Economics 25/09/2009: Notes on trade flows

Per separate CSO release (see national accounts and broader trade flows discussion here), however, the positive trends in exports shown in the figures for Q2 2009 have not held into Q3: seasonally adjusted exports fell by 8% in July 2009, relative to June 2009 and imports hit a new low point for recent years.

June 2009 exports showed some bounce (due to volatility) having increased by 5% relative to May 2009 while imports decreased by 9%. Thus, July changes erase positive momentum in exports and continue to exacerbate negative movements in imports.

Given that for volatile time series during the periods of contraction seasonal adjustments can mask true extent of falls, taken on an unadjusted basis, the value of exports in July 2009 was 5% down on July 2008, while the value of imports was down 31%. The value of exports in June 2009 was up 5% on June 2008 and the value of imports was down 24%.

This is worrisome, as H1 2009 posted overall rise in exports of 2% on yoy basis. This was led by MNCs-dominated sectors: medical and pharmaceutical products increased by 22%, organic chemicals by 19%, other transport equipment (including aircraft) by 262% (€414m) and professional, scientific and controlling apparatus by 11%. On the back of large layoffs in the sector, computer equipment decreased by 27%. Capital investment cycle hit hard electrical machinery (down 28%), industrial machinery down 37%, telecom equipment fell 23% and power generating equipment contracted by 45%.

Imports decreased 21% in H1 2009. Aside from predictable cars and retail goods, investment-related goods imports also contracted severely: computer equipment by 40%, specialised machinery by 54%, industrial machinery by 36% and electrical machinery by 16%.. Petroleum products imports fell by 38%, signaling that MNCs might be reducing output here, while increasing value of output registered to Ireland (transfer pricing). Ditto for small increase of 4% in medical and pharmaceutical products, and organic chemicals also rising by 4%, - both major inputs into allegedly booming pharma and medical devices sectors. Goods from the United States increased by 34% - again a sign of more value being booked on importation side of MNCs.
Table above shows that MNCs-dominated sector of chemicals and related products (pharma etc) has increased its overall share of exports in June 2009 and in H1 2009. Other sectors remained relatively stable with modest increases in the share, except for computers-dominated machinery and transport equipment sector. But there is more trouble ahead:
In bold in the above table I have marked those sectors where there has been expanding imbalance between exports and imports. This imbalance suggest to me that international companies are shipping fewer inputs into Ireland, while managing to ship more outputs. This can only be done in a wondrous world of accounting procedures designed to reduce tax exposure.

Again, banana republic…

Economics 24/09/2009: There used to be a real economy in there...

Enough of Nama, for now. Data from CSO is coming thick.

Initial estimates for the second quarter of 2009 show year on year declines in both GDP (-7.4%) and GNP (-11.6%), with the gap between GDP and GNP widening. Compared with the corresponding quarter of 2008, GDP at constant. Quarter-on-quarter, GDP remained constant in Q2 2009, while GNP slid 0.5%. It is worth recalling that GDP-wise Q1 and Q2 2008 were already negative growth territory, so current ‘stabilization’ comes on top substantial declines taken in 2008.

Predictable sources of declines: consumer spending (down 6.8% yoy), capital investment (down 24.4% in Q2 2009 yoy), net exports are up yoy boosted by MNCs (goods manufacturing) and by collapse in imports. Industry output down 11.3% yoy and within construction sector – 30.8%. Every sector is posting fall-offs.

Incidentally, do tell me there is demand for credit out there that urgent we have to break the back of the entire country to repair it. I can't see one - capital investment tanked, so companies are not in a mood to invest in future capacity (see stocks changes, too), while personal consumption is bouncing at the bottom, every time a little lower. Oh, I get it, if only the banks were issuing new loans, we all can go out, borrow some more dosh to pay for... hmm... Brian Cowen's excesses in spending? But back into non-Nama land:

Q1 2009 annual rate of decline was 13.1%, so Q2 decline looks positively slower at 11.6% when it comes to GNP at constant prices. For GDP these figures were 9.3% and 7.4%. But, of course, one has to remember that Q1 2009 annual changes were against Q1 2008, when both GDP and GNP grew by 0.1%. Q2 2009 changes, however, came on top of 0.4% growth in GDP and 0.6% growth in GNP.

In constant euros, our Q1 2009 GNP, at €35,182mln was comparable to the level of income in Q1 2005 (€35,238mln), while Q2 2009 GNP of €35,175mln was below that recorded in Q2 2005 (€35,862mln).

Gross domestic capital formation has fallen to €7,659mln in Q2 2009 down from €8,217mln in Q1 2009. We are now at the lowest level in capital formation terms since the end of 2002 (as far as these series stretch). Physical change in stocks has totalled -€911mln in Q1 and Q2 2009 the greatest cumulative drop for half-year of any year on record (since the start of 2003).

Two charts below illustrate some less apparent trends:
Services balance is deteriorating as financial and legal services exports are suffering. Of course, our hospitality and tourism exports have fallen off as well, thanks to economically illiterate Budget 2009. This is a point of alarm. Our exports of services are now below those recorded in 2007 in constant prices. Our total exports have fallen 2.5% in Q2 2009 (yoy) – a less deeper cut than in Q1 2009 when total exports contracted 3.0%. Goods exports have fallen 3.1% in Q1 2009 and 3.7% in Q2 2009, so things are getting worse here. Services exports contracted 2.8% in Q1 2009 and -0.9% in Q2 2009. Imports overall have declined 10.6% in Q1 and hen 7.1% in Q2 2009 – better than before, but still third deepest fall since the series revision in Q1 2004. Goods imports are down 22.3 in Q2 2009 yoy – marginally better than 24.8% contraction in Q1 2009.

