12/09/2011: CHF and the "soon-to-be-busted" peg

Some weeks ago I have addressed one of the core reasons why the CHF/Euro peg, announced last week by the SNB will not hold for longer than 1-2 months. Here are the previous links to:

1. Small Open Economy argument (link)
   
2. Small Open Economy as safe haven argument (link)

Since then, in last weekend comment to the Sunday Times, I outlined another core reason for the peg to fail - the SNB has been brandishing the war chest of some USD 230 billion of FX funds that it says will be delivered into the battle field to support CHF, should pressures on CHF/Euro cross continue to mount. Now, that number above is roughly 1/2 of the Swiss 2010 end-of-year M1 money supply.

• Imagine the scale of intervention and the resulting interest rates hikes that will be required to extinguish inflationary pressures arising from this?Up by 50-100%?
• Now imagine what will happen with CHF cross with the euro if the interest rates in Switzerland were to, say, rise by 50-100%? Correct - demand for CHF will go through the roof, undoing any CHF/euro supports erected before.
• And alongside this, imagine what the 50-100% increase in interest rates do to capital investment and corporate balancesheets in Switzerland? Again correct - corporates, spared by SNB peg from being destroyed by the exchange rate appreciation will now face the very same FX pressures as before, plus higher cost of capital

And now, folks, for the third weighty reason why SNB will be forced to abandon its peg. Medium-term promise of a devalued CHF coupled with zero interest rates (0-0.25% on 3mo Libor target against Euribor 1.56% comp) implies a huge incentive for carry trades origination in very short term run, while in the medium-term, expected long-term revaluation of the CHF creates an incentive to make carry trades very short-lived. Both are not so much the forces to drive demand up, but the forces to destabilize fundamentals-determined medium-term FX rates.

Good luck betting that CHF peg holds, my friends...

12/09/2011: IMF admits failures in debt risk forecasting frameworks

In the analysis published just minutes ago, the IMF ("Modernizing the Framework for Fiscal Policy and Public Debt Sustainability Analysis" by the Fiscal Affairs Department and the Strategy, Policy, and Review Department, dated for internal use from August 5, 2011) implicitly admits deep errors in the methodology for analyzing public debt dynamics. Given the magnitude of errors reported by the IMF (see table summary below), the entire exercise puts the boot into the EU-led attacks on the Big 3 ratings agencies - it turns out that the wise and uncompromisable IMF was not much good at dealing with fiscal sustainability risks either.

Here are the core conclusions: "Modernizing the framework for fiscal policy and public debt sustainability analysis (DSA) has become necessary... [This paper] proposes to move to a risk-based approach to DSAs for all market-access countries, where the depth and extent of analysis would be commensurate with concerns regarding sustainability..."

DSA could be improved, according to the IMF report, through a greater focus on:

• Realism of baseline assumptions: "Close scrutiny of assumptions underlying the baseline scenario (primary fiscal balance, interest rate, and growth rate) would be expected particularly if a large fiscal adjustment is required to ensure sustainability. This analysis should be based on a combination of country-specific information and cross-country experience." (Note that in Ireland's case such analysis would probably require, in my view, using GNP metrics in place of GDP).
• Level of public debt as one of the triggers for further analysis: "Although a DSA is a multifaceted exercise, the paper emphasizes that not only the trend but also the level of the debt-to-GDP ratio is a key indicator in this framework. [Apparently, before the level of debt didn't matter much, just the rate of growth in debt - the deficit - was deemed to be important] The paper does not find a sound basis for integrating specific sustainability thresholds into the DSA framework. However, based on recent empirical evidence, it suggests that a reference point for public debt of 60 percent of GDP be used flexibly to trigger deeper analysis for market-access countries: the presence of other vulnerabilities (see below) would call for in-depth analysis even for countries where debt is below the reference point." [So, now, folks, no formal debt bounds, but 60% is the point of concern. Of course, by that metric, IMF would have to do country-specific analysis for ALL euro area states]
• Analysis of fiscal risks: "Sensitivity analysis in DSAs should be primarily based on country-specific risks and vulnerabilities. The assessment of the impact of shocks could be improved by developing full-fledged alternative scenarios, allowing for interaction among key variables..." [Another interesting point, apparently the existent frameworks fail to consider interacting risks and second order effects. That is like doing earthquake loss projections without considering possibility of a tsunami.]
• Vulnerabilities associated with the debt profile: IMF proposes "to integrate the assessment of debt structure and liquidity issues into the DSA." [Again, apparently, no liquidity risk other than maturity profile analysis is built into current frameworks]
• Coverage of fiscal balance and public debt: "It should be as broad as possible, with particular attention to entities that present significant fiscal risks, including state owned enterprises, public-private partnerships, and pension and health care programs." [It appears that the IMF is gearing toward more in-depth analysis of the unfunded state liabilities, such as longer-term liabilities relating to pensions and health expenditure, as well as more explicitly focusing on unfunded contractual liabilities, such as specific contractual exposures on state pensions. If that is indeed the case, then there is some hope we will see more light shed on the murky waters of forthcoming sovereign exposures that are currently outside the realm of exposures priced in the market.]

