Where stands the crisis of 2020? Some insights from a century of leading and lagging indicators

The Irish economy is no stranger to crisis.  Since the 1950s, the most severe of these have occurred in roughly 25-year intervals.  The current crisis has brought about the sharpest downturn, at least in employment terms, that the economy has ever experienced.  As the duration remains uncertain it is cannot be definitively classed as severe so it may be that comparisons to previous crises aren’t wholly appropriate but it may be instructive to look at what preceded and coincided with previous episodes.

Regardless of whether  COVID19 has ended the sequence of 25-year intervals between severe economic crises hopefully we have not returned to the rhythm of the early years of the State when no decade passed without a severe crisis, or more, of some form or another.

The chart below shows a time series for the real growth of the Irish economy since just after Independence. The series is smoothed by taking a three-year, centred average.

The shaded periods are when this three-year average growth rate was negative, and this will also be used in the charts that follow.  Five such negative growth episodes can be identified:

• 1930s: Great Depression and Economic War
• 1940s: The Emergency (WWII)
• 1950s: Balance of Payments Crises
• 1980s: Procyclical Fiscal Policy
• 2000s: Bursting of the Credit Bubble

The Gerlach and Stuart (2015) estimates are based on GDP and provide the most plausible annual estimates up to the late 1940s.  A series based on GNI* from Fitzgerald and Kenny (2017) is shown from then but it differs little from the Gerlach and Stuart series right through to the end of the 20th century. 

The Fitzgerald and Kenny series is chosen because it better fits with the constant price GNI* for 2013 on as published by the CSO.  A chart showing unsmoothed versions of both historical series, and illustrating the strong overlap between the two, is here.

The negative growth episodes of the nineteen thirties, forties, fifties, eighties and a decade ago could be joined by a similar outturn for the start of the twenty twenties.  Given that we have gone through periodic economic crises it may be instructive to look for some “then and now” comparisons for some key indicators.

The most severe of Ireland’s economic crises have typically being preceded by a deterioration in the current account of the balance of payments.  From Fitzgerald and Kenny (2017) we have annual estimates of the current account balance as a share of gross national income beginning in 1938 which here is combined with the modified current account of a share of GNI* from 1995 on.

As stated, a deterioration in the current account has been a leading indicator for major negative growth episodes, with the deteriorations in the late-1970s and mid-2000s in particular due to economic mismanagement and pro-cyclical fiscal policy.  The presence of a large balance of payments deficit before these crises hit severely restricted the policy options available to respond to the downturn with “restoring order” taking precedence of over supporting incomes and economic activity. 

But in a case of “this time it’s different” we can see that in the past few years there has been a balance of payments surplus that is unmatched since the years of The Emergency (World War II to the rest of the world).  Indeed the 6.3 per cent of GNI* figure for the 2019 current account surplus taken from the Stability Programme Update may be an underestimate.  This strongly suggests we do not have structural imbalances that need to be corrected first before responding to the crisis.

When the slowdown took hold in 2008 one of the first fiscal responses was to announce a package of spending cuts in July 2008.  This time around one of the response was to announce a multi-billion package of increased spending.  A year ago, we said that the economy had savings that could have been spent but suggested it maybe should be a sector other than the government sector that did so. 

We can look at how the sectoral balances contribute to that six per cent of national income surplus we have been running on the current account (with all adjustments to make the sectoral balances consistent with the modified current account applied to the non-financial corporate sector which is where the MNC distortions occur).

A chart showing the domestic sectors for recent years stripping out the impact of foreign-owned companies is here.  Previously, we thought it might be the household sector that could cut loose a bit, but needs must, and it is the government sector that is doing the spending.  Indeed, it could be that the household sector, which has been deleveraging for a decade actually increases its savings during the crisis which is something we will come back to. These savings can be used to fund the government’s spending.

Of course, flows are only part of the story. Stocks matter too.  From Fitzgerald and Kenny (2017) we also have a long-run series of government debt as a share of national income.  The path of the ratio of public debt to national income before each crisis has not been the same.

The debt ratio was already rising in advance of the crises of the 1950s and the 1980s.  The ratio was declining in advance of the 2008 crash but that still saw the largest run-up of public debt of any crisis (to date).  In recent years the debt ratio was on a declining path, however the level is still elevated and at around 100 per cent of national income is the highest it has been as the country potentially enters a severe crisis.

For private debt we can get a measure of personal, i.e. household, debt from Stuart (2017) and this shows that increasing household debt was really only a factor in advance of the crash of 2008.

And in the decade since, the Irish household sector has undertaken a remarkable level of deleveraging – reducing debt was what a large share of the household sector surplus shown with the breakdown of the current account was used for.  Household loan liabilities have fallen from €205 billion at their peak to around €130 billion now.  As the chart shows, the household debt to income ratio peaked at around 215 per cent in 2009; at the end of 2019 it was 115 per cent and is approaching ‘normal’ levels faster than anyone could have imagined.

As stated earlier, it could be that the household sector actually increases its savings in response to the crisis – this may show through an increase in deposits.  This would not be unusual.  The household savings rate is something that tends to react to a crisis rather than something that foretells it. 

Using Stuart (2017) we have estimates going back to 1945 and it can be seen that the savings ratio does increase at the start of each negative growth event meaning the reduction in household consumption is greater than the reduction in household income.  Remarkably, the Stability Programme Update estimates that the household savings rate will jump from 10 per cent in 2019 to close to 20 per cent this year, which would be the highest for the series by some distance.  In nominal terms this would be an increase of around €10 billion.

