Irish Debt Dynamics (Feb 11)

8/7/2019 Irish Debt Dynamics (Feb 11)

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Irish Debt Dynamics

With a little help from our friends

EU-wide solution to banking problems required - Without theenormous fiscal cost of the banking crisis (36% of GDP), the taskof returning Irish public finances to stability would have beendifficult but eminently more achievable. It is clear that the Irishsovereign cannot continue to bear the burden of the bankingsector liabilities on its own, as the scale of the increase in debt

makes it less likely that it will be able to afford to pay it back in thefuture. The IMF/EU response has been piecemeal andunderwhelming thus far. Shared responsibility is required. Thereis currently 21.5bn in unsecured, unguaranteed bank debtoutstanding. Ireland cannot and should not unilaterally decide torestructure these debt holders, but the new Government shouldpush this agenda at an EU level. Another option is to allow theEFSF to directly recapitalise weak banking systems such asIrelands or facilitate the sale of Irish banking assets through anEU-wide insurance scheme. It is in Europes interests, as well asIrelands, that the problem is solved. Sorting these problemswould provide a double benefit of easing pressures on thesovereign and supporting economic growth.

Reduction in sovereign debt levels will be a long haul - Evenassuming Ireland achieves its budget consolidation over the nextfour years, tight fiscal policy i.e. a significant primary surplus -will be required for possibly up to twenty years if Irelandsdebt/GDP ratio is to return to levels consistent with the Stabilityand Growth Pact targets. Starting in 1987, Ireland was able toreduce its debt level through running a primary surplus of 4% andstrong economic growth exceeding real interest rates. This is notlikely to be repeated over the coming years in the context of thedeleveraging of the economy here, and, therefore, it may bedifficult to convince markets that Ireland can achieve a significantreduction in the debt level without a restructuring. However,

sovereign debt restructuring is not a realistic option until Irelandachieves a primary surplus, which is not likely until at least 2014.

Reduction in interest rate would provide a near-term positive

-At a minimum, the interest rate on the IMF/EU funds for Irelandmust be reduced. Every 1% reduction in the rate on the loanssaves 675m per year on interest payments. This equates to0.4% of GDP, in the context of an estimated interest bill of 5.2%of GDP in 2014. There is also a prospect of debt buybacks atcurrent market prices. If all the debt was bought back at currentmarket prices, it would reduce Irelands gross debt position by 8%of GDP. In reality, only a small proportion of outstanding Irishsovereign bonds will be purchased, reducing the benefits of such

an action. Recent rhetoric suggests that these issues are activelybeing considered at EU level, which is a net positive for Ireland,but it will not be the silver bullet.

Economist: Dermot OLeary T +353-1-641-9167 E [email protected]: Juliet Tennent T +353-1-641-9005 E [email protected] 8 February 2011

Goodbody Stockbrokers is regulated by the Central Bank of Ireland and is a member firm of the Irish Stock Exchange and the

London Stock Exchange. Please see the end of this report for analyst certifications and other important disclosures

0

500

1,000

1,500

2,000

2,500

3,000

3,500

Feb-11

Apr-11

Jun-11

Aug-11

Oct-11

Dec-11

Feb-12

Apr-12

Jun-12

Aug-12

Oct-12

Dec-12

mln

Source: Bloomberg

Redemption profile of Irish unsecured and senior

subordinated bank debt

-100

-50

0

50

100

150

1998 2002 2006 2010 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050

NetDebt/GDP

Scenario 1 Scenario 2 Scenario 3 1980s

Government debt levels beyond 2014 under different

scenarios

Source: Goodbody estimates

1987 level

rebased to 2014

Goodbody Fiscal forecasts

2010 2011f 2012f 2013f 2014f Budget Deficit (% of

GDP) -31.7% -9.7% -7.8% -6.0% -4.3%

Excluding Banking

costs -11.8% -9.7% -7.8% -6.0% -4.3%

General Government

Debt (% of GDP) 94.7% 103.4% 109.8% 113.3% 114.9%

Interest/GDP 2.6% 3.7% 4.3% 4.8% 5.2%

Average interest rate 3.9% 4.9% 5.0% 5.1% 5.3%

Assumed interest rate

on new debt 5.0% 5.8% 5.8% 5.8% 6.0%

GDP growth (real) -0.4% 1.1% 2.1% 2.0% 2.0%

GDP growth (nominal) -1.0% 1.0% 2.6% 3.5% 3.5%


I r e l a n d


2/15

DEBT DYNAMICS AN UPDATE - INTRODUCTION

Back in early September, we published a report looking at the sustainability of the Irish

public finances, taking into account the effects of large and persistent budget deficits and

the enormous cost of the banking crisis. It goes without saying that a lot of water has

passed under the bridge since that time, so we update that piece of analysis in this report.

