The Irish Economy

Here’s a few thoughts on aspects of the pro-note deal concluded last week.

The GGB Interest Saving

One of Karl Whelan’s slides at the recent irisheconomy conference sported the title ‘Eurostat and Reality’. The ‘general government’ concept used by Eurostat and consequently employed in the EU Commission’s implementation of budget rules and bail-out programmes has other critics besides Karl. One critic is the IMF.

http://blog-pfm.imf.org/pfmblog/2009/07/consolidation-of-central-bank-operations-into-the-governments-financial-statements-practice-in-selec.html

The Fund argues that, once central banks begin undertaking quasi-fiscal functions, they may as well be consolidated with the fisc. Australia and New Zealand consolidate their central banks into the fiscal accounts. More pertinently the IBRC was not part of general government and NAMA is not either. Since the fisc was and will be on the hazard for both, the same argument applies to them. The fact that these three institutions, the CBI, the IBRC and NAMA are not part of general government has muddied the waters regarding the budget impact of the pro-note deal as John McHale points out in his post.

The true cost of the pro-note was the interest paid at the ECB’s MRO, the main re-financing rate, currently 0.75%. This will continue to be the cost when the pro-note passes to the CBI and is replaced with long-dated floaters. Transfers of interest arising from the pro-note and its floating successor between Irish government entities wash out in terms of economic impact. But they do not wash out in terms of the measured GGB deficit as per Eurostat, since these entities are not consolidated into general government.

This is the reason why there is an interest saving to the GGB (in addition to the discontinuation of front-loaded capital payments, which had to be funded but are excluded from GGB spending). Funds were being transferred, at high interest, to the IBRC, an operating subsidy if you will which would revert fully to the DoF eventually as part of the residual net worth (positive or negative) of IBRC. The excess interest was treated by ESA-95 as current spending, even though it was really the Exchequer lending money outside the GGB club to an entity it owned, guaranteed and planned to liquidate six years from now. No such sums will now be paid to NAMA or to any other state entity outside the GGB club. Hey presto, an interest saving of €1 billion. The interest shown, although heading in the right direction, is still not ‘correct’, in the sense that it does not equal the figure that would be shown if the Exchequer’s offspring were all living at home. The figure still looks too high, but by less. The ‘correct’ figure will rise eventually for two reasons: the 0.75% will rise as the Eurozone economy improves, and the amounts borrowed at this favourable rate will decline as the floaters in the CB’s book are re-financed in the market.
There has been no creative accounting and the DoF have done everything by the book. ESA-95 is just not a very coherent book. For more on all of this in an Irish context, see

http://researchrepository.ucd.ie/bitstream/handle/10197/561/mccarthyc_article_pub_005.pdf?sequence=3

The Floaters

The NTMA has already issued to the Central Bank eight long-dated floaters.
The base rate is six-month Euribor, recently a little under 0.4%. The margins over Euribor average about 2.6% so the government has issued €25 billion in very long dated floaters with opening yields of around 3%. The margin is fixed to maturity.

The rate does not matter (neither Euribor nor the margin) until the Central Bank sells some of the bonds and coupons start to leak outside the (fully consolidated) Irish state system. The CBI has agreed a schedule of minimum sales of the floaters, starting at €0.5 billion by end-2014 with steadily rising amounts that will see the lot gone by 2032. This means that the availability of concessionary state finance at the MRO rate contracts from 2014, slowly at first but more rapidly as 2032 approaches. The state is exposed at a diminishing rate to the ECB’s MRO rate and to the margin and Euribor at an increasing rate as the Central Bank sells out. The MRO will doubtless be higher during the life of these bonds, as will Euribor. The margin could compress or blow out. The exposure to this margin would have arisen anyway, and sooner, without the deal, as the pro-notes would have been replaced with market funding sooner. The margins, which are fixed through the life of the notes, have had to be estimated, since long-dated floaters are relatively rare and Ireland has none in issue. The initial margins chosen do not matter – it is the margin when the bonds are sold on that determines the effective cost. Floaters normally trade close to par, but the margin over Euribor for Irish sovereign risk could prove volatile and these bonds, when they come to be dealt in the secondary market, could trade further from par (on either side) than highly-rated sovereign floaters. Over the long haul, floaters are closer to index-linked bonds, since Euribor should follow the inflation rate.

Options in Favour of the CBI

The Central Bank will have some interesting but, it would appear, not very valuable options. Where these are options against the issuer, they have of course no net value to the state. The CB has an apparent option to convert the floaters to fixed, but only with the agreement of the NTMA. This option expires as the bonds pass to market purchasers. Without this provision the NTMA could get stuck with a growing component of long-dated floaters in its debt portfolio, for which market appetite is unknown. The NTMA rather than the CBI will likely call the shots on the exercise of this option – it will really be an option in favour of the NTMA, against the CBI as holder, but not against the ultimate market purchasers.

