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<\/a>In this post, I discuss the new arrangement and put some numbers on its benefits.\u00a0 I also discuss some of the objections to the deal that have been raised in Ireland\u00a0and conclude with a discussion of some of the legal issues considered by the ECB when approving the deal.<\/p>\n
Some History<\/strong><\/p>\n 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\u00a0to pay off creditors.\u00a0 This money was created with the approval of the Governing Council of the ECB.\u00a0 The Irish government provided guarantees to the Central\u00a0Bank of Ireland\u00a0that these loans to the state-owned IBRC would be repaid.\u00a0 The repayments would see the money created by the original loans taken out of existence.<\/p>\n 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 \u201cpromissory notes\u201d.\u00a0 These notes provided the bank with payments of \u20ac3.1 billion per year over the next decade from the Irish government, approximately 2 percent of Irish GDP each year.\u00a0 \u00a0In calculations I reported here\u00a0before<\/a>, I estimated that IBRC would have paid off its debts to the Central Bank by 2022.\u00a0 While the promissory notes had additional payments scheduled for years after 2022, these payments could have been cancelled and the bank liquidated.<\/p>\n Instead, the IBRC was liquidated last week.\u00a0 However, rather than the Central\u00a0Bank of Ireland\u00a0taking possession of the promissory notes, an agreement was reached to rip up the promissory notes and instead provide the Central Bank with \u20ac25 billion in new very long-dated bonds.<\/p>\n <\/p>\n The New Bonds<\/strong><\/p>\n As described\u00a0here<\/a>, 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.\u00a0 The bonds carry a variable interest rate that tracks six-month Euribor rates with an average additional margin of 263 basis points.<\/p>\n The impact of these interest payments on the cost of the transaction will change over time.\u00a0 At first, the bonds will belong to the Central Bank of Ireland.\u00a0 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.<\/p>\n Crucially, however, the Central\u00a0Bank of Ireland\u00a0has 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\u00a0presentation<\/a>\u00a0from the Department of Finance states:<\/p>\n 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 (\u20ac0.5bn), 2015-2018 (\u20ac0.5bn p.a.), 2019-2023 (\u20ac1bn p.a.), 2024 and after (\u20ac2bn p.a.)<\/p><\/blockquote>\n If this minimum amount of sales is stuck to then it will take until 2032 for all the bonds to be in private hands.\u00a0 On Irish television on\u00a0Sunday<\/a>, however, Patrick Honohan said the bonds would be sold \u00a0\u201cas soon as possible\u201d but also said he didn\u2019t see pressure from the ECB being applied to force a quicker pace of sales than the minimum agreed last week.<\/p>\n The fact that the bonds need to be sold to the private sector (and at an uncertain pace) means that claims that the deal \u201cpushes the cost out over 40 years at low interest rates\u201d are not entirely correct.<\/p>\n 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.\u00a0 At present, we can have no guarantee that the sales of these bonds will occur at par value.\u00a0 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.\u00a0 So while it turns out the new arrangements place a far lower burden on Irish taxpayers over the next few years, they don\u2019t \u201ckick the can\u201d of refinancing the IBRC debt quite as far down the road as many have been assuming.<\/p>\n Some Calculations<\/strong><\/p>\n Here is a\u00a0spreadsheet<\/a>\u00a0that I\u2019ve put together that allows for a comparison of the new arrangements involving \u20ac25 billion in new bonds with how this \u20ac25 billion would have been paid off under the previous promissory note structure.\u00a0 The calculations of the annual cost of the promissory notes are along the lines of those reported in my\u00a0post<\/a>\u00a0from last November.<\/p>\n 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.\u00a0 It also assumes that the sales of private bonds will occur at par value and won\u2019t add to the estimated costs.\u00a0 Future Euribor rates up to 2024 are estimated by deriving forward rates from the mid-swaps interest rates reported in Friday\u2019s Financial Times and then held constant for subsequent years.<\/p>\n A summary of the calculations:<\/p>\n There are a number of ways to think about the benefits of the new arrangements.<\/p>\n <\/p>\n Objections to the Deal<\/strong><\/p>\n Some of the reaction to the deal in Ireland\u00a0has been negative. \u00a0Some have criticized the new arrangements because they don\u2019t involve a full write-off of the IBRC\u2019s debt.\u00a0 However, the European Treaty\u2019s outlawing of \u201cmonetary financing\u201d makes it clear that loans from central banks to state-owned banks can\u2019t simply be written off and there was never any chance whatsoever that such a write-off could have emerged from negotiations with the ECB.