Tuesday, April 18, 2017

Is Ireland’s business sector doing better than we think?

After the previous post’s trawl through the household sector accounts, here we have a look at the non-financial corporate sector in the Q4 Institutional Sector Accounts released last week.  Of course, whatever caveats there are about revisions are even more pronounced for the NFC sector but there is likely to be value in the data, particularly if we can gain some insight into what is happening in the domestic business sector (by assuming that revisions are more likely from the MNC side). 

First, the current account:

NFC Sector Current Account

We should immediately be drawn to the 21.3 per cent rise in Gross National Income in 2016.  Working through the numbers we can try to see what the source of this increase was.

It doesn’t appear to be increased output or profits.  Gross Domestic Product (i.e. value added) of the NFC sector grew by 3.8 per cent in 2016 and with COE paid growing by double that amount at 7.5 per cent there was “only” a 2.2 per cent rise in Gross Operating Surplus (akin to EBITDA).

So if profits are up two per cent how is Gross National Income of the NFC sector up more than 20 per cent?  It may be down to who is earning those profits.  It is a well-worn path but we know that the net profits of foreign-MNC subsidiaries operating in Ireland are rightly attributed to their foreign parents.  This can be explicitly through the payment of dividends or implicitly through the attribution of any retained earnings to the foreign parent.  The split doesn’t really matter.  Their sum gives us an indication of net MNC profits earned in Ireland.

In 2015, dividends paid and retained earnings owed by the NFC sector summed to €57.7 billion.  For 2016, it is estimated that these summed to €49.9 billion, a drop of almost €8 billion.  So while NFC profits may have increased by €3 billion it appears that the performance of domestic companies was much stronger as MNC profits appear to have fallen by €8 billion.

Increased profits and reduced factor outflows explain most of the increase in GNI (accounting for €11 billion of the €14 billion increase).  The remainder is explained by increased factor inflows. 

It can be seen that retained earnings owed to Irish-resident NFCs grew by more than 40 per cent in 2016, a rise of nearly €4 billion.  Although these could be the foreign-source profits of Irish MNCs most of the changes in the item have recently being driven by the foreign profits of companies which have redomiciled their headquarters to Ireland.  It is clear that these companies had a good 2016 but these profits bring no benefit to Ireland.

And we have one further caveat to explore before coming down strong that the performance of domestic companies was strong in 2016: depreciation.  The above table gives gross measures.  It will be the case that some of this gross income will be absorbed by depreciation.  If there has been an increase in the amount of depreciation attributed to the Irish assets of foreign-owned companies then the changes in gross income will not be reflective of changes in domestic businesses.  We can try and get some insight from this in the capital account.

NFC Sector Capital Account

There is a good bit going on but our focus is on “consumption of fixed capital”.  We can see that this was relatively stable in 2016, showing growth of just 1.9 per cent.  This is in marked contrast to what happened in 2015 as shown below.

NFC Depreciation

The dramatic rise in depreciation is obviously related to mobile assets.  The two candidates are aircraft and intangibles.  The scale of the increase in the capital stock means intangibles are the culprit.  This is the onshoring of intangibles by MNCs.  A transaction involving c.€24 billion of intangibles occurred in Q4 2016 (as reflected in the quarterly national accounts described here) but the impact this had on depreciation was small relative to the hundreds of billions of intangibles that were on-shored in early 2015.

The acquisition of these assets will enable the companies to avail of capital allowances to offset the capital expenditure incurred against their trading profits.  Although the Revenue Commissioners have not yet published the aggregate Corporation Tax statistics for 2015 we can expect that they will show an increase in the capital allowances used by companies of something approaching €30 billion.

In 2015, the Gross Operating Surplus of the NFC sector increased by €53 billion.  The amount of Corporation Tax paid by the NFC sector increased by €1.8 billion.  This suggests an increase in Taxable Income of around €20 billion.  The reason a large part of the increased Gross Trading Profits did not translate into Net Taxable Income was because of the use of Capital Allowances.  If Capital Allowances were not available then one could surmise that CT receipts would have been around €2.5 billion higher again.  However, if the Capital Allowances were not available then the IP would not have come here in the first place.

And it is also because of Capital Allowances that the distinction between gross and net profits in the NFC sector is important and why we have to be careful about drawing implications about the domestic sector from gross measures.

