Irish policy & rising jobs losses

750 job losses at First Active, over 2,800 jobs losses last week alone... we are in a meltdown mode by all possible means and the social partnership, the government and most of the opposition are clearly out of depth on what needs to be done.

I said 'most of the opposition' because there are pieces and bits of forward thinking still coming through in a handful of statements issued by FG and Labour. However, these do not, as of yet, represent a credible and effective platform for a policy response.

Here is a statement from Fine Gael Enterprise Spokesman Leo Varadkar TD issued today:

"Fine Gael has called on the Government to waive PRSI payments in 2009 for companies taking on new employees, declare war on red tape, launch an immediate review of overpriced electricity and gas charges, and impose a freeze on local authority charges and Government levies. The Government must also scrap the damaging VAT hike in the Budget, and overhaul FÁS into a rapid reaction agency which can provide public works schemes for the unemployed.”

Good beginnings of a policy here, but take a deeper look:

• Waiving PRSI payments in 2009 for companies taking on new employees is, in effect, a subsidy for jobs creation, not for jobs retention. On the margin, it is an incentive to create lower-end jobs, but it will do nothing to preserve thousands of financial services jobs;
• Declaring war on red tape is simply sloganeering. Most of our red tape comes from Brussels and the Irish Government has no say on this. Instead, culling the army of quangoes that mushroomed in recent years and rebating the savings back to the taxpayers might help;
• Reviewing energy prices - a good idea, but beware: it will spell an end to the Green Party agenda of subsidising wind and other alternatives via minimum price guarantees. I personally have no problem with this, though;
• Freezing local charges and levies - at current levels - will do nothing more than provide an injection of a vitamins potion to a dying patient. We need a wholesale reform of the local authorities structure to lead in cutting - dramatically - these costs;
• VAT increases must be scrapped, and in fact, a cut in the VAT rate should be implemented, but the main problem is in declining after-tax incomes, not in rising consumption expenditure;
• Overhauling Fas into some sort of a lean, mean jobs-creation machine ignores the basic problem with this organisation - no state body can 'create' jobs. The best Fas can do is take money from the taxpayers and spend this money on token training programmes. The efficiency of such programmes to date has been €250K spent per job added. Even if Mr Varadkar manages to cut this by 2/3rds, it will still be more than €2.40 spent per €1 in average wages added. You might as well pay the unemployed that €1 in welfare and burn the remainder €1.40 in a fireplace. At the very least you'll get some heat - more than what you'll get out of 'overhauled' Fas. For a real solution to the Fas problem - see the second bullet point above.

This brings us to the issue of what should be done. The main problems, as I have pointed on numerous occasions, faced by our economy are:

1. Public sector insolvency;
2. Households' and companies' indebtedness; and
3. Uncompetitive domestic economy dragging down exports growth with it.
   

All three require a small number of resolute measures.

Public Sector: cut the spending (capital and current) by ca 10-15% and use one half of that to plug the deficit hole, while the other half should be rebated to the households to pay down homeowners' and pensions' deficits;

Households' balancesheets: the above will address, in part, the issue of precautionary savings demand and repair household balancesheets. More, though will be required to restore demand for credit, so use banks recapitalisation scheme to raise equity in the banks and rebate this equity back to the households via a voucher-like scheme;

Companies balancesheets: Many of the domestic Irish companies struggling today are, frankly, insolvent and incapable of operating as an ongoing concern in the environment where growth is slower than 4% per annum. These must be allowed to fail. As there is no better mechanism to sort the sick from the healthy than the market, the State should resist the desire to 'repair' companies' balancesheets. Instead, the state should enact emergency cuts in local authorities budgets and cut local authorities charges and tax cuts to consumers to stimulate demand (see below). One policy on business side to be enacted should involve a PRSI tax cut and the introduction of the full credit for private health insurance purchases against the health levy contributions.

Local Authorities & Quangoes/Regulatory Authorities (RA): Within 4 months, the Government should produce the first draft of a local authorities reforms package cutting the number of local authorities down to 4 - GDA, North East & Midlands, West and South. The savings to be achieved in this reform should be set at a minimum 50% of the combined budgets of the current authorities being pulled. A comprehensive review of the Quangoes and Regulators must be carried out by a non-political independent panel working in a transparent, open manner, reporting by April 1 2009. The objective should be to:

• completely and effectively separate regulatory authorities from their respective sectors and the Government;
• introduce effective RAs oversight by the Dail;
• reduce the number of quangoes by at least 75% and the number of RAs by at least 30%, with corresponding reductions in staff and budgets; and so on.

