16/11/2011: Irish Mortgages Crisis

Unedited version of my latest Sunday Times article (November 13, 2011).

Per latest data available to us – at the end of June 2011, there were 777,321 outstanding mortgages in Ireland. Of these, 55,763 mortgages were in arrears more than 90 days, up 53% on same period a year ago. In addition, 39,395 mortgages were ‘restructured’ but are currently ‘performing’ – in other words, paying at least some interest. Adding together all mortgages in arrears, repossessions, plus those that were restructured but are not in arrears yet, 95,967 mortgages (12.3% of the total) amounting to €17.5 billion (or 15.2% of the total outstanding mortgages amount) are currently at risk of default, defaulting or have defaulted.

Given the trend in these developments to-date, we can expect that by the end of 2011 there will be some 114,000 mortgages in distress in Ireland. By the end of 2012 this number can rise to over 161,000 or some 21% of the total mortgages pool in the country.

This is a staggeringly high number. When considered in the light of demographic distribution and vintages, 21% of all mortgages that are likely to be in arrears around the end of 2012-the beginning of 2013 will account for up to 30% of the total value of mortgages outstanding.

Mortgages at risk of default

Source: Central Bank of Ireland and author own calculations

This is a simple corollary from the fact that mortgages crisis is now impacting most severely families in their 30s and 40s, with more recent and, thus, larger mortgages signed around the peak of the property bubble. These households are facing three pressures in today’s environment.

Firstly, they are experiencing above-average unemployment and income pressures. Per Quarterly National Household Survey, in Q2 2011, unemployment rate for persons aged 25-34 was 16.5% and unemployment rate for those in age group of 35-44 was 12.4, both well ahead of the 8.95% average unemployment rate for older households. By virtue of being more concentrated in the middle class earning categories, they are also facing higher tax burdens than their lower-earning younger and more asset-rich older counterparts.

Secondly, they are facing higher costs of living, further depressing their capacity to repay these mortgages. More likely to live on the outer margins of commuter belts, our middle-income earners are facing more expensive cost of commute, courtesy of higher energy prices, high taxes associated with car ownership and the lack of viable public transport alternatives. In September this year, prices of petrol were 15.4% above their levels a year ago. Inflation in diesel prices is running at 14.8%. Cost of road transport increased 5% in a year through September, and bus fares are up 10.8% These households are also facing higher costs associated with raising children. Since the time these families bought their houses (e.g. 2005-2007), primary and secondary education costs went up 21-22%, and third level education costs rose 32%. On average, larger families require greater health spending, the cost of which rose 3.4% year on year in September and now stands at 16% above 2005-2007 levels. The three categories of costs described above comprise ca 19% of the total household budget for an average Irish household and above that for a mid-aged household with children.

Thirdly, as their disposable incomes shrink and mortgage costs rise (mortgages-related interest costs are up 17.2 year on year and 11% on 2006), the very same households that are hardest hit by the crisis are also missing vital years for generating savings for their old age pensions provisions and most active years for entrepreneurship and investment.

In short, courtesy of the crisis and the Government policy responses to it to-date, Ireland already has a ‘lost generation’ – the most economically, socially and culturally productive one. And this generation is now at the forefront of the largest homemade crisis we are facing – the crisis of mortgages defaults and personal bankruptcies.

Against this backdrop, the forthcoming Personal Bankruptcies Bill should form a cornerstone of the Government’s policy.

This week, the media reported some of the specifics of the forthcoming legislation, which include two crucial details: the 3-years release period for personal bankruptcy and the non-recourse nature of the arrangement. Under the former, the current period of bankruptcy will be cut from 12 years to 3 years, while under the latter, the new bankruptcy law will limit the extent of the household liability to the current value of the property underlying the mortgage. It is uncertain, at this stage, what claims, if any, can be levied against personal and family savings and other assets.

The provisions, as reported in the media, appear to be well-balanced for a normal bankruptcy reform, but remain excessively harsh for the legislation designed to tackle an acute crisis. Here’s what is needed.

A conditional bankruptcy release period for mortgages taken in the period of 2003-2008 should be set at 12 months subject to satisfactory completion of court-set conditions. Full release should apply after 3 years. There should be no restriction on companies directorships for those in the process, so as not to reduce entrepreneurship and small business ownership.

The lien against the personal income and assets should be designed as follows. No more than 25-35% of the after-tax disposable income can be diverted to the repayment of the mortgage, to allow for private sector rent payments. No more than 30% of the household assets below €25,000 can be used to repay the residual mortgage post-foreclosure. The amount can rise to 50% for assets valued between €25,001 to €50,000 and to the maximum of 70% for assets valued over €50,000. This will minimize losses to the banks, disincentivise strategic defaults and reduce moral hazard, while still allowing families to retain safety cushion of savings to offset the risks of sudden income losses or illness.

Banks objections to relaxing bankruptcy laws, raised this week, is that the new law will trigger a significant demand for capital as losses due to non-recourse clauses will be borne by the lenders. This is simply not true.

Firstly, with some claim on family assets in place, bankruptcy process will still be used only in the cases of extreme financial distress. A combination of a limited liability applying to some family assets and a 3-year repayment period will create both a disincentive to abuse the system and a cushion of burden sharing, reducing the end losses to the banks.  Savings on interest payments supports and legal costs will further reduce taxpayers potential exposure.

