21/7/2012: Sunday Times July 8 - ESM deal for Ireland

An unedited version of my Sunday Times column for July 8, 2012.

Last week’s Euro zone rush to make some sort of a deal on the common currency debt crisis was originally heralded as a ‘path-breaking’ event. A week on, and the markets have largely discounted the deal, while internal disagreements between the member states are tearing it to shreds.

Within a few days following the summit, heads of Bundesbank, Deutsche Bank and Commerzbank came out opposing the core premises of the deal, including the banking union. Finnish, Dutch and Estonian governments strongly disagreed with the ideas of ECB engaging in direct purchases of sovereign bonds, and equal treatment of ESM debt alongside private bondholders. German and Slovak leaders have pledged to respect these countries positions. Austrian parliament’s approval of European Stabilisation Mechanism (ESM) fund came with some severe conditions attached, also altering the June summit conclusions. Lastly, the ECB’s Mario Draghi was clearly guarded about the deal implications for the ECB independence during his press-conference this Thursday.

Meanwhile, the markets have moved from an euphoric reaction to the deal last Friday back to shorting the euro zone by Thursday, despite the ECB interest rate cut.

Despite these, and other developments, the Irish Government continues to put much hope on the June 28-29 deal. Rhetoric aside, the new deal can, at the very best, allow Ireland to convert some of our government debts into the debt held against Irish consumers and mortgage-holders.

The Government assumes that under the deal, ESM will be allowed to retrospectively cancel government debts relating to banks bailouts and convert these into debts held against the banks themselves.

Assuming this is correct, even though the actual agreement does not mention any retrospective actions, Ireland will be able to move some unknown share of its €62.8 billion total exposure to the banking crisis off the government debt account. The Government has already admitted that it is unlikely to recover any of the NPRF funds ‘invested’ in the banks. Which leaves us with roughly €30-35 billion of promissory notes and other debts that can be in theory restructured via ESM.

On the surface, this looks like a great opportunity, to reduce our official Government debt from 117% of GDP to just over 100% of GDP.

However, the problem with this proposition is that it ignores the actual nature of the deal and the likelihood of such a deal going through.

Let’s start from the latter point.

For Ireland to restructure such a large amount of debt, will require one of the following two options. Either all of the states involved in ESM should be given similar retrospective considerations of past sovereign recapitalisations of the banks , or Ireland must be deemed to be a special case, warranting special intervention.

The former will mean that Germany, Belgium, the Netherlands, Austria, not to mention Spain, Portugal, Greece and Cyprus will all have to be granted access to the same restructuring process as Ireland. These states have collectively pumped some €400 billion worth of taxpayers’ funds into their own banking systems during the crisis. ESM’s lending capacity is €500 billion. In other words, ESM will effectively have not enough funds to cover the second bailout for Ireland and extensions of bailouts for Portugal and Greece, let alone provide any backstop for Italy and Spain.

Italy has just raised its forecast budget deficit for 2012 by some 50%, while Spain will require €7-10 billion of additional fiscal cuts to meet its 2012 target. Greece has been lax on tax collection during May and June elections. The likelihood of these countries needing additional funds in 2013-2014 is rising, just as ESM lending capacity is shrinking.

The latter possibility would require making a convincing argument that Ireland’s case is unique when it comes to the hardships of recapitalising the banks. In addition, it will require proving that we desperately need special help. This can only be done by admitting that our deficit and debt adjustments, as envisioned in the multiannual programme with Troika, are not sustainable. This would contradict all Troika assessments of the Irish fiscal stabilization programmes to-date.

Now, let’s take a look at the more important point raised above – the point about the actual nature of this deal. In a nutshell, even if successful, the restructuring of our banks-related debts via ESM, as envisioned by the Government, will accomplish little in terms of lifting the burden of unsustainable debts off the shoulders of the economy.

The reasons for this conjecture are numerous.