The increase in the estimated cost of the banking crisis has had the most material impact

on Irelands debt dynamics since then and also effectively forced Ireland into the IMF/EU

facility. At that time, it was our belief that the gross fiscal cost of the banking crisis would

amount to 35bn or 22% of GDP. Following the completion of the NAMA valuation

process, the updated capital requirements by the Financial Regulator and the

conditionality contained in the EU/IMF program, this overall cost is now likely to rise to at

least 57.5bn (36% of GDP). This includes 46bn that has already been invested in the

banks, a further 5bn for Anglo Irish Bank (as per Regulators worst-case scenario), a

further 4.7bn for AIB and an additional 1.5bn for Bank of Ireland. As per the IMF/EU

agreement, of the 35bn that has been earmarked for the banking system, 10bn will be

injected immediately (accounted for above), while there is a further contingency fund of

25bn available should the need arise. While Irish officials assume that this fund will not

need to be tapped, this will not be known until the full scale of the losses on the banks

loan books becomes clear. On this front, the PCAR (Prudential Capital Assessment

Review) process to be completed in March will provide the most important input. The

IMFs view is that it is unlikely that bank recapitalisation needs will exceed 35bn. Given

that it has undoubtedly scrutinised the banks books, it does not fill us with confidence that

the contingency fund will not be used at all.

The major news in relation to the underlying public finances has been the higher fiscalconsolidation. Consolidation measures amounting to 7.5bn were originally in prospect,

but this amount was doubled in November when it became clear that previous economic

growth forecasts were unachievable and the cost of the banking crisis was going to be

higher.

Returning debt levels to normal will be a long haulConclusions on sovereign debt sustainability are subjective in nature, as they depend on

assumptions about future interest rates, economic growth and the stance of fiscal policy.

In theory, a sovereign has unlimited control over fiscal policy, as it can decide to cut

spending or raise taxes by more if growth falls short or the interest rate is too high. In

practice, this is not the case as the actions have social and political consequences. Withthis in mind, Ireland faces a tough road ahead over the coming years. By our analysis,

even if the targets for growth and the budget deficit over the coming years are achieved,

reducing debt levels to Maastricht Treaty levels would require tight fiscal policy for up to

twenty years. Some countries have been able to reduce debt from the sorts of levels that

Ireland is projected to rise to. Indeed, Ireland did it in the 1980s and 1990s, while Belgium

also managed to do it.

As we have laid out in this note, however, it will involve significant fiscal restraint for some

time. The task has been made very much harder by the socialisation of bank debt. We

believe that there should be a form of risk sharing with taxpayers and bond-holders for

the banking crisis above and beyond what we have seen already. However, we would

note that Ireland cannot do this on its own due to the implications for Irelands funding

ability even beyond the current IMF/EU programme, both for banks and for the sovereign.

2

Increase in cost of banking

crisis has had biggest impact

on debt levels over recent

months...

...while the upcoming PCAR

will determine any further cost

Fiscal restraint will be required

for possibly up to two decades

to return debt to Maastricht

levels

I R I S H D E B T D Y N A M I C S - A N U P D A T E


3/153

It needs the cover of a European-wide resolution to the problem. But it needs it quickly.

The longer Ireland and the EU delay the setting up of a European-wide bank resolution

scheme, the lower the incentive there is for doing it, as the bonds are gradually paid off

over the coming years. For example, 5.7bn of unguaranteed senior debt matures in

2011 and 7bn in 2012. Our work on debt dynamics suggests that recent events and the

likely evolution of debt over the coming years makes it more likely that Ireland will not be

able to afford to pay back its debt in the future. If that is the case, markets will continue

to recognise this, current unsustainable market interest rates will remain and a default

event will be forced by the market (either that or IMF/EU funding continues indefinitely).

There is no easy choice here. Ireland must push through a tough budget consolidation

over the coming years to bring about a primary budget surplus. If it can do this, it can

stabilise its debt level and start to reduce it from 2015 onwards. Whether markets believe

this and interest rates fall accordingly though is a different story. There is a possibility of

sovereign debt buybacks but this will only modestly improve Irelands debt position. The

room for further error is narrowing rapidly. Ireland cannot decide to restructure bank debt

unilaterally, but given the systemic importance of Ireland to the euro-area and the banksto Ireland, there should be collective responsibility and burden-sharing involved in the

restructuring of the Irish banking system. This could involve the EFSF taking equity

stakes in the Irish banks or a European backstop being provided for the facilitation of the

sale of the Irish banks to larger international ones.

Likely path for deficit and debt levelsBack in early September 2010, we set out our projections for debt and deficit levels in the

period from 2011-2014. At the time, we suggested that debt levels would reach 105% in

2013 and stabilise at that level. This was based on a fiscal consolidation plan being

implemented, amounting to 7.5bn, and banking costs of 35bn. The total consolidation

efforts have now been raised to 15bn but this does not accelerate the reduction in the

deficit and lower the forecasted debt level. Rather, the higher consolidation efforts stem

from a combination of lower GDP levels, lower economic growth forecasts and higher

costs associated with the banking sector. The final reason has the largest impact.

