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Japanese investors are not buying foreign bonds, they’re selling

Posted on 23 May 2013 by Mike Riddell

One of the stories that has driven global financial markets higher for the past few months has been about how Japanese investors are piling, or will pile, into foreign assets. Surely a rational Japanese investor would dump Japanese assets in an attempt to escape the exploding yen and the ravages of domestic inflation, or at the very least seek out a bigger yield than the puny returns available on the artificially suppressed domestic government bonds?

Well, they haven’t been buying foreign bonds; actually they’ve done the opposite. There were lots of headlines earlier this month after Japanese investors were (just about) net purchasers of foreign bonds in the three weeks to May 10th. But data out overnight showed that there were ¥804.4bn worth of net sales of foreign bonds in the week to May 17th, which more than reversed the previous three weeks’ purchases.

The chart below shows the weekly net purchases of foreign bonds, where the data is based on reports from designated major investors including banks, insurance companies, asset management companies etc. The blue line in the chart below is the 3 month moving average, and it shows that Japanese redemptions of foreign bonds are running at close to the highest rate since data began in 2001.

It’s difficult to deduce too much from all the data, but it appears likely that the rally in the Nikkei, the drop in the yen and the rally in semi-core Eurozone government bonds has been down to foreign investors front running something that so far has not actually happened. Japanese investors may still flee their domestic market, but it will require (mostly foreign) investors’ already high inflation expectations to be realised (the bond market is pricing in Japanese inflation averaging +1.8%pa for the next 5 years, despite there being little evidence that QE in Japan or other countries has succeeded in either generating inflation or in weakening currencies). It probably also requires changes to the higher capital charges that major Japanese investors face when investing in overseas assets, although even with this, funding costs and hedging requirements will ensure that home bias continues.

The King speech

Posted on 15 May 2013 by Richard Woolnough

Today is the last inflation report for Mervyn King, Governor of the Bank of England. He has served the bank for many years and has been the key figure at the bank for the past eight years.

King’s abdication (retirement) is a time to reflect on his achievements at the top. A keen football fan who happily uses soccer analogies, King would probably recognise his time as Governor has been a game of two halves.

The first half was great, with no apparent need to interfere with a perfectly balanced, strong growth, low inflation economy. The second half involved a great deal of stress and the need for intervention as the economy was weak, the inflation target was constantly missed, and he faced the financial equivalent of Chernobyl, as the banking sector began to meltdown.

King is not only a football fan but is also a regular sight at Wimbledon. Rudyard Kipling’s poem ‘If’ is the guide to how players should play on its perfect English grass courts. It is fair to say that King has appropriately treated success and failure in the same way. I would argue that his failures were in the first half of his term and his strength and ability shone through in the second half of his term. Although his critics may say that the seeds of the financial crisis were sown under his watch.

I think the seeds of the UK financial crisis were as follows:

Inappropriately low interest rates in the USA following the tragic events of September the 11th.

The removal of bank supervision from the Bank of England by Gordon Brown.

The need to hit a rigid inflation target when the world was enjoying low inflation because of world trade and productivity growth meant the use of over stimulative policy, causing a boom to keep inflation on target.

The euro creation resulted in an unstable financial system in Europe.

The first three of these have been resolved with the passage of time, a change in UK banking regulation back to the old ways, and a move around the world to more flexible inflation targeting. The last – the issue of banking in the eurozone – remains unresolved, but there are strong signs that potentially successful attempts are underway to solve the dichotomy of banking support from sovereign states within the eurozone.

We are avid watches of the inflation reports, and will be watching it today. The journalists get to ask questions. If I was there these are the three I would like to ask:

1. What do you think of the euro as an economic concept?

2. How close were we to financial Armageddon?

3. How does QE work?!

Sadly I think Mervyn will be as discreet as always in the press conference. Let’s hope that when he is allowed to speak freely, we get to see a little less candour and more transparency and insight into what has been an exciting time to be at the bank.

I think history will show that Mervyn King did a good job in handling the crisis. After all, that’s what central banks were created to do as lenders of last resort. From an economist’s point of view, what does his leadership prove? Well, Goodhart’s law was again proving itself to be correct. You aim to be a boring central banker and look what happens!

A look at housing affordability in the US and UK

Posted on 10 May 2013 by Guest contributor - Mark Wheatley-Smith, M&G Investments Graduate

In recent months we have blogged about the recovery in the US housing market that is currently underway. This is in contrast to the UK experience, where the housing market appears to be stuck in the mud. We thought a quick look under the bonnet could reveal the dynamics at play in both countries.

In order to do this, we have constructed a housing affordability index that captures the three main barometers of the health of the housing market; wages, house prices and mortgage rates. By combining average house prices and mortgage rates, we can estimate the typical payments facing a mortgage holder in either country. We have then divided the average wage in both countries by this number. We think that this enables us to get a pretty good read on how affordable housing is in the respective countries.

As the chart shows, owning a house has become considerably more affordable in the US relative to the UK since 2007. There are a number of reasons why this has occurred.

