Monday, 4 April 2011

Affordable, manageable and sustainable

Michael Taft: Some commentary has suggested that Black Thursday wasn’t all that bad; in particular the bail-out won’t add much to our general debt. Therefore (and this is a curious QED) the debt remains sustainable. Phew. I was worried there for a moment. In our own little bubble, we can content ourselves with the notion that our debt is ‘affordable, manageable and sustainable’.

It is difficult to say how much of the €24 billion bail-out will find itself in general government debt. Government sources claim only €2 billion – but even then, this depends on how Eurostat categorises the ‘expenditure’. So let’s factor in this marginal increase. What follows projects debt-to-GDP and GNP ratios – but this is not the only ‘sustainability’ measurement (the other measures interest rates, primary balances and growth).

If we use the last Government’s overly-optimistic growth (and, so, deficit) projections our debt will have to be revised upwards to 104 percent due to the poor 2010 GDP outcome.

However, let’s substitute the more sober IMF’s projections for growth and the deficit up to 2014. They project that growth will be an annual 2 percent; this contrasts with the last Government’s 2.7 percent; regarding the deficit, the IMF projects that the balance will be -5.1 percent; the last Government hoped to reach -2.9 percent (but that’s gone by the boards under the new Government).

If we use the IMF’s projections, we find the Government debt rising to 113 percent by 2014. How does this compare to the IMF’s projections for EU countries by that year?

We will be well above the EU average, behind dysfunctional Greece and long-time high-debt Italy (which relies on domestic savings to support its debt).

But let’s look at this from another perspective – debt as percentage of GNP (or Gross National Income).

If we take the Government’s optimistic projections, we’re still far in excess of the EU-15 average, coming second in the table.

However, if the IMF projections hold, we will top the league – ahead of even insolvent Greece (note, however, that the Greek numbers will probably rise as their austerity programme is driving down growth and increasing the debt burden; just like Ireland).

With the markets convinced that Greece will default, how far behind can Ireland be? And this assumes that not one extra cent, as Minister Leo would put it, finds its way on to the state books. What odds on that not happening?

But even though we may be heading towards Greek levels of debt, we won’t have to worry. It will all be ‘affordable, manageable and sustainable’.

Just as long as we keep cutting (and cutting and cutting) social welfare, public services and investment.


Seamus Coffey said...

Hi Michael,

This is a fair take on the situation but it is becoming clear that the debt will probably be sustainable.

This is the word I am using and I am taking it to mean that "we can afford the interest costs" - i.e. the debt will not push us to default. At this remove I cannot see how we can pay off this debt, even over a 20 year plus horizon, so this is a huge millstone that will be dragging us down for a long, long time.

Why is it sustainable? There are three reasons
1) We entered this crisis with a low debt/GDP ratio (c. 25%)
2) During the boom we built up a huge sovereign wealth fund (c. €25 billion in the NPRF)
3) During the crisis the NMTA built up significant cash reserves (c. €15 billion at 31/12/2010)

Absent any of these elements and it is unlikely we could survive this pillaging of the State's resources.

Up until last week we had committed to borrowing €35 billion for the banks, with another €11 from the NPRF making the €46 billion wasted so far.

As you say the €24 billion recap from last week could require an additional €2 billion of borrowing. I would note that the €2 billion refers to new borrowings. Some of the State's contribution will come from our cash reserves which were actually created by new bond issues by the NTMA in the run up to the crisis.

The State will still be contributing about €17 billion of the €24 billion required for the latest recap. This will be divided between a further raid on the NPRF, a reduction of existing cash balances and the €2 billion of new borrowings.

This will bring the total contribution of the State to €63 billion. A debt of €43 billion can be carried by a country with a GDP of €154 billion.

Of course, this is not to say that we should do it. I could get up off my chair and walk to Dublin. That would be madness when I can get the train to do it for me. We could use State resources as part of a bank bailout. This is madness when it should be bondholders doing it for us.

