Wednesday, January 11, 2012

Willem Buiter on an Irish Default

Citigroup’s Chief Economist Willem Buiter’s comments that Ireland will need a second bailout have been getting an inordinate amount of coverage.  There have been plenty of observers who have made the same point from as early as the beginning of the EU/IMF programme in November 2010 and even Minister Leo Varadkar admitted as much last last May.  “Bailout 2” is not news.

What is more interesting are Buiter’s comments on the prospects of an Irish default.  This following are interlaced from two media reports of his Dublin press briefing.

“Ireland needs further assistance,” said Buiter, predicting that although Portugal and Greece will need to restructure their debts and will effectively default, Ireland can avoid going down the same route by having a plan ready in the event a second bailout is needed. (1)

“Ireland is not Portugal, nor is it Greece, but it is, because of the bank debts from September 2008, in very bad fiscal shape,” said Buiter. “I think the politicians and European partners will pursue the option of more generous funding terms before they get to sovereign-debt restructuring.” (2)

One of the primary concessions Ireland should look for is the cost of the Government promissory notes that have been put into Anglo Irish Bank, now known as Irish Bank Resolution Corp, said Buiter. “What Ireland needs to do is refinance expensive debt more cheaply,” said Buiter, saying that a deal on the notes would provide the Government with “material help”. Minister for Finance Michael Noonan was reported to be attempting to convince the European Central Bank to lower the cost of the notes last month, ultimately unsuccessfully. Buiter said that although these notes carry an interest rate of 6% or 7%, the ECB could shoulder some of the burden and that in time it may decide to do so. (1)

Buiter said a refinancing of 30 billion euros ($38.2 billion) of so-called promissory notes that Ireland used to recapitalize Anglo Irish Bank Corp., recently renamed Irish Bank Resolution Corp., at a rate of about 3 percent through the euro region’s bailout fund would “be a material help.” It “would also politically show a recognition of Ireland’s extraordinary efforts to get its fiscal house in order.” (2)

So Ireland can avoid a debt restructuring (default) if it has a “plan ready”.  As agreed last July Ireland will have access to EU funds after the end of the current programme in 2013 when they said that “ We are determined to continue to provide support to countries under programmes until they have regained market access, provided they successfully implement those programmes.”  So part A is all sewn up.

Part B is a restructuring of the Promissory Notes.  Unless we can get a reduction in the €31 billion capital amount I’m not sure there are substantial savings by reducing the interest rates on the Promissory Notes.  The notes have an interest rate of up to 8% but we are not paying the interest to a third party.  The Exchequer pays the interest to the IBRC who in turn pay it to the Central Bank.  This was summed up by Lorcan Roche Kelly with this neat graphic.

This is somewhat paraphrased from the original post (apologies to Lorcan who was making a related but different point).

The interest on the current promissory note is set with reference to the 10 year Irish bond yield. This note could be set with reference to anything and it doesn’t really matter. We will either be paying the interest to a bank that we own, or to a central bank that we own. We pay them €1 bn, they make profit of €1 bn and pay that back to their shareholder – the state. The payment is circular, so the interest rate doesn’t matter, we are paying it to ourselves.

Most important is the term (the point in the future where we actually pay this back). Ireland does not need to worry about any debt roll-overs coming in the near future, so make it a 100 yr term. We will ‘promise’ to have this paid back by the 2111. Hopefully, inflation will have taken care of some of the burden by then. With this exceptionally long term ,we are not disadvantaging any of our creditors, because they will have been paid their money up front, via the nationalised banks. The drop on the ‘real’ value of the debt will not matter at all, because we owe the money to ourselves.

Buiter wants the interest rate reduced from an interest rate of 6% or 7% to about 3%.  This actually doesn’t save us anything.  What if the interest rate was more than doubled to 15%?  Would that cost us money?

We would be paying 15% interest to the IBRC (which we own) who would continue to pay the Central Bank of Ireland (which we also own) interest for the €40 billion of Emergency Liquidity Assistance that the IBRC is using.  The IBRC would have a surplus on this transaction and this money would be returned to the State as a dividend.  The IBRC would make a profit which they can return to us or maybe use to buy golf club memberships for their staff. 

The losses in the bank would be covered by the €31 billion of capital provided by the Promissory Notes.  The interest has no bearing on that.  The details of a restructuring plan for the IBRC have been released by  This says that:

The total cost to the taxpayer for IBRC under the stress case is estimated at €35.8bn

The State has provided €30.9 billion of Promissory Notes and a €4.1 billion direct cash injection into the entities that make up the IBRC.  This is €0.8 billion short of the total cost estimated under the “stress” case.  That cost of the Anglo/INBS debacle is going to be around €35 billion and we have already provided that money.  The issue is how we repay it.

To followed Buiter’s advice and to somehow convert or transfer the Promissory Notes over to the one of the EU bailout funds would actually be a mistake.  Even if this was done at 3% we would be paying the 3% to an external entity and the interest would be lost.  It is better to be paying 7% to ourselves rather than 3% to someone else.

Of course we are involved in the slow-scale transformation of the Promissory Note debt into lower interest debt through the €3.1 billion annual repayment at the end of March.  There are now €28 billion of the original Promissory Notes outstanding following the first payment last year.  To money to make the payment came from the Exchequer which is borrowing from the EU/IMF at an average rate of 3.55% to fund the deficit.

This coming March we will make an further €3.1 billion payment.  This transforms the debt from €3.1 billion of Promissory Notes owed to the IBRC to €3.1 billion of loans owed to the EU/IMF.  This does not increase our debt but instead of paying interest on this debt to the IBRC we will be paying interest to the EU or IMF.  From 2013 this process will slow considerably as the interest due on the Promissory Notes start to be accrued from then.  See here.  Over time the Promissory Note debt will be refinanced to “cheaper” debt but is this actually a good thing?

As Lorcan correctly points out it is the term that matters.  Why should we be repaying the Promissory Notes now?  The interest rate doesn’t really matter and nobody really loses if we repay them 100 years from now.  The only ‘cost’ is that there is around €30 billion of cash floating around that the Central Bank of Ireland (or the ECB more like) would like to see “put back in the vault”. 

But why do we have to do this now we the State is in a hugely distressed financial position?  Why not give the €30 billion back to the Central Bank 20, 50 or even 100 years from now as Lorcan suggests.  Prof. Karl Whelan has been excellent on this point here and here, and explains it in much clearer terms.

Willem Buiter thinks that Ireland needs a two-point plan that will enable us to avoid a sovereign default.  This is a reasonably positive diagnosis.  “The patient is sick, but he will survive” could be one way of putting it.

We will get the official funding that he (and practically everyone else) thinks we need.  We might get to “refinance expensive debt more cheaply” through a reduction in the interest rate on the Promissory Notes by transferring them to either the EFSF or EFSM.  However, rather than being of benefit to us that  could actually cost us money.   What we need is to stop repaying them until we are in a far better position to do so.

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