Economics 22/7/10: Irish bonds auctions - a Pyrrhic victory?

“Despite Moody’s downgrade on Ireland’s credit rating on Monday, the NTMA successfully borrowed €1.5bn yesterday. Yesterday’s auction showed increased demand from investors for Irish debt and now means that the NTMA has completed 90% of its 2010 long-term borrowing programme.”

That was the swan song from one of Irish stock brokerages.

Lex column in the FT was far less upbeat, saying Ireland “offers a not terribly encouraging example of how difficult it is to overcome a massive debt binge.”

NTMA might have pre-borrowed 90% of this year’s €20bn borrowing target . But two things are coming to mind when one hears this ‘bullish’ statement.

Firstly, the €20bn is a target, not the hard requirement. If banks come for more cash, Brian Lenihan will have to get more bonds printed.

Secondly, Irish spread over German bunds is now higher than it was at the peak of the crisis in early 2009.

Want see some pictures illustrating Irish borrowing ‘success story’?

Let us start on the shorter end of maturity spectrum – 5 years and under:

Chart 1Average yields are trending up over the entire crisis term and are soudly above their entire crisis trend line since June. More significantly, the trend is now broken. As yields declined in 2009, hitting bottom in October, since then, they have posted a firm reversion up and once again, June and July auctions came at yields above those for this dramatic sub-trend.

Worse than that – in complete refutation of ‘improved demand’ claim by the brokers – yield spreads are now elevated. This spread – the difference between highest yield allocated and lowest yield allocated – suggests that markets are having trouble calmly pricing Irish bonds issues. Success or psychosis?

Chart 2 below illustrates the same happening in terms of price spreads.

Chart 2Auctions cover for shorter term paper is still below the long term trend line, although the line is positively sloped.

Chart 3Chart 3 above shows just how dramatic was the price decline and yields rise in Q2 2010 and how this is continued to be the case in July.

Chart 4Chart 4 gives a snapshot on pricing.

Next, move on to longer term bonds (10 years and over). There has been only one issue of 15 year bonds, so it is clear that the NTMA is simply unwilling to currently issue anything above 10 year horizon because of prohibitive yields.

Chart 5Chart 5 above shows upward trend in yields and July relative underperformance compared to longer term trends. It also shows yield spreads – again posting some pretty impressive volatility in June and bang-on long-term average (or crisis-average) performance in July. If that’s the ‘good news’ I should join a circus.

Chart 6Weighted average price is not changing much over the crisis period, so no improvement is happening here. In fact, since May it is trending down below the long term trend line, suggesting significant and persistent deterioration. Cover is on the up-trending line, but came in below the trend in June and July.

Chart 7 below shows more details on max and min prices and yields.

Chart 7Chart 8Chart 8 above clearly shows how average price is now in the new sub0trend pattern since November 09 price peak. May-July prices achieved are clearly below long term trend line and even more importantly – below the sub-trend line.

Finally, chart 9 shows the maturity profile of auctioned bonds:

Chart 9Notice how before the 2014 deadline, the Exchequer is facing the need to roll over €6,381 million in bonds issued during the 2009-present auctions. If Ireland Inc were to issue more 3-year bonds, that number will rise. That should put some nasty spanners into Irish deficits-reduction machine. But hey, what’s to worry about – our kids will have to roll over some €21,264 million worth of our debts (and rising), assuming the Bearded Ones of Siptu/Ictu & Co don’t get their way into borrowing even more.

Let us summarize the ‘success story’ that our brokerage houses are keen on repeating:

Table 1In other words, we are now worse off in terms of the cost of borrowing than in January 2010 – despite the ‘target’ for new issuance remaining the same throughout the period. We are even worse off now than at the peak of the crisis in March-April 2009 in short-term borrowing costs, although, courtesy of the German bund performance since then, we are only slightly better off in terms of longer maturity borrowings.

The compression in yield term structure delivered in June-July this year is worrisome as well. It suggests that the markets are not willing to assume that Irish Government longer term position is that much different from its shorter term prospects.

So on the net, then, what 'success' are our stock brokers talking about then? The success, of course is that NTMA was able to get someone pick up the phone and place an order, at pretty much any price? Next time, they should try selling pizzas alongside the bonds - the cover might rise again and they might convince the Eurostat that pizza delivery services are not part of the public deficit...

Economics 22/7/10: Banks downgraded - expect more fireworks

After hammering Irish sovereign ratings, Moody’s rightly took the shine off the six guaranteed banks’ bonds. Not surprising, really, and goes to show just how meaningless the term ‘stable outlook’ can be. Now, few facts:

• Moody’s has downgraded the long-term ratings for EBS Building Society and Irish Life & Permanent from A2 to A3, stable outlook didn’t help much here.
• Moody’s also downgraded the government-guaranteed debt of all six guaranteed institutions: AIB, Bank of Ireland, EBS, Anglo, IL&P and Irish Nationwide.
• Prior to the latest downgrade, AIB and BofI both had stable outlook, and this has been maintained.
• The reason for the downgrades was the reduction in the government’s ability to support the banks stemming from the sovereign debt downgrade announced Monday.
  

What’s next, you might ask? Barring any news on loans impairments etc, the growth prospects for banks will have to be the key. And here, folks, there isn’t any good news. No matter how you can spin the thing.

BofI and AIB are disposing of their performing assets – divisions and businesses in the US, UK and elsewhere – in order to plug the vast holes in their balance sheets caused by their non-performing assets.

And it’s a fire sale: Polish BZWBK – 70.5%-owned by AIB – is the only growth hopeful in the entire AIB stable. Yesterday, some reports in Poland suggested that PKO Bank Polski, Banco Santander, BNP Paribas and Intesa San Paolo are the only ones remaining in the bidding. Neither one can be expected to pay a serious premium.

Take a look at M&T in which AIB holds a 22.5%. Not a growth engine, but a solid contributor to the balance sheet. The US bank Q2 profit quadrupled as it is facing the market with structural aversion to banks shares. So M&T is losing value in the market as it is gaining value on AIB’s balance sheet. But hey, let’s sell that, the gurus from Ballsbridge say, and pay off those fantastic development deals we’ve done in Meath and Dundalk.

Likewise, BofI are selling tons of proprietary assets, including proprietary wholesale services platforms, which are performing well.

