Economics 21/9/10: This Little PIIGSy Went to the Market

So here we go again: NTMA went to the market, ECB came along, the results are suspiciously identical (save for obviously increased costs of borrowing) to those achieved in August.

We sold €500 million of 4 year debt due in 2014 at an average yield of 4.767%, compared with 3.627 percent at the previous auction on August 17. Cover on 4 year paper was We also sold €1 billion wort of 8 year paper due in 2018 a yield of 6.023%, up from 5.088% in a June sale.

Short term stuff first:
Cover support is clearly running well above average/trend, indicating potential engagement by the ECB. Price spread is down, suggesting that the yields achieved are reflective in the perceptions compression on behalf of bidders, which in turn might mean that the markets are getting more comfortable with higher risk pricing of Irish bonds.

Next up: yields and prices achieved:
The dynamics are crystal clear - we are heading for a new territory in terms of elevated yields and lower prices. Actually, setting historical record in both, despite likely ECB interventions.

Weighted average accepted price:
Boom! The curve is getting curvier.

On to longer term stuff:
Yield spread down as well - same reason - higher yields are now a 'normal' for the markets as average accepted yield shot up.
Cover slightly up, perhaps being pushed by the bidders flowing from the shorter term paper - crowded out by Jean Claude Trichet's boys. Price spread is down (see yield spread discussion above).

Predictably, longer-term accepted average price is testing historical lows:
Boom, redux!

And the maturity profile of debt is getting steeper for the folks who'll take over the Government in the next round, and our teenagers (that'll teach'em a lesson, for those, of course who'll stay on these shores):

Economics 19/9/10: Irish banks - Government intervention still has no effect

Returning to my old theme - let's take a fresh look at the Government and its policy cheerleaders success rate with repairing our banking sector. Here is a quick snapshot of history and numbers as told through the lens of Irish Financials index.
So clearly, we have some really powerful analysts out there and keen commentariat (actually one and the same in this case) on the future prognosis for our banks.

But what about recent moves in the index itself?
Take a look at the chart above, which maps the Financials Index for two subperiods:
Period 1: from Guarantee to March announcement of the 'final' recapitalization of our banks,
Period 2: from Guarantee to today.
Now notice the difference between two equations. That's right, things are not getting any better, they are getting worse.

Next, let's put some historical markers on the map:
Surely, our financials are getting better, the Government will say, by... err... not getting much, much worse. The reality, of course is, any index has a natural lower bound of zero. In the case of Irish Financials Index, this bound is above zero, as the index contains companies that are not banks. As far as the banks go, there is a natural lower limit for their share values of zero. Our IFIN index is now at 80% loss relative not to its peak, but to its value on the day of Guarantee!

Having pledged banks supports to the tune of 1/3 of our GDP already, the Government policy still has not achieved any appreciable improvement in the index.

Forget longer term stuff - even relative to Q4 2009, Government policies cannot correct the strategic switchback away from Irish banks shares that took hold:
A picture, is worth a 1000 words. Unless you belong to the upbeat cheerleaders group of the very same analysts who missed the largest market collapse in history, that is.

Economics 19/9/10: What's human capital got to do with our policies?

Having spent last week giving three presentations in Ireland on our IBV paper (link here) concerning the role of human capital in urban and regional development, and having spent a week before given another five presentations/briefings on the same topic in Russia, I should probably take a break from the topic.

So here is a quick note: I finally came about to read an interesting study from McKinsey & Co on the importance of talent as a driver of competition between firms, published back in February 2008. It is a very insightful piece.

Here's an interesting quote, referring to two McKinsey Quarterly global surveys (emphasis is mine). "The first, in 2006, indicated that the respondents regarded finding talented people as likely to be the single most important managerial preoccupation for the rest of this decade. The second, conducted in November 2007, revealed that nearly half of the respondents expect intensifying competition for talent—and the increasingly global nature of that competition—to have a major effect on their companies over the next five years. No other global trend was considered nearly as significant."

Furthermore, "Three external factors—demographic change, globalization, and the rise of the knowledge worker—are forcing organizations to take talent more seriously."

Amazingly, there is little evidence to-date that policymakers have any idea the process of global competition for talent is underway in their economies. With exception of the US and Switzerland, every OECD economy puts the heaviest burden of taxation onto shoulders of the very same talent for which companies in these countries compete.

