A very Irish Default, or When Is a Default Not a Default?
Stephen is a lecturer in Economics at the Kemmy Business School, University of Limerick, Director of the Centre for Organisation Science and Public Policy, and a research associate of the Geary Institute, University College Dublin. His website is www.stephenkinsella.net.
Default can be defined simply as not paying interest or the principal on debt owed when it falls due. At the time of writing, November 2011, international bond markets are highly volatile, expecting a Greek default and clearly worried about an Irish default. The stability of the global economic system and the Euro as a currency, and the credibility of the crisis resolution institutions of the European Union, are at stake.
The goal of this chapter is to examine the possible effects of an Irish default on the European economy as a whole. We will look at the past performance of the Irish economy, examine the types of debt Ireland holds at the moment in some detail, and discuss what type of default Ireland might engage in. We will finish by sketching out the possible consequences for the European economy and the Eurozone of such a default.
Recent history ensures that there are several complicating factors in the Irish case. It is therefore very important to understand this historical context when examining Ireland’s current difficulties.
The scale of Ireland’s funding problem is vast. In 2010, Ireland’s domestic economy as measured by its gross national income (GNI) was worth about €131 billion.1 In 2010 the sum of Ireland’s borrowing was about €148 billion. By the end of 2011 it is estimated to be €173 billion, and is expected to peak at around €193 billion by the end of 2014. In ratio terms, the ratio between the output of the domestic economy in a given year and the total level of debt built up over time to be repaid by the sovereign is expected to peak at 140 per cent in 2014 or 2015. By comparison, in 1988, at the nadir of Ireland’s last economic crisis, the same ratio was 119 per cent, with a larger funding cost than today, and with a roughly similar unemployment picture to today – approaching 14 per cent of the total workforce.
Karl Whelan2 argues that a confluence of factors created the preconditions for an economic miracle during the 1980s. In the 1980s the problem was purely fiscal – increasing taxes and cutting expenditure was sufficient to help the economy recover. Other factors contributed, including a series of currency devaluations in 1986 and 1992/1993, our access for the first time to the European single market following the Maastricht Treaty, Ireland’s stable labour market, and the demographic dividend Ireland enjoyed as ‘the Pope’s children’ came of age with a high level of freely provided third-level education, just at a time when foreign direct investment was beginning to wash over the nation. Economic growth and prosperity broke out, with Ireland’s GNI rising from €49 billion in 1995 to €131 billion in 2009.3 Ireland’s unemployment rate fell from 12.9 per cent in January 1995 to 4.4 per cent in December 2007. Throughout this period, Ireland’s inflation rate remained low and relatively stable.
From the end of 2007, things only got worse for Ireland. Ireland’s debt levels, only 28 per cent of GNI in 2007, grew in three years to over 114 per cent of GNI by the end of 2011. Unemployment rose from 4.4 per cent in December 2007 to 14.3 per cent in September 2011. Household net worth in Ireland has fallen almost 34 per cent from its peak of €641 billion at the end of 2006.
Ireland had an old-fashioned asset bubble.4 Over the period 2002–2006, the structure of the Irish economy became increasingly dependent on the construction sector, and by 2006 construction output represented 24 per cent of GNI, as compared with an average ratio of 12 per cent in Western Europe. By the second quarter of 2007, construction accounted for over 13 per cent of all employment (almost 19 per cent when those indirectly employed are included), and generated 18 per cent of tax revenues.5
Thus the background for Ireland’s current debt problem is a fifteen-year period of robust growth, followed by a four-year period where the gains of the previous fifteen years have been lost to a greater or lesser extent by a large proportion of Irish society. The balance sheets of Ireland’s banks were damaged by their exposure to property-related lending. Private bank borrowings on international markets to fund property lending grew from less than €15 billion in 2003 to close to €100 billion in 2007. When the bubble burst, these banks were highly exposed.
The Irish government in September 2008 agreed to guarantee the liabilities of six of Ireland’s banks. A series of policies implemented to nationalise, recapitalise and reformat the banks have taken place since 2008, including the setting up of the National Asset Management Agency (NAMA) to oversee the management of good and bad loans taken on by Ireland’s wayward banks on behalf of the taxpayer, while issuing government-backed bonds to help shore up banks’ balance sheets. As each policy has been implemented the national debt has risen.
