Colm’s columns

Colm Rapple
Irish Mail on Sunday January 18th, 2009

“Told ya so!” reads the balloon caption emanating from the picture of Karl Marx gracing the mug I got as a Christmas present. But Marx, were he still alive, would doubtless have more than that to say. However, there are plenty of other “told ya so’s” out there and, like Marx, most of them didn’t get it completely right. In so far as they did, it had more to do with luck than with economic insight, research or experience.

There was a general realisation that the property bubble had to bust at some stage. But most commentators, including the prestigious Economic and Social Research Institute, predicted a soft rather than a hard landing. That was the central forecast in the ESRI’s medium term outlook published only eight months ago based on fair assumptions built into a very sophisticated economic model.

There were those who warned about a more traumatic busting of the bubble but no-one foresaw the combination of global economic shocks which hit us at the same time as the inevitable slow-down in the domestic economy as the property boom came to its inevitable end.

We were always going to have an economic downturn but without the external shock it would certainly not have been as bad as it has turned out to be. And no one is claiming to have foreseen the extent of the world financial crisis.

But whether the downturn was going to be slight or severe, we should have been preparing for it.

It was all too clear that the tax base was not adequate to deal with any kind of downturn in the property market, whether great or small. But few commentators were critical of the ideologically motivated erosion of the tax base.  The Celtic Tiger preceded the tax cuts and while it may have been encouraged on its way by some of the cuts that followed in its wake, they clearly went too far.

In 2000 income tax rates were lowered from 24% and 46% to 22% and 44%. Now they are down at 20% and 41%. Were they back up at even 22% and 44% the Exchequer would be about €2 billion a year better off – the amount that the Government is committed to saving by its current round of pay and spending cuts.

The tax cuts did little or nothing to promote economic growth during the good years. They were part of the return we got from the Celtic Tiger, paid for from the exceptionally buoyant tax yield from the property sector. But in retrospect we would have been just as well off without them. We might have avoided the mad spending sprees that pushed asset prices to clearly unsustainable levels. Certainly the State finances would now be in a much healthier state.

But there were very few who argued, as this column has consistently done,  against the tax cuts. To do so, required a vision of sustainable social and economic growth far removed from the liberal free market model that was so seldom questioned by commentators during the go-go years, not least by some of those who now claim to have predicted the current recession.

Until relatively recent times, there were few voices raised in protest at the laxness of the regulatory systems supposedly charged with ensuring the effective operation of  free markets in areas such as financial services, telecommunications and energy supply where owners and managers have long experience of circumventing attempts to impose competitive pressures on their operations.

The cosy relationship between Financial Regulator and financial institutions, often enough raised in this column, was seldom questioned elsewhere until the horse had effectively bolted.

No one seemed to have studied why our energy costs, which were amongst the lowest in Europe when ESB and Bord Gais operated monopolies, are now, in a supposed free regulated market, amongst the highest. Ironically the truth is that, in order to entice new entrants into the market, the Regulator was forced to not only concede buy to actually demand higher prices.

Those who forecast the recession can claim to have long advocated cut-backs in  Government spending. But that was mainly because it’s a natural part of the liberal, free market, reduced government, agenda to which most subscribed. So it’s not surprising that it is currently being pushed as a primary solution to the Government’s budgetary problems.

But the truth is that we need not only to raise taxes but also more Government spending, at least in the medium term. Higher taxes, even on the wealthy and higher paid,  just might impact adversely on confidence at this time although the risk is possibly worth taking.

Government spending needs to be prioritised, made more efficient and effective, even possibly cut in some areas. But we spent far less of our national income on public services than other euro-zone countries. If we want the type of state services that we deserve and demand, we’re going to have to spent a lot more.

According to figures included in a euro-zone economy commentary published by the OECD during the week in 2006 we were spending 34% of GDP on state services. The next lowest was Spain at 39% while Belgium, Finland, Austria, Italy and France were all spending more than 48% of their GDP on state services.

We trailed most of the others in practically every area except health where we actually topped the league table. In 2006 we were spending 7.7% of GDP on health compared with 6.3% in Germany, 6.8% in Belgium and 7.2% in France.

Clearly we could be getting better value for some of our money but the case for massive spending cuts is based on assumptions every bit as unsound as those on which  some of those economic forecasts were based.

