Cyprus and Capital Controls

Having failed to agree a bank resolution regime more than four years into the Eurozone banking crisis, the EZ authorities have, at the second attempt, come up with a resolution of the Cypriot banks. The haircuts of uninsured bank creditors appear to be 60% and more.

After a bank resolution, the surviving banks are solvent. Naturally, depositors may feel sore, and there could be deposit flight as soon as they re-open, even where the haircuts have been severe enough to make them adequately capitalised again. But not to worry, the central bank is there to deal with irrational deposit flight. It is after all the lender of last resort.

But lo and behold, the Cypriot government has imposed capital controls – even insured deposits not facing a haircut are restricted. But since the written-down assets of the surviving banks are now in excess of their liabilities (they have been resolved) these assets will be money-good at the central bank.

Not so apparently. If the ECB believes that the surviving Cypriot banks are now solvent, why is there any need for restrictions on depositor withdrawals? Is the ECB prohibiting liquidity provision through ELA after a bank resolution to which it has been a party? 

Of course the haircuts may, in the eyes of the ECB, be inadequate to ensure solvency. In which case why is the deal not modified further? Capital controls effectively create an inconvertible currency trapped in Cypriot banks, a precedent likely to be remembered when trouble strikes elsewhere. Do re-opening US banks decline to release deposits after the Feds have done their work, for the want of a lender of last resort?

Toxic Debt Scare

Teams of economists have detected traces of bank-debt DNA in samples of Irish sovereign debt in portfolios all over Europe. Genuine Irish sovereign debt is believed safe for humans but bank debt is toxic. The economists believe that as much as 30% of all Irish sovereign debt is not genuine. The source of the contamination appears to be a premises in Frankfurt, Germany. The contamination dates from 2010, when a sovereign debt knackering plant was run from the premises by a Monsieur Trichet, a French national. It is alleged that he gathered up large quantities of toxic bank debt and mixed it up with genuine sovereign debt in the middle of the night, when nobody was looking.

 

There is no licensing or supervision of sovereign debt knackerers at European level and it is understood that the Frankfurt plant was staffed by people with no previous experience in the trade. Genuine debt from several other European countries was processed through the Frankfurt plant in 2010 and 2011 and may also have been infected. The plant, which claims to be the only sovereign debt processing facility in Europe, is now run by a Signor Draghi, an Italian. Monsieur Trichet has retired from sovereign debt knackering and has commenced a new career in the aviation business.    

 

The Irish Department of Finance has been seeking to return the infected sovereign debt to the Frankfurt plant with a view to removing the toxic component. They are afraid that retailers might remove the sovereign debt from their shelves. Signor Draghi has promised to do his best, but one of his assistants, Herr Weidmann, a German, believes that the toxic bank debt is harmless, and that anyway nobody will notice. He is refusing to operate the decontamination equipment.

More on the Pro-Note Deal

Here’s a few thoughts on aspects of the pro-note deal concluded last week.

The GGB Interest Saving

One of Karl Whelan’s slides at the recent irisheconomy conference sported the title ‘Eurostat and Reality’. The ‘general government’ concept used by Eurostat and consequently employed in the EU Commission’s implementation of budget rules and bail-out programmes has other critics besides Karl. One critic is the IMF.

http://blog-pfm.imf.org/pfmblog/2009/07/consolidation-of-central-bank-operations-into-the-governments-financial-statements-practice-in-selec.html

The Fund argues that, once central banks begin undertaking quasi-fiscal functions, they may as well be consolidated with the fisc. Australia and New Zealand consolidate their central banks into the fiscal accounts. More pertinently the IBRC was not part of general government and NAMA is not either. Since the fisc was and will be on the hazard for both, the same argument applies to them. The fact that these three institutions, the CBI, the IBRC and NAMA are not part of general government has muddied the waters regarding the budget impact of the pro-note deal as John McHale points out in his post.

The true cost of the pro-note was the interest paid at the ECB’s MRO, the main re-financing rate, currently 0.75%. This will continue to be the cost when the pro-note passes to the CBI and is replaced with long-dated floaters. Transfers of interest arising from the pro-note and its floating successor between Irish government entities wash out in terms of economic impact. But they do not wash out in terms of the measured GGB deficit as per Eurostat, since these entities are not consolidated into general government.

This is the reason why there is an interest saving to the GGB (in addition to the discontinuation of front-loaded capital payments, which had to be funded but are excluded from GGB spending). Funds were being transferred, at high interest, to the IBRC, an operating subsidy if you will which would revert fully to the DoF eventually as part of the residual net worth (positive or negative) of IBRC. The excess interest was treated by ESA-95 as current spending, even though it was really the Exchequer lending money outside the GGB club to an entity it owned, guaranteed and planned to liquidate six years from now. No such sums will now be paid to NAMA or to any other state entity outside the GGB club. Hey presto, an interest saving of €1 billion. The interest shown, although heading in the right direction, is still not ‘correct’, in the sense that it does not equal the figure that would be shown if the Exchequer’s offspring were all living at home. The figure still looks too high, but by less. The ‘correct’ figure will rise eventually for two reasons: the 0.75% will rise as the Eurozone economy improves, and the amounts borrowed at this favourable rate will decline as the floaters in the CB’s book are re-financed in the market.
There has been no creative accounting and the DoF have done everything by the book. ESA-95 is just not a very coherent book. For more on all of this in an Irish context, see

http://researchrepository.ucd.ie/bitstream/handle/10197/561/mccarthyc_article_pub_005.pdf?sequence=3

The Floaters

The NTMA has already issued to the Central Bank eight long-dated floaters.
The base rate is six-month Euribor, recently a little under 0.4%. The margins over Euribor average about 2.6% so the government has issued €25 billion in very long dated floaters with opening yields of around 3%. The margin is fixed to maturity.

The rate does not matter (neither Euribor nor the margin) until the Central Bank sells some of the bonds and coupons start to leak outside the (fully consolidated) Irish state system. The CBI has agreed a schedule of minimum sales of the floaters, starting at €0.5 billion by end-2014 with steadily rising amounts that will see the lot gone by 2032. This means that the availability of concessionary state finance at the MRO rate contracts from 2014, slowly at first but more rapidly as 2032 approaches. The state is exposed at a diminishing rate to the ECB’s MRO rate and to the margin and Euribor at an increasing rate as the Central Bank sells out. The MRO will doubtless be higher during the life of these bonds, as will Euribor. The margin could compress or blow out. The exposure to this margin would have arisen anyway, and sooner, without the deal, as the pro-notes would have been replaced with market funding sooner. The margins, which are fixed through the life of the notes, have had to be estimated, since long-dated floaters are relatively rare and Ireland has none in issue. The initial margins chosen do not matter – it is the margin when the bonds are sold on that determines the effective cost. Floaters normally trade close to par, but the margin over Euribor for Irish sovereign risk could prove volatile and these bonds, when they come to be dealt in the secondary market, could trade further from par (on either side) than highly-rated sovereign floaters. Over the long haul, floaters are closer to index-linked bonds, since Euribor should follow the inflation rate.

