Wake up calls for Irish Government

My new article in Business&Finance magazine:

Last week two international reports provided an interesting analysis of Irish policies to date and highlighted some scepticism amongst the international analysts as to the ability of our Government to lead the necessary reforms.

First, caught up in the media feeding frenzy, the IMF Article IV Consultation Paper has raised some serious questions about NAMA. Second, much unnoticed by Irish media, the EU Commission report on public finances in the Euro area have provided an in-depth look at Irish fiscal position relative to our peers.

Let us start with the IMF’s analysis, focusing on the major area of the Fund’s oncerns that received little cover in the media. Our policymakers were quick to present the IMF statement that NAMA can be a break-even proposition for the taxpayers as a major endorsement of the Government plan.

Here is what the IMF report actually did say on the topic: “If well managed, the distressed assets acquired by NAMA could, over time, produce a recovery value to compensate for the initial fiscal outlays.” In other words, the IMF is benchmarking NAMA ‘success’ solely against a possibility for earning zero return on initial public investment. The IMF is simply unconcerned here with the associated costs, such as the cost of bonds financing, NAMA management and the cost of post-NAMA recapitalization of the banks. Yet, these costs are non-trivial from the point of view of expected taxpayers’ losses due to NAMA.

Using the balance sheet model for NAMA developed by Professor Brian Lucey and myself, table below provides estimated discount rates that would achieve break-even for the taxpayers on total costs of creating and operating our bad loans bank.
* All in billion 2009 Euro, assumed inflation: 3% pa, 15-year horizon
** ca 33% of the total value of bonds issued, plus the face value of loans purchased into NAMA
*** Ex-operating cost of €20mln pa (rising at 2% pa from 2010)

Even under optimistic scenarios of 10% impairment on loans, and assuming current cost of financing Irish bonds of 5.9% (consistent with last week’s syndicated bond issue) for 2009-2014, and moderate bond finance costs for 2010-2024, the discount on assets purchased by NAMA required to achieve zero loss on NAMA-associated public outlays ranges between 27% and 50%. Higher impairment charges (12-15%) and/or financing costs raise the required break-even discount above 60%.

In other words, there is no reasonably probable scenario whereby NAMA will end up breaking even on total taxpayers outlays in real terms. Perhaps this is precisely the reason as to why the Government has to date produced not a single estimate for expected costs and returns under NAMA, despite making numerous unfounded claims that it will not result in significant taxpayers losses.

In fact, the IMF report was rather clear in its critical assessment of the Irish authorities lack of proper cost-benefit analysis of this undertaking. “The authorities did not formally produce any estimate for aggregate bank losses. …Staff noted that losses are likely to extend beyond the property-development sector as the economy weakens and the design of NAMA should incorporate that possibility.”

Furthermore, “the debt to be incurred to support the financial sector remains uncertain,” says the IMF. “If the losses suffered by banks are about 20 percent of GDP, as estimated by staff, then bank recapitalization needs could be around 12-15 percent of GDP.” These numbers correspond to the two most extreme scenarios presented above. But the IMF Report also states that in such an eventuality “assets would be acquired against this debt...” Injecting €21-25bn in public funds would do the shareholders in Irish banks will be a de facto nationalization – a scenario consistent with IMF staff estimates, yet denied by the Government.

One day before the IMF report, the 300-pages strong EU Commission paper, titled Public Finances in the EMU, 2009 put forward the picture of Irish Exchequer presiding over the worst performing (fiscally) economy in the entire EU.

The diplomatic Commission said in its report that the scale of the downturn was unexpected by the Irish authorities, “with the end-2007 update of the [Government] stability programme expecting real GDP growth of +3% in 2008, while the Commission services’ interim …forecast estimated growth at -2% in 2008”. Irish “deficit was not considered temporary”, suggesting that the EU Commission disagrees with the Government view that most of our troubles are cyclical.

As per credibility of our Exchequer plans to bring the deficits under control by 2013, Commission said that “the January 2009 addendum to the [Government] stability programme targeted a deficit …below 3% of GDP in 2013, based on yet to be specified consolidation measures. In view of the above, the Commission concluded that the deficit criterion in the Treaty was not fulfilled.” In other words, Brussels does not believe that our plans to reduce the deficit in line with the EU rules by 2013 are credible and, therefore, we are now in a full breach of the EU Treaties.

