24/2/17: Monetary Policy Outlook for 2017

My article for Manning Financial covering monetary policy outlook is out and can be viewed here: https://issuu.com/publicationire/docs/mf_february_2017__1_?e=16572344/44717793.

Alternatively, click on the following images to enlarge

12/1/17: NIRP: Central Banks Monetary Easing Fireworks

Major central banks of the advanced economies have ended 2016 on another bang of fireworks of NIRP (Negative Interest Rates Policies).

Across the six major advanced economies (G6), namely the U.S., the UK, Euro area, Japan, Canada and Australia, average policy rates ended 2016 at 0.46 percent, just 0.04 percentage points up on November 2016 and 0.13 basis points down on December 2015. For G3 economies (U.S., Euro area and Japan, December 2016 average policy rate was at 0.18 percent, identical to 0.18 percent reading for December 2015.

For ECB, current rates environment is historically unprecedented. Based on the data from January 1999, current episode of low interest rates is now into 100th month in duration (measured as the number of months the rates have deviated from their historical mean) and the scale of downward deviation from the historical ‘norms’ is now at 4.29 percentage points, up on 4.24 percentage points in December 2015.

Since January 2016, the euribor rate for 12 month lending contracts in the euro interbank markets has been running below the ECB rate, the longest period of negative spread between interbank rates and policy rates on record.

Currently, mean-reversion (to pre-2008 crisis mean rates) for the euro area implies an uplift in policy rates of some 3.1 percentage points, implying a euribor rate at around 3.6-3.7 percent. Which would imply euro area average corporate borrowing rates at around 4.8-5.1 percent compared to current average rates of around 1.4 percent.

15/12/16: Long-Term Fed Path May Force ECB to Act

My post-mortem analysis of the U.S. Fed's FOMC meeting and policy changes announcements for Sunday Business Post: https://www.businesspost.ie/opinion/constantin-gurdgiev-positives-ireland-feds-move-373461.

Hint: It's about longer term game and the neutral federal funds rate... and traces back to August...

12/9/16: Fiscal Policy in the Age of Debt

In recent years, there has been lots and lots of debates, discussions, arguments and research papers on the perennial topic of fiscal stimulus (aka Keynesian economics) on the recovery. The key concept in all these debates is that of a fiscal multipliers: by how much does an economy expand it the Government spending rises by EUR1 or a given % of GDP.

Surprisingly, little of the debate has focused on a simple set of environmental factors: fiscal stimulus takes place not in a vacuum of environmental conditions, but is coincident with: (a) economies in different stages of fiscal health (high / low deficits, high/low debt levels etc) and (b) economies in different stages of business cycle (expansion or contraction). One recent paper from the World Bank decided to correct for this glaring omission.

“Do Fiscal Multipliers Depend on Fiscal Positions?” by Raju Huidrom, M. Ayhan Kose, Jamus J. Lim and Franziska L. Ohnsorge (Policy Research Working Paper 7724, World Bank) looked at “the relationship between fiscal multipliers and fiscal positions of governments” based on a “large data-set of advanced and developing economies.” The authors deployed methodology that “permits tracing the endogenous relationship between fiscal multipliers and fiscal positions while maintaining enough degrees of freedom to draw sharp inferences.”

The authors report three key findings:

“First, the fiscal multipliers depend on fiscal positions: the multipliers tend to be larger when fiscal positions are strong (i.e. when government debt and deficits are low) than weak.” In other words, fiscal expansions work better in case where sovereigns are in better health.

“For instance, our estimates suggest that the long run multiplier can be as big as unity when the  fiscal position is strong but it can turn negative when the fiscal position is weak. A weak fiscal position can undermine fiscal multipliers even during recessions. Consistent with theoretical predictions, we provide empirical evidence suggesting that weak  fiscal positions are associated with smaller multipliers through both a Ricardian channel and an interest rate channel.”

By strong/weak fiscal position, the authors mean low/high sovereign debt to GDP ratio. And they show that fiscal expenditure uplift for higher debt ratio states results in economic waste (negative multipliers) in pro-cyclical spending cases (when fiscal expansion is undertaken at the times of growing economy). Which is important, because most of the ‘stimuli’ take place in such conditions and majority of the arguments in favour of fiscal spending increases happen on foot of rising economic growth (‘spend/invest while you have it’).

“Second, these effects are separate and distinct from the impact of the business cycle on
the fiscal multiplier.” Which means that debt/GDP ratio has an impact in terms of strengthening or weakening fiscal policy impact also regardless of the business cycle. Even if fiscal expansion is counter-cyclical (Keynesian in nature, or deployed at the time of a recession), fiscal multipliers (effectiveness of fiscal policy) are weaker whenever the debt/GDP ratio is higher. In a way, this is consistent with the issues arising in the literature examining effects of debt overhang on growth.

“Third, the state-dependent effects of the fiscal position on multipliers is attributable to two factors: an interest rate channel through which higher borrowing costs, due to investors’ increased perception of credit risks when stimulus is implemented from a weak initial fiscal position, crowd out private investment; and a Ricardian channel through which households reduce consumption in anticipation of future fiscal adjustments.”

What this means is that low interest rates (accommodative monetary policy) may be supporting positive effects of fiscal expansion, but at a cost of reducing private investment. In a sense, public investment, requiring lower interest rates, crowds out private investment. Now, no medals for guessing which environment we are witnessing today.

Some charts

First, median responses to increased Government spending

Once you control for debt/GDP position with stimulus taking place during recessions:

“Note: The graphs show the conditional fiscal multipliers during recessions for different levels of fiscal position at select horizons… Government debt as a percentage of GDP is the measure of fiscal position and the values shown on the x-axis correspond to the 5th to 95th percentiles from the sample. …Fiscal position is strong (weak) when government debt is low (high). Solid lines represent the median, and dotted bands are the 16-84 percent confidence bands.”

In the two charts above, notice that the range of public debt/GDP ratios for positive growth effect (multiplier > 1) of fiscal policy is effectively at or below 25%. At debt levels around 67%, fiscal expansion turns really costly (negative multipliers) in the long run. How many advanced economies have debt levels below 67%? How many below 25%? Care to count? Five  economies have debt levels below 25% (Estonia, Hong Kong, Macao, Luxembourg and San Marino). For 67% - nineteen out of 39 have debt levels above this threshold. Not exactly promising for fiscal expansions...

Overall, the paper is important in: (1) charting the relationship between fiscal policy effectiveness, and debt position of the sovereign; (2) linking coincident fiscal and monetary expansions to weaker private investment; and (3) showing that in the long run, fiscal expansion has serious costs in terms of growth and these costs are more pronounced for countries with higher debt levels. Now, about that idea that Greece, or the rest of PIGS, should run up public investment to combat growth crisis…

11/6/16: 5,000 Years Record…

A quick classic from the 11-months-old Andrew Haldane’s chart plotting history of interest rates from 3000BC through NIRP/ZIRP

Oh, and yes, this is record low…

You can read the full speech here:
www.bankofengland.co.uk/publications/Pages/speeches/default.aspx  - search for Haldane, June 30, 2015 speech.

