Economics 05/12.2009: Budget 2010 Estimates

The Department of Finance has published estimates of income and expenditure for next year on Friday. These form the DofF outlook for 2010 before incorporating any Budget 2010 changes.

The format in which the estimates are published is such that one cannot operate standard Adobe pdf features and requires by-hand copying of data in order to transpose the table into the Excel or any other database. One can only speculate why this is done by DofF, but any economist out there can probably wish that someone obliges the DofF to start publishing things in modern documentary formats and provide separate excel files suitable for analysis.

So here is the data with my own parallel estimates. As with DofF, my estimates do not include any promised or signaled ‘savings’ and ‘tax increases’ that might be announced in the Budget 2010.

The main table:
The above shows that DofF projects a rise in current spending next year of over €5bn, (higher social welfare and debt service costs). My projection is for a rise of under €6bn (because of even higher social welfare costs, plus an increase debt-raising fees, but no difference on DofF’s estimate of debt financing cost). Details are, of course, to follow below.

So what do these estimates (My v DofF) suggest:

• On Current Receipts side, tax revenue differences are explained below, as are non-tax revenue differences, all in these allow for some €2.4bn discrepancy between my estimates and DofF estimates;
• On Current Expenditure side, my view is that net voted expenditure is underestimated by DofF, primarily in terms of social welfare increases and some crime-related increases (I believe we will see growing number of criminal convictions for acts against property), plus the Government is underestimating the scale of costs which will be involved in dealing with households defaulting on mortgages and going to courts against the banks. I also think the Government has no idea just how expensive litigation relating to Nama will be;
• So deficit on Current Account is much wider – by €2.6bn;
• On Capital account (see below) the main difference is driven by my view that Anglo will require €2bn in 2010 and that other banks will also swallow the same amount via NPRF ‘investment’ or something of the sorts. This is atop the similar spending via Nama issuance of new own bonds;
• So deficit on Capital Account is now €5.7bn wider in my case than in the case of DofF estimates.
• Net effect, Exchequer balance is, in my view, heading for a deficit of €30.4bn in 2010, up on €25.3bn in 2009 and up on DofF estimate of €21.9bn for 2010. Do tell me if you think things will improve so significantly on 2009 once January 2010 arrives as to justify DofF’s optimism.
  

Receipts side:
The differences between my and DofF estimates come from my view that:

• shopping to Northern Ireland will not decelerate, assuming no change in our VAT relative to UK and no changes in the FX rate
• no redundancy payments windfall and lower self-employment taxes will mean lower income tax
• MNCs transfer pricing will slow down due to investment by MNCs outside Ireland picking up
• lower deposits with CB will arise due to lower loans levels, depressing CB income
• lower dividends activity due to semi-states slowdown and arrears build up;
• lower pay out under Guarantee scheme due to creation of the Third Force, decline in banks returns on loans and Anglo fall-off.
  

All in, total Tax and non-Tax revenue will be lower by €1,039mln and €571mln respectivel

Next, let’s look at the detailed expenditure lines as stipulated above.
My main concerns (driving the differences to DofF estimates) are:

• Social welfare costs will be much higher due to transition to welfare from long-term unemployment;
• DETE will be more involved in artificially creating ‘training’ jobs for unemployed;
• Health will also see increases in costs due to welfare cost rising;
• All organizations dealing with crime will experience an increase in costs due to rising number of crimes against property;
• Internal public sector employment conflicts will be driving costs of arbitration and conflicts resolutions;
• Rising numbers of households insolvencies will be pushing up courts and related costs;
• Costs of Nama and Banks supervision/oversight will also rise, etc.
  

Net impact, I expect costs to rise by €1.1bn more than DofF does.

Details of non-voted current expenditure below:
No major differences here between mine and DofF estimates. Unlike in the case of non-voted capital expenditure:

Of course, this table incorporates my view that Anglo and other banks will swallow some €4bn in 2010 in new capital. This already assumes that most of the funding for other banks will come via Nama issuing new Nama-own bonds that the Government will attempt to keep off its own balancesheet. Of course, this is a bogus accountancy trick, but let us entertain it as the Government insists we should.

