My reaction to the final agreement on Cyprus including a link to an op-ed I wrote for the Irish Times.
Lots of people I’ve spoken with about the dreaded Anglo promissory notes are mystified at why the Irish government seems willing to replace the notes with a 40-year bond. Isn’t it just replacing one kind of debt with another? Won’t we just end up paying more over the long-run? Here‘s a post where I try to answer these questions. Warning: This is a tricky topic and it’s an unusually wonkish post.
I’ve been very busy lately so I haven’t had much time for blogging. Here is a belated assessment of where Ireland stands after a week in which it became clear that Ireland was “a special case” (even if nobody knows quite what that means).
My thoughts on Enda Kenny’s Time magazine cover are here.
I haven’t been as euphoric as some commentators about Ireland’s prospects of getting a “seismic” “game-changing” deal on bank-related debt. Still, even my relatively mild hopes have been dashed a bit by this evening’s statement by the German, Dutch and Finnish finance ministers. Thoughts here.
An updated version of my promissory note paper is now available. Details here.
The byzantine complexities of the IBRC’s promissory note-emergency liquidity assistance arrangements are such that it is inevitable that even the smartest of people will get confused. Unfortunately, Irish Times reporter Arthur Beesley (who does excellent work covering Brussels) came a cropper in this morning’s article on the negotations over restructuring Ireland’s bank-related debt.
Arthur’s article discusses the issues as follows:
On the table is the provision of about €30 billion in bonds from a European bailout fund to the former Anglo Irish Bank to replace expensive State-funded promissory notes …
The release of European bonds to the former Anglo would be in addition to the €40.2 billion Ireland is receiving from European sources under the original bailout agreement.
This is one element of the package which would certainly necessitate parliamentary votes in a number of countries.
The key issue in this part of the negotiation is the rate of interest which would be charged on any bonds from the temporary European Financial Stability Facility or its successor, the ESM.
The basic idea is that the Government would remain on the hook for EFSF or ESM bonds given to the former Anglo but that the annual interest rate charged would be far lower than the 8.2 per cent which applies now.
Precisely what rate would be charged remains subject to negotiation, the official said.
Under present arrangements the State would pay €16.8 billion in interest by 2031, bringing the total cost of the Anglo note scheme to €47.4 billion.
This description misses the key issues at stake here in a number of ways.
The problem with the promissory note arrangement is not that it causes the state to incur high interest costs. In fact, the opposite is the case. The 8.2 percent interest rate quoted here relates to interest payments that the state is making to IBRC, a state-owned institution. This is one arm of the state paying another so the interest rate has no impact on the state’s underlying debt situation.
In the same way, the IBRC uses its promissory note payments to repay its ELA debts to the Central Bank of Ireland (another arm of the state) and the (lower) interest rate it pays on ELA also has no relevance. The Central Bank returns the profits it makes on these ELA loans to the state (see its 2011 annual report).
What is the interest cost to the state of the current arrangement? As I described in detail in this paper, the Central Bank takes in the principal payments on ELA and then retires the money that it created when granting the ELA in the first place. This reduces the balance sheet item “Intra-Eurosystem Liabilities” which the Bank currently pays 0.75% percent on.
So the effective interest rate to the state of the promissory note arrangement is 0.75%, not 8.2%. The problem with the current arrangement is not the interest rate but rather the schedule for repayment of the principal, which will see a punishing 2 percent of GDP paid over each year over the next ten years.
The article mentions a figure for the total cost of the promissory notes of €47.4 billion. However, because most of the interest cost is returned to the state, the true net cost is far lower. Effectively, the total cost will be the €31 billion in principal on the notes that were issued plus the cumulated interest costs calculated at the ECB refinancing rate. This will be far less than €47.4 billion.
In relation to substance, the article suggests the negotiations are focused on replacing the promissory notes with bonds from the EFSF and or ESM, which could then be repo’d with the ECB allowing most of the ELA borrowings to be paid off. The state would then provide EFSF\ESM with the funds to cover the annual interest on the bonds with funds.
One version of this arrangement could see the bonds pay out €30 billion in 2042, with the Irish state providing the principal to EFSF\ESM and IBRC finally repaying the ECB. A more likely scenario would see a gradual repayment of the principal via repayment of ECB and retirement of the EFSF bonds.
If these bonds are placed directly rather than borrowed from the market, then one could argue that they should carry an interest rate of close to zero, since the EFSF is no longer adding a profit margin to its cost of funds (and the cost in this case is zero).
An arrangement of this type could mimic the low interest cost to the state of the current arrangements while adding a long-term schedule for repayment of principal. However, it carries with it some serious political complications. As the Times article notes, this arrangement would require political approval throughout Europe and that may be difficult obtain. In addition, this debt would have to be repaid even if Ireland left the euro because of its official status, while a post-euro Central Bank of Ireland would have the option of agreeing to a unilateral restructuring of the promissory notes.
An alternative arrangement that avoids these political risks is to simply alter the current arrangements to have the promissory note schedule be far more back-loaded than at present. This requires only the agreement of the ECB. As I wrote here a few weeks ago, there is a strong argument that it is time the ECB could Ireland some slack.
I have written a new briefing paper for the European Parliament’s Economic and Monetary Affairs committee. The paper discusses the ECB’s role in Ireland’s financial assistance programme. Here’s the abstract:
This paper reviews the role the ECB has played in financial assistances programmes in the Euro area, focusing in particular on Ireland. The ECB’s involvement in Ireland—in particular its policy in relation to senior bank debt—has raised questions about whether it has over-stretched to act beyond its mandate. The ECB is not providing official assistance to the Irish government and its involvement in monitoring the programme has confused the public about the nature of the programme’s conditionality and contributed to undermining its legitimacy. I recommend that future financial assistance programmes should not feature the ECB as a member of a Troika tasked with monitoring the programme. The ECB’s relationships with other crisis countries are reviewed. I conclude that Europe needs to clarify its policies on bank resolution and systemic risk—and the role of the ECB in relation to these policies—before it is too late.
The other briefing papers (some more on the ECB’s role in financial adjustment programmes and others on the response of central banks around the world to the crisis) can be found here. Click on 09.07.2012.