This is an unedited version of my column in Business & Finance magazine for October 2010.
James Carville famously remarked that: "I used to think if there was reincarnation, I want to come back as a president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody."
Three years into financial, fiscal and growth crises, Ireland’s continued lack of progress in resolving our long term fiscal deficits has finally caught up with our policymakers. Since mid August, the bond markets have been breathing the fear of fundamentals.
Make no mistake, all the talk about ‘ridiculously high’ bond yields on Irish sovereign debt, foreign analysts errors and conspiracy theories according to which a number of home grown academics have colluded with international media to play down Irish success story are nothing more than saber rattling. Damaging to our internal process of shaping the correct policies and disastrous to our external reputation, these claims have no foundation in the reality.
The facts that inform, at least in part, market assessment of our sovereign bond risks, are simple. After three years of struggling with deficits, Ireland is once again facing an Exchequer shortfall in excess of 11% of our GDP this year. Even ex-banks recapitalization measures, we are the worst performing country in the Eurozone in terms of fiscal balances two years in a row. With banks support measures counted in, we will post the worst peace-time fiscal deficit in the history of Europe.
More than that, looking forward, we are facing a daunting task of brining our deficits down to 5.3-5.9 percent of GDP by 2015. Repeated promises by our Finance officials and politicians to cut deficit to 2.9% by 2014 are now firmly relegated to the realm of fiction.
Combining Department of Finance, IMF and my own forecasts (which fall closer to those of IMF), the expected deficit path for Irish Exchequer through 2011-2015 is shown in the table below.
In difference with our official forecasts, IMF predicts Ireland’s 2014 deficit to reach 5.3% of our GDP based on May 2010 estimates for economic growth and absent accounting for the latest banks recapitalization costs. Adjusting this path to reflect stickier unemployment and lower growth (both across GDP and GNP) as consistent with IMF revisions of global economic growth forecasts since May 2010 yields the expected exchequer deficit of 5.99% of GDP for 2014.
Equally important is a steeper debt curve that is factored in the above projections courtesy of higher cost of financing, cumulated banks and NAMA losses and lower growth. By my estimates, total state liabilities, inclusive of Nama and banks recapitalization measures, will reach 127% by 2013. The risk to these numbers is to the upside.
These estimates have some serious implications to the pricing of Irish debt in the markets.
In August IMF published research (WP/10/184) titled "Fiscal Deficits, Public Debt, and Sovereign Bond Yields" which provides analysis "of the impact of fiscal deficits and public debt on long-term interest rates during 1980–2008, taking into account a wide range of country-specific factors” for 31 economies.
The paper finds that “higher deficits and public debt lead to a significant increase in long-term interest rates, with the precise magnitude dependent on initial fiscal, institutional and other structural conditions, as well as spillovers from global financial markets. Taking into account these factors suggests that large fiscal deficits and public debts are likely to put substantial upward pressures on sovereign bond yields in many advanced economies over the medium term. …An increase in the fiscal deficit of 1 percent of GDP was seen to raise real yields by about 30–34 basis points."
By the above numbers, Irish bonds currently should be yielding over 7.5% in real terms, not 6.5% we've seen so far. This puts into perspective the statements about 'ridiculously high' yields being observed today.
If we add to this relationship the effect of change in our public debt position plus a risk premium over Germany (+180bps), the expected historically-justified real yield on our 10 year bonds will rise to around 9.3%.
Looking at a historic range of values, our ex-banks deficits warrant the yields in the range of 8-20%. Alternatively, for our bond yields to be justified at 6.5% we need to cut our deficit back to around 5.2% mark and hold our debt to GDP ratio steady.
The IMF findings are hardly alone. Another August 2010 study, this time from German CESIfo, titled "Long-run Determinants of Sovereign Yields" produces similar results, while using distinct econometric methodology and data from that deployed in the IMF paper. "For the period 1973-2008 [the study] consider the following countries: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, Sweden, Spain, UK, Canada, Japan, and U.S."
Current Account deficits, Debt to GDP ratios, and fiscal deficits all have predictable effect on the long-term interest rates and thus bond yields. Crucially, the Current Account channel of risk transmission to bond yields is based on the view that “the deterioration of current account balances may signal a widening gap between savings and investment, pushing long-term interest rates upwards."
Ireland shows relatively weak sensitivity in interest rates to debt, moderate to current account balances but severely strong (3rd strongest, in fact) to deficits. By combined measures of three responses, we are now firmly in the PIIGS club, with our bond yields based on fundamentals justified at the levels well above Portugal.
