Economics 3/8/10: Ireland's PMIs

NCB Stockbrokers today released their latest data for Irish PMIs for Manufacturing.

Core conclusions: "the rebound in the Irish manufacturing sector lost momentum again in July.
Both output and new business increased at slower rates, while employment fell for the second month running. Reduced capacity at suppliers led to the fastest lengthening of lead times in the history of the series. The seasonally adjusted NCB Purchasing Managers’ Index™ ...fell for the second month running, posting 51.4 in July, down from 51.8 in the previous month.

The reading indicated that although operating conditions in the sector improved, the rate of strengthening was the weakest in the current five month sequence. Output growth eased for the third successive month..."

Overall - a very balanced analytical note from NCB, as usual. Worth a close read.

As usual, let me update my charts based on the NCB dataset.

First manufacturing:
The downward pressure is clearly visible in all three PMI-underlying core series. A close up snapshot reveals it in more details:
Output and new export orders series are perhaps the most significant signals of the weaknesses ahead.

Much of the improvements in PMIs globally (and in Ireland) were driven earlier this year by the need to restore supply capacities: This momentum now appears to be close to exhaustion despite the fact that slack capacity remains unfilled.
Prices are showing continued deterioration in margins. Overall input prices deviation from the output prices and the recent crossing of output prices into contraction zone for the index suggest that margins are being significantly undermined. The uptick in employment index, though significant since the crisis lows, is yet to translate into new hires and is now back in contraction territory (since June).

Next, updating Service PMIs (note - the latest data is for June 2010).

Services are posting much more sustainable recovery trend (albeit with less impressive peak of growth so far) than manufacturing. New business trending alongside overall PMIs suggests that unlike the case of inventories-driven manufacturing PMIs expansion, new business is driving most of the service activity rebound. The snapshot of data below highlights this:
However, it is worth watching some of the macro sub-components of the services PMIs:
In particular, both business expectations and profitability are appearing to be on cusp of a shift downward. More importantly, both profitability and employment appear to be stuck in contraction territory.
In terms of prices, inputs deflation is almost exhausted, but outputs are stubbornly refusing to move into higher prices territory - margins are thus down, which should be bad news for employment in months ahead.

Employment picture overall is not too encouraging:
Original support at modest expansion levels in manufacturing, registered earlier this year has now slipped back into contraction. Services employment remains below expansion line, though the rate of contraction is slowing pretty aggressively. It remains to be seen, however, what July data will tell us about services component.

Economics 2/8/10: External corruption - Ireland's scores

Transparency International published Progress Report 2010: Enforcement of the OECD Convention on Combating Bribery of Foreign Public Officials (July 28).

The main conclusions of the report:

• Active Enforcement: Denmark, Germany, Italy, Norway, Switzerland, UK and US;
• Moderate Enforcement: Argentina, Belgium, Finland, France, Japan, Netherlands, South Korea, Spain and Sweden;
• Little or No Enforcement: Australia, Austria, Brazil, Bulgaria, Chile, Czech Republic, Estonia, Greece, Hungary, Ireland, Israel, Mexico, New Zealand, Poland, Portugal, Slovak Republic, Slovenia, South Africa and Turkey.
  

TABLE A: FOREIGN BRIBERY ENFORCEMENT IN OECD CONVENTION COUNTRIES

TABLE B: STATUS OF FOREIGN BRIBERY CASES

Detailed findings (relevant to Ireland):

1) Inadequacies in Legal Framework

• Jurisdictional limitations (e.g. Australia, Canada, Czech Republic, Denmark, Estonia, France, Greece, Ireland, Israel, Japan, the Netherlands, Poland, Spain);
• Lack of criminal liability for corporations (e.g. Argentina, Brazil, Czech Republic, Estonia, Germany, Greece, Ireland, Italy, Japan, New Zealand, Poland, Turkey);
• Inadequate sanctions (e.g. Brazil, Chile, Denmark, Estonia, Germany, Greece, Ireland, Japan, Korea (South), the Netherlands, New Zealand, Poland, South Africa, Sweden, Switzerland, Turkey).
  

So Ireland scores poorly in 3 out of 6 categories.

2) Inadequacies in Enforcement System:

• Inadequate complaints system and/or whistleblower protection (e.g. Argentina, Australia, Austria, Belgium, Brazil, Chile, Czech Republic, Denmark, Estonia, Greece, Hungary, Ireland, Israel, Italy, Korea (South), Mexico, Netherlands, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Turkey).
  

So Ireland scores poorly in 1 out of 6 categories.

Overall, Ireland's performance is below satisfactory by category, but not below the average (by country). Ireland's performance is also significantly below all other small and significantly open to trade economies (except Austria).

This, however, should not be confused with the measures/performance in terms of our overall corruption. I would expect that TI's forthcoming report on overall corruption perceptions in Ireland will show significant deterioration on past performance due to significant 2009-2010 newsflow of revelation of some of the worst governance practices in public sector and banking.

Economics 1/8/10: California's lesson for IRL?

