20/6/2013: Stalled Irish Banks Reforms: Sunday Times, June 16, 2013

This is an unedited version of the Sunday Times article from June 16, 2013


The latest data from the Central Bank shows that in two years since the current government took office, Irish banking sector is not much closer to a return to health than in the first months of 2011.

Objectively, no one can claim that the task of reforming Irish banking sector is an easy one. However, credit and deposits dynamics in the sector point to the dysfunctional stasis still holding the banks hostage. Despite ever-shrinking competition and vast subsidies extended to them, Irish banks are not investing in new technologies, systems and models. Banks’ customers, including businesses and households, are thus being denied access to services and cost efficiencies available elsewhere. In short, the Government-supported model of Irish banking is failing both the sector and the economy at large.


In April this year, total inflation-adjusted credit advanced to the real domestic economy, as measured by loans to Irish households and non-financial corporations, stood at EUR175,419 million. Since Q1 2011, when the current Government came to power, real credit is down EUR32,302 million. This figure is equivalent to roughly twice the annual rate of gross investment in the economy in 2012. Total credit to non-financial corporations has now been in a continuous decline for 48 months.

Half of this contraction came from loans over 5 years in duration. These loans are more closely linked to newer vintage capital investment in the economy, generation of new jobs, R&D and innovation activities, as well as new exports, than loans with shorter duration. Let’s take this in a perspective. The fall in total longer duration lending since mid-2009 is equivalent to losing 70,000-90,000 direct jobs. Factoring in interest income plus employment-related taxes, the foregone credit activity has cost us close to the equivalent of the tax increases generated in Budgets 2012-2013.

It would be fallacious to attribute credit supply declines solely to the property related lending. Based on the new data reported this Thursday by the Central Bank, loans levels advanced to private enterprises have fallen, between Q1 2011 and Q1 2013 in all sub-sectors of the economy, with largest loans supply declines recorded in domestic, as opposed to exports-oriented, sub-sectors.  All loans are down 6%, while loans to companies excluding financial intermediation and property related sectors are down 5.8%.

However, on the SMEs lending side, some of the steepest loans declines came from the exports-focused enterprises, such as ICT sector, where credit has fallen 9.7% on Q1 2011, or in computer, electronic and optical products manufacturing where loans are down 6.5%. Even booming agriculture saw credit to SMEs falling 5.7% over the last two years, while credit for scientific research and development is down 13.3%.

The picture is, in general, more complex for the levels of credit outstanding in the SMEs sector. On the demand side, in Ireland and across the euro area, there has been a noticeable worsening in the quality of loans applications filed with the banks during the crisis. In a research paper based on the ECB SAFE enterprise level survey data for euro area SMEs, myself and several co-authors have identified the problem of selection biases in companies’ willingness to apply for credit. In simple terms, SMEs more desperate for funding due to deteriorating balancesheets are more likely to apply for credit today. In contrast, healthier firms are more likely to avoid applying for bank credit.

ECB data also shows that Ireland’s problem of discouraged borrowers is much worse, than the euro area average. For example, in Ireland, 21% of all SMEs that did not apply for credit stated that they did so for fear of rejection, almost 3 times the rate of the euro area average and nearly double the second worst performing economy – Greece.


On the funding side, Irish banks have been and remain the beneficiaries of an unprecedented level of funding support compared to their euro area counterparts.

A recent research paper from the Dutch think tank CPB, titled "The private value of too-big-to-fail guarantees" showed that through mid-2012, the pillar banks in Ireland have availed of the largest subsidy transfers from the sovereign and Eurosystem of all banking systems in Europe. Funding advantages, accorded to the largest Irish banks, alone amounted, back in June 2012, to more than double the share of the country GDP compared to Portugal, and more than seven times those in Spain and Italy.

Removal of the explicit Guarantees was supposed to serve as a major step in the right direction. Alas, Irish pillar banks continue to depend for some EUR39.5 billion worth of funding on Eurosystem.  The latest Fitch report on the pillar banks shows that this reliance is likely to persist as loan/deposit ratios remain relatively high. Latest figures put Bank of Ireland, AIB and PTSB loan/deposit ratios at around 120%, 130%, and over 200%, respectively.

And there are further issues with funding in the system. By mid-2014, AIB is required to raise EUR3.5 billion to redeem the preference shares held by the National Pension Reserve Fund. Bank of Ireland will have to find EUR1.8 billion for the same purposes. In both cases there are questions as to how these funds can be secured in the current markets without either further reducing money available for lending or tapping into taxpayers’ funds.


Subsidies to the ‘reformed’ Irish pillar banks go hand-in-had with the regulatory protectionism, which completes the picture of massive transfers of income from the productive economy to the zombified banking sector.

Since 2008, Irish financial services continue to experience ongoing process of consolidation and, underlying this, the reduction in overall competition. Data from the ECB shows that the number of financial institutions operating in the country has fallen in 2012 to the levels below those recorded in 2000-2008. Dramatic declines in the fortunes of the third and the first largest lenders – Anglo and AIB - should have led to a drop in the combined market share held by the top 5 banks. Instead, the market share of top 5 credit institutions rose over the years of the crisis.

To a large extent, this reflects exits of a number of foreign lenders from the market. However, unlike in the case of the US and the UK, there are no new challengers to the incumbent players in the Irish asset management, investment, corporate and merchant banking, and credit unions sector. Neither the regulators, nor the banks have any incentives to encourage new players' entry.

And this has direct adverse impact on the overall health of the economy. When we studied the effects of banking sector concentration on firms’ willingness to engage with lenders, we have found that higher concentration of big banks’ power in a market is associated with lower applications for credit and higher discouragement.

