A quintessence of Lenihan's economics

Hat tip to Linda - here is a descriptor of the logic of 'shared pain' policies that ask us all - ordinary me and you, a lavishly paid Secretary General of Department of Somethingness, a patrician head of some Quango in charge of Everythingness etc - to make sacrifices in the name of the country - to go that extra step beyond our already up-to-my-ears-in-work existence...

So what makes 100%? What does it mean to give MORE than 100%?
If: A B C D E F G H I J K L M N O P Q R S T U V W X Y Z
is represented as:1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26.

Then:
H-A -R -D-W-O -R -K 8+1+18+4+23+15+18+11 = 98%
and
K -N -O -W-L -E-D-G-E 11+14+15+23+12+5+4+7+5 = 96%
and
A-T -T -I -T -U -D-E 1+20+20+9+20+21+4+5 = 100%

But
B -U -L -L -S -H-I -T 2+21+12+12+19+8+9+20 = 103%
and
A-S -S -K -I -S-S -I -N-G 1+19+19+11+9+19+19+9+14+7 = 118%

So, one can conclude with mathematical certainty, that
While Hard Work and Knowledge will get you close, and Attitude will get you there, its the Bullshit and Ass Kissing that will put you over the top - all the way to Brian Lenihan's national sacrifice economics...

Ireland, ECB & Recent Commentary

Reading Ambrose Evans-Pritchard (Sunday Telegraph, 12/04/09) strikes me as an interesting case-study of stranger than life UK views of ECB - a mixture of truth, more truth and, all of sudden, bizarre ranting...

Judge for yourselves: “If Ireland still controlled the levers of economic policy, it would have slashed interest rates to near zero to prevent a property collapse from destroying the banking system. The Irish Central Bank would be a founder member of the "money printing" club, leading the way towards quantitative easing a l'outrance.”

I am far from being convinced by these arguments. Given that the ECB rates are at historic lows, an independent Irish Central Bank would only have room to move on further, say, 75bps-100bps down maximum. So what would have happened in this case?

Evans-Pritchard claims that “Irish bond yields would not be soaring into the stratosphere. The central bank would be crushing the yields with a sledge-hammer, just as the Fed and the Bank of England are crushing yields on US Treasuries and gilts.”

A maximum 100bps cut in rates would imply that Irish yields on 3-year paper would fall by ca50bps from their current levels. This assumes that the markets will take the same credibility to Irish Government commitments on fiscal policy stabilization as under the ECB oversight. This is highly unlikely. Instead, I would expect Irish yields to rise to 7-8.5% range on 5-year paper – consistent with the market pricing in double-digit deficits through 2012. Has Mr Evans-Pritchard ever seen John Hurley? or the dynamic trio of our Politbureauesque Leaders? Can anyone have confidence in their governance abilities? Being bootstrapped in the long run by the ECB does have a positive impact on our credibility and not having our currency managed by the corporatist consensus Government that we have at the very least insulates us from the monetary policies of disaster.

“Dublin would be smiling quietly as the Irish exchange rate fell a third to reflect the reality of trade ties to Sterling and the dollar zone,” says Evans-Pritchard.

Ok, but how is such a devaluation consistent with yields falling for Irish bonds? Unless these bonds were issued in Euro, devaluation would have acted to increase yields as FX risk increases would have driven bond prices down. In fact, I would suspect that the fall in our currency woud be deepr than that - say 60% (30% to restore references to the UK/US and 30% to reference the unttrustworthy Government). Such a fall would wake up even Mr Hurley - pushing him to raise interest rates to stave off a run on the Punt. The yo-yo of Irish monetary-fiscal-monetary-fiscal... debacles will commence.

“Above all, Ireland would not be the lone member of the OECD club to compound its disaster by slashing child benefit and youth unemployment along with everything else in last week's "budget from Hell".” Clearly, Mr Evans-Pritchard has failed to read the Budget. Our Government did precisely the opposite of what he claims – retained excessively lavish welfare benefits and current expenditure, taxing its way through the entire fabric of the middle class earnings and wealth creation incentives. Even child benefits and youth unemployment benefits cuts that Mr Evans-Pritchard claims to be welfare cuts are predominantly transfers to the middle and lower-middle classes. Majority of our poor are on permanent (not unemployment insurance) welfare and are collecting different types of child benefits.

“But what caught my ear was his throw-away comment that prices would fall 4pc, which is to admit that Ireland is spiralling into the most extreme deflation in any country since the early 1930s. Or put another way, "real" interest rates are rocketing. This is torture for a debtors' economy. You can survive deflation; you can survive debt; but Irving Fisher taught us in his 1933 treatise "Debt Deflation causes of Great Depressions" that the two together will eat you alive.”

I agree with Evans-Pritchard on this: real interest rates and the combination of debt and deflation will be drivers of misery for years to come. What is even more egregious is that our debt is actually growing, not shrinking and that this process will accelerate as Brian Lenihan pillages through our pockets.

“Mr Lenihan hopes to shield banks from the calamitous consequences by creating a buffer agency. It will soak up €80bn to €90bn in toxic debt - or 50pc of GDP. He borrowed the plan from Sweden's bank rescues in the early 1990s, but overlooks the key point - it was not the bail-out that saved Sweden's financial system, the country recovered only by ditching its exchange peg and regaining its freedom of action.”

Evans-Pritchard forgets couple other things that also helped to save Sweden – a rapid growth in the US and subsequently global economies during the 1994-1998 period that helped Sweden’s exports and capital inflows, and a robust programme of reforms that saw large scale privatizations and markets openings in many sectors of previously state-controlled economy.

Nationalize or else?..

I just received a good comment to an earlier post (here) that warrants a separate attention.

"Regarding NAMA, it seems to me that the one big advantage to this scheme is that it means someone will lend us enough money to cover the bank's bad debts, via the sleight of hand of issuing government bonds to the banks and then them redeeming this in hard cash from the ECB. I strongly suspect the Irish government would be hard pressed to borrow this kind of money from anywhere else.

What I don't understand is why we don't first just nationalize the banks. The question of proper pricing then becomes less of an issue. We'd be just moving money between different arms of the state.

One thing I've wondered about: can this device for swapping government bonds for euros only be done by a commercial entity? If we first nationalized the banks would such a move then be precluded? If so, maybe the government do secretly intend to largely nationalize them at a later stage after the cash has already been received from the ECB. I do hope there's some technical reason like this for not first nationalizing the banks, that the reasons are not purely political, because I've no confidence that the taxpayers will end up paying a fair price for these assets. Finbar."

There are several arguments in favour of nationalizing first, then deleveraging bad assets, recapitalizing and re-floating the banks. And there are several arguments against such an approach. I will first deal with arguments in favor of nationalization...