Still, the three pieces of evidence we have point us in the direction of a strong performance of domestic enterprises in 2016:

  • the sum of outbound dividends paid and retained earnings fell by €8 billion;
  • depreciation was relatively stable  increasing by just €1 billion;
  • retained earnings of re-domiciled PLCs accounted for a little over a quarter of the rise in Gross National Income

It is these muddying features it is hoped that the proposed GNI* will throw some transparency on to allow us to see what is happening the domestic economy.  As we said before:

In rough terms GNI* will be the standard “GDP less net factor income from abroad” to get to GNP with the (positive) balance of EU taxes and subsidies used to get to GNI.  After that, additional adjustments will be made for the depreciation of intangibles that MNCs have located here and the net income earned by redomiciled PLCs.  With these adjustments we should get a better measure of aggregate income developments for Irish residents.

When the Q4 QNAs were released we suggested that:

It’s little more than a guess but, assuming some fall in MNC profits last year, a growth rate in 2016 for GNI* of somewhere around 6 to 7 per cent may not be too wide of the mark.

There was nothing in the institutional sector accounts to contradict that conclusion.  As shown here the evidence supports it.

Aggregate improvement in the household sector continues

The publication last week of the Q4 Institutional Sector Non-Financial Accounts gives us a preliminary view of the various sectors of the economy in 2016.   The figures are subject to revision but can still offer some useful insights.  We’ll start here with a look at the current, capital and financial account of the household sector. First the current account.  Click to enlarge.

Household Sector Current Accounts 2007-2016

The headline is towards the bottom and shows that (nominal) gross disposable income is estimated to have grown by 4.5 per cent in 2016.  With consumption expenditure growing at a slower 3.5 per cent this means the saving rate increased in 2016 – which it did from 11.0 per cent in 2015 to 11.8 per cent in 2016.

The path to this 4.5 per cent increase in gross disposable income shows a few interesting developments.  Compensation of employees from the non-financial corporate sector continued its strong recent performance in 2016 growing by 7.5 per cent and is now up a remarkable 31 per cent from the level recorded in 2011.  Although it is the smallest source of compensation of employees the fastest growth in COE was actually from the household sector itself (through unincorporated entities).

Employee Compensation Paid

Compensation of employees from the corporate sector (financial plus non-financial) is now eight per cent greater, in nominal terms, than the local maximum recorded at the end of 2007.   Most of this is due to the NFC sector as shown in the first table from which COE paid in Q4 2016 was up ten per cent on it end-2007 peak.  Here is compensation of employees received by the household sector since the series began in 1999.

Compensation of Employees Received since 1999

This increase in COE is reflected in higher taxes on income and social contributions paid by the household sector. Taxes on income paid by the household sector rose 3.4 per cent and social contributions paid to the government sector rose 7.8 per cent.   So working through these gives the 4.5 per cent increase in gross disposable income.

Another notable feature of the data, as pointed out above, is that disposable income is rising faster than consumption expenditure.  Here are the seasonally adjusted series provided by the CSO.

Income and Consumption - Seasonally Adjusted

The widening gap between income and consumption in 2016 is evident.  A couple of asides on the chart:

  1. Looking at the chart would appear to suggest as though the growth of consumption in 2016 was close to nil.  In fact the Q4 number is actually slightly below the Q1 number.  However, that does not mean the annual growth figure for consumption was close to zero.  We have already seen that consumption expenditure grew by 3.5 per cent in 2016 and the seasonally adjusted figures in the chart above correspond with that.  The growth is as a result of the “carryover effect”.  Consumption might have been flat in 2016 but because there was growth in 2015, the quarterly levels in 2016 were above those from 2015.  The fact that consumption ended 2015 higher than it began the year causes a “carryover effect” for growth in 2016 which will give an annual growth rate even if there is little quarter-on-quarter growth from that level in 2016.
  2. The measure of income in the chart is Total Disposable Income.  This is Gross Disposable Income plus the adjustment for pension funds.  This adjustment adds back in a deduction which is counted as a social contribution but is actually a form of savings, i.e. contributions to pension funds.  This money is being put aside to fund consumption in the future.  The adjustment for pension funds is the difference between social contributions paid to the financial sector and social benefits received from the household sector.  For example, in 2016 the household sector paid €5,538 million of social contributions to the financial sector.  The household sector received €2,980 million of social benefits from the financial sector.  The adjustment for pension funds at the bottom of the table of €2,558 million is the difference between these two numbers.

