21/3/2012: Anglo's Promo Notes - perfect target for debt restructuring

This is an unedited version of my Sunday Times article from March 18, 2012.

At last, courtesy of the years of economic and financial mess, Ireland is waking up to the problem of our debt overhang. For those of us who have consistently argued about the unsustainability of our fiscal and real economic debts predicament, this moment has been long coming. The restructuring of some of the debts carried by the Government directly or indirectly, on- or off-balancesheet is a matter of when, not if. Enter the debate concerning the Promissory Notes.

Per international research, State debt in excess of 90-95% of the real economic output is unsustainable. In real economics, as opposed to fiscal projections, debt becomes unsustainable when it exerts a long-term drag on future growth.

At the end of 2011, official Government debt in Ireland has reached 107% of our GDP or 130% of GNP, according to NTMA. The Irish economy is now operating in an environment of records-busting exports, current account surpluses, and healthy FDI inflows, and yet there is no real growth and unemployment remains sky-high. By comparatives, Irish economy is a well-tuned, functional car stuck in the quicksand – engine revving, power train working, wheels engaging, with no movement forward. This is a classic scenario of a debt overhang crisis – the very same crisis that Belgium has been struggling with since 1982, Italy – sicne 1988, Hungary – since 1991, and Japan – since 1995.

Something has to be done to deal with this problem in Ireland no matter what our Government and the EU say in public.

Uniquely for a euro area country, Ireland’s debt overhang did not arise solely from fiscal or structural economic shocks, but was strongly driven by the country response to the financial crisis rooted in a number of forces, including policy and regulatory errors by the EU and ECB. Also, Ireland has undergone the most severe adjustments in its fiscal position to-date compared to all other ‘peripheral’ economies, proving both our capability and commitment to reforms.

Lastly, in contrast with all other countries, Ireland’s economy is capable of getting back to sustainable levels of economic activity. Irish economy needs a supporting push out of the quicksand of banks-linked debt overhang to deliver on its sovereign debt commitments, and become once again a net contributor to the sustainable fiscal system within the euro area.

The IBRC Promissory Notes are a perfect focal point for such a push for a number of reasons.

First, the magnitude of the Promissory Notes allows for significant room to reduce Irish Government’s future liabilities, combining €28.1 billion of debt, plus 17 billion in interest repayments. These represent 29% of our GDP. Eliminating this liability will restore Ireland back onto sustainable fiscal and growth paths. Restructuring the Notes will not constitute a sovereign default. Although their value is counted in Irish Government debt, they are not traded in the markets. The Notes are, de facto, Irish Government IOUs to the Central Bank of Ireland with IBRC acting as an agent.

Second, Promissory Notes underwrite €28 billion of €42 billion IBRC debts to the ELA programme run by the Central Bank of Ireland. ELA funds are not borrowed by the Central Bank from the Eurosystem or the ECB, but are created by the Central Bank under its mandate. There is no offsetting physical liability the Central Bank needs to cancel by receipt of payments from the Government. The Notes also do not constitute Central Bank funding for the Government as they finance stabilization of the Irish (and thus European) banking system. Lastly, the ELA funding extended to the IBRC is already in the financial system. Removing requirement on the Irish state to monetize the Promissory Notes will not constitute an inflationary quantitative easing.

The Government is correct in focusing much of its firepower on the IBRC’s Promissory Notes. Alas, efforts to-date suggest that it is not setting its sights on the real solutions needed. This week, Minister Noonan has identified the direction in which the talks are progressing: restructuring the Promissory Notes repayment time schedule, plus possibly reducing the interest rate attached to the notes via converting the notes into ESM debt.

The problem with this approach is that a transfer of liabilities to ESM will convert Promissory Notes into a super-senior Government debt. This is likely to have a negative effect on Ireland’s ability to borrow funds from the markets in the future and make such borrowing more expensive.

In addition, lowering interest rate on the Promissory Notes carries two associated problems with it. The move can only have an appreciable effect on Exchequer finances after 2014, when interest on the notes ramps up to €1.8 billion from zero in 2012 and €500 million in 2013.