Now, several interesting factoids on sovereign debt forecasts and sustainability as per IMF paper.

Here's the summary of IMF own assessment of its forecasting powers when it comes to Ireland: "The 2007 Article IV staff report included a public DSA, which showed that government net debt (defined as gross debt minus the assets of the National Pensions Reserve Fund and the Social Insurance Fund) was low and declining. In the baseline scenario, net debt was projected to fall from 12 percent of GDP in 2006 to 6 percent of GDP by 2012. The medium-term debt position was judged to be resilient to a variety of shocks. The worst outcome-a rise in net debt to 16 percent of GDP in 2012-occurred in a growth shock scenario. Staff identified age-related spending pressures as the most significant threat to the long-run debt outlook. The report noted that, although banks had large exposures to the property market, stress tests suggested that cushions were adequate to cover a range of shocks. Net debt to GDP subsequently increased nearly fivefold from 2007 to 2010, owing to a sharp GDP contraction and large fiscal deficits linked mainly to bank recapitalization costs."

No comment needed on the above. The IMF has clearly missed all possible macroeconomic risks faced by the Irish economy back in 2007.

On Greece: "In the 2007 Article IV staff report, staff indicated that fiscal consolidation should be sustained over the medium term given a high level of public debt and projected increases in pension and health care costs related to population aging. ...In the baseline scenario, public debt to GDP was projected to fall from 93 percent in 2007 to 72 percent in 2013. All but one bound test showed debt on a declining path over the medium term. In the growth shock scenario, debt was projected to rise to 98 percent of GDP by 2013. Two years later, staff warned that public debt could rise to 115 percent of GDP by 2010-even after factoring in fiscal consolidation measures implemented by the authorities-and recommended further adjustment to place public debt on a declining path."

So another miss, then, for IMF.

Here's the summary table on these and other forecast errors:

Next, take a look at a handy summary of debt sustainability thresholds literature surveyed by the IMF (largely - sourced from IMF own work):
So for the Advanced Economies (AE), debt thresholds range from 80-150 percent of GDP, the range so wide, it make absolutely no sense. Nor does it present any applicable information. By the lower bound, every euro area country is in trouble, by the upper bound, Greece is the only one that is facing the music. Longer term sustainability bound is a bit narrower - from 50% to 75%, with maximum sustainable debt levels of 183-192%.

And, for the last bit, off-balance sheet unfunded liabilities and actual debt levels chart:
Here's an interesting thing. Consider NPV of pension and health spending that Ireland is at - in excess of aging economies of Italy, Japan and close to shrinking in population Germany. One does have to ask the question: why the hell does the younger economy of Ireland spend so much on age-linked services and funds?

Another thing to notice in the above is that there appears to be virtually no identifiable strong statistical relationship between debt levels and pensions & health expenditures. This clearly suggests that the bulk of age-related spending looking forward is yet to be factored into deficits and debt levels. Good luck with getting that financed through the bond markets, I would add.

12/09/2011: Bilateral trade with Russia - latest data

Speaking at today's Croke Park conference "Finding New Markets: Doing Business in Russia, Central & Easter Europe and the Gulf", organized by Enterprise Ireland and Ulster Bank, I realized that in the rush of recent markets and crises, I forgot to update the charts on our bilateral trade with Russia, to reflect the latest data for May 2011 (released a couple of weeks ago).

Not to be a harbinger of only bad news, here's the latest bilateral trade results. And they are even more impressive, folks, than our overall external trade performance (see the latest data covered here).

The chart above shows truly dramatic gains in Irish exports since the beginning of this year. In May 2011, Irish exports to Russia amounted to €63.3 million against our imports from Russia of €9.2 million, implying the monthly trade balance of €54.1 million - the highest on the record. May was the second consecutive month of records-breaking trade surpluses in our bilateral trade with Russia with April surplus standing at €36.5 million.

In annualized terms, these numbers are also impressive. Using data from January through May 2011 and historical trends for monthly series from 2004 through present, my forecast for Irish exports to Russia for 2011 is to reach €569 million (range of €560-575 million) against projected imports of €115.7 million, to deliver a massive trade surplus of €454 million for the year as a whole.
If delivered, this level of trade surpluses will be more than double achieved in 2010 (€213.1 million) and will be 83% above the trade surplus achieved in 2007.

