Thursday, February 28, 2013

Retail Sales slip again

With December’s retail sales failing to live to the the Xmas hype, today’s release of the January 2013 Retail Sales Index does little to alter the landscape.  Retail sales excluding the motor trade fell on a seasonally adjusted basis in January.  The fall was greatest in the volume series which has given up more than half of the increase that occurred in the six months after June 2012.

Ex Motor Trades Index to November 2012

On an annual basis both the volume and value indices are above where they were at the same time last year (but only just).

Annual Change Ex Motor Trade Index to November 2012

The monthly volatility in the series is evident  but after a sequence of four monthly increases both the volume and value series have recorded monthly declines in two of the past three months.

Monthly Change Ex Motor Trade Index to November 2012

Turning the corner? Caveat emptor.  We’ve been offered that pup before.

Monday, February 25, 2013

Central bank holdings of Irish government bonds

In the discussion around the Promissory Note/Long-Term Government Bond swap it quickly became clear that the benefits of the new arrangement are dependent on how long the Central Bank of Ireland holds the €28 billion of bonds it has received. 

On Thursday, the ECB also confirmed the substantial bond holdings that it and the various National Central Banks (NCBs) in the Eurosystem of Central Banks (ESCB) accumulated as part of the now-defunct Securities Market Programme.  Here are the figures published by the ECB along with the nominal amount of a percentage of 2012 Gross Domestic Product (GDP) and 2012 General Government Gross Debt (GGD) using IMF estimates.

SMP Holdings

Here is the list of Irish government bonds from which the €14.2 billion held by the ESCB will be drawn. Click to enlarge.

Daily Bonds

As previously pointed out an agreement in the Eurogroup made in February 2012 will see the income profits the NCBs make on their Greek bonds recycled back to Greece.  In November 2012 this was confirmed as:

A commitment by Member States to pass on to Greece's segregated account, an amount equivalent to the income on the SMP portfolio accruing to their national central bank as from budget year 2013.

As can be seen in the second table the average annual interest coupon on Irish government bonds is close to five percent.  The NCBs will be paying for the facility to hold the bonds at the ECB’s main refinancing rate, which is currently 0.75%.  Even allowing for other costs, and a possible transfer to the reserves of the NCBs, it is clear that a significant profit will be made by the NCBs on the interest from these bonds.

When the Greek arrangement was re-affirmed in November 2012 it was estimated that it would reduce Greek government debt by 4.6 percentage points of GDP by 2020.

Relative to GDP the Irish holdings are about half as large as those of Greece though the average maturity is one year longer.  It is possible that if a similar arrangement was put in place for Ireland the amounts involved over the next few years could be from 1.5% to 2% of GDP – a very significant sum.

The €14 billion of bonds held by the ESCB are likely to generate close to €700 million of interest payments this year, though it is likely that a significant portion of bond due to mature on the 13th of April will be in the holding.  A profit on the interest for the NCBs of around €500 million (0.3% of Irish GDP) is possible this year, and this will decline as the bonds mature.

The balance sheet of the Central Bank of Ireland (.xls) does not indicate that it holds a significant portion of these bonds.  From the time the SMP was instituted in May 2010 “Securities of other euro area residents in euro” held by the CBoI increased from €16.5 billion to €20.7 billion by the time the SMP was shelved in March 2012.  Both transactions and revaluation effects will have contributed to the increase.  The asset item “General Government debt in euro” has never had a non-zero figure reported in the balance sheet.

I appeared before the Joint Oireachtas Committee on EU Affairs last Thursday and this issue was raised during the meeting (full transcript).  My comments in response to the query are below the fold. [Note: The ECB published the actual figures on the amount of bonds at the same time as the meeting began but it is clear that the estimated figures in the public domain were “in the ball park”.]

Mr. Seamus Coffey: I will take the issue of the ECB bondholdings first and, maybe, then move on to some subsequent issues.

The Chair has introduced a useful topic. The figures in this regard are unconfirmed, although a set of figures was presented to the Governor of the Central Bank, Professor Patrick Honohan, at the Joint Committee on Finance, Public Expenditure and Reform recently and he did not deny them. I think we can take it that they are in the ball park.

The ECB had what it calls the securities market programme where it bought Government bonds. It started in 2010. The programme ended in March of last year. The programme is now over but its legacy is substantial government bondholdings by the various national central banks in the eurozone which carried out the policy on behalf of the ECB. Most of the activity took place after the July 2011 European Council meeting that finally admitted that a Greek default was necessary but, perhaps, did not go far enough. Because private sector involvement was finally admitted in the case of Greece, to try to cushion some of the consequences for the other countries that were under pressure the ECB stepped in and really stepped up its bond buying over the coming months. Irish bonds formed part of that. It looks like they had somewhere in the region of €18 billion to €22 billion of Irish Government bonds bought in a fairly short period. Most of them focused on what we might call "the short end." These were bonds coming to maturity over a fairly short period - two, three or four years. Since then, there have been two sovereign bond maturities in Ireland. There was a November 2011 bond that matured and also a March 2012 one. Many of the bonds that were bought might have matured and been redeemed, but the figures would still have been quite large.

