Economics 27/8/10: Manifesto I (?)

I will continue posting on this and will aggregate all ideas in my Long Term blog, with a banner link on my main page as well. All suggestions welcomed & will be published, some will make it to the list as well (as always - with proper attribution). So engage with me on this one!


Given the current market and economic conditions and the dire lack of credible economic policies (from any political party) aimed at moving Irish economy out of the combination of:

• deeply rooted crisis in public finances;
• structural collapse of the banking sector;
• stratospherically high and increasingly long-term unemployment levels;
• lack of significant gains in competitiveness (not limited to the area of wages competitiveness, but including basic utilities costs, and costs of living and doing business relating to state-controlled sectors);
• malfunctioning markets for provision of domestic services - dominated and restricted by the excessive market power of the incumbent state-owned and state-regulated oligopolies;
• a clear predominance of policy measures that are designed to saddle ordinary families and individuals (consumers and taxpayers) with the full cost of stabilizing vested interests and elites (manifesting themselves in rising tax burden, falling provision of public services, lack of reforms in banking and public sectors); and
• continued devastation of private entrepreneurship and businesses, contracting investment and lack of confidence in the future of the economy and broader social progress

it is now time to ask:
Is Ireland's electorate ready for an alternative political and popular movement that would put the interests of consumers and taxpayers at the top of governance and policy agenda?

Irish democracy cannot be surrendered to the vested interests, no matter how broadly-based, and elites (no matter how meritocratic or mobile they might be).

The current crisis has clearly shown that the corporatist state - where a group of vested interests colludes with the Government and state structures to set economic and social parameters for development priorities - is morally, politically and economically bankrupt.

The only two ways forward from this status quo are

• a generations-long and exceptionally deep crisis of stagnation and declining standards of living, or
  
• a path of structural reforms aimed at realigning the current political system to serve the interests of consumers and taxpayers - aka - the ordinary citizens and residents of this land.
  

Such a reform can only be achieved by creation of a radically different alternative to the existent structures. A new popular movement can champion the rights of consumers and taxpayers to counterbalance existent system that promotes the interests of the vested pressure groups and elites.

It is therefore, clear to me that at this point in time Ireland is on the cusp of either opting for change or electing to undertake decade (if not decades) long descent into the nightmare of economic stagnation.

In my view, the agenda of such a movement should include the following reforms:

1) Banking reforms:

• Banks should be recapitalized following Swedish model (imposing haircuts/equity swaps on bond holders; accepting correct amounts of writedowns; equity taking by the State in the name of taxpayers; equity to be held in a Trust for individual taxpayers until disbursal; at disbursal - equity sales proceeds to be rebated, net of cost to the taxpayers)
  
• Nama to be reversed
• Anglo Irish Bank and INBS to be shut down and their liabilities and assets to be wound up within 5 years
  
• All banks boards and senior management teams replaced within 3 months
• All banks middle management teams reassessed and rebuilt within 12 months
  
• FDIC insurance scheme to be set up for the future needs of the sector
  
• No future bailouts constitutional amendment to be put to a referendum to prevent a possibility of any future calls on taxpayers wealth from any private sector firm
  

2) Fiscal reforms:

• Flat tax to be enacted on all incomes (preliminary estimates suggest 15-17% tax rate) with no discretionary deductions, but a generous upfront deduction of 1/2 of the median wage to be made available to all earners, plus 1/5 median wage deduction per child.
  
• Provision of strong (current level -10%), but life-time capped welfare provisions. Life-time cap will allow any able bodied adult in the country to have access to a cumulative maximum of 7 years of welfare provisions over their life time. Provision of welfare supports to those unable to work due to health or family circumstances (e.g caring for the disabled relative etc) to continue without life-time limits.
  
• Strong support for the disabled and the elderly must continue
• Wages for politicians and all senior servants earnings are to be tied to the National Disposable Income (NDI) on per capita basis (pcNDI): Taoiseach=3.5 times pcNDI; Ministers=3 times pcNDI; senior civil servants=max 2.7 times pcNDI; TDs/Senators=2.5 times pcNDI and so on. If the country earns more in disposable income, then those running it should get a reward, otherwise, they will automatically bear the same burden as the rest of economy. No bonuses to be allowed and all pensions to be converted to Defined Contribution plans.
  