Table below compares trade performance relative to corresponding quarters of 2007:


The above chart shows that taxes, public administration and defence contributions to GNP are falling over time – since Q1 2007 and despite April Budget and October 2008 budget, this fall continues today. This is not to be confused with the falling cost of Government in terms of taxation-exerted drag on growth. The decline in Government share of GNP is reflective of two things:
(1) there has been a marked decline in capital investment (i.e we still waste piles of cash on non-investment activities);
(2) the rising interest rate bill on Government debt is now adversely impacting GNP.

Now, GNP/GDP gap illustrated…
Self explanatory, really.

Now, recall those evil Americans who, according to our Taoiseach and his Cabinet members, gave Ireland this recession... Chart below illustrates:
Yeps, they (Americans) sneezed, Europe got a slight fever, the UK is out with a major flu and Ireland is... well... Ireland is busy dumping tens of billions in cash it does not have on public sector wages, social welfare payoffs and, next best thing to Partnerships - Nama...

Economics 23/09/2009: Cost of Nationalization

Today's note from Davy Stockbrokers throws into public domain a challenge and an accusation:

"Regrettably, the public debate on NAMA has been anything but rational and dispassionate. Confusion, misinformation and, at times, rank deception has run riot over the past several months... Tellingly, the brunt of discussion has majored on an anti-NAMA rant, with scant exposition of any credible alternatives."

If Davy is so dismissive of the 'alternatives' - of which there have been several rather involved ones - then Davy should be even more dismissive of the Nama proposal itself, for the Government still has no estimates for costs, returns, time horizons, detailed haircuts, borrowing terms for Nama bonds etc - after 6 months of working on it with an army of civil servants, highly paid consultants and having the likes of Davy on their side!

"Nowhere is this more depressingly obvious than in relation to the nationalisation option, wherein protagonists have tended to confine their treatises to a short paragraph or three, and where the potentially ruinous funding consequences for both the banks and sovereign have been glossed-over..."

Of course, unlike Davy or other stockbrokers, it is the independents: Brian Lucey, myself, Karl Whelan and Ronan Lyons who actually bothered to estimate - to the best of our resources - the expected costs of Nama to the taxpayers. Instead of focusing on the benefits and costs to the taxpayers, Irish stockbrokers focus on benefits to the banks and their shareholders. This is fine, and I will not accuse them of doing anything wrong here - their clients are, after all, not taxpayers, but shareholders. But it is rich of Davy team to throw around accusations of us, independnt analysts, 'glossing over' aspects of Nama - we are not the ones being paid by anyone for doing this work.

The emphasis on 'estimate' and 'expected' is there to address Davy accusations of 'rants' or 'deceptions'. If estimates are rants, Davy-own entire daily research output can be labeled as such.

But Davy folks are correct in one thing - we, the critics of Nama, have not produced an estimate of nationalization option cost. Instead, it was, me thinks, Brian Lenihan who promised to produce such estimates. May be Davy note was addressed to his attention?

Seeing the eagerness with which Davy folks would like to see some numbers on nationalization, below is the summary of estimates of such an undertaking developed by Peter Mathews (you can see his article on this in Sunday Business Post (here) and confirmed and elaborated by myself and Brian Lucey. (Again, note, one can only assume that our Davy folks do not read Sunday Business Post's Markets Section.)

I have argued in my Nama Trust proposal (aka Nama 3.0) (here) that we can avoid nationalization by buying out equity in the banks to support writedowns and then parking this equity in an escrow account jointly owned by all taxpayers. The banks will, then be owned by the Trust, not by the Government. Their shareholders will be Irish taxpayers as individuals, not the Government. The Trust will be there simply to provide a time buffer for orderly dibursal of shares over time.

Now, whether you call it 'nationalization' or 'Trust' or anything else, the problem with the banks in Ireland is that they need to write down something around 40% of the troubled assets values. This can be done by gifting them bonds (as Nama will do), or by buying equity in the banks in exchange for the same bonds, except, as below shows, at much lower cost.

In the first case, you get a promise of repayment from the banks and a pile of heavily defaulting loans. In the latter case, you get shares in the banks.

In the table above, the first set of red figures refers to the amount of equity capital that will be need for repairing banks baance sheets today (it can be issued form of bonds, just as Nama intends to do, which will be convirtible through ECB repo operations at the same 1% over 12 months). The amount we will need to put into banks under 'nationalization' or Nama Trust option is Euro30.88bn.

The bondholders will remain intact (so no additional cost of buying them out).

This upfront cost is over Euro 23bn cheaper than Nama. And it can be further reduced if we get at least subordinated bond holders to take a debt-for-equity swap, which they might agree to as they will be taking equity in much healthier banks.

The second and third red figures refer to the expected recovery on this equity purchase in 5 years time (not 15 as in the case of Nama). And all assumptions used to arrive at these two scenarios are listed. The figures are net of the original Nama cost. In other words, under these two scenarios, we can generate a healthy profit on Nama Trust, which we cannot hope to generate in the case of overpaying under the proposed Nama scheme.

In addition to the table above, I run another third scenario that assumes:

• 5% growth pa in banks shares (as opposed to 15% and 10% growth under scenarios A and B);
• Banks fully covering 1.5% cost of Government bonds (as in scenario B);
• Banks paying a dividend to the Exchequer of 2% on loans (net of bad loans) and charging 0.5% management fee, so net yeild is 1.5% on loans (as in Scenario B).

The bottom line in this scenario was ca €9bn in net return to the Exchequer on 'nationalization' within 5 years of operations.


Back to Davy note: "...the potentially ruinous funding consequences for both the banks and sovereign have been glossed-over..." Well, let me glance it over.

