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 TheStory.ie.  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.

3.55% Interest on the EU/IMF loans

Here is an update of a table showing the interest rates on the loans we are getting as part of the EU/IMF programme (HT: Kevin).  The data is for loans drawn down as of the 14th of November 2011.  Click image to enlarge.

When we last looked at this back in August for loans drawn down by June the average interest rate was 5.58%.  We can now see that this has been reduced to 3.55%.  This is because of the reduction in the EU loans agreed at the EU summit on July 21st last.

The interest rate on loans from the European Financial Stability Mechanism (EFSM) has fallen from 6.99% to 2.97%, while the interest rate on loans from the European Financial Stability Fund (EFSF) has fallen from 5.90% to 3.06%.

The highest rate is the 4.83% that applied to the UK bilateral loan but that is due to be reduced.  As a result of this the IMF loans will have the highest rates but they could also be reduced as there are some suggested changes to Ireland’s quota with the IMF.

A previous post suggested we need to source around €25 billion of funding to get through 2014, as the €67.5 billion of funds under the current EU/IMF programme will be exhausted by the end of 2013.  From the above we can see that we need to be in a position to begin repaying the EU/IMF loans (by borrowing from someone else) from July 2015. 

Replacing funding that comes at a cost of 3.55% will not be easy but for the moment it does keep a cap on our interest payments.

State Funding through 2013

Over the next two years the Irish government needs about €46 billion of funding.

We still have to draw down around €33.5 billion of the loans agreed as part of the EU/IMF programme.    The remaining €12.5 billion can come from a combination of our existing resources, State Savings Schemes and some market funds. 

There was €13 billion in the Exchequer Account at the end of 2011.  The NTMA have suggested that this could be reduced to around €5 billion over the next two years although the European Commission have indicated that they would prefer to see the cash buffer maintained at its current level.

It is forecast that €1.5 billion a year will be raised from the State Savings Schemes over the next two years.  This is well above the 2000-2007 average but in line with performance over the last few years.  At €1.36 billion the amount raised in 2011 was just below this. 

If the €1.5 billion a year is achieved then the State needs around €10 billion to see it through to the end of 2013.  We have €13 billion of cash on deposit (and there is also around €5 billion remaining in the National Pension Reserve Fund (NPRF)). 

How much of this cash is used will depend on how much market funding can be raised.  The plan for the NTMA to “dip its toe” back in the markets before the end of this year, but given the amount of cash on reserve this can be delayed until 2013.

All told the State is in a reasonably secure position for the next 24 months (where ‘reasonably secure’ simply means we won’t run out of money).  After that there is the small matter of a €12 billion bond maturing in on the 15th January 2014.

We are due to begin repaying some of the EU and IMF loans in 2015 and there is also the need t0 find funding for the €10 billion Exchequer deficit due to arise in 2014 and the €7 billion deficit in 2015.

While the plan is to “dip” back into bond markets before the end of 2012 we have to ensure that we have the capacity to meet the €12 billion debt rollover in January 2014 and that year’s €10 billion Exchequer deficit.  Even if the balance on the Exchequer Account is allowed to fall from €13 billion to €5 billion we will still need to raise around €25 billion of market funding by the end of 2014.

This will be a challenge but we will not face a crunch until the start of 2014 and there is a lot that can happen over the next two years.

National Savings Schemes

Although have we been “shut out” of bond markets, the EU/IMF is not the only remaining source of funding for the State.  The National Treasury Management Agency (NTMA) run a series of State Savings Schemes and they have seen a substantial inflow of funds in the last few years.

After seeing annual increases of no more than a couple of hundred million between 2001 and 2006 and even a reduction in 2007 the annual change in the amount held in various State Savings Schemes soared from 2008 on.  In 2010 almost €3 billion was put into this schemes and this dropped to under €1.5 billion in 2011.

The total amount in the schemes is almost €12 billion.

We don’t have details for 2011 yet, but the NTMA’s 2010 Annual Report gives some insight into the breakdown of the total amounts and annual changes for the different schemes in 2010 when inflows peaked at about €3 billion.

There was also close to €2.5 billion is various Post Office Savings Bank Deposit Accounts (including savings stamps) which took in almost €500 million in 2010. 

Although small in the greater scheme of things this source of funding makes a useful contribution.  An added advantage is that is cheap, the average interest rate is likely to be less than 3%.  The average rate of the EU/IMF funds we had drawn down by the middle of November 2011 was 3.55%.  At the end of 2011 the €12 billion in the State Savings Schemes will make up around 7.5% of Ireland’s General Government Debt. 

