Friday, February 8, 2013

“Legacy of Debt”

Lots of talk about a “legacy of debt” in response to yesterday’s re-arranging of the Promissory Notes/ELA framework.  First up, governments don’t repay debt, they roll it over.  And, as well as the size of the debt, there are two things that matter for debt rollovers:

  • average maturity
  • average rate of interest

Today’s announcement does not change the size of the debt but the maturity and interest rate changes are very significant (and beneficial in case there is any confusion).

Yesterday, Ireland was faced with the prospect of carrying a debt of €25 billion on the Promissory Notes and needed to roll that over with payments of €3 billion every year at whatever the best available rate at the time was.

At the end of the Promissory Notes (which would probably have been around 2022) the debt would still exist and what would need to be rolled over would have been the borrowings undertaken in the interim to meet the €3 billion annual repayments.  This legacy of debt was always going to exist and would have needed to rolled over in 2025, 2035, 2045 or whenever.  Government debt is not extinguished, the burden of carrying it (the interest) is eroded through growth and inflation.

Yesterday’s announcement offers some significant benefits for Ireland on both fronts.  Firstly, the average maturity has been extended to an average of 34 years.  This means the debt has to be rolled over far less frequently and through that reduces risk.  Under the current arrangement there would be €25 billion of debt being paid off in chunks of €3 billion and these would quickly accumulate into a total of tens of billions that would need to be frequently rolled over depending on the nature of the borrowings used to fund the annual payments.

The new arrangement postpones this roll over to an average duration of 34 years.  Rolling over €25 billion of debt in 2020 could present significant difficulties.  Rolling over €25 billion of debt on a staggered basis between 2038 and 2053 will be far less onerous.

The new arrangement also offers the significant interest rate benefits.  Under the Promissory Note arrangement debt with a very low net external cost of 0.75% (the ECB MRO rate) was transformed into much more expensive debt (EU/IMF loans at 3.3%) at a rate of €3 billion per annum. 

The net external cost remains at 0.75% but the rate at which the debt is transformed into more expensive debt has been significantly reduced.  As a result of the Central Bank of Ireland selling the bonds it receives as part of the swap this will happen at a rate of €0.5 billion per year up to 2018, €1 billion a year from then until 2023 and €2 billion a year thereafter.

The €25 billion of Promissory Notes would have been turned into full interest-costing sovereign debt by around 2022.  Today’s announcement means that the full €25 billion will not become fully interest-costing until around 2032.  We have gained because the debt with a net external cost of the ECB MRO rate is now available for longer.

Future generations were always going to have a “legacy of debt” of €25 billion.  What yesterday’s announcements have ensured is that they will have access to lower interest rates for longer and will be faced with rolling over the debt less often.  In the arena of public debt both of these are a win.

Here are some figures since 2008:

  • 2008: €10.9 billion
  • 2009: €15.4 billion
  • 2010: €11.8 billion
  • 2011: €10.2 billion
  • 2012*: €7.0 billion
  • 2013*: €3.4 billion

This figures will give a “legacy of debt” of €58.7 billion.  This is more than €30 billion greater than the total in question in yesterday’s restructuring.  What are these figures?  They are the underlying primary deficits (the deficit net of interest costs and banking measures) that the state ran from 2008 to 2011 and the projections of what the primary deficit will be for 2012 and 2013.

This is the excess of government expenditure on public sector pay, intermediate consumption, social transfers, capital formation and subsidies for the current generation over the tax revenue the government is raising from the current generation.  Over a six- year period the government is spending nearly €60 billion more on us in services and transfers than it is collecting from us in taxes and charges.  Why is no one concerned about this “legacy of debt” for future generations?

If we could borrow this money with a zero-interest perpetual bond there would be no need to worry about future generations.  They would have to pay nothing for our borrowings.  This highlights that for governments it is not the amount of debt that matters.  With governments debt doesn’t matter, deficit spending does.

The debt only matters insofar as it generates an interest cost.  If this money has to be borrowed at 4% it will cost future generations over €2 billion a year in interest for the privilege of us spending more on ourselves than we are willing to pay in taxes.  Is this a legacy we are willing to impose on future generations?


  1. Excellent piece Seamus.

    One point I'd like to raise, in the first paragraph when you say "First up, governments don’t repay debt, they roll it over". I disagree.

    Goverments DO repay debt; they don't reduce it(which you point out). A sublte different but significant none the less. I think it is misleading to state "governments don’t repay debt".

  2. Hi Séamus

    A well put together piece.

