Author: John McHale

Stabilising Ireland’s Debt Ratio

To explore Ireland’s chances of avoiding default, the tool of choice has been simulations of debt dynamics under various assumptions about growth rates, interest rates, primary balances and the direct costs of the banking bailout.   Various domestic and international commentators have usefully produced such analyses, but they can be hard to compare given the combinations of assumptions involved.  Unfortunately, there is still a lot of confusion about our chances of stabilising the debt ratio.  An additional complication is that in their recent “Information Note on the Economic and Budgetary Outlook” the Department of Finance did not report their assumptions for interest rates and the primary balance.   This makes it hard to do a clean sensitivity analysis of the DoF’s projections. 

In a brief note (available here; associated spreadsheet here), I use a simpler decomposition of the change in the debt to GDP ratio than normal, but link the analysis closely to the DoF’s baseline case.   Under their baseline, they project the debt ratio will peak in 2012 at 106 percent of GDP before falling to 101 percent of GDP in 2014.  However, there is concern that the growth projections are too optimistic: 1.75%, 3.25%, 3.00%, and 2.75% for real GDP growth from 2011 to 2014.   For some reason they do not report nominal growth rates for 2012 to 2014.   However, the decomposition allows us to infer the nominal growth rate assumptions.  

To test the robustness of the DoF’s projections, I examine a quite pessimistic growth scenario with just 1 percent real growth and 1 percent inflation (GDP deflator) in each year out to 2014 holding the projected deficits as a share of GDP at the DoF target levels.  Under these assumptions the debt ratio is not stabilised — though we still come surprisingly close.   Encouragingly, however, a sustained additional adjustment in the deficit equal to 1 percent of GDP in 2011 would stabilise the ratio at 112 percent of GDP in 2013.   Moreover, combining the low growth scenario with a 10 percent of GDP increase in the starting debt ratio due to a higher bank bailout cost, we still have the debt ratio peaking in 2013, but at the higher level of 121 percent of GDP. 

While the challenge of bringing the deficit down and avoiding explosive debt dynamics (and ultimately default) is daunting, I see these simulations as reasonably hopeful.   Even under a quite pessimistic scenario on growth and banking costs — there may be views on whether it is pessimistic enough — the gross debt ratio is stabilised at what should be a manageable level for a high-income country.   This also does not take into account our cash reserves and assets in the Naional Pension Reserve Fund, amounting together to 28 percent of GDP.   Provided we have the political capacity to make the needed adjustments, the path through the crisis without default and back to creditworthiness is clear enough. 

Not All About the Banks

The government has pushed the line in recent days that the flair up in the crisis is all about the banks.  There is little doubt that the trigger was ECB concern about their large and rising exposure to the Irish banking system.   But the idea that the banks are the problem and the state is fine – happily pre-funded as it is through the middle of next year – is nonsense.   As it stands, the Irish state is not creditworthy.   All else equal, it will become even less creditworthy as it burns through its valuable cash buffer.  The vanishing credibility of the ELG guarantee along with the creditworthiness of the state is the major cause of the banks’ increasing reliance on the ECB.  The intensified banking crisis is a (very significant) symptom of a deeper problem.

Of course, hopes are pinned that we can demonstrate political capacity to stabilise the debt to GDP ratio through a credible four-year plan and budget.  This will be a massive challenge.   Funding support on good terms – part of which could be used to “overcapitalise” the two main banks – would be a significant advantage in regaining market access; indeed, probably indispensible.   The last thing we need is another incorrect diagnosis of the problem. 

A Bailout Worth Considering

Even though it’s hard to separate fact from fiction in the fast-moving bailout story, reports that the Commission and ECB are pushing for Ireland to avail of the EFSF for broader European stability reasons could change the calculation in an important way.   I still believe that Ireland’s best bet is to regain creditworthiness through a demonstration of political capacity with the budget and the four-year plan.   The alternative of being forced to seek a bailout would involve at least as much austerity as our own adjustment and would do long-term reputational damage.   

But acceding to a request to avail of the facility is potentially a different proposition.   I don’t think our European partners could simply expect us to pursue a less nationally advantageous path in the interest of broader euro zone stability.   The terms would have to be mutually advantageous relative to the next best options for both sides.   One reasonable agreement that could meet this requirement is for our European partners to support our four-year plan with a credit line from the EFSF at a reasonable rate of interest (say the 5 percent rate provided to Greece).  Access to the funds would be conditional on meeting the targets under the plan, which after all is being developed with input from the Commission and the ECB.   The intention would still be to return to markets for funding rather than the use the facility, but the backstop of a dependable credit line on reasonable terms would give us a substantially greater chance of actually being able to access market funding both for the state and the banks. 

Of course, it would be a mistake to exaggerate our bargaining power.   The increasing reliance of our banks on the ECB means we are heavily dependent on their willingness to provide extraordinary support.   But if the right deal is on offer, I worry that the government would be too inclined to resist for fear of a political backlash.  All bailouts are not created equal.   An invited bailout – on the right terms, and in line with our own chosen strategy – might well be worth accepting.

Is Ireland’s Number Up?

Constantin Gurdgiev and I offer different views on Ireland’s capacity to avoid default in today’s Irish Examiner.  Articles here.    The articles follow an introductory piece by the paper’s political reporter, Mary Regan.

Report on Macroeconomic Policy and Effective Fiscal and Economic Governance

The Joint Oireachtas Committee on Finance and the Public Service’s report on a new fiscal framework is now available.   It can be downloaded here (MS Word file).   Unfortunately, Philip Lane’s background report for the Committee does not appear to be available for download at this time.

Update (from Philip): The full report (including the background paper that I prepared) is now available in PDF here.