19/4/15: Russian Current Account Surplus 1Q 2015

Preliminary data for Russian balance-of-payments for 1Q 2015 shows current account surplus slipping to USD24 billion down to just over 3% of GDP over the 12 months through 1Q 2015.

Exports fell 30% y/y in USD terms, on foot of c. 50% drop in Urals grade oil prices. Value of non-oil goods exports was down 13% and the value of goods imports was down 36% in USD terms.

Effective real exchange rate for the ruble was down about 25% y/y in 1Q 2015.

19/4/15: The costs of deflations: a historical perspective

An interesting article from the BIS on the impact of deflation risks on growth and post-crises recovery. Authored by Borio, Claudio E. V. and Erdem, Magdalena and Filardo, Andrew J. and Hofmann, Boris, and titled "The Costs of Deflations: A Historical Perspective" (BIS Quarterly Review March 2015: http://ssrn.com/abstract=2580289), the paper looks at the common concern amongst the policymakers that falling prices of goods and services are very costly in terms of economic growth.

The authors "test the historical link between output growth and deflation in a sample covering 140 years for up to 38 economies. The evidence suggests that this link is weak and derives largely from the Great Depression. But we find a stronger link between output growth and asset price deflations, particularly during postwar property price deflations. We fail to uncover evidence that high debt has so far raised the cost of goods and services price deflations, in so-called debt deflations. The most damaging interaction appears to be between property price deflations and private debt."

But there is much more than this to the paper. So some more colour on the above.

"Concerns about deflation [are] …shaped by the deep-seated view that deflation, regardless of context, is an economic pathology that stands in the way of any sustainable and strong expansion."

Do note that I have been challenging this thesis for some time now, precisely on the grounds of: 1) causality (deflation being caused by weak growth, not the other way around) and 2) link between corporate and household debt and deflation via monetary policy / interest rates channel.

Per authors, "The almost reflexive association of deflation with economic weakness is easily explained. It is rooted in the view that deflation signals an aggregate demand shortfall, which simultaneously pushes down prices, incomes and output. But deflation may also result from increased supply. Examples include improvements in productivity, greater competition in the goods market, or cheaper and more abundant inputs, such as labour or intermediate goods like oil. Supply-driven deflations depress prices while raising incomes and output."

Besides the supply side argument, there is more: "…even if deflation is seen as a cause, rather than a symptom, of economic conditions, its effects are not obvious. On the one hand, deflation can indeed reduce output. Rigid nominal wages may aggravate unemployment. Falling prices raise the real value of debt, undermining borrowers’ balance sheets, both public and private – a prominent concern at present given historically high debt levels. Consumers might delay spending, in anticipation of lower prices. And if interest rates hit the zero lower bound, monetary policy will struggle to encourage spending. On the other hand, deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive."

Note: the authors completely ignore the interest cost channel for debt.

Meanwhile, "…while the impact of goods and services price deflations is ambiguous a priori, that of asset price deflations is not. As is widely recognised, asset price deflations erode wealth and collateral values and so undercut demand and output. Yet the strength of that effect is an empirical matter. One problem in assessing the cost of goods and services price deflations is that they often coincide with asset price deflations. It is possible, therefore, to mistakenly attribute to the former the costs induced by the latter."

The BIS paper analysis is "based on a newly constructed data set that spans more than 140 years, from 1870 to 2013, and covers up to 38 economies. In particular, the data include information on both equity and property prices as well as on debt."

The study reaches three broad conclusions:

• "First, before accounting for the behaviour of asset prices, we find only a weak association between goods and services price deflations and growth; the Great Depression is the main exception."
• "Second, the link with asset price deflations is stronger and, once these are taken into account, it further weakens the association between goods and services price deflations and growth."
• "Finally, we find some evidence that high private debt levels have amplified the impact of property price deflations but we detect no similar link with goods and services price deflations." Note: this means that the ECB-targeted deflation (goods and services deflation) is a completely wrong target to aim for in the presence of private debt overhang. Just as I have been arguing for ages now.

Let's give some more focus to the paper findings on debt-deflation links: "Against the background of record high levels of both public and private debt (Graph 7 below), a key concern about the output costs of goods and services price deflation in the current debate is “debt deflation”, ie the interaction of deflation with debt."

"The idea is that, as prices fall, the real debt burden of borrowers increases, inducing spending cutbacks and possibly defaults. This harks back to Fisher (1933), who coined the term.16 Fisher’s concern was with businesses; today the focus is as strong, if not stronger, on households and the public sector. This type of debt deflation should be distinguished from the strains on balance sheets induced by asset price deflations. This interaction has an even longer intellectual tradition and has been prominent in the public debate ever since the re-emergence of financial instability in the 1980s."

Yep, you got it - the entire monetary policy today is based on the ideas tracing back to the 1930s and anchored in the experience that is only partially replicated today. In effect, we are fighting a new disease with false ancient prescriptions for an entirely different disease.

To assess the link between debt and deflation effects on growth, the authors take two measures into account:

• "One is simply its corresponding debt ratio to GDP." 
• "The other is a measure of “excess debt”, which should, in principle, be more relevant. We use the deviation of credit from its long-term trend, or the “credit gap” – a variable that in previous work has proved quite useful in signalling future financial distress."

