Garret Fitzgerald writes on the Irish tax system in today’s Irish Times: the article is here.
Low Tax Levels
- Post author By Philip Lane
- Post date September 25, 2010
- Categories In Fiscal Policy
- Tags Irish tax level
- 63 Comments on Low Tax Levels
Category: Fiscal Policy
The text of Peter Sutherland’s speech to the Institute of Directors is below:
Notwithstanding the successful auction of €1.5bn of government debt on Tuesday, there is no doubt that in recent weeks (and in particular in the last two weeks), Ireland’s position in the debt markets has deteriorated markedly and the sale came at a high cost. This has been the consequence of a number of factors. Some of these are objective facts about the dire state of our public finances. Others are the result of market perceptions. It is hardly surprising at present that there is an air of fatalism consistently nurtured by negativism but it is surely not in our character to give in to this. We can and will get out of this mess if we have the will to do so.
Let me say a word first about market perceptions. We seem to have a remarkable capacity to damage our public image abroad. The prevailing and understandable sense of depression in Ireland is made worse by a media often seemingly intent on presenting the worst perspective on current events. The recent Barclay’s analyst report, which was wrongly presented by some in the Irish press as being far more negative than it actually was, is a case in point. You may say, “Well so what? Those professionally concerned with our credit worthiness surely do not decide their approaches on the basis of second hand commentary on an analysts report?” Well, yes and no. The national media reaction is taken seriously and market reactions are often instantaneous.
It is time that we separated two big issues, the underlying budget deficit and the bank crisis. The first of these presents a very challenging issue but it can be dealt with if we have the collective will to do so. The collective will can only result from an understanding of the facts. We are running a revenue to spending gap of circa €20 billion p.a. and simply cannot continue to do so. As Willem Buiter, formerly of the London School of Economics, said this week, the cost of borrowing is becoming unsustainable. Our national debt is accumulating still at an alarming rate as a result of government spending but is being obscured as an issue in public debate by the constant and intense focus on the nature and effects of the banking crisis. Terrible though these are, they are identifiable and should be considered separately.
This is the view of Michael Vaknin of Goldman Sachs Global ECS Markets Research:
Irish bonds have substantially underperformed the rest of EMU periphery.
A heavy pipeline of Irish bank debt rolling off soon brings back memories of the Greek turmoil.
But we believe risks are overpriced, as several backstops are in place:
The banks can increase funding through the ECB liquidity programs.
And the ECB could intervene again in ‘dysfunctional’ sovereign markets.
More fundamentally, we argue that Ireland’s issue is liquidity, not solvency…
…Hence if the EFSF is activated, spreads would likely fall significantly.
Watch for signs of ECB intervention and banks’ reduced issuance to cement the case for ‘long’ Ireland.
We’ve had lots of comments about yesterday’s bond auction, many of them from people confused by headlines about the “heavy demand” for the bonds. If the demand was so heavy, these folks are asking, why couldn’t we have sold the bonds at a lower interest rate? We’ve also had some good responses from people who know the answer but it’s perhaps worth putting the answer on the front page.
Take the €1 billion euro 8-year bond that was issued yesterday. The interest rates that we pay on these bonds are determined in an auction. People submit private bids detailing how much of the debt they want to acquire and what rate they are willing to pay. NTMA want to pay the lowest interest rates possible, so they allocate the bonds to those offering to take the lowest interest rates until they have handed out the full €1 billion of bonds.
Yesterday’s auctions featured €2.9 billion in bids (this is what is meant by the bid-cover ratio being 2.9) and the widely-advertised rate of 6.046% was the highest rate offered that received a full allocation of debt. The business about the “heavy demand” relates to the fact there were €1.9 billion in bids from people who were not allocated bonds. Pretty clearly, however, the existence of these bids can’t lower the rates that we are actually paying since these people weren’t willing to purchase the bonds at lower interest rates.
Also, we don’t know how serious all of these unsuccessful participants were. For all we know, some could have submitted bids at 10%: NTMA don’t release information about the nature of the unsuccessful bids. In the absence of this information, I’d recommend not reading too much into bid-cover ratios.
(Note, for those who want to be picky, I’m deliberately not getting into technicalities about Dutch and non-Dutch auctions and the like but informed commenters can fire away on this stuff if they wish.)
Today’s bond auction has attracted a lot of media attention. However, quite a lot of the comment has been a bit confused. Let me set out the usual framework that economists use to think about bond yields. Our more financially sophisticated readers know this stuff anyway but it’s still worth briefly spelling out.
Consider an investor who has two options for their investment.
Option A is to purchase a risk-free bond which carries an interest rate of RF.
Option B is to purchase a bond with potential default risk. This bond delivers two possible outcomes. The first outcome occurs with probability p and in this case, the bond is defaulted on and the investor only recovers a percentage c of their original investment. The second outcome B occurs with probability 1-p and in this case the bond delivers the promised interest rate of RR and also repays the principal.
(Weighted) averaging over these two outcomes, the expected return from option B is
p(c-1) + (1-p) RR
Now assume that investors are risk-neutral, meaning they will pick the bond with the highest average return (and won’t shy away from option B just because it carries some uncertainty).
In this case, for investors to be willing to purchase both bonds, they must have the same average expected return. Setting the above return for option B equal to RF and re-arranging, this determines the interest rate on the risky bond as
RR = RF / (1-p) + p (1-c)
If one knows what the “recovery rate” parameter c is, then one can also back out the implied probability of default as
p = (RR – RF ) / (1 –c + RR)
Now to our current situation. As of this evening, the FT is reporting yields on ten-year Irish bond at annualised rates were 6.3% while the comparable German bond was yielding 2.46%. Let’s use 0.5 as the implied recovery rate should Ireland default. Now plug in RR = .063, RF = .0246, C = 0.5
p = (0.0630 – 0.0246) / .563 = .0682
When considering ten-year bond yields, this tells us the implied probability that the bond will not default over the 10 years is (1-.0682)^10 = 0.493.
In other words, this simplified calculation would suggest that investors are pricing in that a default is more likely than not at some point in the next ten years.
So, when one hears a Fianna Fail TD say on Prime Time say that if international investors didn’t have confidence in Ireland, they wouldn’t be willing to invest in the country (i.e. purchase sovereign bonds) it needs to be kept in mind that the rates on longer-dated sovereign bonds suggest that these investors believe that it’s as likely as not that the country will default over the next ten years. Not much of a vote of confidence.
Now, of course, the framework above is very basic. One can assume that investors are not risk-neutral which would mean there would be a risk premium in addition to the one related to default probability. This would lower the estimated default probability but it wouldn’t change the damage that perception of the possibility of default is doing.
Also, the 50% figure for recovery rate might be kind of low. A recovery rate of two-thirds would give a higher implied default probability of also about two-thirds from the above framework.
The other line I heard going round today was how we shouldn’t be surprised that the auction was successful because the rates being offered were “very attractive.” This is wrong on two counts. First, the rates were determined in an auction—the NTMA didn’t set a high minimum rate that they were willing to pay to attract interest. Second, once we know the market is factoring in default risk, there’s no point in judging bond yields as being “attractive” just because they are high. The high rates are compensation for the possibility that you might lose a lot of money if things go badly.
A key point to keep in mind is one that has been stressed recently by Willem Buiter. When perceived default probabilities rise there can be two possible self-confirming equilibria. In the good one, the government calms the nerves of the markets, borrowing rates decline and the day is saved. In the bad one, the high yields due to high default probabilities start to make fiscal stabilisation seem more difficult, which further raises estimated default probabilities until borrowing from the bond market becomes unfeasibly expensive or else simply impossible.