Economics 25/02/2010: European economy and EU Commission

"Curiously enough, the only thing that went through the mind of the bowl of petunias as it fell was Oh no, not again. Many people have speculated that if we knew exactly why the bowl of petunias had thought that we would know a lot more about the nature of the Universe than we do now." The Hitchhiker's Guide to the Galaxy.

Indeed. Today's ECFIN weekly newsletter said it all. Titled cheerfully "ECFIN e-news 8 - EU interim economic forecast: fragile recovery has begun" it featured the revised interim forecast for EU economy from the EU Commission. It turns out, per forecast that (unbeknown to most of us in the real world) "the longest and deepest recession in EU history came to an end as real GDP in the EU started to grow again in the third quarter of 2009." This comes despite the fact that growth actually fell (and almost reached back into negative territory) in Q4 2009. Thus, in line with Commission optimism, Brussels now expects "seven largest EU Member States, ...to expand by an anaemic 0.7%".

"Weaker housing investments and continuing balance-sheet adjustment across sectors are expected to restrain EU growth in 2010. Unemployment remains on the rise and would thus dampen private consumption as well. Inflation projections remain largely unchanged at 1.4% and 1.1% in the EU and the euro area respectively".

I am not sure if this rather gloomy prospect matches the headline, but the same issue of the newsletter contains another piece titled "Rebound in economic sentiment slows in February". So can someone explain to me, please - is it that the recovery has begun, or is that the recovery is running out of steam? Clearly, I would tend to believe the second one, since it is based not on projections by the Commission (which famously predicted, and actually planned for overtaking the US in terms of productivity, economic growth and economic wellbeing by 2010, moved to 2012 and later to 2015), but on hard data.


In February 2010, the EU's Economic Sentiment Indicator (ESI) rose by statistically insignificant 0.2% to a still-recessionary 97.4. ESI was down to 95.9 (-0.1% on January) in the euro area. The latter correction follows an unterrupted climb up over 10 months, suggesting that the growth momentum might have been exhausted.

February reading of the Business Climate Indicator (BCI) for the euro area rose for the eleventh month in a row. Happy times? Not really - the relatively low level of the indicator suggests that year-on-year industrial production in January 2010 was still contracting, not expanding.

Drilling deeper into data: all sub-components of the confidence indicators remained below growth levels in January and February 2010. And one - retail trade confidence indicator actually reversed back into contraction territory after December when it crossed over the growth line. Employment conditions in services have turned negative again in January, as did construction confidence indicator.

Which part is showing that the recovery has begun, I wonder?

May be, just may be - the business climate is improving somehow? Well, not really:
EU Commission own BCI is still stuck at -1 - below expansion levels.

Consumers picking up, then? Nope: "In February 2010, the DG ECFIN flash estimate1 of the consumer confidence indicator2 for the euro area signals the first fall after 10 months of improvement (down to -17.4 from -15.8 in January). Confidence declined also among EU consumers, but to a lesser extent (down to -13.6 from -13.1 in January)."


So: consumers are down, producers are in the red and overall economic indicators are turning South again... yet 'recovery has begun'.

A bowl of petunias signalling the nature of the Universe from its Brussels windowsill.

Economics 25/02/2010: Wholesale prices - deflation is still a problem

Wholesale and Producer prices are out today for Ireland, January 2010.

Per CSO: Monthly factory gate prices are up 1.5% in January as compared to 0.4% rise a year ago. Annual percentage change now stands at -2.8% in January 2010, compared with an annual decrease of 3.8% in December 2009.

Exports prices rose strong 2.0%, while the index for home sales was down 0.2%. In the year there was an increase in the exports price index of 3.3%, primarily due to positive currency movements and a decrease of 0.9% for domestic sales prices.
Producer price deflation is moderating
but this moderation is driven primarily by external factors.