At a eurogroup meeting in February last it was agreed that the national central banks would recycle some of the profits they were making on these bonds back to Greece. As attempts were made to bring down their debt-to-GDP ratio, one approach taken was that there was this money flowing out of Greece and maybe they could get it to flow back in. In the main, as we now will be aware, when central banks make profits they return them back to their sovereign. In our case, we expect the Central Bank to make substantial profits on Government bonds, but these merely happen to be our own Government's bonds and we hope the Central Bank can hold on to them for as long as possible because the interest we pay on them to the Central Bank is then recycled back to the Exchequer. If there is a profit on any interest that is paid on the Irish bonds now held by the national central banks across Europe, it can be returned to the exchequer in those countries and we hope, perhaps, they will return it to us.

The issue is made up of two elements. The Chair spoke about the profit that the central banks will make. The profit is made up of the annual interest - coupon - they get every year and the capital appreciation. There is not too much we can do about the capital appreciation. The central banks will require a certain return for taking on the risk of buying Irish Government bonds, and this was particularly the case in the autumn of 2011 when sovereign bond markets were quite heated.

We can focus particularly on the annual interest, which might not grab as large a headline as focusing on the capital but which sums can be quite large. Here, the central banks are making a cheap and easy profit. The central banks get access to funds at a very cheap rate. They can get the funds at the ECB rate and they have bought these Irish Government bonds. They might have made a profit by buying them at 70 bps or 75 bps, but they are making that profit off somebody else. They are making that profit off the person who sold the bonds. That really is of little concern to us. We borrowed €100 whenever the bonds were issued, say, in 2006 or 2007, and we will pay back €100. The central banks themselves are not making a profit off us on that basis. What they are making a profit on will be the interest that we will now pay on an annual basis on those bonds. Perhaps we should target and try to get back the interest, which is the substance of the Greek deal where the interest that is paid on bonds is then recycled back to the Greek central bank which can return it to the Greek exchequer.

The sums have potential to be reasonably large. Given some of the redemptions, there could be - I merely pick a figure - €12 billion of these bonds still being held by the national central banks across Europe. At a rough 5% annual coupon, one is talking about €600 million of interest per year. We have a massive interest bill, approaching €8 billion. Some €600 million of that could be going to the national central banks of Europe. The money they are borrowing from the ECB for this facility could be costing them €100 million and, potentially, there is a €500 million per annum profit or income for the national central banks across Europe on their holdings of Irish Government bonds. The central banks will benefit because they got to buy them cheap but as of yet, there has been no benefit for Ireland. We were not in bond markets in July and August 2011 when these bonds were being bought. This was, apparently, done for our benefit. It was to try to stabilise European bond markets but as of yet, we have got no real benefit because it is only subsequently that we got back into markets. This potential €500 million is there and could be recycled back to the Central Bank of Ireland which would give it back to the Exchequer. It would be a welcome boost to the public finances.

Monday, February 11, 2013

S&P on Ireland

Standard and Poors have changed their outlook on Ireland’s BBB+ rating from negative to positive.  This in itself is not a very significant move.  Far more attention will be directed to the Ba1 (outlook negative) currently assigned by Moody’s to Irish government bonds.  This puts Ireland below investment grade or having ‘junk’ status.

The statement released by S&P is below the fold and details their opinion that last week’s announcement “supports medium-term fiscal consolidation.”  It also discusses how the switch adds about 10% of GDP to their measure of the government debt as, unlike Eurostat, they include NAMA bonds in their gross debt figure.  Their net debt figure also rises by the same amount as they view the NAMA-held assets as “illiquid”.

Read the full statement below.

Ireland Outlook Revised To Stable On Promissory Notes Exchange; 'BBB+/A-2' Ratings Affirmed

Publication date: 11-Feb-2013 12:51:43 EST

  • In our opinion, the exchange of promissory notes, which the Irish government had provided to Irish Bank Resolution Corporation, for long-dated Irish government bonds, should reduce the government's debt-servicing costs and lower refinancing risk.

  • We believe the success of the exchange increases the likelihood of a full return by Ireland to private financing and, therefore, of Ireland successfully exiting the EU/IMF bailout program, at the end of 2013.

  • We are therefore revising our rating outlook on Ireland to stable from negative.

  • We are affirming our long- and short-term foreign and local currency sovereign credit ratings on Ireland at 'BBB+/A-2'.

LONDON (Standard & Poor's) Feb. 11, 2013--Standard & Poor's Ratings Services today affirmed its long- and short-term foreign and local currency sovereign credit ratings on the Republic of Ireland at 'BBB+/A-2'. We revised the rating outlook to stable from negative.

The outlook revision reflects our expectation that the exchange of promissory notes for longer-term government bonds significantly reduces the Irish government's debt-servicing costs and refinancing risk, and supports medium-term fiscal consolidation. By improving the government's debt-maturity profile, the transaction also increases the prospects of Ireland leaving the EU/IMF bailout program as planned at the end of 2013.

The Irish government's announcement involves liquidating the Irish Bank Resolution Corporation (IBRC) and transferring its assets (including the promissory notes) to the Central Bank of Ireland (CBI), thereby paying down the Emergency Liquidity Assistance that had been financing the CBI's loan book. The assets would then be transferred from the CBI to the balance sheet of National Asset Management Agency (NAMA) in exchange for new government-guaranteed NAMA bonds, which will be held as an asset at the CBI.

