20/09/2011: Wholesale Prices - more margins pressure

Wholesale Price Index for Ireland is out today - monthly series (note - these are highly volatile series in general) and the results are not too good for profit margins in Irish manufacturing.

Monthly factory gate prices declined 0.4% in August 2011 against an increase of 0.2% in August 2010, implying annual rate of contraction of 1.0%. In July 2011, annual rate of decrease stood at 0.4%.

Overall price index for manufacturing industries (NACE 10-33) stands at 97.2 in August 2011, down from 97.6 in July and 98.2 in August 2010. We are now in the third monthly decline in a row.

Stripping out effects of food, beverages & tobacco sector, manufacturing price index fell to 92.2 in August 2011, down from 92.5 in July and 94.2 in August 2010. Year on year index is now down 2.1% against annual decline of 1.5% in July.


In the month, the price index for export sales was down 0.5% while the index for
home sales (domestic sales) increased by 0.1%. In the year there was a decrease of 2.2% in the price index for export sales (this can be influenced by currency fluctuations, as CSO correctly points out). In July 2011 annual rate of decline was 1.6%. However, CSO fails to point out that deflation has been affecting severely our largest exporting sectors - pharma and ICT (see below on this). In August 2010, annualized rate of change in export prices was +0.2%.

There was an increase of 4.7% in respect of the price index for home sales (this can be influenced by state-controlled producers ripping-off domestic consumers, but hey, no mention of that in CSO release). In July 2011 there was a 4.9% increase yoy in same prices. And in fact, domestic sales prices have been rising every month since December 2009, implying increasing pressures on retail sector here and domestic consumers.

So the two-tier economy is well supported by price changes as well as production volumes: our exports are getting cheaper (last increases in exports prices yoy were recorded in January 2011), while our domestic sales are getting more expensive and fast. The last time changes in prices in domestic sector fell behind changes in prices (in same direction) in exports sectors was July 2010. And not a peep from either our policymakers or the CSO about these facts.

What CSO does highlight is that: "Contributing to the annual change were increases in Dairy products (+10.1%), Meat and meat products (+8.1%) and Other Manufacturing including Medical and Dental Instruments and Supplies (+3.2%), while there were decreases in Computer, electronic and optical products (-6.4%), Basic pharmaceutical products and pharmaceutical preparations (-3.6%) and Other food products including bread and confectionary (-1.1%)."
Now, recall that pharma accounts for 90% of our trade surplus. Basic pharma sector wholesale prices have now fallen to 87.4 in August 2011, down from 90.7 in August 2010 and from the local peak of 106 attained in November 2008.

CSO does report that "The price of Energy products increased by 3.3% in the year since August
2010, while Petroleum fuels increased by 9.1%. In August 2011, the monthly price index for Energy products decreased by 1.4%, while Petroleum fuels decreased by 3.7%." I would add that electricity remained unchanged at 115.2 year on year and most of price increases in this sector are due to Petrol and Autodiesel (both +9% yoy), Gas oil (+10.3%) and Fuel oil (+8.8%).

Year on year, the price of Capital Goods decreased by 5% in August, to 82.5 and it was down 4.3% in July. The index now stands at 82.5, down from 83 in July 2011 and 86.8 a year ago. Intermediate goods ex-energy price index rose 2% in August (yoy) against yoy rise of 2.7% in July. This index remain in the positive territory since November 2011.

19/09/2011: Highly Leveraged Banks' real impact on economy

An interesting paper from CEPR sheds some (largely theoretical) light on the real side of the current global financial crisis.

CEPR DP8576 titled "Financial-Friction Macroeconomics with Highly Leveraged Financial Institutions" by Sheung Kan Luk and David Vines (September 2011: available here) models the current crisis by adding "a highly-leveraged financial sector to the Ramsey model of economic growth". The paper shows that the presence of high leverage in financial sector "causes the economy to behave in a highly volatile manner" and thus exacerbate the macroeconomic effects of aggregate productivity shocks.

The model is based on the mainstream financial accelerator approach of Bernanke, Gertler and Gilchrist (BGG). The core BGG model assumes leveraged goods-producers are subjected to idiosyncratic productivity shocks, inducing them to borrow from a competitive financial sector.

Luk and Vines, by contrast, assume that "it is the financial institutions which are leveraged and subject to idiosyncratic productivity shocks." As the result of this, leveraged financial institutions "can only obtain their funds by paying an interest rate above the risk-free rate, and this risk premium is anti-cyclical [ in other words the premium is higher at the time of adverse productivity shock, i.e. during the recession], and so augments the effects of shocks."

Luk and Vines parameterise the model to US data under the assumption that "the leverage of the financial sector is two and a half times that of the goods-producers in the BGG model". The assumption is relatively robust for the current environment in the US. It is probably less robust in the case of the EU where financial sector leverage is likely to be higher in a number of countries due to:

1. Traditional over-reliance on debt financing of the banking sector
2. Lower rates of deleveraging in the banking sector than in the US, and
   
3. Greater deposits attrition during the crisis.
   

The study finds that the presence of leveraged financial institutions "causes a much more significant augmentation of aggregate productivity shocks than that which is found in the [traditional] BGG model."

