Economics 6/11/10: Regulation in Financial Services Sector

This an unedited version of my column in the current issue of Business & Finance magazine.

The New Regulatory Normal: banking and financial services future

The latest poll of public opinion on the issues of domestic and cross-border competition, released in late October, has found that citizens across the EU identified energy (44%), the pharmaceutical products (25%) and telecommunication (21%) as the main sectors where they perceive lack of competition to remain a major problem. Irony has it, banking and financial services (18% concerned) came out closer to the bottom of the list in terms of perceived competition deficit.

Even though more than a quarter of Greek (31%), Irish (28%) and British (27%) residents said that, based on their own experiences, a lack of competition was causing problems for consumers in the financial services sector, these proportions are still below those for other sectors. For example 30% of Irish respondents are concerned with lack of competition in transport sector, and 41% in pharmaceutical sector.

This is despite the fact that across the EU, and indeed the entire developed world, banks are being supported directly (via taxpayers’ financed measures) and indirectly (via the Central Banks supply of liquidity) to the extent well in excess of the combined subsidies delivered to all of the aforementioned sectors of concern. Writedowns of banks assets remain a top priority for policymakers and the adverse newsflow from the sector is abating extremely slowly (chart below).

Total asset write downs by category, October 2009–April 2010
$ billions, Revisions to estimates
Source: IMF GFSR database, 2010

In addition, banks and financial services companies are facing a tsunami of regulatory reforms, which dominate the newsflow and will likely result in more restricted competition and lending in the sector in years ahead.

Banks and financial services companies across the EU play by far much more dominant role in financing economic activity of firms and households than they do elsewhere in the world, as was highlighted in the latest Global Financial Stability Report from the IMF. In contrast with consumers, business leaders worldwide perceive the financial services to be the current hot spot for adverse pressures on the economy. Banks and financial services providers are expected to be more significantly impacted by the uncertainty induced by the policymakers responses to the crisis. For example, Global CEO Study, 2010 conducted by the Institute for Business Value, IBM shows that a large number of CEOs worldwide expect the Banking and Financial Services sector to be subject to greater structural change and volatility over time than the public sector, despite the fact that public sector itself is experiencing unprecedented debt and deficit pressures.

So the latest public opinion polls seem to be at odds with the reality of the potential crisis-and reforms-induced distortions to competition in the banking sector.

This is an unfortunate oversight, for today, more than ever before financial services need a serious debate about the role for and the future direction of regulatory and supervisory regimes in the sector.

Regulatory structures in the traditional banking and financial services sector have failed to keep up with the increasing complexity, demand for services and interdependence of products and service providers. At the heart of the current crisis, by all accounts, were the imbedded conflicts of interest and outdated regulatory regimes.

For example, the overreliance on prescriptive regulation, an approach that is now being promoted as the panacea to the future crises, is itself partially to be blamed for the meltdown in the rated instruments. Per IBM research paper “The yin yang of financial reform: Embracing maxims to enable financial stability and healthy financial innovation”, when regulations mandated that institutions use of the credit rating agencies to assess risks inherent in MBSs and CDOs, “internal credit research essentially died. Had institutions done their own credit analyses, perhaps the ultimate outcome would have been different or, at the very least, less severe.”

This points to a major potential pitfall in the ongoing process of increasing regulatory systems reliance on prescriptive rules as a protection against future crises.

Since the Lehman collapse, governments in the US and Europe have been addressing the imbalances in their national financial systems by passing both structural and operational reforms. These focus on size, scope, societal costs and “too big to fail” institutions (i.e., cross-firm reforms). Operational reforms, typically implemented by regulators or multilateral international organizations, focus on capital, liquidity, incentives and taxation (i.e., what firms need to do within their own organizations).

As our research at the IBM’s Global Centre for Economic Development (GCED) highlights, on a nutshell, the direction of reforms adopted by the US and EU legislators to-date can be described by a stylized formula measuring the returns on equity (ROE) in the banking sector. So far, new regulatory regimes being introduced imply that in the future banking sector will see “Lower R + Higher E = Lower ROE”. This is a structural threat to the viability of the sector, and many new regulations coming on-line globally are the main culprit.

From the international Basel III framework to the Dodd-Frank Act in the US, increased quality and quantity of capital reserves on the financial services companies is likely to drive down global credit supply both in the short term (as banks engage in rebuilding their balancesheets) and in the long run (as financial services providers compete for a severely reduced capital pool).Per Josef Ackermann, the Deutsche Bank CEO, “There can be no doubt that [Basel III] will produce a drag on economic recovery.”

This statement relates to the core headlines coming out of Basel III and to the auxiliary parts of the framework. Specifically, higher capital reserves under Basel III, increasing common equity capital to 4.5% of risk-weighted assets by 2015 and to 7% by 2019, are expected to cost global economy some 3.1% of overall worldwide income over 2011-2015, implying a loss of almost 10 million jobs worldwide.