The table on the next page shows our latest fiscal forecasts for the Irish economy. Deficit

forecasts have not changed dramatically over recent months, but the gross debt and net

debt forecasts have increased. Gross debt is now expected to reach 115% of GDP in

2014, with net debt estimated at 110%. The reason why the gap between these twovariables has narrowed so significantly is due to the run-down of Irelands cash position

due to no new funding and the part-liquidation of the National Pensions Reserve Fund,

which was a condition of the IMF/EU aid deal. Less than 5bn will be in the NPRF by the

end of this year, outside of the directed investments in the banks. It is under the direction

of the IMF/EU that an immediate 10bn is used to recapitalise the banking system.

Because this comes from existing resources, it does not increase the gross debt position,

but it does increase the net debt position and is incorporated in our forecasts below.

No easy options but a primary

surplus is a necessity

Bigger consolidation and

higher banking costs

Gross debt will now peak at

115% of GDP



4/15

Cost of the banking crisis is a moving target...We accept that the main moving variable in our fiscal forecasts of late has come from the

large and growing costs of the banking crisis. A further 25bn contingency fund is

available for the banking system should loan losses and thus recapitalisation costs

exceed the Irish authorities estimates, although the IMF states that they do not expect the

additional cost to exceed the further 35bn (10bn immediate plus further 25bn

contingency). Lets review the costs thus far and the possible additional costs.

...with latest estimate put at 36% of GDPThe gross fiscal cost for the Irish government of recapitalising the banking system may

now come to 57bn, as illustrated in the table. This amounts to 36% of 2010 GDP. We

have not included the gross costs of the purchase of NAMA loans from the banks. As can

be seen below, this puts Irelands crisis at the very top of our list of developed economy

crises (based on IMF data).

4

Contingency fund for banks is

available...

...should losses exceed current

estimates


Goodbody Fiscal forecasts2009 2010f 2011f 2012f 2013f 2014f

Budget Deficit (% of GDP) -14.6% -31.7% -9.7% -7.8% -6.0% -4.3%

Excluding Banking costs -11.9% -11.8% -9.7% -7.8% -6.0% -4.3%

General Government Debt (% of GDP) 65.6% 94.7% 103.4% 109.8% 113.3% 114.9%

Interest/GDP 1.6% 2.6% 3.7% 4.3% 4.8% 5.2%

Average interest rate 3.2% 3.9% 4.9% 5.0% 5.1% 5.3%

Assumed interest rate on new debt 5.1% 5.0% 5.8% 5.8% 5.8% 6.0%

GDP growth (real) -7.6% -0.4% 1.1% 2.1% 2.0% 2.0%

GDP growth (nominal) -11.3% -1.0% 1.0% 2.6% 3.5% 3.5%


Fiscal costs of banking crisis by institution in millions Anglo INBS AIB BOI EBS ILP Total

Equity 4,000 - 3,700 1,663 - - 9,363

Preference Shares - - 3,500 1,837 - - 5,337

Promissory Note 25,300 5,300 - - 250 - 30,850

Special Investment shares - 100 - 625 - 725

Possible further capital required 5,000 4,700 1,499 11,199

Total 34,300 5,400 11,900 4,999 875 - 57,474

% of 2010 GDP 21.7% 3.4% 7.5% 3.2% 0.6% 0.0% 36.4%

Source: NTMA, Central Bank, DoF, Goodbody estimates

Fiscal costs of banking crisesSystemic

banking crisis

(starting date)

Fiscal cost

(gross, as %

of GDP)

Minimum real

GDP growth

rate

Ireland 2008 36.3 -12.3

Korea 1997 31.2 -6.9

Japan 1997 24.0 -2

Iceland 2008 13.1 -9.1

Finland 1991 12.8 -6.2

Netherlands 2008 12.7 -5

Hungary 1991 10.0 -11.9

UK 2008 8.7 -5.9

Luxembourg 2008 7.7 -8.5

Czech Republic 1996 6.8 -0.8

Spain 1977 5.6 0.2

Belgium 2008 5.0 -4.1

United States 2008 4.9 -4.1

Austria 2008 4.1 -4.6

United States 1988 3.7 -0.2

Sweden 1991 3.6 -1.2Greece 2008 3.6 -2.5

Denmark 2008 3.1 -6.9

Norway 1991 2.7 2.8

Source: IMF & Datastream


5/155

Further stress tests are to be completed on the banks in March that may lead to further

capital being required. At this stage we do not believe the full 25bn will be required but

the cost of the banking crisis has continued to surprise us on the upside over the past two

years. If we were to assume that the full 25bn contingency fund had to be utilised

(assuming 15bn in 2011 and 10bn in 2012), this would bring the peak gross debt

position to 131% of GDP by 2014.

FISCAL SUSTAINABILITY

Interest costs Although the timing of external intervention was earlier than we would have thought,

triggered by the precarious position of the banking system, it was becoming clear from

September onwards that Ireland would have to apply for aid. If the ECB hadnt effectively

forced the issue, it would not have made sense for Ireland to continue to fund itself in the

market at unsustainable interest rates when alternative funding at lower rates was

available. A look at the chart below shows the record high real yields on Irish ten-year

debt. With deflation, real ten-year yields are over 9%.