In the nutshell, this provides a plausible explanation as to the channels through which financial sector funding and operational strategy risks (leading to higher leverage) transmit through to real economy. It also links more directly monetary policy to the real economy as well. Ben, keep that printing press running... nothing can possibly go wrong with negative interest rates, mate.

17/09/2011: QNHS 2Q 2011 - public sector v private sector trends

This is the second post on the data from QNHS for 2Q 2011.

Table below summarises data from QNHS results, showing changes for specific sectors of the economy as well as core figures for overall employment, labor force and unemployment.
Using the data from core QNHS we can compute decomposition of employment pool into three broadly defined subsectors, as shown below. The core trends here are the following:
Ratio of private sector employees to those employed in public sector now stands at ca 2.76 private sector workers per 1 public sector employee. Sacred yet? That ratio rose from 2.73 in (an improvement, in fact) qoq between 1Q 2011 and 2Q 2011, but is down from 2.78 in 2Q 2010 and 3.00 in 2Q 2009. In other words, there are fewer private sector employees now per each public sector employee than in either 2010 or 2009 or indeed in 2008 and so on.

The same is true across the specific sectors. There are more people in employment in education per private sector worker now than 2007-2010, there are more people employed in public administration per private sector worker now than in 2007-2010, there are more people employed in healthcare per person employed in private sector today than in any moment since 1Q 2004. This, after the allegedly savage cuts in numbers in public sector employment.

QNHS also now reports EHECS-based public sector employment estimates. Table 1.1 below (reproduced from QNHS release) shows the estimates of public sector employment broken down by the different high level areas within the public sector. I've added the red line below showing proportional allocation of employment - the number of private sector workers per each public sector worker. This only slightly differs from the same metric I derived above based solely on QNHS. Again, there are, broadly speaking, 2.82 persons working in private sector per each 1 person in public sector. A year ago, there were 2.86, 2 years ago, there were 2.85... savage cuts folks? Not exactly. Looks more like continued steady burden on private sector from supporting public sector employment.
That's a tough thing to swallow, folks. Per CSO: "The number of employees in the public sector showed no change over the year to Q2 2011. However, the employment figures for this quarter include 5,300 additional temporary Census field staff who were employed during the periods covering Q1 and Q2 2011. When these staff are excluded there was a fall of 1.3% in employment over the year to Q2 2011." Give it a thought, folks - a fall of 1.3% when unemployment rose 3.93% and underemployment went up 20.89% and employment fell 2.1% and private sector employment declined 2.4%.

"The number of employees in the public sector has continued to fall over the last three years with a total decrease of 24,600 up to Q2 2011 when excluding census field staff." Drama unfolds? Let's check that table above. Since 4Q 2008 through 2Q 2011:

• Private sector employment is down 12.9%
• Civil service employment is down 7.5%
• Semi-states employment is down 8.5%
• Total public sector ex-semi-states employment is down 5.5%
• Total public sector employment is down 5.9%
  

Draw your own conclusions as to whether the Croke Park is delivering or not.

16/09/2011: QNHS 2Q 2011 - things are getting frighteningly worse less rapidly

This is the first of two posts on QNHS 2Q 2011 data released yesterday.

Yesterday's QNHS results for 2Q 2011 confirmed the continuation in the trend weaknesses in Irish labour markets, with some moderation in the rate of deterioration qoq.

Per CSO: "There was an annual decrease in employment of 2.0% or 37,800 in the year to the second quarter of 2011, bringing total employment to 1,821,300. This compares with an annual decrease in employment of 2.9% in the previous quarter and a decrease of 4.1% in the year to the second quarter of 2010."

Other core stats and changes are:

• The annual decrease in employment of 2.0% is the lowest annual decline since 3Q 2008.
• On a seasonally adjusted basis, employment fell by 3,200 (-0.2%) in the quarter. This follows on from a seasonally adjusted fall in employment of 7,200 (-0.4%) in Q1 2011. The 2Q 2011 fall in employment is the lowest quarterly decrease recorded in the seasonally adjusted series since 1Q 2008.
• The largest decrease in employment over the year was recorded for the 25-34 year age group (-27,500 or -5.0%). A reduction of 21,100 was also recorded for the 20-24 age group (-15.0%). Numbers in employment are now down 324,900 on the peak attained in 4Q 2007.
  

The total number of persons in the labour force in 2Q 2011 was 2,125,900, representing a decrease of 26,800 (-1.2%) over the year. This compares with an annual labour force decrease of 50,400 (-2.3%) in Q2 2010. This marks a decrease of 128,500 on the peak reached back in 1Q 2008.

Unemployment rose 10,900 (+3.7%) in the year to 2Q 2011 with 304,500 now unemployed (male unemployment increasing by 5,600 (+2.8%) to 205,700 and female unemployment increasing by 5,200 (+5.6%) to 98,800). The unemployment rate increased from 13.6% to 14.3% yoy in 2Q 2011.

The long-term unemployment rate increased from 5.9% to 7.7% over the year to Q2 2011. Long-term unemployment accounted for 53.9% of total unemployment in Q2 2011 compared with 43.3% a year earlier and 21.7% in the second quarter of 2009.