The widening gap between income and consumption means the savings rate has increased.  The savings rate is the gap as a percentage of Total Disposable Income.

Savings Rate - Seasonally Adjusted

What are people doing with these savings?  To answer that we need to look at the capital and financial accounts.

First, it could be that people are using the savings to fund investment expenditure.  We can look for evidence of this in the capital account.  As would be expected the 2016 capital account for the household sector is hugely different to its 2007 equivalent.

Household Sector Capital Accounts  2007-2016

In 2007, the household sector has gross savings of €6.3 billion and undertook €23.2 billion of gross capital formation.  Thus to fund consumption and investment expenditure the household sector was a net borrower in 2007 to the tune of €16.9 billion (overall borrowing was growing much faster but that was due to transactions – buying existing houses off each other). 

A decade later and the household sector has gross savings of €11.7 billion but only undertakes €8.6 billion of gross capital formation.  Capital spending by the household sector is rising (and grew 16.5 per cent in 2016) but remains below the level of gross savings.  Thus the household sector is a net lender, and this was at a level of €3.4 billion in 2016.

Net Lending-Borrowing

We can see how this borrowing in 2007 was funded and get some insight into where the  lending of recent years is going by looking at the financial account – and in particular the transactions of the financial account.  The 2016 update won’t be published until later in the year but we can see the general trends in the changes to 2015.  Of course, these are net figures with lots of underlying movements.  The household sector isn’t a homogenous group.  Some people are borrowing to fund expenditure now, others are saving to fund expenditure in the future and others are saving to repay previous while others may be buying or selling financial assets.

Household Sector Financial Transaction Accounts 2007-2016

The most significant change is predictably enough for transactions relating to loan liabilities.  Back in 2007 loan transactions increased household indebtedness by nearly €25 billion (drawdowns far exceeded repayments) while for the past few years loan transactions have reduced household indebtedness by between €5 billion and €9 billion (repayments have exceeded drawdowns).  We can expect this to have continued in 2016.

On the asset side there has generally been an increase in deposits while transactions with insurance and pension reserves have seen a steady inflow of funds.  The pension component of these transactions corresponds to the “adjustment for pension funds” seen in the current account, i.e. the difference between contributions to, and drawdowns from, certain private pensions.  The transactions account also shows that the household sector is generally a seller of equity with the bulk of this made up of unlisted shares (private companies).

Here is the turnaround in financial transactions over the full period for which data is available.  Net financial transactions was negative up to 2008 and has been positive since then.

Financial Transactions

Transactions are only one factor that affects the balance sheet which will also reflect the impact of reclassifications and revaluations.  These are unlikely to significantly effect items like currency and deposits but can be a big factor behind changes in equity and pension reserves.

Household Sector Financial Balance Sheets 2007-2016

The net financial wealth of the household sector almost doubled between 2007 and 2015.  This was due to three factors:

  • €18.3 billion increase in Currency/Deposits (€18.2 billion of transactions)
  • €37.9 billion increase in Insurance/Pension Reserves (€22.9 billion of transactions)
  • €44.7 billion reduction in Loan Liabilities (€35.7 billion of transactions)

Of the €101 billion improvement in these items €77 billion was due to transactions. Reclassifications and revaluations had little impact on the change in Currency and Deposits.  The increase in Insurance and Pension Reserves was €15 billion more than that explained by transactions while the reduction in loans was €9 billion greater than the reduction due to the transactions.  Pensions funds have benefitted from rising asset values and there has been some write-offs of household debt. 

The household sector’s financial balance sheet has been improving but around three-quarters of it has been the result of ongoing saving and debt reduction rather than revaluations.  The overall balance sheet will include real assets (such as property, land, valuables etc.) but they are not part of this data. 

Here are the aggregate financial assets and liabilities of the household sector since 2002.

Financial Balance Sheet

The gap between the two lines above represents household net financial wealth.  This passed €200 billion for the first time in 2015 and there is little doubt that this improvement is ongoing.

Net Financial Assets

If housing assets were included net wealth would still be below the level seen in 2007.  To conclude here is a measure of debt-to-income for the household sector.

Debt to Income