Back to blogging again after a rare bit of time off over the summer, here are some comments on the current disagreement between Eamon Gilmore and the Troika about the upcoming Irish budget.
Probably the biggest economic story in Europe this week has been the release of recorded phone calls from 2008 between executives of the now-notorious Anglo Irish Bank. Anglo was a recklessly aggressively property development bank with, as the euphemism goes, serious corporate governance issues. When the bank got into trouble, its liabilities were guaranteed by the Irish government.
Paying off Anglo’s creditors ended up costing the Irish government over €30 billion, the equivalent of about 20 percent of GDP or about €6500 (or $8500) per person in the country. The newly-released recordings (from the weeks prior the guarantee decision) show Anglo executives were aware that the bank was undergoing a severe crisis and needed more state financing than they were willing to admit to the public officials. They also show a fairly contemptuous attitude to these same officials.
The Anglo tapes raise many questions and I’ll return to these questions later. However, for now I want to make a few points about the guarantee decision and the role that it played in Ireland’s economic crisis.
The reaction to the tapes in Ireland has, justifiably, been one of outrage. However, there is also a growing public perception that the fiscal austerity of recent years has largely been the responsibility of a few rogue bankers. I think this perception is incorrect and it would be a mistake for the public to ignore the crucial roles played by a far wider set of economic policy mistakes made by governments they elected.
Here is a new paper I have written titled “Ireland’s Economic Crisis: The Good, the Bad and the Ugly”. One of the points the paper makes is that Ireland would be undergoing a severe fiscal crisis even the state hadn’t spent a cent on its banks. The public debt-GDP ratio went from 25 percent in 2007 to about 120 percent today while a sovereign wealth fund worth about 20 percent of GDP has largely been wiped out.
Bank-related costs have been about 40 percent of GDP, with about half of that due to Anglo. This means that large fiscal deficits, rather than bank-related costs, have accounted for the majority of the build-up in net debt over the past few years. Even without spending a cent on Anglo, Ireland would have a debt ratio of 100 percent of GDP and a large fiscal deficit.
The additional debt due to bailing out bank creditors certainly played a crucial role in Ireland having to enter an EU-IMF program in 2010. However, while it is easy to blame external bodies for the pain associated with austerity, Ireland’s policy makers have had little choice over the past few years in relation to tax increases and spending cuts.
As I discuss in the paper, Ireland’s fiscal crisis is largely the consequence of the extreme over-concentration of the economy in the years prior to the crisis on the construction sector. Lax banking regulation allowed an excess supply of credit to fuel a huge housing bubble, construction activity was off the charts and the government relied heavily on revenues from this sector to finance tax cuts and spending increases. Once the bubble popped and the construction sector collapsed, the government was left with a massive loss of revenues and a substantial increase in welfare spending.
Without budget cuts, Ireland was heading for deficits of over 20 percent of GDP in 2009 and even this year, after years of spending cuts and tax increases, the deficit is still over 7 percent of GDP. Deficits on this scale were not sustainable for a euro area member state, so Ireland would be undergoing austerity today even if the EU and the IMF had never arrived to provide funding.
This point is important because it makes it all the more difficult get the public to accept tax increases or spending cuts when they view these cuts as simply the fault of a group of rogue bankers. This viewpoint also distracts from the rogue economic policy making of elected politicians and senior civil servants.
Worth noting is that this is the second Irish economic crisis of my lifetime. Sometimes, the current era feels like a repeat of my teenage years with fiscal crises and high unemployment blighting the country. To avoid another future crisis, debate in Ireland needs to move beyond blaming Anglo’s bad eggs towards asking wider questions about how to run their economy on a sustainable basis.
Having made these points, I want to emphasize that I do not at all agree that the bank guarantee was a correct or unavoidable decision, even given what Irish policy makers knew at the time. This is the position put forward by Irish economists, Donal Donovan and Antoin Murphy in an extensive chapter on the guarantee in their new book. (In fact, Donovan and Murphy argue that the guarantee would have been the correct policy even if the authorities knew the true state of the banks so that it would cost 40 percent of GDP!)
This book makes a number of points I disagree with but, since it’s not available for people on the internet to read, there is perhaps little point in going into too much detail here. I will quickly make two observations.
First, the strength of the arguments made by Donovan and Murphy is well summarized by their argument for why it may have been reasonable to include subordinated bank debt in the guarantee. They argue that
It has been suggested that, given the high degree of uncertainty, if not panic, prevailing, attempts to fine-tune the coverage of the guarantee might not have been well understood by markets the following morning and could have derailed the overriding objective of restoring confidence in the Irish banks.