Firstly, ESM will still require repayment of all the debts transferred from the Government to the fund. Except, instead of the taxpayers, the onus for repaying these debts will fall on Irish consumers.

Even an undergraduate student of economics knows that when the market power is concentrated in the hands of a small number of players, any taxes and charges imposed onto them will be passed directly to consumers. Now, recall that under the Irish Government plans, Irish banking system is moving toward a Bank of Ireland, plus AIB duopoly. In such an environment, the repayment of banks debts to the ESM will simply involve higher banking services costs to mortgagees and bank accounts holders.

Only a regulated duopoly, under certain conditions, can be prevented from gouging consumers to pay charges, and even then imperfectly. Yet, under the deal, the Government will be ceding control over the banking sector to the ESM (who will own the banks and their debts) and the ECB (who will act as the pan-Euro area supervisor of the banks). This means we can expect mortgages and banking costs to rise and with them, foreclosures, personal insolvencies and business liquidations to accelerate.

Secondly, per Irish Government statements, last week’s deal will allow for relieving the burden of the banks debt and promises to restart our economy back to growth. If the former proposition, as argued above, is questionable, the latter is outright bogus.

Ireland’s crisis is not driven by who owns the banks debts. It is driven by too much debt accumulated in all of the corners of our economy: households, companies, Government, and the banks. But the swap of banks-related debts from the Government to the ESM will not reduce the volume of this debt.

And the Irish economy will have an even lower capacity to repay these debts after the swap.

The Government is already committed to taking €8.6 billion out of the economy between 2013 and 2015. Most of it - €5.7 billion – is officially earmarked for ‘cuts’ to the Government expenditure. However, majority of the expenditure cuts are really nothing more than a concealed tax, as these cuts reallocate the costs of services to the households. In the Budget 2012, single largest expenditure reduction measure was a hike on private insurance costs of medical services.

On top of this, further €1.5-1.8 billion will have to be clawed out of the economy due to changes in the EU funding and reductions in state revenues from banks guarantee and support schemes.

In short, put against the reality of Ireland’s struggling economy and battered by the internal disagreements within the euro zone, the so-called ‘seismic’ deal is now turning into a storm in a teacup.

Box-out:

Ireland’s much-awaited ‘return to the bond markets’ on Thursday was greeted in the media by a number of erroneous reports. The truth is simple as are the questions surrounding the NTMA motives for the auction. Firstly, Ireland returned not to the bond markets, but to a short-term T-bill market. Very short-term, in fact. The two markets are significantly different to pretend the auction was a major breakthrough. Greece, in May this year – amidst the on-going collapse of its economy and political turmoil, also ‘returned’ to the T-bill market. As did Portugal in April when it faced an unexpected need for banks supports. Ireland itself last dipped into this market back in September 2010, while facing an impending bailout. T-bills auctions, therefore, are not exactly the vote of confidence. Secondly, 3 months-dated bills are effectively risk-free and do not constitute a recognition of Irish economic revival. Instead, they are backed by the Troika funds. As per questions raised, one that stands out is why did NTMA need this auction to take place in the first place? There is no need for the Government to borrow any money short-term, as our receipts of the Troika funds are regular, fully funded and without any uncertainty. It appears the whole exercise was about a public and investor relations management by the Government. Thus, the only apparent net positive from the auction is that we did not get rejected by the markets. Then again, neither did Greece in May or Portugal in April.

21/7/2012: Sunday Times July 1, 2012 - Not a 'stimulus' again...

An unedited version of my Sunday Times article from July 1.

One of the points of contention in modern economics is the role of fiscal spending shocks on economic growth. Various empirical estimates suggest Irish fiscal multiplier at 0.3-0.4, implying that for every euro of additional Government spending we should get a €1.30-€1.40 in GDP uplift. However, these are based on models that do not take into the account our current conditions. Despite this fact, Irish policymakers continue talking about the need for Government to stimulate the economy, while various think tanks continue to argue that Ireland should abandon fiscal stabilization or more aggressively tax private incomes to deliver a boost to our spending.

