms in 2009. New construction might replace only 30-40pct of the already low 2008 levels, while our unemployment is likely to climb to 11-12pct. This will be moderated, on the paper, by a rapid outflow of foreign workers and younger Irish employees. But in reality, emigration will take the most productive future employees out of this economy first. Deflation in the private economy will be exacerbated by continued inflation in the public sector as our semi-state companies squeeze Irish consumers in pursuit of increased profits demanded by the Exchequer. Taxes – both on personal income and indirect business and consumer levies – will climb, inducing a rising tide of tax evasion and minimization measures by businesses and sole-traders. All of this will imply that the Exchequer revenue will slide ca 10-12pct in 2009 on the back of a more severe growth contraction (-4.5pct GDP and -5-5.5pct GNP).

At the same time, there is little hope for spending discipline to be imposed on the public sector by this Government. For 2008, despite the extremely modest demand for €440 million in savings issued by the Exchequer in July, overall spending was up 0.7pct or €351 million. In part, this reflected high demand for social welfare benefits due to collapse in employment. In part, however, it reflects the fact that our public sector still managed to award itself the pay increases and pensions hikes set out under the last Social Partnership agreement.

A new set of challenges
New pricing fundamentals in the bond markets support the proposition that the State will find it very difficult to raise funds in international markets and that this will translate into more economic hardship for the private sector.

In 2009, debt markets will favour those sovereign issues that will be placed to provide direct growth stimuli to the economies. In contrast, Irish borrowing will be focusing on maintaining already unsustainable levels of Exchequer expenditure with little stimulus potential.

Can anyone really believe that serious international investors will back our Building Ireland's Smart Economy framework? Or that they will have serious confidence in this Government’s ability to jump-start Ireland’s economy? To date, Irish Government record on taking decisive action is, as the box-out shows, abysmal.

The problem with the current Government’s handling of the economy is that instead of facilitating growth, the State is exacerbating the effects of the global economic slowdown. Majority of Irish businesses are currently operating in the environment of severe shocks to sales, exchange rate valuations, contracting global demand, shortages of credit facilities and rising domestic costs. At the same time, majority of Irish consumers are feeling besieged by the rising risk of unemployment, taxes, debt and falling disposable incomes. None of these players can take on the task of rescuing the Exchequer out of the unsustainable spending increases.


Box Out: A record of errors
Credit ratings agencies reviewing Irish Government creditworthiness in the recent weeks have made sweeping claims that their unwillingness to downgrade Irish ratings from the gold-standard level of AAA are motivated by the speedy and adequate response by the Government to the economic crisis. In reality, our Government has shown zero capacity for leadership and for admitting its own errors. Consider the facts.

Fact: 2007 general elections brought up the need for public sector reforms to the forefront of policy debate. All parties involved made serious hay out of the calls for changing the way this state spends tax revenue on various political white elephants, bogus investments, excessive wages and perks in the public sector and so on. By the end of 2007, the Government has seen the OECD blueprint for change. By the second half this year it had its own assessment of the OECD report. There has been no action by the Government on the issue of public finances.

Fact: in mid 2007, as the credit crisis first manifested itself, a number of commentators, including this column, has told the Government that the spending path it embarked on was out of touch with reality. In late 2007, many analysts, this column included, were predicting a record slowdown in 2008 and a precipitous fall in taxes. The Government ended 2007 in deficit – despite the windfall from SSIAs and buoyant economy. The same leaders are now denying knowing anything about the crisis prior to July 2008.

Fact: The Exchequer registered a 6pct drop in Q1 2008 receipts compared to Q1 2007, 10pct drop in receipts in Q2 2008 relative to Q2 2007, 12pct decline in Q3 2008 and a catastrophic fall of 22pct in Q4, bringing about an unprecedented, by all European benchmarks, deficit of €12.7bn with a span of the year. All of this was happening right in front of this Government’s eyes and with complacent silence of the boffins from our Department of Finance. This Government still insists that it could not have foreseen these events until after the end of Q2 2008 – 7 months after the revenues collapse began.

Fact: Since the beginning of 2008, when the scope of the crisis became apparent first to the independent economist (in January-February 2008), then to the financial services experts (March-April) and later even to the ESRI and other official policy pundits (by April-May 2008), the Government took lengthy vacations and extended tea breaks to evade making any policy decisions that can be considered even remotely effective or decisive. In the year of extraordinary crisis, both the Dail and the Cabinet did not bother to take any significant extra time to deal with the issues.

In the course of 2008, this Government produced four policy documents:
• a banks guarantee scheme which provided no real support to the economy and preciously little support for the banks,
• the Budget 2009 which managed to bludgeon ordinary consumers and small businesses with new taxes and levies but produced not an ounce of reformist thinking,
• the recapitalization scheme for our banks that failed to address the issue of catastrophic household and corporate indebtedness, and
• the farcical Building Ireland's Smart Economy framework, promising more waste and government spending on politically motivated pet projects amidst the trite catch phrases richly sprinkled across 100-plus pages of largely meaningless policy proposals.

Per Hitchhiker’s Guide to the Galaxy, can this Government, please start delivering its future reports and policy papers in a plastic cover with ‘Don’t Panic’ printed on it. At least we will be properly forewarned.


This article appears in the current edition of Business & Finance magazine (January, 16, 2009).

