Economics 08/02/2010: PIIGS or PIGS?

For those of you who missed my article in yesterday's Sunday Times, here is an unedited version of it, as usual:

This week marked a new low for the euro zone. Despite all the posturing by Brussels officials about Greek deficits and the incessant talking up of the euro by the ECB and the Commission, the events clearly show that the common currency is lacking credible tools to bring order to public finances of its member states. Thanks to the clientilist politicians and the electorate, keen on piling up debt to pay for perks and inefficient public services, the Greeks really blew it. Then again, given their performance over the last fifteen years – inclusive of massive persistent deficits and outright manipulation of official data to conceal them – about the only surprising thing in the ongoing Greek tragedy is that their bonds are still trading at all.

Much more interesting events, related to the Greek debacle, are unfolding in Ireland. Boosted by the factually erroneous, yet ideologically pleasing statements by international observers, Ireland’s image in the euro area has improved significantly since the publication of the Budget 2010.

Which, of course, is out of line with economic reality on the ground. Far from exiting the PIIGS club of sickest euro economies, comprised of Portugal, Ireland, Italy, Greece and Spain, we are now looking like a country to which the wrath of international bond markets might turn next, once Greece is dealt with.

Let me explain.

This week, writing in the Financial Times, a respected economist, Nouriel Roubini has clearly shown just how escapist is the current thinking about the state of public finances in Ireland.

"The best course [for Greece] would be to follow Ireland, Hungary and Latvia with a credible fiscal plan heavy on spending cuts that government can control, rather than tax hikes... This approach is working in Ireland – spreads exploded as public debt ballooned to save its banks, but came back in as public spending was cut by 20 percent."

Professor Roubini’s comment was echoed later in the day by ECB’s President Jean-Claude Trichet who lent unprecedented amount of good will to the ‘right policy choices’ made by Ireland.

Even our Department of Finance has not, officially, claimed such a thing.

First off - Irish fiscal adjustments from the beginning of the crisis to-date are split approximately 50:50 between higher tax burden and ‘savings’. This debunks Professor Roubini’s general analysis of our policies.

But more importantly, it shows that our Government policies have focused on providing fiscal and financial supports to a select few at the expense of the entire economy. Some €70 billion plus of real future taxpayers’ money has been already committed and €10-15 billion more is still waiting to be deployed post-Nama to rescuing Irish banks’ bondholders. Slightly less comfort was given to the developers who will get a three year holiday on loans repayments courtesy of the taxpayers.

In a real world, economic recovery can only start with ordinary households and businesses. In Ireland, public policy assumes that raising taxes and charges at the times of shrinking incomes and revenues to sustain banks bondholders and narrow interest groups within this society passes for ‘doing the right thing’.

International observers might overlook this fact. For them the costs of encountering a deep and prolonged Irish recession are nil. But for us, the spectre of the 1980s is painfully evident.

In contrast to Greece, Ireland has been hit by an unprecedented, in magnitude and duration, economic recession. Our house prices bust and financial assets collapse was deeper than that of Greece. We also are facing a much more severe banking crisis and a significantly more dramatic rates of deterioration in public deficits. Ditto for our unemployment levels and credit contraction rates.

Our sole claim to better health is a substantially lower existent public debt burden. Alas, this too is optical. In real per capita terms, total levels of debt in Ireland (combining public and private debts) are several times greater than those in Greece.

Even when it comes to budgetary adjustments – as far as Governments plans go – the Greeks are ahead of us. Starting from marginally higher deficit in 2009, the Greeks are planning to bring their deficit to within 3% of GDP limit by 2012. We are planning to do the same by 2014. Of course, both plans are unrealistic, but whilst the EU Commission will attempt to force the Greeks to comply with their target, no one will be closely monitoring our Government’s progress.

In summary, we are nowhere near exiting the PIIGS club.

But let’s take a look at the ‘Love the Irish Policies’ media circus going on in international press. Contrary to Professor Roubini statement, Irish Government has been unable to achieve meaningful cuts in public spending to-date. Instead, we delivered a reallocation of some funding from one side of public expenditure to another. ‘Cuts’ in majority of departments have been simply re-diverted to social welfare and Fas.