Domestic economy reforms:

(1) Tax policies:

• cut VAT back to 17% across the board,
  
• cut CGT to 15%,
  
• replace stamp duty with a land-value tax (or a variant of such) phased along some amortization schedule for stamp duty paid by the existent homeowners;

(2) Structural reforms

• dissolve the Social Partnership;
• privatise - via a public voucher system for disbursement of state shares - all semi-state enterprises (those state enterprises that hold more than 50% market share in their respective sectors - e.g ESB, CIE, DAA, VHI, etc) must be broken up in the process of privatisation;
• beef-up the Competition Authority with direct enforcement and prosecution powers;
• reform CBFSAI to detach it completely from the Department of Finance.

This is, by any measure, only a partial list of priorities. In fact, if anyone wants to add to the list, feel free to email your suggestions to me.

Eurzone's growing pain

Willem Buiter's post makes a timely and an obvious point that the new stage of the global financial crisis is beginning to pull Eurozone monetary structures apart. Buiter starts the argument by describing a rising tide of financial protectionism:

“Consequently, we have seen two forms of re-nationalisation of banking and finance. The first form of nationalisation has been the taking into partial or complete public ownership of banks and other financial institutions deemed too systemically important (too big, to interconnected or too politically connected) to fail. This has happened virtually everywhere... More examples will follow. The second form of re-nationalisation of banking and finance is the restriction of access to the fiscal and financial resources of the nation state just to those banks and other financial entities that have a significant presence in that nation state.”

Buiter points to the lack of coherent single fiscal policy platform for the EU as the underlying cause for these developments. In particular, he stresses that the Eurozone has common monetary policy, but national regulatory environments and fiscal polices, all pulling in different directions at the time of the crisis.

“The Eurozone is in a bit of a pickle here, because although it has a central bank with supposed uniform access to its resources for all Eurozone banks, regulation and supervision remain national and fiscal bail-outs (recapitalisation by the state, guarantees, insurance, loans or whatever provided by the sovereign) definitely remain national. When the central bank acts as market maker of last resort, as the Banca d’Italia is now doing in the Italian interbank market, it takes on significant credit risk which requires a fiscal back-up - the Italian Treasury. But that undermines the principle of equal treatment of banking institutions across the Eurozone...”


Solutions:
• either a “supranational fiscal authority with its own tax and borrowing powers, accountable to the European Parliament …and the Council...” or
• “…a pan-Eurozone fund, fully pre-funded and containing, say, 2 or 3 trillion euro to begin with. This Eurofund could be managed by the European Commission, subject to parliamentary oversight and control by the European Parliament and the Council. The fund could be drawn upon to provide financial assistance to systemically important troubled banks in the Eurozone, according to guidelines agreed by the EC, the EP, the Council and the ECB. …the fund [is] to raise its resources through the issuance of bonds that would be guaranteed jointly and severally by all Eurozone member states.”

Of course, there are other solutions, which Buiter omits for obvious political reasons. These include:
1. Doing nothing, threatening a disorderly collapse of the Euro, should the current crisis continue to deepen; or
2. Partially re-introducing parallel national currencies to run alongside the Euro.

The last option is a milder version of a ‘nuclear’ first option, but desperate times do call for desperate measures.

The two solutions Buiter proposes are about as realistic as Salvador Dali’s landscapes:

• A common fiscal policy is a complete non-starter at this time.
• While a joint EU15-wide fund would be welcomed by the EU officials – ever hungry to get more power – underwriting such a fund (in excess of 32% of the Eurozone 2008 GDP) will be crippling for national governments, especially at the time when their own finances are under immense pressure from banks bailouts and fiscal stimuli.

In addition, the ages old concern of Germany and other states that the fund will be abused by the less fiscally prudent states, e.g Italy, Spain and France, constrains its feasibility, while strained sovereign debt markets are constraining the feasibility of raising such amount of money to capitalize the fund.

In this framework, unless the current downturn is reversed in the next 3-6 months, it is clear that an evolutionary process of fiscal policy responses and monetary policy constraints across the Eurozone will be creating more incentives for Balkanization of the Euro. Short of lapsing into oblivious denial of the reality, it is only a matter of managing this process that the ECB can be concerned with at this moment in time.