Ireland is the case study here. After a decade and a half of aggressively incentivising foreign investment into the country (not a bad thing in my books), Irish leadership has left human capital - and especially internationally mobile human capital - bearing more than 3/4 of the total tax burden in the country. Now, this proportion is rapidly increasing (see chart), having risen from 75.31% in Q2 2007 to 80.42% in Q2 2010.
This process is accelerating per table below:
Unbeknown to our policymakers (it appears), labour, especially skilled labour in the sectors the Government promotes as the future of Ireland Inc (e.g. the 'knowledge' economy) is the largest cost input for firms. Yet, through the crisis, the Government has elected a two-path approach to resolving our fiscal difficulties:

• massive cuts in capital investment, and
• disturbingly high increases in income tax burden and other tax burden on disposable income by households.

Anyone to spot a contradiction here?

Economics 18/9/10: It's not just IMF

As argued in my earlier post (here), based on the IMF analysis, our sovereign bonds yields are still some distance away from those justified by fundamentals.

It turns out the IMF paper cited in the earlier post is not alone in the gloomy assessment of our realities. Another August 2010 study from German CESIfo (CESIfo Working Paper 3155), titled "Long-run Determinants of Sovereign Yields" and authored by António Afonso Christophe Rault throws some interesting light on the same topic, while using distinct econometric methodology and data from that deployed in IMF paper.

Here are some insights from the paper (available for free at SSRN-id1660368). "For the period 1973-2008 [the study] consider the following countries: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, Sweden, Spain, UK, Canada, Japan, and U.S."

Take a look at table 2 of results from the paper estimation across listed countries. The model is based on 3 variables here - Inflation (P), Current Account (CA) and Debt Ratio (DR). All have predictable effect on the variable being explained. Per study authors: "Results in Table 2 show that real sovereign yields are statistically and positively affected by changes in the debt ratio in 12 countries. Inflation has a statistically significant negative effect on real long-term interest rates in ten cases. Since improvements in the external balance reduce real sovereign yields in ten countries, the deterioration of current account balances may signal a widening gap between savings and investment, pushing long-term interest rates upwards."

Ok, here are those results:
Ireland clearly shows relatively weak sensitivity in interest rates to debt.

But take a look on our sensitivity to deficits. Per study: "Moreover, when the budget balance ratio is used (Table 3) a better fiscal balance reduces the real sovereign yields in almost all countries"
Clearly, Ireland shows 3rd highest sensitivity of interest rates to Government deficits. We are in the PIIGS group, folks, based on 1973-2008 data!

Now, this firmly falls alongside the IMF results - further confirming my guesstimate in the post earlier.

Economics 18/9/10: IMF data on bond yields

With all the debate, recently fueled by the Governor of our Central Bank and Minister for Finance, concerning the level of Irish bond yields, it is always insightful to look at the historic evidence as the source of better understanding of the underlying bond markets realities.

Fortunately, courtesy of the IMF, there is some new evidence on this issue available. IMF working paper, WP/10/184, titled "Fiscal Deficits, Public Debt, and Sovereign Bond Yields" by Emanuele Baldacci and Manmohan S. Kumar (August 2010) does superb analysis "of the impact of fiscal deficits and public debt on long-term interest rates during 1980–2008, taking into account a wide range of country-specific factors, for a panel of 31 advanced and emerging market economies."

In a summary, the paper "finds that higher deficits and public debt lead to a significant increase in long-term interest rates, with the precise magnitude dependent on initial fiscal, institutional and other structural conditions, as well as spillovers from global financial markets. Taking into account these factors suggests that large fiscal deficits and public debts are likely to put substantial upward pressures on sovereign bond yields in many advanced economies over the medium term."

But the detailed reading is required to see the following: "the impact of fiscal balances on real yields provided results that were quite similar to the baseline, although the size of the estimated coefficients was larger: an increase in the fiscal deficit of 1 percent of GDP was seen to raise real yields by about 30–34 basis points." (Emphasis is mine). Table below provides estimates:
By the above numbers, Irish bonds currently should be yielding over 7.54%. Not 6.5% we've seen so far, but 7.54%. This puts into perspective the statements about 'ridiculously high' yields being observed today.

