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Friday, September 05, 2008

Trichet Announces New Rules For ECB Funding

In the photo above you can see European Central Bank President Jean-Claude Trichet welcoming Irish Finance Minister Brian Lenihan to the 10th anniversary celebration of the ECB, in Frankfurt on Monday, June 02, 2008.

Time To Stop The Abuse?

The ECB and the Spanish banks are back in the news, following the decision by ECB president Jean-Claude Trichet to take advantage of this week's regular interest rate press conference to announce a number of funding rule changes affecting European bank access to ECB liquidity provision. These changes will affect all those financial entities that have developed an excessive dependence on the cheap "you can see my wallet if I can see your securities" funding which has been available up to now from the bank. The changes were judged by many analysts to have been slightly more radical than expected, and bank stocks in the Eurozone and the UK fell sharply on the news.

Irish and British banks fell the most in European trading after the ECB announcement. Anglo Irish Bank had fallen 12 percent by Friday afternoon. HBOS, a U.K. mortgage lender that has accessed ECB funding via its Irish operation, was down 8.2 percent over the same period, while Barclays, the UK's third-biggest lender, dropped 9 percent. In Spain Banco Sabadell fell 4.4 percent, Banco Santander, the country's largest bank, sank 6.1 percent and Bankinter SA fell 7.7 percent.

Since the UK is not a member of the eurozone, this fall in bank shares may give us some sort of measure of the kind of "abuse" which many have long thought was occurring, but which was not evident due to the lack of transparency surrounding such operations. Other European banks who were "badly affected" by the news were the Swiss bank UBS, and some smaller regional banks such as Erste Group in Austria and Piraeus Bank in Greece.

Ireland in the Forefront

What may well surprise many readers of this blog - although not perhaps after reading this post yesterday - is that it seems to be Ireland and not Spain which has been at the heart of most of the abuse (certainly you wouldn't have known this from the number of articles in the popular press which have been busy pointing the finger at the Spanish banks in recent weks though). Last week the ECB lent a total of 467 billion euros to European banks, or should I say to banks which have some sort of operating facility inside the 15-country euro area - although with banks like HBOS, UBS and even Australia's Macqarie on the list, the term "European" is getting to be a bit stretched - and in return had been accepting a broader range of collateral to back the loans than has been the case at Bank of England. Such collateral may include bonds with credit ratings five levels below AAA as well as asset-backed securities. The existence of this policy differential seems to have prompted a pretty motley crew of non eurozone financial firms to create bonds of variable quality solely and exclusively for use as collateral for ECB borrowing.

But when we look at how this money lent by the ECB has been allocated, then even more eyebrows may be raised on learning that lending to the much castigated Spanish banks has been "only" running at around 49 billion euros (as of July), while lending to Irish banks reached 44.1 billion euros according to data from the Irish central bank in Dublin. I say only, since everyone is aware that Spain's banks have a sizeable problem, so if a facility has been created to help them I would have thought that it is only natural that they use it. Thus I am not sure why this use by the Spanish banks has been being called "abuse", since a sizeable chunk of the lending has been going to Spain's hard pressed savings banks (see below), so I think it is worth asking what exactly it is they are supposed to do? Or put it another way, if people really are so concerned about Spain, then maybe a more appropriate question is why the ECB aren't doing more to help? Certainly US banks don't seem to be labouring under this kind of difficulty with the Federal Reserve, although of course it is precisely this position which has attracted criticism from a chorus of European commentators. Rather than talking about abuse in Spain, perhaps it might be more interesting to ask why we only have a temporary and transitional facility for what is clearly now a longer term and structural problem in the Spanish banking system.

To put what has been happening in perspective, since Ireland is about one tenth the size of Spain, it is as if the Irish banks had been accessing some 440 billion euros in funds. And things only get worse when we come down to the details, since about half of the funding from the ECB has been going of to the Dublin-based units of lenders from outside Ireland, according to analyst Eamonn Hughes at Goodbody Stockbrokers.

HBOS and Barclays are just two of the British banks that have been borrowing from the ECB. Earlier this year it emerged Macquarie Bank had set up a deal backed by Australian car loans specifically for use at the ECB. But the whistle really was blown in mid August when the UK's largest building society, Nationwide, got a lot of media coverage for saying it was planning to expand into Ireland to take advantage of "funding opportunities".

