Friday, February 3, 2012

Repaying the Debt?

A lot of attention recently has been given to the fiscal rules that formed the basis of the recent EU treaty (inter-governmental agreement?).  One that has attracted significant attention is the Debt Brake or “One-Twentieth Rule”.  The balanced budget rule allowed a structural deficit is no more than 0.5% of GDP is probably more important but some of the commentary on the Debt Brake is worth considering.

On last night’s Primetime, Miriam O’Callaghan introduced a question to Kieran O’Donnell by saying:

“People are talking about €6 billion needed to take out on an annual basis”

On the previous night’s Vincent Browne, Stephen Donnelly said:

“To pay down €100 billion in five years you’ve got to pay down €5 billion a year, that’s what the treaty says.”

I have read the treaty and I don’t know where this is coming from.  The opening report on Primetime suggested that if our debt peaks at 118% of GDP in 2013 we would then have 20 years to reduce the debt and that we would have to “dramatically pay down this debt”.  The prospect of repaying debt is not an attractive one given the current state of the Irish economy.  However, it is not a prospect we are are not likely to face.

Ireland is currently in an Excessive Deficit Procedure which is largely about getting the annual fiscal deficit below 3% of GDP.  For 2012, we are targeting a deficit of 8.6% of GDP, and the current plan is to get that down to 2.9% of GDP by 2015.  As long as a country is in the EDP it is that annual deficit rather than the total debt that is key metric. 

And then once the country gets the deficit below 3% of GDP it enters a three-year transition period before the debt rule becomes effective.  This was explained in this Council Regulation:

"For a Member State that is subject to an excessive deficit procedure on 8 November 2011 and for a period of three years from the correction of the excessive deficit, the requirement under the debt criterion shall be considered fulfilled if the Member State concerned makes sufficient progress towards compliance as assessed in the opinion adopted by the Council on its stability or convergence programme. "

The implications for each country are more clearly detailed in this press release.  The last line confirms that Ireland will not be subject to the "numerical debt reduction benchmark", the one-twentieth rule, until 2018.  This is likely to be the earliest.  The three-year transition period does not begin until the excessive deficit has been corrected.  In this three-year period a country has to show is “sufficient progress towards compliance”, which is rather woolly.

It is also important to note that the “one-twentieth” rule does mean the debt has to reach the 60% of GDP target in 20 years.  It specifies that about one-twentieth of the gap between the current debt level and the 60% of GDP target must be closed each year.

Under the rule a country with a debt of 120% of GDP has 20 years to get the debt down to 70% of GDP, with the one-twentieth improvement getting so small that it can take another 20 years to bring the debt down to the 60% of GDP level.

Debt Brake

The required reductions in the debt ratio appear large at first but do moderate significantly as the debt converges on the 60% level.  This is not a linear projection that will require €x billion to repaid each year.

Given our deficit problems, the focus until 2015 and beyond will be on bringing down the deficit rather than repaying debt.  There is no requirement to repay debt and bringing down the deficit will stabilise and, in time, reduce the debt ratio.

So what happens in 2018?  Will we have to start “taking out” money from then?  Debt projections out to 2018 are unlikely to be very reliable.  In its last published review the IMF projected a General Government Debt of 111% of GDP in 2016.  With the planned reduction in the deficit that could be down to 105% of GDP in 2018.  No one can be sure.

If the debt brake is applied for a country with a debt of 105% of GDP they would have to reduce the debt ratio to 101% of GDP the following year. [Technically they only have to budget to achieve the required debt reduction rather than actually achieve it.]

A country with a balanced budget would achieve that with a real growth rate of 2% and an inflation rate of 2%.  There would be no necessity to make any debt repayments.

In fact, once the debt ratio gets below 90% of GDP, a country with 2% inflation and growth rates would be able to run (small) deficits and still meet the debt reduction requirements.  The debt brake does not eliminate the potential to borrow additional money but it does substantially limit the rate at which this money can be borrowed.

From an Irish perspective (and the perspective off all other countries) the balanced budget rule  is far more significant.  This requires a structural deficit of no more than 0.5% of GDP (1.0% of GDP for countries with a debt of below 60% of GDP).  If by 2018 Ireland has a structural deficit of less than 0.5% of GDP it is likely that we would satisfy the conditions of the “one-twentieth” debt brake rule without the need for any additional measures.

If the budget has been brought into balance by 2018 (a big if but we have the luxury here of just having to assume it) it is likely that growth and inflation would do most of the heavy lifting for the debt ratio reduction.  With a balanced budget an inflation rate of 2% and a growth rate of 2% would be enough to bring the debt ratio down from 105% of GDP to 101% of GDP and all the way down to the 60% target.  We would not have to make any debt repayments but could choose to do so.

As stated above it is the balanced budget rule which will potentially have a greater effect .  The conditions and effect of the debt brake are fairly objective and clear.  There is no consensus on how a structural deficit should be measured so the precise implications of the balanced budget rule cannot be objectively assessed.  The 3% limit on the overall budget deficit remains.

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