Tuesday, May 31, 2011

Central Bank Funding falls but…

The Central Bank have released the April Credit, Money and Banking Statistics.  They should that the reliance of the covered banks on central bank funding has fallen again.

Central Bank Funding

The banks are using €74.2 billion of ECB funding down from €79.2 billion in March and the “Other Assets” category from the Central Bank of Ireland’s balance sheet fell from €66.7 billion to €54.1 billion.  Total reliance of the banks on central bank liquidity is now around €127 billion.  This is a big drop from the level of more than €150 billion recorded in February.

This appears to be a good thing but if we look to see what funds the banks are looking to replace the central banking funding the shine is knocked off this somewhat.  Specifically we look at deposits from Irish residents in the covered banks as this explains most of the above drop.

Irish Resident Deposits in Covered Banks

The reason the covered banks have reduced their demand for central bank liquidity is because of a jump in deposits from government.  The Irish government now has €21.3 billion on deposit with the covered banks.  For most of the previous three years it had hovered close to €3 billion.

The increase is because the government has already received the money for the bank recapitalisation process from the EU/IMF.  Over the coming months this money will be taken off deposit (which the government has to get back) and used as capital (which the government has no guarantee of getting back).

It does seem that the fall in private sector deposits in the covered banks seems to stalled and these deposits actually increased from €106.3 billion to €108.2 billion in April.

Friday, May 27, 2011

Retail Sales slip again

The April Retail Sales Index has been published by the Central Statistics Office.  The volatility that has seen the core series fall, rise, fall, rise over the previous four months continued into April, when March’s rise was followed by a fall in April.

Here is the retail sales index excluding motor trades.

Ex Motor Trades Index to Apr

The gap between the value and volume series has been narrowing in recent months, though this has been driven more by the continued fall in the volume series rather than any significant rise in the value series. 

The volume series has fallen and is now only higher then when the severe weather resulted in a sharp downswing last December.  The value series has performed slightly better and although it is down 2.4% on the year it is still at the same level as was recorded last July.  It should be noted that this has more to do with rising prices than increased spending.

The annual changes reflect these patterns with the annual changes in the volume index falling below the annual changes in the value index.  This has not been a feature of the recession to date that has generally seen the value index fall at a faster rate than the volume index. 

Annual Change Ex Motor Trade Index to Apr

Here are the monthly changes which as stated above have moved from positive to negative for each of the past five months.

Monthly Change Ex Motor Trade Index to Apr

How much do we need? Where can we get it?

This is an revision to the conclusion of a previous post.  The key question is how long can we last using the funds available from the EU/IMF assistance package?  The five elements we need to determine are:

  1. How much money do we need to fund the annual deficits?
  2. How much money do we need to cover the maturing of existing debt?
  3. How much money do we have now?
  4. How much money can we get from the EU/IMF package?
  5. Can we get money from anywhere else?

Now that a consensus has emerged on Ireland’s medium term debt projections the answer to first question can be identified relatively easily.  Between now and the end of 2014 the IMF forecast that the cumulative general government deficits will be €51.5 billion.  The Department of Finance forecast is that they will be €50 billion.

This analysis excludes the bank recapitalisations required after the recent stress tests.  The EU/IMF deal had a €35 billion contingency fund included for the banks, with half coming from the EU/IMF package and half coming from our own resources (NPRF, cash balances).  This will not be used in full and the €20 billion required from the State for the bank recapitalisation will see a further €10 billion removed from the NPRF with the remaining €10 billion coming from the EU/IMF funds.  The money for the bank recapitalisation is available and is not being used in full.

To get a measure of the ongoing cash requirements of the Irish government we can use the Exchequer Deficit as a proxy.  This includes the gap between government revenue and expenditure, debt interest and the annual €3.1 billion repayments on the Promissory Notes.  It excludes some small miscellaneous items which would likely cancel out and also the accrued interest on the Promissory Notes that will become due but will not be paid until into the 2020s.  We will use the forecasts of the Exchequer Deficit provided on the last page of the recent Stability Programme Update.

We also need money to repay the money due on existing debt that will mature over the next few years.  The National Treasury Management Agency provide a useful table in this regard.  From this table we will use the annual totals for maturing government bonds, short term debt and other debt.  We will exclude the assumed maturity profile of retail debt such as Savings Certificates, Savings Bonds, Prize Bonds and Post Office Savings Funds Accounts which have variable amounts and varying or unknown maturities.  The NTMA state that:

For the purposes of constructing an overall maturity profile of the National Debt, it is assumed that 10 per cent of retail debt matures each year for the next five years and 50 per cent in the sixth year.

Using the Exchequer Deficits and Maturity Profile of Existing Debt we can construct the following table.

Funding Requirements

The second last column gives the annual funding requirement for each year and the last column gives the cumulative requirement between now and that date.  To fund the Exchequer Deficits and repay existing debt between now and the end of 2015 we need just over €100 billion.  How much do we have?

At the end of 2010 we had €16,164 million of cash and other liquid assets that was built up by the NTMA in 2008 and 2009.  The EU/IMF package provides €50,000 million of funding for the State.  This €66 billion will bring us to about the middle of 2013.  After that both our cash reserves and the funding from the EU/IMF will have been exhausted and we need €73 billion to get to the end of 2013.

Would there be any more money in the kitty?  After the current round of recapitalisation there will be around €5 billion of non-banking assets in the National Pension Reserve Fund.  See point 2 in this Information Note.  This €5 billion would bring the total up to €71 billion.  With the interest earned on our cash holdings and maybe a reduced interest rate on the EU borrowings it is possible that we would be able to stretch things out as far as the end of 2013.

As we said in the initial post, the start of 2014 is a crucial time when projecting Ireland’s public finances.  On the 15th January 2014, €11,857 million of government bonds are due to mature.  As things stand we will not have the money to repay these bonds. 

If you look at the schedule of outstanding bonds you will see that these bonds have the highest yield.  At the close today (27/05) the yield on these bonds was 13.12%.  The next bond redemption date after that is not until April 2016 when a further €10,168 of bonds mature and these have a current yield of 11.81%.  This is still in the stratosphere but the big problem we face is the €12 billion of bonds due to be repaid at the start of 2014. 

If we get over that we have nearly two and a half years until the next redemption date for government bonds falls due.  However, it should be noted that repayment of the EU/IMF loans is due to begin in 2015 with about €10 billion due as can be seen in this graph from page 38 of a European Commission report from February.

Maturity Profile

In our previous post we suggested that if the €7.5 billion contribution of the EU/IMF to the bank contingency fund that is not being used was redirected to fund the State we could get through the early 2014 squeeze.  This is patently not true.  At current rates our cash balances and the original €50 billion from the EU/IMF will be exhausted in mid-2013.  This extra €7.5 billion would keep us going until the start 2014 but we would not be able to repay the €12 billion of bonds maturing in January of that year.

Of course, there is a lot that can happen in the three years between now and 2014.  The hope is that a lot of the uncertainty that currently shrouds the sustainability of Irish public debt, and also the Irish banks, will have been replaced with a realisation that the situation is difficult but not terminal, and that the domestic economy will have shrugged off the torpor of the exploding property bubble and returned to moderate growth.  By 2014 these are hopes that can be achieved. 

If this comes to pass it is likely we can return to bond markets to raise private funds.  The current plan is that this will begin in mid- to late-2012, but with ten year yields north of 11% it is hard to imagine this coming to pass in that timeframe.  It is possible but I think a timeframe of mid- to late-2013 will be more likely and the numbers above suggest that we can fund ourselves until that time. 

If the additional €7.5 billion was available as a contingency it would add further support to that view.  The consensus view of the DoF, EC and IMF is that the General Government Debt to GDP ratio will peak in 2013 and begin to decline thereafter.  If, by 2013, signs of this are evident rather than projected then it would strengthen the view that the debt is sustainable and the possibility of raising private funds would be increased. 