Per authors, "The results point to little evidence in support of the debt deflation hypothesis, and suggest a more damaging interaction of debt with asset prices, especially property prices. Focusing on the cumulative growth performance over five year horizons for simplicity, there is no case where the interaction between the goods and services price peaks and debt is significantly negative. By contrast, we find signs that debt makes property price deflations more costly, at least when interacted with the credit gap measure."

So deflation in asset prices (property bust) is bad when household debt is high. Why?

Per study: "…these results suggest that high debt or a period of excessive debt growth has so far not increased in a visible way the costs of goods and services price deflations. Instead, it seems to have added to the strains that property price deflations in particular impose on balance sheets. …Why could the interaction of debt with asset prices matter and that with goods and services prices not matter, or at least less so? A possible explanation has to do with the size and nature of the corresponding wealth effects. For realistic scenarios, the size of the net wealth losses from asset price deflations can be much larger. Consider, for instance, the 2008 crisis in the United States,... the corresponding losses amounted to roughly $9.1 trillion and $11.3 trillion, respectively. By contrast, a hypothetical deflation of, say, 1% per year over three years would imply an increase in the real value of public and private debt of roughly $1.1 trillion (about $0.4 trillion for households and roughly $0.35 trillion each for the non-financial corporate and public sector). Moreover, the nature of the losses is quite different in the two cases. Asset price deflations represent declines in (at least perceived) aggregate net wealth; by contrast, declines in goods and services prices are mainly re-distributional. For instance, in the case of the public sector, the higher debt burden reflects the increase in the real purchasing power of debt holders."

And herein rests a major omission in the study: following asset (property) busts, accommodative monetary policy leads to a reduced cost of debt servicing for households that suffer simultaneous collapse in their nominal incomes and in their net wealth. This accommodation is deflating the cost of debt being carried. If it is accompanied by goods and services price deflation, such deflation is also boosting purchasing power of reduced nominal incomes. In simple terms, there is virtuous cycle emerging: debt servicing deflation reinforces real incomes support from goods and services deflation.

Now, reverse the two: raise rates and simultaneously hike consumer prices. what do you get?

1. Debt servicing costs rise, disposable income left for consumption and investment falls;
2. Inflation in goods and services reduces purchasing power of the already diminished income.

Any idea how this scenario (being pursued by the likes of the ECB) going to help the economy? I have none.

19/4/15: New Evidence: Ambiguity Aversion is the Exception

A fascinating behavioural economics study on ambiguity aversion by Kocher, Martin G. and Lahno, Amrei Marie and Trautmann, Stefan, titled "Ambiguity Aversion is the Exception" (March 31, 2015, CESifo Working Paper Series No. 5261: http://ssrn.com/abstract=2592313) provides empirical testing of ambiguity aversion hypothesis.

Note: my comments within quotes are in bracketed italics

When an agent makes a decision in the presence of uncertainty, "risky prospects with known probabilities are often distinguished from ambiguous prospects with unknown or uncertain probabilities… [in economics literature] it is typically assumed that people dislike ambiguity in addition to a potential dislike of risk, and that they adjust their behavior in favor of known-probability risks, even at significant costs."

In other words, there is a paradoxical pattern in behaviour commonly hypothesised: suppose an agent is facing a choice between a gamble with known probabilities (uncertain, but not ambiguous) that has low expected return and a gamble with unknown (ambiguous) probabilities that has high expected return. In basic terms, ambiguity aversion implies that an agent will tend to opt to select the first choice, even if this choice is sub-optimal, in standard risk aversion setting.

As authors note, "A large literature has studied the consequences of such ambiguity aversion for decision making in the presence of uncertainty. Building on decision theories that assume ambiguity aversion, this literature shows that ambiguity can account for empirically observed violations of expected utility based theories (“anomalies”)."

"These and many other theoretical contributions presume a universally negative attitude toward ambiguity. Such an assumption seems, at first sight, descriptively justified on the basis of a large experimental literature… However, …the predominance of ambiguity aversion in experimental findings might be due to a narrow focus on the domain of moderate likelihood gains… While fear of a bad unknown probability might prevail in this domain [of choices with low or marginal gains], people might be more optimistic in other domains [for example if faced with much greater payoffs or risks, or when choices between strategies are more complex], hoping for ambiguity to offer better odds than a known-risk alternative."

So the authors then set out to look at the evidence for ambiguity aversion "in different likelihood ranges and in the gain domain, the loss domain, and with mixed outcomes, i.e. where both gains and losses may be incurred. …Our between-subjects design with more than 500 experimental participants exposes participants to exactly one of the four domains, reducing any contrast effects that may affect the preferences in the laboratory context."

Core conclusion: "Ambiguity aversion is the exception, not the rule. We replicate the finding of ambiguity aversion for moderate likelihood gains in the classic ...design. However, once we move away from the gain domain or from the [binary] choice to more [complex set of choices], thus introducing lower likelihoods, we observe either ambiguity neutrality or even ambiguity seeking behavior. These results are robust to the elicitation procedure."