International research on this matter is more advanced, although it too leaves much room for a debate.

June 2012 IMF working paper titled “What Determines Government Spending Multipliers?” by Giancarlo Corsetti, Andre Meier and Gernot Muller (June 2012) studied the effects of government spending on the economy under the variety of macroeconomic conditions.

What IMF researchers did find is that the initial conditions for stimulus do matter in determining its effectiveness – an issue generally ignored in the domestic debates about the topic.

Under a pegged exchange rate regime, similar to Ireland’s but still allowing for some exchange rate and interest rates adjustments, trade balance is likely to worsen in response to a fiscal stimulus, while output can be expected to rise. Domestic investment and consumption will decline in response to the positive stimulus shock. These factors are likely to be even more pronounced in the case of Ireland’s currency ‘peg’ that permits no adjustment in real exchange rate except via domestic inflation.

The role of weak public finances in determining the effectiveness of fiscal spending stimulus is also revealing. The study defines fiscally constrained conditions as the gross government debt exceeding 100 percent of GDP and/or government deficit in excess of 6 percent of GDP. Both of these are present in the case of Ireland. On average, the study shows that consumption response to fiscal stimulus is negative-to-zero following the stimulus, but becomes positive in the medium term. Impact on output and investment is negative. The core reasons for the adverse effects of fiscal expenditure on economic performance are losses from stimulus through increased imports of goods and services by the State, internal re-inflation of the economy through inputs prices, plus the expectation from the private sector consumers and producers of higher future taxes required to cover public spending increases.

In the case when financial crisis is present, increase in Government spending results in a positive and strong output expansion, rise in consumption and, with some delay, rise in investment. However, net exports still fall sharply and the stimulus leads to the inflationary loss of external competitiveness in the economy.

The problem with the above results is that the IMF study still does not consider what happens to a fiscal stimulus in a country like Ireland, combining a strict currency peg, exclusive reliance on trade surplus for growth generation and characterized by historically high levels of fiscal imbalances and financial system collapse. In other words, even the IMF research as imprecise as it is, is far from conclusive.

These are non-trivial problems in the case of Ireland. Official estimates for fiscal policy multiplier in this country range between 0.38 (European Commission) and 0.4 (Department of Finance).  These are based on relatively simplistic models and are, therefore, likely to be challenged by the reality of our current conditions. A more recent study from the Deutsche Bank cites Irish fiscal multiplier of 0.3 without specifying the methodology used in deriving it. Either way, no credible estimate known to me puts the fiscal multiplier above 0.4 for Ireland.

In short, Government stimulus is not exactly an effective means for raising output, even at the times when the economy can take such stimulus without demolishing the Exchequer balancesheet. And lacking precision in estimating the fiscal multiplier, the entire argument in favor of fiscal stimulus is an item of faith, not of scientific analysis.

In my opinion, Ireland does not need a Government expenditure boost. Instead we need a policy shift toward stimulating domestic and international investment, plus the public expenditure rebalancing away from current spending toward some additional capital investment.

Quarterly National Accounts clearly show that the problem with the Irish economy is not the fall off in private or public consumption, but a dramatic collapse in private investment. While private consumption expenditure in Ireland has declined 13.6% relative to the economy’s peak in 2007, net expenditure by Government is down 12.0% (including a decline in public investment). However, overall private investment in the economy is down 67%. 2011 full year capital investment was, unadjusted for inflation, at the level last seen in 1997, while consumption is down ‘only’ to 2005-2006 levels and Government spending is running at around 2006 levels. With nominal GDP falling €33.5 billion between 2007 and 2011, our investment declined €32.6 billion over the same period, personal consumption dropped €12.8 billion, while net Government expenditure on goods and services is down a mere €3.4 billion. Between 2007 and 2011, total voted current expenditure by the Government rose 12%, while total net voted capital expenditure fell 44%.

