What to do with the €3bn?

The Government has decided to proceed with the sale of 25% of AIB, and has indicated that it expects to raise around €3bn from the transaction. What to do with the money has been the source of some political debate, although the constraints imposed by the EU’s fiscal rules may leave the authorities with little room to manoeuvre.

The proceeds of the sale will not affect the General Government balance , as under Eurostat rules it is classed as a financial transaction , merely  exchanging one type of asset within general government for another, in this case cash. However, the €3bn inflow will impact the Exchequer Borrowing Requirement (EBR), the  deficit on a cash flow basis. The 2017 Budget made no allowance for  any sale proceeds and projected a €2bn EBR  so on the face of it the Exchequer may now emerge with a €1bn surplus at end-year, assuming the initial underlying target is achieved .

The Budget also indicated that the NTMA would  over-fund in 2017 (i.e issue more debt than required to finance the EBR and to cover redemptions)  so in sum gross Government debt was projected to rise by around €4bn, to  €204.6bn or 72.9% of forecast GDP. Adding in the AIB proceeds would therefore reduce the forecast debt level to €201.6bn, or 71.9%.

The limited impact on the debt ratio ( just 1 percentage point) has prompted some to question whether the money might be better utilised to fund capital or even current spending, with most of the argument centred on the former. Whether this would be wise given that the economy is operating at or even above potential is one consideration, albeit not an argument one often hears from politicians, but there is a more significant constraint; Ireland is subject to the budgetary rules of the EU’s Preventive Arm, designed to reduce the risk of utilising one-off receipts, like the AIB monies, to fund increases in spending.

To that end an Expenditure Benchmark is in place setting a limit on the level of General Government spending ( Fiscal Space) allowed, net of any taxation changes, and the AIB  proceeds are not classed as General Government revenue. Capital spending, it could be argued, differs from current spending in that an asset for the State is created, but total capital spending is not exempt from the spending rule, only any increase relative to a 4-year average. For example, if the Government announced it intended to spend €6bn next year and the 4-year average was €4bn, a net €2bn would be exempt from the Expenditure Benchmark, However, the €6bn would obviously boost the  Budget deficit, which is also subject to EU rules, in this case a requirement to reduce it by at least 0.5% of GDP when adjusted for the economic cycle.

Putting the money aside or into a special fund would make no difference in terms of the above constraints. Ireland could simply ignore the rules, of course, and de facto there seems little prospect of any State being fined for a breach, but one doubts if there would be any appetite from the current Administration for such a move, as it risks alienating  key European partners amid Brexit negotiations .

Irish Household wealth climbs and debt falls

Irish household debt (defined as outstanding borrowings from financial institutions) peaked in late 2008 at €204bn and has been falling since, declining to  just under €150bn in the fourth quarter of 2015, according to the Central Bank, the lowest in a decade. The debt burden (debt relative to household disposable income)  has also declined significantly, to 155% from a peak of 215%,  although still leaving the Irish ratio well above the euro area average ( which is under 100%) and the third highest in the European Union.

No one can be certain at what point the deleveraging will stop but one factor which may impact is that Household wealth continues to recover, with the result that Household net worth has risen from a cycle low of €440bn to €626bn, the highest since early 2009. The upturn in wealth  was initially driven by rising equity markets ( boosting pension fund reserves) but over the last few years the recovery in residential property prices has been the made driver. Indeed, financial wealth actually fell in the latter half of 2015 but was offset by further housing gains.

Last year also saw a substantial rise in the (gross)  Household saving ratio, to 9.5% from 5% in 2014. On the face of  it then, Irish households are rebuilding savings, despite the meagre returns on deposits, and regardless  of a significant improvement in their financial position, at least in the aggregate, are still more comfortable repaying debt rather than borrowing.