21/4/16: Economic Outlook: Advanced Economies

My article on economic outlook forward for the Advanced Economies is now out at the Manning Financial quarterly: https://issuu.com/publicationire/docs/mf_magazine_april_2016_web_19042016?e=16572344/35062140.

21/11/15: Be Kind to Economic Forecasting Dodos...

Oh, spare a kind thought for the economists... crippled by the intellectual feebleness of algebraic (and utterly useless) models and hamstrung by the need to sell 'good news' to naive retail clients pounded by the sell-side 'research', they have it tough in this life. And the things are going to get tougher.

So far, in anticipation of the U.S. Fed hikes, virtually all economics analysts working for sell-side stuff brokers have been declaring their firm conviction that once the Fed raises rates, things are going to be off to a neatly clean start - the U.S. economy will shake off any risks to growth, while the Euro area economy will get a devaluation boost from stronger dollar.

Which, by the way, may or may not happen, but as Reuters article (link here) clearly shows, it wouldn't be the economists crowd that will have any idea what is going to happen.

Here are two charts from Reuters:

Now, give this a thought: 2014 and 2015 were relatively 'trend' years for the U.S. economy. And yet, in both cases, analysts surveyed by Reuters vastly, massively, grossly missed the boat on their forecasts. The dodos did predict back in January 2015 that 1Q 2015 growth will be 2.8%, missing the mark by 3 percentage points. And they did chirp out a forecast of 2.5% growth for 1Q 2014 back in January 2014, missing the reality by a massive 5.4 percentage points.

And to give you some more flavour, here is a summary of IMF forecasts for advanced economies (not just the U.S.):

Which confirms the aforementioned truth: economic forecasts ain't got a clue where the major advanced economies are heading, with or without Fed rate hikes.

It would be laughable, if this was not serious: the same types of economists inhabit the forecasting halls of the Fed, providing 'technical (mis-)guidance' to the FOMC on which the decision to hike rates will be made. In other words, the blind are driving, the deaf are navigating them and we are all the passengers on their happy runaway train.

So buckle up. When Fed hikes rates, things might go smooth or they might go rough - we just don't know. But we do know as much: all these economic forecasters have not a clue what will happen...

28/9/15: Blow Outs in the Markets: Beware of Debt Financing

 This is an unedited version of my article in the Village Magazine from June 2015.

Three recent events, distinct as they may appear, point to a singular shared risk faced by the Irish economy, a risk that is only being addressed in our policy papers and in the mainstream media.

Firstly, over the course of May, European financial markets have posted surprising rises in Government and corporate bond yields amidst falling liquidity, widening spreads and increased volatility.

Secondly, both the IMF and the Irish Government have recognised a simple fact: once interest rates revert back to their 'normal' path, things will get testing for the Irish economy.

And thirdly, the Irish Government has quietly admitted that the fabled arrears solutions to our household debt crisis are not working.

Deep below the lazy gaze of Irish analysts, these risks are connected to the very same source: the massive debt overhang that sits on the back of our struggling economy.

Stability? Not So Fast.

Take the first set of news. The problem of spiking yields and blowing up trading platforms in the European bond markets was so pronounced in May, that the ECB had to rush in with a bold promise to accelerate its quantitative easing purchases of Government paper to avoid an even bigger squeeze during the summer. All in, between January and the end of May, euro area government bond yields rose by some 6 basis points, cost of non-financial corporate borrowings rose by around 9 basis points, and banks' bond yields were up 1 basis point. All in the environment of declining interbank rates (3-month Euribor is down 10 basis points) and massive buying up of bonds by the ECB.

In one recent survey completed by the Euromoney before May bond markets meltdown almost 9 out of 10 institutional investors expressed deep concerns over evaporating market liquidity (higher costs of trading and longer duration of trades execution) in the sovereign bond markets. In another survey, completed in late 1Q 2015 by Bank of America-Merill Lynch, 61% of large fund managers said that European and U.S. stocks and bonds are currently overvalued - the largest proportion since the survey began back in 2003.

In the U.S., current consensus expectation is for the Federal Reserve to start hiking rates in 3Q 2015. In Europe, the same is expected around Q3 2016. And recently, both estimates have been moving closer and close to today, despite mixed macroeconomic data coming from the economies on the ground. If the process of policy rates normalisation coincides with continued liquidity problems in the bonds markets, we can witness both evaporation of demand for new government debt issues and a simultaneous increase in the cost of funding for banks, companies and the Governments alike.

Cost of Credit

Which brings us to the second point - the role of interest rates in this economy.

In recent Stability Programme Update (SPU) filled with the EU Commission, the Department of Finance provided a handy exercise, estimating the impact of 1% rise in the ECB key rate. The estimates - done by the ESRI - show that in 2017, a rise in ECB rate to 1 percentage point from current 0.05% will likely cost this economy 2.1% of our GDP in 2017, rising to 2.4% in 2018 and 2019. By 2020, the effect can amount to the losses of around 2.5% of GDP.

This increase would bring ECB rates to just over 1/3rd of the historical pre-crisis period average - hardly a major 'normalisation' of the rates. Which means that such a hike will be just a start in a rather protracted road that is likely to see rates rising closer to 3-3.5 percentage points.

But here is a kicker, the ESRI exercise does not account fully for the realities on the ground.

In addition to the ECB rate itself, several other factors matter when we consider the impact of the interest rates normalisation on the real economy. Take for example cost of funds in the interbank markets. Average 12 months Euribor - prime rate at which highest-rated euro area banks borrow from each other - averaged 3.29% for the period of 2003-2007. Today the rate sits at 0.18%. Which means rates normalisation will squeeze banks profits line. If euro area, on average, were to hike their loans in line with ECB increases, while maintaining current 12 months average lending margins, the rate charged on corporate year and over loans in excess of EUR1 million will jump from the current 2.17% to 3.37%.

It turns out that due to our dysfunctional banking system, Irish retail rates carry a heftier premium than the euro area average rates, as illustrated in Chart 1 below. Which, of course, simply amplifies the impact of any change in the ECB base rate on Ireland’s economy.

The reason for this is the pesky issue of Irish banks profitability - a matter that is distinct from the euro area average banking sector performance due to massive non-performing loans burden and legacy of losses carried by our banking institutions. Per latest IMF assessment published in late April, Irish banking system is the second worst performing in the euro area after the Greek when it comes to existent levels of non-performing loans. In today's terms, this means that the average lending margin charged by the banks in excess of ECB policy rate is 3.4% for house purchase loans, 5.63% for loans to Irish companies under EUR1 million with a fix of one year and over, and 4.0% for loans to same companies in excess of EUR1 million. Which means that a hike in the ECB rate to 1% will imply a rise in interest rates charged by the banks ranging from 0.84% for households loans, to 0.92% for smaller corporate loans and to 1.22% for corporate loans in excess of EUR1 million.

Chart 2 below highlights what we can expect in terms of rates movements in response to the ECB hiking its base rate from the current 0.05% to 1%.