Proposition for the additional support we need came from the IMF last week.  In a conference call following the release of their latest review of the Irish programme Ajai Chopra said:

“European partners need to make clear that for countries currently with programs there will be the right amount of financing on the right terms and for the right duration to foster success. In other words, the countries cannot do it alone and putting a disproportionate burden of the cost of adjustment on the country may not be economically or politically feasible. The resulting uncertainty affects not only these countries but through the high spreads and lack of market access it increases the threat of spillovers and creates downside risks to the broader euro area. Hence, these costs need to be shared including through additional financing if necessary.”

Of course, there are many potential downsides ready to spring up and undermine the view that we can resume funding ourselves independent of official support.  These uncertainties are manifold and we do not need to revisit them here.  The conclusion here is that the State has funding that can see it through until after the middle of 2013.  Between then and now they key is to restore the credibility that will allow us source funds from that point on private markets.

We started the crisis trying to hide the true extent of the economic catastrophe we faced with claims such as:

We have long passed the point where “others believe in us” and statements such as the above, and many more besides, have completely undermined our credibility.  More recently we have moved to a position where we are much more open and accepting of the huge problems we face.  The Department of Finance is now aligned with the views of the EC and the IMF.  The recent stress tests have earned validity that previous attempts have not.  The external view is that we may still have some skeletons in the closet as has been the case with the now beleaguered Greece. 

However, I think that give or take €5 billion or so (which would be largely down to forecasting difficulties), we have put our problems out in the open.  The true scale of the problems in the public finances and on the balance sheets of the banks is now accepted.  We now need to deal with some domestic overshooting pessimism and external underrunning credibility. 

These are deservedly reflected in the current bond yields.  Over the next 18 months if it can be shown that we have finally gotten a handle on our problems (which I believe we largely have) this pessimism will dissipate and our credibility can be restored.  If we achieve that we can find the €100 billion needed to keep country funded until the end of 2015, and particularly the €20 billion needed for 2014.

Thursday, May 26, 2011

The 21 Countries Most Likely to Default

The Atlantic ran a short piece that listed the 21 countries it felt were most likely to default based on the price of Credit Default Swaps (CDS). Why 21?  The published list is in a rather annoying click through format so it is reproduced here.  The numbers give the price of 5-year CDS in basis points.

  1. *Greece, 1393.33
  2. Venezuela, 1026.92
  3. *Portugal, 663.67
  4. *Ireland, 662.83
  5. Argentina, 612.77
  6. Ukraine, 450.02
  7. Lebanon, 359.35
  8. Vietnam, 305.45
  9. *Spain, 275.67
  10. Croatia, 264.83
  11. Hungary, 260.00
  12. Romania, 230.17
  13. Bulgaria ,203.50
  14. Lithuania, 201.50
  15. *Italy, 167.88
  16. Turkey, 164.21
  17. *Belgium, 156.88
  18. Kazakhstan, 151.52
  19. Israel, 147.98
  20. Poland, 140.32
  21. Russia, 136.83

The list is dominated by European countries (in bold) and has six eurozone countries (asterisk).  You may not be able to access CDS markets but maybe you could make some money on this very thin market provided by Intrade.  I would not buy this contract at any price above 5 for 2011.  If a 2013 contract was available the price would have to be below 25.

Unlike the view coming from the CDS market I am not of the opinion that “default is inevitable”.  We are going to need a lot of help, almost all from the EU/IMF package, and a reduced interest rate, an extended repayment schedule , and access to the €15 billion of the €35 billion set aside for the banks that will not be used will be necessary.  If this unused €15 billion could be added to the €50 billion already committed to funding the State then a re-entry to bond markets in mid-2013 would not be required.

At this remove it is impossible to see how we could obtain sustainable interest rates from bond markets.  The 10-year yield on the secondary market is over 11%.

Bond Yields 3M to 27-05-11

The drop in yields that followed the bank stress tests that revealed that €20 billion of the €35 billion contingency fund would be used to recapitalise the banks was short lived.  Yields quickly returned to 10% and have now broken through the 11% barrier.  We could not sustainably borrow money at these rates.

As Prof. Karl Whelan has usefully pointed out the current €50 billion package and the use of our existing cash resources would probably get us towards the end of 2013.  Prof. Whelan concludes:

My conclusions on this are that even an optimistic scenario sees the state requiring additional funding of €11.7 billion over and above the EU-IMF money to finance the state for the next few years. With cash balances apparently dwindling to about €7 billion in a couple of months time, it seems that we may soon be faced with the prospect of either an intensification of fiscal adjustment in an attempt to reduce deficits to fit the size of our funding or else a return to the markets some time during 2013 with no margin for error. An alternative prospect would be to attempt to negotiate a new EU-IMF deal next year that would allow the state to defer a return to the markets.

Going into 2014 we would still have a large, but hopefully declining, annual deficit to fund and on the 15th January we have €11.9 billion of bonds maturing.  After that we do not have any bonds maturing until April 2016.  At 12.97% these bonds had the highest yield of all Irish governments bonds in today’s trading.

If the €15 billion earmarked for the banks could be transferred to the State it would delay the necessity to return to the markets until the middle of 2014.  This is also reported here.  It is probably a little incorrect to say that there is €15 billion of EU/IMF money that will go unused.  Of the original €35 billion contingency fund for the banks €17.5 billion was coming from the EU/IMF and €17.5 billion was coming from our own resources - €10 billion from the NPRF and €7.5 billion from our cash balances.

Now that the final bank recapitalisation will require €20 billion we know it will be €10 billion from the NPRF and €10 from the EU/IMF package.  The €15 billion that is unused is €7.5 billion of our own cash we obviously still have access to and €7.5 billion of EU/IMF money which we are no longer using.  So the actual change to the EU/IMF deal would require €7.5 billion of money to be allocated to funding the State rather than the banks.

If we could get to the middle of 2014 we would be two years from having to rollover any of our existing debt and the requirement for new debt would be substantially reduced, provided we have brought the deficit under control.  At the most we may need to borrow an additional €4 or €5 billion in 2014 if the full €15 billion could be redirected.

I do not think the threat of default is as clear as the above table would indicate.  However, if we are to avoid that in 2014 we do need access to around €20 billion of funding.  It is very hard to imagine that we will be able to obtain that from bond markets.  If we cannot access the funds the outcome will be a default.  This is the outcome that those trying to resolve this crisis are trying to avoid.  In my view there is the capacity to do.

The OECD and Unemployment Assistance

This week the OECD published an update of it’s economic outlook.  The projections for Ireland did not reflect the optimism of College Green earlier in the week.  There was more coverage of a presentation given by the OECD’s Patrick Lenain to the Foundation for Fiscal Studies.  The Irish Independent reported the story as ‘Cut the Dole and get the Jobless back to Work’.  This seems to indicate that one follows the other which is a clear non-sequitur.

The feature of Lenain’s presentation that has garnered most attention is to recommendation to have declining assistance payments to the long-term unemployed.  The slides of Lenain’s presentation can be found here.  This element can be found on slide 32 of the 35 in the presentation. The contents of the slide are reproduced here.

Unemployment benefits (UB): support income without reducing work incentives

  • UB (JA and JB) prevent jobseekers from falling into poverty.
  • But their design implies high replacement rates and work disincentives for low-skilled workers, especially when combined with secondary benefits.
  • In due time, review UB level to reduce risk of unemployment persistence and reduce fiscal cost.
  • Best practices: allow benefits to decline with duration; increase monetary incentives to take up work offers.
  • Return to work is best protection against poverty.

The suggestion is that the “best practice” is that unemployment assistance payments should decline with duration.  The slide indicates that “return to work” is the best protection but it seems to ignore the possibility of returning to work.

In normal labour market conditions there may be some merit in declining unemployment assistance payments, though Irish labour market conditions are distressed rather than normal. 

Here is a graph from Denmark that gives appears to give credence to view.  The Danish system was mentioned in a television discussion of the OECD presentation.  The graph is taken from page 92 of this report (in Danish!).  The graph shows the percentage of unemployed people who return to employment each month.  The green line shows data from 2005 to 2007 when unemployment benefits lasted for four years.

