24/10/2011: Euro CDS disaster Redux?

A picture (table) worth a 1,000 words...

via CMA.

24/10/2011: Euro area competitiveness indicators update

ECB posted updated Harmonized Competitiveness Indicators data for Q2 2011

Chart above shows that euro area HCI (unit labour cost adjusted) have deteriorated (higher values in the graphs reflect lower competitiveness) from 96.4 in Q1 2011 to 99.2 in Q2 2011. Q2 2011 reading was 2.5% above Q2 2010 reading, but 6% below Q2 2009 reading. Relative to Germany, euro area HCI(ulc) index now stands at 17.4% premium, reflecting relatively much stronger competitiveness of German economy.

Considering the charts above (note that the top chart reflects annualized data, while quarterly data is shown in the second chart above), Ireland retains its relatively uncompetitive position vis-a-vis all 'old' euro area countries. For larger economies:

• Germany's HCI(ulc) rose from 82.6 in Q1 2011 to 84.5 in Q2 2011, marking deterioration in competitiveness qoq. Year on year, index is not 3% higher, and the gains in competitiveness since 2009 have been virtually erased, as Q2 2011 index reading is just 0.3% below Q3 2009 reading. However, Germany remains the most competitive economy in the euro area in terms of HCI(ulc) index with own index reading currently 14.8% below euro area overall index.
• Spain's HCI(ulc) was virtually unchanged, rising from 107.3 in Q1 2011 to 107.4 in Q2 2011. Spain's competitiveness index has fallen (improved) by 2.0% yoy in Q2 2011 and is down 5.0% on same period 2009. Spain remains 8.3% less competitive than the euro area and 27.1% less competitive than Germany.
• France's HCI(ulc) deteriorated from 102.6 in Q1 2011 to 104.2 in Q2 2011, rising (deteriorating competitiveness) 1.8% yoy and 0.1% no Q2 2009. Relative to Germany, France is 23.3% less competitive in terms of HCI(ulc) and 5% less competitive than euro area.
• Italy's HCI deteriorated from 110.1 in Q1 2011 to 111.2 in Q2 2011, rising (deteriorating competitiveness) 1.65% yoy and improving (falling) 1% on Q2 2009. Relative to Germany, Italy's HCI is now at 31.6% premium (poorer competitiveness) and Italy is 12.1% less competitive than euro area average.

Smaller economies are charted above.

For Ireland, HCI(ulc) also posted deterioration in Q2 2011 rising from 113.2 in Q1 2011 to 113.8 in Q2 2011, marking decline in Ireland's competitiveness as measured by HCI. Ireland's competitiveness, however, improved yoy by 1.6% and is up on Q2 2009 level by 12.1%. Despite these gains, Ireland remains the least competitive 'old' euro area economy with Ireland's competitiveness gap of 34.7% compared to Germany and 14.7% compared to euro area.

As I have noted on numerous occasions before, much of the gains in our competitiveness in 2009 can be explained by the wholesale destruction of less competitive sectors: construction and domestic services (retail, security etc). The concern is that our future competitiveness gains will be compressed by the fact that from here on, we will need much harder to attain productivity growth in remaining sectors. So far, some nascent costs inflation in other economies have helped us to continue improving compared to euro area average. But in absolute terms, it is clear that since Q2 2010 we have lost momentum in gains in HCI(ulc) measures.

24/10/2011: New Orders for Industry: August data

Cheerful update today from the Eurostat on New Orders in Industrial Production series:

"In August 2011 compared with July 2011, the  euro area (EA17) industrial new orders index rose by 1.9%. In July the index dropped by 1.6%. In the EU27 new orders increased by 0.4% in August 2011, after a fall of 0.6% in July. Excluding ships, railway & aerospace equipment, for which changes tend to be more volatile, industrial new orders rose by 0.7% in the euro area and by 0.5% in the EU27. In August 2011 compared with August 2010, industrial new orders increased by 6.2% in the  euro area and by 6.5% in the  EU27. Total industry excluding ships, railway & aerospace equipment rose by 5.0% and 5.2% respectively."