Pro-nationalization arguments:

1. Clarity of valuations: banks are not going to willingly reveal all pertinent information concerning loans quality to NAMA, so nationalizing them and then opening their books will provide much needed clarity concerning fundamentals relevant to valuations and pricing;
2. One-shot recapitalization: whatever price NAMA sets for impaired and stressed assets, such a price will either be too low to allow the banks to continue operating without further recapitalization injections, or too high to allow the Exchequer to recoup significant share of losses. Nationalizing the banks will resolve the problem, as capital requirements can be dropped significantly under a public guarantee on publicly-owned banks. The upside here is significant (see below);
   
3. Ownership-liability symmetry: under nationalization, ownership of banks assets will be fully coincident with the holder of liabilities - the State. This prevents a situation where taxpayers money is being used to underwrite private shareholders and bondsholders objectives;
4. Bond holders can get a haircut: under nationalization scheme, the Government can impose a stamp duty on bondholders in Irish banks, allowing for a partial recovery of funding and imposing a haircut on banks bondholders (currently covered by a blanket taxpayers'-financed guarantee);
5. Maximizing recovery for the taxpayers: if the objective of NAMA is to deliver value to the taxpayers, while deleveraging the banks balance sheets, nationalization, with a clear pre-commitment by the state to disburse banks equity via a voucher-based privatization within say 3-5 years will deliver both (see below for an outline of the scheme);
   
6. Avoiding discriminatory treatment of individual loans: Under NAMA arrangement, some developers / business owners that have performing loans against them might not want to face an arbitrary transfer of their loans to NAMA. This might be a litigious issue that can be fully resolved by an outright nationalization of the banks;
7. Change of the guard: Under nationalization, the Government will have a full right to change the executive structure of the banks and their boards to bring in new blood to run these institutions, breaking away with legacy issues in management.

Voucher scheme
To pre-commit to such a scheme, the Government can issue 3 or 5 year options on shares of the banks. For example, a part of existent equity in AIB can be converted into options at a price on the day of nationalization. Suppose, for the sake of illustration, that nationalization takes place on May 4, 2009.

Suppose that the Government commits to voucher-privatizzing 50% of the value of shares, retaining 50% shares in own account. April 30 closing price for AIB is €X. The European-style call options are issued on May 4, 2009 at an exercise price of €X with maturity date of, say, May 4, 2012.

The Government re-floats a part of its share holding in AIB on May 4, 2012 (Swedish Government retained ca25% of the banks shares on own account after re-privatization, so Irish Exchequer might want to do something similar). This sets the expiration price on AIB shares at S. If S>X, households holding options will exercise them, collecting S-X in profit. If not, they will forefeit any gains with no loss.

Two questions arise concerning such transaction:

• How the vouchers should be disbursed? My preference is to issue vouchers on a flat-rate basis to all households in Ireland in order to achieve a voucher-distribution that is reflective of the economic stimulus in line with an across-the-board tax cut;
• What will happen to AIB shares when vouchers are exercised? Nothing: markets at IPO will be pricing in an inflow of shares from the households as it will be pre-announced in advance.
  

The Government can collect a special rate CGT on such profit realization at, say, 30%, so that in effect there will be a 0.3*(S-X) payout to the Exchequer in addition to the retained shares value.

The upside to capitalization savings

Banks equity capital (BEC) = assets net of liabilities must legally not fall below 8% of the Risk-Weighted Assets (crudely for any given asset - e.g a loan or a bond - held by the bank, RWA =risk weight*asset value=RW*AV).

At the end of 2008 both banks hold ca €80bn in property loans of various quality. Not all of these loans will be earmarked for NAMA, so, having no better guidance from the NAMA itself, assume that the banks would want to off-load ca 3/5ths of this amount or €48bn.

(How do I get to this number? AIB has total assets of €182bn, RWA of €116bn, RW of 116/182= 63.7%, BEC €9.28bn and the actual Tier 1 capital of €9.9bn. BofI has assets of €204bn, RWA of €134bn, RW of 65.7%, BEC requirement of €10.72bn against the actual T1 capital of €10.1bn. Note that RW(BofI)>RW(AIB) implies lower quality of the BofI book. Prior to the first round of recapitalization, combined RWA €250bn, BEC Tiers 1&2 requirement of €20bn (0.08*250bn) just covered by the actual Teir 1 held. Any change in the NAV of underlying assets would have triggered a rise in RW thus driving the banking system below the 8% requirement, so the Government injected €7bn, thereby providing for the €87bn RWA cushion and raising Tier 1 capital to 10.8%. While sounding like a high number, this is pittance compared to the US and UK trend toward raising T1 ratios to 12-14% that would require a further injection of €3-8bn in cash, assuming there has been no deterioration in the assets quality since the end of 2008. Further note that total 6-banks property exposure ex Poland for AIB is €165bn. So far, we do not know how much NAMA will take on, but in the case of Securum - Sweden's bad bank - only took on non-performing loans. Now, AIB assumes max 25% non-performing loans on total development & property investment loan book, with current running non-performing loans at 3.5%, so our €48bn assumption is about coincident with the ca 25% non-performing loans assumption on property exposure across the 6 banks).

As Government bonds carry a RW=0, the value of NAMA bonds replacing specific assets will be excluded from RWA calcualtions. If NAMA buys €Xbn in loans at discount d%, then banks will get to write off €Xbn of assets, get €(1-d)*Xbn in state bonds in return and face a net cost of €dXbn to their capital, so that the combined banks RWA becomes €(250-(1-d)X)bn against Tier 1 capital of €27bn post re-capitalization. Writing off €dXbn of the value of the loans will hit the banks straight into their book value, thus cutting their equity capital - and directly hit their Tier 1 capital as well.

So Tier 1=27bn-dX=8% of RWA=250-(1-d)X. In other words, 0.08*[250-(1-d)X]=27-dX. Now, solving for discount factor:
d=[7+0.08X]/(1.08X).

If the Government wants to buy 3/5ths of the property-related loans, X=€48bn and d=20.9% - a scenario that would see the state issuing €38bn in new bonds - over 1/2 of the entire current Government debt.

Analysts estimate that the total loans impairments across BofI and AIB can run between €19-25bn. Adverse selection under the voluntary NAMA scheme imply that the banks will dump the lowest quality assets first. This means that under the scheme of 60% of loans being purchased by NAMA, the cost of the scheme - €38bn will be underwriting the asset base with expected recovery of just €48bn-19 or 25bn = 23-29bn, making an immediate loss to the taxpayers of €9-15bn.

Under nationalization scheme, the Government can blend assets at its own choosing, spreading the loss-implying assets across the books and it can drive T1 capital to 6% if it wants to. This would imply that, under an unbiased weighting scheme, NAMA will get €11.4-15bn in loss-inducing assets against the book that has
d=[14.9+0.06X]/(1.06X)=[14.9+0.06*48]/(1.06*48)=35%
costing the Exchequer €31.2bn in new bonds for an asset base with underlying recovery of €33-36.4bn - a nice expected profit of €1.8-5.2bn.

And this is the exact value of nationalization...

Arguments against nationalization will be dealt with in the follow up... (I need a smoke break!)

Daily Economics 14/04/09

University Quality & Earnings: this week's paper "University Quality and Graduate Wages in the UK" (IZA Discussion paper 4043, available here) estimates the relationship between the quality of UK universities and earnings of their graduates. From the abstract: "We examine the links between various measures of university quality and graduate earnings in the United Kingdom. We explore the implications of using different measures of quality and combining them into an aggregate measure. Our findings suggest a positive return to university quality with an average earnings differential of about 6 percent for a one standard deviation rise in university quality. However, the relationship between university quality and wages is highly non-linear, with a much higher return at the top of the distribution. There is some indication that returns may be increasing over time."