Ratio of capital to risk weighted assets held on balance sheet
% of Assets
Source: World Bank Financial Stability Indicators

In addition to the cost of rising capital reserves, Basel reforms include the idea of imposing a tax on the systemically important (aka larger) institutions, known as SIFIs. In addition to amounting to a tax on consumers (especially in the markets where a small number of larger banks controls the market for services, such as the Euro zone), such a charge will not address the issues of product (rather than institutions) specific risks.

Finally, Basel III introduction of the new liquidity and funding rules offers another example of a potentially market-restricting intervention that can end up costing the sector dearly, while producing little real benefit in alleviating systemic risks. The idea behind these measures is to ensure that financial institutions hold sufficient liquid reserves buffers to withstand a bank run, as well as to reduce the banks over-reliance (especially in Europe) on short-term wholesale funding. At the very best, these measures will lead to a significant cut in the banks’ ability to generate credit in the future.

At the same time, it is highly doubtful that any level and quality of reserves can ever guarantee a sufficient insurance against significant asset busts or even large liquidity events. Past history, as for example, analysed by a recent research paper from the University of Pennsylvania, clearly shows that regulatory tightening following previous episodes of major financial markets corrections had inevitably failed to prevent or even to significantly alleviate future financial busts. Instead, every episode of deep markets corrections was followed by severe tightening of financial regulation, prompting lenders to increase their reliance on more complex financial products. The levels of reserves never once were found sufficient to cover the sector.

More specific potential adverse effects of Basel III and Dodd-Frank Wall Street Reform and Consumer Protection Act changes relate to all three core sides of financial services business models: the trading side, the capital side and the funding side. On the trading side, increased capital reserves will likely constrain trading exposures, and cover for securitization and counterparties. The positive here will be a shift from narrowly traded derivatives to exchange-traded and centrally cleared derivatives. The net effect, however, will be smaller new products base in the sector and tighter margins, leading to a pressure on the returns.

Another study, titled “Global financial services: a New Regulatory Normal” prepared by the GCED identified a series of other potential risks in the latest regulatory reforms processes worldwide. In addition to the main headlines on capital side of the reforms outlined earlier, ongoing regulatory changes imply introduction of pro-cyclical capital bases, tighter restriction of capital allowances to paid up capital and retained earnings, elimination of hybrid products from capital base, as well as deferred taxes and intangibles. Restriction of minority equity and leverage ratios alongside with aforementioned capital rules changes will also likely lead to higher cost of banks capital and origination bases, implying restricted lending and associated jobs and income losses in the real economy. Lastly, stressed liability-linked liquidity provisions and efforts to reduce maturity mismatch via reduced reliance on short-term funding will further depress lending.

All of this suggests that going forward, banking sector in Europe and the US will face significant difficulties in generating new lending. In line with this, financial services growth is likely to shift away from traditional banking and brokerage, and toward less regulated and liquidity-rich sovereign wealth players and alternative lenders and investors.

This, in turn, will have profound effects on economic development, as the aforementioned GCED research highlights. In addition to tighter credit markets for companies and households, new rules are likely to lead to significant increases in costs and access barriers to capital for long term assets, such as infrastructure and plant investment. This development can also amplify, not reduce, the links between the exchequers and the banks. As banks will play an increasingly important role as the holders of public debt and as the source of tax revenue, current liquidity traps will be deepened. Liquidity supply and velocity of money will be reduced and M2 and broader money supply metrics will continue to lag liquidity injections from the central banks.

The resulting risk of closer political and economic integration between the financial services providers and the states can create simultaneously a new layer of inefficiency in financing of economic growth. It can also amplify shared risks, setting up the next crisis, this time around – with potential for a full contagion from the financial services to the sovereigns.

In the light of these regulatory changes and the convergence of regulatory regimes, banking and other financial services institutions face the need to provide sufficient internal buffers against the rising regulatory risk. These buffers require service providers to:

1. Rethink their business models to simplify operations and enhance ability to deal with systems and models complexity
2. Rebuild their balance sheet and focus on the new capital and leverage requirements
3. Actively pursue opportunities for mergers and divestitures
4. Improve their understanding of clients’ behaviors and preferences
5. Reconnect with their clients by investing in client analytics to gain insights
6. Provide clients with more and more complex and better responding services and data
   

In short, addressing business challenges presented by the ongoing processes of regulatory reforms worldwide, the banking and financial services sector will have to get much smarter in structuring future strategies for growth and operational processes.

Economics 6/11/10: Private sector response to DofF estimates

Yesterday’s morning note from Eurointelligence.com – a politically neutral economics site read: “A really bad day for European peripheral bond markets, as market participants realise that the Irish recovery plan is a pile of baloney, based on wishful thinking and unrealistic forecasts (which are shocking also believed by private sector forecasters in Ireland). The assumption is essentially that the crisis has no real GDP effect. This is the Irish government’s official forecast for the growth, inflation and unemployment for the next four years, contained in the Irish budget plan."

Summary here:

Their analysis is illustrated by a chart from Calculated Risk showing scary dynamics:


But the ‘happy-to-parrot DofF’ quasi-official analysts of IRL Inc took a different view of the numbers. So was Eurointelligence right in being sarcastic about ‘private sector forecasters’ misfiring in their enthusiasm for DofF numbers?