Just to make it more clear the Commission provides a graphic illustration as to how far off we really are in delivering on the 2013 targets. Like IMF in its report last week, the Commission data shows that whilst the Government has proposed a ca 2.75% of GDP contraction in its deficit in 2009-2010, the required rate of reductions should be more than 3 times greater – at ca 8.5% of GDP.

Using the change in the current level of the structural deficit required to make sure that the discounted value of future structural balances covers the current level of debt as the indicator for long-term sustainability of current Government policies, the Commission puts Ireland in the highest category of fiscal instability risk – one of only two Euro-zone countries (alongside Spain) in the group. At the same time, we came out as the most impaired country in the Euro area in overall assessment of our fiscal position.

The IMF and EU Commission papers do agree on another point. Both state that the start of the fiscal crisis we experience today predates the current crisis by at least 4 years. At the same time, clear downward trend in our fiscal stability was visible, according to the EU Commission back in 2003.

There are some serious discrepancies between the Commission and the Government assessments of the ongoing budgetary consolidation process. According to the Commission spring 2009 forecast, “the deficit is projected to widen further to 12% of GDP in 2009, the highest in the euro area.” The deficit target set out by the Government in April 2009 is 10.75% (up from 6.5% in budgeted for in October 2008). “The projected deterioration of the deficit would take place despite successive consolidation efforts since mid-2008, …with an estimated overall net deficit reducing effect of around 4% of GDP in 2009.” Thus, the EU does not buy into the Department of Finance estimate that the total consolidation to date yields 5% of GDP reduction in the deficit, as table below illustrates.

And in contrast with the Government’s rosy projections of 9% deficit for 2010, the Commission projects the deficit to widen to 15.6% of GDP on a no-policy-change basis. “The difference to the authorities’ target …is mainly due to different projections for the 2009 budgetary outcome and ...the non-inclusion of the indications for the budgetary measures for 2010 presented in the April supplementary budget.” Once again the Commission appears to be sceptical about the willingness of this Government to actually follow through with the targets set out in April.
Thus, in major reports published in one week, two international bodies gave a rather forceful negative assessment of the current Government plans for dealing with the banking and fiscal crises. And yet, the Fitzgaraldo of self-congratulatory remarks from Irish public officials pushes on – ever deeper into the denial of our bleak fiscal reality.


Box-Out:
All last week we have been hearing about the IMF endorsing Irish Government ‘austerity measures’ aimed at bringing under control our runaway train of public spending. Rhetoric aside, real numbers suggest that at least in one area – that of public sector employment – months after setting itself some modest targets for public workforce reductions, the Government is nowhere near delivering the real progress. Chart below, taken from the latest Quarterly Household National Survey data released last week, clearly illustrates the prevalence of past trends in overall employment.
While private economy employment shows catastrophic collapse in total numbers working in industry, construction, wholesale and retail services, basic repairs, accommodation and food services, administrative and support services and professional and technical support services, the same data shows precipitous rise in employment numbers across all three broadly defined public sectors.

Subsequently, the chart below shows an even more disconcerting trend.
In addition to by-now customary steady and precipitous rise in unemployment, we are also experiencing rapid withdrawals from the labour force participation as more and more people are falling into our deep welfare trap or undertake an emigration option. This trend – of collapsing employment and rising unemployment – now poised to threaten our long-term demographic dividend, or the expected higher returns to younger labour force that many of Irish policy makers and analysts close to the Government circles are so keen on referring to in their rosy forecasts.

Well, of course the public sector is rolling in the dough as we are taking a pay cut:

Economics 03/07/2009: Ireland's Research Sectors - a net positive

CSO released their latest data on R&D spend in Ireland for 2007/2008.
Chart above shows overall R&D expenditure by type of firm in 2007 and 2008. In both 2007 and 2008 larger firms dominated overall R&D expnditure in Ireland, but there was a marginal increase in the share acruing to small firms as well. There has been only marginal growth in terms of overall spend between 2007 and 2008. Still a net positive, when compared to the rest of economic activity.
Total capital spending on R&D declined for larger firms, but rose for smaller firms. Ditto for foreign owned enterprises as opposed to domestic enterprises. Across the board, foreign owned companies vastly dominate R&D spending space in Ireland, though domestic enterprises are closing the gap. Again, a net positive. Capital spending overall declined, as expected, given the fall in the value of land and buildings.
Current expenditure on R&D (inclusive of labour costs) rose for all categories of firms. The smallest percentage increase was for foreign owned enterprises and manufacturing. Again, net positive, albeit marginal. And in the long run, this might be signalling rising pressure on R&D competitiveness. No analysis is provided in terms of off-set in R&D Capital spending savings agains Current spending inflation.Labour costs rose at a significant margin for all players, except for manufacturing enterprises. Net negative for the 'knowledge' economy. Apparently - doubling PhDs output does little to reduce their cost.Own funds are dominant as a source for R&D financing, with small firms, expectedly, leading larger firms in the importance of public funding. In general, public funding is extremely marginal. Again, this is good news. This is true in relative - percentage - terms (above) and in absolute terms (below).
Table below shows the sectoral breakdown of total R&D spending:
Predictably, MNCs-led sectors account for over 70% of the total spend. This is ok in the short run, but must be reduced in the long run if we are to lower the risk of significant withdrawal of one or two leading MNCs from the market.