Delaying repayment of notes instead of reducing the principal amount owed on them will not provide significant relief to the Exchequer in the future and will make the period over which the debt overhang occurs even longer than 20 years envisioned under the current Notes structure. This will pose serious risks. History of business cycles suggests that between now and 2025 when Notes repayments will fall significantly, we are likely to face at least two ‘normal’ or cyclical recessions. During these recessions, Notes repayments will coincide with rising deficit pressures and national income contractions that will exacerbate the Promissory Notes already adverse impact on Irish economy. Extending the period of notes repayments risks compounding more recessionary cycles in the future.

Furthermore, delaying notes repayments can risk increasing the overall future demand for debt issuance by the state. Currently, Ireland is facing two debt-refinancing cliffs during the life of the Promissory Notes: €45.6 billion refinancing over 2013-2016 and €62.4 billion over 2017-2020. If Notes repayments are delayed, their financing will stretch further into post-2020 period, just when the subsequent roll-overs of Government bonds will be coming due.

In more simple terms, current proposals for Promissory Notes restructuring are equivalent to making quicksand pit shallower, but much wider.

Ireland needs and deserves a direct restructuring of the ELA. The most optimal outcome of such a restructuring would be de facto cancellation of ELA requirement for repayment of IBRC-borrowed €42 billion. Once again, such a move would have zero inflationary impact on the economy as on the net no new money will be created in the euro system over and above the amounts already present.

There remains, however, one sticky point. Allowing Ireland to restructure its ELA can, in theory, lead to other Central Banks following the suit. This problem of moral hazard can be easily mitigated by ECB by ring-fencing Irish ELA restructuring solely for the purpose of winding down IBRC. Making ELA writedown conditional on shutting down Anglo and INBS, plus potentially Permanent tsb will disincentives other countries from using their own ELAs to rescue solvent banks. Irish restructuring can be further isolated by tying ELA writedown to progress already achieved by Ireland in tackling fiscal deficits and restructuring its banking sector. Put simply, with such a proviso in place, no other Euro area country would want to dip into its National Central Bank vaults if the associated cost of doing this will amount to over 50% of its GDP.

Ireland’s crisis is unique in its nature and its resolution provided a buffer to cushion the credit crisis blow to the entire euro area banking sector. Ireland both deserves and needs a breakthrough on the debts assumed by taxpayers in relation to the insolvent IBRC. Even more importantly from Europe’s point of view, the ECB needs a positive example of a country emerging from the deep crisis within the euro system. Ireland is the only candidate for success it has.

Source: NTMA and author own calculations.

Note: In computing second round of rollovers, only Government bonds are included and taken at 95% of the principal amount. All other debts are excluded.

Box-out:

In the wake of last week’s Quarterly National Household Survey release, the Government was quick to point to the improvement in the number of employed on a seasonally adjusted basis as the evidence the employment policies success. Overall numbers in employment rose in Q4 2011 by 10,000 or 0.56% compared to Q3 2011, once seasonal adjustments were made. Furthermore, per seasonally adjusted data, full-time employment was up 8,700 – accounting for 87% of this jobs creation. Alas, this is not the entire picture of the job market health. Year on year, seasonally adjusted employment was down 17,800 or 0.97%. More ominously, unadjusted employment was up just 2,300 in Q4 2011 compared to Q3 2011 – an addition of statistically insignificant 0.1%. Interestingly, full-time unadjusted employment figure fell by 700 jobs (-0.1%), while part-time employment rose 3,000 (+0.7%). At the same time, number of part-time workers who are underemployed has jumped 5,800 in a quarter and 28,100 year on year. Two reasons can help explain the above disparities. First, Government training programmes have been aggressively taking people out of unemployment counts, increasing employment numbers. In the case of Job Bridge, for example, these are unpaid ‘internships’ with questionable rate of post-internship transition to work so far. Second, since Q1 2011, CSO has used a new model for seasonal adjustments, which may or may not have an effect on seasonally adjusted headline numbers. Lastly, seasonal adjustments can increase, not reduce quarterly data volatility at the times when trends change. Particularly, with flattening out of the employment figures after years of steep declines, seasonal adjustments can introduce a temporary bias into subsequent data. In short, making conclusions about the actual changes requires more careful reading of the numbers than a simplistic headline figure referencing. With all annual indicators pointing to a shallow decrease in employment, the Government would be best served to have some patience and see how subsequent quarters numbers play out before jumping to conclusions on the success of its policies.

