29/1/16: Events… and oil

Bloomberg recently posted a chart summing up some (although claimed all) of the key events in recent history of oil prices. A neat reminder of what has been happening in terms of oil-related factors for crude demand and supply:

29/1/16: Estonia - A Safer Bet than France?

Euromoney have a good summary article on Baltic states’ economies and sovereign risk ratings (all of which are improving).

My comment toward the end.

http://www.euromoney.com/Article/3524950/Estonia-offers-safer-ption-than-France-or-South-Korea.html

Here is my take on Baltics ratings in full:

Given macroeconomic and geopolitical environment, Estonia's credit rating by all three rating agencies clearly lags overall trends in risks evolution. The geopolitical and external macroeconomic risks these ratings reflect are consistent with early 2015 assessments and are well behind the more recent trends. In simple terms, Estonia is over-due a one notch upgrade across all agencies, as reflective of expected re-acceleration in growth from 1.9 percent estimated in 2015 to 2.6 percent forecast for 2016-2017, and improving labour markets performance and inflation outlook.

Another key driver for the upgrade is significant abatement in geopolitical risks faced by Estonia in the context of the Russian-Ukrainian conflict that has evolved into a localised and frozen conflict with no expected spillover to the broader region.

Estonia also enjoys significant improvements in its terms of trade, via Euro devaluation, which is reflected in its relatively strong current account dynamics.

As far as Latvia and Lithuania ratings go, both countries' present ratings are in line with generally weaker economic, political and social institutions and with long term structural problems at play in both economies. While geopolitical risks have abated for these two countries since the start of 2015, supportive monetary and euro devaluation-driven competitiveness tailwinds are yet to manifest themselves in terms of current account balances and gains in real  productivity.

Unlike Estonia, both Latvia and Lithuania run current account deficits in presence of significantly higher unemployment and continued outflows of human capital. Of the two countries, Latvia is probably closer to a rating upgrade, which can come later in the first half of 2016.

29/1/16: Nama and Value Destruction

There is a neat video circulating around that sums up Mick Wallace's questions about Nama, worth watching: https://vimeo.com/143933468?ref=tw-share.

For those who want to see a more extensive listing of Nama firesales or, as I put them, Value Destruction deals, read here:  http://trueeconomics.blogspot.com/2015/11/251115-nama-that-gift-horses-mouth.html and follow the link in my post to more.

Beyond this, on top of Wallace's questions, there is an outstanding issue of Nama involvement in continued legacy of Anglo interest overcharging http://trueeconomics.blogspot.com/2015/06/17615-mr-john-flynn-letter-to-tds-on.html (and see links at the bottom of that post).

28/1/16: Irish M&As: Not Too Irish & Mostly Inversions

Experian latest figures for *Irish* M&A activities for 2015 show some astronomical number: Per release: “The number of deals on the Irish mergers and acquisitions (M&A) market increased by 10 per cent last year, its strongest performance since 2008…” Which is not what is impressive. Although the overall number of actual transactions hit 458 in 2015, up from 416 the previous year, it is the value of transactions that is beyond any belief.

Again, per Experian: “The total value of transactions reached €312 billion – up from €154 billion in 2014 and by some way the most valuable year for corporate deal making in the country’s history. Activity continues to be driven by the pharmaceuticals and biotech sector.” This number is a third higher than the value of exports of good and services from Ireland over the period of 12 months through 3Q 2015 and it is almost 60 percent higher than Irish GDP. In other words, using normal valuations multiples, you should be able to buy anywhere between 1/4 and 2/5 of entire Ireland on this money. In one go, and forever… And that’s one year worth.

Per Experian: “Irish deals accounted for around 3.6% of the total volume of European transactions in 2015, but 20.5% of their total value. In 2014, the Republic of Ireland again featured in 3.6% of European deals but contributed just 12.7% to their overall value.”

So conservatively, let’s say 1/3 of Ireland bought last year and, say 1/5 in 2014… that’s half the country economy in two years.

