14/11/2013: With banks or without, things are heading for desperate in Italy...

The banks stress tests are coming up and the Euro periphery system is quickly attempting to patch up the massive cracks in the facade. The key one is the continued over-reliance of banks on sovereign-monetary-banking loop of cross-contagion. The banking system weakness is exemplified by Italy: Italian banks are the main buyers of Italian sovereign debt, which in turn means that Italian government stability rests on the banks ability to sustain purchasing, which implies that the ECB (with an interest of shoring up Italian economy) is tied into continuing to provide cheap funding necessary for the Italian banks to sustain purchasing of Italian Government debt… and so on.

Three key facts are clouding this 'stability in contagion' picture:

1. Banks in Italy and elsewhere are not deleveraging fast enough to allow them repay in full the LTROs coming due January and February 2015;
2. Banks in Italy are now fully saturated with italian Government debt, posing threats to future supply of Italian bonds and putting into question the robustness of the banking stress tests; and
3. Italian Government is running out of room to continue rolling over its massive debts.

If all 3 risks play out at the same time or close to each other, things will get testy for the Euro.


Point 1: Banks in the euro zone continue to carry assets that amount to three times the size of the euro area economy. This puts into question the core pillar of banking sector 'reforms' that the ECB needs to see before the banking union (BU) comes into being. The ECB needs to have clarity on quality of assets held by banks and, critically, needs to see robust deleveraging by the banks before th BU can be launched. If either one of these conditions is not fully met, the ECB will be taking over the banking system that is loaded with unknown and unpriced risks.

Per recent ECB data, Banks in the euro zone held EUR29.5 trillion in total assets by the end of 2012. That is down 12% on 2008. Too slow of a pace for a structural deleveraging. Worse, the bulk of the adjustments was back in 2009 and little was done since. Which makes the level of assets problem worse: on top of having too many assets, the system has virtually stopped the process of deleveraging. Knock on effect is that the firming of asset markets in Europe in recent two years was supported by a slowdown in assets disposals by the banks. In turn, this second order effect means that many banks assets on the books are superficially overvalued due to their withholding from the market. Nasty, pesky first and second order effects here.

Worse. Pressure on assets side is not limited to the 'periphery'. German banks held EUR7.6 trillion in total assets at the end of 2012, followed by the French banks with EUR6.8 trillion. Spain and Italy's banking sectors came in distant second and third, with EUR3.9 trillion and EUR2.9 trillion in total assets.

Capital ratios are up to the median Tier 1 ratio rising from 8% in 2008 to 12.7% in 2012. Quality of this capital is, however, subject to the above first and second order effects too - no one knows how much of the equity valuation uplift experienced by the euro area banks in recent months is due to banks reducing the pace of assets deleveraging…


Point 2: Assets quality in some large banking systems is too closely linked to the sovereign bonds markets. Italy is case in point. ECB tests are set to exclude sovereign debt risk exposures, explicitly continuing to price as risk-free sovereign bonds of the peripheral euro area states. But in return for this, the ECB might look into gradually forcing the banks to limit their holdings of sovereign bonds. This would be bad news for Italian banks and the Italian treasury.

The problem starts with a realisation that Italian banks are now primarily a vehicle for rolling over Government debt. Italy's Government debt is over EUR2 trillion. EUR397 billion of that is held by Italian banks. Another EUR200-250 billion can be safely assumed to be held by Italian banks customers who also have borrowings from these banks. Any pressure on the Italian sovereign and the ca EUR600 billion of Italian debt sloshing within the banking system of Italy is at risk.  That puts 20.7 percent of Italian banks assets at a risk play. [Note: by some estimates, Italian banks directly hold around 22% of the total Italian Government debt - close to the above figure of EUR397 billion, but way off compared to Spanish banks which are estimated to be holding 39% of the Spanish Government debt, hence all of the arguments raised in respect of Italy herein also apply to Spain. A mitigating issue for Spain is that it's debt levels are roughly half those of Italy. An exacerbating issue for Spain is that its deficit is second highest in Europe, well ahead of Italain deficit which is relatively benign).

Worse, pressure cooker is now full and been on a boiler for some time. In the wake of LTROs, Italy's banks loaded up on higher-yielding Italian Government debt funded by cheap LTRO funds - Italian banks took EUR255 billion in LTROs funds. In August 2013, Italian banks exposure to Italian Government debt hit EUR397 billion, just shy of the record EUR402 billion in June and double on 2011 levels. I

Either way, with or without explicit ECB pressure, Italian banks have run out of the road to keep purchasing Italian Government debt. Which presents a wee-bit of a problem: Italy needs to raise EUR65 billion in new debt in 2014. Italy is now in the grip of the worst recession since WWII and its debts are rising once again.