Last week the State of California declared official emergency in relation to its fiscal shortfall. The problem, you see, is that torn between various vested interests, California's legislature is unable to approve a new budget for 2011. The State deficit is currently running at $19bn, which represents 22% of the general budget fund. As a part of emergency declaration, Governor Schwarzenegger ordered three days off without pay per month beginning in August for tens of thousands of state employees to preserve the state's cash to pay its debt, and for essential services. Now, 3 days out of each month represents roughly speaking a 14% straight cut across all lines of wages, pensions liabilities, overtime etc. A bit more dramatic than Irish Government 2-year old programme of cutting PS pay by an average of 5-7%.

May be the depth of California's crisis is that much (say 2.5 times?) deeper than the fiscal crisis in Ireland?

Well, let's compare, shall we? To do so, I took budgetary projections (latest available) for California and Ireland and put them side by side. I computed the extent of expected and planned deficits in both locations as a share of the net Government expenditure.
It turns out that in its state of emergency, 'insolvent' California is not 2-3 times worse off than Ireland. It is the 'turning the corner' Ireland that looks 1.5 times worse off than California. And not just now - all the way through the next 4 years.

So California - its Governor and Legislature - are at the very least trying to work through the summer to hammer out some sort of a resolution. Our own legislators and Government are out to enjoy a spot of recreation. And why not, you may ask, if the economy has finally turned the corner... err... sort of... for the 15th time since May 2009 that is...

Economics 1/8/10: Merrill Lynch & Minister Lenihan's Banks Guarantee

Those who follow my tweeter contributions (@GTCost) would have probably seen the following quotes from the 3 documents relating to Merrill Lynch advice given to the Irish Government regarding the banks guarantee of September 2008. Nonetheless, I've been asked by a couple of readers to provide their summary in a single place so here it is.

In relation to Minister Lenihan letter to the Irish Times (here) which stated amongst other things that: "In the papers on the bank guarantee recently released by my Department and published by the Public Accounts Committee, the Government’s financial advisers Merrill Lynch strongly endorsed the principle that no Irish bank should be allowed to fail against the backdrop of what the Governor describes in his report as “the hysterical state of global financial markets”. Merrill Lynch also recommended a blanket guarantee of Anglo Irish Bank, including, incidentally, subordinated debt."

The Minister was referring to 4 documents available on the Oireachtas site (here) and numbers 3, 4, 5 and 6. Document 6 contains no information on the actual position of the Merrill Lynch.

Transcript of the meeting Merrill Lynch & DoF 26/09/2008: page 1 "On a blanket guarantee for all banks: Merrill Lynch felt could be a mistake and hit national ratings and allow poorer banks to continue" Link: http://www.oireachtas.ie/viewdoc.asp?fn=/documents/Committees30thDail/PAC/Reports/DocumentsReGruarantee/document5.pdf

Same source, page 2: "More generally, institutions should be encouraged to sell assets & get equity." So Merrill referred to equity capital injections (either in the style of Swedish recapitalizations by the state or private equity sales, with the latter being an unlikely outcome. At no time does the document references the need for a blanket bailout! Minister Lenihan was present at the meeting (see last paragraph of the document to prove this, although the official list of attendees at the top of the document does not include his name).

Merrill's presentation on 26/09 does state (p2) that a guarantee, covering subordinated debt holders as well is: "Best/Most decisive/Most impactfull from market perspective" option of considered. It does not state this to be the case from the taxpayers perspective. Minister Lenihan does not represent the markets interests. He represents taxpayers interests. Thus, if he indeed take the advice from the above statement, he thus knowingly or unknowingly altered the terms of his core responsibilities.

The same presentation voices a number of concerns, some of which are blacked out by DofF... What are these? Link: http://www.oireachtas.ie/viewdoc.asp?fn=/documents/Committees30thDail/PAC/Reports/DocumentsReGruarantee/document4.pdf)

Email from Merrill to K. Cardiff from 29.09/08 18:43(just a few hours before the guarantee was issued and containing final advice by the investment bank to the Government) does not contain any endorsements of the Guarantee (or of any other singular option), despite being based on 26/09 presentation cited in the earlier quote.

But the email does say (p2): "There is no right or wrong answer [to strategic options available to the Gov]... preserving flexibility is key & solution may be different for each institution"

Does this advice sound like a call for a blanket guarantee on all debt holders?
Link: http://www.oireachtas.ie/viewdoc.asp?fn=/documents/Committees30thDail/PAC/Reports/DocumentsReGruarantee/document3.pdf

There are even deeper issues involved in Minister Lenihan's statement. One of the most troubling ones is why has the Minister summoned the advice of an investment bank that two weeks before the advice was sought (on September 14th) was taken over by Bank of America in questionable condition?

Congressional testimony by Bank of American CEO Kenneth Lewis, as well as internal emails released by the House Oversight Committee, indicate that Bank of America was pushed into the purchase of Merrill Lynch by the US regulators. BofA executives and board were, allegedly, threatened with the firings and were warned of "damaging the relationship between the bank and federal regulators". Full three weeks before Minister Lenihan engaged Merrill Lynch, the company was severely downgraded by its peers in the market (September 5 downgrade by Goldman Sachs is indicative of this and was public at the time).