1. Nationalization can be avoided per my Nama Trust proposal, so there goes entire Davy 'argument'.
2. If the banks balance sheets are repaired with a 40% writedown of bad loans under the above costings while Nama would achieve only 30% writedown at a much higher cost, what 'ruinous' consequences do Davy folks envision for the banks? Their balancesheets will be cleaner after the above exercise, than after Nama!
3. If Irish Exchequer were to incur the total new debt of €30bn (per above proposal) and will end up holding real equity/assets against this debt, will Exchequer balancesheet deteriorate as much from such a transaction as it would from an issuance of €54bn in new debt secured against toxic assets such as non-performing loans? Again, it seems to me that a rational market participant (perhaps not the Davy researcher authoring the note) would prefer to lend to a state with smaller debt and real assets against it than to the one with higher debt and dodgy assets in hand.
   

Back to Davy: "...the retention of impaired assets on bank balance sheets ...would continue to cast a deep pall over perceived solvency risks in the Irish banking system, leaving this country still bereft of the necessary refinancing flows from which green shoots might grow."

I would suggest that this statement is itself either a deception (deliberate) or a wild speculation (aka rant). There is absolutely no reason why fully repaired banks (with 40% writedown on the loans under the above costings and as opposed to Brian Lenihan's proposed Nama writedown of much shallower 30%) cannot have access to the same lending markets as banks post-Nama would. However, under the above proposal:

• Irish Government will take much lower (24bn Euro-lower) debt on its books, implying healthier bonds prices for the Government into the future - some savings that won't happen under Nama;
• Banks enjoy much more substantially repaired balance sheets (again, not the case with Nama);
• There is no second round demand for new capital from the banks (not the case with Nama as proposed).

So, again: judge for yourself. When is the insolvency risk for Irish banking system higher:
Case 1: more substantially repaired banks balance sheets and more fiscally sound positioned Exchequer; or
Case 2: lesser writedowns of bad loans and more indebted Exchequer?
If you vote for Option 1 (as any rational agent in the market would do), you vote for the above 'nationalization' exercise.

Lastly, Davy note lands a real woolie: "When all is said and done, NAMA is not a bail-out of developers, or bankers, but of a banking system and its host economy. In that respect, it is a bail-out of ourselves."

Under Nama, developers will be able to delay or avoid insolvency declarations and subsequent claims on their assets. If this is not a bail-out, it is a helping hand of sorts.

As per 'repairing economy' - there is absolutely no evidence to support an assertion that Nama will have any positive economic impact, but given that it will impose much higher cost than alternatives on households, it can have a very significant negative impact on the economy. Perhaps, Davy think that households are simply there to be skinned and that our economy does not depend on them.

Then again, Davy folks thought CFDs and leveraged property deals were gods-sent manna.

Now, let us get to the more rational side of economic impact debate:

1. Under my proposal above, banks get deeper repairs, so they will be healthier and their reputational capital will not be based on a handout rescue, but on actually having equity capital injection. This is a net positive that Nama does not deliver;
2. Under my costings above, the Exchequer and/or households end up being investors with a strong prospect of higher net recovery value over shorter term horizon than in the case of Nama. This is a net positive that Nama does not deliver;
3. Under the above exercise, the banks will not be able to unilaterally take liquidity arising from the injection overseas, so whatever liquidity is generated, will have to stick to our shores, and thus to our economy. They still can use this liquidity to pay down their expensive inter-bank loans, but at least they won't be able to run investment schemes with taxpayers' money abroad. Shareholders might look badly on this one, since the shareholders will be not foreign institutional investors, but domestic taxpayers. This is a net positive that Nama does not deliver;
4. Under the above exercise, we won't have to pay Nama staff and consultants any costs - banks will continue dealing with their bad loans. This is a net saving that Nama does not deliver;
5. Under the above Irish taxpayers won't have to face a massive tax bill of 54bn, but a smaller (though still massive) bill of 30bn. This is a net saving that Nama does not deliver;
6. Under the above proposal Irish banks will be able to access the same ECB window on the same terms as any other bank in the Eurozone. The will also be able to do the same with Nama, so there is no additional cost when it comes to borrowing.
7. Under the proposal above Irish Government debt will be €23bn lower (and adding the second round recapitalisation demand under Nama - €29bn lower) than in the case of Nama, providing potential easing to our cost of borrowing. This is a net benefit that Nama won't deliver.
   

I can go on with these arguments. But I am afraid it will be a bit too much rant for our Davy folks.

Economics 22/09/2009: Bleeding jobs...

CSO’s Quarterly National Household Survey (QHNS) Q2 2009 shows ongoing collapse in employment in the country. After peaking at 2.14mln in Q1 2008, employment has now steadily declined and is now down 8.2% - the steepest fall in the history of these series. My prediction – by the year end the fall will total around 8.2-8.5% in annual terms, marking the sharpest decline since 1960s. Current employment stands at 1,938,500 – below the politically important 2 million mark for the second quarter in a row. The pace of employment falloffs is accelerating – in Q1 2009 employment contracted by 7.5% yoy, in Q2 2009 the rate of decline was 8.2%.

Per Ulster Bank note: “To put this in an international context, employment in the US fell by 4.3% from its peak (in Q1 ’08) to the second quarter of this year and that in the UK fell by about 2% on the same basis. So, mirroring the comparative weakness in the broader economy, the Irish labour market is experiencing a much more severe adjustment in employment than is the case among our main trading partners.” Then again, they’ve got a bit more competent political leaderships in the US and UK, that doesn’t raise taxes to pay its cronies wages, don’t they?

