## EU Interest Rate Calculations

Well thanks Silvio! If it weren’t for the comical actions of Signor Berlusconi, I doubt if we would have obtained yesterday’s long-hoped-for interest rate cut on our EU loans. Certainly, the cut isn’t in any way related to the negotiating skills of the government – who were last seen essentially waving a white flag on this issue.

On the substance of the deal, like Namawinelake, I’m frustrated at the lack of useful detail about the new interest rate and potential changes in loan maturities.

An annual saving of €800 million is being widely cited but I have my doubts if the correct amount has actually been calculated. My guess is that the final savings could be a bit larger, perhaps as much as €1.2 billion annually.

The first open question relates to which funds the cut is being applied to and the second relates to the size of the cut in the interest rate itself. The statement merely says

The EFSF lending rates and maturities we agreed upon for Greece will be applied also for Portugal and Ireland.

However, Ireland is only borrowing €17.7 billion from EFSF and no reasonable multiple of this number delivers annual savings of about €800 million. It seems most likely that the reasonable assumption is being made that the interest rate will also be cut on Ireland’s €22.5 billion of loans from the EFSM, though as this is an EU vehicle, last night’s meeting could not announce such a cut.

If we applied a cut of “about two percent” to the “about €40 billion” of EFSF and EFSM loans, then my fuzzy math calculations come up with “about €800 million”. So that’s the likely source of the figure.

However, it seems likely to me that the terms of Ireland’s €4.8 billion in promised bilateral loans from the UK, Denmark and Sweden will be renegotiated, so a more accurate fuzzy math would apply “about two percent” to exactly €45 billion to arrive at “about €900 million”.

Then there’s the question of the size of the interest rate cut. The Irish media have clung firmly to the notion that the average interest rate on our loans was about 5.8 percent, despite plenty of evidence that the cost of the EU component was going to be higher than had been projected last November.

As I reported here a few weeks ago, by my calculations (spreadsheet here), the average interest rate on Ireland’s EU loan was going to be 6.21 percent. The Eurozone statement promises an interest rate

equivalent to those of the Balance of Payments facility (currently approx. 3.5%), close to, without going below, the EFSF funding cost.

That could imply a cut of 2.7 percent, which if applied to the full €45 billion would give “about €1.2 billion”. That may be right or wrong since we don’t have much information yet. But I suspect that once things are worked out, the savings will be greater than the €800 million being quoted.

Update: Sean O’Rourke just put my calculations to Michael Noon on the RTE News at One. The Minister conceded that it was likely that the interest rate cuts would be extended to the bilateral loans and that this would get the savings up to €900 million.

When a higher figure of €1.2 billion was put to him, the Minister noted that this might have included the likely reduction in future IMF rates (something I’ve written about before but wasn’t including here.)  The difference here comes from my comparison of the “about 3.5 percent” with my calculated current average EU rate of 6.2%.

With the average margin over cost of funds currently running at about 300 basis points, it still seems to me that a reduction of this margin to get the interest rate “close to” the funding cost sounds like a reduction closer to three percent than two percent. But I could be wrong.

European politicians are engaged in frantic negotiations to deal with both the Greek debt problem and the wider question of the EU’s approach to the problems of peripheral countries.

On the approach to the Greece, I’m not encouraged by the reporting from the financial press which has focused on a bank tax and debt buybacks.

First, we’re being told that the idea of a tax on European banks to raise about €30 billion is emerging as a “popular consensus” approach to getting private creditors to “help pay for the estimated €115bn bail-out”.  As reported, it’s pretty unclear what happens with the €30 billion. Is it loaned to Greece and then later paid back to the banks that paid the tax? If so, it’s not really a tax in the usual sense of the word.  Anyone who understands this is welcome to explain it in comments.

However it’s structured, this seems to be the wrong approach to the wrong problem.  The goal seems to be to keep Greece’s debt burden exactly where it is (thus not solving the key problem) but to reduce the headline number for the size of a second EU-IMF loan (which solves a political problem in some countries).  In relation to private sector “burden sharing”, the approach still seems to view a Greek default as unthinkable (despite almost everyone viewing it as inevitable) while adopting a very strange approach to the demand for “private sector involvement”: Why should banks that don’t own any Greek debt have to pay a tax to contribute to a second bailout?

Maybe there’s a good idea hiding under this reporting: If so, I’m happy to have it explained to me.

Then there’s the increased focus on debt buybacks. The idea of debt buybacks is popular with both politicians and holders of debt. The politicians get to claim that there was no coercive default on the outstanding debt, thus saving face. The creditors usually manage to get the debt bought back at a nice premium to the current market value, so many of them make a tidy profit.

Academics that have looked at this issue generally don’t like debt buybacks. Here‘s a short article from VoxEU by some IMF staff. And here and here are two classic older articles written in the context of the 1980s Latin American debt crisis.