So the first thing to have clear is that the real abuse of the ECB funding has not been coming from Spain, and that access to these funds by Spanish banks has been more or less policed by Bank of Spain Governor Miguel Fernández Ordóñez and his team, who have attempted - as he explained in June in his appearance before the Economy and Taxation Commission of the Spanish Congress - to ensure that participation in eurosystem fundings rise "without going far beyond the "key" subscription of the BoS to the ECB capital" (which is 7.55%). And if Spain's banks have recently gone increasingly beyond this level (10.3% of total loans in July) then this is surely more to do with the pressing needs of Spain's savings banks sector (who really do need liquidity, see below), than it is with any organised system of abuse. But be that as it may, it is Spain's banking sector who will take the lions share of the hit from yesterday's decision, since while in some other countries the ECB funding may well have been considered to be mere "froth on the daydream", for Spain's struggly banking system the lifeline is likely to turn into a life and death issue.

The Measures Themselves

Trichet announced a battery of measures yesterday, all of them having one feature in common: they will increase the cost of using asset-backed securities to obtain ECB funds. Access will also now specifically exclude deals involving underlying mortgages or other loans not denominated in euros.

The changes - which will take effect as of February 1 2009 - include increases in the average “haircuts” applied to asset-backed securities. A haircut is the amount deducted from the market value of a product when judging its value as collateral. In future, a blanket 12 per cent haircut will apply to all securities, instead of the earlier sliding scale of between 2 and 18 per cent. There will be penalties for asset-backed securities valued using computer models and for unsecured bank bonds. Banks will in fact have to take an initial markdown of 5 percent on any ABS that has been valued using a computer model. At the same time restrictions already in place on banks using assets they themselves had created were extended to stop banks using assets from issues to which they had offered currency hedges or liquidity support above a certain level.

Analysts at Barclays Capital are quoted as saying that the extra haircuts would mean banks might have to post an additional €25bn-€45bn of securities for collateral purposes. The general opinion is that the changes will make it less attractive for banks to use asset-backed securities as collateral and will certainly push up the overall cost of borrowing funds from the ECB.

The asset class which will be most affected by the changes are ABS with a residual maturity of up to one year, which currently have a haircut of just 2 percent. In these cases, instead of receiving 98 euros in exchange for a security with a face value of 100 euros, banks will often now receive just 83.60 euros.

Spanish Savings Banks Will Be Affected

Spanish savings banks, such as La Caja de Ahorros del Mediterraneo (CAM), are likely to be hit quite hard by the new rules, and this on the face of it seems to be most unfair, since if there has been abuse of the earlier ECB rules it is hardly towards this quarter that we should be looking given the now evidently parlous state of their balance sheets. The savings banks accounted for almost 70 percent of the total growth in funds borrowed by Spanish financial institutions from the ECB over the last year, according to a research note from Banco Santander. Spain-based financial institutions borrowed 49 billion euros ($71.14 billion) from the ECB as in July, up from 18 billion over the same time last year, according to Bank of Spain data (so the savings banks have had approximately 21 billion euros in the last 12 months). Borrowing by Spain savings banks accounted for 4.4 percent of the 467 billion euro total funding from the ECB last week, up from 0.9 percent last year, according to the Santander research note issued yesterday. Regular Spanish banks increased their participation to 5.6 percent, from 4.6 percent.

Caja de Ahorros del Mediterraneo, which is based in Spain's Valencia region, has now been put on a watch list by ratings agency Standard and Poor's, and S&P's could downgrade the bank by as many as two notches due to the fast deterioration of its asset quality. Spanish RMBS's are currently trading in the secondary market at levels which vary between Libor plus 170 and Libor plus 350 basis points.

And this brings us to the heart of the question. Basically, either what has been happening recently is one of the most brillant recent pieces of "counter information" (or smokescreening) or someone somewhere really quite important just hasn't grasped what is actually going on. Maybe the fact is that the attention recently being focused on Spain's banks wasn't in fact to distract attention away from abuses which have been taking place in Ireland and elsewhere (yes, I am sure there are elsewheres, since total lending is, after all 476 billion euros), but the fuss about abuse could have been a way of diverting attention from the fact that some kind of longer term support system for the Spanish banks is being put in place (this is what I hope is happening, but there really is no visible evidence to support my hope). You see, if Spanish banks really are, as some are urging, going to have to "mark to market" and thus pay up to 350 basis points over 3 month Libor, then as they rollover the stock of existing cedulas over the next 5 years (which are financing existing mortgages, remember), there is just no way they can continue to charge the kind of basis points over 1 year Libor that their mortgage customers are currently paying, which means there will have to be another substantial hike in Spanish mortgages payments, over and above the upward movement we have seen in euro Libor itself. And we have already seen the extent of the damage that is being caused to the Spanish real economy with mortgage rates at their present levels. Do we really want to get to find out what would happen if everybody had to pay 200 to 300 basis points on top of this? I don't know about anyone else, but personally I could happily live out the rest of my life without getting to know the answer to this question. This is certainly the kind of "reality check" I could most definitely live without.