Unemployment rate amongst males now stands at 15.1% up from 4.8% in Q2 2007. Female unemployment rate has risen from 4.4% in Q2 2007 to 8.1% in the latest survey. Overall unemployment has gone from 4.7% in Q2 2007 to 5.7% in Q2 2008 and 12% in Q2 2009.



Numbers employed in various sectors are shown in the table below. Public sectors still showing no signs of cost reductions while the rest of economy is bleeding jobs… Public sector employment in Q2 2008-2009 is up ca 16,000. Now, An Bord Snip Nua recommended total numbers reduction of 17,300, which, if delivered would still leave Ireland at ca 2007 levels of public sector employees. Are you laughing yet? For a country borrowing €400mln per week – good half of which goes to pay wages in the public sector – this is really an achievement.
Table above shows another disturbing trend - forced 'entrepreneurship' - notice how more robust are the numbers of self-employed with no employees through the downturn, actually rising between Q2 2007 and Q2 2009. This is a sign of more people being forced to take up self employment in view of lacking full time jobs.

Charts below illustrate some other trends.
Lastly, it is worth noting that QNHS-recorded 2,500 increase in labour force in Q2 2009 is a seasonal aberration as part time employment rises in the summer months. This is going to go into negative territory in Q3-Q4 2009.

We are on track to reach 15-15.5% unemployment sometime in mid 2010. And on track to get close to 10% long-term unemployment by mid 2011. That would be a fitting tribute to the Government that raises taxes in an economy experiencing severe recession...

Economics 22/09/2009: Emigration raging

Per CSO release today, Ireland is now back in the age of net outward migration, or in that ugly 1980s term – emigration. “The number of emigrants from the State in the year to April 2009 is estimated to have increased by over 40% from 45,300 to 65,100, while the number of immigrants continued to decline over the same period, from 83,800 to 57,300. These combined changes have resulted in a return to net outward migration for Ireland (-7,800) for the first time since 1995.”

But, per one net positive outcome of recession, “the number of births reached a new high of 74,500 (not seen since 1896) while the number of deaths was 29,400, resulting in strong natural growth for the year to April 2009 of 45,100.” Of course, as unemployment and higher taxes take a bite out of workforce participation rate and employment (see below) – with women withdrawing into maternity leave as a temporary cover against possible lay offs and as a result of falling returns to second income earners in the family – we are on a path of more children to be borne in Q32009-Q2 2010, after which the rate should start falling slightly.

“The combined effect of the natural increase and migration resulted in a population increase of 37,300 (+0.8%) bringing the population estimate to 4.46 million in April 2009.

“Of the 65,100 people who emigrated in the year to April 2009, EU12 nationals [Eastern Europe] were by far the largest group accounting for 30,100, with Irish nationals being the second largest at 18,400.” Now, CSO won’t tell us the comparative quality of those emigrants, but standard theory and logic suggest that there is a strong selection bias amongst those who leave the country. The emigrants are most likely those who can obtain better employment abroad and/or who can earn higher wages working abroad than the Irish social welfare entitlements provide. In other words, we are losing higher quality people than those who stay behind and sign onto the Live Register in similar circumstances (e.g unemployment spell within family).
Another interesting feature of data is shown in the Table below. Note that only two categories of migrants were either increasing or steady between 2008 and April 2009. Irish nationals returning from abroad (most likely having lost their jobs elsewhere) and EU15 nationals (steady inflow into MNCs employment).
Per US and Rest of World figures - undoubtedly idiotic migration and naturalization restrictions that operate in this country and are actually being tightened by our authorities this year (Green Card regime tightening) are not helping...

Economics 22/09/2009: Two further Nama points

Updated below:

Global Finance Magazine on the concept of ‘long-term economic value’ of distressed assets (here) and on effectiveness of bad assets purchasing schemes:

“Meanwhile, the passage of the Troubled Asset Relief Program (TARP) into law in the United States failed to alleviate strains in the financial markets...

The TARP empowers the US Treasury to buy troubled assets at heavily discounted prices, well below their long-term economic value. “No one yet knows what price will be paid for the toxic paper, or what the default rates will be on the underlying mortgages,” said Carl Weinberg, chief economist at High Frequency Economics. “

Over time, people will realize that all the underlying mortgages are not defaulting, and panicky market conditions should abate, according to Weinberg. “We have seen this game before,” he says. “In the 1980s highly indebted economies like Mexico, Brazil, the Philippines and Argentina bought back their own debt from panicked small banks at 20 cents on the dollar.”

20 cents on the Dollar, folks? Nama is buying defaulting developers loans (not sovereign bonds) at 79 cents of the Euro!!! I’d rather have Brazil’s and Argentina’s bonds, thank you very much.


Another interesting bit:

Robert Boyer’s paper “Assessing the impact of fair value upon financial crises” published in the Socio-Economic Review, 2007 deals with the expected effects of LTEV application to accounting standards, but the implications of this are pretty much the same for pricing (as in Nama). Boyer concludes that LTEV “gives at each instant a seemingly relevant liquidation value, but obscures the value creation process by mixing present profit with unrealized capital gains and losses. This discrepancy increases with an increased degree of uncertainty, which is at odds with widely held beliefs about the efficiency of existing financial markets. Fair value introduces an accounting accelerator on top of the already present and typical financial accelerator. …If fair value accounting is applied to banks, an extra volatility may be created...” What is this about? Three things, as far as Nama is concerned:

1. LTEV will simply translate future value (capital gains) on assets underlying Nama-purchased loans into monetisable value as if all future price appreciation expected under LTEV can be captured in full. This, of course is a matter of timing (knowing when to sell) and efficiency of sales (having zero cost of selling and no impact on selling price of the volumes of sales that Nama will have to undertake);
2. LTEV neglects to price in the effect of large asset holdings off the market (Nama holding vast portfolio of property-backed loans off the property market), which is likely to depress property prices over the life-time of Nama itself. The end result here – a gross overestimate of future expected prices.
3. As the two points above coincide in timing, they act to reinforce each other – an accounting accelerator occurs.
   