Options in Favour of the CBI

The Central Bank will have some interesting but, it would appear, not very valuable options. Where these are options against the issuer, they have of course no net value to the state. The CB has an apparent option to convert the floaters to fixed, but only with the agreement of the NTMA. This option expires as the bonds pass to market purchasers. Without this provision the NTMA could get stuck with a growing component of long-dated floaters in its debt portfolio, for which market appetite is unknown. The NTMA rather than the CBI will likely call the shots on the exercise of this option – it will really be an option in favour of the NTMA, against the CBI as holder, but not against the ultimate market purchasers.

The CB has the option to sell more than the minimum required, but the MRO would have to exceed Euribor plus about 2.6% for this to be attractive, and would have to look like staying that way. This is most unlikely so this option has negligible value.

An Option in Favour of the ECB?

The CB has agreed (at the behest of the ECB) to a schedule of minimum sales into the market which will see the Central Bank dispose entirely of these securities by 2032, vaporising €25 billion of blameless money along the way. This schedule lengthens the duration of access to funds at the MRO relative to the duration under the pro-notes and is the key benefit of the deal. Any acceleration of this schedule diminishes the value of the deal.

The ECB can seek accelerated sales of the CBI’s holdings of the bonds, curtailing access to low-cost funds. This is potentially a serious option against the state as issuer. Governor Honohan also stated on RTE on Sunday that the CBI had agreed to retire the floaters as quickly as possible. He said: ‘The CBI has undertaken to sell these bonds as soon as possible, subject to financial stability’. This leaves the terms on which the state retains access to low-cost finance unclear. What is ‘financial stability’? Who decides if financial stability prevails, the CBI or the ECB? Is there a written understanding on the criteria that will be used? If so, it would be nice to know what it says. If not, there is a risk of future conflicts here.

What Caused the Eurozone Crisis, & Does it Matter?

 

The outline of a future European monetary union less vulnerable to crises than the current Franco-German design is beginning to emerge. It will need a banking union, including centralised supervision and resolution, as well as some common system of deposit insurance to curtail destabilising runs. It will also need stronger bank equity with minimum non-equity capital that can be bailed in when banks get into trouble. Sovereign debt ratios are now so high that future rescues by national treasuries will simply not be feasible, so the cost of debt to European banks will unavoidably be higher. The monetary union could do with a common macroeconomic policy – Europe as a whole is almost as closed an economy as the US.

But getting to first base in a re-designed monetary union means sorting out the current mess, and the willingness to accept and distribute losses is absent, largely because of the persistence of the belief that the crisis was caused principally by fiscal excess, and that sinners should pay. Sinners in this case means debtors. 

There have been numerous papers arguing that the origins of the crisis were not fiscal, but principally monetary. Here’s another one, with references to some more: 

http://www.hnb.hr/dub-konf/18-konferencija/mccarthy-ocallaghan.pdf

The European economy faces a re-building task on a scale corresponding to the aftermath of a (small) war. One of the lessons of twentieth-century European history is that allocating blame is not a good re-construction strategy after wars. The current impasse bears comparison to the ‘sinners should pay’ response to WW 1. 

After WW 2, with lessons learned, the blame-game was avoided to a considerable degree. It does not matter (except perhaps to lawyers) what caused the mess. What is the feasible allocation of costs  (infeasible allocations include pretending that the Greek default was big enough, for example) that offers the best prospects of economic recovery?

The costs have not all been incurred – failing to distribute the costs already incurred lets them grow.

DEW Economic Policy Conference 2012

The Dublin Economics Workshop holds its annual Economic Policy Conference on October 12 to 14 next at the Ardilaun House Hotel in Galway. Details of the programme and booking details are at dublineconomics.com. Sarah Condon does all the work, sarah@dublineconomics.com

The keynote speakers are David Laidler, from the University of Western Ontario, and Jerry Dwyer from the Atlanta Fed. David taught me monetary economics 40 years ago and claims to be too old for jet-lag!  I am thrilled that David is coming to Ireland again in October. David Laidler has forgotten more about monetary economics than the rest of us are likely to  learn, however long we survive.  Jerry Dwyer gave a terrific paper at a conference in Greece a few months ago and has promised to update it. 

25 Irish economists, young and old, will aso be giving papers, including two regular commenters from this blog, Michael Hennigan and Paul Hunt 

All are welcome at DEW 35 in Galway

Reminder: DEW October Conference

Proposals are still being accepted for the DEW conference in Galway on October 12-14 next. Topics in any area of economic policy will be considered and proposals should be emailed to colm.mccarthy@ucd.ie

Daivid Laidler (University of Western Ontario) will be the keynote speaker and the programme, with booking details, will be issued early in September.

Dublin Economics Workshop October Conference

The Workshop’s annual Economic Policy conference will be held at the Ardilaun Hotel, Galway, from October 12th to 14th next.

 

Invited papers will focus on the Eurozone banking and sovereign debt crises and on Ireland’s fiscal consolidation programme. Contributed papers are invited on these topics and in any area of Irish economic policy.

 

Brief proposals should be forwarded to colm.mccarthy@ucd.ie before August 20th. The programme and booking details will be circulated early in September.

The Devil is in the Principles

Twenty years ago this summer, Europe’s currency arrangement, the ERM, began to tear apart. Fixed exchange rates last as long as the markets fear that central banks can out-buy the sellers. The Bank of England ran out of reserves in September, making George Soros famous, and the system broke up in the middle of 1993. There was no buyer of last resort for the weaker currencies.

 

Under EMU the sovereign bond market plays the role of the forex market. There is no buyer of last resort for the weaker sovereign bonds. The unwillingness of the ECB to play this role means that Spain and Italy can be forced out of the market. Their total bond stock is approaching €3 trillion. Ongoing deficits and rollovers mean their gross issuance could not conceivably be financed by official lenders.

 

So they must be kept in the market or the crisis enters the endgame. The ECB has suspended its SMP (Securities Market Programme) which bought sovereign bonds in the secondary market. It pursued this programme in half-hearted fashion, worrying in public about the quality of the bonds it was buying. Sterling would have crashed out of the ERM more rapidly if the Bank of England had gone around bad-mouthing the quality of the sterling it was supporting back in 1992.

 

Selling sterling to the Bank of England, if the latter possessed unlimited reserves, would have been a mug’s game. Selling Spanish or Italian bonds to somebody with unlimited stocks of Euros would be suicidal.

 

The Brussels summit has opened the way for the ESM to buy bonds in the secondary market, so the ECB has been replaced with a buyer whose balance sheet constraint is known. This is actually a retrograde step. The ESM could quickly become Bank of England Mark II if a sizeable bond market run re-emerges.

 

Nobody in their right mind will short an asset into the Central Bank against money. They cannot run out of the stuff. Nobody can operate a credible reverse tap in the Spanish and Italian bond markets except the ECB, or some agency with unlimited facilities at the ECB.

 

Some useful decisions were taken at Brussels last week but the crisis will persist until this central issue is addressed. Spain and Italy cannot pay more than 4%, or maybe 4.5%, and retain debt sustainability. A reverse tap operated by the ECB places credit risk on its balance sheet and extends the moral hazard (liberally available to European banks) to Mediterranean governments. So the fiscal compact must be implemented and the political commitment problems resolved.

 

The devil is never in the details. The devil is in the principles.   