To briefly explain why buybacks are not as great an idea as they appear, consider the case of a country with debt and GDP of €100 billion, so the debt ratio is 100%. The market doubts this debt burden is sustainable and so prices the debt at 60 percent of its face value.

Now a programme is announced whereby funds are provided to allow the country to buy back all its debt. Those behind the plan imagine they can go into the market and start purchasing debt at 60c and get the debt ratio down to 60%.  However, because the debt ratio would be sustainable at 60% and at that point the government would be able to pay back all of its debts, there would be no need in such a situation for there to be a market discount on the price of the debt.

So, as the programme is announced and the government intervenes to start repurchasing its debt, the price of the debt would jump above 60c.  The final price of the debt would depend upon a number of factors including the terms on the money being provided externally to fund the programme. But the end result would probably be significantly less debt relief than obtained, for example, by a straight swap of new for old bonds involving a forty percent reduction in net present value.

In relation to the wider Euro area problems, I’m somewhat optimistic that Thursday will see a harmonisation and reduction of EU programme interest rates, extension of maturities, as well approval of EFSF loans for debt buybacks. Personally, I would like to see the remit of EFSF extended to allow it to lend directly to banks, replacing excessive ECB funding as well as Emergency Liquidity Assistance. Of course, I doubt if this is even being considered.

We’ll see what happens but my prediction is that political face saving will take precedence over economically efficient solutions.

Update: The FT has an answer to my question about the bank tax which mixes it together with the buyback plan: “According to officials, it would amount to a 0.0025 per cent levy on all assets held by eurozone banks and would raise €10bn per year for five years. The cash would go to the bail-out fund, which would then use the money to conduct a Greek bond buy-back.”

## 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.

## 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. Continue reading “New Projections of Interest Rates on EU Loans”

## Lowered Ambitions

Ok, so it’s true. The headline in the Times piece says it all.

THE GOVERNMENT has conceded it is seeking a smaller reduction in the interest rate of the EU-International Monetary Fund bailout package than the 1 per cent originally sought, and only on the remaining money it has yet to draw down.

In what the Opposition portrayed as a U-turn and a tacit acceptance that a cut is no longer achievable, Taoiseach Enda Kenny yesterday said the maximum savings the Government could achieve from an interest rate cut were €150 million per annum, compared to €400 million if the rate on the whole loan was cut from 5.8 per cent to 4.8 per cent.

Mr Kenny, speaking in the Dáil, based the reduced figure on the fact the interest rate reduction would not apply to the €15 billion in European loans already drawn down, and only to the €24.6 billion remaining.

Let’s be clear about this. There is no reason whatsoever why the EU could not grant Ireland a one percent reduction on all its borrowings (not just those yet to be drawn down) as was previously granted to Greece. The EU has decided to add a particular margin on to its borrowing costs. The EU can decide to reduce it.

The lowered ambitions appear to be a combination of preparation for a deal barely worth accepting and (more relevantly) an attempt to use a fake argument (“can’t change the interest rate on funds already withdrawn”) to present the “feasible” rate reduction as not that big a deal.

I suspect “lowered ambitions” could prove to be the epitaph for this government.

## Bailout Interest Rate White Flag Department

Journalists sometimes get things wrong, so I’m going to phrase this as follows. Tell me this isn’t true:

Minister of State Brian Hayes has said the Government is looking for a 0.6% reduction in the bailout interest rate during its ongoing negotiations with the EC and the ECB.

Mr Hayes told RTÉ’s Drivetime programme that this would amount to a saving of €150m per year on the remaining amount of the loans which has not yet been drawn down.

All the signs are now that the government has gone into white flag mode on this one (what with the little-remarked-upon previous concession on Anglo-INBS bank bondholders, the flag’s had a busy week).  The key thing to watch for here is the approach of claiming lower and lower figures for what an interest rate reduction can achieve, with the benefit now down to €150 million per year.

Look, this isn’t rocket science. Greece, which hasn’t been very successful in implementing its package, received an interest rate cut of one percent in March. No Irish government could possibly be looking for less than a similar cut of one percent. We are borrowing €45 billion from the EU, so a one percent cut would save us €450 million a year, three times the figure being quoted. With an average maturity of seven and a half years, let’s call it seven, this would save the Irish taxpayer €3.15 billion or about €700 a head. It’s not a game-changer on the debt stability front but it’s not worth dismissing either.

Focusing on getting a cut in the remaining loans that have been drawn down is a red herring. It doesn’t matter that the EU has already sourced funds to lend to us as what we’re discussing cutting here is the EU’s own margin on these loans.

The only possible reason to define down the potential gains from an interest rate cut is to prepare the public for failure to achieve this cut, at which point we’ll be told that it wasn’t important.

Any hope that we might show some backbone on this issue (a la Namawinelake) is fading.