No one - not the ESRI, nor the Central Bank, nor any other state body - knows what effect such increases can have on mortgages arrears, but is pretty safe to say that households and companies currently experiencing difficulties repaying their loans will see these problems magnified. Ditto for households and companies that are servicing their debts, but are on the margin of slipping into arrears.

While the ESRI-led analysis does enlighten us about the effects of higher rates on tax revenues and state deficits, it does little in providing any certainty as to what happens with consumer demand (linked to credit), property investment and development (both critically dependent on the cost of funding), as well as the impact of higher rates on enterprise formation and survivorship rates.

In addition, higher rates across the euro area are likely to imply higher value of the euro relative to our major trading partners' currencies. Which is not going to help our exporters. Multinational companies trading through Ireland are relatively immune to this effect, as most of their trade is priced internally and stronger euro can be offset by accounting and other means. But for SMEs exporting overseas, every percentage point increase in the value of the euro spells lower sales and lower profits.

Debt Overhang: It Matters

Across the euro area states, there are multiple pathways through which higher rates can drain growth momentum in the economy.

But in Ireland's case, these pathways are almost all invariably adversely impacted by the debt overhang carried by the households and the corporate sectors. Current total debt, registered in Irish financial institutions as being extended to Irish households and resident enterprises stands at just over EUR263.7 billion. And that is before we take into the account our Government debt, as illustrated in Chart 3.

A 1 percentage point increase in retail rates can see some EUR2.64 billion worth of corporate and household incomes going to finance existent loans - an amount that is well in excess of EUR2.28 billion increase in personal consumption recorded in 2014 compared to 2013, or 24% of the total increase in Ireland's GNP over the same period. Add to that added Government debt costs which will rise, over the years, to some EUR1.5 billion annually.

What is not considered in the analysis is that at the same time, rising cost of credit is likely to depress the value of the household's collateral, as property prices are linked to credit markets conditions. Which means that during the rising interest rates cycle, banks may be facing an added risk of lower recovery from home sales.

The effect of this would be negligible, if things were relatively normal in Irish mortgages markets. But they hardly are.

At the end of Q4 2014, total number of mortgages in arrears stood at 145,949 accounts, amounting to the total debt of EUR29.8 billion or 18% of total lending for house purchases. 94,929 accounts amounting to EUR14.94 billion of additional debt were restructured and are not in arrears. Roughly three quarters of the restructured mortgages involve 'solutions' that are likely resulting in higher debt over the life time of the restructured mortgage than before the restructuring was applied. We cannot tell with any degree of accuracy as to how sensitive these restructured mortgages are to interest rates changes, but arrears cases will be much harder to resolve in the period of rising rates than the cases so far worked out through the system.

When, Not If…

You'd guess that the ESRI and Department of Finance would do some homework on all of the above factors. But you would be wrong. There is no case-specific risks analysis relating to interest rates changes performed. Perhaps one of the reasons why majority of analysts have been dismissing the specific risks of interest rates increases is down to the lack of data and models for such detailed stress-testing.

Another reason is the false sense of security.

Take the U.S. case. The U.S. economy is now in an advanced stages of mature recovery, based on the most recent survey of economic forecasters by the BlackRock Investment Institute. But the underlying weaknesses in growth remain, prompting repeated revisions of analysts' expectations as to the timing of the Federal Reserve rates hikes. Still, the Fed is now clearly signaling upcoming rate hike.

The Fed is pursuing a much broader mandate than the ECB - a mandate that includes the target of full employment. The twin mandate is harder to meet than the ECB's singular objective of inflation targeting.

While the European inflation is low, it is not as low as one imagines. Stripping energy - helped by the low oil prices - inflation in the Euro area was estimated to be at 0.7% in April 2015. Combined, prices of gas, heating oil and fuels for transport shaved 0.66 percentage points off headline inflation figure. Although 0.7% is still a far cry from 'close to but below 2%' target, for every 10% increase in energy prices, HICP metric watched by the ECB will rise approximately 1.06 percentage points. So far, in April 2015, energy prices are down 5.8% y/y - the shallowest rate of decline in 5 months. Month on month prices rose 0.1 percentage points.

Sooner or later, interest rates will have to rise.  In the U.S., explicit Fed policy is that such increases will take place after the real economy recovers sufficiently to withstand such a shock. In the euro area, there is no such policy in place, in the aggregate, across the entire common currency area, and in the case of specific weak economies, such as Ireland, in particular.

18/2/15: Inflation Expectations and Consumers' Readiness to Spend

In an earlier post I provided a rough snapshot of the evolving relationship between inflation and consumer demand. But here is a fresh academic paper covering the same subject:

Bachmann, Rüdiger, Tim O. Berg, and Eric R. Sims. 2015. "Inflation Expectations and Readiness to Spend: Cross-Sectional Evidence." American Economic Journal: Economic Policy, 7(1): 1-35. https://www.aeaweb.org/articles.php?doi=10.1257/pol.20130292 (h/t to @CHCEmsden for this link)

From the abstract: the authors examined "the relationship between expected inflation and spending attitudes using the microdata from the Michigan Survey of Consumers. The impact of higher inflation expectations on the reported readiness to spend on durables is generally small, outside the zero lower bound, often statistically insignificant, and inside of it typically significantly negative. In our baseline specification, a one percentage point increase in expected inflation during the recent zero lower bound period reduces households' probability of having a positive attitude towards spending by about 0.5 percentage points."

In other words, when interest rates are not close to zero, consumers expecting higher inflation do lead to a weak, statistically frequently zero, uplift in readiness to increase durable consumption (type of consumption that is more sensitive to price variation, and thus should see a significant positive increase in consumption when consumers anticipate higher inflation).

But when interest rates are at their zero 'bound', consumers expecting higher inflation in the future tend to actually cut their readiness to spend on durables. Not increase it! And this negative effect of future inflation on spending plans is "significantly negative".

Now, give it a thought: the ECB is saying they need to lift inflation to close to 2% from current near zero (stripping out energy and food). Based on the US data estimates, this should depress "households' probability of having a positive attitude towards spending" by some 1 percentage point or so. In simple terms, there appears to be absolutely no logic to the ECB concerns with deflation from consumer demand perspective.


Update: a delightful take on deflation from Colm O'Regan: http://www.bbc.com/news/blogs-magazine-monitor-31489786. And a brilliant vignette on prices, markets, consumers and ... thought for deflation too: http://www.eastonline.eu/en/opinions/hobgoblin/economics-elsewhere-three-tales-that-may-rock-the-boat by @CHCEmsden h/t above.

4/9/2014: ECB: Little Done. Loads More to Be Done Still...

In its latest move in attempting to combat the risk of deflation in the euro area, the ECB pushed the policy interest rate down to 0.05% from 0.15%. Here are some historical dynamics of the rates and comparative analysis of the ECB policy relative to other Central Banks:

Let's start from the historical chart:

The chart is showing the historical evolution of the rates in six advanced economies. At this stage, we have a statistical convergence between the US, Japanese and Euro area rates at the lower margin feasible.