Return to Employment

The graph shows that for all durations of unemployment of between one and four years that about 2% of people return to employment.  It is slightly higher for shorter durations and then declines to the 2% level until it spikes dramatically at four years.  The proportion of people who have been unemployed for four years that return to employed surges to nearly 14% and declines thereafter.  The clear implication is that cutting unemployment benefits encourages people to return to unemployment.

I am not sure that the implication is supported by the evidence.  The graph does highlight that people respond to incentives.  I cannot read the Danish report and it would be interesting to see how many people actually remained unemployed for the full four years.  It may that 14% of people unemployed get a job as soon as the payments expire but this could be 14% of a very small number of people if most people have got a job before the four year deadline is reached.  This is likely true as about 2% of unemployed people at each duration up to four years re-entered employment.   How many would be left after 47 months have passed?

Saturday, May 21, 2011

Medium Term Debt Projections are all the same

We now have updated versions of the medium term projections of the Irish Economy from our own Department of Finance and externally from the European Commission and International Monetary Fund.  The relevant documents are:

Here we will focus on the medium term government debt projections of the three bodies.  The following table gives their General Government Debt (GGD) projections up to 2015.

General Government Debt Projections

It is evident that up to 2013 the forecasts for the three bodies are closely aligned with just 1% between the forecast levels.  Over the next two years, though the forecasts diverge substantially and by 2015 there is a €13 billion gap between the DoF forecast at the lowest level and the IMF forecast at the highest.

What is driving this change?  The next table looks at the forecasts provided for the annual General Government Balance (GGB) over the same period. Note that the 2011 figures exclude the money required for the bank recapitalisations but these are included in the total debt figures above.

The figures in this table represent the gap between government revenue and expenditure that is added to the general government debt.  

General Government Balance Projections

It is is immediately obvious that these figures are very similar right up to 2014.   This is not true for 2015 when the IMF have a forecast GGB of €8 billion as opposed to around €5 billion for the other two organisations.

In fact over the five years from 2011 to 2015, the cumulative general government balances are €55 billion for the DoF, €58 billion for the EC and €60 billion for the IMF (with most of this increase accounted for in the 2015 figure).

Although there is a €13 billion gap between the highest and lowest GGD figures for 2015 there is “only” a €5 billion gap between the highest and lowest cumulative general government balances up to 2015.

The IMF project that funding the government balance from 2012 to 2015 will require €43 billion and they add this full amount to the debt (216 – 173 = 43).  The DoF have a funding requirement of €39 billion for the same period (the difference again mainly being the 2015 figures) and they add €30 billion of this to the debt level (203 – 173 = 30).  It seems the DoF are €9 billion short in their forecast of the debt increase or they are getting €9 billion from somewhere other borrowing to provide the full €39 billion required (30 + 9 = 39).

So have the DoF lost €9 billion of debt?  No, they are using the fact that we had €16 billion of cash we have on deposit at the end of 2010.  See Table 2 in the recent Information Note from the NTMA.  The use of this money will reduce the necessity for borrowing.

The difference between the debt figures is not because of any differing views on the medium term projection of the Irish economy (in fact up to 2014 the projections of all three bodies are virtually identical).  The difference between the figures is down to the treatment of the cash balances we have built up.  The DoF are forecasting that we will use €9 billion of them; the IMF are forecasting that we will use none.  The IMF might have a higher debt figure but in their scenario we will also have higher cash balances.  The net effect is pretty much identical (apart from in 2015).

Of the €13 billion gap in the 2015 debt levels between the DoF and the IMF, €9 billion can be accounted for by the use of cash balances, €3 billion for the difference in the 2015 government balance figure and just €1 billion for differences in the general government balances between 2011 and 2014.

The DoF, EC and IMF debt projections between now and 2014 are very closely aligned (and none of them approach €250 billi0n.)  The projection on this site of a 2015 GGD of €211 billion before the use of cash balances is also consistent with these.

The last thing we’ll look at is why there is a €3 billion difference between the DoF and IMF figures for 2015.  To be fair, projections for five years from now will have a large margin of error but there may be some interest in seeing what factors underlie the difference between the forecasts without necessarily put huge stock in the forecasts themselves.  Then again there may not be, so this is below the fold.

Here are the DoF and IMF government accounts for 2015.

2015 Government Accounts

It is clear that revenue does not explain the €3 billion difference as the total revenue figures are very close.  It is likely that differences on the definitions of the components of revenue explain the differences between Social Contributions and Other Revenue.

The €3 billion difference is explained by expenditure.  The IMF are forecasting the government expenditure in 2015 will be €3.5 billion higher than that forecast by the DoF.  Up to that year the expenditure forecasts had been pretty much identical.  From this remove we are not focussing on the actual forecast levels of expenditure but for the reason for the differences in the 2015 figures.

Looking at the breakdown of expenditure it again suggests there may be some differences in the definitions used but the big difference can be seen when it comes to social and transfer payments.  The IMF are forecasting that social welfare payments will be higher in 2015.  I think it is unusual that the difference can be attributed to just one factor. 

Again because of issues of definition we cannot assign the difference in the level entirely to different forecasts but here we give the forecast annual change in transfer payments for the DoF and IMF.  Here the definition doesn’t matter as this is the percentage change in the same figure.

Transfer Payment Projections

Up to 2014 the cumulative changes from 2010 are almost identical (-12% for the IMF and –11% for the DoF).  However after being identical for four years, in 2015 there is a huge gap between the forecasts.  The D0F forecast that transfer payments will decline by a further 2%.  The IMF forecast can our largest expenditure item will increase by 6% in 2015.

The DoF are forecasting that transfer payments will fall by €0.5 billion in 2015 while the IMF are forecasting that they will rise by €1.6 billion.  I haven’t looked in depth but I can find no reason for this forecast increase in the IMF document.  Are lots of people about to turn 65 in 2015?  Are they expecting an acceleration of the baby boom?  They do expect the unemployment rate to drop from 12.3% in 2014 to 11.3% in 2015 so this sudden increase in transfer payments in 2015 is hard to follow.

Aside from this one number the IMF and DoF forecasts for 2011 to 2015 are very closely aligned.  It seems everyone is now on the same page as we move to resolving this crisis.  The €3 billion difference for 2015 is unusual and what is even more unusual is that it can be “explained” by just one factor.

Thursday, May 19, 2011

Quarterly Financial Accounts

The Central Bank has released the Q4 2010 data for its Quarterly Financial Accounts series.  The release is here and the data is here.  The numbers give an insight into the improving balance sheet of the household sector in Ireland.

Household Assets and Liailities

Net financial wealth in the household sector has been increasing since the beginning of 2009 but is largely unchanged from where it was in 2002 when the series begins.  This has been brought about by a combination of increases in financial assets and decreases in financial liabilities.

Although the total amount of financial assets held by households increased from 2002 to 2007, this increase was offset in net financial wealth by a similar increase in liabilities.  The graph below gives the largest of those household financial liabilities: loans.

Household Loans

The total amount of loans owed by households has been falling since end of 2008.  This is the result of a huge slowdown in the drawdown of new loans, particularly mortgages, and repayments of existing loans.  The amount of outstanding loans in the household sectors peaked at €203 billion in Q4 2008.  In the eight quarters since then it has fallen to €186 billion.

At 120% of GDP this is still very high but the data show that it is declining as households undergo significant deleveraging.  The vast majority of this reduction will be the result of loan repayments rather than loan write downs.  Most of the loan write downs applied by the banks to the loans books so far have been as a result of the transfer of their developer loans to NAMA.

Saturday, May 14, 2011

Constantin Gurdgiev on Ireland’s Public Debt

There has been a huge amount of comment on Irish public debt over the past few days.  The debate was raised up a notch by the €250 billion figure that was thrown into the pot by Prof. Morgan Kelly in his most recent article in the Irish Times.  We took that to task here and all our contributions to the public debt debate can be followed here.

On Wednesday night there was a further debate on the National Debt on Tonight with Vincent Browne on TV3.  You can watch the show here and the debt discussion is from the start until about 20 minutes in.  In this piece we focus on the contributions of Dr. Constantin Gurdgiev to the show.  This is not because of any wish to attack Dr. Gurdgiev but rather because his contributions allow us to focus on many of the popular misconceptions that have arisen in the recent debate about our public debt.