The savings rate only reflects the difference between income and consumption; one would need to add the impact of investment spending to get the final non-financial position of the household sector. Such a sectoral breakdown of investment is only available back to 1995 and is what is shown in the chart of sectoral composition of the current account.  The large borrowing position of the households sector in the decade before 2008 is clearly evident, as is the net lending the sector has done in the decade since.

Another response variable or lagging indicator can be the real growth in household disposable income.  Using Stuart (2015) we can see that this followed the same pattern as each of the last three major negative growth crises took hold: it too turned negative.

We do not yet know what will happen to aggregate household income in this crisis.  Yes, earnings will fall very significantly for a period but there will be an offsetting effect from government transfers.  As already pointed to, additional social welfare spending of almost €7 billion has been allowed for (thus far).  This is countercyclical policy and is maybe another reason why comparisons to previous crises are not be appropriate.  We still don’t have enough information but if there is a shaded area for the early-2020s added to future versions of these charts it could be the first time the real growth of household disposable income does not also turn negative (on a three-year average basis).

Fiscal policy was a contributory factor to the reduction in household income seen in the 1950s, 1980s and a decade ago.  Some automatic stabilisers would have played a role in mitigating income losses but steps taken to address imbalances, perceived or otherwise, which included tax increases and real expenditures cuts, meant that the impact of the downturns on incomes was exacerbated by fiscal contractions.  Fiscal policy was procyclical.

From Fitzgerald and Kenny we have a long-run series of the balance of the government sector right back to the earliest years of the State.  It can be seen that there was a wide range of levels and trends in the government balance prior to the previous three negative growth events.  There was a deficit that was reducing in the mid-1950s; the late-1970s saw a large government deficit that was increasing and during the mid-2000s budget surpluses were recorded. 

But what is as significant is what happened to the government balance not long after economic growth turned negative in the 1980s and 2000s: it improved.  And this was a forced improvement brought about through tax increases and real expenditure cuts which started almost as soon as those crises hit which is the opposite of what is required to support incomes and economic activity in a downturn.

The past few years have seen the headline government balance improve and move to a (small) surplus.  If the government had stuck to its own spending plans maybe the surplus would have been a bit bigger and fiscal policy was probably acyclical, at best.  But there is capacity now for policy to be countercyclical and in large part it is down to what is shown below.

At the end of 2019, government debt was equivalent to almost 100 per cent of national income.  In the 96 years since 1924, according to the estimates from Fitzgerald and Kenny there have been only been 13 years when the debt ratio was higher.  But if we look at the interest chart we see that the interest to national income ratio does not reflect this.  In fact, since 1924 there have only only be 35 years when the interest ratio was lower than the 2.2 per cent recorded in 2019. 

As some of this interest is paid to the central bank it is recycled back to the government.  And as long as the ECB keeps the taps opened the massive additional borrowing that will happen will not significantly increase the interest ratio – in the short term at least.

And to conclude, here another lagging indicator that illustrates why this crises will be different to previous ones: the escape valve of emigration is unlikely to be available to alleviate unemployment.

This is yet another series where the response to the 25-year crises is clearly evident.  In fact, it has been pointed out that the crisis of 2020 may be the first since that linked to The Great Depression in the early 1930s when net outward migration does not increase.  Emigration did increase in the mid-1930s but by then the international economy was pulling out of The Great Depression. 

Taking the unemployment series from Gerlach, Lydon and Stuart (2016) it is probably safe to predict that the record unemployment from 1935 of 18 per cent will be exceeded in 2020 (at least for part of it).

So where stands the crisis of 2020? The short-term shock is likely to be the most severe the economy has ever experienced.  But relative to what has gone before we have identified a number of key differences. 

The most significant of these is probably the large balance of payments surplus.  The government might not have a rainy-day fund but the household sector has been saving for a decade.  And as the government cuts back on its emergency measures there will be capacity, and hopefully the confidence necessary, for households to increase their spending. 

A second difference arises from the fact that this is a global crisis. If a country using a common currency experiences an asymmetric shock there is a risk of interest rates exacerbating the problem.  Ireland has a high level of government debt but the medium-term risk of adverse interest rate moves is low so we can expect the interest burden of public debt will remain low.

We enter the crisis from a position of structural strength.  And the response so far, at a macro level at least, can be considered to have been appropriate.  Duration remains the key unknown.  But if the phased re-opening of the economy is successful, and microeconomic policy can keep viable businesses alive, it may that this shock, sharp and all as it will be, does not break the 25-year cycle between severe, multi-year negative growth events of the Irish economy.  Here’s hoping.

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Debt Charts and Tax Arbitrage

Charts like the following appear fairly regularly.

The latest occurrence was on the website of The Wall Street Journal.  There is nothing wrong with the chart.  It is 100 percent accurate in what it represents.  The problem is in how it is subsequently used and interpreted, particularly in Irish media.  And as if to keep the record intact the chart appeared in the Sunday papers to declare us to be “the most delinquent of European debtors”.

The constituent components of the figures for Ireland in the chart above are:

SECTOR	DEBT, €bn	DEBT, %GDP
Households	€172bn	105%
Non-Financial Corporate	€330bn	202%
Government	€193bn	118%
TOTAL	€695bn	425%

Ireland has a massive debt problem but the real impact on “us” needs to be understood.   The figures for the Household and Government sectors are not in dispute.  The scale and problems associated with each are fairly well understood even if resolving them is still some way off.

