Economics 15/11/2009: When Ryanair gets serious...

Per my continued opposition to absurd tax measures, see the following statement from Ryanair and my comment below:

Apart from landing another rainy cloud on Mrs Coughlan's fine parade (after all it does call Tanaiste out as being somewhat disingenuous in her claims), this statement is worth looking at a bit closer:

If the Irish economy is losing €600mln in tourism revenue, the VAT on this loss will likely be ca €80-100mln (as some services bear reduced VAT). This is the first round of losses to the Exchequer.

But every euro spent by a tourist in this country goes to pay for goods and services here, which in turn generates banks deposits and payments to suppliers. These payments are then used to generate new economic activity, thus triggering a second round of tax receipts. And the merry-go-round then goes on to the third round and so on. 

Given the average OECD private spending multiplier is approximately equal to the M1/M3 multiplier, which is roughly 3.8-6 (depending on the range of years chosen, with the lower number coincidentally referring to the years of the most recent global markets boom), then these losses are indeed much greater than those claimed in Ryanair note. 

Back of the envelope calculation suggests the Exchequer will be foregoing some €120-250 million more in revenue on top of the first round losses. And this is before we factor in income taxes and other taxes, such as charges on fuel that foreign motorists might pay while touring Ireland.

So we are now back to the old equation: put a €10 tax in place, lose some €100-230 million in revenue. Good luck running the country with these mathematics...

Note: that article attacking my and Ryanair analysis of the travel figures that predicted the yet-to-materialise substitution effects of Irish travel tax is available from the Irish Times site (here).

Economics 14/11/2009: Irish Insitituional Accounts 2008

CSO is not the quickest of institutions when it comes to timely release of data, so when it comes to Institutional Accounts, all we have to go for now is 2008 end of year data released earlier this week. Here is my take on it.
Chart above shows broad GDP composition. The decline in GDP in 2008 is pronounced and it is relatively clear that Non-Financial Corporations lead the way in driving down our gross domestic product. To see this in more details, consider the decomposition below:
Absent real growth in private sectors, public sector becomes more pronounced. In other words, as overall economy decline, public spending picks up in relative terms. Everything else is tanking. Not surprising, really. But in percentage terms, this is throwing some additional insights (below):Now, the story of our economic downturn is very much in full view - productive part of domestic economy (non-financial corporations and households and financial sector) is in deep retreat. Non-productive public deficit financing of state consumption is swinging into positive. Also, note that household contribution fall off is pretty much in line with financial sector fall off. This is indicative of the fact that (as I have argued consistently before) our financial crisis was not caused by external forces of credit crunch, but by internal mountains of bad debts accumulated by corporates and households.

Another point from above is just how dire are the conditions in non-financial corporate sector. Only a fool would believe that this precipitous collapse in the relative share of GDP accruing to non-financial companies in Ireland can be repaired by injection of more debt into the system.
Chart above shows that Net National Income (NNI=GNI-depreciation, GNI=GDP+net receipts from abroad of wages and salaries and of property income), which by its definition nets out along with depreciation some of the effects of transfer pricing has fared pretty much in line with GDP. Interestingly, households contribution to NNI is in excess of their contribution to GNP, suggesting lower depreciation and potentially rising inflows of income from abroad when it comes to Irish households. It also reflects the outflow of foreign workers (either out of Ireland or onto unemployment benefits), reducing income outflow out of the country. General Government line shows clearly that net income multiplier of government spending is negative - which is logical when you consider the fact that the Government borrows from abroad to finance current spending at home.
Percentage contributions to NNI are equally revealing of the fact that Government spending cannot be seen as income-additive when it comes to net income accruing to this country. Remember - per earlier slides, Government spending was a positive contributor to GDP, but a negative contributor to NNI.
Gross operating surplus in the economy fell in 2008 across all private sectors and rose for Government sector. Why? Because while talking about the need to correct deficit, to cut spending and to take tough measures necessary to rebuild exchequer finances, our leaders were all too keen to actually pre-borrow as much as possible before 2009 hit. 'Do as I say, not as I do' is the motto...And thus net savings collapsed for Irish Exchequer as net borrowing soared. In contrast, households - scared first by rising joblessness and tanking stock markets and collapsed house prices, then by Leni's VAT measures and Government's inability to act - have moved early on into precautionary savings. Good for them - Irish non-financial corporations, in contrast decided to cut their savings - a sign of debt overhang in a recession. This means that overall, Irish corporations will emerge from this crisis with no spare cash to sustain restart of capital investment. This might be a good thing, given that over the last 10 years, most of Irish corporate 'investment' involved buying up competitors' firms at peak market valuations in a hope that if you make your company bigger, it will grow faster.