Here are the details:

Start at the top: EU17 new orders index is now at 115.11 for August, up on 112.93 in July, down on 115.54 in May. The index is now back into the comfortable expansion territory, where it has been since April 2010. 

2008 average reading was 110.09, 2009 average was 86.99 and 2010 annual average was 102.2. So far - through August - 2011 average is 112.93 - not a bad result. But miracle it is not - reading of 100 is consistent with activity back in H1 2005, so in effect, through August 2011 we have achieved growth of 2.05% annualized in terms of volumes of output. Given that since then we had pretty hefty doses of inputs inflation and moderate gate prices inflation, the margins on the current activity have to be much lower than for pre-crisis years. Which means relatively robust improvements in volumes of industrial new orders are not necessarily implying robust value added growth in the sector.

Meanwhile, German new orders have shrunk in August 2011 from 122.4 in July to 120.9 in August. Month on month German new orders are down 8.04% and year on year activity is down 13.34%. This marks the lowest reading since April 2011.

 Of the big players:

• France posted an increase in new orders index to 102.90 in August from 100.1 in July. France's 2011 average to-date is 100.43, well ahead of 2010 average of 90.93 and 2009 average of 84.31. France's new orders index averaged 100.06 in 2008.
• Spain posted a surprising improvement in August to 96.43 from 93.85 in July and yoy rise of 2.0%. Spain's 2008 average was 102.93, 2009 average of 81.57 and 2010 average of 89.61. For 8 moths through August 2011, Spain's new orders index averaged 94.27.
• Italy;s new orders index hit 117.21 - very robust increase of 6.14% mom from 110.56 in July. Italy's new orders index is now averaging 113.58 for eight months of 2011, up on 2010 annual average of 103.09, 2009 average of 89.75 and 2008 average of 104.59. It's worth noting that Italy exemplifies the fallacy of 'exports-led growth' argument - the country has posted very robust recovery in its significant and highly exports-oriented industrial sector, and yet it also posted virtually no growth over the last 2 years.

Other countries are illustrated below.

 So on the net, industrial production new orders signal some bounce back from the troughs of the slowdown in early summer 2011, but this can be immaterial for the wider Euro area economic growth and a temporary improvement. September and October data will be more crucial, signaling into early 2012.

24/10/2011: Some interesting links

Couple of interesting links on various topics of the crisis:

Fist, my most recent post for The Globe & Mail EconomicsLab: Europe’s (non) bailout plan predictable in its absurdity

Second, a very good graphic from NYTime on debt-default interlinks globally: Chart 1 and an interactive version here.

Third, some interesting points on global yield curves here.

And lastly, a good summary of contagion dynamics from the zerohedge blog which roughly outlines the scenario that I presented on Friday, October 14th, at the American Bar Association meeting in Dublin - that of the inevitable destruction of the euro as we know it (either in composition or in its totality) - here. 

24/10/2011: Budget 2012 - doing the right thing right

This is the unedited version of my article in Sunday Times (October 23, 2011).

As the Troika gives another ‘thumbs up’ to our fiscal policies, the reality check on our medium term fiscal objectives suggests that the real cuts are yet to come.

Staring into the barrel of the next budget, the Irish nation is now slowly, but surely coming around to the realization that the medicines for our twin malaise of unsustainable debt and deficit to-date not only failed to cure the disease, but instead made it virtually incurable.

Now the fourth year into the austerity, per latest figures, Irish budget deficits for H1 2011 remain stuck above 13% of the country GDP. Taken against the more realistic metric, GNP, the shortfall between Exchequer spending and revenue is running at ca 17.6%. Even per Stability Programme Update, current expenditure – stripping out banks measures and capital investment, for 2011 is expected to run ahead of the 2010 levels.

Austerity, to-date, has been visible solely in capital investment cut backs and tax increases on personal incomes of the households. The rest of the ‘savings’ are really a game of shells – shifting expenditure from one side of the balance sheet to the other. In medical terminology, courtesy of the Irish Government choices of policy tools, our economy is now like a body consuming itself from the inside.