Secondly, the stress tests carried out earlier this year were supposed to provide ample supports for the banks against mortgages defaults. Blackrock estimates of the worst-case scenario losses on Irish mortgages over the life-time of the loans amount to €16.3 billion split between €10.2 billion owner-occupier and €6.1 billion for buy-to-let borrowers. Central Bank of Ireland assumed 3-year losses amount to the total of €9 billion. Reformed bankruptcy law is unlikely to raise the Blackrock estimates for life-time losses, but is likely to push forward the defaults that would have occurred outside the Central Bank-assumed time frame of 2011-2013. In other words, unless the stress tests performed were not rigorous enough, or the Central Bank assumptions on 2011-2013 defaults were not realistic, capital supplied to the banks post PCARs already incorporates expected losses.

Either way, there is neither an economic nor moral justification for using bankruptcy laws as a tool for locking borrowers in servitude to the lender. During the boom, the Irish state and banks have acted recklessly toward the very same borrowers. The duty of care to protect consumers and investors was abandoned by the previous Financial Regulator, the banks, public authorities in charge of regulating property markets and, ultimately, the Governments that presided over the system, which put full burden of risks associated with property purchases on the buyers. Remedying this requires giving distressed borrowers some powers to compel burden sharing vis-à-vis the banks.

Box-out:

This week, the entire world was consumed with the saga of Silvio Berlusconi’s resignation. Played out across the media – from print to facebook – the story of the ‘departing villain’ was almost comical, were it not tragic in the end. Tragic not so much in the inevitable rise in Italian bond yields, but in the sense of denial of reality that the media and political circus that surrounded Mr Berlusconi’s departure from power. Italy is a Leviathanian version of the zombie economies of Greece and Portugal. Between 1990 and 2010, Italian real GDP grew at an average rate of less than 1% per annum, less than half the rate of Spain, Greece and Portugal. Italian growth in exports of goods and services, over the same period was roughly one half of the rate of growth in Spain and 1.5 times lower than that for Greece and Portugal. Italy’s unemployment rate averaged just below that for other 3 countries. Italian fiscal deficits, at an average of 5.2% per annum, were greater than those of Portugal (3.3%) and Spain (3.1%), but lower than those in Greece (7.8%). Ditto for structural deficits. These are hardly attributable to Mr Berlusconi alone and are unlikely to be altered dramatically by his successors. While it is easy to point the finger at the internationally disliked leader, the truth remains the same – with or without Berlusconi, Italy is a nation with a dysfunctional economy.

15/11/2011: Q3 2011 Growth in Euro area

Latest data on euro area economies:

• France posted a quarter-on-quarter +0.4% in GDP in Q3 2011 after -0.1% contraction in Q2. Household spending +0.3% in Q3 from -0.8% decline in Q2. Domestic demand +0.3% from -0.3% fall in Q2. Production in goods and services +0.4% in Q3 compared to -0.1% drop in Q1.
• Germany GDP +2.6% y/y in Q3, 0.5% qoq and Q2 is revised up to +0.3% from +0.1% in preliminary release.
• Spain posted 0.0% growth qoq and 0.8% yoy growth in Q3 2011 against 0.2% qoq and 0.8% yoy growth in Q2 2011.
• Italy is yet to report data
• Overall, Euro area 17 posted 0.2% growth qoq in Q3 2011, same as in Q2 2011, with yearly growth of 1.4% in Q3 2011 down from 1.6% in Q2 2011. The slowdown is now evident in the yearly growth terms with Q4 2010 coming at 1.9%, rising to 2.4% in Q1 2011 and falling to 1.6% in Q2 2011 followed by the latest preliminary growth estimate of 1.4% for Q3 2011
• EU 27 also posted a slowdown in Q3 2011: Q4 2010 annualized growth was 2.1%, rising to 2.4% in Q1 2011, and falling back to 1.7% in Q2 2011 and 1.4% in Q3 2011. Quarterly growth rates in EU27 were 0.2% in Q3 2011 against 0.2% in Q2 2011, down from 0.7% in Q1 2011.

The above compares against:

• Q3 2011 growth of 0.6% qoq against Q2 2011 growth of 0.3% in the US. Yoy growth in the US was 1.6% unchanged from Q2 2011.
• Q3 2011 growth of +1.5% qoq against contraction of -0.3% in Q2 2011 in Japan. Yoy growth in Japan in Q3 2011 was -0.2% against -1.0% growth in Q2 2011.

Updated:


NY Fed manufacturing index reached back into positive territory, albeit barely, in November following five consecutive months of negative readings. Index rose to 0.6 in November from negative 8.5 in October. However, underlying conditions remained generally poor: new orders index fell to negative 2.1 in November from 0.2 in October and inventories fell to negative 12.2 in November from negative 9.0 in October. The employment index fell to negative 3.7 in November from 3.4 in October while the average workweek rose for the first time in six months. The prices paid index fell to its lowest level in nearly two years and this pressured margins.


U.S. retail sales were up 0.5% in October, driven by higher purchases online and higher spending on electronics and appliance. Sales of autos rose just 0.4% after a big surge in September while gasoline sales fell. Ex-auto sector, retail sales increased 0.6%. Retail sales for September were up 1.1%, were unchanged. Yoy through October retail sales are up 7.2%.

14/11/2011: Tourism to Ireland - Q3 2011 data

Q3 2011 data for overseas travel to and from Ireland is out today and here are the updates.