• Benchmark Government spending to 35% of GDP, with emergency spending not to exceed 37% of GDP in any given year, and a balanced budget over every 3 year period. This allows for small emergency spending boosts in recessions, but prevents spending sprees in elections etc
  
• All quangoes, except those with immediate independent oversight authority (e.g FR and Competition Authority) are to be abolished and their functions transferred to respective departments. Responsibility for governance and management must rest with the executive branch of the state - i.e. Government.
• There should be no taxation without representation - self-employed individuals who are fully tax compliant should have access to same unemployment benefits as anyone else.
• Tax system should be fully reformed to simplify existent taxation and ensure full compliance. This will include, in addition to the flat income tax - abolition of all indirect charges and taxes, other than direct user fees which will be fully ring-fenced to provide revenue necessary to maintain specific service (e.g. bin charges, water rates etc). VRT will be abolished. Any excise taxes will be set at a level required solely to support provision of services directly associated with the underlying consumption charged. For example, petrol levy will apply only to the amount required to support environmental programme related to CO2 abatement and improvement of the environment. It will not be allocated into the general budget. There will be a fully transparent tax on land values (LVT), but not a property tax. The revenue from LVT will be split 50:50 between central & local authorities and local authorities will be allowed a discretion to vary their rate of LVT within reasonable parameters. For example, if LVT is levied at 1% pa, then local authority can be allowed to charge between 0.25% and 0.5% as it deems suitable, while the central government will collect 0.5%. CGT and CAT will be abolished for all investments held for 5 years or longer to encourage longer term savings and investment.
  

3) Governance reforms:

• Core change to the Government model will be transparency and accountability based on automatic systems of disclosure and control that are not subject to tampering by individual ministers/politicians or civil servants
  
• Transparency: all state data/decisions/discussions not subject to secrecy of the state considerations will be published on the web and made accessible free of charge to all residents of the state. Commercially sensitive data will be published with exclusion of sensitive information and identifiers, until the time when it can be published in full. All data requested under FOI will be released free of charge to the requestee and will be automatically published also on the public web portal to remove any need for future FOI requests
• Accountability: performance and productivity metrics will be designed for all branches of public sector and wages and earnings in the public sector will be tied into these.
  
• Any attempts by public employees or office holders to undermine the principles of transparency and accountability in dealing with the public will be punished on the basis of publicly available procedures. All disciplinary actions against aforementioned employees or office holders will be made publicly available.
• Local authorities will be reformed, reducing the overall number of local authorities to 7, covering: West & North West, South, Greater Cork, Greater Dublin, Greater Limerick, Greater Galway and Border & Midlands.
• Seanad will be reformed (subject to referendum) to give it real powers of the upper chamber comparable to the US Senate. It will be elected directly by the people of Ireland, with equal representation of 5 senators from each of the 7 geographic region outlined above.
• Dail will be reformed - there will be no expenses, no additional pay for work in special committees (every TD will be required, subject to seniority to carry such work as a part of their duties). The number of TDs will be reduced to roughly 2/3rd of the current. TDs will be entitled to a defined contribution pension top up to their existent private pensions with the state matching 1:1 every euro they put into their pension.
• Members of the cabinet will have no drivers, state cars and there will be no Government jet. Members of the cabinet will qualify for a car allowance equivalent to €10,000 per annum. All members of the Oireachtas and Government traveling on official business will be reimbursed only to the full cost of the ticket for economy flight on any flight under 5 hours of length and business class for flights of longer duration. No employee of the State will be entitled to any travel reimbursement in excess of an economy class ticket.
  
• No member of the Oireachtas or employee of the state will be exempt from any of the standard tax codes or laws of this land. There can be no privilege for the servants of the public that the public itself cannot claim.
• All state purchasing will be carried on-line, made public and transparent.
  
• State will purchase services, such as health care, care for the elderly, disabled etc for those who cannot afford them, but the State will not own service providers. Instead, public companies will be mutualized or privatized and forced to compete directly for the custom of the people. Transition to such an arrangement will require significant reforms, but also support for current employees in training them in running a private/mutual/non-profit etc enterprises. This support will be provided.
• Higher education will be fees-based, with fees set by universities and overseen by the Department for Education. The State will set up (with participation of charities and other private agencies) a number of funds that will administer financial aid to students based on need (with an objective of creating an equal opportunity for all qualified students to undertake studies) as well as merit (with an objective of rewarding real achievement).

In the name of sanity, I should pause for now. I will continue posting on this and will aggregate all ideas in my Long Term blog, with a banner link on my main page as well.

All suggestions welcomed & will be published, some will make it to the list as well (as always - with proper attribution). So engage with me on this one!

Economics 25/8/10: Derivatives time bomb?

An interesting number popped out today from the dark depths of the past (hat tip to Ed).

With my emphasis, quoting from the article published in December 2008 by the Chartered Accountants Ireland (linked here) titled "Financial Derivitives (sic), Villian (sic) or Scapegoat" written by Grellan O'Kelly (who worked at the time in the Policy Section of the Financial Institutions and Funds Authorisation Department of the Financial Regulator):

"...when looking at the outstanding derivative positions (notional values) of our main banks as reported in their annual reports, the amounts are extremely small when compared to the total global amounts. A recent BIS survey2 on global OTC positions shows that global notional amounts come to a staggering $516 trillion. The most recent disclosures from our two main retail banks show that their gross notional exposures amount to €640 billion, only 0.17% of the total. ...noting that access to accurate data on derivative products is not always publicly available."