Update: Looking at yesterday’s Dail proceedings, one can find Minister Noonan stating that a one percent reduction in our interest rate will save us about €200 million a year. I know the Minister has the combined brain power of the Department of Finance officials on his side but it still seems to me that one percent of €45 billion is €450 million.

## Leogate and Green Jersey Economics

Throughout Ireland’s economic crisis, our government has adopted policies based on overly optimistic assumptions. The language of corners turned, manageable problems and final estimates has dominated communication of these policies. And throughout this period, the approach of the Serious People in Leinster House and at institutions such as the Irish Times has been to attack those who question these overly optimistic assumptions as unpatriotic folk who are talking the economy down.

Against that background, this green jersey editorial from the Irish Times on Leo Varadkar’s comments is deeply depressing. It adopts Michael Martin’s ridiculous line about “loose talk costing jobs” as if serious businessmen thinking about creating jobs were not already aware of the likelihood of a further EU-IMF deal for Ireland. It makes claims about sovereign bond markets that serve to illustrate that the writer clearly doesn’t understand these markets. If Leo’s comments created “doubt and uncertainty in financial markets among those that most matter, the bond investors from whom the State hopes to borrow again next year” then how come sovereign bond yields didn’t budge?

Then we get this gem:

As the euro zone debt crisis has unfolded, Ireland has lost credibility and sustained major reputational damage at various levels – government, public service, banking and business – which the Fine Gael Labour Government is attempting to regain and restore. This was best exemplified last November when talks about an EU-IMF bailout were under consideration while Fianna Fáil ministers issued public denials. It will take some time to re-establish trust in what governments say and confidence they can deliver on commitments made.

So Fianna Fail lost credibility by lying about the scale of our problems and ultimately denying things that everyone knew were true. And the IT’s reaction to this loss of credibility is to condemn a minister who makes a statement everyone knows to be true and to encourage the government to repeat a mantra about “no second deal” that will, in time, be just as discredited as the previous government’s approach.

The Irish Times may not wish to hear government ministers admitting that, despite best efforts, we may not be able to get back to the bond market. However, the “everything’s going to be fine” approach runs the risk of being exposed as just as false as the corner-turning rhetoric of the previous government. And it hardly helps with negotiating better terms on the current deal.

## IIEA Talk on Sovereign Debt

Given that Irish politicians and media have decided that Leo Varadkar’s comments about Ireland probably having to get a second EU-IMF deal is some kind of faux pas, it is perhaps worth pointing out that this opinion is widely shared by pretty much everyone I have to talked to in recent months.

Anyway, given that this issue is being discussed, now might be a good time to put up a link to this talk that I gave at the IIEA a few weeks ago. I discuss the risks relating to the current EU-IMF plan the likelihood of the need for a new deal. The slides for the talk are also on the page.

## Noonan on the EU-IMF Bailout

Listening to the News at One on RTE Radio One, I heard Minister for Finance Michael Noonan dismissing comments over the weekend from Minister Leo Varadkar that Ireland would probably have to seek a second bailout as it would not be able to return to the markets. That’s fair enough, one would expect a Minister for Finance to say the current programme is going to work and Varadkar was clearly off message.  However, it worries me that Noonan’s comments completely misrepresent the true picture in relation to Ireland’s funding situation.

Noonan said (I’m paraphrasing here but the audio links will be available later) that the EU and IMF are providing enough money “to carry us forward in all eventualities” and that the deal runs through Two-Thirteen (which I take means 2013). Noonan indicated that while there was a plan to return to borrowing from the markets in, yes, Two-Twelve, that this wasn’t actually necessary. The clear implication from these comments is that Ireland would not have to request a new deal until after 2013 if at that point market funding cannot be located.

This is not an accurate representation of the EU-IMF deal. Here‘s the European Commission’s report on Ireland, released in February. The last page shows the financing needs. It is clear that the EU and the IMF are not providing enough money to get us through the end of 2013. Indeed, the EU and IMF funds probably only get us to early 2013 (this was clear before the Commission’s report) and that market financing is required. So if we cannot obtain this market funding, we will have to request a new deal from the EU and IMF.

It’s reasonable to expect bluster from our Minister for Finance but we should at least expect him to show a clear understanding of the parameters of the state’s financing needs.

Update: Here is the updated European Commission programme document from this month. Financing needs are discussed on page 22. They differ a bit from the February document but the key point is the same. The programme calls for €14 billion in market financing in 2013 to fund the state.

## Dan O’Brien on the Story of the Bailout

Dan O’Brien has an interesting article (and an accompanying news piece) in today’s Irish Times on the “behind-the-scenes” story of Ireland’s bailout. The article is based on interviews for a radio documentary to be aired tomorrow on BBC Radio 4.

I suspect that regular readers of this blog won’t be surprised at the story of how the ECB triggered Ireland’s bailout and then favoured a plan involving a larger upfront fiscal adjustment than the government were comfortable with and a massive and rapid downsizing of the banking sector.

