A Patent Lie: Ireland's Capital Investment Stimulus

In its April 2008 review of Ireland's economy, seen by the Government some 5 months prior to its publication, OECD has identified two salient medium term problems linked to the twin crises we are currently experiencing:

Reforming the taxation of housing. "...the unusually favourable tax treatment increases the role of housing in the economy and adds to volatility in the housing market. There should be a gradual move towards a more neutral system of housing taxation," said OECD. Thus, even assuming its ignorance prior to the OECD report, the Government had at least 15 months since to design a functioning system of either land-value or property taxation, there by reducing the impact of the house prices slowdown.

Public spending needs to slow. "Fiscal performance has been strong in recent years but revenue growth has moderated as the economy, particularly the housing market, has weakened. Public expenditure is set to slow but it is important to avoid locking-in expensive commitments, particularly on public sector pay. As spending rises more slowly, improving public services will have to rely more on undertaking further reforms to public sector management and getting better value for money." Once again, nothing has been done in over 15 months to address these recommendations.

Chart below - taken from the OECD report, illustrates the extent of the problem.
However, a closer examination of the components of the public expenditure in Ireland show even more dramatic failure by the Irish Governments to stop the gravy train of wasteful expenditure.

Consider the following chart plotting actual net current expenditure against capital expenditure, incorporating my own forecast for fiscal consolidation in 2009-2010 and DofF January 2009 forecasts for the same period.
Two features can be glimpsed from the chart:

1. Over the last decade, there has been a steady, unrelenting rise in the current expenditure - largely reflecting social welfare spending and the wage bill increases in the public service.
2. Even before the mini-Budget this month, our capital expenditure has peaked in 2008. Recall that Brian Cowen and Mary Coughlan are endlessly repeating that in 2009-2010 NDP-linked capital investments will act as a stimulus to the economy. Either they have not seen their own Government projections, or cannot comprehend the reality. During the recessionary 2009-2010, Ireland Inc is planning to spend decreasing net amounts of funds on capital programmes. If the Government can think of the NDP (created two years ago) as a recession-busting stimulus, then it has fired virtually all of its ammunition in 2008. And, of course, that has made no difference to the recession, as we all know.

But there are more sinister trends in the expenditure figures. The DofF does not provide a historical data set for budgetary dynamics over time. Instead, possibly to keep the taxpayers in the dark about the real nature of our spending, DofF produces a multitude of largely useless, technologically backward annual reports. A troll through these reveals the following.

Chart below shows the net current and capital expenditures as a percentage of GDP.
According to this chart, the economically unproductive spending which is largely absorbed into public sector wages and social welfare subsidies (our current expenditure):

• has grown virtually exponentially as a share of economy, whilst the capital investment programmes have bounced along a declining trend, and
• has far outstripped capital investment in terms of its role in the economy.

This blows apart Governments' arguments that since the beginning of this century Ireland Inc was aggressively investing in the productive capacity of its economy. Instead, it shows that we were 'investing' in wages, perks and working conditions of our public sector 'servants' and in welfare subsidies at the time of unprecedented growth in prosperity and low unemployment. First Bertie & Cowen and now Cowen & Lenihan have engaged in a classic tax-and-spend banquet where the already-stuffed were getting fatter and fatter on taxpayers cash.

Should you wonder how high were the rates of growth in current and capital expenditure over the last decade, chart below shows that in 2000-2009, even by DofF own (excessively optimistic) projections for this year, cumulative capital investment's importance in overall economy will decline by 39%. In contrast, cumulative current expenditure growth will reach +27%.In short, the above figures show that:

• Our leaders have deceived us about the importance of capital investment in the economy: between 2000 and 2009, capital expenditure share of GDP has actually fallen, while the current expenditure share of GDP has risen much faster than the GDP itself;
  
• Since 2000, our Governments have misled the public about the nature of Exchequer expenditure growth by stressing less rapidly expanding investment portion of the budget and downplaying a rampant expansion of payoffs to the public and social welfare sectors promoted by the Social Partners;
• Our current leadership is now deceiving the country and the markets by referring to a falling capital-spending programme as economic stimulus. That 'stimulus' applied to 2008 and not 2009-2010 and even in 2008 it was relatively small, compared to the current spending waste;
  
• Our Governments since at least 1999 have engaged in reckless and unsustainable increases in the current expenditure - in 2000-2009, current spending has grown in nominal terms by 138%, outstripping almost 2:1 the rate of growth in the nominal GDP (72%). Meanwhile capital expenditure has grown by 57% - over 2.5times slower than the current expenditure.
  