While we expect the liquidation of IBRC will modestly weaken the general government fiscal balance in 2013, we project savings on interest payments on the promissory notes will narrow the Irish government's fiscal deficits in 2014 and 2015 by at least 0.6% of GDP--probably somewhat more--given that delayed refinancing reduces compound interest payments. In addition, the potential for higher dividend payments from the CBI over the medium term could improve the reported headline general government deficit during 2014-2016.

We believe that the arrangement will, however, effectively add an amount equal to about 10% of GDP to the government's existing explicit debt burden, as our criteria define this term. This is because we will include the new NAMA bonds, issued in exchange for IBRC assets, as part of our calculations of general government debt (whereas Eurostat does not include the bonds). Our inclusion of the NAMA bonds in Ireland's general debt total reflects our view that the sovereign-guaranteed debt is equivalent to government debt, in all cases, under our accounting methodology. At the same time, the arrangement will not increase the overall level of public sector debt. Under our methodology for estimating net general government debt, we do not net out NAMA assets from Ireland's general government debt burden as we view these as illiquid. Nevertheless, we anticipate that, as NAMA disposes of its portfolio of distressed property assets, the proceeds will be used to pay down government liabilities such as the NAMA bonds. Paydown should improve Ireland's general government debt ratio in both gross and net terms.

The ratings reflect our view of the government's commitment to stabilizing Ireland's public finances, as well as the high wealth, openness, and resilience of the Irish economy which we assess as more flexible than most of its eurozone peers. These strengths are moderated, however, by Ireland's still-substantial fiscal deficits, heavy public and private debt burdens, and the weaknesses of its financial system. In our view, these factors collectively reduce Ireland's growth prospects as well as its capacity to respond to material economic and financial shocks.

The stable outlook balances our view of Ireland's progress toward rebalancing the economy and consolidating its fiscal position against the prevailing downside risks we see to its financial sector stability and its already-highly-leveraged balance sheet, as well as what we view as the uncertain growth prospects for its domestic economy.

We could revise the outlook to negative or lower the ratings if the government fails to comply with the EU/IMF program. In our opinion, this could jeopardize the government's progress in regaining market access and consequentially complicate negotiations for a new program. We could also lower the ratings if the government were not able to access the capital markets sufficiently to meet its 2013 funding needs, or if economic growth slows amid a weaker
external environment.

We could consider raising the ratings on Ireland if the government sustains its fiscal strategy, enabling it to pay down its general government debt and reduce refinancing risks. If the government can sell its sizable equity position in the domestic banking system to nonresident investors, this could also help reduce debt, which would be positive for the ratings.

Saturday, February 9, 2013

What’s next on our agenda with the ECB?

Patrick Honohan’s recent appearance at the Oireachtas Finance Committee included the following exchange.

Deputy Kevin Humphreys:  “The ECB purchased significant amounts of distressed euro sovereign debt in the secondary bond market in 2010 and 2011 through the security market programme. I understand that approximately €200 billion worth of bonds are being held to maturity. It is estimated that between €15 billion and €20 billion of Irish bonds were bought, mostly at distressed prices well below par.

The Barclays Capital report of January 2012 stated that about €19 billion of Irish Government bonds were being held by the ECB. Is that the correct sum?

We heard a lot about how Franklin Templeton made huge returns by buying Irish bonds at low prices. It is difficult to estimate the profits the ECB will make on the capital proportion of these bonds bought through the SMP but it could be in the range of €3 billion to €5 billion. The problem is, and I asked about this in private session before and was given short shrift, we do not know what the ECB profits may be because the ECB will not tell us. The Governor sits on the board, however, so does he know and will he tell us?”

Patrick Honohan:  “I know how much Irish paper is held by the ECB in the security market programme. I could try to calculate the profits.”

Kevin Humphreys:  “Am I far off in my calculations?”

Patrick Honohan: “I would steer the Deputy away if I thought he was. I think that more information about the SMP holdings will be provided. The SMP has terminated as a programme and the reasons of market sensitivity that caused it not to be disclosed would fade away. At present, however, I am not at liberty to give out those numbers.”

Here is the set of Irish government bonds that was in issue around the time the Euro System of Central Banks (the constituent elements of the ECB) were making these purchases under the Securities Market Programme in the second half of  2011.

It is likely that the ECB purchases were focussed on the short end of the market.  The first two bonds on the list have been redeemed.  The next on the list is the bond maturing on the 18th of April coming.  A bond swap last July reduced the amount outstanding on this bond which now is just over €5 billion.  The ECB are likely to be significant holders of this bond and also of the remaining €8 billion of the January 2014 bond.

The November 2012 Eurogroup meeting included the following agreement:

A commitment by Member States to pass on to Greece's segregated account, an amount equivalent to the income on the SMP portfolio accruing to their national central bank as from budget year 2013.

Can we get this too?

Friday, February 8, 2013

Interest costs under the “debt deal”

As explained in the previous post it is not the size of the government debt that has a direct impact on the public finances; it is the interest cost it generates (though the size is obviously a big factor in that) 

What was in play with yesterday’s restructuring was a €25 billion Promissory Note debt.  It was a €25 billion debt on Wednesday, it is a €25 billion debt today and it will be a €25 billion debt in 2053.  But because of inflation not all €25 billions are created equally.

Anyway, the debt in question generates two interest costs for the State:

  1. The interest on the central bank funding which carries an interest rate equals to the ECB’s main refinancing rate.
  2. The interest on the borrowings used to pay down the central bank liquidity.