By Government-own admission, there will be no net reduction in public expenditure in Ireland since 2009. Department of Finance’s "Ireland – Stability Programme Update, December 2009" provides some stats. In 2009, Gross Current Government Expenditure in Ireland stood at €61,108 million. In 2010 it is budgeted to reach €61,872 million. The latter figure does not include the cost of recapitalizing the banks post-Nama. In 2011-2014 the Government is projecting the Gross Current Expenditure to rise steadily from €63,518 million to €65,768 million.

To Professor Roubini this might look like savings, but to me it looks like the Government continuing to leverage our economic future in exchange for avoiding taking necessary medicine now.

The only reasons why our deficits are expected to contract from 2011 through 2014 is because the Government has been slashing public investment, raising tax burden and is banking on a robust recovery after 2010.

Overall, DofF plans for a 2.8% cut in the General Government Balance in 2010, and that will leave us (per their rosy forecasts on growth and tax revenue) at 11.6% deficit relative to GDP, down a whooping 0.1 percentage point on 11.7% deficit achieved in 2009. Adding expected costs of banks recapitalization, our Government deficit can easily reach beyond 14-15 percent of GDP this year. Greece is now aiming for 8-9% deficit this year under a watchful eye of the Commission. Do tell me Budget 2010 qualifies us for being treated as a stronger economy than Greece.

Stripping out its interest rate bill, Greece is planning for lower per-capita state borrowing in 2010 than Ireland. But Irish Exchequer is planning to raise its borrowing this year by 3%. If international observers are correct, why would the Government that managed to cut its spending by 20% increase its borrowing? That would only make sense if the revenue is expected to fall by more than 20%. Yet Budget 2010 assumes tax revenue decline of only 4.7% in 2010 and an increase in non-tax revenues.

So what has Irish Government done to deserve such a sweet-heart treatment from the EU and Professor Roubini?

One word comes to mind – smart marketing. Budget 2010 simply took €4,051 million from one Government pocket and loaded it into another. Then, the Government promptly reversed itself out of some of the higher profile cuts, such as those imposed on higher earners in the public sector. Even at the highest point of estimates, the savings – before they get cancelled out by rising spending and falling revenue – amount to the total of 6.42% of the Gross Total Expenditure in 2009.

After 2 years of the deepest economic crisis in the euro area, we are now facing one of the heaviest upper marginal tax burdens in the developed world, and a deficit that is simply out of control. Hardly the road map to a recovery.

Economics 07/02/2010: Human Capital, Immigrants and Social safety Nets

A very interesting piece of research that tends to support my view that higher minimum wages and more extensive welfare nets / social services nets are acting to reduce overall levels of productivity amongst the immigrants.

One paper, published this week, titled Indian Entrepreneurial Success in the US, Canada and the UK, by Robert W. Fairlie - University of California, Santa Cruz, Harry Krashinsky - University of Toronto, Julie Zissimopoulos – RAND and Krishna B. Kumar – RAND (available here) takes a look at the differences in entrepreneurship (incidence and outcomes) and education amongst one large sub-group of immigrants to the US, UK and Canada. Having a culturally homogenous and relatively large group of immigrants allows the authors to set aside the need for measuring sending country attributes, thus improving substantially the accuracy of their results.

What they found is pretty interesting.

Indian immigrants in the US and other wealthy countries are successful in entrepreneurship. But how successful these entrepreneurs are once they reach different countries and encounter different social systems, and what are the sources of their success?

The study finds that “in the US Indian entrepreneurs have average business income that is substantially higher than the national average and is higher than any other immigrant group. High levels of education among Indian immigrants in the US are responsible for nearly half of the higher level of entrepreneurial earnings while industry differences explain an additional 10 percent. In Canada, Indian entrepreneurs have average earnings slightly below the national average but they are more likely to hire employees, as are their counterparts in the US and UK. The Indian educational advantage is smaller in Canada and the UK contributing less to their entrepreneurial success.”

Hmmm… why so, you might ask?

Immigrants are most likely to enter both the US and UK as ‘family sponsored.’ Since the 1960s U.S. immigration policy has strongly favored family reunification. The UK’s immigration policies over the past four decades have shifted towards emphasizing family reunification and employment. On the other hand, Canada's point-based system which awards immigration admission points based on education, language ability (English or French), years of experience in a managerial, professional or technical occupation, age, arranged employment in Canada, and other factors leads to more skilled immigrants compared to the US.

So far so good – Canada has longer lasting and much more selective immigration policies than the US and UK.

Because of the point-based system, in Canada, roughly half of all immigrants are admitted through employment-based preferences. In contrast, slightly more than 10 percent of immigrants in the US are admitted under this classification.