Firstly, US house buyers are feeling rate cuts to a greater extent than their UK counterparts. For example, at the end of 2012 30-year US fixed rate mortgages were 3.35% compared to an average UK fixed rate mortgage of 4.10%. As outlined earlier this month, UK building societies are finding it difficult to pass on any rate cuts because of the impact that such a move would have on their profits. Secondly, wage increases have also favoured potential American homeowners. In the US, wages have risen by nearly 16% compared to an increase of 12% in the UK.

The US has improved on two metrics relative to the UK, but the difference isn’t enough to explain the divergence in affordability between the two markets. The dominant affordability factor has been house prices.

US house prices saw a greater correction, falling by 30% from the peak to trough, while UK prices only fell by 18%. We have now seen US house prices generate solid returns for buyers, with prices now growing at over 10% year-on-year. This is likely to have a significant impact through the multiplier effect on consumption and GDP growth. In contrast, the UK housing market recovered relatively quickly, but since late 2010 house prices have been anaemic.

With the standard variable mortgage rate rising over the last 11 months, limited upward pressure on wages, and stable house prices it appears unlikely that the UK housing market is going to become more affordable for home buyers anytime soon. It is thus understandable that in order to assist potential homeowners, the government has launched its “Help-to-Buy” scheme (following the muted impact of its Funding for Lending scheme) which will come into effect in January next year.

Whether the scheme will work or not will continue to be debated amongst economists. The Help-to-Buy scheme should theoretically impact house prices in a positive way. But this could actually have a negative impact on those looking to buy and potential homeowners may end up borrowing more to purchase a house than they would if the scheme didn’t exist at all.

Five reasons why Mark Carney might be short of options when he becomes BoE Governor in July

Posted on 2 May 2013 by Jim Leaviss

Mark Carney, currently Canadian central bank governor, will become the Governor of the Bank of England at the start of July. Handpicked from outside of the official application process by Chancellor George Osborne, he comes with high expectations about what he can do to get the UK economy out of a downturn arguably more severe in GDP terms than was seen during the Great Depression (or The Slump as it was known here). This now famous chart from the NIESR shows the extent of the underperformance of the economy relative to past recessions.

Carney’s stock is high – whilst the UK and the Eurozone remain in, or around, recessions, Canadian GDP is growing at 1.7% year on year, and its growth has outperformed the US economy both during and post the financial crisis. Inflation in Canada has averaged 1.8% over the past 6 years, compared with 3.1% CPI in the UK – perhaps the real blemish on inflation puritan Mervyn King’s legacy.

With Osborne having ruled out fiscal policy as a tool to get the UK out of its current Slump, our hopes now rest on either a significant and speedy recovery of our biggest trading partner, the Eurozone economy (and that looks to be going in the wrong direction), or monetary policy. In other words do the government’s hopes all rest on Carney doing something new and different, or massively increasing the scale of what the Bank of England has done before? If so we might all be disappointed. Here are five reasons why Mark Carney’s degrees of freedom might be fewer than he, and we, had hoped…

1 You can’t cut bank rate in the UK because you hit the building societies.
Easy right, you fly over, cut rates and give a small but welcome boost to the economy. But bank rate has been stuck at 0.5% since early 2009, through double dip recessions and increases in Quantitative Easing. There is clearly scope to cut towards zero (like the Fed) and this would clearly have some benefit to consumers and companies who have mortgages and loans linked to base rate, or Libor. But the Bank has repeatedly rejected calls to cut from here – not because those benefits might be modest (although that was a line at one point) but because the building societies might well become loss making if further cuts were made. And we need our building societies – as banks’ appetite to lend has fallen, the societies now provide 22% of gross mortgage lending compared with 13% in 2009. Why do the societies get hit disproportionately by lower bank rate? The first problem is the amount of tracker mortgages that they sold historically, where homeowners pay interest explicitly based on a bank rate plus (and in some cases MINUS) basis, so revenues fall as rates fall. And at the same time the societies have very little share of the current account market, so to fund mortgage lending they rely on having market leading savings rates to raise deposits. In recent years much of this has been done on a fixed rate basis. The chart below shows that net interest income as a percentage of assets has been falling steadily as bank rate fell from 5.5% to 0.5% over that period. Once costs are taken out (the “net of costs” margin is shown in blue) there is little room for revenues to fall before the sector becomes loss making. As for negative bank rate (mentioned by Paul Tucker as being “unlikely…but we should think about all sorts of things”), that would be even more harmful.