However, the main issue that arises from Minister Lenihan's letter is that of the purpose of its existence in the first place. Is Minister saying that the Guarantee decision was the correct one? If so, why does he need the defense of being given such an advice? If no, what does his statement about Merrill Lynch advice really tells us? To say that Guarantee was issued because Government advisers said that it was the best option is equivalent to saying that poor weather forecasts has caused Titanic to sink.

Economics 1/8/10: Retail Sales data: to spin or not to spin?

The latest retail sales figures for Ireland highlight two interesting issues. One - deeply fundamental, another - deeply disturbing.

The first issue - the fundamental one - relates to the basic philosophy of 'reporting' the data. CSO's publication on RSI was headlined "Retail Sales volume index increases by 1.0%". The first paragraph of the 'analysis' reads (emphases are mine):

"The volume of retail sales (i.e. excluding price effects) increased by 1.0% in June 2010 when compared with June 2009 and there was a monthly decrease of 0.2%. If Motor Trades are excluded the volume of retail sales decreased by 1.3% in June 2010 when compared with June 2009 and the monthly change was -0.5%."

This, to me, as an example of the poor application of economics to what is essentially a purely economic data series. And it is also an example of poor statistical analysis. Here is why:

1. The series reported are monthly and seasonally adjusted. This means these series are first and foremost about monthly, not annual deviations (annual comparisons can be made unadusted for seasonal / monthly variations). Why does the CSO then elects to report an annual deviation headline?
2. The volume series of retail sales are secondary in importance to the value series. What matters to gauging the overall demand in economy is not the physical quantity of stuff traded, but the value of the sales. Imagine a situation whereby an economy is plagued by a recession (like Ireland). Country largest retailer goes out of business and has a firesale of its stocks. Suppose it sells lock stock and barrel in one month, but at a price of zero euros per item, i.e. it gives stuff away for free. What happens? Volume of sales goes up dramatically. Value of sales goes down. CSO records an increase in volume and reports a headline that implies demand is up, sales are up. Yet, economic impact of this transaction is nill. If anything, it shows that economy has no real demand underlying it. Exchequer returns are nill. Value of stuff sold is nill. Value of transactions is nill. Patient is as dead as it can be!
3. Monthly, not annual series show shorter term dynamics. And it is the dynamics of sales, not their absolute levels or longer term changes that should frame short-term policies, that are suited for a recession.
   

Of course, you might object, saying - hey, you should have read the first paragraph, mate. Not just the headline. Alas, our politicos making bullish noises about turnarounds can't be relied upon to do this much. "It's the good news, folks! Retail sales are up year on year".

CSO has more disturbing analysis presented in the latest release. Paragraph two, in fact, is about as manipulative, as the preceding text:

"A number of sectors showed year on year increases in June 2010, with the most
significant being: Motor Trades up 13.9%, Non Specialised stores up 1.4%, Clothing, Footwear and Textiles up 2.6%".

Now, let's take a look at CSO own data to decipher the spin in the above statement:

• Motor Trades up 13.9% yoy in volume, and 1.4% mom - good news (driven, as I've said before by a tax off-set for new cars - aka the scrappage scheme, and to a larger extent - by the vanity plates for 2010), but Motor Trades are up less significant 9.2% yoy in value and 1.3% in mom terms. So one might ask the question then - why is value of overall Motor Trades lagging behind the volume of these. Is it due to (a) rebates by the Government (VRT offset?) or (b) competition in the Motor Trade sector or (c) because people are buying lower quality, cheaper priced cars? CSO doesn't even attempt to provide an answer. My earlier analysis (here and here) suggests that all three might be at play. If so, Motor Trades figures for the entire 2010 are not exactly a shining example of economic turnaround.
• Non Specialised stores volumes up 1.4% yoy, but down 0.9% in mom terms. Values of these sales are down 3.5% yoy and 1.3% mom. Discounts, discounts, discounts. Selling cheaper doesn't really generate more economic activity, though it does benefit consumers. And this 'cheaper selling' in turn drives up not new demand, but induces a movement right along the same, recessionary demand curve. But wait, seasonally adjusted monthly changes are negative in value, which means that deflation is still there and demand for quantity is not exactly booming.
• Clothing, Footwear and Textiles up 2.6% in yoy volume terms. Really? Well, mom the same series are down 4.1%. In terms of value of Clothing, Footwear and Textiles sold in Ireland in June: yoy sales collapsed 8.1% and mom change was 4.1%. In a normal economy that should start ringing the 'Recession Alert' bells. In Ireland, for CSO this is bunched together with the aforementioned 'good news'.

Here is another good look at the CSO own data, not brought up to anyone's attention by CSO:

• All Businesses excl Motor Trades & Bars: Value down -1.3% mom and -3.9% yoy, Volume down -1.1% mom and -0.2% yoy. Some turnaround!
• All Bus. Excl. Motor Trades, Fuel & Bars: Value down -1.9% mom and -5.3% yoy, while Volume is down -1.1% mom and 0.3% yoy. No turnaround here either.
• Non-Food (Excl Motor Trades, Fuel & Bars): Value off -1.2% mom and -7.1% yoy, while Volume is off -1.7% mom and -0.6% yoy.
• Household Equipment (white goods stuff) Value down -3.1% mom and -6.3% yoy, Volume off by -2.6% mom and -0.1% yoy. Now, this category is important as white goods are subject to demand due to depreciation and new demand. We've had at least 2 years of collapsing demand for these goods, implying that things are so bad, people are reluctant to replace depreciated washers, dryers, dishwashers, fridges etc. Forget buying new jeans and coats...