Adding a Government investment stimulus of €2 billion would have an impact of raising net capital expenditure by the Exchequer in 2012-2014 to the levels 22.4% below those in 2007 and will lift our GDP by under 1.8% according to the EU measure of fiscal multiplier. However, factoring in deterioration in the current account as estimated by the IMF, the net effect might be closer to zero. Based on IMF model re-parameterized to our current conditions, the net result can be as low as 0.1% increase in GDP.

Again, the problem here is the effect of capital spending on our imports. As a highly open economy, Ireland imports most of what it consumes. This includes Government and private capital investment goods – machinery, materials and know-how relating to construction, assembly, installation and operation of modern transport systems, energy and ICT, etc. Some of these imports will continue well beyond the period of actual investment. In other words, using fiscal stimulus to finance public capital investment risks providing some short-term supports for lower skilled Irish labour and few professionals with the lion’s share of expenditure going to the multinational companies supplying capital goods and services into Ireland from abroad.

The fiscal cost of such a stimulus, however, would be exceptionally high. Between 2008 and 2011, Irish Government has managed to cut €4.3 billion off the annual capital spending bill while increasing current spending by €662 million. This resulted in total voted spending reduction of only €3.6 billion. A stimulus of €2 billion on capital investment side will throw the state back to 2009 levels of expenditure, erasing two years worth of consolidation, unless it is financed out of cutting current spending and transferring funds to capital programmes. The extra capital spending will lead to further retrenchment in private consumption and investment, as households and businesses will anticipate relatively rapid uplift in tax burdens to recover the momentum to the fiscal consolidation. This, coupled with already committed €8.6 billion in further fiscal adjustments in the next three years, will further reduce growth effects of the stimulus and shorten its positive effects duration.

Overall, the right course of policies to pursue today requires restructuring of the debt burden carried by the real economy, starting with household debts and stimulating, simultaneously domestic and foreign investment into small and medium enterprises and start-ups. Instead of focusing on the less labor-intensive MNCs’ investments, we need to put in place tax and institutional incentives to increase inflow of equity capital, not new debt, to Irish businesses. Such incentives must target two areas of investment: investment into activities associated with new jobs creation by the SMEs, plus investment into strategic repositioning and restructuring of Irish SMEs to put them onto exporting path.

Lastly, if we really do want to have a stimulus debate, the discussion should not be focusing on creating a net increase in the public expenditure, but on the potential for reallocating some of the funds from the current expenditure side of the Exchequer balancesheet to capital investment.

  

Box-out:

The latest Index of Failed States published this week ranks Ireland the 8^th best state in the world. Our overall score in the league table was helped by extremely high performance in some specific indicators. Surprisingly, according to the Index authors, we are having a jolly good time throughout the crisis. Allegedly, Ireland’s problem in terms of emigration is relatively comparable to that found in New Zealand and Germany. Our economy, heavily dominated by MNCs exports in pharma, medical devices and ICT sectors ranks higher in terms of the balance of economic development than majority of the advanced economies that have more diversified and domestically anchored sources of growth. Our ‘balanced development’ model, having led us into the current crisis, is allegedly more sustainable, according to the Index, than that of Canada – a country that escaped the Great Recession. In terms of poverty and economic decline we are better off than France, Japan and New Zealand, which had a much less severe recession than Ireland over the last 5 years. In quality of public services, we are better than Belgium and the UK, and are ranked as highly as Canada. And our elites are less factionalized than those in the vast majority of the states of the Euro area. In short, according to the Foreign Policy, index publisher, Ireland is a veritable safe haven within a tumultuous euro zone, comparable to New Zealand, Luxembourg, Norway and Switzerland. We rank well ahead of Canada, Australia, the UK and the US, as well as all other states that currently receive tens of thousands of Irish emigrants.

