Economics 31/7/10: Credit flows in Ireland

Central Bank quarterly was published yesterday. Here are some updated charts on credit flows (data through May). The main conclusions are:

1. Private sector credit continues to contract and is again accelerating in the annual rate of decline (-10.4% yoy in May as compared to -9.3% declines in April and March).
2. Mortgage credit contractions are steadily declining (-1.8% in May against -1.6% in April & 1.4% in March).
3. Non-mortgage credit is accelerating in the rate of decline (-12.8% in May compared to -11.4% in April)
   
4. Nama - now through 50% of the loans purchases - has had no positive impact on credit supply. If anything, as charts for households lending show blow, it is being accompanied by a dramatic increase in the cost of borrowing for ordinary families.

Charts:
Aggregate private sector credit above. Disastrous trends of the last 2 year continue unabated, despite the already significant contraction in the credit supply. This suggests that we are in a continued downward spiral when it comes to business and household investment (future capacity is under continued pressure down and the only thing that provides some positive support to capital side is, most likely, MNCs own inter-company investments). This goes to explain why one cannot accept earlier DofF projections for 2013-2015 potential rates of growth. We are in a situation very similar to Japan in the mid-1990s, where existent production is being driven at the expense of capital stock.

Mortgages:Clearly, no signs of moderation in the rates of decay anywhere here. But the picture is more sluggish than that for non-mortgages lending:
The reason for the different dynamics is that it is easier for households to cut back on smaller credit demand than on massive mortgages burden. Hence, non-mortgages lending is a leading indicator for what we can expect to follow in the mortgages markets. Not exactly a bright future for the housing markets, then.

Deposits side of our financial system:
Notice that deposits are down, mom, across the board, except for shorter term maturity corporate deposits. But yoy all deposits are down. Combined decline in all deposits in volume since January 2010 is €1,869 mln, or 3.4%. Not a small change. All deposit rates are down year on year - we are being paid less to save, but are charged more to borrow.

Loans stats next.
Loans for house purchases are falling, while mortgages rates are rocketing. The orange line above shows just what is happening with the cost of financing one's own home in Ireland, courtesy of our regulators (keen on talking about 'moral hazard'), all the special 'Working Groups' aiming to address the problems in the housing markets, and Nama. Remember - our Government (by now pretty much every minister in the cabinet) had sworn to us that Nama will restore functional banking. May be this is what they had in mind...

Last year I predicted that the game in the mortgages markets will play as follows:

• Once Nama starts transfers, incentives for the banks to play a Good Fella will diminish - repossessions will remain low, but rates will rise. We now can see this happening around us.
• Once Nama completes transfers, banks will go in earnest at rebuilding their margins & capital, meaning - repossessions will accelerate dramatically and rates will rise to the levels where the burden of financing mortgages will become a driver for more repossessions.
• 3-6 months after the above stage, banks will start hoarding repossessed property on their books. They will be forced to start selling it ca 6-9 months after February 2011 (completion date for Nama purchases).
• Combined effect of massively more expensive mortgages credit and inflow of repossessed properties into the market will drive prices in housing markets even further down.
  

So far, we are through the 1st bullet point and getting closer to the second one.

Meanwhile, in the land of short term loans, rates are more steady and credit supply is falling gently.
Now, let me ask you this question. What should be the priority here? Making sure people are not being skinned to pay for their homes, or making sure that credit cards rates and car loans are being underpinned by more stable interest rates?

Credit to non-financial corporations is continuing to slide. Year on year, shorter term (working capital) credit is now off a massive 19.3%. Longer term credit is off 2.7% yoy. What does this tell me about the economy?

1. Capital investment is going nowhere fast, with any rosy figures on volumes we might hear over the coming weeks being most likely driven by the MNCs own in-house investment flows; and
2. Companies have no capacity to refinance shorter term credit obligations, resulting in a cash flow pressures and lack of operating capital.

Not exactly a success story for our financial system administrators and regulators, then.

Economics 30/7/10: No double dip for the euro area, yet...

New data from eurocoin is out - time to update euro area forecasts. Aptly in line with the US Q2 growth now coming at a slower 2.4% annualized rate, both the leading eurocoin indicator of activity (down to 0.4 in July from 0.46 in June) and my forecast for Q2 and Q3 2010 growth for the euro area are also moderated. Chart below illustrates:
GDP forecast range is for quarterly growth of -0.1% to +0.05% in Q3 2009.

So no double dip for the euro area yet, but things continue to head that way...