January 2010 most significant changes were:

• Basic chemicals (+4.9%),
• Pharmaceuticals and other chemical products (+1.7%)
• Other food products including bread and confectionery (+1.4%),
• Beverages (-0.3%)
• Building and Construction All material prices increased by 0.9% in the month

On an annual basis:

• Basic chemicals (-9.6%),
• Office machinery and computers (-4.1%),
• Radio, television and communication equipment (-3.7%),
• Other food products including bread and confectionery (+1.8%)
• Tobacco products (+7.8%)
  
• Building and Construction All material prices -1.4% in the year since January 2009.

Capital goods – a very important driver for recovery, posted a yoy price drop of 0.6%, and a mom rise of 0.4%. Thus, mom changes were too weak to signal any significant turnaround in business investment cycle.

Wholesale price of Energy products fell 3.9% in the year since January 2009, while Petroleum fuels increased by 24.1%. In January 2010, there was a monthly increase in Energy products of 0.8%, while Petroleum fuels increased by 2.7%.

Overall, therefore, while some moderation in deflation at wholesale level is evident, there is not enough momentum to suggest that we are out of the woods yet. Chart above clearly shows that the deflationary trend prevalent since May 2009 was broken in December 2009 and the positive trend has accelerated in January 2010. It will require 1-2 months of continued upward trend to signal sustained movement toward a recovery and the risk here is for a double-dip.

The same stands for Industrial producer prices (Manufacturing). But there is far less optimism in the numbers for Capital goods, which show more volatility and reversals than broader indices.

Economics 25/02/2010: Exports under pressure

A quick note on Ireland's trade flows for December 2009 - published yesterday.

As I warned earlier, the stellar performing Chemicals (inc Pharma) sector is now starting to retreat. Exports of Chemicals are down 9.54% in November and, per CSO statement, went further down in December. Machinery and Transport Equipment is down 38.9% in November (year on year).

Charts below illustrate the problems and showing the trends:
Overall, exports are down and the trend is also down - there goes a hope of exports-led recovery (not that it makes any sense, to be honest, given the global trends for trade). Imports are again heading South - suggesting two things:

• a renewed pressure on consumer demand side; and
• continued weakness in imports of intermediate inputs by the MNCs (signaling potential further declines in exports as a result).

Trade balance is not improving despite imports fall-off. There is a clear flattening out of the upward trend, suggesting that we are now close to exhausting the stage when collapsing demand drove trade balance up. It is down to exports from here on to influence the trade balance and the signs are pretty poor.
Chart above shows that the adverse changes in exports are not coincident with changes in terms of trade which continue to improve since Summer 2009. However, as the next chart clearly indicates, we are now away from the historic relationship between exports and terms of trade:
This implies that decline in exports we are experiencing is driven by other factors. Might it be a longer term pressure on MNCs activities in Ireland? Global trade flows changes? Or both?

Either way, there is no sign of exports-led growth. Irish exporters have performed miraculous well in 2009, compared with the rest of this economy. But one cannot hinge all hopes, as the Government is doing, on exporting sectors. Even more importantly, one cannot take exports performance for granted (as our Government is doing as well) - we need coherent strategy to get exporting back onto its feet.

Economics 24/02/2010: What's heading for Nama land

On a serious note - good post by Gerard O'Neill here.

On a lighter note: wanna see one Nama-bound investment courtesy of Anglo Irish Loose Loan Giveaways?

Check it out here - replete with grammatical errors and misspellings in the text. 'Autentik' stuff...

Since Anglo holds the loan and we (taxpayers) hold Anglo, I wonder if being an Irish taxpayer qualifies one for a free drink in this place.

Economics 24/02/2010: Greeks, Germany and the euro

There is a fine mess going on in Athens. And it is both

• detrimental to the Euro; and
• predictable (see here).

Exactly a month ago to date, I have predicted that Greece is going into a Mexican standoff with EU. We now arrived at exactly this eventuality (see this link to a good summary of Greek Government views - hat tip to Patrick).