Bundesbank on Banking Union

‘Talk of a banking union in the euro zone is premature, a key member of the executive board of Germany’s Bundesbank said Tuesday, arguing that such a plan could only follow deeper fiscal union.

“The recent proposals of a so-called banking union appear to be premature,” Bundesbank board member Andreas Dombret told an audience of bankers at a conference in London.’

Fiscal union, in Bubaspeak, means political union, which takes forever. So Dombret is arguing for a continuation of a currency union without banking union for many years to come. He presumably believes that this will prove sustainable.
Courtesy FT.Com:
‘Sabine Lautenschläger, vice-president of the Bundesbank, said banking union could only work in tandem with fiscal union – meaning some common cross-border binding rules on how countries could set budgets.

Banks in Germany have already signalled opposition to having their existing deposit guarantee schemes potentially used to rescue banks in other countries.The “decisive question” of banking union was the “interplay between liability and control” because a crisis in one country’s banks could require financial help from taxpayers in other countries, Ms Lautenschläger said. “Whoever accepts liability also has to have a right to control, especially when it is potentially a question of very large sums as in the case of a banking crisis.”

Speaking at a Bundesbank conference in Frankfurt, she said banking union without fiscal union would, in particular, benefit banks in weaker economies with higher refinancing costs. If those banks then bought more of their own countries’ sovereign bonds, they would, in effect, pass on cheaper refinancing costs to their domestic governments, Ms Lautenschläger said.

“The extremely important discipline of the market would be partially lost. Even more seriously, joint liability for banks would, at least, partially extend to the sovereign bonds of these countries,” she said. “The result would be joint sovereign liability through the back door – without the possibilities for intervention and control, and therefore the protection, of a fiscal union.”

Ms Lautenschläger also cast doubt on how quickly any banking union could be implemented, saying “comprehensive EU treaty changes” would be needed.

Readers will be greatly encouraged to learn of the Buba’s late conversion to the merits of market discipline. Does this mean market discipline only for sovereigns or for banks also?. Did the Bundesbank oppose the policy of the ECB on this matter in October 2010 when the Irish government was coerced into payouts on zombie bank bonds by the other central bank in Frankfurt?

There have been some flaky versions of the ‘banking union’ notion, including mutualised moral hazard for banks. Banking union means (funded) deposit insurance, centralised bank supervision and, critically, proper bank resolution, including the de-commissioning of the ECB’s moral hazard machine. Without bank resolution the sovereign debt crisis is not soluble. Could the Bundesbank be prevailed upon to address two questions:

(1) Can the sovereign debt crisis be resolved with permanent moral hazard for banks and indefinite contingent liability for their sovereigns?

(2) What suggestions can the Bundesbank offer to resolve the current undercapitalisation of the Eurozone banking system?

The perception is inescapable that people who continually rule out the measures needed to rescue the common currency project are indifferent to its fate.

 

 

Daniel Gros, Dirk Schoenmaker: a Sense of Urgency

Today’s proposals from the EU Commission on banking union offer a draft directive whose operative date would be January 1st. 2015, by which time the game will be well and truly over. It would also apply to the EU as a whole, and has that familiar, watered-down, look to it. 

Here’s a slightly more urgent suggestion from Daniel Gros and Dirk Schoenmaker:

http://www.voxeu.org/index.php?q=node/8069

In Greece, they argue, the sovereign has brought down the banks, while in Spain the banks are about to bring down the sovereign, as happened in Ireland, with a little help from the ECB.

The new ESM needs to be deployed to re-capitalise the Spanish banking system, pronto, as soon as the stress tests have been completed. Placing the burden on the sovereign, before the stress tests, is insane. We have been here before.

They also have a better idea for stopping the bank run in Greece.

What Kind of Banking Union?

It has become almost fashionable to call for a banking union to complete the monetary union. This is what I had to say in today’s Sunday Independent:

The referendum result is a relief rather than an achievement. A No vote would have made a bad situation worse. The government needs to move on quickly in exploiting whatever opportunity has been created to reduce the burden of bank-related debt imposed on the Irish Exchequer. The misfortune of Spain presents an opening, since an Irish-style response to the Spanish banking crisis is clearly unwise. The banking crisis in Spain needs a European solution and the European leadership appears to understand that Spain cannot be cut adrift to embrace unknown, and unknowable, liabilities for the debts of mismanaged banks. Ireland was SETF (Small Enough to Fail) but thankfully Spain and Italy cannot be dismissed as peripheral. It is a shocking state of affairs when European countries can see the misfortune of others as a welcome development, but this is the sad reality which has been fashioned in pursuit of the single currency project.   

 

The European Union is not structured in a way which encourages decisive management of crises. The intergovernmental nature of the Union and the inevitable reversion to national political priorities when crisis strikes create a predisposition to muddle, delay and half-measures. These features have been prominently on display since the Eurozone banking and sovereign debt crises erupted in 2008 and have seen both sets of problems intensify. One of the unambiguous lessons of history is that the costs of financial crises magnify when the policy response is too slow.

 

There have however been some potentially promising developments in the weeks leading up to the Irish referendum which received little public attention here, drowned out by the torrent of referendum babble.

 

The president of the European Central Bank, Mario Draghi, made an important speech at the European Parliament on Thursday. He described the existing Eurozone structure as ‘unsustainable’, and called for the creation of a banking union to under-write the failing currency union. The currency union has clearly lost the confidence of the markets and, more importantly, of the public, as evidenced by continuing deposit flight in several countries. Draghi is to be congratulated on his candour, a sharp contrast to the waffle and evasions of his predecessor, Jean-Claude Trichet.

 

Draghi’s remarks come in the wake of a series of speeches from ECB executive board members drawing attention to the need for centralised bank supervision and resolution, the absence of which helped to propel this country into a blind alley back in October 2010. The ECB’s behaviour on that occasion, insisting that a sovereign unable itself to borrow, should repay unguaranteed and unsecured holders of bonds issued by insolvent and closed banks, will come in time to be seen as an appalling misjudgement. Without helping the bank bond market in any discernible way, this ECB policy choice helped to undermine confidence in Eurozone sovereign debt across the board. This discretionary action by Trichet’s ECB was resisted at the time by IMF officials, whose judgement has been thoroughly vindicated by subsequent events.  

 

The popular narrative that the sovereign debt problems derive from fiscal excess may be a reasonable characterisation in the case of Greece, but Ireland and Spain ran budget surpluses through the pre-crisis period, and had amongst the lowest debt ratios in the Eurozone in 2007. It has taken far too long for European decision-makers, in particular ECB officials, to acknowledge that this is mainly a banking crisis. Regional banking crises are to be expected in a currency union. They have been a recurring feature in the United States but are dealt with at federal level, without bankrupting individual states. The failure to anticipate regional banking crises in Europe and the subsequent decision of Trichet’s ECB to prohibit haircuts for unsecured senior bank debt has turned banking crises into sovereign debt crises, weakening banks which hold sovereign bond portfolios and inserting a new short-circuit into Europe’s financial system. A circuit breaker in the form of bank resolution would have been the better option.          