So to do what I usually do on this blog - here are updated charts plotting actual data (no spin):
If you look closely at the last three months in the series, you can see continued deterioration pressures in both. But to highlight this trend - check out the chart below:
Monthly changes are now in the negative territory, and a positive annual volume bounce of the first quarter 2010 is about to be exhausted.

Removing motor trade:

Why wouldn't CSO just report data, plus charts and leave 'commentary' to others? At least they would be purely objective reporters of data, instead of playing the amateurish 'Spin Economics' commentators?

Economics 31/7/10: Credit flows in Ireland

Central Bank quarterly was published yesterday. Here are some updated charts on credit flows (data through May). The main conclusions are:

1. Private sector credit continues to contract and is again accelerating in the annual rate of decline (-10.4% yoy in May as compared to -9.3% declines in April and March).
2. Mortgage credit contractions are steadily declining (-1.8% in May against -1.6% in April & 1.4% in March).
3. Non-mortgage credit is accelerating in the rate of decline (-12.8% in May compared to -11.4% in April)
   
4. Nama - now through 50% of the loans purchases - has had no positive impact on credit supply. If anything, as charts for households lending show blow, it is being accompanied by a dramatic increase in the cost of borrowing for ordinary families.

Charts:
Aggregate private sector credit above. Disastrous trends of the last 2 year continue unabated, despite the already significant contraction in the credit supply. This suggests that we are in a continued downward spiral when it comes to business and household investment (future capacity is under continued pressure down and the only thing that provides some positive support to capital side is, most likely, MNCs own inter-company investments). This goes to explain why one cannot accept earlier DofF projections for 2013-2015 potential rates of growth. We are in a situation very similar to Japan in the mid-1990s, where existent production is being driven at the expense of capital stock.

Mortgages:Clearly, no signs of moderation in the rates of decay anywhere here. But the picture is more sluggish than that for non-mortgages lending:
The reason for the different dynamics is that it is easier for households to cut back on smaller credit demand than on massive mortgages burden. Hence, non-mortgages lending is a leading indicator for what we can expect to follow in the mortgages markets. Not exactly a bright future for the housing markets, then.

Deposits side of our financial system:
Notice that deposits are down, mom, across the board, except for shorter term maturity corporate deposits. But yoy all deposits are down. Combined decline in all deposits in volume since January 2010 is €1,869 mln, or 3.4%. Not a small change. All deposit rates are down year on year - we are being paid less to save, but are charged more to borrow.

Loans stats next.
Loans for house purchases are falling, while mortgages rates are rocketing. The orange line above shows just what is happening with the cost of financing one's own home in Ireland, courtesy of our regulators (keen on talking about 'moral hazard'), all the special 'Working Groups' aiming to address the problems in the housing markets, and Nama. Remember - our Government (by now pretty much every minister in the cabinet) had sworn to us that Nama will restore functional banking. May be this is what they had in mind...

Last year I predicted that the game in the mortgages markets will play as follows:

• Once Nama starts transfers, incentives for the banks to play a Good Fella will diminish - repossessions will remain low, but rates will rise. We now can see this happening around us.
• Once Nama completes transfers, banks will go in earnest at rebuilding their margins & capital, meaning - repossessions will accelerate dramatically and rates will rise to the levels where the burden of financing mortgages will become a driver for more repossessions.
• 3-6 months after the above stage, banks will start hoarding repossessed property on their books. They will be forced to start selling it ca 6-9 months after February 2011 (completion date for Nama purchases).
• Combined effect of massively more expensive mortgages credit and inflow of repossessed properties into the market will drive prices in housing markets even further down.
  

So far, we are through the 1st bullet point and getting closer to the second one.

Meanwhile, in the land of short term loans, rates are more steady and credit supply is falling gently.
Now, let me ask you this question. What should be the priority here? Making sure people are not being skinned to pay for their homes, or making sure that credit cards rates and car loans are being underpinned by more stable interest rates?

Credit to non-financial corporations is continuing to slide. Year on year, shorter term (working capital) credit is now off a massive 19.3%. Longer term credit is off 2.7% yoy. What does this tell me about the economy?

1. Capital investment is going nowhere fast, with any rosy figures on volumes we might hear over the coming weeks being most likely driven by the MNCs own in-house investment flows; and
2. Companies have no capacity to refinance shorter term credit obligations, resulting in a cash flow pressures and lack of operating capital.

Not exactly a success story for our financial system administrators and regulators, then.

Economics 30/7/10: No double dip for the euro area, yet...

New data from eurocoin is out - time to update euro area forecasts. Aptly in line with the US Q2 growth now coming at a slower 2.4% annualized rate, both the leading eurocoin indicator of activity (down to 0.4 in July from 0.46 in June) and my forecast for Q2 and Q3 2010 growth for the euro area are also moderated. Chart below illustrates:
GDP forecast range is for quarterly growth of -0.1% to +0.05% in Q3 2009.