Back on January 24th, I wrote:

"The EU can give Greece a loan – via ECB... But the EU will have to impose severe restrictions on Greek fiscal policy in order to discourage other potential would-be-defaulters today and in the future. That won’t work – the Greeks will take the money and will do nothing to adhere to the conditions, for there is no claw back in such a rescue.

Alternatively, the EU might commit ECB to finance existent Greek debt on an annual basis. This will allow some policing mechanism, in theory. If Greeks default on their deficit obligations, they get no interest repayment by ECB in that year. ...but what happens if the Greeks for political reasons default on their side of the bargain?

If ECB enforces the agreement and stop repayment of interest, we are back to square one, where Greece is once again insolvent and its insolvency threatens the Euro existence. Who’s holding the trump card here? Why, of course – the Greeks. And, should the ECB play chicken with Greeks on that front, the cost of financing Greek bonds will rise stratospherically, and that will, of course, hit the ECB as the payee of their interest bill.

Thus, in effect, we are now in a Mexican standoff. The Greeks are dancing around the issue and promising to do something about it. The EU is brandishing threats and tough diplomacy. And the problem is still there."

There are three possible outcomes from the standoff:

• Greece backs down and Germany accepts an apology - which pushes us back to square one, with Greeks still in the need of funds and EU still without a plan;
• Greece goes for the broke and remains within the euro, implying a rapid and deep (ca 30%) devaluation of the euro; or
• Greece is forced out of the euro (there is, of course, no mechanism for such an action).

The first option is a delay in the inevitable; the last one is an impossible dream for fiscally conservative member states. Which leaves us only with the second option.

And incidentally, the only reason German bunds are still at reasonably low yields is because Germany is linked to Greece (and other PIIGS) only via common currency. Imagine what yields the German bunds might be at if a full political union was in place?

This, of course, flies in the face of all those who preach political federation as EU's answer to structural problem of hinging desperately diverse economies to common currency.

So hold on to your pockets - after the Exchequer raided through them via higher taxes; Greek default will prob their depths through devaluation. And then you'll still be on the hook for our banks claiming their share in an exercise of rebuilding their margins.

Economics 24/02/2010: Ireland and EU16 Competitiveness

Charts below show our relative competitiveness, as measured by the harmonized competitiveness index (HCI) based on consumer prices (CPI) and reported by the ECB.

Charts 1-3:

Despite massive deflation, compared to the rest of Euro area, Irish economy has managed to record only a small improvement in HCI (CPI) of 1.57%, while the Euro area recorded an improvement of 2.22%.

Charts 4 and 5 show the latest data for harmonized competitiveness indicator based on GDP deflator.

Charts 4-5


Once again we are not in a very good club, folks. And another worrying thing – we are not at the competitiveness gains game anymore either. Table below illustrates

Figure 6

After Q1 2009, we stopped gaining in quarterly change in competitiveness and instead moved into positive territory – signaling deterioration in competitiveness. Net positive – we did so at a slower pace than the Euro area as a whole. But does this help much, when you consider that we are the third sickest economy by this measure in EU16 after Luxembourg and Spain?

So, ok, may be labour costs adjusted for productivity help us in our quest for competitiveness. After all, we do have pharma and medical devices sector here that is performing miracles when it comes to transfer pricing-backed growth in output per worker? And the two sectors weathered the storm of the crisis pretty well so far.

Charts below illustrate:

Figures 7-8
Not really. Harmonized competitiveness index based on unit labour costs also shows us to be the weakest point in the Euro-land chain. And it also shows that in Q3 we have gone into reverse when it comes to gaining competitiveness. We are now pulling away (once again) from the Euro area average.

All of this is instructive – for all the robust talk about Ireland gaining in competitiveness, restoring our advantageous relative position compared to EU counterparts, real data shows we are now getting economically-speaking sicker, not healthier… Time to start thinking about changing our policies, anyone?