Recourse to external aid

became inevitable


Trajectory of Irish government debt levels

0%

20%

40%

60%

80%

100%

120%

140%

1998 2000 2002 2004 2006 2008 2010e 2012f 2014f

Debt/GDP

With full use of 25bn contingency fund Without use of 25bn contingency fund

Source: DoF, Goodbody estimates

Irish real* 10-year yields

-2

0

2

4

6

8

10

12

Sep-

85

May-

87

Jan-

89

Sep-

90

May-

92

Jan-

94

Sep-

95

May-

97

Jan-

99

Sep-

00

May-

02

Jan-

04

Sep-

05

May-

07

Jan-

09

Sep-

10

Realrate(%)

Source: Datastream *using CPI less mortgage costs

Average 1985-1995 = 6.7%Current = 9.2%


6/15

This bond yield is now largely irrelevant with Ireland not having to fund itself for the next

three years because of its agreed facilities with the EU, IMF and some individual

countries. The yield which Ireland can access funding has been subject to a great deal of

debate since it was announced in late November 2010. The current understanding is that

the interest rate on the debt will average 5.8% but there are negotiations ongoing that

may lead to a lowering of that rate, possibly to be announced at the time of the European

Council meeting in late March, along with other measures to reinforce the EFSF and

finalise details on a permanent mechanism.

Interest bill rising sharplyWe estimate that Irish interest costs will rise to 4.4% of GDP in 2012 (see table) and to

5.3% of GDP in 2014. This compares to an interest bill of just 0.9% as recently as 2008.

This is clearly a dramatic increase in interest costs and has led to the Government having

to continually increase its target for the primary balance over recent years. According to

European Commission estimates, Ireland will have the third highest debt interest bill in

the euro-zone by the end of 2012 behind Greece (7.4% of GDP) and Italy (4.9%). One

can also assess debt dynamics on the basis of interest/revenue ratios. Once again, thisratio has risen sharply, with European Commission forecasts putting it at 13% in 2012.

Our forecasts have the ratio going as high as 17% by the end of 2014. While high, we

reiterate that this ratio was over 25% during the 1980s fiscal crisis in Ireland, before it fell

for a period of two decades.

6

Possibilitiy of lower interest

rate on EU loans

Ireland will have the third

highest interest bill in euro-

zone in 2012


Public Finances - Key Data (% of GDP)2010 2011 2012 2010 2011 2012 2010 2011 2012 2010 2011 2012 2010 2011 2012

Ireland -11.8* -9.7 -7.8 2.5 3.2 4.4 -6.7* -5.6 -4.6 95 105 111 74 95 104

Greece -9.6 -7.4 -7.6 6.0 6.2 7.4 -1.4 2.1 2.6 140 150 156 93 105 110

Spain -9.3 -6.4 -5.5 2.0 2.4 2.8 -5.4 -2.5 -2.0 64 70 73 43 49 53

France -7.7 -6.3 -5.8 2.6 2.7 2.8 -3.5 -2.0 -1.5 83 87 90 57 62 65

Cyprus -5.9 -5.7 -5.7 2.3 2.4 2.4 -2.8 -2.6 -3.0 62 65 68 n/a n/a n/a

Slovenia -5.8 -5.3 -4.7 1.6 1.7 1.8 -2.4 -2.1 -2.0 41 45 48 5 10 13

Slovakia -8.2 -5.3 -5.0 1.4 1.8 2.1 -6.5 -3.2 -3.0 42 45 47 25 28 31

Portugal -7.3 -4.9 -5.1 2.9 3.7 4.0 -3.8 -0.1 -0.3 83 89 92 63 68 70

Belgium -4.8 -4.6 -4.7 3.5 3.5 3.6 -0.2 -0.2 -0.5 99 101 102 82 84 85

Italy -5.0 -4.3 -3.5 4.6 4.8 4.9 1.0 1.3 1.6 119 120 120 103 105 105

Netherlands -5.8 -3.9 -2.8 2.2 2.3 2.4 -1.9 0.0 0.9 65 67 67 35 38 40

Austria -4.3 -3.6 -3.3 2.8 2.8 2.9 -0.6 -0.1 -0.1 70 72 73 42 44 46

Malta -4.2 -3.0 -3.3 3.1 3.1 3.1 -0.8 0.2 -0.4 70 71 71 n/a n/a n/aGermany -3.7 -2.7 -1.8 2.4 2.4 2.4 -0.4 0.2 1.1 76 76 75 51 52 52