It is worth noting that from January 1999 through September 2008, pre-crisis average for the Euro rates is 3.10 which is now 3.05 percentage points above the current rate. In the case of the US, current rates are 3.37 percentage points below the pre-crisis average. In the UK, historical pre-crisis average is 4.83% which means we are at 4.33 percentage points below the historical average.

The dynamics of deviations in the ECB rates from their historical average are shown below:

Statistically, mean reversion in rates is now well-overdue and accounting for likely overshooting we are looking at the mean reversion taking the rates above 3.25-3.5%. Total duration of periods of deviation from the mean in the last episodes (for rates both above and below the mean) is 85 months over 9 years and 11 months. Current deviation is already 70 months long and counting. Excluding the 1999 period, which is consistent with the period of early establishment of the euro policy, total length of combined deviations from the historical average is 78 months, just 8 months short of the current period duration.

The higher the hill in the above chart gets, and the deeper the blue line goes, the greater pain will be required to revert the rates to their historical mean. This pain is coming, whether we like it or not and its timing and extent will have nothing to do with the legacy debts in Ireland or with our capacity to service them. It will come on foot of the Big 4 euro states data.

Meanwhile, this will do preciously nothing for the euro area economy. Why? Because the problem in the euro area economy is not the rates on loans to banks or between banks, as illustrated by the chart below. The problem is that policy rates are not feeding through to the retail rates charged on real loans for real companies and households in the real economy:

As the above chart clearly shows, the banking rates track reasonably well the policy rate (blue line, showing 12 months euribor rate deviation from the ECB repo rate), but the real rates (retail rates charged on loans in excess of EUR1 million with 1-5 years maturity for euro area non-financial companies) are getting increasingly more expensive compared to the ECB repo rates (red line).

The latest cut in rates is not going to do anything to the above story. And the ECB, so far, has found no means for breaking the financial markets blockage that prevents the policy rate to feed through to the retail rates. Nor, incidentally, has the ECB discovered any means so far to break the cycle of fragmentation in the credit system - the situation where by credit rates for non-financial companies and households diverge between different countries of the euro area.

Two real and actual problems: not cured. One imaginary problem - of official policy not being absurdly accommodative enough - is now addressed. Little done. Loads to be done still... and the future interest rates hikes super gun is loaded, primed and the fuse lit already...

17/5/2014: Growth Forecasts: What Matters and What Doesn't

This is an unedited version of my Sunday Times article from April 20, 2014.



Nothing sums up frustrations of the policymakers and general public with economics as well as the famous quote from the US President, Harry S. Truman: “Give me a one-handed economist, all my economists say is ‘on the one hand …and on the other hand…”

Quips aside, human choices and activities - the fundamental forces driving all economics - are unpredictable and painfully complex to model and measure. But beyond behavioural intricacies, complex nature of modern economic systems implies that data we use in analysis is often rendered non-representative of the realities on the ground.

Take for example the concept of the national income. Economists define this as a sum of personal expenditure on consumer goods and services, net expenditure by Government on current goods and services, domestic fixed capital formation, changes in stocks and net exports of goods and services. Combined these form Gross Domestic Product or GDP. Adding Net Factor Income from the Rest of the World (profits and dividends flowing from foreign destinations into Ireland, less payments of similar outflows from Ireland) gives us Gross National Product or GNP.



All of this seems rather straightforward when it comes to an average country analysis. By and large the overall changes GDP and GNP are closely linked to other economic performance indicators, such as inflation, investment, employment and household incomes.

Alas, this is not the case for a tiny number of small open economies with significant share of international activities in their total output, such as Ireland. In such economies, both GDP and GNP can be severely skewed by tax optimisation and global rent-seeking strategies of multinational enterprises. Faced with large share of domestic accounts distorted by tax arbitrage, economists are left to deal with high degrees of uncertainty when forecasting national output and employment. Even past data becomes hard to interpret.

In recent months, various analysts published a wide range of forecasts and predictions for Irish economy for 2014-2015. Consider just three sources of such forecasts: Department of Finance, the ESRI and the IMF.

Budget 2014 projections, forming the basis of our fiscal policy predicted average annual real GDP growth of 2.15 percent, with underlying real GNP growth of 1.7 percent. These projections were based on the assumed annual growth of 1.5 percent in personal consumption, and 6.35 percent growth in investment. These projections were also in-line with IMF forecasts.

Around the same time, ESRI was forecasting GDP growth of 2.6 percent for 2014 and GNP growth of 2.7 percent, well ahead of the Department of Finance outlook. ESRI forecasts were much more skewed in favour of domestic investment and personal consumption.

Fast-forward six months to today. In its latest analysis, IMF lowered its forecast for our GDP growth to 1.7 percent for 2014, leaving unchanged their outlook for 2015. The Fund forecast for GNP growth remained unchanged for 2014 and was raised for 2015.

ESRI has shifted decidedly into even more optimistic territory. The Institute's latest predictions are for GDP expansion of 3.05 percent on average in 2014-2015. GNP growth forecast is now at 3.6 percent. ESRI's rosy projections are based on expectations of a massive 10 percent growth in investment, with private consumption expectations also ahead of previous projections.

Finally, this week, Department of Finance upgraded its own forecasts, lifting expected 2014-2015 growth to 2.4 percent for GDP and 2.5 percent for GNP. Domestic demand growth is now expected to average 2.4 percent through 2015, and investment growth is expected to run at a head-spinning rate of 13.9 percent.

Everyone, save the IMF, is getting increasingly bullish on Irish domestic economy, which, in return, spells good news for employment and household finances.



The problem is that all of these forecasts give little comfort to anyone seriously concerned with the impact of economic growth on the ground, in the real economy.

Even the ESRI now admits that we cannot forecast this economy with any degree of precision. More significantly, the Institute recognises that our GDP figures are no longer meaningful when it comes to measuring actual economic performance. Instead, the ESRI claims that GNP is a better gauge of the real state of the Irish economy.

In truth, the proverbial rabbit hole does not end there: Irish GNP itself is still heavily skewed by the very same distortions that render our GDP nearly useless.

The ongoing changes in our exports and imports composition are throwing thick fog of obscurity over our net exports, which account for 22.6 percent of our GDP and 26.7 percent of our GNP – not a small share.

Since 2012, expiration of international patents in the pharmaceutical sector, triggered billions in lost exports revenues and shrinking trade surplus. In colloquial terms, Irish economy is now running weak on expired Viagra.

Just how much the patent cliff depresses our GDP and GNP is a mater of dispute, but we do know that pharma accounts for about one quarter of our total exports and one eighth of the gross value added in economy despite employing very few workers here. The patent cliff was responsible for a massive 1.25 percent drop in our labour productivity across the entire economy last year. But, as ESRI analysis previously shown, the overall effect of patents expirations on our GDP (and by corollary on GNP) is extremely sensitive to the assumptions relating to where pharma companies book their final profits. Profits booked in Ireland yield significant adverse impact. Profits channeled through Ireland to offshore destinations have negligible impact.



Which brings us to the second force contributing to rendering both GDP and GNP growth largely irrelevant as measures of our economic wellbeing.