The seasonally adjusted unemployment rate increased from 13.9% to 14.2% over the quarter.
Full-time employment fell by 53,000 (-3.7%) yoy with declines in both male (-33,700) and female (-19,300) full-time employment. Per CSO: "This decline in full-time employment was partially offset by an increase in the number of part-time workers where the numbers increased by 15,200 (+3.7%) over the year. Part-time employment now accounts for 23.4% of total employment. This had been as low as 16.7% in Q3 2006." Full-time employment is now down 367,600 on peak (4Q 2007) and part-time employment is now at its new peak at 426,800 - up 40,800 on 4Q 2007.


Part-time underemployment (a form of unemployment, really) increased by 23,000 (+20.9%) from 110,100 to 133,100 over the year. Part-time underemployment now represents just under one-third (31.3%) of total part-time employment, up from 26.8% a year earlier. Among males, part-time underemployment is close to half of total part-time employment (46.7%), up from approximately 42% a year earlier. For females the comparative proportion is one quarter (25.0%), but as with males this proportion has been increasing over time.

Now to the frightening number: combined unemployed and underemployed part-timers now stand at a frightening 434,700 or 20.5% of the labor force. This number is up from 400,300 a year ago (+8.6%).

So, on the net we have:

• flattening out of the unemployment increases curve, but continued increases, nonetheless
• flattening out of labor force decreases rate, but continued declines in labor force
• increasing share of employment taken up by part-time employed
• increasing share of long-term unemployed and underemployed in the labor force.
  

And LR confirms this diagnosis:
It's not exactly 'turning the corner' moment, is it?

15/09/2011: Some observations on NTMA & NAMA statements to the Oireachtas Committee

I was going over the statements issued by NTMA and NAMA to the Oireachtas Committee last week and was struck by some rather interesting bits...

Let's start with the Statement by John Corrigan, Chief Executive NTMA, to the Joint Committee on Finance, Public Expenditure and Reform, 9 September 2011:

"The banking stress tests carried out by the Central Bank in the first quarter of 2011 quantified the additional capital support required by the banking sector at €24 billion. The NTMA Banking Unit has worked very hard to minimise the amount of this additional capital to be provided by the taxpayer. Through initiatives like burden sharing with the junior bondholders and the sourcing of private capital for Bank of Ireland, the net amount of this capital provided by the State is now expected to be around €16.5 billion. The savings generated can be redirected to funding the day-to-day operation of the country."

Can Mr Corrigan explain this: as of August 1, 2011, the State has injected (under PCAR/PLAR allocations) €17.292bn (here) according to DofF note. That €792mln difference is not exactly a pittance...

Oh, and while we are on the issue of being accurate - PCAR/PLAR capital allocations are designed to deliver capital & liquidity cushions for the period 2011-2013. Not a trivial issue, mind you, especially since Mr Corrigan repeatedly relies on PCAR/PLAR recapitalization exercise as a definitive (aka permanent) line in the sand on banking crisis.

Now, as to the "savings can be redirected to funding the day-to-day operation of the country" - that is pure rhetoric, sir, isn't it? Mr Corrigan himself shows that it is (see marked with italics next quote below).

"In order to stabilise our debt/GDP ratio Ireland needs to get back to running a primary budget surplus (the budget balance excluding interest payments) as soon as possible. Indeed in the context of debt sustainability, this metric is far more important than the absolute level of debt per se. Ireland still has the biggest primary deficit of any eurozone country, a fact not lost on investors..."

So, wait a sec, Mr Corrigan. You said "savings [from PCAR/PLAR recaps] can be redirected to funding the day-to-day operation of the country". You also said that we need to run a primary surplus. You can't have your cake, Mr Corrigan, and eat it.

"The objective of the [banks] deleveraging process is to achieve a more prudent loan to deposit ratio for the institutions concerned through a reduction of their balance sheet assets of some €70 billion while avoiding sales at prices which absorb excessive capital."

Was Mr Corrigan trying to say that we need to deleverage the banks while minimizing the calls on the banks' capital for losses incurred in the process of deleveraging? Ok, that would imply selling good - aka performing - assets first. What would that do to the banks balancesheets, Mr Corrigan? It will undermine banks balancesheets, leaving them with poorer quality average assets. Is that Mr Corrigan's idea of restoring banking system to health? And is that covered by PCAR/PLAR definitive line in the sand? You know, Mr Corrigan, that it is not.



There was also Mr McDonagh speaking on the day...

Opening Statement by Mr. Brendan McDonagh, Chief Executive of NAMA, to the Joint Committee on Finance, Public Expenditure and Reform Friday, 9th September 2011"

"We have now recruited over 190 staff with the specialist skills and experience required to manage a portfolio of property loans with balances in excess of €72 billion."

So NAMA chief thinks it is a great achievement of NAMA that it managed to hire 190 people. Boy, Mr McDonagh would do well in public sector where the metrics of spending are more important than those of earning...

