Back from the snow

I am back in Dublin after a few days of snow-capped Italian Alps, great food, great wine, sunshine, crisp and clean mountains air. Friuli was, as it always is, a marvel!

What did I miss while away?

First, the recapitalization announced last week is not working. The magic, if a promise of the state taking a large chunk out of any future profitability, growth strategies and competitiveness of the Irish banks has had any magic in the first place, is now all gone. Gone because of the terms of this senile arrangement for all sides involved.
Here is how:
(1) The state is borrowing money at ca 5.5-5.7% in the market and injects money into the banks at 8%, earning risk unadjusted 2.5% return implying a risk-adjusted return (assuming our banks CDS spreads for last week) of ca -2-2.5%,
(2) The banks get money at 8%. Hostage to Government's demands on boards composition and lending, their profitability is shot for the foreseeable future,
(3) The banks are required to lend money out to businesses at... 8% (cost of funds) + admin cost (1.5%) so, say, ca 10% to repay the state,
(4) Businesses will stay away from this latest Government-engineered rip-off, while Ireland Inc's corporate and household balance sheets will still carry excessive levels of risk and debt and the economy will continue to spiral downward.
So, Minister Lenihan, the scheme cannot work even in theory. Forget about trying to make it work in practice.

Second, my favourite charts are updated to show that the things I missed while away were duly priced into Irish shares valuations by the market. Hey, at least the market still functions...

Third, I've missed some lively debates on certain 'academic' blogs about the pesky foreign commentators 'talking down' Irish Miracle Economy (and Government credit ratings). Needless to say, I am not amused:
(1) Some of those who made these comments themselves are keen on offering consultancy services advising foreign governments and commenting on their policies. Do their comments suggest that they claim a privilege to do what others should not be allowed?
(2) A part of this debate has finally exposed the undemocratic, technocratic nature of some of the members of the Irish intellectual elite. One commentator went as far as state that any publicly open debate exposes Ireland to the irrationality of the masses and that openness and freedom of expression thus are best reserved exclusively for discussions involving only 'informed' policymakers and analysts.

Which brings us to today's news: Irish 5-year CDS spreads have hit 378bps today, with a recovery rate of 40%, implying (assuming frictionless markets and no arbitrage) a lower bound of the Ireland Inc's default rate of 22%. Adding thinness of the markets (Irish bonds being traded in relatively small volumes, plus the half-day trading yesterday in the US) our implied sovereign default rate stands probably closer to 25%.

These are the resignable-level figures for our Brian-Brian-Mary Triumvirate of the Incompetents.

The end of the road?

Prepare for carnage once the markets open tomorrow. Per latest RTE report (here), Irish Life & Permanent admitted that it provided 'exceptional support' to Anglo Irish Bank following the taxpayers-paid-for Government [banks] Guarantee Scheme.

According to IL&P at the times of 'unprecedented turmoil' there was 'an acceptance that financial institutions would seek to provide each other with appropriate support where possible'. It is claimed that the transactions were fully and appropriately accounted for in the books and in regular reports to the Financial Regulator.

Anyone still surprised that the global markets are treating Irish equities as some sort of the corporate governance lepers? Any surprise that some institutional investors are no longer willing to hold any shares in the cozy cartel of 'supporters' that is Ireland Inc?

Here are some questions that must be asked immediately and with a view of taking up resolute corrective measures should any wrongdoing be uncovered:

1. Can these actions by IL&P be interpreted as a deliberate manipulation of the market? Corporate deposits are the components of bank's balance sheet that support share price valuations. Interbank loans - a normal procedure - are not. If deposits were made to provide 'support' to the Anglo, without an immediate publication of these deposits and their underlying causes to the markets, did IL&P and Anglo collude to alter the bank's balance sheet without revelation of this price-sensitive information?
2. Did IL&P deposits undermine own balance sheet and were they properly cleared through the risk-assessment process? Was IL&P shareholder value safeguarded in the process of making this gesture of camaraderie?
3. If IL&P did disclose such deposits to the Financial Regulator, why these deposits were allowed to proceed and why this information was not made public immediately? If the FR knew about the covert nature of deposits, were they de facto a party to concealment of a price-sensitive information?
4. We are all aware of the rumors that both the Guarantee Scheme and the Anglo's nationalization were carried out due to some critical events involving the Anglo and (in the case of the Guarantee) some other banks. Withdrawals of corporate deposits on a massive scale were rumored in late September and December 2008. Why is the Government unwilling to disclose the nature, the extent and the timing of these problems? After all, the Government is (largely rightly, I believe) using taxpayers money to shore up our financial system, committing tens of billions of our own and our children's funds to underpin the Guarantee, the nationalization and the bailouts.
   
5. At an even deeper level: has there been an implicit (hear-no-evil, see-no-evil) or explicit (via refusal by the Government to admit the nature and extent of the triggers for emergency measures) collusion between the Government and the banking sector to sweep under the rug the problems of governance and management at some of our financial institutions?

