KBC ECONOMIC RESEARCH (GCE) ECONOMIC UPDATES Austin Hughes and Siegfried Top

12 FEBRUARY 2013

Update on Ireland: Promissory notes deal paves the road for successful programme exit

The facts: The Irish Parliament voted on a deal to dissolve the Irish Bank Resolution Corporation (IBRC), thus eliminating one of the most visible reminders of the Irish banking crisis. In tandem with this liquidation, the Irish government swapped 25 bn short-term promissory notes, which were used to recapitalize Anglo Irish Bank during the financial crisis, for longerterm Irish government bonds. This development has the effect of easing Irelands debt burden somewhat over the next few years. This occurs both through a reduction in the amount of sovereign refinancing over the next ten years and also through slightly lower interest payments. Last week, the Troika concluded the 9th review of the Irish EU/IMF-programme, acknowledging the strong adherence to the programme, and discussing a durable exit from programme financing. This new deal, together with the ECBs Outright Monetary Transactions and a potential lengthening of the maturity of EFSF/EFSM bonds by the Council, will lay the foundations for a successful exit of the programme at the end of 2013. The impact of the new deal on KBC Ireland can be seen as positive, mainly for two reasons. Firstly, the general operational background has improved, as the economic outlook looks better after this deal, with the need for new austerity measures having somewhat eased. Secondly, there has been an immediate positive financial impact, which is most visible in the lower government bonds yields and the improved liquidity and funding environment.

Deal on IBRC and the promissory notes Last week, the Central Bank of Ireland (CBI) and the Irish government struck a deal on the liquidation of the IBRC (Irish Bank Resolution Corporation, the wind down vehicle for the merger of the failed Anglo Irish Bank and Irish Nationwide Building Society). This was linked to a decision to replace the so-called Promissory Notes, which were used to recapitalize Anglo Irish during the financial crisis with a portfolio of long term bonds with maturities between 2038 and 2053. The Promissory Notes originally amounted to EUR 30 bn, and were used among other assets - by IBRC as collateral for 40 bn of central bank funding (Emergency Liquidity Assistance, or ELA).

Under the new deal, IBRC will be dissolved in an orderly manner and thus be removed from the financial landscape. Its remaining loan assets will go to the government bad bank NAMA. The liquidation of IBRC means the Irish Central Bank takes charge of the promissory notes that had been used as collateral against the Emergency Lending Assistance provided by the Bank to IBRC. In turn,some 25 bn shortterm promissory notes (weighted average life of 7 years), have been swapped for longer-term Irish government bonds (avg. 34-35 years). This results in an end to related ELA funding. As IBRC is liquidated, the Central Bank acquires the ownership of the new bonds. It will initially hold these bonds but gradually sell part of them, to avoid to create a precedent of monetary financing the main fear of the ECB. According to a Central Bank statement The bonds will be placed in the Central Banks trading portfolio and sold as soon as possible, provided that conditions of financial stability permit. The disposal strategy will of course maintain full compliance with the Treaty prohibition on monetary financing. 1 However, a too sudden sell-off will be avoided, in order not to be disruptive to financial stability, and thus not impede efforts to regain full bond market access. 2 It has been suggested that the average length of holding of these bonds will be about 15 years.

Financial sector consequences IBRC will be removed from the financial landscape. Special liquidators will wind up all of its business and operations. Remaining assets and liabilities will be transferred to NAMA. Assets and subsidiaries will also be valued, and partially sold. Eligible depositors, bondholders and counterparties will be repaid under the Deposit Guarantee Scheme and Eligible Liabilities Guarantee (ELG-) