Economics 6/11/10: Two charts - IRL & Spain

Two interesting charts on 5 year bonds for Ireland and Spain, courtesy of CMA:
What's clear from these charts is the extent of inter-links between banks and sovereign credit default swaps. In Spain at least three core banks - La Caixa, BBVA and Banco Santander act as relative diversifiers away from the sovereign risk since late October. In Ireland - all of the banks carry higher risk than sovereign. Another interesting feature is a significant counter-move in the Anglo CDS since late September. This, undoubtedly underpinned by the large-scale bonds redemption undertaken by Anglo at the end of September. Thirdly, an interesting feature of the Irish data is that CDS contracts on Anglo, IL&P and AIB are now trading at virtually identical implied probability of default.

Lastly, Irish sovereign debt is now trading at probability of default higher than that of the Spanish banks!

Economics 4/11/10: Early DofF Estimates for Budget 2011

DofF has published some preliminary projections for Budget 2011 tonight, titled "Information Note
on the Economic and Budgetary Outlook 2011 – 2014 (in advance of the publication of the Government’s Four-Year Budgetary Plan)". Catchy, isn't it?

Here's my high-level read through:

1) pages 2-3 (note DofF couldn't even number actual pages in the document) present some rosy scenarios concerning growth. Most notably, DofF doesn't seem to think that Dollar is going to devalue against the Euro significantly in 2011. As if QE2 will have no effect or will be offset, under DofF expectations by a QETrichet. This is non-trivial, of course. Price of oil is expected to rise by 10.4% over 2011, but dollar will devalue by just 3.7% and sterling by 2.3%. Absent robust demand growth (per DofF-mentioned global slowdown) what would drive oil up at a rate more than 4 times dollar devaluation? This is non-trivial - any devaluation of sterling and dollar will impact adversely our exports and will increase our imports bills, chipping at GDP and GNP from both ends.

2) "in overall terms, real GDP is projected to increase by 1¾% next year (GNP by 1%). This takes account of budgetary adjustments amounting to €6 billion, which are estimated to reduce the rate of growth by somewhere in the region of 1½ - 2 percentage points. Nominal GDP is set to grow by 2.5% in 2011, implying a GDP price deflator of ¾%." Errr... ok, I can buy into low inflation, but... folks - DofF is talking tough budget. which will mean inflation on state-controlled sectors is going to be rampant. To keep total inflation at just 0.75%, you have to get either a strong revaluation of the euro (ain't there, as we've seen in (1)) or a strong deflation in the private sectors (possible, but if so, what would that do to Exchequer returns and to domestic activity? Interestingly, DofF refer to HICP, not CPI when they talk about moderate inflation of 3/4%. Of course, they wouldn't dare touch upon the prospects of our banks skinning their customers (err... also shareholders, rescuers etc) with mortgage costs hikes.

3) Now, consider that 1.75% growth in real GDP and 1% growth in GNP. Where, exactly will this come from? IMF projection for WEO October 2010 (before Government latest adjustment in deficit announcement) factored in 2.277% growth in constant prices GDP for 2011. DoF says that the reduction in Government consumption will amount to 1.2-2% point in the rate of growth. This is, I assume, before factoring in second order effects of higher taxation measures - just a brutal cut. So IMF, less DofF estimate leads to growth rate of 0.227-1.077%, which is less than what DofF assumes. Of course, that range - with a mid-point of 0.652% still does not capture the adverse effects of increased taxes and other charges, which - if we are to take €6bn headline figure for deficit reductions, applying 1.2-2% of GDP net adjustment on expected Government consumption side and factoring in stabilizers of 20% implies that DofF is aiming to get well in excess of €1.9-3bn in new revenues in 2011. Of these, maximum of €1.1-1.2 billion can be expected to arise from DofF forecast growth, leaving €0.8-1.9bn to be raised from tax increases and other charges. Apart from being optimistic, it does look to me like DofF didn't factor the effects of this into their growth projections.

