13/10/17: Debt Glut and Building Dublin

Just back from Ireland, a fast, work-filled trip, with some amazing meetings and discussions, largely unrelated to what is in the 'official' newsflow. Some blogposts and articles ahead to be shared.

One thing that jumps out is the continued frenzy in building activity in Dublin, predominantly (exclusively) in the commercial space (offices). Not much finished. Lots being built. For now, Irish builders (mostly strange new players backed by vultures and private equity) are still in the stage where buildings shells are being erected. The cheap stage of construction. Very few are entering the fit-out stages - the costly, skills-intensive works stage. And according to several sector specialists I spoke to, not many fit-out crews are in the market, as skilled builders have not been returning to the island, yet, from their exiles to the U.S., Canada, Australia, UAE, and further afield.

Which should make for a very interesting period ahead: with so many construction sites nearing the fit-out stages, building costs will sky rocket, just as supply glut of new offices will start hitting the letting markets. In the mean time, many multinationals - aka the only clients worth signing - have already signed leases and/or bought own buildings on the cheap. Google owns its own real estate (hello BEPS tax reforms that stress tangible activity over imaginary revenue shifting); Twitter has a refurbished home; Facebook is quite committed to a lease (although it too might take a jump into buying); and so on. Tax inversion have slowed down and Trump Administration just re-committed to Obama-era restrictions on these, while Trump tax plan aims to take a massive chunk out of this pie away from Ireland. So demand... demand is nowhere to be seen.

Will this spell a twin squeeze on office blocks currently hanging around in a pre-weather tight conditions?

The market timing for a lot of this real estate investment is looking shaky. Globally and across Europe, corporates are doing relatively well. But, despite this, there is no investment cycle on the horizon. And revenues growth rates have been sustained by a massive glut of legacy credit sloshing in the international monetary system. Courtesy of Daniel Lacalle @dlacalle_IA, here is a Deutsche Bank chart illustrating what the past monetary excesses have produced:

Three lessons are to be extracted from the above:

1. Lags in corporate investment activity imply that the current level of demand for hard assets worldwide is driven by the 2016 ultra low borrowing rates; 
2. Forward corporate investment activity is starting to show the pressure of rising rates and reduced (or even negative) assets purchases by the Central Bankers, with negative rates share of the total debt market shrinking from over USD12 trillion at the end of 2016 to USD8 trillion now; and
3. The glut of debt continues to rise through 2017, albeit at a slightly slower rate than in 2016.

These points suggest that, barring a new miracle of monetary variety, forward debt financed investment and growth is bound to slow. And the cost of debt carry is bound to rise. Which should be bad news for the European and U.S. debt-funded real estate activity. 

And it will be an even tougher pill to swallow for the crop of new (Nama-linked) Irish developers who were quick in raising hundreds of millions in funding in form of cheap (ultra cheap) debt and frothy equity. Many of these lads have nearly zero experience in building, some are backed by 'experts' from Nama's top cohorts of 'specialists' - the cohorts that were dominated by the pre-bust advisers, not developers. 

The bust is still unlikely at this stage, as majority of current sites that are in mid-stage development have a low acquisition cost, thanks to the fire sales by Nama, and still enjoy a couple of years of cheap debt carry costs. 

But inflation in construction costs will sap whatever wind the housing building sub-sector might have had in it (which is not much, as housing construction is still sitting well behind offices activity). Planning permissions for new housing are languishing sub 1,500 per quarter, comparable to 2010 levels. Planning permissions for ex-residential are at late 2007- early 2008 levels, aka stronger.

In other words, the upcoming cost squeeze is likely to do two things to the Irish market:

• Cost inflation at fit-outs will probably dent future development activity, instead of creating a large-scale bust; and
• Commercial development sector will continue pressuring house building, driving up rents and residential property prices.

9/10/17: Nature of our reaction to tail events: ‘odds’ framing

Here is an interesting article from Quartz on the Pentagon efforts to fund satellite surveillance of North Korea’s missiles capabilities via Silicon Valley tech companies: https://qz.com/1042673/the-us-is-funding-silicon-valleys-space-industry-to-spot-north-korean-missiles-before-they-fly/. However, the most interesting (from my perspective) bit of the article relates neither to North Korea nor to Pentagon, and not even to the Silicon Valley role in the U.S. efforts to stop nuclear proliferation. Instead, it relates to this passage from the article:

The key here is an example of the link between the our human (behavioral) propensity to take action and the dynamic nature of the tail risks or, put more precisely, deeper uncertainty (as I put in my paper on the de-democratization trend https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2993535, the deeper uncertainty as contrasted by the Knightian uncertainty).