To begin let’s reiterate what our projection of the 2015 public debt is:

This means that by the end of 2015 the General Government Debt will be in the region of €205 billion.  As €15 billion of the promissory notes will have been paid out, the total amount actually borrowed will be €190 billion.  These are huge sums of money and puts the country right of the border of sustainability.

As with all projections there is an element of uncertainty involved.  When it comes to projecting Ireland’s future public debt these uncertainties are significant.  When making the above projection we noted that:

There are other issues related to the banking collapse that are not included.  These are the final outcome of the NAMA process, whether the shutdown of Anglo and INBS will require further injections of capital, and how to unwind the €140 billion of liquidity the banks have taken from the European and Irish Central Banks.  There is also the long-term hope that we will be able to sell off our stakes in the two ‘pillar’ banks to recoup some of the money swallowed by the bailout.  There is a great deal of uncertainty about all of these.

Most of these are covered in the commentary that follows.  Anyway on with the show.  Here in a nutshell is what Dr. Gurdgiev said.  Transcripts of the segments that provided these gems are also provided below.

  1. Start with a 2015 public debt prediction of €225 billion from the IMF
  2. Add in €31 billion for NAMA (but the final losses could be more)
  3. Add €16 billion for loan losses in the banks that are not covered by the €24 billion recapitalisation.
  4. Add €4 billion of bank recapitalisation not covered by the State's €20 billion contribution
  5. Add €25 billion as a 16% risk weighting on the central bank liabilities of the banks

This “sound-bite analysis” cannot be countered with simple “sound-bite responses”.  T0 reply to this we need the facts and they need to be provided carefully.  This post is long.  If you want to see a factual presentation of our projected debt position you’re best to go  here rather than plough through this.  If you want to see why the above commentary is wrong read on.

This IMF projection of a €225 billion debt by 2015 must be very important.  

Constantin Gurdgiev: I don’t buy this.  I looked at Morgan Kelly’s figures and I don’t care what the ESRI frankly says I look at the IMF and I look at their forecasts.  IMF clearly forecast 2015 figure of €225 billion in terms of debt.  That’s the government debt. 

You toss into it €31 billion that the NAMA is issuing in terms of the bonds.  That is debt as well.  You can call it a Special Purpose Vehicle.  You can call it whatever you want. Off balance sheet accountancy. I don’t care.  It’s a taxpayer guaranteed debt which has been written by the government agency. So that is our debt as well. 

We are €256 billion in. Bingo! Morgan Kelly is correct in terms of the figure.  2015 simple numbers.  €225 billion in terms of the government debt. IMF forecast.  NAMA €31 billion. €256 billion in total.  That is €142,000 per each working person in this country as of today.

This €225 billion figure is directly referenced on six occasions in the first 20 minutes of the show, and forms the underpinning for much of the “analysis” that followed.  Unfortunately, it is wrong and even the IMF tell us that it is wrong.

The number can be found in the World Economic Outlook Database which gives the projected Gross General Government Debt of €224.904 billion for Ireland in 2015.  This is 123% of the IMF 2015 GDP projection and is an extremely dangerous level of debt.  Or it would be were it actually to come about and the IMF tell us that it won’t. 

The projection comes from the IMF Report that followed the setting up of the EU/IMF rescue package for Ireland last November.  Here are the projections from page 36 of that document

IMF Debt

This confirms the 123% debt level for 2015 which in itself confirms the €225 billion figure.  However, this was last December and the IMF had to make certain assumption about what would happen in 2011, especially about the stress tests for the banks.  To make the above projections they assumed that all of the €35 billion “contingency fund” to recapitalise the banks set up as part of the deal would be used.  As we know the banks require €24 billion of additional capital, with between €18 billion and €20 billion coming from the State.  The IMF acknowledge this in the ‘Debt Sustainability’ Appendix on page 43.

The debt dynamics will depend on the amounts drawn down for bank recapitalization. Although it is anticipated that the notional amount designated for bank support under the program (€35 billion) will not be used, the baseline scenario incorporates the cautious assumption that €17.5 billion available to the authorities under the overall EU-IMF program is drawn for this purpose (with the other half provided from the authorities own resources).  The baseline thus defines the most conservative debt trajectory.

Debt dynamics would improve if the stress tests (and diagnostics) or liability management lower the financing needs for bank recapitalization. Thus, if €25 billion were used, debt would peak at 119 percent of GDP in 2013, and if only the initial €10 billion were used, debt would peak at 109 percent of GDP.

Each of these scenarios assumes notionally that one half is financed by the authorities’ liquid assets, and the remainder from the resources available under the overall EU-IMF financial package. The implication also is that if the amounts needed for recapitalization are smaller, the government can use its liquid assets to cover the budgetary financing need or repay debt.

None of these numbers are right and the IMF were just guessing what the outcome of the stress test process would be.  We now know that the banks will be consuming around another €20 billion of the State’s resources rather than the full €35 billion that the €225 billion figure is based on.  Half of this will come from the further destruction of the NPRF and half from borrowed money as part of the IMF deal. 

Using the actual €20 billion injection into the banks means that the IMF projections are that the debt would peak at some amount below 119% of GDP in 2013.  What does our own Department of Finance think it will be in 2013.  See here for the answer, which is 118.3%.  The IMF and Department of Finance projections are virtually identical.  Let’s not be getting excited that the IMF have found a load of debt that the rest of us cannot see.  They haven’t.

There is no €225 billion debt projection from the IMF.  The only way that can happen is if you think 20,000,000,000 and 35,000,000,000 are the same number.  For those who might be confused they are not.  Once we subtract the difference between these figures and the interest that will no longer accrue on the difference it is very clear that the IMF is forecasting a general government debt of around €208 billion for 2015.  This is much closer to our estimate of €205 billion than the €225 billion attributed to them on the show.

We are then told that if we add €31 billion for NAMA to this (incorrect) figure of €225 billion then “bingo! Morgan Kelly is correct”.  This is not what Morgan Kelly did.  He added an unspecified €30 billion to a €220 billion estimate from namawinelake.  This €220 billion was also based on the assumption that the banks would require the full €35 billion.  Take off the fact that it will be €20 billion and bingo! “the best source on the Irish economy” thinks our forecast of €205 billion is pretty much correct.

Anyway, Morgan Kelly added €30 billion to the €220 billion and it wasn’t just the total bonds issued by NAMA that got him there. He got to his figure by “subtracting off the likely value of the banks and Nama assets”.  Kelly’s imaginary gross debt figure was actually €270 billion.  If Morgan Kelly was adding bingo calls he might be right but he is not right on our public debt.

A figure of €205 billion looks good to me and I’m pretty sure it does to most reasoned commentators.  Let’s go through some of the significant uncertainties that surround this projection.  First up, is the bank recapitalisation process.

Constantin Gurdgiev:  The ESRI said the banks’ debt are factored.  According to the latest exercise from the Central Bank which was issued on the 31st March, €24 billion worth of that debt is not factored in to these figures at all because they are yet to come.  On top of that if you look into the numbers deep inside, BlackRock estimates that it will be actually €41 billion, not €24 billion and the reason why is because the Central Bank of Ireland is looking only through 2013 and BlackRock is looking beyond 2013.  The peak of mortgage defaults mortgage defaults according to BlackRock assumptions is going to happen in 2017 not in 2015.  So all those debts are not factored in.

There is some merit to this.  The numbers are a little out though as can be seen from the stress test document.  BlackRock Consultants estimated that there would be €40.1 billion of lifetime loan losses in the adverse scenario on the loan books presented to it by the banks.  The Central Bank forecast that €27.7 billion of these losses would either crystallise before 2013 or result from defaults that occur before 2013.  So there is €12.4 billion of loan losses excluded from the current recapitalisation process. 

So why are we not covering these losses?  One reason is that they are not due to materialise until 2014 and beyond.  Why would we give money to the banks now for losses that could occur five, eight or even ten years into the future?  If we gave money to cover the future projected losses to the banks now, they would earn interest on that money and we would actually have given them too much money.  The banks would be making a profit off the bailout.