Public Sector: A Feast Amidst the Plague: Update I

Here is another interesting observation concerning Public Sector earnings.

The figure below clearly shows that wages in the lowest earning categories of public sector fall within 1 standard deviation of the total public sector wage (i.e the average). This disputes an argument that there is any significant degree of heterogeneity in pay within our public sector.

Statistically, this shows that not a single category of workers in the Public Sector (identified by their respective sub-sectors of employment) earn less than the overall Public Sector average.

Indeed, this data (taken from the CSO - see here) proves that within the public sector, the so-called 'low paid' areas or professions enjoy a relatively average rate of pay, with the average itself being artificially inflated by the higher earning categories. In other words, there is no pleading relative poverty for any sub-sector of the public sector employment.

PS: Did anyone notice an apparently bizarre logic our public sector trade unions have taken to in arguing against any cuts in public sector wages?

Well, they are arguing that such a cut would be deflationary (in case you have not noticed, deflation is a new evil). Thus, their argument goes, to rescue our economy out of the current crisis, one should stick to the excessive wage increases granted to the public sector employees under the last Social Partnership deal. But hold on, weren't the same trade unions also arguing that high inflation in the past made it imperative to raise wages paid to the public sector employees?

In other words, ICTU/SIPTU and the rest of them are having it both ways: inflation or deflation, they'll have a pay rise in the name of the nation's economic health...

Have a cake, eat it, and get the rest of us to pay for both?

Public Sector: A Feast Amidst the Plague

According to the latest CSO figures (here):
“Average weekly earnings in the Public Sector (excluding Health) rose by 2.9% in the year to September 2008. The index of average earnings …rose by 3.6% for the same period. Average weekly earnings rose by 1.7% in the year to June 2008 while the index of average earnings rose by 2.5% for the same period.”

Oh, no, I am not making this up. Here is an illustration from CSO's release:Only a month-and-a-half after Mr Lenihan thundered first about saving €440mln in 2008 (he actually ended the year overspending €370mln rather than saving a penny) and €2bn in 2009 (we know where that promise is going) and a month before he launched his ‘patriotic’ tax increases in Budget 2009, according to CSO:
• Public sector wages were still climbing up, while
• Public sector employment… well, shall we let CSO speak on this:
“A total of 258,200 people were employed in the Public Sector (ex Health) in September 2008 compared to 251,100 in September 2007 [a rise of 7,100]. In the year to September 2008 employment in the Education sector increased from 93,500 to 97,900, a rise of 4,400. Overall employment in the Public Sector was 369,100 in September 2008, an increase of 5,200 compared with September 2007. Employment in the Health Sector decreased from 112,800 in September 2007 to 110,800 in September 2008, a decrease of 2,000.”

Chart illustrates…
All sub-sectors of public employment are up! While the rest of the economy is buckling under the weight of a severe recession.

Oh, dear, who can now take our Brian-Brian-Mary Trio seriously?


PS: to our previous post (here):
According to CSO release today, retail sales volumes fell by 1.2% m-o-m in November, with the annual rate of decline of 8.1% (exacerbating a 7.5% decline in October). The last time the annual rate fell to these levels was in February 1984. November core sales (ex-motor) volumes fell by 1.9% m-o-m, and by 7.8% y-o-y. Car sales were down 11% y-o-y. Overall, core retail sales have now fallen - in y-o-y terms - at a rate not seen since April 1975. Consumers are clearly boycotting Brian-Brian-Mary policies and spending only on bare necessities at home, preferring to take their Euros to Northern Ireland, the UK, the Continent, the US or anywhere else where they are welcomed. In doing so, they indeed fulfill their real (ass opposed to Lenihaenesque) patriotic duty of serving their families' needs!


PPS: a fellow economist (hat tip to Brian) just asked (rhetorically) if these figures mean that we might register and unadjusted decline in December retail sails. My view - quite possibly. And January sales, and February sales, and so on, well into a -4.5-6% fall in retail sales for 2009! Laffer Curve is merciless - raise taxes, see revenue evaporate. Brian-Brian-Mary should have been sent to Economics 101 before they were allowed to run the country!

Living in the world of delirium

Irish Times today reports that "the Cabinet will today continue its discussions on ways to achieve a €2 billion reduction in costs."