If we toss into this relationship the effect of change in our public debt position, plus a risk premium over Germany (note that the estimates refer to the average for countries that include not just Ireland, but 29 other developed economies, including US, Germany, Japan and so on), the expected historically-justified yield on our 10 year bonds will rise to

• deficit-induced 7.54% +
  
• country risk premium driven by deterioration in economic growth adjusting for ECB rates) of 1.46%+
• change from initial public debt position 0.30%

So the total, fundamentals-justified Irish 10 year bond yield should be around 9.30%.

Don't believe me? Well here's a historic plot that reflects not a wishful thinking of our policymakers, but the reality of what has transpired in the markets over almost 30 years.
Ooops... looks like our ex-banks deficits warrant the yields well above 10% and on average closer to 15%, nominal (remember the above yields computed based on model results are real). Alternatively, for our bond yields to be justified at 6.5% we need to cut our deficit back to around 5.2% mark and hold our debt to GDP ratio steady.

Someone, quick, show this stuff to our bonds 'gurus' in the Government.

Economics 17/9/10: Busting some myths on CEOs compensation

Another fascinating paper that I came across last night trolling through old files.

Published by FEEM as a working Paper 89, 2010, titled “Executive Compensation: Facts” it was authored by Gian Luca Clementi and Thomas S. Cooley of NYU and NBER. The link to the paper is here.

In this paper the authors look at the executive compensation in the US from 1993 to 2006.

Per paper: “Notable facts are that: the compensation distribution is highly skewed; each year, a sizeable fraction of chief executives lose money; the use of security grants has increased over time; the income accruing to CEOs from the sale of stock increased; regardless of the measure we adopt, compensation responds strongly to innovations in shareholder wealth; measured as dollar changes in compensation, incentives have strengthened over time, measured as percentage changes in wealth, they have not changed in any appreciable way.”

Given hysteria around the world about executive compensation and commonly held views that:

• Executive compensation is getting more and more generous over time
• Executive compensation is now more unrelated to firm performance over time
• Executive compensation improving generosity is divorce from shareholder wealth

the study findings are enlightening.

The Clementi-Cooley study looks at a comprehensive measure of compensation – a combination of “salary, bonus, the year-on-year change in the value of stock and option holdings, the net revenue from the sale of stock and exercise of options, and the value of newly awarded securities.”

The study does some basic stats. For example, in contrast to the Trade Unions’ claims that the average US executive compensation for larger corporations was $10.8mln in 2006, the study shows that due to a significant skew in the data, the average metric is meaningless. The median compensation for the largest corporate executives in the US therefore, was much smaller (although still substantial) at $4.85mln.

The study also reflects on the well understood, but rarely cited fact that due to significant share of compensation of CEOs being in the form of stock and stock options, in many years, many CEOs actually experience losses in terms of their overall compensation, not gains.

The study is certainly worth reading as it contains factual analysis unencumbered by ideological bull usually found in the media.

Economics 17/9/10: Free markets are good for human capital

World Bank Policy Research Working Paper 5405, titled “Economic Freedom, Human Rights, and the Returns to Human Capital: An Evaluation of the Schultz Hypothesis” by Elizabeth M. King, Claudio E. Montenegro and Peter F. Orazem published in August 2010 is a very insightful read into the role of proper market institutions and rights in economic development. Paper link here.

T.W. Schultz postulated, back in 1975, an important hypothesis for why returns to schooling might vary across different markets. According to Schultz, human capital is most valuable when individual workers face unexpected price, productivity or technology shocks that require managerial decisions to reallocate time and resources.

In other words, in Schultz’s view, human capital acts as a hedge against such uncertainty. If skilled individuals are not exposed to shocks that require resource allocation decisions or if they are denied the freedom to make those decisions, then they will not be able to capture the economic returns from their skills.

It stands as a logic corollary that if a country imposes economic or political institutions that cushion the shocks or hinder individual economic choice, then we should observe lower returns to skill in countries that limit exposure and/or individual responses to uncertainty.

