More on the Interest Rate Question

It is obviously true that a lower interest rate on the EU loans to Ireland would help debt sustainability. As written by Karl and highlighted in the FT today:

The overall cost of funding from the EU sources appears likely to be over 6% per year. If this is the rate that the Irish state will be paying in coming years, the national debt will grow by 6% each year even if the state is running a zero primary deficit (the headline deficit minus interest payments.) This would require a 6% growth rate in nominal GDP to stabilise our debt-GDP ratio even when we are not running a primary deficit. In other words, an interest rate of 6% will make debt stabilisation far more difficult in the coming years than an interest rate that doesn’t carry a large profit or risk margin.

This is an important point to make and is a standard way to illustrate the impact of the interest rate on debt sustainability.

However, for the 2011-2015 period, it is important to appreciate that the impact of a lower interest rate on this source of funds would be limited:

  • There is a lot of Irish government debt outstanding, much of it funded at substantially lower interest rates.  There is about €81 billion outstanding, maturing at various dates between 2011 and 2025 (see the interest rates and maturity dates at the NTMA website).
  • Also, there is short-term debt outstanding and John Fitzgerald has pointed out that the NTMA could do more short-term debt financing under the ‘umbrella’ of the EU/IMF deal
  • A substantial amount of the new borrowing needs of the Irish sovereign will be met by drawing down cash balances and the assets of the NPRF

Putting these factors together means that the projected average interest rate on Irish sovereign debt over 2011-2015 will be 3.9%, 4.0%, 5.3%, 5.3%, 5.4%  (according to the IMF’s December 2010 Ireland report) so that the near-term impact of shifts in the marginal cost of funds from the EU will be limited. (Still nice to have a lower rate, however!)

In addition, Karl’s illustrative example focuses on a zero primary deficit.  The IMF projections are that Ireland will run primary surpluses of 1.2% in 2014 and 1.5% in 2015 – of course, this assumes that the fiscal plan is implemented and that nominal output growth meets the IMF’s projections. A different way to express the same point is that, for a given path for nominal GDP growth, the higher the average interest rate, the higher the primary surplus that will be required to stabilise or reduce the debt/GDP ratio.

20 thoughts on “More on the Interest Rate Question”

  1. George Soros was just interviewed on Bloomberg in Davos – and he mentioned the Irish situation a lot – he also said the new goverment will seek to renegotiate interest rates and in the tangential cryptic way of his mentioned the expansion of the Euro balance sheet to incorporate short term deposits rather then Goverment debt as mentioned by Buiter………… something big is coming

  2. @Philip Lane & Karl

    “This would require a 6% growth rate in nominal GDP to stabilise our debt-GDP ratio even when we are not running a primary deficit. In other words, an interest rate of 6% will make debt stabilisation far more difficult in the coming years than an interest rate that doesn’t carry a large profit or risk margin.”

    Doesn’t this assume that the debt/GDP ratio stabilize around 100%.
    If the debt/GDP ratio is 120% then doesn’t the required 6% nominal growth become 6% X 120% = 7.2%?

  3. Having brilliantly demolished the 6% interest rate claim, perhaps Philip Lane might also take account of soaring inflation across the globe to get an estimate of the real interest rate. EU inflation is now up to 2.6% and rising. UK inflation is now up to 3.7% and rising. The Governor of the Bank of England predicts that UK inflation will hit 5% this year. Those, both in Ireland and abroad, who predicted years of global deflation ahead, are being made to look fools. Commodity prices are soaring. Shortages loom. Figures out this morning show agricultural output prices in Ireland were up 12.8% in November 2010 over November 2009. The era of deflation is over. We are now going into an era of moderately high inflation. On Philip Lane’s figures, the average interest rate Ireland will pay up to 2015 is 4.8%. Yet, at a minimum, inflation in developed countries is likely to average 2.5% up to 2015, quite possibly higher. I wouldn’t be the least surprised if it averages 3% to 4% in that period. Against that background, an average 4.8% interest rate (Philip Lane’s figure) between 2011 and 2015 doesn’t look that onerous (although, naturally, if anyone can get a lower one, good luck to them).