Here are two tables that showing some hypothetical the interest costs of the old Promissory Note and new Long-Term Government Bond arrangements until 2033. 

These are only hypothetical scenarios designed to gauge the relative difference in the cost of each approach rather than a definitive estimate of the cost of each.  There are a number of simplifying assumptions made.

  • The ECB interest rate is expected to rise from 0.75% to 3.00% over the next six years and stay at 3.00% thereafter.
  • The ‘margin’ of Irish government borrowing over the ECB rate is assumed to be constant 3.25%.
  • All interest is paid from current revenue.
  • Borrowings are only made to fund capital payments.  This only impacts the Promissory Note arrangement and from each €3.1 billion annual payment the Central Bank profit is subtracted as it is returned to the Exchequer and also the external interest cost of the ELA as it is assumed that is paid from current revenue.  This keeps the borrowing at €25 billion in both cases so we can assess the interest cost.
  • The discount rate used is 6%.

As we are looking for relative differences the assumptions are not hugely significant as both scenarios are played out under the same set of assumptions.

First the Promissory Notes:

Pro Note Interest

And the new Long-Term Bond arrangement:

Long Term Bond Interest

The interest mix of both changes.  In the first case it is because the Promissory Notes/ELA costing the ECB rate is paid off with new government borrowings at the “market rate”, while in the second case the Central Bank funding at the ECB rate is reduced through the Central Bank selling the bonds it holds thereby making the interest payable to a third party. By 2034 both arrangements are identical in this setting - a debt of €25 billion with an annual interest cost of €1.56 billion (assumed interest rate by then is 6.25%) - as all the Central Bank funding is repaid

So what do we find in? In nominal terms the interest costs are

  • Promissory Notes: €27.0 billion
  • Long-Term Bonds: €20.6 billion

Getting the present value of the interest payments gives:

  • Promissory Notes: €14.3 billion
  • Long-Term Bonds: €10.3 billion

The interest cost under the new arrangement is around 30% lower.  This is a gain to the State of the new change which arises from having access to borrowings at the lower ECB rate for longer.  It increases from c.7 years to c.15 years.

The are other gains from the new arrangement.  The above just reflects the interest cost of each arrangement.  The accounting treatment of the Promissory Notes meant they had a very large impact on the deficits over the coming years.  That has now been reduced.  Also the new arrangement means that the debt doesn’t have to be rolled-over until the first of the new bonds matures in 2038 significantly reducing the medium term funding needs of the State. 

The is little doubt that the new arrangement is anything other than a gain for the State.  And unless your expectations were incredibly unrealistic (or more accurately based on fantasy), yesterday’s announcements were pretty much as good as could have been hoped for given the institutional constraints faced.

“Legacy of Debt”

Lots of talk about a “legacy of debt” in response to yesterday’s re-arranging of the Promissory Notes/ELA framework.  First up, governments don’t repay debt, they roll it over.  And, as well as the size of the debt, there are two things that matter for debt rollovers:

  • average maturity
  • average rate of interest

Today’s announcement does not change the size of the debt but the maturity and interest rate changes are very significant (and beneficial in case there is any confusion).

Yesterday, Ireland was faced with the prospect of carrying a debt of €25 billion on the Promissory Notes and needed to roll that over with payments of €3 billion every year at whatever the best available rate at the time was.

At the end of the Promissory Notes (which would probably have been around 2022) the debt would still exist and what would need to be rolled over would have been the borrowings undertaken in the interim to meet the €3 billion annual repayments.  This legacy of debt was always going to exist and would have needed to rolled over in 2025, 2035, 2045 or whenever.  Government debt is not extinguished, the burden of carrying it (the interest) is eroded through growth and inflation.

Yesterday’s announcement offers some significant benefits for Ireland on both fronts.  Firstly, the average maturity has been extended to an average of 34 years.  This means the debt has to be rolled over far less frequently and through that reduces risk.  Under the current arrangement there would be €25 billion of debt being paid off in chunks of €3 billion and these would quickly accumulate into a total of tens of billions that would need to be frequently rolled over depending on the nature of the borrowings used to fund the annual payments.

The new arrangement postpones this roll over to an average duration of 34 years.  Rolling over €25 billion of debt in 2020 could present significant difficulties.  Rolling over €25 billion of debt on a staggered basis between 2038 and 2053 will be far less onerous.

The new arrangement also offers the significant interest rate benefits.  Under the Promissory Note arrangement debt with a very low net external cost of 0.75% (the ECB MRO rate) was transformed into much more expensive debt (EU/IMF loans at 3.3%) at a rate of €3 billion per annum. 

The net external cost remains at 0.75% but the rate at which the debt is transformed into more expensive debt has been significantly reduced.  As a result of the Central Bank of Ireland selling the bonds it receives as part of the swap this will happen at a rate of €0.5 billion per year up to 2018, €1 billion a year from then until 2023 and €2 billion a year thereafter.

The €25 billion of Promissory Notes would have been turned into full interest-costing sovereign debt by around 2022.  Today’s announcement means that the full €25 billion will not become fully interest-costing until around 2032.  We have gained because the debt with a net external cost of the ECB MRO rate is now available for longer.

Future generations were always going to have a “legacy of debt” of €25 billion.  What yesterday’s announcements have ensured is that they will have access to lower interest rates for longer and will be faced with rolling over the debt less often.  In the arena of public debt both of these are a win.