In terms of international comparatives, Russian market importance to Irish exporters is hard to overestimate. Take the first 5 months of 2011. Against bilateral trade surplus of €231.3 million achieved with Russia (an increase of 162% on same period in 2010), we have:

• Bilateral trade surplus of just €33.4 million with Brazil (with trade surplus falling in the first five months of 2011 by 23.7% compared to the same period of 2010)
• Bilateral trade deficit of €130 million with China (with trade deficit in the first five months of 2011 contrasted by the small trade surplus of €74 million achieved in the same period of 2010)
• Bilateral trade deficit of €86.2 million with India (with trade deficit in the first five months of 2011 showing further yoy deterioration on the deficit of €56.2 million achieved in the same period of 2010)
• Bilateral trade surplus with our traditional trading partners: Australia (€262 million down from €291 million yoy), Canada (€89.9 million down from €123.8 million yoy), Japan (€340 million down from €382.7 million yoy), Turkey (€99 million up on €83 million yoy)

11/09/2011: What gold coins sales tell us about the 'bubble'

Here is the extended version of the article published by Globe & Mail on the topic of US Mint sales of gold coins.

Of all asset classes in today's markets, gold is unique. And for a number of reasons(i).

Firstly it acts as a long-term hedge and a short-term flight to safety instrument against virtually all other asset classes.ii Secondly, it supports a wide range of instruments, including physical delivery (bullions, coins and jewellery), gold-linked legal tender, gold-based savings accounts, plain vanilla and synthetic ETFs, derivatives and producers-linked equities and funds. All of these are subject to diverse behavioural drivers of demand. Thirdly, gold is psychologically and analytically divisive, with media coverage oscillating between those who see gold as either a long-term risk management tool, or a speculative investment, a "barbaric relic" prone to "bubble"-formation.

In the latter context, it is interesting to look closer at the less-publicised instrument - gold coins, traditionally held by retail investors as portable units to store wealth. Due to this, plus demand from collectors, gold coins are less liquid and represent more of a pure 'store of value' than a speculative instrument. Lower liquidity of coins is not driven by shallow demand, but by reluctance of owners to sell them when prices change. Gold coins are economically-speaking "sticky" on the downside of prices - when price of gold falls, holders of coins are not usually rush-prone to sell as they perceive their coins holdings to be 'long-term accumulations', rather than speculative (or yield-sensitive) investments. They are also "sticky" on the upside of prices - while demand is impacted by price effects (with generally higher gold prices acting to discourage new accumulation of coins), holders of coins are not quick to sell to realize capital gains, again due to entirely different timing to the holdings motives. Think of a person setting aside few thousand dollars worth in gold coins to save for child's college fund.

In general markets, classical bubbles begin to arise when speculative motives (bets on continued and accelerating price appreciation) exceed fundamentals-driven motives for opening new long positions in the instrument. Bubbles blow up when these tendencies acquire wide-based support amongst retail investors.

In late stages of the bubble, we should, therefore, expect demand for gold coins to falter compared to the demand for financially instrumented gold (ETFs shares and options). In the mid-period of bubble evolution, however, as retail investors just begin to rush into the asset, we can expect demand for coins to rise in line with demand for jewellery and smaller bullion. But we do not expect a flood of gold coins into the secondary market (and hence a collapse in gold coins sales) until literally past the turn of the fundamentals-driven prices toward the stage of mid-cycle "bubble" collapse.

The US Mint data on sales of gold coins suggests that we are not in the last days of the "bubble". But there are warning signs to watch into the future.

August sales by the US Mint were up a whooping 170% year on year in terms of total number of coins sold, while the weight of coins sold is up 194%. On the surface, this gives some support to the theory of gold becoming short-term overbought by retail investors (see chart below), but it also contradicts longer-term view that gold coins sales should fall around bubble peak.

Source: US Mint and author own analysis

In part, monthly comparatives reflect huge degree of volatility in US Mint sales. Looking at the longer term horizon, since January 2008, US Mint sales volumes averaged 97,011 oz with average coin sold carrying 0.82 oz of gold, the standard deviation of these sales was 45,196 oz and 0.19 oz/coin, implying that August results comfortably fit within the statistical bounds of +/- 1/2 STDEV of the mean for the crisis period. Equally importantly, August results fit within +/-1 STDEV band of the historical mean since 1986 through today. In other words, current gold coinage sales do not even represent a 1-sigma event for the entire history of gold coins sales supplied by the US Mint and are within 0.5-sigma risk weighting for the crisis period since January 2008.

Neither is the current monthly increases in demand represent a significant uptick on previous months or years demand. At 112,000 oz of gold coins sold, August 2011 is only the 19th busiest month is sales since January 2008. It ranks as the 34th month in terms of the gold content per coin sold. Again, not dramatic by any possible metrics. Since January 1988 there were 87 months in which average gold content per coin exceeded August 2011 average and on 38 occasions, volumes of gold sold in the form of coins by the US Mint exceeded last month's volume.

Again, not dramatic by any possible metrics, especially once we recognize that in terms of risk-related fundamentals, August was an impressive month with US and EU debt crises boiling up and economic growth slowdown weighing on global equities markets.