This pretty much finishes my analysis of the Exchequer estimates. If the Government does not attempt to dramatically reduce its own spending in the next Budget, we might see our annual deficit rising to over 16% of GDP. Even if DofF is correct and the deficit will be 13.5%, this does not change the bleak reality that some 9% of this figure is a purely structural deficit. In other words, no matter what, we will have to shave off ca €15.4bn worth of spending in the next 2-3 years. No other way about it.

Economics 01/12/2009: A real breakthrough of Mr Cowen

So per latest reports, the nation is saved. Facing a systemic deficit of €14bn per annum, the leaders of the Social Partnership have been contemplating a dramatic reduction in the cost of Government business. The dramatic news from the Government buildings, suggested a pay cut for public sector workers of 5% gross, or less than 3% net, delivering something to the tune of €836mln in gross savings (as claimed by the unions). Which, of course, will be clawed back to less than €600mln through automatic stabilizers (taxes on earnings paid through taxes and so on - per reported estimates by the DofF). For a moment, it all looked like our Taoiseach Brian Cowen reigned over the business-as-usual at the Partnership Table.

Credit for derailing this 'savings' deal goes to the public outcry, the media, a handful of backbenchers, the Department of Finance and also to Brian Lenihan - all of whom have managed to restore our policy back to senses. The numbers bandied around by the unions' heads were simply not adding up.

For a moment - it all looked like:
As one fellow economist described the 'New Deal' to me: “a Dora the Explorer bandaid on a shark bite”. Optimist he is – more like a prehistoric shark bite, judging by its gaping size.

Now recall, Brian Lenihan has promised three things to the nation and the EU:

1. cut €4bn in deficit this year and the same next;
2. no new taxes (except for carbon tax and, may be, higher taxes on the so-called 'rich');
3. cut €1.3bn in public sector spending
   

As long as the talks with the Partners are dragging on, this is becoming an impossible trinity of policy objectives. Will Joseph Brodsky's ending for his Elegy serve as a perfect descriptor of the Government's real legacy in the history of Ireland?

... And it says on the plinth
'commander in chief'. But it reads 'in grief', or 'in brief'
or 'in going under'.

Oh, and one last thingy - if you think that €600mln in 'savings' ever had a chance of materialising, think of public sector workers taking a 14-day holiday who will have an option to do agency work to replace their own jobs... earning a nice tidy premium...

Economics 01/12/2009: Irish Banks - something stirring in the dark

An interesting, but at this stage purely theoretical conjecture that can play out in the next couple of days.

I will posit it after I go over the facts that led me to this conjecture:

1. Today's reporting on BofI and the banks in general has been focusing on the possible conversion of preference shares into ordinary shares to plug in capital holes. Considering that (a) such a conversion will de facto spell near nationalization of the banks; (b) it will destroy Government's case (supported by the stockbrokers and the banks) that preference shares represent significant cash flow positive back to the taxpayers in exchange for recapitalizations to date; and (c) such a conversion will amount to a swap of a guaranteed asset (preference share dividend) in exchange for of a falling asset (as ordinary shares are tanking and are bound to continue to tank if conversion takes place), the statement is alarming. In fact, the statement is extraordinary in nature, similar to the Banks Guarantee Scheme announcement back in September 2008;
   
2. The RTE has completely failed to explore the very core idea of what effect the conversion will have on both capital reserves at the banks and the value of taxpayers' shareholdings in the banks. This might suggest that the story was potentially heavily 'managed' as a staged release as RTE business editors and correspondents should have been aware of such consequences;
3. The extent of demand for capital post-Nama has been approximately estimable from the sheer size of impairments faced by the banks against banks balancesheets (loans to deposits ratios) and did not come as surprise for, say Anglo earlier this month. Why such a hype then all of a sudden? Did Nama haircut change dramatically? Not, Bloxham note today in the morning explicitly worked its estimates from the assumed Nama-signalled haircut of 30%. No change spotted here, then.
4. Core tier 1 capital already includes preference shares, so conversion will only aid the banks balancesheets if and only if it will allow the banks to keep the preference shares dividend. This means that taxpayers get nothing from these shares. And it also means that things are getting so desperate in the banks that they are having trouble (potentially?) repaying these dividends to the state. What can the impetus for such deterioration be, given both banks already guided recently on expected impairments? Why did RTE reporters never bothered to ask about this issue.
5. The whole mess of demand for post-Nama recapitalizations was predicted by some, and publicly aired in the media. In fact, my estimates from one month ago (here) accurately predicted the numbers involved. While some 'experts' from stock brokerages interviewed today by RTE's flagship News at Nine programme might have been unaware of such estimates back then, their arriving at the same numbers one month later is not really that much of a market-making news. So, again, why the hype today?
   