 

ECB executive council member Peter Praet, speaking in Milan on May 25th. last, concluded that

 

“…….more is needed for the euro area to break the link between fiscal imbalances, financial fragmentation and financial instability. Europe needs to move towards a “financial union”, with a single euro area authority responsible for the supervision and resolution of large and complex cross-border banks. This authority should also be responsible for a euro area deposit insurance scheme. With bank resolution and deposit insurance funded primarily by private sector contributions, taxpayers would be shielded from picking up the bill for future banking crises. Essentially, I envision an authority similar to the Federal Deposit Insurance Corporation in the United States”.

Two other Executive Council members, Jorg Asmussen and Benoit Coure, have expressed similar sentiments in recent speeches. The EU commission has also been working on bank resolution proposals according to newspaper leaks and a definitive document is due to be released later in June. EU Commission president Barroso has also stressed the desirability of a banking union.

Whether Europe’s single currency needs a fiscal union, for which there is little political support, is unclear, but a currency union unaccompanied by a banking union is inherently unstable (‘unsustainable’, in the admirably concise judgment of ECB president Draghi). With free capital movement, no perceived currency risk, freedom of establishment for banks and a worldwide liquidity bubble, it is clear that bank balance sheets expanded far too rapidly in several countries, including Ireland, through the pre-crisis decade. The delegation of bank supervision to national authorities and the imposition on them of the no-bank-bondholder-left-behind policy is, Greece excepted, the principal source of the sovereign debt crisis. It is also a moral hazard machine, removing market discipline from banks in countries still solvent and capable of spawning further crises in the years ahead.

The solution is not a Europe-wide bank rescue fund, which could make the moral hazard problem worse, through substituting more credible backstops for the next round of banking excess. The solution is the restoration of market discipline through exposing bank bondholders to the risk of loss. Europe’s single financial market has been sundered through deposit flight and nation-by-nation re-matching of assets and liabilities. This is no longer a monetary union in any meaningful sense – no country has departed the Euro but it has already ceased to be a trusted common currency. Further financial dis-integration can be avoided only if bank deposits in all Eurozone countries are seen as equally secure, which means a Europe-wide deposit insurance scheme, ideally funded through risk-reflective and fair premiums. Banks, including those deemed too big to fail, should be required to carry substantial bond liabilities which can be bailed-in should the banks get into trouble. If this means more expensive funding for banks, so be it. This is hardly an unintended consequence.

The common currency introduced in 1999 was poorly designed, and the failure to build a banking union to accompany the single currency was the principal weakness. It is enormously important that both the EU Commission and the ECB are now persuaded that the monetary union project is incomplete pending new structures to deal with this omission. It is Ireland’s misfortune to have been the first casualty of this design failure, largely our own fault of course, but no country should face punishment to the point of national insolvency for the sins of bank mismanagement and poor bank supervision. It is too late to lament Ireland’s decision to join the Eurozone in the first place. There is no option of painless exit, as Greece may be about to discover. Countries not already in the Eurozone are thinking twice about joining and those who stayed out are silently thankful for the foresight of their politicians. The best outcome for those already in the common currency is that the design flaws are admitted and remedied, sooner rather than later. The referendum result is welcome but the flood of admissions that the common currency needs to be re-designed is far more significant.

Creating a Europe-wide deposit insurance scheme on the hoof is challenging and there are numerous difficult issues to be addressed in the design of a new bank supervision and resolution regime. One tough question for policymakers is whether a banking union can be confined to the Eurozone or must embrace the full European Union. The banking union cannot however be long-fingered until things get back to normal. Its absence is at the heart of the current crisis.   

The Glidepath Rule

In addition to the 0.5% ‘structural deficit’ rule in the fiscal compact, there is also a requirement that any excess in the debt ratio over 60% be eliminated in annual steps of one-twentieth, the glidepath rule. (This requirement dates back to Regulation 1467 of 1997). It is repeated, but not introduced, in the fiscal compact. The compact says we really, really, mean it this time. 

In an economy with a zero or low deficit and even moderate growth in nominal GDP, the debt ratio tends to fall without fresh fiscal effort. The conditions in which Ireland regains market access and exits official borrowing are likely to be conditions in which the glidepath rule will not be a constraint.

If Ireland gets back to, for the sake of argument, a measured deficit of zero in a future year (say 2016 for resonance), is back in the market and able to borrow for roll-overs without any extended official lending, would this rule bind and how would it bind?

If Ireland was still in an official lending programme in 2016, the fiscal targets would be whatever was specified in that programme and would supercede other requirements. Note also that the 0.5% rule would hardly bind – there would probably be a structural surplus at a zero actual deficit, or at least it could plausibly be argued that there was one.

The glidepath rule is in terms of the actual debt/GDP ratio and accordingly would constrain the actual, not the structural, deficit. However the constraint looks unlikely to bind in a benign scenario. To get back in the market Ireland will need borrowing rates that can be afforded and that means growth rates of 2 or 3%, combined with inflation of say 2%. For simplicity, let’s pretend that the debt/GDP ratio at the end of 2016 is 100% and that nominal GDP is expected to grow at 5% (3% growth plus 2% inflation). 

If debt is 120% and nominal GDP growth below 5%, chances are we would still be in a programme. If you think we can exit official lending without some relief on bank-related debt, you can do the sums for alternative high debt ratios and higher nominal GDP growth rates.

On the 100% debt assumption, with nominal GDP growth at 5% and with an actual deficit of 0, the debt ratio at year’s end will be 100/105, = 95.2%, well within the glidepath ceiling of 98%. Even a deficit at the Maastricht 3% would be almost inside the glidepath limit.

So we could still be in a programme in 2016, or in the clear. But it seems unlikely that we would be both in the clear and in trouble with the glidepath.

Endgame?

At the time of the first Greek bail-out in May 2010, several commentators felt that there should have been a default, haircut, PSI, roll-your-own euphemism. It seems this view was shared at the IMF but not at the ECB and not by EU decision-makers so extend-and-pretend won the day. That deal has come unstuck, as predicted. This story in today’s Sunday Telegraph looks like it has decent sources:
The debt sustainainability analysis in the last IMF report on Greece looked like a triumph of hope over experience. The Telegraph is reporting new troika calculations that Greece faces, in 2020, and after a large haircut, a second bailout and eight further years of austerity, an exit debt ratio of 129% of GDP.
The Bundesfinanzministerium, according to the paper, is preparing for an endgame earlier than 2020. Perhaps they have seen Becket’s play:
‘Ever tried. Ever failed. No matter. Try Again. Fail again. Fail better.’

Re-Designing the Eurozone

I argue that the fiscal ‘compact’ will not turn the currency union into a full monetary union in this paper from a conference before Christmas;

http://www.ucd.ie/t4cms/WP12_02.pdf

and in another that Croatia, which voted to join the EU a couple of weeks back, should think carefully about joining the currency union as currently constituted:

http://www.ucd.ie/t4cms/WP12_03.pdf

It would be nice to get solemn acknowledgement all round that fiscal rectitude is a good thing. It would be even nicer if some political attention could focus on what kind of EMU 2.0 might actually work in the long term.