But what is this about €72 billion portflio balances? NAMA valued the portoflio it purchased at €30.5bn gross (inclusive of the LTEV uplift). Banks, who sold NAMA that portfolio wrote down the losses realized, implying that NAMA end valuation in their view was a reasonable reflection of the value of portfolio NAMA bought. So is Mr McDonagh deploying Eugene Sheehy's approach to claiming balances on loans to be assets under management and refusing to write down the actual loans values to the publicly disclosed valuations that NAMA itself prepared?

And is Mr McDonagh conveniently forgetting that the book value of these assets has fallen since that LTEV was assessed and assets were valued? May be Mr McDonagh should consult his own annual report to see his organization taking charge against that loss?

Of course, Mr McDonagh is just pumping up NAMA's (aka his own) importance. NAMA, you see, is not managing €30.5 billion-valued undertaking, or an odd €25 billion actual undertaking (once we factor in at least some of the value losses on NAMA's portfolio), but a €72 billion portfolio. In a way, Mr McDonagh is like Montgomery Burns checking his old ticker for the price of his Federated Slaves Holdings plc...

I love Mr McDonagh's next statement:
"There is a third, small group of debtors ... with whom we could work but who are not co-operating adequately with the process and who appear to believe that, after all that has happened, the taxpayer somehow still owes them a living. We have been as fair, reasonable and patient with these people as any court could possibly expect us to be but, in the circumstances, it is likely that we will be left with no option but to instigate additional enforcement actions before the year is out. Above all else, ...the self-indulgent behaviour of a few has no place in resolving the national crisis with which, collectively, we are grappling."

Now, close your eyes, imagine a summer night, chirping of birds in the distance. From an open window dark woods staring into the room. Armchair. The house owner, with mustache, in military tunic, pipe in hand, explaining in deep Georgina accent to two smaller (in evident statue) men the rationale for dealing resolutely with a small group of dissidents who refuse to cooperate, betraying self-indulgent decadent behavior amidst the national crisis... Mr McDonagh's rhetoric is permeated with Joe Stalinesque tonalities, innuendos, juxtaposing reasonable (NAMA) against the decadent and asocial (developers), the 'few' against the 'many'. Himself positioned in a high priest fashion at the head of the judgment table, burdened with the duty of carrying NAMA's burden of justice to the few unwise dissenters. Why not visit Lubyanka Museum in Moscow on your next corporate outing, my dear NAMAnoids?

There's more of the same, pardon me self-indulgent and arrogant stuff in relation to the public allegedly asking politicians uninformed questions and some people (unknown to us) making uninformed statements about NAMA. "The accusation that NAMA is bureaucratic and slow in dealing with these approvals is unfair and unwarranted but, unfortunately, in the current environment, when it comes to NAMA, many seem to feel that they have no obligation to check the facts before making the accusation."

Ok, Mr McDonagh. I would like to make an informed observation. Where do I get the facts? From you? From NAMA? Who can assure me that the facts you &/or NAMA present are full, correct and not mis-represented?

Let's try the 'trust your NAMA' thingy. Here you say: "There has been much interest from the public (over 100,000 downloads) [in relation to NAMA list of properties under receivership] and in particular from younger people who are keen to use the current correction in property prices to purchase their own homes."

How do you know these are young people? I downloaded the list without any registration. Are you tracking my IP address and accessing, unbeknown to me my details? Are you acting legally in doing this? Or are you simply making a claim that cannot be verified? So much for 'trust your NAMA' proposition then.

And now to the conclusion: "It is our intention that NAMA will be a creative and dynamic force in the property market and, more generally, that it will contribute significantly to the economic resurgence of Ireland in the years ahead." Sorry, Mr McDonagh, but you are not getting it. NAMA has a defined - according to your own chairman and legislation establishing NAMA - mandate. That mandate does not envision NAMA becoming either 'creative' or 'dynamic', nor does it envision 'NAMA contributing to the economic resurgence of Ireland'. Your mandate is to:

1. Recover taxpayers' funds, and
2. Close the shop after doing so.

In case you weren't paying attention on September 9th, Mr Frank Daly said in his statement - made alongside your own: "...the objective that has been set for us by the legislature, under Section 10 of the NAMA Act, is to recover, at a minimum, that amount plus whatever additional funds we need to advance as working or development capital for projects." Mr Daly repeats this objective (in slightly different wording) twice in his statement. Mr Daly does refer to NAMA being "creative and flexible", but unlike Mr McDonagh, he limits this to the reference to properties that NAMA is working with, not to the entire property market and not to the economic resurgence of the whole country.

“Ἀπόδοτε οὖν τὰ Καίσαρος Καίσαρι καὶ τὰ τοῦ Θεοῦ τῷ Θεῷ” (Matthew 22:21), Mr McDonagh. And please, extinguish that pipe and change the tunic... Being Uncle Joe is not only uncool, it is also, fortunately, infeasible for you.

14/09/2011: More soft slop from Irish stuff-brokers

You gotta hand it to the Irish stuff-brokers community. They do routinely produce pearls of wisdom that we, the mere mortals can only aspire to. Here's one latest installment from one morning note issued today:

"If Ireland can meet its deficit cutting/growth targets over the next 2 years, then investor demand for Irish bonds should remain firm".

