Friday, 15 October 2010

How to deal with the bond markets

Jim Stewart: Recent Government policy decisions (postponing the monthly bond auction, recapitalisation of banks, etc. and other announcements) have been evaluated in terms of changes in Irish Government bond yields - a rise indicating poor policy and a fall good policy. The problem with such analysis is that bond yields are determined by forces that may be only loosely connected to economic policy. Trading in Government debt is once again dominated by hedge funds (Financial Times, 15 September 2010). This may partly explain volatility in the prices and hence yields on government debt. Greek bonds although yields are the highest in the eurozone, provided the highest eurozone bond returns over the entire month of September.

The Minister for Finance stated on September 30 that subordinated bond holders will suffer losses in both Anglo-Irish and INBS via resolution and reorganisation legislation. At the same time, he specifically stated that there would be no ‘legislative’ changes in relation to senior bond holders. However, negotiation with bond holders does not require legislation or permission from any other body, and the Regulator, Matthew Elderfield, on October 6th raised the possibility of negotiating with senior bond holders.

The Financial Times, in an interview with the Minister for Finance (October 12), reported that, typically, a voluntary negotiation with bond holders is done to ensure that it does not constitute a default as regards credit default swaps - instruments which apart from enabling speculation in bond values may also provide insurance in the event of default . This raises the issue of why holders of such bonds who have also purchased Credit Default Swaps on those bonds, would enter into negotiations which would result in a diminution of the value of their investment without recourse to the guarantees given by the counterparties of credit default swaps. In this case, in the event of ‘default’, the counterparties of credit default swaps would make large losses. Who are they? Most likely Goldman Sachs, Merrill Lynch, etc. Hence we can expect representatives of such institutions to be vociferous in their condemnation of burden-sharing policies with owners of bank bonds, and rather emphasise ‘austerity' (see reports of speech by Peter Sutherland, September 25). Yet such policies must be pursued. The greater the loss faced by existing bondholders, the lower the required capital contribution to banks by the State, and the lower government borrowing. As a result, the greater the likelihood that the cost of future state borrowing will fall. There is a clear distinction between the existing debts of the nationalized banks and State debt. What is bad for the former is good for the latter.

In the coming months, the State should pursue strategies that drive down the market price of existing debt of the now nationalized banks. This can only be done in the context of the removal of guarantees on existing debt.

Will Ireland be ‘Shut Out’ of the Bond Markets?

Given the high cost and volatility, the decision ‘not to proceed’ with bond auctions scheduled for October and November is rational. The minister stated, that “as the NTMA is fully funded until late June 2011 the Agency has decided not to proceed with bond auctions” until early 2011.

The NTMA has a policy of prefunding, so that cash balances at the end of June amounted to €20 billion (NTMA). This is explained by the NTMA, who state that “maintaining large cash balances has underpinned investor confidence and provided valuable flexibility in the timing of its borrowing”. The NTMA are also quoted as stating that, if they do not issue debt, the market will interpret this as a signal that the Government cannot issue debt.

Policy pursued up to September 30 appeared to be that new debt must be issued every month to ensure the overfunding position remains. So, even though interest rates on Irish government debt rose throughout 2010, the NTMA continued to issue debt. Rather than signalling that the government cannot issue debt, this policy may have signalled that the NTMA held non-public information which would be adverse for bond prices.

The NTMA should suspend bond auctions until there is greater certainty (for example in relation to future government policies). This may mean suspending auctions until March next year or later. Reduced uncertainty will result in some convergence of Irish bond yields with eurozone bond yields. It is also possible that speculative forces in the bond market will diminish and will result in greater convergence in eurozone bond yields. This means rising German yields and falls in the yields of peripheral countries such as Ireland and Portugal.

An issue that may arise is that uncertainty rather than diminishing may continue to exist, for example in relation to the formation of a new government, or the policies of a new Government. Hence it is desirable that financing the deficit is less dependent on external investors (international investors hold 85% of long term debt). One solution is to use the remaining funds (€14 billion) in the National Pension Reserve Fund after providing for bank funding, to provide support for the Irish bond market.

Establishing the National Pension Reserve Fund was misguided (although hailed by some such as the current Governor of the Central Bank, as the most important policy decision for a decade). Transfers of resources (bread, haircuts, etc.) to future retirees can only come from future output. The best way to safeguard current and future pensions is to ensure that the current and future economy is as productive as possible.

Borrowing to invest in equities and other risky assets is equivalent to the State behaving like a hedge fund. There is a national crisis. In this crisis the National Pension Reserve Fund should be utilised. One way is to announce that the investment policy will change, so that from the New Year the National Pension Reserve Fund will be used to purchase new Government debt if prospective yields are above some stated figure (say 5%). If Ireland remains part of the Euro system (which is highly likely), such returns would be much higher than those achieved to date. Volatility and risk would be reduced.

