Monday, November 18, 2019

The exploding balance sheet of the Irish-owned non-financial corporate sector

The previous post looked at the current and capital accounts of the domestic non-financial corporate (NFC) sector and painted a positive picture of rising output, employee compensation, profits, corporation tax, investment and savings. 

Here we look at the financial balance sheet of the Irish-owned NFCs (excluding redomiciled PLCs) from table 2.9 of the release.  Before getting to the detail here is a summary chart.

Domestic NFC ISA Financial Balance Sheet 2012-2018 Chart

The data go back to 2012, and though there has been some volatility in between, the bottom line, financial net worth, is pretty much the same in 2018 as it was in 2012.  The financial net worth of the sector was –€108 billion in 2012 and was –€104 billion in 2018.  To get overall net worth we would need the value of non-financial assets such as fixed capital and land which is not provided but there is value in looking just at the financial balance sheet.

Although, the bottom line is essentially unchanged the size of the balance sheet of the Irish-0wned NFC sector has exploded in the last six years – and particularly in 2015 and 2016.  For example, total financial assets increased from €167 billion in 2012 to €428 billion in 2018.  This is equivalent to increase from 132 per cent of GNI* in 2012 to 217 per cent of GNI* in 2018.

So, lets see what the detail shows (click to enlarge):

Domestic NFC ISA Financial Balance Sheet 2012-2018

Unfortunately, there are some categories where suppressed values means we can’t complete the above table.  All values are included in the balance sheet for the overall NFC sector so we can see roughly where the residual amounts would show.

For financial assets, we can see actually where most of the increase arose: loans and equity.  Loan assets rose from €54 billion to €121 billion and equity assets rose from €56 billion to €177 billion.  There was also an increase in ‘other accounts receivable’ from €39 billion to €99 billion.  These increases account for almost all of the €260 billion increase and again it should be noted that they took place in just six years, with €170 billion of the increase accounted for by 2015 and 2016 alone.

On the liability side the increase is from €275 billion in 2012 to €532 billion last year.  The available figures show some increase in loan liabilities but most of the increase is accounted or by equity liabilities.  There was also about a €60 billion increase in financial liabilities accounted for by the suppressed categories with most of this due to ‘other accounts payable’. 

For this, note that for overall NFC sector (Irish-owned, foreign-owned and redomiciled PLCs), the amount of debt securities rose from €10 billion to €18 billion while there are relatively minor overall amounts in the other suppressed category above: financial derivatives and employee stock options.

It’s well and good going through the increases by category but the overall increase is immense.  Usually, we can point to the activities of US MNCs when trying to pick through the distortions in Ireland’s national accounts but the above shows that Irish-owned firms might be throwing a distortion or two of their own into the mix.

The Irish economy has been performing well in recent years but nothing that would seem to justify a quarter of a trillion expansion in the financial balance sheet of the Irish-owned non-financial corporate sector.  The concurrent rise in financial assets and liabilities could point to circular transactions of some kind. 

However, at this stage, it is hard to tell what impact this expansion of the financial balance sheet has had on output, income and other flows in the national accounts.  That is likely where the real story lies.

Friday, November 15, 2019

The Domestic Non-Financial Corporate Sector in the Institutional Sector Accounts

The release by the Central Statistics Office of the 2018 Institutional Sector Accounts saw their work in helping users overcome the impact of globalisation in Ireland’s national accounts.  In this year’s release, the non-financial corporate sector was subdivided into “foreign-owned” and “domestic” sub-sectors with figures provided back to 2013.

In general terms, sub-dividing the NFC sector is something that is set out in the European System of Accounts (ESA2010), and the CSO say:

Non-financial corporations are sub-divided into foreign-owned (S.11a), domestic (S.11b) and redomiciled (S.11c) in these accounts. [.]  The sub-sector S.11a corresponds to the ESA 2010 definition of sub-sector S.11003, foreign controlled non-financial corporations.

The ESA2010 manual gives the definition of foreign NFCs as:

Foreign controlled non-financial corporations (S.11003)

2.54 Definition: the foreign controlled non-financial corporations subsector consists of all non-financial corporations and quasi-corporations that are controlled by non-resident institutional units.