Ireland’s Debt Dynamics turn more benign

Irish government debt stood at €47bn in 2007, just 24% of  GDP, one of the lowest ratios in the euro area. Debt then ballooned, rising to over €215bn by 2013, reflecting capital injections to the banking system, the impact of the recession on the underlying budgetary position, and latterly, the inclusion of IBRC’s liabilities. The impact on the debt ratio was compounded by the trend in the denominator, nominal GDP, which fell by some €32bn or 16% from 2007 to 2010, with only a modest pace of recovery evident up to 2013.  As a result the debt ratio ended  the latter year at 123.2% of GDP, one of the highest debt burdens across the single currency area, and one some felt was not sustainable. That ratio now appears to have peaked, however; the CSO  estimates that  the debt ratio fell to 109.7% in 2014, with the level of debt declining to €203.3bn, in part due to the sale of liquidation and sale of IBRC assets.

Ireland’s debt dynamics are now turning positive and , based on current expectations, the debt ratio should now fall steadily, with the caveat that events can and do throw up consequences which render previous expectations redundant. That aside, the factors which determine the debt ratio are all moving in a more benign direction for Ireland.

Take nominal GDP.  That rose by 6.1% in 2014, to over €185bn,and the Government is currently projecting a  5.3% increase this year, with a similar rate of growth forecast out to 2018. The 2015 figure is based on real growth of 3.9% , which some feel is now too low, and an upward revision is possible when the next set of official projections appear (they are due later this month).

The other key drivers in terms of debt dynamics are the average interest rate on the debt and fiscal position excluding interest payments , or primary balance. The former is projected to average 3.5% this year( which appears too high now in the light of QE) but in any case is well below the growth rate of GDP, a  reverse of the malign  dynamics operating between 2008 and 2013 and one that will now put downward pressure, albeit modest, on the debt ratio.  The official forecast envisages a marginally upward path  in the interest rate  over the next few years. although still below the projected growth in GDP, which implies a further continuation of that more benign trend.

In addition, Ireland is now running a primary surplus (i.e. revenue exceeds non-debt expenditure) which is required to ensure a more rapid decline in the debt burden. In 2015, for example, the primary surplus is currently projected at 1.1% of GDP, rising to  4% by 2018. The debt ratio is also influenced by one-off adjustments ( e.g. the NTMA  running down cash balances, revenue from asset sales)  and leaving those aside the above interaction of  nominal GDP,  the interest rate and the primary surplus results in Ireland’s debt ratio falling to 107.5% this year before declining to under 100% in 2017 and 94% by 2018.

That projection is also  based on the current forecasts for the fiscal balance, which envisages a steady decline in the overall  deficit, from 2.7 % of  GDP this year to 0.9% in 2017 and a marginal surplus in 2018. That now also looks conservative, given the strength of tax receipts in the year to date, and so a stronger primary surplus path may emerge, albeit one  that takes no account of the political cycle, although any Irish government will be constrained by EU rules on government spending, even if some leeway is given in terms of interpretation. A noted above,  economic shocks may  emerge but in their absence the Irish debt ratio does look to be on a downward path to a more sustainable level, if at a steadier pace than experienced during its upward trajectory.

Early repayment of Ireland’s IMF debt

The Irish Government is exploring he possibility of  early repayment of the monies borrowed from the IMF and below we examine the issue.

How much does Ireland owe the IMF?

Ireland  arranged to borrow €22.5bn from the IMF as part of the bailout deal agreed with the Troika, although the fund actually lends in Special Drawing Rights (SDR’s) , the IMF’s unit of account, which is constructed as a basket of four currencies (the US dollar,  euro, Yen and Sterling) with the dollar having the largest weight followed by the single currency. Ireland drew down SDR19.47bn from early 2011 through to late 2013 and the loans have maturities ranging from 4.5 years to 10 years, with an average maturity of 7.3 years. The SDR ‘s value against the euro changes daily and at the time of writing buys €1.16 so Ireland currently owes 22,6bn in euro terms, although the loan has to be repaid in SDR’s. In that sense Ireland can be said to have borrowed from the IMF in four currencies.

What is the interest rate on the loans?