Will the money raised go to provide a basis for growth in revenue in 2010-2012? Not really. BofI needs new capital. Not as badly as AIB, but still - €2.9bn capital injection in June is not going to be enough to cover future losses. It is just a temporary stop-gap measure to cover already expected losses plus new regulatory capital floors. Future losses will require future capital.

AIB is desperate. €7.4bn is a serious amount of dosh and there are indicators they’ll need more. Of course, in order to properly repair its balance sheet, AIB will need closer to €10bn this side of Christmas (as estimated by Peter Mathews - see here).

However, the bank won’t make any noise about that for political reasons.

Even after getting no serious opposition to their banks recovery plans for some two years already, the Government is starting to get concerned about continuous and never diminishing demand for capital from our banks. This concern is not motivated by the suddenly acquired desire to be prudent with taxpayers’ cash. Instead it is motivated by the optical impressions Irish banks appetite for Exchequer funding is creating around the world. Sovereign ratings are now directly being impacted by banks weaknesses and some investors are starting to ask uncomfortable questions about viability of AIB outside state control. There’s an added sticky issue of Irish Government deficit potentially reaching 20% of GDP this year should our banks come for more cash.

And they will... not in 2010, possibly, but in 2011, once Nama last tranche closes in February (or thereabouts - remember, it has blown through few deadlines already and can strategically move past February 2011 with closing off its purchases, to allow more time for banks to play the 'Head in the Sand' game).

If you want to see what is really happening in our sovereign bonds markets, check out the next post on this blog, which will be covering this.

Economics 20/7/10: EU test - have a Pass grade before you turn up for a check...

Per Bloomberg report today: “Hypo Real Estate Holding AG, the commercial-property and public-finance lender taken over by the German government, failed a Europe-wide banking stress test, two people familiar with the results said.” Crucially, however, “the Munich-based lender is probably the only German bank to fail the test, one person said.”

Makes you wonder – what kind of test is that if out of 91 not exactly rude-health institutions, only one is expected to fail? At an expected 99% success rate, the EU stress test is clearly designed to put a PR spin on banking sector shares, bonds and interbank credit markets.

The only sticky part is that if any of the ‘passed’ banks fail in the near future, the investors should be able to sue the EU for any losses incurred. You see, the EU stress test is designed – at least in theory – to provide important markets-relevant information to investors. If so, someone should be liable for the quality of the test. Had the EU authorities given this a thought?

The test is farcical. And you don’t need to see the results to know this much. European banks are set minimum requirement of 6% Tier 1 capital ratio. This is the number being tested. But the US banks had this requirement 2 years ago, and since then have beefed up their capital ratios to well in excess of 9%. UK banks are now in excess of 10%. Where does this put the Eurozone with its banking system ‘tested’ to 6%? In a circus terminology – with the clowns, large shoes, red noses and curly wigs in place. So the EU regulators’ decision to put some more powder over their mugs wont be doing much good.

FT blogs' Tracy Alloway reported today on what the markets think. The article (linked here) reports that there has been a 50% or more rise in the short positions held against a number of Eurozone banks. Ireland’s sick puppies – BofI and AIB are actually most active on long investors’ lists with long positions up ca 20%. But the two are also amongst the most expensive securities to borrow. In other words, it does seem like shorts are heavily on the side of Ireland Inc’s grand dames.

Funny thing, relating to the stress tests, is that a number of public officials – from Greece, to Belgium to Ireland – have already been leaking heavily the ‘news’ that stress tests will clear their banks’ names. One wonders if there is anything else the EU can do to make the whole exercise even more farcical?

Economics 20/7/10: Is Zombie Nama propping up Mummified Irish Banks?

As the independents – Brian Lucey, Karl Whelan, Peter Mathews and myself – have warned (actively denied by the Government and its backyard ‘experts’), Nama Tranche II turned out to be yet another unmitigated disaster.

Nama paid €2.7bn for loans that its experts valued at €5.2bn. Of course, these ‘experts’ include many who were responsible for some of the most disastrous valuations of the Celtic Tiger era and are now ‘entrusted’ as being ‘experienced’ with re-valuing their own errors, while collecting a handsome pay packet courtesy of the Irish taxpayers. The implied average discount these folks put on the loans this time around is 48%. Anglo failed to transfer its loans – some €7-8bn worth – due to delays caused, per what I am hearing, by a rather shoddy documentation quality.

Per RTE: “The biggest discount on the second batch of loans was for those from Irish Nationwide. NAMA paid the society just €163m for loans of €591m, a discount of 72% [an increase of 14% on Tranche 1]. The figures for AIB and EBS were 48.5% [on €2.73bn marking a 6.5% increase on Tranche 1], and 46.5% [on €35.9mln and an increase of 9% on Tranche 1] respectively, while the Bank of Ireland discount was 37.8% [on €1.82bn - an increase of 2.8% on T1].” Overall, Nama now has in its vaults €20.5bn worth of loans (or rather largely worthless paper few years ago labeled as loans) for which it paid at a discount of 50.7%.

The loans are concentrated - related to just 23 property developers who are deemed to be 'second tier' aka less flamboyant than those in Tranche 1 and most likely, less experienced too.

It makes me laugh when I recall how our stock brokerage 'analysts' were chirping a year ago that a 20-25% haircut would be warranted by market valuations of these loans.

However, the real problem with all of these numbers is that while the discounts might sound impressive, they are not reflective of any reality. Instead, they are now fully bootstrapped to the capital commitments issued to the banks by Brian Lenihan. You see, as we warned from the start – and this too was vigorously denied by the Government – the heavier the haircut, the greater will be banks’ demand for capital, the greater will be the share of bank equity owned by the taxpayers. Mindful not to take too much stake in BofI – for that would produce poor optics internationally – Brian Lenihan is content to oversee a 38% discount on its loans. Having pumped capital up to 50% of risk-weighted assets transfers to Nama for AIB, the Minister is equally happy not to impose heavier haircuts on AIB Tranche 2 transfers than 50%. Hence the ‘magic’ 48.5% figure. Ditto for EBS. Sounds precise – not 49%, nor 48%. But in the end – the number is most likely utterly bogus.