As the result of the reforms undertaken in the Irish banking sector, our banking services are left to stagnate in the technological and strategic no-man's land.

Mobile and on-line banking systems remain nothing more than appendages to the existent services, with only innovation happening in the banks attempting to force more customers to on-line banking to cut internal costs.

Currently, worldwide, banking services are migrating to systems that can facilitate lower cost customer-to-customer transactions, such as direct payments, e-payments, peer-to-peer lending, and mixed types of investment based on combinations of equity and debt. All of this aims to reduce cost of capital to companies willing to invest. Irish financial services still operate on the basis of high-cost traditional intermediation and the Government policy is to keep hiking these costs up. Instead of moving up to reflect the true levels of risks inherent in Irish banks, deposit rates for non-financial corporations and households are falling. Interest on new business loans for non-financial corporations is up 105 to 197 basis points in April 2013, depending on loan size, compared to the average rates charged in Q1 2011. Over the same time, ECB policy rates have fallen by 75 basis points. This widening interest margin is funding banks deleveraging at the expense of investment and jobs.


Combination of the lack of trust in the banking system, alongside the lack of access to direct payments platforms means that many businesses in Ireland are switching into cash-only transactions to reduce risk of non-payments and invoicing delays. Currency in circulation in Ireland is up 10.3% on Q1 2011 average, while termed deposits are down 6.3%.

With big Pillar Banks unable to lend and incapable of incentivizing deposits growth, we should be witnessing and supporting the emergence of cooperative and local lending institutions. None have materialized so far. If anything, the latest noises from the Central Bank suggest that the credit unions can potentially expect to take a greater beating on the loans than the banks will take on mortgages and credit cards.

All-in, Irish banking system is far from being on a road to recovery so often spotted in the speeches of our overly-optimistic politicians and bankers. The credit squeeze on small businesses and sole traders is likely to continue unabated, and with it, the rates of business loans arrears are bound to rise.

Box-out:
In this month’s survey of economists by the Blackrock Institute some 64% of the respondents stated they expected euro area economy to get e little stronger over the next 12 months and none expected the recovery to be strong. In contrast, 74% of respondents thought German economy will get better and 81% forecast the same for the UK. In the case of Ireland, however, only 57% of respondents expected Irish economy to become a little stronger in a year through June 2014 (down on 75% in May 2013 survey). None expected this recovery to be strong. Interestingly, 69% of respondents describe Irish economy's current conditions as being consistent with an early or mid-cycle expansion - both normally consistent with above-trend rapid growth as economy recovers from a traditional recession. Thus, the survey indicates that majority of economists potentially see longer-term prospects for the Irish economy in the light of slower trend growth rates. Back in 2004-2005, I suggested that the Irish economy will, eventually, slowdown to an average rate of growth comparable to that of a mature small euro area economy. This would imply an annual real GDP growth reduction from the 1990-2012 average of 4.9% recorded by Ireland, to, say, 1.8% clocked by Belgium. Not exactly a boom-town prospect and certainly not the velocity that is required to get us to the sustainable Government debt dynamics.

19/6/2013: European Federalism and EMU Experience

There is a number of flaws in the euro area design that were exposed by the current crisis. Perhaps the most fundamental is the flaw relating to the system complete incapacity to generate critical capacity. Despite the crisis continuing for the 7th year in a row, the EU and the euro area as its core sub-set remains unable to ask the key question of viability of the social, political and economic project based on the premise that ever-increasing levels of policies and institutions integration, harmonisation and coordination is a feasible and a desired direction to pursue.

Let's start from the top.

Firstly, it is now pretty much an accepted wisdom that in shaping the EMU, European leaders have failed to see even the basic implications of deep integration. The implications missed were not just monetary or economic. Current crisis has shown deep divisions within the euro area on matters such as inflationary preferences, expectations formation mechanisms, conditionality evaluations and fiscal transfers, all cutting across social and cultural division lines, rather than purely economic ones. This failure has led to the design flaws that are principles-based and, as such, cannot be corrected by managerialist solutions. They require structural change - a matter of concern for Europe, so far incapable of following through with even managerialist changes, such as adherence to well-specified Maastricht Criteria targets at the times of aplenty or expression of any solidarity at the times of constraints. There is little hope the EU can deliver on much less defined, broader and, at the same time, culturally and socially more challenging reforms and changes required to move the euro project forward, away from the danger zone.

Secondly, it is also pretty clear that the EU institutions are incapable of learning from the mistakes of their leaders and from the signals transmitted from the nation states and the electorates. Instead of making an effort to understand the underlying causes for a rushed, poorly planned and poorly executed monetary policy harmonisation, the EU leaders are now jumping head-in into attempting to cure the sever hangover from the common currency creation by doing more of the same - embracing the idea of banking and financial services integration (the Banking Union - EBU) and political consolidation (the Political Union - EPU).

A combination of the two directions will, under these conditions, risk leading Europe toward a repeat of the EMU fiasco on a much grander scale - a failure of all three 'unions' - the EMU, the EBU and the EPU. History can repeat itself, having shown its hand today as a structural crisis in one area of the system, with a replay of the crisis across the entire system.

There are number of reasons for this conjecture.

The EU's latest drives - across political and banking dimensions - into deeper integration are lacking the deep foundations on both, the demand and supply sides of their respective equations. In this, they are  exactly mirroring the EMU creation that too faced the original minor crisis in the 1990s only to be pushed through in the noughties.