Our true credit ratings

The credit ratings agency, Fitch, has downgraded all Irish banks closer to the junk-bond status:
• Allied Irish Bank and Bank of Ireland went down a mile from AA- to A,
• Anglo fell two stories to A-,
• Irish Nationwide, having fallen from BBB+ to BBB-, is now just one inch away from being valued as pure junk,
• IL&P sits pretty (thanks to its insurance arm) at A+, down from AA, while
• EBS is now up for a review of its A- status.

All moves were triggered by Fitch’s (somewhat belated) realization of “the deteriorating economic environment, an abrupt contraction in forecasts for Irish economic growth in 2009, rising unemployment and a worsening outlook for commercial property", that threaten earnings and loan book losses.

Clearly, Fitch's folks have not been listening to
• the increasingly irrational pronouncements from our Taoiseach in Tokyo about the imminent return of the age of prosperity and the bottoming out of the housing market in 2009 (made on the day when RGE Monitor pushed back expected date of the US housing market bottoming out to 2010 (see here), as did the UK);
• the oblivious statements from the Exchequer about the low-debt competitive economy that is Ireland Inc; and
• those voices of the Irish knowledge economy pioneers that RTE’s Wednesday Prime Time programme unearthed (how can one fail to see the bright future for the country covered by fish farms with a perpetuum mobile machines providing zero-cost energy? As we speak, I am quite confident Eamon O'Cuiv is seeking state funding for a Galetacht company to produce tin whistles for export, while SFI is funding the path breaking research in alchemy).

But Fitch did swallow some propaganda junk from our leaders. Chris Pryce from Fitch Ratings told the UK Telegraph that “Ireland had shown great courage by facing up to the full implications of the global crisis earlier than others. "We're very impressed by the vigour of the Irish government," he said.”

What courage? What vigour? A lifeless cabinet limping from one crisis statement to another? What 'facing up'? We have a PM who finds nothing better to do than attack American foreign policy and the UK monetary authorities in between lunches and receptions in Tokyo? A Deputy PM who is incapable of a single meaningful thought on this crisis on an hour long program on the national broadcaster devoted to it?

Next stop for the country? An honest reappraisal of our sovereign debt ratings to reflect the fact that our actual debt ratio to committed obligations under the banks guarantee and recapitalization schemes is about 1:5, yielding a total expcted Exchequer exposure of ca 120-150% of GDP should impairment charges at the banks reach UK's 1990s levels, implying that Ireland’s own bonds cannot be traded at the prices far off the banks bond levels.

Of course, not willing to follow S&P’s delirious review that left Ireland’s sovereign rating at AAAa week ago (here) and Fitch’s yesterday’s failure to mention the execpected impact of their banks downgrade on Irish sovereign debt, the markets have already started the repricing process. Our five-year credit default swaps are being quoted at a 250bps, roughly 66bps above Monday levels.

We are now at par with Greece, while enjoying a much more rapid deterioration in the economy and public finances, implying our debt rating should be at or below their A-/A-2 range.


PS: at the rate our CDS spreads deteriorate, it is worth a mention that our NTMA is about the only properly functioning branch of the State.

The Oligarch of the Upper Merrion Street

Flip-Flop-Flip Brian
On October 23, 2008, just two and a half months ago, Minister for Finance has gone out of his way to explain that the State investment in the banks was the 'very final option' he was willing to take. On that date, Anglo’s shares were trading at €1.80 or almost 90% down on their historic high. Flip! Brian's jacket of being 'conservative with taxpayers' money' came undone!

Fast forward 2 months ahead – on December 15, 2008, announcing the rescue plan for Irish banks, Mr Lenihan has flopped the ‘very final option’ into an actual policy. By that date, Anglo’s shares moved to €0.36 or 80% below their October 23 level, yet still the ‘very final option’ was to involve no more than a 3/4 stake in Anglo with no voting rights for the Exchequer. The fig leaf of decorum of being only 1/4 true to his October statement was all that was left of a respectable Exchequer.

Today, Brian ‘The Flipper’ Lenihan has completely reneged on his October-December claims. The state is now poised to take the entire Anglo – toxic and healthy assets, workforce and physical capital alike. Flip! The fig leaf is sailing across the Upper Mount Street - its new Bank-owning Oligarch is now fully exposed as Minister whose words must be read between the lines.

Details? Go straight to the consequences!
Whatever the deal price might be the main point of this performance by the Government has been totally lost in the media to date. The nationalization of the Anglo Irish Bank is simply wrong. Full stop.

Let me focus on this point:

Irish Exchequer has no business taking money from the working families at this time of need (or at any time indeed) to rescue a handful of large development deals and bail out a party of investors. No financial stability emergency, no amount of bad loans on the books, no balance sheet analysis can ever justify the Exchequer using ordinary peoples' cash to buy assets into its own ownership.

If the Anglo needed capital, the Exchequer should have placed money with the institution, collect the shares in return to the current value of the money deposited and then immediately disburse the shares to those who are paying for them – the people.

And I do not mean some collective People – aka the public sector who will reap most of the benefit of any future recovery in Anglo’s fortunes, but the people whose cash 'The Flipper' has so princely pledged to Anglo’s creditors.

To be morally justifiable, the nationalization of the Anglo Irish Bank should:
(1) involve a rigorous investment case analysis carried out by an international assessor with NO connection to Ireland, the Anglo Irish Bank or any other party to the transaction before any announcement of the takeover was made; and
(2) if allowed to proceed, be carried out as a voucher nationalization scheme, with all new Anglo Irish Bank’s shares (underlying the State liquidity injection) being distributed uniformly amongst all households in Ireland.