Back to eight percent

The last time we looked at Irish government bond yields we wondered whether they were heading back to ten percent.  In the space of just two days the the yield on the nine-year Irish government bond as calculated by Bloomberg surged from 8.2% to 9.6%.  Since then the yields have shown a gradual decline back to 8.2%.

On the 6th of January 2011 the yield as given by Bloomberg closed at 8.80%.  Today it finished at 8.13%.  In relative terms these bonds are viewed as a lower risk now then they were 12 months ago.

We can’t infer a huge amount from these changes.  The volume may not be very high and we cannot be sure who is doing the buying, if any.  Also we will not be borrowing from these markets any time soon so there is no direct impact from these changes.

The relative performance of 9-year Irish (green) and 10-year Italian (orange) bond yields for the past month has been markedly different.

Expenditure in the Exchequer Statements

We seem to spend an inordinate amount of time going through every possible representation of the tax revenue figures in the Exchequer Statements.  The latest post is a good example of this.   Why not devote even a fraction of this attention to the expenditure figures in the Exchequer Statements?

The answer of course is that the Exchequer Statements do not contain expenditure data that can be analysed in any meaningful fashion.  The appendix with the Analysis of Net Voted Expenditures shows that net voted expenditure was €45,711 million in 2011; in 2010 it was €721 million higher at €46,432 million.  What does this mean?

It is very hard to say.  Net voted expenditure is gross expenditure adjusted for departmental receipts (known as appropriations-in-aid).  If net expenditure changes it can be difficult to determine if this is as a result of expenditure changes or changes in departmental receipts.

This leads to statements like the following in the Information Note to this month’s Exchequer Statement:

The underspend on the Social Protection Vote was due to higher than expected PRSI receipts, which more than offset overspends on a number of schemes, including Jobseekers Allowance. 

Huh.  Spending is down because receipts are up.  Underspending and overspending in the same sentence.  All in all it is almost impossible to tell if spending is up or down.  There are changes and adjustments in the tax revenue figures but in general they are easier to track, and more information is presented, than those in the expenditure figures.

Note 4 in the Exchequer Statement indicates that expenditure in health has increased to €12,897 million from €11,578 million in 2010.  In the current era of austerity and expenditure cuts it seems unusual to suggest that expenditure in health increased by 11.4% in the last year.  Of course, this is nonsense but that is what the Exchequer Statement shows.

The reason for the change is the abolition of the Health Levy.  In 2010, the Health Levy was a departmental receipt for the Department of Health.  The receipts of €2,018 million were subtracted from gross expenditure to get the net expenditure figure for health reported in the Exchequer Statements.

Although net voted expenditure for health has risen we cannot use this to say that we are spending more money on health.  We don’t get monthly updates of actual (i.e. gross) expenditure in the Exchequer Statements but we can get the annual figures from the Databank provided by the Department of Public Expenditure and Reform. 

Gross expenditure in health fell from €15,169 million in 2010 to €14,316 million in 2011.  There was a 5.6% reduction in expenditure in health in 2011 but it is impossible to determine this from the monthly Exchequer Statements.  It would be extremely useful if the gross expenditure figures were also provided in the monthly Exchequer Returns. 

As it is the best we can do are annual tables like the following for the Health Group.

Reporting net expenditure figures as is done in the Exchequer Statement has no impact on the reported Exchequer balance but we do not see how the figure is reached.  Even if monthly gross expenditure figures were provided for every department there would still be difficulties due to the abolition and creation of some departments and changes in the functions and responsibilities of others.

Anyway, the conclusion is that expenditure in health fell in 2011, particularly non-pay expenditure of the HSE (-8.5%) and the Office of the Minister for Children (-45.3%) even if the Exchequer Statement is reporting an increase in “net” expenditure.  As a result of issues like this there is little value in spending much time exploring the expenditure figures in the Exchequer Statements.

End of Year Tax Receipts

The Department of Finance have released the end of year Exchequer Statement for 2011.  The relevant documents are:

• Exchequer Statement
• Analysis of Tax Receipts
• Analysis of Net Voted Expenditure
• Information Note from the Department

Here we will have a look at the figures in the usual detail.  First up cumulative tax revenue by month.

Cumulative tax revenue has been ahead of the 2010 outturn for every month of the year.  The increase peaked in September at 8.7% (when the new pension levy was collected) and has eased since then to finish the year up €2.3 billion or 7.2%.  This has been hailed as the first rise in tax revenue in three years.

By looking at the individual tax heads we can see that virtually all of this increase is due to Income Tax.