In case of the EPU, the lack of these foundations is even more fundamental than in the case of EMU or EBU. EPU has no political legitimacy and is losing any potential future legitimacy on a daily basis. EU institutions and even the core ideas of the later-stages EU (EMU, Fiscal Compact, 6+2 Pack packages of legislation etc) are deep under water when it comes to popular mandates. All Eurobarometer surveys show rising dissatisfaction across the EU with the European institutions, including the common currency. The two words 'democratic deficit' that were present in the European politics prior to the crisis are now, probabilistically-speaking, dominate the popular and national discourse about Europe in every country of the Union, including the new Accession states. A popular mandate in Iceland has led to cancellation of the EU Accession talks this month.

Only doctrinaire Europhiles, and even then, predominantly within smaller countries' national elites, as exemplified by some members of Ireland's ruling coalition, today deny the presence of this deficit at the fundamental level across all European institutions.

There is also a major problem of Europe's 'capability deficit'. Brussels - full of (mostly) men in suits with offices to go to after lunch is hardly a source for inspiration or for leadership. And absent inspiration, perspiration does not work all too well. The entire European project lacks vitality, and thus - viability. There is no enthusiasm, no ideal, no dream. These were exhausted at the stages in the project history when 'peace between France and Germany' had meaningful referential counter-point (it no longer has, as no one sane enough would conjecture that absent the EU, Alsace will be once again dug into an anti-tank trenches giant washing board) or when the EU (brilliantly and correctly) was expanding the liberty of trade and freedom of movement across its internal borders. Absent purpose, leadership is wanting too. The void is filled with simulacra of bureaucrateese: the alphabet soup of 'programmes' such as ESM, EFSF, EFS, OMT, EBU, and so on, all the way until ordinary European gets lost in the world of corridors, meeting rooms, windowless conference venues, meaningless letters and mumbo-jumbo of various white papers, etc.

To confront these deficits, the EU is creating even more bureacrateese - papers, positions, plenaries, meetings, councils, pacts, compacts, conferences, agendas.

Amidst this, Europe still lacks a single face capable of holding its own in front of the electorate. Lacks, that is, on the 'federalist' or pro-EU side. There are rhetorically competent MEPs on the opposition side of the chamber, but there is not a single appointed or elected leader of the 'official' Europe capable of not putting to sleep at least half of his/her audience.

Europe has 4 'Presidents' today: President [of the Commission] Mr Jose Manuel Barroso, President [of the Council] Herman von Rompuy, President [of the Parliament] Martin Shulz, President [of the Eurogroup] Jeroen Dijsselbloem. Absent the latter one, not a single one have been known for talking straight on any hard issues. Including the latter one, none inspire many to anything akin the commitments and sacrifices required to achieve meaningful federalisation of the EU. All, with no exception, got their EU positions bypassing direct election by the voters of Europe. Power and responsibilities of each are directly proportional to the distance by which they are removed from the European electorate. When these levels of confusion and power politics dispersion are not enough, there's always a fifth President lurking around: the Head of the Presidency State. In Henry Kissinger's terminology, the question is not 'Who do you call when you want to speak to Europe?' can now be replaced by 'Who do you not call?' Latest G8 summit photos stood as a great exemplification of the problem: there amidst leaders of 8 nations stood three 'leaders' of Europe, not because they had anything to say, but because they had to be there to upstage one another.

The five-headed 'leadership' beast is now on a quest to 'increase democratic mandate' of the EU Commission. To do so, it is proposed that the blocks of parties shall be formed in the EU Parliament to 'nominate' the next Commission and its President. In other words, the EU leadership sees 'renewal' and 'democratic participation' as a function of optics. Dominant blocks of largely sclerotic national-level parties will be dominating the EU legislature and executive to simply replicate the stasis that has captured national political platforms of the main EU states: Germany, France, Italy and Spain. Effective opposition will remain impossible, just as it remains today, but the fig leaf of 'more direct' ('slightly less-managed') democracy will act to cover this up from, hopefully, oblivious or satisfied electorates.

Thus, by design from above (not by will from below), the EU is supposed to move toward a two-party system, replicative of the traditional core parties of the national politics: the centre-left with a clientilist base in unions, state employees and 'social pillars' - the 'social democratic centre'; and the centre-right with a clientilist base of 'employers confederations' and state managers - the 'populist & conservative movements'.

The dynamism of such a system will be equivalent to the excitement of a turtles race on sticky putty. Or differently, a two-party system will do for the political leadership what the Euro did for the monetary policy - put a straightjacket of superficial conformity onto the society that for centuries was based on differentiation-driven boundaries and nation states.

Both demographic and socio-economic changes from the 1945 through today, in Europe as elsewhere, have meant emergence of more diversity and differentiation in markets for everything, starting with simple products, such as diapers to complex services, such as healthcare. To assume that politics and ideologies can remain in the stasis of the two, adjoining at the centre and even overlapping, sets of ideals and policies is about as naive and counterproductive as it was to assume that Greece and Finland, or Latvia and Portugal, can be brought into single currency within a span of one/two decades.

There are three key ingredients that are required to sustain two-party system: 1) stability of ideological preferences (informed by popular objectives for policy), 2) allegiance to the single unifying institution of the state overriding local/national/ethnic or even more atomistic allegiances and interests, and 3) organic evolution of the two-party system (usually out of the bifurcating economic power balance, such as land-owners vs capital owners, workers vs capital owners etc).