What remains is the massive figure for business debt.  Do Irish businesses have €330 billion in debt?  Well, businesses in Ireland do, but not necessarily Irish businesses.  We have looked at this in more detail before and here is a chart worth reproducing:

At the zenith of the boom in 2007, non-financial corporate debt was around €200 billion.  The banking sector seized up around then but NFC debt surged to close to €350 billion.  As the previous post explored much of this was down to the treasury activities of MNCs with operations in Ireland.

What were the MNCs doing?  They were trying to get money out of Ireland.  MNCs have been able to create “double non-taxation” on their profits using hybrid loan instruments. 

In this arrangement a MNC subsidiary in Ireland will be financed by a parent elsewhere using an intra-company loan.  The Irish subsidiary will be charged “arms-length” interest for this loan.  Naturally, the interest paid will be allowed as a deduction in Ireland to taxable income as loan interest is a legitimate business expense.  The double non-taxation arises when the MNC originates the loan from a country that does not tax the interest income from the loan (in many cases the loan will be classified by the originator such that the income received is a dividend – this is the “hybrid” instrument).  The expense generates a deduction in Ireland and the income is a tax exempt dividend distribution in the destination country.

Back in November the EU announced efforts to clampdown on such double non-taxation arrangements.  Under the proposals the income will not be tax exempt in the destination country. [These proposals will not change Irish tax law as we do not have a dividend exemption that allows these hybrid-loan mismatches.]

Here is the outflow from Ireland of Direct Investment Income: Income from Debt in the Balance of Payments Annual Series:

The years don’t exactly match up but it can be seen that there has been a massive jump in the outflow of Income on Debt for Direct Investment Income.  The outgoing payments are now almost €5 billion a year.  Once again the tax arbitrage strategies of MNCs of skewing Irish macro data.

So how much debt do “Irish” non-financial corporates have? The turmoil in the banking system means that we really don’t know.  What we do know is the lending of banks in Ireland to businesses in Ireland peaked at €175 billion in early 2008.  Of this, around €115 billion was to property, construction, development and other real-estate activities with around €60 billion to companies outside the construction sector (though a lot of this was also property related).

Thus, €175 billion gives something approaching the extent of NFC debt of Irish companies.  There have been lots of changes since 2008.  Some banks have left the market, some banks have folded and lots of loans have been transferred to NAMA.  How much of the €115 billion property-related debt still exists six years later?  How much of it will actually be repaid? 

The non-payment of huge amounts of NFC debt has added significantly to the government debt.  A large part of the €40 billion loss made by the NAMA banks when their loans were transferred to NAMA was covered by the government.  We can expect that the NFC sector won’t be repaying that much of that.  At best we can hope that the €30 billion or so paid by NAMA will be recouped.

Losses by non-NAMA banks on development loans will be substantial as well, maybe up to €20 billion.  The €60 billion lent to non-property related sectors has decreased by around €20 billion in the past six years as lending by the banks has contracted.  Conservatively, we could knock €80 billion off the peak lending to NFCs to get the current figure.

Here is a stab at end-2013 debt figures for the three sectors (estimated GDP: €165 billion)

SECTOR	DEBT, €bn	DEBT, %GDP
Households	€170bn	103%
Non-Financial Corporate*	€100bn	61%
Government	€200bn	121%
TOTAL	€470bn	285%

* Figure reflects “Irish” NFC debt of €40 billion lending to non-property-related sectors and property loans net of loss on NAMA transfers (these losses have already been counted in the gross debt of the Government sector) and similar losses outside the NAMA banks .

It’s a massive mountain of debt but not as unique as the opening chart above would suggest.  A total debt of 285% of GDP would be mid-table in the chart.

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Redemption Profile

The NTMA are going to very busy organising bond sales for the coming decades.  Here is a chart from the latest IMF review showing the impact that a €200 billion debt will have on redemptions.

Using their assumptions it can be seen that redemptions are going to average over €25 billion a year (which assumes an average maturity of around 8 years which is relatively long.) 

It is not clear that the above chart includes the redemption of the new bonds created through the Promissory Note swap in February.  These bonds begin to mature from 2037 on though the chart does include their sale by the Central Bank of Ireland into the private market beginning next year.

The above chart will be changed by today’s formal agreement to extend the maturities of the EFSM/EFSF loans Ireland has drawn down from the EU/EZ.  The will have a positive impact in the medium term as loans for the coming decade are pushed out but, as shown above, the rollovers that will be required in the 2020s are going to be very substantial.

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Central bank holdings of Irish government bonds

In the discussion around the Promissory Note/Long-Term Government Bond swap it quickly became clear that the benefits of the new arrangement are dependent on how long the Central Bank of Ireland holds the €28 billion of bonds it has received. 

On Thursday, the ECB also confirmed the substantial bond holdings that it and the various National Central Banks (NCBs) in the Eurosystem of Central Banks (ESCB) accumulated as part of the now-defunct Securities Market Programme.  Here are the figures published by the ECB along with the nominal amount of a percentage of 2012 Gross Domestic Product (GDP) and 2012 General Government Gross Debt (GGD) using IMF estimates.

Here is the list of Irish government bonds from which the €14.2 billion held by the ESCB will be drawn. Click to enlarge.

As previously pointed out an agreement in the Eurogroup made in February 2012 will see the income profits the NCBs make on their Greek bonds recycled back to Greece.  In November 2012 this was confirmed as:

A commitment by Member States to pass on to Greece's segregated account, an amount equivalent to the income on the SMP portfolio accruing to their national central bank as from budget year 2013.

