26/09/2011: Ireland's Debt Overhang - unprecedented, unmanageable & unsustainable

A recent paper, titled "The real effects of debt" by Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli (05 August 2011) presented at the "Achieving Maximum Long-Run Growth" symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 25-27 August 2011 put forward evidence on the overall effects of debt overhang - across public, private corporate and household debts - on the real economy.

Here is the summary of their findings, followed by a closer look at the implications of these for Ireland. I have to warn you - the latter are highly disturbing.

The authors argue that although debt can be used to drive growth and development, "...history teaches us that borrowing can create vulnerabilities. When debt ratios rise beyond a certain level, financial crises become both more likely and more severe (Reinhart and Rogoff (2009)). This strongly suggests that there is a sense in which debt can become excessive."

The authors set out to answer a simple question: When does the level of debt go from good to bad? 'Bad' as in producing the effect of lowering long term economic growth in the economy.

To do so, the authors used a new dataset that includes the level of government, non-financial corporate and household debt in 18 OECD countries from 1980 to 2010.

The core results "support the view that, beyond a certain level, debt is bad for growth":

• "For government debt, the threshold is in the range of 80 to 100% of GDP... Our result for public debt has the immediate implication that highly indebted governments should aim not only at stabilising their debt but also at reducing it to sufficiently low levels that do not retard growth. Prudence dictates that governments should also aim to keep their debt well below the estimated thresholds so that even extraordinary events are unlikely to push their debt to levels that become damaging to growth." Furthermore, "when government debt rises to [threshold] level, an additional 10 percentage points of GDP drives trend growth down by some 10-15 basis points."
• "Up to a point, corporate and household debt can be good for growth. But when corporate debt goes beyond 90% of GDP, our results suggest that it becomes a drag on growth."
• "And for household debt, we report a threshold around 85% of GDP, although the impact is very imprecisely estimated."
  

The table below shows the core results from the paper and adds the comparable data for Ireland (Ireland was not included in the analysis). Make sure you are seating before reading it:
As shown in the table above, using the study estimates, the potential reduction in Irish GDP growth over the long term horizon arising from the combined debt overhangs is 2.1%.

The table also shows that the largest impact from debt overhang for Ireland arises from corporate debt, followed by household debt. Despite this, our Government's core objective to-date has been to deleverage banks and to contain Government debt explosion. In fact, the Government is consciously opting for loading more debt onto households - by reducing disposable after-tax incomes and refusing to implement significant savings in the public sector expenditure.

Yet, folks, our debt levels are extreme. They are more than extreme - the table below shows comparable combined public and private (non-financial) debt for the countries in the study sample, plus Ireland.
And the reates of our debt increase during the crisis are also extreme:

In fact, we have both - the highest level of debt to GNP ratio, the second highest debt to GDP ratio and the fastest increases in 2000-2010 in both ratios in the developed world. In the nutshell, this means we are more bust than the most bust economy in the world - Japan. Unlike Japan, however, we are faced with:

• No prospect of devaluation
• No prospect of controlling our interest rates
• Young population that requires growth and jobs creation, and
• Much heavier levels of private and corporate debt - i.e. debt that has more significant adverse economic effects than sovereign debt.
  

Yet, even exporting powerhouse of Japan is not delirious enough to believe their debt overhang can be brought under control via 'exports-led' growth.



Now, much of the issues and data discussed in this post relate to the question raised in the Dail by Peter Mathews, TD, who relentlessly pursues, in my view, public interest in raising such questions. The record of his question and Minister Noonan's answer is provided below:

16/05/2011: Debt Restructuring - two insights

What if, folks... what if default or debt restructuring is the end game?

Here are two sets of thoughts on the topic. The first one is from the Lisbon Council and the second set is adopted (via my edits) from here.