Who says you overpay only once?

Here is the rate at which the Government can currently borrow on a 6-months basis:
Let me explain:

• we can borrow in the form of ordinary bonds at 0.481% for 6 months period. These are convertible at repo window of ECB at a discount of 12% on face value and 1% interest rate. Total cost of injecting €1 into bank balance sheet is, thus, 15.2 cents; or
• we can issue Nama bonds at 1.5% with 5% in subordinated bonds, with banks taking these to the ECB repo window at 12% and 16% discounts respectively, borrowing at 1% against both. Total cost of injecting €1 into bank balance sheet is, thus, 16.4-18.1 cents depending on how ECB risk-weights subordinated bonds.

Cheap money in the Frank Fahey World of Stupid Economics?

Economics 21/09/2009: ECB's penalties?

Updated version (00:42am September 22)

On June 23, 2009, ECB opened bidding for its first 12-month refinancing operation.

Back in May 2009, the ECB announced that it would double the maximum length of time it lends money from six months to a year and in June it set the rate for 12-months financing at 1%.

Last time it applied a longer term horizon, ECB placed 348.6 billion euros in December 2007.

So in the nutshell, 1.5% coupon on our bonds bound for ECB and bearing 6 months maturity is a rotten deal.

How rotten? If we were to issue bonds at the ECB own long term financing facility rate with 12 months maturity. The expected cost of total borrowing over 15 years inclusive of the expected costs of roll-overs and reflective of the expected yield curve for ECB rates will be around €15.4bn. In contrast, current structure of 1.5% pa coupon plus 6-months maturity is expected to yield total interest cost of ca €17.5-18.9bn. Then again, what’s €2.1-3.5bn for the Government that burns through €400mln in borrowing on a weekly basis?

What is interesting is why didn't ECB make a similar deal with the Irish Government, allowing it to issue lower coupon bonds or extend maturity of these bonds or both? One can only speculate, for ECB will never tell one way or the other, but I suspect the answer to this lies within the ECB statement that Nama should not overpay for assets it purchases.

Hmmm... Leni took his plan to the ECB men, saying we will buy €77bn worth of stuff, that includes €9bn of rolled up interest, and we will pay €54bn for it. The ECB men pulled out a calculator and extracted: [€54bn/(€77bn-€9bn)-1]*100%=20.6%. The ECB men stared at Leni in disbelief... "Herr Brian, yor ekonomi iz in truble? Djast less fan 21% dropp in yor properti praicez?" 'Oh," replied Brian Lenihan, "but Frank Fahey School of Economics says you'll give us free money!" And here the ECB men smelled a rat...

Otherwise why would the ECB, amidst quantitative easing exercise, impose sanction-level conditions on our bonds? 6-months paper and 1.5% is worse than what ECB gives money to commercial banks at. Much worse, folks.

Now, ECB is no stranger to being taken for a ride. What is telling is that ECB's reaction to 'abuses' in the past is very similar to its reaction to Nama to date.

Most recently, back in July 2008, both the Australian bank, Macquarie Group and the British building society Nationwide have used their Irish subsidiaries to upload hundreds of millions of dodgy ABS packages (in the case of Macquarie, €455mln was borrowed against the most ridiculous collateral –Australian car loans) at the ECB discount window.

On September 4, 2008, ECB’s President, Jean- Claude Trichet stated that he will make it more expensive for banks to borrow from the ECB against most asset-based securities, starting from February 1, 2009. Amidst the crisis gripping European markets at the time, ECB raised `haircut' on the securities it allows to be used as a collateral for 12-months borrowing from 2% to 12%. Additional 4.4% were to apply to paper with no immediate market price.

Note, Irish haircut on bad debts is in effect just below 21% - not that far off the haircuts applied by the ECB (16.4%) on lending backed by much more robust collateral (average European mortgage-securing assets - i.e prperty markets - are down single digits across the entire crisis) than dodgy Irish development projects (down 60-80% and some down 90% in value and falling). When ECB haircut on unsecured banks bonds is added, the total asset discount that ECB could have applied was in excess of 21%. But what is even more significant, the value of the underlying assets accepted by the ECB is supposed to be calculated as the market price less the haircut.

Again, this stands in contrast to Nama which is taking not senior bonds, but ordinary loans, and which is using farcical long-term-economic-value 'pricing', not current market prices. Despite this, Nama haircuts are just 20.6% (once rolled up interest is accounted for) on lower grade assets than the ECB would consider at its window…

No wonder they won’t let Ireland issue bonds with a coupon of 1% or less with 12-months maturity - as would be consistent with a rating on par or better than that for commercial banks. In effect, contrary to the assertions of Brian Lenihan, it is now clear that the 1.5% for 6-months paper deal is far from being endorsed by the ECB. Instead it is a reflection of ECB’s unease with the details of Nama plans. All in, the ECB is now applying nearly as strict terms to the Irish Government Nama bonds as it does to private sector bonds issued by less than thriving European banks.

In July 2008, before changes were announced, the ECB run two-tier pricing system, whereby haircuts of 0.5-5.5% applied to Government paper against the key ECB rate of 4.25%. Mortgage-backed securities – especially Spanish and Irish ones – incurred 18% haircut. Now, do the maths – the spread of 0.5-5.5% haircut on 4.25% lending rate implies the cost of capital of 5-10% for government bonds collateral and up to 24% for MBS. Since July 2008, Irish property markets have fallen by over 12%, so the same collateral rules, that were described by analysts as being loose back in 2008 would require a haircut of ca 27% at the very least, for 1-year long holding period. Again, Nama is implying a haircut of 20.6% on a 15-year holding period.