Deeper uncertainty involves a dynamic view of the uncertain environment in which potential tail events evolve before becoming a quantifiable and forecastable risks. This environment is different from the classical Knightian uncertainty in so far as evolution of these events is not predictable and can be set against perceptions or expectations that these events can be prevented, while at the same time providing no historical or empirical basis for assessment of actual underlying probabilities of such events.

In this setting, as opposed to Knightian set up with partially predictable and forecastable uncertainty, behavioral biases (e.g. confirmation bias, overconfidence, herding, framing, base rate neglect, etc) apply. These biases alter our perception of evolutionary dynamics of uncertain events and thus create a referencing point of ‘odds’ of an event taking place. The ‘odds’ view evolves over time as new information arrives, but the ‘odds’ do not become probabilistically defined until very late in the game.

Deeper uncertainty, therefore, is not forecastable and our empirical observations of its evolution are ex ante biased to downplay one, or two, or all dimensions of its dynamics:
- Impact - the potential magnitude of uncertainty when it materializes into risk;
- Proximity - the distance between now and the potential materialization of risk;
- Speed - the speed with which both impact and proximity evolve; and
- Similarity - the extent to which our behavioral biases distort our assessment of the dynamics.

Knightian uncertainty is a simple, one-shot, non-dynamic tail risk. As such, it is similar both in terms of perceived degree of uncertainty (‘odds’) and the actual underlying uncertainty.

Now, materially, the outrun of these dimensions of deeper uncertainty is that in a centralized decision-making setting, e.g. in Pentagon or in a broader setting of the Government agencies, we only take action ex post transition from uncertainty into risk. The bureaucracy’s reliance on ‘expert opinions’ to assess the uncertain environment only acts to reinforce some of the biases listed above. Experts generally do not deal with uncertainty, but are, instead, conditioned to deal with risks. There is zero weight given by experts to uncertainty, until such a moment when the uncertain events become visible on the horizon, or when ‘the odds of an event change’, just as the story told by Andrew Hunter in the Quartz article linked above says. Or in other words, once risk assessment of uncertainty becomes feasible.

The problem with this is that by that time, reacting to the risk can be infeasible or even irrelevant, because the speed and proximity of the shock has been growing along with its impact during the deeper uncertainty stage. And, more fundamentally, because the nature of underlying uncertainty has changed as well.

Take North Korea: current state of uncertainty in North Korea’s evolving path toward fully-developed nuclear and thermonuclear capabilities is about the extent to which North Korea is going to be willing to use its nukes. Yet, the risk assessment framework - including across a range of expert viewpoints - is about the evolution of the nuclear capabilities themselves. The train of uncertainty has left the station. But the ticket holders to policy formation are still standing on the platform, debating how North Korea can be stopped from expanding nuclear arsenal. Yes, the risks of a fully-armed North Korea are now fully visible. They are no longer in the realm of uncertainty as the ‘odds’ of nuclear arsenal have become fully exposed. But dealing with these risks is no longer material to the future, which is shaped by a new level of visible ‘odds’ concerning how far North Korea will be willing to go with its arsenal use in geopolitical positioning. Worse, beyond this, there is a deeper uncertainty that is not yet in the domain of visible ‘odds’ - the uncertainty as to the future of the Korean Peninsula and the broader region that involves much more significant players: China and Russia vs Japan and the U.S.

The lesson here is that a centralized system of analysis and decision-making, e.g. the Deep State, to which we have devolved the power to create ‘true’ models of geopolitical realities is failing. Not because it is populated with non-experts or is under-resourced, but because it is Knightian in nature - dominated by experts and centralized. A decentralized system of risk management is more likely to provide a broader coverage of deeper uncertainty not because its can ‘see deeper’, but because competing for targets or objectives, it can ‘see wider’, or cover more risk and uncertainty sources before the ‘odds’ become significant enough to allow for actual risk modelling.

Take the story told by Andrew Hunter, which relates to the Pentagon procurement of the Joint Light Tactical Vehicle (JLTV) as a replacement for a faulty Humvee, exposed as inadequate by the events in Iraq and Afghanistan. The monopoly contracting nature of Pentagon procurement meant that until Pentagon was publicly shown as being incapable of providing sufficient protection of the U.S. troops, no one in the market was monitoring the uncertainties surrounding the Humvee performance and adequacy in the light of rapidly evolving threats. If Pentagon’s procurement was more distributed, less centralized, alternative vehicles could have been designed and produced - and also shown to be superior to Humvee - under other supply contracts, much earlier, and in fact before the experts-procured Humvees cost thousands of American lives.