As can be seen in the second table the average annual interest coupon on Irish government bonds is close to five percent.  The NCBs will be paying for the facility to hold the bonds at the ECB’s main refinancing rate, which is currently 0.75%.  Even allowing for other costs, and a possible transfer to the reserves of the NCBs, it is clear that a significant profit will be made by the NCBs on the interest from these bonds.

When the Greek arrangement was re-affirmed in November 2012 it was estimated that it would reduce Greek government debt by 4.6 percentage points of GDP by 2020.

Relative to GDP the Irish holdings are about half as large as those of Greece though the average maturity is one year longer.  It is possible that if a similar arrangement was put in place for Ireland the amounts involved over the next few years could be from 1.5% to 2% of GDP – a very significant sum.

The €14 billion of bonds held by the ESCB are likely to generate close to €700 million of interest payments this year, though it is likely that a significant portion of bond due to mature on the 13th of April will be in the holding.  A profit on the interest for the NCBs of around €500 million (0.3% of Irish GDP) is possible this year, and this will decline as the bonds mature.

The balance sheet of the Central Bank of Ireland (.xls) does not indicate that it holds a significant portion of these bonds.  From the time the SMP was instituted in May 2010 “Securities of other euro area residents in euro” held by the CBoI increased from €16.5 billion to €20.7 billion by the time the SMP was shelved in March 2012.  Both transactions and revaluation effects will have contributed to the increase.  The asset item “General Government debt in euro” has never had a non-zero figure reported in the balance sheet.

I appeared before the Joint Oireachtas Committee on EU Affairs last Thursday and this issue was raised during the meeting (full transcript).  My comments in response to the query are below the fold. [Note: The ECB published the actual figures on the amount of bonds at the same time as the meeting began but it is clear that the estimated figures in the public domain were “in the ball park”.]

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What’s next on our agenda with the ECB?

Patrick Honohan’s recent appearance at the Oireachtas Finance Committee included the following exchange.

Deputy Kevin Humphreys:  “The ECB purchased significant amounts of distressed euro sovereign debt in the secondary bond market in 2010 and 2011 through the security market programme. I understand that approximately €200 billion worth of bonds are being held to maturity. It is estimated that between €15 billion and €20 billion of Irish bonds were bought, mostly at distressed prices well below par.

The Barclays Capital report of January 2012 stated that about €19 billion of Irish Government bonds were being held by the ECB. Is that the correct sum?

We heard a lot about how Franklin Templeton made huge returns by buying Irish bonds at low prices. It is difficult to estimate the profits the ECB will make on the capital proportion of these bonds bought through the SMP but it could be in the range of €3 billion to €5 billion. The problem is, and I asked about this in private session before and was given short shrift, we do not know what the ECB profits may be because the ECB will not tell us. The Governor sits on the board, however, so does he know and will he tell us?”

Patrick Honohan:  “I know how much Irish paper is held by the ECB in the security market programme. I could try to calculate the profits.”

Kevin Humphreys:  “Am I far off in my calculations?”

Patrick Honohan: “I would steer the Deputy away if I thought he was. I think that more information about the SMP holdings will be provided. The SMP has terminated as a programme and the reasons of market sensitivity that caused it not to be disclosed would fade away. At present, however, I am not at liberty to give out those numbers.”

Here is the set of Irish government bonds that was in issue around the time the Euro System of Central Banks (the constituent elements of the ECB) were making these purchases under the Securities Market Programme in the second half of  2011.

It is likely that the ECB purchases were focussed on the short end of the market.  The first two bonds on the list have been redeemed.  The next on the list is the bond maturing on the 18th of April coming.  A bond swap last July reduced the amount outstanding on this bond which now is just over €5 billion.  The ECB are likely to be significant holders of this bond and also of the remaining €8 billion of the January 2014 bond.

The November 2012 Eurogroup meeting included the following agreement:

A commitment by Member States to pass on to Greece's segregated account, an amount equivalent to the income on the SMP portfolio accruing to their national central bank as from budget year 2013.

Can we get this too?

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Interest costs under the “debt deal”

As explained in the previous post it is not the size of the government debt that has a direct impact on the public finances; it is the interest cost it generates (though the size is obviously a big factor in that) 

What was in play with yesterday’s restructuring was a €25 billion Promissory Note debt.  It was a €25 billion debt on Wednesday, it is a €25 billion debt today and it will be a €25 billion debt in 2053.  But because of inflation not all €25 billions are created equally.

Anyway, the debt in question generates two interest costs for the State:

1. The interest on the central bank funding which carries an interest rate equals to the ECB’s main refinancing rate.
2. The interest on the borrowings used to pay down the central bank liquidity.

Here are two tables that showing some hypothetical the interest costs of the old Promissory Note and new Long-Term Government Bond arrangements until 2033. 

These are only hypothetical scenarios designed to gauge the relative difference in the cost of each approach rather than a definitive estimate of the cost of each.  There are a number of simplifying assumptions made.

• The ECB interest rate is expected to rise from 0.75% to 3.00% over the next six years and stay at 3.00% thereafter.
• The ‘margin’ of Irish government borrowing over the ECB rate is assumed to be constant 3.25%.
• All interest is paid from current revenue.
• Borrowings are only made to fund capital payments.  This only impacts the Promissory Note arrangement and from each €3.1 billion annual payment the Central Bank profit is subtracted as it is returned to the Exchequer and also the external interest cost of the ELA as it is assumed that is paid from current revenue.  This keeps the borrowing at €25 billion in both cases so we can assess the interest cost.
• The discount rate used is 6%.

