Central Bank Funding Falls (but is still massive!)

The reliance of the six covered banks on funding from central banks fell for the first time in a year in March.  Last April the borrowings of the covered banks from central banks fell from €52 billion to €47 billion.  In March it fell from €153 billion to €144 billion. 

It might have fallen for the first time in a year but it is also €100 billion bigger!  The six banks are borrowing the equivalent of 94% of GDP from central banks.  It will take more than one monthly drop to solve this problem.

The banks’ borrowings from the ECB have fallen for the past two months and are down to €79 billion from the peak of €93 billion in January.  The green line actually represents the “Other Assets” category in the Central Bank of Ireland’s balance sheet.  It is widely accepted that all bar about €2 billion of this is Emergency Liquidity Assistance (ELA) that the is being provided to the banks.

As the assets being provided by the banks were shunned by the ECB the banks turned to the ELA on offer from Dame Street.  This is generally at a rate about 2% above the ECB rate. 

The level of ELA first became noticeable following the nationalisation of Anglo in January 2009.  It then stayed between €10 billion and €12 billion between then the the expiry of the original blanket guarantee in August 2010. 

As soon as the guarantee expired it ballooned as the banks lost huge amounts of deposits (as well as paid off a few bonds) and did not have assets that the ECB would accept.  In just five months it went from around €10 billion to be near €70 billion.  In the light of those increases the falls this month are nothing to be getting excited about.

Slight uptick in Retail Sales

The March Retail Sales Index has been released by the CSO.  Core retail sales are showing a slight improvement on the February levels.  Nothing huge, but both the value and volume series edged upwards.

As expected the annual changes remain negative as the first quarter 2011 figures are being compared against the short-lived “turning the corner” momentum of early 2010.

The volatility in the monthly changes continues.  The severe weather in December is a major factor in this but we can expect to be able to read more from these over the coming months.

Evening Echo Article 22/04/2011

Here is the text of an article I wrote after this week’s publication of the Review of State Assets and Liabilities that was carried by Friday’s Evening Echo.

The Review of State Assets and Liability published this week identifies around €5 billion of assets which could be sold. The report was undertaken by a group of three, but it is the group chairman, UCD Economics Lecturer, Colm McCarthy who is associated by name with the report. The other members of the group were Alan Mathews, an Economics Professor in Trinity College and Donal McNally who is the Second Secretary in the Department of Finance.

The report gives a useful insight into the activities and outcomes of 15 commercial state bodies, including the ESB, Bord Gáis, CIE, An Post, RTE and the airport and port authorities. Some commercial bodies were excluded from the report. These were the VHI, NAMA and the now nationalised banks as these are all subject to separate processes.

The report makes some strong recommendations about how these assets should be used, but emphasises that an immediate sale of these assets should not be contemplated. The recommendations of the report are to be considered by government and it is only once their actions are announced that we will know what the outcome of this process will be. The report, though, does give us the information they will be using on which these decisions will be based.

At the end of 2009 the 15 bodies covered by the report had just over 40,000 employees which was identical to the number of employees at the end of 2007. The average annual salary was €54,600, with pension contributions bringing this up to €63,200. As the country experienced economic collapse average salaries increased by 2.6% from 2007 to 2009, and once pension contributions are included the increase was actually around 4%.

In 2009, these companies earned an aggregate operating profit of nearly €400 million. Although the State is the beneficiary of these profits, subsidies to loss making elements, particularly rail travel and rural transport, meant that the State had a negative dividend of €340 million to keep these companies running. There has been no year since 2002 when the aggregate of these companies has produced a positive return for the State.

Since 2002, the ESB has paid over €700 million in dividends to the Exchequer with Bord Gáis contributing over €130 million. These two companies provide over 70% of the total dividends paid to the State from these enterprises, though it must be remembered that these dividends are generated from the prices charged in providing electricity and gas to households up and down the country. All the other companies covered the report are not significant contributors of dividends to the State.

The ESB and Bord Gáis also have the highest salary levels. In 2008, the average annual salary for the ESB’s 8,000 employees was €76,000. Once pension contributions by the company are accounted for the average annual salary rises to nearly €90,000. This is two and a half times the average industrial wage. The average annual salary for the 1,000 employees of Bord Gáis was €67,000 with pension contributions bringing this up to €77,000. Again, these salaries are funded from the revenue collected from households.

These companies have total debts of around €6.5 billion with the bulk of this in ESB, Bord Gáis and the Dublin Airport Authority. CIE does not have a significant level of debt as investment in the transport infrastructure it uses is directly funded by the State. This debt reduces the potential sale value of these enterprises.