Mr Cowen and the rest of the Government should stop talking about Ireland's plans to invest in infrastructure and knowledge economy. They should come clean on the fact that their leadership has left the country with a current spending bill well beyond our means.

Irish bonds - on the move again (updated)

UPDATE: see below

In case you've missed it, Irish bonds spreads are on a renewed march upwards - needless to say, in anticipation of the mini-Budget maxi-soaking-of-the-middle-class by Brian^2+Mary. Hat tip to BL, the chart explains all:The same story told in price indices:Of course, our primary (and not-so-primary) dealers keep telling us that Government bonds are fine, things are going swimmingly indeed. In the mean time, another local maximum is breached, 10-year at 223.4 and 5-year at 217.9. Term premium widened again. Perhaps the prospect of an imminent roll-over of the last month issue at maturity (2012) coinciding with still gargantuan budget deficits is driving the 10-year spread away from the 5-year bonds?.. Wait until we issue the next tranche.

Update: From NTMA press-release on February Euro4bn bond issue: "The bond attracted strong demand from domestic investors who subscribed 55% of the total, as well as investors from euro area countries (20%), the UK (13%) and the Middle East (9%). As would be expected with a relatively short maturity bond, banks accounted for 72% of the amount invested. Pension funds contributed 11%, fund managers 10% and Central Banks 7%." Does this suggest that most of the bond was 'bought-in' by the publicly-supported Irish Banks and the Euro-area Central Banks? After all a whooping 79% of the bond placement went to Banks and Central Banks (BCBs), 75% went to 'investors' (inclusive of BCBs) tothe euro area countries, and only a meagre 21% went to private institutionals (although how does one treat funds run by the state-supported banks?). As I said before, February issue was a pipe-priming for the low-quality issues to come that will aim from the origination date for placement with the BCBs. A helicopter drop, indeed, but not of money - of public waste!

Now, per current spreads: term premium on 5-10year bonds yield spreads is now at +2.52% or in pricing terms +6.6%, implying that our 3-year bond, priced at an annual yield to maturity (YTM) of 4.01% is equivalent, roughly, to a 5.7-5.9% yield for a 10-year security.

Insanity of our policies

Limbering through crises since the end of 2007 (for its was painfully clear, following the credit markets stalling in July-August 2007, that the near future promises no prospect of continuity of the orgy of credit and debt that we partook in from the beginning of this century) we now have reached that state of nature where the Government is, once again, embarking on an effort to 'do something' about the economy. The latest promise is that of a mini-Budget 2009 by the end of this month.

It reminds one of a famous fable about Albert Einstein's last exam. Upon being told that his final pre-retirement term paper in physics contained the same questions as those posited on the previous year exam, Einstein remarked: "Ah, yes, the questions are the same. The answers, however, have changed".

And so it is with Ireland Inc. The questions, or rather the issues faced by us are painfully the same as we faced before:

• Public spending that is running at ca 38% (current expenditure) ratio to GNP - the same as in the early 1980s;
• Businesses insolvencies and personal bankruptcies rising like an unstoppable tide - too great to see it before it breaks over our heads;
• Financial system that is facing ruin in real terms and a currency that is no longer offering any comfort;
  
• Collapsed taxes (some 25% down y-o-y already and counting) drawn out of a folding economy (having contracted ca 4-5% to date, heading for triple that rate in cumulative terms over 2009-2011);
• Rising tax burdens amidst shrinking economic activity and private sector incomes;
  