To put some fluff in the air about ‘Nama is a tough player with the banks’, Tranche 2 hammered INBS and most likely will hammer Anglo. Unless, that is, Anglo fatigue has finally reached Upper Merrion Street buildings. In this case, a discount can be less than that for INBS. Not because Anglo loans have miraculously become sterling in quality, but because the DofF might be just slightly concerned that the bank will come with a fresh capital demand.

So instead of pricing the loans to market, Nama now appears to be pricing them to keep required post-Nama recapitalizations at the levels consistent with earlier Government capital commitments.

In the end, however, a 48% average discount is still a gross overpayment on these loans. Let’s do a back of the envelope calculation here.

25% of Nama loans are ‘cash generative’ – i.e. paying some sort of an interest repayment on interest due. Suppose – just for the sake of making an assumption – that 50% of those cash generative loans are paying full interest due and 50% are paying ½ interest due. Assuming average interest rate on the loan of 8% (a generous assumption, given that banks were lending at lower rates than that) and cost of refinancing banks funds at 3% (well below current yields on banks bonds, even way lower than the latest Exchequer yields of 5.25%, but let’s be generous), if the cost of managing loans at 1% (consistent with Irish banks’ margins), then:

• 75% of Nama loans are losing have a negative yield of 12% (annual loss on interest alone);
• 12.5% of Nama loans are losing 2% pa in net costs, plus 8% rolled up interest, implying their negative yield of 10% pa;
• 12.5% of Nama loans are losing net 8% pa.
  

Expected average annual loss on Nama overall portfolio is therefore 11.25% pa. Value this at x3 revenue flow. Nama portoflia of loans would have a negative, yes, negative, - 34% break-even valuation in the market. Just on the back of interest and costs alone, the value of Nama purchased portfolio of loans should be no more than 66 cents on the euro of face value.

Next, subtract the percentage of loans that are unsecured – while allowing for the expected recovery, subject to the risk. Suppose that 20% of loans taken on by Nama are unsecured (again, likely to be conservative assumption). Suppose these are distributed across the same 12.5%, 12.5% and 75% sub-portoflia following a uniform distribution (again, this is a generous assumption as lower quality loans are more likely to be less secured in the real world). The value of the entire package of loans is now worth only 59 cents on the euro.

Secured loans are also subject to a recovery risk. In general, risk of recovery implies that over 70% for loans in arrears will be non-recoverable, ca 50% for loans under stress (e.g. failing to pay principal when it is due) and 20-25% for loans that are fully performing (e.g. those that are repaying principal and interest to the full amount). These are numbers consistent with the 1990s experiences in Sweden and UK. Translating these into our valuation, adjusted for risk of recovery implies the value of Nama-bound loans around 30-32 cents on the euro.

Other risks can be priced as well, but let us stop here.

Even with relatively rosy assumptions, the value of the loans being purchased by Nama should be at maximum 32 cents on the euro.

Allowing for assets appreciation of 10% over 3 years would imply a valuation of no more than 37 cents on the euro without applying a PDV adjustment.

We are told that Nama is being a tough buyer, paying 52 cents on the euro. Who’s fooling who here?

Incidentally, 30 cents on the euro is what independent banking expert Peter Mathews has estimated as recoverable for all development and property loans held by the banks. It is also the number that myself and Brian Lucey have arrived at in our previous estimates of required haircuts, which were based on analysis of underlying property markets.

What is now clear is that 24 months since the crisis fully exploded in our faces and 15 months after the independent analysts started telling the Government that it is committing a grave error in pushing forward the solution that, under the original name TARP was rejected in the US two weeks after it was put in place, the Irish Government remains hell-bent on pursuing this wrong approach to banks recovery. More egregiously, with Tranche II loans in, there is a strong enough reason to suspect that Nama has turned into nothing more than a façade for delaying even more capital demands from the banks until the end of 2010. The reason for this, one might speculate, is to keep our 2010 public deficit from exploding to beyond 20% of GDP.

A zombie institution (Nama) now is fully in charge of our mummified banking system. What can they do next to make things even more dynamic than that?

Ecoinomics 19/7/10: Moody's downgrade Redux

As Brian Cowen has been telling the world that Ireland has turned the corner, the country got some rude awakening.

First, Moody’s – aka the lagging indicator – pushed Irish bond ratings one notch down to aa2. Second - and I will be covering this in a separate blog post - Nama has completed transfer of the second tranche of loans.

With it, Moody’s also downgraded to aa2 that ‘not our problem, says Lenihan’ debt called Nama bonds. Irony has it, for all the SPV accounting tricks deployed by the Government, Nama bonds are rated on par with sovereign bonds and Moody’s statement justified both downgrades as being primarily driven by “the government’s gradual but significant loss of financial strength, as reflected by its deteriorating debt affordability”.

Per Moody’s, the third key factor driving rating cut is “the crystallization of contingent liabilities from the banking system... Overall, the recapitalization measures announced to date could reach almost €25bn …and Moody's expects that Anglo Irish Bank may need further support. … While we do not expect the government -- not even in a moderately stressed scenario -- to incur permanent losses in excess of 25% of the country's 2009 GDP as a result of [Nama] obligations, we believe that the uncertainty surrounding final [Nama] losses would exert additional pressure on the government's financial strength.”

Oh, mighty. So Moody’s believes that Nama will generate final losses. May be not as bad as €41bn (1/4 of GDP), but certainly losses. And notice that losses below 25% of GDP are expected by Moody’s explicitly in the scenarios that are better than or equivalent to their ‘moderately stressed scenario’… Of course, Nama’s Business Plan Redux envisions losses only in the ‘worst case scenario’ and even then, the modest €800mln.

“Moody's notes that the country could experience downward rating pressure in the event of (i) a failure of the economy to rebound in a meaningful way; and/or (ii) a severe deterioration in the country's debt metrics triggered by a further crystallization of bank contingent liabilities beyond Moody's current expectations.”

Err… let me see…

Bank recapitalizations that Moody’s have factored in – at €25bn to date – have already been exceeded, with current running estimate at €32bn committed, plus last week’s open-ended offer to give AIB anything it needs from Brian Cowen. These are likely to rise once again after today’s announcement from Nama on tranche II transfers. So condition (ii) is already satisfied.