From the top figures:

• In Q3 2011, total number of overseas trips to Ireland rose 6.49% yoy (+129,600 visitors). Relative to peak of Q3 2007, the number of visits to Ireland remains down 19.66% (-520,200 visitors).
• Number of overseas trips from Ireland fell 7.02% yoy (-150,000) and is down 15.64% on peak of Q3 2007 (-368,500 visitors).
• Net travel to Ireland in Q3 2011 was 139,000, up on 10,600 in Q2 2011 and up on -140,600 in Q3 2010, making this quarter the second highest in terms of net number of visitors to Ireland since Q1 2007 and the highest since Q3 2007.

• Numbers of visitors to Ireland from Great Britain rose to 910,500 in Q3 2011 (+6.79% yoy) but remains 28.27% (-358,800) down on same period in 2007.
• Numbers of visitors from Other Europe rose 5.84% yoy to 741,800 in Q3 2011, but remains down 15.09% on Q3 2007 (-131,800).
• Numbers of visitors from North America rose 5.17% yoy (to 350,000) and is down 10.33% on Q3 2007.
• Proportionally, visitors from Great Britain to Ireland comprised 42.82% of all visitors to Ireland in Q3 2011, up on 42.7% in Q2 2011, but down on 47.96% in Q3 2007.

So overall, some encouraging news for tourism and transport sector. This is especially encouraging since Q3 2011 was a quarter of heightened economic concerns across the EU, UK and the US, so it is hard to argue that some sort of 'recovery bounce' is driving tourists to Ireland. Which might suggest that improved costs of hotels and associated services are working through to make Ireland more attractive destination. That and PR stunts by the Queen and the US President?

PS: after I have posted the above, one of the twitterati @hayspender came back with a comment:
"you dont think zombie hotels have a influence also? ie not true economics!" I agree, sometimes, when you write, not all possible permutations of potential causes can be captured. Of course, part of the 'improved competitiveness' is the factor of NAMA-owned hotels which receive an implicit (and very real) subsidy on their capital costs, allowing them to offer rooms at rates well below true cost that is faced by other hoteliers.

Yet another potential factor, also overlooked by me and flagged by another twitterati, is that some of the overseas travel relates to people commuting for work. This, however, does not appear to be reflected in the data, since the CSO releases data based on surveys which do collect information about the residency of travelers and reasons for travel.

13/11/2011: Non Performing Loans and links to macroeconomy

‘Often, the banking problems do not arise from the liability side, but from a protracted deterioration in asset quality, be it from a collapse in real estate prices or increased bankruptcies in the nonfinancial sector’’ (Kaminsky and Reinhart, 1999).

How true this sounds today. Take Euro area banks:

1) Collapse in US and European real estate valuations in recent years has triggered fall off in the value of linked assets held on the banks balance sheets

2) Collapse in the European bonds valuations has triggered a precipitous decline in core assets, including capital-linked assets

3) General recession have further undermined core assets on the loans side in corporate, SME and household lending.

A recent IMF paper: “Nonperforming Loans and Macrofinancial Vulnerabilities in Advanced Economies” by Mwanza Nkusu (2011) (IMF WP/11/161, July 2011) looks into the asset-focused linkages between financial and macroeconomic shocks, aiming “to uncover macro-financial vulnerabilities from the linkages between nonperforming loans (NPL) and macroeconomic performance in advanced economies”.

Based on a sample of 26 advanced countries from 1998 to 2009, the paper deals with two empirical questions on NPL and macrofinancial vulnerabilities: 

1) the determinants of NPL and 

2) the interactions between NPL and economic performance. 

With respect of the first question, the literature suggests that the determinants of NPL can be macroeconomic, financial, or purely institutional. In addressing the second question, the paper investigated “the extent to which falling asset prices and credit constraints facing borrowers may backfire and lead to an extra round of financial system stress and subdued economic activity”. 

The findings show that “NPL play a central role in the linkages between credit markets frictions and macroeconomic vulnerabilities. The results confirm that a sharp increase in NPL weakens macroeconomic performance, activating a vicious spiral that exacerbates macrofinancial vulnerabilities. …The broad policy implication is that, while NPL remain a permanent feature of banks’ balance sheets, policies and reforms should be geared to avoiding sharp increases that set into motion the adverse feedback loop between macroeconomic and financial shocks.”

Per authors: “empirical regularities …shape the modeling of NPL, …include the cyclical nature of bank credit, NPL, and loan loss provisions. In particular, in upturns, contemporaneous NPL ratios tend to be low and loan loss provisioning subdued. Also, competitive pressure and optimism about the macroeconomic outlook lead to a loosening of lending standards and strong credit growth, sowing the seeds of borrowers’ and lenders’ financial distress down the road. The loosening of lending standards in upturns depends on the existing regulatory and supervisory framework. In downturns, higher-than-expected NPL ratios, coupled with the decline in the value of collaterals, engenders greater caution among lenders and lead to a tightening of credit extension, with adverse impacts on domestic demand.”

In other words, first order effects of ‘positive’ pressures on lending expansion are reinforced by ‘positive’ second order effects of reduced risk management provisions, regulatory slackening and counter-cyclical capital buffers. Once things blow, however, the same effects again reinforce each other. The bubble acceleration is supported by both moments as well as the bubble explosion – yielding higher peaks and deeper troughs.

Thus, the determinants of NPL “are both institutional/structural and macroeconomic”.