Here are some figures since 2008:

  • 2008: €10.9 billion
  • 2009: €15.4 billion
  • 2010: €11.8 billion
  • 2011: €10.2 billion
  • 2012*: €7.0 billion
  • 2013*: €3.4 billion

This figures will give a “legacy of debt” of €58.7 billion.  This is more than €30 billion greater than the total in question in yesterday’s restructuring.  What are these figures?  They are the underlying primary deficits (the deficit net of interest costs and banking measures) that the state ran from 2008 to 2011 and the projections of what the primary deficit will be for 2012 and 2013.

This is the excess of government expenditure on public sector pay, intermediate consumption, social transfers, capital formation and subsidies for the current generation over the tax revenue the government is raising from the current generation.  Over a six- year period the government is spending nearly €60 billion more on us in services and transfers than it is collecting from us in taxes and charges.  Why is no one concerned about this “legacy of debt” for future generations?

If we could borrow this money with a zero-interest perpetual bond there would be no need to worry about future generations.  They would have to pay nothing for our borrowings.  This highlights that for governments it is not the amount of debt that matters.  With governments debt doesn’t matter, deficit spending does.

The debt only matters insofar as it generates an interest cost.  If this money has to be borrowed at 4% it will cost future generations over €2 billion a year in interest for the privilege of us spending more on ourselves than we are willing to pay in taxes.  Is this a legacy we are willing to impose on future generations?

Tuesday, February 5, 2013

“Lots of Debt” in the IBRC?

On last night’s Primetime, Professor Hans-Werner Sinn seemed to support a default on the upcoming €3.1 billion payment on the Anglo Promissory Notes.  From the interview:

PK: If, for example, we decide we are not going to pay the 3.1 billion on the Promissory Note which is due at the end of March.  That means that the former Anglo bank will not have the cash to do what it needs to do – to wind down.  The ECB will say “that’s a default”.

HWS: Why don’t you let it default? Default is the best way to solve such a problem. It doesn’t mean the bank comes to an end; it just means that the creditors have to forgive some of the debt and this is quite natural.  They made the investment decision.


HWS: Well there is still lots of debt in the banking sector, including the Anglo Irish Bank, the follow-up bank, the bad bank.  It has bondholders; it has creditors.

PK: So burn them?

HWS: Well, ask them to forgive some of the debt.

“Why not let it default?”  That could be done but it is clear that Professor Sinn does not know what is left in Anglo/INBS, now known as the Irish Bank Resolution Corporation (IBRC).  Here is an abridged version of the IBRC balance for the end of June 2012 taken from its latest interim report (page 24)

IBRC Balance Sheet June 2012

IBRC does have a lot of liabilities but 85% of it is the Exceptional Liquidity Assistance (ELA) it drew down from the Central Bank of Ireland in 2010 to repay the huge amount of deposits that left at that time.  The €3 billion of “Deposits from Other Banks” is the repurchase agreement entered into with Bank of Ireland last year with an Irish government bond that was used to meet last year’s Promissory Note/ELA repayment.  The IBRC must repay this in June.

There is not “lots of debt” to renege on unless Professor Sinn means a default on the ELA that is ultimately owed to the ECB and that we should ask them “to forgive some of the debt”.  However, when pressed further he doesn’t seem to advocate this.

PK: The ECB will allow us to do this?

HWS: I don’t know what the ECB will say.

Hans-Werner Sinn: Interview Transcript.

German Economist, Professor Hans-Werner Sinn of the Ifo Institute appeared on tonight’s Primetime.  Professor Sinn has been the question to many answers and tonight was no different.  Some of what he says make absolute sense, some makes a little sense, while more makes no sense at all.

He proposes, or seems to propose at any rate, a default on the Anglo Promissory Note, a default on liabilities of the other banks, and a default on Irish government debt – basically default on anything to ensure the German taxpayer is insulated. Right at the end he seems to suggest that the Target2 balances created as part of the process that saw the Irish banks repay over €100 billion of foreign deposits were some form of “public credit provided to Ireland at low interest rates”.

The preview to the show said that:

And in studio, we’ll be joined by top German economist Hans-Werner Sinn, who’ll tell us why he believes Ireland does not need a deal on its bank debt.

See for yourself what Professor had to say.  Here is the transcript.

Pat Kenny: My next guest has been described by The Economist magazine as “the closest Germany has to a celebrity economist”.  Bloomberg said he “can rally enough voters to actually influence Chancellor Merkel”.  In 2011, The London Independent named him as one of “ten people who changed the world”.  And last summer he caused a sensation by joining 270 other German economists who signed a letter opposing Chancellor Merkel’s Brussels agreement on direct recapitalisation of ailing banks.  Professor Hans Werner Sinn you’re very welcome to the programme.

Now you saw the video we did in Rochfortbridge.  People are feeling the pain.  Almost one-in-three men out of work; almost one-in-five women…more than one-in-five women out of work.  This cannot go on.

Hans-Werner Sinn: No, of course not.  We have very difficult situations in quite a number of European countries.  It’s even worse in Spain, in Greece as you may know the youth unemployment there is 50 percent.  The total unemployment rate is approaching 30 percent, it is twice as large as Ireland’s.  And Ireland’s is very difficult indeed. So let’s hope that the situation will soon improve and in my view it will.

PK: But why?

