Should Japan intervene to weaken her currency? And the implications of Ireland’s credit downgrade

Markets were braced yesterday for data on US housing sales from the National Association of Realtors. These turned out to be worse than the recently revised lower expectations for them and in July they fell by 27.7% on a monthly basis to 3.83 million units. Indeed they were 25.5% lower than in July 2009 and if you look at the levels on a chart it is a little chilling as we are back to levels seen more than a decade ago. If you read down the report you also see that months of supply rose from 8.9 in June to 12.5 in July. This has implications for future prices as the normal level is considered to be 6 months. So very poor and with implications for future prices too. Data today from the Census Bureau on the housing market will be awaited nervously.

The US equity market fell heavily with the Dow Jones Industrial Average registering a 133 point fall to 10040 and continuing a sequence of recent falls.We are due some sort of correcting rally one might think as we are at some important levels for technical analysts but so far there is little sign of this and Far Eastern equity markets continued the falls with the Nikkei 225 equity index in Japan falling some 150 points to 8845. Indeed if America follows the  Japanese pattern her equity markets have further to fall.

For followers of commodity price inflation the CRB spot index rose by 0.92 to 454.14 will only the metals component falling. However whilst oil prices rose yesterday they have been weaker recently overall and are likely to be offsetting the commodity price rises so the pattern is mixed. West Texas Intermediate crude has fallen from 81 dollars per barrel to just above 72.

Standard and Poors downgrades Ireland’s long-term credit rating

After reporting yesterday on Ireland’s continuing difficulties in her property and banking sectors I was checking some of the closing data for her when I noticed that the US ratings agency Standard and Poors had downgraded her. Her long-term credit rating was reduced from AA to AA- and she was also put on negative watch. Whilst this has some shock impact one also has to remember that the other two main ratings agencies Fitch and Moodys had already done this so Standard and Poors was something of a johnny come lately in doing this. However their report does have some relevant insights as to Ireland’s position.

The downgrade reflects our opinion that the rising budgetary cost of supporting the Irish financial sector will further weaken the government’s fiscal flexibility over the medium term. In light of the recent announcement of new capital injections into Anglo-Irish Bank Corp. Ltd. (BBB/Watch Neg/A-2), our updated projections suggest that Ireland’s net general government debt will rise toward 113% of GDP in 2012. This is more than 1.5x the median for the average of euro zone sovereigns

In essence the deteriorating property markets effects on the banking sector will also adversely affect the sovereign nation and they too have particular worries about Anglo-Irish Bank.

In our view, the total cumulative amount of capital injected into Anglo-Irish by the government could reach €35 billion (22% of GDP) over time. The higher capital injections relate to the recognition of worse-than-expected deterioration in Anglo Irish’s asset quality. We believe similar developments could take place at some other Irish banks.

So far the Irish government has indicated it will inject a maximum of 25 billion Euros into AIB so there is a ten billion Euro deterioration here. Also I notice the implications in the last sentence for “some other Irish banks”. They feel that all capital injections will take place this year and add that if this happens.

We view these capital injections into the banking sector as having an extraordinary impact on the general government deficit in that year. As a result, the headline deficit could increase to 35% of GDP.

The only reply to that is “ouch” as a fiscal deficit amounting to 35% of Gross Domestic Product would make investment markets take a close look again at Ireland.

Comment

One useful service that ratings agencies do provide is that their reports accompanying a change in status often have some valid analysis and there are some concerning numbers here. Having looked at it I feel that it does not fully account for the deterioration in the asset quality at NAMA that I reported on yesterday (they talk of 46% haircuts when the latest figures were 55%) so they are still behind the times a little. Even so the deficit and national debt figures are concerning. A lot will depend going forward on if and how much Ireland’s economy can grow as economic growth is the best way out of such situation as all factors, banks property market and fiscal deficit will be improved by it. So the apparent deterioration in the economies of Japan and the US will be a concern if it continues.

As to the specific credit rating then yet again a ratings agency has reacted too slowly which is a familiar theme.If you were a marxist economist you would look at the ratings agencies and argue that they are an example of market inefficiency and at times failure and if I was in a debate with him/her then I could only agree. A ratings report on the ratings agencies would not make pretty reading.Also it makes me think of the recent stress tests for Europe’s banks which do not seem to have factored into them the full state of Ireland’s banks,which of course reduces their credibility even further.

As to the market impact of the changes then it has been at the shorter end of the Irish government bond market as two-year yields have risen by 0.34% to 3.54% whilst ten-year yields edged higher to 5.53% according to Bloomberg. The spread between her ten-year yields and those of the German bund has risen to 3.3% this morning which is a new high. So the real problem here is a more subtle one than usual. The actual yield levels are unfortunate but not disastrous but the relative yield levels as indicated by the spread shown shows that unlike many other countries Ireland is not benefitting from falling government bond yields. Just to rub it in Ireland has around 500 million of bills to issue today and her debt office will not be thanking Standard and Poors! Perhaps the European Central Bank can help.

Ireland has in my view taken many of the right actions to try to get a grip on her banking and property sectors with NAMA being an example of this. However once you put yourselves effectively in hock due to a banking system you need to reform the banking system itself and like the UK and indeed much of the world there are no clear signs of this. To my mind taxpayers deserve better.

Japan: will she and indeed should she intervene in currency markets?