Economics 03/07/2009: Exchequer returns

So we have June Exchequer returns. Pretty nasty stuff, though some say it’s all ok. Here is why I disagree:

Much of the effect in flatter declines in tax revenue was due to frontloading corporation tax (October 2008 Budget). Now, Government April 2009 budgetary forecast did not reflect the expected revenue from this source, so the windfall should have boosted the overall tax receipts in June. Hmmm... but we are still €188m or 1.2% behind forecasts.

What gives? Brian Leninham has unleashed a savage April 2009 mini-Budget (-1.3% of the national disposable income was expropriated by the State or Euro 1.23bn, split as 2/3 to income tax and 1/3 to Health and PRSI levies – the latter two not entering tax receipts on the Exchequer banalce sheet, but counted as income to Government departments, yet another trick by which our obscenely high tax regime is classified as a ‘low tax’ one) and June was the first month where all new changes (errr – tax hikes) were in. So consumers are now on a renewed push down in spending:

Excise duty down 11.5% yoy in June, as opposed to 8.1% in May – tell me that after the improbably strong fall in 2008 a new double digit dip is not a collapse, and I would have to ask you what you are having for a drink that’s so strong;

VAT was down 23.3% in June yoy – also deeper than the -21.2% average decline in a year to May (although these are not seasonally adjusted figures);

Income tax is down 15.6% yoy or 2 percentage points behind DofF estimates.

Net result: deficit is now at €14.71bn against revenue of €16.31bn. Chart below illustrates revenue trends in terms of monthly average receipts.

All of this, however, is beyond the main point - even if revenue is flowing in at the rate the DofF forecast - which seems to be the desired objective of all our observers, analysts and the Government, this revenue will be bleeding the real economy. There is no point of balancing the Government expenditure at the cost of killing the economy - which is what our Exchequer is currently attempting to do...

Economics 02/07/2009: Downgrade on Irish debt

Moody's downgraded Ireland from top Aaa government-bond ratings one notch to Aa1 (hat tip to PMD) saying that Ireland's policy response to the economic downturn had been decisive and the government had a strong balance sheet before the crisis struck, so there was only a need for a moderate downgrade. The ratings were on watch for possible reduction since April. So the move was widely expected.

"The review process focused on the nature of the policy response and the extent to which the Irish economic model was durably affected by a sudden and brutal economic and financial adjustment," said Moody's Sovereign Risk Group analyst.

Despite politically correct chatter about ‘decisive response’ etc, Moody's still has a negative outlook on Irish ratings. Why? Risk of further deterioration in terms of debt affordability (as measured by the share of government revenue used for interest payments) and financeability (the cost at which the country can raise more debt).

Per WSJ report, the ratings agency said debt dynamics will remain unfavorable for the country for several years, and that downside risks outweigh upside risks in the near to medium term.

Economics 01/07/2009: Live Register

Per CSO release today, standardised unemployment rate is now at 11.9% in June (as compared to 10.2% as measured in Q1 2009 by QNHS) as the seasonally adjusted Live Register increased from 402,100 in May to 413,500 in June, an increase of 11,400. In the year to June 2009, there was an unadjusted increase of 197,781 (+89.6%). This compares with an unadjusted increase of 195,115 (+96.7%) in the year to May 2009.
Unadjusted change in LR for males between May and June was +10,302, for Females +11,419 so we are now seeing female unemployment moving ahead (in rates of growth). This shift was evident in both under 25 year olds and 25+ years of age categories. The new risk to household solvency now comes from second earners starting to lose jobs at a faster pace.
When looking at weekly changes, chart below shows clearly the renewed pressure on employment. Clearly no 'green shoots' here.