Time will tell whether the ECB’s actions in November helped or hindered the resolution of Ireland’s economic problems.  However, the story of November’s events does raise very serious questions about the role the ECB now plays in European politics. Should the key role in this historic decision have been played by an unelected and essentially unaccountable organisation?

## Business and Finance Article on EU-IMF Negotiations

Here‘s an article I wrote for Business and Finance on the ongoing negotiations with the EU and the IMF. I wrote the article before last Thursday and have to admit to being a bit less positive now that I was when I wrote it but the general point about the need for a careful approach to ongoing negotiations over the coming year or so still stands.

## April Fools One Year Ago

Given the day that’s in it, I was contemplating whether to do a funny story. But then I remembered the Irish Independent’s entry in the April Fool’s stakes from last year and figured I couldn’t beat it.

Brendan Keenan interviewing Brian Lenihan:

“With the banks playing for time, and the regulatory system discredited, we needed to establish an asset-relief programme like NAMA. That takes time to put into practice. It can’t be done overnight.”

He makes a point that tends to be overlooked in discussions of whether more should have been done sooner. It could not have been done 12 months ago, with the financial markets fretting over the scale of the budget deficit.

The country came close to not being able to borrow the money to keep it running. Attempting to cover the bank losses as well might have made that danger a reality.

At the time, however, I didn’t find it that funny.

## Irish Times Needs Better Sources

Prior to today’s announcements, the Irish Times were flagging the following:

Mr Noonan will make a “watershed” argument for a EU-wide solution around passing bank losses on to bondholders in response to the tests on Bank of Ireland, AIB, Irish Life and Permanent and EBS building society. Government colleagues last night described it as the first radical policy departure from the previous Fianna Fail-led government.

A few months ago, just prior to the announcement of the EU-IMF agreement, the Times had reported:

The source said there was a “common understanding” between delegations from the EU Commission, the European Central Bank and the IMF that senior and junior bondholders should each pay a share of the rescue costs.

Two conclusions to draw from this. First, people shouldn’t pay much attention to the Irish Times reports on these matters. Second, the Times need better sources.

## Daniel Thomas: Irish Bail-Out Terms Endanger EU’s Future

Here‘s an article by my UCD colleague Daniel Thomas that makes an important argument. If the Irish authorities are to get anywhere in relation to getting a better deal on issues such as the interest rates on official loans or dealing with our banking problems, they cannot rely on arguments based on narrow self interest.

Dan points to the dangers to the EU political reform process stemming from Ireland getting a bad deal. I think one can also argue that a deeper role for the EU in solving Ireland’s banking crisis can also be justified on the grounds that it can help to maintain financial stability throughout the Eurozone.

## Kenny Returns from Brussels

Enda Kenny has returned from Brussels without any agreement yet to reduce Ireland’s interest rate (Irish Times story here and FT story here). Not surprisingly, Mr. Kenny wasn’t too keen to give up Ireland’s 12.5% corporate tax rate in return for a mere one percent reduction in the interest rate on the EU loans.

To my mind, there is a lot of shadow boxing going on here. The EFSF is an EU institution and it cannot set the terms of its lending on a bilateral basis with individual countries. I’d be surprised if thee tradeoff between these two elements ended up being as explicit as suggested in this weekend’s news stories.

I think the business about interest rates and corporation tax rates has a feel of fiddling while Rome burns. More interesting were Kenny’s comments about the ECB:

“I made the point that for me to conclude a deal here I need to be much clearer in respect of elements related to the ECB,” he said.

“I spoke to president Jean-Claude Trichet and the Minister for Finance will be meeting with him on Monday. He has agreed that I should meet with him before the [next EU summit on March] 24th/25th to discuss a number of issues relating to the ECB and its positions.

“Before the council meets again in two weeks time we hope to be in a much clear position insofar as Ireland’s position is concerned and continue on our progress arising from the mandate that I’ve got about an improvement in the terms of the package for Ireland,” the Taoiseach said.

He continued: “In the next couple of weeks I expect to be in a much clearer position in respect of the state of what we have inherited is in respect of Ireland’s position.

“We’ll have had discussions with the ECB in respect of a number of matters. We’ll have a much clearer picture of what’s emerging from the stress tests and as the principle has now been accepted and implemented of a reduction in the interest rate I . . . would regard that actually as the beginning of a process.”

I reckon they could fill Croke Park if they sold tickets for those discussions with the ECB.

## The Fine Gael “Black Hole”?

I was accused yesterday in the comments of being biased against Fine Gael and for Labour. However, today I’m going to have to wave the yellow card at Labour for their role in the ongoing rumble about fiscal plans, specifically the supposed €5 billion “black hole” (e.g. here and here) in Fine Gael’s budgetary plans.

