Economics 19/8/10: Irish bonds & our fndamentals

This is an unedited version of my article in the Irish Examiner from August 18, 2010.

The latest Irish bonds auction was perhaps the most eagerly anticipated event in the NTMA’s history. Its outcome was a small victory for NTMA, but a Pyrrhic victory for Ireland.

A quick guide to the results first. Facing svere headwinds from the markets, NTMA managed to sell 4 and 10 year bonds at average yields of 3.627% and 5.386% respectively.

This means that NTMA improved on July auction of 10 year bonds, but is still locked into what amounts to the third highest cost of borrowing over the last three years. A year ago the same bonds were placed at an average yield of 4.55% - which means that borrowing €1 billion today is now €8.4 million costlier than a year ago.

However, the NTMA results are hardly a reason to cheer, from the economy wide perspective.

Three events have triggered the extraordinary global attention to Irish bonds over the last few weeks. Firstly, there was a public relations flop when the ECB had to step in provide support for Irish bonds by directly buying the surplus paper out of the market. Second by Monday this week, Irish bond spreads over the benchmark German bunds rose to a stratospheric 300 basis points. At the same time, our CDS spreads hovering above 310 basis points benchmarks, were
signaling that markets anticipated a significant probability of Irish Government default on its sovereign debt.

All of these developments, especially set against much calmer changes in yields and CDS spreads in other Eurozone economies have indicated that the markets are changing not just in terms of the overall willingness of bond investors to underwrite risk in general, but in their attitudes to Irish debt in particular.

You see, during the first quarter of this year, sovereign debt crisis has engulfed the peripheral economies of Europe, collectively know as PIIGS (Portugal, Greece, Ireland, Italy and Spain). The crisis, of course, was triggered by the markets belated realisation that these countries economies cannot sustain massive debt and deficit financing liabilities they have taken on before and during the current Great Recession. That was the moment when Ireland was lumped together with the rest of the Eurozone’s sickest economies.

This time around, we are on our own. Over recent months, all of the PIIGS countries have unveiled a series of aggressive deficit reduction and austerity programmes aimed at significantly reducing their future borrowing requirements. All, that is, except for Ireland. Instead, Irish Government has spent the last 9 months waiting for the Trade Unions to vote on the Croke Park deal that actually limited our future ability to address deficits. On top of that, we staunchly resisted markets, the IMF and the EU Commission repeated calls for clarity on specific budgetary measures planned for the period of 2011-2014. Currently, the IMF forecasts Irish deficit to remain at over 5% of GDP in 2015.

In May 2010, before factoring in the latest funding allocations to banks, IMF Fiscal Monitor provided an estimate for Ireland’s borrowing requirements for 2010. These figures are strikingly different from the deficit numbers presented by our official framework. IMF forecast that Ireland will need to borrow at least 19.9% of its GDP in order to finance debt roll overs from previous years maturing in 2010, plus the deficit of -12.2% of GDP. In approximate terms, Ireland’s Government borrowing this year would amount to roughly €33bn before Anglo Irish Bank and INBS latest projections for new funding.

Thus, in the last two weeks, the bond markets have finally began to re-price Irish sovereign debt as if the country is no longer the leader in the PIIGS pack in terms of expected future deficit
corrections.

In the end, the markets are right. Ireland is facing a massive debt and deficit overhang that is well in excess of any other advanced economy in the world. And contrary to official statements uttered on the matter this week, this twin problem is not a matter of one-off recapitalization of the Anglo Irish Bank. Instead, it is a long-term structural one.

Take first the banks. The recapitalization and balance sheets repair approach undertaken by the Government so far means that Nama alone can be expected to lose around €12 billion over the next 10 years. These losses will have to be underwritten by the Irish economy.

In addition, total losses by the Irish banks are likely to add up to between €49 and €53 billion over the next three-four years. These can be broken down to €33-36 billion that will be needed in the end for the zombie Anglo, €6bn for equally gravely sick INBS, at least €8 billion for AIB and up to €2 billion for the healthiest of all – Bank of Ireland.

These numbers are based on my own analysis and are confirmed by slightly more pessimistic estimates by the independent banking sector analyst Peter Mathews. Once again, Irish economy – or in other words all of us – can be expected to underwrite these. Thus, total bill for ‘repairing’ Irish banks via Government preferred approach of Nama, plus recapitalizations is likely to be €61-65 billion over the next decade.

Now, consider our current spending. Having slashed capital expenditure down to the bone, the Government has committed itself to preserving public sector pay and employment through 2014. Transfers – including welfare and subsidies – are pretty much a no-go area for serious
savings, given continued rises in unemployment, long term nature of new joblessness and political dynamics in the country. Between them, these two spending headlines account for over 1/3 of the entire deterioration in our public spending from 2008 to-date.

Budget 2010 forecasted that our debt to GDP ratio will peak at around 84% in 2012 and will slowly decline thereafter. This, of course, is clearly an underestimate, but even by that metric, we are looking at a debt mountain of over €152 billion.

All of this means that at the very least, Irish state debt will be well in excess of €210 billion by 2014-2015. Given yesterday’s auction results, the interest bill on this debt alone will total €11.3 billion annually – more than 1/3 of all tax revenue collected in 2009.

Let’s put this into more easily understood perspective. If Ireland were a household and its debt constituted its mortgage taken over 30 years, the ‘family’ will be spending more than half of its total gross income on interest and principal repayments.

Or put differently, the legacy of this crisis and systemically mistaken approach taken to repairing the banking sector will amount to over €111,000 in new debt dumped on the shoulders of every currently employed person in the country. To say, as our policymakers and official analysts do, that this figure doesn’t really matter because it is a ‘one-off measure’ is adding insult to the injury.