Based on data through Q4 2013, since the bottom of the Great Recession in 2010, our net exports of goods and services rose EUR10.6 billion, driven by EUR14.4 billion in new exports of services offset by the decline of EUR3.05 billion in exports of goods. Ireland’s exports-led recovery was associated with a massive shift toward ICT exports.

Much of this trade was associated with little real activity on the ground.

Consider for example tax revenues. In 2010-2013, for each euro in added net exports, the Exchequer revenues increased by less than 3.3 cents. Back in 2000-2002 period the same relationship was more than six times higher. Of course back then both the MNCs and domestic companies were in rude health or on steroids of cheap credit and patents protection, depending on how a two-handed economist might look at the numbers. Still, the core composition of our exports was more directly connected to real production and value creation taking place in this country.

This can be directly witnessed by looking at other metrics of current activity, such as Purchasing Manager Indices published by Markit and Investec Ireland. Since Q1 2010, both Services and Manufacturing PMIs have been consistently signaling a booming economy. Meanwhile, GDP posted an average annual rate of growth of just 0.22 percent. Employment in industry ex-construction is down 21 percent on pre-crisis peak, employment in professional, scientific and technical activities is down 4.3 percent and employment in information and communication sector is down 1.1 percent.

The new crop of multinational corporations driving growth of GDP and GNP in Ireland is much more aggressive at tax optimisation than their predecessors. Which means that they also tend to use fewer domestic resources to deliver real value added on the ground.



All of which suggests that gauging true extent of economic growth in Ireland is no longer a simple matter of looking at either GDP or GNP figures. Instead, we are left with other aggregate measures of the real economy, such as: non-agricultural employment and the final domestic demand – a sum of private and public consumption and gross fixed capital formation.

By the latter metric, this economy has managed to deliver 6 consecutive years of uninterrupted annual declines in activity. In 2013, inflation-adjusted domestic demand fell by some EUR366 million on previous year. Cumulated losses since 2008 now stand at EUR32 billion or almost 20 percent of our GDP. Good news is that the rate of declines has been de-accelerating every year since 2009. And in H2 2013 demand rose 1.75 percent year on year. Bad news is that in real terms, our final domestic demand is currently running at the levels just above those recorded in 2003. In other words, we are now into the eleventh year of the ‘lost decade’.  At H2 2013 rate of growth, it will take Ireland until 2026-2027 to regain pre-crisis levels of domestic economic activity.

Meanwhile, employment figures are painting a slightly more optimistic picture, albeit these figures too are not free of methodological problems. In Q4 2013, non-agricultural employment in Ireland stood at 1,793,000, with H2 figures on average up 1.91 percent or 33,550 on the same period of 2012. To-date, non-agricultural employment numbers are down 13 percent or 266,550 on pre-crisis levels. However, when one considers total population changes in Ireland since the onset of the crisis, the ratio of non-agricultural employment to total population is currently at 39 percent, which is the level below those recorded in Q4 2000.


To the chagrin of the Irish policymakers and general public, our economy is, like an average economist, two-handed. On the one hand, our employment and total demand figures show an economy anemically bouncing close to the bottom. On the other hand, a handful of MNCs are pushing our GDP and GNP stats up with profits from their operations in far flung places retired here. Harry Truman really had it easy compared to Enda Kenny.

Box-out

The latest data from the Central Bank covering retail interest rates confirms two key trends previously highlighted in this column.

The first one is the rising cost of borrowing compared to the underlying European Central Bank policy rate. In January-February 2014, average retail rates on new loans for house purchases were priced 3.32 percent higher than the ECB rate. A year ago the same margin was 2.89 percent. For non-financial corporations, average margin rose from 4.58 percent to 5.03 percent for loans under EUR1 million, and from 2.42 percent to 3.1 percent for new loans over EUR1 million. Lending margins over the ECB rate in January-February 2014, averaged two to three times the margins charged in the same period of 2007 at the peak of credit bubble.

The second trend relates to the spread between rates paid by the banks on deposits and interest charged on loans. Since October 2011, Irish households consistently faced deposit rates that are by some 2 percentage points lower than the average annual cost of new loans for house purchases. In January-February 2014 this gap widened by some 0.27 percent compared to the same period of 2013. The spread is now running at double the rate recorded at the peak of the pre-crisis credit boom. The same holds for interest rates differential between loans and deposits for non-financial corporations which is now at the second largest levels since January 2003 when the data reporting started.

In short, credit today is historically more expensive, while deposits are cheaper. Irish banking sector continues to extract emergency rents out of the real economy with no easing in sight.

13/5/2014: BIS on Unwinding Global QE: There Will Be Pain...

BIS Working Papers No 448 "The exit from non-conventional monetary policy: what challenges?" by Philip Turner published last week offers some interesting analysis of the risks we can expect in the process of the unwinding of the QE measures and other non-orthodox supports extended by the Central Banks following the GFC. The topic of huge importance for anyone interested in the forward analysis of the advanced economies and the one I have covered over the recent years under my thesis of the impossible monetary policy dilemma both on this blog and in my Sunday Times articles.

Note: link to the paper http://www.bis.org/publ/work448.pdf.


"One legacy of the monetary policies pursued since the financial crisis is that central banks in most advanced economies now have exceptionally large balance sheets. And commercial bank reserves (“money”) have risen by several multiples. These policies have made the exit challenge faced by central banks more complex. But there is no consensus on the New Normal for the balance sheet of central banks.

This paper argues that the crisis has forced a critical examination of some widely-held beliefs about the division of labour between different agencies of government in implementing macroeconomic policies. The central bank has become more dependent on what the government decides – on fiscal policy, on government financing choices and on regulations requiring banks and other financial firms to hold government bonds. The exit will succeed only if central banks remain free of fiscal dominance and financial dominance."

But what does this really mean?

The paper starts by positing three orthodoxies or dogmas that dominated the past thinking on monetary-fiscal policies interlinks and that have been proven to be wrong by the current crisis:

"In recent years, The New Keynesian perspective incorporating rational expectations and perfect asset substitutability also had a number of convenient implications for policymakers. It shaped what has been called the pre-crisis “doctrine” of monetary policy, and
therefore was partly responsible for the severity of the recent crisis… [the] three “dogmas” that are of interest for the purpose of this paper:
a) Open market operations in government bond markets (or in foreign exchange markets) do not change relative prices. … [in other words] any purchase or sale of particular assets would lead only to offsetting changes in private demands, with no impact on prices. One corollary of this is that government debt management (that is, the relative supply of short-dated and long-dated bonds by the Treasury) can be separated from monetary policy.
b) The central bank short-term policy rate is the unique instrument of monetary policy aimed at macroeconomic objectives. The impact of policies on other core financial market prices – such as the term premium in the long-term interest rate – was neglected…
c) The “liquidity” of the balance sheets of commercial banks is irrelevant. If adequate capital standards are in place to ensure the viability of a bank, there was no additional need for bank regulators to worry about the liquidity of banks because a sound bank could borrow readily in interbank markets to meet any “temporary” liquidity squeeze. Hence the failure of international regulators in the 1980s to develop common measures of the overall liquidity of a bank (and the decline in liquid asset ratios) seemed unimportant."