We've paid for them, Mr Lenihan, in case you've failed to notice!

Renewing appetite for risk?

“I have some good news, at least for the intermediate term: Investors are slowly regaining their appetite for risk”, wrote Marketwatch’s Mark Hulbert in his today’s column (here)
“This represents a big shift from the situation that prevailed last fall, when investors became so repulsed by any kind of risk that the yields on safe-haven investments like Treasury bills actually went negative.”

But now, says Hulbert, with January effect in full swing, things are looking up – investors are looking for risk once again.

“Of the several straws in the wind that point to at least a partial return of a risk appetite, one of the more compelling is the recent relative strength of risky small-cap stocks over the more conservative large caps. So far this year through Tuesday night, for example, large-cap stocks (as measured by the Standard & Poor's 500 index (SPX: S&P 500 Index) have fallen 3.5%. Small-cap stocks, as measured by the Value Line Arithmetic Index (92040310), have declined by just 1.1%.”

Now, I am not convinced by Hulbert’s main argument.

January effect is a tax-minimization event, driven by heavier sales of shares with lowest capital gains potential to maximize losses in December (blue chips down) and re-balancing portfolio toward higher capital gains potential (small cap) in the new year. In normal years, movements correlate positively with risk, i.e. small cap – higher expected return, higher risk, blue chip - smaller expected returns, lower risk. But is that the case this time around? In other words, the markets might be going into smaller cap because the larger cap is actually relatively riskier (controlling for current valuations), not because they are seeking higher risk-return strategies.

Chart below illustrates Mark Hulbert’s point – at its right-hand margin. Indeed, the short-term performance by the two indices does suggest that the markets are placing more faith in the small-caps. But it shows that this was true for much of the 2008 with exception of the late autumn. In other words, if current divergence vis-à-vis S&P is a sign of new appetite for risk, what did the market have appetite for in July 2008 when small caps went up and S&P stayed relatively flat? Why did the price of risk implicit in the difference in two indices has fallen in April-June and July-early August? Were these the ‘turning’ points in underlying appetite for risk or just traditional bear rallies?
An alternative explanation for the ‘January effect’-like pattern observed is that investors' risk perception might have shifted. Consider the following scenario: You are in a market with four broad asset classes:

• large-cap,
  
• small-cap,
  
• corporate bonds and
  
• Treasuries.

You believe that too much risk-taking has taken place in the second half of December by pursuing a bear rally in S&P500 stocks and the Treasuries. If you move into relative safety, you will move into the two remaining assets. You will have an incentive to prefer the small caps if you believe that they have taken the heaviest beating to date (which they did – see peak to trough moves around September-mid November) and you invoke another powerful anomaly of the ‘Winner’s Curse”. The real question then becomes is what does the analysis of relative position changes in corporate debt and small cap shares tell us. The large cap stocks are irrelevant here.

Hence, what appears to be a renewed appetite for risk can be interpreted as a hedging strategy against rising risk levels and falling expected returns in the so-called traditionally ‘safer’ asset classes.

What Hulbert is right about is that one should not overplay the story too much. Instead, the return of the January effect pattern (or something else resembling it) might mean “that the stock market will gradually resume its normal function of assessing different securities' relative risks and returns, a function it couldn't fulfill when it was indiscriminately punishing virtually everything other than Treasuries.”

Yes, but… even if Hulbert is correct, the return to rationality in the markets will be bound to:
• trigger fresh downgrades in many companies and indices as corporate returns deteriorate throughout H1 2009, as the bath water gets muddier with longer recession; and
• this rationality will remain extremely fragile and prone to collapse every time the elephant in the room – the US Government – moves about.

Hulbert omits the latter issue, but it is non-trivial to his topic. We are in the changing political cycle – and with it – a prospect of a new stimulus that is bound to prop up smaller business. If, as is the case, Uncle Sam’s rescue packages for many blue chips were already priced into these companies valuations in late December, Obama's first 100-day sweetheart package for Congress is yet to be fully priced into stocks valuations. It might be that the ‘January effect’ is simply the reflection of this delay in recognizing that the next Uncle Sam's move will a stimulus for smaller companies?..

Foot-in-Mouth Outbreak update I

From today’s WSJ – hat tip to Paul – see the first comment here:

“So the Fed is again in the position of "pushing on a string" and finding that nothing happens. Some economists describe this as a "liquidity trap." Money creation loses its stimulative power -- vastly overrated even in ordinary times -- because public demand for loans is weak. Americans are too strapped financially, too short on investment opportunities, or too concerned about the future to borrow. They prefer to save instead.”

This makes sense, especially in Ireland – the incessant blabber we are now accustomed of hearing from the Dail – the Government and the Opposition – is that the banks must start lending to the households and the corporates. But, as I pointed out on numerous occasions since last summer (including in the posts here), there is no demand for these loans – Irish households (the most indebted in the EU) and companies (the most indebted in the EU) simply have no demand for new loans. Hence, the main problem faced by the Irish government is de-leveraging of companies and households, not recapitalizing the banks!

According to WSJ:
“Some economists argue that... the new money the Fed has pumped into the economy to replace the financial-sector liquidity wiped out by the collapse of the bubble has to go somewhere, they point out. It has to end up in someone's bank account and banks have to quickly convert deposits (liabilities) into investments or go broke even faster than some have by loading up on polluted, mortgage-backed securities. Maybe "liquidity malfunction" is a better term than "trap."”