Per one ‘research note’ Irish deficit problems are attributable, at least this year, to things like ‘decrease in GDP’ (apparently, something no one could have foreseen). And palatable comparisons are being made between the UK adjustments planned ahead (less than 6% of GDP over next 5 years) and Irish adjustments envisioned by DofF (9.5% of GDP through 2014), without actually bothering to check what’s happening between Euro and Sterling lately, or possibly worse – without understanding the relationship between currency value and deficits.

One of our most cheerleading ‘analysts’ remarked that markets “may take some consolation from the depth of next year's adjustment, which is at the high end of expectations” obviously confusing their own sales pitch to the clients with the market view. Markets promptly corrected this by bidding up our bond yields.

Defending DofF ‘forecasts’ was done on a reference to a single figure that almost matches this broker’s view and a claim that we can’t really tell much about their realism because there isn’t enough detail provided by DofF. It sounds like an argument that famines are caused by the lack of food. The entire point of the DofF 'forecasts' was to provide certainty. The fact that the Department failed to do so escaped the broker.

Funny thing – the same broker lauded the details provided on interest payments from the recapitalization promissory notes. “The general government balance will reflect no promissory interest charge until 2013, when the charge will be €1.75bn for two years, reducing thereafter. Alleviating uncertainty around these charges is a positive but also reinforces the reality of a challenging fiscal situation.” Alleviating uncertainty? Did anyone notice the fact that DofF is projecting forward 4.7% interest rate – the average for 2009 – despite the fact that the entire universe expects ECB rates to rise by 2013? You’d expect the brokers to understand that no yield curve in this world remains flat for 5 years. Then again, may be this is not something our official ‘economists’ are aware of.

Another broker produced an equally priceless analysis: “The revised forecast [of 1.75% real growth next year] is below the median projection of 2.0% growth in the latest Reuters monthly Irish economists’ poll.” Oh, mighty, that wouldn’t be the same economists’ poll that missed the Great Recession and predicted soft landing for the property markets, failed to detect the beginning of collapse in Exchequer revenues and spot a market crash. Oh, and just in case you still doubt the powers of the Reuters ‘Irish economists’ poll’ – the poll covers only the 'economists' who thought Irish banks shares back in 2007 were not overvalued and Anglo was a great little bank besieged by bad short-sellers…

About the only research note on Irish Government announcement that didn’t cause a severe tooth-ache like reaction when I read them was NCB’s note.

The prize for the least readable (and least informative) commentary goes to Goodbody’s note, which spots a host of typos, grammatical errors, confusion and absolutely ludicrous assertions that “recent bond market jitters have been caused by factors outside of Ireland’s control, namely the fear that some European nations are considering a mechanism for restructuring of euro-area member’s sovereign debt at some stage in the future.” I mean what can you make of an ‘economics’ analysis that claims that ‘factors outside’ country control can override the fact that we have 32% deficit this year?! To me, it looks like a worldview which would miss a nuclear blast for a match strike.

Economics 6/11/10: Two charts - IRL & Spain

Two interesting charts on 5 year bonds for Ireland and Spain, courtesy of CMA:
What's clear from these charts is the extent of inter-links between banks and sovereign credit default swaps. In Spain at least three core banks - La Caixa, BBVA and Banco Santander act as relative diversifiers away from the sovereign risk since late October. In Ireland - all of the banks carry higher risk than sovereign. Another interesting feature is a significant counter-move in the Anglo CDS since late September. This, undoubtedly underpinned by the large-scale bonds redemption undertaken by Anglo at the end of September. Thirdly, an interesting feature of the Irish data is that CDS contracts on Anglo, IL&P and AIB are now trading at virtually identical implied probability of default.

Lastly, Irish sovereign debt is now trading at probability of default higher than that of the Spanish banks!

Economics 4/11/10: Early DofF Estimates for Budget 2011

DofF has published some preliminary projections for Budget 2011 tonight, titled "Information Note
on the Economic and Budgetary Outlook 2011 – 2014 (in advance of the publication of the Government’s Four-Year Budgetary Plan)". Catchy, isn't it?

Here's my high-level read through:

1) pages 2-3 (note DofF couldn't even number actual pages in the document) present some rosy scenarios concerning growth. Most notably, DofF doesn't seem to think that Dollar is going to devalue against the Euro significantly in 2011. As if QE2 will have no effect or will be offset, under DofF expectations by a QETrichet. This is non-trivial, of course. Price of oil is expected to rise by 10.4% over 2011, but dollar will devalue by just 3.7% and sterling by 2.3%. Absent robust demand growth (per DofF-mentioned global slowdown) what would drive oil up at a rate more than 4 times dollar devaluation? This is non-trivial - any devaluation of sterling and dollar will impact adversely our exports and will increase our imports bills, chipping at GDP and GNP from both ends.

