Follow the money to find answers

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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. 

17 Responses to “Follow the money to find answers”

  1. Brian Woods II Says:

    +1

    Your NPV of the benefits of the New Deal agree well with Seamus Coffey’s. I can see the figure of 4bn getting traction, Marion Finucane used it on RTE this morning.

    You say it surpassed your expectations. I thought it was looking fairly likely since last June that there would be a massive lengthening of the maturity profile. I think the concept of accelerated privatisation of the bond issues is clever but an unexpected twist.

  2. DOCM Says:

    I agree!

    One of the benefits of what may be called the “post mortem” debate – apart from confirming the old adage that success has many parents while failure is an orphan – is that it makes the domestic choices very clear, notably;

    “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.”

    David Begg clearly does not agree, openly advocating, if I understood him correctly, for applying for OMT – as recommended by the FT – but without mentioning that it comes with conditionality i.e. a secon bailout. There is merit in the case that too much austerity may be more damaging than too little. As far as I can assess the arguments, the proof of the pudding will be in the eating i.e. if the economy continues to pick up, it will be proof that the current mix is about right. If not, it may be back to the drawing board.

    The other thing that strikes me is how the outcome of the European Council has been completely swamped (as has been the fate of the ordinary staff of the IBRC) in a rather predictable but disappointing debate.

    The deal struck on the long-term budget for the period 2013-2020, apart from defusing a dangerous dispute with the UK and, indeed, giving Cameron considerable assistance in his major difficulties with the euro-sceptic wing of the Conservative party, is also clearly skewed in the direction of the countries in difficulty. Indeed, this is explicitly stated at several points in the conclusions setting out the agreement reached.

    http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/135344.pdf

    Spain and Italy have also been cut considerable slack on the revenue side. The sums involved have no real macro-economic significance but the agreement is a telling example of the ability of the institutions of the EU never to waste a good crisis.

  3. DOCM Says:

    Indeed, there is specific reference to the impact of the euro crisis on the Club Med + Ireland.

    “50. A number of Member States have been particularly affected by the economic crisis within the euro-area which has had a direct impact on their level of prosperity. To address this situation and in order to boost growth and job creation in these Member States, the Structural Funds will provide the following additional allocations: EUR 1.375 bn for the more developed
    regions of Greece, EUR 1.0 bln for Portugal, distributed as follows : EUR 450 million for more developed regions of which EUR 150 million for Madeira, EUR 75 million for transition region and EUR 475 million for the less developed regions, EUR 100 million for the Border, Midland and Western region of Ireland, EUR 1.824 bn for Spain, out of which EUR 500 million for Extremadura and EUR 1.5 bn for the less developed regions of Italy, out of which EUR 500 million for non-urban areas.”

    Having left the peloton, Ireland blew it through gross mis-management of its economy!

  4. grumpy Says:

    A few points.

    “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 looks much woollier than is being generally assumed. We don’t know the mood various EZ representatives are in about going along with this deal – or how that mood might be affected by tactics and negotiating positions used by other bank recapping states.

    If Irish gilts continue to trend tighter against the core and substantial gilt issuance resumes with lots of cover, why should accelerated sales by the Irish central bank be assumed to be ruled out on the grounds that “it would endanger financial stability”?

    “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. ”

    see:

    http://www.irisheconomy.ie/index.php/2010/11/04/government-plans-e6-billion-adjustment-in-2011/#comment-88983

    Has something changed in the last two and a bit years? ;-)

    “The extra deficit reduction would provide some insurance against missing the fiscal targets given the risk that growth disappoints.”

    Watch out, phrasing like that is likely to wind up people inclined to think you can’t see the trade-off against social safety net ‘insurance’.

  5. David O'Donnell Says:

    @John McHale

    I responded as follows to Philip Lane: and it applies here -

    A well reasoned piece based on the underlying assumption that the Promissory Notes should be honoured.

    I strongly disagree with this ‘assumption’.