Chart below shows that:
1) Italian Sovereign exposures to external lenders declined in the wake of the LTROs, but are back to rising in recent quarters;
2) Italian banks reliance on foreign funding rose during the LTROs period, declined thereafter and is now again rising; while
3) Other (non-financial and non-state) sectors remain leveraged at the levels consistent with late 2006.

Point 3: Overall, Italian Treasury is now competing head on with the banks for foreign lenders cash and Italian corporate sector is being forced to borrow abroad in absence of domestic credit supply. Foreign investors bought almost 2/3rds of the last issue of Italian bonds, but how much of this appetite can be sustained into the future is an open question. Foreign investors currently hold slightly over a third of Italy's debt, or EUR690 billion, down from more than EUR800 billion back in 2011. The Italian Government is now turning to Italian households to mop up the rising supply. Italy issued EUR44 billion worth of inflation-linked BTP Italia bonds with 4 year maturity. As long as inflation stays low, the Government is in the money on these.

Next in line - desperate measures to raise revenues. Per recent reports, there is a proposal working its way through legislative corridors of power to raise tax on multinational on-line companies trading in Italy. The likes of Google, Amazon and Yahoo will be hit with a restriction on advertisers to transact only with on-line companies tax-resident in Italy, per bill tabled by the center-left Democratic Party (PD). The authors estimate EUR1 billion annual yield to the state - a tiny drop in the ocean of Italian government finances, but also a sign of desperation.

14/11/2013: New Vehicles Licensed: January-October 2013

So the car sales... they are booming, right? Confidence is up, consumers are back to spending, the worst of Budgetary cuts are behind us, the economy is growing, unemployment falling, etc, etc, etc... We've heard them all. So let's think about it... we are into sixth year of the crisis; cars are getting older and replacement pressure is rising. You would expect the 'turnaround economy' to produce a rise in car sales. To accommodate such, the Government changed license plates.

So here are the numbers for January-October new licenses issued:

The uptick in new licenses in 2013 is due to used cars sales. New car registrations are down 2.62% y/y for the period, down 12.8% of 2011 (same period), down 46% on 2000-present average. New Private cars registrations are down 6.3% y/y, down 18.3% on same period 2011, down 46.2% on 2000-present average.

Back to that Consumer Confidence for some sugar buzz... 

14/11/2013: Human Capital & The Age of Change: TEDx Dublin

My TEDx Dublin talk on Human Capital Age is now available on YouTube: http://www.youtube.com/watch?v=y1sueM_jhSk

13/11/2013: That Feta Feeling... a quick reminder...

Remember that Michael Noonan's gaffe about him missing feta cheese in the supermarket should Greece exit the euro back in 2012? Reminder:

Speaking at a Bloomberg event in Dublin, the Minister said: “Apart from holidaying in the Greek islands, I think most Irish people don’t have a lot (of connections with Greece),” he said. “If you go into the shops here, apart from feta cheese, how many Greek items do you put in your basket?”

Now, here's 2011 distribution of Greek exports via http://www.atlas.cid.harvard.edu/explore/tree_map/export/grc/all/show/2011/

All cheese exports accounted for 1% of total Greek exports. Just thought I'd share while rummaging through the data piles...

Oh, and while on the topic... latest Leading Economic Indicators for the euro area:

Spot numbers 1, 2 and 3... Let's not stay too arrogant...

12/11/2013: OECD Leading Indicators: September 2013

The poverty of non-recovery recovery...

OECD Leading indicators numbers are out and we have... 100.7 current (barely any growth) against 100.6 prior (barely any growth)... In other words, things are going nowhere fast:

• Japan beats OECD trend at 101.1 but a weak expansion on prior 101.0
• Euro area 100.7 same as OECD average, on 100.6 prior (weak expansion) and ditto for Germany which is now under-performing regional at 100.5 up on 100.4 prior. France - the 'laggard' before - is still a drag: 100.1 current on 99.8 prior.
• US 100.8 against 100.9 prior (so slower, but still slightly ahead of OECD average)
• UK 101.3 (ahead of OECD average) compared to 101.1 prior
• In contrast, two BRICs: China 99.4 on 99.2 prior - anaemic, and India 96.7 on 96.9 prior - weak.

So all in - tough conditions remain, but at least OECD is above 100...

Euro area set:

12/11/2013: Clawing out of the Great Recession...

In all of the excitement of the 'recovery' and the 'exit' and the 'regained independence' and all other newsworthy flow of PR material around, it is hard to keep track of where we are today as compared to the days before the Celtic Garfield sighed for the last time in his deep sleep... And yet, just a few numbers will do...

The latest data we have so far is for Q2 2013, which also gives us H1 2013... Here's the comparative to Q2 and H1 2007:

Yes, in nominal terms (that is in terms of actual countable euros), our GDP is still 15.3% below that in H1 2007 and or GNP is even worse - at 17.53% discount on H1 2007.

