The Irish Economy

Today’s media have lots of what appear to be leaks about what AIB’s capital requirements are going to be. I say “appear to be” because reliable leaks tend to lead to all the journalists singing off the same hymn sheet and reporting the same figures. In this case, Business and Finance are reporting a capital requirement of €7.5 billion, the Irish Independent reported a requirement of “up to” €7 billion and the Irish Times are reporting “some €6 billion to €7 billion”. So I’d take these with a pinch of salt for now.

What isn’t being reported, however, is quite how bad that news (if such it is) would be for AIB’s current shareholders. AIB’s 2009 annual report showed that the bank had risk-weighted assets of €120 billion at the end of last year. If €20 billion in property loans are transferred to NAMA and replaced with NAMA bonds (formerly known as free money from Europe) then (assuming a risk weight of one for the property loans) this would reduce risk weighted assets to €100 billion.

It has been heavily flagged that the Regulator will be looking for a core equity capital requirement of 8 percent, so this would require the bank to have €8 billion in core equity capital and I’d assume that the preference shares would not count towards this total.

The annual report tells us that at the end of last year, the bank had what it called “core equity capital” of €9.5 billion, but this included €3.5 billion in government shares.

Now consider what a capital requirement of even €6 billion would imply. If the bank needs to have core equity of €8 billion, then a requirement of €6 billion means that after the transfers and writedowns, AIB would have equity capital of €2 billion. This would mean losses of €7.5 billion on the transfers and writedowns. As far as I can see, this would mean the transfers wiping out the private equity in the bank.

Perhaps I’ve done these calculations wrong: Commenters feel free to tell me what’s wrong with the above. There certainly seem to be shareholders out there who don’t agree with it. In any case, we won’t have long to wait.

The National Competitiveness Council reports on key competitiveness issues facing the Irish economy together with recommendations on policy actions required to enhance Ireland’s competitive position.

One of the NCC’s annual publications is Benchmarking Ireland’s Performance. In 2009, this analysis of Ireland’s competitiveness performance used approximately 140 indicators to see how Ireland compares internationally on, for instance, living standards, export performance, prices and costs, productivity, innovation and infrastructure. Now, in preparation for the 2010 report, the NCC would welcome suggestions for additional/alternative internationally comparable indicators that could further our understanding of Ireland’s relative competitiveness.

If you are aware of such indicators and would like to suggest them for inclusion, please email ncc@forfas.ie .

Previously used indicators can be seen in the Annual Competitiveness Report 2009, Volume One: Benchmarking Ireland’s Performance.

RTE and the Irish Times are reporting that administrators have been appointed to Quinn Insurance. RTE report

Mr Justice John Cooke made the order following an application by lawyers on behalf of the Financial Regulator.

The application was made under the 1983 Insurance act.

The court heard the Regulator took this action following serious concerns about the way the group was managing its affairs.

The Times reports

The court heard that the company had moved from a position where it had an excess of assets over liabilities of more than €200 million to a position where it had €200 million of liabilities over assets.

As if today wasn’t busy enough already.

Without knowing the details of today’s deal, it is still worth thinking about the macroeconomics of public sector reform.  I will take it that the deal delivers widespread productivity growth in the public sector.

All else equal, an improvement in the quality or output of public services should be valued by the population. It is desirable that this be reflected in the measurement of GDP and various countries are attempting to capture quality and output measures for public services to this end. (The alternative is to measure public sector output by the volume of inputs - but this cannot capture productivity growth.)  The value to the population of extended opening hours, for example, should be considerable.  It would be helpful if Ireland made efforts to improve the measurement of the public sector contribution to GDP.

Next, for given levels of output and quality, an improvement in productivity means that the public sector requires fewer workers.  This expands the supply of labour to the private sector.  This will benefit private-sector enterprises, including via the attendant downward pressure on wage levels.  A cautionary note:  the initial impact of technological progress can be contractionary, since rigidities in the labour market may mean that it takes time for private-sector employment to expand to absorb the extra supply of workers.

Next, the financial savings from the reduction in public sector numbers [and/or the elimination/reduction of premium payments for some types of overtime] can be allocated in several ways:  (a) reduce the deficit; (b) increase the provision of public services [equivalently, avoid service reductions] ; (c) reduce taxes [equivalently, avoid tax increases beyond what is inevitable]; or (d) increase public sector pay levels [equivalently, partial or full restoration of previous pay cuts].

It is currently unclear about the intended allocation of savings across (a) through (d).

I further note that uncertainty in the provision of public services is damaging for the population, such that the commitment to avoid strike action and other types of service interruption is very welcome.