2) "in overall terms, real GDP is projected to increase by 1¾% next year (GNP by 1%). This takes account of budgetary adjustments amounting to €6 billion, which are estimated to reduce the rate of growth by somewhere in the region of 1½ - 2 percentage points. Nominal GDP is set to grow by 2.5% in 2011, implying a GDP price deflator of ¾%." Errr... ok, I can buy into low inflation, but... folks - DofF is talking tough budget. which will mean inflation on state-controlled sectors is going to be rampant. To keep total inflation at just 0.75%, you have to get either a strong revaluation of the euro (ain't there, as we've seen in (1)) or a strong deflation in the private sectors (possible, but if so, what would that do to Exchequer returns and to domestic activity? Interestingly, DofF refer to HICP, not CPI when they talk about moderate inflation of 3/4%. Of course, they wouldn't dare touch upon the prospects of our banks skinning their customers (err... also shareholders, rescuers etc) with mortgage costs hikes.

3) Now, consider that 1.75% growth in real GDP and 1% growth in GNP. Where, exactly will this come from? IMF projection for WEO October 2010 (before Government latest adjustment in deficit announcement) factored in 2.277% growth in constant prices GDP for 2011. DoF says that the reduction in Government consumption will amount to 1.2-2% point in the rate of growth. This is, I assume, before factoring in second order effects of higher taxation measures - just a brutal cut. So IMF, less DofF estimate leads to growth rate of 0.227-1.077%, which is less than what DofF assumes. Of course, that range - with a mid-point of 0.652% still does not capture the adverse effects of increased taxes and other charges, which - if we are to take €6bn headline figure for deficit reductions, applying 1.2-2% of GDP net adjustment on expected Government consumption side and factoring in stabilizers of 20% implies that DofF is aiming to get well in excess of €1.9-3bn in new revenues in 2011. Of these, maximum of €1.1-1.2 billion can be expected to arise from DofF forecast growth, leaving €0.8-1.9bn to be raised from tax increases and other charges. Apart from being optimistic, it does look to me like DofF didn't factor the effects of this into their growth projections.

4) About the only realistic assumption that DofF makes is that investment will contract by far less next year than in 2010. The reason is simple - stuff is going to start falling apart in private sector, so companies will have to replace some of the capital stock sooner or later. I can tell from here whether investment will fall 6% (as DofF assume) or 10%, but I doubt there is much upside from DofF assumption. The problem is that if you expect investment goods decline to be reversed on plant and machinery side (continuing to allow for investment to fall further on housing and construction sides) you are going to get an increase in imports, as we import much of equipment we use. So I suspect imports are going to rise more than 2.75% that DofF factored into their estimates.

5) I also think DofF are too optimistic on the employment contraction side. The Department assumes -0.25% change in overall employment levels in the Republic. I would say that several longer term trends are going to push this deeper into the red: pharma sector restructuring, continued shutting down of MNCs-led manufacturing, declines in public contracts etc.

6) All of the above is crucial, as per Table 3 we can see that even with the €6bn taken out, 2011 Exchequer balance will be exactly the same as in 2010: €19.25bn deficit in cash terms. In other words, folks - of the total €6bn in cuts almost €3.1bn will go to cover... errr... you've guessed it - BANKS! another €1.25bn to cover interest on the BANKS rescue notes (net under Non-voted expenditure). More bizarre, unless you understand our Government's logic, which escapes me - our Current Expenditure will not fall next year at all. Instead it will rise from €47.25bn in 2010 to €49.75bn in 2011, while Current Revenue will fall by €500mln, leaving our Current Budget Balance at -€16.25bn - deeper than -€13.5bn achieved this year. Under this arithmetic, the only way this Government can claim that it will be on any track in the general direction of 3% deficit by 2014 is by building in some mighty optimistic assumptions on growth side, plus projecting no further demands for funding from the banks.

7) Now, let me touch upon the last part of the concluding sentence in (6) above. Oh, boy. The Government, therefore is reliant on €31bn in promisory notes to cover the entire rescue of the banking sector. Yet, not reflected in any of DofF estimates, AIB's latest failure to raise requisite capital is likely to cost this Government additional €2bn on top of already promised funds. Toss into the mix expected losses for 2011-2012 on all banks balancesheets, and you get pretty quickly into high figures. Let's suppose that the whole banking sector will cost the state ca €60bn (this is well below my estimate of 67-70bn, Peter Mathews' estimate of 66.5bn, etc). The state will be on the hook for some €29bn more in 'promisory' notes. Suppose none are redeemed and no new borrowing against them takes place. The gross cost per annum of these notes will be roughly at least what DofF estimated for €31bn or €150mln in 2011, while the borrowing requirement for the state will have to go up by €2.9billion annually (if structured as previous promisory notes).

Overall, I have significant doubts that the numbers presented in these early estimates will survive the test of reality. However, the Department of Finance seemed to have gotten slightly more realistic in these estimates, when compared to the stuff produced a year ago. It remains to be seen if the learning curve is steep enough to get them to reach full realism by the Budget 2011 day.

Economics 3/11/10: Live Register update

As promised, here are the updated charts for the Live Register:
Unemployment (implied rate) above clearly shows the relative size of adjustment over the last 3 months. Chart below shows the last 4 years worth of Live Register:
Next, rates of change
Monthly series clearly showing some serious decreases over the last 2 months.