Economics 24/02/2010: Wages, Euro and the crisis

Per latest ECB data, Euro area wages grew by 2.1% in annualized terms in Q4 2009, despite the economy remaining near zero growth and despite the fact that any recovery is tenuous at the very best. In the entire period of the current crisis, wages in the Euro area have shown no signs of declining. Two charts below illustrate the point that Euro area economy is not gaining any competitiveness when it comes to labour market.
This pretty much means that we are now boxed into the situation where medium term devaluation of the Euro is a requirement.

Oh, and when it comes to Ireland - see for yourself - chart below combines ECB data with the Central Bank of Ireland data on Average Hourly Earnings Index in Manufacturing:
We really are in a league of our own...

Economics 23/02/2010: IMF on some of the Irish crisis policies

So we keep hearing how the entire world is applauding the Irish Government for doing "the right thing" (as Minister Eamon Ryan asserted today on Prime Time). Hmmm... I guess IMF isn't amongst the 'entire world' set.

IMF paper released today, titled "Exiting from Crisis Intervention Policies" states:

"For most advanced economies, including the very largest ones, fiscal stimulus vis-à-vis 2008 levels will be broadly maintained in 2010.

Among G-20 advanced economies, only Canada and France are expected to start a significant adjustment—on the order of ½ and 1 percentage point of GDP in 2010, respectively, in terms of their structural balance.

Larger reversal of stimulus is expected in Spain, and especially in Iceland and Ireland, but from very high structural deficit levels in 2009."

This doesn't sound like an endorsement, just a clinical admission of the fact, but... notice the words 'reversal of stimulus'. This really implies that the IMF is treating our cuts imposed in the Budgets 2009, 2009-bis and 2010 as being largely cyclical (consistent with a reduction in a temporary stimulus).

Of course, the IMF - as well as any reasonably literate macroeconomist - would like to see Irish government (and other governments as well) cutting structural deficits, not cyclical. And the IMF makes this point by stating:

"Few G-20 advanced economies have so far developed full-fledged medium-term fiscal adjustment strategies, although some have announced medium-term targets or have extended the horizon of their fiscal projections.

A notable development is the adoption by Germany’s parliament, in June 2009, of a new constitutional fiscal rule for both federal and state governments that envisages a gradual move to (close to) structural balance from 2011. The rule requires the federal government’s structural deficit not to exceed 0.35 percent of GDP from 2016. States are required to run structurally balanced budgets from 2020."

Might it be the case the IMF views our cuts as being at risk of turning out to be short-lived? It might.

Another interesting feature of the report is the following statement (which comes right after the Fund saying that it expects the governments to start lifting banks guarantees since funding conditions have been easing):
"Deposit insurance schemes have not undergone any significant modifications since their expansion at the beginning of the crisis. The average duration of schemes is about three years. Since June 2009, New Zealand and the United States (for transaction accounts) adopted changes and extensions to their programs, including a rise in participation fees to better reflect market prices and risks."

Now, give it a thought: the Government has extended banks guarantee, but cut the deposits guarantee - exactly the opposite of what other governments are doing. Another uniquely Irish way of 'doing the right things' for the banks and taxpayers?

Doubting? Take IMF's data for the extent of support we have given the banks to date:
Do remember - the above figures for Ireland do not include the full exposure due to Nama and the latest stakes-taking exercises the Government is engaging in with BofI and will be engaging in with AIB in three months time. Notice just how massive is our exposure relative to GDP when compared to two other crisis-stricken countries - Denmark and the Netherlands. Also notice just how much more aggressive these countries are in writing down their banking systems' bad debts? In fact, not a single country comes close to us in terms of engaging in bad assets purchases from the banks. Why? They do not believe in the 'long term economic value' that Nama is based on?

Another interesting table from the paper:
This, of course, shows that majority of countries out there are completing their programmes for stabilisation of the banking sectors in 2010-2011 period. Ireland is not at the races here. Unlike majority of our counterparts, we are bent on dragging out Nama through some 15 years worth of the zombie banking, zombie development and zombie economy - Japan-style. Except, unlike Japan, we have young population.