2 You can’t target a weaker £ because the impact on consumption is higher than the boost to manufacturing.
A competitive devaluation of the pound would lead to a windfall for our manufacturing economy as exports become cheaper. Contrary to urban myth and legend, we do make stuff (manufacturing is 12% of the economy and the UK is good at making cars, jet engines, chemicals and military hardware). Carney could use Open Mouth Policy to talk down our Winston Churchill branded currency (slogan “I have nothing to offer but blood, toil, tears and sweat”), or failing that intervene by printing pounds and selling them to buy foreign currencies. We could even end up with our own Sovereign Wealth Fund! Again there is a “but”. It feels like the Bank of England already tried this, and realised that it wasn’t going to work – trade weighted Sterling fell by 7% in January and February this year before Mervyn King stated that “we’re certainly not looking to push sterling down…we’re moving to a properly valued exchange rate. I think we’re probably there”. The problem is that whilst manufacturing is important, consumption is much more so. Morgan Stanley research shows that contrary to popular opinion, UK manufacturing barely benefits from declines in the pound. And rising import prices as a result of a weaker pound mean that inflation rises, which means that real incomes fall, which means that consumption falls. And as the consumption impact is greater than the manufacturing boost impact (negligible), the impact of a weaker pound on the UK economy is negative.

3 You may be the boss, but the only power is in voting last and thus having a deciding vote.
And right now 6 out of the 9 MPC members don’t want to do more monetary stimulus. You could be in the minority forever, although a prudent Governor probably realises that this kind of split might be damaging for perceptions of stability – not what you want when foreigners are net buyers of on average £6 billion gilts every month. The Canadian monetary policy framework is based on “consensus” rather than voting – my gut feel is that this delivers more power to senior Council members in comparison to a straight vote.

4 If there was a chance to review the Bank of England’s remit from the government to make it significantly more pro-growth, it may have gone.
In the March Budget, George Osborne set out a new remit: “the new remit explicitly tasks the MPC with setting out clearly the trade-offs it has made in deciding how long it will be before inflation returns to target”. He is also changing the timing of the exchange of letters between Chancellor and Governor when the inflation target is breached. And he asked the Bank to review its communications policy (it “may wish” to provide forward guidance). But Osborne didn’t wait for Carney to arrive before changing the remit and given the market’s expectations of a much more pro-growth Governor arriving (helped by Carney’s Nominal GDP speech to the CFA Society of Canada in December), these remit changes feel modest. Perhaps the only hope for a more radical Bank comes with that potential change in communications strategy – does that open the way for statements linking future rate hikes to sustained GDP growth rather than just inflation changes?

5 And finally, the UK is not Canada.
Our banks are broken (Canada didn’t even have an official bailout during the credit crisis, although some speculate there was significant support through the state mortgage agency the CMHA). Our biggest trading partner is broken (Canada’s biggest export market is the US, which is far stronger than the Eurozone). Our natural resources are in decline (North Sea oil is producing 1.5 million barrels per day compared with 4.5 million in 1999; Canada is the world’s largest uranium and hydro-electricity producer, and the world’s fifth largest energy producer in total). And most importantly Canada had its fiscal crisis in the 1990s. S&P cut it from AAA to AA+ in 1992 triggering a consensus amongst politicians to reduce the national debt burden. Debt/GDP peaked in 1996 at around 70%, and by 2002 Canada was AAA/Aaa again. The UK is in a very different economic position, and one with substantially greater fiscal headwinds than those experienced by Mark Carney during his time in charge of Canada’s central bank.

But it’s not all bad news. Although there are clear limits to what Mark Carney will be able to do, he might have luck on his side when it comes to timing. To quote Deputy Governor Paul Tucker, who spoke last night, “looking over the past year (the UK economy is) perhaps not as bad as the headline figures suggest…I think there’s a long way to go but there’s certainly reason for hope”.

Panoramic: The effect of globalisation on corporate bond valuations

Posted on 16 April 2013 by Gordon Harding

Corporate bonds have had an incredible run over the past few years. A combination of sub-par growth, the sovereign crisis in Europe and massive amounts of QE on a global scale has driven government bond yields down to historically low levels. At the same time, corporate bond spreads have tightened significantly from the crazy levels we saw in 2009. This has meant double-digit annualised returns from parts of the investment grade market (as you can see from the chart Richard posted yesterday), albeit with some spread volatility in ‘risk-off’ periods.

How do corporate bonds generate similar returns from here? Well, there’s no doubt it’s going to be difficult. Given the duration of the iBoxx £ Corporate index of just under 8 years, we’d need to see yields fall roughly 1% further. So, either 10 year gilt yields would have to rally to less than 1% (from today’s 1.7% level) with spreads staying broadly flat, or spreads would need to tighten significantly with gilt yields stable (or of course any other combination of gilt yield/credit spread moves equivalent to about a 1% fall in overall yield).

Focussing purely on the credit spread and using history as a guide, there certainly is room for further tightening – for example, the spread of the BofA Merrill Lynch BBB Sterling Corporate & Collateralised index was 292bps at the end of March, 191bps wider than the pre-crisis tight of 101bps at the end of May 2007. But what could be the catalyst for such a tightening of spreads?

In the latest version of our Panoramic series we look at what drives the relationship between corporate and government bond pricing, how this has been changing over time and what might ultimately lead to corporates trading at even tighter levels than before the financial crisis.