• A specter of mass emigration (with net outflows of workers out of Ireland recorded in 2008 already) and double-digit unemployment (expected to reach 14% this year);
• Public sectors war against the rest of society waged to ensure that the privileges - in employment, monopoly power, wages etc - of the few will be protected even at a cost of sacrificing the prosperity of the many;
• Corruption (this time - primarily of legal nature) led by the interest groups that stand close to the center of power;
• Elites, incapable of any new thinking, neurotically running for cover of failed ideologies;
• Academia that is so far removed from reality that its practitioners forget ABCs of their own disciplines (finance and economics) in their desire to embrace the consensus;
• Desperate electorate that, in a Stockholm Syndrome moment of truth, are begging their captors - the State and its leaders - to 'do something', 'anything', 'to present a plan for the future'; and so on.

The issues are, frighteningly, the same - beyond any doubt, despite repeated assurances by the Government to the contrary - we are now in the §980s Redux scenario. But have the answers changed?

Sadly, not. The menu of economic policy potions on offer from the Government and academe is:

• Conviction-driven hikes in direct income and consumption taxation (Priority 1);
• Ideologically motivated (the ideology of public greed) hikes in indirect taxation so desperate in their scope that we are now facing a prospect of a tax on text messages and a clawback of pension deductions (Priority 2);
  
• Ambiguous & vague promises of some current expenditure cuts (Priority 3);
• Empty & often outright senile promises of an NDP stimulus packaged along with a pork train of 'knowledge' economy, 'green' economy and 'social' politics measures (Priority 4).

In other words - continued waste, new waste and taxes is what passes for leadership in Irish political environment: Government and Opposition alike.

Has anyone noticed that having raised VAT in October, we are seeing continued collapse in VAT revenue? Having raised income tax from January on, we are seeing continuous deterioration in the income tax receipts? Having implemented not a single pro-growth policy since the beginning of 2008, we are seeing real costs of living and working in this country remaining stubbornly high and real returns to work depressingly declining?

How long will it take? How many homes will have to be repossessed? How many personal bankruptcies and corporate insolvencies declared? How many of us and our children will have to emigrate out of here before our policy idiocy will lead us to the conclusion that you cannot tax yourself out of a recession?

Some years before his final exam, Einstein remarked that "Insanity is doing the same thing over and over again and expecting different results".

For now our politicians soldier on, with Unions whistling in step, back into the 1980s. Back into the 1980s answers to the 1980s-like problems. Stop cheering them on!

Germany and the Euro

This post is a response to a comment by Tim (here):
"I just heard that Germany is considering leaving the euro. ...What do you think?"

I have not heard such a rumor - at least not at any credible level. I would be surprised if such sentiment was gaining significant strength in Germany. Here is the latest data I could find and my understanding of what is happening.

Per Eurobarometer 70, December 2008, 56% of German population tend to trust in the ECB - a fall of 4 percentage points on Spring 2008. EU27 average was significantly lower at 48% (a fall of 2 percentage points on Spring 2008). This still places Germany as 13th ranked country in the EU27 in terms of overall trust in the ECB. Ireland is 14th with 52% (down 6 percentage points on Spring 2008). In general, decline in trust for ECB tends to be rising with the worsening in economic conditions: Portugal leads the fall with -10%, Spain follows with -8%, Ireland comes next.

Also significantly, the decline in those trusting ECB has translated into an even higher rise in those who tend not to trust the ECB (as opposed to those who declined to answer): in Germany, 8 percentage increase in those who do not trust the ECB, in Spain +13%, in Ireland +10%, and so on. This shows that people are actually becoming more decisive in their negative position vis-a-vis ECB policies. But, again, it does not show Germans swinging decisively against the Euro membership. In my view, the rising negative perception of the ECB is driven by the policy lags with which the ECB greeted the economic crisis between July 2007 and July 2008.

As far as I understand, there was no direct question on the Euro in the preliminary EB70 results available at this time.