So is ambiguity hypothesis dead? Not really. "Our rejection of universal ambiguity aversion does not generally contradict ambiguity models, but it has important implications for the assumptions in applied models that use ambiguity attitudes to explain real-world phenomena. Theoretical analyses should not only consider the effects of ambiguity aversion, but also potential implications of ambiguity loving for economics and finance, particularly in contexts that involve rare events or perceived losses such as with insurance or investments. Policy implications should always be fine-tuned to the specific domain, because policy interventions based on wrong assumptions regarding the ambiguity attitudes of those targeted by the policy could be detrimental."

18/4/15: Escaping the Middle Income Trap: Historical Evidence and China's Chances

A very interesting paper from the Asian Development Bank Institute on the topic of the middle income trap (see below) and the debate as to whether China can escape one.

Full paper is available here: http://ssrn.com/abstract=2590289.

In basic terms, when the economy starts at lower income levels, this usually involves increasing productivity in agriculture - often a dominant sector in a lower income economy - which frees surplus labour and makes it available to industrial activities and services. As manufacturing and industrialisation rise, the economy moves into middle income category.

When surplus labour from agriculture moves into manufacturing, its productivity is low, so naturally, the emerging middle income economies are focused on low wage, low productivity and low value-added manufacturing. As income rises toward middle-income levels, wages also rise. In order to continue growing, the economy requires either to increase quantity of inputs (capital and labour) - a pattern of development known as extensive margin, or it needs to increase quality of its economy activity, raise the value added by workers and capital used - a pattern of development known as the intensive margin.

The problem is that for an economy with relatively fixed (in the short run) workforce, attempting to continue growing on the extensive margin is simply impossible. Instead, the economy needs to switch - at some point - toward producing better quality and higher value-added output.

As the authors remind us, this "requires a shift in the types of products that it makes (shirts to computers), in the value or sophistication of those goods (low quality shoes to designer shoes), and/or in the value-added contribution to end products (electronics assembly to chip manufacturing)… These shifts require increases in the sophistication of technology, an educated workforce, and changes in work organization and motivation."


The authors thus investigate "the situation of middle-income economies around the world. Since 1965, only 18 economies with a population of more than 3 million and not dependent on oil exports have made the transition to being high income. Many more have not been able to move beyond the middle-income stage." In simple terms, the authors confirm existence of a significant middle income trap.

By testing "differences between two groups of economies across a range of growth and development variables", the authors find that "middle-income economies are particularly weak in the following areas: governance, infrastructure, savings and investment, inequality, and quality — but not quantity — of education." In other words, to shift from extensive margin growth to intensive margin growth you need serious institutional, communications and social capital.

With this in mind, the authors then turn to China. "While the size of its economy is large, the PRC is still a developing country with a modest per capita income. Only in the late 1990s did it graduate from low- to middle-income status. As it continues to expand, increasing attention is now focused on whether it will become a high-income country like several of its neighbors in Northeast Asia or, instead, whether it will suffer the fate of Latin America and
Southeast Asia by remaining at the middle-income level of development for decades."

Interestingly, the authors find that China "…already has many of the characteristics of a high income country, the key exceptions being governance and possibly inequality." The best way to look at the paper results relating to China is presented in Table 23, where the authors "developed a ranking system based on the medians" for all the drivers that were found to be significant in helping countries escape the middle income trap. "For each
variable, the economy received three points for being above the median, two points for
being below the median but above the median of the median, and one point for being
below the median of the median. The results were summed and divided by the number
of variables for which there were data for each economy."

The result is below (partial table)

The core conclusion is that China does indeed appear to rank well in terms of key drivers necessary for escaping the middle income trap. Should it continue gaining in the near future in terms of all these factors at the same rate as it has been gaining in the past, China will join the club of the rich nations, not only because of the scale of its economy and population, but also because of the average or median per capita incomes.

18/4/15: Fitch Postpones Russian Ratings Review on Improved Data

As noted yesterday, both Fitch and S&P came out with (well, sort of came out in Fitch case) updated ratings for Russia. I covered S&P ratings here: http://trueeconomics.blogspot.ie/2015/04/17415-conservative-to-surprising-degree.html

Now onto Fitch.

According to the Russian Finance Minister, Anton Siluanov, Fitch postponed formal ratings review and held Russian ratings at BBB- - just a notch above junk grade. Fitch, thus, retains the only non-junk rating for Russia amongst the Big 3 agencies, with S&P at BB+ and Moody's at Ba1. According to Siluanov, the postponement reflects improved data outlook for the Russian economy.

Fitch was the first of the Big 3 to cut Russia’s rating back on January 9 (see http://www.reuters.com/article/2015/01/09/fitch-downgrades-russia-to-bbb-outlook-n-idUSFit89012120150109). Since then, Russian eurobond issue, maturing 2030 posted a 13 percent plus rise. In part, this reflects firming up of the ruble, and to a larger extent - the unprecedented levels of liquidity flowing into sovereign bonds markets worldwide. But in part, improved yields are also reflective of adjusting expectations concerning Russian economy. For example, alongside their February downgrade, Moody's estimated Russian capital outflows for 205-2016 at USD400 billion and Russian GDP was forecast to fall by 8.5%. Current consensus in the markets is that outflows will be closer to USD150-170 billion (on expected debt maturities) and the economy is likely to contract by closer to 4-4.5%.