External balance has improved, but underlying it, trade flows to and from Ireland have come under pressure:
To nobody's surprise, net worth fell off the cliff in 2008 for the entire economy, although household savings allowed for a rise in their net worth position. 2008 marked the first year in modern history when Irish households net worth exceeded that of the Irish Government. Just think about it: the state dependent on taxpayers has had higher net worth than those who financed it... Spot anything here? How about 'fairness' idea our political leaders love waving around.Net lending positions (above) are also self-explanatory. But here is an interesting angle on CSO's data:
While Government share of GDP rose, its share of Net National Income declined. Even more dramatically, Government share of net disposable income fell even faster than that of NNI. Why? Because as Government deficit went through the roof, net disposable income fell -4.66% which is even faster than GDP (-4.18%). How? One word: Taxes!

Economics 12/11/2009: ECB's latest view

I will be blogging on the latest monthly bulletin from ECB published today, but here are few early previews:

One interesting snapshot showing just how silly is all the talk about decoupling in growth between emerging economies and the West:
Since mid 2008 there is absolutely no difference in leading indicators for two series. So anyone still thinks that emerging markets up 90% in a year is a good thing?

And here is a latent illustration of the trend I described some weeks ago using raw ECB data:
Of course anyone knows by now that money supply is not growing, despite the ECB vastly expanded liquidity pumping operations as banks hoard cash in capital reserves, while Government mop up all and any liquidity they can get into their vast deficit financing exercises. Clearly, M3 is showing that things are going swimmingly in the euro area economy.

Don't believe me? Well, here is another illustration:
So things are not getting much better on the credit markets side. The mountain of debt on private sector side is still intact, the mountain of debt on Governments' side is rapidly rising. Hardly a sound exit from the crisis.

Economics 11/11/2009: Lagging indicators and leading signals

McKinsey have published their review of the global economic conditions survey for November. Good read as always (here). Few snapshots of main results first:

"For the first time in a year, a majority of respondents—51 percent—say economic conditions
in their countries are better now than they were in September 2008.... [but] only 19 percent say an upturn has begun. This figure rises to a remarkable 33 percent, however, among respondents in Asia’s developed countries."

Cool, but... 49% state that economy either did not improve or worsened relative to September 2008. 64% expect their economy to be better than in September 2008 by the end of Q1 2010 (up from 61% reading in September 2009). So almost 50% believe that their economy is no better now than at the beginning of this recession (full 4 quarters ago) and some 36% believe that it won't come out of the recession even after 6 quarters of straight contraction.

"A larger share of executives also expects the good news to continue, with 47 percent expecting GDP growth to return to pre–September 2008 levels in 2010 or 2011, compared with 40 percent
six weeks ago." Key point here is that this is an improvement in the indicator, not the actual growth signal (which would require a reading above 50%).

"Although the global news is good, there are marked regional differences; executives in the developed countries of Asia are generally the most optimistic, and those in Europe are the least." This tell us what we all knew - European companies are suffering still through the remnants of old pains, banks are yet to suffer most of their pains, and households - well, households in Europe are in a perpetual pain given sticky unemployment and slow consumption growth and household investment. Thus: "Everywhere except Europe, more executives describe the economy over the next several months as “battered but resilient” than say it is frozen, stalled, or regenerated." (see pic below)So much for the European Century story.

But what are the causes of this pessimism in Europe / optimism in Asia scenario? One can speculate:

For example, despite all the crises, all public spending and monetary easing, business leaders worldwide still see Government regulation as one of top three problems (chart below).
What this tells me is that structural issues that have precipitated the current recession have not been addressed. Can one be out of crisis when the causes of crisis in the first place remain intact?

Another interesting issue - future profitability.
I am not sure how you feel about this, but it makes me very uncomfortable for several reasons:

1. Again, Europe acts as a global drag (just as it was before this crisis), and this is before the hefty tax increases necessary for underwriting recent profligate spending are factored in;
   
2. US - think of this as the indicator of future equity values and you can see just how massively is overbought the US equity market;
3. Overall, all countries which used large state reserves of liquidity to finance current crisis measures (India, China, Asia-Pacific) are on the tearing path for profitability relative to Europe and North America.
   