This subsector includes:

(a) all subsidiaries of non-resident corporations;

(b) all corporations controlled by a non-resident institutional unit that is not itself a corporation; for example, a corporation which is controlled by a foreign government. It includes corporations controlled by a group of non-resident units acting in concert;

(c) all branches or other unincorporated agencies of non-resident corporations or unincorporated producers which are notional resident units.

However, deviations from ESA2010 arise with the domestic sector due to the treatment of government-owned NFCs and the presence of the ‘headquarters’ of re-domiciled PLCs in Ireland:

Redomiciled PLCs and domestic NFCs are a part of sub-sector S.11002, national private non-financial corporations, however, following the treatment in the definition of modified GNI, Redomiciled PLCs are separated out in these accounts as S.11c. Government controlled non-financial corporations (S.11001) are included as part of S.11b.

Here we will focus on new domestic NFC sector.  First, the current account (click to enlarge):

Domestic NFC ISA Current Account 2013-2018

The current account takes us through production, generation of income, allocation and distribution of income and the use of disposable income (which for companies is just saving as they don’t engage in final consumption – they have intermediate consumption). So what do we see?

In the past five years, the output produced by the domestic NFC sector has increased by €26 billion (27 per cent).  Intermediate consumption (goods and services used in the production process excluding labour) has not increased in line with output so that the Gross Domestic Product (Gross Value Added) of the sector increased by €23.5 billion (54 per cent).

What we have seen though, is an increase in the pay bill of companies in the domestic NFC sector.  This has risen in line with output.  In 2013, these companies spent €28.0 billion compensating their employees; by 2018 this had risen to €40.4 billion, a rise of 44 per cent, with 2018 showing an increase of 6.4 per cent.

Labour costs did not consume all the additional value added and the Gross Operating Surplus for the sector rose €11 billion (76 per cent) in the past five years.  Over the five years, the labour share of value added for domestic NFCs fell from 64.8 per cent in 2013 to 60.5 per cent in 2018.

After Gross Operating Surplus, we get different allocations due to property income such as interest, dividends and retained earnings.  In line with the increased profits the dividends distributed by these firms has increased.  They distributed €1.5 billion in 2013 with this increasing to €2.7 billion by 2018.  These distributions are relatively small compared to the overall Gross Operating Surplus generated meaning most profits are not distributed to other sectors.  The use of the non-distributed profits will be shown in the capital account.

However, in the allocation of income account the most significant change is the increase, on the resource side, in the retained earnings of direct foreign investment.  This is the profit earned by foreign-subsidiaries of companies in Ireland’s domestic NFC sector that are retained in the country in which they are earned rather than being transferred as a dividend to the parent in Ireland.  Such retained earnings have increased from €0.9 billion in 2013 to €3.4 billion in 2018, a near 300 per cent increase.  Whoever these companies are their foreign subsidiaries seem to be doing pretty well. [There are likely to be genuine reasons underpinning some part of this success but one might wonder whether there is a tax story related to it as well.]

Adding and subtracting the above property income from Gross Operating Surplus gets us to Gross National Income. This has increased from €11.6 billion to €25.4 billion in the past five years, with the increase (€13.7 billion) slightly outstripping the increase in Gross Operating Surplus.

The increased profits has led to an increase in the Corporation Tax paid by these companies from €0.7 billion in 2013 to €1.7 billion in 2018 which shows that some of the recent surge in Corporation Tax has come from companies in the domestic NFC sector.

We can get a measure of the effective tax rate on these companies by looking at Net Operating Surplus.  This is Gross Operating Surplus less the consumption of fixed capital (i.e. depreciation, which is shown in the capital account below).  The national accounts measure of Net Operating Surplus is akin to the accounting concept of EBITDA (earnings before interest tax depreciation and amortisation).

Over the five years, the effective rate on NOS averaged 8.2 per cent and exhibited a slight upward trend over the period going from 7.2 per cent in 2013 to 8.7 per cent in 2018. This could be linked to the exhaustion of losses generated during the crash for use against future profits.

After current transfers (mainly linked to insurance premiums and claims) we get to Gross Disposable Income and as firms don’t have final consumption this is equivalent to Gross Savings.  As shown, this increased from €10.2 billion in 2013 to €23.5 billion last year. 

