Bond yield tranquillity

There has hardly been a day in the past fortnight when bond yields have been outside the top three stories in the news.  However, it is been Greece, Italy and Spain and latterly Belgium and France that has been attracting the attention.  Our bond yields have already caused a peep.  Here is the nine-year Irish government bond yield as calculated by Bloomberg for the past month.

For the past month yields have been in a range between 8.1% and 8.6% and are at the lower end of that range now.  It could be that attention is directed elsewhere but it is noteworthy nonetheless.

Also interesting is following graph which gives the relative performance of Irish nine-year yields and German ten-year yields for the past year.  A reading of 0 means the yield is unchanged relative to the yield on the starting day of the graph.  A reading of 100 means the yield is twice as high.

Irish bond yields are at almost the exact level they were at 12 months ago (8.1%).  The surge in the summer ahead of the July 21 summit is clearly visible and that quickly dissipated which these gains largely maintained.  German yields are about 33% lower than they were this time last year (2.6% down to 1.8%).

How are Irish yields relative to those of France?

French yields took the same downward pattern as those of Germany during August and September but have been rising since the start of October and are now about 20% higher than they were this time last year.

On a pure price basis compared to this time last year:

• a German bond is worth more
• an Irish bond is worth about the same, and
• a French bond is worth a bit less

What does this mean? Not a whole lot.  It does suggest that we have gotten most the uncertainty surrounding the solvency of the State into the open, in particular in relation to the banks.  Clearly there are doubts that remain (reflected in the yield above 8%) but in a period of European volatility the relative tranquillity in the Irish setting is interesting.

Core inflation stays low

The headline rate of inflation from today’s Consumer Price Index release is 2.8%.  However 2.33 percentage points of that are accounted for by just two categories: energy products and mortgage interest.  These make up about 15% of the index.   Mortgage interest is up 18.1% on the year and energy products are up 13.4% on the year.

The remaining 85% of the index, which we are using as a measure of ‘core’ inflation, contributes just 0.47 percentage points to the overall inflation rate and is showing annual inflation of 0.55%.

The headline rate is inflation is nearly 3% but outside of mortgage interest (and it is only standard variable rates that are picked up in the index) and energy products inflation remains low.

The deficit and “the banks”

The Medium Term Fiscal Statement released last Friday projects that the general government deficit in 2012 will be €13.6 billion or 8.6% of GDP.  This is the number we have to reduce to less than 3% of GDP by 2015, which is what measures to be introduced over the next few Budgets will be targeting.

The simple question here is: how much of the €13.6 billion deficit is due to the banks?

So far we have poured about €62.5 billion into AIB, BOI, EBS, PTSB, Anglo and INBS and all of this has been accounted for in the general government deficits of the last three years.  No further payments are planned so there are no direct payments to the banks in the €13.6 billion deficit for 2012.

What about providing this €62.5 billion?  Surely there are huge interest costs associated with providing this money to the banks.

Of this money €17 billion came from the destruction of the savings we had built up in the National Pension Reserve Fund.  This money was not borrowed so there are no interest costs.  There is the loss of income that this money could have earned but this loss has no bearing on the general government balance.

Of the remaining €45.5 billion almost two-thirds is accounted for by the Promissory Notes given to Anglo and INBS in 2010.  This €30.6 billion was included in full in the €49 billion general government deficit in 2010 and due to some complications in their construction there will be no interest paid on these notes in 2012. 

In 2011, a cash payment of €3.1 billion was made on the Promissory Notes.  This will not affect the debt as the €3.1 billion simply changes from being a Promissory Note debt to a cash debt.  There is now around €28 billion of Promissory Notes outstanding but this will have no impact on the €13.6 billion general government deficit for 2012.

That means we are down to the final €18 billion.  This is split between €11 billion paid from the Exchequer and €7 billion taken as part of the EU/IMF programme.  The money from the Exchequer includes €4 billion given to Anglo in 2009 and €3 billion paid into the NPRF in the same year to help fund the initial recapitalisation of AIB and BOI.  It also includes the €3 billion payment made on the Promissory Notes this year.  It is safe to assume that all of this money was borrowed (or at least increased our borrowing by the same total which amounts to the same thing).

The €7 billion from the EU/IMF was used to fund the State’s  €17 billion contribution to the  €24 billion recapitalisation of the banks this year.  The other €7 billion came from haircuts to subordinated bondholders, some minor asset disposals and some private sector investment in BOI.

We will assume that the average interest rate on this €18 billion is around 4.5%.  At this interest rate, borrowings of €18 billion would require an annual interest payment of around €800 million.  This interest cost does form part of the general government balance for 2012.