HWS: Why? Because you did have the austerity.  That’s the difference between Ireland and all the other crisis countries.  Ireland came earlier into the crisis than the others.  In 2006 the real estate bubble burst already, and the others came into trouble after Lehman, 2008.  So when Ireland was in trouble, no one was helping Ireland.  The Irish people had to help themselves and they were cutting their wages and prices and increase their competitiveness with huge success.  We still have let me say…

PK: But the prices…

HWS: …the price level relative to the other eurozone countries in Ireland has declined by 15 percent.  No other country has achieved that and that has really…

PK: So we’re becoming more competitive? However…

HWS: Indeed. And it will create jobs.  It has already improved the current account, the trade balance enormously and you see the results of this austerity programme.  I don’t think there would another five years or even ten years of problems for Ireland.

PK: But we have a massive debt overhanging us.  Much of it debt that we didn’t incur as a nation; individual banks incurred it and all of those banks were underwritten by the Irish government.  Bondholders in German and France got paid when in a normal capitalist economy they would have had to take a bath.

HWS: Indeed.  And this was a big mistake.  Ireland gave guarantees of 240 percent of the Irish GDP. Incredible! For what? In order to help these rich people who had invested the money in Irish banks.  The right thing would be…

PK: But we know the pressure was on the Irish government.  On the night of the bank guarantee they were told “save the Irish banks” because if the banks go down, European banks will go down, German banks will go down, French banks will go down.

HWS: Well, they did go down.  And Germany itself had a Promissory Note of 240 billion euros to save some of its banks.  I think this whole business was handled badly and so far the problem is that some investors, rich people, gave the money to the banks and the banks can’t repay and then they say let’s ask the taxpayer to foot the bill.  This is not right, it is not just and it is not the right incentive for the future because these banks will go on with their crazy business in the future.

PK: But what are we to do? Because we have already given those banks the money.  They have paid the bondholders…

HWS: You should…there are still lots of bondholders, people, creditors of the Irish banks, you should deprive them of some of their claims.  If the banks don’t have enough equity because they have write-off losses then someone has to bring in this new equity. Is it the taxpayer or is it the creditors?

PK: If, for example, we decide we are not going to pay the 3.1 billion on the Promissory Note which is due at the end of March.  That means that the former Anglo bank will not have the cash to do what it needs to do – to wind down.  The ECB will say “that’s a default”.

HWS: Why don’t you let it default? Default is the best way to solve such a problem. It doesn’t mean the bank comes to an end; it just means that the creditors have to forgive some of the debt and this is quite natural.  They made the investment decision.

PK: The ECB will allow us to do this?

HWS: I don’t know what the ECB will say, but these economists whom you cite from Germany said that that should be done. And actually it was not just 270, it was a total of 480 professional economists in Germany who said it is much better to forgive the debt and ask those people who have miscalculated their chances to reduce their claims against the banks.

I mean we can’t have capitalism in the way that, if there are profits they are being distributed to someone and once there are losses that the taxpayer steps in and solves the problem.

PK: I think you would find many people here who would agree with you that the people who invested should have been burned, but they weren’t. Many of them have been paid from the very beginning and that debt is now being repaid by the Irish taxpayer.  And people are saying…

HWS: No, that was a big mistake as I said.

PK: But what do we do to rectify it? Can we rectify it?

HWS: Well there is still lots of debt in the banking sector, including the Anglo Irish Bank, the follow-up bank, the bad bank.  It has bondholders; it has creditors.

PK: So burn them?

HWS: Well, ask them to forgive some of the debt.

PK: What about the fundamental reason for our problem? Which was that we got lots of money here, very cheap money, at a time when our economy was booming.  It didn’t suit us; it suited Germany and France perhaps at that time but it didn’t suit us.  The euro was the child of France and Germany but the architecture was wrong.  So the people who got the architecture wrong, perhaps we should all share the burden.

HWS:  Yes, the architecture was wrong I fully agree.  Too much money was flowing around in Europe under the euro.  The excessive credit flows came to those countries which are now in a crisis, creating a credit bubble which meant a real estate bubble in Ireland, in Spain; meant basically a government bubble in Portugal and Greece. And that was a very artificial and unnatural development.  Everything became too expensive and these countries lost their competitiveness.  These countries are now stuck in a situation where their prices and wages are no longer competitive and they have to come down, but coming down through austerity is very difficult.  You can increase the prices but you cannot cut the prices easily and that is the sort of trap in which some euro countries have ended.

PK: In our situation…

HWS: Ireland was the only exception escaping this trap.

PK: Alright, but we still have a massive amount of debt. Some say its around 140% of the hybrid of GDP and  GNP.  We don’t need to be technical about it, but its unsustainable for Irish taxpayers to reduce that debt anytime within the next ten years or even longer.  So what to do?

HWS: Well that’s not true.  I mean Japan has 100 percentage points more.  It is difficult enough… Twenty years ago Ireland had 95% debt/GDP ratio.  You may have forgotten. In the meantime due to the growth the debt/GDP ratio declined.  It is difficult indeed, and so what has to be done? Ask those people who hold the debt forgive the debt if necessary but don’t ask the taxpayer to do that.

PK: The point is…  I think what Hans Werner is talking about is also the European taxpayer, isn’t that so.  You don’t want the German tax payer. [To audience] So if you thought you got home free here, no, no, no, no.