The score card for more recent performance is more encouraging but still weak:

So here's a medical analogy: a patient had a heart attack. A patient has progressed from being classified as being in an 'extremely critical' condition (2008 - 2010) to 'critical' (Troika 2010 - H1 2012) to 'critical but stable' (H1 2012 - H1 2013). It's a long way before we get back to a 'discharge' state... but we are starting to claw out.

11/11/2013: A Great Tech Future for Ireland… or a Bubble? Sunday Times, November 10

This is an unedited version of my Sunday Times column from November 10, 2013.

Depending on which measure one uses Ireland slipped into the Great Recession as far back as in the mid-2007. Since then and through the first half of this year, our nominal Gross Domestic Product is down 15.3 percent or EUR14.55 billion. Despite the claims about the return of growth, played repeatedly from early 2010, our economy posted 19 quarters of negative growth and only 7 quarters of expansion.

These numbers reveal the unprecedented collapse of the domestic economy, ameliorated solely by continued growth in exports, primarily driven by the multinationals. At the end of last year, total exports of goods and services from Ireland were up 16 percent on 2007 levels. However, the latest global and domestic trends suggest that this growth is at risk from a number of factors. These include both the well-known headwinds that are currently already at play, as well as the newly emerging signs of distress. 

The former cover the adverse impact of the ongoing patent cliff in pharmaceutical sector and the continued migration of manufacturing to Eastern and Central Europe and Asia-Pacific. Added pressures are building up from our competitors for FDI, such as the Netherlands, Belgium, Sweden, Finland and, more recently, Austria.

The risks that are yet to fully materialise, however, pose a threat to the biggest post-2007 success story Ireland has had - the Information and Communications Technology (ICT) services. This sector, most often exemplified by the tech giants, such as Google and blue chip firms such as Microsoft. More trendy and smaller players include the games developers, cloud computing and data analytics enterprises, as well as on-line marketing and advertising companies.

While easy to discount as being only potential, these threats are worrying. 

Since 2007, goods exports from Ireland grew by a cumulative 2.1 percent, against 33 percent growth in exports of services. If in 1998-2004 goods exports averaged over 67 percent of our GDP, today this share has declined to 51 percent. Meanwhile, share of services exports rose from an average of 23.3 percent of GDP in 1998-2004 period to 58.4 percent projected for this year. More than half of this growth came from ICT services.

More importantly, as the Budgets 2012-2014 have clearly shown, the Government has no coherent plan for supporting the growth capacity of the domestic economy. This means that the entire economic strategy forward remains focused on the ICT services to deliver growth in 2014-2015. 

And herein lies a major problem. Increasingly, international markets and global developments are signaling the emergence of an asset bubble within the ICT services sector. These signs can be grouped into three broad categories.

Firstly, we are witnessing the development of a bubble in investors' valuations of the ICT companies. Controlling blue chips, tech valuations have grown over the last decade at a pace roughly double that found in other sectors. Many tech stocks are currently trading in the range of 25-50 times their sales, dangerously close to the levels last seen at the height of the dot.com bubble. Last 18 to 24 months have also seen a series of tech IPOs with post-listing annual returns in 50 percent-plus ranges - another sign that investors are rushing head-in into the sector. Meanwhile, blue chip technology companies are trading near or below their multi-annual averages, suggesting that hype, not real performance is the driver of the market for younger firms. MSCI ACW/Information Technology benchmark tech stocks index is up ca 90 percent over the last 5 years. Recent research from PWC shows that IT sector M&A deals in Q3 2013 were up 34 percent year on year.

Secondly, costs inflation is now driving profitability down across the sector. Take for example Ireland. In 4 years through June 2013, average weekly earnings in the economy fell 1 percent. In the ICT sector these rose 11 percent. Back in Q2 2009, ICT sector posted the third highest average weekly earnings of all sectors in the Irish economy. This year, it was the highest. Other costs are inflating as well. Specialist property funds with a focus on the tech sector, such as Digital Realty Trust, are awash with cash from their massive rent rolls.

CSO publishes a labour market indicator, known as PLS4. This combines all unemployed persons plus others who want a job but are not seeking one for reasons other than being in education or training and those who are underemployed. In Q2 2013 this indicator stood at nearly one quarter of our total potential workforce. Yet, the ICT services sector has some 4,500-5,500 unfilled vacancies. With tight labour supply, stripping out transfer pricing in the sector, value-added is stagnating in the sector, implying lagging productivity growth.

Thirdly, as in any financial bubble, we are nearing the stage where the smart money is about to head for the doors. In recent months, seasoned investors, ranging from Art Cashin, to Tim Draper to Andressen Horowitz announced that they cutting back their funds allocations to the sector. 

To see how close we are getting to forming a bubble, look no further than the recent fund raising by Supercell - a games company - which raised USD1.5 billion in funding in October. The firm has gone from zero value to USD3 billion in just three years on last year profit of just USD40 million. The investor who financed the Sueprcell deal, Japan's Masayoshi Son is now declaring that he is investing based on a 300-year vision for the future. Expectations and egos are rapidly spinning out of synch with reality. In tandem with this, Irish politicians are vying for any photo-ops with the ICT leaders and industry awards, summits and self-promotional gala events are musrooming. In short, the sector is becoming a new property boom for Ireland's elites.