Economics 22/02/2010: Detailed analysis of Live Register

Updated (below)

CSO published its analysis of the Live Register Data for 2009 which shows some interesting details.

Per CSO data, reproduced below, the highest risk of unemployment by sector was found in:

• Construction (with LR contribution from the sector reaching 170% of the sector own contribution to total employment);
  
• Hotels and Restaurants (with Live Register contribution from the sector standing at 161% of the sector weight in overall employment);
• Other Production Industries (136%);
• Financial & Other Business Services (131%) and
• Wholesale & Retail Trade (120%).
  

All state-dependent or provided jobs were the safest ones (see above marked in blue bold).

Update: since both Health and Education sectors are heavily reliant on public sector workers, we can consider a broader definition of the Public Sector to include the above sectors together with Public Administration & Defense. In this case, broader PS accounted for 23.1% of total employment in Q4 2008 and 6.9% of total number of new LR signees in Q1 2009, implying a 29.9% relative incidence of unemployment by sector - a number that is more than 3 times smaller than the average for the entire economy.

The above relative incidence number for the broader PS is actually biased in the direction of overstating the overall incidence of unemployment in the PS, as a number of employees who lost their jobs in Health and Education sectors were most likely from private firms providing these services.


And here is another table, also slightly adjusted by me. This time around, I am adding several categories together - people who are left on the Live Register (aka the Unemployed), people who moved from the LR to illness benefit (aka also the Unemployed), people who have retired from the Live Register to a state pension and people who are unaccounted for (aka - emigrants who left Ireland, immigrants who left Ireland and people who just dropped off Live Register into gray economy 'entrepreneurship').

Notice couple of things here - virtually the same number of foreigners and Irish who have joined LR in Q1 2009 stayed in some sort of 'Unemployment' by the end of Q2 2009. Actually, this percentage was slightly higher for the Irish LR signees, but the difference does not appear to be statistically significant.

Those over age 25 tended to remain on LR with higher probability than those who are under 25. The trick part here is that many under 25-year olds went off to training and education, dropping off the LR. One hopes they will have a job to go to, once their Fas-run courses and college programmes end.

Males were more likely to remain broadly unemployed (83.46%) than females (80.26%) but the difference is small and there are several factors here. One might wonder how the birth rate increase affects this number and also how it depends on transition to single parent family supplement. Also, younger women are more likely to undertake new training and education than younger males. Can these three factors explain the difference between men and women in re-employment rates?

Once we look at differences across sectors, one striking detail shown in the table above is that sectors with higher wages and better jobs are suffering the largest non-returns to jobs by the Live Register Signees. Table below details:
So in the nutshell - the jobs our LR signees are getting after they lose their primary occupation are of poorer quality and in less productive sectors.

Economics 22/02/2010: Leading indicators of an Irish recovery

For those of you who missed my Sunday Times article yesterday, here is the unedited version (note: this is the last article of mine in the Sunday Times for the time being as Damien Kiberd will be back with his usual excellent column from next week on):


The latest Exchequer results alongside the Live Register figures clearly point to the fact that despite all the recent talk about Ireland turning the corner, the recession continues to ravage our economy. And despite all the recent gains in consumer confidence retail spending posted yet another lackluster month in December 2009. Predictably, credit demand remains extremely weak, with the IBF/PwC Mortgage Market Profile released earlier this week showing that the volume of new mortgages issued in Ireland has fallen 18% in Q4 2009.

Even industrial production and manufacturing, having shown tentative improvement in Q3 2009 have trended down in the last quarter.

As disappointing as these results are, they were ultimately predictable. Economic turnarounds do not happen because Government ‘experts’ decide to cheer up consumers.

Instead, there is an ironclad timing to various indicators that time the recessions and recoveries: some lead the cycle, others are contemporaneous to it, or even lag changes in economy.

In a research paper published in 2007, UCLA’s Edward E. Leamer shows that in ten recessions experienced in the US since the end of World War II, eight were precluded by housing markets declines (first in terms of volumes of sales and later price changes). The two exceptions were the Dot Com bust of 2001 and the end of the massive military spending due to the Korean Armistice of 1953. Residential investment also led the recovery cycle.