Now take the outlook for 12 months ahead:
Let's look at this closer:

1. Low customer demand for our products or services: the main driver for all types of firms - with profits at risk (66%), static (46%) and expected to rise (41%). Just think what this means for countries that like Ireland are staring at higher taxes into foreseeable future and destroyed households' net worth;
2. Loss of business to low cost competitors: do I need to say anything here in terms of threats to Ireland Inc? Well, let me put 5 cents in - think of wages path in this economy. While private sector did some cutting (and hardly enough to reach long run equilibrium wages) public sector did none and is unlikely to do much (the latest plan for 6.85% cuts is (a) insufficient, and (b) won't happen in real terms). So overall level of wages in Ireland is really stuck somewhere around 2006 levels.
3. Competition from new entrants is the worry for leaders in profitability, but it will also impact the developed world economies. Why? Because to counter such entry you need new investment and to have new investment you need capital. Currently, capital is mopped up by Governments financing their deficits through Central Banks' issuance of new cash. Later it will be cleaned out by higher taxes. Not a good prospect going forward.
4. Low levels of innovation - again go back to capital in (3) and the same investment cycle restart bottlenecks. Ditto for Inability to get funding - Number 7 on the list.
   

We can go on, but you can see where all this is leading us -

• our current fiscal and monetary policies will be haunting us down the line into the so-called recovery,
  
• while more frugal Governments in China, India (you get the irony here?), Asia and so on, having stayed pre-crisis off the path of unsustainable increases in public spending at rates much faster than growth in their real economies, were able to absorb the crisis with lesser burden of debts.

This is where optimism is now resting globally. We are, therefore, back to the paradigm of "Smaller Governments, Happier Economies"... and healthier households, one might add?

Economics 10/11/2009: Our Unique Path to Solvency

Updated: FX outlook (below)

And so two things come to pass in the last few days that will have a significant bearing on Ireland in years to come.

Issue 1: the ECB has firmly set its sight on exiting from money printing business sooner rather than later. Per ECB's statement last week, the bank will close off its 1 year discount window, cutting maturity of the loans available to the banking sector in the euro area from 1 year long term maturity to 3 months traditional maturity. This will mean two things for Irish banks who are the heaviest borrowers from the ECB by all possible measures (see here):

1. Irish banks will face much faster transmission of any rates increases into their cost of borrowing increases;
2. Irish banks will see higher cost of borrowing directly due to them being unable to access 3-12 months maturity instruments outside the interbank lending markets (currently they are collecting a handsome subsidy from the ECB’s discount window by borrowing at rates well below those offered in euribor).

And all of this will mean that our banks will once again see their margins squeezed by the credit markets, implying an even greater incentive for them to go after their paying customers with higher mortgage rates, credit cards rates and banking fees and costs.

Issue 2: earlier this week, the EU produced an estimate that the Union members’ total public debt could reach 100% of GDP by 2014 up from 66% in 2007. Last month, the Commission forecast that EU debt levels will rise to 84% in 2010 and 88.2% in 2011. Now, it says that not only the debt will top 100% of GDP in 2014, but that it will keep on rising after that. And the Commission named the row of culprits most responsible for fiscal debacle: Greece, Ireland, Latvia, Spain and the UK. This is linked to the earlier paper from the Commission that looked at long-term demographic challenges to deficit financing, where Ireland and other countries were presented as basket cases in terms of pensions liabilities and expected healthcare costs associated with ageing population.

This, of course means the following two things for Irish economy:

1. Despite all extension for 2013 deadline for Mr Cowen to deliver SGP-compliant budget for Ireland, the EU is going to put more pressure on Ireland to bring its house in order. Not doing so will risk derailing of stimulus exits and deficits rollbacks by the likes of Italy, followed by Austria, Spain, Portugal and France. This simply cannot be allowed for the fear of undermining euro’s credibility and with it any plans Brussels might have for the tidy earnings from reserve currency seignorage in the future;
2. Brussels will be pushing harder and harder for own tax revenue source – some sort of a unified federal tax – in order to divorce itself from the precarious and uncertain (i.e volatile) sources of state-level revenues.

The net effect of all of this – taxes will go up. To put this into perspective, should the EU allow us the deadline of 2014 to sort out our deficit, this will mean our debt will be up by another €20-22bn and our cumulative interest bill will rise (by the end of 2014) by another €5.5-7bn.

Alternatively, consider the annual bill for this debt – at 4.7-6% per annum (a reasonable range starting from today’s low rates and reaching into rates consistent with ca 1.75-2.0% base ECB rate), the new, shall we call it ‘delay the pain SIPTU’-debt, will cost us every year something to the tune of €940-1,320 million, or just about what Mr Cowen is now promising to shave off the public sector pay bill.