27% cut held over 1 year was a ‘loose’ condition that had to be drastically revised by the ECB, but 20.6% shave on 15-year holding is deemed by the Irish Government to be reasonable? Who do they think they are foolin?

Another interesting note: following the expression of it dissatisfaction with ‘loose’ borrowing by Spanish and Irish banks, the ECB started quietly talking to the banks urging them to fall in-line. Exactly the same has happened when the ECB issued its thinly veiled directive to Leni – ‘do not overpay for Nama assets’…

Economics 19/09/2009: Nama, bondholders and shareholders

Setting aside, for now, the issue of who subsidises who in Nama, a quick note on opportunity cost of the undertaking when it comes to the structure of Irish Financial Services in general.

June 2009 paper from a group of US and Canadian researchers, published for the European Finance Association, 2009 meeting (here) provides an interesting read. The study delivers "...a comprehensive analysis of a new and increasingly important phenomenon: the simultaneous holding of both equity and debt claims of the same company by non-bank institutional investors (“dual holders”). The presence of dual holders offers a unique opportunity to assess the existence and magnitude of shareholder-creditor conflicts. We find that syndicated loans with dual holder participation have loan yield spreads that are 13-20 basis points lower than those without. The difference is even greater after controlling for the selection effect. Further investigation of dual holders’ investment horizons and changes in borrowers’ credit quality lends support to the hypothesis that incentive alignment between shareholders and creditors plays an important role in lowering loan yield spreads."

Without giving too much technical detail, the study effectively says that inducing greater share of bond holders to also hold equity (or vice versa) results in lower cost of credit to the firm.

Now, recall that my Nama3.0 or Nama Trust proposal (here) has, as one of the first conditions for taxpayer bailout, a full or partial conversion of Irish Banks' debt holders into equity holders. This would have achieved two positive outcomes simultaneously:

1. reduce demand for taxpayer funds, while assuring that some private markets trading in banks' equity will remain post-Nama Trust implementation; and
2. per above study, lead to a long term improvement in the cost of liquidity for Irish banks.

Incidentally, the third net positive impact of such conversion would be effective risk-sharing, as bondholders will be given a direct stake in the Nama process, something that is not even attempted in the current 'risk sharing' proposals on the table.

Economics 18/09/2009: An Illustration to the Idiot's Guide to Economics

Per chart below, average monthly bond spreads for Irish Government 10-years paper for the last 8 months.We've read Brian Lenihan's lips and here is what he said:

August 2009 (here): "The proposal to establish a National Asset Management Agency has been widely supported internationally by bodies such as the IMF and the OECD and tellingly since
the announcement of the establishment of Nama in April, bond spreads above the German benchmark for Irish sovereign debt have halved, from almost 3 per cent over 10 year German Bonds to now just 1.5 per cent. Irish 10 year bond yields are now 4.8 per cent."

August 2009 (here): "Indeed, during May I had to undertake a tour of EU financial centres to correct misinformation that existed about Ireland. This tour had a positive impact and there has been a significant reduction in the spreads on the State’s borrowing."

Plenty more to be found in the same vein. So per chart above, we've read your lips, Minister and... they produce gibberish so far. As I have remarked on many occasions, Irish bond spreads decline was

• in line with other countries (and in particular - with APIIGS);
• had more to do with the global change in appetite for risk and little-to-nothing to do with Minister Lenihan's decisions or policies;
• lastly, per chart above, while Minister Lenihan was trying to sell his disastrous policies to the nation on the back of declining bond spreads, Ireland has moved from the already dubiously distinctive position of being the second most screwed up economy in the Eurozone after Greece prior to May 2009 to being the worst economy in the Eurozone in terms of its bonds spreads over German bund since Minister Lenihan (per above quote) undertook his courageous road show to Europe.
  

Per one observer comment on this: "we are now the largest pig in the APIIGS pen" - welcome to Lenihanomics?

And on a funny note (credit here)and courtesy of bocktherobber :

Economics 18/09/2009: hard numbers for our delusional leaders

Retail sales for July gotta be hard read for our delusional leaders (here).

Per CSO release today: "The volume of retail sales (i.e. excluding price effects) decreased by 15.0% in July 2009 compared to July 2008. There was a monthly increase of 0.2%... partially explained by the increase in new motor sales in July 2008 that coincided with the introduction of the new VRT system." Ex Motor Trades retail sales decreased by 6.2% in July 2009 compared to July 2008 and fell -0.7% in monthly terms. Things are getting worse once again, after a short reprieve of June.

A good summary above (from Ulster Bank economics team). Food, Bars and Other Goods improved in monthly series, everything else is tanking. But all three categories of 'improved' goods are about people staying at home instead of leaving for a vacation, so here we go - have a sandwich and a pint instead of a break - Lenihanomics at work.

Few charts below (back to my favorite hobby):

It is worth noting that, of course, changes in our retail sales = changes in our VAT receipts. This said, can you spot where the 'No New Taxes' Lenihan's statement yesterday can be supported here?