Economics 29/7/10: PTSB house prices

PTSB/ESRI house price index is in for Q2 2010. The core result: house prices were down, again, by 1.7% qoq in Q2 2010 - a lower rate of change on Q1 2010 contraction of 4.8% qoq. Thus, prices are now off-peak by 35% to an average of €201,364.

Dublin prices are down 3.5% qoq in Q2 2010 and are off 44% relative to peak. This gap between nation average and Dublin, assuming (as seems to be reasonable) that capital prices appreciation prior to the current crisis were significantly affected by underlying demand, should be erased over the next 12 months plus. Which means we can expect at some point that Dublin will lead the recovery across the country, while other regions continue to contract toward the 45-50% nationwide average off-peak pricing.

NCB stockbrokers gave a good comparison to fundamentals-determined prices. Per their analysis,

• Rental yield model implies house prices equilibrium at between €118,000 and €157,000, or a mid-range house price of €137,500;
• Earnings multiples model implies €170,000;
• Present value model (although not detailed as to the assumptions built in) implies the range of €158,000 to €236,000 for an mid-range of €197,000

You can see where these valuations are heading, don't you? Take a full range of estimates mid-range point of €177,000 - that would be a decline of 43% off the peak prices. Take the simple average price of all mid-range points to get 46% decline.

Now, recall - these are equilibrium prices. In normal price adjustments, there is a relatively pronounced undershooting in prices - in other words, we can expect prices to fall below equilibrium levels before reverting toward longer term values over time.

The depth of this undershooting and its duration depend on some external factors, such as the ease of getting mortgages approvals, mortgage conditions etc - none of which are currently helping the housing markets. So there is a very strong possibility for prices to hit the floor at around -55-60% off the peak.

Lastly, there is a question to be asked as to the validity of PTSB's data - the country largest mortgages holder might no longer be the country largest mortgages issuer. And the sample size globally has shrunk substantially. In other words, if a desperate homeowner in the distant province sells a house for, say, €120,000 while a dozen of his neighbors are not braving the market, does this really tell us anything about the market clearing price? Not really. Imagine what the said homeowner would have got for his dwelling if 12 more identical dwellings in the neighborhood had a 'For Sale' sign.

So a grain of salt is due - the size of an orange...

Economics 27/7/10: Stress tests of Irish banks? Get real!

An excellent comment on AIB and BofI 'stress tests' results from Peter Mathews, worth a direct post (rather than 'just' a comment) on this blog. Read it here.

Economics 26/7/10: Old Capital Investment 'news'?

Updated: per some detailed feedback from the DofF, see updated text below.


The latest announcement of the extended capital investment programme for 2010-2016 is sounding like a PR exercise. Majority of the projects announced in the programme are the left-overs from the previous National Development Plan. So there is no real news on spending volumes / stimulus extent in the Taoiseach's announcement.

This does not imply that the programme is without a merit, but it does imply that the media circus about 'major new investment programme' announcement is seriously overdone.

There are, however, some details worth covering.

First, the level of 'new' investment. At €39 billion over 7 years it is hardly a 'significant' increase on the historic levels. Taken as an average of 2008-2010 gross voted capital spending, the six year plan that would have stuck to the average would imply a capital spending of over €51.8bn through 2016. Well in excess of Mr Cowen's latest 'Great 7-year Leap Forward'.

DofF latest projections submitted to the EU in SPU2010, prepared in December 2009, show expected capital investment of €5,500 per annum in 2011-2014, which, is now exactly matched by today's 'new' announcement.

Chart below illustrates, drawing on data from Department of Finance own projections delivered for the Budget 2010.

The news component of the announcement is in the detailed breakdown of the numbers by department and within departments - by the specific lines and projects. This is a significant improvement on the SPU 2010, where the same €5,500 million in annual investments was just a number. And then there are cuts in some of the really less economically feasible (or I would say 'White elephant') investments envisioned in the original NDP.

These are welcomed changes that are worth the report that DofF did produce to accompany the announcement (links here). Where credit due...


Second, Department of Finance SPU submission to the EU has built in (Table 9: Additional Annual Measures to be delivered in 2011 and 2012) as "Capital already identified and incorporated into the base" the following cuts to capital investment: 2011=1bn, 2012=2bn.

If Taoiseach's announcement relates to the new investment on top of the planned NPRF contributions, then the future (2013-2014) savings will have to come out of some other lines of Exchequer balance sheet. Croke Park deal effectively closed the doors on generating new savings from the non-welfare lines of current spending. This means that our Taoiseach, in making today's announcement will be aiming for clawing at least €3bn in new taxes on top of the at least €2bn already planned in Budget 2010 for the years 2011-2012.