Modern world, especially the world of Europe, does not support either one of these preconditions. Current conflicts and, thus, incentives lines are drawn across generations; skills groups; risk-taking capabilities and preferences of populations; national and even sub-national distinctions; ethnic, historical and cultural differences and grievances; external threats that range across a very wide spectrum from immigration from the South to hegemonic threat from the East, to cultural threat from the West, and so on. Two ideologies can never capture this diversity, let alone provide a sufficient basis for forming participatory democratic institutions. Look no further than internal nation states' dynamics in the UK (Scotland, Norther Ireland, Wales), Italy (North, South, East), Spain (Centre, North-East, North-West), Belgium, and recall the fate of Czechoslovakia, Yugoslavia. Look at the emergence of challengers to the two-party systems in all European states - never quite capable of displacing one of the parties of the 'old' system, but always present, reflective of the ongoing process of atomisation, or rather customisation of politics.

At the same time, with hundreds of millions spent on propagandising the concept of European citizenship, Europeans remain in deep allegiance to their nation-states, and in many Federal states - to their local 'tribes'. In fact, the EU has been recognising this and reinforcing the locally-anchored distinctions. Culturally, everyday life matters more to the majority of Europeans today that the 'geopolitical' aspirations of Brussels. And culturally, we are living in an increasingly 'goo-cal' world, where trade delivers to us goods and services from all over the world, but we identify ourselves on the basis of goods and services that are local in origin.

In the countries, where two-party system seemingly is stable - e.g. the US and the UK - underneath the surface, the fact that the two-party system fails to capture sufficient percentage of population in an ever-increasingly individualised world is also evident. It is expressed in the stalemate produced by the system where mainstream parties are captive to small minorities of activists and are often torn internally by sub-groups and sub-interests.

Lastly, the two-party system of ideological debate has been shown inadequate in the face of the current crisis.

Looking forward, this failure is extremely significant. In order to work, compared to today's EU, the EPU must be either comprehensive or devolved. On the latter, see below. The former requires significant transfer of power and power base to the EU, implying ca 20% of GDP-sized Federal Government, dominant power of taxation, harmonisation of core public services, such as health, social security, pensions, education. The member states will be allowed some 'gold-plating' of the Federally-set standards, but the standards will have to be set nonetheless. The reason for this is that in a real Federal Union, there will be a functional Transfer Union and that implies standardisation of services funded by transfers. A two-party system will never be able to break away from the sub-national political bases sufficiently enough to deliver such homogenisation.


If European federalism is to evolve, it will have to evolve on the basis of accommodating more diversity, not by homogenising the system by reducing differentiation and fragmentation of the political institutions. It will have to adopt market-like features where turnover of ideas is fast, deployment of solutions (goods and services) is rapid and never permanent, and the system thrives on diversity. This is the exact opposite of the harmonisation and consolidation implicit in traditional federalism, but is rather more consistent with Swiss federalism. The key to this form of federalism is that it severely limits the central powers of taxation and redistribution of resources and vests powers of policy origination, design and implementation in local hands. It also acts to encourage policy heterogeneity - an added bonus in the world of uncertainty, as it allows for creation of policy hedges: a shock impacting different systems differently necessarily shows both the pitfalls and the strengths of various institutions and regulations. In other words, Europe needs less of European centralisation and more of European diversity.

Before this can be delivered, however, Europe needs to systemically dismantle or reduce those institutions that act as an impediment to bottom-up governance - the institutions of centralisation of power.

The first for a review should be the strictest of them all - the euro. Here, the required change will see assisted exits from the euro of non-core states, leaving behind only those countries for which monetary harmonisation makes sense. Most likely these are Germany, Finland, Czech, Austria, and possibly Belgium and the Netherlands. Other countries can revert to their own currencies and/or run open currency system with euro remaining one of the legal tenders in their economies. Belgium and Luxembourg can run in a union with France, if so desired.

The second candidate for restructuring will be the EU Commission. The President of the Commission should be elected on the basis of direct vote with state-based 'electoral' voting system similar to that of the US, to alleviate extremes of population-weighted distribution of votes. The President then can appoint her/his own Commission on the basis of: (1) each member state must be represented in the Commission, (2) Commission candidates can be nominated by member states, the EU Parliament and the President, (3) each member is confirmed independently by the EU Parliament and the Senate.

The third candidate for reform is the EU legislature. The European Parliament should be augmented by the independent, separately elected Senate, based on member states' representation principle and vested with the powers similar to that of the US Senate. The Senate should be directly elected and it should replace the current Council. To strengthen direct links between nation states and the Senate, the formal leaders of the nation states (e.g Italian and Irish presidents) should serve as senators representing their states.

The fourth candidate for reform should be the system of European checks and balances. This should, among others, include a Constitutional ceiling on taxation and redistribution powers.


There are other reforms that will be required. This is hardly a place to attempt to narrate them all. However, the key principle is that the EU needs a drastic reconstruction of its upper levels of legislative and executive powers. And the key question that is yet to be asked and debated (a necessary pre-condition to deriving any solutions) is whether the proposed EPU (and to a less important extent, the proposed EBU) stand a chance of working out any better than the failing EMU?

18/7/2013: QE or Not-QE... spot the difference?

My recent exchange with @LISwires on the issue of risks involved in both continued QE and pursuing an exit strategy.


The tweet the started it: "Both are… RT @LISwires: QE is "Treacherous" RT @livesquawk: Roubini: Fed Exit Strategy Will Be 'Treacherous' fw.to/gWL3DCg @CNBC"

Explaining my view that QE & Exit strategies are both consistent with structural and grave risks are:

[Both QE and exit is] like being between a rock and a hard place... inside an iron pipe… Exit = QE = non-QE = stimulus = austerity = disaster. The whole point of a structural depression is EXACTLY that!