The institutional / structural determinants are found in financial regulation and supervision and the lending incentive structure. “Intuitively, disparities in financial regulation and supervision affect banks’ behavior and risk management practices and are important in explaining cross-country differences in NPL.” 

The macroeconomic environment drivers work by altering “borrowers’ balance sheets and their debt servicing capacity. The set of macroeconomic variables [includes]… broad indicators of macroeconomic performance, such as GDP growth and unemployment...”

The core findings of the study are: 

• “A sharp increase in NPL triggers long-lived tailwinds that cripple macroeconomic performance from several fronts. …of all the variables included in the model, NPL is the only one that has both a statistically significant response to- and predictive power on- every single [macroeconomic performance] variable over a 4-year forecast period. …Regardless of the factors behind the deterioration in loan quality, the evidence suggests that a sharp increase in aggregate NPL feeds on itself leading to an almost linear incremental response that continues into the fourth year after the initial shock.”
• “The confluence of adverse responses in key indicators of macroeconomic performance—GDP growth and unemployment—leads to a downward spiral in which banking system distress and the deterioration in economic activity reinforce each other.”
• “The broad policy implication [is that] …policies and reforms should be geared to avoiding sharp increases that set into motion the adverse feedback loop between macroeconomic and financial shocks. … preventing excessive risk-taking during upturns through adequate macroprudential regulations is the first best.”

In other words, folks, you can’t ignore the macroeconomic effects of Non Performing Loans, as Ireland’s Government is implicitly doing by refusing to focus on repairing household debt overhang here. And, via a link between negative equity and NPL (the study cites evidence that house prices have direct negative effect on NPL – with house prices collapse leading to increased NPLs), we can’t ignore negative equity effects either.

13/11/2011: Euro area - history of insolvency

Nouriel Roubini makes a very compelling argument as to the nature of the Euro area crisis - the nature revealed by unsustainable economic model based on running excessive external deficits and accumulating debt (see his blogpost here).

I have frequently referenced this problem to a deeper underlying force - the propensity of the European social democratic models to spend beyond their means. As the Euro area economies pursued populist agendas of 'social' services and subsidies expansion throughout the 1990s and 2000s, some (indeed majority) of the European economies stagnated, implying diminished capacity to sustain subsidies transfers within the vested interests-run Union. Thus, current account deficits - mask both Government and private sectors imbalances (with Governments in effect pumping the private economy with steroids of debt and cheap interest rates to extract tax rents that can be used to finance political largesse).

To see this, look no further than the links between Current Account deficits (external imbalances across entire economy - public and private) and Government deficits (fiscal imbalances), as well as Structural deficits (fiscal imbalances corrected for recessionary impacts).

Chart below shows cumulated current account deficits for 12 years since 2000 as well as cumulated structural deficits.

The striking feature of this chart is that over 12 years horizon, only 6 countries of the Euro area have managed to post a cumulative external surplus, while only one country (Finland) has managed to live within its means both in terms of external balance and fiscal balance. Any wonder that Finns are so opposed to the idea of 'burden sharing' that will see their surpluses transferred to the profligate states?

Another striking feature of the graph is that, contrary to Mr Roubini's assertion, France too was running dual external and fiscal deficits. Albeit, its deficit on current account side was small. Germany - another paragon of 'stability' run structural deficits on the fiscal side - i.e. spent beyond its means when it comes to Government expenditure outside that needed to correct for recessionary imbalances. Ditto for the Netherlands.

Ireland - our engine of 'exports-led growth' - is, alas, firmly NOT an engine of external balances. Cumulated current account deficit for the country is -19.5% of GDP. Any hopes for reversing 12 years of that experience, folks, will require re-wiring of our economy, preferences, political and institutional structures etc. Good luck getting there before the whole house of cards comes tumbling down.

In fact, deficits are sticky - hard to reverse. Past deficit experience, it turns out, shapes much of the future achievement, as illustrated in the chart below.

Once you are insolvent for a decade (1990s) you are likely to remain insolvent for the next decade too (2000s). And, hence, the headwinds against us (Ireland) reversing that and moving into strong surpluses on current account in years ahead are strong. Not that they can't be overcome. If we look at transition from 1990s external balance position to 2000s position, the following holds:

• Finland and the Netherlands stand out as the only 2 countries that managed to improve their surpluses on the current account side between 1990s and 2000s averages
• France, Belgium and Luxembourg are 3 countries that managed to retain surpluses, but weakened their performance between 1990s and 2000s
• Malta was the only country that managed to reduce its external deficits between 1990s and 2000s in terms of averages
• Portugal, Greece, estonia, Cyprus, Slovak Republic, Sapin, Ireland, Slovenia and Italy all saw average deficits of the 1990s deepening in the 2000s
• Only two economies - Austria and Germany have managed to reverse previous deficits (in the 1990s) to surpluses in the 2000s. 

That means that, historically, a chance of reversing average current account deficit in the previous decade to a surplus in the next decade is 2/17 or less than 12%. not an impossible feat, but an unlikely one.

And current account deficits do appear to relate closely to the General Government deficits and Structural fiscal deficits as the two charts below show (note of caution - the equations estimated below are imprecise, of course, due to small sample).

At last, a table to summarize:

Yep, insolvency - of the deepest (across all three measures) variety is the domain of 10 out of 17 member states when it comes to the last 12 years of Euro area history. Another 5 member states are insolvent by two out of three criteria. Lastly, only two member states - Finland and Luxembourg - were actually fully solvent since 2000.