Let's start peeling this profoundly rhetorical onion:

1. The problem with Irish bonds is that there is NO demand for them. This is why we can't sell them and this is why we are reduced to borrowing from EFSF/EFSM/IMF/Bilateral Begging Bowl. So - the law of physics lesson for stuff brokers - that which doesn't exist cannot "remain firm".
2. If we can sustain our "deficit cutting / growth targets" over the next 2 years (i.e., given I see on my calendar "September 14, 2011") we will be in mid-September 2013 - at which point, per IMF/DofF/ESRI and other folks, usually not renown for their pessimistic assessments of our 'targets', Ireland will be at the peak of our substantial sovereign debt pile. If our stuff-brokers think that is a scenario consistent with "firm" investor demand for bonds, I wonder if the FR should suggest they attend some basic courses in finance.
3. What the hell does construction "deficit cutting / growth targets" mean? Usually, "/" implies "or". At the very least - "and / or", though that construction has own logical sign "v" as in "A ∨ B is true if A or B (or both) are true" of course, "A ⊕ B is true when either A or B, but not both, are true, which can also be written as A ⊻ B". So suppose our stuff-brokers think that delivering on our "deficit cutting" or "growth targets" (but not both) will assure "firm demand" for our bonds. We can, therefore, have NTMA going into the market telling the potential investors: "Give Ireland a chance. We have budgetary consolidation (economic growth), but no economic growth (deficits and debt sustainability)". Again, such a proposition suggests that more basic finance & economics courses are in order.

I am not being pedantic, folks. The problem is that this rhetorical exhortation can easily serve as an example of what passes for policy thinking in Ireland's more august quarters (DofF, Government, Dail, etc). It is an exact formula of what the Government / ESRI / IBEC etc have been putting forward as our policy to resolve the crisis. And yet... yet it makes absolutely no sense.

14/09/2011: Ireland & Portugal are allowed to restructure some of their sovereign debts

The EU Commission issued its proposals for altering terms and conditions of loans extended under the EFSM (and same is expected for EFSF). The details of release are here.

The move comes after July 21 EU summit agreement to alter these terms and took surprisingly long to deliver. This has nothing, I repeat - nothing - to do with the claimed efforts by the Irish Government to secure similar reductions over recent months. The reductions come on the foot of the EU-wide deal for Greece.

Per Commission statement: "The Commission proposes to align the EFSM loan terms and conditions to those of the long standing the Balance of Payment Facility. Both countries should pay lending rates equal to the funding costs of the EFSM, i.e. reducing the current margins of 292.5 bps for Ireland and of 215 bps for Portugal to zero. The reduction in margin will apply to all instalments, i.e. both to future and to already disbursed tranches."

Two critically important points here:

• The reductions, especially for Ireland, are significant in magnitude and will improve Ireland's cash flows and net small reduction in debt burden over time. However, much of these are already factored in recent debt and deficit projections.
• The reductions are retrospective, which is a very important point for Ireland.

Further per EU Commission statement: "...The maturity of individual future tranches to these countries will be extended from the current maximum of 15 years to up to 30 years. As a result the average maturity of the loans to these countries from EFSM would go up from the current 7.5 years to up to 12.5 years."

Two more important points follow from the above:

• Extended maturity in combination of lower coupon on borrowings imply significant cuts in NPV of our debt from EFSM, which, in turn, means that under current EU Commission proposal we will undergo a structured credit event (aka - an orderly default). When this course of action was advocated by myself and others calling for the Irish government to force EU hand on providing for structured default, we were treated as pariahs by the very same 'green jersey' establishment that now sings praise to the EU largess.
  
• Second point is that, as I have noted back in July, this restructuring implies longer term maturity period and can result in total net increase in our overall debt repayments, were we to delay implementation of austerity measures. The silver lining, folks, does have a huge cloud hanging over it.

Lastly: "...the new financial terms will bring benefits such as enhanced sustainability and improved liquidity outlooks. Moreover, indirect confidence effects through the enhanced credibility of programme implementation should result in improved borrowing conditions for the sovereign as well as the private sector."

In effect the above implies that absent such reductions and maturity extensions, Ireland and Portugal are unable to remain on a "sustainable" path and/or lack or experience a deficit of "credibility" whne it comes to their adjustment programmes. That, of course, is plainly visible to all involved.

So here we are, folks - we now had:

1. Bank defaulting on some of its liabilities - and cash machines kept on working
2. Government undergoing debt restructuring - and cash machines keep on working.

Not the end of the world, is it?

14/09/2011: Clueless from the world of finance

I had to get this riddle solved, folks: In the pic below, spot 1,000,023 clueless doorknobs


Answer:

Clueless Number 1: Erin Callan
Clueless numbers 2-15: 14 Goldman Sachs analysts who labored hard to produce that recommendation
Clueless number 16-23: 8-strong crew on CNBC who decided to carry this drivel unchallenged
Clueless numbers 24-1,000,023 (or so): all those who rushed out to buy Lehman's shares on GS recommendation

(I obviously made the numbers up, but, hey... in the world full of clueless analysts this gets one paid loads of money, apparently. Just ask GS)

13/09/2011: Latest research on Tax Havens & Safe Havens

A recent CEPR research paper (CEPR Discussion Paper No. 8570, "TAX HAVENS OR SAFE HAVENS" by Patrice Pieretti, Jacques-François Thisse and Skerdilajda Zanaj, from September 2011) attempts to explain -at least in theory - the policy choices of a small open economy (SOE) that wants to be a viable international banking center (IBC).