Although many of the companies cover the entire country, there are three instances that relate to specific assets in the Cork region. These are Cork Airport, the Port of Cork and SWS Natural Resources, which was acquired by Bord Gáis in December 2010.

The report does not recommend that Cork Airport be sold. The report is, however, critical of the capital expenditure undertaken in the airport and describes the new terminal as “controversial”. The report states that there is “excess terminal capacity” in Cork Airport. This is undoubtedly true but it does mean that using Cork Airport is now a far more enjoyable experience than under its predecessor.

The report then states that it is the customers who are paying for this excess capacity through higher airport charges and suggests that, if the airport were a private enterprise rather than a public one, it would be shareholders rather than customers who would absorb the capital loss.

The report, however, stops short of recommending privatisation of the airport and merely suggests that the regulatory arrangements need to be reviewed. This may see the current situation changed where Cork Airport is actually controlled by the Dublin Airport Authority rather than acting as an independent entity. Cork Airport will remain in public ownership.

The report’s recommendations for the 11 seaports owned by the State are somewhat different. Here the report recommends that the ports be restructured around three “multi-port” companies built around Dublin, Cork and Shannon Foynes. It seems that Cork could become the largest part of an entity that would see it merge with Waterford, New Ross and, possibly, the CIE-controlled Rosslare port. Some of the smaller ports may actually be closed.

Once this amalgamation process has been completed, the report recommends that some or all of the ports should be privatised. Unlike the airport, it is not certain that the Port of Cork will remain in public ownership.

The port currently has 111 employees and in 2009 generated a profit of €1.5 million on sales of €21 million. In 2008 there was a profit of €6 million on sales of €26 million. The report does not indicate how much could be raised by the sale of the port but, if it was to happen, the likely return would be relatively small.

SWS Natural Resources is a wind-generating company based in Bandon that employs 50 people and was bought by Bord Gáis from IAWS for €500 million in December 2009. The report is unambiguous in its recommendation that this, as well as other parts of Bord Gáis excluding the actual network, should be privatised. One final recommendation that has a specific local bearing is the selling by Bord na gCon of its holding in greyhound tracks around the country.

In general the report is largely as expected. Given the current economic environment we are unlikely to see substantial sales of State assets in the medium term. Over a timeline longer than three years the outcome is less clear. Experience from other countries suggests that privatisation brings its own problems and our own experience with eircom should not be forgotten.

The sale of eircom raised over €6 billion for the Exchequer but the company and the infrastructure it should provide have been beset by problems ever since. In total, the sales recommended in this report have a net asset value of €5 billion. In the context of a banking crisis that is set to cost €60 billion and an ongoing budget deficit that will add €100 billion to the National Debt over six years, the figures in this report are quite small.

It is more likely that the sales that could be undertaken in the near term will raise about €2 billion.  This is a once-off gain and €2 billion is a lot of money but it would be far better if policies that generate an annual reduction of €2 billion in the deficit were introduced.  This is an issue that has not got sufficient attention in recent times.

The country faces more pressing concerns than deciding to sell off some of our assets at a time when values are depressed. Some of these companies are substantial profit earners and provide an annual dividend for the State. Maybe in the future we can look more calmly at what can be done with these assets. In the meantime the State should look to reduce the debt levels and labour costs of these companies. The middle of a crisis, with a delinquent banking system and an €18 billion annual budget deficit, is not the time to be rushing into unnecessary firesales.

Bond yields soar

Two weeks ago we looked at the fall in Irish government bond yields that occurred in the week following the announcement of the stress test results.  The stress tests offered some credibility to our attempts to solve the banking crisis, but making AIB a ‘pillar’ bank with annual losses of €12 billion to be covered, bringing to €20 billion the total pumped in by the State may have dampened the optimism somewhat.  Looking at bond yields now, we can see that they’re at new record levels. 

Here’s the 3-month graph from Bloomberg showing the yield on 10-year Irish government bonds. 

For further confirmation of this deterioration you can see the yield on two-year bonds here.  These are streaking upwards and at nearly 12% are almost three percentage points higher than they were at the start of the month.  A similar pattern can be seen for five-year Credit Default Swaps (the cost of insuring Irish debt) here.

There has been little in the way of economic data released recently and nothing so negative to explain the surging bond yields.  Those buying or recommending Irish bonds have gone rather quiet.  Talk of the stable outlook from Standard & Poor’s has been replaced by the continued negative outlook from Moody’s.