I wrote about this issue yesterday as I considered the impact of the rising value of the Yen on Japan’s exporters and the implied impact of it on her economy which is not good. As the day progressed we saw extreme movements in her currency with the value against the US dollar rising to below 84 Yen and the value against the Euro rising to below 106 Yen.Speculation became rife that the Bank of Japan should intervene to stop this.

In theory this should be easy as a country with a strong currency can simply create or print more of it. The increased quantity should in itself reduce the value of the currency and the Bank of Japan could add to this by using it to buy other currencies. Notice this is quite different in theory to defending a weak currency as UK readers may well be mulling over at this point! In theory it works quite well.

Sadly in practice it is not quite so easy. Japan has tried this before and it has not worked particularly successfully with the Bank of Japan sitting on some quite substantial unrealised losses from it. So here is the first issue it has not worked in practice particularly well on the scale the Bank of Japan is willing to intervene in, indeed when faced with a long-term uptrend it has invariably failed. In case it had forgotten this the Swiss National Bank’s interventions this year have cost it around 7.5 billion Euros in a similar situation and it too failed.So fear of new losses to add to the existing ones will probably restrain the Bank of Japan.

The other impact of intervention and creating money to do so is that you are raising the money supply. In Japan’s circumstances I am sure you can find many economists who think that this would be a good idea on its own. However I feel that in practice it too has its own dangers. The real problem in Japan as elsewhere is the connection between the monetary system and the real economy and this needs fixing first in my view. Otherwise if you pour money in and things improve she could lurch from disinflation to considerable inflation or worse.

So in my view the best thing for the Bank of Japan to do is nothing. It is a humbling thought that even such a strong organisation is subject to the whims of the markets but it is also true.The Bank of England was forced to accept this long ago. Added to this is a theory that I have developed which goes as follows, talk of official exchange rate intervention seems to encourage markets to take the proposed intervention on and I think that we saw some of this yesterday. Sometimes they get bored easily and move onto other matters.

So there are real dangers to my mind in foreign currency intervention and is usually does not work. You might not get that impression from the media who like such news stories but it is true. Politicians like to be seen to do something and so the Bank of Japan may come under increasing pressure but it should hold fire in my view.Markets may concentrate on something else in the short-term which would help and if this is a long-term move then there is little it can do anyway. Accumulating more unrealised losses improves nothing. Sometimes you have to accept the limits of what can be achieved.

Greece and her banks proposed mergers

I notice a news story that Greece’s Finance Minister and the Bank of Greece’s Governor have called on her banks to consider “partnerships”. An interesting idea which suggests that a crisis where one of the issues is and was that many banks are too big to be allowed to fail can be helped by making them even bigger. In the film Full Metal Jacket the drill instructor would respond with an “outstanding” at this point whereas I am unsure whether to laugh or cry. Have the world’s authorities really learnt so little? Perhaps a kinder summary is that this is a sign of desperation.

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  • Shireblogger

    Hi Shaun and thanks
    Its like watching a slow car-crash. I heard one of the rating agency chiefs say they concentrate on two important issues beyond the daily events : 1)debt to net revenues; 2)unfunded liabilities for ageing populations and increased healthcare costs going forward which is drastically reducing room for manoeuvre.The bond dealers might well be looking at the immediate issues but sovereign debt affordability is being plotted out now for decades.The higher the opening deficits for indutrialised countries going in to this Great Recession, the longer it takes for them to get back to fiscal balance/surplus. Those who duck dealing with the unfunded liabilities mentioned will pay the most. Longer debt maturities and redemption obligations give some room for manoeuvre I suppose.

  • KG
  • johnspoone

    Nice link. Their projections are much worse than Dylan Grice’s
    http://www.sgresearch.com/publication/en/37815477D4EF75B3C12576320026B86A.pub?download

    I am wondering what Japan’s numbers would look like.

    js

  • johnspoone

    Oops, wrong link, many apologies. Here is the correct one for Dylan Grice’s analysis:
    http://www.sgresearch.com/PUBLICATION/en/19C05683D1CC9042C12576C7003152D1.pub?download=true

    js

  • Shireblogger

    KG and johnspoone – thanks for links. Read with interest and concern.

  • http://notayesmanseconomics.wordpress.com notayesmanseconomics

    Hi KG
    Thanks for posting this. I did particularly enjoy the sentence “Investors should be prepared to face financial oppression, a credible threat against which current yields provide little protection.” Actually many current govenrment bond yields provide little protection against anything. A logical forecast of what a yield of 2.15% for ten years on German bunds implies quite a serious correction in world economies or of course a “bubble”.

  • http://themeanoldinvestor.blogspot.com/ Mr.Kowalski

    With the rising yen, the sharp decline in Japanese economic growth, and a declining working age population, Japan has essentially arrived at the Keynesian End Game. There is no answer to this except “restructuring”. Morgan Stanley is absolutely correct. I look for Japan’s Financial Waterloo to arrive by the end of 2012.

    http://themeanoldinvestor.blogspot.com/2010/08/samurai-sunset.html

  • SeanBroseley

    The support for the banking sector also distorts the Irish economy. It is hoovering up assets of companies it advanced loans to. Those companies don’t have State support.

  • http://notayesmanseconomics.wordpress.com notayesmanseconomics

    Thanks John
    I have looked for some corresponding numbers for Japan but they are not so easy to find even on the latest IMF update. One nice analogy I remember reading is that Japan’s economy is like a bumblebee which according to the laws of aerodynamics should not be able to fly and yet year after year it does.To stretch the analogy further perhaps the decline in bee populations will turn out to be a portent.