This is a bizarre argument. For starters, the guarantee was fine-tuned because undated subordinated debt was excluded. However, the idea that financial market participants would have been “confused” that the government failed to guarantee debt that is explicitly contractually required to take losses in the event of a liquidation simply defies belief. I spoke with many financial market professionals in the years after the guarantee and their only reaction to the guaranteeing of subordinated debt was confusion as to why it was included.
More importantly, Donovan and Murphy’s extensive chapter does not consider the most obvious alternative to the type of guarantee offered by the Irish government. This alternative was to guarantee deposits for some period of time as well as specified new bond issues but to leave previous bond issues uncovered.
This ECB paper from 2009 details the emergency measures taken by all EU countries and shows that guaranteeing new bond issues only was the approach taken by almost all countries. Such a guarantee would have had the exact same impact in providing a (temporary) improvement in the funding situation for Irish banks without unnecessarily guaranteeing the bonds owned by investors who had unwisely given money to a recklessly-run bank.
Anyone who thinks there was no way to tell in “real time” that the guarantee was a bad decision is advised to watch this video of my colleague Morgan Kelly’s instant reaction to the decision. The arguments of the other participants in the debate also give you an idea how weak the case was for making this decision.
So the guarantee decision was a bad one and exacerbated the losses associated with Ireland’s banking crisis. But the austerity being suffered in Ireland has wider causes than the behavior of a few bad apples at Anglo Irish Bank and debate on future policies needs to focus on a wider set of issues than how to deal with rogue bankers.
My reaction to the final agreement on Cyprus including a link to an op-ed I wrote for the Irish Times.
Ding dong the wicked bank is dead. Anglo Irish Bank is no more. Its successor, the Irish Bank Resolution Corporation is being liquidated. Unfortunately, its legacy of debt piled on the Irish public’s shoulders is not dead. Still, last Thursday’s announcement, which saw the infamous promissory notes replaced with a series of very long-term bonds, is a useful step in reducing the burden associated with the IBRC. Credit is due, in particular, to the Central Bank of Ireland Governor, Patrick Honohan, who oversaw new arrangements being put in place that secured the approval of the ECB Governing Council.
In this post, I discuss the new arrangement and put some numbers on its benefits. I also discuss some of the objections to the deal that have been raised in Ireland and conclude with a discussion of some of the legal issues considered by the ECB when approving the deal.
IBRC was created from merging two institutions that had borrowed extraordinary amounts of money under an Extraordinary Liquidity Assistance (ELA) program from the Central Bank of Ireland to pay off creditors. This money was created with the approval of the Governing Council of the ECB. The Irish government provided guarantees to the Central Bank of Ireland that these loans to the state-owned IBRC would be repaid. The repayments would see the money created by the original loans taken out of existence.
To allow the IBRC to repay its loans (and to provide collateral for those loans) the Irish government agreed in 2010 to provide it with so-called “promissory notes”. These notes provided the bank with payments of €3.1 billion per year over the next decade from the Irish government, approximately 2 percent of Irish GDP each year. In calculations I reported here before, I estimated that IBRC would have paid off its debts to the Central Bank by 2022. While the promissory notes had additional payments scheduled for years after 2022, these payments could have been cancelled and the bank liquidated.
Instead, the IBRC was liquidated last week. However, rather than the Central Bank of Ireland taking possession of the promissory notes, an agreement was reached to rip up the promissory notes and instead provide the Central Bank with €25 billion in new very long-dated bonds.
The New Bonds
As described here, the new bonds have maturities ranging from 27 years to 40 years with a weighted-average maturity of 34.5. So this means no repayment of principal on these bonds for 27 years. The bonds carry a variable interest rate that tracks six-month Euribor rates with an average additional margin of 263 basis points.
The impact of these interest payments on the cost of the transaction will change over time. At first, the bonds will belong to the Central Bank of Ireland. However, the Central Bank hands back its surplus income to the Irish Exchequer, so these interest payments can be considered a circular transaction in which interest is handed over to the Central Bank to eventually be handed back to the Irish government.
Crucially, however, the Central Bank of Ireland has agreed to dispose of the bonds over time by selling them to the private sector. This will gradually increase the amount of interest that is being paid out and not simply returned by the Central Bank. A presentation from the Department of Finance states:
The Central Bank of Ireland will sell the bonds but only where such a sale is not disruptive to financial stability. They have however undertaken that minimum of bonds will be sold in accordance with the following schedule: to end 2014 (€0.5bn), 2015-2018 (€0.5bn p.a.), 2019-2023 (€1bn p.a.), 2024 and after (€2bn p.a.)
If this minimum amount of sales is stuck to then it will take until 2032 for all the bonds to be in private hands. On Irish television on Sunday, however, Patrick Honohan said the bonds would be sold “as soon as possible” but also said he didn’t see pressure from the ECB being applied to force a quicker pace of sales than the minimum agreed last week.