Capital outflows figures stabilisation has been rather significant, especially given the level of debt redemptions in 1Q 2015 (see here: http://trueeconomics.blogspot.ie/2015/04/14415-russian-external-debt-redemptions.html). In 1Q 2015, estimated outflows totalled just USD32.6 billion, compared to USD77.4 billion in 4Q 2014 and with USD48 billion outflows in 1Q 2014. While banks continued to deleverage, non-financial sector was able to roll over much of maturing debt and were repatriating assets into Russia. The net result was inflow of forex into the Ruble market.

Deleveraging in the Russian economy is going at a breakneck pace: in mid-2014 Russian external debt (over 90% accounted for by private sector) stood at just over USD730 billion. By the end of 1Q 2015 estimated external debt has fallen to USD560 billion, implying net debt reductions of USD170 billion over the span of 9 months, well above my earlier estimate of net repayment of USD96.5 billion that excluded Ruble devaluation effects. The USD170 billion estimate includes devaluation of the Ruble and roll-overs when these involved conversion from forex-denominated inter-company loans and equity into Ruble-denominated ones. It is worth remembering that roughly 1/4 of Russian external debt is denominated in Rubles.

When it comes to sovereign ratings, it is also worth remembering that Russian public sector external liabilities amount to less than 10 percent of the total external debt.

Overall, Fitch decision to hold Russian ratings under review is a reflection of the recent improvements in the economic outlook, but also the fragile and early nature of these. As I noted on numerous occasions before, the situation is fragile and the risks to the downside are prominent, so Fitch's more cautious approach to ratings is probably better justified by the current environment.

17/4/15: Conservative to a Surprising Degree: S&P Russia Ratings

Two ratings agencies updated their ratings for Russia today. Here are some highlights:

S&P first (Fitch later, so stay tuned):

S&P kept Russia’s foreign-currency credit rating at BB+ or one step below investment grade with negative outlook. ""We are affirming our 'BB+/B' long- and short-term foreign currency ratings and our 'BBB-/A-3' long- and short-term local currency ratings on Russia".

The agency claimed that Russian policy makers are struggling to boost growth and the country financial system risks are increasing due to continued external funding drought caused by the sanctions. Per S&P statement, “Our base case assumes that the sanctions on Russia will remain in place over the forecast horizon, absent a resolution of the conflict in Ukraine.”

S&P first pushed Russian ratings below investment grade on January 26, based on the adverse impact of lower oil prices and ongoing sanctions.

The rating came in as expected, though negative outlook might be a touch gloomy for some observers. The reason is that since January, Ruble gained significant ground in value, while capital outflows projections for 2015 improved (in 2014 Russia experienced capital outflows of USD154 billion, and 2015 latest forecast is for outflows of USD90 billion). Ruble trade at 68.0 to USD back on the day of S&P previous decision, today it is around 52 mark. Growth outlook is stabilising, albeit remains highly challenging. Inflation is matching S&P previous expectations, but against lower CBR rates. Ukrainian conflict drags on, for sure, but there is at least a fragile pause in place and if in January new sanctions were looming, today there appears to be no momentum for their introduction. Finally, oil was at around USD48 pb then, at USD55 pb now. Russian authorities have said this week that they may return to foreign borrowing markets in 2016, while expectation in January was that the earliest date we might see Russian issuance in international markets is 2017.

On the higher risks side, March consumer demand appears to have worsened despite improved Ruble exchange rate as preliminary retail sales data shows a 8.7% drop y/y and consumer sentiment index down 14 percentage points on Q4 2014. Economy is expected to post a contraction of 2-4 percent in 1Q 2015. Preliminary data suggests investment declined 5.3% y/y and industrial production is down 0.6%. Inflation is running at 16.8% annualised rate, but that is, actually, a slowdown from over 18% earlier this year.

Still, at 2-4 percent, things in 1Q 2015 are not as bad, and certainly not worse, that full year consensus forecast of 4.1 percent this year. And capital outflows eased significantly in 1Q 2015 to USD32.6 billion from USD77.4 billion in 4Q 2014.

So it is a mixed bag, but crucially, the economy is performing close to previous expectations, with no significant downside surprise between January and today. Which means that it is rather unclear which part of expectations forward warrants 'negative' outlook, given there is already a 'negative' outlook reflected in the affirmed ratings?

S&P tries to explain: “The outlook remains negative, reflecting our view that we could downgrade Russia if external and fiscal buffers deteriorate over the next 12 months faster than we currently expect. We could also lower the ratings if Russia’s monetary policy flexibility were to diminish further.”

But contrasting this, is S&P own outlook published in recent weeks covering key sectors and economic activity. In April 13 note, S&P estimated that 5 largest Russian banking groups have lost USD4-5 billion in 2014 (ca 20-25% of their aggregate operating income) due to their exposure to Ukrainian assets. But forward outlook is not exactly any worse, as S&P said that 2015 losses from the same can be about the same. More significantly, S&P said that they "…estimate that Russian banking groups face aggregated Ukraine-related risks of less than 3% of their aggregated assets…. We nevertheless believe that Russian banks can withstand such costs, and that there will therefore be no rating impact for rated Russian financial groups."

