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.

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

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.

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

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.

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

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.

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.

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?

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:

And the new Long-Term Bond arrangement:

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?

“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.

And

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 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.