Per economy’s likelihood of a rebound – well, give it a thought. Government policy over the last two years was characterized by increased taxes, retained waste, lack of reforms in public sector, lack of reforms in state-controlled private economy, lack of reforms in bankruptcy laws, massive waste of funds on poorly structured banks supports, and laissez fare in relation to banks and semi-state companies ripping off consumers and businesses. None of it is likely to change in 2011-2012. Which part of this litany of economic policies misfires can contribute to an increasing likelihood of a robust economic rebound?


Ireland is clearly not out of the woods when it comes to bonds ratings and this persistent problem of continued deterioration of public debt ratings will be a costly one.

Mark my words – as Ireland’s public finances continue to deteriorate, our debt will become more costly to finance. Should the Government opt for any tax increases in order to raise 2011 revenue, it will face continued fall off in income and transactions taxes collected, as people engage more actively in tax liability minimization. This will trigger widening of our deficits in excess of international forecasts (no one pays attention to our own ‘rosy’ forecasts anymore), leading to further debt downgrades. In particular, I would expect Fitch to move first once again to put two notches between itself, Moody’s and S&P.

One more point before we conclude. Irish banks are heavily dependent for capital and collateral on Irish sovereign and Nama bonds. The latest downgrade must have an adverse longer term impact on the quality of the banks balance sheets. Regardless whether AIB and BofI pass their EU-administered stress tests or not, I would expect the Moody's downgrade to have potentially significant adverse effect on Irish banks ability to tap private markets for funding in the near future. This, of course, might trigger another run on the Exchequer and customers by our leading banks.

Economics 19/7/10: Urban growth, education & knowledge intensive services - part 2

In the previous post (here) on the issues of growth, education and knowledge intensive sectors, I showed that

• There is a strong positive resilience in income per capita levels across urban economies, with almost 94% of variation in income per capita in 2007 being associated with the variation in income per capita found in 1999. This strong persistency in GDP levels over time implies there is only a weak (but positive) relationship between the past and the future growth rates.
• Data also shows that there is a weak positive relationship between long term growth in education and long term growth in income per capita. Growth in education between 1999 and 2007 was able to explain just 0.54% of the overall variation in growth in income per capita across various regions.
• However, over time, the relationship between the levels of education of the workforce and the levels income per capita is becoming stronger both in terms of education impact and the overall explanatory power as to the direct positive correlation between education and income. By 2007 over 14.5% of variation in income per capita across major urban regions was explained by variations in education, up from 7.3% in 1999. If in 1999 1% increase in the proportion of population with 3rd level education was associated with a USD336.53 increase in income per capita (PPP-adjusted), by 2007 this effect rose to USD730.92.
• Lagged period education levels were shown to be a better determinant of income per capita than contemporaneous levels of education, which suggests that causality flows from education to growth, rather than the other way around.
  

Chart 7 below explores the relationship between the levels of education in the labour force and two core higher value added sectors of economy: high tech manufacturing (HTM) and knowledge intensive services (KIS).

Chart 7
Consider the blue and the red lines. More educated workforce, it seems, is negatively correlated with high tech manufacturing role in the economy. And this correlation is becoming more negative over time (with lags). In other words, an urban centre that started with highly educated workforce in 1999 is more likely to see declining share of its economic activity accruing to HTM in 2007.

This can be related to the changes in manufacturing that took place over the last two decades, with manufacturing in general becoming increasingly more capital intensive. It is also likely to be due to the fact that with greater outsourcing of core activities and greater offshoring of manufacturing, much of higher value added activities related to high tech manufacturing, such as design and development, and marketing of new products, is now classed separately as services, and geographically removed from manufacturing activities, despite being physically embodied in the value of manufactured goods.

The opposite is true of the relationship between education levels of the workforce and knowledge intensive services role in the economy, although the positive correlation here is not becoming stronger over time (orange and green lines).

Knowledge economics – at least as proxied by education levels – is about the positive role of education in services, but it is not about the links between high-tech manufacturing and education. The dumber is your workforce (in extremely simplistic terms), the higher will be the importance of HTM to your economy… or so it appears…

Chart 8
A look at contemporaneous data reported in the chart above also confirms the previous chart 7 conclusions.

What is even more interesting here are the slopes of the two relationships.

First, the negative correlation between the degree of workforce education and high-tech manufacturing (HTM) had become more negative, from -0.1032 in 1999 to -0.1633 in 2007, while the overall relationship has strengthened (R2 = 0.0836 back in 1999 to R2=0.2341 in 2007).

This relationship is very robust and shows relatively less dispersion in the data than the relationship between education and knowledge intensive sectors.

Second, the slope of the positive relationship between the degree of workforce education and knowledge intensive sectors (KIS) has become weaker over time (from 0.5961, R2 = 0.3104 to 0.3877, R2 = 0.1396).

This result is surprising. Are we hitting diminishing returns to education in terms of increasing importance of KIS in the economy? Or are we simply at the flatter end of asymptotic KIS growth curve with much of knowledge economy already in place so that new education yields lower marginal returns? Alternatively, this might suggest that education is an imperfect instrument for skills and talent and that today, skills and talent gained outside formal classrooms matter more than before.

Finally, it is also worth noting that KIS results are significantly impacted by three observations which tend to drag the slope of the relationship down somewhat. The three, however, do not appear to represent statistically significant outliers.

Another striking relationship is shown in chart 9 below. Greater importance of high-tech manufacturing in the economy is associated with lower GDP per capita, and this negative relationship is strengthening over time, both in the explanatory power and in the size of overall negative effect. This again illustrates, most likely, the growth in capital-intensity of high tech manufacturing and disembodiment of the services-related components of high-tech manufacturing (such as R&D etc).

Chart 9
Lags in data confirm the above conclusion.

Chart 10
Chart 10 shows that identical conclusions to those presented in Chart 9 are warranted when we look at the lagged structure of economy with respect to high-tech manufacturing role in overall economic activity, so that regions that started (back in 1999) with greater share of HTM in overall economy tended to have lower GDP per capita 9 years later.

Lastly, unlike High-Tech Manufacturing, Knowledge Intensive Services are strongly positively correlated with GDP per capita, as shown in chart 11 below. This relationship is true for contemporaneous correlations and for the lagged one. And it is increasing in strength (slopes) over time, as well as in statistical significance. Furthermore, between 1999 and 2007 there has been an acceleration in the strengthening of the relationship. Finally, it is worth noting that lagged role of KIS in economy is almost as strong as 2007 contemporaneous relationship, suggesting that there is significant persistence in the positive effect that KIS have on overall income per capita.