As we are looking for relative differences the assumptions are not hugely significant as both scenarios are played out under the same set of assumptions.

First the Promissory Notes:

And the new Long-Term Bond arrangement:

The interest mix of both changes.  In the first case it is because the Promissory Notes/ELA costing the ECB rate is paid off with new government borrowings at the “market rate”, while in the second case the Central Bank funding at the ECB rate is reduced through the Central Bank selling the bonds it holds thereby making the interest payable to a third party. By 2034 both arrangements are identical in this setting - a debt of €25 billion with an annual interest cost of €1.56 billion (assumed interest rate by then is 6.25%) - as all the Central Bank funding is repaid

So what do we find in? In nominal terms the interest costs are

• Promissory Notes: €27.0 billion
• Long-Term Bonds: €20.6 billion

Getting the present value of the interest payments gives:

• Promissory Notes: €14.3 billion
• Long-Term Bonds: €10.3 billion

The interest cost under the new arrangement is around 30% lower.  This is a gain to the State of the new change which arises from having access to borrowings at the lower ECB rate for longer.  It increases from c.7 years to c.15 years.

The are other gains from the new arrangement.  The above just reflects the interest cost of each arrangement.  The accounting treatment of the Promissory Notes meant they had a very large impact on the deficits over the coming years.  That has now been reduced.  Also the new arrangement means that the debt doesn’t have to be rolled-over until the first of the new bonds matures in 2038 significantly reducing the medium term funding needs of the State. 

The is little doubt that the new arrangement is anything other than a gain for the State.  And unless your expectations were incredibly unrealistic (or more accurately based on fantasy), yesterday’s announcements were pretty much as good as could have been hoped for given the institutional constraints faced.

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“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?

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Deficit-, debt- and expenditure-impacting banking measures

A recent post over on Notesonthefront has attracted a lot of attention on “the cost of the banking crisis”.  The figures from Eurostat show that Ireland contributed 42% of the EU total and have been widely quoted including this prominent piece in The Irish Examiner

42% of Europe’s banking crisis paid by Ireland

Ireland has paid 42% of the total cost of the European banking crisis, at a cost of close to €9,000 per person, according to Eurostat.

This is not the correct interpretation of the Eurostat figures.  The Eurostat figures used to support the claim give one impact of the banking crisis on public finances, that is:

1. The impact on the flow of annual government deficits

It is not the case that this reflects the full cost of the banking crisis.  As will be discussed below not all of the measures introduced in response to the banking crisis are deficit impacting.  An additional impact that could be considered is:

2. The impact on the stock of the gross government debt

There is no reason to expect #1 to be the same as #2.  There may be transactions with the banking sector that are counted as deficit increasing but if they are funded from existing resources they will not add to the stock of debt. 

It will also be the case that there may be transactions which are not counted as deficit increasing but if funded with borrowed money they will add to the stock of debt.

Eurostat have produced figures on #1 as they can measure the revenue and expenditure flows on an annual basis.  However, they will not produce statistics on #2 for the simple reason that money is fungible.  Governments borrow money because their overall expenditure exceeds their revenue.  It is difficult to attribute changes in debt to a single expenditure item because reductions in any expenditure would reduce the need to borrow.  That doesn’t mean it isn’t attempted though!

The Eurostat figures show that between 2008 and 2011, measures related to the banking crisis contributed €41 billion to Ireland’s general government deficits.  By the end of 2011, the government had contributed around €63 billion to the banking sector and, of this we can guess that around €47 billion was with “borrowed” money (essentially it is non-NPRF money, but the assumption is that this expenditure increased borrowings).

The above paragraph shows a third, a more complete, measure of the impact of the banking crisis on the public finances:

3. Total expenditure incurred by general government as a result of the banking crisis.

Again Eurostat are not going to produce statistics on this as much of the expenditure will be by public investment funds (such as the NPRF) or by special purpose vehicles (such as NAMA).  A lot of these are “off-balance sheet” transactions.

So for Ireland, at the end of 2011, the figures were:

1. €41 billion
2. c. €47 billion
3. €63 billion

The first figure has received lots of attention but it is actually the smallest.  The second figure is a bit of a guess and although the largest the final figure could yet be under-stated. 

Number 3 will be clouded by the use of special purpose vehicles which initially keep the expenditure outside the government sector.  NAMA has spent €32 billion acquiring loans with a nominal value of €74 billion from our delinquent banks.  NAMA is not going to lose €32 billion but a shortfall of, say, €5 billion is possible on its operations which will have to be made good with expenditure by the government.

In Ireland in 2011 #1 makes up about two-thirds of #3.  In other countries the gap between #1 and #3 is likely to be even greater.  In part, this is down to the type of bailout adopted in Ireland, rather than the total cost.

For example, we know that the UK has contributed £66 billion to just two banks: Lloyds and RBS.  That is around €80 billion which would count in #3 (full expenditure) but the figure for the UK in the Eurostat deficit data is just €11 billion.  Where did the other €69 billion go?

To answer this question we must explore what Eurostat measured when they provided figures for the deficit-impacting measures introduced in response to the banking crisis.  This all comes back to a Eurostat decision published in July 2009.