    There exists not an angstrom of honour or justice in such a capitulation to the rapacious forces of the financial elite at the expense of the ordinary Irish Citizenry. Democracy has been turned on its head. It merely represents a short term amelioration of the terms (a lengthening of the chain) of our servitude to the Financial System. In acepting such a ‘deal’ we acknowledge our servitude.

    @Colm McCarthy

    A similar response to your piece in the Sunday Independent.

    However, you are the only one of three to raise the quickly forgotten issue of ‘legitimacy’ and I commend you for this.

    @all

    Non serviam. This in not a legitimate deal; this odious debt is not the responsibility of the Irish Citizenry. It is a crime.

  6. Brian Woods II Says:

    Laura Noonan (Reuters ex IT) made a good point on RTE. The government have used up a lot of political capital in Europe on this. This doesn’t bode well for the rest of a bank deal.

    In the first place there will be a reluctance by our EZ partners to cut us any more slack. In the second place, recognising this reality, the government will be wise not to make such a make or break issue of it with the electorate – the PNs very nearly backfired for the coalition.

    Electoral self preservation will dictate that they rest on their laurels and not make any more rods for their back.

    If this is a correct assessment then overall we will have got a very modest reprieve on our bank legacy.

  7. David O'Donnell Says:

    @Karl Whelan

    Any comment on the so-called PN “DEAL” other than removing the skeleton of Anglo-Irish from your blog page?

    http://karlwhelan.com/blog/?page_id=22

  8. John Maynard Keynes Says:

    Well done John on a good succinct article on the clear benefits of the promissory note deal.

    It’s great to see balanced analysis, and article the stands out pariculalry well set against David McWilliam’s bizarre and confused article on the opposite page. Suffice to say David focuses on the cloud and the not the silver lining. After a bit of ranting, his only clear message seems to be that Ireland’s growth prospects are poor, because productivity growth in services is weaker than manufacturing. Whatever about this argument, I don’t see why it has anything to do with assessing whether getting longer term cheap funding from the ECB is a good thing or not

    . Anyway……

  9. DOCM Says:

    @ Brian Woods II

    I also heard the comment and it, and your comment, make a lot of sense.

    I linked some time back to a major article in Die Welt dealing with the issue of excessive calls on the ESM which had the benefit of highlighting the fact that Irish taxpayers were fronting up the same amount to bailout banks as German taxpayers were in absolute terms. It is this reality which, I think, lies beneath the willingness of Merkel to repeat the reference to Ireland being a special case. That and the need to have a success story i.e. to put Ireland back in sight, at least, of the leading economies in the EU.

    I think that there is a strong likelihood of some relief being organised but certainly not at this juncture rather at the point when (i) the banking union outline is largely agreed and (ii) the EA has emerged from the current economic dip (if it emerges!).

    The point that you made elsewhere about the massive transfer of wealth that has occurred is, of course, also true and the quiescence in the reaction of the electorate is a form of delayed shock at having allowed it to happen which has blotted it from the collective conscience. That and the huge debts now held by the losers in an almost officially sanctioned property pyramid scheme.

    But the transfer of wealth was far from confined to this area and is still continuing – funded by borrowing – in the aptly named protected sectors.

    The temptation to summon up another “foreign devil” must be enormous. On the CPA Mark II, for example, I think I heard an ominous reference to the medium-term by the minister concerned.

    Another point which keeps coming to mind is the curious inability on the part of not only of Irish politicians but many commentators to recognise that other players also have political constraints. Weidmann, for example, seems to view his position as head of the Bundesbank as being, not just sole defender of the euro, but something from Wagner where everything is seen in absolute terms (the most recent example being his delaying of his agreement on Thursday).

  10. DOCM Says:

    @ All

    Next item on the agenda; Cyprus.

    http://www.spiegel.de/wirtschaft/soziales/ezb-direktor-asmussen-macht-bei-hilfen-fuer-zypern-druck-a-882510.html

  11. Brian Woods II Says:

    @ DOCM

    I have bad news for you. I have reduced your Wooden rating to 1.