Economics 3/11/10: Live register

Being away from Dublin this week means I am missing both the Exchequer returns and Live Register data. I will, of course, update the charts on both in due time - probably closer to the weekend.

While I am away, here is the best analysis of the LR data I've seen so far (well done, Brian!) issued earlier today by the NCB Economics team:

" On a seasonally adjusted basis there was a monthly decrease of 6,600 in the Live Register (unemployment claims) in October 2010, following a fall of 5,400 in September. This is the largest monthly fall in the numbers on the Live Register in the last ten years

[I seem to think it is in 14 years, but I might be wrong - again, need my trusted database off my trusted Apple to check]

In terms of flows in/out, which are not seasonally adjusted figures, there were 49,827 new registrants on the Live Register in October. 62,691 persons left the register in October.

It does appear as if job shedding is easing in the economy with redundancies (separate statistics from Live Register) in September down 30% from September 2009 levels . In Q3 2010 redundancies were down 24% from Q3 2009, but despite this the rate of inflows into the Live Register is still elevated highlighting that net job creation is still anaemic given the growth in the labour force.

We have no timely data on employment creation and emigration. In other words it is impossible to decipher whether emigration rather than job creation is causing the large outflows from the live register. It is likely a combination of both, as even in the good times Ireland was characterised by a large amount of churn in the labour market, with for example approximately 13% job gains in 2006 versus 10% job losses for a net gain of 3%. This points to the flexibility of the Irish labour market, which is ultimately required for Ireland to dig its way out of its problems.

The standardised unemployment rate in October was 13.6%, down from 13.7% in September and the peak of 13.8%."

So my two cents to add are:

• Decreases in long term claimants numbers (173 yoy) are small compared to unadjusted decreases in short term claimants (36,008 yoy) suggesting that we might be witnessing some exits from the long term list of older LR recipients (by duration, not age) and simultaneous transfer of newer vintage LR recipients into the long term lists. If true, then it is more likely that as older LR claimants lose their benefits or migrate or both, newer recipients move into their places.
• Net decreases in LR claimants can be accounted in part by the terminations of JB claims and failures to secure means-tested JA status.
  
• The numbers of part-time and casual workers on LR is still rising (+ 1,045 mom), suggesting that quality of employment (remember, we are after higher quality jobs in this country, aren't we) is deteriorating.
• 3,100 exits from the LR are accounted for by workers of age 25 or less, in other words the very demographic that is more likely to engage in education or is at a higher risk of emigrating, suggesting that a significant proportion of the LR decrease might have little to do with net jobs creation in the economy.
• Lastly a quick comment on labour force flexibility referred to in NCB note. In my view,w e do have much more flexible flows out of the country (disregard for now inflows into the country, as these hardly matter in our current economic environment). However, in contrast with previous recessions and certainly in contrast with 2006, the little data we have shows that foreigners and younger Irish are dominating the outflows through emigration, while the longer term unemployed of older age and middle-aged families are stuck either due to lack of skills (the former) or due to negative equity (the latter). This implies that if the current trends continue, we are at a risk of encountering significant drain of talent and human capital out of this country. Of course, our bankruptcy laws will make it impossible for those who emigrate alongside defaulting on a mortgage to come back into the country when recovery takes place.
  

Economics 2/11/10: Spot the odd ones out

As of yesterday's close, implied probability of default based on CDS spreads and spreads themselves are:
Source: CMA.

Economics 31/10/10: Mortgages, relief and stimulus

David McWilliams' idea of deferring mortgage repayments for 2 years is continuing to generate some discussions in the 'new' media. Here are my thoughts on the topic.

David's idea starts from the right premise that households are currently suffering from mortgage/debt repayment burden that is non-sustainable in the current economic conditions and acts to depress consumption and household investment. But in my view, it is not going to yield any significant impact on the economy.

As expected incomes fall due to:

• continued recession in the economy (courtesy of the insolvency crisis we face across the entire economy);
• elevated risk of unemployment (ditto);
• rising tax burden on households (courtesy of the Government's perverse logic which puts the needs of financial services and Exchequer ahead of those of the real economy - households and firms);
  
• heightened risk of further tax increases in the future (ditto);
  
• behavioral implications of the severe and deepening negative equity (being further reinforced by the FR and Government denial of the problem and asymmetric treatment of development debts and household debt); and
• continued increases in the cost of mortgages finance and credit (courtesy of the Government approach to dealing with the banking crisis)
  

Irish households are indeed under a severe financial stress. This stress is amplified by the adverse selection of younger (and thus more heavily leveraged) households into the higher risk of unemployment. These very households are also more important contributors to future private investment side of the economy, as older households are dis-saving to consume.

Collapse of consumption and household investment we are witnessing today is the direct outcome of the above forces and it will continue to worsen as long as households' disposable after tax incomes continue to decline and remain at risk of further pressure. In addition, non-discretionary segment of consumption (energy, education, transportation and health) show no signs of price deflation, implying that discretionary disposable after tax income - the stuff we get to spend in the shops or invest - is even more distressed.

