The UK’s Brexit Bill and the European Investment Bank

The annex to the EU-27 negotiating position released yesterday in Brussels states clearly that the UK will be departing the European Investment Bank, in which it is a 16.1% shareholder.

The UK will expect to be credited with the value of these shares when the exit bill comes to be totted up. How much are they worth?

According to the latest accounts the EIB had net worth of €66.2 billion at end 2016, and has been posting annual profits around €2.7 billion. By Brexit Day (March 29th 2019) the UK share of net worth should be at least €11 billion, not a small amount in the context of the row about money which has already commenced.

There are complications: the EIB retains all earnings and does not pay dividends, so owning shares has not been much fun. But as a result it has a CET1 ratio of 26.4 and leverage under 9, as well as a AAA credit rating, high liquidity and ECB access. This will be the last European bank to go bust.

There is very substantial uncalled capital, in the UK’s case €35.7 billion. This is in effect an option against the shareholders and hence a contingent liability. However there seems to be very low likelihood that this capital will ever be called. If it were called from all shareholders leverage would drop towards 2!

When the UK is ejected, who buys the shares? It could most conveniently be the EIB itself, from reserves. The bank looks to be over-capitalised. Numerous other angles will arise – the EIB shares are a substantial item and have been overlooked.

GDP Carry-over Carry-on

If the economy expands through a new year by, say, 1% each quarter from the previous Q4 number, the growth rate on an annual basis will be about 4%, right?
Wrong. It depends on the intra-year pattern the year before. If the previous year saw quarterly improvements, with the Q4 figure ahead of the year’s average, a flat performance in the new year will yield apparent year-on-year growth, even though the economy is not expanding.
The seasonally adjusted GDP numbers for 2016 were released on March 9th, also and not coincidentally the data cut-off for the ESRI forecast of year-on-year growth in 2017 of 3.8%. Subsequent forecasts from the Central Bank and the Department of Finance came in at 3.5% and 4.3% respectively.
The sum of seasonally adjusted GDP for the four quarters of 2016, according to the CSO, came to €256.3 billion. But the Q4 number was 26% of the annual total at €66.6 bn. A flat performance from Q4 through each quarter of 2017 would yield an annual growth rate of 4%. So the ESRI projection is consistent with no improvement, indeed a slight decline, from Q4 last year. The CB projection implies a bigger decline, the DoF a tiny increase. All three sets of projections were heralded in the press coverage as signalling continued economic expansion through 2017.
The problem is the so-called ‘carry-over’ effect – Joe Durkan has been on about this for aeons. The CSO has been publishing quarterly macro data for over twenty years. Perhaps it is time for forecasts to be done on the same basis.
For the record, if you expect GDP to grow 1% per quarter from the Q4 2016 base through 2017, the year-on-year growth rate will be 6.6%. If the forecasters feel the Q4 figure was odd, and that there will be a dip for Q1 2017, better to say so.

Supply Curves Explained

Numberless ‘experts’ have misunderstood the government’s mortgage deposit subsidy. It’s all about the supply elasticity, as Michael Noonan helpfully explained to the Irish Examiner on Tuesday.

“The economists are saying we should have concentrated on the supply side. When there’s a demand for something, it leads to increased supply. If we can give deposits to people there will be an increased supply. The [building] industry will move to supply the extra demand.

To give you an example: When it was done previously, the first [car] scrappage scheme was introduced by Ruairi Quinn back in the 1990s. The theory then was the motor-car business was on the flat of its back — no cars being sold. So, with the scrappage scheme, people were given money and that money expressed itself in demand for new cars and a lot of new cars were sold. So, when there is demand backed by cash, supply responds and that’s the theory of it.”

So you whistle up some guy in Germany and he ships over 100,000 houses, at yesterday’s price.

Why didn’t I think of this ? Does Philip Lane read the Examiner?