Beware the demise of the Hungarian forint

Posted on 27 March 2013 by Tolani Benson

Guest contributor – Tolani Benson (Financials/Sovereign analyst, M&G Credit Analysis team)

Hungary has a substantial amount of debt outstanding – the IMF estimates levels were around €75bn at the end of last year, corresponding to 74% of GDP. Its local currency debt makes up a decent proportion of emerging market indices, constituting a not insignificant 4.6% of the widely used JPMorgan GBI-EM Global Diversified Index. A drop in Hungarian government bond values and/or the Hungarian forint means a drop in the index.

Not an EM investor? A substantial proportion of Hungarian sovereign debt is also owned by its banks, which are themselves owned by the Western European banks you may be more familiar with. Hungarian government bond holdings at three of Hungary’s biggest foreign owned banks were equal to between 10% and 25% of their parent banks’ tangible common equity at YE 2011 (2012 data isn’t out yet for the Hungarian banks). These three large parent banks have all had to receive bail-out capital from their respective governments since 2008 – a writedown of their Hungarian government bonds would not be a minor event for any of them. Appetite for recapitalising banks in the Eurozone is moving increasingly away from government capital injections towards bailing in unsecured senior and subordinated creditors and uninsured depositors, as we have seen with this week’s debacle in Cyprus.

So what is going on in Hungary? Hungary’s currency, the forint, has always been a high beta version of the euro (see chart), but it has significantly underperformed since mid-October, plummeting 10% against the euro. And on Friday we saw the forint reaching a 52-week low after S&P changed their outlook on Hungary to negative (currently rated BB by the agency).

Some may argue that for a highly indebted nation suffering from a stagnant economy, a devaluing currency should be a good thing – Hungary becomes more competitive, economic activity picks up, government revenues increase, the deficit decreases, and government debt levels fall – great.

If only things were that simple. Forint weakness is a serious problem for Hungary. It has huge amounts of foreign currency debt across the whole economy; the government, its citizens, and corporations. The weaker the forint becomes the more expensive it is for both the public and private sectors to service their debts. Plus, almost half of the government’s local currency debt is held externally (see chart), making it extremely vulnerable to sell-offs in the forint. If foreign investors pull out, Hungary’s funding costs will soar and the country will struggle to refinance. The ECB puts the Hungarian economy’s gross external debt (i.e. any liabilities held by foreign creditors, including foreign owned domestic debt) at almost 130% GDP. Economists Reinhart and Rogoff in their paper ‘Growth in a time of debt’ have estimated that growth is significantly impaired when external debt is beyond 60% of GDP, and growth rates are halved above 90% of GDP. In their 2003 study with Miguel Stevanso, ‘Debt intolerance’, they also found that when external debt to GNP ratios are above 30-35% in emerging market economies, there is a substantial increase in the likelihood of a credit event. Hungary is well beyond these threshold levels, which should set alarm bells ringing.

Though the weak forint has helped Hungary’s trade balance, it is not enough. Despite posting a trade surplus of €6.8bn in 2012, GDP contracted by 1.5%. Unemployment is high and rising, reaching 11.2% in January this year. Hungarian businesses have been stifled by the credit crunch that has come about as a result of the government’s measures to reduce its citizens’ foreign currency debt burdens by writing off huge amounts of individuals’ debts, forcing losses onto the banks and restricting their ability to lend. And herein lies the root of most of Hungary’s problems; government policy.

Since taking power in 2010, the current government has been chugging out reams of controversial and counter-productive policies whilst making countless changes to the constitution. Such behaviour has been making investors uncomfortable, causing the forint to devalue. The business environment in Hungary is far too volatile to attract external investment – the key to growth – due to constantly changing regulation, heavy industry levies, and the possibility that the government may nationalise private corporations. Economic policy has been questionable, relying more upon one-offs such as the highly contentious appropriation of citizens’ private pension fund assets onto the government balance sheet, and much less upon vital structural change. Attitude towards the IMF since requesting a bailout loan in 2011 has been confrontational, with various government departments dismissing any need for assistance. The government started publishing anti-IMF propaganda in local media portraying the IMF as a threat to the country’s sovereignty. Unsurprisingly, any IMF deal now seems to be off the table.

Even more troubling than the government’s handling of the economy are the changes it has implemented at key institutions. It has thrown out the independence of the central bank by taking control of appointments, dismissing independent members, and placing the government’s former Economy Minister in the top seat as Governor, and in the process replacing the hawkish former governor, András Simor, who consistently resisted government attempts to influence monetary policy. The most concerning change is doing away with the Constitutional Court’s ability to perform its intrinsic function. Its power to overrule legislation that is deemed unconstitutional has been removed, so that it may only object on procedural grounds. This also allows any previous rulings by the Constitutional Court to be thrown out, effectively allowing the government to undo work done by the court to protect Hungary’s citizens in the past.

