21/3/2012: Anglo's Promo Notes - perfect target for debt restructuring

This is an unedited version of my Sunday Times article from March 18, 2012.

At last, courtesy of the years of economic and financial mess, Ireland is waking up to the problem of our debt overhang. For those of us who have consistently argued about the unsustainability of our fiscal and real economic debts predicament, this moment has been long coming. The restructuring of some of the debts carried by the Government directly or indirectly, on- or off-balancesheet is a matter of when, not if. Enter the debate concerning the Promissory Notes.

Per international research, State debt in excess of 90-95% of the real economic output is unsustainable. In real economics, as opposed to fiscal projections, debt becomes unsustainable when it exerts a long-term drag on future growth.

At the end of 2011, official Government debt in Ireland has reached 107% of our GDP or 130% of GNP, according to NTMA. The Irish economy is now operating in an environment of records-busting exports, current account surpluses, and healthy FDI inflows, and yet there is no real growth and unemployment remains sky-high. By comparatives, Irish economy is a well-tuned, functional car stuck in the quicksand – engine revving, power train working, wheels engaging, with no movement forward. This is a classic scenario of a debt overhang crisis – the very same crisis that Belgium has been struggling with since 1982, Italy – sicne 1988, Hungary – since 1991, and Japan – since 1995.

Something has to be done to deal with this problem in Ireland no matter what our Government and the EU say in public.

Uniquely for a euro area country, Ireland’s debt overhang did not arise solely from fiscal or structural economic shocks, but was strongly driven by the country response to the financial crisis rooted in a number of forces, including policy and regulatory errors by the EU and ECB. Also, Ireland has undergone the most severe adjustments in its fiscal position to-date compared to all other ‘peripheral’ economies, proving both our capability and commitment to reforms.

Lastly, in contrast with all other countries, Ireland’s economy is capable of getting back to sustainable levels of economic activity. Irish economy needs a supporting push out of the quicksand of banks-linked debt overhang to deliver on its sovereign debt commitments, and become once again a net contributor to the sustainable fiscal system within the euro area.

The IBRC Promissory Notes are a perfect focal point for such a push for a number of reasons.

First, the magnitude of the Promissory Notes allows for significant room to reduce Irish Government’s future liabilities, combining €28.1 billion of debt, plus 17 billion in interest repayments. These represent 29% of our GDP. Eliminating this liability will restore Ireland back onto sustainable fiscal and growth paths. Restructuring the Notes will not constitute a sovereign default. Although their value is counted in Irish Government debt, they are not traded in the markets. The Notes are, de facto, Irish Government IOUs to the Central Bank of Ireland with IBRC acting as an agent.

Second, Promissory Notes underwrite €28 billion of €42 billion IBRC debts to the ELA programme run by the Central Bank of Ireland. ELA funds are not borrowed by the Central Bank from the Eurosystem or the ECB, but are created by the Central Bank under its mandate. There is no offsetting physical liability the Central Bank needs to cancel by receipt of payments from the Government. The Notes also do not constitute Central Bank funding for the Government as they finance stabilization of the Irish (and thus European) banking system. Lastly, the ELA funding extended to the IBRC is already in the financial system. Removing requirement on the Irish state to monetize the Promissory Notes will not constitute an inflationary quantitative easing.

The Government is correct in focusing much of its firepower on the IBRC’s Promissory Notes. Alas, efforts to-date suggest that it is not setting its sights on the real solutions needed. This week, Minister Noonan has identified the direction in which the talks are progressing: restructuring the Promissory Notes repayment time schedule, plus possibly reducing the interest rate attached to the notes via converting the notes into ESM debt.

The problem with this approach is that a transfer of liabilities to ESM will convert Promissory Notes into a super-senior Government debt. This is likely to have a negative effect on Ireland’s ability to borrow funds from the markets in the future and make such borrowing more expensive.

In addition, lowering interest rate on the Promissory Notes carries two associated problems with it. The move can only have an appreciable effect on Exchequer finances after 2014, when interest on the notes ramps up to €1.8 billion from zero in 2012 and €500 million in 2013.

