5/11/2012: Lehman Bros & Irish ISEQ

Here's an interesting little factoid. The theory - usually advanced by the Irish Government - goes that Lehman Brothers bankruptcy has been a major driver of the Irish crisis. I have disputed this for ages now and more and more evidence turns up contrary to that when more and more data is considered.

Now, here's a new bit.

Suppose Lehman Bros did contribute significantly to the Irish crisis gravity. In that case, given Lehman Brothers bankruptcy contributed adversely to the global markets, we can expect a dramatic contagion from the global markets panic to Irish markets. One way to gauge this is to look at the changes in correlations between the measure of overall 'panic' in the international markets and the behaviour of the returns to Irish stock market indices.

Let's take ISEQ index for Irish markets and VIX for a measure of the panic sentiment in the global markets. Let's take weekly returns in ISEQ and correlate them to weekly changes in VIX. I use log-differencing in that exercise and 52 weeks rolling correlations.

What should we expect to see? If the 'Lehmans caused Irish crisis or worsened it' theory holds, we should expect correlation between ISEQ weekly returns and changes in weekly VIX readings to be negative (VIX rising during the crisis signals rising risk aversion in the markets). For Irish markets to be influenced significantly, or differently from other markets around the world, such negative correlations should be larger in absolute value than for other countries.

What do we see? Here is a table of averages:

Contrary to the hypothesis of 'Lehmans caused Irish crisis', we see that throughout the period of the crisis, ISEQ suffered shallower, not deeper, spillover from global risk aversion to equity valuations, save for Spanish IBEX index. In other words, evidence suggests that Irish 'disease', like Spanish 'disease' was driven more by idiosyncratic - own market-specific - factors rather than by global panic.

Here's the chart, showing just how consistently closer to zero ISEQ correlation to VIX was during the post-Lehman panic period:

And here is a chart showing skew in the distribution of weekly returns which shows that during the crisis, Ireland's ISEQ suffered less from global markets 'bad news' spillovers (at the point of immediate global markets panics, such as Lehmans episode), but exhibited  a much worse negative skew than other peers in the period from June 2010 through Q1 2012.

5/11/2012: Bank credit to SMEs - demand side

My paper with Javier Sánchez Vidal, Ciaran Mac an Bhaird and Brian M. Lucey "What Determines the Decision to Apply for Credit? Evidence for Eurozone SMEs" is available here.

30/10/2012: Eurocoin signals continued recession in October

Euro area economy did not improve significantly in September-October, according to the leading composite indicator eurocoin published by the CEPR and Banca d'Italia.

Per eurocoin,

• October growth reading stood at -0.29%, statistically indistinguishable from -0.32 and -0.33 recorded in September and August, respectively. 
• October marks thirteenth consecutive month of contraction being signaled by eurocoin
• Crucially, 3mo MA is now at -0.313 which is the same as 2008-2009 average (-0.31). 6mo average is at -0.23.
• We are now into the fourth month of statistically significant sub-zero readings.

As charts below show, ECB remains in the operating range where inflationary target is not consistent with Taylor Rule target.

And here's a chart from Morgan Stanley Research showing PMI-based indicators are also pointing South:

30/10/2012: Feeble defense for tax arbitrage

Saturday, October 27, 2012: http://www.irishexaminer.com/ireland/gilmore-bids-to-reassure-merkels-heir-apparent-212198.html#.UI2WTN8hVo4.twitter

"Ireland’s corporation tax rate was in the sights of the man most likely to succeed Angela Merkel as German chancellor when he met Tánaiste Eamon Gilmore in Berlin. Peer Steinbruck, the Socialists’ candidate to lead the party in next year’s election, also said he doesn’t personally believe in using EU funds to pay down bank debt."

Now, here's the problem: Steinbruck has been "deeply critical of Ireland’s generous corporation tax, blaming it for Germany losing income from German companies, when he was finance minister in the previous coalition government with Ms Merkel."

Per report, "the Tánaiste tried to reassure him that Ireland’s tax rate of 12.5% — the second lowest in the EU — posed no threat to Germany… …Over 1,000 multinationals are based in the country and last year was a record for inward investment. "This is not a threat to Germany or to our other partners in Europe — there are more jobs in Irish companies operating in Germany than there are in German companies operating in Ireland. "In fact, in many instances we are competing for mobile investment with other parts of the world and not with our fellow European," said Mr Gilmore."