The malfunction, according to the WSJ is that the money creation feeds US Government spending, yielding little benefit for the private sector. It is, according to the WSJ article – a Keynesian policy Redux, not a monetary policy paradigm.

I agree with that view. In September this year I authored a research note – which was never published – saying that the US Fed’s monetary operations – ‘helicopter drop of money’ and monetary policy easing can be viewed as a Ponzi game. Ditto for Ireland’s banks guarantee scheme and banks rescue package. I returned, briefly, to this is my Business&Finance column in November 2008.

Effectively, the rescue policies work like an old fire engine pump – the flow of funds from the Treasury to the Fed to the Treasury passing through the markets creates a vacuum of liquidity in the associated securities markets. Think buying bonds, liquifying existent positions at a discount, and then selling new bonds at a premium, thus generating net negative position. These flows sap private and foreign liquidity out of the private sector loans market and into public sector stimulus financing (or assets purchasing, banks propping and Detroit rescues). In effect, this ‘liquidity’ pump is destroying any hope of private credit markets return to some sort of stability, while financing Treasury's operations.

The thing is that, while we do need to prop up some financial institutions, if you push liquidity flows through household balances – by forcing the banks to issue new equity/options and write down loans – you use the liquidity to achieve both – provide a pool of potential loans and deleverage households. Only then will you simultaneously solve the twin problem of:
(1) shortage of loans supply;
(2) shortgae of loans demand.
Not a single politician to date cared to listen.

Yet, this is exactly what the article in the WSJ is saying...

Surprise! Our Brian's new 'foot-in-mouth' outbreak

As stated in the Financial Times today (here):

"Brian Lenihan, the Irish finance minister, accused the UK authorities of, in effect, devaluing the pound by expanding the UK money supply, action that was causing “immense difficulties” in the Irish economy. “It is a question for all of us in the EU as to the extent to which a competitive devaluation can be used as any kind of weapon,” he said."

Oh, dear. Our Brian does not get it - British monetary policy is about British economy. It is not - and should not be - about some abstract idea of European solidarity (which seems to work for our Government only when solidarity means that others do something 'nice' for Ireland) or coordinated responses to the crises (if the UK were to coordinate things with Ireland, they would be rising taxes, squeezing consumers, issuing blanket guarantees and wasting billions on inefficient public sector).

Whether the UK is engaging in a competitive devaluation, or is simply conducting more pro-active monetary policy than 'we-don't-give-a-damn-if-you-are-in-pain' ECB is a moot point. Bank of England has a mandate to manage money supply for the UK. British Exchequer has a mandate to respond to the real needs of the UK economy. It is Brian Lenihan who has a mandate (if only theoretically) to sort out his own Government's response to the crisis in Ireland. Does the fact that the latter does not seem to be up to his job imply that the former two are obliged to help him finance his wobbling decision-making?

Oh, when one hears an ex-lawyer talking about Forex valuations, ...it sounds only half as bad than when one realises that he is in charge of our entire Exchequer!

Near Sovereign bonds - the next frontier II

Brad Sester on the same topic of the US Federal paper (here) gives pretty much the same analysis of the Treasury's supply and demand imbalance emerging at this time, with pretty much the same implications:

"My guess is that central bank demand for US Treasuries will fall both absolutely and as a share of the US borrowing need. That is no bad thing. It is a byproduct of a smaller US current account deficit and a smaller current account surplus in much of the emerging world."

And a bit more beef on the direction of US foreign holdings sales and foreign withdrawals from the US equities:

"To be clear, official demand for Treasuries surged in the fourth quarter even as reserve growth slowed – as central banks shunned Agencies and likely pulled big sums out of the hands of private fund managers and parked those funds at the Fed. But once that reallocation is finished, growth will be driven by the underlying growth in countries reserves. And that is slowing …"

At current valuations in the sovereign debt markets, you have to be mad to follow the crowd into buying low yield paper when the governments issuing it have extended near sovereign guarantees to higher yielding corporate debt and are about to do so for quasi-government / local government debt as well.

Near Sovereign bonds - the next frontier?

We all know 2008 wasn’t a good year for securities markets. Now that the data is trickling in, we can see just how badly things turned out. Foreign investors unloaded almost $90 billion of U.S. securities in Q3 2008 alone – the greatest quarterly sale by overseas shareholders since 1960. In return, US investors sold ca $85 billion worth of foreign equities and bonds, according to the US Bureau of Economic Analysis.

It is too early to tell how much of this $175bn liquidity went into Treasuries and how much into the US corporate debt. But, after a week of weakening fixed income ETFs discounts, it is now looking increasingly likely that the markets are running a bit too hot in the sovereign paper area. This means it is time to look for a new class of 'favorites' and long over-looked US state bonds and municipals might be coming back into play. Maybe on the back of some sort of a Federal Government guarantee.

The reason is two fold: (1) the sovereign debt markets for US and European paper are teetering at what appears to be the zenith of a mini-bubble; and (2) more recent institutional investors’ interest in corporate bonds might be leading to a renewed appetite for some risk.