So no double dip for the euro area yet, but things continue to head that way...

Economics 29/7/10: PTSB house prices

PTSB/ESRI house price index is in for Q2 2010. The core result: house prices were down, again, by 1.7% qoq in Q2 2010 - a lower rate of change on Q1 2010 contraction of 4.8% qoq. Thus, prices are now off-peak by 35% to an average of €201,364.

Dublin prices are down 3.5% qoq in Q2 2010 and are off 44% relative to peak. This gap between nation average and Dublin, assuming (as seems to be reasonable) that capital prices appreciation prior to the current crisis were significantly affected by underlying demand, should be erased over the next 12 months plus. Which means we can expect at some point that Dublin will lead the recovery across the country, while other regions continue to contract toward the 45-50% nationwide average off-peak pricing.

NCB stockbrokers gave a good comparison to fundamentals-determined prices. Per their analysis,

• Rental yield model implies house prices equilibrium at between €118,000 and €157,000, or a mid-range house price of €137,500;
• Earnings multiples model implies €170,000;
• Present value model (although not detailed as to the assumptions built in) implies the range of €158,000 to €236,000 for an mid-range of €197,000

You can see where these valuations are heading, don't you? Take a full range of estimates mid-range point of €177,000 - that would be a decline of 43% off the peak prices. Take the simple average price of all mid-range points to get 46% decline.

Now, recall - these are equilibrium prices. In normal price adjustments, there is a relatively pronounced undershooting in prices - in other words, we can expect prices to fall below equilibrium levels before reverting toward longer term values over time.

The depth of this undershooting and its duration depend on some external factors, such as the ease of getting mortgages approvals, mortgage conditions etc - none of which are currently helping the housing markets. So there is a very strong possibility for prices to hit the floor at around -55-60% off the peak.

Lastly, there is a question to be asked as to the validity of PTSB's data - the country largest mortgages holder might no longer be the country largest mortgages issuer. And the sample size globally has shrunk substantially. In other words, if a desperate homeowner in the distant province sells a house for, say, €120,000 while a dozen of his neighbors are not braving the market, does this really tell us anything about the market clearing price? Not really. Imagine what the said homeowner would have got for his dwelling if 12 more identical dwellings in the neighborhood had a 'For Sale' sign.

So a grain of salt is due - the size of an orange...

Economics 27/7/10: Stress tests of Irish banks? Get real!

An excellent comment on AIB and BofI 'stress tests' results from Peter Mathews, worth a direct post (rather than 'just' a comment) on this blog. Read it here.

Economics 26/7/10: Old Capital Investment 'news'?

Updated: per some detailed feedback from the DofF, see updated text below.


The latest announcement of the extended capital investment programme for 2010-2016 is sounding like a PR exercise. Majority of the projects announced in the programme are the left-overs from the previous National Development Plan. So there is no real news on spending volumes / stimulus extent in the Taoiseach's announcement.

This does not imply that the programme is without a merit, but it does imply that the media circus about 'major new investment programme' announcement is seriously overdone.

There are, however, some details worth covering.

First, the level of 'new' investment. At €39 billion over 7 years it is hardly a 'significant' increase on the historic levels. Taken as an average of 2008-2010 gross voted capital spending, the six year plan that would have stuck to the average would imply a capital spending of over €51.8bn through 2016. Well in excess of Mr Cowen's latest 'Great 7-year Leap Forward'.

DofF latest projections submitted to the EU in SPU2010, prepared in December 2009, show expected capital investment of €5,500 per annum in 2011-2014, which, is now exactly matched by today's 'new' announcement.

Chart below illustrates, drawing on data from Department of Finance own projections delivered for the Budget 2010.

The news component of the announcement is in the detailed breakdown of the numbers by department and within departments - by the specific lines and projects. This is a significant improvement on the SPU 2010, where the same €5,500 million in annual investments was just a number. And then there are cuts in some of the really less economically feasible (or I would say 'White elephant') investments envisioned in the original NDP.

These are welcomed changes that are worth the report that DofF did produce to accompany the announcement (links here). Where credit due...


Second, Department of Finance SPU submission to the EU has built in (Table 9: Additional Annual Measures to be delivered in 2011 and 2012) as "Capital already identified and incorporated into the base" the following cuts to capital investment: 2011=1bn, 2012=2bn.

If Taoiseach's announcement relates to the new investment on top of the planned NPRF contributions, then the future (2013-2014) savings will have to come out of some other lines of Exchequer balance sheet. Croke Park deal effectively closed the doors on generating new savings from the non-welfare lines of current spending. This means that our Taoiseach, in making today's announcement will be aiming for clawing at least €3bn in new taxes on top of the at least €2bn already planned in Budget 2010 for the years 2011-2012.

Now, recall that the same SPU - which is now replicated in the 7-year plan for capital investment - had its validity questioned by the IMF as being too optimistic on the assumptions, imprecise on planned savings and at a risk of failing due to the possible Government fatigue to cuts. Are we now seeing the very things that IMF was warning us about unfolding in front of our eyes. The IMF also said that it is likely that the additional (not planned in SPU) adjustments to fiscal balance will require savings and/or tax increases of ca 2.3% of 2014 GDP, or roughly speaking €5bn.