Not a single revelation about the mis-conduct events associated with the Anglo has been made public by the Government in a voluntary fashion. Not a single piece of information concerning the due diligence process in re-capitalisation decisions by the State has been made public by the Government. In light of this it is legitimate to ask questions of the Government as to the nature of the silence that shrowds the taxpayers' bailout of the banaking sector.

Over recent days there has been a lot of talk in the international finance circles about the skeletons hidden in the closets of Irish banks. Reputational capital of Ireland Inc is no longer running thin - it is, by now, about as hole-ridden as a slice of Swiss cheese!

Functioning markets require compliance with the letter and the spirit of law. The law requires that all price-sensitive information relating to the publicly listed companies should be disclosed in a timely and appropriate manner. The IL&P-Anglo case suggests that, potentially:

1. The law that supports functioning markets might have been severely breached; and
2. Public safeguards that were entrusted to enforce this market-supporting law might have comprehensively failed.

If this is the case, it is time for heads to roll. Now! Starting at the top of the Financial Regulator's office and right through to the companies involved.

And as per re-capitalization scheme, any injection of public money must be preceded by a comprehensive independent (internationally-administered) review of the banks' balance sheets and books, prior to any State-financed repairs can be made.

Paul De Grauwe View: Credit Trouble Ireland

"Spreads of sovereign debt within the eurozone have increased dramatically during the last few months, largely as a result of panic in the financial markets. When it engages in quantitative easing, the ECB should privilege the buying of Irish, Greek, Spanish and Italian government bonds to eliminate the distortions and the externalities that these spreads create,"
says Paul De Grauwe in his yesterday's post on Vox - a worthy reading.

What this means is that, as predicted in my earlier posts, Ireland is now a prime candidate for an ECB-led rescue. De facto, De Grauwe's proposition implies Irish Government issuing (near-)worthless bonds and placing these with ECB in return for loans - a scenario that is indistinguisheable from an actual lender-of-last-resort rescue or equivalent to IMF lending money to Ukraine, Latvia, Hungary and Iceland.

De Grauwe offers a rather conventional - but not necessarilly wrong - view of the bond markets as being gripped by a speculative panic:
"My hypothesis is that the widening bond spreads within the eurozone are the result of panic in the financial markets. The panic that followed the banking crises has led investors into a stampede away from private debt into assets that are deemed safe. These are mainly government bonds of a few countries. The US, Germany, and possibly France are a few of these countries that, for some strange reason, have been singled out as supplying safety. Other countries do not profit from the same 'panic flight to safety'."

This statement prompted, yesterday, a rushed welcoming from a member of the officialdom of Irish ecnomics (see here). And yet, had Irish econocrats read through De Grauwe's article in full, they would have arrived at the following statement:
"Only Greece and Ireland saw their bond rates increase significantly over the last year, suggesting that the increased spreads of these countries are not only due to panic."

Needless to say - I agree with De Grauwe. Irish (and PIIGS in general) spreads are fundamentally linked not to those of the other Eurozone states but to the lack of national competitiveness (see De Grauwe's chart on unit labour costs reproduced below), economic diversification, cumulative wealth of society, infrastructural and human capital and indeed many other economic fundamentals which determine the resilience of economy in a downturn. In short - not a panic, but a low productivity of the PIIGS economies drives the crisis.

Relative unit labour costs in Eurozone
Source: http://www.voxeu.org/index.php?q=node/3009

In short, our econocrats, so keen on pumping public sector investment into building up Ireland's capital base, infrastructure, education etc somehow managed to convince themselves that our deficit in these areas, alongside our vast and widening Exchequer shortfall, uncontrollable public spending growth, massive banks guarantees and recapitalization commitments by the state and macroeconomic management that requires raising taxes during a severe recession, all matter little to the bonds markets. Instead, the panic - that deus ex machina of economics - is the answer.

No need to panic then...

DofF Forecast: Update II

As promised - here are two scenarios estimating the state of the nation's finances.
The tables are based on DofF Update January 2009. Benign scenario assumes moderately deeper growth contraction (GDP), a fall-off in the tax receipts (as outlined in my previous update - in line with January 2009 Exchequer returns), a contraction in semi-state companies returns and my forecast for the 'savings' to be achieved in 2009-2013. All changes are marked in red. Blue color denotes differences in assumptions between moderate and benign scenarios, with moderate scenario assuming slightly deeper contractions in tax revenue, semi-states returns and shortfall in committed 'savings'.

Perhaps the most important lines to consider in both scenarios are lines: GEN GOV BALANCE and Gen Gov balance as % of GDP, which show that even under benign scenario, current dynamics in tax receipts and semi-states' revenue imply that Ireland will not be able to achieve Growth and Stability Pact limits on Governement deficit of 3% by 2013. The range for Gen Gov Balance Deficit is between €21bn and €22bn in 2009 - a far cry from the DofF forecast of €17.2bn.

Another important aspect of these estimates is the sensitivity of the general deficit to the assumption on 'savings' to be generated in 2009-2013. Given last week's fiasco with Mr Cowen's proposals, it is now absolutely clear to me that:

• the cuts planned by the DofF for 2009-2013 are not going to materialise in full;
• the cuts that will have a cumulative effect over the years forward are not going to cover the entire amounts planned, so that one-off-measures will play a significant role in total savings to be achieved.

