Ireland

Irish Debt Dynamics

With a little help from our friends

• EU-wide solution to banking problems required - Without the

enormous fiscal cost of the banking crisis (36% of GDP), the task Government debt levels beyond 2014 under different
scenarios
of returning Irish public finances to stability would have been 150 1987 level
difficult but eminently more achievable. It is clear that the Irish rebased to 2014

sovereign cannot continue to bear the burden of the banking 100

sector liabilities on its own, as the scale of the increase in debt

Net Debt/GDP
50
makes it less likely that it will be able to afford to pay it back in the
future. The IMF/EU response has been piecemeal and 0
underwhelming thus far. Shared responsibility is required. There
is currently €21.5bn in unsecured, unguaranteed bank debt -50

outstanding. Ireland cannot and should not unilaterally decide to -100

restructure these debt holders, but the new Government should 1998 2002 2006 2010 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050
Scenario 1 Scenario 2 Scenario 3 1980s
push this agenda at an EU level. Another option is to allow the Source: Goodbody estimates

EFSF to directly recapitalise weak banking systems such as

Ireland’s or facilitate the sale of Irish banking assets through an
EU-wide insurance scheme. It is in Europe’s interests, as well as
Ireland’s, that the problem is solved. Sorting these problems
would provide a double benefit of easing pressures on the
sovereign and supporting economic growth. Goodbody Fiscal forecasts
2010 2011f 2012f 2013f 2014f
• Reduction in sovereign debt levels will be a long haul - Even Budget Deficit (% of
assuming Ireland achieves its budget consolidation over the next GDP) -31.7% -9.7% -7.8% -6.0% -4.3%
Excluding Banking
four years, tight fiscal policy – i.e. a significant primary surplus - costs -11.8% -9.7% -7.8% -6.0% -4.3%
will be required for possibly up to twenty years if Ireland’s General Government
debt/GDP ratio is to return to levels consistent with the Stability Debt (% of GDP) 94.7% 103.4% 109.8% 113.3% 114.9%
and Growth Pact targets. Starting in 1987, Ireland was able to 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%
reduce its debt level through running a primary surplus of 4% and Assumed interest rate
strong economic growth exceeding real interest rates. This is not on new debt 5.0% 5.8% 5.8% 5.8% 6.0%
likely to be repeated over the coming years in the context of the GDP growth (real) -0.4% 1.1% 2.1% 2.0% 2.0%
deleveraging of the economy here, and, therefore, it may be GDP growth (nominal) -1.0% 1.0% 2.6% 3.5% 3.5%
difficult to convince markets that Ireland can achieve a significant Source: Goodbody estimates

reduction in the debt level without a restructuring. However,

sovereign debt restructuring is not a realistic option until Ireland
achieves 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 Ireland Redemption profile of Irish unsecured and senior
must be reduced. Every 1% reduction in the rate on the loans subordinated bank debt
saves €675m per year on interest payments. This equates to 3,500

0.4% of GDP, in the context of an estimated interest bill of 5.2% 3,000

of GDP in 2014. There is also a prospect of debt buybacks at 2,500

current market prices. If all the debt was bought back at current 2,000
€mln

market prices, it would reduce Ireland’s gross debt position by 8% 1,500

of GDP. In reality, only a small proportion of outstanding Irish 1,000
sovereign bonds will be purchased, reducing the benefits of such 500
an action. Recent rhetoric suggests that these issues are actively 0
being considered at EU level, which is a net positive for Ireland, Feb- Apr- Jun- Aug- Oct- Dec- Feb- Apr- Jun- Aug- Oct- Dec-
11 11 11 11 11 11 12 12 12 12 12 12
but it will not be the silver bullet. Source: Bloomberg

Economist: Dermot O’Leary T +353-1-641-9167 E dermot.c.oleary@goodbody.ie

Economist: Juliet Tennent T +353-1-641-9005 E juliet.c.tennent@goodbody.ie 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
 I R I S H D E B T D Y N A M I C S - A N U P D AT E

D EBT D YNAMICS – A N U PDATE - I NTRODUCTION

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 Ireland’s 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 Increase in cost of banking

process, the updated capital requirements by the Financial Regulator and the crisis has had biggest impact

conditionality contained in the EU/IMF program, this overall cost is now likely to rise to at on debt levels over recent

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

banks, a further €5bn for Anglo Irish Bank (as per Regulator’s 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 ...while the upcoming PCAR