    However, I think we have all been fooled by the long-term maturity dates of the bonds.

    According to Philip Lane who was at the Press Conference, the Central Bank is expected to hold the bonds for a weighted average of 15 years.

    So when the Central Bank sells the bonds, what will it do with the proceeds? Presumably it will repay the ECB.

    So we will be effectively repaying the cheap financing in 15 years with whatever the market rate of interest is then. The Central Bank will sell these 3.5% floating bonds in the market and the price will reflect the price of Irish government bonds at the time. So, in effect, they will be refinanced at the market rate.

    Brendan Burgess

    1. Hi Brendan,

      The maturity/roll-over benefits are because the bonds used range from 2038 to 2053 (with larger amounts in the later years).

      The interest rate benefits last as long as the CB holds the new bonds and that is until 2032.

  3. Surely, as per the terms of the fiscal compact, it is not the case that we can just pile-on debt?

    Unless the economy starts growing we're going to have to start paying some debt off in order to reduce our debt/GDP ratio.

    In the past, maybe governments did just inflate their way out of debts, but with the ECB running the show that no longer seems likely.

    1. Just to clarify, by ECB running the show I mean targeting inflation at 2%.

    2. Hi delacaravanio,

      There is no "new" debt from yesterday's changes. It is a restructuring of existing debt.

      The Fiscal Compact does not require any country to repay debt. If the debt ratio isn't falling in line with the debt brake rule (which is actually a relatively benign constraint) the provisions of the Treaty mean that the country will enter the Excessive Deficit Procedure meaning that the attempts to reduce the debt ratio will be directed on
      - a smaller government deficit
      - policy changes to improve growth
      The EDP will not require cash repayments of debt.

    3. Thanks for clearing that up, Seamus. Here's to 40 years of high inflation :)

      PS: love the blog.

  4. There is something about this particular bit of debt that gets people's backs up. And the 'making this into sovereign debt' myth only adds to it. We do intergenerational rip offs all the time in this country, as pointed out, there is €58bn of it already!

  5. Seamus,

    Great posts.

    "The maturity/roll-over benefits are because the bonds used range from 2038 to 2053 (with larger amounts in the later years)."

    Couldn't the original PN repayment schedule also have been funded with bonds that matured between 2038 and 2053, so that that element of the equation is a wash?

    1. Hi Bryan,

      Yes, it could have been proposed to fund the original PN payments with long-term bonds (and maybe it was at some stage) but that wouldn't have washed. Last year's payment was met with a bond but the actual cash had to come from BOI (after a bridging loan from NAMA).

      Paying the CB with bonds definitely would be monetary financing.

      What we have is a shuffle that smells a lot like monetary financing but has been passed as acceptable. The Euro System of Central Banks (the constituent parts of the ECB) hold over €200 billion of government bonds as a result of the now-defunct Securities Market Programme. This weeks shuffle sees the portfolio of the CBoI increase with €25 billion of Irish bonds. There is lots of moving parts but somehow the CBoI has ended up with €25 billion of bonds issued by the Exchequer. The link to the funding needs of Anglo has been broken but the money still needs to be repaid. This will happen when the CBoI begins the process of selling the bonds, and the Exchequer will eventually pay out on them when they mature.

      Somehow, this has been approved and essentially all the Promissory Notes/ELA have been repaid with the long-term government bonds. There are lots of moving parts but if this isn't monetary financing, what is? This means there will no longer be fortnightly approval needed for the ELA. In fact the only oversight the ECB has now is an annual review of the CBoI's Investment Portfolio where the ECB can recommend changes to the asset disposal schedule.

      I don't think the Promissory Note payments could have been made with 2038 to 2053 government bonds. The only way they could have been used was to totally restructure the arrangement as had been accomplished. The funding benefits of the new arrangement would not have been possible under the old structure.

    2. Although of course it is purely academic at this point, I still don't see why very long-term bonds could not have been used with the original scheme. I think the schedule for the reduction of the CBI funding and the type of collateral used to support that funding at any point in time are separate - i.e. you can change each aspect independently. If a 2025 bond last year was OK, then I think a 2038 bond would also have been OK. If not-OK it would seem to imply the existence of a threshold year between 2025 and 2038 that marked an upper bound for acceptable maturities, which seems a bit arbitrary.

      On the "monetary financing" issue, I think Noonan's statements in his Pat Kenny interview are instructive. The original PN scheme was "totally illegal", and the new scheme is more legal/less illegal. So it's still a sin, but less of a sin than before.