In the case, relevant to Ireland, this logic extends not only to traditional factors, such as:

• Degree of labour force unionization
• Extent of social welfare safety net
• Existence of the minimum wage laws
• Restrictions on mobility into public sector jobs and protected professions jobs
• Structures of pay and promotion divorced from productivity considerations
• Visa restrictions

and other buffers, but also more novel factors such as

• Negative equity
• Housing markets access restrictions (e.g. birth-right to development of homes in some areas)
• Cultural restrictions (e.g. Gaeltacht)
  
• Lack of credit supply, etc

Per World Bank study cited above:

“A cursory inspection of the data yields support for the hypothesis. … [dividing] data from 86 developing countries into three groups based on their relative ranking in the Heritage Foundation’s Economic Freedom Index, with 25% each placed in the least and most free economies and the rest being placed in the middle. … Private returns to schooling for the freest economies average 9.7% per year of schooling, 3 percentage points higher than the average returns in the most restrictive economies. Returns for the middle group fall between the two extreme groups. [The authors] repeat the exercise … for private returns to years of potential experience. Again, average returns are highest in countries rated as the most economically free (5%) versus the middle (4.7%) and least free (4.2%) countries. These results are broadly consistent with the proposition that freer economic institutions raise individual returns to human capital.”

Furthermore:

“T. P. Schultz (1998) found that about 70% of the income inequality in the world is due to country-specific fixed effects that would include the impacts of country-specific political and economic institutions on earnings. Acemoglu and Robinson (2005) argued that these institutions were formed in response to exogenous influences existing at the time of a country’s founding, and that these institutions tend to persist across generations. [World Banks study] use measures of economic and political institutions to determine if they can alter returns to human capital across countries sufficiently to explain some of the persistent cross-country income inequality reported by T. P. Schultz. [The study found] that, consistent with the T.W. Schultz hypothesis, human capital is significantly more valuable in countries with greater economic freedom. Furthermore, the positive effect is observed at all wage quantiles. Economic freedom benefits the most skilled who get higher returns to schooling; but it also benefits the least skilled who get higher returns from experience.”

Now, this has three basic implications for Ireland.

Firstly, the study results show that higher human capital returns (in other words greater incentives to invest in human capital) are associated with less restrictive labour market policies, greater extent of basic human rights protection, more pluralist system of social organization and lesser emphasis on equalization of outcomes in economic environment. In other words, market wins, crony capitalism (Irish model) and socialism (Swedish model) lose.

Secondly, the study also implies that if Ireland were to be focused on developing a viable knowledge economy (aka human capital-intensive economy), the country needs more market, more freedom, less protectionism and lower restrictions in the labour market.

Thirdly, the study suggests that environments with lower tax burden on labour and lower Government/State interference in private activities are more likely to produce better human capital base.

Instead of farcical Mr Top Hat Kapitalist, it looks like free markets and societies benefit Ms Advance Degree Holder.

Economics 16/9/10: Analysis of global banks rescue packages disputes Irish policy case

A very interesting paper that a year ago should have alerted this Government to the fallacy of its preferred path to interventions in the banking crisis. Alas, it did not.

Michael King Time to buy or just buying time? The market reaction to bank rescue packages, BIS Working Paper Number 288, September 2009 (linked here).

The paper suggests and tests the following three hypotheses concerning banks rescue packages put in place at the beginning of the crisis (January 2008):

• H1: The announcement of government rescue packages will be associated with a narrowing of bank CDS spreads relative to the market.
• H2: Capital injections will be associated with a rise in bank stock prices relative to the market if the benefits of lower leverage and a lower probability of financial distress outweigh the potential dilution of existing shareholders or restrictions on payment of common dividends.
• H3: Asset purchases and asset insurance will be associated with a narrowing of bank CDS spreads and a rise in the stock price relative to the market.

What the study found is that rescue packages confirm H2. But there was significant difference in the effectiveness of interventions.

• In the US, “bank stock prices outperformed reflecting the decline in the probability of financial distress and the favourable terms of the capital injections. The risk of US bank failures was high following the failure of Lehman Brothers and IndyMac, and the government take-over of AIG, Fannie Mae, and Freddie Mac. While the US Treasury’s preferred shares included warrants with the potential to dilute shareholders, the favourable terms of the capital allowed the average US bank share to outperform the market following the announcement of government support.”
• In contrast in Europe, “the risks of financial distress were also high as seen in the capital injections for Fortis and Dexia and the nationalisation of Bradford & Bingley. While banks were recapitalised, the cost and conditions of European rescue plans were punitive for existing common shareholders leading to an underperformance of bank stocks in most countries.” In other words, Europeans, predictably soaked equity holders but didn’t touch bondholders.
• “The UK package appears to have been the most costly for existing shareholders, which explains the fall in stock prices when the terms were disclosed. Given that only three out of six banks accepted the capital, the fall for banks receiving capital was offset by the positive response of banks that did not.”
• “Swiss banks were the exception as the average Swiss bank was relatively unaffected.”