Global ICT services sector hype is pushing up companies valuations across the sector and delivering more and more FDI into Ireland. This is the good news. The same hype, however, also brings with it an ever-increasing international exposure of Ireland's tax regime, the main driving reason for the MNCs locating into this country. This, alongside with rampant wages inflation and skills shortages, is one of the top domestic reasons for the tech-sector vulnerability. 

Overall, risks to the ICT services sector are material for Ireland. Our economy's reliance on the tech sector FDI has grown over time, and even a small contraction in the sector exports booked via Ireland can lead to us sliding dangerously close to once again posting negative current account balance. 

Our capacity to offset any possible downturn in the sector with other sources of growth has been diminished. Post-2001 dot.com bust we compensated for the collapse in ICT and dot.com companies activities by inflating property and Government spending bubbles. This time around all three safety valves are no longer feasible. Between Q1 2001 and Q2 2003, ECB benchmark repo rate declined from 4.75 percent to 2.0 percent. Today, the ECB rates are at 0.5 percent and cannot drop by much into the foreseeable future. 

Besides credit supply, there is a pesky problem of credit demand. The evidence of this was revealed to us last week, when we learned that the Government Seed and Venture Capital Scheme (SVCS) and the Micro-enterprise Loan Fund turned out to be a flop. Both schemes are having trouble finding suitable enterprises to invest in. May we wish better luck to yet another ‘state investment vehicle’ launched this week, the ‘equity gap’ fund for medium-sized companies.

Ireland's policymakers today have little to offer in terms of hope that we can weather the next storm as well as we did ten years ago. 

Based on numerous multi-annual initiatives by the Government and business lobbies, Ireland’s 'new school' of economic thinking post-crisis is solidly focused on tax incentives to rekindle a new property and construction boom and on advocating more Government involvement in the economy. The latter includes such initiatives as more state investment and lending schemes for SMEs, a state bank, state-run agencies to sell services to foreign state agencies, state-supported access to exports markets, and state-funded R&D and innovation. 

This reality is compounded by the fact that in recent years, much of our development agencies attention has focused on attracting smaller and less-established firms and entrepreneurs from abroad to locate into Ireland. Both IDA and Enterprise Ireland have active campaigns courting these types of ventures. Of course, such efforts are both good and necessary, as Ireland needs to continue diversifying the core base of MNCs trading from here. Alas, it is a strategy that not only brings new rewards, but also entails new and higher risks. Should the tech sector suffer significant market correction, in-line with dot.com bubble bursting or banking sector crisis, majority of the younger firms that came to Ireland to set up their first overseas operations here will be downsizing fast. Unlike traditional blue-chip firms, these companies have no tangible fixed assets. They own no buildings, employ few Irish workers and have no technology domiciled here. For them, leaving  these shores is only a matter of booking their flights.

In short, our policy and business elites seem to be flat out of fresh ideas and are ignorant of the potential threat that our over-concentration in ICT sector investment is posing to the economy. Let’s hope the new bubble has years to inflate still, and the new bear won’t be charging any time soon. 

Update: new article on the topic from the BusinessInsider: http://www.businessinsider.com/4-billion-is-the-new-1-billion-in-startups-2013-11

Box-out:

Just when you thought the Euro crisis is nearing its conclusion, here comes a new candidate state to join the fabled periphery.  Last week, the IMF concluded its Article IV consultation assessment of Slovenia. The Fund was more than straightforward on risks and problems faced by the country bordering other ‘peripheral’ state – Italy. Per IMF: “Slovenia is facing a deep recession resulting from a vicious circle of strained corporate and bank balance sheets, weak domestic demand, and needed fiscal consolidation. Cleaning up and recapitalizing banks is an immediate priority to break this cycle.“ Some 17.5 percent of all assets held by the Slovenian banks were non-performing back in June 2013. Worse, over one third of all non-performing loans were issued to 40 largest companies in the country, putting strain on the entire economy. Corporate debt is so high in Slovenia, interest payments account for 90 percent of all corporate earnings. If that is a ‘cycle’ one might wonder what constitutes a full-blow crisis? Spooked by the Cypriot crisis ‘resolution’, Slovenian Government has so far rejected the use of international assistance (re: Troika funding) in addressing the crisis. However, the country fiscal deficit is running at 4.25 percent of GDP, net of banks’ restructuring and recapitalisation costs. In other words, Slovenia today is Ireland back in 2010. Brace yourselves for another Euro domino falling.