Take a step back:

National deficit for 2009 is projected by the Department of Finance to reach 10.5% of GDP in 2009 before any adjustments (i.e Bord Snip cuts and Mr Lenihan's 'patriotism' tokens from July) are taken. That is, assuming a 4% drop in GDP in 2008 levels, a cool €18.9bn. Now, add €5bn in April bonds redemption due and the cost of banks recapitalization, as estimated by the Government - we are potentially €33.9bn in a hole. From there on, its anyone's guess what the cost of operating the nationalized bank(s) and other ancillary spend items might be, but let's be 'patriotic' and stop at that €33.9bn figure.

The Government is now 'working hard' to get €2bn through the door - the same €2bn that Lenihan demanded in savings for 2009 back in July 2008! Six months later, he is still at it.

In other words, and here the Irish Times is naturally silent, this Government cannot get even a lousy €2bn in savings out of ca €34bn that it will need! And they have audacity to talk about 'national sacrifices'?

Forget Sean Fitzpatrick's loans, forget incompetent bankers who could not get risk/return relationships right in their lending decisions - the real scandal is the fact that this Government is playing us all for their willing milking cows. There is no national recovery plan! There is no willingness to take tough decisions! Hell, there is not even a realisation of the true extent of the problems we face! There is an incompetent, cronyist Government-by-appeasement that is clearly banking on borrowing and taxing its way through the recession to avoid angering its main constituency - the public sector unions.

And now, run through the Irish Times again (here):

No one on the Times team connected the dots from the gutless, incompetent governance to the economically illiterate and morally insulting Budget 2009 to the news that Superquinn will axe 400 jobs and shut its store in Dundalk. And yet this connection is there for anyone to see.

In 2002-2007, the current FF Government (for there is no real change save for Charlie McCreevy's and Bertie's departures) squandered away billions of our money to pay off its own constituencies. All of this waste has gone up to fuel business costs increases across the country that left Ireland in a position of being completely uncompetitive relative to our, already uncompetitive, neighbour - the NI. Mr Cowen presided over this gratuitous mismanagement of public finances as the Minister of the Exchequer. Mr Lenihan was on the sidelines of economic policymaking, but he did not seemed to have minded what was going on around him. Ms Coughlan was at the coalface of the FF-led welfare banquet as a minister for agriculture, although she was wasting billions of European taxpayers money there.

The same Trio has passed the Budget 2009 income tax levies and has raised VAT – wiping out thousands of jobs in this economy. The same Trio is now presiding over a charade process that is supposed to bring the state budget under control and resuscitate economy.

The end game? We will end up being forced to accept worthless 'National Recovery Bonds' in a way of pay, as our taxes will rise to 25% & 50% range by Q3 2009, our savings wiped out to pay the army of inefficient and over-paid state workers.

Update: Mushroom Cloud III

Here is an updated chart...

After talking to a couple of fellow economists - both admittedly gloomier than myself - I came to a conclusion that Brian Lenihan simply must face the nation on what is holding him back from putting forward a real rescue plan for Ireland's bettered economy:

• is it the internal opposition by the Cabinet to do anything that will potentially anger public sector trade unions, or
• is it his own Department inability to provide logistical support for a credible and effective plan?

It is now clear, despite a recent 'consensus' amongst the Government-fed economists, that the country needs rapid and significant cuts in public spending, a tax stimulus (across income tax, VAT and payroll tax) and a round of privatizations (carried out in voucher form to transfer ownership of state enterprises to the public, improving private households' balance sheets). These must be enacted before the end of February. In the medium term, we need a dramatic reform of the stamp duty on property (moving in the direction of a land value taxation system), a long-term reform package for public services and a political reforms pack to include reduction and consolidation of local authorities, reduction of the number of TDs and the size of the Cabinet and an overhaul of our Byzantine system of Departments and Quangoes.

Given the above chart, we have no longer the luxury of time to wait for various Committees and Commissions' reports - it is time to act now!