Again, sounds like Canada should be really the land of entrepreneurial and higher quality immigrants.

The related category of employment creation or investors who face minimum net worth and business experience requirements, and self-employed immigrants who must have relevant experience in occupations. A larger (but still relatively small – just 7%) share of immigrants in Canada are admitted under these policies than in the US (0.1%) and UK (2.4%).

So, ex-ante data analysis, it is pretty clear that “Canada's point-based immigration system results in a higher share of employment-based immigrants compared to the US and UK. On the other hand, the UK admits a much higher share of immigrants under its refugee and asylee programs than the US or Canada. All else equal, we would expect skill levels of immigrants to be the highest in Canada and the lowest in the UK.” (emphasis is mine)

In other words: the authors “find some evidence that the educational advantage of Asian immigrants compared to the national average is lower in the UK than in the US, [consistent with differences in immigration policies]. But, we also find that the educational advantage in the US is higher than it is in Canada, which runs counter to the greater emphasis of Canada's immigration policy on rewarding points for the general skill level of immigrants.”


Why? “A more generous redistribution system, more egalitarian earnings, and other institutional and structural factors, however, may make Canada less attractive to higher skilled immigrants such as Indian immigrants.”

Boy, this is some statement – especially considering the EU policies to achieve ‘Social’ economy – economy based on greater earnings equality, greater rights-based outcomes equalization and maintaining a very generous welfare and redistribution systems. And this is serious, folks. Canada, US and UK are much younger – demographically – societies than EU-core states. This means that in general, the EU has a much more acute need to import younger entrepreneurial talent and skills in order to pay even comparable welfare rates to those in Canada, US and UK. Let alone to afford a more generous system of benefits. The prospects of this happening are not that good, folks.


Let us get back to the study, though:

“We find that Indian entrepreneurs are much more successful than the national average in the US. Indian businesses also perform well in Canada and the UK, but the evidence is not as strong. In the US, Indian entrepreneurs earn 60 percent more than white entrepreneurs and have the highest average business income of any immigrant group.”

No, wait – income inequality is actually favoring ethnic minorities in the US? Without an EU-styled rights legislation that polices allocations of income to specific ethnic groups? Who would have thought that to be possible!

“Estimates from business-level data sources also indicate that Indian firms have higher profits, hire more employees, and have lower failure rates than the average for all U.S. firms.”

Ouch - higher profits = hire more workers + have lower failure rates? And all without help of SIPTU/ICTU/etc to protect the interests of workers and to curb profiteering? Who could have thought?


But what drives such astounding results?

“To explain to relative success of Indian entrepreneurs we focus on the role of human capital. ...We test the hypothesis that a highly-educated Indian entrepreneurial-force is responsible for their superior performance in business. Indian immigrants in all three countries have education levels that are higher than the national average, and in the US the education levels of Indian immigrants are particularly high relative to the entire population. In the US, 68 percent of Indian entrepreneurs have a college education which is twice the rate for whites or the national average. Some of the variation in the education of Indian immigrants across the US, Canada and UK is likely due to immigration policy. Another possibility is that the higher returns to education in the US result in a more selective immigrant pool in the US compared to Canada and the UK.”

Bu wait – ‘higher returns to education’ = greater income inequality between educated and non-educated. Again, who could have thought that this might be a good thing, especially for a ‘knowledge economy’?

“When we examine business income, we find large, positive effects of education in the US and Canada. We also find large positive effects of education on employment in Canada, but smaller positive effects in the UK. The findings for education imply that the relatively high levels of education among Indian entrepreneurs have a large effect on business performance at least in the US and Canada. Decomposition estimates provide exact estimates of the contribution of higher levels of education among Indian entrepreneurs to their higher business incomes and employment levels.

• In the US, higher levels of education among Indian entrepreneurs result in a business income advantage of 21 log points, which represents 43.9 percent of the gap.
• High levels of education also contribute substantially to why Indian entrepreneurs earn more in Canada (12.5 log points), but the difference is not as large as in the US.
• “The combination of the larger education advantage held by Indian entrepreneurs and the larger return to education is responsible for the increased importance of education as an explanatory factor in the US compared to Canada.
• “In contrast to these results, the smaller educational advantage and lower returns to education in the UK result in less explanatory power in the UK.”
  