There is a basic, fundamental failure in our centralized public decision making bodies - the failure that combines inability to think beyond the confines of quantifiable risks and inability to actively embrace the world of VUCA, the world that requires active engagement of contrarians in not only risk assessment, but in decision making. That this failure is being exposed in the case of North Korea, geopolitics and Pentagon procurement is only the tip of the iceberg. The real bulk of challenges relating to this modus operandi of our decision-making bodies rests in much more prevalent and better distributed threats, e.g. cybersecurity and terrorism.

9/10/17: BRIC Composite PMI 3Q: Failing Global Growth Momentum

Two posts above cover Manufacturing PMIs and Services PMIs for 3Q 2017 for BRIC economies. The following updates Composite PMIs performance.

Global Composite PMI came in at 53.7 in 3Q 2017, matching exactly 1Q and 2Q 2017 readings and basically in line with 53.6 reading in 4Q 2016. In other words, Global Composite activity PMI index has been showing relatively robust growth across the two key sectors for the last 4 quarters running. 

In contrast to Global indicator, BRIC economies posted relatively underwhelming performance with exception of Russia.

• Brazil Composite PMI index stood at 50.0 (zero growth) in 3Q 2017, which is a marginal gain on 49.8 in 2Q 2017. This marks the first time since 1Q 2014 that Brazil Composite indicator reached above the outright contraction levels, but it is a disappointing reading nonetheless. For one, one quarter does not signal stabilisation in Latin America’s largest economy. Worse, Brazil’s economy has been performing poorly since as far back as 2H 2011. It will take Brazil’s Composite index to hit above 52 mark for 2-3 consecutive quarters to start showing pre-2011 levels of activity again.
• Russia Composite PMI, on the other hand, remains the bright spark in the BRIC’s dark growth universe. Although falling to 4 quarters low of 54.1 in 3Q 2017, the index remains in strong growth territory. 3Q 2017 marked 6th consecutive quarter of robust post-recession recovery, consistent with 2.5-3 percent growth in GDP, quite ahead of the consensus forecasts from the start of 2017. The last quarter also marks the sixth consecutive quarter of Russian Composite PMIs running above Global Composite PMIs. This means that for the last 18 months, Russia has been the only positive contributor to Global growth from amongst the ranks of the BRIC economies.
• China Composite PMI firmed up in 3Q 2017, rising to 51.9 from 51.3 in 2Q 2017. 3Q 2017 reading was, however, the second weakest in the last four quarters and suggests relative weakness in the growth environment. 
• India composite PMI fell below 50.0 mark in 3Q 2017, reaching 48.7 - a level signifying statistically significant contraction in the economy for the first time since 4Q 2013. The robust recovery in 2Q 2017 put India Composite PMI at 52.2, but this now appears to be a blip on the radar which shows anaemic growth in 4Q 2016 and 1Q 2017.

As chart above clearly shows, the growth dynamics as indicated by the Composite PMIs have been weak in the BRIC economies over the last 4 consecutive quarters. This is highly disappointing, considering that 4Q 2016 held a promise of more robust expansion. Russian growth conditions have now outperformed Global growth dynamics in every quarter since 2Q 2016, although the latest reading for PMIs suggests that this momentum has weekend in 3Q 2017. In fact, Russian data is quite surprising overall, showing growth conditions largely in line with pre-2009 levels since 4Q 2016. This is yet to be matched by the GDP figures, suggesting that something might be amiss in the PMI data. 

Finally, the chart above shows sectoral dynamics for BRIC group of economies in terms of PMI indices. Both Services and Manufacturing PMIs for BRIC grouping are now running close to or below statistical significance levels for positive growth. More importantly, on-trend, current performance remains within the bounds of growth consistent with H2 2013-present trend: shallow, close to statistically insignificant expansion, that is distinct from robust growth in pre-2008-2009 period and the short period of post 2009 recovery.

Thus, PMI data still indicates that BRIC economies currently no longer act as the key drivers of global growth.

9/10/17: BRIC Services PMI 3Q 2017: Another Quarter of Weaker Growth

Having covered 3Q 2017 figures for BRIC Manufacturing PMIs in the previous post, let’s update the same for Services sector.