Secondly, the banks themselves will be generating an operating profit that will cover some of the losses.  The banks have huge losses on their balance sheets but on a day-to-day basis they remain very profitable.  In the three years from 2011 to 2013 BlackRock estimate that in the adverse scenario the four banks will earn an operating profit of €3.9 billion.  These profits are earned on performing loans, current accounts, bank charges and other services provided to customers. 

When compared to the total loan losses that is expected to materialise on the banks’ balance sheets this is a relatively small amount, but it cannot be ignored.  By 2015, the annual loan loss provisions will be much smaller than they are now and the assumption is that they can be covered by the banks’ operating profits.

There are some concerns about this process but not enough to suggest that we should be pumping more money  into the banks to cover the full €40.1 billion of losses that BlackRock are forecasting.  In fact under the “base scenario” BlackRock have total lifetime losses of €27.5 billion so the full lifetime loan losses under the base scenario are being covered.

We are covering €27.7 billion or 70% of the €40.1 billion of adverse scenario lifetime loan losses and that is plenty for now.  In fact between existing capital and reserves in the banks, existing loss provisions on their balance sheets and the expected operating profit over the next three years the amount of capital required to cover these losses is and meet the capital requirements is €18.7 billion.  There is also an additional €5.3 billion “capital buffer” going into the banks and this will be there to meet any losses above €27.7 billion should they arise. 

The €18.7 billion capital requirement and the €5.3 billion capital buffer give the €24 billion recapitalisation required by the banks.  From page 9 of the stress test document.

There is no expectation that capital requirements should be set to cover remote lifetime stress losses (which may have offsetting income). However the capital buffers that are in place have been designed to provide comfort concerning post 2013 losses in the years immediately following the assessment period, as an additional layer of conservatism.

When it comes to mortgages BlackRock estimate total losses of €16.9 billion.  The recapitalisation is covering €9.5 billion of them.  This is 56% of the total.  I can find no evidence that BlackRock think the peak of mortgage defaults will happen in 2017 but there are significant losses that happen after 2014. 

Again, putting money into the banks now for losses than will happen five years down the line is not sensible but there is the concern that the significant operating profits of the banks will not be enough to cover them.  The €12.4 billion of losses outside the three year horizon also have the €5.3 billion capital buffer to cover them.  Between future operating profits and the capital buffer there is no need to expect that this €12.4 billion will have to be met by the State.  On to NAMA.

Constantin Gurdgiev: NAMA is a debt that is issued. NAMA assets are not owned by us, yet the debt is held by us. It is held against us.  It is my name as a taxpayer on the debt signature.  I have no control over NAMA assets and NAMA is not accountable to me or to anyone else. 

Yes, they are worth something. So far, what we have is a declared loss on the first year of operations. You have to factor in the risk. You have to look on the underlying assets that they carry. You also have to look at the cost that NAMA is carrying and also on the activities that NAMA is planning to engage. Let’s look then into all the possibilities and all the possible scenarios can lead to actually greater losses than €31 billion.

I’m not saying that they’re worth nothing.  Today on the books they might be worth an X amount. That is not the value that will be realised down the road itself.  It can be much less. It depends on your overall projections.  If you look at the overall economy how can NAMA factor in any sort of the uplift in the property market into 2015. I don’t know.

NAMA is not promising to pay us anything right now and it cannot guarantee to pay us anything right now as the taxpayers in 2015. We’re talking about debt in 2015.  €225 billion is the estimation by the IMF.

I’d like to know who owns the NAMA assets so? We own the liabilities but not the assets. Ah hear.  And then there is the suggestion that NAMA can make a loss greater than €31 billion.  This could only happen if NAMA collects virtually nothing on the €71 billion of loans it has acquired.

NAMA’s most recent quarterly report states that “the percentage of performing loans in the €71.4 billion portfolio at December 31st 2010 was 23%”.   That means that €16.5 billion of the loans are performing.  If only those loans are repaid and zero is collected on the remaining €55 billion of loans then NAMA would make a loss of €14.5 plus the cost of servicing that money.

It is also important to believe that around €20 billion of the NAMA loans are outside Ireland.  These are mainly in the UK where commercial and residential property markets are performing much better than they are in Ireland.  It is likely that NAMA will collect a significant proportion of the money lent into the UK market.  There will be losses (Irish property developers do not have a good track record) but the performance of these loans should be reasonable.

Next note that NAMA will be trying to recoup to full €71.4 billion that is due on these loans and not just the €30.5 billion it paid for them.  To this end NAMA has reached agreement with 16 of top 30 developers as it states here, with two more close to agreement.  Negotiations continue with five and seven have already been forced into receivership.  NAMA will be pressing on guarantees and other collateral to try and recoup the money.  It is not clear how much this will be, and there will likely be significant legal roadblocks, but NAMA is not entirely dependent on the value of the assets tied directly to the €71.4 billion of loans it acquired to try and recoup the €30.5 billion it paid for them.

Using those assets the ‘best source on the Irish economy’ estimates using current property prices that NAMA would make a €3.5 billion loss and needs a 12.9% weighted average increase in property prices in order to break even.  It is hard to tell where property prices will go but a €3.5 billion loss is a long way from being “greater than €31 billion”.

I would like to see NAMA included in gross debt figures as it would significantly reduce confusion.  NAMA does not put any cash obligations on the Exchequer.  However, NAMA does increase the amount of accrued interest our debt generates but because it is self-financing it does not change the amount of cash interest payments we have to make.  NAMA would add to the debt/GDP ratio but it would not change the interest payments/government revenue ratio which is crucial for sustainability.  Anything over 20% here is of huge concern.  We are going to be below that and adding NAMA to the gross debt would not change that.

If the NAMA liabilities are to be included in the debt then the assets that NAMA holds must also be given fair consideration.  Simply ignoring them because “we do not have control of them” is disingenuous. Now on to the ECB money.

Constantin Gurdgiev: But let’s not forget that there roughly €110 billion which the Irish banks owe to the ECB which is clearly also in some line a liability of the taxpayer.  And there is a very direct liability of the taxpayer to the €50 billion that the Irish banks owe to the Irish Central Bank.  That is directly in line because the taxpayer is the first line of fire there.

No economy is operating on the basis of just one year projection. You have to have an outlook for 2015 and what I am telling you is that IMF says in its outlook €225 billion. It looks to me pretty much on the money. It is pretty consistent with my own projections as well.

Then we are arguing about so called quasi-sovereign debt which is the NAMA debt in total.  That’s what Morgan Kelly does correct in his article.  He takes their number and adds to it the €31 billion of the NAMA debt.

But Morgan mentions but doesn’t do any allowance for the debts of the banks which we can actually say there is an assumption made that there about 17% average losses on the banking book which is going forward for the six institutions. 

We can assume apply the same 16% percent as a possible risk weighting for the €50 billion that they owe to the banks. Bang! Another €8 billion is gone.  You can apply the same amount to the European Central Bank as well. Bang! €17.6 billion gone as well on top of that.  That is not in this figures.  That is also a risk to the downside.  And if you are planning an economy.

This is complete nonsense.  We are not on the hook for any of the money the banks owe to the ECB or the Central Bank of Ireland and creating €26 billion of debt here is a little more than disingenuous.  This money the banks owe to the ECB and CBoI is a liability.  The problems we have with the banks is that their assets, primarily customer loans, are not worth what was originally lent out. 

There has never been a problem on the liability side, and there never will be.  The problem with banks is that they are suffering huge losses on their assets.  It is an accounting impossibility to make a loss an a liability. 

If I owe you money how I can make a loss.  You can only make a loss on a asset.  You don’t stress test liabilities, you stress test assets.  The only way we will be liable for any of the money the banks owe to the ECB and Central Bank of Ireland is if they make additional losses above what has already been accounted for.  Looking at the liability side of the banks’ balance sheet and we might be liable for it is nonsense. 