Finally, as part of the overall package, a commitment to no further pay reductions is also welcome by providing certainty to public sector workers  - this should reduce the level of excess precautionary savings. (I made this point back in January 2009 in my paper “A New Fiscal Strategy for Ireland“  -  the ideal time profile for pay cuts is to make a significant initial cut but not to pursue a sequential process of gradual pay cuts.) Since there are likely still significant pay premia for many public sector occupations, it will be important to closely monitor future public pay dynamics by reference to labour market conditions across the economy.

The Minister for the Environment has made another announcement on municipal waste policy.

There are two components. One is not new: There is to be a cap on incineration. There is no rationale for creating an artificial scarcity, as explained by Gorecki and Lyons. Using both price and quantity instruments is double regulation. Tinbergen (1952) shows that this is unnecessarily costly.

The new element in the latest announcement is that the incineration levy is not constant, but increases with the size of the incinerator. Both the ESRI and the Eunomia report recommend an incinerator levy, albeit at different levels. However, they recommend the same levy, per tonne, regardless of the size of the incinerator — although one could argue that larger incinerators burn cleaner and therefore should have a lower levy.

There is no economic or environmental rational for putting a higher levy on larger incinerators.

UPDATE: Story in the Irish Times

UPDATE2: PJ Rudden says the proposed levies may be illegal. I’ve heard say that it would be anti-competitive to put one levy on a small incinerator in Cork and another levy of a big incinerator in Dublin, but as inter-county trade in waste will be verboten too, I’m not convinced that that argument holds.

UPDATE3: RTE looked at the letters between the City Manager of Dublin and the Minister for the Environment; they are not particularly friendly to one another.

The main points are summarised in this IT article.

Tomorrow we should finally see a resolution of much of the uncertainty that has been hanging over the Irish banking system. We are being told that the estimated prices for NAMA transfers will be announced, as well as the capital requirements set by the Central Bank and the new legal framework for the Central Bank and Financial Regulator.

With the news so soon to be released, there is little point in me speculating as to what is going to happen. What I would flag, however, is that there is something of a disconnect between two sets of statements doing the rounds in today’s media coverage.

First, there has clearly been widespread leaking that the NAMA loan transfers will see some banks taking considerably larger writedowns than had previously been expected. For instance, in the Irish Independent, Emmet Oliver writes that “AIB is set to be hit with a discount of up to 40pc”.

Second, much of the coverage mentions the idea of the state owning 70 percent of AIB and 40 percent of BoI. See, for instance, here and here. And note that Emmet Oliver’s full sentence is “AIB is set to be hit with a discount of up to 40pc, making majority State control all but inevitable” and he mentions the Minister’s “plan to take a 70pc stake in the lender.”

The disconnect is that these two sets of figures don’t seem to add up. There is nothing new about the idea of the state potentially owning 70 percent of AIB. Even based on previous expectations for NAMA discounts, this was always a possibility. For instance, I’m looking now at a Davy stockbrokers report from April of last year that projected a base case of the government owning 78% of AIB.

However, it is hard to reconcile the continuing circulation of the same ownership statistics as before with the new information (if such it is) on discounts and also on capital levels.

To give a concrete example, AIB’s annual report says that it had €9.5 billion in core equity capital at the end of 2009. This included the government’s €3.5 billion in preference shares (this isn’t core equity in my book, or most people’s, and it is likely to be converted to ordinary equity.) So that leaves €6 billion in private core equity capital. AIB is supposed to be transferring €24 billion in loans to NAMA. Forty percent of €24 billion is €9.6 billion.

So, do the math on this and you’d probably come to a different conclusion about ownership percentages than have been flagged by the media. One way or another, we’ll find out tomorrow, but today’s leaks are confusing, perhaps deliberately so.

Update: This post should have been clearer that AIB’s annual report already allows for €4.1 billion in provisions for losses on loans going into NAMA. So the calculations would involve an additional €5.5 billion in losses over and above that. With half a billion in equity capital and the need to get up to a core equity ratio of eight percent, the 70 percent state ownership doesn’t add up. Still, perhaps I’ll see tomorrow how it’s going to add up and still end up with the 70 percent outcome.

In today’s Examiner, PJ Rudden estimates the costs of changing government waste policy (as opposed by the ESRI) at around 2.5 billion euro and warns that environmental quality may deteriorate too. As Rudden points out in Friday’s Times, his cost estimate omits the damage to Ireland’s reputation should the government decide not to honour the contract with Covanta, and indeed the cost of breaking the contract.

For Greece (or any other fiscally-challenged member) to ‘leave the Euro’ involves the launch of a new curreny. From scratch. People talk as if the drachma lives on, cryogenically preserved in some icy Limbo for Currencies.