That, folks, makes for a rather spectacular failure of the Euro area institutional design.

12/11/2011: Russian economy - Summary 2011

Summary of the Russian economy in the light of the removal of the final barriers to the country accession to the WTO (see the related note here). To see the slides, click on the individual frame to enlarge

12/11/2011: Russia's accession to the WTO - opportunities for Irish exports & investment

This week, finally, with much delay, there is a full agreement for Russia accession to WTO, clearing the few issues that remained the stumbling block to the country membership. It is now expected that Russia’s membership will be approved at the WTO Council meeting on December 15-17. The decision is expected to go for ratification to the Duma some time in early 2012. Following the ratification, Russia will be formally admitted to the WTO within 30 days after the vote.

Under the core conditions for entry, import tariffs will be reduced from the average of 10% to 7.8% with at least 1/3 of all tariffs reductions to take place on the date of formal accession. 25% of the rest of tariffs reductions will take place after 3 years of transition. The balance will take effect after 7 years of transition (these focusing in the 'sensitive' areas of car manufacturing and aircraft manufacturing) and 8 years for some agricultural tariffs (e.g. poultry).

One core achievement will be in the area of customs clearance, with maximum customs fee to be reduced from the current Rb90,000 - or ca USD2,900 to Rb30,000.

Another core development is that the previously-announced major privatisations programme will be subject of reporting to the WTO

More specifically, in the areas of importance for irish exporters:

• Agricultural imports will see average tariffs falling from 13.2% current to 10.8% post-adjustment period. Cereals tariffs will declined from 15.15% to 10% and dairy tariffs will fall from 19.8% to 14.9%. Domestic agricultural supports - subsidies - will be reduced from USD9bn in 2011-2012 to USD4.4bn in 2018. 
• Russia will privatise 100% shareholding in the United Grain Company in 2012, as well 50%+1 share of the Rosagrolizing (by 2013).
• Overall, agricultural measures can be expected to drive significant change in the sector in Russia post-2020, with some expected capex growth in advance of these as domestic enterprises re-tool to enhance competitiveness.
• Manufacturing tariffs are to fall from 9.5% average to 7.3%. While automotive manufacturing imports tariffs are to declined from 15.5% to 12% over 7 years period. 
• In chemicals sector, average tariffs are to decline from 6.5% current to 5.2%.
• In telecoms sector, by the end of 2016 there will be lifting of the restriction on foreign ownership from the current 49% to allow full ownership of enterprises.
• Similarly, there will be no restriction on full foreign ownership of banks. However, foreign banks combined market share of the Russian market will remain capped at a maximum of 50%. In addition, by 2021 foreign insurance companies will be allowed to open fully-owned subsidiaries and branches in Russia.
• In transport sector, there will be equalization of treatment of foreign-made aircraft to that of the Russian-made aircraft in terms of leasing, eliminating current preferential treatment of Russian manufactured aircraft. By mid 2013, Russian railways will phase out price differentials for shipments of Russian-made and foreign-made goods.
• In services, the restriction on share ownership for wholesale, retail and franchise companies will be lifted immediately after the accession.

It is unlikely, however, that the accession will have an immediate impact on Russian trade and investment relations with the rest of the world, as compliance period relating to the accession is long, especially in the more 'sensitive' areas, such as car industry, transport industry, agriculture etc. However, we can expect an improved drive toward domestic (Russian) enterprises increasing their competitiveness and the Russian Government to accelerate efforts to improve institutional frameworks and enhance institutional capital. More active Government drive to secure key internal markets reforms is expected and this is likely to shape forthcoming Presidential elections.

On the net, I expect significant changes in the markets for Irish exporters into Russia and a long-term process of reforms and investment growth for Russian markets as the result of the accession. This is hugely positive development. The market potential for Irish trade with Russia is in the region of €1.3-1.5 billion or roughly double the current levels of exports.  The market potential for Irish investment into Russia is in the region of €1 billion per annum, although achieving this potential requires significant changes in the supply of auxiliary services to Irish investors (access to functional banking and investment advice).

Lastly, there is also a huge potential for Russian investment into Ireland. In recent years, Russian investments into EU have been increasing from about €3 billion annually in 2008 to the expected volume of €4.1 billion in 2011. But Ireland remains off the map for Russian investors with just two Russian-owned companies being clients of the IDA.

Note: Russia is currently the largest economy in the world outside the WTO, with GDP in excess of USD1.9 trillion expected in 2011. The World Bank estimates that joining WTO will add 3.7% to the country GDP between 2012 and 2016 and 11% within 2012-2021. See a follow up note summarizing the Russian economy.

11/11/2011: Ireland's Consumer Prices: October

Irish CPI and HICP figures for October show continued pattern of public sector-controlled costs inflation and continued pressures on prices in the domestic economy. Here are the details.

Per chart above, Irish CPI rose from 104.4 in September to 104.7 in October compared to December 2006 when it stood at 100. Re-based to December 2001, October CPI was at 123.6, up on 126.2 in September. Mom CPI rose 0.3% and 3mo change is 0.8%. Annualized rate of change is now 2.8% - the highest since April 2011. All items CPI rose from 2.6% in September to 2.8% in October. 3mo MA is now at 2.53% and 6mo MA is at 2.62%.