Eurobarometer 69, Spring 2008, does show results for trust in Euro itself. Even before the crisis pushed Germany into a recession, only 17% of Germans tended to claim that their approval of the Euro is one of the top two reasons for supporting the ECB. Same as in Ireland, but below the EU27 average of 19%. Table below gives results for "QA25a Which of the following are the main reasons for trusting the European Central Bank?":
"QA26a Which of the following are the main reasons for not trusting the European Central Bank?" Table below shows response to the above question:When it came to mistrusting the ECB, 18% of Germans named being against the Euro as one of the top two reasons for their position vis-à-vis the ECB.

These numbers do not show a significant doze of skepticism about the Euro amongst the Germans, but they do show that the two tails of the attitudes to Euro distribution are both ‘fat’ and virtually identical in size. In other words, anti-Euro enthusiasts are roughly as prevalent as Euro supporters in Germany. In Ireland, those mistrusting the ECB due to their dislike for the Euro are less numerous than those who support ECB because of the Euro.

Overall, 60% Europeans (EU27), 69% of Germans, and 87% of Irish approved of the Euro in Spring 2008. Going further back in time, Eurobarometer 68 (Autumn 2007) shows 68% of Germans supporting the Euro, 87% of the Irish doing the same. EU27 average was 61%. Eurobarometer 67 (Spring 2007) showed 71% of Germans supporting the Euro, as opposed to the EU27 average of 63% (Ireland – 88%).

So on the net, the trend in the EU27 is for a very slight decline in support for Euro from 63% in the Spring 2007 to 60% in Spring 2008. For Germans these figures were 71% to 69% and for Irish – 88% to 87%. This is hardly a sign of a decisive shift in opinion against the Euro.

It will be interesting to see, once full Eurobarometer 70 results are in, if there has been further erosion in support for the Euro. Most likely, given the current economic conditions, there would be a rising sense of pessimism. But I still doubt Germany will reach a swing point.

Needless to say, the implications of a German exit from the Euro would be disastrous for the global financial system and for Ireland in particular.

First there will be an effect of unwinding the Euro positions worldwide and a monumental mess of absorbing ex-Euro positions (assets and liabilities) into national currencies.

Second, there will be a logistical nightmare of reintroducing new exchange rates, as the original (EMU-entry point) exchange rates are no longer reflective of the actual economic conditions.

Third, there is a problem of divesting the ECB roles back to the national Central Banks and re-establishing these Central Banks' reputational capital.

Fourth, for countries like Ireland, indeed for the APIIGS, the end of the Euro would spell a massive and instantaneous devaluation. Imagine the trade flows and investment positions disruptions that would arise if the reintroduced 'punt' were to be devalued by ca 50% instantaneously.

Fifth, the Euro has become a part of the reserve currencies basket around the world. It is hard to see how the central monetary authorities around the world can unwind their Euro holdings in an orderly fashion in the current environment.

Sixth, the resulting crisis at the EU level - triggered by a removal of the fundamental pillar of EU expansionism and internal markets supports - will be of a magnitude equivalent to the current economic and financial crises combined. Amongst obvious economic implications, there will be a significant political cost of the tearing up of the entire fabric of the EU elite built on the singularly integrationsit agenda.

Fortunately, once again, I am not seeing any significant signs of the public opinion in Germany shifting decisively against the country membership in the Euro.

Euronews is now Purer than Before: says Heathrow Sign

Euronews - a channel co-financed by the EU Commission and that virtually never bothers to broadcast any opinion or analysis of the events that does not mirror to a letter the views of the EU Commission and the rest of the establishment is doing some re-branding (see the pic below for a truly Pravda-esque advertising, possibly also co-financed by the European citizens' hard earned taxes).
Being launched as a hard-news 're-focused' channel, its new identity is now Euronews Pure. The latest linguistic twist has been added to distinguish it from the presumably 'poluted' CNN, BBC, Bloomberg, Reuters, etc. Given Euronews record of almost never being able to actually break news, the 'purity' must be in analytical capabilities of the channel. Alas, since Euronews never gives credit to its journalists - anonymity in journalism is the best cover of all - and since it never interviews those critical of the official EU positions, it is hard to imagine exactly how this can be the case.