But how on Earth can a little country like Ireland attract such a level of financial activity? Why, remember that magic word… ‘inversions’ - yes, that same word that out Government denies applies to Ireland.

Well, Experian provides a small insight (they wouldn’t tell us the full story, but they can’t quite escape from telling us some. Enjoy the following: per Experian, Top 5 “Irish” deals announced in 2015 includedd:

• Pfizer-Allergan at EUR143.564 billion
• Teva Pharma - Generic drug business of Allergan at EUR35.454 billion
• Shire - Baxalta at EUR29.533 billion
• Willis Group Holdings - Towers Watson deal at EUR15.566 billion, and
• CRH - Holcim & Lafarge deal at EUR7.671 billion

So, yep: tax inversion at the top, related to tax inversion at No.2, tax inversion at No.3… and none (repeat - none, including CRH deal) related in any way to Ireland, except for tax domicile of the companies involved.

Repeat with me… “There are no tax inversions into Ireland”… now, with zombie like intonation, please… “There are no…”

27/1/16: Russian Capital Outflows 2015: Abating, but Still High

In two recent posts, I covered Russian External Debt dynamics and drawdowns on Russian Sovereign Wealth Funds. Last, but not least, I am yet to cover capital inflows/outflows for 2015. So, as promised, here is a post covering these.

Based on data that includes preliminary reporting for 4Q 2015, full year 2015 net capital outflows from Russia amounted to USD56.9 billion, composed of USD33.4 billion outflows in the Banking Sector and USD23.5 billion outflows in ‘Other Sectors’. In the banking sector there were simultaneous disposals of some USD28.2 billion of assets and reduction of USD61.6 in liabilities (repayment of maturing debts and deposits).

Thus, 2015 marked the second lowest year in the last 5 in terms of net capital outflows. In comparison, 2014 net capital outflows stood at a whooping USD153 billion and 2013 saw outflows of USD61.6 billion. Net banks’ position improved from outflows of USD86.0 billion in 2014 to outflows of USD33.4 billion in 2015. Other Sectors outflows also improved in 2015. In 2015, this category of outflows amounted to USD23.5 billion, against USD67 billion in 2014. 2015 marked the slowest outflows year in this sector in 8 years.

Chart to illustrate dynamics:

On a quarterly basis, net capital outflows from Russia in 4Q 2015 are estimated at USD9.2 billion, down from USD76.2 billion in 4Q 2014. Capital outflows were lower in every quarter of 2015 compared to corresponding quarter of 2014 and in 3Q 2015 there was a net capital inflow of USD3.4 billion - the first net inflow in any quarter since 2Q 2010.

So on balance, Russian capital outflows remain strong, but are abating rapidly. Most of the outflows is accounted for by the deleveraging of the Banks followed by shallower deleveraging of the ‘Other Sectors’.

26/1/16: Chances of Repairing Greece?..

When someone says that Europe (or anyone else) "has missed a chance to" stabilise or repair or make sustainable or return to growth Greece, whilst referencing any time horizon spanning the last 8 years - be it today or 6 months ago, or at any recent iteration of the Greek crisis, I have two charts to counter their claims:

You can't really be serious when talking about stabilising Greece. Greece has not been stable or sustainable or functioning by its Government deficit metrics ever since 1980, and by Current Account balance in any year over the same time horizon, save for the last 3 years.

Yes, there probably are means and ways to significantly improve sustainability of the Greek economy. But such means and ways would have to be radical enough to undo three and a half decades of systemic mismanagement.

26/1/16: 'More than 1,000 jobs per week' Government Claims v Reality

One senior TD and a Junior Minister with position relating, indirectly, to employment and the labour market has just posted an interesting statement. A part of the statement goes thus: “we used the Action Plans for Jobs process to drive job creation, creating more than a 1000 jobs a week”.

Now, let’s raise two points. One philosophical, another purely arithmetic.