A View From the Musroom Cloud III

As another day of carnage ensues, there are several new and old issues worth giving a thought to:

(1) Recall S&P ratings update (here): now that Irish 10-year spreads, predictably, are pushing beyond 300bps spread on German bund, what service did S&P provide to the bonds buyers who subscribed to the latest Irish issue of 5-year bonds on the back of AAA rating? The yields, as I have predicted (see here and here) on our bonds have moved in above the Greeks' leaving a wave of devastation behind in the balance sheets of those who bought into this paper on the back of S&P's ratings;

(2) Despite Mr Lenihan's assurances to the contrary on last night's Prime Time, the government is appearing to run thin on actual liquidity (in addition to running thin on any ideas). Do the maths. Mr Lenihan (who was, it must be said, trying to do his best in answering tough questions and did solicit some real compassion from this observer for being, evidently, under immense pressure both inside the Cabinet and in the wider world) stated that banks recapitalization requirements were ca €10bn in 2009.

Now, we know this figure was hammered out but the incompetent risk-pricing non-entities in the Department of Finance on the basis of the following assumptions:
(a) BofI and AIB raising some €2-3bn of their own funding,
(b) Anglo's depositors staying put (saying nothing about other banks' depositors),
(c) shares valuations for the three banks at twice above current, and
(d) no skeletons in the closets when it comes to loan books.

All four of these assumptions have now been challenged. So why is Mr Lenihan sticking to this figure? Is it because he has nothing new coming in with the morning briefing papers from our civil service mandarins?

Some commentators estimate the state exposure under recapitalization/guarantee schemes at €30bn. I would put the figure at a more modest €16-18bn. This would leave Mr Lenihan with just €2-4bn reserve to finance, in 2009 alone:

• a 10% deficit (ca €8bn in borrowing in excess of already acquired funds);
• a 'stimulus' package (ca €2bn);
  
• state credit pumping operations (via Anglo) (ca €5bn); and
• €5bn worth of maturing bonds...

In other words, no matter how you spin things, we are in the hole for, in the better case scenario, €16-18bn in 2009. Can the Minister really look straight into the voters eyes (as he did last night) and tell us - 'It's ok, folks, we'll just tap the credit markets for that. We have low sovereign debt'?

(3) David McWilliams brought back the specter of external rescue yesterday (here) with Ireland using a threat to leave the Euro if the ECB/EU Commission to get some funds. I am not sure this is going to be necessary. It is more likely that the Government will tap ECB/EUC for money under the argument that Ireland is yet to have a second Lisbon vote and that denying it emergency aid will be detrimental to the cause of getting us to vote Lisbon in. The funds will arrive in a combination of a straight ECB loan, acceptance of state paper as a collateral for more borrowing, some mixture of the 'knowledge' economy and capital spending investment assistance from the EUC and support for dwindling multinational employment in the likes of Limerick. Saving the face publicly, however, will not fool the debt markets and the yields will go further up.

(4) And while we are on the subject of the Euro - imagine our current Gang of Three running the monetary policy and managing our currency if we were to exit the common currency area? Close your eyes and watch Mary Coughlan trying to compute a three-party FX arbitrage parity, while Brian Cowen discusses a helicopter drop of money with Mr Hurley... Frightening!

(5) More from the bond markets - as our 10-year spreads moved above 300 bps, our short and medium term paper (6-24 months) breached 290bps last night. This suggests a temporary compression in the time structure of the bonds, implying that our 5 year yields will be climbing up and up and up in days to come.

(6) On the positive side, we have the latest comprehensive Government programme for dealing with this crisis (hat tip to Brian, courtesy of the source) in line with our closest competitor for being the worst performing economy in Europe, Latvia (here):

Talking up our economy

Today, Brian Cowen has issued a Bertiesque warning to commentators 'talking down Irish economy'. I beg to disagree. Firstly, the problem Ireland is facing is not that some commentators want to uncover the truth, but that our Government is failing to listen to anyone, save for a handful of public sector mandarins and political appointees. Secondly, lest anyone accuses myself of scaremongering, I remind our Taoiseach and his Cabinet that I have publicly put forward a constructive proposal for dealing with the current crisis as far back as in August 2008.

Here are few details:

In August 2008 edition of Business&Finance magazine, I predicted that Ireland will continue its downward trajectory in terms of stock market valuations and economic performance unless the Government were to tackle the issue of public sector overspend and consumer debt. In early October, from the same platform, I re-iterated a call for the Government to get serious with the problem of rising household insolvencies and corporate debt burden. At that time, I provided an outline of a basic plan that I hereby reproduce (some of the modifications to the original plan were featured in my article in Business&Finance in November).