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

IMF’s 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 fiscal
consolidation. 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 haul

Conclusions 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. With
this in mind, Ireland faces a tough road ahead over the coming years. By our analysis, Fiscal restraint will be required

even if the targets for growth and the budget deficit over the coming years are achieved, for possibly up to two decades

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

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

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

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

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 No easy options but a primary
this and interest rates fall accordingly though is a different story. There is a possibility of surplus is a necessity
sovereign debt buybacks but this will only modestly improve Ireland’s 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 banks
to 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 levels

Back 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 Bigger consolidation and
efforts have now been raised to €15bn but this does not accelerate the reduction in the higher banking costs
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 two
variables has narrowed so significantly is due to the run-down of Ireland’s cash position
due to no new funding and the part-liquidation of the National Pensions Reserve Fund, Gross debt will now peak at
which was a condition of the IMF/EU aid deal. Less than €5bn will be in the NPRF by the 115% of GDP
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.

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

Goodbody Fiscal forecasts

2009 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%
Source: Goodbody estimates

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
Contingency fund for banks is
large and growing costs of the banking crisis. A further €25bn “contingency fund” is
available...
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). Let’s review the costs thus far and the possible additional costs.

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

...with latest estimate put at 36% of GDP

The gross fiscal cost for the Irish government of recapitalising the banking system may
...should losses exceed current
now come to €57bn, as illustrated in the table. This amounts to 36% of 2010 GDP. We
estimates
have not included the gross costs of the purchase of NAMA loans from the banks. As can
be seen below, this puts Ireland’s crisis at the very top of our list of developed economy
crises (based on IMF data).

Fiscal costs of banking crises

Systemic Fiscal cost Minimum real
banking crisis (gross, as % GDP growth
(starting date) of GDP) 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 -1.2
Greece 2008 3.6 -2.5
Denmark 2008 3.1 -6.9
Norway 1991 2.7 2.8
Source: IMF & Datastream

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

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.

Trajectory of Irish government debt levels

140%

120%

100%
Debt/GDP

80%

60%

40%

20%

0%
1998 2000 2002 2004 2006 2008 2010e 2012f 2014f
With full use of € 25bn contingency fund Without use of € 25bn contingency fund
Source: DoF, Goodbody estimates

F ISCAL 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 hadn’t effectively Recourse to external aid
forced the issue, it would not have made sense for Ireland to continue to fund itself in the became inevitable
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%.

Irish real* 10-year yields

12

10
Current = 9.2%
Average 1985-1995 = 6.7%
8
Real rate (%)

-2
Sep- May- Jan- Sep- May- Jan- Sep- May- Jan- Sep- May- Jan- Sep- May- Jan- Sep-
85 87 89 90 92 94 95 97 99 00 02 04 05 07 09 10
Source: Datastream *using CPI less mortgage costs

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

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 Possibilitiy of lower interest
debate since it was announced in late November 2010. The current understanding is that rate on EU loans
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 sharply

We 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 Ireland will have the third
European Commission estimates, Ireland will have the third highest debt interest bill in highest interest bill in euro-
the euro-zone by the end of 2012 behind Greece (7.4% of GDP) and Italy (4.9%). One zone in 2012
can also assess debt dynamics on the basis of interest/revenue ratios. Once again, this
ratio 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.

Public Finances - Key Data (% of GDP)

Interest Cyclically-adjusted
Budget deficit expenditure primary balance Gross Debt Net Debt
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/a
Germany -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

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

Forecast interest/Gov. revenues ratio 2012

20%
18%
16%
Interest/gov. revenues

14%
12%
10%
8%
6%
4%
2%
0%
Interest bill rising sharply
K
SA
Po aly

y
ta

G rus
Be in

m d
Ire e

Eu gium

e
nd

Au ia

ia
Sl rea

C ia

g
ov s
ga

an

nc
ec

xe an
nd
U

ur
a

ak

en
al

r
st
la

It

Sp
rtu

yp
A

bo
M

m
re

ra

Lu Finl
rla
ov
l
ro

er
G

F
he

Sl
et
N
Source: EC, Goodbody estimates

Interest costs/total revenue in Ireland

30%

25%

20%
Interest/revenue

15%

10%

5%

0%
96

08
82

84

86

88

90

92

94

98

00

02

04

06

f
e

12

14
10
19

19

19

19

19

19

19

19

19

20

20

20
20

20

20

20
20

Source: DoF, Goodbody estimates

D EBT ARITHMETIC
While 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:
To stabilise debt, this condition

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

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.