The CB has the option to sell more than the minimum required, but the MRO would have to exceed Euribor plus about 2.6% for this to be attractive, and would have to look like staying that way. This is most unlikely so this option has negligible value.

An Option in Favour of the ECB?

The CB has agreed (at the behest of the ECB) to a schedule of minimum sales into the market which will see the Central Bank dispose entirely of these securities by 2032, vaporising €25 billion of blameless money along the way. This schedule lengthens the duration of access to funds at the MRO relative to the duration under the pro-notes and is the key benefit of the deal. Any acceleration of this schedule diminishes the value of the deal.

The ECB can seek accelerated sales of the CBI’s holdings of the bonds, curtailing access to low-cost funds. This is potentially a serious option against the state as issuer. Governor Honohan also stated on RTE on Sunday that the CBI had agreed to retire the floaters as quickly as possible. He said: ‘The CBI has undertaken to sell these bonds as soon as possible, subject to financial stability’. This leaves the terms on which the state retains access to low-cost finance unclear. What is ‘financial stability’? Who decides if financial stability prevails, the CBI or the ECB? Is there a written understanding on the criteria that will be used? If so, it would be nice to know what it says. If not, there is a risk of future conflicts here.

I give my take on last week’s deal today in the Sunday Business Post.   Cliff Taylor has kindly allowed an unedited version to be posted here.  

After the drama of Wednesday’s late-night liquidation of IBRC, attention turned on Thursday to attempts to make sense of the deal on the promissory notes.  To assess the merits of the deal, economists were looking for answers to four big questions: How would the deal affect the burden of the IBRC debt as measured by the present value of the state’s obligations?   How would it affect the funding pressures on the state over the next decade?   What would be the impact on the General Government deficit and thus on need for further austerity measures?   And would the deal ease the precarious position of having to get ECB approval of Exceptional Liquidity Assistance every two weeks?  

We must follow the money the money to answer these questions.

My take on the transaction is in this Irish Times op-ed article.

Research seminar in contemporary Irish history, Centre for Contemporary Irish History, Trinity College Dublin. 13th February.

The seminar will take the form of a witness seminar focusing on contributions from Sean Cromien, former Secretary General of the Department of Finance.  He will speak to the theme ‘The Department of Finance and its critics, 1956-1996’.

The seminar will take place at 4.00p.m. in the IIIS seminar room C6002, Level 6 Arts Building, Trinity College. All welcome.

Under the old Promissory Notes arrangement there were four interest rates involved:

• Promissory Note Interest Rate: 8.2% (from 2013)
• ELA Interest Rate: 2.50% (MRO + 1.75%)
• ECB Interest Rate: 0.75% (MRO)
• Government Borrowing Rate: 3.3% (under EU/IMF Programme)

As was eventually realised it is really only the latter two that matter.  The repayments in the Promissory Notes converted very cheap debt at the ECB MRO rate to more expensive debt at the government borrowing rate.  The problem was never the interest rate on this debt, the problem was that it needed to be paid down too quickly transforming it into higher-interest debt.  Under the old arrangement the average duration for this was around seven years.

If we just focus on the Promissory Notes element of the arrangement (and ignore the transfer of IBRC assets to NAMA) the key interest rates in the new arrangement collapse to:

• Long-Term Government Bond Rates: c.3.5% (spread over Euribor)
• ECB Interest Rate: 0.75% (MRO)

Initially the interest rate on the new government bonds doesn’t really matter.  The interest is paid to the Central Bank which repays it back to the Exchequer.  The Central Bank pays the ECB MRO for the facility to hold the bonds.

Once the Central Bank sells the bonds the interest becomes payable to a third party and will no longer be returned the the state.  This will start slowly with €0.5 billion of the bonds to be sold by the end of 2014.  This will continue at a rate of €0.5 billion per year up to 2018, €1 billion a year from then until 2023 and €2 billion a year thereafter.  Under the proposed schedule the Central Bank will have fully disposed of the bonds by 2032.

It is through this process that the cheap debt (based on the ECB MRO) will be transformed into more expensive debt (based on the rate on the new bonds).  The difference now is that this process takes place at a much reduced speed over an extended period.  The average holding period by the Central Bank is nearly 15 years.

In effect the period we have access to funding at the ECB rate has been extended by nearly eight years.

After the bonds have been fully disposed there is little difference between the Promissory Note arrangement and the Long-Term Bond arrangement.  As stated this will happen in 2032.

The emphasis on what happens with the bond redemptions from 2038 to 2053 is somewhat misplaced.  There was always going to be debt to service/roll-over during this period as a result of the Anglo catastrophe.  As pointed out the real cost of this will likely have been significantly reduced but yesterday’s announcements make little real difference to this period.

The key gains are the short-term funding benefit with the cancellation of the Promissory Note repayments and the fact that the period for which cheap ECB funding is available has been extended from around 2022 out to 2032.  The benefits are not related to the length of the bonds used (and nor does using long-term bonds generate an additional cost).