The national debt of any country is the sum of all the previous issuances of debt, usually (but not always) in the form of government bonds that have not been repaid yet. Governments borrow over fairly long time horizons when they can, and must repay the interest (and/or the coupon) on the debt until the time comes to repay the principal. Once that time comes, the debt can also be ‘rolled over’, refinanced or bought back with another debt issuance at higher or lower rates, depending on the conditions in the market at the time. Sometimes the debt is even repaid.
All government debt carries a risk of default. Ireland’s national debt profile is composed of several categories, each of which must be considered when thinking about default. We will go through them one by one, but they are government bonds, which includes the pre-crisis government debt; other medium and long term debt; state savings schemes; short-term debt issued for liquidity purposes; promissory notes; debts of central and local government; and sundries.
We will focus mostly on the increasing government deficit financed through international borrowing. We will also look at the emergency liquidity assistance afforded to Ireland’s banks, which are being paid off using the promissory notes written to cover some of the cost of bailing out Ireland’s banks in addition to the ministerial comforts given for several types of asset classes. We will examine the loans from the European Central Bank (ECB), the European Commission and the International Monetary Fund (IMF), as well as from Denmark, Sweden and the United Kingdom. In addition, the €30.7 billion of state borrowing to fund NAMA must be paid back at some stage, though it is not appropriate to treat this as part of the national debt as yet. Interest must also be paid on all of this debt at varying rates. The total cash cost of debt servicing in Ireland is estimated to be €5.2 billion in 2011, rising to €9.2 billion in 2015.
Table 5.1 shows the various categories and magnitudes of Irish debt as they existed at the end of 2010, and we will go through them one by one in the next section.
Government Bonds
The boom years of the Celtic Tiger are often portrayed as years when the national debt was paid off. In ratio terms, the national debt as a percentage of Ireland’s GNI did fall from 89 per cent in 1995 to 28 per cent in 2007. However, the reason for this fall is not that the level of indebtedness fell (the numerator in the fraction), but that total economic output as measured by GNI increased (the denominator). In absolute terms, the Irish state owed €43.6 billion in 1995. The Irish state owed €47.4 billion just as the economy began to collapse in 2007.
Since 2007 the Irish state has added €43.1 billion in state-issued government debt raised on the international bond markets. The cost of funding the state grew at an increasing rate as confidence in the solvency of the state diminished in 2009 and 2010. Because of the erosion of market confidence in Europe’s peripheral nations, as well as its own internal problems, Ireland was forced to apply for a loan facility to the International Monetary Fund (IMF) on 21 November 2010.
The EU/IMF loan facility will add to the national debt. The loan facility is worth €85 billion over a three- to four-year period. The facility takes €22.5 billion from the IMF, €17.7 billion from the European Financial Stability Facility (EFSF), controlled by the ECB, and €22.5 billion from the European Financial Stability Mechanism (EFSM), controlled by the European Commission, with €17.5 billion from Ireland’s cash reserves (€5 billion) and National Pension Reserve Fund (€12.5 billion).
In addition, the United Kingdom has pledged €3.8 billion, and Denmark and Sweden have pledged €400 million and €600 million respectively. Each of these different ‘pots’ of loanable funds comes through the IMF with an interest rate. The rates of interest applied by the EFSF and EFSM, on average 3.9 per cent, in each quarterly tranche have been substantially higher than the IMF rates of 3.1 per cent. The EFSF and EFSM rates have come down from an initial average interest rate of 5.82 per cent.
The EU/IMF loan facility attaches stringent ‘conditionality’ measures to be implemented to receive further tranches of capital. The current set of measures include bringing the budget deficit to within 3 per cent of a primary balance by 2015, various supply side measures, and a privatisation programme of state assets.
State Savings Schemes and Central Government Bodies
A full €12.7 billion of state borrowing exists as state savings schemes, where the lender in this case is the Irish citizen through the national postal service An Post, for example. Another €6.6 billion (€5.8 and €0.8 billion, respectively) exists as borrowing from state agencies and for the purpose of financing local authorities. For obvious reasons, no default can occur for these categories of government debt.
Short-Term Debt
Since 2007, mainly due to a fall in taxation revenues from construction-related activities as the construction bubble burst, the Irish government’s expenditures have been much greater than its receipts, and so it has had to run a large primary deficit. The deficit is financed through borrowing at different maturities. The short-term borrowing came in the form of treasury bills to the value of €6.2 billion. The long-term borrowing came from the international bond markets initially, and from 2011 until 2014 at least will come from a consortium of funding bodies led by the IMF, the ECB and the European Commission, though the Irish government has stated its intention to return to the markets in a small way in 2012.