As Turner notes: "…all three “dogmas” have been shown by recent events to be false."

In particular, "Central bank balance sheets matter. Large-scale central bank purchases of bonds (and other assets) have lowered long-term interest rates, leading economists to re-examine the portfolio rebalancing affects that the New Classical school had dismissed. The neat separation between central bank open market operations and government debt management has been blurred. And banks now pay much closer attention to the liquidity of their balance sheets (with bank regulation in this area having been strongly reinforced since the crisis). Equally, the scale of balance sheet measures taken by central banks actually reinforces the fundamental logic behind the New Classical theories. An intertemporal perspective – a key insight of rational expectations – has become even more necessary. Because of the substantial lengthening in the maturity of central bank assets, the decisions taken during this crisis will have more long-lasting (and therefore more uncertain) effects than if policy action had been limited to short-term interest rates or short-dated paper."

How big is that 'long-lasting effects' bit?

And more crucially, as we know the size of the problem, how difficult or painful will it be to undo this QE legacy?


Consider one aspect of the legacy: the link between asset prices (financial markets valuations) and the interest rate risk (the cost of undoing the QE). Per Turner: "Getting long-term rates down has contributed to bringing financial asset prices in the core economies back to pre-crisis levels, even higher. And, ...Gambacorta et al (2012) show that the expansion of central bank balance sheets did
increase real GDP. In this sense, QE policies have worked."

But just because it worked in the past, does this mean unwinding it will be cost-less even if 'handled right'?

As Turner points, "there is a reassuring answer. The massive purchases of central banks have had wealth effects that should, in time, stimulate global demand. In addition, stronger asset prices should raise the value of potential collateral for new loans and therefore ease the borrowing constraints facing firms and households. Once stronger aggregate demand is assured, the central bank
could readily unload the assets acquired during the crisis."

In other words, the idea of the 'well-managed exit' is that it will come at the time of demand boom and this demand boom should reduce adverse costs of the exits. In theory.

"The problem with this reassuring answer is that the recent recession – now more than five years long – has lasted so long. Financial asset prices did get a considerable boost. Yet the hoped-for growth in real GDP that would have allowed central banks to scale back crisis-related asset purchases did not materialise."

The good times arrived, but not for the real economy. 'Well-managed' exits are not really on the books, since "this disconnect between the rapid rise in asset prices and the persistent weakness of demand is worrying. Is this a bubble that could suddenly deflate? Or do forecasters underestimate the strength of real demand over the next couple of years?"

And there is more: "Another worry is that global net interest rate exposures must have risen substantially since the crisis. At the core of this is US Treasury debt outstanding held outside the Federal Reserve. This rose from $3 trillion in early 2007 (yielding an
average of 5%) to $8 trillion (with an average yield of 1%) by mid-2013. The rise of government debt in other advanced economies – financed at yields that track US Treasuries – is well-known. Much of this risk is in the banking system: sovereign exposures accounted for 19% of total banking book exposures of large international banks in mid-2012, compared with 11% at end-2008. Lower-rated corporations have also benefited from the negative or zero term premium in government debt markets, so credit risks have probably risen too." Turner does not mention households, but they too were allowed breathing room on funding their debts - as policy rates scaled back, cost of funding mortgages and other debts fell. But debt levels did not fall significantly enough, with exception of bankruptcies and foreclosures cases.

"Furthermore, the link between US yields and yields on EM bonds has increased substantially over the past decade, and EM bond issuance has risen."

In plain English: we are all (governments/taxpayers, corporates, households and even emerging markets) are sitting on a ticking time bomb: once rates start rising, we start feeling the pain of higher debt funding costs. What miracle of 'well-managed exit' strategy can deliver us from this predicament?

The latter is the rhetorical question. "The scale of market turbulence in global bond markets from May to September 2013 demonstrates the importance, in any correction, of the outstanding stocks of assets. Quantities matter. The vastly increased volume of bonds outstanding, some held in leveraged portfolios, means that volatility will rise much more when market sentiment changes than it did in the past when outstanding stocks of bonds were much lower." What's that I hear? More volatility than in previous crises? Surely this cannot be good.

"The turbulence also illustrates the dominance of US Treasuries. A substantial rise in US long-term rates took place without any change in the policy rate in the United States." In other words, the Fed did not pause priming the pump, but rates went up… oops… "Such a strong and global market reaction suggests some sudden unwinding of leveraged positions and powerful contagion across markets."

Bingo! In the markets bubbly high on cheap liquidity, there is no 'well-managed exit' feasible.

Turner is, of course, all BIS on this point. "It is difficult to know what lies ahead."

Except this: rates will go up. "Central banks in the advanced economies are not comfortable with the size and structure of their balance sheets. From September 2009, governors of the major central banks (including Messrs Bernanke and Trichet) expressed the hope that they would soon be able to begin their “exit” from unconventional policies. But such hopes were dashed by the deepening euro crisis from mid-2010. Not only have central bank balance sheets further expanded but – equally important – the maturity of their assets has become much longer."

And with this 'staying in QE', Central Banks are gaining a new risk / problem: "Since their liabilities have remained of very short maturity (typically bank reserves), central banks have a growing maturity mismatch. A sizable term spread gives the central bank a positive running yield: this has boosted its profits typically remitted to the Treasury, often creating a favourable impression with parliaments." (Do recall my recent article on Irish Central Bank annual report published in Sunday Times… Bingo!)

"But higher short-term rates could at some point lead to central bank losses. This has no fundamental significance because the central bank does not face the financing constraint in its own currency that a private agent faces: it can print money." Oops… not Irish Central Bank can't… and ECB does not like to…

"Likewise, the government can raise taxes." Oops again, Irish Government can barely run a deficit at less than double European SGP limits on already sky-high taxes. Raising taxes further would be committing political seppuku.

So the conclusion is that "There will be many years ahead when central banks will have government and other bonds on their balance sheets. The accumulation of such substantial holdings was warranted only by the crisis situation that confronted central banks. It is difficult to know at present what the new “normal” size of such holdings will be. How quickly central banks reduce their bond portfolio will depend on (unknown) macroeconomic or financial developments over the next several years."

That's it, folks, the drunk will have to be primed with whisky for years ahed, lest he wakes up with a horrific hangover. That's the 'solution' to the 'exit' dilemma.

And this might not even solve the problem either. Here is why. Per Turner: "Could central bank sales or purchases of government bonds become viewed as a second policy instrument once monetary policy begins be tightened? Policies of Quantitative Tightening could well moderate any increase in the policy rate." In other words, can Central Banks hold off sales of government paper to allow higher liquidity in the system to offset interest rates increases?

Not so fast: "…one practical difficulty is that it is impossible to quantify how bond markets would react to central bank sales. Using estimates based on past experience of the policies that change the volume and maturity of government debt to be sold (such as those mentioned above) fail to take account of signalling effects. News of central bank selling even on a modest scale could send markets a signal that is more powerful than the actual sales (“They are testing the water for further, larger sales”). …The hyper-sensitivity of markets to guesses about future central bank sales was very well illustrated over the summer of 2013. The mention by Chairman Bernanke of what should have been obvious – that at some point the Fed would reduce the pace of its purchases – wreaked havoc in global bond markets … even with the very clear commitment of the Fed to keep short-term rates close to zero for a considerable time. The size and spread of this market adjustment suggest that many investors had highly leveraged positions."