The key is whether a measures is considered as a “financial transaction” or a “capital transfer”.  Financial transactions are not deficit impacting; capital transfers are deficit impacting.  The impact of both in the debt is not objective, while their impact on expenditure is unambiguous.  So what is a “financial transaction”?  Per the Eurostat decision:

The valuation of financial transactions: In principle the ESA 95 provides for financial transactions (which do not impact on the government deficit) to be recorded "at the transaction values, that is, the values in national currency at which the financial assets and/or liabilities involved are created, liquidated, exchanged or assumed between institutional units, or between them and the rest of the world, on the basis of commercial considerations only" (paragraph 5.134).

However it is acknowledged in paragraph 5.136 that "in cases where the counterpart transaction of a financial transaction is, for example, a transfer and therefore the financial transaction is undertaken other than for purely commercial considerations, the transaction value is identified with the current market value of the financial assets and/or liabilities involved".

It does, of course, leave something of a grey area but we can see that if a financial transaction is done at the “current market value” it does not impact on the government deficit, whereas if it happens above the “current market value” the transaction value is identified and the amount above that is considered a capital “transfer”. 

The Eurostat decision goes through different forms of banking support and shows whether they impact on the deficit or not.

1. Recapitalisation operations
2. Lending
3. Guarantees
4. Purchase of assets and defeasance
5. Exchange of assets
6. Classification of certain new bodies
7. Recording of certain transactions carried out by public corporations

Eurostat did not need to provide a separate decision for the general government gross debt measure it produces.  The debt is just the sum of all of the liabilities of the general government sector.  It does not matter what the money is used for.  All that matters is whether a liability exists or not.

For example, when the Promissory Notes were created in 2010 they were classed as a “loan to government” from Anglo/INBS and would immediately be added to the general government gross debt.  There was some issue of whether they would count in the 2010 deficit but the counter transaction to the loan was recorded as a “notional capital transfer” as the government promised to repay a €31 billion loan without first receiving the money from the bank as is the case with a typical loan.

Here is the full set of recapitalisation payments made to the banks since 2009, classified as “financial transactions” or “capital transfers”.

The payments under financial transactions were not deficit-increasing, whereas those recorded as capital transfers were deficit increasing.  It remains to be seen what value can be realised through the sale of the assets acquired through the financial transactions. 

There have been some sales already.  In 2011, €1.1 billion was realised from the sale of a 35% ordinary shareholding in BOI, while in January 2012 the €1 billion contingent capital note in BOI was sold at close to par.  There was also a transaction in 2010 that saw €1.7 billion of the preference shares in BOI converted into ordinary shares.

It can be seen that 75% of the capital transfers total arises from the Promissory Notes issued in 2010.  No other country has used such a scheme to prop up a bust bank and the loan loss figures mean that any mechanism devised would have been recorded as a capital transfer.

The transactions are split between those undertaken by the NPRF (directed by the Minister for Finance) and those undertaken by the Exchequer (directly by the Minister for Finance).

All of the financial transactions involving preference and ordinary shares in AIB and BOI were done through the NPRF.  It should be noted that the €3.5 billion of preference shares in both AIB and BOI bought in 2009 by NPRF was funded with €4 billion from the NPRF and a “front-contribution” of €3 billion from the Exchequer to the NPRF.  All the contingent capital notes transactions as well as the ordinary shares in PTSB and Irish Life were funded, and now held, by the Exchequer.

Most of the capital transfers were provided by the Exchequer but the €6 billion capital transfer provided to AIB in July 2011 was split with €2.3 billion coming from the Exchequer and €3.7 billion coming from the NPRF.  This €3.7 billion from the NPRF was a deficit-increasing expenditure (though didn’t impact on the debt as it came from pre-existing funds).

So has Ireland carried 42% of the total EU cost of the banking crisis?  Impossible to say.  We do know that Ireland has incurred 42% of the deficit-impacting measures introduced in response to the crisis.  But that is not the same thing as the total cost. 

In Ireland’s case, the Promissory Notes have pushed up the capital transfers to an extraordinarily high figure relative to other EU countries.  In fact the explanatory notes to the data say (on page 12) that:

The only case where government liabilities increased much more than government assets is Ireland. This can be explained by the fact that most interventions have been immediately recorded as deficit-increasing government expenditure and not as financial transactions.

Most EU countries have generally recapitalised their banks using financial transactions (purchase of shares and other instruments).   Ireland didn’t have any money to buy anything in Anglo and, as stated above, Anglo was nursing such loan losses that all efforts to keep it solvent were going to be recorded as capital transfers anyway.

Throughout the EU it remains to be seen what the assets acquired through these the financial transaction approach to recapitalising their banks will actually be worth.  If losses relative to the purchase price are crystallised on the sale of these assets then the difference will be recorded as a capital transfer and Ireland may not be such an outlier.

How much of the £66 billion pounds provided to Lloyds and RBS will be returned to the UK Exchequer? Will they get back much of the £14 billion (€17 billion) capital contributions that Lloyds through Bank of Scotland(Ireland) and RBS through Ulster Bank have made to their loss-making Irish subsidiaries?  In total, the UK has made a cash outlay of around €145 billion to rescue its banks.  See question on “current level of support” in this set of FAQs.

For the moment though, Ireland is extreme when it comes to the deficit-increasing impact of the banking crisis.  It makes a good headline and the extent and cost of the disaster in Ireland will always be high relative to other EU countries.  But it should not be thought that other countries have escaped lightly from the banking crisis.  They have simply gone about it in a different manner and haven’t used Promissory Notes.  The true cost of this period will only emerge over the next decade or longer when their investments and special purpose vehicles are unwound.

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Where was the Xmas “surge” in Retail Sales?

The CSO have released the December 2012 Retail Sales Index.  There is something missing from the data – the much heralded “surge” in retail sales that apparently took place around the Christmas period.  Here is the core retail sales index which excludes the Motor Trades.