Being a member of the EU, Hungary’s actions have not gone unnoticed, but as yet appear to be unpunished. Hungary is like the naughty student that gets called up to the headmaster’s office every day – only the headmaster is the EC, and rather than silly classroom pranks, this bad behaviour is much more concerning. Should the forint continue its gradual demise it is the Hungarian citizens that suffer with a stagnating economy, a credit crunch, and the gradual withdrawal of their human rights. They will also have to deal with the long period of painful austerity that is inevitable when the IMF eventually has to pick up the pieces after years of terrible policy decisions have run the country into the ground. If that IMF assistance involves restructuring of sovereign debt, it is also the holders of EM debt and creditors of some large Western European banks that may be feeling the pain.

Germany doesn’t like its own fiscal union, so why would it ever agree upon a European one?

Posted on 26 March 2013 by Markus Peters

If I asked you how the structural problems of the Eurozone may be resolved, I am sure that the suggestion of a fiscal union in which transfer payments will be made by the “rich” Northern member states to the “poor” ones in the South of Europe would rank amongst the top answers. I’ve been wondering for a while if the member states could ever agree upon major fiscal transfer payments and if it would indeed lead to greater degree of convergence within the Eurozone. I feel that we have come closer to an answer to my questions this week. And I am not referring to the issues around Cyprus.

Yesterday the German federal states Hesse and Bavaria filed a lawsuit against the existing mechanism of fiscal transfer between the federal states of Germany, the so-called “Länderfinanzausgleich”. The German constitution states that the objective of this fiscal transfer mechanism is the convergence of the financial power across its federal states. The current system consists of vertical payments between the German state (“Bund”) and the federal states (“Länder”) as well as horizontal payments from federal state to federal state. The eligibility for transfer payment receipts is determined by an index (“Finanzkraftmesszahl”) which indicates the relative financial power of the federal states. Bavaria, Baden-Württemberg and Hesse are currently the only net contributors, while Berlin is the biggest net recipient of these fiscal transfers.

Bavaria and Hesse argue that the current mechanism does not create any incentives for the net recipients to improve their financial position. It is said that sanctions for fiscal mismanagement are missing, while the net contributors are discouraged to consolidate their finances further as long as they have to redistribute their wealth. Basically, one rich German state is arguing why it should transfer its fiscal revenues to a poor (and arguably irresponsible) German federal state. If you already see significant opposition against a redistribution mechanism of wealth within a country, how is it possible to picture Germany, the Netherlands or Finland agreeing on major fiscal transfer payments to Southern Europe? Furthermore, the implication here is that the German Constitutional Court will have to decide if a stricter central enforcement of fiscal discipline has to be institutionalised and which set of sanctions can possibly be introduced to do so. Could you see anything like this to be enacted in the Eurozone in the near future, including lawsuit files from Germany, the Netherlands and Finland in response to any agreement as well as the subsequent court rulings on national and European level? In this context, it might be worth noting that the German Constitutional Court indicated last year that any further European integration, e.g. fiscal union, would require a referendum. Ultimately, German taxpayers might get to decide whether they want their tax payments to be transferred to other parts of Europe.

There remains the question about the potential long-term effect of a fiscal union. Would fiscal transfer payments from the North to the South lead to economic and social convergence in Europe? In Germany, fiscal transfers from the South to the North-East have certainly helped these federal states to converge in terms of their financial power and standard of living since the German unification in 1990. Nevertheless, after 23 years of fiscal transfer payments, the economic situation in these states remains highly unequal. For instance, the German unemployment rate varies significantly across federal states. While the unemployment rate in Mecklenburg-West Pomerania stands at around 14%, it is nearly as low as 4% in Bavaria and Baden-Württemberg. And the historic ties of companies, the geographical location and different geostructural fundamentals, infrastructure disparities, qualitative differences between educational and research institutions and many other factors might prevent them to ever fully converge.

This is the crux of the Eurozone matter for me. Only if we accept the fact that full convergence and homogeneity in Europe will not be achievable – even within a fiscal union – we may become sufficiently pragmatic to deal with the Eurozone issues. We might finally arrive at the conclusion that we could be able to improve the economic prosperity and dismantle some social stress in the periphery, but that we will not make these economies as competitive and prosperous as Northern Europe as a whole. Take the US as an example. No one expects the standard of living, the average income level and economic competitiveness to be anyhow equal or homogenous across the country. Despite a long established currency and fiscal union, the economic situation and opportunity set still varies enormously depending on whether you live in New York, Detroit, Kentucky or Las Vegas. But you can reasonably move from Detroit to Kentucky if you want or have to because the same language is spoken and partly similar traditions are followed. You certainly won’t be able to say that about your move from Athens to Munich. It has been taken as a given in the US that some degree of inequality and heterogeneity is the function of a free market economy (the rest is a function of bad policy-making), and that might be one of the reasons why the US model, including monetary and fiscal union, has managed to succeed.

This would be an inconvenient and unpopular insight in Europe which would fundamentally question the current ambitions of the European convergence project. If you discount the possible long-term return of the Eurozone to its member states because of a lack of German support for a fiscal union, you might want to ask where the Euro project is heading.