Finland -3.1 -1.6 -1.2 1.2 1.3 1.6 0.6 1.7 2.2 49 51 53 -57 -52 -49

Luxembourg -1.8 -1.3 -1.2 0.4 0.4 0.5 0.7 1.2 1.1 18 20 21 -42 -39 -37

Euro-area -6.3 -4.6 -3.9 2.9 3.0 3.2 -2.1 -0.5 0.0 84 87 88 59 62 63

UK -10.5 -8.6 -6.4 2.7 3.0 3.2 -5.7 -3.8 -2.0 81 89 95 51 58 62

US -11.3 -8.9 -7.9 2.7 2.8 2.8 -7.1 -5.5 -3.6 93 99 101 68 74 78

Japan -6.5 -6.4 -6.3 2.7 2.8 2.8 -5.5 -5.6 -5.4 198 204 210 114 120 127

Source: European Commission, OECD, Goodbody estimates

*Excluding c.20% of GDP of one-off banking costs

Budget deficit

Interest

expenditure

Cyclically-adjusted

primary balance Gross Debt Net Debt


7/157

DEBT ARITHMETICWhile these ratios are useful in comparing debt dynamics across countries, they do not

give conclusive evidence of whether a sovereign is on a sustainable debt path. This is

better gauged using some budget arithmetic. Simply, to stabilise the debt level, the

government must target a primary balance (deficit/surplus excluding interest payments)based on the following formula:

Pbb=ND*[(r-g)/(1+g)]

Pbb is primary budget balance, ND is net government debt, r is the real interest rate and

g is the real growth rate of the economy. The term on the right hand side of the equation

tells us the addition to the debt level as a result of the difference between growth and the

interest rate. If the interest rate is higher than the real growth rate, a primary surplus must

be targeted to stabilise the debt level. In the table below, we detail the various required

primary surpluses that are required under varying assumptions for growth and the interest

rate, using 110% (our estimate for the net debt/GDP ratio in 2014) as the net debt

assumption. We have highlighted in yellow the rough target that the government has set

for the primary balance.

Interest bill rising sharply

To stabilise debt, this condition

must be met


Forecast interest/Gov. revenues ratio 2012

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

Gree

ce

Irelan

dIta

ly

Portu

gal

USA UK

Malt

aSp

ain

Belgi

um

Euro

Area

Slov

akia

Austria

Cyprus

Germ

any

Fran

ce

Nethe

rland

s

Slov

enia

Finlan

d

Luxe

mbo

urg

Interest/gov.reve

nues

Source: EC, Goodbody estimates

Interest costs/total revenue in Ireland

0%

5%

10%

15%

20%

25%

30%

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

e20

12f

2014f

Interest/revenue

Source: DoF, Goodbody estimates


8/15

While some are making the conclusion that some sovereigns in the euro-area are

insolvent, this is a very subjective argument. As long as a country can run a primary

surplus big enough to offset the difference between the interest rate and the growth rate,

it can, in theory at least, stabilise its debt level. Greece is a case in point. The EC expects

Greece to run a cyclically-adjusted primary surplus of 2.6% of GDP in 2012, while interest

will amount to 7.4% of GDP. It, like Ireland, will have to sustain primary surpluses for a

number of years to stabilise and then bring down the debt level. To come up with a

scenario where debt is stabilised in a reasonable timeframe, Ireland has been increasing

its target for the primary balance. For example, in Budget 2010 in December 2009, the

targeted structural primary surplus was 0.4% in 2014, but now the government is

targeting a primary surplus of 2.1%. This is as a result of a higher debt burden, higher

interest rates and thus increased interest costs.

8

Government has been

targeting higher primary

surpluses


1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0%

9.0% 8.7% 8.1% 7.5% 7.0% 6.4% 5.8% 5.3%

8.5% 8.2% 7.6% 7.0% 6.4% 5.9% 5.3% 4.8%

8.0% 7.6% 7.0% 6.5% 5.9% 5.3% 4.8% 4.2%

7.5% 7.1% 6.5% 5.9% 5.4% 4.8% 4.2% 3.7%

7.0% 6.5% 5.9% 5.4% 4.8% 4.3% 3.7% 3.2%

6.5% 6.0% 5.4% 4.8% 4.3% 3.7% 3.2% 2.6%

6.0% 5.4% 4.9% 4.3% 3.7% 3.2% 2.7% 2.1%

5.5% 4.9% 4.3% 3.8% 3.2% 2.7% 2.1% 1.6%

5.0% 4.3% 3.8% 3.2% 2.7% 2.1% 1.6% 1.1%

4.5% 3.8% 3.2% 2.7% 2.1% 1.6% 1.1% 0.5%

4.0% 3.3% 2.7% 2.2% 1.6% 1.1% 0.5% 0.0%

3.5% 2.7% 2.2% 1.6% 1.1% 0.5% 0.0% -0.5%

3.0% 2.2% 1.6% 1.1% 0.5% 0.0% -0.5% -1.1%2.5% 1.6% 1.1% 0.5% 0.0% -0.5% -1.1% -1.6%

2.0% 1.1% 0.5% 0.0% -0.5% -1.1% -1.6% -2.1%

Real GDP

Realinterestrate

Primary budget balance needed to stabilise debt under varying

assumptions for growth & interest rates

Developments in interest and structural primary balanceInterest expenditure 2008 2009 2010 2011 2012 2013 2014

