Economics: 28/06/2009: Consumer spending and ECB rescue

Two things worth noticing this week: both relating to longer running developments in the economy, and both not discussed widely enough in the past.

First, the issue of consumer spending in light of unemployment data from QNHS. As I highlighted earlier, it is the younger workers who are being laid off in droves. This, of course, puts pressure on spending power, as highlighted by several other economists and commentators. Doh! Younger workers save less and spend more out of their income. Layoffs are an immediate hit to their consumption. More ominously – and less discussed in the media and by analysts – young workers save for two reasons: car purchases and home purchases. That is when they are not scared sock-less with the prospect of unemployment (traditional precautionary savings motive) and by the threat of the older generations ripping them off via higher taxation (unorthodox exclusionary savings motive – piling up of savings to offset future loss of voting power and access to career growth due to unfair competition from established and entrenched older generations: this is my own theory of savings contribution, by the way).

In Ireland’s case, precautionary savings motive will always be stronger for younger workers – courtesy of the bearded men of SIPTU/ICTU crowd who routinely betray younger workers in their quest for tenure-based job security and pay awards. Public sector leads here too, as many more temporary and fixed-term contract employees in the public sector are the younger one. Guess who will lose their jobs once Minister Lenihan takes to cuts in the public sector?

But the exclusionary savings motive is a new one for Ireland and it is the most venal of them all. Up until recently, Irish younger workers were virtually outside the effective tax net, courtesy of larger transfers and smaller wages. Next Budget will see their incomes decimated in order to pay lavish public sector wages. In the society that is much younger demographically than our fellow Eurozone travellers, our younger workers will, therefore, lose not only money, but also political power. This process is fully a result of perverse Social Partnership arrangement that has predominant concentration of power in the hands of the ageing public sector employees representatives and business groups aligned with public sector monopolies (also dominated by older workforce).

While precautionary savings effects are themselves long-lasting – hard to reverse and ‘sticky’ over time, the effects of exclusionary savings motive are even longer-term, depressing consumption and investment over much longer time horizon, as loss of power in the society cannot be rectified over business cycles and will have to wait for political cycles to play out. Ireland is going to pay for this ‘socialism for the geezers’ of our Labour Party, FF, ICTU/SIPTU/TGWU/CPSU etc for many years to come through:

  • lower innovation in consumption (with young people withdrawing from actively leading the new products/services adoption process);
  • lower general consumption (with young people and their families clawing back on consumption);
  • lower investment in productive capital (with younger people looking increasingly abroad for jobs and life-cycle investments);
  • lower entrepreneurial activity in traded sectors (with younger people preferring the perceived safety of the public sector to risky business of entrepreneurship);
  • lower overall career-cycle risk-taking (with less on the job innovation drive);
  • lower rates of growth both in domestic sectors and exporting sectors;
  • net emigration of the most skilled young in search of societies that politically and socially empower their youth, instead of turning them into taxation milk cows for the elderly bureaucrats;
  • lower rates of economic growth (per bullet points above).

In short, Ireland is now at a risk of becoming like geriatrically challenged Germany, courtesy of Cowen & Co.

Second, there is an interesting issue of ECB rescue for Ireland. My IMF sources told me that they fully anticipate to put in place an IMF team to monitor developments in Ireland as they expect, over the course of 2009-2010 a serious deterioration in Ireland’s fiscal position and a renewed risks to the bond market. But the more interesting comment came on the foot of my questions concerning ongoing ECB rescue of Ireland Inc.

The fact: chart below (courtesy of Davy) shows the ECB lending to Irish institutions.Irish retail clearing banks (AIB, BofI and the rest of the zombie pack) have raked up €39bn worth of ECB lending, up from around €2bn a year ago. Non-clearing foreign banks have declined in their demand for ECB dosh. Mortgage lenders (ca €66bn) and non-clearing domestic financial institutions (€72bn) are by far the biggest ECB junkies.

Here is Davy take on this: “Headline private sector credit is off about 3% from its November peak and, if you extrapolate the trend forward to the end of the year, the year-on-year (yoy) rate could be -6% (+2.4% yoy in April). However, the economy is likely to contract by maybe 8-10% this year in nominal terms, which means credit is going to have to shrink by a lot more if de-gearing is to take place in Ireland. Otherwise, we are really borrowing from future consumption and investment.