One wonders if Mr Gilmore is simply playing an ignorant or is indeed unaware of the fact that beyond his own prowess of policy foresight, other countries in Europe, including Germany, would like to see European HQs of non-EU MNCs set up in their jurisdictions? Or perhaps Mr Gilmore thinks that Peer Steinbruck is some naive school-teacher-turns-politico and that the German Socialist has no desire to correct for often absurd tax arbitrage on which Germany is losing billions in tax revenues and which Ireland facilitates (see links here : http://trueeconomics.blogspot.ie/2012/10/13102012-irish-corporate-tax-haven-in.html). This tax arbitrage not only imposes direct cost on Germany (via German MNCs accounting practices via Ireland operations), but also massive indirect costs as non-German MNCs trade into German economy bypassing German tax system.

In reality, all tax havens are small open economies, so Mr Gilmore's 'Ireland is small, so it needs special tax regime' argument is hardly a defense.

30/10/2012: Not all austerity is equal

August 2012 paper (link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2153486 ) "The Output Effect of Fiscal Consolidations by Alberto F. Alesina , Carlo A. Favero and Francesco Giavazzi published by CEPR (Discussion Paper No. DP9105) looked at "whether fiscal corrections cause large output losses." Italics are mine:

The authors "find that it matters crucially how the fiscal correction occurs. Adjustments based upon spending cuts are much less costly in terms of output losses than tax-based ones. Spending-based adjustments have been associated with mild and short-lived recessions, in many cases with no recession at all. Tax-based adjustments have been associated with prolonged and deep recessions.

The difference cannot be explained by different monetary policies during the two types of adjustments. Studying the effects of multi-year fiscal plans rather than individual shifts in fiscal variables we make progress on question of anticipated versus unanticipated policy shifts: we find that the correlation between unanticipated and anticipated shifts in taxes and spending is heterogenous across countries, suggesting that the degree of persistence of fiscal corrections varies."

"Estimating the effects of fiscal plans, rather than individual fiscal shocks, we obtain much more precise estimates of tax and spending multipliers". And "the key result is that while expenditure-based adjustments are not recessionary, tax-based ones create deep and long lasting recessions." The reason for this that "the aggregate demand component which reflects more closely the difference in the response of output to ECB and [tax-based] adjustments is private investment. The confidence of investors proceeds with the economy and therefore recovers much sooner after a spending-based adjustment than after a tax-based one. ...These results are consistent with the descriptive statistics presented in Alesina and Ardagna (2012) who show that the fiscal stabilizations which have the mildest effect on output are those that are accompanied by a set of structural reforms which signal a "decisive" policy change. They [like the present study] do not find any difference in the monetary pol- icy stance between spending-based and tax-based adjustments, but mostly differences in the policy packages regarding supply side reforms and liberalizations."

29/10/2012: German banks exposure to GIIPS

Here's a pic courtesy of Morgan Stanley Research of the German system exposure to GIIPS - pre-crisis, and now:

That is a massive deleveraging (if you look at now, through September), but it is also a massive exposure. Few years ago I said that German banks didn't have a property bubble at home. The had one abroad (in GIIPS) instead. Now, with their banks close to 2005 levels of exposure, it is pretty clear where the Euro area policy train is heading before the station 'Legacy Debts' is reached.

29/10/2012: More on CDS markets woes

Few days ago I mentioned I stopped watching CDS on a daily basis... and here is more on the same: link.

Well done, Europe. Nothing like sledgehammering the markets. Step next: shove loads of sovereign debts into ESM, OMT and on the 'emergency' lending lines at ECB and NCBs. That'll teach the markets how to price risk.

29/10/2012: Euro Area and GIIPS: banks & bonds

An interesting set of two charts from BIS (through Q2 2012) documenting Euro area banks' exit from GIIPS (click to enlarge):

29/10/2012: BAML note on Ireland's Troika Review

A glowingly positive, albeit un-detailed, under-researched and rather tenuous on the subject covered, note from BA Merrill Lynch on Ireland's latest quarterly Troika review (link). This suggests that (1) all that matters for Ireland is 'exiting' Troika bailout, (2) OMT take up of a whooping €24bn of banks debts is just a matter of technicality, to be resolved in early 2013 (oh, we wish) and (3) the ECB is somehow going to find it plausible to support the banking-fiscal systems tie up that according to ECB and the rest of Troika is performing well without ECB/OMT/ESM support.