HWS: No taxpayer. Neither the Irish taxpayer nor the German taxpayer nor any taxpayer, because the taxpayers are not the richest people.  Those people who have invested their money, they have lots of wealth and why should they not give up some of their claims.

PK: So it’s only the private investors we can hope to get some help from in your view whereas what we are hoping for is first of all a deal on the Promissory Notes and secondly some sort of restructuring of our deal.  We’ll say “we’ll pay everything back but, like German after World War 1, a hundred years, a hundred years…”

HWS: But its the wrong… I think you have entirely the wring discussion.  You keep those people who really have the wealth out of the picture.  I tell you a number. Take the six crisis countries of which Ireland is one, including Italy.  The total debt of the banking sector…sectors is 9.4 trillion euros.  This is an astronomical sum of money.  If some of that, these claims against the banks, cannot be satisfied how can you ask the taxpayers of any country of Europe to foot the bill.  You can only ask these people who hold the claim.  I mean a claim, a debt of a bank, is also wealth of someone who holds this claim against the bank. And only this group of people has the wealth to bear the losses. No one else in Europe has it.

PK: So there is no way in which Europe, the eurozone countries, the ECB can actually dig us out of this.

HWS: Well, the ECB has helped a lot and I find this appropriate.  The ECB, don’t forget, has given Ireland an extra credit beyond the liquidity services at home of 150 billion euro.  This is one GDP and then came the rescue packages through inter-governmental rescue operations, was another 50 billion which reduced then the ECB credit to Ireland. But still we are talking about a sum of 150 billion euros public credit being provided to Ireland at low interest rates so there is some help, there is some help.  And quite so.

Friday, February 1, 2013

Deficit-, debt- and expenditure-impacting banking measures

A recent post over on Notesonthefront has attracted a lot of attention on “the cost of the banking crisis”.  The figures from Eurostat show that Ireland contributed 42% of the EU total and have been widely quoted including this prominent piece in The Irish Examiner

42% of Europe’s banking crisis paid by Ireland

Ireland has paid 42% of the total cost of the European banking crisis, at a cost of close to €9,000 per person, according to Eurostat.

This is not the correct interpretation of the Eurostat figures.  The Eurostat figures used to support the claim give one impact of the banking crisis on public finances, that is:

1. The impact on the flow of annual government deficits

It is not the case that this reflects the full cost of the banking crisis.  As will be discussed below not all of the measures introduced in response to the banking crisis are deficit impacting.  An additional impact that could be considered is:

2. The impact on the stock of the gross government debt

There is no reason to expect #1 to be the same as #2.  There may be transactions with the banking sector that are counted as deficit increasing but if they are funded from existing resources they will not add to the stock of debt. 

It will also be the case that there may be transactions which are not counted as deficit increasing but if funded with borrowed money they will add to the stock of debt.

Eurostat have produced figures on #1 as they can measure the revenue and expenditure flows on an annual basis.  However, they will not produce statistics on #2 for the simple reason that money is fungible.  Governments borrow money because their overall expenditure exceeds their revenue.  It is difficult to attribute changes in debt to a single expenditure item because reductions in any expenditure would reduce the need to borrow.  That doesn’t mean it isn’t attempted though!

The Eurostat figures show that between 2008 and 2011, measures related to the banking crisis contributed €41 billion to Ireland’s general government deficits.  By the end of 2011, the government had contributed around €63 billion to the banking sector and, of this we can guess that around €47 billion was with “borrowed” money (essentially it is non-NPRF money, but the assumption is that this expenditure increased borrowings).

The above paragraph shows a third, a more complete, measure of the impact of the banking crisis on the public finances:

3. Total expenditure incurred by general government as a result of the banking crisis.

Again Eurostat are not going to produce statistics on this as much of the expenditure will be by public investment funds (such as the NPRF) or by special purpose vehicles (such as NAMA).  A lot of these are “off-balance sheet” transactions.

So for Ireland, at the end of 2011, the figures were:

  1. €41 billion
  2. c. €47 billion
  3. €63 billion

The first figure has received lots of attention but it is actually the smallest.  The second figure is a bit of a guess and although the largest the final figure could yet be under-stated. 

Number 3 will be clouded by the use of special purpose vehicles which initially keep the expenditure outside the government sector.  NAMA has spent €32 billion acquiring loans with a nominal value of €74 billion from our delinquent banks.  NAMA is not going to lose €32 billion but a shortfall of, say, €5 billion is possible on its operations which will have to be made good with expenditure by the government.

In Ireland in 2011 #1 makes up about two-thirds of #3.  In other countries the gap between #1 and #3 is likely to be even greater.  In part, this is down to the type of bailout adopted in Ireland, rather than the total cost.

For example, we know that the UK has contributed £66 billion to just two banks: Lloyds and RBS.  That is around €80 billion which would count in #3 (full expenditure) but the figure for the UK in the Eurostat deficit data is just €11 billion.  Where did the other €69 billion go?

To answer this question we must explore what Eurostat measured when they provided figures for the deficit-impacting measures introduced in response to the banking crisis.  This all comes back to a Eurostat decision published in July 2009.

The key is whether a measures is considered as a “financial transaction” or a “capital transfer”.  Financial transactions are not deficit impacting; capital transfers are deficit impacting.  The impact of both in the debt is not objective, while their impact on expenditure is unambiguous.  So what is a “financial transaction”?  Per the Eurostat decision:

The valuation of financial transactions: In principle the ESA 95 provides for financial transactions (which do not impact on the government deficit) to be recorded "at the transaction values, that is, the values in national currency at which the financial assets and/or liabilities involved are created, liquidated, exchanged or assumed between institutional units, or between them and the rest of the world, on the basis of commercial considerations only" (paragraph 5.134).