    Higher global inflation is allready affecting Ireland’s GDP deflator and nominal GDP. Between Q4 2009 and Q3 2010, Ireland’s real GDP increased by 1.7%, but nominal GDP rose by 4.2%. That is for three quarters. They annualise to 2.2% and 5.6% respectively. The IMF target (that Philip Lane referred to) for Ireland’s nominal GDP in 2010 was 157.2bn. Yet, ESRI last week revised up their estimate for Ireland’s GDP in 2010 to 159bn, mostly due to higher global inflation and its effect on Ireland’s GDP deflator (although they also revised up their estimate for Ireland’s real GDP growth in 2010 as well).

  4. Keep it simple folks. We have been furnished with access to €45 bill from the Europeans. A 1% cut in the rate relieves €450 mill per annum. The planned deficit for 2011 is c. €19 bill…….

  5. @John the optimist
    I presume the figures you use are CPI like figures that closely match commodity and service inflation that most people feel as real to their day to day lives – but I get the impression that you think that is a good thing (correct me if I am wrong)
    Now that the bankers are directing housing asset inflation into basic living inflation so that they can again profit from peoples misery isn’t it best to redirect these vast central bank fuelled commodity chasing funds into something inert and useless for the day to day struggle of life ?

    Ps – did you at one time serve at the heels of the great maestro of the Fed perhaps in a previous life ?

  6. “Having brilliantly demolished the 6% interest rate claim”

    Here we go again — let’s make up something I never “claimed” so that one can then characterise perfectly civil and informative discussions as actually being a dramatic fight of good versus evil.

    Yawn.

  7. Talk of interest rate reductions etc is all a bit academic. No pun intended.
    Its a little like saying that the donkey’s load won’t be as heavy as it was going to be. The problem is the load is far too big for the donkey at present.
    The funny thing is that when a horse or a donkey knows that the load is too big after the first pull, he generally won’t attempt it a second time. It is a great pity that our leaders don’t display the inate sense of intelligence of donkeys. There is however a good reason for this. They are not the ones pulling the load.

  8. @Keith Cunneen

    But I get the impression that you think that is a good thing (correct me if I am wrong).

    JTO again:

    Yes, I think moderate inflation (under 4%) is a good thing. High inflation, such as we had in the 70s and 80s, when it was 10% to 20%, is a bad thing. Negative inflation is a bad thing. The ideal is lowish positive inflation of around 2%, 3%, 4%. During periods when there has been high economic growth going on for a long time (eg 1960s, 1990s), inflation has been around that level. Above 4%, things starts to get a bit dicey. The ideal for Ireland over the next few years would be inflation of around 2%, combined with around 3% in the Eurozone, and around 4% to 5% in the UK. I don’t know if that is what will occur, but it is starting to look plausible.

    @Karl Whelan

    Here we go again — let’s make up something I never “claimed” so that one can then characterise perfectly civil and informative discussions as actually being a dramatic fight of good versus evil.

    Yawn.

    JTO again:

    I never mentioned you or referred to ‘good’ or ‘evil’. I devoted less than one line of a twenty-five line post to congratulating Philip Lane on showing that the average interest rate Ireland will pay up to 2015 is about 4.8% and not 6%. However, that was simply an aside and not my main point. My main points were: (a) global inflation is rising sharply and that this should be taken into account in assessing how onerous is any particular interest rate and (b) this rising inflation is leading to upward revision of the estimates for Ireland’s nominal GDP (as evidenced by the ESRI forecast last week). Both these points are totally valid and highly relevant.

  9. But inflation
    1: Causes the ECB to raise its rates which
    2: Increases the number of mortgage defaults which
    3: Increases the money needed by the banks

  10. @D_E

    Doesn’t this assume that the debt/GDP ratio stabilize around 100%. If the debt/GDP ratio is 120% then doesn’t the required 6% nominal growth become 6% X 120% = 7.2%?