Now, recall that the same SPU - which is now replicated in the 7-year plan for capital investment - had its validity questioned by the IMF as being too optimistic on the assumptions, imprecise on planned savings and at a risk of failing due to the possible Government fatigue to cuts. Are we now seeing the very things that IMF was warning us about unfolding in front of our eyes. The IMF also said that it is likely that the additional (not planned in SPU) adjustments to fiscal balance will require savings and/or tax increases of ca 2.3% of 2014 GDP, or roughly speaking €5bn.

So in the nutshell - either we will be borrowing more to finance that which we already announced years ago, or we will be taxed to death to pay for it. Or both.


Oh, and on a funny note - the Irish Times (here) reported that Government is hoping that the new 'investment' will create some 270,000 new jobs, directly and indirectly.

My original comment was: so we spend ca €6,500 mln to generate 270,000 new jobs? At this rate of 'expected' jobs creation, we should have some 6.5 million workers in Ireland, using 2009 GDP levels. Was someone in the Government buildings smoking something funny coming up with these numbers?

A person close to the report came back to me with their explanation of the numbers. The figures quoted on the aggregate are multi-annual 6-year forward projections that incorporate previously announced jobs targets from IDA and EI. So the direct jobs creation (remember - indirect jobs creation is highly uncertain, while IDA and EI targets are not subject to the announced investment measures) is around 1/2 that number. Now, at 130-140,000 per 7 years and at €39bn total would be in the region of €280-300,000 per job in one-off gross investment.

It still looks to me like something a tad too optimistic is happening here:

• Suppose we spend €5,500 million in year 2011 building stuff. This means we hire builders etc. Suppose we manage to get them at a pittance of €100,000 per job (a very low number). We just increased employment by 55,000.
  
• Suppose in 2012 we spend €5,500 again on building some more stuff, plus spend more funds on running the stuff just completed in 2011 (remember, we cannot use €5,500mln allocation in 2012 to operate the stuff just built in 2011, as it would be a current expenditure item). So we have to hire new and re-hire old, but the same number of 55,000 workers.
  
• Between 2 years, new jobs creation is 55,000. Not 110,000.
  

And this is what worries me here. Despite the explanations I got from DofF, the document numbers on the jobs front still do not add up to me.

Worse than that. Some of the programmes envisioned in the plan will require people to run/operate them in the future, post-construction, and will also require considerable spending of funds on amortization and depreciation, maintenance and operations.

Are there any estimates as to what will be the budgetary impact of these 'new investments' on the current expenditure in the future?

Let me explain here. Suppose I spend €2mln building a school building. Unless I get the existent staff to run the building, I will have to hire new teachers, new service providers, and I will have running and operating costs. For a school, suppose I will need 2 teachers and 1 service personnel (split into part-time admin and part-time maintenance staff). That's ca €150K annually in wages, plus mark ups for pensions etc - roughly speaking €280-300K per annum. Utilities etc, plus scheduled maintenance, say another €50K. So my initial investment of €1mln creates a continuous liability of up to €350K. Of course, I can cut my construction workforce hired in 2011 and divert 'investment' to funding staff operating my new facility. But that makes it a current expenditure. And it means that the rate of jobs creation will be crowded out over time by the newly added infrastructure demands.

Note, these are illustrative figures, but they add up.

• In 2012: projects from 2010 come on-line, implying (using above assumptions) that current spending side swells by €1,100 million (gross side);
• In 2013: projects from 2011 come on-line, yielding another €950mln, adding to 2012 to generate a permanent increase in gross current spending of €2,050mln.
• and so on...

These are crude illustrations, but you get my concerns? Yep - these current costs will have to be paid by us, the taxpayers. And it scares me.

And yes, I still do not believe that 270,000 figure. In fairness to the DofF - they have been stressing since yesterday that the figure is there just because they needed some anchor to the economic impact. It is neither rigorous, nor definitive.


Lastly, I would like to thank DofF for engaging in the debate and providing some very fair clarifications and explanations of their position on the paper.

Economics 25/7/10: What lending markets tell us about EU policies

So the markets are not that enthused about the stress tests. After the initial bounce on the back of 'pass' grades, there are rising concerns about some 19 banks, including AIB, which were given 'all clear' with some serious stretch of assumptions.

But to see what is really going on behind the scenes, look no further than the actual interbank lending rates. In fact, the interbank lending markets provide a good reflection on the combined euroz one policies enacted since the beginning of the Greek debt crisis. Both euribor (the rate for uncollateralized lending across euro zone's prime banks) and eurepo (lending rates for collateralized loans between euro zone's prime banks) are significantly elevated on twin concerns about:

1. The quality of the borrowing banks (recall - these are prime banks); and
2. The quality of the collateral (with sovereign bonds being top tier quality, deterioration in sovereign debt ratings is hitting interbank markets hard).