Turning to the cases of asset purchases or asset insurance schemes, “market reaction provides only partial support for the third hypothesis (H3) that creditors took comfort from the reduction in potential losses and the decline in risk-weighted assets”. Oops, I’d say for the Leni/Nama plans. And this was known as of September 2009, despite which our Government has charged ahead with Nama.

“Overall, globally, asset purchases or insurance were used in only four cases with mixed results.”

Bingo – only in 4 cases: “the Dutch, Swiss, and US governments supported specific financial institutions by purchasing impaired assets or providing insurance against losses on specific portfolios. In an asset purchase, the government buys impaired securities or loans from the bank, reducing the bank’s risk-weighted assets and lowering the amount of capital it must hold against potential losses. While the government bears the risk of losses, it also retains the profits if the assets recover. While the US and Germany announced asset purchase plans, only the Swiss had taken action by the end of January 2009, buying $39.1 billion of illiquid assets from UBS on 16 October. The assets were removed from UBS’s balance sheet and placed in a special purpose vehicle, significantly reducing UBS’s risk.”

So in the end in the duration of 2008, no country has undertaken a significant Nama-like operation with exception of Switzerland in relation to UBS alone. Clearly the claim that Minister Lenihan was acting consistently with other countries in setting up a Nama vehicle is not true.

Here’s an interesting bit: see if you can spot where Mr Lenihan has gone the path differing from everyone else back in 2008. “Under asset insurance, the government assumes a share of the potential losses on a specified portfolio after a first loss amount (or deductible) is absorbed by the bank. In return, the bank pays the government an insurance premium based on the riskiness of the portfolio. By limiting the bank’s potential losses, asset insurance also reduces a bank’s risk-weighted assets and lowers the capital it must hold. The government, however, is left with a large potential liability if the assets fall substantially in value. The US and the Netherlands offered asset insurance to three banks. The US provided protection to Citigroup and Bank of America against the possibility of unusually large losses on asset pools of $301 billion and $118 billion, respectively. In both cases, the US government bears 80% of the losses after the deduction of a first loss tranche paid by the bank but does not share in any profits. The Dutch authorities created an illiquid asset backup facility to insure most of the risk from $35.1 billion of Alt-A securities owned by ING. The Dutch government shares in 80% of the downside and the upside. Asset purchases or asset insurance should be positive for both the stock price and the CDS spread, as both interventions lower the potential losses faced by common shareholders and reduce the risk of default. As a result, the share price should rise and CDS spreads should narrow. In three out of four cases the government’s actions coincided with the injection of capital.”

To conclude: “the October [2008] rescue packages provided governments with time to assess the situation and formulate their policy responses. At the same time, these policy interventions did not represent a buying opportunity as seen in the underperformance of bank stocks in most countries studied.”

Predictably, our stockbrokerages analysts, Nama, Department of Finance, Government and the usual crowd of suspects claimed that:

• Nama will lead to significant improvement in the banking sector health;
• Irish Government interventions were value additive for shareholders - all stockbrokers in Dublin and majority of them outside had 'Buy' recommendations on banks based on Government rescue package;
  
• Banks guarantee scheme is structurally important to the resolution of the crisis (not a delay, but a resolution),
• The rest of the world was doing the same.

International evidence on the matter suggests that banks supports are only as good as the measures to reform banks taken after the supports enactment. Of course, in the case of Irish banks, no such reforms took place since September 2008.

All I need to add here is that this paper was available to Minister Lenihan's advisers, to Nama and to DofF and Central Bank handlers. The latter, alongside their Financial Regulator counterparts are linked to BIS.

Economics 16/9/10: Why a rescue package for Ireland might not be a bad idea

This is an edited version of my article in today's edition of the Irish Examiner.