Despite being exports-dependent, Irish economy shares one important trait with the US. Housing investments constitute a major proportion of our households’ investment. In fact, the weight of housing in our investment portfolios is around 65-70%. It is around 50% in the US. As such, house markets determine our wealth and savings, and have a pronounced effect on our decisions as consumers.

Consider the timing of events. Going into the crisis, Irish house sales volumes turned downward in the first half of 2007. House prices declines followed by Q1 2008, alongside changes in manufacturing and services sectors PMI. A quarter later, the whole economy was in a recession.

House price declines for January 2010 indicate that roughly €200 billion worth of wealth was wiped out from the Irish households’ balancesheets since the end of 2007. With this safety net gone, the first reaction is to cut borrowing and ramp up savings, to the detriment of immediate consumption and new investment.

So, if housing markets are the lead indicator of future economic activity, just where exactly (relative to the proverbial corner) are we on the road to recovery? Not in a good place, I am afraid.

Per latest data from the Central Bank, private sector credit continues to contract in Ireland, with December 2009 recording a drop of 6% on December 2008. Residential mortgage lending has also fallen from €114.3 billion in December 2008 to €109.9 billion a year later. This suggests that at least some households are deleveraging out of debt – a good sign. Of course, the decline is also driven by the mortgages writedowns due to insolvencies.

Worse, as Central Bank data shows, the process of retail interest rates increases is already underway. In November 2009 retail interest rates for mortgages have increased for all loans maturities and types. Irish banks, spurred on by the prospect of massive losses due to Nama, are hiking up the rates they charge on existent and new borrowers.

And more is to come. Based on the current dynamic of the interest rates and existent lending margins for largest Irish banks compared to euro area aggregates, I would estimate that average interest rates charged on mortgages will rise from 2.67% recorded back at the end of November 2009 to around 3.3-3.5 % by the end of this year, before the ECB increases its base rate. This would imply that those on adjustable mortgages could see their cost of house financing rise by around 125 basis points, while new mortgage applicants will be facing rates hike of well over 150-160 basis points.

On the house prices front, absent any real-time data, all that we do know is that residential rents remain subdued. Removing seasonality out of Daft.ie most recent data, released this week, shows that downward trend in rents is likely to continue. Commercial rents are also sliding and overall occupancy rates are rising, with some premium retail locations, such as CHQ building in IFSC, are reporting over 50% vacancy rates.

Does anyone still think we have turned a corner?

The problem, of course, is that the structure of the Irish economy prevents an orderly and speedy restart to residential investment.

First, there are simply too many properties either for sale or held back from the market by the owners who know they have no chance of shifting these any time soon. We have zoned so much land – most of it in locations where few would ever want to live – that we can met our expected demand 70 years into the future. We also have 350-400,000 vacant finished and unfinished homes, majority of which will never be sold at any price proximate to the cost of their completion. To address these problems, the Government can use Nama to demolish surplus properties and de-zone unsuitable land. But that would be excruciatingly costly, unless we fully nationalize the banks first. And it would cut against Nama’s mandate to deliver long-term economic value.

Second, there is a problem of price discovery. Before the crisis we had ESRI/ptsb sample of selling prices. Based on ptsb own mortgages, it was a poor measure. But now, with ptsb having pushed its loans to deposits ratio to 300%, matching Northern Rock’s achievement, there is not a snowball’s chance in hell it will remain a dominant player in mortgages in Ireland. Thus, we no longer have any indication as to the actual levels of property prices, and absent these, no rational investor will brave the market. The Government can rectify the problem by requiring sellers to publish exact data on prices and property characteristics.