The issue relates to the following statement on page 29 of European Commission’s report on Ireland:

If the consolidation to reduce the deficit to 3% of GDP needed to be achieved by 2014, this would risk choking the recovery and further weakening the banking sector, possibly resulting in additional budgetary costs. The necessary additional budgetary effort in 2011-14 would amount to around €4 ½ to €5 bn, according to the Commission services forecast.

Fine Gael’s plans use what they call “the Department of Finance’s forecasts”, which presumably means the growth projections in the four-year plan (though it would be nice if they said that and produced a table being explicit about how their growth assumptions and other spending and tax promises translate into deficit ratios.) Based on this, they project reaching a deficit of 2.8% in 2014, just like the Four Year Plan.

Since FG are promising to deliver a deficit below 3% in 2014, does the Commission’s statement mean there is a €5 billion “black hole” in FG’s plans? Well, no. The additional adjustments that the Commission believe would be necessary to reach the 3% target stem from the Commission’s lower forecasts for the growth rate of nominal GDP. The Commission projects an average growth rate of 3.1% for nominal GDP over 2011-2014, compared with 3.9% in the Four Year Plan (and 3.85% in Labour’s projections.)

This means lower GDP and higher deficits in 2014 than are projected by the government and FG. However, FG are explicit that they will not introduce additional cuts to meet the 3% target in 2014:

We will review the pace and timeframe of the fiscal adjustment with the EU and IMF on an annual basis to take into account developments in the real economy. Should growth rates disappoint, we will continue with the same level of fiscal adjustment, but will avail of the extra year to reduce the deficit to under 3% of GDP offered by the EU-IMF Programme of Support.

Of course, it’s questionable whether the 3% target can be achieved by 2015 either and the IMF, freed from the strictures of having to pretend the Stability and Growth Pact matters, forecast that it won’t be.

Anyway, the black hole business is unfair to FG and the truth is that the differences between the overall stance of fiscal policy being proposed by FG and Labour are fairly small. FG planning to implement €9 billion in adjustments over the next three years, while Labour are planning to implement €7 billion. One can debate whether a slightly slower pace of adjustment is a better idea but the fact remains that policy will be severely contractionary whichever party gets its way.

When looking for black holes in the Fine Gael plan, one would be better off focusing on whether the promised efficiency improvements can really generate the predicting savings on the spending side.

## IMF Projections Show EU-IMF Funding Not Big Enough

One of the odd aspects of the election campaign so far is that despite constant references to the EU-IMF deal, nobody seems to have pointed out that even by the IMF’s own calculations, the deal does not in fact provide enough money to fund the state for three years.

I’ve been over this before in detail but here’s a quick reminder. The IMF’s report on the Irish deal projects cumulative general government deficits of €43.5 billion over the period 2011-2013. This includes a phantom €1.8 billion for interest on promissory notes that will count on the deficit in 2013 but for which cash payments are intended to be deferred. So the IMF are really projecting a cash requirement of €41.7 billion to fund deficits over the next three years. (See spreadsheet with calculations here.)

Add in €16.4 billion to honour long-term bond redemptions and €9.3 billion for principal payments on promissory notes and you get €68.7 billion.

The EU-IMF programme provides €50 billion over the period 2011-2013 to fund budget deficits and other cash payments. This means that, based on the IMF’s own deficit projections, the Irish government will need to come up with an additional €17.5 billion to fund the state over the next three years and also honour comittments on bonds that it has issued.

Do we have this €17.5 billion? Unfortunately not. After €10 billion is contributed to the bank recap, the NPRF will have €4.9 billion remaining. Exchequer balances were €15.7 billion at the end of 2011. Deduct the remaining €7.5 billion for the banking package and €6 billion for paying off our remaining T-bills over January to March and we’re left with €2.2 billion.

So, by my calculations, we don’t have the €17.5 billion that the IMF figures imply are required to get us through 2011-2013; we have €7.1 billion. (Note that we would still need €11.5 billion if the government’s deficit projections came to pass, implying we’re still not funded for the three years.) Since none of the above calculations are based upon secret information, one must assume that the IMF officials overseeing the deal also believe that insufficient money has been promised to meet the stated goal of three years of funding for the Irish state.

Two questions, then, that might be worth asking over the next few weeks of the campaign:

1. Do the various parties running for election intend to request additional funds from the EU or IMF to allow the state to be funded through 2013 or are they intended to return to the bond market before the end of 2013 to fund the country?

2. Given that the €7.1 billion left in liquid funds are not sufficient to fund the country for the next three years, do those who propose spending these funds on windmills, broadband and electric cars accept that they will need to negotiate a larger borrowing package with the EU-IMF because of this spending? If not, what is their plan for funding the state through 2013?

There are many potential answers to these questions. But the questions seem worth asking.