So in the nutshell - either we will be borrowing more to finance that which we already announced years ago, or we will be taxed to death to pay for it. Or both.


Oh, and on a funny note - the Irish Times (here) reported that Government is hoping that the new 'investment' will create some 270,000 new jobs, directly and indirectly.

My original comment was: so we spend ca €6,500 mln to generate 270,000 new jobs? At this rate of 'expected' jobs creation, we should have some 6.5 million workers in Ireland, using 2009 GDP levels. Was someone in the Government buildings smoking something funny coming up with these numbers?

A person close to the report came back to me with their explanation of the numbers. The figures quoted on the aggregate are multi-annual 6-year forward projections that incorporate previously announced jobs targets from IDA and EI. So the direct jobs creation (remember - indirect jobs creation is highly uncertain, while IDA and EI targets are not subject to the announced investment measures) is around 1/2 that number. Now, at 130-140,000 per 7 years and at €39bn total would be in the region of €280-300,000 per job in one-off gross investment.

It still looks to me like something a tad too optimistic is happening here:

• Suppose we spend €5,500 million in year 2011 building stuff. This means we hire builders etc. Suppose we manage to get them at a pittance of €100,000 per job (a very low number). We just increased employment by 55,000.
  
• Suppose in 2012 we spend €5,500 again on building some more stuff, plus spend more funds on running the stuff just completed in 2011 (remember, we cannot use €5,500mln allocation in 2012 to operate the stuff just built in 2011, as it would be a current expenditure item). So we have to hire new and re-hire old, but the same number of 55,000 workers.
  
• Between 2 years, new jobs creation is 55,000. Not 110,000.
  

And this is what worries me here. Despite the explanations I got from DofF, the document numbers on the jobs front still do not add up to me.

Worse than that. Some of the programmes envisioned in the plan will require people to run/operate them in the future, post-construction, and will also require considerable spending of funds on amortization and depreciation, maintenance and operations.

Are there any estimates as to what will be the budgetary impact of these 'new investments' on the current expenditure in the future?

Let me explain here. Suppose I spend €2mln building a school building. Unless I get the existent staff to run the building, I will have to hire new teachers, new service providers, and I will have running and operating costs. For a school, suppose I will need 2 teachers and 1 service personnel (split into part-time admin and part-time maintenance staff). That's ca €150K annually in wages, plus mark ups for pensions etc - roughly speaking €280-300K per annum. Utilities etc, plus scheduled maintenance, say another €50K. So my initial investment of €1mln creates a continuous liability of up to €350K. Of course, I can cut my construction workforce hired in 2011 and divert 'investment' to funding staff operating my new facility. But that makes it a current expenditure. And it means that the rate of jobs creation will be crowded out over time by the newly added infrastructure demands.

Note, these are illustrative figures, but they add up.

• In 2012: projects from 2010 come on-line, implying (using above assumptions) that current spending side swells by €1,100 million (gross side);
• In 2013: projects from 2011 come on-line, yielding another €950mln, adding to 2012 to generate a permanent increase in gross current spending of €2,050mln.
• and so on...

These are crude illustrations, but you get my concerns? Yep - these current costs will have to be paid by us, the taxpayers. And it scares me.

And yes, I still do not believe that 270,000 figure. In fairness to the DofF - they have been stressing since yesterday that the figure is there just because they needed some anchor to the economic impact. It is neither rigorous, nor definitive.


Lastly, I would like to thank DofF for engaging in the debate and providing some very fair clarifications and explanations of their position on the paper.

Economics 25/7/10: What lending markets tell us about EU policies

So the markets are not that enthused about the stress tests. After the initial bounce on the back of 'pass' grades, there are rising concerns about some 19 banks, including AIB, which were given 'all clear' with some serious stretch of assumptions.

But to see what is really going on behind the scenes, look no further than the actual interbank lending rates. In fact, the interbank lending markets provide a good reflection on the combined euroz one policies enacted since the beginning of the Greek debt crisis. Both euribor (the rate for uncollateralized lending across euro zone's prime banks) and eurepo (lending rates for collateralized loans between euro zone's prime banks) are significantly elevated on twin concerns about:

1. The quality of the borrowing banks (recall - these are prime banks); and
2. The quality of the collateral (with sovereign bonds being top tier quality, deterioration in sovereign debt ratings is hitting interbank markets hard).

Here are the usual, updated charts:

Chart 1Long maturities have been signalling extremely adverse effect of the Euro rescue package since its inception.

Medium-term maturities show severe deterioration since the euro rescue package. Steepest, and uninterrupted rise in 3 months euribor signals that the rescue package is faltering in delivering anything more than a buy-time for the euro… In other words, we have an expensive (€750 billion-sized) buy-in of short time.

The ECB claw back on longer term lending window did not help this process either. But the stress tests are doing nothing to stop the negative sentiment dynamics.