I predict a CypRIOT: Three major implications for the European and UK banking systems

Posted on 20 March 2013 by Ben Lord

Stefan blogged earlier this week about the landmark sovereign bailout occurring in Cyprus, and about some of the interesting issues this raises. Sure enough, the parliament did not approve the package in the form talked about at the weekend. The reason? The taxes were felt too painful for the poor and too lenient for the more wealthy. This harks back to a blog I wrote about a couple of years ago, and goes to reiterate the issues we discussed then. However, for now I wanted to highlight some of the issues that this raises more specifically for the European banking system at large.

Firstly, depositors were presumed to be guaranteed by governments up to at least €100,000 in Europe. Last weekend, that notion was dealt a brutal blow by the Cypriot situation. However, it feels to us as though the main reason for the parliamentary delays is that deposit guarantees could and should remain in place – or at least to a greater extent than was implied in the original bailout package. This package stated that those people with deposits of less than €100,000 would pay a 6.75% tax, whilst those with more than this amount would be taxed 9.9%. The politicians that have delayed the approval of the rescue package want to see greater amounts of the burden borne by the wealthier (those with more than €100,000, and perhaps an even higher rate borne by those with greater amounts than, say, €500,000 in deposits), and so lesser amounts of the burden borne by those with small amounts of deposits.

My guess is that this is the key issue here. If the tax rates are not changed, then I would expect to see some significant moves in Spanish, Italian and other peripheral deposit flows and movements. As a risk, this must not be underestimated by the Troika. Why not maintain the deposit guarantee and generate the amount raised by the taxes, through taxing more on those with more than €100,000, more still on those with more than €250,000, and more still on those with more than €500,000?

Secondly, subordinated debt bail-in is a key part of the package, and without it one senses the Troika will not part with the bailout funds needed. We have expected weaker banks in weaker regions to have to use this as a necessary tool to break the sovereign-bank link for some time now. It is now official, and being used. I would expect more of these to come.

Thirdly and finally, sovereign bailouts of banking systems where the sovereign is already in an over-levered position will no longer be tolerated. It is time to break the sovereign-bank feedback loop (as we previously wrote about here). This has to be through bail-in and burden-sharing. However, the most unpalatable part of the proposed package to us (and I guess to many riotous Cypriots) is this: up until 2007 it was believed that senior bank bondholders ranked pari passu with depositors in the event of a bank failure. And now in 2013 we learn quite vividly that in actual fact in Cyprus depositors are likely to be subordinated to a bunch of wholesale and institutional (ie banks and insurance companies) investors?

The capital stack has been turned on its head in this regard. No one used to buy senior unsecured bank debt because they thought that depositors would take losses before them. Rather, it was because the markets believed 100% in the government guarantee of depositors. The pari passu relationship of depositors and bondholders supported high valuations on senior bank bonds. Thus to be pari passu with depositors, senior bank bonds need to take the same losses as depositors are. In my opinion, this part of the proposed deal is the most disgraceful.

So, I find myself wondering how on earth a deposit tax found its way into the package. The answer to me seems to be quite simple: contagion, or the avoidance thereof. We all know that in Europe and the UK in the future (as in the US already), senior bank bonds will be bail-in-able or writedownable if a bank fails or gets into difficulty. We were originally told that the date for senior bank bond bail-in in Europe would be 2018, although there has recently been much talk about bringing this forward to the beginning of 2015. It has long struck me that this should be the favoured route out of the bank-sovereign interconnectedness problem in Europe: continue to promote and enable senior issuance in Europe by banks, and then implement a higher level piece of legislation that at some date in the future makes all debt in the Eurozone and UK writedownable.

No matter how small Cyprus is relative to the rest of the Eurozone, if the Troika had forced senior bank bondholders to accept losses before 2018 – or is it 2015? – senior bank debt spreads would have suffered significantly across Europe. Given that this is the most attractive funding market for banks at the moment, as it is still cheap to issue from a bank’s perspective, and as sovereigns do not want to have to (or cannot, in the Cyprus case) step in to take on more liabilities on behalf of their banks, the Troika has ripped up the rule book and done the insane.

I think parliamentarians in Cyprus should force a rethink on the sovereign-bank feedback loop, as well as forcing a more palatable (ie Robin Hood) sharing of the burden between smaller and larger depositors. After all, can anyone truly imagine the French, German or any core European government accepting losses for their depositors whilst a bunch of international senior bank bondholders get made whole? Our view is that depositors should be protected (at least to the guaranteed amount) over and above all wholesale creditors, whether senior or subordinated. This is the first step to break the sovereign-bank loop. The second step, only to be used in cases where there is not enough senior and subordinated debt to prevent the sovereign, and so tax-payers, from having to bail out the failed institutions, is to look at forcing losses on depositors, but with preserving the preceding guaranteed amounts of deposits. The final, most radical, and rarest, step is to have to renege on that deposit guarantee amount, so as to avoid tax-payer bailouts and increased probability of sovereign default.