Colm Rapple
Irish Mail on Sunday, July 20, 2008

Finance Minister Brian Lenihan won’t raid the National Pension Fund to help ease his budgetary problems. So he says. So what? Nobody said that he should.  The word “raid” suggests robbing the fund and frittering away the money. That would be stupid. But there are other options. Mr Lenihan could, for instance, take a contribution holiday. That would save the Exchequer about €2 billion a year – money that could greatly ease the need for cut-backs particularly in areas such a health, social welfare and education.

Of course, the opportunity should still be taken to trim some of the fat from the system. Undoubtedly a lot of fat has accumulated during the recent Celtic Tiger years when the Exchequer was flush with money.

But there are signs that some cuts are biting into the flesh. State services are going to be curtailed and the productive potential of the economy eroded. There was a small but significant indication of what may lie ahead this week with the announcement that third level grants were not to be increased for the coming term while the means-test income thresholds are being increased by only 2.8%, far less than the rate of inflation. That means that fewer students are going to qualify for a grant.

As a sop the special low income threshold under which a student qualifies for a top-up grant of up to €3,270 is being raised from €11,055 to €20,147. But not many students from families with incomes that low ever get to third level.

Grant levels may be increased in the December budget but the thresholds won’t.

If money had to be saved it would have been easier to reform the whole third level grant system which is riddled with inequities and anomalies. In particular the means test favours the wealthy and the self-employed who are able to adjust their incomes to ensure that their offspring qualify. That’s make easier by the fact that assets are ignored in the means-test.

The policy imperative should be to encourage greater participation in third level education. But it’s clear that Education Minister Bart O’Keefe’s objective is solely to save money.

There’s doubtless worse to come and taking a holiday from our national pension fund contributions could help to ease the pain and economic damage.

Alternatively some of the near €20 billion in the fund could be switched out of foreign stock markets and invested instead in developing Irish infrastructural assets that could yield every bit as good a return.

Those were suggestions made in this column some weeks ago when it was reported that the Fund had lost over 10% of its value during the first quarter of the year and that those losses were continuing.

The official figures released this week confirm that prediction. The value of the fund has fallen by 12% over the six months – a drop of about €2.6 billion.

While the investment performance has been dismal, the fund has fared better than the average Irish managed pension fund. Taking the long-term view, that pension fund managers can afford to take, the current downturn may be seen as a somewhat large blip, but blip none-the-less.

The money in the fund is to be used to help finance the State’s pension obligations from 2025 onwards so the investment managers are justified in taking a long term view and investment performance is not the issue at present. But it is still legitimate to question the fundamental investment strategy and, perhaps more urgently, to question the wisdom of actually borrowing to finance the one per cent of national income that the Government is committed to put into the fund each year. Because that’s what is going to happen this year and next and maybe even the year after.

When the fund was established, our politicians rather stupidly agreed that, in each and every year until 2025, the Exchequer would contribute one percent of national income. There is no doubt that the Merrion Street mandarins had a hand in getting the Dáil to sign away it’s discretion in the matter. It can be changed, of course, but not by a simple budgetary decision. It would require a specific vote of the Oireachtas.

In the buoyant Celtic Tiger years there was no great problem about putting one percent of national income aside each year but the State finances were obviously going to fall into deficit at some stage before 2025 when the first pay-outs from the fund will be made. So it was crazy not to give subsequent finance ministers a more easily applied discretion to postpone, reduce or completely cancel contributions to the fund as budgetary conditions required.

But the mandarins, of course, don’t trust the politicians. Not without reasons either. But the politicians are our elected representatives and they are supposed to call the shots. The mandarins have a personal interest in the fund, of course. While it is always stated that the purpose is to help fund social welfare and public sector pensions from 2025 onwards, the fact is that the first call on the fund will be for public sector pensions. Public servants have a contractual right to their pensions while social welfare recipients do not.

The investment strategy, of course, is also seriously flawed given that this is a State rather than a private fund. The performance of at least part of the fund should be measured not solely by the market value of the investments but rather by the total benefit conferred on the economy.

Colm Rapple
Irish Mail on Sunday, 24th February 2008

Allied Irish Banks had its Northern Rock moment back in 1985 after its subsidiary ICI ran up massive liabilities in the London insurance market. It has come a long way since then.