Chart 2Per chart 2 above, short-term maturities are showing that despite supplying underwriting to about a half of the full year worth of euro area bonds refinancing, the rescue package has achieved no moderation in the short-term risk perceptions of the market. In fact, the rise in euribor is more pronounced in the short term than in longer maturities, suggesting that short term risks of sovereign default remain unaddressed by the rescue package and are exerting a continuous pressure on interbank lending.

Introduction of the stress tests also did nothing to reduce overall cost of borrowing amongst the prime banks which were fully expected to pass the test even before the EU got on with setting test parameters.

In turn, all of this spells much higher costs of funding for the banks which have shorter term financing needs, such as the Irish banks. The implicit cost of taxpayers’ guarantee for Irish banks debt is therefore rising.

And panicked markets are not about to surrender their fears to the EU PR machine. With all the increases in the euribor, the volatility of the interbank lending rates also increased, across all maturities, as shown in charts 3 and 4 below.

Chart 3Chart 4As evident, in particular, from chart 4, in the longer term, credit markets are absolutely not buying the combination of the EU rescue package, ECB liquidity measures and the stress tests. Euribor trajectory for maturities of 6 months and higher firmly re-established and vastly exceeded volatility that preceded the pre-rescue panic. We are now worse off in terms of the cost of banks financing than we were before the Greek crisis blew up.


To remind you - eurepo is the rate at which one prime bank lends funds in euro to another prime bank if in exchange the former receives from the latter the best collateral in terms of rating and liquidity within the Eurepo basket. Eurepo rates have posted dramatic increases since mid-June 2010. The original effect of the June 2010 closure of the longer maturity (12 months) ECB discount lending was a temporary reduction in the rates, followed by a stratospheric rise two week later that has been sustained through the end of this week. This is especially true for shorter term maturities, suggesting that part of the adverse effect was due to the heightened uncertainty around the EU stress tests. Chart 5 below illustrates.

Chart 5Chart 6The u-shaped response in the interbank lending rates to ECB lending changes and to stress tests is even better reflected in the longer maturity eurepo rates, as highlighted in chart 6 above.

3-months and 12-months eurepo rates are now at the levels consistent with the height of the sovereign default crisis. There are significant differences in the rates by maturity group and vis-à-vis euribor due to the fact that the quality of collateral offered in the markets is now itself uncertain as sovereign credit quality continues to deteriorate both in terms of increasing probabilities of default and thus associated risk premia, but also due to the regulatory treatment of collateral that is being signalled by the stress tests.

As with euribor, eurepo rates are showing remarkable increases in volatility, for both shorter and longer term maturities.


Let us finally put the two rates side by side to compare evolution of euribor against eurepo, setting index for all at 100=January 4, 2010

Chart 7Chart 8
Some pretty dramatic stuff. To round off, recall that since the beginning of April 2010, the eurozone has undertaken the following measures to shore up its financial markets:

1. Set up a sovereign rescue fund worth more than €750 billion to underpin roughly 50% of the total borrowing requirement in the euro zone (which could have been expected to yeild an improvement in banks collateral and thus a reduction in overall systemic risks in the interbank markets as well);
2. Reduce maturity profile of ECB lending window (which was from the get-go equivalent to dumping more petrol on the forest fire);
3. Deploy aggressive quantitative easing by the ECB (again, this should have reduced uncertainty in the interbank markets as in theory improved pricing for sovereign bonds should have increased the quality of interbank collateral and improve banks own books);
4. Conduct an absolutely discredited stress test of the banks (designed to provide positive newsflow for the banks, especially for prime banks which should have seen their risk profiles reduced by a mere setting up of the test).

In short, none of the measures seem to be working, folks... May be, just may be, the real problem with EU banks is their unwillingness to come clean on loans losses and start honestly repairing their balancesheets?

Economics 22/7/10: EU stress tests - what do they tell us, really?

The EU stress tests of the banks confirm the worst fears of all analysts – including myself. The tests were simply a PR exercise, so poorly conducted that no one can have any credibility in their outcomes. Worse than that, the whole circus:

• The difficulty with which the EU member states appeared to be willing to release information about the tests;
• The way in which information is being released (via a drip feed – bit by bit over time, with massive leaks beforehand);
• The struggle through which member states have gone in order to even agree to carry out the tests in the first place;
• The rhetoric from the EU regulators assigning an almost heroic quality to its efforts to test the banks in the face of a clear shambolic nature of the whole exercise.
  

All of these things provide for a strong suspicion that the EU will not be able to undertake robust regulation and monitoring of the euro zone banking system in the future, plus a clear cut realization that the entire idea of the euro member states coming together to police their own fiscal behaviour will be even less honest, transparent or robust. In other words, how can we expect the EU to act as a functional policeman of its members fiscal policies if:

1. It failed to do so over years past, even armed with already robust and automatic regime of the Stability & Growth Pact, and
2. It failed to properly stress test its own banks?
   

In the nutshell: German banks, including Landesbanken, have already privately leaked the ‘news’ that they all had passed the test. Ditto for banks in France, Ireland and Italy. Only one German bank – already failed HRE – has failed the test from among 91 institutions.

