Category: Bailout

Improving the bailout terms

The Government rightly continues to make the case that there is a common interest in lowering the interest rate on EFSF/EFSM borrowings, among other adjustments to the programme.   Writing in the Sunday Independent today, Peter Mathews – in one of the milder articles in the paper – goes quite a bit further and accuses “EU partners” of “profiteering” (see here).    

Last January, the European Financial Stabilisation Mechanism charged Ireland an interest rate of 5.51 per cent for money that it borrowed at 2.59 per cent. A month later, the European Financial Stabilisation Fund charged Ireland an interest rate of 5.9 per cent for money that it borrowed at 2.89 per cent. On this basis, the EFSF earns a profit margin of 3.01 per cent and the EFSM earns a profit margin of 2.93 per cent.

These margins are draconian. The majority of the interest that Ireland pays is not used to pay for the EU’s borrowing costs. It is excessive profit for the countries that are lending us money. For every €1m that Ireland pays in interest costs, Ireland must pay another €1.08m so that our EU partners make a profit. This, clearly, is not a bailout. It is exploiting our vulnerability. It is financial bullying.

It would appear that Peter believes that the EU is taking on zero risk in lending to Ireland.   (Formally, at least, the EFSF has eschewed IMF-style preferred creditor status.)   I would be interested if readers agree that these official funders can rest assured their loans are riskless. 

 

The Sunday Business Post provides its usual welcome calm analysis of the options (no web access until Monday).   Understandably frustrated with the pace at which EU governments are responding in terms of providing a mutually-advantageous exit route from the crisis, its lead editorial advocates taking a tougher line, notably with Anglo (and presumably) INBS) senior debt. 

With our government bond interest rate soaring and our banks locked out of the markets, we haven’t got a lot to lose.   We are most unlikely to be able to return to the markets on the schedule set down in the EU/IMF programme late next year, or in early 2013.   It would be much better realise this and arrange some restructuring of the deal now – and there are many ways this could be done.  [Emphasis added]

Just looking at the first sentence, my interpretation of the first clause is that the resulting dependence on external support means, unfortunately, we do have a lot to lose.   With popular pressure for a tougher line ramping up, it seems a worthwhile issue to debate. 

Guest Post from Daniel Gros: How to Make Ireland Solvent

Daniel Gros from CEPS has provided the following guest post based on his recent IIEA talk.

How to Make Ireland Solvent

The Republic of Ireland can no longer raise funds on the capital market and has had to accept a bail-out financed jointly by the IMF and the European Financial Stability Facility or EFSF (the EU’s rescue fund).  Many investors fear that by the time European support ends as planned in 2012, the country will not have market access, and might then be forced into default if anti-bail-out forces are determining policy in Germany at that point. 

But this dependency of Ireland on foreign support is difficult to understand given that the country has not lived continuously above its means in the past.  Ireland has run a current account deficit (which means the country uses more resources than it produces) only for a few years; and if one totals the current account balances over the last 25 years, one arrives at a foreign debt of about €30 billion.  This should not be too difficult to finance given that it represents only about 20% of the country’s GDP of €150 billion. Moreover, Ireland is on track to run a current surplus this year and should thus not have any need for additional foreign funds.

So why does the government need a continuing bail-out?  The reason is that the government has a huge foreign debt whereas the Irish private sector has huge foreign assets.  To make matters worse, the government pays exorbitant interest rates on its large foreign debt whereas the private sector earns very little on its foreign assets (and keeps these meager returns for itself).  If this is allowed to go on, the government could indeed still have to default.

This was the case in Argentina where the private sector had large foreign assets while the government had an even larger amount of foreign liabilities.  The Republic of Argentina went bankrupt with only a moderate net foreign debt because wealthy Argentines had spirited their assets out of the country, and thus out of the reach of the government, while the poor Argentines refused to pay the taxes needed to satisfy the claims of the foreign creditors. 