Harmonized Index of Consumer Prices also increased 0.3% mom to 107.1 in October from 106.8 in September. A year ago, index reading was 105.5, so controlling for rounding yoy HICP rose 1.5% in october, up on 1.3% in September and 1% increases in July and August.

 CPI by household budget components was also worrying:

• Food and non-alcoholic beverages prices inflation remained at 1.4% for the third month in a row, with 6mo MA of 1.17% and 3mo MA of 1.4%. In 3mo through October, average price inflation rose 50% on 3mo period through July.
• Alcoholic beverages & tobacco remained in deflation of -0.5% for the fourth month running. 3mo MA is -0.5% and 6mo MA is -0.3, which means we are witnessing slightly accelerating deflation.
• Clothing & footwear posted -0.3% CPI in October, same as in September, down from -1.2% deflation in August. 3mo MA is -0.6% and 6mo MA is -1.2%, so we are seeing some slowdown in deflation.
• Housing, water, electricity, gas and other fuels posted another double-digit price increase of 10.2% in October, up on CPI of 8.9% in September. 3mo MA CPI is now at 8.77% and 6mo MA CPI is at 9.07%. Largest yoy increases in this category were: 20.5% increase in natural gas prices, 20.3% hike in liquid fuels prices, 18.1% increase in mortgage interest costs, 11.5% rise in electricity prices, and 6.9% price increase for bottled gas.
• Deflation continued to build up in Furnishings, household equipment and maintenance category with CPI of -2.2% in October against -2.3% in August and September. 3mo MA is now at -2.27% and 6mo MA is at -2.37%.
• As far as state-controlled sectors go, Health had another bumper crop year with price increases of 2.3% in October, against CPI of 3.4% in June-September. 3mo MA is at 3.03% and 6mo MA is at 3.42%. Hospital services drove inflation here with annual rate of price change of 9.8%. In contrast, pharmaceutical products prices are down 3.3% yoy in October.
• Transport - another heavily state-controlled or dominated sector also posted robust inflation of 3.6% in October against 4.2% in September. CPI for the sector is now at 3mo MA of 3.67% and 6mo MA of 3.52%. Costs of purchasing vehicles have fallen 4.3% yoy through October, but costs of fuels and lubricants rose 14.5%. Rail transport costs are up 1.8%, Bus fares are up 10.0%, Air transport costs up 5.6% and Sea transport costs up 6.4%.
• Communications CPI in October stood at 1%, same as in previous 2 months. 6mo MA is now at 2.08%.
• Recreation & culture CPI posted -0.8% growth in October, more deflationary that -0.5% in September. 3mo MA is at -0.7% and 6mo MA at -0.65%.
• Education CPI showed the buoyancy of the Celtic Tiger era with 6.5% increase in October on the foot of 12 previous months posting deflation. 3mo MA is now at 1.1% and 6mo MA at -0.1%. THe swing in CPI was a massive 8.1 percentage points. Virtually all inflation in the sector was accounted for by the third level education costs - up 13.4% yoy in October (+13.5% mom). Education costs now run +21.9% ahead of December 2006 level for primary education, +22.7% for second level education, +50.1% for third level education and only +4.7% for Other education & training.
• Restaurants and hotels CPI came in at -0.9% in October from -0.8% in September. 3mo MA is at -0.8% and 6mo MA is at -0.65%. Accommodation services posted the largest deflation of -3.8% mom and -3.0% yoy, with Restaurants, cafes & fast-food posting deflation of -0.2% mom and -1.9% yoy.
• In Miscellaneous Goods and Services category, the only notable changes were: 12.7% yoy increase in insurance costs, broken down into a massive 23.8% yoy rise in Health insurance costs, and 4.2% rise in Transport Insurance costs. Overall, this category costs rose 6.4% yoy in October and 0.5% mom

State-controlled sectors and prices inflation is now running at 1.15% in October, up on 1.03% in September. 3mo MA and 6mo MA for the series are both at 1.0%. In contrast, private sectors prices are rising at 0.51% in October down from 0.55% in September. 3mo MA for these prices increases is 0.50% and 6mo MA is at 0.56%

Cumulative gap between state-controlled sectors prices and private sectors prices from December 2007 through today now stands at 140.51%, up from 139.62% in September.

11/11/2011: Some interesting recent links

Few links worth saving and reading - on diverse topics:

• Two Economist articles on our ability to access others' thoughts (here) and a related piece (here). 
• And excellent piece from the Irish Times on the role of data storage in changing the ways we think (here).
• Irish Times piece on electricity pricing and our state plans to export renewable energy: are we going to subsidise foreign consumers (here).
• Krugman's comment on Roubini's summary of the effects of 'internal devaluations' (here).
• Thomas Begley's piece on losses in Irish third level education competitiveness (here).
• My interview with Max Keiser from kilkenomics on the global financial crisis and the role of the markets and governments (here).
• A good graphic on latest ECB purchases of Italian bonds (here).
• An excellent set of graphics that provide visualization of euro area cross debt holdings (here).

11/11/2011: Industrial Production & Turnover - September

Industrial production and turnover figures for September provide some interesting reading. Monthly figures are significantly volatile, so some comparisons are tenuous at best, but overall, despite some downward pressures, the figures are encouraging. Here's why.