Now, what logic can lead BAML to conclude any of the things above remains a mystery.

My own view on the Troika review is provided here.

28/10/2012: Long term investor risk perceptions

Blackrock research on risk attitudes of long-term investors:

So within 1year we have a massive flip on perceptions concerning pensions decisions, amidst a relatively robust markets performance.

28/10/2012: BNP note on Spanish Bonds risks

A neat summery from BNP on (1) current bond ratings, and (2) links between ratings and eligibility for inclusion in bond indices:

And a few words on the importance of Spanish ratings risks to ESM/OMT etc:

"As has been demonstrated throughout the EU debt crisis, credit ratings can have a material impact on sovereign bond markets. ...However, not all downgrades have the same effect on bond yields. More specifically, the loss of an AAA rating (S&P on France and Austria, for example) and, more importantly, the loss of investment-grade status (Greece, Portugal) matter more than other downgrades and may have dire consequences for sovereign bonds, because of the significance of those two ratings levels as critical thresholds for investors."

"The downgrade to sub-investment grade, in particular, is linked to the eligibility criteria for various global bond indices, i.e. the minimum rating required for a sovereign bond to be included in an index. Fund managers tend to track the performance of major bond indices and, as a result, when a country’s sovereign bonds drop out of an index due to ratings ineligibility, investors have to adjust their portfolios and offload the country’s bonds. So, any downgrades to sub-investment grade could lead to massive selling flows and have a huge impact on the bond yields of the country in question. More than that, quite often, markets tend to front-run the ratings agencies and start to offload the bonds of the country they suspect may be downgraded to sub-investment grade in the near-term future."


"... Currently, Spanish ratings are getting extremely close to those same [as Portugal in 2011 downgrade case] eligibility thresholds. In general, BBB- is the critical limit for bond index eligibility, but different indices have different rules on calculating a single rating for each country (they can use, say, the average, middle, best of all, or specific ratings). For Spain, currently rated BBB-/Baa3/BBB, any trio of one-notch downgrades is going to push the average rating below the eligibility threshold."

"Credit ratings are important not only with respect to eligibility for the major bond indices, but also in calculating the haircut the ECB applies to collateral posted by European banks. According to the ECB’s graduated haircut schedule, an extra 5% haircut is applied to ratings in the BBB+/BBB/BBB- range (the ECB uses the best rating of S&P, Moody’s, Fitch and DBRS). This extra 5% haircut applies only to category 1 assets, which include government bonds. For other assets, like bank, corporate and agency debt, this extra haircut can reach up to 23.5%, creating severe additional collateral requirements for banks."

"This is particularly important for Spanish banks, which tend to absorb around EUR 400bn of liquidity from ECB’s open market operations. The ECB recently announced that it is suspending the application of the minimum credit-rating threshold to its collateral eligibility requirements for the purposes of the Eurosystem’s credit operations for marketable debt securities issued or guaranteed by the central government of countries that are eligible for OMTs or are under an EU-IMF programme and comply with the associated conditions. However, this does not affect the application of the previously mentioned graduated haircut approach."

"So, focusing on Spain, a one-notch downgrade by DBRS would mean that marketable securities issued by Spain would fall into the higher haircut range and Spanish banks would have to post additional collateral with the ECB. A trio of one-notch downgrades by S&P, Moody’s and Fitch would push the Spanish average rating below BBB- and Spanish bonds out of those bond indices that use the average rating as the threshold for eligibility. For those bond indices that use the middle rating of S&P/Moody’s/Fitch (or the better of the first two), a one notch downgrade by each of Moody’s and S&P would be enough to push the single rating below the eligibility threshold, too. Because of this, any upcoming developments in relation to (1) direct bank recapitalisation by the ESM, (2) a Spanish request for a precautionary programme, (3) economic and social developments in Spain and (4) funding rates are going to be critical, as they could prompt further downgrades, with severe implications for the Spanish bond market."