What about the option of just allowing bonds to mature, thus preventing the need for sales? As Turner points out, this still will not be a neutral policy choice. "It would mean central bank balance sheets remaining large beyond 2020. And it would also mean that the timing of shrinking – which would have effects on financial markets and the macroeconomy – would depend only on the pattern of past purchases and be quite independent of future economic conditions. It could even continue into the next recession." Ah, the dreaded bit no one mentions at all, but the BIS grim reaper… the next recession. You know, while all Governments and Central Banks keep droning on about the next expansion, one has to remember the simply fact of nature: there will be another recession. And given the duration of the current anaemic recovery, it might arrive well before the economies have fully recovered from the previous shock.


Where's me parachute?.. cause this saucer is increasing looking likely to crash.

20/3/2014: ECB Rates and Policy Expectations

My comment on ECB policy in Portugal's Expresso:

Click on image to enlarge

17/8/2013: Long-Term Great Unwinding for ECB?..

On foot of David Rosenberg's pressie on Long-Term Inflation strategy switch (link here), here's the ECB Monetary Policy dilemma illustrated.

First, the steep hill 'walking':

Per chart above, the wind-in-your-face breezing down the interest rates slopes for ECB is more severe than the Fed trip so far. And the duration of this episode is longer in the ECB-own historical context:

In fact, we are into 55th month now of staying away from the mean and that is for the euro era (already too-low by historical metrics) mean. Last two episodes of deviations lasted 30 and 33 months respectively. In severity terms: average overshooting post-revision in previous downward episode (June 2003 - June 2006) was -46 bps and in this period (since March 2009) it is currently running at -146 bps or 317% of the previous episode.

Good luck to anyone believing that ECB policy (repo) rate is not going to head for 3.75-4.0%...

16/8/2013: David Rosenberg Breaks Consensus on Long-Term Inflation

The most important note on the market written in the last 12 months, if not longer (and for those forward looking - the most important note written about the next 5 years plus):

http://www.gluskinsheff.com/Assets/Documents/Musings%20and%20Special%20Reports/Special%20Report%20-%20From%20Inflation%20to%20Deflation%20And%20Back%20-%20August%2014-2013.pdf

And 11 core snapshots from the ppt:

A must-read stuff!

2/8/2013: The Impossible Monetary Dilemma: July update

Two charts updating the Impossible Monetary Dilemma through July:

Good luck to all believing tapering will be enough to get monetary policy to mean-revert. Oh, and in case you wonder, mean reverting refers to historical mean - which is skewed downward by the period of historical lows of 2001-2005 and H2 2008- present. Even that historical mean is out of reach for any ordinary tightening.

2/5/2013: ECB's message: "don't let the bed bugs bite..."

In light of today's 'historic' decision by the ECB to lower its refinancing rate to 0.50% from 0.75%, let's just not get too excited, folks.

Consider the historical perspective:

1) ECB rates are low. By ECB-own standards. But they are not low by pretty much anyone else's standards, save for countries, like Canada and Australia, which didn't really have a Great Recession. At least not yet.

2) ECB rates are low today, but they will be higher one day:

And when they do get to those averages, oh… the bond markets valuations are going to fly out of the window (leaving big black holes in banks balance sheets and pension funds assets ledgers), while equities are going to also suffer risk-repricing away from current dizzying expectations. Meanwhile, mortgages and credit costs will rise and rise faster than the ECB rates for 2 reasons: (a) legacy margins rebuilding that is not even started yet, and (b) see 'black hole' on the bonds valuations side. So when we do start heading toward that green dashed line (and above, as ECB averages are above that green line), things are going to go South fast.

3) And the ramp up back to the mean will have to be sustained and drastic:

We are clearly in an unconventional period when it comes to mean reversion. In all previous episodes, mean reversion took at most 40 months of deviation from the mean to deliver on (red lines). This time around we are already into month 53 and counting. The longer the duration of deviation, the greater the imbalance built up as the blue line above clearly shows.

Based on average overshooting of the mean in each reversion episode, we are currently 1.79 percentage points away from the mean target and are likely to see additional 1.71 percentage points overshooting of the target on adjustment, which means that the direction we are heading toward, if previous history of ECB rates were to be our guide (very imperfect, I must add) is 0.5%+1.79%+1.71%=4.0%

Close your eyes and imagine your mortgage bill with:
1) ECB rate at 4.0% and
2) Bank margin on ECB rate of x2 at least of pre-crisis levels.

Now, good luck sleeping.

But, hey, for now, there's more room for ECB to 'ease'…

And yet… things are already bad enough… ECB is running policy at massively above the G3 average rates and there is no real relief to the euro area economy in sight.

So what is really going on? My quick comment for Express today:

"ECB's 25 bps cut in the refinancing rate is the central bank's de facto admission of the limitations to its ability to have a meaningful impact on the ground, in the real economy. Let's start from the diagnosis. With previous rate cuts failing to stimulate credit flows and private sector investment, it is now painfully obvious that the euro area economy is suffering from a structural crisis, not a cyclical or a liquidity crisis.  going into today's rates decision the ECB had really just three choices: 1) Do nothing and keep pressure on the Euro area governments to introduce and implement real structural reforms, 2) Do marginally little to sustain some outward expression of monetary activism, and 3) Do something big to attempt unfreezing both demand and supply of credit. The latter would have entailed a cut in the refinancing rate of 70 basis points and setting up an LTRO- like 3- to 5- years programme for lending against collaterilised business and household loans. It would have been risky, but it would have stood a chance of possibly shifting increasing significantly new credit creation. even more dramatic would have been a programme for indefinite financing of the weaker banks - a super-LTRO - set against explicit targets for their writing down of some SMEs and household loans.

That, in the end, ECB has opted for the second option of providing token expressions of accommodative monetary policy using largely weak tools, speaks volumes about the ECB's inherent legal dilemma. The ECB is facing the problem of a structural crisis in the economy, while being armed with a mandate that forces it to explicitly ignore the real economy. Thus, as the result of the crisis, the ECB has consistently traded-down the reputational curve by continuously deploying 'extraordinary' measures of ever-increasing complexity, which are having little real impact in the private economy. ECB's most-lauded OMT, for example, has had zero positive effect outside the Government bonds markets. In short, much of what ECB is doing is providing backstop insurance for the crisis amplification, but little actual means for dealing with the crisis itself.

As the result, ECB's monetary policy decisions of late can be best viewed in the prism of the EUR foreign exchange rates and European stockmarkets valuations. Liquidity supply into the financial channels that are trapped outside the real economy so far have meant firming up of the euro and increased speculative inflows into European equities that stand contrasted with both the fortunes of the euro area economies and the realities of the European companies earnings. Today's decision simply reinforces this trend. yet, as the recent years have shown, the divergence between financial markets valuations and the real economic activity is the sign of systemic malfunctioning in the monetary, fiscal and economic environments. This is exactly the road down which we are traveling, guided by the ECB Governing Council."