Industrial production index for manufacturing has declined from 116.4 in August to 113 in September - monthly drop of 2.92%. Year on year, September 2011 is still up 0.18% although index is down on September 2007 some 0.1%. The average of the 3mo through September 2011 was 2.2% ahead of the average for 3mo through June 2011 and 2.1% ahead of the 3mo average through September 2010. September 2011 reading is ahead of 6mo MA of 112.3 and 12mo MA of 111.7.

All of the above suggests the slowdown in activity in September was not as sharp as we might have expected given the adverse news flow from the rest of the Euro area.

All industries index has fallen from 115.2 in August to 111.2 in September, registering a yoy decline of 0.1% and mom drop of 3.47%. The index is down 1.67% on September 2007. Just as with Manufacturing index, All industries index 3mo average through September 2011 was up 2.59% on previous 3mo period and also up 1.82% on 3mo period through September 2010. The index was also above its 6mo MA of 110.7 and 12mo MA of 110.2. Again, this suggests that the slowdown is still shallow and there is some robustness in the series.

Both indices are still ahead of their readings in July and June. In fact, Manufacturing sub-index is resting at the second highest level since January 2011. The same holds for All Industries index.

Modern Sectors sub-index fell from 130.2 in August to 128.4 in September (-1.38%mom) but is up 1.18% yoy and 11.3% ahead of the reading for September 2007. 3mo average through September is 3.1% ahead of the 3mo average through June 2011 and is 1.8% ahead of the 3mo average through September 2010. The sub-index is ahead of its 6mo MA of 127.3 and its 12mo MA of 126.2. Modern Sector production activity remains at the second highest level since July 2010.

Per chart above, traditional sector production sub-index has fallen to 89.8 in September from 98.5 in August. The overall trend in the sub-sector is uncertain. Massive break out from the long term decline trend in August - with index posting the strongest performance since November 2008 is now followed by a contraction of 8.8% yoy and 1.8% mom in September. However, September reading still rests comfortably above the long term trend line and ahead of 6mo MA of 89.3 and 12mo MA of 89.1. This is the second strongest reading for the sub-index since September 2010.

Having shrunk to 31.7% in August, the gap between Modern and Traditional sectors has widened once again to 38.6%.

In terms of turnover, Manufacturing industries saw a significant decline in overall turnover activity from 104.3 in August to 100.5 in September. The index is now down 0.4% yoy and 3.64% mom. The index is also down 6.8% on September 2007. However, 3mo average through September is up 3.5% on 3mo average through June 2011 and also up 1.2% on 3mo average through September 2010. The good news is that September was the third consecutive month with turnover index at or above 100, which means that September reading is ahead of 6mo MA of 99.9 and 12mo MA of 99.5. But the gap is extremely small.

Transportable goods industries turnover also declined in September 2011 from 103.8 in August to 100.1. Mom, yoy and relative to September 2007 dynamics are virtually identical to those for Manufacturing sector. Similarities persist in comparatives for 3mo averages and for 6m and 12mo MA.

Hence, overall, turnover data is less encouraging than volume data, which is expected during the overall build up of pressures in global trade flows.

Also per chart above, new orders index came in at disappointing 99.6 in September down from 102.1 in August (decline of 1.09% yoy and -2.45% mom). Compared to September 2007 the index is now off 8.93%. 3mo average through September 2011 is 2.1% ahead of the 3mo average through June 2011, but is only 0.1% ahead of the 3mo average through September 2010. Current reading is very close to 6mo MA of 99.52 and to 12mo MA of 99.18.

So on the net, I am reading the numbers coming out for September as rather positive developments, signaling some resilience in Irish manufacturing and industrial production in the face of challenges across the euro area and other core trading partners. Of course, this data requires some confirmation in months ahead before we can pop that celebratory cork...

10/1/2011: Some simple Italian Auction maths

Italy's latest auction of 12mo t-bills came in at:

• Allocation: €5bln 
• Average yield 6.087% vs 3.57%  in last month's auction
• bid to cover ratio 1.989  vs 1.88 last month

The auction proves that

1. Italy is now insolvent (reminder - Italy is heading for 120% debt/GDP ratio with average real growth rate 1990-2010 of under 1% pa, implying that as ECB bound for inflation, Italy's annual expected growth over the next 20 years is unlikely to cover 1/2 of Italy's funding costs for its debt)
2. Italy is now illiquid (see chart below for funding requirements forward, courtesy of the ZeroHedge)
3. EFSF is now blown out of the water, with Italy's funding needs over 2012-2015 alone accounting for more than 1/2 of the entire enlarged EFSF pool of liquidity (good luck raising that, folks)
4. Italy's banking system is now insolvent as well, with Intesa's exposure at €60.2bn, UniCredit exposure of €49.1bn, Banca Monte at €32.5bn
5. Euro area top banks are now also insolvent with BNP Paribas exposure of €28bn, Dexia (aha, that one again) exposure of €15.8bn, Credit Agricole exposure of €10.8bn, Soc Gen exposure of €8.8bn, Deutsche Bank exposure of €7.7bn
6. A 30% haircut on Italy, in addition to 75% haircut on Greece requiring a direct hit on banks capital in Europe of some €315bn (that's on top of EFSF exposure to shore up Italian sovereign alone)

07/11/2011: Don't blame 'Johnny the Foreigner' for Western markets collapse

Global current account imbalances have been at the forefront of policy blame game going on across the EU and the US. In particular, the argument goes, savings glut in net exporting (mostly Asian) economies was the driving force behind low cost of investment flows around the world, producing a credit creation bubble via low interest rates. The deficit countries - the US, EU etc - have thus seen easing of lending conditions and world interest rates fell. The credit boom, therefore, was fueled by these savings surpluses, increasing risk loading on investment books of banks and other lenders and investors in the advanced economies.