Quarterly National Accounts clearly show that Gross Fixed Capital formation in the economy is no longer sufficient to cover amortization and depreciation on private and public capital stocks accumulated between 2004 and 2008.

Meanwhile, in nine month through September this year, income tax alone accounted for 38.4% of the entire Government tax revenues, up from 28.4% for the same period of 2007.

Taking out tax increases, Irish Government austerity has delivered no real, long-term changes to-date. Neither public sector pensions, nor numbers employed, nor public wages paid relative to comparable grades in the private sector have seen much of a change worth talking about.

Adding more injury to the economy, tax increases have been concentrated at the top of earnings distribution, creating in effect the unsustainable environment where by our exports-oriented, higher value-added economy is being starved of the main input into its activity – human capital.

In 2009, Irish residents earning ca €58,000 and above, faced an average income and social security tax burden of 39.9% - ahead of the OECD average of 39.4%. The OECD average tax calculations do not adjust for the fact that whilst in Ireland income tax and social security levies and charges yield no tax-specific benefits, in other countries, social security charges include payments into private pensions and insurance funds. After Budgets 2010 and 2011, and adjusting for private pensions and health insurance contributions, this figure has most likely risen to above 45%.

Lacking competitively priced access to early education, childcare, healthcare and transport services taken for granted in other European member states, Ireland has now lost its competitive edge in attracting, retaining and developing skills needed for successful growth of our core modern sectors: research-intensive pharma, biotech and ICT, and skills-intensive international financial and legal services, business analytics and creative industries.

All of this means two things for the forthcoming Budget 2012 and for the medium term budgetary framework. Firstly, to restore Irish public finances back to health, the next four budgets will require dramatic cuts in the current public spending. Second, there is no room for new tax revenue measures.

Any further increases in taxation even at the lower end of the earnings spectrum will increase effective tax burden on highly skilled workers. This will act to further undermine our economy’s competitiveness in the core growth areas of the skills and knowledge-intensive sectors.

The problem is not a trivial one. Currently, there are between 3,500 and 5,000 vacancies in the ICT sector alone that cannot be filled by indigenous and multinational employers in Ireland. Despite the fact that ICT workers have the highest private sector average earnings of all sub-sectors in Ireland and enjoy average earnings almost 20% above their EU counterparts, companies cannot fill these vacancies. The reason is simple – we are not competitive, compared to our European counterparts, when it comes to the value for money that our after-tax earnings provide.

And this problem is not restricted to ICT sector. In the last two months at least seven internationally competitive researchers previously working in top Irish universities and institutes have packed their bags and moved overseas, leaving highly paid positions to seek better value for money and career opportunities abroad.

The next Budget must, therefore, address the problem of current spending overhang by cutting into the most painful areas of spending: social welfare, education, health and public sector employment bills.

Education-related spending has remained constant over the years of this crisis, accounting for ca 18% of the total budgetary allocations in the nine months through September 2008 and in the same period of 2011. Department of Health share of total expenditure has risen from 27.9% in 2008 to 30% in the nine months through September 2011. Social Protection share rose from 19% in 2008 to over 30% so far this year. Combined, three top spending heads accounted for almost 79% of the total voted expenditure by the State in 2011 to-date. Year on year, for the period of nine months through September 2011, there has been zero change in Education spending, a 10% increase in Health spending and a 4% increase in Social Protection.

Any serious effort at fiscal austerity requires much more dramatic cuts in these three departments.

Combined deficit reduction measures between 2012 and 2015, envisioned by the agreement with the Troika add up to €11.8 billion. Last week, the Fiscal Council has correctly proposed revising this figure up to €15.8 billion, to be delivered with €4.4 billion adjustment in 2012 and €3.7-3.9 billion every year thereafter. In my view, the measures are not front-loaded enough. In my view, Ireland’s economy will require €5.0-5.5 billion adjustment in deficits in 2012 and 2013, followed by €3.5 billion in cuts in 2014 and a €2 billion or less cut in 2015 to the total target for deficits reduction of €16-16.5 billion.