Here is a bold, but a realistic proposal for moving the Government beyond its current position of playing catch up with deteriorating fundamentals. The Exchequer should:

• Announce a 10% reduction across the entire budget and an up to 60% cut on the discretionary non-capital spending under the NDP, generating ca €12-15bn in savings. The cut should include a 100% suspension of all overseas assistance until the time the economy returns to its long-term growth path of ca 2.5-3%.
• Cut, permanently, 10% of the public sector employment (effecting back office staff alone), saving ca €1bnpa after the costs of the measure are factored in.
• Freeze pensions indexation in the public sector for 2008-2015 and make mandatory a 50% contribution to all pensions plans written in the public sector, generating ca €1-2bn in savings.
• Stop the unfunded contributions to the NPRF, saving some €1.5bn per annum.
  

Combining all the savings, the Government should be able to :

• Bring 2009-2010 deficits to within the Eurozone limits; and
• Supply temporary tax refunds of ca €5,000pa per household in 2009-2010 ring-fenced for pensions plans and mortgages funding only.
  

The resulting capital injection of ca €7.5bn pa will be able to:

1. de-leverage the households (amounting, by the end of 2010 to a ca 25% reduction in the total households’ debt), improving consumer sentiment and re-starting housing markets;
2. help recapitalize the banks and improve their loans to capital ratios more efficiently than a debt buy-back, a nationalization, a direct injection of capital from the Exchequer or a debt guarantee.
   

It will result in a sizeable (ca 5% of the entire economy) annual stimulus, without triggering inflationary pressures associated with the Santa-like Government subsidies or consumption incentives.

This proposal implies no burden on the future generations, as the entire stimulus will be paid from the existent fiscal overhang and the set-aside public funds, with the public pensions covered by the contributory schemes.

Lastly, to achieve a morally justifiable and economically stimulative recapitalization of the banks, the plan would require Irish institutions receiving any additional public financing to issue call options on ordinary shares with a strike price set at the date of the deposit and maturity of 5 years. These shares should be distributed to all Irish households on the flat-rate basis.

Thus, assuming the need for additional capital injections of €6-9bn in the Irish financial institutions through 2010 (over and above the €7.5bn pa injected through mortgages repayments and pensions re-capitalizations), Irish households will be in the possession of options with a face value of €4,000-6,000 per household, thus increasing their financial reserves. At the time of maturity, assuming options are in the money, the Exchequer will avail of a special 50% rate of CGT on these particular instruments. Assuming that share prices appreciation of 40% between 2009 and 2014, the CGT returns to the Exchequer will yield ca €1.8bn, ex dividend payments.

Mushroom Cloud II

No words needed... (Hat tip to an anonymous reader pointing to July 9 event)

Watching a mushroom-shaped cloud rising

Sadly, my quick prediction last night has turned into a reality - bleaker than I could have anticipated. As, at the time of writing, FTSE EUROTOP100 index is trading in the green territory, ISEQ-FINANCIAL is over 34% in the red, with AIB down 41.5%, and BofI and IL&P both down 27%.

We are now safe to assume that the Anglo Irish Bank, taken over by the state last week, was on the verge of becoming a moneyless institution. That despite the tough talk from Mr Lenihan about freezing some deposits, all sizeable corporate deposits have now left the bank's vaults. That the Exchequer downside from the bank 'rescue' is going to be in excess of €10bn, prompting his yesterday's remark that the other banks are now effectively on their own, and in effect admitting that the Exchequer itself may be now out of money, if commitments to date were to be honoured!

All of this has not been lost to international investors, who are currently dumping anything they might still have in the form of Irish banks shares. The surprising thing for now is that Irish bonds yields appear to be holding.

The question, however, is: for how long. If the Black Monday is not reversed, and unless the Government comes out in public with the actually believable statement on its current financial position (including a detailed and credible forecast as to how it plans to manage its exponentially increasing commitments for 2009), Irish yields will rise and prices will fall.

Whatever you do, I would think thrice before switching into Irish bonds... they are far from being a safe harbour...

Will mayhem begin?

This is an unusual post for this blog - short and an attempt to 'call' the market - but given the comments, reportedly, given on RTE today by Mr Lenihan, I would venture to attempt to predict this week's start of trading (6 hours 30 min from now). With the Government once again faltering at the banks recapitalization policy and talking gibberish (with RTE reporting that "Brian Lenihan said each bank had to take responsibility for its own bad debts"), it is difficult to see how we can avoid another deep meltdown in the markets. I hope I am wrong, but today might be the first Black Monday of 2009... Stay safe, ye all who trade today!