Economics 18/09/2009: Idiot's guide to the Galaxy

One of my favorite books in the Universe, The Hitchhiker's Guide to the Galaxy has been surpassed, if only momentarily, by a publisher in Ireland producing this superb Idiots' Guide to Science and Economics. Behold, the front page of today's Indo:
Of course, Mary Coughlan's theory of Relativised Evolution or Evolutionised Relativity and the absolutely unfortunate nature of the venue at which she managed to live up to her well-deserved name 'Calamity Coughlan' are straight out of the chapter 'National Embarrassment Exemplified'. It is a serious public blemish on an otherwise worthy event of IDA launching a serious campaign to attract more FDI into Ireland that I wrote about before (here). No need to detail much here, Indo's article speaks volumes, one can wonder now as to what evolutionary process can lead to the emergence of the species so ignorant of basic knowledge as Mrs Coughlan. One note worth making - the fiasco perfectly exemplifies Kevin Meyers' excellent argument in the same paper today (I might not agree with it myself, but Mrs Coughlan has made his case iron-clad).

But Brian Lenihan's lack of grasp of simple realities of public finances and economics is as breathtaking as Mrs Coughlan's lack of basic erudition. After weeks of being fed drivel of FF backbenchers' and hacks' version of economic ("Nama bonds are not debt", "We will get cheap money from ECB", "ECB supports us" etc), it seems our own Finance Minister got convinced that there is such a thing as a Free Lunch. Per Indo's article here, Lenihan "gave his firmest pledge yet that there would be no tax hikes in the December Budget. And Mr Lenihan challenged anyone who doubted him to "watch my lips"... Mr Lenihan said he was committed to introducing a carbon tax... But he gave his clearest indication yet that the Government would not bring in a property or water tax this year. "I am not aware of any other (new tax hikes)," he said.

Ok, three Indo reporters (including senior ones) failed to actually query the details of this statement the Minister made. But the very fact that Lenihan actually said what he did is a testament to the fact that this Government has no real financial brains in the Cabinet at the time of fiscal and financial crises. None at all.

Per statement itself, Minister Lenihan obviously does not consider introduction of the Carbon tax to be a new tax. Presumably, he lived so long outside the real world, in the world of chauffeur driven Mercs and vast taxpayer-paid perks that he might be under the impression that Carbon tax already exists, so 'introducing' it will not constitute an imposition of a new charge on taxpayers.

The Minister also indicated that he has seen no other tax proposals (other than the Carbon Tax and Property Tax). Has he read his own Commission for Taxation voluminous report? Or has it escaped his field of view as the Lisbon Treaty volume had escaped Brian Cowen's view earlier?

Finally, the Minister has to be living in the surreal world where a €20bn-plus shortfall between tax receipts and liabilities can be covered by something other than taxes. Indo's journos refer to the possibility of €4bn savings on the expenditure side as the means for avoiding new taxes. Have they done a simple sum ever before? Has Minister Lenihan done a simple sum ever before?

Even if the Government does deliver on €4bn in savings, and even if part-year measures announced in April 2009 budget continue through the full year 2010, the entire savings will not be able to cover a quarter of the fiscal spending gap. If the Government commits to fully ending all capital expenditure in 2010 and if the economy grows by 5% in 2010, the expected fiscal gap will still be in excess of €8bn in 2010.

This money will have to be borrowed in the international markets. The roll-over of a vast sea of short-term debt issued in 2008-2009 will have to happen. Is Minister Lenihan really buying the idea that these state liabilities - some €30bn worth already accumulated, plus Nama's €54bn expected plus the ones awaiting NTMA's printing press on the back of long term unemployment increases into foreseeable future can be 'deflated' away at the current rates of spending and taxation without raising new taxes?

Well, only in the world where Einstein authored On the Origin of Species, perhaps?

Irish Economy: a longer view

Yesterday I was asked to give a quick talk to the Marketing Institute - at a lovely breakfast gathering - on my view of Ireland's economic prospects. Here are the notes from my speech:

First, 'we are where we are'...

Fiscal problem - the real crisis:

• 2013= Euro 131bn or 91% of 2009 GNP, Euro 47,640 per adult person in debt. We will be spending 21.1% of our 2009 tax revenue servicing this debt – these are DofF projections-based estimates without Nama.
• With Nama up to 204bn in 2013, 140% of 2009 GNP or 74,200 euro per adult person. We will be spending 33% of our 2009 tax revenue on servicing the debt.
• In effect, Ireland’s debt servicing charge alone will be bigger than the entire health and social welfare bill today.
• It pays for three things - services (some we need, others we can do without), social welfare (mostly excessive in levels) and public sector wages and pensions (absurdly excessive burden). Not a hell of a lot for the loot they collect.
  

Implications:

• Credit conditions will remain very tight in the country so old model of credit-fueled growth is out of the window.
• Households spending will be down, savings will rise, but capital will outflow abroad as banks lending abroad will increase.
• There will be net emigration out of Ireland and inward migration into Dublin.
• Higher taxes are here to stay.
• Opportunities will be limited on public and private sectors sides.
• Irish businesses will be locked in a zero sum game where domestic growth of one company will require domestic losses in another.

Nama problem: a sound of vaporized wealth

• The net cost is likely to be staggering – ca €6,000-12,000 per working-age adult person under benign assumptions.
• Economic cost will be even higher due to zombie banks, zombie developers.
• Even if Nama improves credit supply (doubtful for several reasons) it will destroy credit demand (no deleveraging is possible for the households).
• Investment will be limited to firms with international markets exposure, which means business models will have to change.
• We will be exporting brighter younger people, to be replaced by marginally brighter than the remaining Irish workers younger foreigners from the fringes of Europe and outside the EU – this means our business models will have to change. New consumers will spend minimum in Ireland and will expatriate more cash out in fear of immigration policy reversals and rising nationalism.
• Public sector will remain unreformed, if slightly demoralized, by failed efforts of introducing small reforms. Which means our business models will have to change for all those who relied on public contracts.
  

Economy's problems: dead end in sight?