There was an increase in December but only marginally.  The trend in retail sales is up but this data do not reflect what was feted as “the best Christmas for retailers since 2007”.  Here it might be a little instructive to use the unadjusted series that just looks at the amount of retail sales without taking seasonal factors into account.  This chart has the unadjusted series for core retail sales (with December 2008 equal to 100).

Unsurprisingly there is a spike in retail sales each December.  At 94.2, this year’s December peak was higher than each of the last two years (92.5 in 2010 and 93.3 in 2011 using the base in the chart) but was below both 2008 (100) and 2009 (94.7).

Maybe we are not looking in the right place.  It would be great if the CSO provided a resource that allowed us to create selected sub-indices from the categories provided.  The retail sales shown in the above charts include fuel, furniture, hardware, medicines and other categories which were likely excluded when Retail Excellence Ireland were making their seasonal claims.  These items only make up about one-fifth of the indices shown above so their effect is unlikely to be significant.

Although limited we can use one of the indices to check for the retail surge.  Non-food sales in Department Stores are only about 1/12th of the above indices but might be expected to reflect the broader pattern in Christmas shopping.  Here are the unadjusted series.

That seems more like it.  The volume of non-food sales in Department Stores in December 2012 was indeed the highest since 2007.  In fact, volume was nearly 20% higher than 2008.  However, the value index was identical.  See here.  The adjusted series also shows a jump last month.

And this also shows that the trend in sales in Department Stores has been positive since about April of last year.  However, apart from Department Stores it is hard to find evidence of the Christmas surge.  Sales in bars did jump 5% in December but the underlying trend in this sector is unmistakeable.

The retails sales of electrical goods (computers and peripherals, televisions, radios and DVD players, games consoles and software and telecommunications equipment) has been positive in recent months (in volume terms at least). 

The recent jump was due to the digital switchover in October rather than any pre-Xmas exuberance.  Even still, the volume in this category in December was up 4% on last year, though the value of sales was down by around 1%.

It looks like the warning at the end of this post that “the plural of anecdote is not data” is borne out by the above data.

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Debt and Deficits Decomposed

A new dataset from Eurostat has received a lot of attention recently as it highlights the deficit costs of the bailout of our banking system that began with the blanket guarantee of September 2008.  On the other side of the same coin the data allows us to determine the non-banking crisis element of our recent deficits.

The following table shows the €105 billion of general government deficits that were accumulated between 2008 and 2011.  According to the Eurostat data €41 billion of these was due to measures introduced to deal with the banking collapse.  The final section of the table gives the ‘underlying’ deficit which is simply calculated as the difference between the total and banking-related figures in the sections above it.

Between 2008 and 2011 the ‘underlying’ deficits totalled €64 billion and this is a running total as the deficits continue to accumulate. 

At the end of 2007, the gross general government debt was just over €47 billion.  2007 was the last year when the general government accounts were close to balance and a small surplus of €143 million was recorded.

Since the end of 2007, the debt has ballooned and by the end of 2012 it is estimated to be around €190 billion.  The increase can be broken down as follows:

The figure for the 2012 general government deficit will be finalised later in the year and is likely to come around €13 billion.  With guarantee fees, interest on contingent capital notes, dividends on preference shares it is also likely that the revenues from the banking measures will exceed the expenditures. 

The surplus income paid to the Exchequer from the Central Bank has increased significantly in recent years (2008: €290 million; 2012: €958 million).  The increase is mainly as a result of profits made by the Central Bank on the Exceptional Liquidity Assistance it is provided to Anglo/INBS.  This is not included in the ‘banking’ revenues measured by Eurostat.

The stock/flow adjustment is mainly the increase in cash balances held by the NTMA from €4.4 billion at the end of 2007 to €24.0 billion at the end of 2012.

Just over one-fifth of the 2012 debt is due to the banks though the full cost of the bank bailout is larger when non-deficit increasing expenditures are included.  This includes the value of the some of the funds depleted from the National Pension Reserve Fund to buy ordinary and preference shares in AIB and BOI. It also includes the expenditure by the Exchequer on shares in PTSB and Irish Life and the contingent capital notes remaining in AIB and PTSB.  

Nearly two-thirds of the debt has been accumulated because of deficit spending by the government sector.

The 2007 debt accounts for 25% of the current total and that was the legacy of the last incident of national insolvency in the 1980s. The debt that resulted from the accumulated deficits of the time were simply rolled over and never repaid.  Growth and inflation meant the debt burden fell from 120% of GDP in the late 80s to 25% of GDP by 2007. 

The ongoing deficits since 2008 have contributed around 40% of the current debt mountain but the nature of them is changing as we move closer to a primary budget balance.

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€14 billion in Bank Assets

Today’s sale of a €1 billion contingent convertible capital note (a form of subordinated bond) in Bank of Ireland brings the assets the State holds in the banks into focus.

There is another €1.6 billion of these bonds held from AIB and €0.4 billion from PTSB.  The NPRF holds the State’s preference and ordinary shares in AIB and BOI.  These are currently valued at €8.6 billion.  The Minister for Finance holds the State’s 99.75% holding in PTSB but no value is put on this.  The same goes for Irish Life which it is hoped can be sold for €1.3 billion.

All told, the State probably has about €14 billion of remaining assets in the ‘viable’ banks.