Two weeks into September and the crisis in our sovereign bond markets continues unabated. Ireland Government bonds are trading at above 6% mark and given the perilous state of the Irish banks, plus the path of the future public deficits, as projected by the IMF, Ireland Inc is now facing a distinct possibility of our interest bill on public debt alone reaching in excess of 6% of GDP by 2015. [Note: by now, the magic number is 6.12% as of opening of the markets today].

Sounds like a small number? Here are a couple of perspectives. At the current cost of deficit financing, our Exchequer interest bill in 2009 was 1.7% of GDP or €2.8 billion. Within 5 years the interest bill can be expected to reach over €12 billion, based on the Government own projections for growth. By this estimate, some 30% of our expected 2015 tax receipts will go to pay just the financing costs of the current policies.

It is precisely this arithmetic that prompted the Financial Times this Monday to question not only the solvency of the Irish banking sector, but the solvency of the Irish economy. The very same inescapable logic of numbers prompted me to conjecture in the early days of 2009 that our fiscal and banks consolidation policies will lead to the need for an external rescue package for Ireland.

This external rescue package is now available, fully funded and cheaper (financially-speaking) to access than the direct bond markets. It is called the European Financial Stability Fund (EFSF). More than money alone, it offers this country a chance to finally embark on real reforms needed to restore our economy to some sort of a functional order.

The EFSF was set up to provide medium term financing at a discounted rate of ca 5% per annum for countries that find themselves in a difficulty of borrowing from the international markets. With effective yields on our bonds at 6.05% and rising – we qualify.

The EFSF requires that member states availing of European cash address the structural (in other terms – long term) deficit problems that got them into trouble in the first place. In Ireland’s case this is both salient and welcomed.

It is salient because, despite what we are being told by our policymakers, our problems are structural.

Banks demands for capital from the Exchequer – a big boost to Irish deficit last year and this – are neither temporary, nor dominant causes of our deficits. In the medium term, we face continued demands for cash from the banks. By my estimates, total losses by the Irish banks are likely to add up to €52-55 billion (ex-Nama) over the next three-four years. These can be broken down to €36-39 billion that will be needed in the end for the zombie Anglo, €6bn for equally dead INBS, at least €8 billion for AIB and up to €2 billion for the ‘healthiest’ of all – Bank of Ireland. These demands will come in over the next 24 months and face an upside risk should ECB begin aggressively ramp up interest rates in 2011-2012.

No economy can withstand a contraction in its GDP on this scale. Least of all, the one still running 5-7% of GDP structural deficits over the next 4 years. In 2009, banks demands for Exchequer funds managed to lift our deficit from 11.9% to 14.6%. This year, absent banks bailouts, our deficit will still reach around 11.3%. Only 3.3% of that due to the recessionary or temporary effects. In 2011, IMF estimates our structural deficit alone to be 7% and 5.9% in 2014.

Which brings us to the point that the use of the EFSF funds should also be a welcomed opportunity for Ireland.

A drawdown on EFSF funding will automatically trigger a rigorous review of our fiscal plans through 2015 by the European and, more importantly, IMF analysts. This is long overdue, as our own authorities have time and again proven that they are unable to face the reality of our runaway train of fiscal spending.

Since 2008 in virtually every pre-Budget debate, Minister Lenihan has been promising not to levy new taxes that will threaten jobs and incomes of the ordinary people of Ireland. In every one of his budgets he did exactly the opposite. Under the EFSF, the IMF will do what this Government is unwilling to do – force us to reform our tax system to broaden the tax base, increase the share of taxes contributions by the corporate sector and start shifting the proportional burden of taxation away from ordinary families.

Minister Lenihan has repeatedly promised reforms of spending. In every budget these reforms fell short of what was needed, while the capital investment was made to bear full force of the cuts. Drawing cash from the EFSF will make Mr Lenihan scrap the sweetheart Croke Park deal and start reforming current spending. Politically unacceptable, but realistically unavoidable, deep cuts to social welfare, public sector employment and wages, quangoes, and wasteful subsidies will become a feasible reality.

Starting with December 2009, the Irish Government faced numerous calls from within and outside this state (headed by the EU Commission and the IMF) to provide clarity on its plans to achieve the Stability and Growth Pact criteria of 3% deficit to GDP ratio by 2014-2015. The Government has failed to do this. Drawing funds from the EFSF will help us bring clarity as to the size and scope of fiscal adjustment we will have to take over the next 5 years.

