Monday, September 23, 2013

The Promissory Note “savings” revisited

As outlined in the previous post it was projected in the Budget last December that the 2014 deficit would be €8.9 billion.  Just four months later the forecast of the 2014 deficit in April’s Stability Programme Update was €7.7 billion, a decrease of €1.2 billion.

The improvement was due to two things.  The first was around €200 million of revenue buoyancy from taxes that performed better than expected in the final 2012 outturn with carryover effects into 2013. 

The other €1 billion of deficit reduction in the projections was due to the “saving” from the Promissory Note restructuring. This arrangement did have the effect of improving the general government deficit for 2014 by around €1 billion (and subsequent years by declining amounts of around €100 million lower) but the change would not necessarily satisfy the dictionary definition of a saving.

The Anglo/INBS disaster resulted in a capital shortfall of around €35 billion in order to cover their massive loan losses and satisfy their depositor/bondholder liabilities that were repaid. A €4 billion cash injection was given to Anglo in 2009 with the other €31 billion being provided through Promissory Notes (a promise to pay in the future) in 2010. Two payments of €3 billion were made on the notes, one in 2011 and 2012, though the 2012 payment was made with a 2025 government bond rather than cash, meaning that there was around €25 billion of the Notes remaining when the restructure was put in place back in February.

Under the old arrangement, the Exchequer paid interest to the IBRC (the merged entity of Anglo/INBS) as the holder of the Promissory Notes. The IBRC was able to use this money, and the capital repayment portion of the €3 billion payment, to reduce its Exceptional Liquidity Assistance (ELA) liabilities with the Central Bank.  The IBRC used the ELA money from the Central Bank to repay its depositors/bondholders and as the loans it held were not going to be repaid sufficiently to, in turn, repay the Central Bank the money from the Promissory Notes was set to make up the shortfall.

Although the IBRC was outside the general government sector for Eurostat deficit measurement purposes, it was a 100% state-owned entity so the interest payment on the Promissory Notes was not going to an external third party.

The IBRC was itself paying interest to the Central Bank of Ireland for access to the ELA and some of that interest was returned to the Exchequer via the Central Bank surplus on its operations. The net external cost of the arrangement was the interest the Central Bank had to pay into the ECB for the facility to create money under the ELA scheme. The cost of this was the ECB’s Main Refinancing Operations (MRO) rate. This is currently 0.5%.

The interest on the Promissory Notes was high (around 8% from 2013) and fixed but was paid to the IBRC which in turn used it to pay down its liabilities with the Central Bank who then used it to reduce the amount of ELA it had forwarded. The interest rate on the Notes was largely meaningless and as Prof Karl Whelan usefully explained the €3 billion repayment would have resulted in the ELA liabilities to the Central Bank being fully repaid by 2022 even though the Promissory Note repayment schedule extended to 2030.

The IBRC was making a massive interest profit on the Promissory Notes and could use this to repay its only remaining liabilities – to the Central Bank of Ireland. As the IBRC was 100% state-owned the extra interest because of the high rate on the Promissory Notes was merely allowing the repayment of the money used to bailout Anglo/INBS depositors to be repaid quicker. 

The high interest rate on the Promissory Notes did not result in any additional direct costs, so a lower interest rate could not result in any direct savings.

Upon the liquidation of the IBRC, the Promissory Notes were cancelled, and the €25 billion owing to the Central Bank under the old arrangement was replaced with €25 billion of long-term bonds. As with the Promissory Notes the Exchequer is liable for the interest due on these.

Under the Promissory Notes the high interest rate on the €25 billion meant around €1.8 billion was due to be charged to the general government sector in 2014. Under the new arrangement the Central Bank holds €25 billion of long-term government bonds and the floating interest rate on these (currently around 3%) means that an interest bill of around €0.8 billion will be due to the Central Bank next year.

The difference between the figures is the €1 billion “saving” from the Promissory Notes restructuring.

However, just like the ELA arrangement the Central Bank will return any profit it makes from holding the bonds to the Exchequer through the Central Bank surplus. The Central Bank is a state-institution but as the monetary authority it is outside the definition of the general government sector used by Eurostat.

The net external cost to the broader or overall government sector is the cost to the Central Bank of creating the €25 billion to ‘buy’ these bonds from the government. The net external cost is just as it was under the old Promissory Notes/ELA arrangement; it is the ECB’s MRO. There is no actual interest rate saving from the restructuring, so the €1 billion “saving” is illusory though it does appear in the general government accounts. The  cost of the debt to the State disaster remains the same.

There is, though, a saving because the repayment schedule of the €25 billion has changed. Under Promissory Note arrangement the relatively cheap Central Bank funding (at the ECB’s MRO) would have been repaid by 2022. Under the new schedule which gives the minimum rate at which the Central Bank must sell the new bonds access to the funding at the MRO will be extended to 2032. See this earlier post.

There are benefits from the restructuring but they come about because of the slower rate at which the Central Bank sells the new bonds (meaning the interest is paid to a third-party and not recycled back to the Exchequer) compared to the repayment schedule on the former Promissory Notes (requiring borrowing to fund the €3 billion annual payments and thus interest to be paid to a third-party).

The new arrangement delays the rate at which a low-cost Central Bank liability (ELA/money to hold bonds in trading portfolio) is transformed into ‘normal’ government debt with the associated interest costs. The actual savings will be at their greatest roughly between 2016 and 2023 (assuming the minimum resale schedule is adhered to).

Of course, for the Excessive Deficit Procedure it is the general government deficit as defined by Eurostat that matters when it comes to the budget. But some consideration can easily show that the government moving from paying €1.8 billion of interest to the former IBRC to €0.8 billion of interest to the Central Bank doesn’t matter in the broader scheme of things as both have the government as their sole shareholder.

There is no “extra” €1 billion because of the Promissory Note arrangement.  The capital hole in Anglo/INBS was not reduced because of the change.  Nobody said we had to pay €1 billion a year less to pick up the bill.  The interest on the Promissory Notes was not a cost so a reduction in that interest is irrelevant.  It is the ECB’s MRO and how long funding at that rate can be accessed that matters.  There will be a small saving in 2014 on that front because of the Promissory Note restructuring but it will probably be around €100 million.

If there is to be a reduction in the fiscal consolidation in next month’s budget the argument has to be framed about why we should run a larger primary deficit now so that future generations can carry our “legacy of debt”.  And it is to primary balances that we turn next.

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