11/11/2013: Irish Construction PMI - September 2013

While on PMIs, let's update Construction PMIs too, to cover September 2013 data. Manufacturing and Services October PMIs are covered here: http://trueeconomics.blogspot.ie/2013/11/11112013-services-and-manufacturing.html

In September, Overall Construction Sector PMI for Ireland rose to 55.7 which is the first reading above 50.0 (and it is statistically significantly different from 50.0) since January 2009.

The rise was broadly anchored, with Housing sub-index up at 59.5, marking the third consecutive month of above 50.0 readings (although previous two months were not statistically distinct from 50.0). Commercial activity sub-index also posted a rise to 56.1, marking the second consecutive month of above 50.0 readings. However, Civil Engineering sub-index remained below 50 at 47.3, although the pace of declines in activity has eased somewhat from 41.0 in August.

11/11/2013: Services and Manufacturing PMIs for Ireland: October 2013

With some delay, let's update the data on Irish PMIs.

Before we do, quick explanation for a delay - I used to be on the mailing list for Investec releases to PMIs for years (way before the organisation became a part of Investec). This all ended some months back when I was struck off the mailing list. Presumably, being a columnist with 2 publications & blogger, who always and regularly cites PMIs and Investec as their publisher, is just not enough to earn one the privilege of being sent the release. Oh, well…

Now to numbers… 

Services PMI hit 60.1 in October, up on 56.8 in September, marking the second highest reading since January 2007 (the highest was recorded in August this year at 61.6). This is a strong return. 3mo average for the period August - October 2012 was 53.9, current run is 59.5, so the distance y/y is 10.4% - statistically significant. 

Notably, from January 2010 through current, the average deviation of PMI from 50.0 is 2.5, so we are solidly above the average.

Quarterly averages are also strong. Q1 2013 posted 54.23 and Q2 2013 was at 54.27, but Q3 2013 came in at 58.67. And we are now running well ahead of that.

With full-sample standard deviation of the PMI reading distance to 50.0 at 7.3  (same for the period from January 2008 through current being 6.84), we are now solidly in statistically significant territory for expansion since July 2013.

Manufacturing PMI also strengthened, although by much less than Services. Manufacturing PMI hit 54.9 in October, up on 52.7 in September and 3mo average through October 2013 is at 53.2, which is 3.% ahead of the 3mo MA through October 2012.

Quarterly averages are signalling weaker growth, however. Q1 2013 was at 50.1 (basically, zero growth in statistical terms), while Q2 2013 stood at 49.3 (same - zero growth in statistical terms). Q3 2013 came in at 51.3 and the October reading is ahead of this. In fact, October 2013 reading is the highest since April 2011. October reading is statistically significant, based on historical data, but it is not statistically significantly different from 50 on the basis of data from January 2008.

The above shows one thing: we are above historical and 2008-present averages for both Manufacturing and Services PMIs (good news). Below chart confirms relatively strong performance for the series on 3mo MA basis (good news):

As chart below shows, there is a third good news bit: both series have now broken away from their asymptotic trend, with Manufacturing at last showing some life.

Note to caveat the above. As I showed before, both manufacturing and services PMIs have relatively weak relation to actual GDP and GNP growth, with Manufacturing PMI being, predictably, better anchored to real growth here. Details here: http://trueeconomics.blogspot.ie/2013/10/3102013-irish-pmis-are-they-meaningful.html

10/11/2013: WLASze: Weekend Links on Arts, Sciences and zero economics

Having spent the entire weekend in the Marble City at Kilkenomics 2013, I hardly had any time to read through many articles on arts and sciences this week. Hence, this week's WLASze: Weekend Links on Arts, Sciences and zero economics will be short.


For a popular science magazine, this article doesn't quite get high accolades for being either well-written or insightful, but the topic of it is very fascinating and, with some stretch of imagination beyond our current technological capabilities, even important. Basically, some astronomy eggheads decided to carry out a relatively simple exercise. Assume that with conditions in other solar systems similar to those found in ours, the distance from the sun and the nature of orbit determine the temperature conditions to be found on planets. Thus, any planet with its orbit falling within the specific range of distance from the sun (star) will be potentially inhabitable. Now, take visible stars and start linking star intensity (energy it emits) to distance to orbiting plants. Count the ones that are close enough not to be ice cubes floating in space and yet far enough not to be like a roasting oven… Simple and rather boring. But also rather significant. It turns out that the closest candidate to Earth we can find is a planet mere 12 light years away from us. (That is just shy of 113,528,765,670,970 kilometers or, like, 272,120,723,085 round trips between Dublin and Cork without stop-overs in McDonalds, that's right over 272 trillion round trips)... some might, one day, call that commuting distance to Dublin...
http://www.popsci.com/article/science/one-five-sun-stars-have-earth-planets?src=SOC&dom=tw
Here is the same story in much cooler and excited language of science:
http://www.pnas.org/content/early/2013/10/31/1319909110.full.pdf

Fig. 4. The detected planets (dots) in a 2D domain similar to Figs. 1 and 2. Here, the 2D domain has orbital period replaced by stellar light intensity, incident flux, hitting the planet. The highlighted region shows the 10 Earth-size planets that receive an incident stellar flux comparable to the Earth: flux =0.25–4.0 times the flux received by the Earth from the Sun. Our uncertainties on stellar flux and planet radii are indicated at the top right.