You have to look at the assets side and we know that banks are going to make huge losses.  BlackRock Consultants and the stress tests told us that.  We are putting money in to cover these losses.  This money to cover loan defaults, and the repayments from performing loans, will allow the banks to repay in time, or replace somewhat more quickly, the liquidity the banks have taken from the ECB.

The figures quoted for the central bank funding are also wrong.   There has been an update since Wednesday, but on that date the correct figures are that the banks had borrowed €79 billion from the ECB and about €65 billion from the Central Bank of Ireland for a total of €144 billion rather than the €160 billion figure given. 

We are then told to multiply these numbers by some loss rate and that then “Bang! Another €25 billion is gone”.  To repeat myself you cannot make a loss on a liability.  It is impossible.  And why is this only applied to the liability the banks owe to central banks?  Why is this the only liability that this “risk weighting” applies to?  The banks have other liabilities as we can see from their balance sheet.  

The banks owe €170 billion to customers from deposits and still owe about €60 billion to bondholders.  The customers and (senior) bondholders all expect to get their money back.  What happens if the banks can’t pay?  Surely we will be on the hook for them as well and then its “Bang! Another €37 billion gone.”  Of course this is complete nonsense.  If you want to look at how much the State will be on the hook for because of the banks you have to look at the asset side, not the liabilities.  We can only be forced to cover losses that materialise on the assets the banks hold.  Looking at the liabilities is rubbish.

It is useful to consider how the banks have obtained a lot of this funding.  They have done it with state-backed instruments.  Anglo and INBS are the main users of the Central Bank of Ireland’s Emergency Liquidity Assistance and they have accessed this by giving €28 billion of Promissory Notes as collateral.  These Promissory Notes form part of the €205 billion debt forecast we have provided here.

If we paid out in these Promissory Notes immediately, Anglo and INBS would simply repay the €28 billion to the Central Bank.  They have sufficient liquidity now so if we paid out on the Promissory Notes they would not need the same level of Central Bank funding.  One payment of €28 billion would reduce the liability created by the Promissory Notes and the liability created by the ELA.  It makes no sense to add them both in as we will only have to pay the money once.  To do so is just double counting and is wrong.

The same holds for the NAMA bonds that the banks have used to access ECB funding.  When the NAMA bonds are paid off (by the assets that NAMA has) then the banks will use the money they get to reduce their reliance on ECB funding.  One payment on the NAMA bonds reduces both the NAMA liability and the central bank liability.   They cannot be added in twice and to do so is again wrong.

The banks have also used sovereign bonds to acquire ECB funding.  These bonds are already in out debt figure and if we pay out on these the ECB funding will again fall.  More double counting.  There is one set of collateral that is a bit dodgy and that is the self-issued bonds the banks have used to get additional funding from the ECB.  These bank bonds come with a government guarantee and if the banks can’t honour them the State will have to. 

Of course, it is not expected that the banks will have to pay out on this bonds.  As they get recapitalisation money, sell off non-core assets or see their loan books fall through repayments, their need for central bank funding will fall.  They will use this money to repay the ECB and the self-issued bonds will disappear into the hole they can out of.  That’s the plan anyway.  Any problems will emerge on the asset side of the balance sheet not the liability side.

The asset side of the banks balance sheets are a mess.  There have been and will be huge losses.  This is why we are pouring money into the banks.  The most pessimistic of estimates suggest the banks could be carrying loan losses of around €110 billion on their €370 billion of loans.  This is a loss rate of 30% and is truly staggering.  It is these losses that have to be covered.

So far there are three groups who have contributed to the banking collapse and here are the amounts they committed to providing:

  1. Equity holders completely wiped out (c. €25 billion)
  2. Junior bondholders taking up to 90% haircuts (c. €14 billion)
  3. State contributions through recapitalisation (c. €66 billion)

All told some €105 billion has been committed to cover the loan losses in the banks.  And this excludes the money the banks have provided themselves through their operating profits over the past few years and through the sale of international assets and operations that the banks previously held. 

The asset side of the banks’ balance sheets are a disaster but the money is being provided to meet these losses.  If the money owed to central banks is going to become a debt of the State than loan losses in excess of those covered above will have to materialise.  There are very few who are suggesting that the loan loss rate will be above 30%.  There will have to be loan losses above this to this liability to be a problem.  A “risk weighting” of 16% of a selected liability is complete nonsense.  I have no idea where this 16% figure come from. Or is it 17%?

Anyway, BlackRock have gone through the banks’ loan books and forecast a loan loss rate of 14.6% in the stress scenario.  There is also the 58% loan loss that the NAMA transfers have imposed on the banks.  Between the stress tests and the NAMA process €85 billion of loan losses have been accounted for.  Other provisions have accounted for even more.  There is little evidence of the additional losses that will be necessary in order to mean that the central bank liquidity will be a debt for the State.

And why are we giving out about this money.  The €79 billion of ECB funding is being provided at 1.25%.  The money from the Central Bank has a rate of around 3%.  There is no way the banks could borrow at anything close to those rates from market sources.  The low rates on this money is a subsidy to the banks that could be worth €5 billion or more on an annual basis.  No mention of this, but some ridiculous loss calculations on liabilities.

Constantin Gurdgiev: I’m not been paid been paid to do any of this work at all. Peter Mathews was not paid to produce any of this work.  Paul Sommerville wasn’t paid. Brian Lucey is not paid.  And yet we are producing the balance sheets. We are putting them in the public domain. 

Nobody can dispute it and then we get the forecasts which are coming out in line very much with Department of Finance as well.  IMF now.  I am telling you. IMF says €225 billion 2015 is the date for which they are projecting it.  That’s general government debt.  Gross general government debt.  Exclusive of NAMA at all.

Thank God nobody is paying for them.  They’re rubbish.  I am disputing them.  The IMF has not forecast that the GGD will be €225 billion in 2015 and if that is your starting point the ground is rather unsteady.  Finally we have the €24 billion recapitalisation for the banks.

Constantin Gurdgiev: You know the borrowing for the banks.  You are assuming here, for example, the Exchequer Balance of €18.25 billion.  Does that include banks? How much have you factored in?  Ok, €20 billion this year and what about the €4 billion they are projecting they need to put in you haven’t put anywhere?  No, well there we go. 

The €16 billion gap between what the Irish Central Bank is projecting for 2013 and what BlackRock is projecting through 2017 is that anywhere else? No, ok Bingo! That’s €20 billion. So you’re €196 billion is very rapidly getting closer towards…

If you are running an economy especially at the time of a crisis you are better off taking conservative downside assumptions rather than constantly trying to chase down.

The banks will need an additional €24 billion of capital based on the recent stress tests.  Of this €18 to €20 billion will come from the State.  The other €4 billion that the ESRI did not “put anywhere” will not come from the State and has no business in a measure of public debt.  This €4 billion will come from haircuts to junior bondholders in the banks.  And they seem to be going pretty well.  There will also be the sale of assets such as Irish Life which could reduce the State’s contribution even more

As we pointed out above there is a €12.4 billion difference between the lifetime loan losses predictd by BlackRock and the three-year estimates used by the Central Bank to calculate the capital requirements of the banks.  There should be a difference between these numbers for the reasons we outlined above.  If the full lifetime loan losses are covered now.

  1. The banks would be able to earn a return on the bailout money for themselves and
  2. The banks would not have to use any of their operating profit to cover the losses.

There is also the €5.3 billion capital buffer in place if it is required.  There  is no adding of €4 billion and €16 billion to get anything.  This needs a level of analysis beyond that required to fill out a bingo card.  We are not getting that analysis here but it seems part of the problem is that policy makers are using “rational analysis” to underpin their decisions.

Constantin Gurdgiev: Of course it all depends on many things. In Ireland we have a very volatile economy.  But we are not factoring in the volatility into these projections.  We are actually basing it on rational analysis. And there is a difference exactly.  The policy makers should not be taking the possibility of the extreme events into the direct account.  It should be behind as a kind of background. So if things turn out to be very rosy and we able to repay the debt out of the very significant uplift. Happy times, great, that’s a bonus to the nation if you want.  If things don’t turn out rosy you have to be prepared to deal with a debt overhang at these proportions.