Ireland is not Argentina and should be able to avoid its fate; but only if the government can mobilize private foreign assets.  This should be possible given that these foreign assets are mostly held by institutions, such as pension funds and life insurance companies. 

The little data published by the associations of Irish pension funds and that of (life) insurance companies suggest that these two groups of financial companies own over €100 billion in foreign assets, of which about €25 billion are in non-Irish government debt and about €72 billion in foreign equities.[1] 

From the point of view of the country, it makes no sense that Irish pension funds invest in Bunds which yield about 2-3%, whereas the government pays close to 6% on fresh money to foreign official institutions (and Irish government bonds promise yields of close to 10%).  A very strong case can thus be made that Irish pension funds and life insurance companies should somehow be ‘induced’ to invest their entire portfolio of gilts in Irish government bonds.  The €25 billion in financing that this would yield for the government is equivalent to the entire contribution of the IMF to the rescue package.

A similar case can be made for the €72 billion in foreign equity investments. If two-thirds of that sum (or €48 billion) were also be invested in Irish government bonds, the total financing available for the government would rise to over €73 billion, more than all the foreign funds made available to Ireland under the rescue package. 

Would this mean robbing retirees of their future?  The opposite seems to be the case: the rate of return achieved by the average Irish pension fund has been only around 1.7% over the last decade (as claimed in a recent report of the public pension fund).  A massive investment in the bonds of their own government, which offer a return of close to 10% (on the secondary market), should actually be in the interest of present and future Irish retirees as well.  Moreover, by doing so, the probability of a state default would actually be much reduced, which in turn will preserve growth prospects for the economy – the most important determinant of future pensions.

The EU might of course protest that any restrictions on the investments of Irish pension funds and life insurance companies smack of capital controls.  But this could be finessed by either a waiver under Article 65 of the EU Treaty, or a clever wording of the ‘directed’ investment.  Moreover, the public pension fund has already been obliged to accept a ‘directed’ investment, without any opposition from the EU.[2]

Given the scale of foreign assets owned by Irish residents there should be no need for the government to depend on the funds of the EFSF and the IMF, which are very expensive in both political and economic terms. There will be practical and political obstacles to mobilizing pension fund assets, but they should be overcome if the future of the entire country hangs in the balance.

 

Daniel Gros,

Director CEPS,

Brussels, May 2011

[1] Sources available from the author.

[2] A technical note: Pension liabilities are bond-like in nature, so the present heavy weighting in equities represents a substantial mismatch and investment risk in itself.  There may thus be scope within appropriately framed solvency requirements to facilitate/encourage pension funds to more closely match their bond-like liabilities with instruments issued by their own sovereign.

Maarten van Eden: Applying same analysis to all Ireland’s debt makes no sense

Maarten van Eden, outgoing CFO at Anglo, has an interesting article in today’s Irish Times (see here).    One useful feature of the second half of the article in particular is that he focuses on what is needed to allow the banks to play their normal lending function in the economy.  

In order for lending to the private sector to resume, the good banks need to be delevered [through debt-funded buybacks of NAMA bonds and promissory notes, with the cash used to pay back the ECB], recapitalised and their funding put on a firm footing.

I am not convinced by his specific solution, but this focus is important given that the debate sometimes seems to have lost sight of the ultimate objective of fixing the banking system.   

As an aside, one of the best papers produced on the Irish crisis is Gregory Connor’s “The Irish Risky Lending Gap”, written back in 2009 (see here).   Greg focuses on the lending decisions of a risk-averse bank holding a distressed asset portfolio with a value that is correlated with the value of potential new lending opportunities.   He shows how the level of lending can be socially sub-optimal, and how various balance-sheet restructuring policies can change the size of the lending gap.  It might be useful to re-read along with the van Eden piece.

Regaining Creditworthiness

Much of the pessimism about Ireland’s predicament has centred on the challenge of stabilising the debt to income ratio.   Undoubtedly this will be challenging, with good outcomes on nominal GDP growth and fiscal adjustment capacity required.    Of course, it has been made much more difficult by the massive bank losses the State has had to absorb.   But I think a focus on the stabilisation challenge misses a critical issue, which is regaining market access at a high if stable debt to GDP ratio (probably somewhere in the region of 120 percent of GDP).   