Getting Back in the Bond Market

Official funding runs out at the end of 2013. Today’s manouvre by the NTMA has converted some two-year debt into three-year debt, at a cost. This is not ‘getting back in the market’ in any sense which confirms debt sustanability. No new debt has been issued. The ability to sell new three- or six-month T-bills is not relevant either.

Think about Belgium. The ten-year bond yields 4%, having been briefly higher during the panic. Belgium has a debt ratio about 100%, GGB deficit about 4% and primary deficit about 1%. Belgium is likely (not certain) to be OK and could probably sell 10-year paper in some size. The 4% interest rate is just about consistent with debt sustainability given 2% inflation and a little bit of economic growth.

Ireland’s exit debt ratio will be higher, there are contingent liabilities we all know about and a deficit down to 4% in 2014 would be doing rather well. Can Ireland expect to sell 10-year bonds, in size, in 2014, at 4% yields?

There is a 2025 bond in issue with a 5.4% coupon. It will be an 11-year bond in 2014. The curve should be flat in this zone. So if you think yields on mediums will be 4% in two years time, you can work out the target price for the 2025 bond in 2014. It is about 111.

The bond has recently been trading about 85. So if you think we will be back in the market in a meaningful sense in 2014, on terms as good as Belgium, you can pick up a nice 5.4% coupon twice, and a 30% capital gain, by taking a flutter.

Alternatively you can insist that Ireland can (sustainably) ‘get back in the market’, and stay there, in size, at higher yields. This is entirely conditional on economic growth resuming quickly and at decent rates. The debt sustainability analysis in the IMF staff report to the executive board should issue in a few weeks and will be a must-read.

Regulatory Reform and Economic Performance

The Memorandum of Understanding between the Irish government and the troika of EU, ECB and IMF was agreed in December 2010. It contained commitments to policy changes designed to improve competitiveness through acting on professional service costs, the structure of the energy sector and similar matters. Several commentators on this site have been arguing recently that the new government is delivering austerity without reform. Here’s an interesting recent article from the Economic Journal and an earlier version on open access if you cannot get into the ucd online library.

Guglielmo Barone and Federico Cingano conclude that OECD countries which have gone furthest in tackling anti-competitive practices have enjoyed enhanced performance in industry sectors which are consumers of the products and services of the formerly rent-absorbing firms and professions.

Their conclusions are supportive of the MoU reform agenda, and of the recommendations in the report of the State Assets Review Group on vertical separation (unbundling) in the energy sector.

Happy New Year to you and yours.

Portuguese Energy Privatisations.

All three ‘programme’ countries, Greece, Ireland and Portugal, are committed to privatisation of state assets.

In Portugal, the state owns 25.05% of EDP, a listed electricity generation, distribution and supply business, which also owns some gas operations. A slice of EDP’s operations are in Brazil, some in Spain, most in Portugal.

The state also owns 51.1% of REN, a listed business which owns the electricity transmission business and the high-pressure gas pipeline network in Portugal, as well as some LNG and gas storage operations. It has no significant activities outside Portugal. Both EDP and especially REN embrace regulated activities. Both gas and electricity were originally state-owned in Portugal.

The government has announced the sale of 21.35% of the shares in EDP to the Three Gorges power company of China for €2.7 billion, which will leave the government with less than 4%. The shares are widely held and Three Gorges will be the biggest shareholder. The government has also announced its intention to sell part of its stake in REN, presumably taking it below majority ownership.

These developments are interesting in view of the Irish government’s decision to eschew vertical separation at the ESB and to seek to sell a minority stake in the existing company. Portugal went for vertical separation of the network companies some years back, along the lines of the recommendation for Ireland in the of the Review Group on State Assets which reported in April 2011, and has now decided to exit ownership in powergen/supply more or less altogether. In addition, they seem willing to go below majority control of REN, the networks business. The State Assets report recommended retention of state ownership, at least for the time being, in these businesses.

More Fiscal Arithmetic

On this recent thread

http://www.irisheconomy.ie/index.php/2011/12/09/fiscal-rules-stocks-flows-and-all-that/#comments

Karl Whelan points out that the 0.5% deficit/GDP rule envisaged in Friday’s ‘fiscal compact’  eventually yields a debt ratio at only 17% of GDP. This happens whether you start from zero or from Greece. Karl’s assumed growth rate is just 1%. If you assume 2% the debt ratio asymptotes to only 10%.

This helps to understand where the unlikely average deficit figure of 0.5% came from. The more natural choice of 0% yields the asymptotic abolition of the sovereign bond market, currently being pursued on a shorter time-scale by other means.  Asymptotic abolition cannot be acknowledged in such an important (they were awake ’til 4 am) communique. Somebody might spot it.

The Maastricht 3% deficit, were it the annual average, yields an asymptotic debt ratio of 60%, with nominal GDP rising at 5%. But 3% is to be an upper limit in this fiscal Nirvana, and so is the 60%. Summiteers were thus posed with the following very tricky problem: how to add an average deficit ratio to the 3 and 60 from Maastricht without looking ridiculous? 

The figure cannot be too high, since it would be too close to the 3% upper bound, and cannot be too low, since it abolishes the bond market (slowly). You are not allowed to ask why the extra average deficit rule had to be added to the Maastricht limits at all. This was a frightfully important summit, and tough new fiscal rules had to be imposed, to save Europe….

Actually the decline from 100% (possible peak debt/GDP ratio for the Eurozone as a whole) at a deficit of 0.5% per annum is pretty slow – takes 20 years to fall below 80% – so plenty of time for more summits. Karl goes on to hint that an ultimate debt ratio of 50% or so might be more prudent than 17%, without giving reasons. Here’s one.

Basel III has spawned something called CRD 4, capital and liquidity proposals for European banks. The liquidity part does not (yet) specify a quantitative ratio of liquid to total assets but could turn out to require 20% or 25%. If balance sheets end up at something sensible like 150% of GDP (UK currently 400%), this implies say 35% of GDP needs to be available as high-quality liquidity. Aside from central bank money, this means short (< 5 yr) sovereign bonds. It can’t all be central bank money (or if it can, explain how monetary policy would work). If the debt ratio drops much below 50%, sovereign debt duration has to drop dangerously.

There are reasons for not having too many sovereign bonds about. There are also reasons for not having too few. No thought appears to have been given to this 0.5% rule, about the only concrete element in the ‘fiscal compact’.

Fiscal Union in the 1990s…

From the FT’s rolling blog:

  • Both Sarkozy and Merkel would prefer treaty change for all 27 European Union members. However, if this cannot be reached, they are happy to move forward with a treaty for the 17 eurozone members alone
  • The treaty favoured by Sarkozy and Merkel would include automatic sanctions for countries that breach the rule on deficits below 3 per cent of gross domestic product
  • Primary tool for enforcing balanced budgets will be a “golden rule” written into the constitutions of all 17 eurozone member states; to be verified by the European Court of Justice…..

 

Let’s cast our minds back to, say, October 3rd. 1990. An asymmetric shock (re-unification) struck the unsuspecting Bundesrepublik. The deficit, on the Maastricht definition, stayed below 3% until 1994 and then hit, hmmm, 9.5% of GDP in 1995. Gott in Himmel! 