Philosophically, I am not aware of any Government that claims creation of jobs. Technically, public jobs are either created by the Civil Service or another Public body, as opposed to the Government itself. Practically, any jobs creation, in public or private sector is enabled by the economy (people working in, investing in, paying taxes in and interacting with public and private sectors) and not by the Government. Thus, Government may facilitate jobs creation by enacting supportive legislation or providing legislative and/or regulatory strategy, or not impede one, but it cannot create jobs. Minister can act as PR middle(wo)men and announce jobs created, but that is about as close to jobs creation as they ever get.

Aside from this, there is a simple matter of arithmetic.

Recall that the current Government came into power at the end of 1Q 2011. Let us suppose the Government really got down to ‘creating jobs’ by 1Q 2012. Which means the Government has been at its jobs game for roughly 14-15 quarters through 3Q 2015 or, at the lower end 3 years and a half. That means that the Government should have created “over” 182,000 jobs in that period. This benign to the Minister claim, because if we are to look at the record of the entire duration of the Government, his claim would have equated to roughly 221,000 jobs created.

Let us note that 1Q 20912 was the lowest point in employment levels during the crisis, so comparatives to that base should improve Government position: prior to 2Q 2012 jobs were being destroyed in the economy, past the end of 1Q 2012 they were being added.

Keep the two numbers in your mind: we are told that the Government has ‘created’ either more than 182,000 or more than 221,000 jobs over its tenure, depending on where one starts to count.

Now, consult CSO QNHS database - the source of official counts for numbers in employment. Between the end of 1Q 2012 and 3Q 2015 (the latest for which we have data), total employment rose 158,000. But wait, these are not all jobs. 4,500 of that increase is in the category of Assisting Relative. And 121,200 of these additions are employees, including schemes. Beyond this, the above increase also includes 30,100 new (added) self-employed with no employees.

It is hard to assume that the Government can claim it 'created' self-employment jobs where there is not enough activity to hire staff, or that it increased the need to help relatives.

So put things together in a handy table:

Numbers speak for themselves. By the very best metric, Government is more than 1/2 year shy of the lowest end of the claim of 'more than 1,000 jobs created per week'. It is more than 1/2 year shy of the claim that there were '1,000 jobs created per week'.

This Government deserves credit for helping sustain conditions for the recovery. Some of these conditions trace to the policies put in place by its predecessor and continued by the present Government, some are down to Troika and implemented by this Government, some are undoubtedly facilitated by the efforts of the current Government. The economy is recovering and, by some metrics, very robustly. And jobs are being created by the economy (yes, by entrepreneurs, enterprises, their employees and their clients and investors, but not by the Government).

This is not to take away from the positives the Government should rightly claim. But it is to point out that some of the outlandishly bombastic claims are not quite warranted.

26/1/16: Russian External Debt: Deleveraging Goes On

In previous post, I covered the drawdowns on Russian SWFs over 2015. As promised, here is the capital outflows / debt redemptions part of the equation.

The latest data for changes in the composition of External Debt of the Russian Federation that we have dates back to the end of 2Q 2015. We also have projections of maturities of debt forward, allowing us to estimate - based on schedule - debt redemptions through 4Q 2015. Chart below illustrates the trend.

As shown in the chart above, based on estimated schedule of repayments, by the end of 2015, Russia total external debt has declined by some USD177.1 billion or 24 percent. Some of this was converted into equity and domestic debt, and some (3Q-4Q maturities) would have been rolled over. Still, that is a sizeable chunk of external debt gone - a very rapid rate of economy’s deleveraging.

Compositionally, a bulk of this came from the ‘Other Sectors’, but in percentage terms, the largest decline has been in the General Government category, where the decline y/y was 36 percent.

Looking at forward schedule of maturities, the following chart highlights the overall trend decline in debt redemptions coming forward in 2016 and into 2Q 2017.

Again, the largest burden of debt redemptions falls onto ‘Other Sectors’ - excluding Government, Central Bank and Banks.

The total quantum of debt due to mature in 2016 is USD76.58 billion, of which Government debt maturing amounts to just 1.7 billion, banks debts maturing account for USD19.27 billion and the balance is due to mature for ‘Other Sectors’.