To explain the above: green box contains Earth-like planets. Or in the terminology of the article: 10 small ðRP=1−2 R⊕Þ planets that receive stellar flux comparable to Earth: FP=0:25−4 F⊕.


Back on Earth, meanwhile, the largely uninhabited and uninhabitable planet Detroit got a fresh start on (some) life in the form of an absolutely fantastic new firm that specialises in reviving what used to be an industrial design powerhouse. Shinola is a superb group of designers and producers that do everything - from fantastic watches to unbelievably well-designed and executed bikes… Enjoy!
https://www.facebook.com/shinola
An awesome brand from an awesome city... The first set of non-Swiss watches I actually would love to own…

From life-restoring design success story of Detroit's wastelands to the story of human's life-destroying activities in the oceans:
http://www.foreignaffairs.com/articles/140164/alan-b-sielen/the-devolution-of-the-seas?cid=soc-facebook-in-snapshots-the_devolution_of_the_seas-110913
Foreign Affairs once again delivers a superb article on a hugely important topic.


And from digging ourselves into the environmental trouble, to digging out a troubled history… Brief history of world's largest hand-made hole:
http://www.atlasobscura.com/places/big-hole-and-open-mine-museum

Attached to it, is the story of the De Beers...

Enough for the day that's left...

9/11/2013: Stress testing zombie banks: Sunday Times, November 3

This is an unedited version of my Sunday Times article from November 3, 2013.


In the marble and mahogany halls of European high finance HQs, the next few months will be filled with the suspense of the preparation for the banks audits.

Much of this excitement will be focused on matters distant to the real economy. Truth is, saddled with zombie banks, and public and private sectors’ debt overhangs, euro area is incapable of generating the growth momentum sufficient to wrestle itself free from the structural crisis it faced since 2008. The latest ECB forecasts for the Euro area economy, released this week, predicted real GDP contraction of 0.4 percent for 2013 and growth of 1 percent in 2014. With these numbers, the end game is the same today as it was two years ago, when previous stress tests were carried out. The system can only be repaired when banks absorb huge losses on unsustainable loans.

New stress tests are unlikely change this. However, the tests are important within the context of the weaker banking systems, such as the Irish one. The reason for this is that the ECB needs to contain the sector risks as it goes about building the European Banking Union, or EBU.

The good news is – there are low- and high-cost options for achieving this containment in Ireland’s case. The bad news is – neither involves any relief on the legacy banks debts necessary to aid our stalled economy. The worse news is – the Government appears to be pushing for exiting the bailout without securing the low cost option, leaving us exposed to the risk of being saddled with the costlier one.


The IMF data suggests that Euro area-wide banks’ losses can be as high as EUR350-400 billion - or just under one third of the total deleveraging that still has to take place in the banks. The ECB needs to have an accurate picture of how much of the above can arise in the countries where banks and Government finances are already strained beyond their ability to cover such losses. The ECB also needs to deliver such estimates without raising public alarms as to the levels of losses still forthcoming.

Taken together, the above two points strongly suggest that in the case of Ireland, the banks will come out of the stress tests with a relatively clean bill of health shaded somewhat by risk-related warnings. Pointing to the latter, the ECB will implicitly or explicitly ask the Irish Government to secure funding sources for dealing with any realization of such risks. Such precautionary funding can only come from either a stand-by credit line with the IMF and/or European stabilization funds, or a commitment to set aside some of the NTMA cash. An NTMA set-aside will cost us the price of issuing new Government debt. This is potentially more than ten times the price of IMF credit line.

In short, Ireland should be using ECB’s concerns over our banking system health to secure a cheaper precautionary line of credit. Judging by this week’s comments from the Government, we are not. One way or the other, it is hard to see how continued uncertainty build up within Irish banks can help our cause in obtaining both a precautionary line of credit and a relief on legacy banks debts.


The ECB concerns about Irish banks are not purely academic. Our banking crisis is far from over.

Consider the latest data on three Pillar Banks: AIB, Bank of Ireland and Permanent tsb, covering the period through H1 2013 courtesy of the IMF and the EU Commission reviews published over recent weeks. On the surface, the three banks are relatively well capitalised with Core Tier 1 capital ratio of 14.1 percent, down on 16.3 percent a year ago. Meanwhile, the deleveraging of the system is proceeding at a reasonable pace, with total average assets declining EUR30.5 billion year on year.

The problem is that little of this deleveraging is down to writedowns of bad loans. This means that high levels of capital on banks balance sheets are primarily due to the extend-and-pretend approach to dealing with nonperforming loans adopted by the banks to-date. All members of the Troika have repeatedly pointed out that Irish banks continue to avoid putting forward long-term sustainable solutions to mortgages arrears and that this approach can eventually lead to amplification of risks over time.