So what happened?  It could be down to the watery statement from the EU/ECB/IMF team that undertook a review of the support process.  The yield rise had begun by the time the statement was released but it had been leaked by degrees over the previous few days.  The statement includes (emphasis mine):

The teams’ assessment is that the program is on track but challenges remain and steadfast policy implementation will be key.

Ireland is making good progress in overcoming the worst economic crisis in its recent history.

The may as well have said “the plan is working, we’ve turned the corner”!  The yield rise actually began earlier that week after the IMF had cut its 2011 growth forecast for Ireland from 0.9% to 0.5%.  Is this significantly different from zero?

So if we take the IMF’s statements from that week and combine them we get “Ireland is making good progress but things are getting worse”.  Sounds a bit like an Irish solution to an Irish problem.  It seems the IMF have learned that trick from us.  The truth is, though, that we need more than wordplay to navigate our way out of this crisis.  And the yields above indicate that the words aren’t working.

Net Lending/Borrowing

This graph follows from a discussion to an earlier post on whether the Irish recession can be classified as a “demand-side recession”.  The graph is a replication of a slide in this presentation on the “balance sheet recession” that the Japanese economy experienced in the 1990s.

Here we use the data in the Institutional Sector Non-Financial Accounts to give the net lending/borrowing positions of different elements of the Irish economy since 2002.

The changes are fairly evident.  The government has gone from a surplus to a huge deficit.  The household sector has gone from borrowing 10% of GDP per annum to saving 5% of GDP per annum.  The changes in the other sectors are not noteworthy.

Mortgage Debt Forgiveness

The issue of mortgage debt forgiveness has come front and centre again.  The last time we looked at this was when 11 economists proposed a huge debt-forgiveness  scheme back in November.

The Irish Times article is here and the response on this site is here.  I remain opposed to the views in the article.  At one stage it says:

In the case of Ireland, such a formula would most likely lead to an implicit writedown of at least 30 per cent of the more recent mortgage amounts on average, yielding an expected total cost to the entire system of circa €37 billion to €49 billion.

I’m not sure the article is actually in favour of such a widespread scheme (but if not, why was the paragraph included I ask) but this is a huge immediate solution to what is a long run problem.  The article also overstates the size of the problem.

Their arrears of €10 billion would compare to total mortgage debt outstanding in the Republic of €115 billion.

This is wildly overstating the arrears problem.  The most recent recent figures from the Financial Regulator can be seen here.  There are 44,500 mortgages in arrears of three months or more.  The total outstanding balance of these mortgages is €8.6 billion and will likely approach €10 billion in the coming months.   This gives an average outstanding balance of around €190,000 per mortgage in arrears.

However, the balance outstanding and the arrears owing are two different things.  The total amount of arrears on these mortgages is actually around €700 million.  The average arrears per mortgage is around €16,000.  It is difficult to imagine the amount of arrears ever approaching €10 billion.  A solution based on clearing the balance of mortgages in arrears is just too broad when the problem is more focussed.  My initial thoughts can be read in the post linked above.

I still think that any solution should be based on interest relief rather than capital forgiveness.  I think the State should pay the interest on a certain portion of the loan for a certain period.  This is offering something to those in need but avoids shifting the burden of capital repayment around.  So, for some mortgages the State could service up to 50% of the loan for a certain period of time.  If these are tracker-rate mortgages the cost may be somewhat contained.  There will be some cost to the State.

[As an aside it would be great to know where the mortgages in arrears actually are.  What is the breakdown between the covered six, other domestic banks (UB, NIB etc.), banks that have left (BoS) and subprime lenders?]

Anyway once the State takes on the servicing of the mortgage to give these people some breathing space we need some process that sees the responsibility move back to the individual.  As in a debt-forgiveness scheme which would see people position themselves to benefit from it, I think the key is "incentives matter".  I would allow the scheme to extend, to say, 15 years but the individual decides when the mortgage moves back to them.

If they do so after three years they just take it back under the original conditions.  For every year after that the interest rate on the loan increases by some incremental amount (say 0.25%).  This extra interest does not go to the bank, but goes to to the State for providing the scheme.  The longer a person needs support from the scheme the more they will have to pay.  If they wait the full 15 years the extra interest will be 3% per annum.  These numbers are only for illustrative purposes.

A lot can happen over a period of five to eight years (even economic growth, inflation and the like can happen!).  I don't think we need a short-run solution (immediate debt-forgiveness) to what is a long-run problem (repaying a mortgage).

I may update this with further thoughts.