So do the math – accumulation of liabilities (interest only) of up to €1.3bn per annum and political process delivering promises of savings of €1.3bn after two years of the crisis… Path to solvency indeed.


Now, per one reader's request, here is my view on what this means for the euro:

Macro side: unwinding of deficits will mean a steep fall off in Government consumption and investment, so both - short term and longer term demand for euro will fall. This will be offset by the simultaneous unwinding of quantitative easing, so supply of euro will also decline. Three scenarios and paths are possible from there:

1. If the two offset each other, we are down to interest rate differences to drive currency pairs against the euro (more on this below);
2. If monetary tightening will be lagging fiscal constraints, then euro will be heading south vis-a-vis dollar but not by much as it is highly unlikely that Obama Administration will be able to sustain its own deficits for much longer;
3. If monetary tightening leads fiscal tightening, then euro might head further north vis-a-vis the dollar.
4. Interest rates effects are most likely to drive euro up for several reasons: the US Fed is likely to continue easing as fiscal stimulus runs out; the ECB has reputation building (re-building?) to do; US has higher tolerance for inflation.
5. Last issue to watch over is the financial sectors demand for liquidity. Here, the US is more likely to face smaller demand for liquidity than euro area and this will imply a net positive to the dollar upside.
   

So my view is that dollar-euro pair will remain volatile over some time, with some limited upside to the dollar in the medium term. Carry trades in dollar will be continuing especially as the BRICs and the rest of the world launch into a new investment cycle in early 2010. Depending on whether this will coincide with monetary/ fiscal tightening in the euro area, we might see temporary testing of $/€1.65 barrier.

Euro-sterling story is a different story. The UK will be unwinding fiscal stimulus, while continuing monetary easing (banks are still in need of capital and writedowns will remain pronounced), which means we shall see plenty excess supply of sterling. The pressure is to the downside here and parity can be approached once again (remember that 0.98 moment in December 2008?).

Economics 04/11/2009: NAMA's first falls in the land of legal finance

International Swaps and Derivatives Association (ISDA) has issued an interesting opinion on Nama worth a read. Here are the main points (mind the legalese):

“…from an international perspective, a particular aspect of the NAMA Bill that has the potential to have a significant adverse effect on the transaction by participating institutions ...of domestic and cross-border financial transactions, including privately negotiated or “over-the-counter” (OTC) derivative transactions (“Relevant Transactions”).

ISDA’s main concern focuses on partial nature of property transfers under Nama.

“We note that ...the fact that the NAMA Bill envisages that partial property transfers – [i.e transfer of of some, but not all, of a participating institution’s rights and obligations arising under a Protected Arrangement, an arrangement with third parties legally protected under the international, Irish, UK, US or other national laws] - may be effected raises a significant risk of legal uncertainty for Protected Arrangements.” [In other words, what might be kosher for the Irish authorities under Nama might be violating international legal rights and obligations of parties related to Nama-impacted loans]

“If some, but not all, of such rights and obligations were “cherry-picked” for transfer pursuant to the NAMA Bill, the net position of that participating institution’s counterparty (and, indeed, of that participating institution) would be disrupted notwithstanding the provisions of Section 213” [of Nama legislative proposal].

“...During the UK consultations [on bailout packages] industry put particular emphasis on the possibility that the stabilisation measures provided for in the UK Banking Act 2009, which included a partial property transfer power (the power to effect a transfer of some but not all of the property, rights and liabilities of an affected UK institution), could be used to "cherry-pick" transactions, or even parts of transactions, under a netting arrangement, or otherwise disrupt the mutuality of obligations under a netting or set-off agreement... It is notable that, in the UK context, the validity of the industry concern in this regard was always acknowledged by the relevant authorities (HM Treasury, the Bank of England and the Financial Services Authority), so that the consultation process, in this regard, focused on how best to structure the relevant protections.” [This of course is not the case with Irish Nama case]

“As you are probably aware, the relevant protections were set out in Article 3(1) of The Banking Act 2009 (Restriction of Partial Property Transfers) Order 2009, as amended by The Banking Act 2009 (Restriction of Partial Property Transfers) (Amendment) Order 2009. Article 3(1) provides that a partial property transfer, within the meaning of the legislation, may not provide for the transfer of some, but not all, of the "protected rights and liabilities" between the affected UK institution and a third party under a "netting agreement". [Once more, in Nama case, no due diligence was even performed in this area – it appears from the note by ISDA that the Irish authorities have totally failed to consider the impact of Nama transfers on third parties]


So what does this mean for participating institutions and their counterparties?

