Strenthening the Ring-Fence (Warning: Wonkish)

Now that we’ve had a bit more time to digest the implications of the EU summit, I would be interested to hear more views on how the measures have strengthened or weakened the “ring-fence” beyond Greece, especially as it applies to Ireland.    The idea of a ring-fence is that measures to improve debt sustainability and the reliability of a lender of last resort attenuate potentially self-fulfilling expectations of default; that is, expectations of default that lead to higher interest rates, thereby increasing the probability of default (in part because countries get pulled into European crisis resolution mechanisms that threaten debt restructuring as part of subsequent financing packages and also because of worsening debt dynamics). 

I think it is fair to say there is general agreement that the interest rate reductions / maturity extensions strengthen the ring-fence given that they improve the chances of debt sustainability.   However, there also seems to be a view that the private-sector involvement (PSI) that is being applied to Greece weakens the ring-fence, as it increases the threat of that PSI being applied to other countries at a later stage.   The latter does not seem right to me.   It is widely recognised that Greece’s debt to GDP ratio makes debt restructuring inevitable.    From the point of view of the ring-fence beyond Greece, it would have been best to have decisive action on Greece’s debt, so that it is unlikely that the necessary PSI would have to be revisited in their case.   As it is, it is likely that further restructuring of Greece’s debt will have to take place, creating ongoing uncertainty about what the PSI element of the Eurozone crisis-resolution mechanisms is going to look like down the road, increasing the uncertainty facing other countries.   In other words, the problem (from the perspective of the ring-fence) is that too little PSI is being applied to Greece, not too much.

Forbearance and Frontrunning in Irish Property Markets

The most recent Financial Stability Report from the Bank of England warns about the danger to U.K. economic stability from excessive debt forbearance by U.K. domestic banks. The governor of the Bank of England, Mervyn King, put stress on this risk in his speech introducing the report (although he also noted that this does not mean that forbearance is always a bad thing). In the report, only the potential UK fallout from the Euro crisis ranks more highly than excessive debt forbearance on the list of risks to the UK banking system. This should ring alarm bells in Ireland, since the level of debt forbearance in Ireland at present is much higher than in the U.K.  Encouraging debt forbearance is a deliberate Irish government policy, and the extreme level of forbearance by domestic Irish institutions is storing up potential problems for the future.

There is a considerable overhang of unwanted or distressed (in some cases unfinished) property assets in Ireland (see Ronan Lyons and Namawinelake for discussion). The smart-money players (foreign-owned banks with Irish property assets) might front-run the slower-footed players (domestic, taxpayer-owned banks and Nama) by selling relatively quickly, leaving the Irish taxpayer to fund any eventual shortfall. (I am including the IBRC, the vestiges of Anglo Irish and Irish Nationwide, in my definition of domestic banks.) So loan forbearance and front-running in Irish property markets could interact to the detriment of taxpayers.   

 

NTMA on Ireland’s Funding

I had missed last week that NTMA had released an information note on Ireland’s financing situation. The note clarifies that funds from the EU and IMF that had been earmarked for bank recapitalisation can be used to fund fiscal deficits if, as the government is currently assuming, there are no further recapitalisation costs. Based on these assumptions, and projecting that fiscal deficits come in on target, they note that Ireland can get to the end of 2013 with minimal new funding.

Worth noting, however, is that there is an €11.8 billion bond maturing in January 2014. So, it would seem likely that if market funding is not accessed at some time before summer 2013 (or perhaps earlier), then the government will have to open negotiations on a new funding deal from the EU and IMF. I doubt if letting the clock tick all the way down to December 2013 would be a good strategy.

Eurogroup Statement

Here‘s a link to the Eurogroup statement from last night. This is promising

To this end, Ministers stand ready to adopt further measures that will improve the euro area’s systemic capacity to resist contagion risk, including enhancing the flexibility and the scope of the EFSF, lengthening the maturities of the loans and lowering the interest rates, including through a collateral arrangement where appropriate. Proposals to this effect will be presented to Ministers shortly.

But I’m not holding my breath waiting for an impressive intervention.

New Projections of Interest Rates on EU Loans

The topic of the interest rate on Ireland’s EU loans has attracted a lot of attention. Unfortunately, however, hard information on the loans and comparisons with the loans being offered to Portugal is not always easy to come by. The purpose of this post is to provide the information that is publicly available on this issue and to present new calculations of the likely interest rates on Ireland’s loans.

The most common media reference point for the cost of Ireland’s loans is this information note released by the NTMA in November. That document projected the cost of Ireland’s loans from the European Financial Stability Mechanism (EFSM) at 5.7 percent and the cost of Ireland’s loans from the European Financial Stability Facility (EFSF) at 6.05 percent.

With €22.5 billion being provided to Ireland by the EFSM, €17.7 billion by the EFSF and €4.8 billion coming from bilateral loans, the NTMA note assumed the interest rate on the bilateral loans would be the same as the EFSF rate. Thus, the estimated average cost of the EU loans was 5.875 percent. (I am leaving aside in this note the question of the cost of funding from the IMF, which is determined according to standard, if somewhat complex, IMF procedures.)

In a briefing note for the Oireachtas Committee on European Affairs, I noted that market interest rates had risen since the November briefing and the pricing of the first EFSM bond had not gone as well as anticipated. Based on those considerations, I suggested that the cost of EFSM funding was likely to be 6.09 percent while the cost of EFSF loans would be 6.44 percent.

The period since that briefing note was written has seen a number of EFSF and EFSM bonds issued to Ireland and Portugal, so now seems like a good time to attempt to get a more accurate picture.

Here’s a link to a spreadsheet that describes each of the bonds issued by EFSF and EFSM as well as the conditions on which they were disbursed to Ireland and Portugal. I have made estimates of what the interest rates will be on funds that are not yet drawn down by assessing their likely average maturity (to match the planned 7.5 year average maturity for Ireland and Portugal), calculating current market interest rates for those maturities (based on the mid-swaps benchmark used by the EFSF and EFSM) and then adding in the estimated margins.

A quick summary:

1. The average interest rate on EFSM loans for Ireland is projected to be 6.13 percent.

2. For Portugal, the EFSM loans project to have an average interest rate of 5.34 percent. The lower rate than for Ireland is because the EFSM’s profit margin on Portuguese loans is 77 basis points lower than for Ireland.

3. The average cost of EFSF loans for Ireland is projected to be 6.29 percent. This is lower than I had estimated in January because I had used the assumption underlying the NTMA’s November document that the margin over funding cost that would determine the effective borrowing cost for Ireland would be 317 basis points. Based on the one EFSF bond issue for Ireland so far, I now estimate that this average margin will be 305 basis points.

4. The average cost of EFSF loans for Portugal is projected to be 5.76 percent.

5. Based on the assumption that Ireland’s bilateral loans (not yet drawn down) will carry the same average interest rate as the EFSF, the average interest rate on Ireland’s EU loans will be 6.21 percent, 33.5 basis points higher than estimated last November. The average interest rate on Portugal’s EU loans is projected to be 5.55 percent, 66 basis points lower than the projected rate for Ireland. 

6. The current terms on Greece’s EU-IMF loans have been widely reported to be 4.2 percent for a 7.5 year average maturity after Greece was granted a 100 basis point reduction at the March 11 meeting of the Heads of Government of the Euro Area member states.

For those interested, here’s a rough description of how the calculations were done.