But sectoral and cultural decompositions also matter: “Lower concentrations of Indian entrepreneurs in agriculture and construction, lower female share*, higher marriage rates, and favorable regional distributions also generally contribute to why Indian businesses perform better than white businesses or the national average.”

Again, give it a thought, folks. The above says that Indian entrepreneurs are so spectacularly successful in all three countries because they avoid investing in ‘losing’ sectors and regions. So where does it put state-led efforts to pump money into such ‘losing’ sectors as, for example, agriculture? And where does this leave Ireland’s ‘National Spatial Development Plans’ that reallocate cash to ‘losing’ regions/areas? In the category of ‘luxury goods’ – an affordable (in certain times) cost of keeping at bay social discontent amongst those who are falling behind?

And it also says that higher marriage rates are positively associated with higher returns to entrepreneurship. Who could have thought?


Some food for thought for our immigration policy bureaucrats and our national development authorities, then…



*[Aside - the issue of lower female share of entrepreneurship is, in my view, a simple statistical legacy. Women entrepreneurs tend to run businesses that are on average younger than those for men, hence, some increased risk in statistical measures. Over time, I would expect as female entrepreneurship gains fully similar footing in types of business, sources of financing etc as male entrepreneurship, this difference will disappear completely.]

Economics 06/02/2010: Nama stalling at the EU doorsteps

For those of you who missed my Thursday musings on Nama in the Irish Daily Mail, here is an unedited version of that article:

Two friends from the distant land of global finance have caught up with me the other day. ‘What’s going on with your Nama?’ they demanded to know.

Their concerns were about the latest hiatus created around our Bank Rescue scheme.

Yesterday’s news that NTMA is to take over management of the Exchequer affairs relating to bank shares bought with taxpayers’ cash is the case in point. Apparently, NTMA – the parent institution to Nama – will hold talks on capital needs with the banks as well as engage in their realignment or restructuring. It will also advise on banking matters, and crisis prevention, management and resolution. Just exactly can this task be achieved without creating a severe conflict of interest between NTMA and Nama, or without stepping on the heels of the Central Bank and Financial Regulator is anybody’s guess. But the bigger problem here is whether such a role for NTMA will constitute an undue interference in the financial markets for banks shares.

This activist approach to managing Nama news is not new, however. Following the quiet publication of the last piece of legislative jigsaw, Nama (Designation of Eligible Bank Assets) Regulations 2009, on the day before Christmas Eve, our Government has gone into an overdrive, trying to spin Nama as a panacea for all economic ills of the country.

Nama was painted as a socially responsible undertaking that will be reporting to the Government ministers on the issues of ‘social dividend’. It will provide housing for the poor and will take off the market vast surpluses of unwanted properties. Nama will also deliver a healthy dividend by charging local authorities for this ‘service’. But the local authorities will still somehow come on top by saving money.

Perhaps mindful of having produced too much gibberish of the above variety, our public representatives have started talking up the discounts that Nama will apply on loans it buys from the banks. Just 6 months or so ago Nama enthusiasts were saying that a 12-20 percent average discount will reflect the ‘true long term economic value’ of the loans? Now we are into 30-35 percent haircuts and rising.

The iron logic of finance tells us that the greater the discount Nama imposes the greater proportion of the original loan will have to be written down by the banks as a loss. This will require fresh capital, of which the taxpayers are the only source for no investor will be willing to buy new shares in Irish banks voluntarily.

By my estimates from some 9 months ago, the Irish banks will require Euro 10-13 billion of fresh capital the minute Nama goes through their books. After months of ignoring this prediction, the Government now admits as much.

But wait, as the discounts estimates increase, so are the concerns in Brussels and Frankfurt about Irish Government’s plan. First, the ECB is now seriously worried about the quality of Irish banks collateral deposited in its vaults. Second, the EU Commission is more concerned that approving Nama will produce poor optics internationally, as Nama will be openly buying trash with taxpayers cash and Europe’s approval.

As if these two issues were not enough, we now have two official versions of financial theory – the Frank Fahey’s Proposition and an Alan Ahearne’s Theorem.

The former claims that ECB is giving us a free lunch – a deeply discomforting statement from ECB’s point of view as it undermines the bank’s credibility.

The latter states that the banks, repaired by Nama, will “stimulate demand” for consumer loans. So our economic policy is being shaped by people who think that the banks can drive up demand for credit in the economy stuck in negative equity, with consumers facing higher taxes and falling incomes. And, of course, there is an added concern about the ordinary homeowners and their bad debts. As the Government is preparing to create another massively risky scheme for ‘helping’ defaulting mortgage holders, the Commission is starting to think – was Nama a limited undertaking, or will Irish banking crisis spill over into a general economic crisis as well.