These are aggregates, so they include debt owed to parent entities, debt owed to direct investors, debt convertible into equity, debt written by banks affiliated with corporates, etc. In other words, a large chunk of this debt is not really under any pressure of repayment. General estimates put such debt at around 20-25 percent of the total debt due in the Banking and Other sectors. If we take a partial adjustment for this, netting out ‘Other Sectors’ external debt held by Investment enterprises and in form of Trade Credit and Financial Leases, etc, then total debt maturing in 2016 per schedule falls to, roughly, USD 59.5 billion - well shy of the aggregate total officially reported as USD 76.58 billion.


So in a summary: Russian deleveraging continued strongly in 2015 and will be ongoing still in 2016. 2016 levels of debt redemptions across all sectors of the economy are shallower than in 2015. Although this rate of deleveraging does present significant challenges to the economy from the point of view of funds available for investment and to support operations, overall deleveraging process is, in effect, itself an investment into future capacity of companies and banks to raise funding. The main impediment to the re-starting of this process, however, is the geopolitical environment of sanctions against Russian banks that de facto closed access to external funding for the vast majority of sanctioned and non-sanctioned enterprises and banks.


Next, I will be covering Russian capital outflows, so stay tuned of that.

25/1/16: Russian Sovereign Funds: Down, but Not Out, Yet…

In the context of 2016 Budget, Russian sovereign reserves dynamics are clearly an important consideration. For example, in his recent statement, former Russian Finance Minister, Kudrin, has suggested that if Budget deficit reaches above 5% of GDP in 2016, the entire cushion of liquid foreign reserves held by the Government will be exhausted by the end of the year, leaving Russia exposed to big cuts in the budget for 2017. This is similar to the positions of Russia's Economy Minister Alexei Ulyukayev and the current Finance Minister Anton Siluanov.

The expectations are based on three considerations:
1) 2015 dynamics of Russian sovereign wealth funds;
2) Funds outflows expected under the external debt repayment schedules; and
3) A potentially massive call on Russian reserves from the VEB capital requirements.

I covered the last point earlier here. So let’s take a look at the first point.

Russia’s main and more liquid Reserve Fund shrank substantially last year as it carried out its explicit mandate to provide support for fiscal balance. Set up in 2008, the fund holds only liquid foreign assets and 2015 became the first year since the Great Recession and the Global Financial Crisis (2009-2010 in Russia’s case) when it experienced net withdrawals. The value of the fund fell from roughly USD90 billion to ca USD50 billion by the end of December 2015.

However, the key to these holdings is their Ruble equivalent, as Russian budgetary expenditures are in domestic currency. By this metric, the Fund has been doing somewhat better. By end of December 2015, the Reserve Fund held assets valued at RUB3.6 trillion, amounting to almost 5 percent of Russian GDP or roughly 1.7 times Budget 2016 requirement for deficit coverage. Budget 2016 is based on expectation that the Reserve Fund will supply some RUB2.1 trillion to cover the deficit.

The sticking point is that Budget 2016 - in its current reincarnation - is based on oil price of USD50pb. The Ministry of Finance is currently preparing amended Budget based on USD30-35pb price of Brent, but we are yet to see the resulting deficits projections. What we do know is that the Government has requested up to 10 percent cuts across public expenditure for 2016. Absent such cuts, and if oil prices remain around USD30pb mark, the deficit is likely to balloon to the levels where 2016 deficit will end up fully depleting the Reserve Fund.

Added safety cushion, of course, will be provided by devaluation of the Ruble. This worked pretty well in 2015, but the problem going into 2016 is that required further devaluations will likely bring Ruble into USDRUB 90+ range, inducing severe redistribution of losses onto the shoulders of consumers and cutting hard into companies investment in new equipment and technologies.

Bofit provided a handy chart showing the dynamics of Fund resources and a breakdown of these dynamics by key factors

Aside from the Reserve Fund, Russia also has the National Welfare Fund which was set up to underwrite public pensions. The Fund has been used to provide capital and funding to Russian banks shut out of the international borrowing in form of bonds purchases and deposits with the banks, as well as to some Russian companies, in form of debt purchases. These deposits and loans, however, are not liquid and, therefore, not available for fiscal supports. About only hope for some liquidity extraction from these allocations is via Russian corporates using cash flows from exports to repay the Fund - something that is unlikely to create significant buffers for the Budget.