Budget 2008 (Dec 07) 1.0 1.1 1.1 - - - -

Budget 2009 (Oct. 08) 1.1 1.8 2.1 2.2 - - -

Supp. Budget 2009 (Apr. 09) - 2.2 3.1 3.8 4.1 4.2 -

Budget 2010 (Dec 09) - 2.1 2.9 3.4 3.8 3.9 3.9

Budget 2011 (Dec 10) - - 3.0 3.3 4.1 5.6 5.5

Structural primary balance 2008 2009 2010 2011 2012 2013 2014

Budget 2008 (Dec 07) 0.7 0.7 0.5 - - - -

Budget 2009 (Oct. 08) -3.9 -3.0 -1.2 0.3 - - -

Supp. Budget 2009 (Apr. 09) - -6.0 -4.4 -2.1 0.2 2.0 -

Budget 2010 (Dec 09) - -7.2 -6.5 -5.1 -3.0 -1.3 0.4

Budget 2011 (Dec 10) - - -6.0 -4.6 -2.8 -0.5 2.1

Source: DoF


9/159

No easy choices for IrelandThe other alternative, of course, is to restructure the debt. Such a course of action would

have massive implications which we will not get into here, but the further a country moves

into primary surplus, the more incentive it has to default on its foreign sovereign liabilities,

as it would not have a need to fund itself in international markets for the running of the

general government. In this scenario, the benefits of having continued access to foreign

funding must then be weighed up against the costs, social and economic, of

implementing and sustaining a significant fiscal consolidation.

What does this imply for Ireland? We have already determined that Ireland will be able to

stabilise its debt level in 2014/2015 if it follows through with its fiscal consolidation plan.

But how long will it take to return the debt level to some normal level? The first point is

that there is no normal level, but we suggest 60% of GDP here as it is the target set out

in the Stability and Growth Pact. The chart below takes a number of scenarios, with the

first being the most realistic in our view at this stage (remember, we are talking about a

post-2014 world in this analysis). All of the scenarios use a 3% primary surplus and a

starting 110% net debt level (our assumption for 2014, although this could be lowered

somewhat by government asset sales). Under the first scenario (our base scenario), thedebt/GDP ratio falls below 100% again as soon as 2018 and below 60% of GDP by 2034.

This happens much quicker in scenario 2 (high growth, high inflation) and doesnt happen

before 2050 in scenario 3 (low growth, low inflation).

A key point here is that Ireland has achieved this sort of debt reduction before. We have

mapped the experience from 1987 onwards onto the chart below, with the peak year for

Irelands debt position (1987) set at what we expect will be the year that debt will peak on

this occasion (2014). The trend up to 2007 was effectively in line with Scenario 2 below,

namely high growth and high inflation. We would expect that the situation over the coming

years will not resemble that of the 1980s/1990s consolidation.

Returning debt to normal

levels could take up to two

decades

A 1980s scenario once again


Scenario analysis post-2014Assumptions Scenario 1 Scenario 2 Scenario 3

Growth 3.0% 4.0% 2.0%

Interest rate 5.5% 6.0% 5.0%

Inflation 2.0% 4.0% 1.0%

Primary surplus 3.0% 3.0% 3.0%

Reaches 100% debt/GDP in: 2018 2016 2023



-100

-50

0

50

100

150

1998 2002 2006 2010 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050

NetDebt/GDP

Scenario 1 Scenario 2 Scenario 3 1980s

Government debt levels beyond 2014 under different

scenarios


1987 level

rebased to 2014


10/15

If we were to start with a 125% of GDP starting net debt position (i.e. the level if all of the

additional 25bn contingency fund for the banks was used, then, in scenario 1, the net

position would only fall to 60% of GDP in 2040, effectively delaying the process by six

years.

The key conclusion of this analysis is that although the pain (fiscal consolidation) will be

taken over the 2011-2015 period, Ireland will need to sustain a prudent budget position

for possibly decades to restore public finances to normal levels. The EU of course will

insist on countries keeping their fiscal affairs in order, but the more likely scenario is that

debt levels will remain high in Ireland for quite some time to come.

CAN COUNTRIES SUSTAIN HIGH DEBT RATIOS?The answer to this question seems to be only if markets let them. The threshold that

markets continue to accept (i.e. continue to lend at sustainable interest rates) is higher in

developed economies than developing economies, but the markets mood can change as

we have learned from the ongoing sovereign crisis in the euro-area. There have been

instances though where countries with persistently high debt levels continued to befunded by the market. Two particular examples in Europe are Belgium and Italy. For

example, gross debt in Belgium reached 140% of GDP in 1993. This was as a result of a

period of close to 20 years when the budget deficit did not fall below 6%, while relatively

high budget deficits were registered over the following three years too (4/5%). Over time,

the debt position fell, reaching a recent low of 94% of GDP in 2008, just prior to the crisis,

while it is expected to rise above the 100% level again this year. During this period,

Belgium ran structural primary budget surpluses averaging 4.5% of GDP. To reduce the

debt level, the government had to run a significant primary surplus, given the weak

growth dynamics relative to interest rates at the time. The same was the case in Italy,

which ran a primary surplus averaging 3.2% over the fourteen year period from 1994 to

2007.