The basic dilemma faced by such an economy is that to attract IBC activity, the economy needs to choose between either becoming a tax haven, a safety haven or both for investors from large economy. In other words, the SOE is required to establish a competitive advantage relative to a large economy in terms of two possible instruments: taxation and institutional infrastructure.

The problem is that in reality, the same SOE will not be able to provide both - quality institutions and tax haven protection, since the latter contradicts the former. One can argue that in the past some tax havens were institutionally extremely robust, but in the current globalization-altered world, good institutions require compliance across the borders, not just within the country.

What the paper shows is that in such a setting, the tax haven can act as a catalyst to induce institutional reforms despite the fact that it cannot create institutional competitive advantage. The reason is that competition amongst tax havens drives institutional improvements in these IBCs.

As surveyed in the paper, a recent study by Dharmapala and Hines (2009) "investigated 209 countries and territories to determine which jurisdictions become tax havens and why. They found that successful jurisdictions are overwhelmingly small, but that they are especially well governed, with sound legal institutions and low levels of corruption. Poorly run jurisdictions fail to attract or retain foreign capital, and many do not even try. Thus, the quality of governance seems to matter for the existence of tax havens. According to Gonzalez and Schipke (2011), there is some empirical evidence that countries that apply stronger regulation rules have benefited from higher portfolio investments."

The CEPR study largely confirms this. The core conclusions are:

• "...whether the small country becomes a tax haven depends on the integration of financial markets and the intensity of the small country's comparative advantage."
• "The nature of government matters too to the extent that benevolent governments never build a tax haven. They prefer to erect an IBC through the provision of better institutional infrastructure."
• "By contrast, tax havens may emerge under Leviathan governments. This may explain why tax havens are developed in microstates where there is almost no conflict between social welfare and tax revenues because the local population benefits from the taxes which are mainly levied on foreign investors."
• "Our analysis also reveals that the presence of heterogeneous investors matters for the viability of the IBC and the nature of the policy mix."
• "IBCs need not be as bad as claimed in the media because they foster institutional competition which is beneficial to all investors."
• "Our results provide evidence that safe havens have a place in the global financial environment and provide benefits to governments, firms and households."
  

13/09/2011: German and French Banks - "extreme" leverage & elevated risks

So what's the real trouble with German (and French) banks, folks? Errrm... they are kinda seriously bordering the "insolvency" territory.

The sources for this information, in addition to those cited below, include an excellent research note prepared by Peter Mathews (FG), TD for the Dail Finance Committee, the IMF GFSR and IMF WEO databases.

Deutsche Bank

Leveraged 52:1 (16 August 2011) based on a Tangible Common Equity (TCE) to Total Asset measurement.

Tangible Common Equity is a better gauge of solvency than Tier 1 capital, particularly in the midst of a liquidity crisis. Tier 1 gives no sense of a bank's ability to withstand a liquidity crunch as it includes market-sensitive instruments that are subject to liquidity and price declines risks. Tangible Common Equity is also a much better indicator of a bank's ability to raise further funds in the market as it inversely relates to the rate of assets dilution implied in any rights issuance. (1), (2)

As TCE of €36.2bn is written against €1.85 trillion of assets, DB has just 1.96% cover in form of TCE against assets it holds - a writedown of just 2% on the asset values (cross the book) will wipe out the DB TCE cushion, rendering its current equity-holders de facto bust. Even excluding derivatives, MorningStar estimated DB leverage (TCE ratio 2.1%) at 47.6:1.

DE's current leverage levels compare unfavorably against 44:1 TCE leveraging on Lehman Bros books at the time of collapse (ordinary leverage ratio in Lehman's prior to collapse was 31:1) and makes DB the second most-leveraged bank in the euro area after Credit Agricole.

To bring DB closer to sustainable levels of TCE delveraging - 8-10% reading (note this is different from Tier 1 capital) will require it raising €110-150 billion in equity (depending on specifics of risk weighting ratios) or 3-4 times the current valuation of TCE or 3-4 times the current market value of the DB. Implied dilution for current equity holders under such scenario bears the risk of 75%- 80% loss on equity.

Note that 8-10% ratios are rather conservative, considering that in 2006-2009 TCEs for countries with banking sector crisis averaged (across top100 banks) TCEs of 11.5% to 15.3%. (3) Raising TCEs to the crisis-average levels of ca 13.4% will require equity raising of ca 5.7 times current market valuations or implied dilution of current equity by 85%.

To match TCE/Total Asset leverage ratio of the most leveraged US bank, JP Morgan chase (5.58%), DB would require €67 billion of additional equity or equity raising to the tune of 1.8 times current market cap.

DE's current market capitalisation of €37 billion as of 2 September matches relatively closely tangible common equity of €36.2 billion. In previous weeks, DE market cap fell as low as €26 billion or 70% of TCE. A market capitalisation at or below TCE is a warning sign that the bank is in trouble and questions surround its solvency and stability.