4) About the only realistic assumption that DofF makes is that investment will contract by far less next year than in 2010. The reason is simple - stuff is going to start falling apart in private sector, so companies will have to replace some of the capital stock sooner or later. I can tell from here whether investment will fall 6% (as DofF assume) or 10%, but I doubt there is much upside from DofF assumption. The problem is that if you expect investment goods decline to be reversed on plant and machinery side (continuing to allow for investment to fall further on housing and construction sides) you are going to get an increase in imports, as we import much of equipment we use. So I suspect imports are going to rise more than 2.75% that DofF factored into their estimates.

5) I also think DofF are too optimistic on the employment contraction side. The Department assumes -0.25% change in overall employment levels in the Republic. I would say that several longer term trends are going to push this deeper into the red: pharma sector restructuring, continued shutting down of MNCs-led manufacturing, declines in public contracts etc.

6) All of the above is crucial, as per Table 3 we can see that even with the €6bn taken out, 2011 Exchequer balance will be exactly the same as in 2010: €19.25bn deficit in cash terms. In other words, folks - of the total €6bn in cuts almost €3.1bn will go to cover... errr... you've guessed it - BANKS! another €1.25bn to cover interest on the BANKS rescue notes (net under Non-voted expenditure). More bizarre, unless you understand our Government's logic, which escapes me - our Current Expenditure will not fall next year at all. Instead it will rise from €47.25bn in 2010 to €49.75bn in 2011, while Current Revenue will fall by €500mln, leaving our Current Budget Balance at -€16.25bn - deeper than -€13.5bn achieved this year. Under this arithmetic, the only way this Government can claim that it will be on any track in the general direction of 3% deficit by 2014 is by building in some mighty optimistic assumptions on growth side, plus projecting no further demands for funding from the banks.

7) Now, let me touch upon the last part of the concluding sentence in (6) above. Oh, boy. The Government, therefore is reliant on €31bn in promisory notes to cover the entire rescue of the banking sector. Yet, not reflected in any of DofF estimates, AIB's latest failure to raise requisite capital is likely to cost this Government additional €2bn on top of already promised funds. Toss into the mix expected losses for 2011-2012 on all banks balancesheets, and you get pretty quickly into high figures. Let's suppose that the whole banking sector will cost the state ca €60bn (this is well below my estimate of 67-70bn, Peter Mathews' estimate of 66.5bn, etc). The state will be on the hook for some €29bn more in 'promisory' notes. Suppose none are redeemed and no new borrowing against them takes place. The gross cost per annum of these notes will be roughly at least what DofF estimated for €31bn or €150mln in 2011, while the borrowing requirement for the state will have to go up by €2.9billion annually (if structured as previous promisory notes).

Overall, I have significant doubts that the numbers presented in these early estimates will survive the test of reality. However, the Department of Finance seemed to have gotten slightly more realistic in these estimates, when compared to the stuff produced a year ago. It remains to be seen if the learning curve is steep enough to get them to reach full realism by the Budget 2011 day.

Economics 3/11/10: Live Register update

As promised, here are the updated charts for the Live Register:
Unemployment (implied rate) above clearly shows the relative size of adjustment over the last 3 months. Chart below shows the last 4 years worth of Live Register:
Next, rates of change
Monthly series clearly showing some serious decreases over the last 2 months.

Economics 3/11/10: Live register

Being away from Dublin this week means I am missing both the Exchequer returns and Live Register data. I will, of course, update the charts on both in due time - probably closer to the weekend.

While I am away, here is the best analysis of the LR data I've seen so far (well done, Brian!) issued earlier today by the NCB Economics team:

" On a seasonally adjusted basis there was a monthly decrease of 6,600 in the Live Register (unemployment claims) in October 2010, following a fall of 5,400 in September. This is the largest monthly fall in the numbers on the Live Register in the last ten years

[I seem to think it is in 14 years, but I might be wrong - again, need my trusted database off my trusted Apple to check]

In terms of flows in/out, which are not seasonally adjusted figures, there were 49,827 new registrants on the Live Register in October. 62,691 persons left the register in October.