Then there is an ongoing saga with loans. Back in the days before Nama Bill was passed, we were told that the Government has an excellent idea as to what security they can get on Nama-bound loans. It turns out they hadn’t a clue. As Namacrats are discovering, the loans held by the Irish banks often have a secondary claim to the underlying assets. And, they are finding that the poorer the loan the lower, usually, is the underlying security.

Suppose the bank has a loan for Euro 10 million secured against the property worth Euro 5 million. Suppose Nama buys the loan for the face value of the underlying property, implying a haircut of 50%. But if loan seniority is secondary in seniority, given the recent cases of our top builders going through the insolvency courts, the post-default value of the asset is somewhere between half a million and nil. Subtract the legal costs of fighting the borrower and better-secured lenders in the courts. The state will be lucky to get a euro from the deal.

This arithmetic is not escaping the ECB. Since December, we are painfully aware of Frankfurt’s intentions to close the discount window through which Irish banks have already pumped some Euro 98 billion worth of junk-rated assets in exchange for cash. By all Euro area standards, Ireland – a minnow accounting for roughly 1.8 percent of the entire common currency economy – has swallowed about 19% of all cash released by the ECB since the beginning of the crisis. More than any other country in absolute terms. Add to that the prospect of Euro 59 billion worth of Nama bonds, plus another Euro 10-12 billion for banks recapitalization, Irish banking system bailout can cost ECB up to Euro 170 billion in loans secured against, you’ve guessed it – unfinished estates in the middle of nowhere.

So understandably, the ECB folks are worried. By May they will start reversing junk securities they loaned against out of their vaults and back into the banks. Should they succeed, Irish taxpayers will be stuck for more cash to plug the new hole in banks balancesheets.

Which in turn will drive the quality of our collateral even lower. Mortgage rates will climb by 100-150 basis points for those of us who are still paying them down. Cost of credit for businesses will rise well into double-digit figures. Credit cards, car loans, consumer loans – all will become as rare in Ireland as polar bears in Sahara. Taxes and charges will increase – by 15-20 percent on average over 2011-2013. Instead of banks stimulating demand for credit, as Alan Ahearne suggests, Ireland Inc will be back on the slippery slope toward deeper recession.

Ultimately, it is the prospect of Ireland sliding back to rival Greece as the drag on the Euro that has been bothering my friends, as well as the ECB and the EU Commission. Sadly, their concerns are our last line of defense against Nama.

Economics 05/02/2010: Prepare for a new slide

Fasten your seat belts and prepare for a new round of bad news. Globally this time around.

All data for January-February is showing that the pressures of jobless recoveries around the world, coupled with continued weaknesses in financial sector and money supply (despite unprecedented stimulus deployment and helicopter drops - more like blanket bombings - of liquidity) are over-powering the weak positive momentum in growth.


December retail season was, officially, a disappointment – down 1.6% on 2008 season across the euro area. The headline Eurozone Manufacturing PMI reached 52.4 in January, highest reading for two years. The index stood at 51.6 in December, so the rise was marginal.

There were noticeable disparities in performance between national manufacturing economies. Countries reporting an increase in output were Germany, France, Italy, Austria and the Netherlands. All improved on December. Spain, Ireland and Greece all recorded lower output and faster rates of contraction.

Sector data indicated that capital and intermediate goods fared best in January. Growth consumer goods production is falling below that achieved in the previous month.

Growth of new orders was the strongest since June 2007 and faster than the earlier flash estimate. The gain in the index between its flash and final releases was the greatest since flash PMI data were first compiled at the start of 2006. New export orders rose at an above flash estimate pace that was the quickest since August 2007. See Ireland PMI in my Sunday Times article this week.

Despite rise in core PMI, manufacturing continued to shed jobs during January, across the Eurozone.

Core retail sales (ex-motors) in Germany were weaker in November than previously reported (down 1.7% mom) but rose 0.8% mom in December. Car sales are down 40% quarter on quarter –driven by the end of the scrappage scheme. Which, of course, shows that Irish experiment with temporary programmes of subsidies is unlikely to work. Interestingly, in Germany, scrappage scheme has benefited primarily foreign manufacturers. Of course, the reason for this is that German car makers are primarily at the top of the price proposition distribution and in a recession, subsidy or none, they will suffer. Foreign care makers sales rose 26% in December and 38% in January, before the scrappage scheme shut down. Domestic car sales were flat.