In the longer term the State is likely to have high levels of borrowing for some time. Current policies to reduce borrowing by cutting expenditure will perversely have the effect of increasing the need for borrowing and may depress property prices further, as well as bank capital. Even if policies change, the legacy of the banking and economic crisis will still ensure high future levels of borrowing. At the same time, it is likely that the extra premium payable on Irish Government debt will remain.

To finance this deficit a greater proportion of government borrowing should and can be sourced internally. For example, investment choice in the proposed new auto-enrolment pension scheme should be limited to the purchase of Irish Government debt. Apart from financing the exchequer deficit until pension payments must be made (10-15 years), this would also have the effect of reducing costs and risk. In effect this new proposed supplementary scheme would then become a type of PAYG system, but with pension payments more closely tied to contributions and returns.

Some commentators, and no doubt some (Department of Finance) officials, would welcome IMF/EU intervention, as cuts could be presented as being externally imposed. The difficult task of increasing efficiency in the public sector by negotiating and implementing necessary change, would be seen as no longer necessary. The existing Department of Finance/McCarthy report on Public Sector Numbers and Expenditures and the forthcoming Department of Finance/McCarthy report on privatization would form a major part of any imposed IMF/EU intervention.

But IMF/EU intervention similar to that in Greece is unlikely. However closer monitoring by the ECB, and EU bodies is certain. This will lead to policy changes but in addition considerable negotiating skills are required to try to ensure that external policies, encourage rather than hinder the prospects for economic success. There needs to be careful monitoring of policies and economic data in other EU countries, in particular those in the eurozone so that Ireland can be presented as ‘average’ rather than an outlier.

The issues discussed above are holding policies. What is needed is a fundamental change in economic policy.


Anonymous said...

Thanks Jim for your informed and constructive piece.
Is it too much to hope that the mandarins in Merrion Square are paying attention and that Government and Opposition politicians will act on these sound recommendations?

paul sweeney said...

This is an important post. We have three interlinked major crises in Ireland, jobs, fiscal and banking, which must be addressed simultaneously. Government is focused only on two and is pursuing the wrong policies, yet again. NESC reminds us of two more - reputational and social, which are also important.
While most PE blogs are focusing on fiscal policy, as mainstream Ireland again chooses the wrong course (as it did in tax-cutting, privatisation and de-regulation a few short years ago) the banking crisis is also vital. The importance of action on bondholders seems to me to be considerably underestimated.
There is a staggering rapid gain to be made for Irish taxpayers if we burn the bondholders. It will save vast sums and greatly restore business and consumer confidence.
Most bloggers here at PE are concerned with the importance of not deflating the economy in the next Budget, with severe cutbacks. They provide a most reasonable and increasingly counter to Irish economic Group Think. Interestingly and increasingly, most foreign pundits, it seems to me, would side with PE and think that Ireland is down a hole, digger deeper as the hole fills with water. Saturdays British papers say that the UK may follow the US with a “major stimulus programme.” Maybe, the mainstream could be correct and these stimuli will lift this sinking ship out of the hole.
Parallel with the fiscal crisis, Jim Stewart is quite correct to focus on the bondholders. Again, many foreign commentators are puzzled as to why Mr Lenihan and his advisors have waited/wasted? two long years to address the bondholder issue.
Is it that many key decision-makers in Ireland are still in awe to the workings of the markets as they were when they were against regulation (interference in its perfect workings) in the boom or perhaps they are overly impressed by really rich bondholders’ representatives like Mr Sutherland of Goldman Sachs? The answer is probably more complex, but cap-doffing to the perceived power of “the markets” by the Dept of Finance, Central Bank and other powerbrokers seems to be a colonial legacy which is costing Irish citizens dearly.
Therefore it is a pity that the cap-doffers do not recognise Jim’s key point (in fairness, they probably never heard it put, nor considered it, such is the paucity of thought within the liberal straightjacket) should be highlighted.
It is that “the greater the loss faced by existing bondholders, the lower the required capital contribution to banks by the State, and the lower government borrowing. As a result, the greater the likelihood that the cost of future state borrowing will fall.”
In short, the cost of future borrowing will be lower if we burn the bondholders. This is very important and has not been discussed at all, till here.
Two questions for Jim: how much can we burn them for? Give them 10%? This is a lot more that they deserve or would have got had not Mr Lenihan foolishly bailed out Anglo and Nationwide in our name and without our mandate.
Secondly, how much would we citizens save if it were say a 90% write-down on all bonds for these two corrupt private sector banks?

Paul Hunt said...

I think what most people would like to know is to what extent the Labour Party's policy is aligned with the Tasc submission, this post by Jim Stewart and Paul Sweeney's comment. The Labour Party is the dominant political force giving expression to the progressive left - and it is in the political arena that decisions about Ireland's future will be made. Is there anyone in the Labour Party with the courage to be explicit about what Labour intends? Or is it expedient to play the populist card and indulge in the dyfunctional factionalism that has blighted Ireland for so long?