Loans loss provisions are up 11 percent to EUR28.2 billion and non-performing loans are up to EUR56.8 billion. Still, while in H1 2012 non-performing loans accounted for 22.2 percent of all loans held by the banks, at the end of June this year, the figure was 26.6 percent. Non-performing loans are now 35.5 percent in excess of banks’ equity, up from just 4.7 percent a year ago. As a reminder, Irish Exchequer holds 99.8 percent stake in AIB, 99.2 percent share in Ptsb and 15.1 percent stake in Bank of Ireland. This means that should capital buffers fall to regulatory-set limits, further writedowns of loans will mean nullifying the Exchequer stakes in the banks and crystalising full losses carried by the taxpayers.

Continued weaknesses in the solvency positions of the banks are driven primarily by three factors. Firstly, as banks sell or collateralise their better loans their future returns on assets are diminished. The second factor is poor operational performance of the banks. Net losses in the system fell between H1 2012 and H1 2013. However, this still leaves banks reliant on capital drawdowns to fund their non-performing assets. The third factor is the weak performance of banks’ non-core financial assets. Over the last 12 months, Irish banks holdings of securities grew in value at a rate that was about 12-15 times slower than the growth rate in valuations of assets in the international financial markets.

In short, the IMF review presented the picture of the banking sector here that retains all the signs of remaining comatose. This was further confirmed by the EU Commission report this week, and spells trouble for the Irish banks stress tests.

In 2011 recapitalisation of Irish banks, the Central Bank assumed that banks operating profits will total EUR3.9 billion over the 2011-2013. So far the banks are some EUR4.5 billion shy of matching the Central Bank’s rosy projection.

This shortfall comes despite dramatic hikes in interest margins on existent and new loans, decreases in deposit rates, and reductions in operating costs. Compared to H1 2011 when the PCARs were completed, lending rates margins over the ECB base rate have shot up by up to 138 basis points for households and 59 basis points for non-financial companies. Rates paid out on termed deposit have fallen some 103 basis points. As the result, banks net interest margins rose.

On top of that, the funding side of the banks remains problematic. The NTMA is now holding almost half of its cash in the Pillar Banks, superficially boosting their deposits. Private sector deposits continue to trend flat and are declining in some categories. This is before the adverse impacts of Budget 2014 measures, including the Banks levy and higher DIRT rates start to bite.

Behind these balance sheet considerations, the economy and the Government are continuing to put strains on households' ability to repay their loans. This week, AA published analysis of the cost of mortgages carry (the annual cost of financing average family home and associated expenses). According to the report, the direct cost of maintaining an average Irish home purchased prior to the crisis is now running at around EUR 21,940 per annum. Under Budget 2014 provisions, a married couple with two children and combined income of EUR 100,000 will spend one third of their after-tax earnings on funding an average house. In such a setting, any major financial shock, such as birth of another child, loss of employment, extended illness etc., can send the average Celtic Tiger household into arrears.


All of this, means that any honest capital adequacy assessment of the Irish banking system will be an exercise in measuring a litany of risks and uncertainties that define our banks’ operating conditions today and into the foreseeable future. Disclosing such weaknesses in the system will risk exposing Irish banks to renewed markets pressures, including possible failures to roll over maturing debts coming due. It can also impair their ability to continue deleveraging, and fund assets writedowns. On the other hand, leaving these stresses undisclosed risks delaying recognition of losses and exposing us to pressure from the ECB down the line.

Not surprisingly, as the ECB goes into stress tests exercise, it is exerting pressure on Ireland to arrange a stand-alone precautionary line of credit. While it is being presented as a prudential exercise in light of our exit from the bailout, in reality the credit will be there to cushion against any potential losses in the banking system over 2014-2018, before the actual EBU comes into force. Should such losses materialise, the Exchequer will be faced with an unpalatable choice: hit depositors with a bail-in or pony up some more cash for the banks. Having a stand by loans facility arranged prior to exiting the Bailout will help avoid the latter and possibly the former. The cost, however, will be an increase in overall interest charges paid by the State, plus continued strict oversight of our fiscal position by the Troika.

A rock of interest charges and Troika supervision, a hard place of zombiefied banking, and a rising tide of risks are still beckoning Ireland from the other side of the stress tests.

Box-out: 

The latest data from the retail sector released by the CSO this week painted a rather mixed picture of the domestic economy’s fortunes. Controlling for some volatility in the monthly series, Q3 2013 data shows that despite very favourable weather conditions over the July-September 2013, Irish core retail sales (excluding motors sales) fell in volume by some 0.3 percent compared to Q3 2012. On the other hand, there was a 0.6 percent increase in the value of sales over the same period. Currently, the volume of total core retail sales in Ireland sits 4.3 percent below 2005 levels. Non-food sales, excluding motor trades, fuel and bars sales, fell 2.1 percent on 2012 in volume and is up 1.2 percent in value. The inflation effects imply that when it comes to core non-food sales, the volumes of retail trade are now down 22 percent on 2005 levels, while the value of sales is up almost 2 percent. Consumers are still on strike, while retailers are getting only a slight prices relief in the unrelenting crisis.

