Friday, May 6, 2011

Public Debt Sums: Past and Future

At the end of 2007 Ireland’s General Government Debt (GGD) was €47 billion, which in itself is a huge amount of money but when compared to the size economy it was relatively small.  By the end of this year, the GGD will be a staggering €159 billion and will be over 100% of GDP. 

It is these numbers that have brought the concepts of ‘default’ and ‘restructuring’ to the fore.  The view here is that default is not inevitable.  Here we work through the €112 billion increase over the past four years and what is likely to happen to the debt over the next four.  Where will we be in 2015 and can we survive? The answers are a debt ratio of around 108% of GDP and probably yes.

Read on to find out why.

The first thing to consider is the reason for the €112 billion increase in the GGD over just four years.  The GGD is an internationally used measure of the gross indebtedness of a country which “consists of the National Debt, excluding any deduction for Exchequer cash balances, plus Local Government debt and certain other liabilities of Government”. 

At the end of 2007, cash balances in the Exchequer and other accounts were just over €4 billion.  During 2008 and 2009 the National Treasury Management Agency had the foresight to borrow funds on international markets to build up these cash balances and by the end of 2010 these stood at almost €16 billion.  This cash buffer accounts for about €12 billion of the increase in the GGD.

Over the four year from 2008 to 2011, financing the services provided by central government has required €56 billion of borrowing.  This money has been used to fill the huge gap that has emerged between government revenue and government expenditure to ensure that the government can continue to meet its pay, pensions and social welfare outgoings. 

There have also been some minor borrowings by local government and a funding shortfall of PRSI contributions into the Social Insurance Fund has meant that money has to be borrowed to ensure the payment obligations of the fund are met.  These have required about €4 billion of borrowings since 2008.

There is then the money that has been used for the bailout of our banking system.  The Exchequer has contributed around €9 billion directly to the banks.  This is evenly split between borrowed money paid into the National Pension Reserve Fund since 2007 that was subsequently used as part of the €11 billion recapitalisations of AIB and Bank of Ireland, and direct contributions from the Exchequer to Anglo, Irish Nationwide and EBS.

This puts the total amount borrowed since 2008 at €81 billion.  To get to the full €112 billion change in the GGD we must look to “certain other liabilities of Government”.  Specifically this is the €31 billion of promissory notes given to Anglo, INBS and EBS in 2010.  These are a promise by the State to pay this money to the banks, but the payment will be spread out over an extended period.  The first instalment of €3.1 billion was made in March of this year and these will continue into the next decade until the full amount, plus interest, is transferred. 

The promissory notes form part of the GGD as they are a liability of the State.  However, it is important to realise that when calculating the interest cost of servicing the debt that the full effect of the promissory notes will not be felt until they have actually been paid out on.  We will also end up paying more than €31 billion as the banks will get interest on the amount outstanding. 

The Department of Finance estimate that the full cost will be around €43 billion.  It will be 2025 until all of this money has actually been borrowed.  This will increase further as interest is paid on the money borrowed to meet the Promissory Notes but the effect of this will be felt incrementally.

The €112 billion increase in the GGD since 2007 can be broken down as follows: 10% to build up cash balances; 54% to fund government services and 36% for the bank bailout.  Although it attracts the most attention the banking disaster has actually contributed just over one-third of the increase in the GGD over the past four years.

The next issue is where the debt level of going to go over the next few years.  The recent stress test announcements have revealed that four of the covered banks need a further €24 billion of capitalisation.  The Department of Finance estimate that the proposed haircuts on junior bondholders in the banks and the sale of Irish Life will provide €4 billion of this sum (page 20).

That leaves a €20 billion hole which will be filled by the State.  On top of the €46 billion already committed to the banks this will push the cost of the banking disaster up the €66 billion.

However, it is clear that the €20 billion will be come from increased debt.  Around €10 billion will come from the further decimation of the savings built up in the NPRF over the past decade.  The remaining €10 billion will come from the continued erosion of the cash balances mentioned above with the final €3 billion borrowed.

Although the total upfront cost of the banking bailout will be around €66 billion, the debt burden associated with by 2015 will be around €33 billion.  Most of this has already been borrowed.  The other legacy of the banking collapse will be the almost complete destruction of the €24 billion sovereign wealth fund we had built up in the NPRF.  Once the Promissory Notes are paid out the debt will rise to over €60 billion.  Interest payments will increase this still further.