Charts below illustrate these points.
Source: US Mint and author own analysis
Source: Author own calculations based on the US Mint data
Source: Author own calculations based on the US Mint data

The data also shows that physical demand for coins is largely independent of the spot price of gold. Historically, since 1986, average 12-months rolling correlation between the spot price of gold and the volumes of gold sold in US Mint coins is negative at -0.09. Since January 2008, the average correlation is -0.2. And over the last 3 years, the trend direction of gold spot price (up) and the volumes of gold sold in coinage (down) have actually diverged (see chart). The latter is, of course, concerning and will require closer tracking in months to come. The correlation between price of gold and volumes of gold sales through US Mint coins is now negative or zero for 13 consecutive months.

Source: Author own calculations based on the US Mint data

Source: Author own calculations based on the US Mint data

The chart above also highlights the fact that the current trend levels of US Mint sales are significantly elevated on previous periods, with exception of 1986-1987 and 1998-1999 demand spikes. Since the global economic crisis began, annual coinage sales rose 7-fold from just under 200,000 oz in 2007 to 1,435,000 oz in 2009, before falling back to 1,220,500 oz in 2010. Using data through August, I expect 2011 sales to remain at around 1,275,000 oz. This implies that the 2008-2011 average annual sales of US Mint coinage gold are likely run at slightly above 2 times the average annual rate of sales of coinage gold in the period 1988-2007.

Given the state of the US and other advanced economies around the world since January 2008, this is hardly a sign of dramatic over-buying of gold by masses of retail investors. Instead, we are witnessing two core divergent trends emerging from the coins markets:

1. Since, roughly-speaking, 2009, the trend in coins sales is moving counter to the trend in spot price for gold, implying that retail investors are not rushing into gold, as one would expect were gold to be a bubble, and
2. The levels of sales of US Mint coins remain elevated, on average, since the crisis began, implying that high demand for coins, relative to historic trends, is most likely being driven by fundamentals-underpinned demand for safety.
   

In short, there is no indication, in the data reviewed, of the bubble beginning to inflate (sharp rises in gold coins demand along the trend with prices) or close to deflating (sharp pull-back in demand for gold coins).

Of course, the evidence above does not imply any definitive conclusions as to whether gold is or is not a "bubble". Instead, it points to one particular aspect of demand for gold - the behaviorally anchored, longer-term demand for gold coins as wealth preservation tool for smaller retail investors. Given the state of the US and other advanced economies around the world since January 2008, US Mint data does not appear to support the view of a dramatic over-buying of gold by the fabled speculatively crazed retail investors that some media commentators are seeing nowdays.


Disclosure: I am long physical gold and hold no long or short positions in other gold instruments.


i These and other facts about gold are summarized in my recent presentation available at http://trueeconomics.blogspot.com/2011/08/20082011-yielding-to-fear-or-managing.html.

ii As shown in the recent research paper by Profs Brian Lucey, Cetin Ciner, and myself, covering the period of 1985-2009: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1679243

09/09/2011: VIX - another blow out

EU debt disaster and US own woes or just EU debt disaster, who knows, but VIX - that indicator of overall risk perceptions in the markets - is again above the psychologically important 40 mark.

Charts to illustrate:
Vix has gone to close at 40.50 today having opened at 35.53 and hitting the high of 40.74. In terms of historical comparatives:

• Intra-day high achieved today was 170th highest point reached by VIX since Jan 1, 1990, 147th highest reading since Jan 1, 2008 and 15th highest since Jan 1, 2010
• VIX closing level was 156th highest in history since Jan 1, 1990, 129th highest since Jan 1, 2008 and 8th highest since Jan 1, 2010. The latter being pretty impactful

Intra-day spread was pretty high, but not too remarkable, ranking as 179th highest since Jan 1, 1990, 102nd highest since Jan 1, 2008 and 49th highest since Jan 1, 2010, suggesting possible structural nature of elevated readings in VIX overall.
3 mo dynamic standard deviation of VIX index reached 8.981 - the highest level of volatility in VIX since January 1, 2010 and 90th highest since both Jan 1, 2008 and Jan 1, 1990. We are now clocking the highest level of VIX volatility (on 3mo dynamic basis) since February 2009.

Looking at semi-variance:
1mo dynamic semi-variance for VIX is now running at 15.73 - not dramatic, but showing persistently elevated trend since August 5, 2011. Today's reading was, nonetheless, only 27th highest since Jan 1, 2010. To flag that - below is the snapshot of short series range:Yep, folks, with VIX stuck at elevated levels with occasional blowouts like today, with European banks beefing up their deposits with ECB and Bank of Japan, with investors throwing money at Uncle Sam and Bundesbank (at negative interest rates) and demand for CHF undeterred by the threats of continued devaluations, what we are seeing is fundamentals-driven run for safety. Nothing irrational here, unless feeling sh***less scared is irrational...