And my tongue-in-cheek top of the line conclusion? "ECB's Council throws a wet napkin at Euro area's economic Chernobyl and rests for lunch… breathless from exhaustion..."

So for all of us in the eurozone, tune in at 00:59:
http://www.anyclip.com/movies/despicable-me/beddie-bye/#!quotes/

29/05/11: Who's to be blamed?

Here's an interesting chart based on ECB data for lending rates charged on various types of loans:
What does this hart tell us? Several interesting things:

1. In so far as the euro area retail rates are linked to the ECB rates, it appears that the lenders were factoring in a positive risk premium on Irish companies for large loans and small loans alike 9as reflected by the positive premia on corporate lending of both types). throughout the 2003-2010 period, Irish companies borrowings were priced at a risk premium relative to the Euro area average.
   
2. This premium has declined (bizarrely) for larger loans (as the risk of borrowers rose during the crisis, the premium fell) and it rose for smaller loans (presumably the SME effect - with SMEs being more risky as borrowers in the crisis).
3. On the net, it is hard to make an iron-clad case that ECB was driving over-lending to Irish corporates, as these corporates did face a risk premium on their borrowings.
4. Where things really break down is in the housing mortgages lending. Here, there was and remains a deep discount on Euro area average when it comes to Irish lenders rates. Only during 2010 did this discount briefly turned to a premium. The trend is still on an increasing discount, which would be consistent with a lenders' perception that Irish house purchasers are lower risk than Euro area average. Which, of course , is a farce.
5. So the net result is that it is hard to make a real direct case that the ECB reckless interest rates policy was the sole or the main driver of Irish over-lending. Instead, the evidence suggests that it was our own lenders' (banks) enthusiasm for underpricing risk in housing finance that was at pay consistently before the crisis onset and since then.
   

Economics 25/7/10: What lending markets tell us about EU policies

So the markets are not that enthused about the stress tests. After the initial bounce on the back of 'pass' grades, there are rising concerns about some 19 banks, including AIB, which were given 'all clear' with some serious stretch of assumptions.

But to see what is really going on behind the scenes, look no further than the actual interbank lending rates. In fact, the interbank lending markets provide a good reflection on the combined euroz one policies enacted since the beginning of the Greek debt crisis. Both euribor (the rate for uncollateralized lending across euro zone's prime banks) and eurepo (lending rates for collateralized loans between euro zone's prime banks) are significantly elevated on twin concerns about:

1. The quality of the borrowing banks (recall - these are prime banks); and
2. The quality of the collateral (with sovereign bonds being top tier quality, deterioration in sovereign debt ratings is hitting interbank markets hard).

Here are the usual, updated charts:

Chart 1Long maturities have been signalling extremely adverse effect of the Euro rescue package since its inception.

Medium-term maturities show severe deterioration since the euro rescue package. Steepest, and uninterrupted rise in 3 months euribor signals that the rescue package is faltering in delivering anything more than a buy-time for the euro… In other words, we have an expensive (€750 billion-sized) buy-in of short time.

The ECB claw back on longer term lending window did not help this process either. But the stress tests are doing nothing to stop the negative sentiment dynamics.

Chart 2Per chart 2 above, short-term maturities are showing that despite supplying underwriting to about a half of the full year worth of euro area bonds refinancing, the rescue package has achieved no moderation in the short-term risk perceptions of the market. In fact, the rise in euribor is more pronounced in the short term than in longer maturities, suggesting that short term risks of sovereign default remain unaddressed by the rescue package and are exerting a continuous pressure on interbank lending.

Introduction of the stress tests also did nothing to reduce overall cost of borrowing amongst the prime banks which were fully expected to pass the test even before the EU got on with setting test parameters.

In turn, all of this spells much higher costs of funding for the banks which have shorter term financing needs, such as the Irish banks. The implicit cost of taxpayers’ guarantee for Irish banks debt is therefore rising.

And panicked markets are not about to surrender their fears to the EU PR machine. With all the increases in the euribor, the volatility of the interbank lending rates also increased, across all maturities, as shown in charts 3 and 4 below.

Chart 3Chart 4As evident, in particular, from chart 4, in the longer term, credit markets are absolutely not buying the combination of the EU rescue package, ECB liquidity measures and the stress tests. Euribor trajectory for maturities of 6 months and higher firmly re-established and vastly exceeded volatility that preceded the pre-rescue panic. We are now worse off in terms of the cost of banks financing than we were before the Greek crisis blew up.


To remind you - eurepo is the rate at which one prime bank lends funds in euro to another prime bank if in exchange the former receives from the latter the best collateral in terms of rating and liquidity within the Eurepo basket. Eurepo rates have posted dramatic increases since mid-June 2010. The original effect of the June 2010 closure of the longer maturity (12 months) ECB discount lending was a temporary reduction in the rates, followed by a stratospheric rise two week later that has been sustained through the end of this week. This is especially true for shorter term maturities, suggesting that part of the adverse effect was due to the heightened uncertainty around the EU stress tests. Chart 5 below illustrates.

Chart 5Chart 6The u-shaped response in the interbank lending rates to ECB lending changes and to stress tests is even better reflected in the longer maturity eurepo rates, as highlighted in chart 6 above.

3-months and 12-months eurepo rates are now at the levels consistent with the height of the sovereign default crisis. There are significant differences in the rates by maturity group and vis-à-vis euribor due to the fact that the quality of collateral offered in the markets is now itself uncertain as sovereign credit quality continues to deteriorate both in terms of increasing probabilities of default and thus associated risk premia, but also due to the regulatory treatment of collateral that is being signalled by the stress tests.

As with euribor, eurepo rates are showing remarkable increases in volatility, for both shorter and longer term maturities.


Let us finally put the two rates side by side to compare evolution of euribor against eurepo, setting index for all at 100=January 4, 2010

Chart 7Chart 8
Some pretty dramatic stuff. To round off, recall that since the beginning of April 2010, the eurozone has undertaken the following measures to shore up its financial markets:

1. Set up a sovereign rescue fund worth more than €750 billion to underpin roughly 50% of the total borrowing requirement in the euro zone (which could have been expected to yeild an improvement in banks collateral and thus a reduction in overall systemic risks in the interbank markets as well);
2. Reduce maturity profile of ECB lending window (which was from the get-go equivalent to dumping more petrol on the forest fire);
3. Deploy aggressive quantitative easing by the ECB (again, this should have reduced uncertainty in the interbank markets as in theory improved pricing for sovereign bonds should have increased the quality of interbank collateral and improve banks own books);
4. Conduct an absolutely discredited stress test of the banks (designed to provide positive newsflow for the banks, especially for prime banks which should have seen their risk profiles reduced by a mere setting up of the test).

In short, none of the measures seem to be working, folks... May be, just may be, the real problem with EU banks is their unwillingness to come clean on loans losses and start honestly repairing their balancesheets?