Monday, September 01, 2008

Have We Seen "Peak" Italian Retail Sales?

Well, since Ugo Bardi recently raised the question of whether Italy had not in fact passed its own historical "peak oil" and "peak mafia" points, I thought it might be interesting to ask what else has peaked in Italy, and what better place to start than with retail sales?

Sharp Drop In June Sales

Italian retail sales fell sharply in June, posting their sharpest drop on the year in more than three years, as sales fell across the board, according to data last week from the national statistics office Istat, but what many observers seem to fail to be taking note of is that Italian retail sales have been dropping steadily for some years now. Even more importantly - as will be argued in this post - there are serious theoretical grounds (in the context of Italy's ageing population problem) for postulating that Italy's retail sales may NEVER rebound again on more than a conjunctural basis, that is we may see local "peaks" and "troughs" but the secular decline may now not reverse. This is a point which most of consensus analysts who look to a cyclically driven "rebound" in domestic consumption appear to fail to take into account.

But before going further with this point, let's take a look at some data. Compared with June 2007, Italian retail sales fell by 3.4% on a current price (ie non inflation corrected basis), thus registering the steepest decline since April 2005, following a 0.5% rise in May. But since annual consumer price inflation stood at a 4% in June, retail sales in real terms declined very sharply indeed in June (more or less comparable to Spain).

ISTAT put it like this:

Per una migliore interpretazione degli indicatori qui presentati occorre considerare che essi si riferiscono al valore corrente delle vendite e incorporano, quindi, la dinamica sia delle quantità sia dei prezzi.

(Which loosely translated say that in order to better understand the data it is important to bear in mind that it refers to the current price value of sales and thus incorporates both the volume and the price dynamic. Of course, to help us better understand the data it would be nice if ISTAT could provide us with some price corrected index, but in the absence of this I have prepared a rough and ready one, but deflating the seasonally adjusted index with the CPI one, thus reducing the sales index to 1995 prices, see charts which follow).

Slight Improvement In The Rate Of Contraction In The August PMI

Now applying the CPI deflator to the index in fact gives us reading which match quite closely the Bloomberg PMI data for retail sales. The latest Bloomberg eurozone Purchasing Managers' Index, based on a mid-month survey of economic conditions in the euro area retail sector, pointed to a continuing contraction in retail sales across the eurozone for the third consecutive month in August. While the PMI rose to a three-month high of 47.7 it remains below the crucial 50.0 zero growth mark.

There was some, however, some variance in retail sales trends across the three largest euro area economies. Italian sales continued to fall, extending the current period of month on month consecutive declines to a year-and-a-half. However we did hit a nine month "high" with sales contracting at the slowest pace since last November, rising to 44.8 (or minus 5.2) from 38.2 (or minus 11.8). Thus August revealed a significant eeasing in the rate of contraction (a finding which is completely in harmony with the rather better consumer confidence index reading for August. Indeed the fall in Italian retail sales in August was not as strong as the one in Germany, where the rate of decline - 44.1 - accelerated to its strongest pace so far this year. So things in Italy are bad, and they are getting worse, but they are now getting worse more slowly than they were. The fact that in August oil prices were significantly down from the July peak obviously has something to do with this situation.

The August PMI data also revealed a rather higher level of pessimism amongst retailers with regard to September sales, with the index for the sales outlook registering 48.0, down from 49.5. The data revealed some variance across countries, while French and Italian retailers expect sales to come in below target next month, which reflects underlying concerns that the economic downturn will continue, German retailers were more positive, forecasting a stronger than previously expected performance.

Indeed Italian consumer confidence bounced back in August from a 15-year low in July as oil prices fell from record highs. The Rome-based Isae Institute's index, calculated from a survey of 2,000 families, rose to 99.5 from 95.8 in July. The index, however, continues to remain at a very low level.