The article contains the usual caveat that "Any views expressed in this article are made in a personal capacity and are not intended to represent the views of the Financial Regulator." Nonetheless, it would be good to get some comment from the FR on this. After all, €640bn might be a small level of exposure to derivatives from the point of view of global banks, but for BofI and AIB to have such an exposure... is roughly 170% of the total 2009 asset base of all Irish banks combined.

For now, I cannot confirm whether this was a typo or not.

The problem is that unwinding even the straight forward swaps can be extremely costly. Buffet's unwinding of lost contracts against reinsurance claims cost Berkshire some $400mln back in 2008. In the case of interest rates swaps written against property, De Montfort University research in June 2010 has estimated that for a book of £143bn of interest rate swaps in the UK (57% of the total existing UK £250bn book of loans is estimated to be hedged by derivatives - here), the cost of unwinding these positions runs into ca £10bn.

So applying the UK estimate to our potential exposure, the cost of unwinding those €640bn in derivatives can be to the tune of €45bn.

Of course, this is just an estimate, but it gives some perspective to the numbers.

But let's ad some relative comparatives (hat tip to Conor for both):

• Ireland accounted for 0.17% of global estimates of OTC derivatives but only 0.03% of Global GDP (based on CIA fact book and CSO data)
• €640bn is 4.12 times our 2008 Gross Value Added (ca €155bn)
  

I am totally at a loss as to this figure - given its size - so any comment on its validity will be appreciated.

Economics 25/8/10: S&P & the horrific cost of banks bailouts

As you all know, Standard & Poor (S&P) downgraded Irish sovereign debt to AA- from AA with a negative outlook. The downgrade was mainly motivated by the fact that the cost of the Irish banking bailout has increased significantly over previous expectations. S&P now estimate the cost of recapitalising the Irish financial system at €45-50bn, up from €30-35bn.

In my view, this is still behind the news curve in terms of estimated total costs.

My projections for total losses are as follows:

• Nama - net loss of (mid-range) €12bn, rising to €19bn in the worst case scenario (although I have not redone estimates for this scenario for some time and they reflect 55% haircut applied on Tranche 1);
  
• Anglo - €33bn in mid-range case, rising to €38.6bn in the worst case scenario (another update is due once the bank reports its results in the next few weeks);
  
• INBS - €6bn, no range as we have little clarity as to their balance sheets details;
• AIB - €7bn mid-range, assuming successful disposal of M&T and BZBWK, worst case scenario €9bn;
  
• BofI - €2bn.

So the total expected banks losses are €50-55.6bn in my estimates.

Importantly, S&P's negative outlook allows for the possibility that the rating could be cut
further if the Government fails to deliver on promised fiscal stabilization. This can occur either due to significant continued deterioration in underlying economic conditions or due to the failure of the Government to actually implement planned cuts, or both.

S&P's current position rates Ireland at the same level as Fitch and one notch below Moody’s, but both of these are keeping Ireland on a stable outlook.

S&P latest estimate is for Ireland net government debt / gross GDP ratio reaching 113% in 2012. Forever cheerful folks at DofF projected this ratio to be 83.9% in 2012 in their Budget 2010 figures. This shows just how much can change in 8 months time. S&P's estimate for debt implies Ireland is facing greater debt mountain than similar rated Belgium and Spain.

But here comes a tricky part. Remember that our debt is currently yielding in excess of 5.5% for 10 year notes. This implies that in 2012, we can expect to pay out 6.215% of our GDP in interest payments alone, or 7.52% of our domestic economy total income. The bill will be €10,241 million - using DofF forecasts - or 20.5% of the total current expenditure planned by the Government. All in, even by rosy projections from DofF for tax revenue, our interest bill alone will be swallowing every third euro revenue will bring in.

This puts into perspective recent ECB research that concluded that debt levels above 90-100% of GDP are, "on average, harmful for growth" and that porblems could arise at the debt levels of as low as 70% of GDP. ECB currently projects that euroarea-wide average debt levels will reach 88.5% in 2011. Does anyone believe anymore that Ireland can run 2.5-3% annual growth rate in the current conditions as projected by the IMF? Or 4.5-4.3% (2012-2013) real GDP growth as projected by DofF?

Economics 24/8/10: Anglo Tranche 2 goes 'Boom!'

Two weeks ago in a post on Anglo (here) I provided a quick explanation of my forecasts for why the mid range expected capital hit on the entire Anglo book of ca €72bn worth of loans (original face value) will be in the region of €33bn. This estimate referred to the mid-range assumptions.