And more. On April 7th, S&P itself upgraded outlook for the Russian economy: S&P own forecasts now expect 2016 growth of 1.9% (as opposed to 0.5% consensus forecasts) and a recession of 2.7% in 2015, as opposed to January 2015 forecast of 0.5% growth in 2015 and zero percent growth in 2016 and against the consensus forecasts cited above.

S&P is not the only research outfit upgrading Russian growth forecasts: JPMorgan revised recently its 2015 forecast from -5% to -4%. Russian official forecasts are also 'stabilising': Ministry of Economic Development forecasts +2.3% for 2016 and +2.5% over 2017 and 2018. CBR forecasts a drop of 3.5–4% in 2015 and growth of +1–1.6% in 2016, rising to 5.5–6.3% in 2017.

The bizarre nature of ratings agencies analysis - including inherent own-contradictions and lags - is one of the reasons why the CBR recently said they are considering gradually abandoning Big 3 agencies ratings for the country banking sector. The move would involve developing internal ratings system and, potentially, relying on other agencies in the mix.

Conclusion: altogether S&P latest ratings make some, but very limited sense and are conservative. So let them be. Russian bonds have been rallying recently and as long as oil stays firm-ish and Ruble does not experience another run, this rally will continue in the medium term. Any adverse repricing of bonds on foot of today's S&P action (and potential downgrade by Fitch) can actually create opportunities for distressed debt buyers, which will firm up prices again. Globally, there is too much money chasing too few bonds, so spike in yields in the short run can be seen by some speculators as an opportunity to pile into Russian paper. 

(Please, do not confuse this with an investment advice, as usual, for I do not do that sort of thing).

17/4/15: Pies in the skies & Irish exports: Jan-Feb 2015

Some interesting numbers on trade in goods for Ireland. As you know, I usually update these series on a quarterly basis - in part due to data volatility, in part due to lack of time. But there is something interesting afoot in the data, so here it is for the first two months of 2015 - subject to future verification of any trend.

Total imports of goods stood at EUR4.563 billion in February 2015, up 11.9% year-on-year, having risen 5.1% y/y in January. This means imports over the first two months of 2015 are up 8.3% y/y. February annual rate of growth in imports was the highest in 9 months.

Meanwhile, exports of goods and services shot to EUR7.937 billion in February, up 16.9% y/y, having posted an increase of 14.2% in January. Again, over the first two months of 2015, exports rose 15.5% y/y.

Trade balance at the end of February stood at EUR3.374 billion, up 24.3% y/y, after posting a 31.4% rise in January. Over January-February 2015, cumulated trade balance is up a whooping 27.7% y/y, and for the December-February 3 months period it is up 31.7% y/y.

These are bizarre and, frankly, unbelievable numbers. Last time we have seen this level of volatility in trade balance to the upside was in August 2012 (for one month only and then, nothing comparable to 41.1% y/y increase registered in December, 31.4% rise in January and 24.3% rise in February).

So something is brewing in the external trade stats. Last year, we had a runaway performance in the National Accounts-registered external trade numbers without having a corresponding rise in the customs reported figures, which was down to 'contract manufacturing' scheme (or whatever you want to call this accounting trick). This time around, either the said scheme is now also polluting our customs trade data or something new is afoot.

The 'new' bit appears to be the 'old' bit - look at the sources of growth in our trade:

and in our trade balance:

In simple terms, ex-Chemicals (pharma), our exports since the start of 2009. Pharma / Chemicals exports are up. Our trade balance in goods, ex-Chemicals is negative. That is right - negative (some 'exporting nation' we are) and pharma trade surplus is vast and on the rise again.

Let's take a slightly more detailed decomposition of movements in trade volumes, cumulated over the last 3 months (December 2014 - February 2015). What do we have?

• Imports of all goods ex-chemical sectors rose 6 percent year on year, or EUR561mln. Exports of same rose 8 percent or EUR683.6 million. So trade deficit here shrunk by EUR122 million y/y - a good result, but accounting for only 5 percent of the entire gain in trade surplus over the same period across the economy.
• Imports of chemicals and related products (pharma in broad sense) were up EUR423.4mln or 16% y/y, but exports of same rose EUR2.592 billion or 22% y/y. Trade balance here rose by EUR2.169 billion.
• So 95% of the trade balance gains in December- February 2015 was down to the category known as Chemicals and related products, n.e.s. (5) and only 5% of the gains were down to the rest of the entire goods-related economy.

And guess what: the 'old' news is truly 'old': the ratio of exports to imports in the economy excluding chemicals sector is falling - steadily, since at least 1995. Meanwhile, the ratio of exports to imports in the chemicals sector, having fallen on foot of patent cliff in 2009-2013 is now rising once again since Q1 2014. Purely as a coincidence, Q1 2014 is when the bogus exports from the 'contract manufacturing' schemes started showing up in the official national accounts data.

Incidentally, the above also explains the miracle of Irish productivity - the massive 'improvements' of which in recent years is nothing more than a pharma (and few other MNCs-dominated sectors, some not included in the goods data and polluting our services data instead) rebalancing into new tax optimisation schemes, post-patent ones.