The ECJ then pronounced that Germany was liable for ‘automatic sanctions’ and in 1996 ……

Stark Prognosis

Juergen Stark of the ECB spoke at the IIEA today and they have posted a video on their website:

http://www.iiea.com/events/crafting-monetary-policy-for-stability-and-convergence

The summary of the proceedings, from the IIEA website, is:

 

‘Dr Stark delivered a keynote address to a packed house in the Institute on the theme of Economic Adjustment in a Monetary Union. Commending Ireland as a “role model” for other countries embarking on programmes of austerity, he nonetheless acknowledged that “strong headwinds” in the global economy threaten to blow its recovery off course. “The sovereign debt crisis has re-intensified and is now spreading over to other countries including so-called core countries.”

Dr Stark delivered a keynote address to a packed house in the Institute on the theme of Economic Adjustment in a Monetary Union. Commending Ireland as a “role model” for other countries embarking on programmes of austerity, he nonetheless acknowledged that “strong headwinds” in the global economy threaten to blow its recovery off course. “The sovereign debt crisis has re-intensified and is now spreading over to other countries including so-called core countries.”

He went on to argue that the crisis was not confined to Europe and that it was in large part a crisis of confidence. It is important that advanced economies do not talk themselves into a second recession. That said, many of these economies urgently need to pursue fiscal consolidation or else their debts will sooner or later become unsustainable. Dangerous fiscal positions are often compounded by structural weaknesses and these too must be addressed. The fiscal outlook for many states threatens the broader economic situation, as do persistent macro imbalances.

Dr Stark recalled that there has historically been little urgency attached to the problem of heterogeniety across Eurozone economies by European leaders. Rates of inflation for example varied widely across Europe in the years leading up to the financial crisis. Risk was inappropriately priced up to 2007 and there are governments that have never properly adjusted to the demands of monetary union, which were well understood by its architects. As far back as 1998, finance ministers and heads of state and government agreed that economic and monetary union should never be used as a justification for financial transfers.

Speaking to journalists after the event, Dr Stark said that “Eurobonds, even if they’re called ‘stability bonds’, won’t solve the sovereign debt crisis in Europe, because they don’t tackle the structural problems some countries are facing.” They “seem to be feasible at a later stage, but only after the transfer of sovereignty.”’

 

Take a look. I promise to let you know what I thought of his presentation when France hits AA+. If this is avoided without a reverse tap  (in Italy or somewhere!) from the ECB, I will devote the rest of my life to writing, on bended knees, the definitive history of the Bundesbank.  

Non-Intersecting Sets?

Searching for politically acceptable policies is fine if the set considered intersects with market-acceptable solutions. Can the Italian bond market be stabilised without mobilising the ECB balance sheet?

The alternative instruments available are essentially a combination of support from reluctant secondary market interventions by the ECB and potentially the EFSF (including its new SPIV) and a credible Italian commitment to cutting the (small) budget deficit. The trouble is that the ECB will not commit to open-ended secondary market support, and is in any event intervening at interest rates which are too high. The EFSF is severely constrained in the short-run and the new arrangements to extend its balance sheet are stuck on the runway. Italy appears to have rejected an IMF standby (or not), and it could hardly have been big enough to matter anyway.

Early fundraising for the EFSF went reasonably well but Monday’s issue was a disaster. The spread over bunds is now outside France, Belgium next stop, has risen over 100 bps since the market debut and lenders have been unnerved by the continuing re-definitions of the status and mission of this supranational borrower. Klaus Regling’s pilgrimage to Beijing the previous week failed to secure any commitment to the new borrowing vehicle and the old one could be on negative watch before France. In any event a balance-sheet-constrained vehicle will always be tested. A bail-out fund paying large spreads with continuing uncertainty about its structure and mission, and which competes with sovereigns in the market, is in danger of itself contributing to instability.

The €350 billion required by Italy over the next year to fund roll-overs and the prospective deficit may not be forthcoming even with a credible new fiscal adjustment programme. Worthy long-term measures to raise the potential growth rate in Italy will not inspire bids at bond auctions. There may be no equilibrium rate above 6% or so.

European policy could be characterised as seeking sequentially the set of previously unthinkable measures needed to stop the rot and continually falling short. Working backwards, the bond and interbank markets could be stabilised by the following shock-and-awe package, with lots of moral hazard: 

– Hard default for Greece and for any other countries (not including Italy or Spain) which need them, calculated to make them unambiguously solvent on exit from their programmes.

– Compulsory re-capitalisation for the banks

– An ECB reverse tap in the Italian bond market

If this set of actions is politically infeasible, and if no lesser package will work at this stage, the inference is inescapable and will be drawn soon.

Most Unique Pleonasm Competition

Bunbury, on another thread, writes

‘…one of the most unique …’

Oh Christ! The standard of English on this website deteriorates by the day. But then, no one thinks twice anymore when they see the phrase ‘close proximity’ (a ‘pleonasm’ in grammatical terms), so the disease has even encroached on the groves of academe.’

I am offering a prize for the reader identifying the most irritating current abusages of the English language. My personal favourites include ‘new initiative’ and ‘almost unique’ (means rare, I think).

The value of the prize to reflect the quality of the entries.

Exciting New Scheme Revealed

The summit communique contains the following:

’12. The Private Sector Involvement (PSI) has a vital role in establishing the sustainability of the

Greek debt. Therefore we welcome the current discussion between Greece and its private

investors to find a solution for a deeper PSI. Together with an ambitious reform programme

for the Greek economy, the PSI should secure the decline of the Greek debt to GDP ratio with

an objective of reaching 120% by 2020. To this end we invite Greece, private investors and

all parties concerned to develop a voluntary bond exchange with a nominal discount of 50%

on notional Greek debt held by private investors. The Euro zone Member States would

contribute to the PSI package up to 30 bn euro. On that basis, the official sector stands ready

to provide additional programme financing of up to 100 bn euro until 2014, including the

required recapitalisation of Greek banks. The new programme should be agreed by the end of

2011 and the exchange of bonds should be implemented at the beginning of 2012. We call on

the IMF to continue to contribute to the financing of the new Greek programme.’

 

I don’t quite see the point of going through a default (which is not, of course, a credit event) in order to get Greece down to 120% of GDP in 2020.

But note the very nifty €30 bill to be contributed by ‘…the Eurozone member states…’.

This could include little us! Imagine, the team taking one for France and we are allowed to tog out!  

What is being proposed here is that European investors who lost money in Greece are getting bailed out to the tune of €30 bill, not by their host governments but by the team. Those who lost money in Ireland got bailed out, and continue to get bailed out, by the host government only.

You have to hand it to the French.

‘Productive Investment’

Use of the phrase ‘productive investment’, without chapter and verse, and within the hearing of job-desperate politicians, is dangerous.

No matter how bad the economic outlook, foolish policy measures can always make it worse. The spectre of politicians seeking to create 100,000 jobs through extra public spending is every economist’s nightmare. The government has announced a New Era programme, funded through privatisation proceeds or otherwise, intended to create 50,000 jobs in the state sector and another 50,000 elsewhere. The state’s 50,000 are apparently to come mainly in the water, telecoms and energy industries, the remaining 50,000 through some mystical process yet to be disclosed.