• €2 billion contingent convertible notes in AIB and PTSB
• €8.6 billion of preference and ordinary shares in AIB and BOI
• €1.3 billion through ownership of Irish Life
• 99.75% shareholding in PTSB

These valuations for AIB and PTSB are questionable as BOI is the only bank the State has been able to sell anything from.  Still it is better to be seeing the banks as vehicles for reducing our government debt levels rather than sinkholes to increase it, not that that problem has completely gone away.

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Government Sector Financial Balance Sheet

The Central Bank have released their Quarterly Financial Accounts for Q1 2012 (release here; data here). This is the financial position of the government sector.

The currency assets of the government are the large cash reserves that have been maintained including more than €13 billion that was in the Exchequer Account.  The currency liabilities are mainly the state-savings schemes and deposits with An Post.

The assets under securities other than shares are mainly bonds held by the government sector.  The NTMA has some bonds in the discretionary portfolio of the NPRF and the state also holds €3 billion of subordinated bonds in the covered banks which forms part of their contingent capital.  The liabilities under this heading is almost entirely made up of the outstanding government bonds.

The €9 billion of loans held as assets will include loans forwarded by state agencies such as the Housing Finance Association.  The €80 billion of loan liabilities is primarily made up of €28.1 billion of promissory notes owed to the IBRC and €42.9 billion of loans drawn down as part of the EU/IMF programme.

The quoted shares will be the state’s shareholding in Bank of Ireland (15%), Allied Irish Bank (99.8%) and Irish Life & Permanent (99.4%) as well a 30% stake in Aer Lingus.  The unquoted shares represents the value of semi-state companies such as the ESB, Bord Gais, Coillte, Dublin Airport Authority and others.

The net financial position has €69.5 billion of financial assets partially offsetting €186.7 billion of financial liabilities giving an outcome of minus €117.2 billion.  The government sector’s net financial position improved from the start of the dataset in 2002 right through to the end of 2007 by which time the net position was negative €2.1 billion.  In the four years since the government sector’s financial position has deteriorated by €115 billion.

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Nominal GDP and the Maastricht Criteria

Today’s National Accounts release from the CSO has generated a lot of reaction.  One peripheral issue is the impact of the figures on the government debt and deficit outcomes.  Back in April, Eurostat published the initial notification of these figures.  The reported 2011 figures for Ireland were:

• General government deficit: 13.1% of GDP
• General government debt 108.1% of GDP

On the same day the Department of Finance released an Information Note which stated that the ‘underlying deficit’ was equal to 9.4% of GDP.

These were based on a preliminary estimate of Ireland’s nominal GDP for 2011 of €156.4 billion.  Today’s figures from the CSO put the actual figure at €158.9 billion.  This has the following impact on the ratios:

• General government deficit: 12.9% of GDP
• ‘Underlying’ deficit: 9.2% of GDP
• General government debt: 106.5% of GDP

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The General Government Debt

At the end of 2007, the gross general government debt was €47.2 billion.  The recent Eurostat debt and deficit release showed that this has increased to €169.3 billion at the end of 2011.  That is an increase of an incredible €122 billion in just four years.  We can use the previous post on the general government accounts to see how that has come about.

There we saw that from 2008 to 2011 Ireland ran underlying primary deficits summing to €48.5 billion.  Interest expenditure over the four years was €15.4 billion.  At the same time temporary or once-off measures totalled €41.4 billion, with bank-bailout payments making up the bulk of this.

These three items sum to €105.3 billion.  To get to the full €122 billion increase we must account for some stock/flow adjustments.  In the main this is an increase in borrowings to build up a cash buffer.  Details from the NTMA show that balances of €17.8 billion “were held
in Departmental Funds + other Accounts, including the Exchequer A/c.” at the end of 2011.  At the end of 2007 these cash balances were just €4.4 billion.

Here is a summary table of the changes in the debt since 2007.

The largest single item is the €48.5 billion of primary deficits run since 2008.  This is the excess of government expenditure on public sector pay, social welfare, services and investment over government revenue. 

The next largest item is the €47.2 billion of debt we carried into the crisis in 2007.  This debt is largely the residual of the last great crisis in the public finances from the 1980s.  Data from the NTMA show that in 1994 (commonly taken as the start of Celtic Tiger Mark 1) the general government debt was €41.7 billion.  It hardly changed over the next 13 years.

Temporary and once-off measures account for €41.4 billion of the increase in the general government debt.  The vast majority of this is the bank payments and of that the bulk is the €30.85 billion of Promissory Notes used to recapitalisation Anglo, INBS and to a lesser extent EBS in 2010.  Once-off measures (though they seem to be happening a lot) account for 34% of the increase in the debt over the past four years and 25% of the stock of debt at the end of 2011.

There is a big drop them to the final two items.  Over the four years interest expenditure was €15.4 billion.  In 2007, interest expenditure was €1.8 billion so if the 2007 debt and interest rates had been maintained interest would still have consumed €7.2 billion over the four years.  The extra debt added about €8.2 billion of additional interest costs over the four years and the bulk of that is due to the primary deficits rather than the once-off measures.  From the last post we saw that social transfers-in-cash totalled €96.7 billion over the four years.

The final item is the stock/flow adjustment that is mainly an increase in borrowing by the NTMA in 2008 and 2009 to build up cash balances.  The NTMA borrowed far more than was needed to fund the deficits and a cash buffer was built up that has been maintained as part of the EU/IMF programme.  The general government debt is a gross measure so no allowance is made for assets even though this cash could be used almost immediately to reduce the debt by that amount.

The composition of the general government debt was provided in this recent PQ to Michael Noonan.

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