The Dog Ate My Wind-Farm

The Irish Times relates this morning an Oxford Mail report of a lucky escape for a corporate financier formerly employed with Barclays and Lehman Brothers. Michael Chase-Sarver copped a four-month prison sentence from Judge Eccles at Oxford Crown Court. He had been prosecuted for perverting the course of justice in attempting to avoid a speeding conviction.
He called a witness from Derry who testified that Mr. Chase-Sarver was the promoter of a wind-farm project in Donegal which would cost €1 billion, occupy 35,000 acres and employ 300 people. The judge suspended the sentence, citing the risk to the 300 jobs.
Neither Donegal County Council nor An Bord Pleanala are aware of this project according to local media.
This is surprising. The average cost of 1 MW of wind capacity is about €2m, so the billion Euro tab would equate to around 500MW, the largest generation facility to be built in Ireland since Moneypoint in the mid-1980s. At 35,000 acres the site (70 acres per MW sounds about right) would occupy 3% of the land area of Donegal, a large county. The witness from Derry, a co-investor in the mystery project, claims that agreement has been reached with 100 very discreet farmers.
Ireland already has about 2,500 MW of intermittent wind capacity. Peak demand is about 5,000 and total capacity about 10,000, of which 7000 is dispatchable. Wind gets priority when available and a price guarantee, or compensation if ‘constrained off’. Further additions of intermittent generation, from wind or solar, will add to the subsidy costs and strand more gas-fired assets, many of which belong to the government.

The EBA Stress Tests: What’s the News Value?

The Irish banks, AIB and Bank of Ireland, show up poorly on the stress test of 51 European banks (33 in the Eurozone) released Friday night. The methodology is explained on the EBA website. Briefly, there has not been a review of each bank by a team of EBA inspectors as is implied by some of the media coverage – RTE’s bulletin referred to an ‘examination’. It is a mechanical exercise based on the ‘static’ 2015 balance sheet, as published, with no adjustment for the plausibility of provisions but also with no credit for retained earnings post 2015. The ‘stress’ is essentially a GDP downturn from 2016 through 2018 resulting in a depletion of capital adequacy as against the end-2015 balance sheet number.

The scale of the depletion reflects the extent of the assumed downturn. The essential reason for the sharper loss of capital adequacy for the Irish banks is that the downturn assumed for Ireland is greater. Against a baseline, the cumulative adverse GDP shock for the main Eurozone countries included is as follows:

Belgium -7.6
Germany -6.6
Ireland -10.4
Spain -6.7
France -5.6
Italy -5.9
Lux -8.2
Neth -8.4
Austria -7.6
Finland -8.3

The adverse shock assumed for Ireland is the largest and 3.2% above the average for the others shown. There are some other factors but the EBA release makes it clear that these numbers are the main driver of the projected capital depletion. The basis for the large Irish shock is a calibration against the experience over 2008 to 2011 when the downturn in Ireland was more severe than elsewhere.

The EBA may have sacrificed plausibility to uniformity of treatment – the exercise is in any event an input into a further phase called SREP, the supervisory review and evaluation process, rather than a definitive assessment of bank capital adequacy. The Irish banks, and numerous others, may of course need to generate or raise more capital but the relative worsening in their position flows from the assumptions employed and not from any ‘news’ uncovered by the EBA sleuths.