However it is acknowledged in paragraph 5.136 that "in cases where the counterpart transaction of a financial transaction is, for example, a transfer and therefore the financial transaction is undertaken other than for purely commercial considerations, the transaction value is identified with the current market value of the financial assets and/or liabilities involved".

It does, of course, leave something of a grey area but we can see that if a financial transaction is done at the “current market value” it does not impact on the government deficit, whereas if it happens above the “current market value” the transaction value is identified and the amount above that is considered a capital “transfer”. 

The Eurostat decision goes through different forms of banking support and shows whether they impact on the deficit or not.

  1. Recapitalisation operations
  2. Lending
  3. Guarantees
  4. Purchase of assets and defeasance
  5. Exchange of assets
  6. Classification of certain new bodies
  7. Recording of certain transactions carried out by public corporations

Eurostat did not need to provide a separate decision for the general government gross debt measure it produces.  The debt is just the sum of all of the liabilities of the general government sector.  It does not matter what the money is used for.  All that matters is whether a liability exists or not.

For example, when the Promissory Notes were created in 2010 they were classed as a “loan to government” from Anglo/INBS and would immediately be added to the general government gross debt.  There was some issue of whether they would count in the 2010 deficit but the counter transaction to the loan was recorded as a “notional capital transfer” as the government promised to repay a €31 billion loan without first receiving the money from the bank as is the case with a typical loan.

Here is the full set of recapitalisation payments made to the banks since 2009, classified as “financial transactions” or “capital transfers”.

Bank Recapitalisation Payments

The payments under financial transactions were not deficit-increasing, whereas those recorded as capital transfers were deficit increasing.  It remains to be seen what value can be realised through the sale of the assets acquired through the financial transactions. 

There have been some sales already.  In 2011, €1.1 billion was realised from the sale of a 35% ordinary shareholding in BOI, while in January 2012 the €1 billion contingent capital note in BOI was sold at close to par.  There was also a transaction in 2010 that saw €1.7 billion of the preference shares in BOI converted into ordinary shares.

It can be seen that 75% of the capital transfers total arises from the Promissory Notes issued in 2010.  No other country has used such a scheme to prop up a bust bank and the loan loss figures mean that any mechanism devised would have been recorded as a capital transfer.

The transactions are split between those undertaken by the NPRF (directed by the Minister for Finance) and those undertaken by the Exchequer (directly by the Minister for Finance).

All of the financial transactions involving preference and ordinary shares in AIB and BOI were done through the NPRF.  It should be noted that the €3.5 billion of preference shares in both AIB and BOI bought in 2009 by NPRF was funded with €4 billion from the NPRF and a “front-contribution” of €3 billion from the Exchequer to the NPRF.  All the contingent capital notes transactions as well as the ordinary shares in PTSB and Irish Life were funded, and now held, by the Exchequer.

Most of the capital transfers were provided by the Exchequer but the €6 billion capital transfer provided to AIB in July 2011 was split with €2.3 billion coming from the Exchequer and €3.7 billion coming from the NPRF.  This €3.7 billion from the NPRF was a deficit-increasing expenditure (though didn’t impact on the debt as it came from pre-existing funds).

So has Ireland carried 42% of the total EU cost of the banking crisis?  Impossible to say.  We do know that Ireland has incurred 42% of the deficit-impacting measures introduced in response to the crisis.  But that is not the same thing as the total cost. 

In Ireland’s case, the Promissory Notes have pushed up the capital transfers to an extraordinarily high figure relative to other EU countries.  In fact the explanatory notes to the data say (on page 12) that:

The only case where government liabilities increased much more than government assets is Ireland. This can be explained by the fact that most interventions have been immediately recorded as deficit-increasing government expenditure and not as financial transactions.

Most EU countries have generally recapitalised their banks using financial transactions (purchase of shares and other instruments).   Ireland didn’t have any money to buy anything in Anglo and, as stated above, Anglo was nursing such loan losses that all efforts to keep it solvent were going to be recorded as capital transfers anyway.

Throughout the EU it remains to be seen what the assets acquired through these the financial transaction approach to recapitalising their banks will actually be worth.  If losses relative to the purchase price are crystallised on the sale of these assets then the difference will be recorded as a capital transfer and Ireland may not be such an outlier.

How much of the £66 billion pounds provided to Lloyds and RBS will be returned to the UK Exchequer? Will they get back much of the £14 billion (€17 billion) capital contributions that Lloyds through Bank of Scotland(Ireland) and RBS through Ulster Bank have made to their loss-making Irish subsidiaries?  In total, the UK has made a cash outlay of around €145 billion to rescue its banks.  See question on “current level of support” in this set of FAQs.

For the moment though, Ireland is extreme when it comes to the deficit-increasing impact of the banking crisis.  It makes a good headline and the extent and cost of the disaster in Ireland will always be high relative to other EU countries.  But it should not be thought that other countries have escaped lightly from the banking crisis.  They have simply gone about it in a different manner and haven’t used Promissory Notes.  The true cost of this period will only emerge over the next decade or longer when their investments and special purpose vehicles are unwound.

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