Friday, September 14, 2012

Bond yields, debt and deficits

It has been an incredible week for Irish government bond yields.  This table has the indicative yield as calculated by Bloomberg for a representative set of maturities on the last day of August and as of this morning.

Term Aug 31 Current Change
1-year 1.79% 1.36% -43bp
3-year 3.35% 2.05% -130bp
5-year 5.19% 3.82% -137bp
7-year 5.68% 4.62% -106bp
9-year 5.94% 5.27% -67bp

The largest proportionate drop has been in three-year yield but the drops have been right along the yield curve.  There has been no improvements in the Irish economy in the past few weeks that can explain these moves.

The announcement of Outright Monetary Transactions (OMTs) by Mario Draghi is important and at the same timeframe used above the Spanish five-year yield as calculated by Bloomberg has moved from 5.50% to 4.41%.  Clearly the moves by the ECB can explain a large part of the yield decrease but the drop for Ireland has been larger.

It is likely based on expectations of the “deal on bank debt” though this has been in the offing since the June 29th EU Council Meeting.  This week’s IMF Article IV Report on Ireland shows what could happen to Ireland’s debt ratio if this deal delivers at the top-end of expectations.

IMG GGD minus banks

A debt ratio of around 80% of GDP by 2020 would be remarkable.  Of course, this is based on a benign growth scenario and a deal with the ESM for the viable banks (the ESM purchasing them for €24 billion) that is unlikely.  In the absence of the debt improvement agreement and underperformance of growth the following could happen.

IMF GGD stagnant growth

The stagnant growth scenario sees the debt at 130% of GDP as early as 2017 and continuing the rise.  This is not a sustainable position.

Current Irish bond yields are more reflective of the “baseline growth and ESM equity and refinancing of promissory note” scenario of the first graph than the “stagnant growth scenario” of the second.

The likely outcome will be between these.  A bank debt deal that doesn’t meet expectations or lethargic growth will bring the second graph into the focus of prospective buyers of Irish government bonds.  The current run of these bonds is a positive but the yields can rise much faster than they fall.

Also, as highlighted by yesterday’s Fiscal Advisory Council Report the biggest threat to debt sustainability is the continuing deficit.  While the debt deal will affect the level of Irish public debt the deficit will determine the trajectory.

FAC Deficit Fan

The FAC are pretty explicit that the risks are to the downside with larger deficits more likely than lower deficits.  The current plan as outlined in last April’s Stability Programme Update are for the deficit to just edge below 3% of GDP by 2015 (2.8%).   The FAC recommend a faster adjustment process which would bring the deficit down quicker, add to the likelihood that the public debt ratio will stabilise and provide buffers against growth underperformance.

Last week, updated National Income and Expenditure data from the CSO and some revisions from the Department of Finance showed that the 2011 ‘underlying’ General Government Deficit (i.e. excluding bank payments) was €14.3 billion or 9.0% of GDP.  In 2010 the ‘underlying’ deficit was €16.7 billion or 10.7% of GDP and in 2009 it was €18.8 billion or 11.7% of GDP.

[This measure of the ‘underlying’ deficit excludes bank recapitalisation payments but does not exclude banking-related revenues such as the Central Bank surplus, bank guarantee fees, dividends and other receipts.]

Since the ‘underlying’ deficit peaked in 2009, the nominal improvement was €2.1 billion in 2010 accelerating to €2.4 billion in 2011 and in terms of GDP the improvements have been one percentage point and 1.7 percentage points respectively.

For 2012, it looks like the rate of improvement will slow although it will be this time next year until that can be ultimately confirmed.  Most projections are for a deficit this year of around €13 billion or 8.3% of GDP and one of €12 billion or 7.5% of GDP in 2013 (though this is influenced by the of the ‘interest holiday’ on the promissory notes).

After seeing the deficit fall to 9.0% of GDP in 2009, the current plan is that it will fall by justa further 1.5 percentage points over the next two years to 7.5% of GDP.  This will add €25 billion to our borrowings.  Even by sticking to the terms of the Excessive Deficit Procedure there will still be a deficit of €5 billion in 2015.

The banking disaster beginning from 2008 has added about €45 billion to the general government debt.  The ‘underlying’ deficits over the same period have totalled around €63 billion.  Another €38 billion of deficits are expected to be accumulated over the next four years.  It is possible that the table of bond yields shown above won’t always look as positive.

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