Welcome to the land where sand castles are sold to visitors as 'de real ting' and pies in the skies are served for desert...

16/4/15: Newsweek on Russian Economic Recovery

An interesting piece on not-so-tanking Russian economy: http://www.newsweek.com/2015/04/24/putin-was-right-be-confident-about-russias-economy-321934.html

The key point is the same I have been repeating throughout my earlier notes: imports substitution.

The only problem is that absent investment, imports substitution is reversible. To make it sustainable, Russia needs reforms and investment. And the two are in short supply, still.

15/4/15: Official Sector Exposures to Greece

As Greek crisis enters a new turn of the spiral, here are full official sector exposures to Greece by country:

Source: @FGoria 

16/4/15: QE and Negative Rates: It's So Good, It Hurts...

Here is an unedited version of my article for Manning Financial on the upcoming pain in the global markets from the Central Banks activism.


With spring sunshine, the glowing warmth of the overheating bonds markets is bringing about the scent of optimism to the macro-analysts' desks. On March 19th, the NTMA issued EUR500 million worth of 6mo notes with a yield of -0.01%. With a few strokes of the 'buy' keys, the markets welcomed Ireland to the ever-expanding club of nations that enjoy the privilege of being paid to borrow from private investors.

In a way, this is the story of Ireland's recovery distilled to a singular event: with the Government borrowing costs at their historical lows, the memory of the recent crises is fading fast from the pages of our newspapers. Alas, the drivers of this recovery are illusory. All are temporary, none are structural or sustainable, in the long run. In fact, the current markets reprieve is concealing the real dangers for domestic investors – dangers of new asset bubbles and potential future losses.

Take a look at the euro area sovereigns at large.

After years of austerity, 2015 is shaping up to be a year of broadly-speaking neutral public spending. In other words, as the euro area Governments' debt remains sky high, public deficits are unlikely to shrink by any appreciable amount. Why bother with reforms, when you can be paid by the markets to borrow? Aptly, as the chart below shows, European economic policy uncertainty remains at crisis period averages, well above the safety range of pre-crisis years.


European Policy Uncertainty Index  (including period averages confidence intervals)

Source: data from PolicyUncertainty.com


Although the Government is usually quick to claim credit for the massive improvements in Irish yields, in reality, Dublin has little to do with these. At every point from Q3 2011 through today, large scale declines in the Government cost of borrowing came courtesy of the ECB. The latest gains are no exception: the ECB has just launched a sizeable bonds-buying programme and with it, the quantum of negative yield debt in the global markets has gone from roughly USD3.6 trillion in January to USD4.2 trillion by mid-March. As of now, 19 percent of the Global Bond Index-listed debt is trading in negative rates territory.

This, by far, represents the largest long term challenge for investors and the greatest risk to the global economies. Expansionary monetary policy pursued by the central banks around the world, including the ECB aims to push up economic growth and reduce the risks of deflation. It also attempts to repair the monetary policy transmission mechanism: that cheap ECB-supplied liquidity is being lent by the banks to companies and households in the forms of new credit.


TANGIBLE RISKS

However, from the investors’ perspective, this monetary activism can end up backfiring. For a number of reasons.

Firstly, as shown in Chart 2 below, monetary policy-driven credit expansion is propelling stock markets and debt markets valuations to all-time highs across the advanced economies with absolutely no tangible connection to real fundamentals, such as growth in economic activity, household incomes, employment, and even capital investment. By the very definition of the financial bubbles, current monetary policies activism is inflating returns expectations unanchored in reality.

Secondly, monetary expansion means that households and firms struggling with debt are given a short-run reprieve from facing the true costs of their borrowings. But the day of reckoning awaits in the future. This means that households and corporates are likely to continue engaging in precautionary savings even as the Central Banks drop rates and bonds markets bid the cost of issuing debt down. Meanwhile, households and companies with low debt exposures are likely to save more to offset declines in their returns on deposits. Taken together, these factors are likely to further suppress domestic demand, while setting us up for a major crisis once the cost of debt starts rising in the future.

Thirdly, negative yields are, like all bubble-generating factors, self-reinforcing in their nature. With central banks increasingly charging commercial banks for deposits, banks prefer buying bonds even in the presence of the negative yields. This means that negative policy rates are reinforcing the dysfunctional monetary mechanism, locking in more liquidity into government bonds and driving yields on government paper further down. The resulting increases in bonds prices incentivise commercial banks to gamble on future capital gains by buying even more bonds. This spiral of demand for government debt depresses banks future profitability as investors bid bonds prices up and loads more risk of significant future losses that will materialise once QE policies begin to unwind.

Another pesky side effect of this is the banking sector stability. Negative interest rates on Central Bank deposits lead to lower deposit rates for banks' customers. Banking sector loans-to-deposits ratios rise, making banks more dependent on the shadow banking system for funding and more levered. Interestingly, in the U.S. at least one large bank, J.P. Morgan has already announced that it will be charging customers for large deposits up to 5.5 percent annual fee.