Chart 11.


So let me summarize the main results:

1. There is a weak positive relationship between long term growth in education and long term growth in income per capita between 1999 and 2007 across various regions.
2. Over time, the relationship between the levels of education of the workforce and the levels income per capita is becoming stronger both in terms of education impact and the overall explanatory power as to the direct positive correlation between education and income
3. Lagged levels of education are a better determinant of income per capita than contemporaneous levels of education, which suggests that causality flows from education to growth, rather than the other way around.
4. More educated workforce is negatively correlated with the importance of high tech manufacturing in the economy. This correlation is becoming more negative over time (with lags).
5. The relationship between education levels of the workforce and the importance of the knowledge intensive services role in the economy is positive. This positive correlation is not increasing over time.
6. Overall, knowledge economy – as far as it is captured by third level education – is positively linked to services, and negatively linked to high-tech manufacturing.
7. The negative correlation between the degree of workforce education and the extent of the high-tech manufacturing (HTM) in overall economy had become even more negative between 1999 and 2007.
8. The positive relationship between the degree of workforce education and knowledge intensive sectors (KIS) has become weaker over 1999-2007 period.
9. Greater importance of high-tech manufacturing in the economy is associated with lower GDP per capita, and this negative relationship is strengthening over time, both in the explanatory power and in the size of overall negative effect.
10. Regions that started (back in 1999) with greater share of HTM in overall economy tended to have lower GDP per capita 9 years later.
11. Knowledge Intensive Services are strongly positively correlated with GDP per capita. This relationship is true for contemporaneous correlations and for the lagged one.
12. The positive correlation between income and KIS is increasing in strength (slopes) over time, as well as in statistical significance.

Note: you won’t be able to read this anywhere else – the two blog posts on urban economies, knowledge, education and the roles of high tech manufacturing and knowledge intensive services is an exclusive, just for the readers of this blog…

Economics 19/7/10: Urban growth, education & knowledge intensive services - part 1

As promised few days ago, here are the first couple results from an interesting data set from the OECD on regional economies.

Let me first explain what I have done to data in order to derive this (and the next post) analysis:

• Out of 350 regions defined by the OECD, I have selected 50 regions that are directly aligned and dominated by capital cities and major industrial and commerce centers.
• Countries covered are: Austria, Belgium, Canada, Czech Republic, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Korea, the Netherlands, Norway, Slovak Republic, Spain, Sweden, UK and US.
• I tested for, and controlled for influential outliers (in particular Bratislava and Washington DC) where their presence distorted the overall results of estimations.
• Time horizon covered by data is years 1999-2000 and 2006-2007.
• Where the data was available for both 1999 and 2000, 1999 data was used. Where the data was available only for 2000, this data was used with 1999 label. Where the data was available for both 2006 and 2007, data for 2007 was used. Where the data was available only for 2006, it was used with 2007 label.
• There were only 7 occurrences where pairs of 1999 and 2000, and 20006 and 2007 data were not available.
• In addition to the OECD original data, I computed 1999-2007 growth rates.
  

The first chart below precisely plots what I call here Greater Dublin and South region (which, in the case of OECD includes Cork). OECD defines two regions for Ireland: Southern region and Border, Midlands and West region. Obviously, these are proxies for our more detailed traditional regional classification – perhaps, they are a hint that a country with 4.5 million inhabitants shouldn’t really have a Byzantine system of local authorities and Napoleonic system of regions that we have. Either way, the chart provides some very striking comparisons.

Chart 1
The size of each bubble corresponds to income per capita. This is not what I am after here. Instead, focus on change between blue dots – regional positions in terms of 1999 levels of education and the share of knowledge intensive services in overall economic activity, and green dots – the same data for 2007.

First, observe that while Dublin & South were clearly no better educated than the rest of the country in 1999, their share of higher value added knowledge intensive services (KIS) was much greater back then.

Second, notice that neither part of the country was anywhere near being in the leaders group in terms of either education or in terms of knowledge intensive services back in 1999 when compared to their peers worldwide. I always said that the claimed Irish advantage in terms of educated labour force back in the 1990s was nothing more than an urban myth. We were, frankly speaking below average in terms of education back then.

Third, note how dramatic was the increase between 1999 and 2007 in the levels of education in Dublin and South, especially compared to Border, Midlands & West. Within just 8 years or so, we moved Dublin & South out of the followers or laggards pack and into the lower end of the leaders group of better educated regional economies.

Fourth, notice that BMW region was rapidly catching up with Dublin in terms of its share of KIS in the economy, closing some of the earlier gap between 1999 and 2007, although still remaining out side the leaders group of regions.

This is interesting for a number of reasons, but chiefly, it is interesting since BMW levels of education did not rise as dramatically. There are couple of things going on here, which might explain this strange result. On the one hand, low early starting position in terms of higher value added KIS in BMW region might have resulted in a more significant growth during the financial services boom years. On the other hand, there might be a diminishing return to growth in education in the labour force present in Dublin & South region, especially as lower value added construction boomed during these years. Finally, one might conjecture that with a gradual decline in manufacturing in the country, BMW region saw increased inflows of less educated, but somewhat more experienced workers into KIS activities.

These are speculative reasons, but some are supported by the evidence presented and discussed below.


Chart 2
Chart above shows that there is a strong positive resilience in income per capita levels across urban economies. This implies that future income levels are strongly correlated with past income levels. Almost 94% of variation in income per capita in 2007 is associated with the variation in income per capita found in 1999.

This means that we have to be careful directly interpreting data showing, for example, that in a specific country, such as the US, a number of cities with highly evolved economic environment to support economic growth might be underperforming in terms of actual achieved growth their less advanced counterparts. In fact, across the 350 regions defined by the OECD, there is no statistically meaningful direct relationship between urban economies growth and levels of GDP per capita, neither in 1999, nor in 2007. Rich states in 1999 might have either lower or higher income growth through 2007 and vice versa.

Chart 3 below shows that strong persistency in GDP levels over time implies there is only a weak (but positive) relationship between the past and the future growth rates.