\u00a0 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.<\/p>\n A second objection has been the idea that the deal simply \u201ckicks the can down the road\u201d or (more emotionally) \u201cforces our children and grandchildren to pay off huge debts\u201d.\u00a0\u00a0 Well public debt rarely ever gets paid off.\u00a0 Instead it is rolled over as long as financial markets believe governments have the capacity to honor their debts.\u00a0 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\u00a0 (Though before Ireland’s\u00a0children 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). It is possible that people have had in mind that the promissory notes could be cancelled if Ireland\u00a0left the euro and so was no longer subject to the monetary financing \u00a0prohibition.\u00a0 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\u00a0from cancelling the new bonds or indicating it would roll them over forever and hand back all interest payments.\u00a0 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.<\/p>\n Monetary Financing?<\/strong><\/p>\n A final question is whether the IBRC\u2019s previous funding or the current arrangements constitute a violation of the\u00a0European Treaty<\/a>\u2019s prohibition of monetary financing. This is probably worth a separate discussion of its own and I may return to it.\u00a0 For now, let\u2019s take a look at the relevant section of the Treaty (Article 123)<\/p>\n 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 \u2018national central banks\u2019) 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.<\/p>\n 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.<\/p><\/blockquote>\n 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.<\/p>\n 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.\u00a0 However, IBRC was going to take at least 10 more years to pay off its ELA loans.\u00a0 Furthermore, it was using a non-marketable instrument (the promissory notes) to provide collateral against these loans.\u00a0 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.<\/p>\n All told, the IBRC arrangements could have been considered monetary financing.\u00a0 However, no legal case was ever taken against it.\u00a0 The ECB Governing Council could have shut down the ELA operation using its powers under Article 14 of the\u00a0ECB statute<\/a>.\u00a0 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.\u00a0 The Article itself isn\u2019t exactly prescriptive on which loans terms are or are not legal.<\/p>\n Anyway, for one reason or another, it was decided to scrap the IBRC altogether and provide replacement bonds to the Central\u00a0Bank of Ireland.\u00a0 Now the question is whether the new arrangements violate Article 123.1.\u00a0 This article forbids the direct purchase of government bonds by central banks in the Eurosystem.<\/p>\n The CBI has ended up with \u20ac25 billion of Irish government bonds, which would be exactly the outcome had they violated the Treaty and directly purchased the bonds.\u00a0 However, because the bonds ended up at the CBI indirectly because of the liquidation of IBRC, it can be argued that last week\u2019s exercise was not monetary financing.<\/p>\n A separate question is whether the current arrangement constitutes a \u201ctype of credit facility\u201d. \u00a0Mario Draghi\u00a0says that the Governing Council members \u201ctook note\u201d of the last week\u2019s events in Ireland.\u00a0 Their reluctance to do any more than take note suggests that the Governing Council members don\u2019t believe the new arrangements are monetary financing.<\/p>\n It\u2019s worth pointing out that the \u201cindirect route\u201d by which the Central Bank has ended up owning these bonds didn\u2019t exactly involve an Act of God by which the Bank ended up holding them accidently.\u00a0 The official story is that IBRC was put into liquidation because a Reuters\u00a0story<\/a>\u00a0reported 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.<\/p>\n On balance, I\u2019m inclined to agree with\u00a0Wolfgang Munchau<\/a>\u00a0that the current arrangements are monetary financing in spirit if not necessarily according to the letter of the law.\u00a0 And like Munchau, I have no great problem with this.\u00a0 A weakening of unnecessary monetary purity may be required if the euro is to be saved.<\/p>\n\n
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\nA 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\u2019t sovereign debt and replaced it with sovereign debt that must be honoured in some way that the promissory notes didn\u2019t have to be.\u00a0 I have no idea why people believe this.\u00a0 The promissory notes were debts issued by the Irish sovereign, hence they were sovereign debt.\u00a0 And they were counted as sovereign debt by Eurostat, the official arbiter of these matters in Europe.<\/p>\n