06/09/2011: Recapitalization of Irish Banks 2011

On August 31, 2011 Irish Government committed €17.3 billion of our - taxpayers - money to underwrite banks recapitalization following the PCAR 2011 exercise carried out by the CBofI. Three "banks" - BofI, AIB and IL&P received the funds. Here is the official summary of how these funds were distributed. No comment to follow.

06/09/2011: Euro area 2Q 2011 GDP analysis

Euro area GDP increased by 0.2% qoq in 2Q 2011, same rate as GDP growth in EU27, according to second estimates released by Eurostat. 1Q 2011 respective growth rates were +0.8% in the euro area and +0.7% in the EU27. Year-on-year, GDP was up 1.6% in the euro area and 1.7% in EU27 in 2Q 2011, down from annual growth rates of 2.4% (both EU27 and euro area) for 1Q 2011.

US GDP also grew 0.2% qoq in 2Q 2011 up from +0.1% in 1Q 2011. Year-on-year US GDP expanded by 1.5% in 2Q 2011 and 2.2% in 1Q 2011. Japan's GDP contracted 0.3% in 2Q 2011, following -0.9% contraction in 1Q 2011. Year-on-year Japan's GDP fell 0.9% in 2Q 2011 and fell 0.7% in 1Q 2011.

Components of GDP:

• In 2Q 2011, household consumption fell 0.2% in the euro area and 0.1% in EU27. In 1Q 2011, the respective numbers were +0.2% and +0.0%.
• Gross fixed capital formation was up 0.2% in 2Q 2011 in the euro area (+1.8% in 1Q 2011) and up 0.4% in EU27 (+1.2% in 1Q 2011).
• Exports were up 1.0% (+2.0% in 1Q 2011) in the euro area and +0.6% (+2.2% in 1Q 2011) in the EU27 (after +2.0% and +2.2%). Imports rose by 0.5% in the euro area (+1.5% in 1Q 2011) and by 0.4% in the EU27 (+1.4% in 1Q 2011).
  

Table below summarizes some of the results.

In terms of Gross Value Added in q/q terms:

• Agriculture, hunting & fishing contracted by -0.2% in 2Q 2011 (against +0.6% in 1Q 2011) in the euro area and contracted -0.5% in EU27 (+0.9% in 1Q 2011)
• Industry, including energy expanded by 0.4% in 2Q 2011 (against +1.7% in 1Q 2011) in the euro area and +0.3% in EU27 (+1.4% in 1Q 2011)
• Construction expanded by 0.0% in 2Q 2011 (against +2.5% in 1Q 2011) in the euro area and +0.3% in EU27 (+1.5% in 1Q 2011)
• Trade, transport and communication services expanded by 0.2% in 2Q 2011 (against +0.6% in 1Q 2011) in the euro area and +0.4% in EU27 (+0.7% in 1Q 2011)
• Financial and business services expanded by 0.2% in 2Q 2011 (against +0.2% in 1Q 2011) in the euro area and +0.3% in EU27 (+0.2% in 1Q 2011)
• Other services expanded by 0.2% in 2Q 2011 (against +0.2% in 1Q 2011) in the euro area and +0.2% in EU27 (+0.4% in 1Q 2011)
• Total gross value added expanded by 0.2% in 2Q 2011 (against +0.7% in 1Q 2011) in the euro area and +0.3% in EU27 (+0.7% in 1Q 2011). In annualized terms, total GVA expanded 1.6% in 2Q 2011 (against 2.2% in 1Q 2011) in the euro area and by +1.7% (against 2.2%) in the EU27.
  

If you think we are in the age of austerity, think again. Government expenditure contributions to GDP, seasonally adjusted series, stood flat in 2Q 2011 at +0.0% growth (against +0.1% in 1Q 2011) in the euro area and in the EU27. Annualized rate of increase for Government spending was +0.1% in 2Q 2011 (+0.2% in 1Q 2011) in both the euro area and the EU27.

Now, on to forecasts forward. Chart below plots updated series for GDP growth against the leading economic activity indicator eurocoin. The series suggest that Euro area GDP for 3Q 2011 consistent with July-August readings of eurocoin is 0.3% (unadjusted for 2Q realization) and adjusting for 2Q 2011 realized rates of growth, the forecast is in the range of -0.1% to +0.1% GDP change.

05/09/2011: Ackermann: cover us

Deutsche Bank CEO, Josef Ackermann, speaking today at a conference "Banks in Transition", organized by the German business daily Handelsblatt in Frankfurt, made some far reaching comments on the state of European banking system.

"We should resign ourselves to the fact that the 'new normality' is characterized by volatility and uncertainty... All of this reminds one of the autumn of 2008." And as a reminder of these very days 3 years ago, the ECB reported that banks have raised their overnight deposits with ECB to €151 billion - the highest level in more than 12 months. Overnight deposits with ECB are seen as a safe haven as opposed to lending money in the interbank markets, with latest spike suggesting that even European banks are now becoming weary of lending to each other.