Delaying repayment of notes instead of reducing the principal amount owed on them will not provide significant relief to the Exchequer in the future and will make the period over which the debt overhang occurs even longer than 20 years envisioned under the current Notes structure. This will pose serious risks. History of business cycles suggests that between now and 2025 when Notes repayments will fall significantly, we are likely to face at least two ‘normal’ or cyclical recessions. During these recessions, Notes repayments will coincide with rising deficit pressures and national income contractions that will exacerbate the Promissory Notes already adverse impact on Irish economy. Extending the period of notes repayments risks compounding more recessionary cycles in the future.

Furthermore, delaying notes repayments can risk increasing the overall future demand for debt issuance by the state. Currently, Ireland is facing two debt-refinancing cliffs during the life of the Promissory Notes: €45.6 billion refinancing over 2013-2016 and €62.4 billion over 2017-2020. If Notes repayments are delayed, their financing will stretch further into post-2020 period, just when the subsequent roll-overs of Government bonds will be coming due.

In more simple terms, current proposals for Promissory Notes restructuring are equivalent to making quicksand pit shallower, but much wider.

Ireland needs and deserves a direct restructuring of the ELA. The most optimal outcome of such a restructuring would be de facto cancellation of ELA requirement for repayment of IBRC-borrowed €42 billion. Once again, such a move would have zero inflationary impact on the economy as on the net no new money will be created in the euro system over and above the amounts already present.

There remains, however, one sticky point. Allowing Ireland to restructure its ELA can, in theory, lead to other Central Banks following the suit. This problem of moral hazard can be easily mitigated by ECB by ring-fencing Irish ELA restructuring solely for the purpose of winding down IBRC. Making ELA writedown conditional on shutting down Anglo and INBS, plus potentially Permanent tsb will disincentives other countries from using their own ELAs to rescue solvent banks. Irish restructuring can be further isolated by tying ELA writedown to progress already achieved by Ireland in tackling fiscal deficits and restructuring its banking sector. Put simply, with such a proviso in place, no other Euro area country would want to dip into its National Central Bank vaults if the associated cost of doing this will amount to over 50% of its GDP.

Ireland’s crisis is unique in its nature and its resolution provided a buffer to cushion the credit crisis blow to the entire euro area banking sector. Ireland both deserves and needs a breakthrough on the debts assumed by taxpayers in relation to the insolvent IBRC. Even more importantly from Europe’s point of view, the ECB needs a positive example of a country emerging from the deep crisis within the euro system. Ireland is the only candidate for success it has.

Source: NTMA and author own calculations.

Note: In computing second round of rollovers, only Government bonds are included and taken at 95% of the principal amount. All other debts are excluded.

Box-out:

In the wake of last week’s Quarterly National Household Survey release, the Government was quick to point to the improvement in the number of employed on a seasonally adjusted basis as the evidence the employment policies success. Overall numbers in employment rose in Q4 2011 by 10,000 or 0.56% compared to Q3 2011, once seasonal adjustments were made. Furthermore, per seasonally adjusted data, full-time employment was up 8,700 – accounting for 87% of this jobs creation. Alas, this is not the entire picture of the job market health. Year on year, seasonally adjusted employment was down 17,800 or 0.97%. More ominously, unadjusted employment was up just 2,300 in Q4 2011 compared to Q3 2011 – an addition of statistically insignificant 0.1%. Interestingly, full-time unadjusted employment figure fell by 700 jobs (-0.1%), while part-time employment rose 3,000 (+0.7%). At the same time, number of part-time workers who are underemployed has jumped 5,800 in a quarter and 28,100 year on year. Two reasons can help explain the above disparities. First, Government training programmes have been aggressively taking people out of unemployment counts, increasing employment numbers. In the case of Job Bridge, for example, these are unpaid ‘internships’ with questionable rate of post-internship transition to work so far. Second, since Q1 2011, CSO has used a new model for seasonal adjustments, which may or may not have an effect on seasonally adjusted headline numbers. Lastly, seasonal adjustments can increase, not reduce quarterly data volatility at the times when trends change. Particularly, with flattening out of the employment figures after years of steep declines, seasonal adjustments can introduce a temporary bias into subsequent data. In short, making conclusions about the actual changes requires more careful reading of the numbers than a simplistic headline figure referencing. With all annual indicators pointing to a shallow decrease in employment, the Government would be best served to have some patience and see how subsequent quarters numbers play out before jumping to conclusions on the success of its policies.