20/7/2012: European Corporatism comes full circle

A very important analysis from Edmund Phelps in today's FT (link here) of the roots and core causes of the euro area crisis.

Some major points of interest:

"The difficulties of many European countries derive from their corporatism: state projects serving cronies and vast social protection programmes, both run by elites. These surged in the 1970s and 1980s. The prospect of a lifetime of such benefits – sweet contracts, soft loans, early pensions and the rest – created something new: social wealth."


On the money. And


"As increases in benefits outpaced increases in taxes, households saved some of the gains in disposable income. So households saw their private wealth rising alongside the social wealth."


Also on the money. Even more so because 1) taxes were already high so there was no room to increase them by much, and 2) lowering of taxes was used strategically to strengthen corporatist re-distribution of income & wealth from the more productive to the less productive activities (a combination of corporate and social welfare state).


"In both Italy and France, the ratio of household net private wealth to household disposable income soared, rising by one-fifth from 2000 to 2007. (The increase was one-sixth in Germany, negative in the US.)" 


Now, note: what does the European (and Irish) Left wanted and still wants? Higher income taxes. Which, of course, will mean wealth/income ratio would have been / will be even higher! This is exactly what I said during my recent appearance on TV3 Vincent Browne's show. 


The role of banks and debt in all of this charade? To cover the widening gap in wealth/income ratio and public deficits, "So it was a relief that the Basel I agreement, which went into effect in 1990, lowered to zero banks’ capital requirement on sovereign debt – no matter how risky." In other words, European sovereigns financed their corrupt corporatist regimes via leveraging private deposits to fund government bonds purchases by the banks - privatizing public waste first. 


So two lessons or questions from above are:

1. Does transfer of private banks debts to public purses in Europe constitute the return of previously privatized public debts? And if it does, the effect is that the state has twice colluded with the banks to defraud the people of Europe - first as savers and consumers, second as taxpayers.
2. Does the ongoing process of increasing government bonds holdings in domestic banks and investment and pensions funds actively promoted by the European and national authorities (see for example ECB LTROs and Irish NTMA latest plans) not constitute exactly the replay of the road to the crisis? 

19/7/2012: Q2 report from the World Gold Council

Q2 analysis of the trends and drivers for gold prices from the World Gold Council is worth a read (here) for a number of reasons. Here are two, from my point of view:

Point 1: Per Gold Council: "Gold prices declined in most currencies during the second quarter with the exception of the euro, Swiss franc and Indian rupee, in part due to a strong US dollar. Despite a 3.8% decline in Q2 to US$1,598.50/oz on the London PM fix, gold was up 4.4% during the first half of the year. Volatility remained elevated amidst a busy event-risk period. However, gold generally outperformed risk assets."

Chart and table alongside:

Table explaining events in the chart above:

Table summarizing Q/Q performance of gold prices in various currencies.

"Gold’s correlation to equities and other risk assets fell towards long-run average levels in Q2 helping portfolio diversification. Gold’s increased correlation to equities in Q1 was an indirect effect related to a weaker global economy coupled with a stronger US dollar."

Tow charts to compare on the above:

So things are reverting to historical levels - just what I drew as a conclusion from the gold coins markets data.

Point 2: More importantly, the theme is that of the 'depletion of traditional safe havens': 

"Over the past year, two national bond markets have provided shelter from turbulence in global risk assets: US Treasuries and German Bunds. Additionally, the US dollar, the Japanese yen and the Swiss franc have benefited from de-risking flows... However, being an asset of last resort is not without consequences. In particular, the investors seeking more “safe” assets must also recognise that the ever-increasing supply of both currency and debt deplete the value of these assets. Furthermore, as declining yields approach zero, they create very skewed pay-off structures with much more downside risk."

In other words, these risk-free returns for safe havens start to look like return-free risks once price upside is virtually exhausted either by persistent policy interventions or by natural exhaustion of the asymptotic valuations (in the case of US Treasuries - zero yield bound on prices).