At the end of 2015, the National Welfare Fund held assets valued at USD72 billion, of which USD48 billion (or RUB3.5 trillion) was held in relatively liquid foreign-currency assets and the balance held in assets written against domestic systemically important banks and companies. Even assuming - optimistically - that 10 percent of the residual assets can be cashed in over 2016, the liquidity available from the Fund runs to around USD50 billion.

Thus, total liquidity cushion held by two Russian SWFs currently amounts to USD100 billion without adjusting for liquidity risks and costs, and if we are to take nominal adjustments for these two factors, liquidity cushion probably falls to USD75-80 billion total.

It is worth noting, however, that Russia has other international reserves at its disposal. Per official data, as of the ned of December 2015, total International Reserves stood at USD368.4 billion, down USD17.06 billion on December 2014 and down USD222.17 billion on all time peak. In accessible reserves, Russia has International funds (excluding SDRs and IMF reserves) of USD363.07 billion.

I will be covering funds outflows schedule for 2016 in a separate post, so stay tuned.

25/1/16: Nordic Model: Not Too Heavy Handed on Corporate Profits

Much of the tax debate nowadays has been around tax base erosion and corporate taxes. But the old issue of what to tax: capital or profits is still unresolved. One interesting myth, associated with this debate, is that Nordic countries run a more ‘balanced’ tax system that relies on corporate profit taxes and avoids the problem of so-called harmful tax competition commonly attributed to Anglo-Saxon models where, again allegedly, corporations are treated softly with low tax rates and more benign tax regimes.

Well, a myth is a myth. And a recent paper, titled “Taxing Mobile Capital and Profits: The Nordic Welfare States” by Guttorm Schjelderup (CESIFO WORKING PAPER NO. 5603 NOVEMBER 2015) goes in depth to dispel it.

Per author: “The Nordic countries have traditionally been characterized by an extensive welfare state, a homogenous population and labour force, and redistributive taxation. This has changed in recent years.”

First point of interest is WHY has it changed. Author attributes the change to

• Increased immigration, 
• Ageing population, and 
• “Competition for capital among countries”

These factors “…have put pressures on public finances and the welfare state. These changes can be attributed to the globalization process whereby national economies become more integrated. Economic integration takes place in terms of increasing factor mobility, in particular mobility of capital, and rising volumes of trade in goods and services.”

Now, we have our first lesson: if you run a globally-integrated economy, while you have a modern (aka post-baby boom society) you will see these three factors at play in your economy too. No one’s immune.

“An argument frequently used by political lobby groups is that with free capital mobility corporations shouldn't be taxed at all and that taxing investment income is actually bad for workers. The argument is that if you cut taxes on investment income, more investment is encouraged. More investment means people have more equipment and technology to work with, which should increase the productivity of labour and thus wages and economic growth. Put differently, a tax on mobile capital would lead to an outflow of capital that would cause wages to fall; effectively shifting the full burden of the tax on capital onto workers. It is then better to tax workers directly and levy a zero tax on capital.”

Ok, we’ve heard this before. But is it making any sense?

Per author: “The argument above relies on strong assumptions, among them that labour is immobile and cannot evade taxation, that there are no country specific rents, and that domestic firms are not owned in part by foreigners.” However,

• “If domestic firms, say, are partly owned by foreigners, taxing capital would imply that some of the tax burden is shifted onto foreigners and that part of the welfare state is then financed by foreigners. This alone may warrant a positive tax on investment capital.”
• “If industrial agglomeration is concentrated in one single country, a government may, through a positive source tax on capital, be able to exploit the locational rent created by agglomeration forces and thus increase welfare.”