Fourthly, negative rates and yields are increasing the probability of monetary policy misfires - a scenario where one or several Central Banks around the world can tighten policy too fast and/or too early, completely derailing economic recovery. This problem is global and contagious. Investment grade government bonds are effectively substitutes for each other in majority of investment portfolios. As the result, negative yields in the euro area today are keeping yields low in other advanced economies. This is already causing discomfort in the U.S. where dollar rise relative to other currencies is being driven by a combination of two factors: the expected mismatch between U.S. and euro area policy rates, and investors' fear of Fed policy errors over the next 3-6 months.

Fifthly, the demand for negative yield bonds appears to be setting the unsuspecting investors for a fall. In a recent research note, the investment bank Jefferies discovered that much of the demand for such paper comes from indexed funds. Investors in these extremely popular funds simply have no idea that the strategy the funds pursue is not designed for the world where top-rated bonds are paying negative yields. And as funds start posting losses, the same investors are likely to rush for safety into other asset classes – namely equity. Yet, with equities already at historical highs, the safety-minded investors will be left with buying even more assets at bubble valuations.

Sixthly, negative yields on Government bonds are a disaster waiting to happen for insurance, asset management and pension sector as they create huge risks at the heart of these companies long-term investment portfolios. As insurance companies and pensions funds chase the yield, premia will have to rise, risks embedded in pensions portfolios will jump and returns on longer term contracts will fall. As the result, some financial analysts are warning of not only economic, but also political consequences of the monetary policy activism.

The bankers' regulatory body, the Bank for International Settlements is not amused. In a recent statement, Claudio Borio, the head of the BIS monetary and economic department said it is simply impossible to tell how investors, consumers, voters and the governments are going to react to the negative yields and interest rates. "…technical, economic, legal and even political boundaries may well be tested. The consequences should be watched closely, as the repercussions are bound to be significant, on the financial system and beyond," Mr Borio said.


IRISH INVESTOR PERSPECTIVE

From Irish investors point of view, the risks arising from the euro area negative rates and yields environment are significant.

In a study published in 2005 (http://www.bis.org/publ/work186.pdf), BIS researchers found asset price busts, especially those associated with large property markets adjustments, to have much more painful economic impacts than deflation. The study covered all advanced economies over the period from 1873 through 2004 and included analysis of deflation effects on Government debt and growth. The same results were on firmed by another BIS study published earlier this year (http://www.bloomberg.com/news/articles/2015-03-18/the-central-bank-of-central-banks-says-keep-calm-about-deflation).


Global Markets, Irish Problems

Source: Author own calculations based on data from CSO, Central Bank of Ireland and Bloomberg

As of today (see Chart 2), Ireland is still experiencing property prices that are 38 percent below the pre-crisis peak (in Dublin 39 percent), private debt that is, once controlled for sales of mortgages, and Nama and bank loans to non-banking investors, stuck around mid-2005 levels, and growth predominantly driven by the multinational corporations' tax optimisation strategies. In this environment, negative rates are masking the extent of the problems still present in the economy, while euro devaluation, coupled with exports growth concentration in the MNCs-led sectors, are creating a false impression of improved productivity and competitiveness.

For domestic investors, this means that both equity, corporate and government debt markets  in Ireland and across the euro area are simply out of touch with macroeconomic reality on the ground. The global Central Banks-led policies are pushing our traditional investment and pensions portfolios into the high risks, low returns corner, commonly associated with financial assets bubbles. While some speculative exposure to the US and Emerging Markets assets is always welcome, the bulk of investment allocation today should be focused on conservative view of key risks presented by the negative rates and yields environment. Tax planning, portfolio cost minimisation, low gearing and high liquidity of investment allocations should take priority over pursuit of short term yields and capital gains.

15/4/15: Global Information Technology Report 2015: Who's the Best? Not We...

We have Silicon Docks and all the ICT IP stuffed into 'knowledge development boxes' and shipped via this country across the world that one can dream about, we have European HQs of dozens of ICT firms that are here solely for the reason of Ireland having the best workforce and skills in the world, and we have policymakers that cut ribbons on 'future jobs' reports on a monthly basis, promising tens of thousands of ICT sector employees 'in your neighbourhood near you' in the next 5-10-15-20... years… or sometime after the tenure of the Government of the day.

And we rank 25th in the world in the Global Information Technology Report 2015, right between the Digital/ICT Powerhouses of Belgium and France. Yes, that is right - we rank the lowest of all English-speaking advanced economies in the world: big, small, oil and natural resources rich and poor, small and large.

Don't believe me? Well, here: http://reports.weforum.org/global-information-technology-report-2015/network-readiness-index/.


In regulatory frameworks sub-index - the so-called "Environment Sub-index", Ireland ranks 12th. Which is, basically a bunch of political tosh. We rank 14th in "political and regulatory environment pillar (nine variables) [which] assesses the extent to which the national legal framework facilitates ICT penetration and a safe development of business activities, taking into account general features of the regulatory environment (including the protection afforded to property rights, the independence of the judiciary and the efficiency of the law making process) as well as more ICT-specific dimension (the passing of laws relating ICT or the software piracy rates)." Doh!

In laws relating to ICT we rank 23rd. Where it matters more… things are slipping and sliding and slipping again.

In IP protection, we do better - 14th place. Because someone needs to guard the prevailing interest of MNCs more than creating legal system to support general ICT sector.