Good luck fitting zero yields into pricing equation for Treasuries, folks...

19/7/2012: Minister Noonan's 'valuations' & NTMA's latest scheme

An interesting - and potentially revealing - contribution from Minister Noonan on the prospective ESM involvement in purchasing Irish banks assets held by the Government - see full link here (H/T to Owen Callan of Danske Markets).

Here are some interesting bits (from my pov - note, emphasis in quotes is mine):

"...if Europe's new rescue fund takes over the government's stakes in its banks, it would need to do so at prices significantly above their current low valuations."

So what should be the prices benchmark to be paid by ESM for Irish banks?

We know what Minister Noonan thinks what they should not be:
"We wouldn't think we were being assisted or treated fairly if we were only offered the terms we could get from a willing hedge fund who wanted to purchase the stake the Irish government has in the banks," Noonan told a news conference"

Ok, a willing hedge fund is mentioned as a benchmark floor. What willing hedge fund? 1) Have there been approaches that set out some valuation? 2) Have these approaches involved sufficient depth of discussion to show the actual price the fund was willing to pay, other than the low-ball first bid? 3) Have these approaches been systematic or random?

Now, suppose there has been a series of approaches and the hedge funds' willing price is €X million. Suppose Minister Noonan insists on ESM paying a minimum price of €Y million that is above €X million, which means there is a positive premium to be paid by ESM.

What principle should guide this premium valuation? "The valuation will be an issue for negotiation but before we could agree, they would need to be significantly in advance of those figures," Noonan added, referring to figures showing that investments by the country's National Pension Reserve Fund (NPRF) in its top two banks were now worth 8.1 billion euros."

Is Minister Noonan seriously suggesting ESM should pay Irish Government more than €8.1 billion? Since NPRF valuations of the banks stakes are make-believe stuff with absolutely no proven testability in the actual markets, will ESM be buying into a loss then? Ex ante?!



Another interesting comment in the article cited above is the following one:

"The NTMA also confirmed plans to diversify its sources of funding later this year with its first sovereign issuance of annuity bonds to Irish-based pension funds and inflation-linked bonds also aimed at domestic investors.

Corrigan said it was not inconceivable that it could raise 3 to 5 billion euros over the next 18 months from the two new instruments.

"International investors don't owe us a living, they don't have to buy our paper, and if the local investors don't have the confidence to invest in the market and aren't seen to have that confidence, it's going to be very difficult to get international investors back," he said."

Which, of course is all reasonably fine but for two matters:

1. Domestic pension funds will be acting against normal practice and investing in low-rated (high risk) government securities within the very same economy in which they face future liabilities (reducing risk diversification). In other words, Irish insurance funds will have to be compelled to undertake such investment in violation of acceptable international standards. Have the Government now also taken over the pensions industry to add to their banking sector portfolio?
2. If foreign investors 'won't owe Irish Government a living' why should domestic investors owe Irish Government anything? By treating two investors differently rhetorically, does Mr Corrigan explicitly differentiate treatment of domestic investors from foreign investors? It appears to be exactly so because the products he references are not going to be offered to foreign investors. Which begs the third question:
3. Will NTMA create sub-category of seniority for Irish pension funds and 'domestic investors' to effectively load even more risk onto them compared to foreign investors? After all, he seems to suggest domestic investor owe him something that foreign investors don't?

17/7/2012: Euro area debt crisis timeline

One hell of an infographic via The Financialist here summarizing the time line for the euro area debt crisis.

17/7/2012: Fiscal Monitor Update - another chart

Here’s an interesting chart from the Fiscal Monitor update released by the IMF yesterday that is worth some attention on its own (see more analysis here).

Basically, this shows that in 2008-2010 period, Irish bonds valuations were not as much divorced from the immediate fiscal sustainability fundamentals as our politicos claimed. If anything, they were virtually in line with the fundamentals, pricing almost no longer-term structural underperformance of the economy.