20/3/2012: There is nothing new about Europe's growth crisis

EU's latest catch phrase is 'growth'. The Commission is banging on about subsidies along with an old tune of EU2020 'plan' for subsidies, picking of winners and rewarding the whiners. The IMF is whinging about 'structural reforms' which is all about extracting some sort of a surplus from something other than domestic consumers demand and investment. National authorities are singing the diverse songs - calling for subsidies and more borrowing from the North in the Periphery, calling for less transfers to the Periphery in the North. Belgium, as ever stuck in-between, has all of the above to the detriment of national dis-unity, which by now is a second-stage show, given all the dis-unity in the European Union.

And the reality is - EU and especially the Euro area are falling out of the world's economic orbit, with speeds that are accelerating - from the modest declines of the 1980s to faster rates in the 1990s and to acceleration in 2000s followed by speedier 2010s.

Note, all data below is sourced from the IMFWEO database with my calculations based on the same.

Here's how the mighty have fallen:

And no, the above charts do not show us performing any better than the US or G7. They show us performing as badly as Italy and worse than Japan:

• Between 1980 and 2010, Italy's share of world GDP fell 46.7%, Euro area's share declined 47.1%, Japan's dropped only 32.8%.
• Between 2010 and 2016, based on IMF projections, Euro area's share of world GDP will decline 15.2%, US' share will drop 9.7%, Germany's 15.0%, France's 13.6%, Italy's 19%, Japan's 15.7%
• In the Decade of the Euro, Euro area's share of world GDP declined 20.7%, while during the decade of the 1990s it fell 15.0% and in the decade of the 1980s it declined just 7.5%

No matter how you spin it - Euro area is going down in world rankings of growth areas and it is moving at the speed worse than the one attained by Japan. 

The last chart above clearly shows that the rate of Euro area's might decline has accelerated dramatically since 2001 and that this rate is invariant to the current crisis.

More subsidies, Brussels, please! More 5-year plans for 'Knowledge, Green, Social, Whatnotwellhaveit Economy', Commission, please! They all have been working so well so far.

19/3/2012: Debt and Unfunded Obligations

Chart of the day (updated):

Sources: http://www.ncpa.org/pdfs/st319.pdf and author own calculations. Update covers latest IMF estimates for GDP change 2009-2011 and rebasing of all liabilities to 2011.

18/3/2012: Fiscal Stimulus Multipliers - US data and some Irish considerations

In a recent paper, “Fiscal Stimulus and Distortionary Taxation”, Thorsten Drautzburg and Harald Uhlig (published Becker Friedman Institute for Research in Economics Working Paper No. 2011-005 ) estimate the fiscal policy multipliers from the federal spending programmes under the American Recovery and Reinvestment Act (ARRA) of 2009.

Fiscal multiplier is the ratio of output changes to the total stimulus policy-driven change in Government spending and transfers. So positive large multiplier means greater response in economic output per unit of spending, negative multiplier means a fall in the economic output for a unit of spending.

In addition to the traditional literature, the authors include a number of coincident effects:

• Fiscal expansion takes place in the environment of recession, which is also coincident with the Federal Reserve carrying out a monetary easing – referenced as the zero lower bound interest rates policy (ZLB). When the fiscal policy stimulus creates positive impact, this translates into incentives for the Fed to exit ZLB earlier, which in turn reduces economic activity rate of growth. The effect is compounded in the case when wages are sticky (for example, if negotiated via collective bargaining) and/or prices are sticky (for example, if set by regulatory authorities).
• In addition, the authors recognize that implementing / deploying fiscal stimulus in practice takes time in practice.
• Third, government expenditures on stimulus are financed, eventually, with distortionary taxes, creating costly disincentive effects in the future.
• Fourth, welfare transfers matter “to the degree to which they are given to credit-constrained households”.
• Fifth, the authors use Bayesian estimation techniques as well as sensitivity analysis to quantify the uncertain nature of the estimated coefficients in the New Keynesian model.