A “Demand-Side Recession”

This has been some criticism recently of the revised elements in the Memorandum of Understanding which forms the basis of the EU/IMF deal.  The details can be read from this DoF statement.  One frequent criticism levelled against the programme is that it offers “supply-side” solutions to what is a “demand-side” problem.  This is most visible if we consider the elements included under the heading ‘structural reforms’.

Structural Reforms

Product and Labour Market Reforms

• We are adopting policies to lower costs in sheltered sectors, thus boosting purchasing power and underpinning further competitiveness gains.
• The Government is due to consider a potential programme of asset disposals based on the Programme for Government and the Review Group on State Assets and Liabilities. The Government will discuss its plans with the European Commission, the IMF and the ECB when it has finalised its response to the Review.
• We are committed to create conditions conducive to job creation through the Jobs Initiative, which will be announced in May.
• The reversal of the cut in the minimum wage will be reversed with the effect on business costs being offset by a reduction in employers' PRSI.
• The review of the EROs/REAs and other measures to increase competition in sheltered sectors of the economy (these measures are not conditional on each other but are part of a comprehensive package designed to make work pay and improve the competitiveness of the economy).

No other structural reforms are listed.  Here is a thoughtful post on some of these changes from UL’s Stephen Kinsella - Will cutting GP and lawyer fees help Ireland?  I too would have concerns about the effectiveness of this list and would largely agree with the conclusion.

The core issues are not supply-side rigidities such as expensive lawyers and doctors and overpaid low-skilled workers. The core issue is the collapse in domestic demand.

Ireland's problem is demand deficiency caused by a collapse in asset prices, expansion in debt, and a fiscal imbalance caused by improper taxation policies during the boom.

Supply-side measures, while useful, won't solve, or even buttress, the problems of our economy, because they aren't the cause of the problem. We should remember this when listening to prognostications from our well meaning EU colleagues.

Although there is a “demand deficiency” I am not sure that demand-side solutions will necessarily work.  If we look at the contribution of the domestic and traded sectors to overall GDP growth we can see the domestic demand story stacks up.

It is pretty obvious that the domestic economy that has been the source of the collapse with falls in ten of the past 12 quarters.  On the other hand net exports has made a positive contribution to growth in eight of the 12 quarters.

As we have done before we can break the fall in domestic demand into it’s constituent parts of consumption, investment and government expenditure.

Although a negative pull of consumption is seen up to Q1 2009 for the past two years two factors have dominated the growth rates.  Net exports has made a positive contribution to growth and investment has made the dominant negative contribution to growth.  Here is the same data presented in a different fashion.

Private consumption has contributed to the fall in GDP but consumption has been unchanged over the past two years.  In real terms consumption in 2010 was 1.2% lower in 2010 than in was in 2009 (because of price falls the nominal change was –2.5%).  However as a result of the falls that occurred in 2008 and 2009, consumption in 2010 was 9.5% below the level seen in 2007 in real terms (the nominal drop is an eye-watering 12.8%).  There is no doubt that a fall in private consumption has been a key component of the downturn but most of this occurred more than two years ago.

On the other hand investment has been falling continually over the entire period.  Although investment makes up a much smaller proportion of GDP than consumption, it has made a much larger contribution to the collapse of GDP.  Since 2007, consumption in constant prices has fallen from €96 billion to €87 billion.  Over the same time investment in constant prices has fallen from €46 billion to €20 billion.  Consumption has fallen €9 billion.  Investment has fallen €26 billion.

One would expect that the fall in consumption is the result of a fall in income, but as we have seen that is not necessarily the case.

In 2009 net household disposable income fell by about 2%.  At the same time, consumption expenditure fell by over four times that rate.  Demand as measured by ability to pay still existed, it was demand as measured by willingness to pay that fell.  We don’t know what happened to disposable income in 2010 but we know that the decline in consumption eased.  The impact of the tax increases in last December’s Budget are likely to further tighten income. 

The above gap was money that was saved and more than likely used to pay down debt.  The savings rate has shot up to near 12%.  It is more probable more accurate to say that we have a “debt problem” rather than a “demand problem”, though the two are obviously related.  Consumption has fallen because the demand has shifted from buying goods and services to paying down debt.  This pattern is likely to continue.

Finally, as we said above, the biggest source of the decline in domestic demand is investment and it is pretty evident that we do not want to go back to the way things were.  Here is what has driven the change in the contribution of investment to GDP growth.

Building houses drove the boom and not building them has driven the recession.  It is likely that investment is undershooting, but the fall in investment from building 90,000 houses a year at the peak is a necessary one.  The fall of this “excess demand” is an adjustment that has to be made.  The task is now to find the replacement.