In a normal recession, one half of the economy's 'cart' gets stuck in the 'mud'. In a structural depression, the entire cart is in the middle of a quick sand trap.

The ONLY thing that would've worked was direct injection of funds to write down household & corporate debts, & in some cases - restructure sovereign debt too. We missed the boat on this by engaging in LTROs/OMT/ESM/EFSF/ESF/EBU/EMU… stupidity of tinkering along the edges. Hence [having engaged in wasting resources on marginal solutions], from here on - it is vast pain over long term. The choice was made by our 'leaders' in ECB/EU/IMF/National Governments/NCBs.

The real failure of economists/economics is NOT our inability to forecast disasters. It is in our inability to see the size & nature of disaster AFTER it hits.

Note: my reference to the direct recapitalisation solution can be traced to this: http://trueeconomics.blogspot.ie/2010/05/economics-16052010-eu-on-brink.html

18/6/2013: The Size of the Eurotanic's Bad Assets Iceberg?

Europe's Non-Performing and Doddgy Banking Assets are a Mount Everest-sized iceberg that no analyst in the Commission or the IMF or the BIS or the ECB or any National Central Bank or... ok, keep inserting official sources, is capable of recognising or estimating.

Thankfully, here's a handy range:

1) Courtesy of the ZeroHedge: http://www.zerohedge.com/news/2013-05-17/europes-eur-500-billion-ticking-npltime-bomb the Eurotanic is heading straight into a EUR500bn chunk of ice.
2) Courtesy of Les Echos, it's EUR1,000bn: http://www.lesechos.fr/entreprises-secteurs/finance-marches/actu/0202834793278-une-bombe-de-1-000-milliards-d-euros-pour-les-contribuables-europeens-576506.php and that's just for 'bad banks'.
3) My own view - the number is well ahead of both. This is a consistent view expressed as early back as, for example, http://trueeconomics.blogspot.ie/2010/05/economics-16052010-eu-on-brink.html and even earlier. Euro area will require some EUR3 trillion in monetary 'assistance' of permanent (or very long-term) nature. The drivers for this are: (a) legacy bad and poor quality assets, (b) stagnation-induced corrections yet to come, and (c) interest rates and ECB exit-induced household and corporate insolvencies crunch looming on the horizon.

17/6/2013: Deutsche, AIB and Cypriot Banks: 3 links

Back in 2011, I wrote about the extreme leverage ratios in some of Europe's top banks: http://trueeconomics.blogspot.ie/2011/09/13092011-german-and-french-banks.html. Deutsche Bank was at the top of the list. Now, 19 moths later it seems others are catching up: http://www.reuters.com/article/2013/06/14/financial-regulation-deutsche-idUSL2N0EO1D220130614.

And while on topic of banks, let's check this one for the record: http://www.independent.ie/business/irish/aib-will-not-repay-35bn-cash-it-owes-to-the-state-29337833.html. I wrote about this in Sunday Times last weekend, in passim, but this is more comprehensive article.

Another link of worth on the topic of banks is Cyprus banks fiasco history from ZeroHedge: http://www.zerohedge.com/news/2013-06-17/guest-post-real-story-cyprus-debt-crisis-part-1

17/6/2013: On Debt of the Nations & Euro Crisis: 2 links

Update from the ZeroHedge on the Debt of the Nations: http://www.zerohedge.com/news/2013-06-04/debt-nations

Worth a read!

And while on the case of crises (for whatever you might read about Reinhart and Rogoff debate, debt overhang is a crisis) we have an excellent contribution by Dani Rodrik on solutions for the Euro area crisis: http://www.project-syndicate.org/commentary/saving-the-long-run-in-the-eurozone-by-dani-rodrik

Thought-provoking and comprehensive summary (albeit I do not necessarily agree with all of Rodrik's conclusions).

17/6/2013: ESM Rules Book Draft

Reuters recently reported [Updated: link is here http://pdf.reuters.com/pdfnews/pdfnews.asp?i=43059c3bf0e37541&u=2013_06_17_11_43_b16e8d8f95d140d2a6693737fcd98885_PRIMARY.pdf  H/T to @Taleof2Treaties] on a document prepared for the Eurogroup meeting in Luxembourg that puts forward more detailed set of rules for ESM deployment in recapitalising the banks.  The rules, as seen by Reuters, involve:

• A private sector bail-in to be required before any ESM contribution can be made. More on this below; and
• The ESM will apply a two-tier test in deciding whether recapitalisation can be carried out: the capital must fall below critical adequacy levels, and the bank must be considered systemic for the eurozone as a whole, not a national system. Which means in the case of Ireland - no recapitalisations of ANY irish bank, neither BofI, nor AIB, nor Anglo. Per ESM rule book, the whole country can go insolvent, as long as Deutsche Bank or Credit Agricole are still floating.

When a bank gets into trouble, the Euro-Troika: ECB, the European Commission and the ESM,

• Will stress-test / value bank’s assets. Euro-Troika will set the required level of capital the bank will require, thus opening the process to the transfer of foreign-held liabilities onto the shoulders of the country taxpayers. For example, suppose an Irish bank X holds 10% of its liabilities against external foreign subordinated lenders. In normal case, these would be forced to take a haircut first. But Euro-Troika can determine that is must make good on full 10%, thus transferring liability fully to the sovereign of bank X domicile via the first requirement that the sovereign must step in ahead of any ESM recapitalization. 
• After determining the amount of capital required, the ESM will also determine if the bank has the minimum legal common equity Tier 1 ratio, currently at 4.5%. If the bank does not meet the minimum, the government would inject between 10% and 20% of the funds shortfall. The ESM will provide the residual.
• If the government cannot meet the demands for 10-20% injection, the ESM will not step in to recap the bank
• Once the bank is recapitalised using ESM funds, ESM will take equity in the bank and will engage in setting bank strategy and business model. The ESM will also track bank performance to targets and will also have power to change bank management and board. This will be a major departure from the modus operandi of the Irish authorities, but to what extent it will be effective / significant remains to be see. After all, pro forma changes can be put in place with minor alteration to the pre-crisis status quo.