If we do a simple counterfactual and magic away the €62.5 billion we have pumped into the banks, the projected deficit for 2012 would fall from €13.6 billion to €12.8 billion or 8.0% of GDP.  Eliminating the effect of the bank payments would knock 5% off the deficit; 95% of next year’s deficit is not related to the bank payments.

There are many claims that the expenditure cuts and tax increases are being introduced to “bail out the banks”, “repay bondholders” and the like.  The changes are being introduced to bring about the necessary reduction in the budget deficit.  There may be disagreements about the make-up of the changes but 95% of the problem there are trying to address is not as a result of the money we have handed over to the banks.

Ireland and Iceland

As Greek fatigue threatens to overcome us all, it may be useful to draw comparisons between Ireland and a country other than Greece.  There have many occasions when comparisons have been made between the differing approaches of Ireland and Iceland to their respective banking crises.  One indicator that is frequently used to aid the comparison is the unemployment rate in both countries. 

The IMF put unemployment in Iceland at 7.5% in contrast to 14.5% in Ireland – a rate that is almost twice as large.  This formed part of a recent presentation from Paul Krugman.  You can watch a 15-minute video of Krugman deliver the presentation here (go to 52:00 of the Session II: Road to Recovery video).

However, this unemployment snapshot only paints a partial picture.

Icelandic unemployment is significantly lower, but it also started from a much lower level.  The unemployment rate in Iceland was 7.5 times larger in 2010 than it was in 2007 (1.0% to 7.5%).  In Ireland the increase was 3.1 times (4.6% to 14.5%).  In Iceland, the unemployment rate increased by 6.5 percentage points, here it rose by 9.9 percentage points.  There is no doubt that unemployment in Ireland is higher and has risen by more than unemployment in Iceland.

As Krugman does, we can account for migration by looking at changes in employment.  Since 2007, the number of people employed in Ireland has fallen further, but the Icelandic figures is somewhat invariant because of the units used by the IMF (tens of thousands with Icelandic employment forecast to be completely unchanged at 150,000 over the four years from 2009 to 2010).

Since 2007, employment in Iceland has fallen 6% while in Ireland the fall has been over 14%.  However, it is hard to argue that this is as a result of the response to the crisis given the huge collapse that has occurred in construction employment in Ireland.  Since 2007, there have been more job losses in the construction sector in Ireland than there are people working in Iceland.

What happens if we move on from unemployment and employment and look at other macroeconomic indicators.  Krugman doesn’t seem to be a fan of using GDP for small open economies but it seems a reasonable place to start.

Judging by the IMF forecasts the “roads to recovery” of Ireland and Iceland are almost side-by-side.  There are also graphs of an index of real GDP per capita and GDP per capita at PPP by clicking the links.

An interesting picture begins to emerge if we look at the relative performances of nominal GDP.

There is a huge break from the onset of the crises in both countries in 2007/08.  Clearly, with the real GDP indices of both countries tracking each other over the same period there must be some significant price effects.  This can be seen if we look at an index of consumer prices.

Annual inflation in Iceland has been higher than in Ireland since 2004 but this gap ballooned in 2008 when Icelandic inflation was 18% compared to just over 1% in Ireland.  The annual inflation rates can be seen here.

Next is the gross government debt to GDP ratios for both countries.

Spot the difference!  In 2007, both countries had a gross debt to GDP ratio of just under 30%.  By 2010 both had ballooned to around 95%.  And note that the Ireland ratio was pulled up with the price deflation in the denominator, while Iceland was experiencing inflation of almost 20% in its denominator.  The Icelandic debt level rose faster and is forecast to moderate at a lower level.  The same can be seen for government net debt.

Iceland does better when the comparison is based on unemployment.  The comparison is not so positive if GDP, inflation and government debt are included.  The same is true if we look at the current account of the Balance of Payments.

The Icelandic current account has been improving but this is more to do with a collapse in imports rather than a rise in exports.  Finally here is the investment share of GDP in both countries.

All in all, there does not seem to be a lot to separate the two countries.  Both have had banking collapses.  Both have struggled to deal with them.  Iceland is perceived as being in a better position but that is not really borne out in the IMF data.

Some general government debt developments

Back in May, Morgan Kelly snapped us out of a Saturday morning stupor with another thought-provoking article in The Irish Times.  Among many topics the issue of Ireland’s public got an airing.