The study distinguishes between short-run and long-run multipliers in a benchmark model, finding:

• “Modestly positive short-run multipliers” that average 0.51, and
• “Modestly negative long-run multipliers” averaging around -0.42.
• The multiplier is particularly sensitive to the fraction of transfers given to [credit constrained] consumers, is sensitive to the anticipated length of the zero lower bound [the expected period of monetary policy easing], is sensitive to the capital share [in overall stimulus – i.e. the share of stimulus spending directed to capital formation as opposed to consumption] and is nonlinear in the degree of price and wage stickiness.
• Crucially, “reasonable specifications are consistent with substantially negative short-run multipliers within a short time frame” meaning that under reasonably realistic assumptions on price/wage stickiness and model parameterization fiscal stimulus can result in a negative effect on economic growth even in a short-run.
• In the US, the stimulus results in negative welfare effects for agents not constrained by debt. The debt-constrained agents gain, if they discount the future substantially.

Now, the above results are quite interesting in the context of the US economy, but they are even more interesting in the context of Ireland, as a small open economy with fixed interest rates. This is so for a number of reasons:

1. Ireland’s domestic demand is closely linked to imports, which means that unlike in the US, Ireland’s short-run multipliers can be expected to be smaller in magnitude due to losses of economic activity to imports. Note – imports enter GDP and GNP determination as a negative component, so any stimulus funds expended on imported consumption (public and private) will have a dual effect on overall economic activity: in the short run, they will reduce economic activity via imports increases (effects not present in the US economy), and they will reduce, in the longer term economic activity via same pathways as those revealed in the paper.
2. Ireland’s public expenditure is heavily leaned in the direction of consumption supports / income transfers. These provide support for both credit ‘unconstrained’ (non-indebted) poor households (who do not have mortgages and are not subject to the adverse effects of debt overhang) and for households of the unemployed who are constrained by debt overhang (hence significant rise in mortgage supplements payments). Those households, constrained by debt (such as mortgage holders still in employment) and the ones unconstrained by debt and not in welfare net (for example older households with no debt overhang) are therefore direct losers in the short run and in the long run. This, per findings above means that increasing social welfare transfers during the current crisis can lead to reduced economic activity even in the short run, while increasing negative effects of the stimulus in the long run.
3. Our monetary policies are determined outside Ireland and hence we can add higher uncertainty and shorter periods of ZLB duration to the Ireland-specific assumptions (remember, the ECB did hike interest rates into the Irish recession and then repeated the same again). This means that any fiscal stimulus in Ireland will be subject to stronger monetary policy headwinds, further reducing the multipliers in the short run and amplifying long-term costs of such a stimulus.
4. Ireland’s tax system became even more distortionary during the crisis and this process is ongoing. Once again, this amplifies the adverse finding from the US data and interacts negatively with point (2) above.

The study also incorporates consideration of the time-varying differentials between the central bank-set interest rates, government borrowing costs (bond rates) and returns to private capital (cost of private sector credit). The paper shows that “these wedges are indeed the key to understanding the recession of 2007 to 2009.” Although the study does not explicitly quantify these drivers effects, one can suspect that in the case of Ireland, dramatic increases in the cost of Government borrowing, alongside the rise in retail-level interest rates due to banks bust would have much more adverse impact on fiscal stimulus effectiveness. Whether or not these effects are enough to swing the stimulus short-run multiplier to the negative territory we do not know. But it is pretty safe to assume that they will make long-term costs of the stimulus more severe.

The use of New Keynesian model specification allows authors to conclude that “the model here is heavily tilted towards a model in which fiscal stimulus is often thought to work well: we therefore believe that the negative long-run effects of fiscal stimulus should give pause to arguments in its favor. Even at the short horizon, the benchmark multiplier is just around 0.5.”

Another interesting result is that consumption taxes, rather than income taxes are a better way to offset the costs of stimulus in the longer term. This is intuitive and consistent with other evidence. However, the paper finds that “adjusting [raising] consumption taxes only yields a slightly higher multiplier than adjusting labor tax rates.”

Please keep in mind that the Irish stimulus theory supporters have ardently argued that fiscal stimulus must be financed via income tax increases, not consumption tax hikes and have opposed even a modest Budget 2012 shift of tax burden on VAT.

17/3/2012: Long-term impact of unemployment - US study, Irish implications

An interesting study by Steven Davis and Til Wachter titled "Recessions and the cost of job loss"published by Becker Friedman Institute for Research in Economics Working Paper No. 2011-009 aims to quantify some of the effects of jobs displacement in the recession on cumulative losses in earnings. The study uses microdata from Social Security records for US workers from 1974 to 2008. 