Lisbon Council launched last week Thinking the Unthinkable: Lessons of Past Sovereign Debt Restructurings See , an e-brief by Alessandro Leipold, chief economist of the Lisbon Council and former acting director of the European Department at the International Monetary Fund (IMF). See www.lisboncouncil.net for full details

Mr. Leipold argues that "European debt resolution requires a much more forward-leaning, information-driven approach, involving

• Supplying markets with better, more timely information (including tougher banking stress tests - I would give credit here to CBofI which did carry out much more rigorous testing of Irish 4 than the EU has ever allowed to take place across the euro area)
  
• Abandoning untenable timelines (such as the “no-restructurings-before-2013” mantra), and
  
• Staying ahead of the game via recourse to tools such as pre-emptive bond exchange offers

Mr. Leipold draws five key lessons from past sovereign debt restructurings:

1. Avoid Detrimental Delays. Delays in restructuring are costly (output losses, entail “throwing good money after bad” via increasingly large official bailouts, and ultimately require a larger haircut on private claims). Realistic debt sustainability analyses are needed to detect, and communicate, the possible need for debt restructuring. The EU’s “read-my-lips: no-restructuring-until-2013” sets an arbitrary and non-credible deadline: the sooner it is abandoned, the better.
2. Repair the Banking Sector. The equation “euro debt crisis = core European bank crisis” needs to be broken. I might add that the equation 'euro debt & banks crises = European taxpayers destruction' must be broken even before we break he debt-banks link. This requires getting tough on bank stress tests, enhancing their rigour and credibility, possibly by associating the Bank of International Settlements (BIS) and IMF with European Union supervisors. Banks tests must be accompanied by much greater pressure from EU supervisors to speed up bank recapitalisation and to close down non-viable entities. Banking resolution legislation should proceed rapidly, as should creation of an EU-wide bank resolution mechanism.
3. Remove Politics from the Driver’s Seat. The current set-up, including the European Stability Mechanism (ESM), which will begin operations in 2013), "virtually ensures that EU creditor countries’ domestic political interests will play a front-and-centre role. The recent attempted quid pro quo with Ireland whereby Europe would agree to a reduction in the cripplingly high interest rate on its loans in return for changes to the Irish corporate tax code is but one indication of this. Put simply, the decision-making and governance mechanism should be distanced from the high-pitched political positioning characteristic of EU ministerial meetings, thereby also facilitating constructive communication with markets, and helping shape expectations as needed to promote crisis resolution". I can only add to this that politicization of the economic concept of debt restructuring is also evident within the PIIGS themselves. In Ireland, we have now a virtual army of pundits - many well-meaning, of course - arguing against the restructuring on the basis of (1) 'default'=evil, (2) our debts are sustainable, and (3) current path of delaying restructuring until post-2013 is the optimal choice. These are supported, in some instances via lucrative public appointments, by the political elite.
4. Stay Ahead of the Curve with Preemptive Exchange Offers. "Traditional bond exchange offers, made preemptively, prior to an actual default, worked well in several emerging country debt restructurings over the last decade or so, including Pakistan, Ukraine, Uruguay and the Dominican Republic. Experience indicates that such voluntary restructurings need not, contrary to some claims, be too “soft” for the debtors’ needs. Reasonably priced, and with proper incentives, deals can be concluded rapidly with negligible free riding."
5. Do Not Expect Too Much from Collective Action Clauses. "Contractual provisions such as collective action and aggregation clauses no doubt help at the margin. But they have not shown themselves to be decisive in debt restructurings. Furthermore, they cannot help in dealing with the current stock of debt".

Much of the above prescriptions/warnings is echoed in the tables summarizing debt restructuring options available to the PIIGS that I have edited based on their original source (here).

Both provide one core lesson to us - any state close to the point of no return when it comes to its debt levels (and no one is denying that we are close to that point, all arguments today are about whether we have crossed it or not) should be:

1. Prepared to act
2. Prepared to act preemptively
3. Be transparent about the problems faced

On all 3 so far our officials are failing miserably, although we are making some progress on the 3rd point...

19/02/2011: Paying down our debt out of Exports

Let's do a quick exercise. Suppose we take our current account - defined as the sum of the balance of trade (exports minus imports of goods and services), net factor income (such as interest and dividends) and net transfer payments (such as foreign aid and remitted profits). Suppose every year we use the current account balance solely for the purpose of repaying our Government debt. How long will it take us to do so.

Let us start with some notes on methodology.

Our current account is in deficit - since 2000, there was only one year - 2003 - when we had a surplus in the current account (charts below), which really means our external trade was not enough to generate a surplus to the economy. So let us assume that the we can reverse this 180 degrees and that the deficits posted in 2009-2010, plus those projected by the IMF to occur in 2011-2015 are all diverted to pay our Government debt.
Notice - this is impossibly optimistic, as our Government does not own current account, but suppose, for the sake of this exercise that it can fully capture net profits transfers abroad and cut the foreign aid to zero, plus divert all interest payments on own debt and private external debts to repayment of the principal on own debt.