The problem is we are basing the projections on “rational analysis”.  Ah hear.  This is one of the most extreme economic crisis this country has faced (it is not the most severe), yet any attempt to resolve our difficulties is decried because it is based on rational analysis. 

What we need is rational analysis not the sort of mumbo jumbo dished out above.  If we take the litany of incorrect figures lashed out above we get the sort of nonsense analysis that attempts to undermine the credible attempts to get us out of this hole.

  1. Start with a phantom debt prediction of €225 billion from the IMF
  2. Add in €31 billion for NAMA and say the losses could be more and completely disregard the assets
  3. Add €16 billion for loan losses that will appear after 2015 with no pr0vision for the earnings of the banks
  4. Add €4 billion of bank losses that will be covered by junior bondholders
  5. Add €25 billion for some “risk weighting” on the central bank liabilities of the banks.

This gives a running total of €301 billion and this is supposed to be the analysis we need of the debt legacy from the crisis we face.  There is no one that believes that the 2015 public debt will be €300 billion yet we are expected to believe commentary like this which is provided on a regular basis. Every single element of this commentary is wrong.  Not some of it, all of it.  It is all wrong. 

It starts with the wrong number, includes no allowance for assets, does not know the difference between an asset and a liability, adds in costs that will be covered by someone else and in general is very loose with the actual figures.  It is nonsense and should be treated as such.

Ireland debt level in 2015 will be between €205 billion and €210 billion.  This will be about 115% of GDP.  We face some huge problems.  Figuring out the numbers should not be one of them.  We should be figuring out the solutions.

Anyway here is a summary of my projection for the 2015 debt.

Projected Debt

All numbers marked with an asterisk are forecasts with NAMA figure will still only be provision by 2014 so the actual General Government Deficit (GGD) will be €205 billion.  What should be added to this sum? And, please, no nonsense.

Friday, May 13, 2011

Core inflation continues to rise

The CSO has released the April CPI numbers.  Core inflation, which excludes energy and mortgage interest, moved to +0.66% from +0.23% in March.  The increase in the headline rate moderated in April and the annual inflation rate now stands at +3.3%.

Core Inflation April 11

Wednesday, May 11, 2011

Two Steps to Economic Ruin: Step One

Earlier we focused on the basis for Prof. Morgan Kelly's diagnosis that the country is freefalling into the economic abyss with no hope escape.  We are undoubtedly in a very perilous position but it is not as severe as he has suggested.  One contrast we have noted is that the public debt will be around €200 billion rather than “closer to €250 billion” as he suggested.  In this instance we will look at the proposed prescription. 

National survival requires … … the Government to do two things: disengage from the banks, and bring its budget into balance immediately.

This is utter nonsense.  Earlier in the piece we had been told that the public debt would be €250 billion.  In this instance,  it was suggested that the debt “can be halved to €110 billion by cutting loose the banks”.  There's something not quiet right with the sums here.

Regardless, there is no way we could save €110 billion of debt by handing the banks over to the ECB. We've committed to spending €66 billion in total on the bank bailout so how can we possibly knock €110 billion off our debt by “disengaging from the banks”.   And as around €16 billion will come from the destruction of the money built up in National Pension Reserve Fund during the good times, the amount of debt that we could save is closer to €50 billion.  Still significant but not €110 billion.

So how much could we save?

We could save on the €28 billion of Promissory Notes outstanding for the zombies that are Anglo and INBS, and the €20 billion required from the State to recapitalise the four "viable" banks (BOI, AIB, PTSB and EBS) as a result of the recent stress tests.  The term viable is used loosely in the context of AIB, but it is clear that we wish to keep this bank open.  This would knock €38 billion off our debt and keep another €10 billion in the NPRF.

That's €48 billion of a savings but we would also be giving up any claim on the potential resale value of the banks.  It is almost impossible to say what this will be but it will not be zero.

Cutting the six banks loose is a different prescription to what Prof. Kelly suggested in January 2009 when he said:

The worthwhile banks need to be maintained by any means necessary, including nationalisation, while Anglo Irish and Irish Nationwide must be allowed to collapse.

It could be argued that we would also save on the €30 billion of NAMA bonds, but they were used to buy €70 billion of developer loans and still carry some value. If we renege on the bonds we'd have to give back the loans. They could be worth some amount less than €30 billion (they might also be worth more) but the saving wouldn't be anything close to €30 billion.  Current estimates from "the best source on the Irish economy" indicate that, given current property prices, the expected loss on NAMA would be around €3.5 billion.  Depending on future property prices it could be more but it will not approach anything near €30 billion.

All told, there might be a maximum debt reduction of maybe €60 billion possible if we abandon the banks.  Half of this comes from the "zombie" banks of Anglo and INBS where such a course of action could be justified.  About a third comes from the four "viable" banks in which cases it is in our interest to hold on to.  The remaining savings are dependent on the final outcome of the NAMA process.

If possible, €60 billion would be an impressive saving but we're left whistling in the wind waiting to see what the ECB would actually do with the banks, particularly the four we want to remain open.  Prof. Kelly was aware of this in January 2009 but it seems to have slipped his mind since then.

You could also look at the €80 billion in liquidity funding owed to the ECB, but like the NAMA bonds this is backed by the assets of the banks. It's a liability of the banks, but will not become a debt of the State unless there are losses generated on those assets. If we give up the banks we do lose this €80 billion in liabilities but we also lose the €80 billion of assets (in nominal terms) that this money is financing. 

The banks also owe around €65 billion to our own Central Bank. This is much like the money owed to the ECB. It will only become a debt of the State if the assets supporting it make losses.

There may be some further losses in the banks but to give credence to the suggestion that there are €110 billion of debt savings possible another €50 billion of losses are necessary, to add to the €60 billion of debt outlined above.

Between the NAMA process and the recent stress tests €85 billion of loan losses have been accounted for the in the covered banks.  Losses accounted for elsewhere would bring this even higher and maybe close to €100 billion.  These losses have been covered by the money we have already committed to the bank rescue package. 

At his most pessimistic Prof. Kelly forecast total losses of €106 billion in the five banks engaged in the NAMA process.  Unlike his inconsistent public debt estimates for which no details are provided, we did get an insight into his accurate prediction of losses in the banks in a spreadsheet on this post over on irisheconomy.ie.  Add in PTSB to his analysis, which does not have a developer loan book, using the same assumptions he applied to the other banks and the total comes to around €110 billion. 

Based on the contribution of equity and reserves to cover the losses he estimated a cost to the Exchequer of around €80 billion.  So far the State has committed €66 billion to the banks.  Could we have to stump up another €14 billion. Unlikely.  So far haircuts to junior bondholders have provided around €10 billion of savings.  We know there will be further haircuts to the remaining junior debt for about another €4 billion of savings.  The sale of Irish Life will generate a further €1 billion or so.

Prof. Kelly was 100% accurate in his forecasts of the losses in the banks.  €110 billion of losses and an €80 billion tab to be picked up after equity takes the first hit.  Of this €66 billion will come from the State with junior bondholders carrying the remaining €14 billion of losses.  He was so accurate it is uncanny.  It truly was a remarkable forecasting performance and huge kudos has accrued to him because of it.

He should have reinforced this and then provided some viable solutions as to how we can work out way out of this mess he has so brilliantly forecast.  Instead he ups the doom level even more suggesting the banks will generate €110 billion of debt by 2014.  By looking at the money committed so far it is hard to see how anything above €60 billion of debt reduction is possible by abandoning the banks.

Where are the additional €50 billion of losses going to come from that would mean we will be on the hook for one-third the €150 billion the banks are getting from the ECB and the Central Bank of Ireland? 

According to the recent data from the Central Bank the six covered banks had €294 billion of customer loans on their books at the end of December 2010.  NAMA has taken €72 billion of developer loans from five of them.  This gives a total of €366 billion of loans originating from the six banks. 

For the numbers used by Prof. Kelly to hold up there would have to a total of about €160 billion of losses on these loans.  That is a loss rate of nearly 44% across the entire loan book.   This is a staggering loss rate.  Also remember that many of these loans are secured loans so the level of default necessary to generate this level of losses would be larger again. 