## On Renegotiation of the EU-IMF Deal

One of the features of political commentary everywhere is that it tends to be dominated by a smallish cadre of insiders who view themselves as “sensible people” and usually figure they know what needs to be done. For example, Washington DC-based political commentary tends to be dominated by folks (Paul Krugman’s Very Serious People) who think politics should be about bi-partisanship and dealing with a crisis in Social Security. In reality, wide political differences make passing bi-partisan legislation impossible and the crisis in Social Security isn’t such a big deal.

In Ireland today, the sensible people have decided that the election should be about two themes. First, that any talk of renegotiating the EU-IMF deal is simply misleading the electorate, with some columnists resorting to much stronger rhetoric. Second, that the electorate should be focusing on the fact that Fine Gael and Labour have different policies. (I’m not singling out any columnists in particular but a few random selections from the Irish Times opinion page should confirm these points).

On the EU-IMF programme, the sensible people seem to have missed that the deal was going to be up for some type of renegotiation even before the ink had run dry. I’ll offer the following observations:

1. The EU-IMF negotiators knew there was going to be an election when the deal was put together and met the main opposition parties during their time here to prepare for the inevitable change in government.

2. When asked in December about what might happen after an election, the IMF’s Ajai Chopra was very relaxed about the idea of the plan being changed saying “as long as the overall objectives of the program are agreed to by all, and that does seem to be the case, the specific policies as to how to achieve that can be discussed.” At a press conference on Thursday, IMF Caroline Atkinson, Director, External Relations Department, stressed the same message. Atkinson refused the opportunity to say that the deficit targets in the programme must be kept unchanged

3. When Mr. Chopra was asked about whether there was a possibility of the overall interest on the package being renegotiated, his answer was “For the IMF, no. This is the rate that is applied to all member countries.” This answer clearly leaves the door open to the idea that the EU rates could be renegotiated. Also, because Ireland’s IMF quota is just about to increase and is likely to increase substantially further in a year or so, the underlying interest rate at which the IMF will be able to lend to Ireland will be about 100 basis points lower than announced last November. This will make the IMF loan rates at least 100 basis points lower than the EU equivalents, even when controlling for the fact they are variable rather than fixed rates.

4. The argument that Ireland cannot unilaterally renegotiate the interest rate on the EU loans is, of course, correct but the implication that the interest rate shouldn’t be discussed in the campaign is a little silly. We are borrowing from the EFSF and EFSM at the rates that these organisations have set for their lending operations and so these organisations would have to change the rates that they set for all countries, not just Ireland. However, right now, they are only lending to Ireland and, at a time of great change in European institutions, the next Irish government would be remiss if they did not raise the issue of lowering the interest rate.

5. Much was made about Jean-Claude Trichet’s comments at his press conference this week that Ireland needs to “apply the plan”. Some seem to interpret this as somehow meaning that the man in charge of the EU-IMF programme had just said that nothing could be changed in the plan but this is simply not correct. M. Trichet is, of course, very keen to see key aspects of the plan implemented, particularly the banking sector measures, and so one wouldn’t expect him to say anything else. However, the ECB does not set the interest rates on the EFSF or EFSM loans and, frankly, I doubt if M. Trichet cares very much about this or about whether there are small adjustments to the fiscal plan.

On the other point being pushed by the sensible people, that Fine Gael and Labour have (gasp!) … different policies, it might be worth pointing out that the last time an Irish election produced an overall majority government was 1977. Coalitions, featuring programmes for government thrashed out between parties with different policies, are now the norm in Ireland. Since Fianna Fail have no chance of forming an overall majority government, perhaps it might be worth also emphasising that they too have different policies than any of their potential coalition partners.

## Further Reductions in IMF Rate Are Likely

A reader has written to me about an important item missing from my briefing paper on the IMF-EU loans. I noted in the report that the amount of money that Ireland can borrow at cheap rates is three times our IMF quota and that this quota was about to increase. However, I did not mention that a much larger increase in Ireland’s quota is likely to occur over the next year or so.

On November 5th, the IMF concluded its 14th General Review of Quotas with the Executive Board recommending that the Fund’s Board of Governors adopt the proposed quotas. The proposals include a doubling of the total amount of quotas and review of each county’s share of the total. Ireland’s share is proposed to increase further from 0.528% to 0.724%). This means that Ireland’s IMF quota will increase to around SDR 3.45 billion, which at current exchange rates would translate to a quota for almost €4 billion.

If implemented, these proposals would allow Ireland to borrow almost €12 billion at IMF’s low interest rate (currently 1.38%) with the remaining €10.5 billion at the higher rate (3.38% for the first three years, 4.38% thereafter). Over a seven and a half year period, this would translate into a loan that had an average margin over the variable SDR base rate of 228 basis points, down from the 326 basis point margin associated with the IMF lending terms that prevailed at the time the bailout deal was increased.

To come into effect, the proposals must be approved by 85% of the IMF’s voting share and 113 member countries. It’s unclear how long this will take but it may take a year or so.