As we have shown already, Ireland achieved a remarkable reduction in government debt

levels over the 1987-2006 period. This reduction was achieved through a combination of

high growth (averaging 6.2%) relative to interest rates and prudent fiscal policy (structural

primary surplus of 3.6%).

The markets have become less forgiving and it is still not clear whether: (1) more

countries in the euro-zone will have to resort to emergency funding facilities like Ireland

and Greece and; (2) these countries will be able to return to markets following the end of

the funding programs. Clearly, the market increasingly believes that debt restructuring is

in the offing. Our analysis above shows that the task facing Ireland to return its public

finances to stability is a daunting one.

10

Extra banking costs could

delay debt reduction by six

years

Belgium, Italy and Ireland have

been able to reduce debt from

very high levels in the past


Successful debt reduction episodesPeakdebt Year

Troughdebt Year

Reduction

in debt

level (% ofGDP)

No. ofyears

Average

structural

primary surplusover period

Average

interest costsover period

GDP

growth

overperiod

Belgium 140.8 1993 88.1 2007 -52.7 14 4.5 6.6 3.5

Italy 121.8 1994 103.6 2007 -18.2 13 3.2 7.2 1.6

Ireland 112.4 1987 24.8 2006 -87.6 19 3.6 4.5 6.2

Source: European Commission, OECD, DoF


11/1511

At a minimum, for Ireland to be able to return to the market for funding following the

IMF/EU loan period, a few conditions must be in place:

(1) Most importantly, Ireland must continue to illustrate its abilities to tackle its fiscal

problems.

(2) Growth-enhancing reforms must bear fruit with a return to economic growth.

(3) The banking sector must be made fit for purpose and the burden removed from the

state and;

(4) Ireland requires an amelioration of the wider concerns in euro-zone sovereign debt

markets.

Latest speculation on debt buybacks Implications for IrelandKlaus Regling, head of the EFSF, has recently been credited with pushing for the EFSF

to be involved in the process of what can be termed sovereign liability management,

where countries are permitted to buy back their sovereign debt at the discounted prices

that they are currently trading at. How could this pan out for Ireland? The following list

shows existing Irish bonds outstanding in the market. There is no way of knowing who is

the owner of these bonds, but the data from last years European stress tests reveal thatthe majority of sovereign debt held by the banking system is in held to maturity books.

Therefore, it is unlikely that these banks will want to sell their government bond positions,

triggering losses.

From a par value of 90bn in sovereign bonds outstanding, the current market value of

the bonds is 76.2bn. Some of these bonds, especially those close to maturity, are

trading at close to par and thus would not be part of a liability management exercise. If

we exclude these bonds, the market value of 66bn is 13.7bn, or 17%, below the par

value. If Ireland was able to purchase all of these bonds on the open market at this price

it would reduce Irelands debt/GDP ratio by 8% of GDP. Even this reduction in debt

though will not be achievable through these means, for the reasons cited above.

Therefore, it seems that while the proposals to reduce sovereign debt without formal

restructuring would help, the scale of the reduction in debt levels is modest and at the

margin.

Number of conditions must be

in place for Ireland to return to

funding markets

Benefits of sovereign liability

management looks small


Outstanding Irish Government bondsMaturity Coupon Outstanding (m) Ask price Market value (m)

11/11/2011 4 4,539 100.56 4,564

05/03/2012 3.9 5,595 100.10 5,600

30/09/2012 8.75 18 104.75 19

18/04/2013 5 6,134 98.00 6,01115/01/2014 4 11,857 92.57 10,976

18/08/2015 8.25 7 102.23 8

18/04/2016 4.6 10,169 86.89 8,835

18/10/2018 4.5 9,256 80.51 7,452

18/06/2019 4.4 7,700 77.75 5,986

18/10/2019 5.9 6,767 85.71 5,799

18/04/2020 4.5 11,852 76.14 9,024

18/10/2020 5 7,716 77.78 6,002

13/03/2025 5.4 8,285 75.49 6,254

Total 89,895 76,531

Discount to par value 13,364-

Discount (%) -15%

Source: Bloomberg


12/15

SCOPE FOR BURDEN-SHARING WITH BANKBONDHOLDERS

Burden-sharing has already occurred with the subordinated bondholders in the Irish

banks. However, this burden-sharing has been small in the context of the total fiscal cost

of this banking crisis. How much more burden-sharing could be done? We have detailed

the outstanding bonds of the five financial institutions which have had to receive financialassistance from the state. There is currently c.6bn outstanding subordinated debt and

15.4bn in outstanding senior unsecured debt. Ireland cannot unilaterally decide to

burden share with senior bond holders in the Irish banks. Indeed, it is clear that the

EU/ECB vetoed any such suggestions in the negotiations last November. However, with

a new incoming government, we believe that this issue should be looked at again,

especially should the upcoming stress tests necessitate further capital into the Irish

banks. As a rule of thumb, every 10% haircut on the unguaranteed, unsecured bank debt

is equivalant to 1.3% of GDP. We would note that the longer the process goes on, the

less incentive there is to burden share with senior, unsecured, unguaranteed bank debt

holders. Time is of the essence.