Some findings:

• In present value terms, men lose an average of 1.4 years of re-displacement earnings if displaced in mass layoff events that occur when the US unemployment rate is below 6 percent. 
• Men lose double that - 2.8 years - of pre-displacement earnings if they lose their job when the unemployment rate exceeds 8 percent. 
• To add to authors conclusions: if you think of it in terms of the life-time losses, this is equivalent to roughly 14% loss in life-time earnings. Now, if you put this into a retirement perspective - this amounts to roughly 1/3 of an average funded retirement stream of earnings.
• Some more granularity on the study results: "For men with 3 or more years of prior tenure who lose jobs in mass-layoff events at larger firms, job displacement reduces the present value of future earnings by 12 percent in an average year. The present value losses are high in all years, but they rise steeply with the unemployment rate in the year of displacement. Present value losses for displacements that occur in recessions are nearly twice as large as for displacements in [economic] expansions. The entire future path of earnings losses is much higher for displacements that occur in recessions. In short, the present value earnings losses associated with job displacement are very large, and they are highly sensitive to labor market conditions at the time of displacement."
• The study also finds "large cyclical movements in the incidence of job loss and job displacement and present evidence on how worker anxieties about job loss, wage cuts and job opportunities respond to contemporaneous economic conditions". 
• More specifically on the above point: "Drawing on data from the General Social Survey and Gallup polling, we examine the relationship of anxieties about job loss, wage cuts, ease of job finding and other labor market prospects to actual labor market conditions. The available evidence indicates that cyclical fluctuations in worker perceptions and anxieties track actual labor market conditions rather closely, and that they respond quickly to deteriorations in the economic outlook. Gallup data, in particular, show a tremendous increase in worker anxieties about labor market prospects after the peak of the financial crisis in 2008 and 2009. They also show a recent return to the same high levels of anxiety. These data suggest that fears about job loss and other negative labor market outcomes are themselves a significant and costly aspect of economic downturns for a broad segment of the population. These findings also imply that workers are well aware of and concerned about the costly nature of job loss, especially in recessions."

While re-parameterizing the US labour market experience as revealed in the study into that in Ireland is not possible, the above results very clearly point to the extremely significant implications of the current unemployment in Ireland on expected future life-time earnings of a large proportion of our population. In Ireland, we have not even began assessing the impact that current unemployment crisis will have on:

• future economic growth (via earnings-savings-investment and earnings-consumption links which imply that previous unemployment-related reduction in life-time earnings will have significant, potentially double-digit-sized adverse drag on savings, investment and consumption levels, let alone growth rates, into the future) 
• fiscal revenues in the future (via earnings-tax revenues links which imply reduced tax revenues levels from consumption, investment and income taxes into the future) 
• retirement funding and demand for public health and pensions (via earnings-savings-investment links which imply reduced funding for retirement and private health)
• education funding for children (via reduced earnings of parent impact on children education) and
• the links between current debt levels, property markets, future investment and economic activity.

Neither do the above results cover the Irish-specific case of household wealth destruction and debt overhang accompanying the stratospheric rise of unemployment.

16/3/2012: ECB policy - Death Star Can't Do Growth

Two charts from the ECB's monthly bulletin that really do describe the anti-inflationary madness of Europe manifested in "Kill Economy, Keep germans Safe from Inflation" mantra:

 And in case you need a summary in numbers:

Look at differentials in growth on M1,M2 and M3 and look at credit to the private sector - also see next chart.

Yep, go into economic slowdown and tighten credit supply growth. Nice.

16/3/2012: Visa Waver for UK visa holders

Per Minister Shatter announcement: Irish Short Stay Visa Waiver Scheme for visitors from almost 20 specified countries (mainly China, India, Gulf Region and Russia) lawfully entering the UK on a valid UK visa are allowed to travel on to the Republic of Ireland without the requirement to obtain an Irish visa has been extended for a further 4 years.

This pilot scheme commenced last July and was due to end this October. 