Managing the Budget with High Debt and No Currency

A sovereign state with low debt can access liquidity through the markets. There are limits and they will be reached when the debt ratio begins to send out distress calls. Until that (unknown) point, there are, in effect, un-borrowed foreign exchange reserves. With an independent currency liquidity can be created for government or banks without external conditionality. There are limits here too and creating excess liquidity brings inflation risk and exchange rate pressure.
With high debt and hence uncertain access to bond markets a short-term expansion cannot safely be financed through debt sales without constraining capacity to repeat the procedure. Without a currency either, the creation of liquidity is conditional on the cooperation of the foreign central bank. If its conditions include constraints on fiscal action there can be no stabilisation policy – no exchange rate, no monetary or fiscal discretion.
Most Eurozone governments can borrow in the markets at low rates, courtesy of QE, despite historically high debt ratios. In the absence of QE the perception of capacity to borrow could diminish rapidly. Availability of QE is in any event not automatic – there is none for Greece, for example. There are also unclear conditions on ELA creation by national CBs. Consent from the ECB can be withdrawn arbitrarily or may be permitted only on penal conditions, such as pay-offs to unguaranteed creditors of bust banks.
The Eurozone governments with high debt face an illusion of policy space in current circumstances, with apparently easy access to debt markets. The constraint appears to be the EU rules about budgetary limits, as long as QE lasts.
But QE will end at some stage and the constraint becomes the market demand for sovereign debt. The design problem for fiscal policy (the only stabilisation tool available) is to manage the trade-off between using it now and having less to use later. Since the election Irish politicians have found agreement on two policies: (i) that the European Commission should be lobbied to relax the budget rules and (ii) that government should borrow ‘off balance sheet’.
Policy (i), lobbying the Commission, sacrifices future budget flexibility explicitly. The inverse demand curve for sovereign debt is r = f(D) where D is the debt ratio. Unless f(D) is flat the sacrifice is real. Moreover f(D) is unknown, although known not to be flat. Unless sovereign bond buyers are unable to count (ii), hiding sovereign liabilities, is just gaming the Eurostat debt definition. This definition (gross general government debt to gross output) is not a serious measure of debt servicing capability and, after QE, a sovereign could easily be inside some EU limit and unable to borrow. Eurostat does not lend money.
There are arguments for battling to borrow: interest costs are low and it is an article of faith that high-value public investment projects are plentiful. The trade-off (looser policy now versus the risk of ill-timed tightening later) would look better if the economy was becalmed, multipliers high, debt ratios modest, macro-volatility historically low and the foreign central bank known to be benign. None of these conditions applies currently in Ireland.
There is a case for using the QE respite to borrow reserves, accepting the negative carry, as NTMA appears to be doing. The case for deferring the attainment of budget balance is harder to see.

The ECB’s Inflation Target

The Eurozone HICP inflation index for February was at roughly the same level it had reached in the early months of 2012. That is to say the inflation rate has been essentially zero for four years.
The cumulative impact of this undershoot on the real burden of debt is getting to be very serious. The ECB’s own forecasts are for just 0.1% in 2016, 1.3% in 2017 and 1.6% in 2018, so they expect the undershooting to continue. By this time next year the price level will have been flat for five years. If GDP deflators had risen at 2% per annum for those five years various indebted countries would have knocked ten points off debt/GDP ratios, other things equal. So the ECB policy failure has consequences and has penalised the countries most heavily indebted.
Unlike the situation in the UK, the USA and other inflation-targeting countries there is not even a clear figure. The phrase (intoned at every Draghi press conference) is ‘below, but close to, 2%’. Why so coy? What does ‘close to’ actually mean? Will the 1.6% predicted for 2018 be deemed to have done the job?
The treaty talks only about price stability so the choice of target is entirely a matter for the ECB Governing Council. The tortured phraseology looks like a compromise – the sound money people getting the ‘below’ part and the rest getting the ‘but close to’. The 2% number had to get a mention, since various central banks had settled on an explicit 2% figure. It would hardly have been feasible to publicly declare a lower target number like 1% and would have had market repercussions. Whichever scribe came up with the form of words has hopefully been promoted.
Suppose the measures announced last week have their desired impact and Eurozone inflation reaches somewhere deemed ‘close to’ 2% in 2018. By that stage the heavily-indebted countries will have been short-changed substantially on real debt burdens. The remedy would be to raise the target, say to 4%, for five or six years in order to compensate, as Olivier Blanchard proposed when he was at the IMF. The indebted countries would be remiss not to push for this when the time comes, assuming the show is still on the road.