Economics 01/07/2009: UK Ad Spend, QNA & US Consumer Confidence

Per Adweek, advertising spend in the UK fell 4% to £18.6bn in 2008. All media experienced declines, apart from internet and cinema fell, according to figures released on 29 June by the Advertising Association. The drop compares with a rise of 4.3% in 2007. Press (newspapers and magazines) was the biggest spending category at £6.8bn in 2008, down 11.8% yoy. TV was the second-biggest spending category (£4.4bn), down 4.9%. Internet spend was third at £3.6bn up 19.1% on 2007. Radio was down 8.5% to £488m, outdoor and transport fell 3.8% to £1bn, while cinema rose 1% to £205m. Three things are worth noting in these figures:

• As consumer confidence and spending collapsed, overall advertising spend stayed surprisingly firm;
• Internet has probably benefited from substitution from costlier print and TV/radio to cheaper on-line advertising. This is potentially a 'recession factor' (in a recession, such substitution is usually a temporary phenomena - once growth returns, the old spending/consumption patterns return rather swiftly), so internet advertising will need to look at adopting some new proposition for selling once the growth cycle restarts;
• The figures do not specify what share of spending contraction can be attributed to lower costs of advertising, in other words, we do not know whether the fall was due to declining client activity or due to improved cost of advertising.
  

More on yesterday's Quarterly National Accounts data. Here is the snapshot of the widening GDP/GNP gap in Ireland - a clear sign of rising weaknesses in domestic sectors:
Note the trend peak in Q1 2005 and the absolute peak in Q4 2006. The first one corresponds to the end of post 2001-2002 correction and the latter to the SSIAs craze sweeping the nation.

Next, to the sectoral contributions to GDP.Our earnings from abroad are negatives and rising in absolute value - those Bulgarian and Romanian properties we've snapped up. Agriculture is overall the least important sector when it comes to GDP contributions. It used to account for 2.54% in Q1 2003, it accounts for 2.51% today (an increase from 2.33% a year ago). I wonder if that yoy increase captures the pumping of dioxins subsidies to pork producers. That was something, as the gravy trains go: Irish pork industry is worth €385mln pa, but in December last, the Government doled out €180mln to the industry in compensation for a one week stoppage (worth just €7.0mln in economic losses).

Then come Public Administration (up slightly from 3% an year ago to 3.25% this Q1, with another pesky side to it in the form of continued inflation in the sector).

Building and construction fell from a high of Q1 output of 8.93% of GDP back in 2006 to 5.99% in Q1 2009.

For what it's worth as an intellectual exercise, were we to invest all overseas property money back in the country, while shutting down:

• Option 1: Agriculture, Building & Construction, and Public Administration all together, we would be still 6% of GDP better off;
• Option 2: Agriculture, Public Administration and all Taxation, we would be 1.9% of GDP better off.

Of course - this is just an accountancy exercise, not a real economic policy, but it does put into perspective the fact that we have a sector accounting for just 2.5% of the economy and yet commanding its own Department with thousands of bureaucrats in employment...


Expecting the expected: US Consumer Confidence has taken a fall, once again, proving that the previous 'rebounds' were just a temporary mathematical correction before new jobs losses and continued weakness in the economy feed through to consumer sentiment. US consumer confidence fell to 49.3 in June from a downwardly revised 54.8 in May, the Conference Board reported Tuesday. Following a large confidence jump in May, consumers grew more pessimistic in June about their present and future. The present situation index declined to 24.8 in June from 29.7 in May, while the expectations index fell to 65.5 from 71.5. Note that the change in expectations was largely in-line with current conditions move, signaling that the US consumers are not exactly treating the current deterioration as temporary decline on significant May improvement.

A lesson for Obama? Don't give tax breaks to the elderly and the poor - give them to the middle classes. Last month improvement in personal income in the US was almost entirely due to Federal tax rebates to the elderly and the poor. This might be fine in the economy that is running at around trend growth, where consumption of non-durables is a problem, but it is not as efficient as a middle class tax break in the economy where precautionary savings are a problem.

A lesson for Ireland? Given that our own economic conditions are much worse than those in the US, and given that the government tax policies in Ireland are intirely internicine, I doubt we can expect significant gains in consumer confidence in months ahead. Instead, we should expect a new wave of layoffs to hit in Autumn 2009 and then again in January 2010.