The scheme is a good example of forward thinking, and the Government should be commended on extending it, but it is only a minor step in terms of encouraging more visitors into Ireland and normalizing border controls to reflect the reality of modern business and tourism environment. More specifically, here is what really needs to be done:

1. Obtaining the UK visa is harder in a number of countries mentioned (inc China and Russia) than obtaining Schengen visas. Ireland needs to significantly relax bureaucratic and compliance burden on visas issued in our embassies to make Irish visas (not UK wavers) more freely available to suitable tourists and visitors.
2. Obtaining the UK visas is also politically restricted in some countries due to their bilateral relations with the UK - e.g. Russia. We must recognize this and act on (1) above.
3. Irish Green Cards holders and long-term/permanent residents with families and households here, need functional Irish residency permits that are (a) recognized as identity documents abroad (current ones are not recognized as such) and (b) recognized as effective Schengen and UK visas. 
4. Residents of Ireland holding foreign passports with EU Family Member or long-term resident stamps should have access to visa-free travel to the UK.

Points 3 and 4 above are critical as many of non-EU nationals who are long-term residents in Ireland are required by their work to travel abroad and the patent absurdity of GNIB status not allowing them to do so without acquiring multiple short-term visas to conduct business in EU is acting as a serious drag on their ability to earn living and generate tax revenues for the Irish state. The Irish Government can negotiate separate agreements on (3) and (4) above with the UK and with Schengen. 

16/3/2012: Greek Bailout 2 - Globe & Mail

A quick link to my article on Greek bailout-2 for Economy Lab with Globe & Mail (here) and related subsequent article on ZeroHedge on the same topic (here).


Below is the full version (unedited) of the Globe & Mail article - double the length of the print version.

With the Greek Bailout 2 on its way, has euro zone escaped the clutches of the proverbial markets? Not a chance. Greece remains the eurozone’s ‘weakest link’ and Europe remains the Sick Man of the global growth. The reasons are simple: debt, liquidity and growth. Let’s first focus on Greece, debt and liquidity, with a subsequent post dealing with Euro area growth.

Part 1:

Debt-wise, Greece is now actually worse off than when the whole mess of the second bailout began. After the PSI that, together with the ECB swap, amounts to a $138bn debt writedown, Greece is now in line for $170bn in new loans, an additional $38bn EFF ‘pro-growth’ lending facility from the IMF, and a standing $40bn reserve loans facility for its banks. As of today, the expected Greek banks bailout bill stands at $63bn. Behind all that looms another $20bn yet-to-be-announced lending package that will be required to get Greece over 2012 targets, given the deterioration in its GDP. All in, Greek debt can rise by as much as $130bn with Bailout-2, although the most likely number will be around $100bn. This would bring Greek gross external debt from 192% of GDP projected pre-Bailout 2, to over 225%, using IMF figures.

Keep in mind that Greece cannot print out of this debt, nor can it expect to grow out of it. The Greek economy is expected to shrink -3.2% this year and post just 0.6% nominal growth in 2013. Thereafter, rosy projections from the IMF are for 3.3% average annual growth out to 2016. All of this growth is expected to come from gross fixed capital formation and exports. The former will be happening, according to the IMF numbers, amidst shrinking public and private demand and zero per cent private sector credit creation through 2014. The latter is expected to add 39% to the country exports of goods and services over the next 4 years. German tourists better start coming into Greece in millions, because feta cheese sales doubling between now and 2016 will not do the trick. In other words, the rates of growth envisioned by the IMF are purely imaginary.

On the liquidity front, European periphery remains largely outside the funding markets. Even Italy is now borrowing in the markets courtesy of ECB pumping cash into the country banks. Of the top ten LTRO borrowers by overall volume, seven are from Spain and Italy. Fifteen out of top twenty banks, measured as a ratio of LTROs borrowings to their assets, are from these countries. Since the beginning of 2009, ECB has unloaded some $1.65 trillion of new funds. Much of this went into the sovereign bonds and ECB deposits.

Now, here’s the obvious problem at the end of the proverbial Cunning Plan that ECB contrived to shore up ailing banks. Euro area banks are the largest holders of Euro area sovereign bonds. This reality was the main channel for contagion from the sovereign balancesheets to the banking system of the current crisis. LTROs 1 and 2 have just made that channel about a mile wider. Mopping up the expected tsunami of bonds that will hit private markets in and around LTRO winding up dates in 2014-2015 will be a problem of its own right. Coupled with the bonds redemption cliff faced by some peripheral countries around that time will assure that the problem will be insurmountable.