Debt Mountain 'Ireland Inc' IV

Spot the odd one out...

Chart 1 shows the most indebted (in absolute terms - gross external debt volumes) nations of this world with their debts expressed as percentage of Ireland's gross external debt. This clearly ranks Ireland as the 9th most indebted nation in the world, and 6th in the Eurozone. Note that in absolute terms, Irish total debt is greater than that of Japan!Now, Chart 2 is even more revealing, as it plots per capita debt levels of the most indebted (in absolute terms) countries in the world. Ireland is a clear outlier!Massive, unpredictable and a (possible) danger to others... Is there something moving in the corner?

Debt Mountain 'Ireland Inc' III

An anonymous reader asked in a comment to the previous post if I can provide any solutions to the problems we currently face in Irish economy.

It is a matter not to be taken lightly, but given time constraints - this has been an extremely busy week for me - here is an outline of what my thoughts are on this subject:

Policy 1: cut excessive public sector expenditure:
DofF projected budgeted expenditure to be in the region of €49bn and receipts in the region of €37.7bn. I forecast, based on the latest Exchequer results the latter to be no more than €33.6bn. My figures now imply (assuming that the €2bn savings factored in by DofF in January and announced this week will yield real savings of €1bn) a General Gov Balance of €23bn (or 12.1% of GDP) up from €17.98bn (or 9.5% of GDP) allowed for by DofF. Note - yes, you've read it right - GGB of €23bn for 2009!

Allowing for the deficit of 7% in 2009 implies Exchequer balance for 2009 of -€13.3bn and savings to be achieved of €9.7bn. Thus, my fiscal plan, inclusive of stimulus package finance (see below) would be to:

• cut by 40% net capital budget expenditure - saving ca €3.3bn in 2009,
• cut by 17% net current expenditure - savings ca €8.3bn in 2009.

To achieve the latter savings, I would suspend up to 75% of the overseas assistance, cut by 75% pre-funding for future pensions liabilities, roll back all public sector pensions indexation to 2006 level, carry out significant cuts in non-front-line personnel in health and education, public service and semi-state companies, and cut welfare payments by approximately 5%.

I would also move to privatise the remaining public assets, etc. Some of the cuts can come through a direct increase in the efficiency of public sector operations. For example, we can use existent IT and university facilities to increase the number of students attending each class, accommodating those who become unemployed and wish to pursue educational opportunities. This will save significant amounts on the Continued Education grants.

Policy 2: Stimulative measures for economy
1) Banks: I would use recapitalisation scheme to inject equity (stock options) into households' savings and draw down household debt - I've outlined such a scheme before. The real stimulative benefit of the planned €10bn recapitalization scheme will be (assuming 15% appreciation in banks shares to 2013 and a one-off 40% CGT on options at maturity) ca €2.2bn pa through 2013. Draw-downs in HHs debt (at 50cents per €1) will imply additional benefit of €1bn pa.
2) Taxation: I would finance through a surplus savings of ca €2bn on the expenditure side (see bullet points above) a tax cut in employer PRSI and expand investment tax credits for labour-intensive investments. I will also freeze local authorities charge and levies, review regulated price controls (energy, gas, water, public transport etc).

Long Range Reforms:
1) Local Authorities: drastic redrawing of the entire local governance structure in Ireland, reducing the number of local authorities to 4 or 5 (e.g GDA, South, North East & Midlands, West) with proportionate 40% reduction in personnel;
2) Property/Land Value Tax: to finance local authorities I would impose a land value tax to be computed on the value and size of the plot occupied by your dwelling. The tax will be phased in allowing for those who have paid stamp duty in recent years to obtain credit against the tax value. Stamp duty tax will be abolished.
3) Flat income tax: on all income, including corporate profits - to be set at a revenue-neutral rate (suggesting, for example a tax of ca 16% flat on all income in 2008 terms). I provided details of calculations and complexities involved in computing this tax years ago, but the core idea remains. If this implies raising our corporate tax a notch - so be it. There is absolutely no economic or moral reason as to why physical capital should be taxed at a different rate from human capital.
4) Balanced Budget & State Property Amendments: pass a constitutional amendment to ensure that the real growth in Government expenditure cannot exceed at any year (with exception of the national emergencies, of course) the real rate of growth in GNP less 1%. Pass a constitutional amendment barring the State from ever holding a stake (except in the cases of emergency, subject to a 2/3 majority vote in the Dail) in any commercial enterprise.
5) Spatial Development & Social Partnership: I will abandon all economic and social engineering projects that do not explicitly and directly involve a 2/3-majority vote in the Dail;
6) Anti-monopoly laws: I will strengthen the Competition Authority to reflect the powers of competition enforcing bodies in the UK and will require that no company in any sector be allowed to control more than 30% of the market share.

Sorry, guys & gals - we are in 1am territory and I have a busy day ahead. I will return to this topic in the future posts, but for now a call to arms - send me your ideas for reforms!