Much of this orthodoxy is rarely challenged, so convenient is the premise that it is the Chinese and Indians, etc are to be blamed for what has transpired in the West. The mechanics of the process appear to be straight forward with current account imbalances going the same way as the causality argument - from surpluses in the East to deficits in the West.

A recent paper from the Bank for International Settlements, authored by Claudio Borio and Piti Disyatat and titled "Global imbalances and the financial crisis: Link or no link?" (BIS WP 346, May 2011), however, presents a very robust counter point to the orthodox view.

According to authors, "The central theme of the Excess Savings (ES) story hinges on two hypotheses: 

(i) net capital flows from current account surplus countries to deficit ones helped to finance credit booms in the latter; and 

(ii) a rise in ex ante global saving relative to ex ante investment in surplus countries depressed world interest rates, particularly those on US dollar assets, in which much of the surpluses are seen to have been invested. 

Authors' objection to the first hypothesis is that "by construction, current accounts and net capital flows reveal little about financing. They capture changes in net claims on a country arising from trade in real goods and services and hence net resource flows. But they exclude the underlying changes in gross flows and their contributions to existing stocks, including all the transactions involving only trade in financial assets, which make up the bulk of cross-border financial activity. As such, current accounts tell us little about the role a country plays in international borrowing, lending and financial intermediation, about the degree to which its real investments are financed from abroad, and about the impact of cross-border capital flows on domestic financial conditions." In other words, looking at current account deficits and surpluses, tell us little, in authors' view, about the financial flows that are allegedly being caused by these very current account imbalances.

This kinda makes sense. Imagine a MNC producing goods in country A, selling them to country B. Current account will record surplus to A and deficit to B. But the MNC might invest proceedings in country C via a fourth location, country D. Net current account position becomes indeterminate by these flows. Thus, per authors, "in assessing global financing patterns, it is sometimes helpful to move away from the residency principle, which underlies the balance- of-payments statistics, to a perspective that consolidates operations of individual firms across borders. By looking at gross capital flows and at the salient trends in international banking activity, we document how financial vulnerabilities were largely unrelated to – or, at the least, not captured by – global current account imbalances."

The problem arises because in traditional economics framework, savings (income or output not consumed in the economy) is investment. But in the real world, investment is not saving, but rather financing - a "cash flow concept… including through borrowing". Thus, per authors', "the financial crisis reflected disruptions in financing channels, in borrowing and lending patterns, about which saving and investment flows are largely silent." So ignoring the difference between the savings and investment financing, the current account hypothesis ignores the very nature of imbalances it is trying to model.

With respect to the second hypothesis, "the balance between ex ante saving and ex ante investment is best regarded as determining the natural, not the market, interest rate. The interest rate that prevails in the market at any given point in time is fundamentally a monetary phenomenon. It reflects the interplay between the policy rate set by central banks, market expectations about future policy rates and risk premia, as affected by the relative supply of financial assets and the risk perceptions and preferences of economic agents. It is thus closely related to the markets where financing, borrowing and lending take place. By contrast, the natural interest rate is an unobservable variable commonly assumed to reflect only real factors, including the balance between ex ante saving and ex ante investment, and to deliver equilibrium in the goods market. Saving and investment affect the market interest rate only indirectly, through the interplay between central bank policies and economic agents’ portfolio choices. While it is still possible for that interplay to guide the market rate towards the natural rate over any given period, we argue that this was not the case before the financial crisis. We see the unsustainable expansion in credit and asset prices (“financial imbalances”) that preceded the crisis as a sign of a significant and persistent gap between the two rates. Moreover, since by definition the natural rate is an equilibrium phenomenon, it is hard to see how market rates roughly in line with it could have been at the origin of the financial crisis."

In other words, the second hypothesis above confuses the observed market cost of capital - interest rates charged in the market - for the equilibrium natural rates that prevail in theory of balanced goods and services flows. The latter do not really exist in the market and cannot be referenced in investment decisions, but are useful only as benchmarks for long term analysis. Natural rates are "better suited to barter economies with frictionless trades" while the market rates are best suited to analyzing "a monetary economy, especially one in which credit creation takes place". And the market rates are driven by largely domestic (investment domicile) regulation, monetary policies, market structure, etc. In other words, market rates are caused by the US, EU etc policies and environments and not by Chinese trade surpluses.

The main conclusion from the study is that while current accounts do matter in economic sustainability analysis, "in promoting global financial stability, policies to address current account imbalances cannot be the priority. Addressing directly weaknesses in the international monetary and financial system is more important. The roots of the recent financial crisis can be traced to a global credit and asset price boom on the back of aggressive risk-taking. Our key hypothesis is that the international monetary and financial system lacks sufficiently strong anchors to prevent such unsustainable booms, resulting in what we call “excess elasticity”."

The former means, frankly speaking, that bashing China et al is not a good path to achieving investment markets stability and sustainability. The latter means that hammering out a new, more robust risk pricing infrastructure back at home, in the advanced economies, is a good path to delivering more resilient investment markets in the future. No easy "Johnny the Foreigner made me do it" way out for the West, folks.