New emphasis on the primary balance

The repeated calls of what should be done with the Promissory Note “savings” is likely why we have seem the Minister for Finance try to put some emphasis on the primary budget balance in recent weeks.  The primary balance excludes interest costs so is the difference between government revenue and government expenditure on goods and services. The primary balance was unaffected by the Promissory Note restructuring discussed in the previous post.

At the time of Budget 2013 in December 2012, the projected primary balance for 2014 was for a surplus of €0.6 billion. April’s Stability Programme Update had an overall balance that showed a €1.2 billion improvement from the budget day figures (mainly because of the Promissory Notes restructuring) but the projection of the primary balance for 2014 was little changed with a primary surplus of €0.8 billion expected.

The SPU states that the improvement was “mainly driven by better than expected taxes in 2012 which have a carryover effect into later years”.

The target of fiscal consolidation is the primary balance. There are no budget measures that directly effect interest expenditure. The effect will be indirect through the interest rate charged by lenders and the size of the debt. This article written for Independent.ie back in April discusses the relationship between the primary deficit and austerity.

Excluding once-off measures such as the bank recapitalisation payments, the recent primary balances and near-term projections are:

• 2007: +€2 billion
• 2008: –€10 billion
• 2009: –€16 billion
• 2010: –€13 billion
• 2011: –€9 billion
• 2012: –€6 billion
• 2013*: –€3 billion
• 2014*: +€1 billion

The process of restoring a primary surplus after the collapse of the public finances in 2008 will have taken seven years and the accumulation of nearly €60 billion of primary deficits. Since peaking in 2009, the primary deficit has been steadily reduced. In most cases running primary deficits in response to an economic downturn is the appropriate policy but we ran up against the immutable element of all maximisation problems in economics – the constraint. In this case it is having someone lend the money to allow you run the deficits.

The reduction in the overall deficit has been slower because interest expenditure has risen from €2 billion in 2007 to €8 billion now – running €60 billion of primary deficits does not come cheap.  Based on figures from April’s Stability Programme Update, the 2014 deficit will be an €8 billion interest bill less a €1 billion primary surplus or €7 billion.

Although the deficit limits set out in the EDP are in terms of the overall general government balance it is the primary balance that matters in a debt sustainability analysis (i.e. the path of the debt/GDP ratio).

If a country runs a primary balance then the debt ratio will be constant if the average interest rate on its government debt is equal to the nominal growth rate of GDP.  This is because both the numerator and denominator in the ratio debt/GDP are growing at the same rate. For a country that wishes to reduce the debt ratio (as Ireland does) then one avenue for this is if the nominal growth rate exceeds the average interest rate.

The average interest rate on Ireland’s government debt is around 4.25%. As discussed in an earlier post on deficit targets this is greater than the current nominal growth rate and debt sustainability is further exacerbated by running a primary deficit. Unsurprisingly, Ireland’s debt ratio will rise this year, but most predictions are that 2013 will give the local peak of the debt ratio after which it will fall. Here is a chart from the IMF’s Tenth Review.

There are some stock/flow adjustments that mean the debt ratio is likely to fall next year almost regardless of economic conditions. This is mainly the €30 billion of pre-borrowing the NTMA has accumulated in advance of our expected exit from the EU/IMF programme this year. Of more importance, though, are the underlying debt dynamics: do the interest rate, nominal growth rate and primary balance satisfy the conditions of a declining debt ratio?

With a 4.25% average interest rate on government debt and current evidence suggesting that a 4.25% nominal growth rate for 2014 may not be achieved the underlying path for the debt ratio is up – unless a sufficiently large primary surplus can be run offset the difference between the interest rate and the growth rate.

While the interest rate on Ireland’s government debt is low by historic standards and a 4.25% nominal growth rate is below the long-run average, there is likely to be a gap between them and not one that favours debt sustainability. If the gap between them was 0.75 percentage points (4.25% interest rate versus 3.50% nominal growth rate) then given current Irish public debt levels at just north of 120% of GDP it would take a primary surplus of around 1% of GDP to stabilise the debt ratio.

With the €3.1 billion of adjustment in Budget 2014 the April SPU projected a 2014 primary surplus of 0.5% of GDP. This is not sufficient to stabilise the debt ratio in 2014 under the assumptions used here. Of course, it is almost guaranteed that the gross debt ratio will fall in 2014 as some of the cash resources built up will be used to finance the deficit as opposed to new borrowings.

It is the underlying debt dynamics that matter and these have yet to move in the right direction. Given the low interest rates, the size of the primary surplus necessary to stabilise the debt ratio is not large. With a further budgetary adjustment of €2 billion planned for 2015 the SPU projects a primary surplus of 2.7% of GDP in 2015.

That is well in excess of the level required to stabilise the debt ratio and, even with lower than projected nominal growth, by 2015 it is likely that the underlying debt dynamics will be for a declining debt ratio. This assumes that the improvement in the primary balance seen over the past few years is maintained.

The importance of primary surpluses for a high-debt country was emphasised in Moody’s statement last Friday on its revised outlook for Ireland:

Why did they improve their outlook on Ireland?

The rating agency expects the government to re-establish debt-stabilising primary surpluses in 2014 and for those surpluses to expand subsequently, resulting in declines in the government's headline debt-to-GDP ratios as well as improving the affordability of its debt.

How might their outlook further improve?

Upward pressure would develop on Ireland's government ratings and/or rating outlook if the government continued to comply with its fiscal consolidation targets, and growth were to resume at a pace that, together with consistent primary government budget surpluses, would be sufficient to firmly position the government debt metrics on a downward path and ensure debt sustainability over the medium to long term.

Conversely, downward pressure would develop on Ireland's government rating and/or rating outlook if the country's fiscal consolidation process were to falter to the extent that Moody's projected that government net debt metrics will increase significantly above their current level of roughly 100% of GDP.

It is all about the primary surplus.  Michael Noonan may be accused of “shifting the goal posts” by now talking about primary surpluses but the game is changing. Under the EU/IMF programme the targets were adopted from the Excess Deficit Procedure and were to reduce the underlying general government balance with little emphasis given to the debt levels that resulted.

Upon exit of the programme the objective will be to obtain funding from financial markets and one of the key parts of their approach is debt sustainability analysis. The change in emphasis to the primary surplus is merely a reflection of the changed position the country will be in but with little emphasis on the primary balance over the past few years it may be a necessary move that does not get much traction.  Especially when people are convinced they have €1 billion of savings to distribute!