Of course, these findings present a much expected dilemma for Irish education system. Over proliferation of degrees-issuing organizations: from ITs to various private colleges and state support for increasing the quantity of graduates and post-graduates produced by our education system have done nothing to improve the quality of degrees in Ireland. With only 3 universities making it into top 1,000 world rankings, Ireland is hardly in the league of top performance by the quality of our research or post-graduate supervision. With less than 1/2 of the top professorial staff actually teaching students, we are not in the top league of teaching either. What have we been paying for over the last 15 years when it comes to the third level education?


Good & Bad Volatility: Before news, a quick note for those of you who are interested in academic finance. Per materials I have covered in my recent MSc course on Investment Theory, here is an interesting study of volatility designed to deal with the issue of skewness. The author argues that asymmetric nature of distribution of conditional returns (skewness) is predicated on the existence of two different dynamic processes underlying volatility of returns. In other words, the author tests whether positive returns volatility and negative returns volatility are driven by different dynamic processes. Good read.

Here is another interesting paper, from different field: "Do More Friends Mean Better Grades?: Student Popularity and Academic Achievement" from RAND looks at 'peer interactions' (socializing) role in student academic achievement. The results indicate that, controlling for endogenous friendship formation results in a negative short term effect of social capital accumulation. In other words, social interactions crowd out activities that improve academic performance. Who would have thought that hanging out at frat parties, attending football matches and going out boozing were supposed to be good for academic achievement in the first place, you might ask? The paper has tons of references to the studies that actually claimed this to be the case...


Thin newsfront today due to Easter break, but the US markets have started another week of the ongoing prolonged (some would say overextended and overbought) rally with a small correction. Despite ending trading in the negative, the markets held firm above 8,000 mark - psychology in action. So it's a 'green shoots' theme for now.

Goldman Sachs reported some good results on higher earnings and revenue and announced commencement of a $5bn common shares issue. GS has been a relative out-performer for the sector since the beginning of the crisis. GS said net earnings to March 31 were $1.8bn ($3.39 a share), compared to $1.5bn ($3.23 a share) in the same period a year earlier. This beats (by 2:1 margin) the analysts forecasts. Analysts expected earnings of $1.64 a share, according to Thomson Reuters data. Revenue net of interest expense rose to $9.4bn from $8.3bn. It is hard to estimate how much of this increase came from lower interest rates and access to preferential (TARP etc) lending. GS said that it intends to use proceeds of the $5bn shares issue to help redeem "all of the TARP capital." Good news indeed.

Wells Fargo & GS however are not enough to convince me that we are in a bounce off the bottom. Rather, it looks to me like a cyclical bear rally is upon us, driven by the simple shift of liquidity out of fixed income, commodities and cash and into equities. Thus, the volumes are starting to fall and it is worth tracing this dynamic:
most importantly, see the volumes. Needless to say - once the support folds, liquidity will outflow from equities and the new rally momentum will move onto commodities (assuming the 'green shoots' are still green) or to fixed income (should corporate reporting season turns out nastier than we expect).

And this view is pretty much coincident with the macro outlook predicted by Lary Summers (here): "I think the sense of a ball falling off the table -- which is what the economy has felt like since the middle of last fall -- I think we can be reasonably confident that that's going to end within the next few months and you will no longer have that sense of freefall," said Summers, director of the White House National Economic Council. The recovery is likely to be slowed by "substantial downdrafts" in the economy. "Economies don't go from losing 600,000 jobs a month to a terribly happy path overnight."


Russian markets rally and this means inflation is just around the corner... Yes, I do mean Inflation West of Oder, not in Russia. How? Russian stocks advanced to a five-month high last week, driven by investors taking inflation hedge against oil price increases. RTS index closed up 6.6% at 810.90, breaching 800 mark for the first time in almost 5 months. Ruble-denominated index Micex also rallied. The latest rally brings overall annual gains to 28% since January 2009, beating by 16 percentage points global MSCI emerging markets index. Two big gainers were: state-controlled OAO Sberbank +12% on the strengthening of global finance shares and the largest independent oil producer OAO Lukoil +6.7% on the back of price of oil consolidating above $50pb.

French Leafs of Green? I am less swayed by the claims that the French economy is starting to show signs of stabilization (see the story here). Why? All the data underlying the claim is related to industrial activities that experienced significant - extraordinarily deep - contractions in recent months. A technical bounce is long overdue and signals nothing in terms of bottoming-out. In addition, French data usually is less volatile than that of the US, simply due to significant persistence around the trend. This means shorter falls and smaller rises, shallower recessions that are more prolonged. Timing-wise, I would not anticipate France to come out of the slump before Germany and Germany will lag the US. The former conjecture is simply based on the lack of investment capacity in France internally and the lags in investment inflows into France relative to the US and BRICS. The latter conjecture is based on the nature of two economies - US growth will restart once US consumers de-leverage (a process that is underway for some time now), German economy will restart when foreigners start buying luxury durable goods. This, in turn, cannot take place before the US consumers recover their demand for smaller consumption items...

Daily dose of fun... Courtesy of www.TheDailyStuff.ie is the following test for budding photo journalists out there: You are on an assignment to photograph flood-striken Dublin.
You shoot Sandymount and waves spilling onto the strand. Liffey waters raging to the bay.
You see a man swept by the current, rushed out to the sea ahead. You suddenly realize who it is... It's Brian Cowen! You notice that the raging waters are about to take him under. You think to yourself, you can save the life of Brian, or you can get a Pulitzer Prize winning photo.

QUESTION and please give an honest answer: Would you select
(A) a high contrast colour shot
or (2) a classic black & white?


More to come later...

Daily Economics 10/04/09: Rappers want Euros

Taxpayer champions?
An excellent argument by David Quinn on the need for someone to step out of the shadows and become a taxpayers champion (here). FG to the front, suggests David. Most likely. But in the end, in my view, even Sinn Fein will do? Or a backbenchers'-led revolt in the FF. The country is now at its knees and the ZanuFF's leadership is so out of touch with reality, Cowen is telling us - private sector workers battered by unemployment, wage cuts, higher taxes and unbearable debts - that public sector employees know pain endured by the economy first hand. "I believe that the reality of the crisis we face as a society is particularly evident to public servants who are dealing at first-hand with the consequences – personal, social and economic – of our current difficulties,” said our out of touch leader (here). Tell me Brian - how? Through their jobs-for-life, strike-for-any-reason, guaranteed-pensions, increments-wage-rises, Partnership-giveaways, excessive-holidays, take-your-time-to-do-anything positions?


Consumer prices... deflation is of little help to the consumers: Per yesterday's figures on Irish CPI, see my comment in today's Irish Independent (here). And a quick comment to the Wall Street Journal from me relating to the latest Gov plan for a 'bad' bank (here).


And Gerard O'Neill has an excellent post on Partnership (here). Stockholm Syndrome at the IBEC and:
"Oh, I forgot: there's the Enterprise Stabilisation Fund - a grand total of €50 million this year. Let's work it out: say there's 1,000 companies eligible for support (about par with the numbers Enterprise Ireland works with every year). That equates to €50,000 in support - or stabilisation - for each company. Jaysus lads, this time next year we'll be millionaires..."
Actually it is even worse - of the €50mln, only €25mln is in new allocations to DETE, the other €25mln is coming from somewhere else - already in existence. And there was no support for export credits - a mad lunacy of the Government that is willing to waste billions on bad developer loans, but pinches an odd €10mln to provide short-term credit to companies with exports waiting at the dock and willing buyers on the other end. Instead of this virtually risk-free financing, we have the net 'stimulus package' is €25mln - a slap in the face to private sector Ireland and a clear indication of the arrogance and incompetence at the head of DETE.