Irish credit II

Here are the facts in support of Irish credit ratings downgrade (for those impatient to get the actual downgrade forecast, see Table 2 at the bottom of this post) taken directly from the IMF’s latest Global Financial Stability Report published in October 2008.

These facts suggest that:
(a) the problem of Ireland’s high risk of sovereign and economic insolvency is not new –by the end of 2007 Ireland has emerged as the most financially exposed country in the developed world, to the total silence of Irish Government, Regulators and other domestic financial services authorities; and
(b) our sovereign ratings have are failing to reflect this risk, despite the fact that the data was available to all rating agencies for some time.

Our financial health ca January 2008...
Ireland ranks last out of the entire group of countries/ regions covered in the report in terms of its overall capital markets/financial stability (see table below). The countries/regions reported by the IMF include: the EU, Euro area, Canada, US, Japan, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, the UK, a general set of all emerging economies. Report parameters are given in IMF’s Table 3 in absolute terms.

Table 1 below ranks Ireland, and its two European competitors for the title of the worst-off (in terms of financial stability) Italy and Greece, across these same IMF-selected parameters.

Table 1: Ranking for Selected Indicators on the Size of the Capital Markets, 2007, expressed as % of country GDP/GNP
Sources: IMF GFS Report October 2008, and author own calculations.

Figures below plot the data that led to the above table results.

Figure 1: Total Reserves, % of GDP/GNPSources for Figures 1-7: IMF GFS Report October 2008, and author own calculations.

Figure 1 above shows total economies’ reserves (net of gold) as a percentage of GDP (and GNP for Ireland). Technically, ceteris paribus, higher levels of reserves relative to the economy size imply higher levels of solvency. Notice that this data is for 2007 – the year when Ireland was still in a relatively benign economic environment. In 2007 Ireland’s total reserves stood at a level almost 6 times below the EU27 average. Out of all main global financial centers selected by the IMF only Greece and Luxembourg showed weaker reserves base than Ireland.

Of course, we knew this already, as most of our wealth was trapped in the deteriorating housing markets. But the rating agencies failed to see this as a serious threat, preferring to focus disproportionately on the deceptively low public debt levels in this country. The irony that the state has managed to drive down its debt at the expense of economic stability (by taxing businesses and consumers to produce a ‘savings’ piggy bank for the public sector) and by imperiling our financial stability (by re-directing private financial flows and diverting investment into property and other state-incentivised schemes), was totally missed by the likes of S&P and Fitch.

Figure 2: Stock Market Capitalization, % of GDP/GNP
As the above figure shows, our stock market capitalization as the percentage of GDP/GNP ranked the second lowest in the world in 2007. Italy was the only country with a relative weight of the stock markets capitalization in its economy falling below that of Ireland. This parameter reflects, indirectly, the overall mammoth share of debt (as opposed to equity) on our corporate balance sheets and the effects of Irish economy’s dependence on leveraging and housing markets.

Figure 3: Debt securities as % of GDP
Figure 3 above shows how extreme were the levels of Irish debt liabilities in 2007, with the country leading the world in terms of private debt share of GDP. In the figure 4 below, the two sources of debt are combined to show that Ireland (as a share of GNP) has achieved a dubious distinction of becoming world’s most debt-ridden country by the end of 2007 – a point also missed by the rating agencies.

Figure 4: Total Debt Securities Outstanding, as % of GDP/GNP
Figure 5: Bank Assets as % of GDP/GNPWhen it comes to the financial system assets side of the balance sheet, Irish banking assets appeared to be relatively healthy in 2007 (Figure 5), although this does not include any correction for these assets quality. However two factors must be kept in mind:
(1) to date, Ireland has been leading the EU in terms of commercial bankruptcies (up 250% on 2007) and in terms of housing and commercial real estate crises, implying mid-term impairment charges for Irish banking system well in excess of those in other European countries;
(2) as the following two figures show, our assets cushion (non-bank assets as % of the total debt) and reserves cushion (total reserves as % of the total debt) were both thin, despite the fact that we are faced with an unprecedented (by global comparisons) total debt mountain.