More importantly, “the zero tax on capital result is also difficult to confirm empirically. Yagan (2014), for example, …finds that it caused zero change in corporate investment in U.S. unlisted firms and that it had no impact on employee compensation. It did, however, have an immediate impact on financial pay-outs to shareholders. Alstadsæter et al. (2015)… find that the Swedish 2006 dividend tax cut did not affect aggregate investment but that it affected the allocation of corporate investment. In particular, …relative to cash-rich firms, cash-constrained firms increased their investments after the dividend tax cut.”

Key, however, is that corporate tax acts as “…a “backstop” to the personal income tax. If a country abolished the corporate tax rate, wealthy individuals in particular would be given an incentive to reclassify their labour earnings as corporate income, typically using offshore corporate structures and escape tax. The corporate tax might also be needed to avoid excessive income shifting between labour income and capital income. Finally, the corporate tax also acts as a withholding tax on equity income earned by non-resident shareholders, who might otherwise escape taxation in the source country.”

Now onto evidence regarding evolution of tax regimes. 

“Countries throughout the world have reduced their corporate taxes in an effort to attract or retain corporate investments. The Nordic countries have pioneered what is commonly known as the dual income tax (DIT). It combines a flat tax rate on capital income with progressive taxation of labour income. One of the arguments in favor of the DIT is that it allows policy makers to lower the corporate tax rate to reduce the risk of capital flight, whilst at the same time tax distributed dividends to personal shareholders.”

But there are “challenges of taxing capital for small open economies. Although the corporate tax share of GDP in most countries is only around 3-4%, it is an important tax because it acts as a “backstop” for the personal tax rate. …The pressures of tax competition are exacerbated by tax planning and income shifting to low tax countries by multinationals. Studies show that multinationals pay less tax than domestic firms and this may give them a competitive edge over domestic firms. The long term effects may be changes in ownership structure that affect competition in markets and make the corporate tax base more tax sensitive. Profit shifting is undertaken through transfer pricing and thin capitalization (excessive debt).” Care to spot Irish trends here? Why, they are pretty obvious.

But back to the Nordics vs Anglo-Saxons arguments. Per paper, “It is interesting to note that the Nordic countries seem to have gone further in terms of abolishing redistributive capital taxes than countries traditionally associated with polices much less tuned to redistribution. Aaberge and Atkinson (2010) shown how income inequality at the top of the distribution has increased in Anglo-Saxon countries, whereas the same rise in top income shares was not experienced by Continental European countries. They find that the Norwegian and Swedish experience over the twentieth century is similar to the Anglo-Saxon countries in that top shares, and the concentration among top incomes have first fallen and then risen. Norway differs from Sweden in that that the top shares rose more sharply in the period 1990-2006. Between 1980 and 2004, for example, the share of the top 1 per cent more than doubled in Norway, but rose less than half in Sweden.”

What are the reasons for these trends?

“Several explanations have been put forward to explain why Norway sets itself apart. The implementation of the 1992 tax reform abolished the dividend tax and lead to a sharp increase in dividends and capital gains among the richest in Norway. Capital taxation in Sweden was less favourable. Substantial oil production in Norway started some 15 years before the rise in inequality, but could still be an explanatory factor due to constrained cash in this sector in the initial phase of production. Capital market reforms with liberalization of interest rates and an upturn in business cycles are also important factors that are hard to disentangle, but they certainly played a role.”

Social impact of tax-linked inequality? “Capital taxation also affects income mobility, and concerns about rising inequality have often been countered by constant changes in the composition of top income earners. If so, the rise in top incomes may not translate into “economic power”. Aaberge et al. (2013) study who enters and leaves the top income groups in Norway in the period 1967-2011. Their main conclusion is that despite large changes in top income mobility over the last four decades, the magnitude of the effect of the changes in mobility on the income shares was moderate.”

What’s the future holds? “Competition among countries to attract mobile capital is a persistent phenomenon and will be a driver towards still lower taxes on mobile capital. A major change from the past, then, is less ability to redistribute, increasing income inequality, and rising immigration from poor countries. In sum these forces may affect trust between members of society. The level of trust is positively linked to economic growth. Herein lies a major challenge for the Nordic welfare states.”