Overall, my suggestion would be for the Euronews/EU Commission's Ministry of Truth to spend some money explaining why do people of Europe, who enjoy (at least for now) virtually unlimited access to global information channels need Euronews at all? They can post the result near all vital locations with captive audience: elevators, EU bureaucrats' offices, European hospitals, public restrooms and so on - in short, wherever the wait is necessary and is necessarily burdensome...

Russian Business Forum

Last week, Irish Management Institute hosted another successful and very well attended Russian Business Forum. IBEC and Enterprise Ireland have promised to post all presentations on their sites, but here are the slides of my own presentation.

How big is our Capital Stimulus - NDP and Public Policy Waste

In the US, according to Bloomberg, $1.6 trillion has been erased from equities values since January 20, implying that approximately $800bn of this is attributable to "the market's reaction to the stimulus plan". Furthermore, since "a standard assumption is that the marginal propensity to consume out of wealth is 5 percent. That would mean $40 billion less in spending. Then there is the effect on investment of the drop in Tobin's q (the ratio of the market value of capital, reflected in stock prices, to the cost of capital goods). These effects kick in immediately, while much of the [Obama] stimulus will not kick in until next year. So is the multiplier for the stimulus positive or negative?"

A good question to ask in the context of Irish Government policies as well. So let us do the maths. Per Table below,
overall Irish Stock Exchange market capitalization (measured by ISEQ Overall Index Cap) lost €4.1bn since January 1, 2009 and €54.3bn since the arrival of this Government. Thus, losses in consumption out of wealth alone over the latter period can be estimated at more than €2.7bn. For Tobin-q induced losses, the figure is a whooping €39.7bn.

In my analysis of Anglo-Irish shares (here), I showed that the regulatory risk premium on the bank implied a 69% downward revision in the share price from fundamentals-determined values. Let us, for the sake of an argument, assume that a similar process of downgrades applies to the Irish market as a whole.

As picture below shows, current market differential between ISEQ and its US peers is in the region of -53% for ISEQ. This is the total risk premium differential on the Irish shares. Suppose that ca 40-50% of this is due to the Government policies in the markets and on economy. Recall that in the Anglo case it was 69%, while in Bloomberg estimate for the US - a country where the Government and Monetary Authorities were much quicker and proactive in policy formation and implementation than our 'Don't Panic' Brians&Mary. Thus, my 40-50% assumption is a conservative one.

What do we have?

Since June 1, 2008 – the time of the new Cabinet take over – a cumulative wealth-destruction effect of the deficient public policies (imputed on ISE losses alone) has contributed to the consumer demand contraction of roughly €1.1-1.4bn, plus a Tobin effect of €6.4-7.9bn. The grand total losses attributable to our Government's policies failures for June 2008-present comes to €7.5-9.3bn.

Now, recall that the Government has promised repeatedly that we are going to have a significant economic stimulus via an NDP-driven capital expenditure program which was aiming to provide €10.3bn in net capital expenditure (per January DofF estimates) in 2009. Together with 2008, total capital investment for 2008-2009 was to be €21.2bn, or roughly €15.8bn between June 1, 2008 and December 31, 2009.

Even assuming this figure holds through the mini-Blood-Letting-Budget of March 2009, Government's failure to present a strong policy front to the market has already cancelled out some 47-59% of the entire 'stimulus'... And we are only 2 months into 2009!

Irish Boardrooms in Denial

This is an unedited version of the article published in Business&Finance Magazine, February 26, 2009, pages 30-31

Almost a year ago, I warned in this column that Irish companies are going to face a tough recession, with rising bad debts, tighter payments collections and accelerating rate of insolvencies. A recession that is likely to last through 2009 and a good half of 2010. Figures for 2008 show us on track to fulfil these predictions with more than doubling of the number of corporate insolvencies in one year. By all possible indications, 2009 is going to be even tougher than the already abysmal 2008. And yet, when it comes to a realistic assessment of business conditions there is a strange sense of denial of reality taking hold in Irish boardrooms.

