Archive for November 24th, 2010

“For each bag, the family makes 32 Indian rupees, about 80 cents. Sixty percent of their income pays the debt, said Chinnapapa. The lender takes the other 40 percent for the family’s room and board. Meanwhile, the loan also accrues interest, causing them to accumulate more debt—creating an endless cycle of bonded servitude.”

The Bondage of Debt, by Shilpi Gupta

Despite the efforts of the United Nations, debt bondage still continues to this day in pockets across the globe. A person that incurs a debt/takes out a loan, must pay it back through their labour. And in some cases their children must continue the repayments of their parents and debt bondage thus crosses generations. Yes the debtor may be provided with food and shelter but they are essentially deprived of freedom as we would understand the word. I wonder would our Governor of the Central Bank, Patrick Honohan describe their circumstances as “manageable”? By the way, I don’t mean to belittle those in debt bondage or say that their dire straits are even comparable with the prospects of the citizenry here. I refer to the extreme of debt bondage to challenge the notion of certain debts being “manageable”. And that word – “manageable” – is how Governor Honohan described the cost of the bank bailout earlier this year. This entry examines the concept of manageability and suggests that just as a debt may be manageable it is logical that a debt may also be unmanageable.

So how much will we owe?

On Vincent Browne’s show last night, there was a discussion about the overall level of debt immediately in prospect for the State and the ranges mentioned were €250-350bn. The previous night a Minister of State said that “in the worst” case the debt would be “in excess of €200bn”. I attempted on here earlier in the week to put a quantum on the imminent bailout required (different to ultimate national debt). When asked “how much will we owe”, the first clarification must be “at what point in the future?” – clearly our national debt at the end of 2010 will be different to 2014 and to 2025, so we need qualify any response by reference to a date. I am choosing 2014 because that’s the timeframe that the NTMA has recently used in a presentation which showed predicted funding requirements. Choose a different date and you’ll probably get a different answer.

We also need to be clear about what is meant by national debt and make assumptions that distinguish between underlying debt and short-term funding shortfalls – for example, if the ECB withdraws its emergency liquidity assistance to banks in January 2011 then the Irish state will need provide the funding to the banks until another source of funds can be found. That €90bn + will be funding which we might hope could be quickly repaid if banks find alternate source of fund. So it would be a short-term funding shortfall but hopefully wouldn’t be a long term debt.

So here is my calculation of national debt at the end of 2014 using what I would suggest is probably an optimistic set of assumptions:

(1) National debt at 24th November, 2010 – €90bn. I think it’s worth looking at the composition of the national debt and the table below is taken from the National Treasury Management Agency’s website and is for the end of September 2010 – the numbers have moved only marginally since then.

(2) Cash on hand today €25bn (I notice Professor Brian Lucey added this last night and for the purposes of calculating interest that seems correct but I am assuming that the €25bn will be used to pay down national debt immediately)

(3) Less liquidation value of the National Pension Reserve Fund of €11bn (€25bn on hand less €11bn earmarked/already invested in Bank of Ireland/AIB)

(4) Add deficit in the day to day running of the State in Nov/Dec 2010 €4bn

(5) Add deficit in the day to day running of the State in 2011-2014 of €43.25bn (inclusive)

(6) Add funding of promissory notes to Anglo, INBS and EBS. The State says that this will be fundable at €3.1bn per annum so the State’s estimate is €14.4bn between 2011-2014 inclusive. My view is that there could well be frontloading on the promissory notes but let’s accept what I regard as the State’s more optimistic view.

(7) The redemption of €38bn of State debt (bonds and treasury bills) in 2011-2014 will need be funded but it will have a negative effect on opening national debt. So the assumption here is that the State can access funds to rollover this debt and that it has a neutral effect on national debt.

(8) The substitution of €90bn+ of ECB emergency liquidity assistance (as at 29 October 2010) with Irish State funding will have a funding impact but the hope would be that by 2014 that other depositors can be persuaded to take the place of the State or that the assets of the banks can be disposed of to repay State funding. So let’s assume nil impact on debt by the end of 2014 but it is a risk.

(9) Additional capital needed by the banks. This will depend on future unprovisioned losses on loans and also future operating losses because the cost of funds is so high. This is a black hole. This is the great unknown, and it may even be the case that funds already committed may be more than is needed (that proposition would be considered fantasy by most observers but it is a theoretical possibility as the future performance of loans and operations is unknown). Let’s say that the figure is nil for the moment.

(10) Let’s ignore NAMA even though the €31bn of debt with which it is paying for bank loans is State guaranteed and the €5bn it will be borrowing will also be State backed. But let’s assume NAMA breaks even and that there is not any call on the State guarantees. Let’s assume that the outlook in 2014 is also that it breaks even. Again many would say these assumptions aren’t realistic.