The document says ESM will deal with legacy assets, which is an ambiguous statement, but potentially holds some hope for Ireland.

17/6/2013: Latvia's Mistake

An excellent piece by ex-IMF Ashoka Mody for Bruegel blog on Latvia's bizarre, one-way (the wrong way) bet on entering the Euro: http://www.bruegel.org/nc/blog/detail/article/1108-latvia-in-the-eurozone-a-bet-with-no-upside/

Mody - having completed pensionable tenure at the IMF - is now going 'free agent' so political correctness can be set aside. He argues, quite correctly, that Latvia's membership in the Euro simply ties its hands on currency valuations and interest rates, without giving it anything tangible in return.

"But the economics does not favor euro adoption by Latvia. The Latvian authorities are giving up the extremely valuable option of floating their exchange rate at a future time. And what may be the offsetting gain? Establishing policy credibility is not one of them. Having proven to the world that Latvia will endure the most intense economic pain to preserve its exchange rate parity, why is a further commitment needed? If the argument is that a future government may be irresponsible and the country may be faced with a new crisis, it is presumptuous to judge that the floating option will not be right one at that time. Binding a future government in this manner is particularly overreaching given how little Latvian public support there is today for a move into the Eurozone."

"More importantly, long-term competitiveness requires a healthy pace of technical change and higher quality products. …If Latvia does successfully climb the technology ladder, it will do as well outside of the Eurozone as inside it; but if it fails that bigger competitiveness challenge, it will face an unpleasant rerun of its recent crisis. Again, Portugal offers a warning: the competitiveness problems that forced a painful adjustment under the Exchange Rate Mechanism in 1993 remerged less than two decades later."

Crucially, per Mody, "...the Eurozone is itself largely dysfunctional. By the admission of its own stewards, the “monetary transmission mechanism” is inoperative. Put simply, when the ECB changes its interest rates, its member countries feel no impact. It is as if the countries were operating on their own. This may improve with time. Those in the Eurozone have no choice; but does Latvia need to rush into this setting?

Indeed, if there was a moment for Latvia to float its exchange rate, this would be it."

Mody does not ask the other question: Why would the euro zone want so urgently for Latvia to join? The answer to this question is even less palatable politically and economically. Euro zone does need another country with a clearly divergent economy and no real dynamic of convergence (shallow growth across the euro zone and still crisis-driven dynamics in Latvia). Nor does Latvia suit the euro zone core - with slower growth and lower inflation targeted by demographically challenged Germany et al. Which means that the only reason for Latvia to be welcomed by the euro zone is geopolitical. Just the same as the only reason for Latvia to enter the euro zone is geopolitical as well. Both, the club and the entrant smell Russia in the distance and feel their early 20th century-stuck fears.

16/6/2013: De ATMs, De Sacred ATMs... Co-Op Bank Haircuts?

So how, oh how on earth an the UK now sustain its ATMs working, wonders (most likely) half of the Irish Cabinet… Per Guardian report: http://m.guardian.co.uk/business/2013/jun/16/co-op-bank-deal-regulators?CMP=twt_fd the Cooperative Bank is planning on plugging a GBP1.5 billion hole in its capital reserves by soaking it bondholders with a 30% haircut.

Of course, there is little new here, as investors expected the haircut for some time now: http://citywire.co.uk/money/co-op-sells-tranche-of-loan-book-as-investors-fear-haircut/a683473

Per citywide: "Britannia building society, which Co-op acquired in 2009, is seen as the root of the bank’s problems, specifically the poor grade corporate loans it acquired."

Obviously, there will be tears when Co-op busts the bondholders bubble, but the tears might be less significant now, given the fact that the bonds have been trading at discounts for some time and that many of the few retail investors have probably sold out of the bonds by now, leaving behind the usual speculative risk-takers. Still, this is a significant test for the small, but very strategic institution that came to challenge the usual banking establishment.

16/6/2013: A Minister in Northern Ireland is Fond of Slaying Dragons

Readers of this blog are aware where I stand on excessively aggressive tax optimisation by some companies that the Irish system permits. There is, however, a major distinction implied by my arguments: Irish system of taxation is fully legal and does not violate other nations' laws. From economics point of view it is a form of tax haven. From legal point of view it is not.

This fine distinction is too often lost on some of this blog's readers, some Irish politicians (not readers of this blog) and, self-evidently after the below, to the Northern Ireland's  Finance Minister.


As reported by BBC (http://www.bbc.co.uk/news/uk-northern-ireland-22925772) "...Sammy Wilson has accused the Irish government of "stealing" UK tax revenue. The DUP minister said he was concerned companies were using the Republic of Ireland to pay tax which he claims should be paid in the UK. ..."My view is that the British government does have some leverage on the Irish government there, because they have a £7.5bn loan, that is a lot of leverage," he told the BBC programme Sunday Politics."

The terms of the loans conditions from the UK to Ireland are explained here: http://www.telegraph.co.uk/finance/financialcrisis/8203912/Key-points-terms-of-UK-loan-to-Ireland.html clearly showing the amount extended to be capped at maximum £3.25 billion (€3.76 billion) - subject to the exchange rate differences.

