Thursday 27 April 2017

Lower taxes and charges needed to deflate debt mountain in short period

Constantin Gurdgiev

There is a simple statistic out there that the vast majority of our corporate leaders, politicians and regulatory authorities simply failed to comprehend. In Q4 (fourth quarter) 2002, the gross level of debts in our private economy stood at $481bn. By the end of 2008 this number was a staggering $2.89trn.

Even in the normal days of rapid growth, this is more than 10 times the entire size of our economy -- a step too far up the leveraging ladder. In the current conditions, when debt refinancing is costly and hard to come by, it is a burden that can break our economy's back.

Supremacy

Ireland's debt mountain is composed of the banking sector debts, corporate and household borrowings and inter-company loans. If banks accounted for 54pc of all private sector debt in Q4 2002, while companies and households captured 30pc, six years later they were responsible for 50pc and 36pc respectively.

Inter-company loans were responsible for the balance. Thus, the overall dynamic of borrowing highlights the fact that Irish non-financial companies and households saw a dramatic increase in their share of national indebtedness in the last six years.

At the end of 2007, according to Central Statistics Office (CSO), personal debt in Ireland stood at €148bn. While no figure is yet available for 2008, various forecasts show that by the end of 2008, Irish households' total debt, inclusive of mortgages, was some 170pc to 185pc of GDP. This indebtedness caused a significant shift in the overall solvency in our economy.

The latest International Monetary Fund (IMF) analysis, presented in a quarterly 'Global Financial Stability Report' from Q4 2008, shows that by the end of 2007 Ireland was the most heavily indebted country in the entire developed world in terms of private sector, household and corporate debt ratios to GDP.

Instead of some economic "miracle" our economic growth was nothing more than a borrowing scheme in which leverage, in the words of one Swiss private bank representative here in Dublin, was "the absolute king".

All of this implies that Irish companies are heavily exposed to any adverse changes in lending conditions. Between 1997 and 2004 estimated failure rates for domestic businesses were in low single digits.

A forecast by the Bank for International Settlements in late 2004 projected the rate of corporate insolvencies of just 1.7pc in Ireland for the period to 2007. By the end of last year, the probability of Irish businesses not surviving until January 1, 2011 had risen to well over 8pc.

In year-on-year terms, 2008 saw an increase in business insolvencies ranging from 700pc in furnishings and interior design, to 400pc for motor trade, to 325pc and 300pc in manufacturing and transport and haulage respectively.

Overall, according to business consultants FGS data released two weeks ago, economy-wide corporate bankruptcies were up 103.5pc in 2008 relative to 2007.

In a June 2008 research note, I predicted this trend, but the sheer speed with which insolvencies cases were rising in Q4 2008 overtook even that forecast.

Now, projecting into 2009, Ireland is on track to double the number of business failures once again, implying the potential loss of jobs due to bankruptcies of 30,000 by December 2009. Indirect effect of this can be an additional 15,000 to 16,000 jobs lost among contractors.

None of these jobs will be replaced in the economy, where a lack of new investment is accompanied by the sky-high debt levels. The year 2008 has spelled an effective collapse in new business creation, as the number of business start-ups has declined by 21pc in year-on-year terms.

Creation

But this number conceals an even more dire state of entrepreneurship in Ireland. Taking out of equation state-financed and involuntary "entrepreneurs" -- workers who were forced by jobs cuts to become part-time contractors -- new business creation in Ireland has probably contracted by 60pc to 70pc.

The underlying causes of our heavy reliance on debt financing in the recent past were the availability of cheap credit across the EU, structurally higher regulatory and public services costs in Ireland, and the system of virtually arbitrary tax breaks and exemptions that drove progressively more business investment into property and land speculation.

A switch from the cheap credit of the 2004 to 2006 period to higher borrowing costs in 2007 and 2008 is commonly cited by our government officials as the root of rising insolvencies amongst Irish businesses.

This is only partially true. IMF data shows that even in 2007 -- the year of tighter credit conditions -- Ireland had the lowest share of banking and corporate debt covered by the non-debt assets of all EU states. We were also the worst in the eurozone it terms of the size of our asset base relative to GDP.

Regulatory

All along, Irish regulatory authorities had at their disposal the policy tool that could have restricted excessive borrowing by the companies. This tool is known in economics as the reserves requirement ratio -- the amount of funds required to be kept on reserve relative to the loans disbursed.

Over two years ago, when I suggested to a central bank executive that we should consider raising the reserve requirements on banks as the means for cooling off excessive mortgage and business lending, his reply was: "The Government will never allow this".

In the end, political, not economic concerns drove the incentives to issue loans to many over-stretched businesses and households. The result?

According to the World Bank database, our main banks' provisions for non-performing loans have fallen from 97pc to 56pc between 2003 and 2006, while regulatory capital reserves relative to risk-adjusted assets stood at a lowly 10.2pc in the beginning of 2008 -- the lowest in Europe.

Similarly, international research shows that higher regulatory costs incentivise firms to assume higher levels of debt, as opposed to using equity or partnership finance.

Companies operating in regulated markets pile on debt in order to increase their market shares, engage in M&A (mergers and acquisitions) activities, or to finance "strategic", often state-incentivised or required, investments.

The end result is a weakened balance sheet and dependency on regulatory price supports. This has been happening in our construction sector, where excessive debt financing went to pay for land, the value of which, as a share of overall project costs, had risen from around 15pc to 20pc in the 1990s to over 40pc by 2007. It has also been happening in our telecoms, transport, energy and manufacturing sectors.

Endgame

The endgame for corporate Ireland and households is that this debt mountain has to be deflated over a short period in the world of higher financing costs and shrinking revenues.

The only way out is to help ordinary taxpayers and companies to deleverage by using some creative policies. We can use banks recapitalisation to drive down household mortgage and short-term debts. We can also introduce tax reductions (including PRSI and the health levy) and impose cuts on local authorities' charges to mitigate the spectre of corporate insolvencies.

To date, by increasing income and consumption taxes in the Budget 2009 and by turning a blind eye to rates and charge increases by the local authorities, the Government has done nothing of the sort.

Dr Constantin Gurdgiev is an Adjunct Lecturer in Finance with Trinity College Dublin.

www.trueeconomics.blogspot.com

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