Promissory note profit hidden in Central Bank footnote

One of the disadvantages of the academic world is that you learn to read the footnotes in any book, and once this skill is acquired, it is difficult to forget. It’s a major handicap in later life as what may otherwise be a very readable book can become hard labour when there are lots of footnotes to be perused. However, a wealth of useful information is often available in footnotes – it pays to read the small print!

The Central Bank’s annual report for 2014, published at the end of April, has some good news for Irish taxpayers – somewhat obscured, both by the technical nature of what was involved, and by its appearance as note 15 to the accounts.

The nice surprise in note 15 is that there is a potential capital gain of over €9 billion on the Central Bank's holdings of the bonds that replaced the promissory notes in the deal done in 2013. This is the profit the Central Bank would have realised if these floating rate bonds had all been sold at the price prevailing at the end of 2014.

As the bonds are held by the Central Bank on its own account (the profit accrues to the Central Bank rather than the ECB), this is good news for the State. Any profit for the Central Bank will ultimately be paid to the Government.

Indeed, since the end of 2014, market conditions have proved even more favourable, which would add to the potential gain.

Positive story

We all know you cannot rely on markets to do the expected. So the eventual outcome, when all the bonds are sold, is uncertain. Nonetheless, this is a positive story.

The Central Bank has agreed to sell the bonds as soon as possible, provided conditions of financial stability permit. A key aspect of financial stability is that the sale of the bonds should not put upward pressure on interest rates.

The factors behind what is classified as a potential capital gain on these bonds are somewhat technical. When the bonds were issued in 2013 as part of the promissory note deal, the terms effectively involved an interest rate premium, relative to Germany, of over 2.5 per cent. If the bonds had been sold early on, the State would have locked in this interest rate over the 30-year life of the bonds. However, financed by borrowing from the ECB, the Central Bank was able to hold on to the bonds temporarily and is now in a position to sell them.

If sold to the National Treasury Management Agency (NTMA) it can, in turn, refinance the bonds at an open market interest rate that is about two percentage points lower than the original interest rate. In other words, Ireland can swap the borrowing represented by these bonds for open market borrowing charging two percentage points less.

Saving

With €25 billion of such bonds, this would amount to an interest rate saving of around €500 million a year. Given that the notes have around 30 years to run, this saving, when capitalised, would amount to the very large sum of €9 billion noted in the Central Bank’s accounts.

The bonds could be sold on the open market by the Central Bank. However, the more likely scenario is that the NTMA will buy back the bonds. While, in accounting terms, the NTMA will pay an extra €9 billion for them (because the bonds are worth more than when they were issued), the State will get this €9 billion back from the Central Bank – it would be a circular transfer.

The real gain to the State would be that the floating rate bonds could then be refinanced at the current lower interest rate.

There is a minor down side to these transactions. Currently the interest rate being paid by the Government on the bonds is effectively zero. If refinanced today, the government could end up paying an interest rate of up to 2 per cent. However, as the bonds will, in any event, be sold over the next few years, this cost must be seen against the very large saving to be made over the 30-year life of the bonds.

Problems

One of the problems with the way government accounts handle these transactions is that the capital gain realised by the Central Bank on the sale of its government bonds is paid to the Department of Finance as part of normal revenue. It may look like current revenue but, in fact, around €600 million of the Central Bank profit paid to the Department of Finance this year is actually a capital gain and it should be applied to reducing the debt, not to financing current expenditure.

The success of the promissory note deal, which is now coming to fruition, will help reduce the ultimate fiscal burden of bailing out the banks. In addition, if properly managed, the State should be able to get back a major part of its “investment” in the surviving banks when they are ultimately sold on the market.

But, while the ultimate cash cost to the State of bailing out the banks now looks like it will be a lot less than the most apocalyptic forecasts at the height of the crisis, the Irish public will still have incurred huge indirect costs from the financial collapse. People suffered a major increase in unemployment, falls in personal income, and many have seen a wipe-out in the value of their assets or remain with large legacy debts.

The welcome bonus we will get as a result of the promissory notes deal won’t offset the cost of what we’ve been through.