12

21.5bn of unsecured,

unguaranteed bank bonds

outstanding


m 2011 2012 2013 2014 2015+ Total

AIB

Senior Secured 2,500 2,250 2,000 1,000 4,350 12,100

Government Guaranteed 510 1,225 2,367 - 2,153 6,255

Senior Unsecured 1,644 3,459 - 750 - 5,853

Senior Subordinated - - - - 2,029 2,029

Junior Subordinated - - - - 765 765

BoI

Senior Secured - 1,744 1,163 1,744 - 4,651

Government Guaranteed 730 755 1,477 56 2,876 5,895

Senior Unsecured 2,780 915 1,128 92 337 5,252

Senior Subordinated - - - - 2,010 2,010


Anglo

Senior Secured - 1,901 2,300 500 350 5,051

Government Guaranteed 286 1,783 917 2,986

Senior Unsecured 1,028 1,964 88 31 35 3,146

Senior Subordinated - - - - 0 0


INBS

Senior Secured - - - - - -

Government Guaranteed - - - - - -

Senior Unsecured - 632 - - - 632

Senior Subordinated - - - - 171 171Junior Subordinated - - - - 0 0

EBS

Senior Secured - - - - - -

Government Guaranteed - - - - 1,025 1,025

Senior Unsecured 223 57 92 65 80 518

Senior Subordinated - - - 60 152 212

Junior Subordinated - - - - - -

Total

Senior Secured 2,500 5,895 5,463 3,244 4,700 21,802

Government Guaranteed 1,526 3,764 3,845 56 6,971 16,161

Senior Unsecured 5,675 7,027 1,308 938 452 15,400

Senior Subordinated - - - 60 4,362 4,422

Junior Subordinated - - - - 1,630 1,630Total Unsecured, Unguaranteed 5,675 7,027 1,308 998 6,444 21,452

Total 9,701 16,686 10,616 4,298 18,115 59,415

Source: Bloomberg

Irish bank debt


13/1513

CONCLUSIONSIrelands problem is that it has combined the effects of record budget deficits with a record

socialisation of the losses in the banking system. There has been some burden-sharing

with subordinated bondholders and equity holders in the banks but this has been small

relative to the scale of losses in the system overall. Taking the period from 2008-2011, we

estimate that the net debt ratio will have increased by 76% of GDP (from 23% to 99%).

Of this, 32% of GDP will have been due to the banking crisis, while the rest is due to

budget deficits. Ireland could comfortably cope with the increase in sovereign debt as a

result of budget deficits, but the bank debt has made it close to unmanageable,

depending on assumptions that are used for future debt dynamics.

Ireland cannot and should not decide to force burden-sharing on senior bank debt-holders unilaterally. The implications for bank, corporate and sovereign funding in Ireland

could be hampered for years to come. Ireland needs to conform with European practice

on this issue. However, we feel the IMF/EU plans for the Irish banking sector are under-

whelming and insufficient. It is clear that the Irish state cannot continue to cover the

liabilities of the Irish banks. This burden must be removed by way of a combination of:

European facilitation of the sale of Irish bank assets, or entire banks;

A European bank recapitalisation fund and/or insurance scheme;

The buy-back of senior debt and/or an orderly restructuring of senior bank debt.

If the Irish banks are systemic to the European banking sector, then collectiveresponsibility must be taken for sorting the problems.

So, whats next? Ireland faces a critical few months. The longer bank debt continues to

be paid off, the lower the incentive for forcing pain on the remaining bondholders and the

higher the burden on the State. This increases the chances of sovereign restructuring

down the road, although we would stress again that such an option cannot be on the table

until Ireland brings about a primary surplus. The new government thus has a small

window of opportunity to convince the EU that it is in everyones interests to implement a

more comprehensive reform of the banking system that recognises that the Irish

sovereign can no longer support the burden alone. There have been moves in the right

direction from Europe, such as the discussions on lowering the interest rates on EFSF

loans and widening the scope of that institution. Policymakers now need to implement

wide-ranging reforms at the March 24/25 summit and thus recognise that the solutions

thus far have not gone far enough.

Inclusion of bank debt has

made sovereign position

untenable

Ireland cannot unilaterally

decide, but EU must recognise

that the sovereign cannot bear

burden of banking collapse on

its own

Critical few months ahead


0

500

1,000

1,500

2,000

2,500

3,000

3,500

Feb-11

Apr-11

Jun-11

Aug-11

Oct-11

Dec-11

Feb-12

Apr-12

Jun-12

Aug-12

Oct-12

Dec-12

mln

Source: Bloomberg

Redemption profile of Irish unsecured and senior

subordinated bank debt


14/15

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