6. RTE stated tonight that the markets anticipated 20% haircut (here). This is simply not true:

• Per today's Davy note: "This has been reviewed by NAMA and the Department of Finance and on the basis of interaction with both and the minister's estimate of €16bn of eligible bank assets, 'the directors believe that the average discount on disposal applicable to these assets should not be greater than the estimated average discount for all participating institutions of 30%'."
• Bloxham are working off 30% assumption.
  
• Goodbody's note was a bit more volatile on assumptions: "As per BOI’s recent interim results and a November’s IMS from AIB, both banks highlight that a number of uncertainties exist as to the specific quantum and timing of loans which may transfer, the price, the fees due and the “fair value” of the consideration. In its statement, AIB refers to the previously highlighted industry average discount of 30% to the gross value of the loans and indicates - as it did at the time of its IMS - that the board’s view is that “there is no reason to believe that the average discount applicable to AIB’s NAMA assets will fall significantly outside of this guidance”. When we wrote on this at the IMS stage, we highlighted that the language here was more vague than previous utterances and note our haircut applied is 28%. Similarly, in the case of BOI, the references in the release today are all based off the generic 30% industry figure referred to be the Minister, though that the discount will vary by institution, with the Court believing this industry figure to be the “maximum loss likely to be incurred on the sale of loans to NAMA”. We are of the view though that BOI’s haircut will be closer to 18%." I'll explain in human language: AIB itself believed that average Nama discount (30%) or something close will apply, while Goody believed 28% will do. For BofI, the management believed before that 30% will apply. But Goody's believed 18% will do (why, beats me). So no evidence on 20% market consensus anywhere here, then.
  
• NCB applied 30% model to both BofI and AIB in today's note. And so on.
  
• Taken over all brokers and banks themselves, AIB assumed discount averages at 29.5%, not 20%, BofI assumed discount averages at 27%. Now, forgive me, but where is RTE taking its 20% market expectation from?
  

So now, let us summarise the evidence:

• Banks announcement today was out of line with ordinary business;
• Banks announcement was never probed or challenged by the official media;
• Banks announcements were not queried by the the brokers to the full extent of conversion implications to the balance sheets;
• Three components can have a dramatic fast impact on bank core tier 1 capital - equity collapse (not the case - banks shares are down by less than 5% today, plus the statements were released in the morning before market prices were revealed); loans collapse on a massive scale (unlikely, given that both banks guided very recently on new impairments and also unlikely given that both banks appear to be impacted simultaneously); or deposits falling off dramatically (there is no way of confirming this unless banks publish their data, but do recall September-December 2008 when deposits flight exposed Anglo to nationalization).
  

So something really strange is happening around the BofI and AIB in the last few days. I do not know what this might be, but some fast moving deterioration in hitting banks balancesheets.

Watch tomorrow's ticker.

Economics 30/11/2009: Budget scope

For those of you who missed my yesterday's article in the Sunday Times, here it is in un-edited version. Note: updated below for estimated probabilities of default.

In their recent note, Fitch has singled out our massive public deficit and rising debt as the drivers for Irish sovereign bonds downgrade to a lowly AA- rating. This warning was in line with broader international markets concern about the mounting public debt liabilities around the world.

After days of falling prices on Chinese and Greek debts, this Tuesday it was Spain’s turn. October figures from Spain have revealed that the country deficit is now set reaching 9.5% of its GDP. The Spanish Government has gone out of its way to assure the markets that it plans to bring the deficit to 3% Euro zone limit by 2012. The plan involves raising VAT and capital gains tax. But the main measures will deal with public expenditure cut of 12-15%.

Spain, or course, is facing a public deficit that is some 3 percentage points shy of Ireland’s. But, unlike Ireland, Spain is planning to take its medicine in full and swiftly. Take another example. Denmark’s deficit is 7 percentage points below ours. In contrast to us, Danish government passed tax breaks and a major tax reform package encouraging more labour supply. The country also used its pension reserves to boost household income in this recession. To keep things under control – Danes cut public expenditure by up to 20% in some areas.