"Peak" Retail Sales

So the question we are faced with now, is whether or not we are faced with a "peak" retail sales phenomenon? The theoretical basis for this assumption is on reasonably solid ground, and there is evidence to show the phenomenon exists in other ageing economies (Germany, Hungary, possibly Japan). In the Italian case, I have constructed my own makeshift index, and the performance of this index since 2003 can be seen below. It seems Italian retail sales may have "peaked" in early 2003, and since that time the decline has been continuous, although sales did stabilise during 2005 and 2006 (I will come to this point later).

Now Italy's population is not in fact contracting at this point, although the natural population change is negative, and has been since 1993. But Italy has been receiving immigrants - an estimated 450,000 in 2007 - and thus Italy's population is still increasing.

But Italy's population is ageing, and we know from basic life cycle theory (Modigliani) that saving and spending patterns change across the life cycle, with the propensity to borrow against future income in order to buy now declining significantly among the over 50s, and since it is increasing consumer credit that drives retail sales growth in the dyamic internal consumption economies, then it is highly likely that ageing will now act as a drag on sales growth in countries like Italy with very high median population ages (43, along with Germany and Japan). As we can see in the chart below (which comes from the US Census Bureau database), Italy's median population age has been rising steadily, and at a very rapid rate (over 1 year's increase in median population age for each calendar year, of course historically this type of rapid ageing is quite unprecedented), with the only real substantial unknowns between now and 2020 being life expectancy, which may accelerate more than anticipated (in which case the population ageing will be even more rapid), and immigration, which will slow ageing down a bit.

The data in the above chart come from the US Census Bureau, and it appears to me they have only made a very slight allowance for the impact of migration, which may mean that the ageing curve has not been so steep in the last three or four years, but equally, and despite the fact that population has risen by nearly 2 million since 2003 due to substantial immigration, the retail sales have barely shown an impact (which means I would hate to see what they would have looked like without the immigants). Although, might we postulate the some of the stability we saw in retail sales in 2005 and 2006 could be the impact of the arrival of the immigrants?

EU Sentiment Index Down In August

Other indicators also seem to confirm the idea that things in Italy continued to get worse more slowly in Italy in August, one of these was the EU Economic Sentiment Indicator (ESI) which fell in both the Eurozone and EU, falling by 1.9 points in the EU and by 0.7 of a point in the Eurozone, to 86.9 and 88.8 respectively. For the EU as a whole the ESI reached its lowest level since December 1993. However, unsurprisingly, perhaps, in view of all the above, while the ESI fell for the zone as a whole in August, in Italy it bounced back slightly to 89.5 from July's 85.4 low.

One of the reasons for this change is undoubtedly the shift in consumer confidence, and one of the underlying reasons for this shift in consumer confidence is the easing in petrol prices and inflation, which fell back to an annual 4% in August from an annual 4.1% in July.

It is to be hoped that producer prices, which were up at their highest rate since September 1995 in July - an annual 8.3% - will now follow the same path. There is some evidence of a moderating trend, since month on month, the index rose 0.5% over June compared with a 0.8% increase the previous month.

Istat said that energy prices in July surged 25% on the year and 1.6% on the month. The price of refined petroleum products continued to drive the index higher year-on-year, since they were up by an annual 31.1% and 1.2% on the month. Excluding energy, producer prices only rose 4.1% on the year and 0.1% on the month in July.

So is it all about energy, well obviously not completely, but it is to some significant extent. Years of declining competitiveness and a complete disregard for the problems that population ageing were going to represent have left the Italian economy completely "groggy", like the proverbial boxer leaning on the ropes, waiting for the knock-out blow. And in it has come, in the shape of an unprecedented and sharp spike in oil prices. Italy is now, as we can see, extremely sensitive to any strongish movement, one way or the other, in oil prices. Thus it seems it may well be worth asking ourselves, along with Professor Bardi, the awkward question of whether Italy's economy can in fact learn to live with oil prices which remain over $100 a barrel in the longer term? The answer is not at all obvious.

An airline is a small economic system that uses fuel derived from oil in
order to carry on activities that generate profits. If oil is too expensive,
profits disappear and, eventually, the system must disappear, too, bankrupted.
Low cost airlines have appeared during the period of relatively low oil prices
that ensued after the first oil crisis, in the 1980s. Can these airlines exist
with oil over $100 per barrel?

A country is larger than an airline but it, too, needs fuel for its
economic activities. And, if deficits run too high, countries can go bankrupt as
well. Italy's industrial economy had its moment of maximum growth in the 1950s
and 1960s; in a period of low and stable oil prices. Can Italy's industry exist
with oil prices over $100 per barrel?