Worse than that, per research from Espirito Santo, DB liquid assets as % of the short term (<1 year) funding in 2010 stood at 47%, well below global leaders Credit Suisse (82%), UBS (77%) and Barclays (59%). At the same time 2010 wholesale funding maturity requirement was 49% - in excess of the iquid assets cover. Again, Credit Suisse had 33% funding call against 82% cover.

DB is structurally important to Germany as its assets stand at around €1.85 trillion, close to 75% of Germany's 2010 GDP (€ 2.498 trillion).

DB exposure to Greek assets is €1.6 billion for the core Group components (sovereign debt only), of which €1.34 billion in Deutsche Postbank AG exposures. Under 70% haircut scenario across the entire DB Group, the total implied loss will be around 5% of TCE.

Commerzbank

Current leverage around 35:1 in TCE terms, which is elevated compared to both historical averages and 2008-2009 crisis levels for comparable institutions. Given current assets valuations at ca €700 billion, the implied TCE is 2.92%, which means that a writedown of 3% of the assets will result in a complete wipe-out of TCE.

The core problem with 35:1 TCE leveraging in the current environment of globally impaired liquidity is that any deleveraging of the balance sheet will require substantial equity rising, similar to that in DE as discussed above. Adjusting for derivatives held, TCE ratio in Commerzbank runs at 30:1 - according to MorningStar who called this leverage ratio as consistent with "extreme" risk rating.

Together with DB, Commerzbank account for ca 102% of German GDP. As German debt to GDP ratio currently stands at 83% and heading for 87% , German taxpayers can see significant adverse impact of the DB and Commerzbank recapitalizations should the calls on PIIGS come in.

Commerzbank is the most exposed of all German banks when it comes to Greek sovereign debt, with nominal exposure at of the end of Q2 2011 of €2.9 billion. Applying the market-expected mid-point writedown in the case of default of 70%, bank losses on the Greek sovereign bonds will wipe out around 19% of the bank equity.

Recent data shows deep concentrations of Greek risks exposures in German banking sector, with German commercial banks holding ca €19.3 billion in public sector debt from Greece, €2.9 billion worth of banks debt from Greek banks and €7.4 billion of corporate and private debt, to the total of €29.5 billion (per BIS data). According to Fitch research, only €13.1 billion of that is on the banks balancesheets, the rest tucked away off the books.


French Banks

Credit Agricole is leveraged 70:1 (assets €1.5 trillion), while BNP Paribas is leveraged 36:1 (assets €1.93 trillion, Common Equity Tier 1 ratio of 9.6% well below minimum standard set for SIFIs of 10%). Bank's assets to market value currently stands at 64:1. BNP's exposure to Greek debt is now at ca €4 billion. SocGen is leveraged 34:1 (assets €1.16 trillion) on TCE basis and 28:1 on ordinary basis (again, recall Lehman's numbers at the point of collapse were 44:1 and 31:1) the bank has huge short term funding requirements presently being exposed by the flight out of Europe by US money market funds and Asian investors. SocGen exposure to PIIGS debt is €4.3 billion, referring to banking book only. SocGen is also in trouble on the liquid assets side with 26% ratio of liquid assets to short-term wholesale funding calls in 2010. Worse, wholesale funding that matured within 1 year of 2010 as percent of total wholesale funding was 69% for SocGen. Three French pillar banks have assets coming in at well over 200% of French GDP.

The banks are aggressively moving out of the PIIGS with SocGen in recent note stated that it cut its exposures to the peripheral states by 23% since early June 2011, taking out $1.5 billion and $2 billion in assets from Greek and Italian books. French banks total exposure to Greece is estimated at around $89 billion.

On top of this, French banks are now becoming effectively shut out of the dollar funding markets (4). And liquidity woes do not stop there. US Prime money funds have cut their holdings in certificates of deposits from French banks by about 40% in the three months through August 11. The proportion of the remaining holdings of French banks short term funding notes maturing in less than a month increased to 56% on August 11 from 17% on June 11. (5) The banks, of course, deny this is happening.

Let's run though some grim figures for one of the French "dogs" - BNP: as of June 30, 2011, the bank had €109bn worth of sovereign bonds on its books, amounting to 190% of the bank TCE (that's JUST Government bonds!), of which €31bn (or 54% of TCE) was in PIIGS bonds split as follows: Portugal - €1.7bn, Ireland - €400mln, Italy - €23bn, Greece - €3.8bn, and Spain €2.5bn. 95% of these exposures were held on banking book. So, now, let's do the same exercise as above - apply 50% haircut to Greek bonds, 25% haircuts to Porto bonds, 15% to Spanish, Irish and Italian bonds - all below market rates of implied haircuts, but let's indulge them with this assumption. This adds up to a writedown of €6.21bn or a wipe out of 11% of TCE. Bank becomes insolvent.


Summary

To summarise the above, two of German core banking institutions are currently operating in the extremely risky environment with leverage levels that can be classified as "extreme". The French banking system is even more sick than the German one with leverage ratios close to those attained by Lehman and PIIGS exposures that are well in excess of "manageable", given already strained capital cushions.

In common parlance, if it barks & wags the tail, it's a dog... regardless of what the official stress tests and powerpoint slides say.