The fact that the bonds need to be sold to the private sector (and at an uncertain pace) means that claims that the deal “pushes the cost out over 40 years at low interest rates” are not entirely correct.
If the Irish government was able to borrow large amounts of money now over 40 years at Euribor plus 263 basis points then they would have done so and used the money to retire the promissory notes and liquidate IBRC. At present, we can have no guarantee that the sales of these bonds will occur at par value. If private investors in the future are only willing to purchase these bonds at higher yields than the Euribor-plus-263bp coupons, then the Irish government (in the form of its Central Bank) will incur a loss on these sales. So while it turns out the new arrangements place a far lower burden on Irish taxpayers over the next few years, they don’t “kick the can” of refinancing the IBRC debt quite as far down the road as many have been assuming.
Here is a spreadsheet that I’ve put together that allows for a comparison of the new arrangements involving €25 billion in new bonds with how this €25 billion would have been paid off under the previous promissory note structure. The calculations of the annual cost of the promissory notes are along the lines of those reported in my post from last November.
Importantly, the spreadsheet assumes that bond sales correspond to the minimum described above, so the estimated benefits will be lower if the bond sales are faster. It also assumes that the sales of private bonds will occur at par value and won’t add to the estimated costs. Future Euribor rates up to 2024 are estimated by deriving forward rates from the mid-swaps interest rates reported in Friday’s Financial Times and then held constant for subsequent years.
A summary of the calculations:
- The promissory notes would have paid off the €25 billion in 10 years, meaning an average net cost of €2.5 billion over the next decade. This is lower than the annual €3.1 payment because some of the payments would have taken the form of interest payments to the Central Bank which could have been returned to the government.
- In stark contrast, the total net payments under the new arrangements over the first decade are only €1.4 billion. While I project €11.2 billion in total interest payments through 2022, all but this €1.4 billion go to the Central Bank. In this sense, the new arrangements provide a very substantial relief over the next decade relative to the previous ones.
- Slightly less positive is the fact that €6.5 billion in long-term bonds must be sold up to 2022. From the point of view of financial markets, these sales will be treated in pretty much the same way as new bond sales. They represent the Irish public sector incurring a new debt to the private sector. So the new arrangement leads to financing demands of €7.9 billion over the next decade (€1.4 billion to pay the interest and €6.5 billion in bond sales) relative to €25 billion required under the promissory notes.
- After 2022, the new arrangements become more demanding. The decade 2023-2032 sees €9.6 billion in interest payments to the private sector and €18.5 billion in bond sales. The decade 2033-2042 sees €13.8 billion in interest payments and €4 billion in principal payments. Finally, 2043-2053 sees interest payments of €7.36 and €21 billion in principal payments.
There are a number of ways to think about the benefits of the new arrangements.
- With the public debt ratio now over 122 percent and investors potentially concerned about the prospects of sovereign debt restructuring taking place if the debt ratio cannot be stabilized, the dramatic reduction in financing requirements over the next decade is helpful. It reduces the chances of a sovereign default triggered by inability to meet payment demands to the private sector.
- More generally, delaying payments off into the future allows them to be dealt with at a time when inflation and economic growth have reduced the burden they impose. For example, the final two principal payments of a combined €10 billion will occur in 2051 and 2053. If made today, these payments would account for 6.25 percent of Irish GDP. However, if nominal GDP grows at 4 percent per annum over the next 40 years, these payments would be closer to 1 percent of the GDP at the time of the payment, making it far easier to simply roll this debt over.
- One way to calculate the reduced burden due to delaying payments is to calculate the net present value (NPV) of the stream of payments. The spreadsheet uses a 6 percent per annum discount rate and calculates the NPV of the promissory note payments as 19.5 billion and the NPV of payments under the new bonds as €12.8 billion. This represents a 34.4 percent reduction in the NPV. While clearly some way short of a full write-off, last week’s deal still represents a clear improvement on the promissory notes.
Objections to the Deal
Some of the reaction to the deal in Ireland has been negative. Some have criticized the new arrangements because they don’t involve a full write-off of the IBRC’s debt. However, the European Treaty’s outlawing of “monetary financing” makes it clear that loans from central banks to state-owned banks can’t simply be written off and there was never any chance whatsoever that such a write-off could have emerged from negotiations with the ECB. Those with moral objections to the nature of this debt should consider whether the Irish authorities should have rejected a deal that reduced the burden of the debt because of the absence of an unattainable deal.