BRIC Services PMI has fallen sharply in 3Q 2017 to 50.8 from 52.1 in 2Q 2017. This is the lowest reading since 2Q 2016 (when it also posted 50.8). The drivers of this poor dynamic are:

• Brazil Services PMI remained below 50.0 mark for the 12th consecutive quarter, rising marginally to 49.5 in 3Q 2017 from 49.0 in 2Q 2017. Current reading matches 1Q 2015 for the highest levels since 1Q 2014. Statistically, Brazil Services PMI has been at zero or lower growth since 1Q 2014.
• Russia Services PMI fell to 54.0 in 3Q 2017 from 56.0 in 2Q 2017 and 56.8 in 1Q 2017, indicating some cooling off in otherwise rapid expansion dynamics. The recovery in Russian Services sectors is now 6 quarters long and overall very robust.
• China Services PMI decline marginally from 52.0 in 2Q 2017 to 51.6 in 3Q 2017. This is consistent with trend established from the local peak performance in 4Q 2016. Overall, Chinese Services are showing signs of persistent weakness, with growth indicator falling below statistically significant reading once again in 3Q 2017.
• India Services sector has been a major disappointment amongst the BRIC economies, with Services PMI falling from 51.8 in 2Q 2017 to a recessionary 48.0 in 3Q 2017. The Services PMIs for the country have been rather volatile in recent quarters, as the economy has lost any sense of trend since around 4Q 2016.

Table below and the chart illustrate the changes in Services PMIs in 3Q 2017 relative to 2Q 2017 and the trends:

With Global Services PMI remaining virtually unchanged (at 53.9) in 3Q 2017 compared to 2Q 2017 (51.8), with marginal gains on 1Q 2017 (53.6) and 4Q 2016 (53.5), the BRIC Services sectors are showing no signs of leading global growth to the upside since 3Q 2016. For the sixth consecutive quarter, Russia leads BRIC Services PMIs, while Brazil and India compete for being the slowest growth economies in the services sectors within the group.

As with Manufacturing, BRIC Services sectors show no signs of returning to their pre-2009 position of being the engines for global growth.

Stay tuned for Composite PMIs analysis for BRIC economies.

9/10/17: BRIC Manufacturing PMIs 3Q 2017: Lagging Global Growth

With Markit Economics finally releasing China data for Services and Composite PMIs, it is time to update 3Q figures for Manufacturing and Services sectors PMI indicators for BRIC economies.

Summary table:

As shown above, Manufacturing PMIs across the BRIC economies trended lower over 3Q 2017 in Brazil and India, when compared to 2Q 2017, while trending higher in Russia and China.

• Brazil posted second lowest performance for the sector in the BRIC group, barely managing to stay above the nominal 50.0 mark that defines the boundary between growth and contraction in the sector activity. Statistically, 50.6 reading posted in 3Q 2017 was not statistically different from 50.0 zero growth. And it represents a weakening in the sector recovery compared to 50.9 reading in 2Q 2017. Brazil's Manufacturing sector has now been statistically at zero or negative growth for 18 quarters in a row.
• Meanwhile, Russian Manufacturing PMI rose from 51.2 in 2Q 2017 to 52.1 in 3Q 2017, marking fifth consecutive quarter of expansion in the sector (nominally) and fourth consecutive quarter of above 50.0 (statistically). With this, Russia is now back at the top of Manufacturing sector growth league amongst the BRIC economies. However, 3Q 2017 reading was weaker than 4Q 2016 and 1Q 2017, suggesting that the post-recession recovery is not gaining speed.
• China Manufacturing PMI rose in 3Q 2017 to 51.2 from zero growth of 50.1 in 2Q 2017. The dynamics are weaker than in Russia, but similar in pattern, with 3Q growth being anaemic. In general, since moving above 50.0 mark in 3Q 2016, China Manufacturing PMIs never once rose above 51.3 marker, indicating very weak growth conditions in the sector.
• India's Manufacturing PMI tanked again in 3Q 2017 falling to 50.1 (statistically - zero growth) from 51.7 in 2Q 2017. Most recent peak in Manufacturing activity in India was back in 3Q 2016 and 4Q 2016 at 52.2 and 52.1 and these highs have not been regained since then. India's economy continues to suffer from extremely poor macroeconomic policies adopted by the country in recent years, including botched tax reforms and horrendous experimentation with 'cashless society' ideas. 

Overall, BRIC Manufacturing Index (computed using my methodology on the basis of Markit data) has risen to 51.0 in 3Q 2017 on foot of improved performance in Russia and China, up from 50.6 in 2Q 2017 and virtually matching 51.1 reading in 1Q 2017. At 51.0, the index barely exceed statistical significance bound of 50.9. This runs against the Global Manufacturing PMI of 52.9 in 3Q 2017, 52.6 in 2Q 2017 and 52.9 in 1Q 2017. In simple terms, the last quarter was yet another (18th consecutive) of BRIC Manufacturing PMI falling below Global Manufacturing PMI, highlighting a simple fact that world's largest emerging and middle-income economies are no longer serving as an engine for global growth.