A solution at hand for Cowen, Lenihan and Coughlan... Here is an excerpt from the post (here) by a celebrity masseuse, Doctor Dot:
"Tonight... I massaged the best looking President on earth, Mikheil Saakashvili... He is the President of Georgia and super fun to talk to. He originally wanted only a 30 minute massage but 90 minutes later, he told me my massage is "the best massage I have had in my life so far". Mikheil had body gaurds [sic] outside the massage room the whole time, who were all over 6 feet tall and like 4 feet wide. One spoke English really well and told me his favorite group is Metallica. Ha. He said "I am a rocker!" so we got along fine, whilst waiting for the President to finish his work out. I was excited to finally get to massage a President. I have massaged the Prince of Saudi Arabia before and a few Mayors, but this was the first President for me."

Thus we have a prescription to presidential joy: get your economy demolished, country demoralised, make some spectacularly disastrous decisions across the board, appease your cronies, get your country into debt to the EU and then, get a massage...

Doctor Dot, we have three Saakashvilli equivalents here in Ireland - not as good looking and with less pleasing body guards, but otherwise, even more spectacular disasters... Massage sessions on taxpayers' bill?


Inflation cometh... Here is an excellent recent blog post from Marc Faber on the issue of upcoming inflation (and a related blog here). I've spotted the risk a while ago (here), so I am happy to report that we are now seeing more and more commentators beginning to concerns themselves with the obvious problem: where can all the liquidity that the Fed and other Central Banks are pumping into the global economy go. From the point of view of the long-term policy consistency for the Irish Government, this is a proper conundrum.

Having raised taxes in 2008-2009, what will Brian do when we have externally imported inflation hammering households, the ECB hiking rates killing off scores of Irish homeowners and we have no control over tax levers (because we have borrowed so much that rising interest rates will simply make it impossible to cut tax rates as the inflationary spiral uncoils)? Oh, I get it - he will simply remind us all of our patriotic duty to keep paying his wages.


Hopes are rising?.. No, not in Ireland, but my hedge funds networking group website has been inundated with jobs offers - sales, technical, trading etc - from US headhunters. For the first time since early 2008, the usual daily page of posts has been dominated not by 'distressed assets for sale' or 'looking for a position' memos, but by jobs offers. May, just may be, should jobs situation abroad stabilise, by the mid 2009 we will have that Irish solution to an Irish problem - emigration - becoming available to Irish financial sector professionals. Then we'll truly arrive in the 1980s scenario.


On the US data: Yesterday's data from the US is painting an interesting, and cautiously encouraging picture.

First, the jobs front. First-time claims for unemployment benefits fell a seasonally adjusted 20,000 to 654,000 in the week ended April 4. The level of first-time claims is 83% higher than the same period in 2008. The four-week average of th2 initial claims fell 750 to 657,250. However, for the week ended March 28, the number of people collecting state unemployment benefits reached yet another new record, up 95,000 to 5.84mln - double the level in 2008. Per Marketwatch, "continuing claims have gained for 12 consecutive weeks, and have reached new weekly records since late January." The 4-week average of continuing claims was up 146,750 to a record 5.65mln. The insured unemployment rate - the proportion of covered workers who are receiving benefits - rose to 4.4% from 4.3%, reaching the highest level since April 1983. All of this signals that while the new unemployment may be bottoming out, workers are not seeing an increase in new jobs availability. Of course, unemployment itself is a lagging indicator relative to, say, capital investment. Inventories declines, posted in recent days, have probably more to say about the underlying dynamics, signalling potentially a flattening of the downward trend in economic activity.

Corporate earnings... Two major corporates announced pre-reporting updates last night. Wells Fargo & Co surprised the markets yesterday with the Q1 2009 earnings note claiming that earnings will rise to $3bn - ahead of analysts forecasts - on the back of falling impairments and rising mortgage lending. Earnings figures were quoted net of dividends on preferred securities, including $372mln due to the Treasury Department. Analysts expected earnings of ca $1.94bn.

Total net charges will be $3.3bn, compared with Q4 2008 net charges of $2.8bn. Wachovia - purchased by Wells Fargo on December 31, 2008, will see net charges of $3.3bn. Provisions will be about $4.6bn in the quarter compared to $8.4bn in provisions during Q4 2008.The news drove US financials to significant gains yesterday as the markets were delighted to see the bank finding a way of generating profits out of free Federal money it received. Who could have thought that possible.

Aptly, US stocks jumped higher across the board, with the Dow Jones Industrial closing its first five-week stretch of gains since October 2007, rising 246.27 points, or 3.1%, to finish at 8,083.38, up 0.8% for the week. The S&P 500 added 31.40 points, or 3.8%, to end at 856.56, a 1.7% rise in the week. The Nasdaq Composite climbed 61.88 points, or 3.9%, to 1,652.54, a weekly rise of 1.9%.

But there were some side-line noises from the real (i.e non-financial) side of the US economy when Chevron and Boeing issued earnings warnings on the back of lower oil prices, high production costs and falling demand for aircraft respectively. No free money from the taxpayers in their sectors has meant that the real economy continues to push lower.

World's new reserve currency... We have arrived - the Euro is becoming a reserve currency. The dollar is toast per BBC's latest report (here). And no, Euro's gains are not just in the market for Russian mafia wealth (remember those €1,000 bills issued in hope of diverting some of 'cash' reserves away from dollars). In fact, it is well diversified. As BBC reports, for some time already there has been a strong movement of US rappers out of dollars into euro. And there has been growing trade in services for euro-based money laundering by the drug cartels. At last, the hopes for a reserve currency challenge on the dollar are being realised.

I am of course being sarcastic - a disclaimer I have to put up for all Brusselcrats so concerned about any criticism of the euro. But to be honest, do we know how much of the EU paper been stuffed into the black markets? Seriously: rappers, mafia, drug barons... and Chinese Government - all think euro is the best thing since sliced bread... we've arrived.


And here is the latest take on the Budget (hat tip J):

Daily Economics 09/04/09: Riches in peril

Today's statement by Peter Sutherland on RTE radio concerning the alleged riches of Irish households is misleading in so far as it focuses on two mis-interpreted claims:

1. Irish GDP per capita is still on of the highest in the OECD; and
2. Irish wealth is well underpinned even despite the ongoing crisis.
   

I will tackle these in order.

Per Irish GDP per capita:

Ireland's GDP is expected to be €170-171.5bn(my forecast and DofF April 2009 forecast) in 2009. Our GNP is €142-144bn (as above). The GDP-GNP gap is standing at 16-16.5% and it is accounted for by the transfer pricing of multinational companies located in Ireland. In other words, the Dells and Intels of this world take inflated price of inputs they import into the country and then inflate value added in this country so they book more profits here. Precious little of the actual activity takes place here, but accounting shows it to be Irish-generated. This then goes into our figures for GDP. GNP excludes multinational transfers, so it is a cleaner measure of what we actually do produce in Ireland (inclusive of the real production by the multinationals).