On point (2) first: Sure the likes of PIMCO and Blackrock will be pushing corporate debt over sovereign, given these fixed income giants have been vacuuming large corporates’ bonds for over a month now (see PIMCO’s Bill Gross’ latest ‘rant’ on TIPS etc here). Nonetheless, there is logic to their strategies, especially the one that Gross is pushing for in his sales pitch - if the US Government is willing to underwrite companies like GM, their debt should be trading closer to the US debt than the current yeilds imply. Yild compression amongst the Washington-'backed' corporates, therefore, might be on the books.

But, there is also a serious concern out there that too much money has now flown into the US Treasuries – pushing the yields to their historical lows. And this brings us to point (1) above.

James Montier, from Société Générale, has found that since 1798 yields on US bonds have never been this low, except under war time price controls in the 1940s. Montier reminds those of us who are quick to forget history (i.e economists in general) that the end of these low yields era of the 1940s was a tearful one. “The Fed drove the 10-year bond down to 2.25pc, much as it is doing today with mortgage bonds”. Post-war inflation did the rest of the damage.

Overall, the historic average for 1798-2008 period is ca 4.5pc nominal yield or 2pc real return. Yields on 10-year US Treasuries have now fallen to 2.4pc, leading one famous bond investor – Jim Grant – to quip that we are now in a ‘return-free risk’ world. In effect, current markets are implying (at present yields) that a decade of deflation will ensue despite the global efforts to re-inflate economy. This is how bad things must get in order to justify current valuations relative to the historic path. The story is the same across the world, with yields at 1.3pc in Japan, 3.02pc in Germany, 3.13pc in Britain, 3.26pc in Chile, 3.47pc in France, and 5.56pc in Brazil.

Thus, globally, investors are betting that deflation will fully offset the effects of near-zero interest rates and over €2 trillion in fiscal stimuli.

A highly unlikely proposition. What is more likely is that the sovereign debt markets are now over-subscribed and the bubble is primed to burst. When this happens, two things will follow:

(1) new sovereign debt issues will become virtually impossible to place (read about the new issues auctions troubles brewing already in my forthcoming Business & Finance article – to be posted here over the weekend), and
(2) first wave of bubble exits will go chasing some new risk in the form of under-priced quasi sovereign debt, a.k.a munis and state notes (ETFs discounts on funds dealing in these are deep now, but if my thinking is right, this is about to change in late Q1-early Q2).

An additional problem with sovereign bonds is that they are also facing a latent glut of supply. China, Russia, Brazil and many other countries will need liquidity for their internal purposes. They are unlikely to continue clinging to their holdings of the US Treasuries. China alone has $1.9 trillion in foreign sovereign bonds and the country now faces a dilemma – issue own debt to pay for domestic stimulus or sell other countries’ debt. It is no brainer that some of the Chinese-held bonds will hit the market at some time in 2009. Sure, they will go about it tactfully, gradually, quietly. But equally one can be sure they will dump somewhere around $90-110bn worth of this stuff in the next 12-15 months - if only to offset currently accelerating capital outflows.

Looking at this from the global perspective, BRICs and Middle Easter oil producers have in effect financed European and American deficits through 2007. In 2008, their appetite for this ‘store of value’ paper has run a bit dry. In 2009, it will turn negative, just as the US and European deficits will balloon to $3.5 trillion.

The only possible response to this is: a helicopter drop of money. The Fed, unlike less experienced and less globally aware ECB, sniffed the trend few months back. Helicopter drop of money – a practice of monetizing sovereign debt by printing money and using it to hover domestic bonds – is a powerful inflationary monetary policy tool. If the Fed was not aware of an incoming opportunity to do so, it would have not ‘unloaded its policy gun’ by cutting rates down to zero. The fact that it did shows that the Fed is more than willing, nay – it is actually happy – to start the printing presses to liquefy the bond holdings.

And just how effective this can get? Look no further than the US mortgage rates, driven – within a span of two months down 150 bps to 4.5pc – by Feds aggressive purchasing of mortgage-linked bonds, some $600bn worth of these. This is dandy, but what happens when the Fed satisfied its hunger for paper and deflation risk abates – possibly toward Q4 2009. The air will burst out of the bond market as the Fed will start gradually clear some trillions of dollars worth of paper off its books.

It will be a bang, not a pop - yields up, prices down, and the current holders of Treasuries belly up. The process will not be complete until the Fed unloads, say $1-1.5 trillion of the bond holdings, implying that no sane person will be buying these in the middle of the lengthy sell cycle. Lengthy because selling such quantity of US paper amidst the world still languishing close to the recession bottom will require care in order to avoid running up the risk of reigniting deflation.

So the longer-term future might be bleak for the US sovereign debt. The near future is also uncomfortable.

The strategy of playing the Fed’s drive into the bonds market during the ‘drop’ phase of money creation is not on the cards for investors, as most likely large purchases will mirror large supply increases from the likes of China, implying limited upside potential early in the purchasing cycle as supply of bonds will always stay near Fed’s demand line.

When to elephants play, stay well out of their way.

All of this means smart money will move elsewhere in advance of the Fed buying cycle (prior to Q3 2009) and munis and state bonds will be just there, at the ‘Welcome’ gate for investors, with some fresh backing from the Feds and a pile of infrastructure projects to finance.

A foreigner? We are not too welcoming in our Public Sector...