Lastly, the EFSF conditions will include a robust change in the way we are dealing with the banks. Gone will be the unworkable Government strategy of shoving bad loans under the rug via Nama and drip-recapitalizations. These, most likely, will be replaced by haircuts on bond holders and equity purchases by the State.

Contrary to what the Government ‘analysts’ say, drawing down EFSF funds will not shut Ireland from the bond markets. Instead, swift and robust restoration of fiscal responsibility and more a more orderly exit of the exchequer from banks liabilities are likely to provide for a significant improvement in the overall markets perception of Ireland. After all, bond investors need assurances that we will not default on our debt obligations in the future. Only a strong prospect for growth and recovery can provide such an assurance. Ministerial press releases and Nama statements are no longer enough.

Economics 16/9/10: One sick pup lifts one ear

Funny thing the market is, at least if you are an Irish banker.

The rationale for AIB selling its profitable divisions to plug the holes in its collapsed domestic business (notice, more detailed analysis of exactly the same fundamentals argument was supplied by Prof Brian Lucey back in March in his article in the Irish Times - see here). The logic of this AIB's perverse move was:

• sell the stakes in M&T and BZWBK to provide capital to write down bad loans on homegrown turf;
• put the bank assets squarely into the geography where it has proven time and again to be incompetent in lending (aka Ireland);
• reinforce the incompetence of the management of the bank by showing to the rest of the world that over the last 10 years, AIB could manage to make money only in those divisions/investments where it had no managerial say (I mean, really, folks - AIB's competent managers - who need to be paid wages comparable to other bankers around the world, cause, you know they are being actively headhunted by global banking syndicates for their ability to turn funding into bad loans - had nothing to do with only two profitable sides of the bank: M&T and BZWBK)

Ex post the sale of BZWBK, the AIB therefore anticipated markets to rush to their rescue. This clearly is not what's on the minds of the markets. S&P last night held its A-/A-2 credit rating on AIB and the negative outlook, implying a new downgrade might be in the works. Oh, how dare they?

AIB needs not €7.4bn (the minimum regulatory requirement capital top up), but more like €10bn to plug the hole in bad loans. It has managed to under-report (thanks to an accounting rule) losses in H1. The bank is now being stripped of the very few assets it has that actually make sense, leaving it with the legacy of its own actions and choices that is purely toxic. The markets don't buy the management 'plan' (what plan?) nor do they by the management team itself. The only thing that separates AIB from heading the Anglo route is the willingness of the Government to throw taxpayers guarantees and cash at the bank to rescue its shareholders and bondholders. How long will that last is an academic point at this moment in time. The real point is - AIB simply has so far shown no capacity to produce viable banking business short of buying into foreign-run assets.

Economics 16/9/10: Improving competitiveness

Recently, there have been plenty of claims concerning improving Irish competitiveness through the crisis. Most refer to the Irish Central Bank-reported Harmonized Competitiveness Indicators (HCIs). Here are some charts to detail what has been going on in this area:

The first chart below shows historical trends in HCIs.

On the surface, it looks like:

1. The story of dramatic improvements in our competitiveness (at least as measured by the HCIs) has been true - we are now back to competitiveness levels not seen since June 2007 (in Nominal HCIs), February 2003 (when it comes to HCIs deflated by consumer prices) and January 2006 (as measured by HCIs deflated by producer prices)
2. At the same time, the gap between our performance in HCIs deflated by producer prices and consumer prices clearly shows that these gains in competitiveness were not due to producer cost deflation (improved productivity), but due to massive deflation in consumer prices (margins erosion and collapse in domestic demand).

A closer look in the chart below, however, shows that the timing of our competitiveness gains is not as straight forward as the arguments put forward in the public suggest:
Starting with the peak year for our bubble (2007), our gains in competitiveness since the beginning of this recession in Q1 2008 are hardly impressive at all. To summarize these, here is a table of relative changes:

Loss of 1.4% (nominal) in competitiveness, contrasted by gains of just 2.4% in producer prices-termed HCI and 5.6% in consumer prices-termed HCI are hardly a matter of bragging rights for Ireland Inc.