Now, per CSO data for April 2008 - the latest we have - total population of Ireland is 4,422,100, which implies that 2009 GDP per capita is €38,443 and GNP is €32,111. There is an added trick. This does not take into the account the relative cost of living in Ireland, compared to the rest of the world. This is done by applying Purchasing Power Parity (PPP) adjustments. I don't have much recent data on PPP rates of exchange, but it does not change dramatically our position in the world rankings.

For example based on 2007 data - the latest for which global comparisons are available - we were still ranked the 3rd highest PPP-adjusted GDP per capita. However, taking PPP- adjustments to GNP and comparing ourselves with the rest of the world shows that Ireland ranked 14th in terms of PPP-adjusted GNP per capita in the world in 2007, which is, incidentally exactly where we were ranked in terms of our PPP-adjusted per capita consumption as well.

This shows two things:

1. using an actual measure of our income (GNP) instead of a bogus measure (GDP) implies that we are scoring below (in order of ranking): US, Iceland, UK, Norway, Canada, Austria, Switzerland, Netherlands, France, Australia, Sweden, Belgium, Germany and Denmark in terms of our income, and
2. that GNP per capita is reflective of our true consumption and investment positions, unlike GDP per capita.
   

Now to the second point concerning our wealth
In March issue of Business & Finance magazine I gave a detailed analysis of the wealth destruction that hit Ireland since 2008. Here is an excerpt.

“The bursting of the property bubble and of the equity bubble… showed that most of the ‘wealth’ that supported the massive leverage and overspending of agents in the economy was a fake bubble-driven wealth; now that these bubbles have burst it is clear that the emperor had no clothes…” said Nouriel Roubini in a recent update on the US economy. The same rings true for Ireland.

Two years ago, the Irish media was full of self-congratulatory patter about our riches. Our social welfare NGOs were using this myth as the grounds for demanding more welfare increases to offset the allegedly growing ‘relative poverty’. At the time just a handful of economists, this column included, were warning that our wealth was excessively geared toward one asset class – property. This lack of diversification, coupled with a lazy and often inept management of investment portfolios by the majority of Irish investors – from the most influential ones, like Sean Quinn, down to the 3-bed-semi families – is now coming to haunt us.

Nursing Real Losses
Majority of us are, by now, aware of the deep declines in housing (minus 30% plus relative to peak already and counting) and commercial (down 15% and still dropping like a stone) property values, and share prices collapse (off ca 70-80% depending on the index used). But few understand that our investments performance to date relative to other countries’ investors has been even more abysmal. This is true because of the opportunity cost of not actively managing our portfolios.

Per July 2007 Bank of Ireland report Wealth of the Nation (based on 2005 data) an average Irish investor held some 70% of gross assets in housing, 10% in cash, 8% in pension funds and 5% in business equity. Direct ownership of equity, investment funds shares and commercial property accounted for 2-3% allocations each. My own study, conducted in February 2007 on the basis of a sample of some 1,200-plus actual and potential high net worth individuals produced very similar results. In addition, it also showed that majority of Irish investors (over 72%) do not actively manage their own portfolios. Some 65% reported zero willingness to let professionals handle their investments. Instead of seeking proper advice (only 30% of Irish investors sought investment advice outside real estate agents’ offices) and acting upon well-researched information (only 43% of our savers actually searched around for best financial product offers), majority of Irish investors were keen on simply leveraging their assets as much as possible and dump most of it into high-risk property and shares deals.

Even less important for Irish investors was the idea of sectoral and geographical diversification. According to my data, only 10% of Irish retail investors held any exposure to non-property asset classes with allocations outside Ireland. Just 8% had more than 25% of their equities in non-property linked plcs.

2008 was a pivotal year in terms of changes in the Irish investment markets. Since then, factoring in the declines in asset values, the composition of the Irish wealth has been changing.

One important aspect of this change is that residential property share of overall wealth is poised to decline from ca70% in 2005 to ca55% in 2010. The latter figure is still roughly 38% above the OECD average, but the dynamic of change suggests some diversification out of property. Does this mean we are getting wiser with our money? Recently, a senior financial services professional suggested to me that because of the large pools of wealth we have allegedly held in the past, once the upturn occurs, cash will be available for investment in shares and financial funds. Sadly, I do not share his optimism.

Most of this diversification away from bricks-and-mortar is happening not because we somehow wised up to the need for diversification, but due to attrition in property values and lack of transparency in business equity valuations. In the longer term, most of this diversification will be going into increasing the importance of cash deposits implying excessively low yields in years ahead. Direct equity, investment and pensions funds and other asset classes that give investors exposure to the potential upside due to active management will remain the poor cousins of property and cash.

Using the changes in values for the main categories of assets held by Irish investors, I estimate that in 2008 Ireland’s total net private wealth has contracted by ca €150bn – from €712bn in 2005 (€805bn in 2006) to €559bn today. By my estimates, the current trend may see private net worth in this country shrinking to €307bn by the end of 2010 – a total loss of a staggering €405bn on 2005 figures. Adjusting for inflation, the total loss in wealth between 2007 and the end of 2010, by my estimates, will equal to roughly €470bn. Assuming marginal propensity to consume out of wealth of, say 3-3.5% (for US, this value is around 5%, so ours is a conservative estimate for Ireland), such wealth destruction will imply a fall-off in overall annual consumption of ca €4.8-5.5bn in 2008-2010, with a knock on loss to the VAT revenue of €900-1,100mln per annum.

A hefty opportunity cost
But this would be only half of the problem, were Irish investment portfolios actively managed through the downturn. During the current contraction cycle equity and property markets have posted unambiguously deep declines in all developed and middle-income economies around the world. However, several other highly liquid asset classes have shown relative gains. Prior to Autumn 2008, a number of international Exchange Traded Funds (ETFs) with commodities and fixed income exposures have recorded double digit dividends that would have seen the returns on these investments offsetting some of the short-term capital losses. Since late 2008, fixed income ETFs focusing on some corporate and public debt have continued to produce strong yields. Other classes of debt were also providing upsides. In many cases, such ETFs offer capital gains potential in the medium term similar to the fully diversified equities-based portfolios, but unlike equities, they pay strong current yields.

So what does this mean in practical terms? Over a dozen balanced managed portfolios blending ETFs, corporate and sovereign fixed income and actively managed money markets funds that I reviewed in recent months have been trading since September 2008. On average, this class of products has delivered a yield of ca 6-7% pa and a capital loss of 2-4%, when traded on a higher frequency basis. Compared to NASDAQ’s – 6% year to date slide, S&P500’s -13%, ISEQ’s -10.4%, accounting for re-invested dividends, some managed non-equity portfolios are returning a premium of 6-17% on average US, Asian, UK, EU and Irish indices.

In terms of the losses in Irish wealth, a switch of personal investment allocations into the actively managed asset classes (pensions and investment funds) and reversal of the direct equity holdings into an actively managed non-equity, yield-generating strategy could have saved some €1.2-3.4bn pa in wealth that is being lost due to asset allocations imbalance in Irish investment portfolios between 2009 and 2010. This is far from chop change. More active management of portfolios can generate enough savings on the investors’ balance sheets side to offset over 30% of the expected fall in our national income between these years. It can also, potentially, generate some €200-570mln in Exchequer revenues annually. The latter, of course, requires for such investment management to take place in this country – a proposition that is not exactly likely, given our poor tax treatment of investment markets and investors.