I think this adjustment of the IMF lending terms is an important point to keep in mind when considering the lending terms on the EU loans. The EU lending authorities have been keen to point out that, once compared in the appropriate fashion, their loans can be viewed as having equivalent cost to the loan that the IMF offered the Irish government in November. This is true. However, when compared against the terms that the IMF is going to offer Ireland in the near future, the European loans are a good deal more expensive.

## Oireachtas Appearance on EU-IMF Interest Rates

I appeared today before the Oireachtas Committee on European Affairs to discuss the interest rates on the EU-IMF loans. I provided the committee with a briefing paper (available here) and a short presentation (available here). I will edit this post later to include the transcript of my opening statement and the questions and answer session when these materials are posted on the Oireachtas website.

There’s a lot of material in the briefing note and I’m not going to repeat it here. One point I would briefly point to, however, is that the note discusses how recent movements in market interest rates and the pricing of EFSM’s initial bond issue on January 5th (EU Commission press release here) meant that, by my estimates, the cost of funding from the EFSF and EFSM would be 40 basis points higher than had been estimated in the December note released by the NTMA.

These materials were prepared prior to today’s €5 billion bond auction the EFSF. Press stories have been very positive about how this bond auction went (e.g. here and here). However, the material I prepared discussed the pricing of the EFSM bond yield relative to swap rates. The January 5th bond was priced at mid-swaps +12 basis points while this bond mid-swaps +6 basis points, so the interest rate on today’s bond would not change my judgment on this issue by much.

Update: As promised here‘s the transcript of my appearance

## For How Long Does EU-IMF Financing Fund the State?

Over the past week, there have been repeated references during the Fianna Fail heave\confidence vote to the government’s achievement in securing funding for the state for a number of years.

The plan was originally presented as funding the state for three years. However, yesterday on Morning Ireland, Brian Cowen claimed that “funding for the state for the next four years had been organised” while on the Vincent Browne show on Monday night, junior minister Tony Killeen swung for the stars and claimed that we had secured “financing for the state for the next ten years or so”. (15.40 in).

Given the hyperbole\confusion on this matter, I thought it might be worth pointing out a few figures that suggest that the maximum length of time that the deal allows the state to stay out of the bond market is three years and that a more realistic assessment would suggest about two and a half years.

Anyone left in any doubt as to which of the outside parties was calling the shots in setting the terms of the EU-IMF agreement should consider checking out the clip from last night’s Week in Politics show. About two minutes in, there is a clip of Green Party TD Trevor Sargent discussing the decision to cut the minimum wage with a protestor. Sargent tells the protestor to take it up with Olli Rehn and that it was the EU, and not the IMF, that insisted on the cut in the minimum wage.

## The EU Commission’s View of Ireland

Despite the constant references to the IMF in the media, on placards and on posters, the truth is that the Irish bailout deal is largely funded by the European Union and most of the reliable reports about the negotiations have suggested that the terms and conditions of the deal largely represent the preferences of the European Union.

Given that, I’ve been surprised at how little attention has been paid to the European Commission’s Autumn forecasts, released on November 29, the day after the EU-IMF deal was agreed. This post examines these forecasts and what they suggest the Europeans think will happen in Ireland.

Growth

The growth assumptions (see page 9 of this document) underlying this year’s budget come from the government’s four-year plan, published on November 24. They assume real GDP growth of 1.7% in 2011 and 3.2% in 2012 and, more importantly for budgetary projections, nominal GDP growth of 2.5% in 2011 and 4.3% in 2012.

The EU Commission forecast published five days later projects real GDP growth of 0.9% in 2011 and 1.9% in 2012. They project growth in the GDP deflator of 0.4% in 2011 and 0.8% in 2012, so their forecasts for nominal GDP growth are 1.3% in 2011 and 2.7% in 2012, putting them 1.2 percentage points behind the government in 2011 and 1.6 points behind them in 2012.

Budget Deficit

Even if the government’s projected budget deficits came about, the lower level of nominal GDP projected by the Commission would produce a higher deficit as a fraction of GDP but this effect is small. Here’s a spreadsheet I’ve put together with various calculations. It’s not too easy to read but it reports that, on its own (i.e. keeping the government’s deficit forecasts), the lower projected level of nominal GDP in the Commission’s forecast would raise the deficit ratio from the government’s projected 9.4% of GDP for 2011 to 9.5% and from 7.3% in 2012 to 7.5%.

The Commission’s actual forecasts for the deficit ratios for the next two years, however, are 10.3% in 2011 and 9.1% in 2012. Based on my calculations of the Commission’s forecasts for nominal GDP, this implies deficit levels of €16.2 billion in 2011 and €14.9 billion in 2012. These figures are €1.3 billion higher than the government’s assumption in 2011 and €2.6 billion higher in 2012.