Few months back I was invited to a presentation by the Immigrant Council of Ireland, attended amongst others by a senior civil servant in charge of one of our core Government Departments. During a lively discussion about racism and discrimination in Ireland, our brave Public Sector employee professed to be concerned about discrimination in the private sector employment. I, somewhat rhetorically, asked him if he perceived a disproportionately small number of foreign nationals employed in the public sector (inclusive of our state enterprises), as compared against their much stronger presence in the private sectors to be a sign of something dodgy going on in the state employment. He flared white with indignation.

Hmmm… figures from CSO’s Foreign Nationals: PPSN Allocations and Employment, 2007 (here) released on January 8 give my concern a strong backing.

Table below lists employment (per CSO) by sector (including foreign share of employment) of foreign nationals in Ireland in 2007.
Note: PS stands for ‘Public Sector’, while NPS denotes ‘Non-Public Sector’. * marks percentages reflective of a slightly different categorization used by CSO in listing various time series.

The share of non-Irish nationals in overall employment in the economy in 2007 was ca 20.1%, with foreign national comprising 30.6% of employment in the broadly defined private sector economy and 6.5% of employment in the public sectors.

Setting aside two public sectors with significant contribution by foreign non-nationals: Education and Health, the rest of public sectors had only 1.4% of their entire employment pool covered by the foreign nationals.

For a foreign national residing in Ireland, the probability of ending up in Public Sector employment ranged from 11.1% in Health & Social Work, to 3.9% in Education, to ca 2.2% in our semi-state companies and 1.6% in Public Administration. In other words, a foreigner is 19 times (!) more likely to gain a job in our private economy than in the most insulated and unions-protected Irish Public Administration sector!

It is also worth noting that within the Education category, only 663 foreign staff were employed in secondary education (heaviest unionization), the rest were working in either primary (1,068 – virtually un-unionized) or tertiary education (less unionized). In Transport, only 98 were in Transport via railways (unionized), while the largest share were employed (6,844) in less unionized Other Land Transport.

At the same time, there is absolutely no sign of lower level of skills amongst the foreigners as compared to Irish workers.

Why wouldn’t our workers’ rights defenders, like SIPTU, ICTU, Impact etc, take up the case of finding out what is going on inside our state-controlled employment?

DofF (In)Stability Report

And so it goes - another weekend, another rushed report. This time around, the boffins in our Department of Finance have decided to give the nation a weekend to digest the infinite wisdom of their outlook for our economy: the Addendum to the Irish Stability Programme Update, January 2009 (link here).

And what a fine read it presents:

"The economic situation is changing rapidly," reveals the report. In case we have not noticed this at the ground level.

"The uncertainty surrounding economic forecasts in the current environment was highlighted in the October Stability Programme Update, and many of the risks identified at the time have subsequently materialised," the report continues. One can only assume they are talking about the risk of a -0.8% economic contraction in 2009, predicted by October edition. Just about the time when a majority of stock brokers and other analysts, including myself, forecast a -3% 2009 growth!

In a nutshell, the update delivers a new forecast for economy to contract by 4% (GDP) and 4.5% (GNP) in real terms in 2009. Mark this space - two-three months from now, justifying new round of tax increases, DofF will cut these to -5%. and -5.5-6% respectively.

"This would also mean a cumulative loss of output of around 6¼ per cent over the period 2008-2010," say our civil service porgnosists. But hold on, GNP contracting 4.5% in 2009 and "positive growth is expected in 2011, with a return to more sustainable growth thereafter."

This implies that 2008 and 2010 contractions in Ireland's real economy will total 1.75% in GNP terms (or 2.25% in GDP terms) net of compounding! Now, that is about as realistic as expecting Michael Dell to outsource all his manufacturing to Waterford Wedgewood.

Outside the planet Civil Service Boffins inhabit - i.e down here on earth - real income contractions are likely to take the following (conservative) route:

• GNP: 2008 -2.8%, 2009 -5.5%, 2010 -2.5%, 2011 flat. Cumulative damage for 2008-2010: 10.4%, not a derisory 6.25% DofF thought up.

Of course, DofF ignores simple compounding rules. Its figures for GDP growth imply a 6.2% compounded contraction (not 6.25%) over 2008-2010, while its GNP forecast yields an 8.2% fall in real income (output) over the same period of time. Where did they get that 6.25% number from?

DofF also ignores the fact that for people living in Ireland, GNP is what we actually produce and what our income relates to, when the transfer pricing by the multinationals is factored out. On this measure, losing 8.2% (DofF forecast) or 10.4% (my guess) of ones income and facing rising tax bills is a bleak prospect.

DofF predict unemployment to rise to 9.2% in 2009 and 10.5% in 2010. This is plausible, but only if one is to assume that net emigration from Ireland will swallow the difference of ca 1-2% of our labour force, annually, in 2009 and 2010.

Here is a quick summary of their outlook (Figure 8):
This is interesting for two reasons:

(1) In mid 2007 I argued in Business & Finance magazine that Ireland will not get close to the potential GDP growth rates of 4% (used by the DofF in their Budget 2008 assumptions) anytime in the near future. I estimated our post-crisis potential GDP growth to be around 2% (and I stick to this estimate).

(2) Notice 'contribution of total factor productivity' growth to potential GDP growth - even after the return of economic growth in 2011. DofF clearly does not foresee our great knowledge economy to contribute more to future growth than the sweat and brawn of pure labour and physical capital. For once, I agree with them. But here is a question - what is then to be made of our Building Ireland's Smart Economy rag published less than a month ago?