And as an aside, here’s the actual draw on Nordic v Anglo-Saxon patterns in taxation: “In 2004, the classical welfare states in Scandinavia and continental Europe had lower ratios of statutory corporate to wage taxes than the Anglo-Saxon countries (except Ireland). In 2004, the corporate tax rate was only 63% of the wage tax rate for an average worker in Sweden, but 171% of the wage tax rate in the United States. Such differences are in striking contrast to the common perception that social democratic governments (as in Scandinavia and continental Europe) share a higher preference for redistribution, as compared to more conservative and free market oriented types of governments.”

Oops… who’s the neoliberal b*&ch now?..

24/1/16: House Prices, Local Demand and Homeownership Status

House prices bust was a major dimension of the recent Great Recession around the world. Nonetheless, contrary to all evidence, many political leaders have opted to dismiss the adverse impacts of shocks like negative equity (due to price declines and pre-crisis debt ramp ups) and wealth effects on aggregate demand (first order price effects).

An interesting study based on the U.S. data tests the aggregate impacts of house prices changes on consumption, while controlling for homeownership status (renters v owners).

Titled “House Prices, Local Demand, and Retail Prices” and co-authored by Johannes Stroebel and Joseph Vavra (CESIFO WORKING PAPER NO. 5607, NOVEMBER 2015) the study used “detailed micro data to document a causal response of local retail price to changes in house prices, with elasticities of 15%-20% across housing booms and busts. Notably, these price responses are largest in zip codes with many homeowners, and non-existent in zip codes with mostly renters.”

In other words, not only impacts of house price changes are significant, they are also bifurcated across two types of home occupiers - owners and renters, with renters exhibiting effectively no sensitivity to home prices changes in terms of their demand.

The authors “provide evidence that these retail price responses are driven by changes in markups rather than by changes in local costs. … Markups rise with house prices, particularly in high homeownership locations, because greater housing wealth reduces homeowners’ demand elasticity, and firms raise markups in response. Consistent with this explanation, shopping data confirms that house price changes have opposite effects on the price sensitivity of homeowners and renters.”

Overall, “taken together, our empirical results provide evidence of an important link between changes in household wealth, shopping behavior and firm price-setting. Positive shocks to wealth cause households to become less price-sensitive and firms respond by raising markups and prices.”

So do house prices matter for aggregate demand? They do. Does homeownership smooth or amplify effects of shocks to house prices on the aggregate economy? It appears to amplify them. Should monetary and fiscal policies be asymmetric for areas with high homeownership concentration as opposed to areas with high renters concentration? Yep. Ditto for countries, instead of areas.

Of course, in the Euro area, how does one structure differential monetary policies across countries so diverse as renters-concentrated Germany vs homeowners concentrated Holland or Ireland? Err… can we check that one as yet another problem with Euro architecture?..

24/1/16: European Financial Networks: Prepare for Bloodletting to Commence

A recent paper, titled "Transmission Channels of Systemic Risk and Contagion in the European Financial Network" co-authored by Nikos Paltalidis, Dimitrios Gounopoulos, Renatas Kizys, Yiannis Koutelidakis (Journal of Banking and Finance, gated) tackles a very interesting problem relating to the systemic stability of the European banking system and the bi-directional contagion channels shifting/transmitting systemic shocks between the banks and the sovereigns.

Following the euro area banking crisis of 2008-2012 (with residual effects of this crisis still strongly present in the so-called euro area 'periphery'), financial systems analysts and modellers came to the realisation that a number of key questions relating to overall system stability remain un-answered to-date. These include:

• What determines the intensity with which exogenous shocks propagate in the financial system as a whole (and how this intensity carries across banking systems)?
• How do we "identify, measure and understand the nature and the source of systemic risk in order to improve the underlying risks that banks face, to avert banks’ liquidation ex ante and to promote macro-prudential policy tools"? 
• How do systemic risks arise in the cases where such risks are endogenous to the banking system itself?
• How resilient is the euro area banking system (under improved regulatory and supervisory regimes) to systemic risk?
• How "…shocks in economic and financial channels propagate in the banking sector"? 
• And related to the above: "In the presence of a distress situation how the financial system performs? Have the new capital rules rendered the European banking industry safer? What is the primary source of systemic risk? How financial contagion propagates within the Eurozone?"