Such frontloading of cuts is required to control for the risk of further economic slowdown in 2012-2015, with 1% reduction in nominal growth rate potentially leading to a debt/GDP ratio deterioration to above 120% and even more dramatic decline in debt sustainability as measured against GNP. Frontloading is also need to provide a buffer against the expected increases in interest rates in post-2013 environment. Current inflation rates and growth dynamics within the euro area imply optimal ECB rates in excess of 2.5%. 2012-2015 period is likely to see significant increases in ECB rates, leading to an uplift in overall debt financing burden for companies and households in Ireland. With Ireland’s private sectors debt well in excess of the majority of our euro area counterparts, imposing more austerity in later period of fiscal adjustment can risk coinciding with the period of reduced private debt affordability and lead to a simultaneous adverse shocks to growth. Lastly, frontloaded cuts will act to rebalance future growth expectations for 2014-2015, helping to restore some investment activity in the economy.

Of the above measures, only about €3.5-3.7 billion can be expected to come from increased tax revenues driven by organic growth in economic activity not new taxes. No more than €1.2-1.5 billion more in savings can be generated by cutting deeper into capital expenditure. This means that the Government must find some €11-12 billion in current spending cuts over the next four years. Spread across current weights of specific top spending heads, this implies cuts of €2 billion in Education, and ca €3.3 billion in Health and Social Protection, each. Much of these cuts will have to come from involuntary redundancies and possibly cuts to indexation awarded previously for existent public sector pensions.

If management is doing things right, and leadership is doing the right things, as Peter Drucker remarked, Ireland’s Government has no choice but exercise both in the forthcoming Budget.

Box out:

The latest European Commission proposals for banning credit ratings changes for euro countries applying for EFSF or IMF rescue funds is the embodiment of the complete detachment of the European leadership from the realities of financial markets. Instead of dealing with the pressing issues of spreading contagion, the EU Commission has largely remained in its usual modus operandi since the beginning of the sovereign debt crisis, seeking new and ever-more elaborate means for raising new taxes, banning markets activities that actually act to increase markets transparency and efficiency, such as short-selling and independent ratings, while issuing vast encycliae on economic growth, invariably based on some new subsidies, state supports and other markets distortions. As with other ‘measures’, the latest proposal can backfire spectacularly. Rating agencies, only recently burned by their own failures to properly assess risks of complex securitized products relating to the US mortgage loans, have been rebuilding their reputations by re-asserting independence and pushing stronger ratings discipline through. In the presence of the ban, off-shored rating functions will be more likely to more severely downgrade euro area sovereigns seeking emergency funding, just to show the markets their own models robustness. Someone should tell the EU Commission that spitting into the hurricane wind might not be such a good idea.

23/10/2011: Economic Freedom of the World 2011

Couple of weeks ago, Ireland's Open Republic Institute and Canada's Fraser Institute published annual Economic Freedom of the World Index - the most comprehensive and academically credible index of institutional quality of economic environments around the world. Unlike other similar indices, EFW uses latest comprable available data for all countries in the index and undertakes detailed assessment of the largest number of criteria in arriving at its final rankings.

The results for Ireland are not good. As well as for Europe overall.

No EU countries in top 5 ranks, only one EU country in top 10 and no Euro area country in top 10. In top 20 ranked countries group, there are only 3 Euro area core EU countries, with 3 more Central and Eastern European states. Ireland ranks only 25th in the world - an extremely poor performance, given that last year we were ranked 11th and in 2009 index we were ranked 9th.

Overall, chart below shows historical trend for Ireland:

We are now ranked back in the position that is consistent with economic environment-determining institutions quality that is worse than the entire 1980s!

Charts below summarize the sources of our underperformance:

The data above refers to performance parameters for 2009. Since then, Irish economic conditions and policies have deteriorated substantially so we can expect further downgrades in the index.