Well, let's move on. Here is another interesting piece of news from the Report:
Oh no, I did not make it up - they really are projecting an 9.5% General Government Deficit and that is after factoring in expected Government efforts to "improve the following year's base". I only hope this is not a sign of what our An Board Snip is preparing in cuts. But this does include (Additional Annual Adjustment line, AAA) the cumulative of July-December 2008 demands for spending cuts made by Minister Lenihan. And beyond 2009 it includes DofF wishful thinking that Mr Lenihan will be decisive and tough enough to actually wrestle these savings out of the dead cold hand of our civil service!

Last week the Government claimed that GGD for 2009 will be in the region of 6.5%, although some rumors were circling the media that it might be 'as high as 8%'. Few days later - we have a magic 9.5% number. Either things have gone totally pear-shape within the span of a couple of days, or DofF simply got it so wrong before, that it is now running over its ar*e for the hedge.

My humble view - 9.5% is a lower end estimate even with An Board Snip cuts into public spending factored in. Why? Because this Government has no guts to implement even a meager €440mln cuts demand (see below), let alone a lofty €2bn, so that AAA line is a wishful thinking for 2009, 2010 and 2011.

Now, suppose these AAA savings reach a more realistic €1bn in 2009, rising to €1.5bn in 2010 and falling to nil (per demands of our trade unions) in 2011. Where does this leave our GGD? In DofF model terms - 10% in 2009, 10.4% in 2010, 8.5% in 2011, 6.5% in 2012 and 4% in 2013. We, the taxpayers, will be paying for this open-ended waste for the next decade or so!

At this point, only a few, albeit still scary, things are left worth mentioning:

"The Government has set as a priority the elimination of the current budget deficit by 2013, that is to stop borrowing for day-to-day spending, and to bring the General Government deficit to below 3 per cent of GDP in that period." In other words, the Exchequer has no plans to bring its own appetite for our money under control any time soon. Is it 'elimination' of the deficit (in plain English a zero deficit), or is it a deficit below 3%? Such a loose use of the language by the budgetary authority is a sign of a deeply seated lack of confidence amongst our top leadership, including that in the civil service.

"Investment in capital projects to enhance Ireland’s productive capacity has been retained at a very high level, of the order of 5 per cent of GNP... given the extraordinary economic and financial circumstances impacting on all countries, including Ireland, this level of investment, which is now being totally funded from borrowings, will provide a significant fiscal stimulus in these difficult times." In other words, don't bet on any real fiscal stimulus - after all, recall that this 5% of GNP (not GDP) package is the same one we had since the passage of NDP two years ago! There is nothing new, nothing innovative, nothing more effective than offering a standard investment plan pre-announced two years before as a workhorse of the crisis resolution package!

"The Government took firm and immediate action on expenditure in mid-2008 to address the emerging spending pressures, securing some €440 million in savings in 2008." Now this truly surreal: 6 months after the crisis in public finances has reached noticeable proportions is hardly an 'immediate' action. Even the Government itself has admitted this much! As far as €440mln in savings being a 'firm action' - instead of savings, this government managed to get a spending over-run of €351mln by year end, missing its 'firm' target by almost €800mln!

Irish taxpayers don't need this belated and politically expedient drivel that borders on insulting to our intelligence at times. We simply want to hear the truth!

S&P's downgrade for Ireland

Here are my two cheers to S&P for today’s note on downgrading its outlook on Ireland –
One Cheer: for getting there late (although it is better than never), and
Another Cheer: for getting it so dramatically wrong, their ‘pessimism’ actually sounds like exuberant optimism when compared with reality.

Here are the details (all quotes are from S&P statement):

“Standard & Poor's Ratings Services said today it revised its outlook on the Republic of Ireland to negative from stable, on what we view as mounting fiscal pressures and deterioration of key economic sectors. At the same time, the 'AAA' long-term and 'A-1+' short-term sovereign credit ratings were affirmed. Standard & Poor's also affirmed its 'AAA/A-1+' ratings on the debt programs and instruments of those Irish banks where they are guaranteed until maturity by the Republic of Ireland.”

Hmm, let me get this right – Irish Government debt is ranked above junk level. Irish Government debt underwrites junk corporate debt of our banks, that in itself is over x2 times Irish GDP or over x5 times Government share of the entire Irish economy. So: 1:6 is AAA/A-1+, while 5:6 is something along the lines of B to CCC quality, absent guarantee. But the whole thing is AAA/A-1+... This does look to me like the logic of securitized mortgages ratings of the good old past – no weighted average can achieve this risk pricing. A BBB for Ireland Inc and B/CCC for the banks sounds to me like a better mark.

"The outlook revision reflects our opinion of the rising economic policy challenges stemming from the contraction of the key housing, construction, and financial sectors, which have spurred many years of strong economic growth and fiscal consolidation," said Standard & Poor's credit analyst Trevor Cullinan. …We have observed that general government debt levels also increased substantially between 2007 and 2008, by more than 16% of GDP, as a result of the widening deficit, although a substantial portion of the increased indebtedness (10% of GDP) remains in Exchequer cash balances as a liquidity buffer.”

This is fine, with a small caveat – all these trends were more than pronounced around the end of Q3 – the time by which the likes of our General Government Deficit has recorded expansion of 6% (Q1 2008 on Q1 2007), 10% (Q2 2008 on Q2 2007) and 12% (Q3 2008 on Q3 2007), the economy was in an official recession (2 quarters running) and the housing prices have been falling for some 11 months! S&P's ‘better late than never’ is hardly a useful time-line from the point of view of bonds investors who subscribed this week to another pile of Irish paper. Is S&P actually timing its notes after the issues are placed or was timing some pure coincidence?