  12. DOCM Says:

    @ BWII

    Duly noted! I was, in fact, a bit puzzled at my earlier rating.

    While Cyprus may appear a bit off-topic, considerable hope is being attached by the “as I predicted brigade” to it causing a major rumpus for their pet theories on the euro as it has become an issue in the German election campaign. The bluntness with which Asmussen intervened in Handelsblatt underlines his stature as a heavy hitter. (Google Translate will give you the gist).

    The view the leader of the SPD takes may be noted, including the conditions he sets for his party’s agreement (which Merkel now needs following the CDU defeat in Lower Saxony) to a bailout. Similar terms would, no doubt, be set for Ireland were a second bailout sought (a matter for “pixie heads” everywhere to consider).

  13. Dermot Says:

    ‘An important caveat is that the Central Bank is required to sell its holdings of government bonds according to a “minimum schedule”. ‘

    If the proceeds from the CB sales is not sufficient to fund the amount the CB originally advanced to Anglo, will the CB come back to the State looking for the shortfall?

  14. Dermot Says:

    ‘This will limit the profits that are returned by the Central Bank to the Exchequer

    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.’

    Just to clarify my question, if the CB sells the government bonds for less that it advanced to Anglo and that loss is recouped through lower profits being returned to the Exchequer then the PV saving referred to above is actually the best estimate of the amount that the CB has to recoup from the State in the future rather than the saving to the State that the promissory note deal provides. Or am I missing something?

  15. John McHale Says:

    @Dermot

    As the bonds carry a floating rate, the Central Bank should be protected against capital losses on the bonds. In the event that the Government defaulted on these bonds, they would be on the hook to recapitalise the Central Bank, so would have no incentive to do so.

    It is also worth noting that the ELA extened to IBRC had been circa 40 billion, more than the 25 billion in outstanding promissory notes. The Central Bank is therefore also receiving government guaranteed NAMA bonds. (They also received the 2025 bond that was used to settle last year’s payment.)

    It will be interesting to see how things develop with the sale of the remaining IBRC assets and the impact on NAMA. It is good that the option remains to transfer unsold assets to NAMA so as to avoid a firesale. But that will raise interesting issues relating to the valuation of those assets. The Government has committed to making up any shortfall in value so that NAMA does not suffer loses as a result of the overall transaction. (Note that NAMA’s liabilities have increased because of the NAMA bonds that have been transferred to the ECB.) At one level, these valuation exercises are not of first order importance, as they involve transactions between effective arms of the State. For example, if NAMA were forced to accept overvalued assets, this would limit the need for the Government to directly compensate NAMA for the loss, but would mean that NAMA with have a larger ultimate loss (or smaller profit).

  16. Frank Galton Says:

    Wolfgang Munchau says it is monetary financing.

  17. John Corcoran Says:

    Ireland–A Democracy or a Propertyocracy?

    In a democracy power comes from the ballot box. Politics is like war,there are three things you need to succeed. The first is money,the second is money and the third is money.
    The group who provide the vast bulk of money which finances Irish politics is ,the cowboy builders,the cowboy developers and the property interests. They own almost all Irish politicians. The payback for this financing is — a corrupt planning system,no residential rates,mortgage tax relief,first-time buyers grant, section 23/24 etc tax breaks, BES schemes,and feudal commercial property lease law i.e. upward-only rent reviews tied to long leases,which the sovereign signed up,on behalf of the taxpayers, and legitimised it for all commercial tenants.
    Many of this group are alumni of The Galway Tent School of Economics. The politicians look after themselves first-then the property interests. The public interest is irrelevant to the politicians.
    When Fine Gael and Labour did their u-turn on on their solemn promise to grant all commercial tenants in existing upward-only rent review leases ,a rent review in 2011 –they were merely being consistent–looking after the interests of their bagmen. Follow the money it always leads to Leinster house.

    Welcome to Europe’s only Propertyocracy,home of the greatest bank and property crash in the history of mankind.

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