Promissory Notes
Ireland’s banks required taxpayer funds to help fund their losses. In particular, Anglo Irish Bank, Irish Nationwide Building Society (INBS) and the Educational Building Society (EBS) have required €30.9 billion in ‘promissory notes’ just to balance their books, such was the scale of their losses.
A promissory note is an unsecured ‘promise to pay’ the sum agreed at a later date. The capital injections required were funded by promissory notes issued by the state to Anglo and INBS in lieu of cash, because normal funding channels were not available to these banks.
Promissory notes are not, strictly speaking, government debt, though for accounting purposes by the European statistical agency Eurostat they are treated as such.
Promissory notes are debt vehicles issued by the Central Bank of Ireland, rather than the European Central Bank. They are not, strictly speaking, backed by the ECB, as these notes are not eligible for refinancing operations by the ECB. The liability for these notes falls on the individual issuing state.
The promissory note repayment structure calls for government borrowing of €3.1 billion plus interest and other capital payments each year to repay these notes over a 10 to 15 year period at varying interest rates. These interest rates are pegged to the interest rates on an Irish ten-year bond at the moment.
In summary, Ireland’s debt levels and debt servicing will increase over the next few years as the repayment of our EU/IMF loans begin, the repayment of the €90.1 billion of bond financing takes place, and the promissory note repayment takes place. All of this must be funded from Exchequer receipts at some point, imposing a large opportunity cost on Irish society in terms of the provision of state services.
Having looked briefly at the recent economic history of Ireland, and in some depth at the current and future debt profile of the nation, then this is the picture we must have in our minds when thinking about an Irish default. There is not one single ‘pot’ of cash to be defaulted upon, but rather selective categories of national debt. Two elements of the picture remain: the role of the ECB and the outstanding liabilities of the covered banking institutions.
Central banks exist to dampen the natural fluctuations within the credit and leverage cycles caused by the movement of capital.6 The ECB has acted as it saw fit to stabilise the European economy, but not as a textbook central bank might. Central banks can issue bonds to ‘cleanse’ the balance sheets of wayward banks, transferring assets to the central bank’s balance sheets to contain the contagion effects of banks getting into trouble. Central banks can also call for debt write-downs and enforce them.
In the Irish case, no debt write-downs of senior bondholders were considered or allowed, while large amounts of emergency liquidity assistance were given by the ECB to Irish banks via the Central Bank of Ireland to allow private banks to continue their operations.
The risk of the creation of emergency liquidity assistance for a private bank is borne by the national central bank that decides to fund the private bank in that manner. The emergency liquidity assistance being given is equivalent to the promissory notes being written for the damaged Irish banks, discussed above, in that the national government, itself in rough shape economically, must have the appearance of guaranteeing large amounts of capital. The implicit lender of last resort – the ECB – waits to learn whether it will be required, or not. In the event of an Irish default, it certainly would be.
Finally, to get a clear(ish) picture of who might be affected by any default, we have to ask who our creditors are. The Bank for International Settlements7 publishes annualised data on debt holdings by banks and by country. These statistics are skewed in the case of Ireland by the presence of large banking conglomerates – hence the use of the ‘(ish)’ above – but Table 5.2 gives the debt position as of March 2011 for Ireland’s banks.
We can see from Table 5.2 that Ireland’s public sector has just over €18 billion held in European and non-European banks, with foreign claims amounting to close to €473 billion outstanding at the end of March 2011. The non-bank private sector in Ireland has €302 billion in European banks and €73 billion in non-European banks. The liabilities of the banking system in Ireland are roughly four times the yearly income of the nation. The liabilities of the banking system matter in the consideration of any Irish default. The reason for this is simple: Ireland’s banks are guaranteed by the sovereign, and are inextricably bound to the state via the banking guarantee and by the provision of emergency liquidity assistance. Any change in the terms of debt settlement agreements between a sovereign and its creditors will perforce damage the banking sector.
What default strategies might the Irish economy employ? Let us work under the assumption that Ireland remains within the Euro currency and therefore is not permitted to require senior bondholders to ‘burden share’ in the losses of the banks they invested in.
It is important to note that the rest of the debt either accrued to this point or locked in via the EU/IMF loan arrangement is either sovereign debt or a mixture of local and savings debt and the promissory notes written to cover the losses some private banks sustained following the collapse of the construction sector.