As the authors correctly note, "These fundamental themes remain unanswered, and hence obtaining the answers is critical and at the heart of most of the recent research on systemic risk."

Lacking empirical evidence (due to proximate timing of events and their extreme-tail nature) the authors create “a unique interconnected, dynamic and continuous-time model of financial networks with complete market structure (i.e. interbank loan market) and two additional independent channels of systemic risk (i.e. sovereign credit risk and asset price risk).”

Summary of the findings relating to sources of shocks:

1. “…A shock in the interbank loan market causes the higher amount of losses in the banking network”;
2. “…Losses generated by the sovereign credit risk channel transmit faster through the contagion channel, triggering a cascade of bank failures. This shock can cause banks to stop using the interbank market to trade with each other and can also lead banks to liquidate their asset holdings in order to meet their short-term funding demands.”
3. “Moreover, we evaluate the impact of reduced collateral values and provide novel evidence that asset price contagion can also trigger severe direct losses and defaults in the banking system.”

So the model does support the view that “the Sovereign Credit Risk channel dominates systemic risks amplified in the euro area banking systems and hence, it is the primary source of systemic risk.” Which is quite interesting from a number of perspectives:

• Firstly, we tend to think about the Global Financial Crisis as a mother of all systemic crises and we tend to attribute the degree of disruption in the crisis to the origins of the crisis shocks: the financialisation of the ‘bubbles’ in real assets (e.g. real estate), leading to liquidity crunch and then to solvency crunch. We think of the sovereign shock channel as being in play only because of banks-sovereign link. And we think that the second order contagion from the sovereign to the banks is secondary in magnitude to the GFC. It appears that things are much more complex and inter-connected both in terms of direction of contagion and orders of disruption caused.
• Secondly, we tend to ignore the relationship between the banks bailouts, QE programmes and equity markets. We think of them as related, but separate acts, e.g.: banks bailouts require funds which are supplied via sovereigns which need to obtain financial resources, which they do via QE, which simultaneously lowers the cost of investment and increases valuations of equities. But the problem is that we also have direct QE —> Equity valuations —> Banks balance sheet pathways. Just as asset prices collapse or illiquidity can trigger a liquidity run by the banks and defaults and losses within the banking system, so are asset prices increases can lead to improved liquidity conditions for the banks and improved banks balance sheets.
• Thirdly, the study provides “…novel evidence that systemic risk in the euro area banking system didn’t meaningfully decrease as it is evident that shocks in the three independent channels -interbank market, sovereign credit risk, asset price risk- trigger domino effects in the banking system.” Which sort of tells us what we suspected all along: the entire ‘firewalls have been built’ brigade of European politicos is eating hopium by truckloads. There are no ‘firewalls’. There are bits of wet cardboard stuck into the cracks and a perennial hope they stay well moisturised by occasional rains. 

Now, let’s give it a thought: since the end of the crisis, we’ve been told that solution to the problem of preventing future crises and alleviating the costs of those that still might happen is more coordination, harmonisation and integration of banking systems under the watchful eye of ECB. In other words, more internationalisation of domestic banks - more linking between them and banks operating in other economies within the Euro area. What does evidence have to say on that? “…we find that the cross-border transmission of systemic shocks depends on the size and the degree of exposure of the banking sector in a foreign financial system. Particularly, the more exposed domestic banks are to the foreign banking systems, the greater are the systemic risks and the spillover effects from foreign financial shocks to the domestic banking sector.”

Ya wouldn’t! No, ya couldn’t! But… baby… we had firewalls and we had EBU and more interconnected system of Euro area-wide banking supervision… and we now have?.. err… Yep, in the words of the authors: “Finally, the results imply that the European banking industry amid the post-crisis deleverage, recapitalisation and the new regulatory rules, continues to be markedly vulnerable and conducive to systemic risks and financial contagion.”