This is not to say that we lack in the room for structural reforms, or that we were well on the way to delivering such reforms. Markets perception of Ireland even during the deeply crisis-ridden days of 2008-2010 seemed to have been much better than that of Portugal, Italy and Spain. Whether that was justifiable or not – is an entirely different question. But what is clear is that compared to other peripherals, our Government had no one else but itself to blame for our bonds spreads.

16/7/2012: Some charts to illustrate Italian 'disease'

An interesting set of charts on Italian public finances.

First, consider Primary Deficits:

Charts above clearly show that Italy has been running significant primary surpluses since at least 2000 and especially in 2007-2011 period. It is also expected to run strong surpluses in 2012-2017, according to IMF projections.

In fact, net of debt maintenance costs, Italy has outperformed Germany in the area of public deficits in every year other than 2008 and 2009:

Yet, Italy's gross government debt is running over 90% of GDP since 1989 and over 100% of GDP since 1992.

The problem for Italy is clearly on the side of interest payments on its debt:

Although these have moderated during the euro era, the cost is now once again rising.

Italy is but one example of debt overhang that presents long-term problems for the economy. Looking at the set of all advanced economies which experienced more than 5 years periods of debt to GDP ratio in excess of 90%, the chart below shows the relationship between growth rates in real GDP and debt:

Although the explanatory power of the relationship above is weak (ca 10% of variation), the negative relationship between debt to GDP ratio and real growth in GDP is traceable. In terms of averages:

Many caveats go along with the above numbers, but overall, two things are fairly clear: once reached, debt to GDP levels of 85-90% become hard to overcome for many economies, and once debt overhang becomes a problem, growth rates tend to falter.

17/6/2012: Services Value Index for Ireland - May 2012

Some good news for a change:


Per CSO: "The seasonally adjusted monthly services value index increased by 5.5% in May 2012 when compared with April 2012 and there was an annual increase of 8.0%." Some notable mom changes were:

• Information and Communication (+12.1%), 
• Business Services (+6.3%), 
• Wholesale and Retail Trade (+4.5%), 
• Other Services (+2.3%) 
• Accommodation and Food Service Activities (+0.3%) 
• Transportation and Storage showed a monthly decrease of 1.4%.

Some larger yoy moves were:

• Information and Communication (+20.0%), 
• Transportation and Storage (+8.7%),
• Wholesale and Retail Trade (+8.3%), 
• Other Services (+0.8%) 
• Business Services (+0.2%) 
• Accommodation and Food Service Activities showed an annual decrease of 2.5%.

16/7/2012: GFSR July 2012 - more alarm bells for European banks

IMF published Global Financial Stability Report update for June 2012, titled “Intense Financial Risks: Time for Action”

Per report: “Risks to financial stability have increased since the April 2012 Global Financial Stability Report (GFSR).

• Sovereign yields in southern Europe have risen sharply amid further erosion of the investor base.
• Elevated funding and market pressures pose risks of further cuts in peripheral euro area credit.
• The measures agreed at the recent European Union (EU) leaders’ summit provide significant steps to address the immediate crisis. Aside from supportive monetary and liquidity policies, the timely implementation of the recently agreed measures, together with further progress on banking and fiscal unions, must be a priority.
• Uncertainties about the asset quality of banks’ balance sheets must be resolved quickly, with capital injections and restructurings where needed.
•  Growth prospects in other advanced countries and emerging markets have also weakened, leaving them less able to deal with spillovers from the euro area crisis or to address their own home-grown fiscal and financial vulnerabilities. 
•  Uncertainties on the fiscal outlook and federal debt ceiling in the United States present a latent risk to financial stability."