Notes

(1) See BASEL III: Long-term impact on economic performance and fluctuations, by P. Angelini, L. Clerc, V. Cúrdia, L. Gambacorta, A. Gerali, A. Locarno, R. Motto, W. Roeger, S. Van den Heuvel, J. Vlc_ek, BIS Working Paper 338, February 2011, http://ssrn.com/abstract=1858724

(2) Note that Tier 1 capital is classified into different Tiers of capital, based broadly on the maturity profile of the capital invested. The most stable capital is Tier 1 capital and consists of items such as paid-up ordinary shares, non-cumulative and non- redeemable preference shares, non-repayable share premiums, disclosed reserves and retained earnings.

(3) Bank Behavior in Response to Basel III: A Cross-Country Analysis, by Thomas F. Cosimano and Dalia S. Hakura1, May 2011, WP/11/119, IMF Working Paper, Table 3.

(4) http://www.forexcrunch.com/bnp-paribas-executive-admits-access-denied-for-dollars/

(5) http://www.businessweek.com/news/2011-09-13/bnp-paribas-socgen-rebound-after-rejecting-funding-concerns.html

13/09/2011: Forthcoming Conference on Economic Sustainability

Forthcoming Feasta conference on, among other things,

• Alternative currencies / parallel currencies
• Site-Value Tax / Land-Value Tax
• Dealing with private debt overhang
• Energy, economic growth and crises, and more
  

Loads of interesting thinkers and usual suspects too. Unorthodox, provocative, and worth attending.

National Strategies for dealing with Ireland's debt crisis: Exploring the options

Link here.

13/09/2011: Global contagion from Greece

In the torrent of newsflow from the euro area, we are forgetting about the wider geography of implications of the Greek default. Here are some of the points in addition to my comment to today's article on the topic in Canada's Globe & Mail (article here).

There are two core pathways through which the Greek default will have an adverse impact on banking and sovereign risk valuations outside the euro zone. Firstly, there is the direct impact via foreign banks exposure to Greek debt. These range from small to medium sized and can be concentrated in a small number of institutions in each country. Secondly, there is a number of inter-linked second order effects, which tend to have much larger implications once propagated across the global financial system.

Direct impacts include:

• Japanese banks hold $432 million in Greek debt
• U.S. banks hold $1.5 billion in Greek debt
• UK banks hold $3.4 billion in Greek debt
• Bulgaria has bank credit exposure of $13.5bn to Greece (banks and sovereign debt)
  
• Serbia's exposure is about $7 billion
• Romania's banking system is tied into $20.2 billion of exposures to Greek banks and sovereign debt
  
• Turkey $30.4 bn exposure
  
• Poland $8.0 bn
• Croatia, Hungary and the Czech Republic combined are exposed to some $460 million.

Indirect impact:

Were Greece to default, core euro area banks - Deutsche Bank (including Deutsche Post) carries ca €2.94 billion exposure, Commerzbank (€2.9 billion), but also SocGen, Credit Agricole, Commerz Bank etc will come under severe pressure to recapitalize. German banks have combined exposure to Greece of ca $22.65 billion, French banks $14.96 billion. Cross positions vis-a-vis Greek banks (with their exposure to Greek sovereign bonds of $62.8 billion) imply strong spill-overs. Thus, Greek default can lead to a severe liquidity crunch and flight to safety of deposits from not only Greek and euro area banks, but from a number of closely inter-connected banking systems, especially those with close trading and investment links to the European Economic Community.

This is bound to induce contagion across the entire euro area and spill overs to euro area banks cross links to Eastern and Central Europe and beyond. In effect, Romanian and Bulgarian banking systems are heavily dependent on Greek banks and their own banks collapse will put huge pressures on Hungary. The ripple effects of this can reach as far as Ukraine and Turkey.

There are other interesting cross-links worth looking at. Greek default can trigger default across Cyprus banking sector which holds ca $28.3bn exposure to Greek banks and sovereign debts (156% of Cypriot GDP). With 30% recovery rate on Greek default, Cyprus is facing with recapitalization bill for its banks to the tune of 10% of GDP. This, irony has it, can put pressure on Russian deposits in Cyprus and capital flows between Cyprus and CIS, which are massive - note that Cyprus is the largest single FDI transfer point for Russia with CB of Russia estimating that in 2007-2010 Cyprus banks channeled some 42bn USD worth of FDI to Russia.

To sum up, Greek default - which will inevitably combine sovereign and banking sectors defaults - will trigger a large-scale revaluation of assets and risk-weightings across a broad range of Eastern and Central European Economies, including Turkey, in effect slamming the breaks on the only growth engine within the European Economic Community and its nearest neighbours.

But there is a global cost to the Greek default as well, which rests with significant dislocations of risk-linked investment markets (equities and corporate debt), insurance and derivative products. The multiplier effects, consistent with 2008-2010 financial markets experience, suggest that magnification of Greek default costs across the global economy can reach 4 times the original volume of default itself. With 50% recovery rate on Greek liabilities, this implies a total expected cost of ca €240 billion, and with 30% recovery rate currently appearing to be more realistic, the propagated effects can sum up to €340 billion.