Ireland has borrowed from the IMF under the Extended Fund Facility and the rate charged is floating, depending on the 3-month SDR rate ( itself a weighted basket of rates in the four constituent currencies) and a surcharge. The SDR rate is currently only 0.05% (the euro and yen rates are actually negative) so the premium is much more significant. That depends on how much one borrows relative to ones contribution to the fund , or quota, which is determined by GDP, population and other economic criteria. Ireland’s quota is SDR1.258bn and a country can borrow up to 3 times that (or SDR3.77bn in this case ) at a 1% surcharge. Anything beyond that carries a 3% surcharge , rising to 4% if the loan term extends beyond three years

So how much is Ireland paying?

If we assume the loan term will average 7.5 years Ireland would pay 1.05% per annum on the first SDR3.77bn and on the remaining SDR15.7bn 3.05% over the first three years and 4.05% on the final 4.5 years. This gives an average blended rate of 3.15%. In fact the loan  also carried a one-off 0.5% charge so averaging that out over the term  and adding it to the cost gives an annual rate of 3.21%. This is an SDR rate of course and Ireland raises taxes in euros, so the NTMA will use the swap market to convert euros in to the appropriate basket of currencies. Consequently the NTMA quotes an average euro rate for the loan based on a 7.5 year maturity swap, and that was put at just under 5% in March of this year, implying an annual interest payment in euros of over €1bn on the IMF loan. Ireland’s total interest bill on all outstanding debt  this year is just over €8bn.

How much is Ireland paying in the market?

Bond yields have collapsed across the euro zone on the expectation that short term rates will stay low for a very long time and, probably, in anticipation of bond purchases by the ECB. Irish yields have fallen precipitously too, with a government bond maturing in 10 years currently trading at 1.85%, with shorter maturities at much lower  yield levels. It would therefore appears that Ireland could borrow much more cheaply in the market than the current cost of the IMF loan  and it would make sense to borrow at a longer maturity given the low level of current yields..  The Minister for Finance has mentioned a figure of €18bn for repayment and yields would presumably rise if Ireland announced a much heavier issuance schedule  than currently planned ( only €10bn was slated for this year in total) but even at ,say 3.0% for a 20 year bond , the saving would be around €360mn a year , not counting any additional costs involved in breaking the swaps.

What’s the problem then?

There are two issues. One is that the other members of  the Troika need to sign off on early repayment, which brings in EU Governments  and in some cases parliaments. The second is the Promissory note deal, which involved the Irish government issuing  €25bn in long term bonds to the Irish Central bank . The ECB was never happy with the transaction, believing it to be ‘monetary financing’, and insisted that the Central bank sell the debt into the market over time. The schedule for the latter is light, with sales of €0.5bn a year out to 2018 before rising to €1bn a year, but Draghi now appears to be linking any ECB support for early IMF debt repayment with a more rapid sale by the Central bank.

Does the Prom deal matter that much?

The Irish Government  borrowed the €25bn from the Central Bank , which in turn borrowed from the ECB, and  the Government pays  a floating rate coupon of 6-month euribor ( currently 0.2%) plus 262 basis points on the bonds , implying an annual interest payment of €700mn. That  means a  large profit for the Central bank as its borrowing cost is now virtually zero, and most of this profit is transferred to  the exchequer. If ,say, the Central bank sold €5bn into private sector hands that circular flow of income would be broken, costing the exchequer, with interest payments now leaking out into the investors who bought the bonds from the Central bank while the latter would use the proceeds  of the sale to repay the ECB.

So the ECB’s call is key?

The ECB’s view is therefore very significant, as a much more rapid sale of bonds by the Central bank, in return for a nod on the IMF repayment,  would reduce the benefit of  the latter, by driving up Irish yields and  via a reduction in Central bank and therefore exchequer income. It is an irony though, and one that may well be pointed out by the Irish authorities, that Draghi is now  keen for the  ECB  to  eventually embark on full scale bond purchases across the euro area, which some might view as ‘monetary financing’ too, although no doubt Frankfurt will argue that the cases are different.