Stay tuned for Services PMIs analysis.

6/10/17: Life-Cycle Wages and Trends: September US Wage Inflation in Perspective

Last month, I wrote an editorial for @MarketWatch on the declining fortunes of the American wage earners. And this week, the BLS released new data on wage growth in the U.S. economy. The new numbers are 'shiny'.

Per headlines reported in the media, the BLS reported that the annual increase in Average Weekly Earnings was an impressive 2.9%, which is:

• Well above the 2.5% rate of growth expected in prior estimates, 
• Well above the 2.5% reported last month, and
• The highest since the financial crisis

This is a great print. Except, it really is not all that exciting, when one reaches below the surface.

Take the following summary of recent growth rates (H/T @BySamRo): 

September 2017 wage increases are still below 2008-2009 averages for all wage earners, except for low-wage industries. The gains 'break out' drivers are in high-wage industries, where growth has risen 20% compared to much of the 2016-present trend. Overall, growth rate is well below 2008-2009 average of 3.4%.

To see how much more poor the current 'spectacular' print is compared to the past trends, look at longer time series:

Low-wage industries wages inflation is running close to pre-crisis average, since roughly the start of 2017. Good news. High and meddle-wage industries wages inflation is running below the pre-crisis average still. We have had roughly 8 years in the current trends, meaning that a large cohort of current workers have entered the workforce with little past gains in wages under their belt. This means a very brutal and simple arithmetic: many workers in today's economy have never experienced the gains of pre-crisis magnitudes. Wage increases are cumulative or compound in nature. Wage increases slowdown is also cumulative or compound in nature. Hence, workers who entered the workforce from around 2004 onwards have had shallower cumulative gains in wages than workers that preceded them. Guess what else do the former workers have that differentiates them from the latter? Why, yes: 1) higher student debt; 2) higher rent costs; 3) greater risk- and age-adjusted health insurance costs, and so on. In other words, for the later cohorts of workers currently in the workforce, lower wages increases came at a time of rampant increases in non-discretionary spending costs hikes.

To say that today's BLS wage inflation print is great news is to ignore these simple facts of economics: to restore wages to pre-crisis trends - the trends that would allow for the return of the Millennial generation to pre-crisis expectations (or to the cross-generational income and wealth growth patterns of previous decades), we need wages growth rates at 5-percent-plus not in one or two or three months, but in years ahead.  The 2.9% one month blip in data is not the great news. It might be a good news piece, but it is hardly impressive or convincing.

And that figure of 5%-plus hides yet another iceberg, big enough to sink the Titanic: given that the Millennials are carrying huge debts and are delaying household formation in record numbers, 5%-plus wage inflation will also hit them hard through higher interest rates and higher cost of debt carry.

This puts your average news headline relating to 2.9% annual increase in wages September figure into a correct, life-cycle perspective.

6/10/17: Italian Banks Tested EU Banking Reform. It Failed.

My article on the patent failures in the EU Banking Crisis resolution reforms exposed by the 2017 events surrounding Italian banking sector is out via @ManningFinancial http://issuu.com/publicationire/docs/mf_autumn_2017?e=16572344/54030271.

6/10/17: CA&G on Ireland's Tax, Banking Costs & Recovery

Occasionally, the Irish Comptroller and Auditor General (C&AG) office produces some remarkable, in their honesty, and the extent of their disclosures, reports. Last month gave us one of those moment.

There are three key findings by CA&G worth highlighting.

The first one relates to corporate taxation, and the second one to the net cost of banking crisis resolution. The third one comes on foot of tax optimisation-led economy that Ireland has developed since the 1990s, most recently dubbed the Leprechaun Economics by Paul Krugman that resulted in a dramatic increase in Irish contributions to the EU budget (computed as a share of GDP) just as the Irish authorities were forced to admit that MNCs’ chicanery, not real economic activity, accounted for 1/3 of the Irish economy. All three are linked:

• Irish banking crisis was enabled by the combination of a property bubble that was co-founded by tax optimisation running rampant across Irish economic development model since the 1990s; and by loose money / capital flows within the EU, which was part and parcel of our membership in the euro area. The same membership supported our FDI-focused competitive advantage.
• Irish recovery from the banking crisis was largely down to non-domestic factors, aka - tax optimisation-driven FDI and foreign companies activities, plus the loose money / capital flows within the EU enabled by the ECB.
• In a way, as Ireland paid a hefty price for European imbalances and own tax-driven economic development model in 2007-2012, so it is paying a price today for the same imbalances and the same development model-led recovery.