Part 2:

With the Greek Bailout 2 euro zone did not escape the clutches of the proverbial markets. The reasons are simple: debt, liquidity and growth. While the previous post focused on Greece, debt and liquidity, the current post deals with the core source of the weakness in the region’s growth dynamics.

With Greek Bailout 2, Europe has run out of options for supporting its failing states and in doing so, it has run out of room for its economies to grow. Domestic savings are stagnant and, given already hefty fiscal spending bills and rising tax burdens, availability of private capital will be a major problem for investment in the medium term.

Take a look at some numbers – again courtesy of the unseasonally optimistic IMF. Between 2011 and 2014, IMF predicts PIIGs economies to grow, cumulatively by between 1.7% for Greece, Italy and Portugal, 4.8% for Spain and 5.7% for Ireland. However, in recent months IMF has been scaling back its forecasts so rapidly and so dramatically, that the above figures can become, by April 2012 WEO database revision, -0.1% for Greece, 5.0% for Ireland, 1.6% Italy, 1.5 Portugal and 3.3% Spain. Not a single Euro area member state, save for Greece is expected to see more than 2 percentage point increase in gross national savings. Coupled with fiscal consolidations planned, this implies negative growth in private savings as a share of GDP in every Euro zone country. Over the same period, General Government revenues as a share of overall economy will increase on average across the old Euro area member states (pre-2004 EU12). The much-hoped-for salvation from external trade surpluses is an unlikely source for growth: between 2011 and 2014, cumulative current account balances are likely to be deeply negative in France (-7.4% of GDP), Greece (-16.9%), Italy (-7.5%), Portugal (-15.5%), Spain (-8.2%) and only mildly positive in Ireland (+4.9%). Average cumulative 2012-2014 current account deficit for PIIGS is forecast to be in the region of -8.7% of GDP and for the Big 4 states -1.6%.

This lacklustre performance comes on top of the on-going and accelerating banks deleveraging that will further choke of credit supply to the real economy. Hence, broad money supply across ECB controlled common currency area is declining and ex-ECB deposits, banks balance sheets have shrunk some $660bn in Q4 2011 alone, roughly offsetting the effect of the LTRO 2. You can bet your house the real retail cost of investment is going to continue rising through 2012 and into 2013, exerting a massive drag on growth. Thereafter, unwinding of LTROs will lead to a spike in the benchmark ‘risk-free’ sovereign rates, once again supporting inflation in the cost of business investment.

With all of this, PIIGS are going to be squeezed on all sides – fiscal, monetary / credit, and the real economy – both in the short run and in the medium term. Spain is the case in point with the latest spat with the EU on widening deficits. This week’s news that the EU decided to back down on its own targets for Spanish deficits does not bode well for the block’s credibility when it comes to fiscal discipline. But it signals even worse news for anyone still holding their breath for Europe to show signs of an economic recovery.

If anything, the last two weeks of the Euro crisis are reinforcing the very predictions I made some months ago – Europe’s governments are incapable of sticking to the austerity targets they set for themselves, and are unable to spur any growth momentum to substitute for austerity. In other words, Europe is now firmly stuck between half-hearted dreaming for Keynesianism by default and fully-pledged monetarism by design. As the ‘Third Way’ – this combination of policies is the fastest path to economic hell.

15/3/2012: Irish Building & Construction Sector Q4 2011

About six months ago I was told by a 'person in the know' that there is huge construction boom about to happen in Ireland as multinationals are allegedly fighting over each other over suitable new office facilities. May be. Or may be not. I am not in the business of building stuff, so would have to wait for a credible flow of news and data to confirm such a shift in the trends. Today's CSO stats on activity in Construction and Building sector is not exactly pointing to a massive uptick.

Let's take a look.

First, data for construction & building ex-civil engineering:

• Value index remained flat at 20.9 in Q4 2011, same as in Q3 2011. Year on year index is down 8.3%. 6mo average is now 0.2% ahead of previous 6mos average and year on year, 6mo average is down 12%. No improvement here. 
• Value of construction and building ex-civil engineering is now down to 18.4% of the peak level.
• Volume index also remained falt at 18.8 in Q4 2011 and Q3 2011, while year on year Q4 2011 index is down 5.5 on Q4 2010. 6mo average for the most recent 6 months is up 0.5% and year on yer last six months activity is down 9.2%. No improvements here either.
• Volume of construction and building ex-civil engineering is now 18.0% of the peak.