    Yes there’s a multiplier which will in practice be greater than 1. The IMF estimate this to peak at 1.25 (i.e. debt/GDP ratio of 125%) in 2013. The equation is

    π = λ(r – g)

    where λ is the debt/GDP ratio; r the interest rate; g the nominal growth rate; π the primary surplus/GDP ratio.

  11. @John the optimist.
    I don’t no which store you shop in but lower prices suit me fine.
    If a society develops in a technological manner the prices of everything drops as people have more time and energy tokens to play with.

    You need to divorce yourself from fraudulent banks that need “growth” inflation to extract income from the rest of us – without this they die financially.
    The pursuit of growth in this present financial system progressively reduces wealth – reject the demons John.
    Embrace deflation and kill the banks.

  12. @Keith Cunneen

    If a society develops in a technological manner the prices of everything drops as people have more time and energy tokens to play with.

    Embrace deflation and kill the banks.

    JTO again:

    I think you’ll find that, since the end of serfdom, periods of inflation have greatly outnumbered periods of deflation, probably by close to one hundred to one. This is true for all developed countries. A pint of Guinness was one old pence in 1790. It cost ten old pence to go to the All-Ireland Final in 1911. You could buy Wayne Rooney in 1905 for about one thousand quid. A cinema ticket in the 1950s cost twenty old pence. Deflation is an aberration. Inflation is the norm. Ireland is virtually the only country in the developed world which still has negative annual inflation. So, by your logic, is Ireland now the only country ‘developing in a technological manner’? Enjoy deflation while it lasts, as it is about to end even in Ireland, and most of us will never live to see it again. In the words of the rousing Wolfe Tones ballad, it will soon be ‘Inflation Once Again’. The question is: how much inflation? Globally, I think it is more likely to average somewhere around 3%, rather than 2%, in the next few years. In the UK, according to the Governor of the Bank of England, inflation is currently heading for 5%. To repeat my earlier point, the resurgence of inflation needs to be taken into account when assessing how onerous is the interest rate the IMF is charging.

  13. “John Fitzgerald has pointed out that the NTMA could do more short-term debt financing under the ‘umbrella’ of the EU/IMF deal”

    On this issue, I’d note that the NTMA did not roll over the €1.85 billion in T-bills that matured in January. (Details here
    http://www.irisheconomy.ie/index.php/2011/01/19/for-how-long-does-eu-imf-financing-fund-the-state/)

    Perhaps this will change in the coming months, but as of now I’d be cautious about assuming that this is an option. Possibly one of the unpublished side-agreements of the EU-IMF deal is that we refrain from short-term debt financing.

  14. @JTO
    Obviously for my system to work currency has to be divorced from debt – otherwise things do really fall apart.
    I suspect the banks that control us will push this to the limit before they decide to recapitalise but in a declining oil world your monetory system is worse then useless – it is incorrect and will be catastrophic.

    A debt free currency or specie backed currency are the only options although I suspect the banks will further decapitalise the system until the pitchforks are at the door
    At a guess I would say less then 10 years.

  15. @JTO
    Obviously for my system to work currency has to be divorced from debt – otherwise things do really fall apart.
    I suspect the banks that control us will push this to the limit before they decide to recapitalise but in a declining oil world your monetory system is worse then useless – it is incorrect and will be catastrophic.

    A debt free currency or specie backed currency are the only options although I suspect the banks will further decapitalise the system until the pitchforks are at the door
    At a guess I would say less then 10 years.

  16. Separate comment related to the “thou shalt not post multiple links” rule.

    Greece also has an umbrella of multiple-year funding but it’s T-bills are not cheap

    http://www.reuters.com/article/idUSATH00587920110118

    “Greece on Tuesday sold 1.95 billion euros ($2.53 billion) of
    26-week T-bills at 4.9 percent”

    This is not cheap at all for this kind of funding. And it is more expensive than IMF funding even for a large long-term loan.

    So this shows that — for whatever reason — having a pile of international organisation money behind you doesn’t seem to translate into very cheap short-term financing.

    Megan Greene from EIU made this point last week in response to my January 19th post.