So the Greek government could thaw it out overnight, at some devalued exchange rate, and Bob’s your Uncle. This is moonshine. The Eurozone is not a fixed-exchange rate system, it’s a common currency area. The drachma has been abolished. This parrot is deceased.

Launching a new currency is a formidable undertaking in calm circumstances. In current Greek circumstances, and abstracting from the enormous logistic challenges, it is not do-able. There would be little point launching a new currency unless people could be induced to hold it. The prospectus would have to mention the debt ratio at 113% of GDP and rising, weak competitiveness, the largest adverse sovereign spread in  the EZ and so forth. Who could be compelled to hold this currency even briefly (while it is being devalued) apart from domestic Greek recipients of pay and social transfers? Does anyone believe that the Euro would disappear from Greek trade and payments? Existing debts would have to be honoured in Euro - there is nothing else at present. Not even lawyers could hold that contracts were to be enforced in a currency which did not exist at the time the contracts were entered into.

There are 16 countries in the Eurozone, but 17 European countries use the Euro, the 17th. being Montenegro, which decided, at independence in 2002, not to launch a new currency. They use the Euro, do not get any of the seignorage as far as I know, but don’t have to spend half their lives in Frankfurt at ECB meetings, which sounds like a reasonable deal. (Memo to Montenegro: You may not have a currency to worry about, but you do have banks. Watch it!).

Who can say that Greece, having ‘left the Euro’, would not become a bit like Montenegro, with admittedly an unloved drachma for government internal transactions but most of the economy dollarised (or Eurinated)? Lufthansa reduces capacity a little on Athens-Frankfurt business class, but what else changes?

David McWilliams has advocated in his SBP column that Ireland should choose to ’leave the Euro’. Please explain, in great detail (this is not a transition-year project) precisely

- how the introduction of a new currency in current circumstances would be executed, and

- how it would pan out in macro-policy terms.

German and other advocates of an expulsion option might join David in this exercise.

Following on from yesterday’s post on misleading hyperbole about Greece choosing to leave the euro or being expelled from it, it was truly depressing to hear an Irish minister today raise the prospect of Ireland having to leave the Euro.

On RTE’s Saturday View program, Minister Eamon Ryan said the following in relation to Anglo Irish Bank:

It would be so nice if we could say we’ll let it go and that will be the end of that. The reality is … and that’s kind of Fine Gael’s position and what Labour seems to be saying. There are .. That means that we have to go and effectively say to the European Central Bank, who has a lot of money in deposit in Anglo, and say sorry we can’t pay you back. Now the European Central Bank, it hasn’t allowed a bank fail across Europe. So we would probably then have to leave the Euro. Now the risk of that, in terms of the tens of thousands of jobs that could leave this country because they’d say well Ireland is a riskier country to do business in, we don’t really want to do business there. That is what you’re talking about. So, it’s not easy, it’s not palatable but that’s the choice you’re faced with.

When RTE political reporter Brian Dowling then discussed the idea that there were alternative options to take, Minister Ryan confronted him saying “Do you think we should leave the Euro?”

I think that these are extremely unfortunate statements for an Irish government minister to make.

The facts are as follows.

1. Whatever happens with Anglo, Ireland will not be leaving the euro. Minister Ryan’s assertions that we would essentially be expelled from the Euro if an Irish bank failed to pay back the ECB are groundless. This is not just my opinion. An ECB legal working paper summarises this issue as follows: “while perhaps feasible through indirect means, a Member State’s expulsion from the EU or EMU, would be legally next to impossible.”

2. The ECB has always been aware that it could lose money from making loans to a bank that is then unable to pay it back. This is why its loans to banks are all collateralised, based on a well-developed list of eligible collateral. This list does not include development loans. While it is still possible for the ECB to lose money on its loans to a failing bank (if the collateral turns out not to be worth the value of the loan) there has never been any rule that such an event would result in the country the bank resided in having to leave the euro.

3. There are, in any case, options for dealing with Anglo’s insolvency that could save the taxpayer money without going as far as failing to repay its ECB loans. For instance, Anglo could be declared insolvent and its subordinated bondholders fail to be repaid, while the Irish government could choose to pay back other more senior creditors. There are serious issues to discuss here. The prospect of leaving the Euro is not one of them.

The bottom line here is that Minister Ryan’s statements about leaving the Euro are without foundation. However, it is perfectly possible that they could form the basis for unfounded speculation that Ireland is somehow on the verge of leaving the Euro. I would urge Minister Ryan to issue a clarifying statement correcting these assertions as soon as possible.

As we await perhaps the most momentous set of financial decisions ever taken by an Irish government, the consistent evidence that senior Ministers do not understand the banking situation is extremely worrying.