We now turn to the capital account to see how those gross savings were used. Again click to enlarge.

Domestic NFC ISA Capital Account 2013-2018

The main use of the Gross Savings (arising from the increased Gross Operating Surplus) shown in the current account is capital formation.  The Gross Fixed Capital Formation of companies in the domestic NFC sector has increased from €7.8 billion in 2013 to €15.4 billion in 2018.  In five years, the sector has essentially doubled its level of fixed capital investment. 

The companies have also been increasing their inventories.  In 2013, inventories in the sector reduced by €350 million while in the four years since inventories were increased by an average of €1.4 billion per annum.

The investment rate (capital formation as a share of gross operating surplus) averaged 60 per cent across the five years and has shown a generally rising trend from 50 per cent in 2013 to 63 per cent in 2018.

After consumption of existing fixed capital (i.e. depreciation) is accounted for from this investment, Net Capital Formation increased from €3.9 billion in 2013 to €8.5 billion in 2018.  In aggregate terms, the domestic NFC sector is reinvesting a large share of the additional profits being made and this is replacing existing capital, adding new capital and increasing inventories.  Of course, we cannot know that the individual companies undertaking the investment are the ones generating the profits but this is what we see in am aggregate sense.

However, it should also be noted that the additional investment is less than the surpluses being generated and the bottom line shows that the domestic NFC sector is a net lender, and this is increasing.  Per the OECD:

Net lending/borrowing reflects the amount of financial assets that are available for lending or needed for borrowing to finance all expenditures – consumption expenditure, gross capital formation and capital transfers – in excess of disposable income.  If it is positive it is described as net lending and if negative, as net borrowing.

So, the disposable income of the domestic NFC sector exceeds all expenditures.  In 2013, this was €3.6 billion and this had risen to €7.9 billion by 2018.  In part, this could be linked to the ongoing deleveraging of the Irish economy – with companies possibly using surpluses to pay down debts.  In due course, we might look at the financial accounts of the sector to see what insights that might through up.

For our purposes here the bottom line of the capital account, net lending, is far enough. And this links to the discussion in the previous post about the large surplus on the modified current account of the balance of payments recorded in 2018. In that post we said:

One reason to pause before we get excited with highfalutin plans to spend the surplus is that, in the latest figures at any rate, almost half of it arises from the non-financial corporate sector and we really don’t know what is going on there.  Given the scale of the gross amounts in this sector revisions to the figure could be significant.

Before the sector accounts it wasn’t clear where the NFC surplus was arising – with some concerns that maybe it was a residual from the adjustments necessary to go from the headline to the modified current account.  Now we know that this is not the case – a large source of the increase in the modified current account in recent years has been the domestic NFC sector, from which companies involved in the so-called “star” adjustments (GNI*, CA* etc.) are excluded.

And we also know one reason why the domestic NFC sector might be running an increasing net lending balance – the increase in the retained earnings of their foreign subsidiaries.  It may that the companies are investing these earnings abroad so they would not be available for investment or other spending in Ireland.  Or they could simply be held as a financial asset by the foreign subsidiaries and would be available for use if they were transferred as a dividend back to the parent companies here.

This retained earnings strand might be something for another day.  All-in-all these new figures on the domestic NFC sector paint a very positive story: all of output, value added, employee compensation, operating surplus, corporation tax, and investment have risen strongly in the last five years.  The domestic NFC sector has been a major contributor to Ireland’s recent growth.

Thursday, November 7, 2019

All sectors of the economy are now net lenders

Ireland’s economic history is one that has been pockmarked by concern for deficits that are too high or debts that might be unsustainable.  We have had numerous examples of both in the past fifteen years with large current account and public deficits and high debt levels across all sectors of the economy. 

While some concerns about debt levels remain, it now seems we are running unprecedented balance of payments current account surpluses as shown here in CSO data from 1970.

BoP Current Account 1970-2018

Data before 1970 would show persistent, and on occasion unsustainable, deficits.  The latest estimates from the CSO of the  the modified current account show it reaching 6.5 per cent of GNI* in 2018.  The patterns of Ireland’s current account from 1975 to 1990 and from 2005 to 2020 will not be dissimilar (see another lap for the Celtic Hare).  But this time the surpluses following the adjustment of living a way beyond our means are at a level not seen before.