Third, the Government can aid the process of households deleveraging from the debts accumulated during the Celtic Tiger era. In particular, to help struggling mortgage payers, the Government can extend 100% interest relief for a fixed period of time, say 5 years, to all households. On the one hand such relief will provide a positive cushion against rising interest rates. On the other hand, it will allow older households with less substantial mortgage outlays to begin the process of rebuilding their retirement savings devastated by the twin collapse in property and equity markets. Instead of doing this, the Government is desperately searching for new and more punitive ways to tax savings. Finance Bill 2010 with its tax on unit-linked single premium insurance products is the case in point.

Fourth, the Government can get serious about reducing the burden of our grotesquely overweight public sector. To do so, the Exchequer should commit to no increases in income tax in the next 5 years. All deficit adjustments from here on will have to take a form of expenditure cuts. Nama must be altered into a leaner undertaking responsible for repairing banks balancesheets, not for providing them with soft taxpayers’ cash in exchange for junk assets.

Until all four reforms take place, there is little hope of us getting close to the proverbial corner for residential investment, and with it, for economy at large.


Box-out:

Back in January 2009, unnoticed by many observers, a small change took place in the Central Bank reporting of the credit flows in the retail lending in Ireland. Per Central Bank note, from that month on, credit unions authorized in Ireland were classified as credit institutions and their deposits and loans were included in other monetary financial institutions. This minute change implies that since January 2009, Irish deposits and loans volumes have been inflated by the deposits and loans from the credit unions. Thus, a search through the Central Bank archive shows that between November 2008 and February 2009, the total deposits base relating to resident credit institutions and other MFIs rose from €166 billion to €183 billion, despite the fact that the country banking system was in the grip of a severe crisis. Adjusting for seasonal effects normally present in the data, it appears that some €14-15 billion worth of ‘new’ deposits were delivered to the Irish economy though this new accounting procedure. Of course, deposits on the banks liability side are exactly offset by their assets side, which means that over the same period of time more than €16 billion of ‘new’ credit was registering on the Central Bank radar. Now, this figure is also collaborated by the credit unions annual reports which show roughly €14 billion worth of loans issued by the end of 2007 – the latest for which data is available. This suggests that the credit contraction in the Irish economy during 2009 is understated by the official figures to the tune of €14-15 billion. Not a chop change.

Economics 21/02/2010: Planes, Buses and Swedes

A crucial difference between the Swedish 'socialism' and Irish Government's 'pro-market Partnership' is that the two are misnomers.

Take airline industry:

• Irish Government owns a share of Aer Lingus - 25% and together with its friends (although sometimes quarrelsome) - the Unions the state controls 40% stake in the 'National Flag Carrier';
• Irish Government monopolistically owns the entire airports system in the country allowing no competition whatsoever into the sector - presumably in line with the Irish Government's pro-private enterprise stance;
• The LFV Group that owns and operates main Swedish airports is similar to our DAA / Aer Rianta and is also state owned - clearly in line with the Swedish Government's socialist credentials;
• But in Sweden there are a private airport and a number of independently (municipalities) owned smaller airports;
• The Swedish State currently owns 21.4% of the SAS - 'Flag Carrier Airline' (less than the shareholding by the pro-private enterprise Irish State in Aer Lingus) and
• Earlier this week, Swedish deputy PM (Mary Coughlan's counterpart) announced that her Government is selling all of its holding in SAS. How come? “In the long run we don’t see any intrinsic value in owning shares in an airline,” she said.
  

Actually, in terms of monopolization of the service provision, Irish Airports stand at 100% monopoly ownership, while Swedish airports are close fringe challenging central monopoly, to the situation in terms of services competition one find in Irish bus services. Funny thing - we claim to have a deregulated bus market in Ireland...

Hmm, Bertie Ahearn had a point saying he was the last standing real socialist in Europe.

Economics 20/02/2010: Greeks ahead

Want to understand the extent to which politicians and the public sector workers are failing to understand the fundamental principles of the markets? Look no further than Greek debt issue looming on the horizon.