Latvia, Estonia, Iceland, and Hungary – all have implemented IMF-mandated cuts in public spending with some inflicting cuts up to 30% on public sector wages. All have seen subsequent rounds of upgrades from economic forecasters and bond markets.

But the signs are, after 27 months of severe crises, the Leinster House is still in the denial as to the full realities of our perilous fiscal position. Even after all the tough talk, Minister Lenihan is now appearing to accept Unions’ compromise for a temporary symbolically modest cut to public sector wages. Yet, the depth of our economic crisis requires nothing short of a drastic and permanent reductions in public spending.

Ireland’s promised €4bn cut in the Budget 2010 – contentious as it might seem to us – is pittance compared to what is needed to restore credibility in our economy.

Per latest set of accounts, we are in the need of raising almost a half of our current spending financing through borrowing. The latest forecasts from the EU Commission and the OECD state that Ireland's general government deficit is expected to be 12.2-12.5% of GDP in 2009 and 11.3-14.7% of GDP in 2010-2011. There is no snowball’s chance in hell that Ireland can reach the required 3% target by 2014 or, for that matter 2015, unless we deal with that share of the deficit that is known as structural deficit.

Any deficit arising in real life, therefore, can be decomposed into a cyclical deficit – that share of the deficit that arises due to a temporary recession – and structural deficit. The latter, of course, is the deficit that arises from structural overspending and cannot be expected to disappear when the economy reaches its long run growth potential.

Hence, the extent of our structural deficit is crucially dependent on the assumptions for the natural rate of growth in Irish GDP. So far this year, our Department of Finance forecasters have assumed that the natural rate of growth for Irish economy lies around the simple average for the 2000-2008 levels –close to 3.8% per annum. Their friends in the ESRI are slightly less optimism, predicting that the natural rate of growth is somewhere around 3% of GDP. All of this suggests that the structural component of our deficit is around 8-9% of GDP per annum or under €14bn. The cyclical component is in the region of 3-4% of GDP or up to €7bn. Hence, the current preferred adjustment path to fiscal solvency envisions cuts of €4bn in 2010 and 2011. Thereafter, reckon our mandarins, things will come back to ‘normal’ and Irish economy will miraculously churn out more tax revenue to cover the remaining hole.

But this bet assumes that Ireland is somehow an outsider to the entire Euro area club of smaller open economies. How else can our potential GDP growth be almost 300% above that of Denmark, 250% greater than Belgium’s, 60% above that for the Netherlands and for the Euro area as a whole? Or why should we assume that Irish economy will overshoot potential growth rate in the first year of recovery, when the majority of European economies are expected to reach theirs some 3-5 years after the end of a recession?

If our potential GDP growth is really in line with the small Euro area countries’ average, then our output gap (the difference between the potential and current GDP) is closer to 6% rather than 7.25% that the Department of Finance builds into its forecasts. This in turn implies that our cyclical deficit is around 2.5%, yielding a structural deficit of ca 9.5-10% of our GDP or €16-17bn in 2009 terms.

To get close to a realistically feasible path to solvency, Brian Lenihan should be aiming to cut some €8bn in public deficit in 2010 alone, followed by €3-4bn cuts in 2011 and 2012 each.

This is the real legacy of excessive exuberance with which Bertie Ahearn handed out cash to various Social Partners constituencies. And it is now manifested in purely toxic extent of deficits that cannot be corrected by any means other than savage cuts. The structure of our expenditure – manifested by the fact that some two thirds of it goes to finance wages, pension and social welfare payments – implies that the cuts must happen in exactly these areas.

Painful as this may be, there is simply no alternative. No productivity increases in the public sector will help deflate the actual costs of the sector. The costs that keep on rising. Per CSO’s latest data, 2009 was a bumper crop year for our servants of the state. Average public sector earnings are up 3.2% in a year to the end of Q2 2009, while average private sector wages are down 6.8% over the same time - a swing of 10 percentage points. Survivorship bias – the fact that earnings figures do not reflect the jobs losses and do not net out resulting redundancy payments in the private sector – suggests that the actual earnings growth differential is much wider than that.