Here are the usual, updated charts:

Chart 1Long maturities have been signalling extremely adverse effect of the Euro rescue package since its inception.

Medium-term maturities show severe deterioration since the euro rescue package. Steepest, and uninterrupted rise in 3 months euribor signals that the rescue package is faltering in delivering anything more than a buy-time for the euro… In other words, we have an expensive (€750 billion-sized) buy-in of short time.

The ECB claw back on longer term lending window did not help this process either. But the stress tests are doing nothing to stop the negative sentiment dynamics.

Chart 2Per chart 2 above, short-term maturities are showing that despite supplying underwriting to about a half of the full year worth of euro area bonds refinancing, the rescue package has achieved no moderation in the short-term risk perceptions of the market. In fact, the rise in euribor is more pronounced in the short term than in longer maturities, suggesting that short term risks of sovereign default remain unaddressed by the rescue package and are exerting a continuous pressure on interbank lending.

Introduction of the stress tests also did nothing to reduce overall cost of borrowing amongst the prime banks which were fully expected to pass the test even before the EU got on with setting test parameters.

In turn, all of this spells much higher costs of funding for the banks which have shorter term financing needs, such as the Irish banks. The implicit cost of taxpayers’ guarantee for Irish banks debt is therefore rising.

And panicked markets are not about to surrender their fears to the EU PR machine. With all the increases in the euribor, the volatility of the interbank lending rates also increased, across all maturities, as shown in charts 3 and 4 below.

Chart 3Chart 4As evident, in particular, from chart 4, in the longer term, credit markets are absolutely not buying the combination of the EU rescue package, ECB liquidity measures and the stress tests. Euribor trajectory for maturities of 6 months and higher firmly re-established and vastly exceeded volatility that preceded the pre-rescue panic. We are now worse off in terms of the cost of banks financing than we were before the Greek crisis blew up.


To remind you - eurepo is the rate at which one prime bank lends funds in euro to another prime bank if in exchange the former receives from the latter the best collateral in terms of rating and liquidity within the Eurepo basket. Eurepo rates have posted dramatic increases since mid-June 2010. The original effect of the June 2010 closure of the longer maturity (12 months) ECB discount lending was a temporary reduction in the rates, followed by a stratospheric rise two week later that has been sustained through the end of this week. This is especially true for shorter term maturities, suggesting that part of the adverse effect was due to the heightened uncertainty around the EU stress tests. Chart 5 below illustrates.

Chart 5Chart 6The u-shaped response in the interbank lending rates to ECB lending changes and to stress tests is even better reflected in the longer maturity eurepo rates, as highlighted in chart 6 above.

3-months and 12-months eurepo rates are now at the levels consistent with the height of the sovereign default crisis. There are significant differences in the rates by maturity group and vis-à-vis euribor due to the fact that the quality of collateral offered in the markets is now itself uncertain as sovereign credit quality continues to deteriorate both in terms of increasing probabilities of default and thus associated risk premia, but also due to the regulatory treatment of collateral that is being signalled by the stress tests.

As with euribor, eurepo rates are showing remarkable increases in volatility, for both shorter and longer term maturities.


Let us finally put the two rates side by side to compare evolution of euribor against eurepo, setting index for all at 100=January 4, 2010

Chart 7Chart 8
Some pretty dramatic stuff. To round off, recall that since the beginning of April 2010, the eurozone has undertaken the following measures to shore up its financial markets:

1. Set up a sovereign rescue fund worth more than €750 billion to underpin roughly 50% of the total borrowing requirement in the euro zone (which could have been expected to yeild an improvement in banks collateral and thus a reduction in overall systemic risks in the interbank markets as well);
2. Reduce maturity profile of ECB lending window (which was from the get-go equivalent to dumping more petrol on the forest fire);
3. Deploy aggressive quantitative easing by the ECB (again, this should have reduced uncertainty in the interbank markets as in theory improved pricing for sovereign bonds should have increased the quality of interbank collateral and improve banks own books);
4. Conduct an absolutely discredited stress test of the banks (designed to provide positive newsflow for the banks, especially for prime banks which should have seen their risk profiles reduced by a mere setting up of the test).

In short, none of the measures seem to be working, folks... May be, just may be, the real problem with EU banks is their unwillingness to come clean on loans losses and start honestly repairing their balancesheets?