Promissory notes debt deal a step in the right direction

The deal reached last week, with the blessing of the European Central Bank, to restructure the infamous promissory notes relating to the former Anglo Irish Bank and Irish Nationwide Building Society is a good one.

Given the constraints imposed by the ECB’s statutes, it was probably close to what was ever achievable and will bring significant gains for the Irish economy.

The core element is that the financial “sword of Damocles”, namely the repayment of €3.1 billion annually over the next 10 years, has been removed. The replacement of the notes by long-term bonds will lower considerably the financing needs of government in the years ahead. This will ease an exit from the bailout and a return to normal market access.

The interest rate on the bonds (about 3 per cent, although this may increase if world market rates were to rise) is significantly below what the Government would otherwise have had to pay. The Coalition has been able to arrange not only cheaper financing but financing over a much more extended period. While the total debt has remained unchanged in nominal terms, in a financial and economic sense the real value of what will end up being paid has been reduced considerably.

Critics, while rather begrudgingly accepting these gains, have argued that the Government should have simply refused to pay any debt associated with the Anglo/INBS debacles. Whatever about the sense of “historic injustice” involved, there is no doubt that such an action would have constituted a default by the Government. While the promissory notes were an unusual financial instrument, the fact remains that they were an explicit commitment on the part of the sovereign Irish government

The ECB ’s statutes and practices rule out any debt write-off owed to it and it would have been naive and a waste of time for the Irish side to have persisted , as some have suggested, in asking for it. Raising seriously the spectre of default would only have been credible if the Government had intended to do it.

But the effects of a default could have been catastrophic: a rupture of relations with the ECB (on whose financing the fragile Irish banks still depend heavily); a major setback for Government efforts to re-enter bond markets; and unpredictable, but potentially very damaging, broader consequences for our reputation as a legally irreproachable location for foreign investment.

Waiting bailiffs

Moreover, simply announcing a default does not mean the debt goes away. More than 10 years after Argentina defaulted, aggrieved creditors are still pursuing the Argentine government, which remains shut out from international financial markets. A few weeks ago President Christina Kirchner was unable to leave Argentina on the government jet for fear it would be seized by waiting bailiffs. Do we really want to run the risk of placing our President in the same situation?

The frenzied discussions must have seemed bewilderingly complex to many members of the public who understandably want to know the practical effect for them. Budgetary savings on the interest rate bill of about €1 billion will be achieved during 2013-2015 . This is essentially due to the difference between the rates payable on the new bonds and the old promissory notes, after factoring in the implications for the profits of the Irish Central Bank, which are transferred to the budget. However, in 2013 the overall net savings will be zero, as payments have to be made to some depositors of IBRC under the State’s deposit guarantee scheme.

Estimating the budgetary savings beyond 2015 is more complex. A key element is that starting in 2014, the Central Bank is committed to selling the bonds according to a pre-agreed schedule so as to reduce the outstanding ECB financing. This aspect is crucial to the ECB’s ability to withstand legal challenges to the arrangement. It implies, however, that the interest paid on the bonds – which would otherwise have reverted to the budget via central bank profits – will henceforth now remain with private bond holders. This will tend to reduce the net interest gains.

While certainly helpful, there will thus be no massive immediate budgetary impact arising from the deal. Taoiseach Enda Kenny and Minister for Finance Michael Noonan had tried to dampen expectations. Nevertheless, assuming the Government’s existing budget deficit reduction targets remain unchanged, there would be room for some reduction in the expenditure-cutting/tax-increase package that would be needed otherwise.

The ECB, apart from recognising the reality that its financing to Ireland was not going to be repaid for quite some time, has also gained. Replacing the non-marketable (ie, they cannot be bought or sold) promissory notes by conventional government bonds has improved the bank’s asset portfolio held as collateral

This pact only addresses about half of the bank-related debt of €64 billion. Talks will proceed on the other half (relating to AIB and Bank of Ireland) throughout 2013. There may also be the possibility of improving the terms on the EFSF loans used to bail out the regular budget.

Measured approach

What happened last week fell short of what some may have (unrealistically) hoped for. But as part of an overall approach aimed at restoring creditworthiness and achieving a sustained economic recovery it is, undoubtedly, a significant step forward.

Finally, the outcome is a vindication of Noonan’s measured approach. The Minister refrained throughout the long and difficult negotiations from speculating on progress or engaging in temperature-raising rhetoric. The Central Bank under Governor Patrick Honohan also worked hard to arrive at the best feasible result.

While the Government’s critics to date have been rather slow to do so, credit should be given where credit is due.

Donal Donovan, a former staff member of the IMF from 1978-2005 before retiring as a deputy director, is a member of the Irish Fiscal Advisory Council and is co-author with Antoin Murphy of a forthcoming book, The Fall of the Celtic Tiger: Ireland and the Euro Debt Crisis, to be published by Oxford University Press