Chart 3

Chart 4
Chart above shows that there is also a weak positive relationship between long term growth in education and long term growth in income per capita. A 1% growth in the proportion of population with 3rd level education between 1999 and 2007 accounted for 0.13% increase in the growth rate of income per capita. Growth in education between 1999 and 2007 was able to explain just 0.54% of the overall growth in income per capita over the same period. Although this contrasts the relationship between levels of education and levels of income per capita as shown in the chart below:

Chart 5
Over time, per above chart, the relationship between the levels of education of the workforce and the levels income per capita is becoming stronger both in terms of education impact and the overall explanatory power as to the direct positive correlation between education and income. In 1999, 7.3% of variation in income per capita across major urban regions was explained by variations in education. By 2007 this has increased to over 14.5%. If in 1999 1% increase in the proportion of population with 3rd level education was associated with a USD336.53 increase in income per capita (PPP-adjusted), by 2007 this effect rose to USD730.92.

Lagged period education levels are better determinants of income per capita than contemporaneous levels of education, which suggests that causality flows from education to growth, rather than the other way around. This is illustrated in the chart below. Notice also that this is true both in terms of explanatory power (R2) and the overall impact of education (slope coefficient). At the same time, compared to 2007 data (previous chart), this relationship (lagged 1999 education to 2007 income per capita) is weaker in the overall effect of education on income, suggesting that in recent years, there has been a significant shift in the importance of education in determining income per capita.

Chart 6

I will explore some of the possible explanations for these results in the next log post on the matter, so stay tuned…

Economics 16/7/10: IMF Article IV CP on Ireland: part 3

This is the third post on the IMF's Article IV consultation paper for Ireland. (The first two posts is available here and here).

V. THE FISCAL OUTLOOK AND CONSOLIDATION AGENDA

35. To counter the deteriorating fiscal position, the authorities moved early to make substantial, balanced, and lasting consolidation efforts. As the fiscal situation deteriorated and a large structural deficit emerged, the authorities acted repeatedly to take additional measures and raise the ambition of their fiscal consolidation goals. This was achieved in a remarkably socially-cohesive manner and represented a balance of economic and social considerations. The strong upfront measures are expected to yield a net adjustment of 5½ percent of GDP over 2009–10.

[The Fund is generally positive on the measures taken so far. However, in the chart at the bottom of page 22, the report shows the overall contribution to fiscal imbalances across various categories of spending and receipts. Picture 1 reproduces, with added details, the IMF analysis. Several things that are not covered by the Fund analysis stand out as significant omissions, most likely politically motivated. First, there is a very substantial role played by the continued deterioration in transfers (social welfare, health etc) which the Fund glances over. Second, public sector wages bill continues to represent further downward pressures on fiscal deficit despite the measures taken in 2009.
Third, noted (to the IMF credit) in the footnote on the following page, banks supports are likely to exert additional pressures in years to come. Per IMF: “A re-classification of a capital injection (2½ percent of GDP) as a capital transfer raised the 2009 deficit to 14¼ percent of GDP. In the first half of 2010, the government issued promissory notes worth 8½ percent of GDP to increase capital in one bank and two building societies. If these injections are considered capital transfers, the 2010 deficit would increase by this amount. As it would represent a once-off adjustment, it would not impact on the trajectory of the deficit for 2011. The further possible capital injection of 5 percent of GDP would add correspondingly to the 2010 deficit.”

Clearly, the Fund is not interested in making any predictions about the markets reaction to such an one-off adjustment. But one must wonder, if the Irish deficit shoots past 20% of GDP mark, even on one-off measures – what will our bond yields be at? And if 2011 brings about more capital injections into the banks, how long can these ‘one-off’ measures continue to hammer our deficits before someone, somewhere screams ‘The Irish Exchequer has no clothes!”]

[In the box-out on page 23, the IMF states:]

When adjusting for the impact of asset prices, the Irish structural deficit reached 8 percent in 2007, spiking to 12 percent of GDP in 2008. Spain and the U.K. also experienced sharp but smaller increases in structural deficits. However, after fiscal adjustment of 5½ percent of GDP, the Irish structural deficit is expected to decline to 8½ percent of GDP in 2010, while discretionary fiscal stimulus has raised the structural deficits in Spain and the U.K.

[Two things worth mentioning here. One: if the Bearded Ones of the Siptu/Ictu alphabet soup economics have their way, what would our structural deficit look like today? 8.5% is a hefty number. Recall that structural deficits won’t go away once economy is back on long term growth path. Second: at 8.5%, structural (long-term) sustainability of our Exchequer finances would require a combined reduction in expenditure, plus increases of taxation (assuming 50:50 split between the two) of roughly speaking a further €6.5 billion cut in spending and €6.5 increase in tax revenues. Given that roughly 700,000 households pay income, stamps & CGT taxes in this country, that would mean an annual tax bill increase of a whooping €9,300 per household. Does the Fund or the Government, or even the Bearded Ones think this is feasible?]

36. The 2010 budget adheres to the consolidation track, but risks remain. The authorities project the 2010 deficit to be 11½ percent of GDP. Because of lower nominal 2009 GDP than assumed in the 2010 budget and a weaker growth projection, staff projects lower revenues, leading to a deficit of 11.9 percent of GDP in 2010. The accounting treatment of the government’s equity injections into the troubled banks is still being determined but could raise the 2010 headline deficit substantially. The authorities noted that the associated fiscal outlays have already been incorporated into the official debt figures.

[Here is an interesting one. So banks-related outlays are in the debt figures already, but they are not in the deficit figures yet. How can Brian Cowen sit with a straight face in front of CNN cameras and tell the world that fiscal consolidation is working if Ireland Inc is heading for a deficit in 2010 that is vastly in excess of the deficit in 2009? And if he can, then why is DofF already factoring in the banks numbers into official debt? Gosh, it does begin to appear that we can’t even do a banana republic thing right.]


37. The remaining sovereign financing need in 2010 is limited. The average maturity of Irish treasury bonds is high—at 7½ years—and the rollover need is therefore limited. [That’s the good news…] For 2010, about three quarters of the planned government bond issuance (€20 billion) had been obtained as of June. The annual financing needs in 2011–12 are projected at about the 2010 level. The authorities maintain sizeable cash balances, financed by short-term debt, which could act as a buffer against any temporary difficulties in issuing long-term debt.