Some background first. Less than a month ago, Greece put on the market an €8 billion 5-year bond package at a 6.1% interest rate. Seemingly, it was able to attract initial interest of investors - the early bidders were keen on taking high yield paper. Of course, the country bond issuers had no idea why institutional investors had sudden interest in Greek bonds. And this led to a bottleneck emerging in later days of the placement.

Institutional investors, especially diversified portfolio managers, might want a bond for its default risk-adjusted returns. This hardly constitutes a significant proportion of the demand for Greek bonds in recent months. Alternatively, they might down-weight the consideration of the default risk and use the bond purchase to simultaneously hedge their FX exposure elsewhere and earn high returns. It is the second component of the market that drives most of the demand for Greek bonds, aka portfolio management side of demand. This second source of demand is by its nature extremely shallow – there are fewer investors in this complex hedging space and those that are in it have many alternative (to Greek bonds) strategies available to them. It does, of course, help the Greek bond issuers’ cause that their yields are the highest in the Eurozone, making their bonds a solid target for single risk hedging on FX side. But it does not help them that the Euro is at risk of substantial devaluation going forward against the dollar and sterling.

In short, the demand for Greek bonds is not fundamentally driven (i.e not based on pure default risk v yield analysis). Adding insult to the injury, if one should rationally anticipate that Euro is going to continue falling against the dollar in the current scenario of contagion from Greece to the rest of PIIGS, then less faint-hearted amongst us might want to take a short position against the Euro. This can be done by not hedging existent non-Euro exposures. The effect of such implicit shorting is to further reduce demand for Greek paper. The folks at the Greek Treasury have missed these simple points. Thus, the aforementioned issue was simply too large for the markets and failed to sustain prices achieved on placement – within just two days after the issue, price fell 3.5%.

Which brings us to the next week – it is expected that the Greeks will be at the markets again, this time with a €5 billion of new 10-year paper. Even to have a go, the Greeks will have to push spreads on their paper over the German bund to a stratospheric height. Currently – 10-year Greek bonds are yielding 6.5%, up from 5.8% back in the end of December 2009 and 1.5 percentage points above their levels in November 2009. But this will have to rise. 7% anyone? Possible.

Short positions in Greek bonds are also signaling that the demand for new issue will be weak. Shorts in Greek bonds have risen to 9.82% up 0.24 percentage points in the first two weeks of February and 1.58 percentage points relative to the end of December 2009. But now they are being closed off. Closing the short means that demand for bonds rises, artificially, in the market – as bonds are being withdrawn for a return to the lender. But this demand is not about market appetite for bonds. Instead it is about a technical need for a re-purchase. With this demand pathway becoming more exhausted in recent days, there will be added pressure on new bond pricing – another aspect of the market the Greeks seemingly do not take into account.

But politicians and their public servants, ignorant as they may be of the markets, might have something else on their minds. Greek’s reckless and silly issuance patterns are driven by more than markets considerations. They are driven by gargantuan deficits and debt overhang – with €20 billion of maturing debt that needs to be rolled over around April this year alone - and the willingness of the Greek Government to sacrifice its own taxpayers (remember – higher yields mean higher cost of borrowing, to be carried by the future taxpayers) in order to force the EU to bailout the country. This strategy, similar to the game of chicken in which both participants hold equivalently credible threats, but one faces asymmetrically higher costs in the case of ‘no bailout’ outcome) is something that the EU leaders themselves do not seem to comprehend.

While the EU is sitting on its hands and issuing conflicting and irresolute statements on the matter, the Greeks are heading straight into a fiasco, should they fail to place new bonds at yields proximate enough to the current 6.5%. At the same time, failure to place this issue will push the Greeks even closer to a direct default on debt, imposing even more pressure on the EU to urgently deal with the matter.

If the EU fails to bail out the Greeks on this round, the Euro will be equivalent to the Titanic grinding against the iceberg. The Greeks will always have an option to walk away from the common currency and default outright – the consequences will be tough, but more palatable than the ones which will hit the country should it go down alongside the Euro. First move advantage is real in the game of chicken.