Sign of troubles ahead for exports growth – German manufacturing orders are down 2.3% in December while output contracted 2.6%.

Greece and Portugal are clearly in the news flow. Both have no market credibility when it comes to their deficits. And the reports from the ground are even worse with virtually all vox-pop reporting suggesting that populations of both countries are in deep denial of the reality. People are talking about ‘fat cat managers earning hundreds of thousand euros’ while ‘ordinary people are suffering’. Long legacy of communist and socialist politics in both countries is clearly evident in the popular unwillingness to face the music.

The next points of pressure will be Ireland and Spain.

On Ireland’s fiscal position and PMIs – read my Sunday Times article this weekend.

On Spain: the country is about 3 times bigger in economic terms than Greece and Portugal – accounting for roughly 11.8% of the euro area GDP. Troubles here will be a much bigger problem for the Eurozone than all the rest of the PIIGS (less Italy) combined. Meanwhile, Spain’s unemployment is rising (just as Ireland's), adding some 125,000 to the dole counts in January. 19% of Spaniards are now officially unemployed, as opposed to Ireland’s 12.7%. In terms of hidden unemployment, Spains problems are also much tougher than Ireland’s especially since grey markets for construction workers which sustained unofficial employment during the boom are now shut in Spain.


Credit is still tight in the euro area and the FX valuations are still around $/€1.36 – way too high for an exports recovery.

It is now painfully clear that the only thing that can resolve euro area’s problem would be a massive one-off emission of liquidity directly into the government budgets. To do this, the ECB can set a target of, say, €1,000 per capita for the eurozone economies, disbursed to each country based on their population. Anything else simply won’t do.

But even such a measure will not provide sufficient support for Greece, Portugal, Ireland and Spain – only a temporary reprieve.


UK’s economy is also in stagnation pattern with full-time employment still falling, individual, insolvencies up to record highs. The uptick in house prices in late 2009 is likely to have been temporary and driven by speculative ‘testing the water’ by international investors. Manufacturing PMI is up robustly January to 56.7, its highest level since October 1994, and from 54.6 in December. The increase was driven by new orders, which rose at the fastest pace in six years, as well as companies' efforts to clear backlogs of existent orders. It remains to be seen if this pace of improvements is sustainable. Services sector PMI meanwhile contracted rapidly from 56.8 in December to 54.5 in January, marking the slowest activity in five months.

Here is a little fact to put things into perspective – manufacturing accounts for less than 20% of the UK economy, while services account for 76%.


Overall, this recovery is coming along with more stress and strain on the labour markets. All global indicators are now appearing to have peaked back in Q4 2009, with the new year starting on downward trajectory. Inventory cuts passed in previous quarters are now being worked out and there is little sign this process will be picked up by a structural increase in new orders. All in, jobs growth is now severely lagging that achieved in the end of the previous recessions. In this environment, growth favours the US where jobs cuts were much more significant and early, allowing firms to rebuild their margins before the onset of any demand improvements. Eurozone is, in contrast, toast. Indicative of this is the volume of global trade – with Baltic Dry Goods index down to 2704 today as contrasted by 3335 reading 3 months ago.


Strategically – I would short Europe as an index, but look for low cost medium margin operations for a long position.

Economics 04/02/2010: McKinsey gets banal with risk

Latest McKinsey Quarterly (here) contains an article on global risks. Sub-titled "Top risk forecasters highlight their picks for this year's economic and political hot spots", the article is short and... really, really, really banal.

Here it is in its full glory (emphasis is mine):

Where will the greatest risks — known and unknown — flare up on the global business landscape this year? In this roundup, three prominent forecasters scan the horizon. [Notice the use of the future tense, forward-looking language]

...Economist Intelligence Unit's latest global business risk assessment highlights ...growing political instability from rising global unemployment, macroeconomic risks as stimulus measures fade, and financial-system risk spreading to sovereign debt in Greece and other countries.

European fiscal divergence makes the list as well at the Eurasia Group, which also sees diminished appeal of economic partnership between China and the United States raising concern, while Iran faces growing pressure at home, regionally, and globally.

And the World Economic Forum's 2010 Global Risks report focused on, among other risks, the barriers to growth posed by structurally deficient or obsolete infrastructure, the spread of chronic disease, and illicit trade."