“We note that the government has also extended guarantees to seven domestic credit institutions through Sept. 29, 2010, increasing general government guaranteed debt to an estimated 228% of GDP in 2009. Banking system exposure to the property and construction sector of about one-third of total loans (excluding interbank lending) suggests a high risk of asset deterioration at these institutions.”

Not a word on banks recapitalization scheme costs here - worth another 5-7% of GDP? Or the fact that the Government is planning to tap the markets for some €20bn in fresh debt in 2009 (possibly €30bn – should recapitalization scheme materialize and should the government redeem April 2009 bonds)? Or the fact that GDP is not something that should be used to peg our credit worthiness on, as GDP/GNP gap stands massive and rising?

As per 1/3 loan books exposure to property and construction sector… Anglo-Irish Bank’s annual results (December 2008) show 87% loan book exposure to Property & Construction. Bank of Ireland (as of July 2008) reported 26% exposure to Property & Construction, plus 44% to Residential Mortgages, so total BofI Property exposure was 70%, with some of the 'Other' loans secured against Property & Construction assets. AIB – also July 2008 figures – showed 37% exposure to Construction & Property, 23% to Residential Mortgages, giving it a grand total exposure to Property & Construction of 60%. Given that the rest of the sector (consider a relative banking minnow of IL&P - Construction & Property exposure of 6% of the banking book and 88% to Mortgages, yielding implicit exposure to Construction & Property sector of 94%) is even more entangled in Property & Construction lending, would the maths genius in S&P who did their sums please raise his hand?

“The ratings on the Republic of Ireland are supported by what we view as the flexibility of its economy, high per capita income, and a favorable demographic structure. The government's commitment to contribute 1% of GNP per annum to the National Pensions Reserve Fund (NPRF), in our opinion, reduces the fiscal burden of population aging more than in some other European countries. However, the government is expected to use NPRF assets to assist in funding an estimated EUR10 billion (5% of GDP) recapitalization of its domestic banking sector.”

Now, this is a pure hogwash.

Let’s start with NPRF. The Fund is hardly a credible buffer for pensions time bomb in Ireland for two major reasons: (1) the Fund was established to pay Public Sector pensions obligations and, as a residual, general government pensions (without stipulating the level of payment guarantees); (2) this year’s pension funds performance has wiped out at the very least 40-50% of the entire pensions provisions in the private sector. In other words, from the point of view of the private sector employees, NPRF is a tax on their output, providing no legal entitlement to a pension benefit. Full stop.

What about the perverse logic that in order to contribute to NPRF in 2008 and 2009, the state will have to borrow funds in the open markets! Is S&P implicitly promoting an equivalence of 'borrow expensively, to save cheaply' policy?

The hodge-podge about the ‘flexibility of Ireland’s economy’ is ridiculous. It was more than aptly illustrated by this week’s events in Limerick, where a quasi-closure of one multinational factory is likely to lead to a collapse of the regional economy. Our own National Competitiveness Council does not subscribe to the myth of some magic ‘resilience’ of our economic model. S&P would be better served to look at composition of our GDP and GNP to discover the fact that Ireland’s economy is severely restricted in its flexibility by: (1) excessive concentration of exports in the multinationals-controlled sectors, (2) atavistic and cost-inelastic structure of our labor markets, (3) one of the highest cost bases in business support public services in the EU27, (4) shortages of skills, and (5) over-reliance on personal consumption and construction in our domestic economy, and (6) excessive public sector waste.

One quick note on demographics: our 'demographic' benefit only works assuming static migration flows. Strong net emigration (in line with, say, 1980s and accounting for adverse selection bias in skills/ work experience) can easily shift our demographic pyramid to resemble EU average.

"The negative outlook reflects our view of the likelihood of a downgrade if ongoing fiscal measures to recapitalize the banks and boost the economy fail to improve competitiveness, diversity, and growth prospects, thereby leaving a more difficult-to-manage debt burden," said Mr. Cullinan. "Conversely, the negative outlook could revert to stable if the government's strategy is successful and allows public finances to return to the stronger position of recent years.”

Oh, mighty! What ‘ongoing fiscal …boost’? What Government strategy? This Government has not produced a single fiscal stimulus package to date! More than that, the Government is actually looking into cutting fiscal spending (something that it must do), without expressing any intent to roll public spending savings into fiscal stimulus (something that it should have pre-committed itself to doing long before it piled on expected debts through banks' guarantees and recapitalization measures).

Just read this from the Department of Finance:
"Investment in capital projects to enhance Ireland’s productive capacity has been retained at a very high level, of the order of 5 per cent of GNP... given the extraordinary economic and financial circumstances impacting on all countries, including Ireland, this level of investment, which is now being totally funded from borrowings, will provide a significant fiscal stimulus in these difficult times."

In other words, don't bet on any real fiscal stimulus - after all, recall that this 5% of GNP (not GDP) package is the same one we had since the passage of NDP two years ago - in late January 2007!

In short, S&P’s note is one of the most bizarre assessments of Ireland’s credit worthiness I’ve seen since the Building Ireland's Smart Economy flop (here). Can someone from their team actually get engaged with those of us who are on the ground next time?