At that time it was bailed out by the Government under then Taoiseach Garret Fitzgerald. He simply nationalised the ailing insurance company making the State liable for its sizeable deficit. A bank levy was imposed to reimburse the Exchequer but it was undoubtedly passed on to customers and it was they who actually picked up the tab.

AIB didn’t even have to cut its dividend and has gone from strength to strength since, even managing to survive relatively unscathed when rogue trader John Rusnak racked up losses of $700 million at its US subsidiary, the Baltimore based Allfirst Bank.

So it’s not surprising that, despite the gloom and doom that has settled on the financial sector in the wake of the US subprime crisis, AIB managed to continue its advance last year and remain optimistic for the future.

This week it reported pre-tax profits of €2.4 billion, not counting profits from the ongoing sale and lease-back of its properties. That’s up 8% on the 2006 figure. Profits from the Irish retail operations were up 13% to €1,094 million. That’s not including some €64 million made from the sale and lease back of some 22 bank branches.

Business lending was up 25%, personal lending by 11% and mortgages by 14%. The Bank now claims 1.5m personal customers, up 67,000 on the previous year, and 220,000 business customers, up 16,000.

Wealth management services, which mainly involve the sale of investment and insurance products, performed particularly well last year. This is an area that AIB has targeted as having particular growth potential. It expects profits to jump from €60 million in 2006 to €150 million in 2010.

The Bank’s credit card business is also reported to have performed strongly. Cardholders were spending more and clearing less of their debt each month – good for the Bank and its shareholders but not so good for the customers.

Pre-tax profits from retail and commercial banking in Britain and Northern Ireland were up 20% on 2006 to €452 million while the Polish divisions contributed a 26% increase at €269 million.

So 2007 was a good year for the Bank. It has achieved better year-on-year growth in the past but profits have never been as high. Ironically shareholders have never before experienced a faster or steeper drop in the value of their shares.

This time last year the shares were trading at a high of €24. This week they were down below €14 and the results, while a little better than expected, did nothing to attract buyers into the market. Potential investors weren’t even impressed by the promised 10% increase in the dividend pay-out.

Launching the preliminary results for 2007 during the week, chief executive Eugene Sheehy was at pains to stress that this was the 15th consecutive year of double digit dividend growth and that the Bank was in a strong position to be able to continue with a progressive dividend policy for years to come.

For investors the message was clear. At current levels the shares are cheap. It’s a message that you would expect from a bank’s chief executive, but the figures do give credence to his claims.

The dividend pay-out for 2007 is covered two-and-a-half times by earnings. Even allowing for an expected slow-down in earnings growth, there will still be plenty of scope to increase the dividend pay-out in the years ahead.

The shares are currently trading on a yield of over 5.5%. In other words anyone investing at the current price can expect to get an income of 5.5% on the investment and the chance of a capital gain. The FT, in its commentary on the results, concluded that “unless conditions deteriorate markedly, AIB should surprise on the upside.”

So why are investors in such short supply?

It seems to be down to the uncertainty about the economic future, a general lack of confidence in the financial services sector, and a firm belief that the eventual upturn is still some way off. One analyst, quoted during the week, predicted that investors will remain cautious until next year at the earliest and maybe into 2010 and that only the brave will be investing in the meanwhile.

He could be right although AIB’s Eugene Sheehy, while predicting only low single digit growth in earnings per share this year, was gushingly optimistic about the longer term future and played down the current risks.

AIB had very little exposure, he stressed, to the bad debts expected from US subprime lending. The American M&T Banking Corporation, in which AIB has a stake, wrote off practically all of its subprime exposure during 2007 and still managed to contribute €120 million to Group profits. The contribution would have been even greater were it not for the impact of a worsening dollar/euro exchange rate.

In Ireland the overall bad debt provision was increased only marginally and the bank is not particularly fazed by the prospect of a continuing fall in property values. Residential property developers are seen to be the most at risk with the bank keeping a close eye on 8% of its loan book in this area totalling about €750 m. But it believes that there are adequate assets to back these loans even allowing for a further 5% reduction in house prices after what it says was a 15% decline last year.

So its good news for shareholders but there was a warning for customers. Profits come first, they were effectively told. In order to bolster profits margins, the expected cuts in European Bank rates over coming months may not be passed on in full to borrowers while savers are bound to take the full hit.