Martin Wolf’s column from last week provides a useful starting point for a diagnosis of the problem – an article that garnered all of one comment on the blog (from DOCM).   It draws on Paul de Grauwe’s insightful work on the susceptibility of countries in a monetary union to a debt crisis (see here), where a country without its own currency and central bank to act as lender of last resort is vulnerable to self fulfilling expectations that it will not be able to roll over its debts.   The EFSF/ESFM/ESM were put in place to help fill this LOLR gap, but have so far proven to be a poor substitute.   It is understandable that Germany and other likely net funders want to eventually reinstate market discipline, and so demand losses are borne by private creditors as part of any new bailout.   It is also understandable that they want to protect themselves from losses under the permanent bailout mechanism (the ESM) by demanding preferred creditor status.   But it is becoming increasingly evident that crisis-hit countries will find it extremely hard to regain market access with a half-hearted LOLR facility in place given any doubts that they will not be able to pass a debt sustainability test under the ESM. 

The official funders have to be willing to take on some additional risk if a mutually damaging combination of default and ongoing dependency is to be avoided.   One element is to clarify the way the debt sustainability test will be applied.   A current problem is that austerity measures weaken growth, thus making it harder to pass the test.   A useful amendment would be to assess growth in the debt sustainability calculation assuming a neutral fiscal stance.   Another useful amendment would be to set a ceiling on the size of any haircut, thereby limiting the uncertainty faced by potential new investors.   

As a quid pro quo for these amendments the government could offer to speed up the fiscal adjustment (along the lines recommended by the ESRI in its Spring QEC).   Of course, more fiscal adjustment is the last thing the economy needs as it struggles to pull out of recession.   Yet a quasi-permanent loss of creditworthiness and dependency on unreliable official support looks to be the bigger threat, as it saps confidence and undermines the perception of the economy’s stability.   Those resisting fiscal discipline must realise that the situation changed profoundly when Ireland’s creditworthiness disappeared in the second half of last year.   Some observers are putting forward the same fiscal policy prescriptions as they did when bond yields were around 5 percent.   They must see that the ground has fundamentally shifted.  

It is hard to see how further public sector pay cuts could not be part of any balanced additional adjustment.   A credible new regime for long-run fiscal discipline is also essential.  

The government should take the offensive in pointing out the incoherence of the current international support approach, while avoiding playing a self-defeating grievance card.   What is needed is a hard-headed look for a mutually advantageous set of policies that allow Ireland to shed its dependency.    The first step is a proper diagnosis of creditworthiness challenge. 

Corporate Tax Saga, May 11 Edition

The saga over Ireland’s request for a reduction in the interest rate on its EU loans continues, with the French continuing to link this issue with Ireland’s corporate tax, a role they swap every so often with the Germans (media stories from today here and here). As Christine Lagarde’s recent comments show, having made such a big deal of the issue, the French are now motivated to achieve the crucial goal that “Everybody will have to save face.”

It is worth noting, however, that the French signed this document “Conclusions of the Heads of State of Government in the Euro Area” on March 11. It stated:

Pricing of the EFSF should be lowered to better take into account debt sustainability of the recipient countries, while remaining above the funding costs of the facility, with an adequate mark up for risk, and in line with the IMF pricing principles.

Note the absence of any mention of corporation tax or renegotiation of deals.

Despite the constant repetition of the line that Ireland is somehow looking to change the status quo, it seems to me that there is a strong case for the opposite position. Having agreed to change the pricing of EFSF loans on March 11, the EU’s principle political leaders have reneged on this agreement for the moment, most likely because the political kudos that come with appearing tough on Ireland outweigh those associated with honouring agreements made at Heads of State level.

Those who believe that Ireland’s situation will end well because European institutions have our best interests at heart may wish to consider how things have played out over the past few weeks.