First consider recent evidence. Two weeks ago, CSO recorded the first drop in industrial output in Ireland since 1982. A combination of collapsed construction sector activity, decimated domestic consumer spending and ever-shrinking global demand, exacerbated by the overvalued Euro all have contributed to this trend. Even more significantly, these forces’ impact on Irish producers, exporters and service providers is getting stronger by the day.

Exporters under pressure
2008 slowdown in output was primarily due to traditional sectors of the economy – down 4.7% in y-o-y terms, with multinational companies expanding their production by an anaemic 1.7%. There is little hope that this latter trend will not continue through 2009 and into a good part of 2010. More ominously, December figures show broadly based collapse in industrial activity with output contracting by more than 10% m-o-m in both multinational sector and amongst domestic companies. 26 out of 29 broader industry categories recorded contractions in output. Figure below highlights this, while removing some of the seasonal volatility.
Source: CSO

This is broadly in line with international experience. Last week figures showed that in 2008 Europe posted its biggest trade deficit in 10 years – a whooping €32.1bn. This marked a deterioration in the trade balance to the tune of €48bn in y-o-y terms. According to the majority of the analysts, coming months will see severe recessionary pressures for eurozone exporters. Irish exports are particularly vulnerable, given the falling consumer demand and business investment activity in the US and UK, as well as in the emerging countries. Exports to the UK, the main destination for the region’s products, dropped 3 percent in the 11 months through November 2008. Exports to the US, the second-biggest buyer of euro area goods, fell 5 percent. In the case of Ireland, the two countries account for more than 36% of the goods exports flow by value and some 50% of all Irish trade is linked to either the Dollar or Pound Sterling.

The end result – our core industrial exports are facing a decline, as illustrated in the figure below, precisely at the time of already collapsed domestic consumption. Our services exports are also facing decline with financial services and tourism struggling to stay afloat, while broader business services exports are feeling the same pressures of currency overvaluation and high cost of credit as our goods trade.Source: CSO

The expectations are that the 2008 growth sectors – ICT and pharma – might be also hard hit by a slowdown in global demand this year. In particular, ICT is sensitive to households and business investment demand. Lack of new investment in plant and equipment, software and operating systems in the US and across Europe is taking its toll on the likes of Dell, Intel and smaller hardware and software suppliers. By all estimates, this sector is not going to see a significant recovery until the earliest second half of 2009. Dell alone accounts for some 6.5% of Irish exports.

At the same time, pharma sector is likely to face mounting cost pressures in the US, a significant decline in demand for higher-end drugs from the emerging economies, plus a stronger generics competition. A recent study by the International Pharmaceutical Policy Council has shown that traditional pharma and bio-pharma sectors are facing significant cuts in research spending and employment, with recession undercutting public and private spending on universities-affiliated research. In the mean time, last week, Israel-based Teva Pharmaceutical Industries Ltd., the world's largest maker of generic drugs, said it expects the deepening global recession to spur demand for generics – bad news for the likes of Big Pharma that dominate Ireland’s exports statistics. In other words, even the so-called ‘recession-proof’ pharma companies are starting to feel the heat.

Yet to face the music
Which brings us back to the corporate boardrooms perceptions of the near term future. Last week’s InterTradeIreland Quarterly Business Monitor sheds some light here.

A comprehensive survey of some 1,000 companies north and south of the border has revealed that businesses are more pragmatic in their assessment of the past than they are about the future. In other words, Irish companies are feeling the pain, but are potentially deluding themselves into believing that the first half of 2009 will turn out to be economically stronger than the consensus forecast predicts.

In terms of the current conditions, roughly four out of five businesses indicated that they have experienced an adverse impact on trading conditions in recent months. This is hardly surprising, given that the biggest problems reported by business leaders were impacting their core parameters: tighter cash flow (68%) and decline in demand (66%). Some 87% of businesses noted a fall-off in consumer spending. 61% of the Republic of Ireland businesses saw a fall in turnover as opposed to 44% in the North.