Colm Rapple
Irish Mail on Sunday, November 11, 2007

Over €30,000 million has been wiped off Irish share values since they hit a peak on February 21 last. Some of the sharpest declines have occurred in bank shares.  Allied Irish Bank shares are down over €10 from the €24.39 they were selling at earlier this year. Bank of Ireland is down over €8 from the high of €18.83 it hit in February.
Stockbrokers are advising clients to buy at these levels but there are still more sellers and buyers.

It doesn’t make sense.

Buy Bank of Ireland share at the current price and the dividend alone would provide you with a return of almost 6% a year. The dividend yield on AIB shares is 5%. The promise of such yields normally indicates that there is a high risk involved in such investments but is there?

Stock markets around the world have been hit by a combination of the crisis in credit markets, the upward spiral in the price of oil and general economic uncertainties. But the Irish stock market has been hit far harder than most.

Irish share values are down 30% on their February values. Elsewhere in the Euro zone share values have been volatile but they are currently only marginally down on where they were in February. So why are investors particularly pessimistic about the future prospects of Irish companies? One possibility is that they have been unduely influenced by those Jeramiahs in our midst who have long been prophesising  doom and gloom.

There is a growing danger that their prophesies will become self-fulfilling.

It would be understandable if the decline in Irish share values was simply a reaction to an unwarranted upturn in the past. But it can’t be explained that easily. There are objective ways of valuing share on the basis of current profitability and future prospects. On this basis Irish shares are significantly undervalued at current levels vis-à-vis their Euro zone counterparts.

Robbie Kelleher of NCB Stockbrokers estimates that to justify this undervaluation, 2008 earnings forecasts for Irish companies would need to be cut by 30% and the probability of that happening is as close to zero as it gets.

Of course some profit forecasts are going to be revised downwards. But not to anywhere near that extent. There is no reason to believe that the Irish banks are particularly exposed to the fall out from the sub-prime lending debacle. The danger of major loan defaults on the Irish market was never great and has been eased with this week’s clear signal from the EU central bankers that interest rates have peaked for the time being.

The economic forecasts remains good, not as good as we’ve become accustomed to but better than in most of our European neighbours. In its quarterly economic forecast published this week the Bank of Ireland predicted GDP growth of 4% this year. That’s a little higher than forecasts for the naturally pessimistic economists in the Department of Finance but 3 or 4% are good rates of growth.

The Bank predicts a bounce back to 5% growth in 2009.

Most  economists are agreed that inflation will slow to less than 3% which should give a boost to consumer spending if the flood of pessimism doesn’t spread too wide. And despite the high profile closures and job losses the number at work continues to rise sharply. The number at work is expected to grow by over 40,000 next year. That’s a slow down from the 72,000 net new jobs expected to be created this year but it’s still a growth in employment.

The Irish economy will continue to grow at a good rate in both historical and international terms.  There’s no justification for the “poor mouth” mentality that’s eroding confidence and is affecting economic activity in all areas. That’s what is showing up in the stock market.

The upswing in Irish share values started early in 2003. Over the previous three years share values had more or less stagnated. There had been a minor rally in 2001 but at the beginning of 2003 the ISEQ Index was down 15% on where it had been three years earlier.

As 2002 closed the ISEQ was a few points short of 4,000 and from then until it hit 10,000 at the end of last year the trend was steadily upwards with only small and short-lived downward blips. There was a similar blip in January with the index back up at 10,000 in February before the recent downward trend began. This week the index sank below 7,000.

At that level investors are some 75% up on where they were when the bull run started in 2003 and still 4% ahead of where they were two years ago. But that’s scant consolation when they are down 30% in nine months. And of course, it’s not “they”, its “us”. That €30,000 million written off share values is reflected in the values of the investment and pension funds that impact most people in the country.

They may only be paper losses at present that can hopefully be regained but they are losses none-the-less. They will encourage, or be used to justify, moves by employers to close down more defined benefit pension schemes. But of more immediate concern is the fact that they will serve to dampen consumer and business confidence.

We need to keep telling ourselves that we are one of the richest countries in the world and that on the basis of current forecasts we need to worry less about wealth creation than the use to which we are putting that wealth.