Irish insolvency is now less a matter of economics than of arithmetic. If everything goes according to plan, as it always does, Ireland’s government debt will top €190 billion by 2014, with another €45 billion in Nama and €35 billion in bank recapitalisation, for a total of €270 billion, plus whatever losses the Irish Central Bank has made on its emergency lending. Subtracting off the likely value of the banks and Nama assets, Namawinelake (by far the best source on the Irish economy) reckons our final debt will be about €220 billion, and I think it will be closer to €250 billion, but these differences are immaterial: either way we are talking of a Government debt that is more than €120,000 per worker, or 60 per cent larger than GNP.

This €250 billion projection was immediately latched onto and generated some articles in response from Murphy and Leddin & Walsh.  In both cases the €250 billion estimate was said to be the result of “double-counting” and other errors.

However, I think the Kelly analysis is technically correct but is inflated by some overly pessimistic assumptions.   It may seem like this is going over old ground but it does give a starting point to summarise the debt developments that have occurred since May.

Up to today it was believed that the general government debt at the end of 2010 was €148 billion.  From the four-year National Recovery Plan (page 110) the planned general government deficits for the years 2011 to 2014 were forecast to be €15 billion, €12 billion, €10 billion and €5 billion.  These are exclusive of any banking costs.  Adding these deficits for 2011-2014 to the 2010 debt of €148 billion brings us to the €190 billion starting point of Morgan Kelly.  There is no double counting of bank-related sovereign debt.

These deficits were revised up in April’s Stability Programme Update (page 50) by a cumulative €8 billion to a total of €50 billion.  The reduction in the interest rates on our EU loans will have brought this down again and this is likely to be reflected in the revised macroeconomic projections to be released by the Department of Finance on Friday.  Of course the starting point in 2010 was reduced by just under €4 billion as a result of a real double counting error in the Department of Finance.  Between the ups and downs it looks we are looking at a 2014 debt of around €190 billion before we start adding bank-related debt.

Thus far, this is equally as  pessimistic as Morgan Kelly so we better inject some optimism into proceedings.  From €190 billion he adds €35 billion for bank recapitalisation and €45 billion for NAMA.  While these figures have an actual basis (and were used in the original Namawinelake estimate) it is now commonly accepted that they will not be simple additions to our government debt.

The €35 billion figure was the “worst-case” contingency amount set aside to recapitalise the banks as part of the EU/IMF programme.  As we know the actual recapitalisation amount was €24 billion as revealed in the March PCAR announcement.  As a result of haircuts to junior bondholders in the banks and some private sector involvement the portion to be covered by the State was around €17 billion.

Of this, €10 billion came from the further destruction of the savings built up in the National Pension Reserve Fund so will not add to our debt.  Although we poured €17 billion into the banks this year, only €7 billion of this is to be added to our debt as €10 billion came from our existing resources.

Some of the money not used will be diverted to the credit union sector where it is anticipated that up to €1 billion could be used to prop up ailing credit unions.  This will add to the general government debt.

The official general government debt (GGD) measure excludes NAMA so we are now looking at a 2014 GGD of around €198 billion.  Using the IMF’s nominal GDP forecast for 2014 of €174 billion this would put the debt-to-GDP ratio at 114%, and it is projected to fall from that point on.  This does not account for three assets that will also be on the balance sheet:

1. €15 billion of cash we had on deposit at the end of September
2. €5 billion in the remaining portion of the NPRF
3. €3 billion of contingent capital provided to the banks to be returned in 2014.
4. Possible resale value of the banks (AIB, PTSB and 15% share in BOI)

It is hard to put a value on the banks and hopefully the view that they have “moved from being a liability to an asset on Ireland’s balance sheet” will gain a greater foothold.  It is easy to suggest that the above four items would reduce Ireland’s net debt to GDP ratio to below 100%.  If you prefer GNP as the appropriate measure of the Irish economy we are probably looked at a net debt to GNP ratio in 2014 that will be less than 125%.  Large but not terminal.

The €45 billion figure for NAMA was the estimated total if all property and construction loans of more than €5 million in the participating banks (AIB, BOI, EBS, Anglo and INBS) were transferred to NAMA.  As we know the transfer of developer loans above €20 million was completed.  In total NAMA bought about €72 billion of these loans and paid €31 billion for them.  The loans of less than €20 million were never transferred to NAMA and the expected losses on these were included in the PCAR analysis undertaken by BlackRock Consultants as part of the stress tests so have been accounted for.

It is impossible to know what the final outcome of the NAMA process will be.  NAMA did create €31 billion of bonds to buy the developer debt, but it bought assets which also had a notional value of €31 billion as valued in November 2009.  If these levels were to be maintained beyond the November 2009 valuation date, NAMA would have no effect on our net debt position.

Of course, property prices have not been unchanged since November 2009 and they have tumbled onward ever downward.  The excellent Namawinelake (the “best source on the Irish economy” remember!) estimates that the value of property backing the loans has fallen by a further €6 billion since the NAMA valuation date. 