[Two things jump out: one the annual financing requirements for 2011 and 2012 are around €20 billion each. Which really means that the Government is not planning any substantial reductions in overall size of its expenditure. The con game of taking spending out of one pocket and shifting it into another pocket, while calling its transition from hand to hand a ‘saving’ will keep going on through the next elections… This explains why, for all our talk of ‘taking the pain’ the Government expenditure stubbornly keeps climbing up. Second, there is a quick sighting of the substantial additional costs of our overspending habits here. Short-term buffers kept by the DofF in order to insure ourselves against the possible tightness of the normal borrowing channels are ‘substantial’ per IMF. These buffers are subject to the higher risk of rising interest rates and also have no productive role in financing public spending. The costs of funding these buffers is a pure insurance premium we have to pay on top of standard borrowing costs in order to keep on rolling the vast social welfare/public spending machine we have created.]


38. Staff supports the appropriately ambitious fiscal consolidation plan through 2014 but cautioned that the required adjustment may be larger than projected by the authorities. The consolidation plan, outlined in the December 2009 Stability Programme Update, aims to reduce the deficit to below 3 percent of GDP by 2014. The plan envisages fiscal adjustment of 4½ percent of GDP over 2011–14, of which about 1 percent of GDP represents reductions in capital expenditures. The staff’s macroeconomic projections imply that the required medium-term adjustment could be larger than projected by the authorities. Starting from a higher projected deficit in 2010 and based on less optimistic macroeconomic projections, staff estimates that the adjustment need over 2011–14 would be 6½ percent of GDP, 2 percentage points of GDP higher than the authorities do.

[Quite a nasty turn for the ‘authorities’ here. The Fund clearly has little faith that the Irish Government can reach the set target of 3% by 2014. In fact, the IMF now projects that Irish Government deficits will be 5.9% of GDP in 2014 (driven by macroeconomic and target differences between DofF projections and IMF forecasts), with our debt to GDP ratio reaching 97.7% ex-banks supports in 2010 (5% of GDP additional to 8.5% announced in March) and 2011 (by my estimates around 5% of GDP). Worse than that – 5.2% of GDP will be our structural deficit in 2014 – a massive 88% of the total deficit.

A little footnote to the table on page 24 gives explanation: “The difference between the fiscal projections of the Department of Finance and the IMF staff is due in part to assumptions of lower growth on the part of the IMF staff. The IMF staff’s baseline fiscal projections for 2011–12 incorporate the adjustment efforts announced by the authorities in their December 2009 Stability Programme Update, although 2/3 of these measures remain to be specified. For the remainder of the period, the IMF staff’s projections do not incorporate the further adjustments efforts outlined in the Stability Programme Update.”

In other words, folks, in IMF terms, these projections include what has been promised but is not specified. And furthermore, the IMF doesn’t really believe anything this Government has set out to do beyond 2012 elections. They rightly suspect that any commitment of FF/Greens made before 2012 will face a serious uphill battle in implementation should the coalition fall apart.]

Economics 15/7/10: IMF Article IV CP on Ireland: part 2

This is the second post on the IMF's Article IV consultation paper for Ireland. (The first post is available here).

Several issues, previously stressed by this blog have made their way into Article IV – a good sign for those who read these pages regularly, and bad news for the Government. Emphasis is mine, throughout.

21. Given the sharp increase in leverage, this will be a drag on the pace of recovery. In order to achieve the required internal devaluation, some fall in Irish prices is necessary. However, in the transition to lower price levels, deflation will slow the pace of recovery. The debt of households and businesses, fueled by the low real interest rates before the crisis and with unchanged nominal values, has now to be repaid in an environment of falling prices, higher real interest rates, and low GDP growth rates. These factors lead staff to conclude that the normally-sharp bounce back to close the output gap after a large output decline will be muted on account of the deflationary drag.

[Let’s revisit the above comment of mine about the shocking state of economics understanding amongst the Irish ‘authorities’ (see the first blog post on Article IV paper). If the Irish authorities disagreement with the IMF on deflation is correct, then surely the state can drive up inflation in sectors it controls to the full extent of inducing deflation of our debt. No need to worry about, as the IMF does, about the adverse effects of deflation on debt sustainability. Alas, the IMF is much more sophisticated in its analysis. The Fund understands that in order to deflate our debt, Ireland will need inflation in capital goods and consumer goods. Not in state-controlled and economically unproductive services and sectors, such as health, public services, public transport, energy, etc. Inflation, you see, is not the same across all goods and services, contrary to what our economics bureaucrats might think.]

[Page 15 of the report shows two very good charts, similar to what I’ve been posting before. Irish households’ debt roughly, per IMF estimate, is ca 215% of our net disposable income, while Irish corporates’ debt (ex banks and financial corporations) is ca 160% of our GDP. Now, recall that our corporates are our GNP, which is roughly 24% below GDP. By both measures we are more leveraged than Spain and Portugal! We are, per these charts, darn close to being insolvent as an economy. But of course, there is not a peep from the IMF about Government programmes for addressing this core problem. For a good reason – there isn’t such a programme. Instead we have denials from all official sources that debt insolvency might be even an issue here.]

22. As banks emerge from the worst phase of the crisis, they remain weak. While capital ratios of the eurozone banks have risen since the crisis, they have declined for the large Irish banks. Banks’ reliance on wholesale funding—and, hence, high loan-to-deposit ratios—has yet to be corrected significantly. The ratio of nonperforming loans (NPLs) to all loans increased from ¾ percent at end-2007 to 9 percent at end-2009 and can only be expected to increase further, particularly if rescheduled loans fall into arrears. In the meantime, the ability to provision for these NPLs has declined sharply.

[Now, let me see. We, the taxpayers, have been taken to cleaners by the bank rescue measures. Something almost the size of our annual national income has been committed by the Government to underwrite the banks – from the implicit expected liability on the Guarantee to the explicit cash injections. Just this week our Taoiseach has gone as far as tell the banks: “Burn cash away, should you need more, we’ll give you as much as you need”. And for all that, the banks “remain weak”.