And the matter doesn’t rest at the macroeconomic fundamentals. The latest bout of bond yields pressure, culminating in a number of large scale interventions in the market by the ECB is based on significant concerns about the quality of the collateral backing our covered bonds – theoretically the safest of all bond instruments. The bonds downgrade by the Moody’s – an action which in itself represents an extremely rare event in the advanced economies – also puts direct pressure on the likes of the Irish Central Bank and our banks’ repos with the ECB. Illustrative here is the case of the Anglo repos and other derivatives – some €14 billion of which have already gone into Nama and €11.5bn of which rests with the Central Bank under an Anglo MLRA repo agreement secured against the non-Nama loans.
Which, of course, brings us to the logical question of what has to be done to correct our current position.
The forthcoming Budget 2011 is the last line of defence the Government can attempt to hold. Failing to deliver significant (well in excess of €3 billion for 2011) reduction in the deficit, while providing a crystal-clear picture of all deficit measures and targets through 2013-2014 will likely see our long term bond yields rising to the levels above 7%, where Ireland’s application to the European Stabilization Fund (aka IMF/ECB rescue) will be inevitable.
Overall, the Government must cut current ex-banks deficit by around 5.5% of GDP before 2015. Using my projection for GDP growth, this amounts to over €10 billion in cuts.
Yes – cuts. My projections for deficits above are based on rather optimistic assumptions concerning Exchequer revenues (rising €8.2 billion between 2010 and 2015 or 23.8% on 2010 figure). Majority of these increases will happen due to tax burden increases, as capital spending and other automatic stabilizers will be weaker in years ahead due to contraction of capital investment. This implies that the Exchequer will have no room for further significant tax increases in years ahead. In addition, my projections factor in the need for a token reduction in cumulated debt, which spikes dramatically around 2014.
Of course, the above estimates do not account for the adverse effects of higher taxes and lower Government spending on our growth and unemployment. Virtually all of the tax increases to-date (both direct and indirect) fell on the shoulders of households. At this point in time, I see no room for further increases in the tax burden. Data from private savings and deposits shows clearly that Irish households are suffering a precipitous decrease in terms of their net financial buffers, resulting in an adverse knock-on effect on future spending and investment.
While no serious analysis of the labour force and growth sensitivity to tax rates and public spending in Ireland is available, both theory and practice elsewhere suggest that these will be non-trivial. Here, not only the level of cuts, but also their sources matter. So far, three quarters of the adjustment in public spending to-date has been carried on the shoulders of capital spending. Yet, capital expenditure is perhaps the only part of Government spending that is not subject to large economic losses to imports. Furthermore, unlike current spending, capital spending has a growth dimensions that is spread over time.
All in, Minister Lenihan needs to refocus our spending cuts away from capital programmes – where the cuts have already been dramatic, leaving very little new room for manoeuvre – and firmly on the side of current expenditure. Per chart below, the latest Exchequer figures strongly show that this has not been the case so far in the crisis. Furthermore, cuts to current expenditure are severely hampered by the Croke Park deal. In effect, by leaving out of the balancing equation current spending on wages and earnings in the public sector, the Croke Park deal is one single largest obstacle on Ireland’s path to solvency.
[see updated chart here]
Looking across the current spending landscape, it is completely inevitable that cuts will have to focus on reducing the numbers employed and the levels of pay in the public sector. Under current conditions in the labour markets, the Exchequer simply cannot avoid dramatically slashing back its wages bills. Thus, the 2011-2014 framework should aim to reduce public sector employment by at least 70-90,000, yielding savings of some €4.5-5.5 billion once statutory redundancy costs are netted out. Another must will involve reforming welfare system, once again reducing the overall costs. Savings here can amount to 12% of the current expenditure target of €10.6bn – much smaller reduction than that in the wages bill, but a very significant number when it comes to vitally important benefits for the most vulnerable members of our society.
Next in line are health and education. The Government can enact an ambitious reform of our health services, shedding completely the responsibility for managing services provision and aiming to act solely as a payer for these services for those who cannot afford private insurance. Such a reform can see savings of ca €2-2.5 billion netted out of the system on both current and capital sides. Education reforms – especially introduction of third level fees – can provide another €1 billion.
The Government should not only slash current spending, but also develop and implement strategic long-term reforms of management in the public sector. Currently Ireland lags behind the average levels of international best practice in deploying advanced management (including ICT) systems in public sector. Reforming the managerial processes in public sector, per international evidence, can yield longer-term savings of ca 5% of the total net current spending of the state, or €2 billion.
Overall, comes December, Minister Lenihan needs to present a convincing and extremely ambitious programme for reforming public spending in Ireland. At this point in time, international bond markets, as well as domestic economy will need to see a serious change in the path to fiscal solvency chosen to-date before our bond yields, as well as our businesses and households propensity to invest in Ireland improve.