"If any of these downgrade combinations takes place before Spain has made an official request for a programme, we believe a request would, in effect, become inevitable. At the same time, if Spain asked for a programme tomorrow, this would not necessarily mean that any further downgrades would be off the cards. Almost all of the ratings agencies have said that they will have to assess whether ESM intervention is likely to become a complement to or a substitute for market access. If it turns out to be the latter, this would be in line with a downgrade to the sub-investment-grade category."

"At this point, we should mention that if Spanish bonds are removed from the global bond indices, this could have an impact on Italian bonds as well. The reason is that some investors may have replaced their Spanish bond holdings with an Italian bond proxy in order to benefit from better liquidity and protect themselves from panic selling, should Spain be downgraded further. As a result, if Spanish bonds’ drop out of various indices, these investors could suddenly find themselves overweight Italy versus the index, so they would have to sell some of their Italian bonds to re-adjust their weightings and track the index."

"We saw this kind of move when Portugal was downgraded to junk by Moody’s in July 2011 (taking into account that this was not completely expected by the markets and PGB liquidity had already dried up). In the five days after Portugal’s downgrade, 5y Italian and Spanish yields jumped by 95bp and 65bp, respectively."

Nasty prospect, albeit the risks are diminishing, in the short run, imo.

28/10/2012: ECB and technocratic decay?

Some interesting comments from BNP on ECB and Mr Draghi's tenure to-date. The note is linked here.  But some quotes are enlightening [comments are my onw]:

"While the ECB justifies the OMT as being to improve the functioning of the monetary system, the fact it has done nothing to help the monetary system in Ireland or Portugal suggests the scheme is about fiscal financing." [I fully agree]

"The balance-sheet implications of buying in the secondary market are the same as if bonds had been bought in the primary market. Mr Draghi’s adherence to the spirit of the Treaty is in question. We support his flexibility, however." [In the short run - yes, Draghi's flexibility is a necessary compromise. Alas, in the long run it is of questionable virtue. Hence, as I remarked ages ago, it's not the measures the ECB unrolls in the crisis that worry me, but the impossibility of unwinding them without wrecking havoc on the economy.]

"...Mr Draghi did [cut rates] in November and December [2011], taking rates back to where they started the year before the two misguided mid-2011 hikes. Mr Draghi cut rates again in July 2012, not only taking the refi rate below the 1% barrier (to 75bp), but also cutting the deposit rate to zero, apparently in an attempt to reinvigorate the interbank market (so far, fruitlessly). Mr Draghi should be praised for cutting rates and for overcoming the 1% barrier, in our view." [I agree.]

"However, he seems to be reluctant to take the deposit rate below zero, which looks timid. Moreover, he has failed to stimulate private credit supply. The LTRO has facilitated the expansion of credit to governments, but to some extent, this has crowded out private-sector credit, where growth is now down 0.8% y/y (-0.4% adjusted for sales and securitisation). The line that this is due to weakness in credit demand is a feeble excuse for the ECB failing to do enough to stimulate supply or to circumvent the lack of credit supply, for example, through credit easing. This has been the major failure of Mr Draghi’s tenure." [I am not so sure on BNP rejecting the idea of weak demand. Most likely, both weak supply and demand are reinforcing each other. More on this once we have our paper on SMEs access to credit published in working paper format, so stay tuned].

And the last blast, the potent one: "If central bankers don’t want politicians to mess with central banking, central bankers would be wise not to mess with politics. Mr Draghi was intimately involved in Italian politics and the demise of former Prime Minister Silvio Berlusconi’s tenure in the summer of 2011. More recently, his plans for the OMT were reportedly shared with the German chancellor’s office well in advance. The ECB is a very political animal under Mr Draghi. As the only institution with pan-eurozone power, a prominent role for the ECB in crisis resolution and a strong link to politics
may be unavoidable, and even desirable. But ultimately, such links may return to haunt it." [Yep, I agree. Mr Draghi's competence in office comes with a typical European price tag - get a technocrat and surrender checks and balances. This both signifies to the sickness at the heart of Europe (technocracy displacing democracy) and the inability of the 'patient' to develop institutional path for dealing with this sickness (with EZ potentially/arguably facing either a collapse in the hands of democracy or decay in the hands of technocracy).]