Let’s take the CA&G report through a summary and some comments.


1) Framing CA&G analysis, we had a recent study by World Bank and PwC that estimated Ireland’s effective rate of corporation tax at 12.4%, just 0.1 per cent below the statutory or headline rate of 12.5%. To put this into perspective, if 12.4% effective rate holds, Ireland is not the lowest tax jurisdiction in the OECD, as 12 OECD economies had an effective rate below 12.4% and 21 had an effective rate of corporation tax above 12.4%. For the record, based on 2015 data, France had the 2nd-highest statutory rate at 38% but the lowest effective rate at just 0.4%. I contrast, the U.S. had the highest statutory tax rate at 39% and the second highest effective rate at 28.1%. There is a lot of fog around Irish effective corporate tax rates, but CA&G The C&AG found that the top 100 in taxable income terms companies had a an average effective corporation tax rate at 9.3%, slightly less than the rate applying to all companies (9.8%).

The CA&G findings show some dramatic variation in the effective tax rates paid by the Ireland-based corporations. CA&G report is based on a set of top 100 companies trading from Ireland. Of these, 79 companies paid an effective corporate tax rate of 10-15 percent, and almost 2/3rds paid a rate of 12% and higher. However, 13 companies faced a tax rate of under 1 percent.

Irish corporate tax system is risk-loaded: per CA&G report, 37% of all corporate tax receipts collected by the Irish Exchequer come from just 10 companies, while top 100 firms supply 70% of total corporate tax receipts. This concentration is coincident with rising reliance of the Exchequer on corporate tax collections, as corporation tax contributions to the State rose 49% in 2015 to reach EUR6.9 billion. The Leprechaun Economics that triggered a massive transfer of foreign assets into Ireland in 2015-2016 has pushed corporate tax receipts to account for 15% of the total tax revenues. Worse, 70% of total corporate tax take in Ireland came from only three sectors: finance, manufacturing and ICT. Manufacturing, of course, includes pharma sector and biopharma, while ICT is dominated by services, like Google, Facebook, Airbnb et al. This reliance on corporate tax revenues is the 6th highest in the OECD, based on 2015 figures. Per CA&G report, “Corporation tax receipts are highly concentrated both in terms of sectors and by number of taxpayers”. In other words, the Leprechaun Economics model is wrought with risks of a sudden stop in Exchequer revenues, should global flows of funds and assets into Ireland reverse (e.g. due to EU disruption, such as policy shift or Brexit/geopolitical triggers, or due to the U.S.-led shock, such as radical changes in the U.S. corporate tax regime).

The above is worrying. Leprechaun Economics model - or as I suggested years ago, the Curse of Tax Optimisation model - for economic development, chosen by Ireland is not sustainable and it is open to severe risks of exogenous shocks. Such shocks can be sudden and deep. And were risks to the MNCs domiciling into Ireland to materialise, the Exchequer can see double digit deficits virtually over night.


2) CA&G report also attempts to compute the net expected cost of the banking crisis to the country. Per report, the expected cost of rescuing the banks stands at around EUR 40 billion as of the end of 2016, while on the long run timing, the cost is expected to be EUR56.4 billion. However, accounting for State assets (banks’ shares), Nama ‘surpluses’ and other receipts, the long term net cost falls just below EUR40 billion. At the end of 2016, per CA&G, the value of the State's share in AIB was EUR11.6bn, which was prior to the 29% stake sale in an IPO of the bank. As history tells us, EUR66.8 billion was used to recapitalise the Irish banks with another EUR14.8 billion paid out in debt servicing costs. The debt servicing bill currently runs at around EUR1 billion on average, and that is likely to rise dramatically once the ECB starts unwinding its QE which effectively subsidises Irish Exchequer.

CA&G report accounted for debt servicing costs in its calculation of the total expected cost of banks bailouts, but it failed to account for the fact that these debt costs are perpetual. Ireland does not retire debt when it retires bonds, but predominantly uses new borrowings to roll over debt. hence, debts incurred from banks recapitalisations are perpetual. CA&G report also fails to a account for the opportunity cost of NPRF funds that were used to refinance Irish banks. NPRF funds generated tangible long term returns that were foregone in the bailout. Any economic - as opposed to accounting - analysis of the true costs of Irish banks bailouts must account for opportunity costs and for perpetual debt finance costs.