The CSO reports that employment fell 46,000 in the year to September and that average weekly earnings rose 1.4% over the same period.  These do not seem like labour market indicators that support a 22.4% rise in Income Tax.  Budget 2011 contained a series of measures that were forecast to bring in about an extra €1 billion of Income Tax in 2011.  So where did the other €1.5 billion come from?

It came about as a result of the reclassification of the old Health Levy into the new Universal Social Charge.  The Health Levy was a departmental receipt collected by the Department of Health and did not appear in the Exchequer Account.  All money collected under the Universal Social Charge enters the Exchequer Account and is included under the Income Tax heading.

In 2010 the Health Levy raised €2,018 million.  This money was collected again in 2011 but under the guise of the Universal Social Charge in Income Tax receipts rather than as a receipt for the Department of Health.  There might have been an increase in tax revenue in the Exchequer Account but there was little or no increase in government revenue.

The other tax showing a strong increase on 2010 is Stamp Duty.  As we said when the September Exchequer Statement was released:

This again is not the positive sign the bare numbers would suggest.  Stamp Duty is only up because the €457 million collected as a result of the Pension Levy introduced in May’s “Jobs Initiative” is included here.  If we compare like-for-like Stamp Duty revenue is performing just like every other tax – i.e. worse than last year.

VAT is down €360 million but about one-third of that is due to the reduction in the 13.5% to 9% for certain goods and services in the same Jobs Initiative.

On a monthly comparison every month was ahead of the 2010 equivalent bar one: the last one.  Tax revenue for December 2011 was €51 million lower than in December 2010.

If we look at the individual tax heads we can see the causes of this.

The standout figure is obviously the 96% drop in Corporation Tax receipts.  The Information Note offers an explanation for this:

[…] some €261 million in corporation tax receipts due for receipt in December were not received into the Exchequer account in time to be accounted for in 2011. The bulk of these receipts have since been received and will form part of the January 2012 tax revenue outturn.

It is not really clear what has happened but this will add a bit of new year ‘pep’ to the Exchequer Returns in 2012.

If we just look at the last quarter of 2011 the picture is a little more benign.

Apart from the continued weakness in VAT receipts and the glitch in Corporation Tax all tax heads in the final quarter of 2011 are ahead of their performance from 2010.  The 40% rises in Capital Gains and Capital Acquisitions Taxes are noteworthy, but the contribution of these taxes to total tax revenue remains small (just 5.8%).

No analysis of Tax Revenue is complete without investigating whether receipts are “on target” which were published last February.  They’re not.

Tax revenue in the final quarter of the year might be up on its 2010 performance but it is clear that the Department of Finance was expecting a much greater bounce.  Over the last three months of the year tax revenue went from being €160 million ahead of target to €873 million behind target.  If we omit the measures introduced in the Jobs Initiative that did not exist when these targets were set it is likely that tax revenue is around €1,200 million or 3.5% below target.

In each the last three months of the year tax revenue was more than €330 million behind the DoF forecast.  It was hoped that there would be a rise of €1,383 million to €10,962 million of tax receipts in the final quarter.  It is not clear why the DoF expected a 15% rise in tax revenue in the final quarter of the year but receipts were actually €9,929 million, almost 10% below target.

For the year as a whole three of the four main tax heads are significantly below their target and the overshoot in Excise Duty is a relatively inconsequential €3 million.

The tax to strongly outperform the target for it set last January is Stamp Duty and this is only because €457 million was collected from a 0.6% private sector pension levy that was only introduced in May.  On that basis of what was to be collected at the time the forecast was made Stamp Duty is also below target.

If we look at the last quarter of the year when it all went wrong.

There is some cover for the almost 25% underperformance of Corporation Tax, but even if the €261 million of delayed receipts are added in Corporation Tax receipts would still be 10.8% behind the target for the quarter.  The largest taxes for the quarter were forecast to be Income Tax and VAT and these were both almost 10% below target.

To be fair the performance in December was slightly better. 

Although there is plenty of red in the table most of the shortfall is due to the Corporation Tax issue.  There is no such explanation for the large undershooting of tax receipts in October and November that is reflected in the quarterly table above.

For 2012 the Department are forecasting a 5.3% increase in tax revenue.

This is largely based on a €1.2 billion increase in Income Tax receipts during the year.  Budget 2012 contained no Income Tax measures so this €1.2 billion increase will have to be the result of the carryover from the measures introduced in the 2011 Budget (estimated at €600 million) and a general upturn in Income Tax receipts (accounting for the remaining €600 million).  I can’t say that I can see that coming down the track.