Depositors across Europe are already watching Cyprus carefully. My guess is that many are starting to check the amounts they keep with any one institution or in any region. Subordinated bondholders are already aware of the risks if those banks get into difficulty, but senior bondholders in my opinion are not. These investors must ask whether the Cyprus package is likely to be copied in future cases. And they must also start to wonder if they still have until 2018 before senior bonds can be bailed in, or if it is significantly sooner.

Insane in the brain. Dangerous precedents being set in Cyprus

Posted on 18 March 2013 by Stefan Isaacs

Depositors in Cypriot banks awoke on Saturday morning to learn a harsh lesson. A guarantee is only as strong as your counterparty. With the Cypriot banking system requiring €10-12 billion of bailout funds – some 60% of GDP – the government has been forced to accept burden sharing with depositors. Depositors who went to bed Friday night believing their savings were safe awoke Saturday to find that it has been proposed that those with deposits below €100k in the bank will be “taxed” at 6.75%; those with deposits above €100k will be “taxed” at 9.9%, contributing approximately €6bn to the bank bailout in total. This is regardless of supposed depositor insurance schemes. Depositors will receive equity in their respective banks by way of compensation and potentially bonds entitling those who leave their money in the banks for 2 years to a share of Cyprus’ future gas revenues. The remaining €4-6 billion will likely come from the Troika.

If press reports are to be believed this was a ‘take it or leave it offer’ from the Troika with German and Finnish finance ministers unwilling to go to their respective parliaments without depositor burden sharing. This highlights the very real current challenges of domestic politics within the European Economic and Monetary Union and raises further issues.

Firstly, there are significant political challenges to be faced. Domestic opposition to this deal is likely to be significant, not least as it will be seen to be disproportionately harsh on domestic savers – who had believed their deposits were protected up to €100k, and favourable to wealthy non-Cypriot depositors who reportedly hold huge sums offshore in the banks. It can be argued that those with over €100k in deposits with the banks should bear the brunt of any proposed bail-in. With a small parliamentary majority, the Cypriot government may struggle to pass the necessary legislation. Approval will also need to be sought from Eurozone member states.

Secondly, alongside the recent expropriation of junior bond holders at SNS Reaal the attitude towards tax funded bailouts appears to be hardening. Whilst this crisis has already witnessed both equity and debt written down, the rubicon of depositor burden sharing has now been crossed. Precedent now exists for this approach over the socialisation of losses across the Eurozone as a whole. Whilst the Troika will endeavour to play its significance down, unintended consequences may still materialise.

Thirdly, the Cypriot situation serves as a reminder of the current fragmented approach of depositor guarantee schemes across Europe. Depositor guarantees are only as strong as the sovereigns providing them. In the case of Cyprus with a banking system seven times the size of its economy, clearly those guarantees were worth very little. With depositor rates currently paying very little across Europe it is unlikely to take much to prompt a change in investor behaviour.

Fourthly, it raises real questions about depositor preference. With only circa €2bn of Cypriot bank debt outstanding, policymakers have judged this too small in and of itself to recapitalise the banking system. That may be true. However by favouring senior debt over depositors it does beg the question whether the individual on the street is in theory better off owning higher yielding bank debt than depositing cash.

Fifthly, the ECB has apparently threatened that if the measures are not agreed, then it would withdraw European Liquidity Assistance (ELA) funding for Laiki Bank, Cyprus’ second largest bank, leaving the Cypriot sovereign with the bill for the entire banking sector and having to pay out on deposit insurance in full. This highlights the extent to which a number of banks in Europe remain reliant on ECB funding, and that if that funding is withdrawn then their collapse is inevitable.

Finally, we have yet another example of a country being forced to face a stark choice between ceding sovereignty to Brussels or facing financial ruin. The Eurozone project continues to ask a great deal of its citizens. Bailouts don’t – and won’t – come cheap.

The Cyprus deal will be in the headlines for the next few days. We can’t help but think that the markets will be listening to Cypress Hill – Insane In The Brain for the next week or so. Maybe the Troika should too.

Irish eyes are crying when they look at the economy

Posted on 13 March 2013 by Anthony Doyle

With St. Patrick’s Day around the corner, we thought there would be no better time to do an economic update on Ireland.

In November 2010, Ireland found itself bankrupt. Dublin’s promise to keep bank creditors whole resulted in a massive increase in its debt obligations – too big for the government to remain solvent; especially after yields on 8 year government bonds rose to over 7% (they would later increase to over 15%). In desperation, Ireland turned to the European Commission, the European Union and the International Monetary Fund (the so-called “Troika”) for assistance.

After lengthy negotiations, Ireland received a €67.5bn international bail-out from the Troika, after yields on Irish government bonds rose to record levels. In return, the Irish government agreed to downsize and reorganise the banking sector so that it became proportionate to the size of the economy. The government also agreed to significant fiscal and structural reform, including austerity measures of €15bn over four years. This adjustment was to be made up of €10 billion in expenditure savings and €5 billion in taxes. This three year assistance programme is due to conclude at the end of 2013.