Poor protection buffers: still the ‘old’ news

Figure 6: Assets CushionFigure 7: Reserves Cushion
It is worth mentioning that our Assets cushion (Figure 6) is artificially inflated by the still high property valuations of 2007. Correcting for 2008 commercial and residential property contractions, Ireland's non-bank assets to GDP or GNP stand at the lowest level in the entire developed countries sub-sample. Of course, as far as our reserves to GDP ratio goes - the fact is that our banking sector reserves stood at a critically low levels even in 2007 invites two observations:
(1) reserve requirement ratios are the prerogative of Irish Central Bank and Financial Regulator - with domestic regulators having full access to the powerful policy lever of raising these requirements. Both did absolutely nothing;
(2) the IMF figure for reserves includes state own reserves (NPRF), implying that the real problem of the banking sector reserves crisis we are currently experiencing is even worse than the official figures suggest.

Given a precipitous fall in Irish shares, property and economic growth – all registering declines well in excess of other European countries – we are now facing the assets and reserves cushions that are critically low, warranting a significant downgrade on our credit ratings.

Ireland’s comparatives (2008-2009) and ratings forecast
Comparing our financial position to that of the peer countries, Table 2 below shows that our current credit fundamentals are woefully out of line with other AAA rated countries in Europe. In fact, even disregarding the realities of our economic slowdown and fiscal challenges facing the country in 2009, comparative analysis of financial stability fundamentals for Ireland suggest that our true ratings should be below those of Greece or Italy.

Table 2: Assets, Reserves and Ratings
Sources: Fitch, S&P and IMF data, author own forecasts

The above results show that Ireland is well over-due a downgrade on its sovereign debt to bring us in line with our relative peers – Italy, Greece and (correcting for Eurzone membership) Iceland. But Table 2 above (see forecasts for financial stability parameters marked in blue) also shows that taking into account our economic and fiscal prospects for 2009, the downgrade currently overdue can actually be much deeper than the one forecasted herein.

Current environment: even more room for downgrades
One cannot ignore the extent of the economic and fiscal deterioration in Ireland to-date. We are facing an officially projected deficit that is unprecedented in the entire EU27. And the official forecast, as I argued before (here) is by all means an underestimate of the fiscal black hole we are heading for.

Even with An Bord Snip delivering significant – ca 10% - cuts in pubic spending (at least half of which is already factored into the Department of Finance forecasts), and even assuming the Government has the guts to implement such changes, Ireland is likely to find itself in ca 10% deficit in 2009.

This alone should trigger our ratings to be downgraded below AA- and our bonds yields to head closer to 6-6.5% for a 10-year paper. Of course, Ireland cannot at this time issue 10-year paper, implying that our borrowings for the foreseeable future will be short-term. Should the downturn extend through 2013, or alternatively, should the post-downturn growth fail to reach above 3%, Ireland will be in a serious trouble when redemptions on 2008-2009 debt issues come knocking on the door.

But the fiscal challenge is not the only one. Ireland’s economic contraction is likely to reach 4.5-5% (GDP terms) in 2009, implying that we will continue to lead the EU in terms of recessionary pressures. Such a scenario also warrants a downgrade of our ratings to AA-/BBB+.

Last, but not least, the Irish Government has underwritten some €450bn worth of debts and obligations on the domestic banks’ books, plus an open-ended commitment to supply capital to the banks. The nationalization of Anglo alone is likely to add something to the tune of €7-10bn to 2009 liabilities of the Exchequer and some economists estimated last week that this liability can easily reach €15-30bn.

Now, do the math. The Government boasts of holding some €20bn in liquid reserves, including surplus 2008 borrowings. Of these, Anglo commitment will eat through, say €7bn, previous capital commitments alongside the underwriting of the equity placements for AIB and BofI – another €5bn, the Exchequer deficit, assuming An Board Snip delivers real savings, will take up the rest. This leaves Ireland Inc naked for 2009 – no stimulus, no cushion for error, no buffers for any bank or building society default and, even more crucially, no deficit financing for 2010 should the sovereign debt markets get tougher throughout the year.

In these conditions, it is highly likely Ireland will push 10-year yields well beyond 350-400bps spread on German bonds and despite Mr Cowen's protestations to the contrary, find itself begging for funds from external donors. IMF or ECB or both - the acronyms are semantic: either one will part with its money only on extremely strict conditions...