It might be possible that Minister Wilson was referencing some headline he read somewhere, e.g. http://www.independent.ie/business/irish/uk-slashes-its-interest-rate-on-our-7bn-bailout-loans-26863834.html but even the article headlined with '£7 billion loan' cites in the body of the text correct amount of £3.25 billion.

Another similar headline relates to the orignal estimates of the potential loan, e.g. http://www.guardian.co.uk/business/2010/nov/22/ireland-bailout-uk-lends-seven-billion, which was capped less a month after, e.g. http://www.guardian.co.uk/politics/2010/dec/08/george-osborne-cap-uk-loan-ireland ... at £3.25 billion.

NTMA reports the latest drawdown amounts here: http://www.ntma.ie/business-areas/funding-and-debt-management/euimf-programme/
According to the NTMA, Ireland has drawn down only £2.42 billion worth of UK funds so far.

We are, indeed, thankful to the UK taxpayers for providing these loans and for offering them on terms that reflected broader restructuring of these loans by other lenders.


On Minister Wilson's tax 'theft' charge, per Journal.ie report: "The Republic’s junior finance minister Brian Hayes, speaking on the same programme, said it was up to other countries to change their own tax laws if they wished to stop companies headquartered there from being able to avoid tax."

I often disagree with Minister Hayes on many matters, but on this occasion he is correct.

16/6/2013: NPRF, Stimulus & Futility of Policy: Sunday Times June 9, 2013

This is an unedited version of my Sunday Times article from June 9, 2013.



With the coalition mulling over the idea of investment 'stimulus', there are only two questions everyone in the Leinster House should be asking: Where is the money coming from? and Is there value for money in these investments?

Since the beginning of this crisis, the State piggy bank, aka the National Pensions Reserve Fund (NPRF) has been as rich of a target for Government raids as the taxpayers pockets. Back in 2007, NPRF assets were valued at EUR21,153 million with almost 94% of these, or EUR19,817 million, held in liquid financial instruments, such as cash, listed equities and bonds. Q1 2013 data shows that the fund discretionary portfolio (portfolio of assets excluding government-mandated 'investments' in AIB and Bank of Ireland) has declined to EUR6,449 million with only EUR4,243 million of this held in relatively liquid assets that can be meaningfully used to fund any stimulus.

The reason for the NPRF’s disastrous demise has nothing to do with the fund management or strategy - both of which were relatively good, compared to some of Ireland's 'leading' private sector asset managers. The cause of the precipitous 79% drop in liquid assets held by the NPRF was the banking sector collapse and the Government decision alongside the Troika to waste some EUR20,700 million of NPRF funds to 'invest' in two pillar banks equity stakes, with EUR16,000 million of this sunk into the black hole of AIB. As of Q1 2013, the NPRF 'investments' in the banks were valued at EUR8,800 million. This, accounting for dividends paid and disposals made to-date, implies a loss of some 47% of the original investment outlay.

The sheer absurdity of the use of the NPRF to fund every possible twist and turn of the State financial crisis is magnified by the latest Government plans. The exchequer returns through May 2013 released this week show clearly that as in previous years, the heaviest burden of spending cuts by the public sector is once again falling onto the capital expenditure side. January-May current voted spending is running 1.6% ahead of the target, with capital spending outstripping targeted cuts by 12.6%. Now, the same state that has been for years slashing voted capital expenditures is angling to raise a capital investment stimulus by raiding the remaining liquid NPRF funds.

The key issue with NPRF asset holdings is that even theoretically liquid funds will have to be leveraged in order to raise cash for any meaningfully sizeable Government investment. Leveraging NPRF funds via Public-Private partnership-type schemes can yield, realistically speaking, around EUR8-10 billion of total funding for the proposed seven years-long investment envelope, or just about 8% of the cumulated gross domestic capital formation taken at the 2011-2012 running levels.

Use of NPRF funds to finance economic stimulus while the state continues to borrow cash for day-to-day management of unsustainable deficits is of a dubious virtue to begin with. The costs of leveraging the NPRF funds will add further pain to the economics of stimulating investment in the environment of already high levels of government and private sector indebtedness. Worse than that, leveraging NPRF will either increase the Government debt and deficits or put a hefty new cost onto the taxpayers and users of services funded via the stimulus. In effect, the very attractiveness to the Government of the leveraged finance via NPRF is that such funding for capital programmes will most likely be off the official balancesheet of the State. This, however, means that it will also become a direct cost to consumers and, possibly, also to the taxpayers.

Let me explain the last point in greater detail. In 2012, Irish Government spent 3.7% of the country GDP or EUR6,133 million on paying interest on its debts implying an average effective interest rate of 3.19%. With the markets in a relative calm, our latest issue of Government bonds on March 20 this year saw NTMA raising EUR5 billion in 10-year debt at 3.9% annual coupon. This is the benchmark rate for any long-term lending in the country.

Even assuming the markets conditions will not change in the wake of a significant leveraging of funds from the NPRF, current cost of funds to the State is well in excess of recent returns earned by the NPRF on its liquid assets portfolio. In Q1 2013, NPRF delivered annualised rate for return of 2.8% on its discretionary portfolio and over 2000-2011 period, compounded returns earned by the NPRF run at 3.23% per annum.

Now, consider the second question posited above. Much of the public investment in infrastructure and general economic activities, as detailed in September 2011 Strategic Investment Fund (SIF) initiative issued by the current Government requires heavy involvement of the Private Sector co-funding. Quoting NPRF annual report for 2011, under  the SIF, "investment on a commercial basis from the NPRF will be channeled towards productive investment into sectors of strategic importance to the Irish economy (including infrastructure, water, venture capital and provision of long-term capital to the SME sector) and matching commercial investment from private investors would be sought." In other words, we are already leveraging the state finances for previous rounds of stimuli.