In the case of AIB – the sick puppy was ‘passed’ by allowing to include into regulators’ calculations the €7.4 billion the bank plans to raise by the end of 2010. Good intentions count for hard evidence, then, per EU regulators. And Bank of Ireland passed - along with all the rest of the PIIGS banks is by the test excluding any possibility of twin shocks - simultaneous continued deterioration in quality of loans and a sovereign debt crisis. Now, in all likelihood, if the sovereign debt crisis continues to rage, does anyone in their right mind thinks that housing and other asset markets in the likes of Ireland and Spain are going to improve to alleviate the loans book pressures?

Farcical!

What the 91 tested banks did ‘pass’ was not a stress test, but a joke, concocted either by those with no understanding of banking (Eurocrats?) or created specifically with an ex ante intent of passing them all. The French and Greek banks privately said that the haircut applied to their holdings of Greek government debt were about 23%. Markets are factoring in 50-70% haircuts, so the EU stress test was less than half as severe as what is being priced already. Worse than that – the sovereign debt haircuts were applied only to bonds held in banks’ trading books. That accounts for just 10% of all Greek bonds held by the euro area banks, as 90% of Greek sovereign debt has been already moved to ‘held to maturity’ parts of banks assets portoflia, not reflected on trading books.

In other words, when it comes to Greek sovereign debt exposure, the EU tests were capturing no more than 5% of the total risk of such exposure for the banks. Like a doctor, looking at the brain activity chart of the patient and saying: ‘Look, there’s no activity at all. But 95% of all other vital signs are performing just fine. Indeed, no worries old man, the patient is still looking 95% alive then…’

And there's more. Per media reports, a memo from Germany's Financial regulator BaFin earlier this year said the real concern should be contagion from "collective difficulties" across the PIIGS, not an isolated default of Greece.

All of this did not prevent Irish stockbrokers from issuing upbeat reports about 'the good news' for BofI and AIB. What good news? The shares in two banks rallied today because someone, somewhere, allegedly decided that if Greece softly defaults, Irish banks will survive? Did that someone actually paused for a second to think, before placing a 'buy' order if Irish banks can survive their own home-made disasters? Or whether they can survive a meltdown of Greek debt default as priced by the markets? Or whether they can survive both happening at the same time?

Irish analysts, who issue these forecasts should be required to read Taleb's 'Fooled by randomness', though one wonders if they will understand much of what Taleb is saying for years now. Investors who chose to belive that AIB and BofI passing of the 'test' this week is some sort of a 'good news' are simply fooling themselves by ignoring a simple fact of life - misdiagnosing a patient with heart attack as being free of an Avian flu is not going to improving the patient's chances of survival. It actually reduces them.

Shamed by this absolutely incompetent, if not outright markets manipulating ‘testing’, you’d think the EU leaders would step back and start an earnest conversation between themselves as to what has gone wrong here. Nope. They are hell bent on creating more Napoleonic sounding, but utterly unrealistic and even disastrously risky plans. This time around – for fiscal harmonization. France and Germany – the two countries that have been clearly at odds with each other in responses to the current crisis have decided that a bout of amicable activism is long overdue. So behold the latest Franco-German alliance on a list of fiscal policy co-ordination proposals.

Per reports in today’s media: a French cabinet meeting took place with German presence, during which Sarkozy called for a complete harmonisation of European tax systems. ‘He did whaaat?!’ I hear you cry… yeah, he did call for that which was explicitly denied by him and the entire EU leadership core as ever having a chance of happening in the run up to the Lisbon II referendum in Ireland.

Now, don’t take me wrong here – this is not a voluntary call for individual states cooperative action – it is a call for an EU-wide ‘reform’. And if you don’t think so, the same meeting called, once again, for member states with excessive deficits to be punished by withdrawal of voting rights in the Council of Ministers, plus a fine and the compulsory imposition of an interest-bearing deposit for member states.

Eurointelligence blog has put it succinctly: “In other words, France and Germany [have called] to continue the same dysfunction regime, except that they strengthen those parts that have prove the most dysfunctional.”

Let me be a tad controversial here - wasn't all of this predicted to happen by Declan Ganley, Anthony Coughlan, Mary Ellen Synon and others who argue in favour of democratic reforms in the EU? Weren't they 'refuted' on exactly these predictions by the entire 'establishment' in Brussels and the all-knowing dons of the Upper Merrion Street? You don't have to agree with their points of view. You might as well agree that the idea of fiscal harmonization is a great thing. But what cannot be denied is that:

1. Any policies absent meaningful ability to honestly, transparently and effectively enforce them (and EU has shown none of these in its stress tests of the banks - the easiest area to deliver them in current political and economic environment) is destined to be nothing more than a bullying pit for some states to arbitrarily control others; and
2. Given grave doubts about EU's capabilities to provide for (a), the automatic default option of any new policies should be to scale opportunism and adopt pragmatic, cautious, incremental reforms approach - when in doubt, measure and caution must be the prevalent guide.
   

After all, if I were a person with the power to shape EU principles, I would adopt the milenia-old medical code of ethics, that is based on the fundamental axiom of morality: Primum non nocere, or First, do no harm.

Then again, adopting such a principle would have meant not conducting these 'stress tests'.