Sunday, June 26, 2011

What can we default on?

Our continued insistence on paying unguaranteed debts in the banks has seen the State pour €46 billion into the six covered banks so far, with a further €18 billion or so to be provided as part of the ongoing recapitalisations.  Of this €64 billion, about €16 billion will have come from money that was built up in the NPRF, so by the end of this year the bank bailout will have created about €48 billion of debt.

There are many who view this as an unsustainable debt for the State to carry and that default is inevitable.  Personally I am still of the view that a sovereign default can be avoided but that does not mean that such a course of action should be discounted.   It is not inevitable but that does not mean it should not be considered as a policy option.

At the end of this year the General Government Debt will be around €170 billion.  In increasing order of importance that will be made up of the following components:

  • Retail Debt: €15 billion
  • Promissory Notes: €28 billion
  • EU/IMF Borrowings: €41 billion
  • Government Bonds: €86 billion

This €170 billion of debt will be about 108% of GDP.  The potential for substantial savings appears to be limited.  The €15 billion of retail debt is Prize Bonds, Post Office Bonds, Savings Certificates/Bonds and the National Solidarity Bonds.  It is very unlikely that there will be a default on these.

At the end of the year there will be €28 billion of Promissory Notes outstanding.  These are used by Anglo, and to a lesser extent, INBS as collateral with the Central Bank of Ireland to obtain Emergency Liquidity Assistance (ELA).   If payment is refused on these Promissory Notes, Anglo will not be a position to repay the ELA it is drawdown from the CBoI.  If that is the case who picks up the tab?  The answer is on page 104 of the CBoI’s 2010 Annual Report:

In addition, the Bank received formal comfort from the Minister for Finance such that any shortfall on the liquidation of collateral is made good.

The €28 billion of Promissory Notes seem an ideal candidate when considering a default as this money will disappear in the zombies that are Anglo and INBS with absolutely zero return for the State.  The problem is that it looks very difficult to escape the liabilities that are being covered by these Promissory Notes.

Default on the EU/IMF borrowings is a non-runner as these institutions have priority status on our list of creditors and are legally guaranteed to get their money back.  It may be possible to reschedule the repayment of these loans.  This repayment is due to begin in 2015.  Such a rescheduling would not be far removed from a default event but it would not reduce the aggregate amount of debt we are carrying.

That means we are down to the outstanding sovereign bonds that were issued prior to our shut-out from markets towards the end of 2008.  A full list of these can be seen here.  At the end of this year there will be €85 billion of these bonds outstanding. 

If a default is going to be worthwhile it would have to reduce our debt/GDP ratio to something around 75% that would mean the aggregate debt would have to be reduced from €170 billion to around €120 billion.

To make these €50 billion of savings it seems the only realistic possibility is to enforce significant haircuts on our outstanding government bonds.  This would have to be of the order of 60% across all government bonds to make the default worthwhile.  If the haircut is less than 60% it is hard to see how the savings to be made could offset the inevitable fallout of a default. 

It is unlikely that such a haircut could be introduced, but if it was it is more than a little incongruous that those who invested in senior bonds from our delinquent banks are getting their money back, while those who invested in the bonds of the country could be forced to carry losses.  Like lots of developments in the response to the crisis, this does not add up.

However, it does not seem that default could generate the required savings to make it a viable policy option.  We are not going to default on out retail debt.  The construction of the Promissory Notes makes it very difficult to escape from the liabilities they cover.  The EU/IMF have preferred creditor status and are virtually guaranteed to get repayment on their loans.  That leaves, our government bonds. 

The yields on these indicate that markets know that this is where the risk lies.  Current market prices have an in-built 40% write-down included in them.  The haircut would need to be half as large again to make it worthwhile.

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