Chart to illustrate:

As annual rates of change suggest - things are getting worse at a slower speed.

In terms of civil engineering output:

• There was a substantial jump in civil engineering output value in Q4 2011 - up 27.7% qoq although still down 11.8% yoy. Latest 6mos average is 10.8% ahead of previous 6mo average and down 16% year on year.
• There was also a measurable increase in volume of civil engineering activity up 27.8% qoq inQ4 2011, although still 9.1% down yoy. 6mo average through December 2011 is 11.1% ahead of preceding 6mos period and 13.3% below the same period in 2010.

So some improvements here in quarterly series and dramatic ones, but still down yoy:

Lastly, residential v non-residential construction activity:

• Value of residential construction activity declined to  9.7 in Q4 2011 from 9.9 in Q3 2011. Value of residential construction sector activity is now 91.0% below its peak and is 90% below 2005 levels. Yar on year value of activity is down 21.1%. 
• Volume of residential sector activity slipped marginally to 8.9 inQ4 2011 from 9.0 in Q3 2011. Year on year the index is down 15.2% and relative to peak it is down 91.5%. Volume of construction activity in the residential sector is now down 91% on 2005 levels.
• Abysmal does not even begin to describe these results and there is no improvement in year on year performance since Q4 2006 in value and since Q1 2006 in volume terms.
• Non-residential activity in value terms improved slightly from 62.7 in Q3 2011 to 63.6 inQ4 2011 - marking second consecutive quarter of improvements. Yoy activity in Q4 2011 was up 1.1% - first yearly rise since Q4 2008. Relative to peak value of non-residential construction activity is still down 48.3%.
• Non-residential construction volume index also improved, marking third quarter of gains in a row, rising from 56.6 in Q3 2011 to 57.8 in Q4 2011. Annual rate of increase is now 4% and this is the first such gain since Q3 2007.

So on the net, some positive moves in non-residential construction which still require continued confirmation to the upside in the next 1-2 quarters in order to call the market bottom and a year or so more of consistent rises to call the upswing trend. Negative newsflow for residential, although some moderation in the rate of decline.

15/3/2012: What's up with 'collateral'?

An interesting point made today by Michael Noonan that carries some serious implications with it (potentially).

"You could take it that the ECB were never particularly happy with the level of collateral provided by the promissory notes and would like stronger collateral," Mr Noonan said in an interview with RTÉ." (as reported on the Irish Times website).

What can this mean? Collateral for the Notes themselves is Government guarantee plus letters of comfort to the CB of I. In other words, the Notes collateral can only be enhanced by making them fully-committed formalized Government debt - aka bonds. Now, Noonan in the recent past had implicitly linked Promo Notes to ESM.

And herein rest the main problem. Right now, Promo Notes are quasi-governmental obligations and as such are ranked below ordinary Government bonds (hence collateral quality concern of the ECB). Although the Notes are counted into our total debt, they are still not quite as senior as other forms of debt. This, in turn, has marginal implications in the valuation of our bonds. Although at this point this is academic, should we return to the markets, potential buyers of Irish Government bonds will consider them as secondary, since the Notes are not traded in the market and represent a tertiary (quasi- bit) claim on the state after ordinary bonds (secondary) and EFSF-IMF-EFSM (soon to become ESM) debt (so-called super-senior obligations of the state).

By converting these notes into ESM funding, the Government will in effect risk making these Notes super-senior, exceeding in seniority those of ordinary Government bonds. Now, the total amount of debt under the Notes - principal plus interest - is €47-48 billion or roughly-speaking 30% of our GDP and ca 27% of our Government debt. This is hardly a joking matter.

It can have material implications for our ability to access bond markets in the future (both in terms of amounts we can raise and rates we will be charged). But more ominously, it can fully convert quasi-public debt into super-senior public debt.

This will satisfy ECB's concerns about the quality of collateral, but it will also mean that these notes will be put beyond any hope of future further restructuring.