It does appear as if job shedding is easing in the economy with redundancies (separate statistics from Live Register) in September down 30% from September 2009 levels . In Q3 2010 redundancies were down 24% from Q3 2009, but despite this the rate of inflows into the Live Register is still elevated highlighting that net job creation is still anaemic given the growth in the labour force.

We have no timely data on employment creation and emigration. In other words it is impossible to decipher whether emigration rather than job creation is causing the large outflows from the live register. It is likely a combination of both, as even in the good times Ireland was characterised by a large amount of churn in the labour market, with for example approximately 13% job gains in 2006 versus 10% job losses for a net gain of 3%. This points to the flexibility of the Irish labour market, which is ultimately required for Ireland to dig its way out of its problems.

The standardised unemployment rate in October was 13.6%, down from 13.7% in September and the peak of 13.8%."

So my two cents to add are:

• Decreases in long term claimants numbers (173 yoy) are small compared to unadjusted decreases in short term claimants (36,008 yoy) suggesting that we might be witnessing some exits from the long term list of older LR recipients (by duration, not age) and simultaneous transfer of newer vintage LR recipients into the long term lists. If true, then it is more likely that as older LR claimants lose their benefits or migrate or both, newer recipients move into their places.
• Net decreases in LR claimants can be accounted in part by the terminations of JB claims and failures to secure means-tested JA status.
  
• The numbers of part-time and casual workers on LR is still rising (+ 1,045 mom), suggesting that quality of employment (remember, we are after higher quality jobs in this country, aren't we) is deteriorating.
• 3,100 exits from the LR are accounted for by workers of age 25 or less, in other words the very demographic that is more likely to engage in education or is at a higher risk of emigrating, suggesting that a significant proportion of the LR decrease might have little to do with net jobs creation in the economy.
• Lastly a quick comment on labour force flexibility referred to in NCB note. In my view,w e do have much more flexible flows out of the country (disregard for now inflows into the country, as these hardly matter in our current economic environment). However, in contrast with previous recessions and certainly in contrast with 2006, the little data we have shows that foreigners and younger Irish are dominating the outflows through emigration, while the longer term unemployed of older age and middle-aged families are stuck either due to lack of skills (the former) or due to negative equity (the latter). This implies that if the current trends continue, we are at a risk of encountering significant drain of talent and human capital out of this country. Of course, our bankruptcy laws will make it impossible for those who emigrate alongside defaulting on a mortgage to come back into the country when recovery takes place.
  

Economics 2/11/10: Spot the odd ones out

As of yesterday's close, implied probability of default based on CDS spreads and spreads themselves are:
Source: CMA.

Economics 31/10/10: Mortgages, relief and stimulus

David McWilliams' idea of deferring mortgage repayments for 2 years is continuing to generate some discussions in the 'new' media. Here are my thoughts on the topic.

David's idea starts from the right premise that households are currently suffering from mortgage/debt repayment burden that is non-sustainable in the current economic conditions and acts to depress consumption and household investment. But in my view, it is not going to yield any significant impact on the economy.

As expected incomes fall due to:

• continued recession in the economy (courtesy of the insolvency crisis we face across the entire economy);
• elevated risk of unemployment (ditto);
• rising tax burden on households (courtesy of the Government's perverse logic which puts the needs of financial services and Exchequer ahead of those of the real economy - households and firms);
  
• heightened risk of further tax increases in the future (ditto);
  
• behavioral implications of the severe and deepening negative equity (being further reinforced by the FR and Government denial of the problem and asymmetric treatment of development debts and household debt); and
• continued increases in the cost of mortgages finance and credit (courtesy of the Government approach to dealing with the banking crisis)
  

Irish households are indeed under a severe financial stress. This stress is amplified by the adverse selection of younger (and thus more heavily leveraged) households into the higher risk of unemployment. These very households are also more important contributors to future private investment side of the economy, as older households are dis-saving to consume.