Nonetheless, when asked which policies the Government can undertake to help business,
• 27% cited the need for improving access to borrowing (most likely indicative of the severe pressures on debt-laden businesses to raise new credit and roll over maturing short-term debt),
• 9% called for reduced levels of VAT and 7% for reduced taxation,
• 7% named assistance for SMEs, and 6% identified financial assistance for distressed companies.
The low numbers supporting consumer confidence improving tax reductions measures suggests that majority of businesses are not perceiving the current downturn to be demand-driven. Instead, there seem to be a much stronger conviction that the recession is a function of the credit cycle. Yet, 61% of business in the South (as opposed to 44% of those in the North) reported declining turnover.

Do the companies underestimate the extent of the collapse in consumer confidence at home, demand for exports abroad and the extent of their exposure to debt markets? Judging by the main policy priorities listed above, the answer is yes. The same answer is supported by the fact that few companies so far have taken significant cost-cutting measures. Only 30% of the Republic of Ireland companies (19% in the North) have reduced their workforce to the end of 2008. This is reflective of the fact that just 18% of businesses expected the downturn to have a severe adverse impact on their business in the next 12 months. Majority (63%) still think that this recession will be a moderate and short-lasting one.

And this is despite the fact that forecasters virtually unanimously predict 2009 to be worse than 2008 when it comes to trading conditions. For example, McKinsey Global Economic Conditions Survey last month has shown that 71% of global businesses expected general conditions to worsen in Q1 2009.

Chart below shows that Irish business leaders pessimism about the future has increased only marginally between the end of 2007 and the end of last year, despite the rapid deterioration in Irish economic conditions.

Potential Impact of Economic Downturn, 12 months forward
Source: InterTradeIreland, 2009

Optimism amongst businesses, although having abated in 2008, remains relatively high. Only 39% of all Irish businesses anticipate a decrease in turnover in Q1 2009 as opposed to 52% of global businesses in McKinsey survey. Similarly, for profitability – only 35% of Irish businesses expect a decline in profitability in Q1 2009, against 67% for the global sample.

Thus, only 14% of businesses across the island (18% in the Republic of Ireland) expected more layoffs and redundancies in Q1 2009. This is well below 29% of the global sample firms that were planning layoffs for this quarter.

In short, consistent with the findings on employment, turnover and profitability, the Intertrade Ireland results suggest that Irish businesses, both sides of the border, expect a mild recession to last no longer than 6-8 months. At the same time, global business leaders expect “a battered but resilient economy …[that] implies a recession of 18 months or so”, much in tune with the forecasts by the EU, IMF and the OECD. One side of the sea is clearly foolin itself here…

Box-out: IFSC Liabilities

A research note from the Davy Stockbrokers last week attempted to clarify the issue of the banking sector liabilities in Ireland. According to the Bank for International Settlements data, in Q3 2008 banking liabilities of the Irish-owned banks totaled €575bn, or 309% of GDP – the third-highest in the euro area. The Irish government has guaranteed €440bn (or 237% of GDP) of this. At the same time, the liabilities of all financial institutions resident in Ireland were €1,424bn, or 839% of GDP. But €849bn of that “…is not in any way a liability of the Irish government,” says the Davy note.

Well, sort of. €849bn might not be a liability under the Government guarantee scheme (although it remains to be seen how the foreign banks deposits and loans by and to Irish residents will be treated in the case of default) but from the economy’s point of view – some share of the €849bn debt represents a potential risk exposure for the state.

Here is how. Recall the good old days when our country leaders trotted the globe telling everyone that IFSC is a flagship of our knowledge-based modern economy? How come we now conveniently shrug off any liability inherent in having IFSC on our soil? IFSC is an asset to Ireland: a major contributor to the exchequer, a large employer of Irish workers and a significant purchaser of associated business services, including the services of the stockbrokers.