Crucially, according to Ackermann, "it is an open secret that numerous European banks would not survive having to revalue sovereign debt held on the banking book at market levels" to reflect their current market value. This is an interesting point - not because it is novel (every dog in the street knows that to be true), but because it is being made by the man who leads the largest banking institution in the land where banks have vigorously fought EBA on methodology and disclosure of stress test results. The battle line drawn back then was precisely their sovereign bond holdings.

And there is an added contradiction in what Ackermann was saying - if banks in Europe will not survive mark-to-market revaluation of their books, then how come Mr Ackermann claims they don't require urgent recapitalization?

In truth, Ackermann was really saying that were the banks in Europe forced to mark-to-market their holdings of PIIGS and Belgian bonds, they would take such losses that can lead to destabilization of banks equity valuations across the EU, thus triggering calls on governments' funding, which will therefore destabilize the bonds markets. Truth hurts, folks. It hurts over and over again when it is denied.

Mr Ackermann also appears to be saying: "Hey politicians. Don't force us to fix our books to the market. Fix the market for us."

Ackermann also repeated his earlier statement that calls for robust and rapid recapitalization of the banks were "not helpful" and threatened to undermine European efforts to assist crisis-stricken euro-zone sovereigns. In his view, such a recapitalization would send the message that the EU had little faith in its own strategy for dealing with the crisis. In other words, in Ackermann's view, if banks need urgent capital to cover losses on sovereign bonds, then the current valuations of these bonds in the market are irreversible. Which, of course, would mean that all efforts of the EU to roll back sky-high yields on PIIGS + Belgian debt are not likely to produce long-term results any time soon.

Which brings us to the point of asking: if so, why the hell are we burning through tens of billions of ECB and taxpayers' funds to buy out sovereign bonds and repay banks bond holders? Is it simply an exercise of buying time?

Another interesting comment from Ackermann relates to longer term prospects of the banking sector: "Prospects for the financial sector overall ... are rather limited... The outlook for the future growth of revenues is limited by both the current situation and structurally." What this means is that with regulatory tightening, new capital requirements (both on quality and quantity of capital) and with devastated savings and investment portfolia of investors, plus rising taxes on income and capital, margins in the banking sector will be depressed over long term horizon, while more risk averse investors will be weary of buying into higher margin high risk structured products.

In other words, all that Mr Ackermann's speech today amounts to is a call by a banker on the European governments to cover up the banks' cover up of losses: "Print money, buy out our bonds, but don't restructure or recapitalize us".

But Ackermann's warning presents an even more dire warning for the Irish officials who have made significant bets (using taxpayers money) on Irish banking sector returning to high rates of profitability soon. If Ackermann is correct and long term profitability of the entire sector is on decline, Irish banks will be unlikely to recover without a dramatic restructuring of their books.

05/09/2011: Euro area governance indicators: evolution or decline?

In recent years, the EU has embarked on a set of institutional reforms and unveiled a number of institutional platforms for reforming the core principles of governance, transparency and accountability. These reforms are rooted in 2000-2005 processes that accompanied direct evolution of the Euro area and the EU enlargement.

In this light, it would be instructive to take a closer look at the dynamics of EU governance evolution, focusing on the specifically more integrated group of countries – the Euro area. Using data from the World Bank Governance Indicators for 1996-2009 (latest available) we can draw some interesting conclusions on the topic.

Before we begin, however, note that WB data is lagged in some cases up to 2 years. In addition, many variables are "sticky" - in a sense that they do not change dramatically year on year as institutional reforms take time to feed through to actual delivery on metrics. Hence, the period from 1996 through 2002 is really covering a period of data closer to 1985 through 2001, on average. Thus, I separate the data into 2 periods: the period prior to the Euro area creation (1996-2002) and post Euro area creation (2003-2009). In addition, note the following two facts: that help support this division:

1. I tested the results for the period split 1996-2001 against 2002-2009, for split 1996-2000 vs 2001-2009 and for split 1996-2003 vs 2004-2009. All came back with very similar, qualitatively, results.
2. A number of Euro area states were in a mode of EU accession prior to 2004, thus splitting the sample at 2002-2003 makes some logical sense to capture better the average effects of governance reforms coincident with the euro period.

Now to the results: charts below plot changes across two periods for the countries members of the euro area, plus euro area as whole (simple average), the new accession states and the old (core) euro area member states. The plots capture all 6 core components of the World Bank Governance Indicators in terms of change in each indicator score (higher score implies better ranking in the league tables).

So to summarize - a table

What the above clearly shows is that Governance scores improvements across the euro area were driven primarily by improvements in the Accession States. In 4 out of 6 criteria, Core euro area member states have, on average, posted deterioration in the scores. Thus, overall euro area scores improved in 3 out of 6 criteria, remained unchanged in 2 criteria and deteriorated in 1 criteria.