Let me re-list them:

• 'growing political instability from rising global unemployment' - hmmm, wasn't that already apparent in Greece back in December? or in Ireland during local and European elections? or in the US in the last Presidential elections? I can go on and on;
• 'macroeconomic risks as stimulus measures fade' - you don't need EIU's forecasting powers to spot that one - everyone trading in financial markets has been factoring it into valuation for months;
• 'financial-system risk spreading to sovereign debt in Greece and other countries' - now what's new here (given the last 15 months of erratic markets behavior and record bond issuance) is the 'financial-system risk spreading' bit. Which financial-system risk? It is a purely nonsensical statement, unless one means by it that the bond finance system itself is under threat (US Treasuries? German bunds?);
• The risk of 'European fiscal divergence' has been with us for some 5 years now and has been growing steadily;
• 'diminished appeal of economic partnership between China and the United States' - but, folks, 'economic partnership between the two is a traffic of investment from US into China in return of exports from China into the US. This 'partnership' was coming under pressure for decade now. It really started to unravel with undervaluation of yuan bearing on the dollar balance of trade in 2006-2007. Since then, the prospect of the 'diminished appeal' was pronounced in US politics, culminating in the last Presidential Campaign. President Obama has been promising a protectionist corporate tax system overhaul to 'diminish appeal' of investing in China for US MNCs since before his election. I wonder if this is really a risk for 2010;
• 'Iran faces growing pressure at home, regionally, and globally' - oh no, who could have guessed. Certainly 2009 elections - with violent clashes, murder of internal opposition leaders etc, all caught on TV news and broadcast around the world were not a sign of 'growing pressures at home'. And Russia moving alongside the US and Europe to attempt to curb Iranian nuclear ambitions (a process that started back in 2006) is also not a sign of 'growing pressures... regionally and globally'. In short - this 'prediction' is too - old news.

Only WEF actually returns some interesting (aka not-banal) risks - infrastructure constraint on growth is a good one (although there is an element of 'old news' here as well, as crumbling bridges in the US and collapsing new builds in Korea have been with us for almost 10 years now). WEF could have added to it the lack of Governments' capacity to find funding to repair this crumbling infrastructure as a new-ish constraint - post-crisis. They did not...

Illicit trade being on the rise? Predictable risk - in any recession, black markets grow.

But the pearl is the prediction of chronic diseases spreading in 2010. Of course 'chronic' refers to the rate of onset of disease and development being spread over longer time horizon (at least 3 months). So how would we know if chronic disease is spreading in the remaining 10 months of 2010? especially ones with gestation periods measured in years?

Precious stuff, really. Makes me want to create my own list of forward-looking risks for 2010 and beyond. It will start with something impactfull, like "Parts of the world will experience droughts while other parts will get flooded. Grey skies will cover Ireland on many occasions throughout 2010."

Any suggestions what else to include?

Economics 04/02/2010: Nama - riskier than Anglo?

I just came across a very interesting paper, written back in November 2007 and published by the Bank for International Settlements as a Working Paper No 238.

As a proposition: I will use the study results to argue that Nama is a more risky undertaking than the Anglo Irish Bank.

Authored by Ryan Stever and titled “Bank size, credit and the sources of bank market risk” the paper “…examines bank risk by investigating the equity and loan portfolio characteristics of publicly-traded bank holding companies.” The study is based on the US banks, with sample being a panel of ‘at least 339 publicly trades BHCs at each point in time” for the period of 1986-2003. “These range in size from American Bancorporation at $31 million in book assets (200 employees) to Citigroup at $1.26 trillion (over 280,000 employees).”

“Unlike the pattern for non-financial firms, equity betas of large banks are two to five times greater than those of small banks. In explaining this, we note that regulation imposes an effective cap on banks’ equity volatility. Because the portfolios of small banks are less diversified, this cap has a greater effect on small banks than large banks.”

In other words, there is plenty of evidence that even when effective, regulators can induce some unintended consequences onto the banking system and that these consequences, if unaddressed can lead to systemic failures. Here is how it works:

• Regulators (and/or shareholders through exercise of their voting rights) place a limit on the total volatility of each bank’s assets regardless of size, which tends to minimize bank risk; however
• Small banks have more idiosyncratic risk inherent in their loan portfolio “because they cannot diversify away idiosyncratic volatility as well as large bank” (practically – smaller banks are more specialized, making their loans books more exposed to idiosyncratic strategy risk).
• Smaller banks inability to diversify comes about in “a number of different ways – for example; less total loans held, less diversity in borrower type (they do not have access to large borrowers) and geographic restrictions (small banks tend to be more localized);
• Because their total equity volatility is limited by regulation smaller banks must then find a way to eliminate their idiosyncratic volatility that is in excess of larger banks’ idiosyncratic volatility.