The problem here is not that we face a temporary shock to our income. The problem is of debt overhang - basically, the insolvent nature of our households' balancesheets.

Thus, any solution to this problem will require a permanent debt writedown. It cannot be resolved by temporarily suspending mortgages repayments for several reasons:

1. Temporary suspension of mortgages repayments will not draw down the overall debt burden, as banks will reload increases in mortgage finance costs into the future to offset for losses incurred during the holiday even if there is no roll up of interest during the holiday. In other words - suspending mortgage repayment for 2 years will likely lead to banks pushing even higher cost of mortgages interest into years 3 and on for all households concerned;
2. Any rational household will anticipate (1) above to take place and will ramp up precautionary savings to compensate for expected cost increases in their mortgages, withdrawing even more cash from today's consumption. A mortgage holiday in these conditions will lead to zombie banks turning into zombie households;
3. Any rational household will, also in anticipation of (1) withhold any purchases of property until the full realisation of true future mortgage finance costs takes place post holiday;
   
4. If any suspension of mortgages finance involves rolling up of the interest for 2 years, the burden of future mortgage liabilities will increase dramatically, which, once again will be anticipated by the rational households. As a result, households will take 2 years worth of 'free' rent and then default at the point of interest roll up kicking in. We can expect a wall of mortgages defaults in 2013;
   
5. In order for the repayment holiday to have any real effect, the long term growth rate in personal disposable income will have to exceed: increase in the cost of mortgage finance post-holiday + inflation - tax increases expected. This, using current growth estimates etc suggests that in order for a 2 year holiday on repayment of mortgages to have any positive effect, our aggregate expected growth rate in personal income should be in excess of 50% in years 2013-2018. This is clearly not anywhere near being realistic.
   

Once again, the problem we face is the size of leverage taken on by the Irish households. Whether reckless lending or borrowing or both caused this problem is irrelevant. Households become long-term insolvent when their total debt liability rises above 4-5 times their earnings even in the moderate growth in income environment.

We have - on aggregate - households facing:

• current long and short term debt burden of ca 145% of GNP, and
  
• expected (2014) sovereign debt burden of ~140% of GDP or ca 165% of GNP (under rather optimistic assumptions on GDP/GNP gap) - at least 80% of this will have to be repaid out of the pockets of our households.
  

The problem is that these headline figures conceal imbalances in distribution of debt.

While on per-capita basis the overall household debt liabilities amount to ca 310% of our national income, in real terms what matters is the incidence of the debt on productive households. We currently have ca 41.3% of population in employment (or 1,859,000). Of these, 552,900 are in the age group of 25-34 years of age, 469,600 are in 35-44 years of age and 393,900 are in the age group 45-54 years of age. Assume that the demographic pyramid does not change (for better or worse) in the next 10 years. Total employment pool of those that can be expected to carry the debt burden is actually closer to 1.42 million or 31.5% of the total population of the country.

This raises public and household debt leverage ratio on population that can be expected to repay it to a whooping x10 times household income. This, folks, is a bankruptcy territory for roughly speaking 1/3 of our entire population or for nearly 100% of our productive population.

A 2 year holiday from mortgages repayment will simply not solve this problem. Only significant debt write-off of household debts or full restructuring of our sovereign debt and deficit (to eliminate the need for future tax increases and reverse recent tax increases) or a combination of both will be able to correct for this severe debt overhang.

Economics 31/10/10: €15bn in cuts will not be enough

This is an unedited version of my article in yesterday's Irish Examiner.

The last three days have seen dramatic volatility and extreme upward pressures on Irish, as well as Greek and Portuguese Government bonds. Briefly, early on Thursday morning, Irish 10 year bonds have set a new all-time record with yields reaching North of 7.07%. Much of these changes have been driven by the budgetary news from all three countries.

First, Greece and Portugal have shown the signs of increasing uncertainty about projected tax revenues and ability to deliver on ambitious austerity programmes.

Then, Ireland came into the line of fire.

Back in December 2009, the Government outlined a plan for piecemeal cuts in deficits over 2011-2014 that added up to a gross value of €6.5 billion (with at least €3 billion in tax measures). This was supposed to get us from having to borrow €18.8 billion in 2010 to a deficit of ca €9 billion in 2014. All courtesy of robust economic growth of more than 4% per annum penned into the Department of Finance rosy assumptions for 2011-2014.

This week, the Minister for Finance had to come down from the lofty heights of the “now you see the deficit, now your don’t” estimates by his Department. Courtesy of continuously expanding unemployment, declining tax revenues, plus ever-growing interest bills on Government debts, the headline gross savings target for 2011-2014 has been increased to €15 billion.

Dramatic as it might be, this figure is still far from being realistic – the fact that did not escape the bond vigilantes and some analysts. More than that, it represents the very conservative ethos of the Department of Finance and the Government that got us into a situation where three years into the crisis Ireland is still light years away from actually doing anything serious about correcting its fiscal position.

Let me explain.