And the cost of poor governance
So enter our Government’s latest attempt at economic policy – the mini-Budget 2009 Part A. Why part A? Well, having predicted in this very column last year that we will face a new Budget by the end of Q1 2009, I can pretty much with certainty predict that whatever comes on April 7 will not be sufficient to plug the hole in the public deficit. Expect Part B some time before the end of the summer.

April’s mini-Budge will attempt to soak any PAYE earner with income above €60,000. The Government will do absolutely nothing to stimulate new investment and savings in this country. This, in turn, will lead to a double blow to our economy. First, in a series of straight jabs rapid flight of private investors’ capital out of the tax-choked economy will lead both to falling national wealth and further shortfalls in the Government revenue. Second, an uppercut of collapsing wealth will hammer pension funds across Ireland, as retail investors lose incentives to save at home and shift their longer term assets to jurisdictions with better management and more economically literate Government.

Should such scenario unfold, we’ll be lucky if our total national net assets pool does not fall below €200bn mark by the end of this recession.

Peter Sutherland is simply wrong to stress our relative wealth - just as the NGO were wrong to stress the importance of the relative poverty. The latest CSO stats on CPI - issued today - show that we are now worse off in real income terms than we were in August 2006.

Daily Economics 08/04/09: Toxic Fumes from Toxic Bank

First a bit of news
A birdie in front of my window has just chirped (hat tip to the birdie) that the ECB has tentatively signaled to the Irish Government that it will finance (largely? or in full?) the 'bad bank'. Under such an arrangement, the state will issue a sea of bonds - say €30-60bn to cover €50-90bn of impaired loans floating out there - and swap these for freshly printed cash from the ECB. Taxpayers get debt. Government gets pile of assets with default rates of, ughh say 20-25% (?). Banks get cash.

Why would the state go for this? Because if we price this junk at a fair market value, taking it off the banks will still leave us exposed to the need to recapitalize the banks. As they write down their assets after the transfer, the value of an asset will drop - from its current risk-adjusted (if only bogus) valuation of, say €0.90 per €1 in face value, to a fair value of, say €0.50, implying a loss of €0.40 per €1 in face value. This will chip into banks' capital reserves, driving down their core capital.

So the state will pay over the odds for the default-ridden paper to avoid the follow-up recapitalization call. This will sound like a right thing to do, but given that the taxpayers will be holding highly risky debt for which they have overpaid, it is not.

Second source of added liability comes from the nature of assets transferred to the bad bank. Banks have an incentive to transfer impaired consumer loans - the loans on which they have hard time collecting. So the state impaired assets pool will be saddled with near-default mortgages and credit cards debt. This is political dynamite, for no state organization will enforce collection on these voters-sensitive assets.

So the taxpayers will end up banking with the state. The fat cats of the public sector will end up banking with BofI and AIB.

Why would the banks go for this? While getting rid of the troublesome assets, the banks will get capital injections and no equity dilution. The bondholders will be happy too - lower risk base, higher risk cushion imply lower spreads and thus higher prices. The taxpayers will have to get a second round of squeezing as repayment to the state will be required to compensate for losses generated by the overly-generous original pricing scheme. These will take form of 'Guarantee' dividends to the Exchequer which, alongside with existent preference shares, will lead to a widening in lending spreads and banking fees. Customers will have to pay the Government via the banks.

Why would the ECB go for this? Ah, the birdie told me that the ECB, desperate to find some solutions to similar banking problems elsewhere, is keen on using Ireland as a sort of policy lab. Given it's newly acquired mandate to print cash in quantitative easing exercise, this means the price of such Social Laboratory Ireland is low enough for them to deal on Irish 'bad' bank.

All happy, save the soon-to-be-stuffed-again taxpayers...


A follow up on the Budget
Following the Budget last night, Irish media has gone into an overdrive. The simplistic terminology and naive analysis dominate the space between print, radio and TV with commentators heralding the Budget as:

• 'tough' - nothing tough about slicing off an odd €3bn off a deficit that is so vast. We will have to borrow half of our annual spending requirement this year - primarily, to pay welfare rates and public sector wages. In family economics, such budgeting is known as 'reckless' or 'subprime'. In Lenihanomics it is known as 'making hard choices' (at the expense of others);
• 'fair' - there is nothing fair about the budget that has taken the pain of adjustments required by the serial failure of this Government (in its various past incarnations) to reign in its own cronies' spending and dumping it all onto the population at large. Nothing can be further away from being fair than an idea that you soak the private sector to insulate and even gold-plate more the lives of the true Irish elite - the public sector dons;
• 'timely' - there is nothing timely about the Budget that delivers in April 2009 the corrections promissed in July 2008;
• 'far-reaching' - aside from 'deep-reaching' into yours and my pockets, the Budget failed to deal with the most pressing issues at hand. The actual deficit problem remains unaddressed. Reform of public sector - unaddressed. Economic stimulus - unaddressed. Banks financing - unaddressed. You name the topic.

For anyone who still needs a more down-to-earth explanation of the budget, here is an illustration
The media reaction to the Budget is hardly surprising.

Irish intellectual milieu is based on a vicious pursuit of any independent analysis and thought with a goal of eliminating any possibility of serious dissent. Anyone with a point of view departing from the consensus is left jobless and/or branded as a hack or a generally diseased mind.

How many dissenters are ever asked to advise or brief the policymakers? None. How many non-consensus economists work for the Government? None. In our Universities? A handful and then only on junior posts. How many differing opinions does the Irish Times feature in its main pages? Virtually none, unless they can be comfortably pigeonholed into some agenda slot.

Hence today's reaction. But also the continuous drift of consensus opinion to the La-La land of pseudo intellectualism of some of our left-of-centre pontificates. This is not reflective of any public opinion in the streets, but it is reflective of the incestuous nature of our public policy discourse.

At least in the Soviet Union they respected dissidents enough to physically hunt them. Here, we are simply growing immune to independent thinking.


And the best non-economist analysis of the state of our affairs

The piers are pummelled by the waves;
In a lonely field the rain
Lashes an abandoned train;
Outlaws fill the mountain caves.

Fantastic grow the evening gowns;
Agents of the Fisc pursue
Absconding tax-defaulters through
The sewers of provincial towns.

Private rites of magic send
The temple prostitutes to sleep;
All the literati keep
An imaginary friend.

Cerebrotonic Cato may
Extol the Ancient Disciplines,
But the muscle-bound Marines
Mutiny for food and pay.

Caesar's double-bed is warm
As an unimportant clerk
Writes I DO NOT LIKE MY WORK
On a pink official form.

Unendowed with wealth or pity,
Little birds with scarlet legs,
Sitting on their speckled eggs,
Eye each flu-infected city.

Altogether elsewhere, vast
Herds of reindeer move across
Miles and miles of golden moss,
Silently and very fast.

W.H. Auden 'The Fall of Rome'

Mini-Budget 2009: A 'Fail' Grade

To summarize, mini-Budget failed to deliver the substantial public expenditure savings promised. As a result of destroying private wealth and failing to cut public sector waste, instead of reducing the Gen Government Deficit to 10.75% of GDP as claimed in the Budget (Table 5), Minister Lenihan has left a Deficit of -12.5% to -13.0% of GDP in 2009. Details below.