As a reminder, the State still owns remaining investments in AIB (71% shareholding), Bank of Ireland (14%) and Permanent TSB (75%) which CA&G estimated to be worth EUR13.6 billion. One way this might go is up: if recovery is sustained into the next 3-5 years, the state shares will see appreciation in value. The other way it might turn a decline: these are sizeable shareholdings and disposing off them in the markets will trigger hefty discounts on market share prices. CA&G expects Nama to generate a surplus of EUR3 billion. This is uncertain, to put it mildly, because Nama might not window any time soon, but morph instead into something else, e.g. ’social housing developer’ or into a general “development finance’ vehicle - watch their jostling for a role in ‘resolving’ the housing crisis. If it does, the surplus will be forced, most likely, into some sort of a development finance structure and, although recorded on paper, will be used to pay continued Nama wages and costs.

In simple terms, the CA&G figure is an accounting underestimate of the true net cost of the bailouts and it is also a gross economic underestimate of the same.


3) As noted above, the third aspect of the CA&G report worth mentioning is the rapid acceleration in Ireland’s overpayment to the EU on foot of the rapid superficial GDP expansion of 2015-2016 period. According to CA&G, Ireland’s contributions to the EU rose to EUR2 billion - up 20% y/y - in 2016. This increase was largely driven by the fake growth in GDP that arises from the multinational companies shifting assets into Ireland for tax purposes. CA&G expects this figure to rise to EUR2.4 billion in 2017.

In simple terms, Ireland is overpaying for the EU membership to the tune of EUR1 billion - an overpayment necessitated by the MNCs-induced superficial expansion of the national accounts. This activity has zero impact on the ground, but it induces a real cost on Irish society. Of course, one can as easily make an argument that our beggar-thy-neighbour tax policies are conditional on us being within the EU, so we are paying extra for the privilege of housing all corporate tax optimisers in Ireland.


All in, the CA&G report is a solid attempt at making sense of the Kafkaesque economics of the Irish State. That it deserves some critical comments should not subtract from its value and the quality of effort.

5/10/17: Leverage Risk, Credit Quality & Debt Tax Shield

In our Risk & Resilience class @ MIIS, we cover the impact of various aspects of the VUCA environment on, amongst other things, the Weighted Average Cost of Capital. One key element of this analysis - the one we usually start with - is the leverage risk. In practical terms, we know that the U.S. (bonds --> intermediated bank debt) and Europe (intermediated debt --> bonds) are both addicted to corporate leverage, with lower cost of capital attributable to debt. We also know that this is down not to the recoverability risks or credit risks, but to the asymmetric treatment of debt and equity in tax systems. Specifically, leverage risk is driven predominantly by tax shields (tax deductibility) of debt.

In simple terms, tax system encourages, actively, accumulation of leverage risks on companies capital accounts. Not only that, tax preferences for debt imply distorted U-shaped relationship between credit ratings (credit risk profile of the company) and the cost of capital, whereby top-rated A+, A and A- have higher cost of capital (due to greater exposure to equity) than more risky BBB and BBB- corporates (who have higher share of tax0deductible debt in total capital structure).

Which brings us to one benefit of reducing tax shield value of debt (either by lowering corporate tax rate, which automatically lowers the value of tax shield) or by dropping tax deduction on debt (or both). Here is a chart showing that when tax deductibility of debt is eliminated, companies with lowest risk profile (A+ rated) enjoy lowest cost of capital. As it should be, were risk playing more significant role in determining the cost of company funding, instead of a tax shield.

Simples. com

5/10/11: The Swedish Crises of 1910s & 1990s: The Lessons Never Learned

Here is an interesting piece of evidence on the nature of real estate bubbles and financial crises these create. One of the largest fallouts from property-driven financial crises in modern European history relates to the early 1991-1992 blowout in Sweden that saw massive collapse in property prices triggering a systemic contagion to financial institutions, The resolution process and the recovery that followed were long. Just about 10 years - the time it took the real property prices to regain their pre-crisis peak.

Source: Zerohedge

But the bigger story is a hundred-years-long bust to recovery cycle that took Stockholm's property prices from 1910 peak until 2007.

What is, however, most telling is the fact that Stockholm's markets show conclusively and without any doubt that all the lessons supposedly 'learned' in the past crises have been un-learned in the aftermath of the 2007-2008 Global Financial Bust. Despite the painful recovery from the 1991-1992, and despite huge efforts put by the successive Governments into highlighting regulatory and market structure reforms that followed it, Swedish property markets have gone into another, this time completely unprecedented in the country history, craze. 

Stockholm is a city that has been so reformed post the 1990s, it makes more sense to live in a hotel, at least in some cases (http://www.businessinsider.com/stockholm-rents-are-so-high-its-often-cheaper-to-live-in-a-hotel-2017-8). It is, of course, worth remembering that Stockholm is the equivalent of 'warm dream' for all rent control enthusiasts worldwide and for all 'moar regulation will save us from ourselves' crowds.