Collapse of consumption and household investment we are witnessing today is the direct outcome of the above forces and it will continue to worsen as long as households' disposable after tax incomes continue to decline and remain at risk of further pressure. In addition, non-discretionary segment of consumption (energy, education, transportation and health) show no signs of price deflation, implying that discretionary disposable after tax income - the stuff we get to spend in the shops or invest - is even more distressed.

The problem here is not that we face a temporary shock to our income. The problem is of debt overhang - basically, the insolvent nature of our households' balancesheets.

Thus, any solution to this problem will require a permanent debt writedown. It cannot be resolved by temporarily suspending mortgages repayments for several reasons:

1. Temporary suspension of mortgages repayments will not draw down the overall debt burden, as banks will reload increases in mortgage finance costs into the future to offset for losses incurred during the holiday even if there is no roll up of interest during the holiday. In other words - suspending mortgage repayment for 2 years will likely lead to banks pushing even higher cost of mortgages interest into years 3 and on for all households concerned;
2. Any rational household will anticipate (1) above to take place and will ramp up precautionary savings to compensate for expected cost increases in their mortgages, withdrawing even more cash from today's consumption. A mortgage holiday in these conditions will lead to zombie banks turning into zombie households;
3. Any rational household will, also in anticipation of (1) withhold any purchases of property until the full realisation of true future mortgage finance costs takes place post holiday;
   
4. If any suspension of mortgages finance involves rolling up of the interest for 2 years, the burden of future mortgage liabilities will increase dramatically, which, once again will be anticipated by the rational households. As a result, households will take 2 years worth of 'free' rent and then default at the point of interest roll up kicking in. We can expect a wall of mortgages defaults in 2013;
   
5. In order for the repayment holiday to have any real effect, the long term growth rate in personal disposable income will have to exceed: increase in the cost of mortgage finance post-holiday + inflation - tax increases expected. This, using current growth estimates etc suggests that in order for a 2 year holiday on repayment of mortgages to have any positive effect, our aggregate expected growth rate in personal income should be in excess of 50% in years 2013-2018. This is clearly not anywhere near being realistic.
   

Once again, the problem we face is the size of leverage taken on by the Irish households. Whether reckless lending or borrowing or both caused this problem is irrelevant. Households become long-term insolvent when their total debt liability rises above 4-5 times their earnings even in the moderate growth in income environment.

We have - on aggregate - households facing:

• current long and short term debt burden of ca 145% of GNP, and
  
• expected (2014) sovereign debt burden of ~140% of GDP or ca 165% of GNP (under rather optimistic assumptions on GDP/GNP gap) - at least 80% of this will have to be repaid out of the pockets of our households.
  

The problem is that these headline figures conceal imbalances in distribution of debt.

While on per-capita basis the overall household debt liabilities amount to ca 310% of our national income, in real terms what matters is the incidence of the debt on productive households. We currently have ca 41.3% of population in employment (or 1,859,000). Of these, 552,900 are in the age group of 25-34 years of age, 469,600 are in 35-44 years of age and 393,900 are in the age group 45-54 years of age. Assume that the demographic pyramid does not change (for better or worse) in the next 10 years. Total employment pool of those that can be expected to carry the debt burden is actually closer to 1.42 million or 31.5% of the total population of the country.

This raises public and household debt leverage ratio on population that can be expected to repay it to a whooping x10 times household income. This, folks, is a bankruptcy territory for roughly speaking 1/3 of our entire population or for nearly 100% of our productive population.

A 2 year holiday from mortgages repayment will simply not solve this problem. Only significant debt write-off of household debts or full restructuring of our sovereign debt and deficit (to eliminate the need for future tax increases and reverse recent tax increases) or a combination of both will be able to correct for this severe debt overhang.