The mini-Budget 2009 Part 1 is in and the Government has done exactly what I've expected it to do - soaked the 'rich'. This time around, the 'rich' are no longer those with incomes in excess of €100K pa, but those with a pay of €30K pa. We are now in the 1980s economic management mode, full stop.

Microeconomic Impact: Households

• The heaviest hit are the ordinary income earners and savers: Income levies up, thresholds down. Impact: reduce incentives for work at the lower end of wage spectrum and generate more unemployment through adverse consumption and investment effects. Before this budget, it would have taken a person on welfare living in Dublin ca €35-37,000 in annual pre-tax wages to induce a move into job market. Now, the figure has risen to over €40,000. PRSI ceiling is up a whooping 44.2% to €75K pa. This is jobs creation Lenihan-style;
• DIRT is up from 23% to 25% and levies on non-life and life insurance are up. CGT and CAT are up from 22% to 25%. The CGT is a tax stripping off the savers/investors protection against past inflation, so Mr Lenihan is simply clawing back what was left to the investors after his predecessors generated a rampant inflation. This is savings and investment incentives Lenihan-style;
• Mortgage interest relief is cut and will be eliminated going forward (Budget 2010) - I hope people in negative equity losing their jobs will simply send their mortgage bills to Mr Lenihan. Let him pay it;
  
• Interest reliefs on investment properties and land development are down. The rich folks who bought a small apartment to rent it out in place of their pension (yes, those filthy-rich Celtic Tiger cubs who saved and worked hard to afford such 'luxury' as a pension investment) are getting Lenihan-styled treatment too.These measures, adopted amidst a wholesale collapse in the housing sector, are equivalent to applying heavy blood-letting to a patient with already dangerously low blood pressure.

Microeconomic Impact: Businesses

• Providing no measures to support jobs creation or entrepreneurship, Lenihan managed to mention only his Government's already discredited programme for 'knowledge and green' economy creation from December 2008 as a road map for what the Government intends to do to stimulate growth;
• No banks measures announced or budgeted for, implying that an expected budgetary cost of ca €4-5bn in 2009 due to potential demand for new banks funds is simply not factored into our expenditures. Neither are there any costings or provisions for the 'bad' bank;
• No credit finance resolutions, PRSI cuts for employers, minimum wage reductions etc;
• CAT and CGT taxes up, income of consumers down, insurance levies up... Lenihan-styled treatment for business support is so dramatic that it is clear we have a Government that only knows how to introduce pro-business and pro-growth policies for their own cronies.

Microeconomic Impact: Public Sector
The only clear winners in the Budget were public sector workers. They face no unemployment prospect, no imposition of any new levies or charges, no cuts in salaries or indeed no changes to their atavistic, inherently unproductive, working practices.

Yet, they can retire earlier with a tax-free lumps sum guaranteed. And no actuarial reduction for shorter work-life, implying that the cost of the Rolls-Royce pensions to all of us has just risen by a factor of at least 1/3! Happy times skinning the taxpayers to pay the fat cats of the public sector elites? Lenihan-styled sharing of pain.

Pat McArdle of the Ulster Bank in an excellent late-night note on the Budget said: "Our main quibble with the Budget is with the split of the burden between tax and spending. ...contrary to the recommendation of practically every economist in the country, they opted for a 55% to 45% split in favour of taxes".

This is correct. On the morning of the Budget day, Mr Lenihan told the nation that not a single economic adviser was suggesting that the Budget impact should fall onto expenditure side. Clearly, he was either incapable of listening or simpy arrogantly ignorant.

Adding insult to the injury, Lenihan also ensured that majority of cuts were to befall the already heavily hit middle classes. Microecnomically speaking, Minister Lenihan has just dug the private sector grave a few feet deeper. It was at 6ft before he walked into the Dail chamber. It was at 10ft once he finished his speech.

Macroeconomic Impact: When Figures Don't Add Up
In Macroeconomic terms, we are no longer living in Ireland. We are living in Cuba where numbers are fudged, forecasts are semi-transparent and the state knows better than the workers as to what we deserve to keep in terms of the fruits of our labour. Mr Lenihan has torn up any sort of social contract that could have existed between the vast majority of Irish people and this Government.

All data is from DofF Macroeconomic & Fiscal Framework 2009-2013 document.
More realistic assessment of the GDP collapse in 2009 is being met with a relatively optimistic assumption that GDP contraction will be only 2.9% in 2010. Even more lunatic is the assumption that Ireland will return to a trend growth of ca 4% in 2012-2013. So my assumptions are: -8-8.5% fall in GDP in 2009, -3.5-4% fall in 2010, +1% growth in 2011, +2% in 2012 and +2.2% in 2013. This will be reflected in my estimate of the balance sheet below.

Another thing clearly not understood by the Government is the relationship between income, excise and import duties. Imagine a person putting together a party for few friends. She had before the Budget €100 to spend on, say, booze. Now she has €90. Her VAT, excise, import duties on €100 of spend would have been ca €66. Now she goes off to Northern Ireland with her €90. Does the Government lose €66? No. It also looses other (complimentary) goods shopping revenue. Say that the cost of party-related goods is €250 worth of purchases at 21% VAT, 10% duties. Total cost of a €10 generated by Lenihan in income tax levies is a loss of over €140 in revenue. Good job, Brian. Your overpaid economic policy advisers couldn't see this coming?

Notice investment figures in the table above? Other sources of GDP growth? Well, DofF did apply a haircut on its projections in January 2009 update, but these corrections are seriously optimistic on 2011-2013 tail of the estimates. This again warrants more conservative estimates.
Judging by the inflation figures estimates, the DofF believes that the era of today's low interest rates is simply a permanent feature of the next 5-year horizon. Again, this is too optimistic and should it change will imply much deeper economic slowdown in 2010-2013 period.

Now to the estimates Table below summarizes the estimated impact of the measures.
Per DofF estimates, the Exchequer deficit drops, post mini-Budget-1, by ca €2.7bn in 2009 or 2% of GDP. This is rather optimistic. In reality, this estimation is done on a simple linear basis, assuming no further deterioration in receipts and a linear 1-to-1 response in tax revenue to tax measures. This also assumes the macro-fundamentals as outlined in the Table 2 discussed earlier.

Now, building in some of my outlook on the budget side and GDP growth side, Table below reproduces DofF Table 5 and adds two scenarios (with assumptions listed): From the above table, we compute the General Government Deficit (the figure that is the main benchmark for fiscal performance) as in the following Table:
This speaks volumes. The Government promised in January 2009 the EU Commission to deliver 9.5% deficit in 2009. It has subsequently reneged on this commitment, producing an estimated Gen Gov Deficit of 10.75% today. However, stress-testing the DofF often unrealistic assumptions provides for the potential deficit of 12.5-13.0% for this year.