Irish HCI data is strongly suggesting that so far in the recession, Ireland's producers have failed to gain significant inroads into productivity gains. Instead, lower retail prices so far remain the primary drivers of the improved indices reading.

Economics 16/9/10: Migration & natives mobility

In my presentation yesterday at IBM's Extreme Blue event, I mentioned that we know very little about the location decisions of the modern migrants - people with high skills, education, aptitude, creativity and innovation capacity.

An interesting new study from the Bank of Italy (“HOW DOES IMMIGRATION AFFECT NATIVE INTERNAL MOBILITY? NEW EVIDENCE FROM ITALY by Sauro Mocetti and Carmine Porello, Working Paper Number 748 - March 2010) assessed the relationship between “native internal mobility and immigration in Italy”. The study attempts to analyse “the impact of immigration on local labour markets and to gauge the consequences for the socio-demographic composition of the local population”.

Traditionally, immigration into a given geographic region is seen as a driver of outward migration of the natives due to jobs displacement (the argument that by taking lower wages migrants force indigenous workers out of their jobs). This is known as a substitution effect. Alternatively, there is a view out there that migration induces clustering of both migrants and domestic workers.

A set of studies in the 1990s and early 2000s have produced mixed results as to the relationship between inward migration and flows of the native workers:

• Frey (1996) shows “a strong correlation between immigrant inflows and native outflows in US metropolitan areas, and argued that this behaviour was bringing about a ‘demographic balkanization’”. Borjas et al. (1997) report a strong negative correlation between native net migration and immigration from abroad. Hatton and Tani (2005) find a negative displacement effect in the UK. Brűcker et al. (2009) find that “foreign immigration replaces native internal mobility in Italy”. (substitution in levels)
• Wright et al. (1997) disagree by showing that “immigrant inflows are unrelated to native outflows in large metropolitan areas.” Card (2001) confirms this in a broader setting. (independence)
• Card and DiNardo (2000) find that “increases of the immigrant population in specific skill groups lead to small increases in the population of native-born individuals in the same skill group.” (clustering)
• Borjas (2006) finds that “immigration is associated with lower in-migration rates, higher out-migration rates, and a decline in the growth rate of the native workforce.” (substitution at the level of growth rates)

In their study, Mocetti and Porello find that “immigration has a negligible impact on overall native mobility while it does have a significant impact on its skill composition” in Italy. Crucially, immigration leads to

• a displacement of low-educated natives,
• immigrant clusterization in the northern regions has partially substituted South-North mobility flows of less-skilled natives,
• immigration is positively associated with highly-educated native inflows
• the impact is concentrated among the young population and is somewhat stronger in more urbanized areas.

Interestingly, the devil is not in the details, but in interpreting the results: “is not clear how these results may be interpreted. If we consider the arguments in the literature on labour, we should read these findings as evidence of the substitution effect for low-educated natives and of complementarities for highly-educated ones. Task specializations and complementarities between immigrants and highly-educated natives might induce higher demand (and productivity) for natives in areas with a higher share of immigrants; having said this, if low-educated natives and foreign workers compete for the same jobs, then immigration might have a depressive effect on labour demand for natives.”

Labour market story aside, and related to our own study at the Institute for Business Value (here), immigration has skills-specific effects on internal mobility due to what I would term quality-of-life considerations. Inflow of migrants can alter quality of state in the recipient city. Mocetti and Porello refer to this effect as “the impact of immigration on natives’ location choices [that] might also work through other channels such as the housing market and the preferences for ethnic composition of the local context.”

Their study includes “house prices in the regressions to control for the effects through the real estate market; regarding “racial” preferences, they are likely to affect neighbourhood choice within a city rather than displacements across regions. Therefore, we argue that our estimates can be reasonably interpreted as the result of the interaction between immigrants and natives in the labour market.” The authors find that housing costs, associated with higher inward migration, do have a negative effect on the regions’ ability to retain domestic workers of similar skills levels.

So on the net, while the study does not deal specifically with the high quality of human capital group involved in migration, the study does suggest that better skilled/educated workers tend to produce a clustering effect leading to complementarity with the native workers of similar skills and creating a pull factor for inward migration of highly skilled workers to a specific location. The offsetting deterioration in living conditions (due to higher house prices etc) is not sufficient in size to cancel out this positive effect.