And notice the IMF statement on expected losses on loans. We are now beyond 9% (as of the end of 2009) and closer to 12% by the end of H1 2010. Recall that our Nama and Government assumed just 9 months ago – in October 2009 – that the banks losses will be on par with those experienced in the UK in the early 1990s – aka 10%. We are past this number already and the banks ‘remain weak’. In what book do these outcomes constitute a successful policy response? Stage three of the banking crisis, per IMF warning, is looming if ‘rescheduled loans fall into arrears’. In other words, all the toxic loans on the banks books back in 2007-2008 that were rapidly re-negotiated by the end of 2008, many of these ‘new’ loans come to the end of the repayment holidays and interest only periods and fall due for recovery around the end of 2010-2011. When these loans tank – and there is really no reason for them not to – the arrears will shoot up. Ask yourselves the following questions – are those billions committed to BofI and AIB and Nama taking into account those possible defaults? Not really. Why? Because for now, until the recovery begins, these are performing loans! So in real terms, the banks are not just ‘weak’ as the IMF says. They are potentially gravely sick.]


[But just how gravely ill are the banks? The IMF says the following:] 23. Liquidity pressures remain serious. The authorities estimate that over €70 billion (44 percent of GDP [or 55% of our annual national income]) of banks’ obligations will mature by September this year. …Irish banks have also been heavy users of ECB liquidity facilities. The stock of retail bank deposits has been either flat or declining.

[This is pretty dire, if you ask me. As noted by me on many occasions before, our banks are close to being the most over-leveraged in the entire developed world. So they are in the poor state when it comes to solvency issues. As the IMF above states, and many other sources – from BIS to many Irish observers, including myself – confirm: Irish banks are also illiquid. That’s like a patient who is brain dead and has no pulse. Dare to call that a corpse? I am no medical specialist, but something tells me that some shock therapy – Significant bondholders haircuts? National cash for equity swaps on massive scales? Debt for equity conversions with deeper haircuts on lenders? – is needed here.]

[But do recall that by now every Government Minister and almost every Governing Coalition TD have gone out on the record telling us that Nama will restore credit flows in the economy. Of course, people like myself, Brian Lucey, Karl Whelan, Peter Mathews, and a number of other observers were saying that this won’t happen. The IMF has said the same before. This time around on page 17 the state: “…staff analysis was cautionary regarding the ability of the banks to lend for a recovery.” And then on pages 18-19: “deleveraging to reduce the loan-to-deposit ratio and banks’ risk aversion will likely constrain lending and the pace of economic recovery, at least in 2010–11. Higher than expected losses, uncertainties in global regulatory trends, and renewed financial market tensions—that may restrict access to funding—create downside risks. In this environment, targets for SME lending, which have been imposed on two major banks in 2010–11, could have adverse effects on credit quality and hence require strong prudential safeguards, as the nonperforming loans of this sector have grown rapidly.”]

[Oh, my goodness, is that the IMF warning that politically motivated targets the Government has imposed on the banks for lending out in this economy might be… hmm… damaging to the banks objective of repairing their balancesheets? Indeed the Fund is concerned. As should be Irish taxpayers. After all, the taxpayers have been repeatedly and routinely deceived by the official statements as to the expected outcomes of Nama and banks recapitalizations despite having been warned by independent economists and bankers that their claims concerning restored credit flows will not materialise. Anyone to take responsibility for that?]

28. … Governance of NAMA is strengthened by its independent board. However, given the government’s large presence in the property market, implementing the provisions for the oversight of NAMA’s operations, is vital.

[Clearly, the IMF is concerned that outside of the main board of Nama, the structure itself is not provided with sufficient oversight, transparency and/or accountability. This is not surprising. Core Nama decisions-making committees are rigged up so as to exclude all and any external independent participation. Nama operations will have a limited and not subject to FOI ‘oversight’ only ex post the operational decisions are implemented. Nama strategy and decisions will not be subject to ex ante or contemporaneous oversight of anyone, save for Nama staff itself.

[It is also interesting to note that the IMF report makes absolutely no references to specific policies aimed at restructuring banking operations in the main two Irish banks. Paragraph 31 does attempt to pay lip-service to Government efforts to “reshape the system” but it so miserably fails to note a single implemented ‘reshaping’ measure adopted that it makes it clear that there has been no meaningful change in the ways Irish banks operate. This contrasts with more robust actions on the regulatory reforms side – paragraph 32.]


[Paragraph 34 is the ill-fated section of the report mistakenly identified by the Irish press as an endorsement of the idea of banks levy:] 34. To complement regulatory safeguards, and to reduce and meet the costs of future crises, a financial stability charge could be contemplated.

Such a charge would have two elements. A risk-adjusted levy, tied to a credible resolution mechanism, would provide resources for a resolution fund to be used for future crises. A financial activities tax, levied on the profits and remuneration (of senior executives) would represent a fair contribution from the sector to general revenues but also serve the purpose of reducing the sector’s size and, hence, its systemic risk. Such tax measures remain controversial but are being contemplated in a number of other countries. The authorities noted that Ireland would be guided by the evolving international practice and these initiatives may need to be deferred until more normal conditions apply.

[So let us summarize the argument here: the levies can be contemplated (not a ringing endorsement by the Fund of the idea) and their introduction will lead to a reduced size of the banking sector in the economy.

The latter, of course, would reduce banks’ ability and willingness to supply credit, thus limiting leveraged investment and growth. Now, that might be a fine objective to set for the future, but… how does it square off with the fact that we already have too constrained of a credit supply in the economy which, per earlier IMF statements, is choking off the recovery? Do you sense a contradiction here? I do.

Irish Times folks don’t. Actually, they can't even exactly reflect what the report says. Hence in today’s paper: “The Government should introduce a tax on senior bankers’ pay and bank profits to help reduce the risks the financial sector poses to the economy, according to the International Monetary Fund (IMF).” I failed to notice where the IMF says the Government ‘should introduce a levy’…

More from Irish Times: “It notes, however, that implementation of such measures may need to be deferred until more normal financial conditions apply.” Opps… it was the authorities – as in Irish authorities, not the Fund staff – who stated this to the IMF, as the above quote from the report itself clearly states.

In short, there is no ‘should’ to the banks levy, just ‘could’… which of course may mean that the Irish Government also could do a number of other things, some palatable in a civilized society, some not. Could does not equate to should, unless you are on a preaching podium, such as the Irish Times.]


More to follow, so stay tuned...