A second objection has been the idea that the deal simply “kicks the can down the road” or (more emotionally) “forces our children and grandchildren to pay off huge debts”. Well public debt rarely ever gets paid off. Instead it is rolled over as long as financial markets believe governments have the capacity to honor their debts. Unless economic growth and inflation come to an end (in which case the Irish people will have a lot more than IBRC debt to worry about) future generations of Irish taxpayers should be able to roll over these debts (Though before Ireland’s children all grow up and have children of their own, the country will face the challenge of selling large quantities of the new bonds next decade without generating losses).
A final objection that has been widely aired is that by replacing the promissory notes with new bonds, the Irish government has taken something that wasn’t sovereign debt and replaced it with sovereign debt that must be honoured in some way that the promissory notes didn’t have to be. I have no idea why people believe this. The promissory notes were debts issued by the Irish sovereign, hence they were sovereign debt. And they were counted as sovereign debt by Eurostat, the official arbiter of these matters in Europe.
It is possible that people have had in mind that the promissory notes could be cancelled if Ireland left the euro and so was no longer subject to the monetary financing prohibition. However, if a euro exit was to occur at some point in the next few years, there would be nothing preventing the Central Bank of Ireland from cancelling the new bonds or indicating it would roll them over forever and hand back all interest payments. In fact, because the transition to the bonds being held in private hands in the new arrangement is slower than the repayment of ELA under the old arrangement, the flexibility to cancel or default on these obligations in a crisis scenario is more significant than it was previously.
A final question is whether the IBRC’s previous funding or the current arrangements constitute a violation of the European Treaty’s prohibition of monetary financing. This is probably worth a separate discussion of its own and I may return to it. For now, let’s take a look at the relevant section of the Treaty (Article 123)
1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.
2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions.
The promissory note arrangements could have been considered a violation of Article 123.2. While it was legal for the Eurosystem to loan money to the IBRC, it was questionable as to whether it was receiving the same treatment as other banks.
ELA loans are generally intended to be provided for a short period of time while emergency measures are taken to save or liquidate a bank. However, IBRC was going to take at least 10 more years to pay off its ELA loans. Furthermore, it was using a non-marketable instrument (the promissory notes) to provide collateral against these loans. IBRC did pay a risk premium on its ELA loans but the profits the Central Bank made from these premium payments were returned to the government.
All told, the IBRC arrangements could have been considered monetary financing. However, no legal case was ever taken against it. The ECB Governing Council could have shut down the ELA operation using its powers under Article 14 of the ECB statute. However, they consistently approved the operation and one could argue that if a ten-year repayment was legal, then a forty-year repayment could also have been legal. The Article itself isn’t exactly prescriptive on which loans terms are or are not legal.
Anyway, for one reason or another, it was decided to scrap the IBRC altogether and provide replacement bonds to the Central Bank of Ireland. Now the question is whether the new arrangements violate Article 123.1. This article forbids the direct purchase of government bonds by central banks in the Eurosystem.
The CBI has ended up with €25 billion of Irish government bonds, which would be exactly the outcome had they violated the Treaty and directly purchased the bonds. However, because the bonds ended up at the CBI indirectly because of the liquidation of IBRC, it can be argued that last week’s exercise was not monetary financing.
A separate question is whether the current arrangement constitutes a “type of credit facility”. Mario Draghi says that the Governing Council members “took note” of the last week’s events in Ireland. Their reluctance to do any more than take note suggests that the Governing Council members don’t believe the new arrangements are monetary financing.
It’s worth pointing out that the “indirect route” by which the Central Bank has ended up owning these bonds didn’t exactly involve an Act of God by which the Bank ended up holding them accidently. The official story is that IBRC was put into liquidation because a Reuters story reported the government was considering liquidating the bank and this rendered the bank unstable. The reality is the IBRC was liquidated because the Irish government preferred the new arrangements that emerged as a result.
On balance, I’m inclined to agree with Wolfgang Munchau that the current arrangements are monetary financing in spirit if not necessarily according to the letter of the law. And like Munchau, I have no great problem with this. A weakening of unnecessary monetary purity may be required if the euro is to be saved.
Update: Alternative Bond Sale Scenario
I have put up a new spreadsheet that illustrates the scenario in which the Central Bank of Ireland sells all €25 billion of its bonds by 2022. This is one possible scenario as to what might be meant by “as soon as possible”.
The spreadsheet shows that this faster pace of sales would undo nearly all the gains associated with minimum-sales scenario. In addition to requiring the Irish public sector to find buyers over the next decade for €25 billion in long-dated Irish notes carrying coupons with modest spreads (a funding requirement not so different from what would have been required with the promissory notes) the net present value gain from the new arrangement falls from 34.4 percent to 6.1 percent.
These calculations show that the benefits from last week’s announcements are fairly uncertain and will likely depend upon future negotiations between the Central Bank of Ireland and the ECB Governing Council as to the appropriate speed at which the bonds should be sold.
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.