  17. If estimates of our sovereign debt interest rate range 4-6% over the next 4 years how come our banks/building societies can offer fixed rate loans for this period at <4%?

  18. @all

    IMF: Transcript of a Press Briefing on the 2011 Fiscal Monitor Update

    QUESTION: Two things, Mr. Cotarelli. First of all, you talked about the in general worldwide fiscal risks to do with the deficits that you outlined there. Could you elaborate on that little bit? Then a specific question on Ireland — as you I’m sure are aware, Ireland is taking on a significant amount of debt related to the banking collapse there. Is it the IMF’s view or is it your view that it is right and proper that the public should take on the debts of private banks and outside of Ireland do you think that there needs to be a system for resolving bank debt beyond that? Thank you.
    MR. COTTARELLI: On the fiscal risk, when we talk about fiscal risks, there are essentially two kinds of risk that we should monitor and have in mind. One is some forms of rollover problems across countries. You know that the first quarter of this year, a rollover is particularly high for advanced countries and this is mostly what we have on our mind. I think that from that perspective the fact that there has been some deceleration in the pace of fiscal adjustment in some important countries is something that makes it even more important that there is a clarification on how these countries intend to address their fiscal problems in the medium term.
    It is also important however to keep in mind that there is another risk– that is a risk of stabilizing the debt-to-GDP ratio at very high levels. I think that it is a concrete risk given how difficult it would be to bring down public debt. I think it should be avoided. This outcome should be avoided because we have pretty clear evidence that countries with high public debt are countries that grow less than other countries. We have seen in the last two decades Italy and Japan characterized by high public debt and low growth rates but there is more systematic evidence that this is a common feature.
    On your other question [Ireland], it is interesting. But I do not think one can answer this in general. I think that on a case-by-case basis one would have to see to what extent private-sector debt should be taken over by the public sector. What I have myself argued is that so far the level of debt that has been taken over by European countries is something that can be managed. Of course it is going to take time to bring down the debt-to-GDP ratio but it is something that over time can be lowered significantly through those fiscal policies, increasing revenues and reducing spending.

    http://www.imf.org/external/np/tr/2011/tr012711.htm

  19. McArdle in the Irish Times today:

    “Already, there is much debate about the interest rate on bailout funds. Generally speaking, the view taken is that an interest rate of close to 6 per cent is (a) penal and (b) unsustainable.

    However, this assumes that all government borrowings are at the 6 per cent rate whereas some, eg Post Office savings, are at lower rates. Also, no one has explained how the IMF concluded that our fiscal position was sustainable at the rates agreed in the bailout.

    In addition, many do not realise that IMF rates of 3 per cent equate to EU rates almost twice that. The reason is that the IMF rates are variable, like a tracker mortgage, whereas the EU rates are for seven and a half years and similar to a fixed mortgage rate.

    If, for example, we decided to fix half of our bailout borrowings and leave the rest floating or fixed for a shorter period, the average rate would fall to around 4¾ per cent, ie equivalent to what we paid in 2009 and 2010 when no one thought borrowing costs were unsustainable. We would, however, be exposed to rising interest rates.”

    Did Karl:s presentation not say that the EFSF/EFSM monies were subject to changes in interest rates? Yet McArdle says they are fixed?

    What about his general point about 4.75%?

  20. Just wanted to pipe in on this debate because it seems to me that, as long the Irish government continues to protect senior bank bondholders, a lower interest rate on the bail-out funds is still unlikely to return Ireland to solvency. The regular reports of Irish bank deposit flights, rising ELA lending and issuance of government-backed own-use uncovered bonds indicate that we have not seen the end of Irish bank losses, which will go onto the government’s books.

    Furthermore, a lower interest rate is likely to be offered only in exchange for a German-Franco “pact for competitiveness”, which would likely entail among other things a common corporate tax rate in the euro area. I expect any Irish government (regardless of its composition) would rather Ireland impose a haircut on its debt (short-term pain) than raise the corporate tax rate (long-term consequences for Irish growth).

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