First of all, take the actual announced plans for cuts in public spending. Over two months ago I have argued in the media that to get us onto the track toward reaching the goal of 3% to GDP deficit ratio, we need ca €7 billion in cuts in 2011, followed by €5 billion in 2012. The grand total of gross deficit reductions from now through 2014 adjusting for the effects of these cuts on our GDP and unemployment, plus steeper cost of financing Government debt, excluding new demand for funding from the banks is not the €15 billion, but €19-20 billion. In other words, once fiscal stabilizers (automatic clawbacks on Government spending) are added in, to achieve 3% target requires more than 33% deeper cuts than Minister Lenihan announced this Wednesday.

The markets know this. Just as they know that given the Government record to date there is very little chance that even €15 billion in cuts will be delivered. This mistrust in Government’s capacity to actually administer its own prescription is manifested most explicitly by the Croke Park agreement that effectively put one third of the current public expenditure out of reach of Mr Lenihan’s axe. It is further highlighted by the fact that this Government has failed to
substantially reduce public spending bills from 2008 through today. Back in 2008, net government spending stood at €55.7 billion. This year, we are likely to post a reduction of just €2.4 billion on 2008, all of which is accounted for by cuts in capital investment programmes.

Third, the markets also understand long-term implications of deficits. Even if the Irish Government manages to bring 2014 deficit close to 3% target, our Sovereign debt will grow by over €5 billion in that year. At this pace, Irish Exchequer is likely to be on the hook for a debt to GDP ratio of 125% by the end of 2014 reaching over 140% if expected additional banks liabilities materialise in 2011-2014. And all of this after we account for Mr Lenihan’s €15 billion cuts planned for 2011-2014.

Fourth, Government budgetary arithmetic falls further apart when one considers economics of the proposed deficit reduction measures. So far, the Government has planned for €3 billion increase in taxes on top of tax revenues gains due to rosy economy growth expectations between now and 2014. €15 billion target announcement raises this most likely 2-fold.

I have severe doubts that this economy has capacity left for tax revenue increases. Signs are, households are struggling with personal debts and their disposable after-tax incomes are barely sufficient to cover day-to-day spending. Credit card debts and utilities arrears are rising, savings are falling – all of which points to growing stress. Weakening sterling is pushing more retail sales out into the North just in time for Christmas shopping season. Cash economy – judging by
anecdotal evidence and corporate tax revenue in light of booming exports sectors – is expanding. The tax base is shrinking due to unemployment, underemployment and falling earnings.

Again, any rational investor will look at this as the evidence that the Government has run out of capacity to tax itself out of the fiscal corner.

But wait, this is only half of the story. The other half relates to the banking side of consumer affairs. In 2011 we can expect significant increases in mortgages costs as Irish banks once more go rummaging through the proverbial couch in search for a new injection of pennies. Bank of Ireland’s bond placing this week, with a yield of 5.4%, suggests a bleak future for lending markets. Any increases in mortgages costs will hike Government expenditure (by raising the cost of interest subsidies), hammer revenues (by reducing household consumption) and trigger new demands from banks for capital (to cover defaulting mortgages).

None of which, of course, appears to be attracting much attention from the Upper Merrion Street. At least judging by the budgetary projections released so far. At the same time, these numbers are impacting our long term growth potential and increasing the probability that Ireland, in the end, will have to restructure its public debt.

This week, similarly brutal arithmetic concerning Greek fiscal situation has prompted Professor Nouriel Roubini to make a dire prediction of the inevitable default by Greece on its Sovereign debt. Given Minister Lenihan’s recent statements and his boss’ staunch unwillingness to scrap the Croke Park agreement, it is hard to see how the forthcoming budgetary framework for 2011-2014 can get us out a similar predicament.

Economics 30/10/10: Euro area growth forecast

Updating leading indicator data for Euro area growth from Eurocoin:
Having posted bang on forecast for September (forecast was 0.34 and this is what the final number came in at), I missed October turning point. The latest uplift suggests growth of 0.9% in Q3, but I am not convinced for a number of reasons:

• Growth in the lead indicator is driven strongly by the EU Comm survey of business expectations which has been trending strongly up since Feb 2010. In the mean time, PMIs-based expectations metric is showing a renewed expectation for a slowdown.
• Consumer confidence surveys are flat.
• Exports (to August) are down

So I am still sticking to Q3/Q4 growth at 0.2-0.25%

Economics 29/10/10: Retail sales

After two weeks of absolutely excessive work loads, including a week of marathon teaching (gotta love that feeling of total exhaustion after 5 days worth of 6 hours straight lecturing on top of regular work), the blog is back.

The first order of the day - catching up with today's data. Retail sales... well, they are still tanking. Predictably, given weakening sterling (incentive to shop North), beginning of the festive season shopping (another incentive to head North for larger ticket items savings) and continued decline of overall economy.

Per CSO today, let's deal with the volumes and values of total sales first

• Retail Sales volume decrease by 0.3% in September 2010 compared with September 2009
• The volume of retail sales (i.e. excluding price effects) decreased by 0.3% yoy and declined 0.9% mom.
• The value of retail sales decreased by 2.6% yoy and there was a mom change of -1.2%.