There are other issues related to the banking collapse that are not included.  These are the final outcome of the NAMA process, whether the shutdown of Anglo and INBS will require further injections of capital, and how to unwind the €140 billion of liquidity the banks have taken from the European and Irish Central Banks.  There is also the long-term hope that we will be able to sell off our stakes in the two ‘pillar’ banks to recoup some of the money swallowed by the bailout.  There is a great deal of uncertainty about all of these.

There is no uncertainty about the ongoing need to fund the annual deficit.  Some steps have been taken to try and control the deficit but it remains at huge levels.  Between 2012 and 2015 the IMF forecast that a further €48 billion will be required to finance the deficit across all areas of government.  However, €12 billion of this is due to the payment on the promissory notes which have already been incorporated into the General Government Debt, thus the forecast GGD increase is around €39 billion.  This is in line with projections of the Department of Finance (page 50).

This means that by the end of 2015 the General Government Debt will be in the region of €205 billion.  As €15 billion of the promissory notes will have been paid out, the total amount actually borrowed will be €190 billion.  These are huge sums of money and puts the country right of the border of sustainability.

By going through this debt numbers, we see that we brought €47 billion of debt with us into this crisis in 2007.  Bailing out the banks will have generated about €33 billion of debt by 2015, with that increasing to over €60 billion once all the promissory notes have been redeemed.   The Exchequer deficits between 2008 and 2015 will generate more than €100 billion of borrowings. 

Although the GGD will be around €205 billion by 2015, just a quarter of it will be due to the banks.  We are swimming in debt of our own making.  In 2015, it is forecast that the annual deficit will still be around €5 billion a year.  It is not the banks that will push us over the edge, it is the annual deficit generated by the provision of the services of government that we benefit from. 

Tax revenue must be increased to pay for these services or expenditure must be decreased through a reduction in these services.  There is no other way to close the deficit, and thus far there is little evidence of either.  Gross current expenditure through all government departments and offices was €53.4 billion in 2008.  For 2011, the forecast is that this expenditure will be €52.8 billion, a reduction of just €0.6 billion or 1%.

We may have had €20 billion of “adjustments” over the past three years but current expenditure has hardly fallen.  Unless the adjustments actually change the amount of tax revenue raised or reduce the level of expenditure incurred, the deficit will not be closed.  Public sector pay, pensions and social welfare transfers make up 75% of current expenditure.  If the deficit is to be closed with expenditure measures these will have to be reduced. If they are to be maintained tax revenue must be increased.

Starting with the €154 billion GDP outturn for 2010, and assuming moderate nominal GDP growth rates of 1.0%, 2.0%, 3.0%, 3.0% and 3.0%  between now and 2015, means that the debt ratio in 2015 will be around 120% of GDP using the General Government Debt measure.  By just looking at the money that would actually have been borrowed by then the debt-to-GDP ratio will be around 108%.   Higher nominal GDP growth would reduce that but there is little sign of that at present.

If the country had avoided assuming the debts of the banking sector the GGD ratio in 2015 would still be around 95% of GDP, which is better than 120% but would not eliminate the fear of default because of the annual deficits. 

Of course, without the bank bailout we would still have an intact €24 billion sovereign wealth fund and have maintained €7 billion of our cash reserves.  This is money that could be used to help revive the domestic economy but it has been poured into the black hole of the banks.

Servicing the €205 billion debt mountain we have created will cost about €10 billion a year and this will consume close to one-fifth of government revenue.  The actual servicing cost will depend on the average interest rate.  This is a huge burden for the country to carry and one that will require further adjustments just to keep expenditure constant.  It will be just possible to manage this but it may be decided that this is a burden that the country should not carry.

There are benefits to taking such course of action, but it is unclear if these will exceed the costs of doing.  There is no simple arithmetic that can provide the solution to this problem.  Measuring the costs and benefits of default, like most of economics, is not an exact science.

As time progresses and the costs of carrying this debt are imposed on Irish society, the decision will become a political one as much as an economic one.  However, at this stage, default remains an option rather than an inevitability. 

A negative outcome on any of the unknowns listed above will move this more towards the latter, but just because there is a lot of noise suggesting default is inevitable is not enough to mean it will happen.  If the necessary steps are taken we can carry a debt-to-GDP ratio of 108% from 2015. In time the debt ratio can be reduced.  It will be painful but it can be done.

If the option to default is to be taken those to suffer will be holders of Irish government bonds.  It is more than a little incongruous that those who invested in our delinquent banks are getting their money back while those who invested in our country may be forced to carry losses.  As with a lot of things in this crisis, this just does not add up.

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