“Risk management policies of parties to Relevant Transactions tend to require such parties to monitor credit exposure to counterparties under Relevant Transactions and, where relevant, put in place appropriate risk-reducing close-out netting and collateral arrangements. In the case of a party that is subject to prudential supervision (such as an Irish or foreign bank), whether it can treat its exposure to a Relevant Transactions counterparty as net, and take related collateral arrangements into account for risk reducing purposes, will also be key to the level of capital that the party is required to allocate to Relevant Transactions with that counterparty.” [So standard legal framework requires third parties to hedge risk vis-à-vis Nama-impacted institutions, but this process is at risk under Nama partial transfers. Which implies that Nama actions will spill over to third parties outside Nama jurisdiction. The legal bonanza that will be Nama is now risking crossing many borders…]

“A supervised institution will not be able to recognise close-out netting or a related collateral arrangement unless it can satisfy its supervisor that the close-out netting or collateral arrangement is enforceable with a high degree of legal certainty and with no unduly restrictive assumptions or material qualifications.” [This is the crux of the argument – if Nama will only partially impact security of collateral, this partiality will imply that counterparties to Irish banks’ transactions will not be able to properly assess the security of collateral held by the banks and in cases where such security is jointly held by an Irish institution and a non-Irish one, there will be no means for assessing the risks incurred by non-Irish institutions due to Nama take over of the loans or underlying collateral titles. Nama, therefore, will risk inducing new risk on unrelated institutions.]

Absent Nama “such opinions can be obtained in respect of potential [Nama-]participating institutions in respect of many industry close-out netting and collateral agreements. If the position in this regard were to change [a change which will be triggered by Nama coming into force], the commercial and financial implications for potential participating institutions and their counterparties to Relevant Transactions would be severe in that:

(a) supervised institutions [aka all non-Irish banks and credit providers] would be constrained in their ability to extend credit, or otherwise incur exposures, to participating institutions;

(b) supervised participating institutions themselves would find their own ability to conduct business constrained by much heavier capital requirements and their access generally to liquidity would be impaired”. [In other words, Nama will mean that participating banks will have to pay a heavy premium in terms of capital provisions due to the Nama-induced deterioration of their own collateral rights].

“…a concern remains that a [Nama-]participating institution’s counterparty’s net exposure could be disrupted by a partial property transfer of the type outlined [above]. If such a partial transfer of a bank asset by a participating institution to NAMA or a NAMA group entity occurred (or by NAMA or a NAMA group entity to a third party) occurs, the fact that the participating institution’s counterparty may terminate the agreement with the participating institution and enforce the close-out netting and collateral provisions will not provide comfort [at the immediate and massive cost to the Irish banks participating in Nama] if, as a result of the transfer, the transactions the subject of the netting/collateral arrangement have changed so that its net exposure differs from that which would have pertained but for the partial transfer.”

So, ISDA “strongly recommends that safeguards be introduced to the NAMA Bill to ensure that a Protected Arrangement may only be transferred as a whole under the NAMA Bill, or not at all, and that individual rights and obligations under the Protected Arrangement should not be vulnerable to cherrypicking.”

[In effect this will severely restrict two aspects of Nama operations:

1. this provision will increase the share of non-performing loans in the overall take up of loans by Nama, putting more pressure on Nama bottom line; and
2. this provision will also mean that some of the most toxic loans (with complex collateral rights, significant redrawing of covenants in the past, and/or substantial cross collateralization) will either have to be left with the banks as a whole or bought into Nama as a whole.]
   

But ISDA has expressed another concern: “An additional issue of concern to us is the proposal that, after acquisition of a bank asset by NAMA, …NAMA may change a term or condition of that bank asset where it is of the view that it is no longer reasonably practicable to operate that term or condition. ...the absence of legal certainty that would arise from this unilateral right to amend other contractual terms of Relevant Transactions – particularly when taken together with the provisions of Section 107 of the NAMA Bill – seems likely to have a negative impact on the ability of participating institutions to transact Relevant Transactions.” [In other words, if Nama is to have serious teeth in changing the terms and conditions of loans, it will risk freezing the entire future ability of the Irish banks to have meaningful access to international counterparties.]

[If anyone thinks things are tough in Irish financial markets now, wait till these aspect of Nama as an entity operating outside international norms and regulations come to play…]