(11) Additional unbudgeted interest payable on the current bailout. Let’s ignore this also.

This would leave us with national debt of €140bn at the end of 2014 using what might be the best possible set of assumptions. I think Professor Brian Lucey’s upper estimate was €353bn (but as the man himself said – at this stage €10bn here or there is akin to landing on a stamp so that could be €350bn give or take €20bn). So there you have it – what I would claim is a very best case of National Debt in 2014 being €140bn, a present upper limit of around €350bn and a Minister of State confirming it as “in excess of €200bn” in the “worst scenario”.  My intention with presenting the information above was to create a lower limit for national debt in 2014 – my own view is that the national debt will tend more towards the mid-upper limit but that a sizeable portion of debt will depend on whether alternate sources of funding can be found for our banks.

What will be the annual rate of interest?

As you can see from the latest repayment profile from the NTMA, we will have some €50bn of existing debt repayable after 2014 and this is secured on relatively cheap 4-5% interest rates. However it seems that borrowing by the State in the immediate future will attract a rate of 5-9% (5% IMF rate, 6-7% EFSF rate, 8.5-9% long term open market rate).

What will the annual repayments be from 2015 onwards?

At the lower end 5% of €140bn in interest = €7bn, at the highest end 9% of €350bn = €32bn. Using a 6% rate on the midpoint €250bn would be €15bn of interest. Our GDP is presently some €160bn and I see S&P’s latest pronouncements today predict “close to zero nominal GDP growth for 2011 and 2012 and 2% in 2013” so by end of 2014 our GDP might be less than €165bn. And what about repayment of the principal itself ? That is more difficult as it will depend on our policy towards debt and what our friends in the EMU will consider appropriate. But if the Stability and Growth Pact commits us to a debt:GDP of 60% then we will plainly need to be paying down principal as well unless our GDP somehow mushrooms.

Will the payments be manageable?

In an absolute sense of course they will be. By setting aside a substantial proportion of national income for a very long period arguably any debt in an absolute sense is manageable even if the interest alone causes the total debt to increase. But of course we’re not talking about an absolute sense, practically speaking we are looking at an area of greyness and forming a subjective assessment on what is acceptable for our country.

There are some studies that claim once the debt:GDP ratio goes over 80% then a debt trap ensues which permanently disadvantages a country which has to put a substantial portion of income aside for interest/principal repayments. Whilst that might be in a sense unsustainable, there are clearly countries in the world which seem to sustain themselves with that level of debt – Japan and Italy are prominent examples.

So what is manageable for Ireland. At what point does a debt become unmanageable? What’s the grey area? This is a very difficult question to answer and will essentially depend on what our society feels is an acceptable balance of services/taxation. And it is complicated by the many what-ifs – what if growth returns, what if prices are re-based. We will get some insight today of what taxes/services will look like with the fiscal four-year plan but remember the four-year plan is designed to rebalance our day-to-day spending, it makes no provision for the bank bailouts. This is a question that will be returned to on here again.

What are the alternatives to this level of debt?

(a) Inflation – yes, quantitive easing for the euro. Unthinkable a year ago, not in the interests of the bigger economies (Germany and France) or Ireland’s creditors. But is there a point at which the Germans weigh the bailouts of Greece, Ireland, Portugal and then Spain with their own desire to keep inflation in check and they conclude that inflation is the better of two evils?

(b) Default – to repeat yet again, aside from the private-sector banking/property mess, Ireland’s woes aren’t at all unusual. We have seen tax revenues collapse on the back of the bursting of our property bubble. Unfortunately we increased public spending in the good years – “we had it so we spent it”, though we did put €25bn aside in a pension reserve. So we now have an imbalance. And we’ll deal with it. It will be painful as we re-base earnings and prices but there’s nothing extraordinary to see here on that front. It’s the losses in the banking sector that is dragging us under. Ireland has thus far used money from its citizens to pay off creditors of the banks – bondholders and depositors.

Whilst continuing to pay for our sovereign debts, can the banks default on their own debts? This is what many are arguing at present. The State is sticking to the line that avoiding default in the banks will be cheaper in the long run. Those calculations will come under closer scrutiny. Meantime bonds are being redeemed, even at discount rates – should these redemptions stop? We have a saying here – “we might as well be hanged for a sheep as for a lamb”. So to those that argue that a bank default would be interpreted as a sovereign default then why not default on our entire debt? As a nation we don’t tolerate deadbeats, we have a draconian bankruptcy regime, we jail people that don’t pay debts and fines. So defaulting on our sovereign debt is not something that would naturally be attractive to us. But if the banking debt is going to drag us under anyway, then why not consider sovereign default as well?


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