Monday, 19 July 2010

Moody's downgrades - an investment upgrade required

Michael Burke: Moody's ratings' agency has just downgraded Irish government debt. The move brings it into line with the other agencies' assessments. The Irish Times reports that a combination of factors is involved including liabilities arsing from the bank bailout, weak growth prospects and and a substantial increase in the debt/GDP ratio.

However, Dietmar Hornung, Moody's lead analyst for Ireland, was a bit more categorical. He said, "Today’s downgrade is primarily driven by the Irish government’s gradual but significant loss of financial strength, as reflected by its deteriorating debt affordability." So, while there are a serious of contributory elements, the downgrade is primarily a function of the weakness of government finances, highlighted by deteriorating debt affordability.

The weakness of taxation revenues reflects the ongoing weakness of the domestic economy- the sector that the government chooses to tax. But the affordability of debt is no less serious. As existing debt government debt matures it has to be replaced by new debt issuance, and, now at higher interest rates. At the same time, borrowing is required to meet the tax-induced widening of the deficit. On top of this, the government, who can in no way risk the country's international reputation by borrowing a cent for investment purposes, can repeatedly find the resources to provide further bank bailouts.

All of this is leading towards disastrous outcomes. This is reflected in the market interest rates on government debt, and does not support the idea widely promoted that the economy is being rewarded for its fiscal austerity drive.

The market interest rate on Irish 10yr government debt is now 5.5%. By comparison the market interest rate on German 10yr government debt is 2.59% and Spain's 10yr debt yields 4.62%.

So, a €10bn 10yr bond issued by NTMA would cost, more or less, €15.5bn in interest and debt repayments over the life of the bond, whereas it would cost the German Treasury €12.6bn, Spain €14.6bn. There are auctions of Irish government debt scheduled for tomorrow, where we will see how great these 'rewards' are.

Worse, the combination of extremely high deficits and economic contraction is pushing the debt burden ever higher. ESRI is forecasting that general government debt will increase by 20% of GDP this year and 8% next. In the impossible event that no new deficits were incurred thereafter, the domestic (taxed) part of the economy would have to grow at 5.5% in nominal terms simply to keep pace with interest costs. The ESRI forecasts for GNP are for a cumulative fall in nominal GNP of 0.5% over the next two years.

If any business were obliged to borrow at above its competitors' rates, it would ensure that there was a significant positive return on that borrowing. That would be the only way to ensure solvency. Luckily, there is a slew of productive investments that can be undertaken that yield an economic and fiscal return way above the break-even level of 5.5%. They are set out in the NDP. In the Mid-Term Evaluation of the National Development Plan (Fitzgerald & Morgenroth) it places the average annual return on investment at between 14% and 18%, depending on the composition of the investment. If the obligation is to borrow at 5.5%, it makes sense to invest only where there is a much higher return. Investment in the areas, sectors and projects identified by the NDP would close the deficit.


Anonymous said...

Is the comment "arsing from the bank bailout" a typo? If it is, it is still a good describtion of the bank bailout!

Michael Burke said...

mmmm, don't know how that one got past my spell-check.

Seems like it must be part of my dictionary. Or I've added it.