The strategy followed is wrong, but recent events suggest, that altough far from best, it can work. I think an acceptance of this does not render objections obsolete, but it does mean that the alternatives provided must be fully costed.

I think the benefits of burden sharing have been lost. In August 2008 there was €108 billion of bonds outstanding for the covered six and €82 billion of that was held by "non-residents".

Since then a huge amount of these bonds have been paid off (using ECB money, where a lot of blame must lie). Non-resident holdings of bonds is now €28 billion - a reduction of €54 billion in two and half years.

There is not a massive difference between this figure and the contribution to this fiasco by the State. The rest of the senior debt holders will get their money back as well.

These bondholders had €82 billion to invest in Irish banks in 2008, meaning they also had €82 billion to lose if the banks failed.

It is good thing that the State had €40 billion of assets coming into this crisis. It is madness that we are using most of this for broken banks. It is because of this that the debt incurred by this bailout are sustainable.

[How much would cost to set up two State-owned "pillar" banks from scratch?]

Just because the current strategy can work does not make it right, but it does look like it can work.

Michael Taft said...

Thanks, Seamus, for that comment. There is much to consider and I will get back on some of these issues. In the meantime, however, I'd just like to ask: in your opinion at what point (nominal, % of GDP, % of tax revenue, etc.)does the debt and/or interest payments become unsustainable?

Seamus Coffey said...

Hi Michael,

A very good question, and you cover the three key issues
- the amount of the debt
- the debt ratio
- the cost of servicing the debt

In my view the issue of sustainability is determined mainly by the latter, which in itself is determined by the first two and also the average interest rate.

[The NTMA should be made to produce an APR for the total debt of the State].

Let's assume an interest rate of 5% which accounts for existing stock of bonds at this rate and lower, the average of 5.7% on the EU/IMF money, and the various lower rates on promissory notes etc. This 5% is just a guess on my part.

At such a rate, a debt of 115% to 120% would be sustainable (again being defined as the ability to service the debt). I cannot see how it can be repaid. The interest costs on this would be 6% of GDP.

With goverment revenue of 35% of GDP this would consume a massive 17% of revenue. In my view this is the border of sustainability, and this would be extremely difficult to the State to carry but it could do it - just.

If the debt gets to 125% of GDP and the goes over 20% of government revenue then default is an inevitability. I am of the view that we can keep the ratio below 120%.

Again, this does not mean that carrying all this debt rather than defaulting is a good thing. As Tom McDonnell stated in another thread there is a world of difference between "can" and "ought".

There are number of reasons why we can keep the debt below 120%. One is the now lower projected costs of the banking fiasco and a second is the structure of some of our existing debt, particularly the promissory notes.

While we have all included the promissory notes as part of the State's liabilities they are constructed so that their actual debt effect is spread out over ten years. The €3.1 billion payment in this month's Exchequer Account is the first of these. It will only be 2021 when the entire effect of these is felt. This has the effect of slightly reducing the servicing costs in the immediate term.

This recent paper from the EC has the debt peaking at 120.5% in 2013. This would be unsustainable except that it also says:

"The debt projections assume partial use of the contingency element of the programme – €25 bn in 2011, of which half is covered by an Irish contribution trough (sic) the Treasury cash buffer and investments of the NPRF. This implies a one-off increase in the debt level by almost 8% of GDP."

We now know that the latest bank recapitalisations will possibly require and additional €2 billion of borrowings rather than the €12.5 billion assumed by the EC. This would be the ratio down below 114% and also reduce interest costs.

Without accounting for this reduction that same document projects that interest costs will be 6% of GDP on government revenue of 35% of GDP. This is right on the border of sustainability but the recent announcements suggest we can fall on the lower side of this limit.

Again, I'm not saying that forcing this huge burden onto the State should be done, merely that the evidence is now suggesting that it can be done. Default is an option rather than an inevitability.