Pretty poor performance for the group of states that set out as their core agenda to achieve transparency, good governance, government effectiveness, etc. And even worse for the idea that more integration yields better policy outcomes. Clearly, in the case of governance at least, it does not.

3/09/2011: Returns to Beauty

A fascinating study by Daniel S. Hamermesh and Jason Abrevaya, titled "BEAUTY IS THE PROMISE OF HAPPINESS?" was released yesterday by the NBER (Working Paper 17327 http://www.nber.org/papers/w17327). This is, folks, economics at its best: great question, great analysis and something that is way more relevant to life than banks, property and/or Obama's administration again blasting through the debt ceiling (oh yeah, they did that this week too - here).

Here's what I am talking about: "We measure the impact of individuals’ looks on life satisfaction/happiness. Using five data sets, from the U.S., Canada, the U.K., and Germany, we construct beauty measures in different ways that allow placing lower bounds on the effects of beauty. Beauty raises happiness: A one standard-deviation change in beauty generates about 0.10 standard deviations of additional satisfaction/happiness among men, 0.12 among women. Accounting for a wide variety of covariates, particularly effects in the labor and marriage markets, including those that might be affected by differences in beauty, the impact among men is more than halved, among women slightly less than halved."

"There are two main general mechanisms through which people’s looks could affect their satisfaction/happiness. The first is through the many channels that have been shown in the beauty literature to offer routes by which beauty affects economic outcomes. These indirect effects may be at least as important as the direct effects of beauty on satisfaction/happiness — the halo that good looks might impart to a person independent of the effects of beauty on any market-related outcomes. In the main economic exercise in this study, ...we decompose any measured impact of beauty on satisfaction/happiness into its direct and indirect components and thus examine the extent to which any beauty-happiness relation works through markets."

Hence, "The main economic question in this study is whether the effect of beauty on
satisfaction/happiness works through markets:

• How much of the effect is direct—with people who are otherwise identical in every respect being happier/more satisfied than their less good-looking peers?
  
• How much is due to the fact that beauty enhances one’s outcomes in various markets, including the labor and marriage markets?"

And here are the conclusions: "Taking the results at face value suggests that roughly half of the gross effect of looks works through the marriage and labor markets". However, "the available data do not allow us to account for impacts in other markets. As just one example, there is growing evidence that beauty confers benefits on good-looking borrowers in lending markets... Moreover, our proxies for the outcomes in the labor and marriage markets that are affected by beauty are far from perfect. It thus seems fair to conclude that the expanded estimates suggest that the direct effect of beauty is at most one-half of the total effect, and perhaps much less. The majority of the impact of beauty on satisfaction/happiness appears to be economic—through its effects on outcomes in various markets."

Yep, being beautiful pays. And hence, investing in beauty is a big business.

One other interesting point - notice that men-women differential in 'returns' to beauty are 0.1:0.12 - not exactly a massive one. "The results ...show only slightly greater gross effects of beauty among women than among men. The direct effects, however, are larger among women, with relatively less of the impact of beauty on women’s satisfaction/happiness working through markets. This gender difference may explain why, although most of the studies measuring the impact of beauty on earnings find larger effects among men than among women, laypeople believe that looks matter more to women."

I will have to add this to my reading lists for Investment Analysis and Economic Risk courses... Simply brilliant!

2/09/2011: Competitiveness in the long run: did the euro help?

Another look at the evolution of euro area competitiveness: in the chart below I plot ECB’s Harmonized Competitiveness Indicators for the euro area since 1995 as measured by the average annual HCIs deflated by unit labour costs. The higher the value of the index, the lower is competitiveness.

Here are some interesting points to observe, based on the data:

• The period since introduction of the euro witnessed deterioration or no improvement in overall competitiveness in all countries, save Germany, once the lags are accounted for (note, there is strong path dependency in many countries’ wages/labour costs due to long term contracts and generally sticky wages). Hence, for the period 1995-2001, euro area HCI averaged at 98.8, while for the period 2002-2010 the HCI averaged 99.8. Similarly, for France, HCI averages for the two sub-periods were 99.1 against 101.7, for Italy: 97.0 against 107.1, for Spain 98.4 against 108.3, for Finland, the Netherlands (Nordics) & Austria: 99.91 against 99.94 (statistically identical), for Ireland: 100.2 to 117.5 and for the rest of the euro area: 99.2 to 113.0.
• The period of highest competitiveness for all countries, except Germany, coincides with the period when pre-euro qualification period forces of improving competitiveness reach their peak: 2001-2002. This overall euro area competitiveness peaks in 2001, France’s competitiveness peaks in 2001, Italian, Spanish, Nordics’ & Austrian, Irish and Rest of euro area competitiveness peaked in 2001.
• After 2001, losses of competitiveness become pronounced across all economies, except Germany, with lowest competitiveness post-2000 points reached around 2008 (France, Spain and Ireland) or 2009 (all other countries, plus euro area as a whole).
• Since the onset of the crisis (again, accounting for lags) there have been significant gains in competitiveness. As I noted elsewhere, in some cases (Ireland and Spain, for example) these gains came primarily due to a wholesale destruction of a number of non-competitive domestic sectors (construction and retail).
• Gains in competitiveness have been very shallow in France (decline in HCI off the local pre-crisis peak of just 2.4%) and Italy (-3.2%), moderately weak in Germany (-5.22%), Nordics + Austria (-4.69%), Rest of Europe ex-Ireland (4.5%). Gains were close to euro area overall average (-9.2%) in Spain (-7.2%) and spectacularly strong in Ireland (-17.1%). It is worth noting once again that Irish gains in competitiveness came to a large extent from destruction of jobs in sectors that were least competitive before the bust (construction and domestic retailing and hospitality).
  