It is impossible to use this as a projection of possible NAMA losses.  In most cases NAMA has control over the loans and not the assets.  NAMA has been making substantial disposals for the past few months but we are not told if the agency is making a loss or even possibly a profit on these transactions. 

NAMA has the potential to make a call on the State’s resources to cover a shortfall on its operations.  Unless there is almost complete collapse in asset values it is hard to see how this shortfall could be more than €10 billion, and it is likely to be substantially less than that. 

It is not clear that there will be losses on the Emergency Liquidity Assistance (ELA) provided by the Central Bank of Ireland.  The banks have been provided with sufficient capital to absorb the losses on their loan books so they should be able to repay the central bank liquidity.   In fact the chief executive of the biggest user of ELA has said that the State is providing them with €1 billion to €4 billion more than is required to meet all their liabilities.

Even with the net value of NAMA included, the 2014 debt level will not be more than €210 billion and may be closer to €200 billion.  This is truly massive, but the difference between a debt of €200 billion and a debt of  €250 billion is material.  We could not survive a debt of €250 billion. If we have to carry a debt that large we would be in a similar crisis to one that Greece is now having to face up to. 

A €200 billion government debt is massive but it can be carried and does not make default inevitable.  Just like in the domestic mortgage market, it is important to distinguish between a borrower who simply can’t pay and one that just won’t pay.  Of course, unlike most mortgages we have little intention of ever repaying this debt.  We need to get into a position where we can sustainably service the interest costs of the debt.

Greece is bust and cannot carry it’s debt which even in the EC’s baseline scenario is forecast to be close to 190% of GDP by 2014.  In Greece the news has been consistently bad.  In Ireland we have some positive debt developments since the Morgan Kelly piece in May:

• lower bank recapitalisation costs,
• lower interest rates on EU loans,
• and even a lower 2010 debt because of a DoF accounting error.

By 2014 our debt to GGD ratio will be 114%.  Even if we went through the equivalent of the banking crisis again and had to borrow an additional €63 billion for some reason this would bring our debt to around €270 billion which would be 155% of GDP.  We would still not be even within touching distance of Greece if the equivalent of the banking catastrophe was to the hit us again.

Greece is bust and their economy is broken.  The EU deal on the table does not go far enough and cannot rescue Greece.  We can fix the mess we find ourselves in without resorting to the tyranny of default.  It will require hard choices but it can be done.

Now you see it, now you don’t

Just two days ago we asked “where is our money?” when discussing the €24.8 billion of cash we are supposed to have at the end of the year as indicated at the top of page 3 in the Maastricht Letter released a little over a week ago.

Today we learned that €3.6 billion of this cash never even existed in the first place.  The error has to do with the treatment of the Housing Finance Agency (HFA) in the general government accounts.  Prior to 2010 the HFA was a standalone entity whose assets and liabilities formed part of the general government accounts. 

For 2010 the HFA’s financial transactions were assumed into the National Treasury Management Agency so the assets and liabilities of the HFA should no longer be individually included in the general government accounts as the figures are incorporated into the NTMA’s accounts.  To include the HFA’s assets and liabilities again is just double counting and that is just what happened.

The NTMA issued €3.6 billion of government notes on behalf of the HFA and this €3.6 billion of debt was included in both the liabilities of the NTMA and the HFA.  However, the State only owes the €3.6 billion once so the debt of both agencies should not be included in the general government accounts.  Similarly the €3.6 billion appeared on the asset side of both agencies’ balance sheets and also should only be counted once.

The NTMA raised €3.6 billion and placed it “on deposit” with the HFA.  The NTMA counted this as a market deposit even though the money was actually not available for use.  This is usefully explained in this note from the CSO.

As the changes affect both our asset and liabilities positions there is nothing “saved” from the discovery of this error.  The final sentence from the CSO note sums it up nicely.

“Overall, the State is no better or worse off as a result of the correction.”

But at least know we know where some of that €25 billion is.  Let’s hope the remaining €21 billion doesn’t do a similar disappearing trick.

Bond Yields

Last week’s announcements from the latest EU emergency summit did not result in much of a change in the nine-year government bond yield as calculated by Bloomberg.  There has been a slight drop over the past couple of weeks and yesterday’s close at 8.15% was the lowest since the 13th of October.

Last week’s agreement might have had little effect but Greek Prime Minister George Papandreou’s announcement last night of a referendum on the deal has had an effect.

This isn’t a big jump and does not have much significance.  It is not significant because yields are still lower than they were last Wednesday (and of course the significance is reduced because we do not plan to borrow from these markets for at least another year).