It was hoped that by implementing these reforms that Ireland would be able to return to the international capital markets and that investors would again lend to the Irish government. And that is indeed what has happened. As recently as January, Ireland issued €2.5bn of bonds maturing in 2017 at 3.32%. There are now hopes to issue a benchmark 10-year bond and possibly a linker in 2013.

Ireland cannot use the billions of euros it received from the Troika to embark on stimulatory policies for the economy. The money loaned to Ireland is sent to Dublin by the Troika, pumped into the Irish banks, and then channelled to Irish bank bondholders. The man on the street doesn’t see a cent. It was hoped that the bailout would benefit the Irish taxpayer by preventing even harsher austerity.

With that in mind, how has the real economy performed?

As would be expected, the evidence suggests a weak recovery at best. Ireland expanded at a pace of 0.8% over the year to September 2012 despite an environment of high unemployment and fiscal austerity. Looking at the sectors that contribute to GDP, we can see some improvement in the combined distribution, transport, software and communication sectors. At around 25% of the economy the Irish government is hoping that an increase in demand for Irish goods, particularly within the pharmaceuticals and information technology sectors, will support growth over the medium term. A weaker euro will help, particularly against the US dollar (the US is a big market for Irish exports – around 24%), but it is not weak enough.

Given that many of Ireland’s major industries – like pharmaceuticals – are highly capital-intensive they tend to employ few people. Additionally, the capital used in these industries is largely owned by foreigners and hence the benefits of profits are repatriated out of Ireland. Thus gross national product, which deducts income paid to foreigners, is a more relevant gauge of how the economy is performing. And on this measure, the Irish economy isn’t too cash hot, remaining significantly below the pre-crisis trend.

The above chart is a good illustration of the housing and construction boom that occurred in the run-up to the financial crisis of 2008. Housing and construction peaked in March 2007 and has since contracted by 65% in real terms. Despite only being around 7.5% of the economy at its peak in 2006, the boom and subsequent bust in this sector highlights the significant multiplier effects that the housing market can have on an economy (and is something we have highlighted here).

Turning to the labour market, it is true that the deterioration in labour market has stopped over the past year. The unemployment rate peaked at 15.0% and has now fallen to 14.2%. Many are pointing to the improvement in the labour market as a sign that the Irish economy is healing. We are less sure.

Holding the participation rate steady at September 2008 levels, the unemployment rate is closer to 19.5%, a full 5.3% higher than the current unemployment number of 14.2% suggests. This equates to around 140 thousand people. Where have they gone?

Net migration figures show that between the years of 2009-2012, a total of 87 thousand people left Ireland and predominantly between the ages of 15-44. Net migration, a declining participation rate and an increase in discouraged workers goes some way to explain the reduction in the Irish unemployment rate. The labour market isn’t healing; in fact the number of employed people in Ireland has fallen from a peak of 2.16 million in the third quarter of 2007 to 1.85 million at the end of 2012.

We have heard much about the internal devaluation going on in Ireland, which has been seen as a sign that Ireland is becoming more competitive in the global economy. True, unit labour costs (ULC) fell by 16% from the peak in Q4 2008 to Q3 2012. But this is misleading of the more recent trend. From Q1 2010 to Q3 2012, unit labour costs fell by only 3.4% and from Q1 2011 to Q3 2012 unit labour costs have actually been flat. This very slow reduction in unit labour costs in recent years suggests that it will be a decade or more before it is competitive. Ireland is seen as a nation with one of the more flexible labour markets in the Eurozone. What hope is there for Italy, Greece, Spain or Portugal with their relatively inflexible labour markets?

We fear for the Irish economy. What is required is stimulus, not austerity. Without some form of stimulus package, the Irish economy will experience sub-trend growth for the foreseeable future (in contradiction to the IMF’s forecasts – see here). A good place to start would be to use using some of the proceeds from borrowing at record low interest rates in the capital markets to stimulate the economy. The €2.25bn stimulus package was a good start last July but much, much more is needed. For example, how about a helicopter drop of cash into the economy Bernanke style? Give the estimated 4.5 million inhabitants of Ireland €200 each? It would only cost €900 million. Cut income tax. Encourage investment and lending. Build infrastructure. Create jobs. Reverse austerity.

Or how about using the money raised to embark on a programme of debt forgiveness in order to provide homeowner relief. Find a way for homeowners to take advantage of low interest rates and refinance despite having limited/negative equity in their homes. Allow refinancing to occur on a mass scale.

I know, I know. What about the loss of faith in Ireland’s credit rating? What about the spike in government bond yields? Well hopefully the stimulus package would work. Besides, ECB President Mario Draghi will do “whatever it takes”. And we believe him when he said “And believe me, it will be enough”.

If Ireland continues to tie its flag to the austerity mast, it is difficult to see a time in the next decade when the economy will cause Irish eyes to smile again.