Follow the money to find answers
This post was written by John McHale
I give my take on last week’s deal today in the Sunday Business Post. Cliff Taylor has kindly allowed an unedited version to be posted here.
After the drama of Wednesday’s late-night liquidation of IBRC, attention turned on Thursday to attempts to make sense of the deal on the promissory notes. To assess the merits of the deal, economists were looking for answers to four big questions: How would the deal affect the burden of the IBRC debt as measured by the present value of the state’s obligations? How would it affect the funding pressures on the state over the next decade? What would be the impact on the General Government deficit and thus on need for further austerity measures? And would the deal ease the precarious position of having to get ECB approval of Exceptional Liquidity Assistance every two weeks?
We must follow the money the money to answer these questions.
The challenge in unravelling the complex changes comes in part because there were two key relationships in the original structure. First, there was the relationship between the Exchequer and state-owned IBRC. The government provided IOUs in the form of promissory notes to fill the massive capital holes left by Anglo and INBS. These notes came with a high interest rate (8.2 percent from 2013). But the interest payments are essentially a transfer from one arm of the state to another and not directly important in evaluating the burden of the debt.
Second, there was the relationship between IBRC and the Central Bank of Ireland. The promissory notes were used as collateral for loans to IBRC from the Central Bank in the form of Exceptional Liquidity Assistance (ELA). Once everything is taken into account (including the transfer of Central Bank profits to the Exchequer), these loans come at a very low interest rate – effectively the ECB’s main refinancing rate, currently just 0.75 percent.
The relationship between the burden of a debt and the length of its maturity is a subtle one. If the ultimate interest rate on the debt is equal to the market interest rate used to discount future payment flows, then there is no advantage in present value terms to extending the maturity. However, if the interest rate is below the market rate, the present value – and thus the burden – falls with the length of the maturity.
A good analogy here is with a low-interest tracker mortgage. If the interest rate is well below the market rate, the holder gets a big advantage from a long maturity.
The challenge facing the negotiators was that the ultimate interest rate on the PN/ELA arrangements was very low – a fact not always appreciated in public discussion. The Irish negotiators sought to extend the maturity without compromising this low interest rate.
This has been achieved. The ultimate interest rate remains at the ECB’s main re-financing rate. On the other hand, the average maturity of the government bonds that replace the promissory notes is 34 years. This compares with an average maturity on the promissory notes of between 7 and 8 years.
An important caveat is that the Central Bank is required to sell its holdings of government bonds according to a “minimum schedule”. This will limit the profits that are returned by the Central Bank to the Exchequer. As revealed at Thursday’s Government press conference, the average Central Bank holding period of the government bonds is 15 years.
Therefore, in calculating the reduction in the burden, the appropriate comparison is between the 7- to 8-year average maturity under the old arrangements and the 15-year average holding period under the new arrangements. Assuming a 3 percent premium for the market interest rate over the ECB rate, the reduction in the present value should be between €4 and €4.5 billion.
Another useful way of thinking about the reduced burden is to calculate the equivalent write-down on the face value of the promissory notes that would yield the same present value as the new arrangements. Again assuming a 3 percent premium over the market interest rate, the equivalent write-down would have been between €5 and €5.5 billion.
But the benefits do not end there. A challenge facing the government is that it has large financing needs over the next decade. This is because a lot of debt will need to be rolled over, including big chunks of the loans from official lenders. The government will also have to finance its ongoing deficits.
Potential private investors tend to be scared off by such large financing needs, worrying that the government might not be able to raise the necessary funds to roll over the maturing debts and pay them back. These fears are compounded by perceptions of de facto seniority of official lenders.
The restructured arrangements reduce the financing needs of the government over the next decade by roughly €20 billion. This will underpin the improvement in the state’s creditworthiness already underway since mid-2011. In addition to the direct benefit of a reduced cost of borrowing, this improvement indicates reduced perceived risk of a state default. Such a default would send the crisis into a new, more vicious phase. Falling yields will also help reinforce confidence in the real economy, supporting a recovery in growth and jobs.
A further dimension is the impact of the deal on the General Government deficit. The complexity of the promissory notes arrangement rears its head again here. Although the high average interest rate on the promissory notes is not the relevant interest rate for evaluating the burden of this debt, general government accounting rules mean that this interest cost does add directly to the measured deficit.
Ireland is committed to bringing the General Government deficit to below 3 percent of GDP by 2015. Given current growth projections, meeting this target requires €5.1 billion of additional fiscal adjustments in 2014 and 2015. The deal is expected to reduce the interest costs in 2015 by roughly €1 billion. It follows that it should be possible to reduce the amount of planned expenditure cuts and tax rises by €1 billion and still be on track to meet the 3 percent target.
The government will face the difficult choice about whether to use the savings to reduce the planned austerity measures or to speed up the fiscal correction.
Much lip service has been paid to the importance of not pushing the burden of the crisis to future generations. The real way to limit this burden is to reduce the deficit and consequent build up of debt. Sticking with the current fiscal adjustment plan would mean that the deficit would be lower by a projected $1 billion in 2015 (or 0.6 percent of GDP). This would put the deficit to GDP ratio on a steeper downward path. The debt to GDP ratio should be falling at a rate of about 4.0 percentage points of GDP in 2015, compared to about 3.5 percentage points under current plans.
The extra deficit reduction would provide some insurance against missing the fiscal targets given the risk that growth disappoints. This would further increase confidence that Ireland will successfully exit the crisis, supporting an emerging virtuous cycle.
The Irish Fiscal Advisory Council has previously recommended that the government aim at additional fiscal adjustments of €1.9 billon beyond current plans out to 2015 to provide a margin of safety given the growth uncertainties. The interest rate savings would provide roughly half of this margin, possibly limiting the need for additional austerity measures.
A troubling feature of the old arrangements was that the Governing Council of the ECB had to approve the extension of ELA every two weeks. While there a reasonable expectation that this extension would be granted, it was a source of vulnerability for the state – and a source of significant unease for the Central Bank of Ireland. The new arrangements are more secure.
While the ECB has reserved the right to demand the Central Bank sell off its holdings of government bonds more quickly than under the current schedule, this would only be done if it did not endanger financial stability. This troubling source of vulnerability has thus been greatly reduced.
Overall, a fair assessment is that the deal has provided significant net benefits to Ireland. From the ECB side, it improves the chances of a successful demonstration of the effectiveness of European crisis-resolution policies and also gives them marketable collateral for eurosystem loans. The negotiation strategy of emphasising common interest worked. The result has exceeded the expectations of at least this economist.
John McHale is Professor of Economics at NUI Galway and Chair of the Irish Fiscal Advisory Council. He is writing here in a personal capacity.