7/11/2013: Taxation and Human Capital: Blundel's Thoughts

A recent paper from Richard Blundel, titled “Taxation of Earnings: the impact on labor supply and human capital” (Becker Friedman Institute, 27th September 2013 available at: http://bfi.uchicago.edu/sites/default/files/research/Blundell_BFI%20_September_27_2013.pdf) argues that the tax system can be reformed “to generate the levels of revenue required to fund public goods while reducing the overall level of distortions implicit in the system”.

“The discussion in this paper draws on the work in the [Mirrlees Review (2011)] and concerns the taxation of labour earnings as well as relevant aspects of the welfare benefit and tax credit systems.” The core focus here is “on the empirical foundations for tax reform” in favour of “placing the analysis of earnings taxation in a lifetime setting, recognising the importance of human capital investments.”

Summary

Per Blundel, earnings taxation:
1) Raises revenue for public goods
2) Acts as the main source for funding redistribution of “resources from richer to poorer households”
3) “… From a more dynamic perspective, it ‘insures’ individuals and families against adverse events such as job loss and disability.

“Not surprisingly, it occupies a special place in debates about levels and structure of taxation.”

Several other important aspects that Blundel fails to consider are:
- Earnings taxation represents an opportunity cost of public goods provision in terms of reduced availability of funding for investment in enterprise creation and entrepreneurship; and
- Earnings taxation levies a charge on that part of personal income that is linked directly to individual effort and investments in human capital.

“One central question in the policy debate on earnings tax reform is whether, and to what degree, ‘supply side’ reforms can be used to relieve the pressure from ageing populations.” Thus, the question is: “How best to increase employment and earnings over the working life?” Per Blundel, evidence suggests that “the key to using tax policy for improving the trends in employment, hours and earnings in the longer-run will be to focus on”:
1) labor market entry (“Enhancing the flow into work for those leaving education and for returning mothers after childbirth”)
2) retirement (“maintaining work among those in their late 50s and 60s”) and
3) human capital (“Understanding the implicit incentives (or disincentives) created in the tax and welfare system or human capital investments .... Encouraging human capital improves the pay-off to work and ensures earnings grow, and hold up longer, throughout the working life.”)

Tax reforms accounting for human behavior 

Key here is that “Reform of the tax system as it impacts on labor supply and human capital is not simply about increasing life-time earnings”. In addition to levels of earnings consideration, we must also account for “many other aspects of human welfare, including the utility from consuming goods, from home production, from reducing risks, etc.”

Thus, taxes on earnings “should be seen as part of the whole ‘tax system’. In terms of an overall reform package, it is important to view corporate and personal taxation together as there are many aspects where they overlap: not every tax needs to be progressive for the tax system to be progressive; not every tax needs to be ‘green’ for the tax system to provide the right incentives for environmental protection.” In other words, “we still need to be aware of the interactions with capital, savings and environmental taxes.”

All of the above suggests that the Irish Government approach to tax policy, based on the explicitly defined premise that no matter what, the corporate tax system rests outside the scope of any tax reforms consideration, is not and cannot ever be a good practice.

Complexity avoidance is real

Another major point raised by Blundel is that “In most developed economies, the schedule of tax rates on earned income is rather complex. This may not always be apparent from the income tax schedule itself, but note that what really matters is the total amount of earnings taken in tax and withdrawn benefits—the effective tax rate. The schedule of effective tax rates is made complicated by the many interactions between income taxes, earnings-related social security contributions by employers, welfare benefits, and tax credits.” In other words, Blundel clearly states that total burden – whether via direct or indirect taxes – matters. This is something that the Irish Government simply refuses to recognize.

However, in criticism of Blundel, I would also add that it is too simplistic to look at the effective macro-level (economy-wide or average/media) level of taxation. We have to recognize that many benefits paid out in the economy do not apply or are not available to all participants in the economy. Thus, for example, famers transfers are not available to non-farmers, youth support schemes relating to training and education are not available to older adults, unemployment benefits are not accessible to entrepreneurs and so on.

Taxes and labour supply

“At a very high level, some of the main points that emerge from this evidence are that substitution effects are generally larger than income effects: taxes reduce labour supply. Especially for low earners, responses are larger at the extensive margin—employment—than at the intensive margin—hours of work. Responses at both the intensive and extensive margins (and both substitution effects and income effects) are largest for women with school-age children and for those aged over 55.”


There is much, much more to read in Blundel’s insights, so do not even for a second think the above summary is a substitute to reading the whole paper.