But there is a tricky question to be asked. Has Lenihan actually gone too far on the tax increases side? Note that the estimated gross impact of the overall budgetary measures is €3.3bn for the remaining 8 months of 2009, implying an annual effect of €4.95bn in fiscal re-balancing. This is ca 2.9% of GDP - a sizable chunk of the economy. From that figure, per Table 5 above, the implied net loss to the economy from the Government measure (estimated originally at -1% of GDP) should be closer to 1.5-1.7%. This in turn implies that instead of an 7.7% contraction in GDP, the DofF should have been using a 9.2-9.4% contraction. In today's note, Ulster Bank economics team provides a revised estimate of GDP fall for 2009 at 9.5% for exactly this reason.
Mr Lenihan and his advisers simply missed the point that if you take money out of people's pockets, you are cutting growth in the economy. Of course, our Ministers, their senior civil servants and advisers would not be expected to know this, given they lead such sheltered life of privilege.

If the above estimates were to reflect this adjustment, we have: 2009 GDP of €168.2bn;General Government Deficit of 11% for DofF estimates, and 12.7-13.25% for my scenarios. I will do more detailed analysis for 2010-2013 horizon in a separate post, but it is now clear that the Government has not achieved its main objective of an orderly fiscal consolidation to 9.25% deficit. Neither has it achieved an objective of supporting the economy through the downturn.

Conclusions
Today's Budget delivered a nuclear strike to the heart of the private sector economy in Ireland. It furthermore underscored the Government commitment to providing jobs and pay protection for public sector workers regardless of the cost to the rest of this economy. We are in the 1980s scenario facing years of run-away, unsustainably high public spending and no improvements in public sector productivity amidst severe contraction in demand and investment at home and from abroad.

Minister Lenihan has promised to go on a road show selling Ireland Inc. I wish him good luck and I wish his audiences a keen eye to see through the fog of demagoguery this Government has produced in place of sensible economic policies. If they do, their response to Mr Lenihan's approaches is likely to be "Thank you, Minister. We don't need to invest in the economy that taxes producers, savers and consumers to protect public sector waste. Thank you and good by."
From an investment case point of view - they will be right.

PS: As the first fall-out from the Budget, Moody's downgraded Irish banks (here)... More to come.

Daily Economics 07/04/09: Lenihan's McHammer Land

I have posted a set of presentation slides on Irish Economy on my partner blog: Long Run Economics. Feel free to check them out.

(scroll for Ireland note below)

Junk-bonds default rates: Per Bloomberg (here) ca 53% of US companies that issued high-risk, high-yield bonds will default over the next five years. Jim Reid, head of fundamental credit strategy at Deutsche Bank AG, further argued in his note yesterday that the recovery rate on this paper will be around 0%. This compares with 31% 5-year default rate in the two previous recessions and 45% in the Great Depression. “...40% high-yield defaults over five years seems to be a minimum starting point for this default cycle,” Reid wrote, with 50% rate being “not unrealistic.”

According to Moody’s Investors Service note from March, the 12-month default rate will rise to 22.5% in Europe and 13.8% in the U.S. by the end of the year. Moody’s forecast the 5-year default rate to be about 29% by February 2014, according to the report.

Reid's forecast is driven by continuously falling property markets and he sees another 16% declines due for the US and 30% in further falls in the UK property markets. And this leaves us here in Ireland in a dust. Reid-assumed implicit cumulative property declines over the 5-year horizon are:

• per Case-Schiller in the US: 32.8% peak to trough fall, and
  
• per Halifax index in the UK: 44% peak to trough fall;
• per Daft.ie index in Ireland (my estimates consistent with Reid's assumptions on the US & UK dynamics): a whooping cumulative implied contraction of 43% peak to trough.
  

This is pretty bad. How bad - consider some mitigating possibilities:

• Things might be not as bleak if one were to take into account Reid's most contentious assumption of the zero recovery rate. Standard assumptions assign ca 20% recovery rate for senior junk-grade paper. Times are not exactly standard, so, say, we get this down to 10%. This will comfortably bring Reid's numbers to the range of Great Depression, but not to the range of the last two recessions.
  
• Now, take a knife to his housing markets forecast. Although extremely tenuous at this moment in time, the US housing market (and indeed the UK market) is starting to show some early signs of stabilization. Suppose that home prices were to bottom at the OECD latest projection: US at -20% and UK at -34% (for Ireland, -38% drop).
  

Combined, these 'rosier' scenarios do imply a possibility of the US reaching the average ca 30-33% default rate on junk bonds this time around. We might be not as bad off as in the Great Depression after all... and we are certainly not as bad off as the equity markets in some jurisdictions (e.g Ireland) where shareholder wealth destruction has been much deeper than 30%, or indeed, 53%. So assumptions are the key and comparatives are the lock-in!

But what Reid's analysis shows is the dire need for stronger credit risk assessment of the fixed income portfolios traded, including in the ETFs universe. Seniority is the king, plus Government underwriting.

Junk estimates default rates: there are new 'estimates' of the Exchequer receipts being floated around today by Brian Lenihan (here): €33bn in tax revenue for 2009. This is about as realistic of an assessment as a snail's own worldview stuck atop a bullet train. The state will be lucky to pluck €30-31bn out of this economy comes December, simply because whatever the boffins of DofF are forecasting today for increased revenue from the mini-Budget tax hikes - all will be undone tomorrow by business and income tax receipts from sole traders and SMEs.

“Two-thirds of our spending is now welfare payments and payments to public servants. If you want an adjustment on the spending side you have to cut pay for public servants or cut rates for social welfare,” he told RTÉ News. “I have not seen many people advising me to do that. Let’s get real where the balance has to be struck here. Anyone who suggests that this cannot be done without tax is deceiving themselves.” Well, Minister, this is what happens when you surround yourself with lackeys for advisers. If 2/3rds of your household bill goes to pay servants and your non-working extended family, you are in an MCHammer-land: fat trousers and bankrupt estate.

My advice to our Minister-in-Charge-of-Bankrupting-Ireland is to get his head of the sand: cut 20% of the public pay bill by laying off some, trimming wages of others and scaling back pensions to those retired will be a good start. Follow it up with welfare spending cuts and stronger enforcement of welfare standards: unemployment benefits down by 5%, social welfare rates down by 15%.

Otherwise, Mr Lenihan's default rates on Budget forecasts will exceed those of the US junk bonds... Then again, it is hard to tell right now which paper is of higher quality.
Capital flows and Irish Capital Acquisitions Data:
Per mu post yesterday, here are two charts (from Follow the Money)showing US financial and trade flows dynamics and an even faster fall off in the capital formation. Clearly, our yesterday's CSO data is somewhat different, which suggests to me that Irish stats on relatively slow-declining capital acquisition in the industrial sectors are linked to some accounting trickery more than to real acquisitions. If the rest of the world is falling through the basement, how can Ireland still be hanging around in its first floor bedroom?

Over5seas Travel Data from CSO is out: predictably, the number of trips abroad by Irish residents fell by 13.4% to 474,000 in February 2009 compared to 547,600 a year ago. February 2009 overseas trips to Ireland were down 5.5% to 445,200 from the same month in 2008. Visits from the UK fell by 15,000 (5.8%) to 244,800. Trips from Other Europe increased by 1% to
149,100 while those from North America fell by almost 20% to 37,500. Chart below (courtesy of CSO) illustrates:
In 2009 to date, trips abroad by Irish residents are down by almost 11% to 976,100, "a complete reversal of the growth rate achieved in 2008". Overseas trips to Ireland are down 4.3% to 869,400 compared to an increase of almost 1% in 2008.