To do this, small banks do not necessarily pursue higher levels of equity capitalization or lending to different sectors in the economy – in other words, they do not strive to become like larger banks, but instead they either

• make loans with less credit risk than large banks (Swiss private banks, for example). This has the effect of reducing idiosyncratic volatility (as desired) and also reducing the beta of each loan (and thus the equity beta of small banks); or
• demand more collateral (e.g. Irish banks).

Of course, the problem with selecting the latter path way (collateral beefing up) as opposed to the penultimate pathway (more conservative, risk-sensitive lending) – as Irish banks should have learned from the current crisis – leads to additional problem, not highlighted in the study. This problem is manifested in the selection bias induced onto collateral – smaller banks opting for higher collateral requirements will take on less diversified collateral that is more likely to be positively correlated with their own (risk-skewed) loans books.

Thus collateral risk becomes positively correlated with loans risk.

Just think of what type of collateral Liam Carroll was supplying for his property development loans? You’ve guessed it – property-based collateral.

In fact, the study does find that small banks did not lower their equity volatility through lower leverage. Instead, “the reduced ability of small banks to diversify forces them to either pick borrowers whose assets have relatively low credit risk or make loans that are backed by relatively more collateral.”


What are the lessons for Nama from all of this? I am afraid not very positive ones. Nama is setting out to purchase loans on the basis of their collateral. Loans that are in distressed with collateral that has breached covenants due to precipitously declining valuations. Guess what – collateral risk is positively correlated with loans risk here from the start. Can this correlation be diversified? Yes, but not within Nama setting.

Remember, Nama promised to take good and bad loans together and mix them to derive cash flow. But these loans are all written against the same types of collateral as in:

• Same instruments;
• Same geography;
• Same vintages;
• Same currencies and so on.

In language of diversification – which loans returns are orthogonal to each other? Answer: none. Hence, no diversification is possible.

Take this back to the study findings and treat Nama as a sort-of-a-bank undertaking (with no deposits, but plenty of loans, although of course it does not matter, because Nama is not facing market funding constraints, courtesy of the state that is willing to give it your and my money with nothing definitive being asked in return).

Recall the last quote: “the reduced ability of small banks to diversify forces them to either pick borrowers whose assets have relatively low credit risk or make loans that are backed by relatively more collateral.” But in Nama’s case – what borrowers with “lower credit risk” can they select? None.

This leaves only option for Nama – to raise the underlying quantity and quality of collateral. Again – can this be done?

Sure, if Nama can either increase seniority of its claims on the collateral, or if it can swap assets for higher quality assets somehow. Alas, this works in theory, but in practice, Nama is saddled with seniority and quality of assets that banks have. It cannot go out to the market and demand that senior debt holders out there step aside and let residual quality claims that Nama might hold to step forward. Nor can it go to the developers and demand that better or more collateral be pledged for the loans. It is neither legally possible, nor feasible, given the dire state of developers’ finances.

Now, step aside and think of the Anglo. Anglo is a bank that is saddled with exactly the same dilemma – poor loans risk diversification. Can it escape this conundrum, assuming it can get funding (remember – Nama has no funding constraint). Of course it can. It can diversify client base and start attracting clients with lower risk profile by offering cheap loans to selected clients. And of course, Anglo has done so in the past – perhaps not enough, but it did. It can go out and lend outside Ireland, to diversify via change of geographies (it has done so in the past as well). And it can load up on collateral – which, once again, Anglo did. And yet, despite doing all these things, Anglo collapsed.

Anyone still thinks Nama – with much more limited ability to diversify key risks – can succeed?

So here you have it – Nama is the ultimately non-diversifiable risk undertaking that is actually worse off in terms of risk profile than the Anglo Irish Bank…


One would hope their board and risk committee understand this. Not really - the board contains such experienced finance and risk people as town managers, and the risk committee - well, that one will be staffed by who knows who, for it will have no one from outside Nama on it.

And this, of course, is where Nama is so nicely reflective of the Anglo...