Private co-investment requires two things to succeed: sovereign assurances and preferential treatment to reduce overall levels of risk, plus annual return well in excess of sovereign debt returns. In other words, in any PPP and joint co-investment scheme, the State must assure premium return to the co-investing private sector agents.

If the State investments were to be financed at a sovereign cost of funding absent any negative effects on Government bond yields from increased borrowings, the underlying returns on public investments through the 'stimulus' scheme, based on a 50:50 split with private funding, would have to be yielding well in excess of 7-8% per annum. These returns will have to come either from the users of services backed by the PPP investments or from the taxpayers via minimum return guarantees.

Do the math: we can borrow at 3.9% in the markets or we can borrow at 7-8% via PPPs. The only difference is that under the latter arrangement, Minister Noonan can pretend that we didn’t borrow at all, as most of the money to repay the PPP investments will simply come out of the economy directly, instead of via the Exchequer.

That is the hope that is driving the Government to use NPRF instead of its own funds to fund capital spending. This hope, however, is based on rather thin analysis of the economic realities of the PPPs.

It is worth noting that between 1999 and the end of 2011, the total volume of PPP-based investments in Ireland, both committed and allocated, was just over EUR6.4 billion - or a fraction of the hoped-for amount of funds currently under the discussion for the next stage stimulus on foot of NPRF assets. This excludes EUR2.25 billion stimulus announced in July 2012 by the Government, which is not producing much of a desired effect of a stimulus on the economy so far.

Setting aside the issues of financial returns feasibility, it is highly doubtful that this level of investment can be economically efficiently deployed in the economy. And this is on foot of rather poor PPPs performance documented for pre-crisis period, as was highlighted in a number of studies on the subject. Several reports found that the final PPP deals involving capital funding for schools, water infrastrcture and transport programmes returned final costs well above the costs of direct procurement. Severe cost transfers to the state from the PPP projects have been found in the cases of major roads contracts in Ireland, including Clonee-Kells project and Limerick Tunnel project.

An in-depth research note on the problems inherent in PPP funded capital investments in Ireland published by the NERI Institute in January 2013 concluded that "it is striking that after thirteen years of procurement under PPP, there has been no official in-depth analysis of the experience to date. Yet PPP is now a major part of the current governments plan to stimulate the economy. The absence of any publicly available body of evidence in support of this plan represents a major shortcoming in terms of the formation of economic policy."

In contrast to the pre-crisis periods, current business, investment and economic environment in Ireland is characterised by high levels of debt overhang in the private sector, involuntary entrepreneurship, falling rates of growth in global demand for indigenous exports out of Ireland, stagnant or declining real assets valuations and a number of other factors significantly increasing the risk of any new investment. In other words, any new stimulus will have to come at the time when investment opportunities are thinner on the ground and risks associated with such investments are higher.

All of the risks associated with PPP-funded projects, thus, are only exacerbated in the current economic environment.

Instead of first attempting to fix the problems with the core financing schemes, the Government is setting out to drive more forcefully into the troubled waters of privately co-funded schemes. Previously announced stimuli, ranging from capital investment supports to stamp duty and R&D tax incentives, to the 2011-2012 announcements of similar PPP-based leveraged capital investment programmes have been insufficient to stimulate the domestic economy out of its structural collapse. This time around, the Government is attempting to up the ante by increasing the amounts of funds it aims to pump into the economy. The hope, obviously, is that doing more of the same on an increasing scale will yield a different outcome.

More likely, the outcome will be a further debasing of the consumers’ disposable incomes via higher taxation and higher cost of services, in exchange for wiping out completely the NPRF – our only remaining cushion against any potential future risks. Doubling-up when losing repeatedly in the economic policy roulette is not a good idea.  Doubling-up using granny’s pension cheques might be outright reckless.

Box-out:

Back in April this year, the IMF stole the headlines in Ireland after pointing that combined unemployment and underemployment rate in Ireland stood at a staggering 23%. However, the only really surprising thing about the IMF statement was that this data was already reported by the CSO before. In fact, CSO reports quarterly broader unemployment statistics since Q1 1998. Last week, CSO database showed that in Q1 2013, the broadest measure of unemployment – the measure that includes unemployed, discouraged workers and underemployed workers – has hit 25%, rising from 23.7% in Q1 2011 when the current Government took office. However, the above measure is still incomplete, as it excludes those workers who are drawing unemployment supports but are classified as participants in state training programmes, e.g. JobBridge. Adding these workers to the broader measure referenced by the IMF, Irish broad unemployment rate in Q1 2013 stood at a massive 29% - a historical high for the metric and up 2.7 percentage points on Q1 2011.

16/6/2013: Euromoney Country Risk Scores Update

Some updates from Euromoney Country Risk (ECR) reports. First a summary of latest credit risk assessment scores moves:

And on foot of Russia's score move, a related story on Russian government delaying issuance of much expected sovereign bond. Via Euroweek:


"Russia is likely to wait until autumn before bringing its mandated sovereign bond, said analysts. Forcing through a $7bn bond in one deal might also be unwise, but demand is deep and the sovereign could spread its funding plan out across separate transactions, said bankers... Investors have already priced in a large sovereign issue and Russia would not struggle to drum up demand, he added. But the problem is price."Everything is 100bp wider than a month ago and so the sovereign will hope things calm down and allow them to issue closer to the historic tights they were looking at just a few weeks ago," said another syndicate banker."