Author: Colm McCarthy

I argue that the fiscal ‘compact’ will not turn the currency union into a full monetary union in this paper from a conference before Christmas;

http://www.ucd.ie/t4cms/WP12_02.pdf

and in another that Croatia, which voted to join the EU a couple of weeks back, should think carefully about joining the currency union as currently constituted:

http://www.ucd.ie/t4cms/WP12_03.pdf

It would be nice to get solemn acknowledgement all round that fiscal rectitude is a good thing. It would be even nicer if some political attention could focus on what kind of EMU 2.0 might actually work in the long term.

Official funding runs out at the end of 2013. Today’s manouvre by the NTMA has converted some two-year debt into three-year debt, at a cost. This is not ‘getting back in the market’ in any sense which confirms debt sustanability. No new debt has been issued. The ability to sell new three- or six-month T-bills is not relevant either.

Think about Belgium. The ten-year bond yields 4%, having been briefly higher during the panic. Belgium has a debt ratio about 100%, GGB deficit about 4% and primary deficit about 1%. Belgium is likely (not certain) to be OK and could probably sell 10-year paper in some size. The 4% interest rate is just about consistent with debt sustainability given 2% inflation and a little bit of economic growth.

Ireland’s exit debt ratio will be higher, there are contingent liabilities we all know about and a deficit down to 4% in 2014 would be doing rather well. Can Ireland expect to sell 10-year bonds, in size, in 2014, at 4% yields?

There is a 2025 bond in issue with a 5.4% coupon. It will be an 11-year bond in 2014. The curve should be flat in this zone. So if you think yields on mediums will be 4% in two years time, you can work out the target price for the 2025 bond in 2014. It is about 111.

The bond has recently been trading about 85. So if you think we will be back in the market in a meaningful sense in 2014, on terms as good as Belgium, you can pick up a nice 5.4% coupon twice, and a 30% capital gain, by taking a flutter.

Alternatively you can insist that Ireland can (sustainably) ‘get back in the market’, and stay there, in size, at higher yields. This is entirely conditional on economic growth resuming quickly and at decent rates. The debt sustainability analysis in the IMF staff report to the executive board should issue in a few weeks and will be a must-read.

The Memorandum of Understanding between the Irish government and the troika of EU, ECB and IMF was agreed in December 2010. It contained commitments to policy changes designed to improve competitiveness through acting on professional service costs, the structure of the energy sector and similar matters. Several commentators on this site have been arguing recently that the new government is delivering austerity without reform. Here’s an interesting recent article from the Economic Journal and an earlier version on open access if you cannot get into the ucd online library.

Guglielmo Barone and Federico Cingano conclude that OECD countries which have gone furthest in tackling anti-competitive practices have enjoyed enhanced performance in industry sectors which are consumers of the products and services of the formerly rent-absorbing firms and professions.

Their conclusions are supportive of the MoU reform agenda, and of the recommendations in the report of the State Assets Review Group on vertical separation (unbundling) in the energy sector.

Happy New Year to you and yours.

All three ‘programme’ countries, Greece, Ireland and Portugal, are committed to privatisation of state assets.

In Portugal, the state owns 25.05% of EDP, a listed electricity generation, distribution and supply business, which also owns some gas operations. A slice of EDP’s operations are in Brazil, some in Spain, most in Portugal.

The state also owns 51.1% of REN, a listed business which owns the electricity transmission business and the high-pressure gas pipeline network in Portugal, as well as some LNG and gas storage operations. It has no significant activities outside Portugal. Both EDP and especially REN embrace regulated activities. Both gas and electricity were originally state-owned in Portugal.

The government has announced the sale of 21.35% of the shares in EDP to the Three Gorges power company of China for €2.7 billion, which will leave the government with less than 4%. The shares are widely held and Three Gorges will be the biggest shareholder. The government has also announced its intention to sell part of its stake in REN, presumably taking it below majority ownership.

These developments are interesting in view of the Irish government’s decision to eschew vertical separation at the ESB and to seek to sell a minority stake in the existing company. Portugal went for vertical separation of the network companies some years back, along the lines of the recommendation for Ireland in the of the Review Group on State Assets which reported in April 2011, and has now decided to exit ownership in powergen/supply more or less altogether. In addition, they seem willing to go below majority control of REN, the networks business. The State Assets report recommended retention of state ownership, at least for the time being, in these businesses.

On this recent thread

http://www.irisheconomy.ie/index.php/2011/12/09/fiscal-rules-stocks-flows-and-all-that/#comments

Karl Whelan points out that the 0.5% deficit/GDP rule envisaged in Friday’s ‘fiscal compact’  eventually yields a debt ratio at only 17% of GDP. This happens whether you start from zero or from Greece. Karl’s assumed growth rate is just 1%. If you assume 2% the debt ratio asymptotes to only 10%.

This helps to understand where the unlikely average deficit figure of 0.5% came from. The more natural choice of 0% yields the asymptotic abolition of the sovereign bond market, currently being pursued on a shorter time-scale by other means.  Asymptotic abolition cannot be acknowledged in such an important (they were awake ’til 4 am) communique. Somebody might spot it.

The Maastricht 3% deficit, were it the annual average, yields an asymptotic debt ratio of 60%, with nominal GDP rising at 5%. But 3% is to be an upper limit in this fiscal Nirvana, and so is the 60%. Summiteers were thus posed with the following very tricky problem: how to add an average deficit ratio to the 3 and 60 from Maastricht without looking ridiculous? 

The figure cannot be too high, since it would be too close to the 3% upper bound, and cannot be too low, since it abolishes the bond market (slowly). You are not allowed to ask why the extra average deficit rule had to be added to the Maastricht limits at all. This was a frightfully important summit, and tough new fiscal rules had to be imposed, to save Europe….

Actually the decline from 100% (possible peak debt/GDP ratio for the Eurozone as a whole) at a deficit of 0.5% per annum is pretty slow – takes 20 years to fall below 80% – so plenty of time for more summits. Karl goes on to hint that an ultimate debt ratio of 50% or so might be more prudent than 17%, without giving reasons. Here’s one.

Basel III has spawned something called CRD 4, capital and liquidity proposals for European banks. The liquidity part does not (yet) specify a quantitative ratio of liquid to total assets but could turn out to require 20% or 25%. If balance sheets end up at something sensible like 150% of GDP (UK currently 400%), this implies say 35% of GDP needs to be available as high-quality liquidity. Aside from central bank money, this means short (< 5 yr) sovereign bonds. It can’t all be central bank money (or if it can, explain how monetary policy would work). If the debt ratio drops much below 50%, sovereign debt duration has to drop dangerously.

There are reasons for not having too many sovereign bonds about. There are also reasons for not having too few. No thought appears to have been given to this 0.5% rule, about the only concrete element in the ‘fiscal compact’.