Exaggeration of Irish debts distorts economic picture

 

OPINION:State’s liabilities have been overstated – debt levels will fall when growth returns this year

IRELAND HAS suffered a wrenching economic and fiscal adjustment over the last three years. Gross national real income per capita has dropped back to its lowest level since 1999. And general government debt has tripled.

In November 2010, the banking problems became so acute that the country had to agree a credit line with the IMF, EFSF, EFSM and some other nations.

Although Ireland’s situation is very challenging, recent superficial commentary (particularly from overseas) has distorted the picture.

First, to the pressing issue: the scale of the potential liabilities arising from the Irish banking guarantee has been wildly exaggerated.

A recent Bloomberg story suggested that the banking guarantee had the potential to raise Irish public debt 12-fold.

The State initially guaranteed the full liabilities of six institutions – Anglo Irish Bank, Allied Irish Bank, Bank of Ireland, Educational Building Society, Irish Life Permanent and Irish Nationwide – in September 2008, but later narrowed the range of liabilities backed by the taxpayer.

The State did not guarantee the UK-owned banks which have a real economy presence in Ireland and were backstopped by the British government.

Moreover, the liabilities of foreign-owned financial institutions with a presence in the International Financial Services Centre in Dublin are not in any way the obligation of the Irish taxpayer.

This is why repeated use of the Bank for International Settlements data on total banking liabilities in Ireland is so dangerous and damaging.

According to that data, total liabilities of banks based in Ireland were $880 billion at the end of September 2010, or 410 per cent of GDP. In comparison, total banking liabilities guaranteed by the State amounted to 135 per cent of GDP. It is still a substantial figure, but far below the irrelevant settlements data that many commentators have used.

Reducing this liability is crucial in the next few years, but to protect the taxpayer, asset firesales are not the means to that end. The State must avoid further unnecessary capital calls, given the already high level of government debt. What about the assets of the domestic-focused banks, in effect private sector credit of Irish residents?

Here the arithmetic becomes trickier, as some foreign-owned institutions that are not guaranteed by the Irish taxpayer such as Ulster Bank (part of RBS), National Irish Bank (Danske) and KBC have also lent to Irish residents. Total loans to Irish householders, businesses and insurance companies/pension funds amount to about €350 billion, or 223 per cent of GDP at the end of 2010. That compares with the euro area average of 179 per cent.

Irish residents took on too much debt and are now deleveraging. But the debt overhang is not quite as bad as some of those who are unfamiliar with the relevant data have portrayed. And that ratio will begin to fall more quickly, as nominal economic growth revives in 2011. Second, the construction bubble, financed by cheap, plentiful credit, made Ireland a net importer of capital in the period 2000-2010. As imports soared, it ran a current account deficit.

The excess of loans over deposits was financed by overseas banks, pension funds and insurance companies. Crucially though, the recession has seen the current account deficit vanish as imports dropped (by 16 per cent from peak to trough) and exports remained resilient.

Ireland is no longer living beyond its means. In the third quarter of 2010, Ireland ran its biggest current account surplus since 2003.

This year, it is likely to run a full-year current account surplus for the first time since 1999.

Despite a substantial, albeit declining, public sector deficit, financial claims on Ireland by foreigners will fall. As a guide to the competitiveness gains made and the reduced future net reliance on overseas investors, that is an important watershed.

The economy has made impressive progress in regaining trade competitiveness since mid-2008.

The European Commission projects that Ireland’s unit labour costs will be in line with the rest of the euro area in 2011, having risen well ahead of the euro area average between 2002 and 2008.

The evidence suggests that internal devaluation is achievable within a common currency zone with the added safeguard of foreign exchange rate stability (compared with say 1992-1993) and a credible lender of last resort. Yet competitiveness is not just about cost.

Why would Ireland’s exports of services have doubled during the 2002-2008 construction bubble, when inflation was rampant?

Ireland has other significant advantages that counted then and matter today; not least its corporate tax rate, well-educated young labour supply and favourable business environment.

Exports of services from Ireland remained more or less flat during the dramatic drop in global trade in late 2008 and early 2009.

In the first nine months of 2010, they jumped 11 per cent in volume compared with the same period in 2009 (services now account for almost half of Ireland’s total exports). The target for Ireland is to mimic the export-led growth of 1994 to 2001 on a less ambitious scale.

Third, the rapid rise in Ireland’s stock of government debt has sparked speculation about its sustainability, some of it based on confused analysis. In this regard, the programme agreed with the IMF, EU and ECB has caused misunderstanding. For example, the Financial Times’s “Short View” column added €85 billion to the estimated end year 2010 general government debt stock of €148 billion (94 per cent of GDP). But the Government is using €17.5 billion of its own resources as part of the programme.

Moreover, the exchequer financing portion includes a €45 billion provision for the budget deficits and bond redemptions that had to be covered in any case in the next two years.

Repayment of maturing existing government bonds using programme funds has no net effect on the level of outstanding debt. Finally, the initial recapitalisation of the viable State-guaranteed banks to a core equity ratio of at least 12 per cent in advance of the Prudential Capital Assessment Review (PCAR) II stress tests will not lead to a rise in gross government debt as it will be financed by the existing resources of the State and by private capital.

Claims that the country is insolvent are often based on misinformation. We know that there is strong domestic resolve across the political spectrum to produce a healthy primary budget surplus, eg the surplus ex-interest payments by 2014.

One important factor that has been repeatedly missed is that the average interest rate (which is what matters for debt sustainability) on Ireland’s stock of general government debt was only 3.3 per cent last year.

Ideally, the marginal rate at which new borrowing or refinancing is conducted would then be kept low to safeguard debt sustainability.

Based on the starting position for debt to GDP at the end of 2010, official GDP growth and interest rate forecasts and assuming that no further public funds are required for bank recapitalisation above the €10 billion committed in advance of PCAR II, a primary surplus of 0.4 per cent of GDP is needed to stabilise the debt to GDP ratio.

For illustration, if the banking recapitalisation cost to the State rose by €10 billion more, growth is one percentage point per annum lower and the average interest rate one percentage point higher, the primary budget surplus required to stabilise the debt ratio (albeit at a more elevated level) increases to 2.4 per cent of GDP. That arithmetic is no doubt tough and it is vital to limit additional taxpayer banking costs, but Ireland achieved much bigger primary surpluses in the sluggish economic times of the early 1990s.