Obviously in some areas higher losses are possible.  Losses of 80% or 90% on some development land loans will occur, but not to the level that can make these numbers feasible in the aggregate. 

For those who think that such a 50% default on all Irish loans is possible how do you counter that with the fact that the household savings rate has been at about 12% for the past two years.  Households account for about half of the loans in the banks, and households are now spending about seven-eights of their disposable income on consumption.  The other eight is been used to build up savings and pay down debt.  Obviously, this is at the aggregate level and there are individual households in dire needs.  This is a serious problem but not the concern here.

This chart from the Central Bank’s Quarterly Financial Accounts shows that households have been saving an average of €4 billion a quarter up to October of last year.  It can be seen that about €3 billion of this (based on the red bar) is going to reduce household liabilities. 

Household Net Lending and Borrowing

Data from the Financial Regulator on Mortgage Arrears show that 92% of residential mortgages are being repaid according to the original terms of the contract.

It must also be realised that the banks hold substantial loans outside of Ireland.  For example, nearly one-third of the residential mortgages held by the banks in the stress tests were in the UK.  That is €43 billion of the total loans.  Here is the table from the recent stress test document. 

Loan Balances

This table shows €274 billion of loans.  The remaining loans to bring this up to near €300 billion are in the carcasses Anglo and INBS.

In the worst case scenario the banks are expected to make a loss of 1% on these €43 billion of UK mortgages.  The banks will also have non-Irish loans in the corporate, small and medium enterprise and non-mortgage consumer parts of their loan books where losses comparable to those in Ireland are not expected. 

Of the €72 billion of NAMA has taken responsibility for nearly €20 billion are in the UK with small amounts in other international markets.   Just taking the mortgage and NAMA loans already reduces the amount of Irish loans to below €300 billion.

With this in mind it is clear that losses well in excess of 50% are needed on the Irish loans in the covered banks for the €160 billion of losses envisaged in this "analysis" to materialise.   There are huge problems in the Irish banking system but we gain nothing by treating them in such a ridiculous manner.

There is no way we can halve our debt by cutting loose the banks as Prof. Kelly suggests. The numbers just aren't there to back it up. At the most, we could knock a quarter of the debt off.  Prof. Kelly believes that that “Ireland’s problems stem almost entirely from the activities of six privately owned banks”.  Our banks have created huge problems but they are responsible for only one-quarter of our public debt.

In 2014, our debt will be around €200 billion.  Here is a new note from the NTMA.  The evidence to suggest that it will be significantly greater than this is lacking.  We brought about a quarter of that into the crisis with us.  Another quarter will be due to our calamitous banks.  Half of the debt will be due to funding the annual Exchequer deficits from 2008 to 2014.  The banks are definitely the single biggest problem in the Irish economy but they are not the biggest source of our public debt.

Prof. Kelly suggests a remedy to that debt generator – immediately bring the budget into balance.  We might come back to this at some stage.  His first suggestion that we “halve our debt” by disengaging from the banks is populist nonsense. 

Undoubtedly, there are debt savings that could be made and the debt legacy from Anglo and INBS is a complete waste.  There is no doubt that on a standalone basis the money going into Anglo and INBS is dead money, but as part of an overall strategy to solve our banking crisis it may offer some merits.  I don’t know the answer to this.

The situation is not so clear cut with the other four as they do have strategic importance for the State.  Any savings from NAMA depend on the final outcome of the process.

The benefits to be made from this suggestion are probably 66% smaller than Prof. Kelly has led people to believe.  He does not indicate what he believes the costs to be.  All this does is feed into the belief that the banks are dominant cause of all our problems.  Get rid of the banks and you get rid of our problems.  This is not true.

Sunday, May 8, 2011

Getting the Public Debt number is hard

One thing that has continually persisted in this crisis is the inability to be accurate with numbers.  After two days examining public debt figures I was somewhat taken aback to see the following headline in the business section of Saturday’s Irish Examiner.

National debt ‘set to hit €173bn’

All evidence had led me to believe that the General Government Balance at the end of this year would be €159 billion. Until I looked for the source of the story.  The Examiner story comes from this BOI report which states that:

Ireland’s debt ratio is set to rise further, however, and recent developments mean that the debt burden may now peak at a higher level than previously projected, as outlined in a revised Stability programme published recently by the Department of Finance. The Department had expected the debt ratio to rise to 99% this year and to peak at 103% in 2013, but now forecasts 111%, rising to a peak of 118%. In cash terms the debt total is forecast to end the year at €173bn, or €25bn higher than 2010, reflecting the Budget deficit and some €10bn to cover the costs of additional bank recapitalisations.

I have tried to figure out what this is based on and here is the April 2011 Stability Programme Update.  In table 11 on page  26 it does indeed indicate that the GGD will be 111% of 2011 nominal GDP, which is forecast to be €156.1 billion (bottom of page 50). It is true that 111% of €156 billion is €173 billion.

Yet, back last March (only nine weeks ago) the DoF forecast that that the GGD for 2011 would be €159 billion not €173 billion as it seems to now indicate .  See page 2 in this document

So how did the end-2011 debt forecast go from €159 billion to €173 billion in a matter of weeks?  Page 20 of the Stability Programme Update provides the answer.

The requirement for additional capital for the banking sector, arising from the results of the PCAR/PLAR process, was announced on 31 March and this will also impact on the overall Exchequer position in 2011.

The results of that process show that a further €24 billion is required by the banking sector. It should be noted that €5.3 billion of this €24 billion represents a buffer over and above the requirements of the stress test. Moreover €3 billion of this figure will represent contingent capital.

€10 billion of the €24 billion will be provided from the National Pensions Reserve Fund (NPRF) and thereby has no impact on the Exchequer position.

This was already included in the budgetary forecasts published in December 2010. Of the remaining €14 billion that is required, a substantial element will come from the Exchequer but there are a number of mitigating factors - such as burden sharing and capital generating asset disposals - which will help reduce the Exchequer funding requirement and alleviate the burden on the domestic taxpayer. For the purpose of the fiscal and debt projections contained in this Update, it is assumed that Exchequer funding in the order of €10 billion will be required. However, the actual amount to be sourced from the Exchequer will become clearer in the coming months in the context of the amount raised from the mitigating factors.

This clearly indicates that €10 billion will be required from the Exchequer to fund the €24 billion recapitalisation of the banks.  The other €4 billion will come from the sale of Irish Life and haircuts to subordinated bondholders in the banks.  I had previously assumed that half of this €10 billion would be drawn from the existing cash balances of the State and thus would not increase our borrowings.  At the end of March these were €22.4 billion.  As it now seems that we are going to leave these cash balances intact are we going to borrow all the recapitalisation money?

The end-2011 GGD should not have been increased by €14 billion. That is a mistake.  At a maximum it should be increased by €10 billion.  The other €4 billion is a mystery.  This brings our end-2014 debt forecast up to €205 billion but also means we have an extra €5 billion of cash to use.  The effect on the net position is zero.

Here are the DoF projections of the GGD for the next few years.

  • 2011: €173 billion
  • 2012 €190 billion
  • 2013 €198 billion
  • 2014 €202 billion
  • 2015 €203 billion

There are still getting to a total of around €200 billion but in a slightly accelerated fashion.  The €14 billion has no increased the debt beyond the projections we have been using so perhaps it is due to the accelerated drawdown on the EU/IMF funds in 2011.  No additional €4 billion of expenditure has been announced.

No other reason is given for the €14 billion increase in the GGD from €159 billion to €173 billion, yet it is clear that only a maximum of  an additional €10 billion will be borrowed for the €24 billion recapitalisation.  The Department’s documents say as such.  At a time when we are scolding others for incorrect debt estimates (as far away as 2014) it is unusual that we would have to provide a similar scolding to the DoF for estimates that are only seven months from coming to pass but they seem to be more measured when it comes to forecasting the end-2014 debt level.

Unsecured Loans Proudly Powered by Blogger