Restoration of our economic health at this junction requires swift and significant cut – of the magnitude of 15-20% - in the total pay bill of the public sector. This can only be achieved through a combination of reduced employment and earnings cuts. It should be accompanied by a 10% cut in social welfare and a 30-40% cut in capital spending.

This is an urgent task that cannot be delayed for future Governments to tackle. Since May this year the Government has gone on a PR offensive arguing that the markets have treated Budgets 2009 as serious efforts to correct deficit.

Most of this is political sloganeering. As the chart clearly shows, although markets estimates of our probability of default on sovereign debt have declined in time from a historic peak in February 2009, this decline was far less significant than the overall market gains experienced by other countries with similar budgetary problems. Having peaked well ahead of all other Euro zone countries, Irish CDS spreads have stayed persistently at the top of the common currency area distribution. And there they remain with a significant risk to the upside.

Here are some index pics, all countries CDSs (5-year) set at 100 on 18/07/2008:

And here is an interesting chart for actual CDSs
The markets are now putting estimated probability of our default above that of Peru!

To put these into perspective, using OECD and EU Commission latest forecasts, taking €8bn in deficit financing out this year will save Irish taxpayers some €3-5bn in interest payments alone over the next 5 years.

The costs of our inaction are mounting.

Here are two charts on estimated probabilities of sovereign default for various CDSs, using a linear formula (not a more accurate PV of contingent claim =PV of fixed payment approach and no bootstrapping).

The above chart shows the cumulative probability of default over 5 year term of life of bonds... we are back in double digits and above Spain and Greece...

Economics 30/11/2009: Nama estimates confirmed

Scroll for a couple of interesting topics (other than Nama) below...

Per Bloxham’s note today (emphasis is mine):

“Bank of Ireland this morning officially announced its intention to participate in the National Asset Management Agency ... The bank sees the first assets as moving from January 20th 2010, and on a phased basis from there on until mid 2010. The group does not know the discount to be applied to the assets on transfer to NAMA. However, the bank expects to receive €11.2 billion for the assets currently shown with a worth of €16 billion in the balance sheet, based on the 30% discount guided by NAMA. Total provisions set aside on the assets to move to NAMA are €1.4 billion resulting in a €3.4 billion loss. The Risk Weighted Assets will be adjusted down by €15.2 billion as a results of the transfer. The bank shows a loan book of €116.7 billion (down from €131.3 billion pre NAMA) after the movement in assets, while Risk Weighed Assets fall from €100.7 billion to €85.5 billion. Core Equity will fall to €3.5 billion from €6.6 billion. Therefore, the reduction in Core Equity Tier 1 would be from 6.65% in September 30th to 4.2% as a result of the transfer to NAMA, and subsequent write down.”

So to restore the bank balancesheet to internationally acceptable risk-core equity balance of over 6% will require some €2.55bn in capital injection post-Nama, not accounting for any additional deterioration in the remaining book. In a note published exactly a month ago (here) I predicted that BofI will need €2.0-2.6bn in fresh capital – bang on with today’s statement.

This is the second estimate fully confirmed by the Nama-participating banks that is in line with my projections of October 30, with earlier this month media reports putting Anglo’s demand for fresh post-Nama capital at €5.7bn.

Further per Bloxham:

“Loss on disposal of assets will be tax deductible as we understood previously. Bank of Ireland also highlights that after 10 years, in the event NAMA discloses a loss the Minister of Finance may bring forward legislation to impose a special tax on participating institutions. The bank goes on to confirm that the interest rate Bank of Ireland will receive from the bonds which replace the transferred assets, is still not know. Therefore the impact on income is still not known.”

Oh and per Davy's morning note: using average 30% haircut implies a loss of €3.4bn on top of the €1.4bn impairment already estimated at September 30, 2009. This implies - per Davy's model - €960mln pre-tax hit which, "combined with some other adjustments to RWAs and sub-debt... would increase the capital required to keep core equity at the trough of 5% from €1.3bn to €2.3bn."

Now, Davy's model, therefore suggests demand for €2.8bn in capital to 6% ratio. Both Davy estimates are therefore comfortably within my range of expected capital demand by BofI. And good luck to those who have a hope that BofI can raise new funding with 5% core equity ratio at anything close to reasonable costs.