Few charts now:
Looks like bottom fishing just got slightly more fun on both value and volume. And it's too bad you can't short retail sales:
Relative to peak, total sales are......errr... sickening?

As I highlighted on many occasions before, our Government's desire to subsidize Japanese, Korean, French, German etc manufacturers of motor vehicles, coupled with the vanity plates year have meant that our total retails sales are rather overly optimistic when it comes to determining the real retail environment out there. So let's drop Motor Trades out of the data:

If Motor Trades are excluded, there was

• an annual decrease of 4.1% in the value of retail sales and a monthly decrease of 0.9%
• volume of retail sales decreased by 2.5% in September 2010 yoy and fell 0.8% mom.
• thus, increases yoy in volumes were posted in: Motors (+13.2%), Non-Specialised Stores (+0.8%)
• of course, decreases were led by Other Retail (-12.4%) and Bars (-11.6%).
• mom declines in the volume "were evident in ten of the categories while only three categories showed monthly increases in September 2010". So broadly, monthly adjusted series were heading down.

Charts:
Yeah, that does look like an AIB share price chart... and then the rates of change:
Painful? Yes. Brian & Brian will not be happy campers - VAT receipts must be depressed. Jobs are also clearly going to be under pressure as we exit festive season, implying that absent a dramatic reversal of the recent trends, retail sector will be in severe pain comes January.

Not that it was avoiding that pain in recent past:

We now have provisional estimates for Q3 2010, so let's update quarterly graphs - which confirm broadly the weakening trend:

• volume of retail sales increased by 0.2% in the third quarter of 2010 compared with the same quarter in 2009, and
• there was no change in the volume of retail sales when comparing the third quarter of 2010 with the second quarter.
  
• If Motor Trades are excluded the volume of retail sales decreased by 2.3% year-on-year, while the quarterly decrease was -2.0%.
  

Economics 14/10/10: Innovation Union from European Union

Just in case you thought our own Government's naive and overly optimistic 'knowledge economy' papers were original in their lack of understanding of business, take a look at the latest EU-wide policy idea.

According to the European Commission boffins, by 2020 we will be living not in a Fiscal Union (won't happen, cause Germans wouldn't want a de jure responsibility for PIIGS) or the Monetary Union (can't last much longer in its current shape due to contradictory forces of sovereign economic policies) or even a Bailout Union (the current reincarnation of the big idea)... instead we will be the happy citizens of an Innovation Union.

The details (if one call them such) of this well-meaning stuff are provided here.

Not to waste anybody's time with navigating the lofty dream space of European 'thinkers' on development policy, let's cut straight to the chase. Two things come to mind reading the document.

1. It is aspirational (good thing) of benefits of the Innovation-driven economy and is strong on traditional bits of bureaucratic competency, promising good targets on legal environment and strategic partnerships, but
2. The big iceberg awaiting the Euro dreamliner (err... Titanic) is also right here - on the Welcome page: "Innovation as described in the Innovation Union plan broadly means change that speeds up and improves the way we conceive, develop, produce and access new products and services. Changes that create more jobs, improve people's lives and build greener and better societies."
   

Spot what's missing in the grand vision? Here:

• Sales
• Marketing
• Logistics
• Commercialization
• Consumer
• Finance (especially the issue of relationship between current fiscal imbalances and promised subsidies)
  

You see, folks in Brussels think that once a nerdy type draws a squiggly thingy on an i-pad and another nerdy types says 'Cool, man!', you instantaneously get more jobs, improve lives and green-up the bettered society. Not much else is required:

• Lower taxes to promote greater consumption, especially given we are facing rapidly aging and more risk averse European demographic, which is not exactly representative of early adopter consumer types needed for Innovation Union? Nope, not needed.
  
• Lower state charges to promote more investment, again especially in economies where savings will be increasingly consumed by pensioners instead of invested by the younger income earners? Why bother!
  
• Fewer Nanny State regulations to improve 'access', especially in the regulatory environment that has by now even managed to ban insurance companies from pricing the basic risks? Will have Innovation without that, thank you.
  
• More entrepreneurship to support deployment of products into the marketplace, again a major bottleneck in the aging and largely socially immobile society of EU? Uh, oh, what's 'entrepreneurship'?
• Improved early stage finance environments with fewer state subsidies inducing distortions in the market, especially crucial given the state of public finances in the non-Innovation EU? We can't have anything that involves 'fewer subsidies'!
  

So this is why, in my view, the latest idea, despite being aspirational and well-intentioned risks becoming yet another Titanic of economic policy, to join such hits of the past as:

• The Lisbon Agenda (which aimed for EU to overtake US in terms of economic growth, jobs creation etc by 2010);
• The Social Economy (which aimed for the EU to become a singular welfare state where the young labour away assets-less and savings-less to preserve the status quo of landed gentry and pensioned state employees);
• The Knowledge Economy (which aimed for the EU to become a heaven for all sorts of knowledge), and
• The Green Economy (which aimed to turn EU into one big nature preserve at a wave of a magic wand of subsidies).

What can possibly go wrong this time around with Innovation Union, then?