Remembering that a sovereign default is simply not paying interest or a principal owed to creditors, there are several default strategies a government might employ.
The first default strategy is the ‘nuclear’ option of reneging on most of the outstanding debt of the nation. There are very few examples of this type of default outside of wartime episodes, where the debtor nation feels it need not pay back the debts accrued to an aggressor. The post-war category includes civil wars, and examples of these defaults would be China in 1949, Czechoslovakia in 1952 and Cuba in 1960. In these cases, the debt reneged upon is characterised as ‘odious’.
The second type of default is partial, and occurs following a credit bubble. These are by far the most common, and Russia’s default in the 1998 (discussed in Chapter 7 of this book) is the largest recent example.
The third type of default is a ‘soft’ default, or a restructuring of privately held debt over time. So the debtor agrees to repay the full amount but over a longer time horizon with perhaps a lower interest rate. This is a default in that the interest applied to the restructured loan will typically not yield the same return as the original debt contract. Examples of post-war debt restructuring abound, especially in the 1970s and early 1980s, and include Turkey in 1978, Romania in 1981 and Poland in 1981. Almost every Latin American economy defaulted or restructured their debts in this period as well.
Ireland really has two choices: it can default on its sovereign debt or try to recoup some of the losses on promissory notes. The first option should be resisted until all other options have been exhausted. The second option carries no fiscal or monetary consequence beyond a renegotiation with the ECB over the terms of the repayment of the promissory notes. This is a default, as defined here. But it is also not a default. No credit default swaps will be triggered; no credit ratings will be damaged. The Irish state is agreeing, through a third party, to pay itself less and over a longer time. This would be a very Irish default.
Now, what would the consequences for such a default be in Europe? We must always consider the political economy of each situation Ireland finds herself in. Assuming Ireland remains steadfast in its application of austerity policies, and assuming the stability of the Eurozone was at stake, a renegotiation of Ireland’s emergency liquidity assistance, or the promissory note structure, would give precedent to other nations to act in a similar manner.
For the ECB, the creation of assets by national central banks with banking systems in trouble is anathema. Yet the dilution of the promissory note structure would, in all likelihood, have no significant effects on the balance sheet of the ECB, beyond the creation of an expectation that the ECB would move to shore up the balance sheets of its wayward national central banks via emergency liquidity assistance measures.
In summary, then, at the end of 2011 Ireland has few options to default, when considering the political economy of a nation inured to austerity policies, bent under EU and IMF conditionality, and zealous to remain in the Eurozone. The benefits of a default are not paying back all of one’s debts. The costs come when new debt must be raised, and when trade depends upon certainty. Markets are forward looking, but they do remember sovereign defaults – for a while, at least. The Eurozone will not tremble at the restructuring of our debts, owed only to ourselves.
Endnotes
1 In this chapter I use gross national income (GNI) rather than gross domestic product (GDP) or gross national product (GNP). Gross national income is similar to gross national product but also deducts indirect business taxes and EU taxes and subsidies. The difference between gross national and gross domestic product is that while GDP includes the income of the multinational sector, GNP does not.
2 Karl Whelan (2010) ‘Policy Lessons from Ireland’s Latest Depression’, Economic and Social Review, Vol. 41, No. 2, pp. 225–254.
3 Colm McCarthy (2010) ‘Fiscal Consolidation in Ireland: Lessons from the Last Time’ in Stephen Kinsella and Anthon Leddin Understanding Ireland’s Economic Crisis: Prospects for Recovery, Dublin: Blackhall Publishing, pp. 103–116, and Stephen Kinsella (in press) ‘Is Ireland really the Role Model for Austerity?’, Cambridge Journal of Economics.
4 Stephen Kinsella and Anthony Leddin (2010) Understanding Ireland’s Economic Crisis: Prospects for Recovery, Dublin: Blackhall Publishing, for an overview of how the crisis came about in the early 2000s.
5 Constantin Gurdgiev, Brian M. Lucey, Ciaran Mac an Bhaird and Lorcan Roche-Kelly (2011) ‘The Irish Economy: Three Strikes and You’re Out?’, working paper available from SSRN: <http://ssrn.com/abstract=1776190>.
6 Hyman P. Minsky (1986) Stabilizing an Unstable Economy, New Haven, CT: Yale University Press.
7 Bank for International Settlements (2011) BIS Quarterly Report, Q4 2011, available from: <http://www.bis.org/publ/qtrpdf/r_qa1109.pdf>.