 

With the unemployment rate in the mid-teens there is inevitable pressure on government to do something, or at least to appear to be doing something, and it is difficult for governments to preach patience when it comes to job creation. However it is inconceivable that sustainable employment on the scale envisaged can be magicked into existence through initiatives from above. The previous government in 2009 produced a ‘Smart Economy’ plan to produce, coincidentally, 100,000 jobs, and which has to date produced no more than sustenance to public expenditure dependants in the universities and barrow-loads of public relations.

 

Job creation schemes will win plaudits in the popular press and gratitude from subsidy junkies in the business community. But they cost money we do not have and cannot borrow. Diverting more funds to public capital ‘investment’ presumes that worthwhile projects are available. Indeed the scale of the New Era scheme presumes that such projects are abundant. Little detail is available on the projects to be pursued, an unacceptable feature in itself. Major commitments should never be made until the details have been scrutinised.

 

The three sectors indicated as having job potential, energy, communications and water, have one thing in common. These are capital, rather than labour, intensive businesses. Once the construction of new facilities is complete, it is not clear that these industries need large additional workforces on a continuing basis. In any event the total workforce in these three sectors is currently about 30,000. It is inconceivable that tens of thousands of extra permanent jobs are required in these areas. The electricity industry has been shedding jobs over the years and I have yet to meet anyone who believes that the ESB is understaffed. The gas distribution network now reaches all of the urban areas in the country that can be served commercially, so there is no job potential there either.

 

As for water, the government intends to meter all users, but this only has to be done once. There will be no permanent jobs in the once-off installation of meters, which will presumably be read remotely, so no jobs there either. The government’s intention is to create a single national water authority to replace the current inefficient and fragmented system of delivery through city and county councils. This is presumably intended to create opportunities for economies in staff numbers, not for a hiring fair. The merger of the regional health boards into the HSE seems to have been a disaster, not least in the creation of new layers of expensive administration. Surely the government is not planning a HSE for water?

There was a depressing discussion of these matters on RTE’s The Week in Politics programme last Sunday evening which paraded three Dail deputies, a junior minister and an RTE anchor none of whom seemed to grasp any of the issues involved. A recurring notion, apparently shared by all five, was that the dividends receivable from state companies (a surprisingly modest sum given the amounts of capital they consume) constitute a recently-discovered treasure trove freshly available to finance job creation schemes. These dividends are part of the government’s current revenue and are already spoken for. A further illusion shared by the participants seems to be that devoting privatisation proceeds to debt reduction, rather than to the New Era schemes, would be tantamount to wasting the money.

 

Patience in pursuit of a feasible macroeconomic plan will halt the rise in unemployment and eventually deliver a recovery in the demand for labour. This is the declared view of the government itself. The strategy of reducing the deficit over the currency of the EU/IMF rescue deal and seeking to stabilise the rocketing national debt is the best plan available and will be de-railed by half-baked and panicky job-creation schemes. 

 

The government seems to lack the courage of its declared convictions. If the macroeconomic strategy is to be subverted with ill-considered job creation schemes, the return to a better jobs market will be delayed. Fortunately the deployment of privatisation proceeds for any purpose other than debt reduction requires sign-off by the troika of EU, ECB and IMF. They should ask the government to explain, in detail, how this plan to conjure up100,000 jobs contributes to national economic recovery

Kenmare Conference Programme

The programme for the Dublin Economics Workshop 2011 Economic Policy conference, to be held in Kenmare, County Kerry, October 14-16, is as follows:

Friday October 14th.

18.00 Understanding the Irish Banking Crisis

Dermot O’Leary (Goodbody Stockbrokers), Don Walshe (UCC): Debt De-leveraging, the Banks and Economic Recovery

Cathal Hanley, Andrew Rae (Competition Authority): Competition, Financial Stability and the Irish Banking Crisis

Pat Farrell (Irish Banking Federation): Building a New Banking Architecture

Continue reading “Kenmare Conference Programme”

Planes, Trains and Automobiles II

Philip Lane posted on this topic earlier in the week and it was my subject in this week’s Farmers Journal too:

Without breaking the speed limit, it is now possible to drive from the outskirts of Dublin to Cork’s Dunkettle roundabout in a little over two hours. Similar time savings have been made possible on the other inter-city routes and the country has, for practical purposes, become smaller. The improvement of the national road network is one of the few unambiguous dividends from the bubble. 

 

On the busiest routes between the capital and the main provincial centres, car journeys are just one option: you can also fly, take the train or catch a bus. The improved road network is good news for bus operators, who can now offer a far better public transport alternative to the car. But it is very bad news for internal air services and for the loss-making Irish Rail. These two options have become markedly less competitive with either car or bus, an outcome which was both predictable and predicted. A rational government would have planned for increased reliance on inter-urban bus services and would have avoided costly, and pointless, subsidies to air and rail services that were bound to lose popularity as motorway development favoured car and bus. There is no absolute need for four different ways of getting to Cork.

 

Rationality however dawns slowly in the make-believe world of Irish transport policy. The government has presided over a massive investment programme in the railway. No less than €2.5 billion has been spent on mainline rail investment over the last decade. The result is that Irish Rail has provided large increases in frequency and capacity despite the obvious threat to passenger numbers. On Dublin-Cork, fifteen trains per day now operate, compared to half that number a decade ago. They offer journey times that are now quite uncompetitive with the car.

 

Air services between Dublin and Cork are not provided by a state-subsidised operator and the reaction has been very different. There will shortly be no scheduled service at all between Cork and Dublin. Ryanair have pulled out, following previous exits by Aer Lingus and Aer Arann. At one stage there were up to a dozen flights a day between the two cities. Ryanair cited passenger migration to the new motorway as a principal factor in its withdrawal announcement.

 

All three airlines which have operated Dublin-Cork services over the years are commercial companies which cannot sustain loss-making routes and their decisions make perfect sense. What precisely is the point though in pouring €2.5 billion into rail investment when a motorway network connecting the same towns and cities is under construction? Did nobody in the Department of Transport foresee what was going to happen?

 

In addition to enormous chunks of free investment capital, the railway enjoys large operating subsidies and a highly restrictive licensing regime for competing bus services. If you fancy running an express bus from Cork to Dublin, without subsidy, forget it. You will not be granted a license. Irish Rail continue, remarkably, to campaign for yet more capital ‘investment’ in the railway – on the grounds that it has become less competitive on inter-urban routes!

 

The government has wisely curtailed capital spending and withdrawn operating subsidies at some of the regional airports, of which far too many were built. The same logic now needs to be applied to the railway. The sheer expense of rail-based public transport systems is invisible to the travelling public, who pay only a portion of the operating cost in fares and none of the capital cost. But the bills of course arrive at the door of the Exchequer.

 

Over the next few weeks, ministers will resume their consideration of the options for cutting expenditure in the years ahead and should assess with a jaundiced eye the rail schemes for Dublin. The most notorious of these is Metro North, a plan for an underground railway through Mr. Ahern’s former Northside constituency serving Dublin Airport. This scheme has been in the plans for many years even though no cost estimate is available. The construction bill would run to several billions, plus the inevitable operating losses. All of this despite the fact that Dublin Airport is easily accessible as things stand, with a road tunnel, built at a cost of €700 million, providing a new link from the city and non-Dublin users able to use the upgraded M50.  