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

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 Government has been
Greece to run a cyclically-adjusted primary surplus of 2.6% of GDP in 2012, while interest targeting higher primary
will amount to 7.4% of GDP. It, like Ireland, will have to sustain primary surpluses for a surpluses
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.

Primary budget balance needed to stabilise debt under varying

assumptions for growth & interest rates
Real GDP
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%
Real interest rate

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%

Developments in interest and structural primary balance

Interest 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

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

No easy choices for Ireland

The 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 Returning debt to normal
in the Stability and Growth Pact. The chart below takes a number of scenarios, with the levels could take up to two
first being the most realistic in our view at this stage (remember, we are talking about a decades
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), the
debt/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 doesn’t 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
Ireland’s debt position (1987) set at what we expect will be the year that debt will peak on
A 1980s scenario once again
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.

Scenario analysis post-2014

Assumptions 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
Reaches 80% debt/GDP in: 2026 2020 2043
Reaches 60% debt/GDP in: 2034 2025 2062

Government debt levels beyond 2014 under different

scenarios
150 1987 level
rebased to 2014

100
Net Debt/GDP

50

-50

-100
1998 2002 2006 2010 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050
Source: Goodbody estimates Scenario 1 Scenario 2 Scenario 3 1980s

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

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. Extra banking costs could
delay debt reduction by six
The key conclusion of this analysis is that although the pain (fiscal consolidation) will be years
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.

C AN 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 market’s 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 be
funded 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 Belgium, Italy and Ireland have
period of close to 20 years when the budget deficit did not fall below 6%, while relatively been able to reduce debt from
high budget deficits were registered over the following three years too (4/5%). Over time, very high levels in the past
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%).

Successful debt reduction episodes

Reduction Average GDP
in debt structural Average growth
Peak Trough level (% of No. of primary surplus interest costs over
debt Year debt Year GDP) years over period over period period
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

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.

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

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. Number of conditions must be
(2) Growth-enhancing reforms must bear fruit with a return to economic growth. in place for Ireland to return to
(3) The banking sector must be made fit for purpose and the burden removed from the funding markets
state and;
(4) Ireland requires an amelioration of the wider concerns in euro-zone sovereign debt
markets.

Latest speculation on debt buybacks – Implications for Ireland

Klaus 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 year’s European stress tests reveal that
the 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.

Outstanding Irish Government bonds

Maturity 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 6,011
15/01/2014 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

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 Benefits of “sovereign liability
value. If Ireland was able to purchase all of these bonds on the open market at this price management” looks small
it would reduce Ireland’s 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.

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

S COPE FOR BURDEN - SHARING WITH BANK

BONDHOLDERS
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 financial
assistance from the state. There is currently c.€6bn outstanding subordinated debt and €21.5bn of unsecured,

€15.4bn in outstanding senior unsecured debt. Ireland cannot unilaterally decide to unguaranteed bank bonds

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

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.

Irish bank debt

€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
Junior Subordinated - - - - 727 727
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
Junior Subordinated - - - - 138 138
INBS
Senior Secured - - - - - -
Government Guaranteed - - - - - -
Senior Unsecured - 632 - - - 632
Senior Subordinated - - - - 171 171
Junior 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 1,630
Total 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

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

Redemption profile of Irish unsecured and senior

subordinated bank debt
3,500

3,000

2,500

2,000
€mln

1,500

1,000

500

0
Feb- Apr- Jun- Aug- Oct- Dec- Feb- Apr- Jun- Aug- Oct- Dec-
11 11 11 11 11 11 12 12 12 12 12 12
Source: Bloomberg

C ONCLUSIONS
Ireland’s 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 Inclusion of bank debt has
estimate that the net debt ratio will have increased by 76% of GDP (from 23% to 99%). made sovereign position
Of this, 32% of GDP will have been due to the banking crisis, while the rest is due to untenable
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: Ireland cannot unilaterally
decide, but EU must recognise
• European facilitation of the sale of Irish bank assets, or entire banks; that the sovereign cannot bear
• A European bank recapitalisation fund and/or insurance scheme; burden of banking collapse on
• The buy-back of senior debt and/or an orderly restructuring of senior bank debt. its own

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

So, what’s 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 Critical few months ahead
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 everyone’s 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.

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I SSUER & A NALYST D ISCLOSURES
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