Aside from the headlines, some interesting points from the report are:

• Market conditions worsened significantly in May and June, with measures of financial market stress reverting to, and in some cases surpassing, the levels seen during the worst period in November last year.  (see Figure 1)

•   The 3-year LTROs helped support demand for peripheral sovereign debt but that positive effect has waned. Private capital outflows continued to erode the foreign investor base in Italy and Spain (see Figures 3 and 4)

An interesting point on Euro area banking sector [emphasis mine]: “Notwithstanding the ample liquidity provided by the ECB’s refinancing operations, funding conditions for many peripheral banks and firms have deteriorated. Interbank conditions remain strained, with very limited activity in unsecured term markets, and liquidity hoarding by core euro area banks. Bank bond issuance has dropped off precipitously, with little investor demand even at higher interest rates.

“Banks in the euro area periphery have had to turn to the ECB to replace lost funding support, as cross-border wholesale funding dried up, and deposit outflows continue. The April 2012 GFSR noted that EU banks are under pressure to cut back assets, due to funding strains and market pressures, as well as to longer-term structural and regulatory drivers. The sharp reduction in bank balance sheets in the fourth quarter of 2011 continued, albeit at a slower pace, in the first quarter of 2012.

Growth in euro area private sector credit diverged significantly. While credit has contracted in Greece, Spain, Portugal and Ireland, it has remained more stable in some core countries.

Survey data on bank lending conditions show that credit supply remains tight, albeit less so than at the end of 2011, but that demand has also weakened more recently.

Deleveraging is also a concern for many peripheral corporations, given their historic dependence on bank funding and the risk that credit downgrades and diminished investor appetite could drive borrowing costs higher, even for high credit quality issuers.”

Now, here’s an interesting point not raised in the GFSR, but linked to the above observations: equities issuance accounts for roughly 55% of total corporate capital in US and EU. However, because the US corporates issue more bonds-backed debt than their EU counterparts, banks lending accounts for 40% of the European corporate funds raised, against 20% in the US. Which means that banks credit is about twice more important in Europe than in the US in terms of funding corporate capex. In fact, recent research from BCA clearly links US corporates ability to raise direct market funding by-passing banks to faster economic recovery in the US than in EU or Japan.

Add to this equation that European banks are worse capitalized than their US counterparts and that they are more leveraged than their US counterparts and you have a bleak prospect for the EU economy. BCA recently estimated that to bring Euro zone banks’ capital ratios to the levels comparable with the US average, the largest EU banks will have to raise some USD900 billion worth of new capital or cut their assets base by a whooping USD 9 trillion.

But wait, there’s more – you’ve heard about the latest report in the WSJ that Mario Draghi proposed to bail-in senior bondhodlers in Spanish banks? Much of the Irish commentary on this was positive, suggesting that Ireland is now in line for a retrospective deal from the ECB to recover some of the funds we paid to senior bondholders in Anglo and INBS. Setting aside the ‘wishful thinking’ nature of such comments – look at Draghi’s idea implications for EU economic activity. If bail-in does make it to the policy tool of European authorities, funding for the EA17 banks will only become more expensive in the medium and long term (risk premium on ‘bail-in probability’), which, in turn will mean even less credit for corporates, which will mean even less capex, and thus even lower prospect of recovery.

You know the story – pull one end of the carriage out of the quicksand pit, the other end sinks deeper… Let me quote BCA: “In Japan, credit contraction lasted well over nine years in the aftermath of the asset bubble bust. During that time, deflation prevailed and economic growth averaged a measly 0.5% annual pace.” Much of hope for Europe then? Not really. Recall that Japan had aggressive fiscal and monetary policies at its disposal plus booming global markets when it was undergoing credit bust. We, however, have psychotic monetary policy, no fiscal policy room and are running debt deflation cycle amidst global economic slowdown.

IMF is also on the note here: “Policymakers must resolve the uncertainty about bank asset quality and support the strengthening of banks’ balance sheets. Bank capital or funding structures in many institutions remain weak and insufficient to restore market confidence. In some cases, bank recapitalizations and restructurings need to be pursued, including through direct equity injections from the ESM into weak but viable banks…”