All I can add is that we borrow from future growth and investment in order to pay wages to the public sector and welfare bills.

On the deposit side, the resident number was running at -2.5% yoy in April – an improvement on January’s -4.5%. Our discussions with the banks would suggest that current account balances, which are a great barometer of economic activity, are still declining but not at the rate that they were – so another positive second derivative for us to consider.

I do not care for second derivatives, for, as I pointed out many times before, mathematics imply that as we fall toward zero economic activity, we are approaching the point of total destruction with a decreasing speed. Which is neither important, nor significant of any upcoming upturn. It is simple compounding past falls with smaller rates of decline acceleration.

Finally, we will also be watching the ECB funding number, particularly the clearing bank figure, to see if it stabilises (see chart) at around €39bn. Dependence on ECB funding shot up in Q1 when Ireland Inc was under funding pressure, but the banks would say that conditions have improved since then albeit the market remains tough. Moreover, some banks are still paying up to get money, so there is a margin impact to be considered. However, the new one-year ECB facility will help ease this a little and give some much-needed duration.

Sure, good news, according to analysts is that we are getting deeper into short-term maturity debt with ECB, then? What’s next? Calling on banks executives to replenish banks capital using credit cards? Let’s consider this Davy-style ‘positive’. Suppose bank A used to take 2-year loans from ECB at a rate R, so borrowing €1 today implied that it had to repay (1+R)^2 in 2011, with associated transactions cost of, say X per issue, the total cost of €1 today to bank A was €(1+R)^2+X. Now, the ECB forces bank A to split the borrowing into 50% into 2-year tranche and 50% into 1-year tranche at rates R1, R2, R3 corresponding to years 1 and 2 one-year rates, plus R3 being an annualized rate of borrowing for 2-year tranche. The issuance cost remains at €X. You have the cost of borrowing €1 now standing at 0.5*[€(1+R3)^2+X]+0.5*[€(1+R1)*(1+R2)+2X]=1.5*X+0.5*[(1+R3)^2+(1+R1)*(1+R2)].

Compare the two costs:

  • if the cost of borrowing does not rise over time, so that R1=R2=R3, then the 1-year lending scheme introduction will cost the banks more than the old 2-year scheme by the amount X;
  • if the cost of borrowing – ECB rates – rise in 2010 by, say Z bps, so that R2=(1+Z)*R1, then a two-year trip will be cheaper relative to the two 1-year trips by a grand total of €[X+Z(R1+R1^2)].

Thus, the idea of ‘easing’ of borrowing constraints that Davy herald is equivalent to saying ‘the banks will be able to borrow more, but at a higher cost’…

The next big development on the funding side is the issue of guaranteed senior notes beyond the September 2010 deadline, the legislation for which has just gone through the Dáil. With the likes of Bank of Ireland having 75% of its funding under one year, this will help slow down the
liability churn, although it will come with a cost. We might be looking at 350-375bps all in, which will not help margins either. As we discussed in our recent Bank of Ireland research note (“When September comes: autumn rights issue can be a big catalyst”, issued June 19th), we do not need credit growth over the next two to three years to make an investment case for the banks. That is just as well as frankly we are going to get the opposite. Margin expansion would be helpful though, and margins will expand eventually. However, with the ECB likely to sit on its hands for a while and the NAMA benefit likely to come through over time rather than in one big bang, we can expect margins to go down before they come back up again.

This talk about extending the guarantee is a mambo-jumbo that is designed to get the banks off the hook of defaulting loans for just a while longer. In reality, there is only one ‘investment case’ for Irish banks – NAMA transfer of bad debts to the taxpayers. This is precisely why the banks will need no new lending to extract value. Once they dump their non-performing loans into NAMA and get recapitalization money from the Exchequer, the Great White Hold-up of Irish taxpayers will be complete. Any growth upside for the banks shares will, thus, come solely from impoverishing Irish taxpayers.

A strong investment case, indeed, thanks to the ECB turning chicken when it comes to forcing Irish Government and Banks to obey market discipline.