In the light of today's speculations/reports (here) that the final Tranche 2 haircut on Anglo loans will be 61.93% I am now more confident in my original lower- and mid-range estimates, though adjusting my upper margin loss estimate down a notch.

To repeat my projections are:

• Worst case scenario for Anglo requires €38.6bn (down from €38.9bn)
  
• The mid-range is €33bn in total hit (same as earlier)
  
• The best case scenario is €30bn (same as earlier)
  

Some details: Tranche 2 of Anglo loans was valued at €6.75bn. Combined total amount of loans transferred to Nama in Tranche 2 is €11.9bn on an average discount of 55.6%. Tranches 1 & 2 combined is €27.2bn of the total €81 bn planned with an average discount of 52.3%. If this discount stands, remaining Tranche 3 transfers of €53.7bn to be completed by February 2011 will incur capital hit of RWA-adjusted €28.1bn - to a combined Nama-induced capital loss to all 6 banks of €42.3bn. Nama expects further €12bn to be transferred by the end of September - a highly unlikely deadline, at least if Anglo-INBS stuff were to be included here. Provisions by the

As telling as the haircuts are the assumed LTEVs - in Tranche 1 the implied LTEV was 11 percent. In Tranche 2 this is down to 9 percent. Since Nama marks to November 2009, this change can be explained either by lower quality of loans being taken on board (bad news for Nama, better news for banks) or by Nama aggressive drive into raising cash flow (good news for Nama, bad news for the banks).

Now, to my valuations. Table below summarizes:
Notice, I allow for interest margins of 1.5% pa in my mid-range assumptions. This is rather unlikely. To end of 2009, interest margin on Anglo loans (performing) was roughly 1% and this did not reflect Nama costs. In addition, my mid-range scenario assumes Nama recovering 100% of the principal amount of the loans - something that I believe to be equally unlikely. Either way, mid-range estimate implies that Messr Aynsley and Dukes will be coming in with new demands for cash soon - to the tune of €8.5bn more based on my mid-range scenario.

Economics 23/8/10: ECB & IRL bonds

Per report today: "FRANKFURT, Aug 23 (Reuters) - The ECB said on Monday it bought and settled €338mln worth of bonds last week, the highest amount since early July and bolstering recent market talk it had ramped up purchases of Irish bonds. The amount is well above €10mln of purchases settled the previous week... It follows recent comments by market participants that the ECB bought 60 million euros of 2012 Irish government bonds just over a week ago, after spreads over German Bunds ballooned. The ECB has not given any details of its bond buying."

I speculated after last auction results were announced by the NTMA that extraordinary level of cover (x5.4) on 4 year bonds issue looked strange and that ECB buying might be the case. To remind you - NTMA sold €500mln of 4-year bonds. It now appears that the ECB did indeed engage in potentially substantial buying of Irish bonds. If so, such buying cold have

1. pushed other purchasers out of the shorter term paper into 10 year bonds; and/or
2. pushed yields on both shorter and longer term paper down.

€338mln figure includes trades executed between August 12 and August 14 - the auction of shorter term paper that is known to have involved ECB buying.

All in, we are clearly now in the yields zone where the markets are happy to watch us lean on ECB, the ECB is happy to watch us skip one-legged across budgetary deficit that keeps opening up wider and wider. Clearly, such an equilibrium is unlikely to be stable. Expect some fireworks once markets come back to full swing a week from now.

Economics 23/8/10: Is ECB contradiciting itself on banks stability?

Updated below

Here is a note of the day, to be followed by a question of the day:

ECB's Axel Weber (a 'hawk' in his pre-crisis life) is proposing in the FT today that the ECB should extended unlimited refinancing operations for Eurozone banks up to three months until at least early 2011.

This call, if followed upon, would

1. make it harder for the ECB to execute any serious QE exit strategy,
2. shows that the situation in the EU banking sector remains critical;
3. indicates that forward looking central bankers, like Weber don't really believe that the funding markets are ready to properly price the risks of European (including, of course, German) banks, even in the short run (under 1 year);
4. shows clearly that despite statements to the contrary, ECB governors (at least some) don;t really buy into the idea that Euro area banks will be able to unwind, absent ECB help, the €1.3 trillion in debt coming due in the next 2 years.

Now, question of the day: If the EU stress tests were anything better than a shambolic PR exercise (I don't think they were, but let's entertain the idea), why would ECB need to worry about the banking sector funding situation? After all, the tests, allegedly, have shown that Eurozone banks are well capitalized and present no systemic risk.

So either the tests were useless (in which case Weber is right in his call) or ECB has no business continuing priming the liquidity pump (in which case Weber is wrong in his call).


And a couple of hours after my question of the day note above, Bloomberg weighed in with a mighty crack at the ECB's position (here).