Colm McCarthy: A coup for the Government – but it still has unfinished business when it comes to debt
Absence of principal reduction does not mean the prom-note deal lacks value.
The two most insolvent of the Irish banks, Anglo and Nationwide, were closed and absorbed into a Government wind-down vehicle, IBRC, in July 2011.
The Government has closed IBRC and secured about as good a deal on the Anglo and Nationwide portion of the legacy bank debt as could have been achieved. To pretend otherwise is to wish that Ireland could hop on to a time machine and unwind the disastrous bank guarantee of September 2008 and subsequent errors.
There is no reduction in the headline level of sovereign and sovereign-guaranteed debt. The real economic burden of the debt, contained in the so-called promissory notes, has, however, been reduced. Principal reduction was never an option on this portion of the debt, since the European Central Bank would have exceeded its legal remit and would have left itself open to court challenges. It would also have set an unwanted precedent were it to countenance a debt write-down.
The simplest way to think about the deal structure goes like this. With the decision taken to repay creditors of the two bust banks, these repayments had to be financed. The Irish Government was unable to provide the funds, so a peculiar government bond (actually a series of them) was issued, free gratis, to the bust banks, which had been nationalised. This bond was then taken round to the Central Bank of Ireland which created money (euros) with which the banks paid off their (mainly foreign) creditors, including both bondholders and depositors.
The Central Bank was permitted to create these euros by the ECB and is charged a low interest rate, currently just 0.75 per cent per annum. It was a huge burden to shoulder, but ameliorated through the low cost of borrowing.
Some of these creditors enjoyed State guarantees, some did not. In any event, the creditors can no longer be 'burned', since they have virtually all been paid. This horse has bolted (or been eaten).
The design of the promissory notes was not ideal. The repayments were front-loaded, with just over €3bn, including a portion of capital, to be paid in each of the first 10 years and rapidly declining sums thereafter. These sums were to go to the Central Bank to be extinguished.
National central banks are not allowed to create European money at will to bail out banks or to lend to governments. If they create temporary cash for illiquid banks they are expected to de-create it in due course.
Each year the Government would have had to borrow the funds to refinance some of the cheap central bank finance at considerably higher rates of interest. If you have a cheap loan, like a tracker mortgage, you would like to hold on to it for as long as possible. The deal arranged last week permits the Government to do this.
The prom-notes have been scrapped to be replaced by a stretched-out repayment schedule using floating-rate government bonds, so the early replacement of cheap funds with expensive funds will now occur on a far slower timescale.
This is an unambiguous benefit of the deal, to which there was considerable resistance from elements in the ECB. The politicians, the Governor and the Central Bank and Department of Finance officials have done as good a job on this issue as could reasonably have been expected.
The principal amount due has not been reduced – this was not legally possible under the rules of the eurosystem and there would have been little point in seeking a principal reduction which could not legally have been granted. To acknowledge this reality is not to concede the legitimacy of the debt burdens which have been imposed on Irish taxpayers.
A combination of mistakes made in Ireland and improper use of its powers by the ECB, during 2010 in particular, have resulted in Irish taxpayers shouldering an undue share of the costs of the eurozone banking crisis.
Some commentators have misunderstood the interplay between the components of a debt instrument. These are the principal amount, the interest-rate payment schedule and the maturity, the date when the debt has to be extinguished.
If you owe €10,000 repayable two years hence, with a 10 per cent interest rate, that is a bigger burden than owing €10,000 repayable 20 years hence with interest at 2 per cent and an option to repay early. The absence of a principal reduction does not mean that there is no value in the deal secured.
The Department of Finance has calculated that the general Government budget deficit, as measured for the purposes of compliance with EU rules, will decline by about €1bn per annum from 2014 onwards. As measured, this appears to be correct, but the measure of this deficit does not include, for example, the revenues and expenditures of Nama, the body to which the residue of the abolished IBRC is heading.
The Government has been paying hefty interest to the IBRC on the promissory notes, a kind of operating subsidy, which will not be going to Nama. This annual payment to IBRC would eventually have come back into the Exchequer in the form of the residual value, positive or negative, of the IBRC.
If Nama was consolidated into the Government's accounts, the claimed interest saving would wash out. However, the inclusion of the full payment to IBRC was an overstatement of Government spending, since the ultimate cost of the funds was just the low ECB rate. In other words the interest charge was mainly money the Government was paying to itself and not really an expense. The new figures for the Government deficit are closer to an economically meaningful estimate.
The precise value of retaining access to cheaper external financing for an extended period is uncertain, since it depends on interest-rate differentials which will fluctuate, but it is significant given the scale of the figures involved. This deal has delivered a real and tangible benefit.
However, there are dangers in over-selling what has been achieved, not least because the Government has unfinished business regarding other elements in the legacy bank debt. About half of the bank-related debt arose through rescues of banks other than Anglo and Nationwide.
It is agreed at eurozone level that, as soon as the new bank supervision arrangements are up and running, probably early next year, the eurozone rescue fund, the ESM, will have the capacity to recapitalise failing banks with European rather than national funds.
There is every chance that more European banks will get into trouble. The Dutch Government had to rescue a bank the week before last, the Italian bank MPS has been embroiled in a scandal about concealed derivatives losses and is being supported by the Italian government.
Eurozone banks generally have not been forced to raise enough new capital. If future bank busts are to be a collective eurozone responsibility, the Government can legitimately claim that, since this is a eurozone banking crisis, the State should not be penalised for facing up to it first. Overstating the benefits of last week's deal for domestic political consumption invites the response that enough has been done for Ireland.
Even with the benefit of the interest reduction officially estimated at €1bn per annum, the budget deficit this year would be about €12bn, rather than €13bn. This is unsustainably high even if the gap to be closed is a little more manageable. It makes no sense to slow down just because the winning post is coming into view. Any deferral of fiscal adjustment raises the ultimate debt level.
There have been serious leaks from the last two meetings of the ECB governing council. It would appear that on both occasions opponents of the Irish Government's plans ran to the news agencies with revelations designed to de-rail the process. One result was the all-night parliamentary session and the midnight repatriation of the President from an official visit to Italy to sign the legislation into law.
Proper central bank boards do not treat elected parliaments like this. The plan executed last week has been discussed in detail with ECB officials for months and the leaks clearly did not come from them. They must have come from one of the central bank governors who join the executives for governing council meetings.
The Irish Government should make its displeasure known – it is important for the credibility of the ECB that these leaks be investigated.