Now, imagine if excess debt exposure of IFSC-based companies was to drive them out of business. Where would that leave the State, not to mention the economy? A rough guess – ca €700mln in Exchequer revenue, plus the returns from employment of ca 20,000 people, plus commercial rents returns and VAT returns due to business activity. The total state take from the IFSC can easily exceed €1.5bn. If the risk of losing this dough is not a liability for the Irish state, what is?

Davy is correct in the strict sense of listing the actual figures. However, ignoring the IFSC-held liabilities creates an illusion that somehow Ireland Inc is independent of what is happening in the Docklands and beyond. It is not. Just as in good times we reaped the benefits of the IFSc, we must, at the time of challenges acknowledge its liabilities as being at least in part our own.

Buffet's Lesson from Ireland

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

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

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

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

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

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

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

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

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

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

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

A sight of carnage: GE

GE - that Titan of global economy - is under a threat of becoming the next AIG.Although the company is forecasting USD18bn in profits this year (on the back of its industrial arm), GE shares have now dipped below USD6.50, their lowest level since 1991. All due to the GE Capital exposure in the risky commercial and residential lending.

Since October, GE sold USD15bn in new shares and USD31bn in new bonds, cut down its loan book and reduced its reliance on short-term debt funding. GE has cut its dividend by 68% to generate additional USD4.4bn.

Sounds good? Not really. GE has set aside roughly USD10 billion in provisions for losses on its USD380 billion in receivables at the finance unit. The company loans total USD680bn against equity cushion of USD34bn in cash and USD36bn in assets. The latter is taking a hit in the current markets, implying today's equity cushion of only ca USD63bn and falling.

It would take a USD9bn hit to earnings and equity for GE were to write down its real-estate portfolio by 25%, according to UBS analysts. GE has transferred some of its real-estate holdings, into real-estate lending. As a result, its total real-estate assets increased USD6 billion, or 8%, last year.

But let us get back to the USD10bn provision. Here is my view on the share price going forward:

Assume they set aside cash (otherwise this set-aside is itself open to downward revaluations over time). This implies expected impairment provision is 2.63% of receivables. Globally, AAA rated CDOs carry the recovery rate of only 32% on face value, while for mezzanine vehicles the recovery rate is only 5%.

So, suppose GE gets a 25% boost on that via higher debt seniority and tighter loans management, etc. Assume the recovery rate of 40% on higher quality junk (hqj) and 8% on lower stuff. Take a blend on the book at 90% hqj, 10% 'stuff', this gives us an average - across-the-book - expected recovery rate of 37%. Suppose 12% of loans are under threat (rather generous in this commercial and residential real estate markets), allowing for some earlier writedowns that already took place. You have a required impairment provision of 12%*(1-0.37)=7.56% or almost 3 times more than the USD10bn they provided for.

This level of provisioning - if set in cash - will take us into a set-aside of an additional USD18.7bn on top of USD10bn set aside today, bringing equity down to USD17.3bn cash and USD34bn in assets or total equity of USD44.3bn - some 30% haircut. Assume deterioration in the assets part of equity pool at 1/4 of the rate of deterioration in broader assets, i.e. 3%pa, you have additional shave-off of 2% on equity, implying equity cushion fall will depress the overall share price by at
least 30% from today's level.

Now, I suspect that when they quote USD34bn cash equity today, they actually include the USD10bn provision into that as well. If so, the total haircut should be based on USD34.3 equity, implying a cut of 45.6% (provisions) + 2.5% (asset deterioration on equity side) = 48% on
today's share price.

So you have USD3.5USD as the equity-underpinned price target. And that is where the stock heading next, in my humble opinion...

Another Day of Carnage

Just pictures...
And this is the day of rates cuts: ECB down 50bps (should have been down 75-100bps, but hey, when was the last time Germans had any guts for serious actions?) and BofE down to 0.5%... If anyone needed a proof that the markets are not treating Irish banks shares as a part of the broader world, preferring instead to price them as sick puppies, here it is:
So is the next stop for this train of sorrow 'Nationalization II: Bank of Ireland'?

Some housekeeping: a handful of updates

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

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

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

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

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

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

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

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

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