We do better in Business and Innovation Environment - scoring 13th place, just ahead of Chile and Israel. But when it comes to availability of latest technologies - the cutting edge 'innovation' stuff - we are 22nd. Below Puerto Rico and New Zealand…

Capital of VCs is Dublin. And we have all the cash disbursed by state innovation funds and enterprise funds and entrepreneurship funds… but… we rank 46th in the world in Venture Capital Availability.

Tax rankings? Well, we do well-ish - ranked 26th. You see, many newcomers to the zero sum game of beggar thy neighbour tax competition are ahead of is, but majority of them are developing countries. Majority, but not all.

We rank 27th in the world in terms of time it takes to start a new business and 23rd in terms of number of procedures it takes to start a new business. That is pretty dire for a country aiming to be an entrepreneurship powerhouse. But then again, the report is not even looking at self-employment and sole traders. My guess, in that early stage entrepreneurship area we would be closer to 50th place.

Want a real wallop? Take Government procurement of advanced technologies - a proxy for how advanced is the public sector in ICT adoption and deployment… we rank dis-respectable 62nd. So our mandarins and ministers presiding over the digital strategies and ICT development and policies are working in an environment that is worse than many African countries when it comes to procuring advanced technologies for their own use. Never mind, abacus is fine for computing economic impacts and jobs potential for all those white papers on Innovation Ireland.

Per report, "The readiness subindex measures the degree of preparation of a society to make good use of an affordable ICT infrastructure and digital content, with a total of twelve variables." In readiness we are… 29th in the World (Ukraine is ranked 28th and Poland 30th). Like the 'neighbourhood'?

"The infrastructure and digital content pillar captures the development of ICT infrastructure" which ranks Ireland 26th in the world, below Slovenia and ahead of UAE. How? Well, our mobile networks coverage puts us into 66th place, between Georgia and Tunisia. Our electricity production environment is ranked 35th, our international internet bandwidth is ranked 20th, and in secure internet servers we rank 21st.

Here's a good one: "The affordability pillar assesses the cost of accessing ICT, either via mobile telephony or fixed broadband internet, as well as the level of competition in the internet and telephony sectors that determine this cost." Why is it good? Because we spent many years talking about cost competitiveness. And here Ireland ranks 87th in the world. Mobile tariffs here are so expensive, we rank 125th in this area in terms of affordability. Fixed broadband tariffs? Better - at 59th in the world. Level of competition index for Internet services, international long distance services, and mobile telephone services puts us at the top tier, ranked 1st with a long list of other 61 countries with the same ranking.

Now, wait a second: in a regulated sector with high degree of competition, prices are still dear. How can that be? Why, of course, only if the regulator is fixing them in excess of what the market would set them. Happy times all around, unless you are a consumer. Oh, and do note - our politicians endlessly talk about the need for 'labour cost competitiveness', but where we really lack competitiveness, it turns out is in the old fashioned regulated services that politicians and public sector regulate and/or legislate.

Finally - skills. The report measures these quite esoterically. "The skills pillar (four variables) gauges the ability of a society to make an effective use of ICT thanks to the existence of basic educational skills captured by the quality of the educational system, the level of adult literacy and the rate of secondary education enrolment."

So this is about basic skills, not specific ones. And here we rank well: 8th in the world overall, 5th in how well does the educational system in your country meet the needs of a competitive economy, but only 24th in the quality of math and science education in schools. This, by the way is the stuff of secondary education, not real level of ICT skills present in the economy (those require tertiary as an entry level and fourth and higher levels education for serious engagement). But, when it comes to high school enrolments (secondary education) we are tops of pops, ranked 6th.


So with all these 'skills' achievements, you would expect that we are heavy users of ICT and new technologies - skilled, savvy, early adopters... but, when it comes to actual usage of ICT in real life, Ireland ranks 28th in the world.

Stop and pause, again: for all the achievements of our Docks and Valleys, Centres of Excellence and Start Ups programmes, Innovation Academies and FDI, incubators and accelerators, hubs and labs, summits and venues relating to tech… Ireland's actual usage of real ICT is just a notch worse than Belgium's (ranked 27th) and a notch better than Saudi Arabia's (29th).


You really don't need to go any further than that to either throw the report into a bin or bring the Government policy papers on ICT sector strategies into your local recycling centre. Because either one spoofs or the other. The two are simply not compatible.

Unless, of course, you remember that we are the land of FDI… where everything is possible: technologically weak domestic economy, government and society can coexist with technologically advanced foreign/exporting economy and society; technologically un-enabled ministers and officials can write eloquent papers about technologically enabled economy… Ah, there, all good now... we are the best... there...


Update: h/t to @prfnv for the following link: http://www.shanghairanking.com/SubjectCS2014.html which lists top 200 universities in Computer Sciences... of which none are from Ireland.

15/4/15: In Case You've Missed it: Google Reply to EU Commission

Google reply to the EU Commission charges: http://googleblog.blogspot.be/2015/04/the-search-for-harm.html. From people who created one of the most successful platforms for innovation (predominantly - innovation by others), a response to the accusations levelled by the people who never succeeded in creating anything innovative.

Still wondering why Europe is celebrating the prospect of reaching 1.2-1.4 percent growth this year as an achievement?...