Economics 18/9/10: It's not just IMF

As argued in my earlier post (here), based on the IMF analysis, our sovereign bonds yields are still some distance away from those justified by fundamentals.

It turns out the IMF paper cited in the earlier post is not alone in the gloomy assessment of our realities. Another August 2010 study from German CESIfo (CESIfo Working Paper 3155), titled "Long-run Determinants of Sovereign Yields" and authored by António Afonso Christophe Rault throws some interesting light on the same topic, while using distinct econometric methodology and data from that deployed in IMF paper.

Here are some insights from the paper (available for free at SSRN-id1660368). "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."

Take a look at table 2 of results from the paper estimation across listed countries. The model is based on 3 variables here - Inflation (P), Current Account (CA) and Debt Ratio (DR). All have predictable effect on the variable being explained. Per study authors: "Results in Table 2 show that real sovereign yields are statistically and positively affected by changes in the debt ratio in 12 countries. Inflation has a statistically significant negative effect on real long-term interest rates in ten cases. Since improvements in the external balance reduce real sovereign yields in ten countries, the deterioration of current account balances may signal a widening gap between savings and investment, pushing long-term interest rates upwards."

Ok, here are those results:
Ireland clearly shows relatively weak sensitivity in interest rates to debt.

But take a look on our sensitivity to deficits. Per study: "Moreover, when the budget balance ratio is used (Table 3) a better fiscal balance reduces the real sovereign yields in almost all countries"
Clearly, Ireland shows 3rd highest sensitivity of interest rates to Government deficits. We are in the PIIGS group, folks, based on 1973-2008 data!

Now, this firmly falls alongside the IMF results - further confirming my guesstimate in the post earlier.

Economics 18/9/10: IMF data on bond yields

With all the debate, recently fueled by the Governor of our Central Bank and Minister for Finance, concerning the level of Irish bond yields, it is always insightful to look at the historic evidence as the source of better understanding of the underlying bond markets realities.

Fortunately, courtesy of the IMF, there is some new evidence on this issue available. IMF working paper, WP/10/184, titled "Fiscal Deficits, Public Debt, and Sovereign Bond Yields" by Emanuele Baldacci and Manmohan S. Kumar (August 2010) does superb 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 a panel of 31 advanced and emerging market economies."

In a summary, 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."

But the detailed reading is required to see the following: "the impact of fiscal balances on real yields provided results that were quite similar to the baseline, although the size of the estimated coefficients was larger: an increase in the fiscal deficit of 1 percent of GDP was seen to raise real yields by about 30–34 basis points." (Emphasis is mine). Table below provides estimates:
By the above numbers, Irish bonds currently should be yielding over 7.54%. Not 6.5% we've seen so far, but 7.54%. This puts into perspective the statements about 'ridiculously high' yields being observed today.

If we toss into this relationship the effect of change in our public debt position, plus a risk premium over Germany (note that the estimates refer to the average for countries that include not just Ireland, but 29 other developed economies, including US, Germany, Japan and so on), the expected historically-justified yield on our 10 year bonds will rise to

• deficit-induced 7.54% +
  
• country risk premium driven by deterioration in economic growth adjusting for ECB rates) of 1.46%+
• change from initial public debt position 0.30%

So the total, fundamentals-justified Irish 10 year bond yield should be around 9.30%.

Don't believe me? Well here's a historic plot that reflects not a wishful thinking of our policymakers, but the reality of what has transpired in the markets over almost 30 years.
Ooops... looks like our ex-banks deficits warrant the yields well above 10% and on average closer to 15%, nominal (remember the above yields computed based on model results are real). 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.

Someone, quick, show this stuff to our bonds 'gurus' in the Government.