Secondly, assume that only Government debt is taken into the account (in other words, we assume away Nama debt, some of the quasi-sovereign financing of the banks resolutions, and all and any potential future banks and spending demands in excess of the EU/IMF assumptions, as well as all future bonds redemptions - the latter assumed to have a zero net effect at roll-over, so no added costs, no higher interest rates, etc).

In other words, here is what we are paying down in this exercise:

Now, suppose we take current account balances for 2009-2015 (projected by IMF) as the starting point. The reason for this choice of years is that they omit fall-off in our exports in 2008 and also the bubble years of 2004-2007 when our current account imbalances were absurdly large due to excessive outward investment and consumption of imports.

Next, assume:

• We deal with present value of the debts
  
• We apply an average 3% annual growth rate to repayments we make (current account transfers grow 3% on average per annum)
  
• Currency effects are removed (so we use flat USD1.33/Euro FX rate throughout)

So here is the result:
And the conclusion is: if Ireland diverts ALL of its net current account (2009-2015 IMF projections taken at 3% average growth rate forward) to pay down Gov debt, it will take us until 2064 to reach 2007 level of official (ex-Nama+banks) Government debt.

Note: incidentally - the charts tell couple of interesting side-points based on our historical debt path:

The Government told us that we are not in the 1980s - as we had much higher levels of debt then. Ok, the figure above shows that as of 2010 - we ARE back in the 1980s: 2011 debt will equal as a share of GDP that attained in 1989. According to IMF database, our debt has peaked at 109.241% of GDP back in 1987. It is projected to be 104.7% in 2013. Not that much off the peak.

But, of course, in the 1980s there was no quasi-Governmental debt - the debt of Nama, some of the banks recapitalization measures and the debts that still might arise post-2013 from the Government banks Guarantees and resolution schemes. If we add Nama's 31bn worth of debt issued, this alone will push our 2011 debt levels to 121.8% of GDP and factoring in coupon rate on these, but 2015 our Official Gov Debt + Nama will stand (using IMF projections again) at 124.8% of GDP - well in excess of the peak 1980s levels of indebtedness.

Secondly, despite what any of us might think about the Celtic Tiger years, the Government never paid down the old debt, it simply was deflated by rising GDP. Which suggests that even during the Celtic Tiger boom years - our exporting economy was NOT capable of paying down actual debt levels.

Economics 5/12/10: Debt, debt, debt... for Irish taxpayers

I decided not provide any analysis of the figures below. These figures speak for themselves. To explain their purpose: I have computed the expected burden on current and future taxpayers from the total ex-banks debt carried by Ireland Inc as:

• Households debts (mortgages, car loans, personal loans, credit cards, etc);
• Government debt (inclusive of quasi-Governmental debt undertaken under the EU/ECB/IMF loans and Nama).
  
• I also incorporate total corporate sector debts, including non-financial corporations debt and debts entered into by non-banking financial corporations. However, the corporate debt DOES NOT form the part of taxpayers liabilities, although at least some of it will have to be repaid out of our (taxpayers) pockets one way or another.

All figures input into calculations were taken from CSO and Central Bank of Ireland databases. All core assumptions are outlined in the second table.

Finally, note - the total figures of debt per taxpayer are for Household Debts and Government (including Nama & ECB/EU/IMF loans) debt. Do not, please, confuse them with the official Government debt alone.

So here are two tables. Interpret them as you wish:


PS: some people accused me of double-counting:

• banks debts and mortgages/households debts. I am not - banks debts are excluded from the above considerations;
• Government bonds outstanding and rolled over. I am not - the only net increase between 2010 and 2014 in Government debt due to roller overs of existent (pre-2011) bonds is due to an increase in the interest rate taken on rolled over bonds at 1% (again, conservative, as per ECB/EU/IMF deal we will be paying 1.13% over the current average rate of interest on already issued bonds).
  

Economics 23/11/10: How much will Government need to borrow in 2011

So we topped the European chart again today:
And a quick one for the start of the day tomorrow:

Let's do some arithmetic again:
Leni's Proposition 2: Through 2011 IRL Gov will need

• €18bn in deficit financing +
  
• €30-40bn in deposits shoring +
  
• €15bn in banks capital (note - some this can be spread over couple of years)+
  
• Banks losses cover of, say, another €10bn =
  
• Grand Total of 73-83bn.
  

Check: is that right, Leni? No answer so far... oh, well... we did the sums, as he asked.