3/10/17: Ambiguity Fun: Perceptions of Rationality?

Here is a very insightful and worth studying set of plots showing the perceived range of probabilities under subjective measure scenarios. Source: https://github.com/zonination/perceptions

The charts above speak volumes about both, our (human) behavioural biases in assessing probabilities of events and the nature of subjective distributions.

First on the former. As our students (in all of my courses, from Introductory Statistics, to Business Economics, to advanced courses of Behavioural Finance and Economics, Investment Analysis and Risk & Resilience) would have learned (to a varying degree of insight and complexity), the world of Rational expectations relies (amongst other assumptions) on the assumption that we, as decision-makers, are capable of perfectly assessing true probabilities of uncertain outcomes. And as we all have learned in these classes, we are not capable of doing this, in part due to informational asymmetries, in part due to behavioural biases and so on. 

The charts above clearly show this. There is a general trend in people assigning increasingly lower probabilities to less likely events, and increasingly larger probabilities to more likely ones. So far, good news for rationality. The range (spread) of assignments also becomes narrower as we move to the tails (lower and higher probabilities assigned), so the degree of confidence in assessment increases. Which is also good news for rationality. 

But at that, evidence of rationality falls. 

Firstly, note the S-shaped nature of distributions from higher assigned probabilities to lower. Clearly, our perceptions of probability are non-linear, with decline in the rate of likelihoods assignments being steeper in the middle of perceptions of probabilities than in the extremes. This is inconsistent with rationality, which implies linear trend. 

Secondly, there is a notable kick-back in the Assigned Probability distribution for Highly Unlikely and Chances Are Slight types of perceptions. This can be due to ambiguity in wording of these perceptions (order can be viewed differently, with Highly Unlikely being precedent to Almost No Chance ordering and Chances Are Slight being precedent to Highly Unlikely. Still, there is a lot of oscillations in other ordering pairs (e.g. Unlikely —> Probably Not —> Little Chance; and We Believe —> Probably. This also consistent with ambiguity - which is a violation of rationality.

Thirdly, not a single distribution of assigned probabilities by perception follows a bell-shaped ‘normal’ curve. Not for a single category of perceptions. All distributions are skewed, almost all have extreme value ‘bubbles’, majority have multiple local modes etc. This is yet another piece of evidence against rational expectations.

There are severe outliers in all perceptions categories. Some (e.g. in the case of ‘Probably Not’ category appear to be largely due to errors that can be induced by ambiguous ranking of the category or due to judgement errors. Others, e.g. in the case of “We Doubt” category appear to be systemic and influential. Dispersion of assignments seems to be following the ambiguity pattern, with higher ambiguity (tails) categories inducing greater dispersion. But, interestingly, there also appears to be stronger ambiguity in the lower range of perceptions (from “We Doubt” to “Highly Unlikely”) than in the upper range. This can be ‘natural’ or ‘rational’ if we think that less likely event signifier is more ambiguous. But the same holds for more likely events too (see range from “We Believe” to “Likely” and “Highly Likely”).

There are many more points worth discussing in the context of this exercise. But on the net, the data suggests that the rational expectations view of our ability to assess true probabilities of uncertain outcomes is faulty not only at the level of the tail events that are patently identifiable as ‘unlikely’, but also in the range of tail events that should be ‘nearly certain’. In other words, ambiguity is tangible in our decision making. 

Note: it is also worth noting that the above evidence suggests that we tend to treat inversely certainty (tails) and uncertainty (centre of perceptions and assignment choices) to what can be expected under rational expectations:

In rational setting, perceptions that carry indeterminate outruns should have greater dispersion of values for assigned probabilities: if something is is "almost evenly" distributed, it should be harder for us to form a consistent judgement as to how probable such an outrun can be. Especially compared to something that is either "highly unlikely" (aka, quite certain not to occur) and something that is "highly likely" (aka, quite certain to occur). The data above suggests the opposite.

1/10/17: The Old, The Young and Resources Leveraging

In our Economics class at MIIS, we have discussed last week - briefly - the dynamics of demographic change (ageing population and cohorts dominance) around the world, with a side-road to the twin secular stagnations theses. We mostly talked about the supply side of the secular stagnation and mentioned the context of long-term technological cycles. Here is an intelligent take on one of the multiple aspects of the issue, the different angle to technological cycles: https://www.bloomberg.com/view/articles/2017-06-13/the-old-are-eating-the-young. The connection between financial debt and environmental/resource capacity leveraging is a rich vein to explore.