• What is our ‘next big thing’? Do you know? I can’t see one.
• Is it ‘knowledge economy’? Not likely – late to the races, high taxes, wrong taxes, power rests with entrenched Social Partners (older, non-productive, fearful of competition). We over-rely on Government sponsored research. Private sector in Ireland is adaptive, not creative, which means it does not want to waste money on longer-term research projects.
• Knowledge economy will be happening in only a few bright spots: international finance will be back (can you leverage anything to get into this field?); few internationally traded services (TCD, UCD in education, some smaller education players; may be some private medicine, though unlikely; legal and tax services – but only domiciling into Ireland. One big and growing bright spot might be in MNCs shifting more into traded services areas (IBM model for some, start-up Googlelites, Facebookers etc).
• Domestic economy will see decline of the Irish Brands – we will be more Anglocized in terms of our consumption patterns, especially if Northern Ireland continues to open up to business.
• Is the future a ‘Green economy’? well, sort of – only with much fewer wind mills and other traditional ‘green’ production firms. Instead, there is room for using our countryside much smarter than we’ve been doing so far – tourism, smart and recovery health tourism and work-and-play tourism have some future, if we can clean up our act on bungalow blitz and passage rights with farmers. Also, smaller boutique producers of ‘green’ agricultural products have a future. But these are all small fry to sustain real growth. Spirit of Ireland is a good initiative, but will it fly or will ESB cronies shut it down?
• On house prices and property prices: peak to trough fall of 50-60% on average. Equilibrium, or long-run prices should be at 3.5-4 times average income. This roughly means 210-240,000 per house. This will be our long-time average. Trough will undershoot this target, so we can see 200,000 tested.
  

Business environment: exit the stage

• Indigenous firms will not be looking at higher margin activities, e.g strategy and market expansion at home.
• Companies will be retooling to grow abroad.
• Europe will continue pursuing regulated markets model – can we get any value out of this? Not likely – loads of competitors closer to the feeding trough and loss of our own agility can spell a disaster for out incoming FDI.
• What do businesses need to grow in this environment – step out of the shell of ‘we are Irish, we are European’ and go for ‘we can bring you into Europe, help you grow in here and keep you as a happy client’ – don’t forget to translate this into Chinese?
  

Alternatives to a slump: Doing the right thing

Reform public sector and policymaking: Introduce separation of payer and provider in public services. Let the state pay for access to service while we, the private sector, provide such services – growth opportunity space is converting some 20-25% of our GDP into world class competitive services and growing them by adding non-public customers.
Examples:
- Medical tourism
- Education
- Legal domiciling
- Logistics and distribution services
- Outsourced sales
- Marketing and advertising outsourcing?

Reduce the size of public sector and use this reduction to cut taxes on personal income at the upper margins. This introduces proper incentives for investment in Human Capital. It also feeds growing education sector that is actually productive.

Eliminate reliance on outsourcing bodies (Quangoes, FAS, Forfas and Social Partnership) in setting public policies. Rebate savings to taxpayers, but also force more direct democratic interactions between people and policies. Require that best practice analysis and economic feasibility (including environmental and social impact assessment) must be performed for any Government ‘investment’ – this improves quality of investment and returns.

Ireland as Western Hong Kong model

Make public procurement and salaries and wages costs transparent – publish them on the web.

Introduce Land Value Tax – infrastructure returns, reduced speculative holdings of land.

Abandon national spatial strategies – focus on Dublin, Cork, Galway and Limerick. This simply reflects the reality of where growth will be concentrated.

Reform immigration policies: we will still depend on inflow of talented foreigners, but we must incentivise these flows:

• Create a meaningful Green Card – giving people full rights (save for voting) and allowing them to travel visa-free across the EU (Schengen plus UK). Green Card should be issued for 1 year, then 3 years, then permanent.
• Allow no access to welfare of any kind for the first 5 years of residence for all foreign nationals. Sign bilateral agreements with other EU states whereby Irish Government will as EU states to pay for their citizens’ access to social welfare and unemployment assistance and in exchange Ireland will assume provision of those services for Irish citizens abroad.
• Have language and educational/experience – tested system of admissions (not a sole route for entry, but one of them).
• Streamline citizenship naturalization to reduce red tape. Access to naturalization should be allowed on the points system basis – number of years in residence in Ireland, having Irish family members, employment type etc should add points and speed up both naturalization eligibility and the processing time to naturalization.
  

Reform bankruptcy and directors laws:

• We must allow those who try and fail to get up back on their feet, so personal and business bankruptcy restrictions should apply for 1 year at most, the record of bankruptcy should apply only for 3 years. It should be fully cleared after 3 years.
• Stop the idiotic practice of pursuing people personal assets in collection of mortgage arrears.
• Directorship disqualifications must be reduced to cases of clear abuse.
  

Reform regulatory systems:

• Link regulators pay and pensions to their performance in office – assessable by the independent review board. If we pay them well, they should perform well.
• Reduce the number of regulators – does a small-town economy really need a Taxi Regulator? a SMS Regulator? and so on.
  

Reform banking:

• Most of reform will come from abroad – EU, G20, Basle III. Most of these reform will be painful and costly – Nama Squared?
• Domestic reforms must include:

1. Breaking a cozy ‘Old Boys’ cartel between banks and other elites. Sadly – we have no record of doing this even after all the banking scandals of the past;
2. Introducing more competitive domestic banking by reducing market shares of Irish banks – sadly, we have no record of doing this either;
3. Using Nama to bring more transparency into Irish banking – sadly, we are doing the opposite.
   

Hope is in a short supply, treat it carefully. We need some serious drastic changes and these will have to take place at the head of the table.