 

There are also schemes to build a new underground railway in the city centre and plans for more tram lines. Sizeable sums have already been spent on designing and planning these projects. But there has been a noticeable drop in traffic congestion in the city recently and parking is easier. The government is flat broke and all of these fancy rail investment schemes should now be put on the long finger, or just abandoned altogether. It is not clear they ever made sense, even when we thought we could afford them.  

Bad Idea from NAMA

From this week’s Farmers Journal, with acknowledgement to Gregory Connor:

 

The state ‘bad bank’ NAMA has bought troubled loans at steep discounts from the Irish-owned banks at a cost of over €30 billion. Many of these loans cannot be serviced by the builders, developers and property speculators who borrowed the money in the first instance so the collateral, in the form of completed and uncompleted buildings and development land, is being seized by NAMA. The intention is that NAMA will realize these assets over time. It has sold very little to date but the clock is ticking and NAMA is due to be wound up within ten years of its inception, so there are just eight-and-a-half years to go.

 

Some of NAMA’s assets are in the form of completed residential property. Outside Dublin the market appears to be pretty slow, with only a trickle of transactions and very little availability of mortgage credit from the banks. There seems to be a bit of a buyers’ strike too – buyers with cash see no urgency about doing deals until prices dip a little more, and asking prices remain unrealistic in many cases.

 

So NAMA is getting impatient and has come up with an attractive-sounding wheeze: if you can get a mortgage to buy a home from NAMA, they will throw in, for free, an insurance policy which covers the risk that prices could drop further.

The scheme would work like this. Nama reckons a house it has for sale is worth €100,000. The purchaser is asked to put up €10,000 in cash and get a mortgage from a bank for €72,000, paying NAMA €82,000 in total.  Nama notionally pays itself the remaining €18,000 and records the house as sold at €100,000.  After an agreed period, say five years, if the fair market value of the house is more than €82,000 the purchaser must pay NAMA the difference up to a maximum of €18,000.  If the fair-market value of the house is €82,000 or less, the homeowner pays no more.

Assuming the initial €100,000 valuation is reasonable, this is a good deal for the purchaser and a bad deal for NAMA, which can never get more than the reasonable value of €100,000 but could get as little as €82,000. In effect, NAMA has given the purchaser a valuable price insurance policy for free. Gregory Connor, an economics professor at Maynooth, has calculated that the discount being offered to the purchaser, allowing for the value of the free insurance policy, is pretty big: on plausible assumptions, the buyer is getting a discount of €12,000 or so.

Before you rush off to phone NAMA, bear in mind that you own NAMA, or more correctly, you will pick up the tab if NAMA loses money, since its debts are on the state balance sheet. The scheme has a number of other drawbacks. Not everyone is an economics professor at Maynooth and able to work out the sums. The scope for confusing purchasers (and the taxpayers) should be clear. Moreover NAMA is not the only, or even the main, seller of residential property in the years ahead. The non-NAMA banks (ones such as Ulster and National Irish) also have re-possessed assets to sell and there are even a few non-bust builders out there trying to stay afloat through selling completed dwellings. Plus there are tens of thousands of individuals interested in selling every year in the normal course of events. None of these people can offer the big upfront discount and assumption of risk built into the NAMA scheme, since they do not enjoy the comfort of reclining on the state’s balance sheet. The NAMA scheme, in brief, could seriously distort the market, and looks anti-competitive. The Financial Regulator and the Competition Authority could have some things to say on this aspect before too long.

The banks have finally been re-capitalised and are now better placed to recover their ability to hold on to deposits. There are prospective purchasers in the residential market who must be a reasonable risk for 75% or 80% mortgages, provided prices are realistic. No doubt NAMA is fearful about the ‘realistic’ bit, but what value is there in anything other than market-clearing prices for residential property at this stage? One real drawback with this scheme is the temptation to use it to hold prices up artificially. The best outcome for the residential market is a more normal flow of mortgage credit to solid borrowers and the discovery of a lower price level which clears the over-supplied market steadily over the next few years. If NAMA paid too much for some of its assets, that is unfortunate but there is no point compounding the error through financial engineering gimmicks which distort further an already dysfunctional residential market.  

Fasten Your Seat-Belts….

In yesterday’s Sunday Independent, noting that Italian and Spanish ten-year yields had closed Friday at just under 5.30 and 5.70 respectively, I wrote:

‘The sole priority for the Eurozone should be to prevent the spread of bond market contagion to Spain and Italy, launching a new financial crisis on a scale beyond the rescue capability of the EU and IMF. If the crisis affecting Greece, Ireland and Portugal can be confined to those three countries there is a reasonable chance that Spain and Italy will retain access to the markets. If the contagion-spreaders in control of European policy continue the shambolic performance of recent months…… Spain and Italy will be swamped and the costs of resolving the Greek, Irish and Portugese problems will begin to look like a bargain. The Spanish Treasury managed to sell some three- and five-year bonds during the week….. But at some stage solvent-for-now issuers such as Spain must face the music in the ten-year market or their outstanding debt bunches shorter and shorter. If the Spanish ten-year interest rate edges much above 6%, the game will probably be up.’

Spanish ten-year yields breached 6% this morning, with Italian yields approaching 5.7%. EU Finance ministers are meeting this evening and might ponder this comment from Reuters:

‘Gary Jenkins, head of fixed income at Evolution Securities, said that while Italy is still a long way from the tipping point in terms of bond yields — markets have focused on yields of 7 percent as unsustainable — recent experience shows how quickly things can get out of control. Greece, Ireland and Portugal spent an average 43 consecutive days trading over 5.50 percent before they went north of 6.00 percent on a consistent basis, Jenkins said. That fell to an average of 24 consecutive days before rising above 6.50 percent, and just 15 days before the 7.00 percent level was breached on a consistent basis.’

In a low-growth economy like Italy and with an inflation target of 2% I am not confident that the ‘tipping-point’ is as high as 7%. But not to worry, the EU Commission is on the case, this from RTE:

The EU has called for a ban on rating agency decisions on countries under internationally-approved rescue packages. Speaking in Brussels, Internal Markets Commissioner Michel Barnier also said that governments should be fully informed before being downgraded by ratings agencies.

So the agencies would have to quit rating Greece, Ireland and Portugal, but could fire ahead rating Italy and Spain. Jose Manuel Barroso, the EU Commission president, also targeted the agencies last week, alleging market manipulation no less, and anti-European bias. The problem, in the estimation of these two EU luminaries, has been caused by the ratings agencies. With no Plan B apparently, the failure of Plan A needs to be assigned somewhere, and US ratings agencies will do fine. 

What precisely is the proposal of the EU Commission to deal with the contingency that Spain and Italy are forced to exit the bond market over the next few months? 

Meanwhile the Italian authorities have banned short selling of bank stocks, which older readers will recall was the source of the problems at Anglo.

Both Spain and Italy need to tap the markets on a continuing basis. The yields they now face at ten years are about the level that persuaded Ireland to take a holiday from the market last September. Their yield curves are also beginning to flatten ominously, with shorter rates rising more quickly than mediums.   

The bank stress tests Mark II are due on Friday. This could be a long week.