The discussion of the Irish forecast on pages 85 to 86 makes it clear that the Commission fully expects the implementation of the adjustment packages of €6 billion in 2011 (though €700 million of this is once-off measures) and €3.6 billion in 2012. This means that the Commission’s higher deficit forecasts are due to their estimates that the weaker economy will mean lower tax revenues and higher welfare spending.

The government projects revenue shares of 35.4% in 2010 and 2011 and 35.8% in 2012. The Commission project revenues shares of 35.1% in 2010, falling to 34.9% in 2011 and 34.7% in 2012.

The government projects an expenditure share of 67.3% this year, with 20.3% of this due to banking costs. The government then project expenditure share of 44.8% in 2011 and 43.1% in 2012. The Commission project expenditure shares of 67.5% in 2010, 45.2% in 2011 and 43.8% in 2012.

It seems clear from these calculations that the Commission do not view the 3% deficit target in 2014 as attainable. If a cumulative adjustment of €8.9 billion over 2011-2012 only succeeds in reducing the underlying deficit from 12.0% to 9.1%, it’s hard to credit how a further €6.2 billion in adjustments will succeed in reducing the deficit to below 3% in the following two years, even if economic growth did turn out to be strong. Indeed, a six percentage point reduction in the deficit over the three years after 2012, thus reaching the 3% deficit in 2015, seems ambitious.

Debt and the Cost of the Banks

One would expect the Commission’s projections for Irish public debt levels to be higher than those of the government over the next two years because of their higher deficit forecasts. However, the higher debt levels in the Commission’s forecasts also appear to reflect the EU’s view on the likely costs related to the banking system.

The Commission are forecasting Debt/GDP ratios of 107% in 2011 and 114.3% in 2012. Based on their nominal GDP forecasts, I calculate that this means debt levels that are higher than those projected in the budget documents by €11.6 billion in 2011 and by €15.5 billion in 2012.

The higher deficit projections will have implied an additional €1.3 billion of debt in 2011 and an additional €3.9 billion in 2012. The remaining €10.3 billion in 2011 and €11.6 billion in 2012, likely reflect the cost of the banking bailout.

The EU-IMF program involved the Irish government committing €17.5 billion in resources from the Pension Reserve Fund and cash balances towards the bank plan. These commitments do not add to the gross government debt. If the Commission are adding an additional €10.3 billion to their forecast for gross government debt in 2011, then this suggests that their estimate of the total cost of the banking package is €27.8 billion. This is already pretty close to the total of €35 billion that has been provided for these purposes. And this is prior to any unveiling of new information on loan losses from the upcoming PCAR stress tests.

Ruling out further costs of bank recapitalisations after 2012, if indeed the deficit is still 9.1% in 2012 and the debt ratio ends that year at 114.3%, it will take a very strong combination of GDP growth and fiscal adjustment to see the debt ratio stabilise at less than 120% in the following years.

I did a short pre-budget presentation today at UCD. Here are the slides. One point I emphasised is whether the level of front-loading of adjustment in the four-year plan agreed with the EU and IMF makes sense.

Up until the past few weeks, it was reasonable to argue that a significant front-loading was necessary (if not sufficient) to regain access to the sovereign bond market. However, now that our banking problems and the ECB have caught up with us and access to the sovereign bond market is not an issue for the next few years, I’m struggling to understand the logic for the extent of front-loading in the current plan (€6 bilion in adjustments in 2011, €3.6 billion in 2012, €3.1 billion in 2013 and 2014).

The economy is still in poor shape, so I’m not sure what the current argument is for further undermining it with such a front-loaded adjustment. As I speculated in the talk, perhaps the EU wanted to lock in as much adjustment as possible with the current government because comittments beyond the 2011 budget were most likely going to be open to negotiations with the next government.

## No Cards?

Writing in the Sunday Independent today, Colm McCarthy characterises the Irish government’s position in the EU-IMF negotiations as follows:

The analogy of a poker game has been invoked, with the Irish negotiators having held, according to economist Antoin Murphy, no more than a pair of twos. In reality they held no cards at all, and could not bluff either. An Irish rejection would have created unwelcome but manageable problems for the eurozone banking system but would have brought immediate financial meltdown in Ireland. The inevitability of the latter is the reason why the bailout providers were in Ireland in the first place.

I’m not sure that I agree with the asymmetry that Colm invokes here: That a meltdown of the Irish banking system would have been a disaster for us but merely an “unwelcome but manageable” problem for the rest of the Eurozone.

An Irish banking system meltdown, complete with senior debt defaults, could have had extremely serious consequences for the rest of the European banking system. If the cavalry had arrived in Ireland but failed to negotiate a deal because of their desire to make the terms too onerous, how could one feel secure about Spanish banks, for instance?

If, as it appears, the Europeans (rather than the IMF) were pushing for faster fiscal adjustment, more intense conditionality, no defaults on senior bonds and a high borrowing rate, rather than have no hand to play at all, the Irish side could still have adopted the Dirty Harry strategy: Go ahead punk, make my day.