EU15 BoP Current Account 2001-2018

In terms of the EU15, the turnaround in Ireland’s modified current account has seen us move from keeping company with Greece, Portugal and Spain in 2007 to near the levels of Denmark, Germany and the Netherlands in 2018.

We can try to get some insight into the underlying changes behind this transformation by looking at the net lending or borrowing from the institutional sector accounts.  Per the OECD:

Net lending/borrowing reflects the amount of financial assets that are available for lending or needed for borrowing to finance all expenditures – consumption expenditure, gross capital formation and capital transfers – in excess of disposable income.  If it is positive it is described as net lending and if negative, as net borrowing.

Due to internal and external distortions we have to do a small bit of cleaning up to get a view of the underlying changes.  The main internal distortion we will try to remove is the bank bailout, a large part of which was a capital transfer from the government to financial sector while the external figures are hugely distorted by the activities of MNCs and in particular the impact of IP onshoring and aircraft for leasing.  Something similar was done in section 7.3 of this recent paper from the Department of Finance.

So for the next chart it should be noted that:

^The impact of Other Capital Transfers (D.99) from general government to financial corporations are removed from both sectors;

* All the adjustment necessary to make the sectoral net lending figures consistent with the modified current account is applied to the non-financial corporate sector.  These adjustments mainly relate to R&D IP imports, aircraft for leasing and net acquisitions of non-produced, non-financial assets.

What we see is not going to surprise anyone. An unadjusted version is here.

Sectoral Net Lending and the Modified Current Account 2001-2018

Although the current account surpluses of mid-1990s had been eroded, up to 2004 the economy was in a position to fund the expansion in net borrowing by the household sector from domestic sources.  However, the continued increase in household borrowing meant this was not possible after 2004 and a significant balance of payments deficit opened up (this would have been funded through transactions which impacted the financial account of the balance of payments).

Household net borrowing as a ratio of GNI* peaked in 2006 by which time net borrowing by the non-financial corporate sector was growing (at least in the adjusted terms shown here).  The surplus that the government sector was running in 2006 could have partially funded this but fiscal policy led to this surplus vanishing in 2007 and the government sector ran a large deficit from 2008 as tax revenues evaporated and social transfer spending rose.

By 2009, the household sector was a significant net lender with these funds mainly used to reduce debts – a position it remains in a decade later.  2009 also saw the underlying deficit for the government sector reach its highest level during the crisis when it was just over 14 per cent of GNI*.  Over the next decade this deficit was gradually reduced and was finally eliminated in 2018.

Indeed, 2018 was the first year when all sectors of the economy were net lenders (% GNI*):

  • Households (2.2%)
  • Government (0.0%)
  • Financial Corporates (1.7%)
  • Non-Financial Corporates (adjusted) (3.1%)

One reason to pause before we get excited with highfalutin plans to spend the surplus is that, in the latest figures at any rate, almost half of it arises from the non-financial corporate sector and we really don’t know what is going on there.  Given the scale of the gross amounts in this sector revisions to the figure could be significant.

There is also the concern due to the impact Ireland’s booming Corporation Tax receipts are having on the government’s position and on the current account. Further, the extent to which the IFSC impacts the net lending of the financial sector is unclear.  That only leaves the household sector without a question mark.

The Department of Finance paper also urges caution with an expectation that increased investment by the household and government sectors will reduce the current account surplus:

The net lending position of the household and government sectors is likely to deteriorate in the coming years, however, due to the expected increase in investment in these sectors (that is unlikely to be fully offset by an increase in savings in these sectors). This will require monitoring as it could result in a deterioration of the current account balance.

This may be downplaying the risks of increased current or consumption expenditure being a source of the possible deterioration.  On the other hand, though, there may be sufficient income growth for the economy to absorb the impact of increased consumption and investment spending on net lending as has been the case in recent years.

One of the remarkable features of the Irish economy has been that recent growth has been so strong even as the government has been reducing its deficit and the household sector has been reducing its debts.  Our conclusion from April is probably still valid:

Eventually the deleveraging will stop.  Whether that leads to an increase in consumption or investment is hard to tell.  The vulnerable position of the government sector probably means that some caution in the household sector is warranted but whether this caution will persist remains to be seen.