Anyone who at this stage in the game still holds illusions that Nama will allow for a restart of lending in this economy has to be simply bonkers.

Oh, and on a funny side of things: today's CSO data release is for:

"Census of Industrial Production 2008 - Early estimates". One question begs asking: When will the later estimates arive? December 20, 2011?

Oh, and do see this on Ireland v Dubai - here. The worrying thing is that it is talking about partial default scenario for Ireland and the ECB rescue ahead of Greece! which, of course, goes nicely with my article in The Sunday Times yesterday - which I will post later tonight.

Economics 28/11/2009: What if... Carry Trades bite the dust in Dubai

Carry trades, Dubai and the direction of the dollar:

Dubai's impending collapse shows that the epicenter of 'Development on Drugs' model implosion is now finally shifting from the US into Middle East and is risking new wave of contagion into Europe. Most of Dubai development has been financed by petrodollars (domestic and inter-regional), but also via carry trades from Europe (intraregional) with Euro area banks dominating the entire Emirate's landscape in foreign banking. This is bound to have long-reaching impact, with as far on-shore as Irish Nama potentially being possibly saddled with loans cross-linked to Dubai property. Bank of Ireland took part in a $5.5 billion (€3.7bn) syndicated loan facility to Dubai World in June 2008, according to stockbroker Davy. Per report in Irish Times today: "The firm said its initial participation in the facility was $93 million (€62 million) but it is understood that the bank’s debt currently stands at about €50 million."

Am I the only one who noticed that Irish investors, semi-states - e.g Aer Lingus, corporates - see here, even Enterprise Ireland succumbed to Dubai's lure: here - have financed the peak of this bubble?

Oh, and is Nama going to end up holding any of this (more here)? Nama folks are saying they know nothing about the Bad Bank taking on Dubai-related loans... Sure... they would know! And what about cross-linked loans? Developers with dual exposures?


So what does Dubai debacle mean globally?

Start with oil: the only way the Emirates are going to escape a meltdown (with domino effect spreading from Dubai to Abu and so on) is by turning on oil taps. An added incentive here is that while autocratic rulers of the Emirates would not blink twice before saddling Western investors with all debts, the structure of Islamic finance used in Dubai developments implies that although junior debt holders have no explicit guarantees on their debt, Emirates simply will not be able to stomach defaulting on Islamic loans. Oil prices will be under pressure for a long period of time before Dubai's debt mountain is cut to size and this will give support to the weakened dollar on asset demand side of the dollarised carry trades involving commodities.

Bigger question is whether Dubai events might trigger the unwinding of the carry trades. This, of course, depends on the value of UAE currency and the main currency pairs used in the region. In my view, devaluation of massive proportions will be required in the short run, putting pressure on the Euro and, again, aiding the dollar.

Another force acting here will be investor confidence. If Dubai served as an island for divestment out of dollar assets in the region, this island is now fully submerged under financial tsunami. Treasuries are to firm up and dollar alongside these. Ditto for gold.

On a separate note, another net positive (longer term) for the dollar is China. President Obama's visit played out as a play of avoiding the issues of yuan, and yielded absolutely no commitment to revalue Chinese currency. This, strangely enough, implies that once revaluation does take place, it will be much more pronounced and abrupt than if the Chinese authorities were to offer President Obama some concessions this month. Here is why. Absent Chinese commitment to play cooperative game with the US on currency front, Obama Administration will let Europeans put pressure on China through bilateral channels and G20. Europe cannot afford to hold the bag in the global devaluation game as it is exports oriented economy. Developing and emerging economies will fight by imposing capital controls, but EU will have to bring this battle to Chinese shores. Thus, in the long run, the stage is now set for overshooting revaluation of the yuan well above its long-term target and firming up of the dollar.

In the medium term, all this uncertainty about the ultimate rebalancing of the FX markets will be pushing on gold. This is likely to coincide with the emerging markets shocker from Dubai and capital controls impositions, further enhancing demand for the store of value assets such as precious metals. Not to be sensationalist, but if we are at the starting point of Wave II of the crisis (even if it is only a smaller aftermath to the 2008 one), is gold at $1,500-$1,700 oz a possibility?

Just asking...