Overall influence of impressive German economic performance over the 2000s in terms of competitiveness can be clearly seen from the chart below.

But what the two charts above clearly suggest in terms of analysis for Ireland is really rather disturbing. Despite significant gains in competitiveness, Ireland remains well behind its peers in terms of absolute levels of HCIs – according to the latest data, we are lagging behind Germany, France, Italy, Spain, Finland, the Netherlands, Greece, Cyprus, Luxembourg, Malta, Austria, Portugal and Slovenia.

More importantly, delivering a similar magnitude decline over the next 2 years (a task that will either require unemployment rising to over 22% or a gargantuan effort in terms of productivity growth not seen in modern history of any state) will get us to the level of competitiveness comparable to 2001 – achieving HCI of ca 96.2.

It might be not bad, but should the trends across the other euro area countries also remain identical to those over the last 2 years, Ireland (with projected HCI under this scenario reaching 98.8) will be still less competitive than the euro area as a whole (92.9), Germany (82.8), the Nordics and Austria (98.7). If anyone expects this type of miracle to occur, good luck to them, but if anyone expects the result of this miracle to be a huge boost to our economic growth, let me point out the last little factoid that the data reveals: back in the 1990s our average HCI was 102.7 – below the euro area average of 104.2. With two consecutive ‘miracles’ we are not even aiming to get to parity of the euro area average.

1/09/2011: Manufacturing PMI for Ireland - a mixed bag for August

Figures for PMIs for Euro area economies released today are hardly encouraging:

• German manufacturing index stands at 50.9 in August, close to contraction, against the local peak of 62.7 in February 2011
• Spain's August data shows fastest fall in output since June 2009, with headline PMI at 45.3.

Now, Irish manufacturing PMIs (released today by NCB) are showing no clear direction from the contraction momentum established in July.

Here are the updated figures:

• Core PMI for manufacturing remains in contraction territory for the third month in a row at 49.7 in August, although the index is marginally up on 48.2 in July. Index 12 mo MA is at 52.2 and 3mo MA is now at 49.2. 2010 same-period 3mo MA is 51.4 against 2009 same period 3mo MA of 43.4. This does not square well with the ESRI assertion that stronger economic performance might emerge in H2 2011.
  
• Output sub-index is out of contraction territory in August (52.4) compared to July (49.8), breaking two consecutive months of contraction.
• New orders sub-index, however, is now at 47.7 down from 47.9 in August, marking the lowest point since September 2010. 3mo MA is now at 48.1 and 12mo MA at 52.7. Per NCB analysis: "The decline in business conditions in August mainly reflected a solid reduction in new orders. Panellists indicated that slowing demand had been behind the contraction in new business, which was the fastest since September 2010".
• In contrast to overall new business measure, sub-index for new export orders increased in August to 53.5 since July 51.3. This marks the eleventh successive month of the index being above 50 expansion marker and the first rise since January 2011. However, August reading was still below the local peak of 61.6 attained in February 2011 and stands well below 12mo MA of 55.7, with 3mo AM of 52.1. New exports demand grew, according to the respondents, in aprticularly strongly in the UK.
  
• Backlogs of work in August were reading 41.7, up on 41.1 in July. The fall in overall new business in August drove this further decline in backlogs of work as companies transferred spare capacity to work on existing projects. This is now the sixth successive reduction in outstanding business and the reduction was substantial.
• August responses pointed to a further and sharper reduction in stocks of finished goods with the sharpest rate of stocks depletion since March - down to 45.2 in August from 49.6 in July. Per NCB: "Post-production inventories have now fallen in each of the past 40 months. Panellists reported that they had made efforts to reduce stock holdings over the month."
• After falling for three successive months, employment increased during August, with the rate of job creation being extremely shallow at 51.1 in August, up from contraction in July of 49.1 and breaking three consecutive months of declines.

Last point to make comes from the final chart above: profit margins have deteriorated in August once again from -15.01 to -15.62 as input prices continued to expand at 58.9 in August, down from 59.3 in July, while output prices switched into contraction territory with a reading of 49.7 in August down from 50.4 in July.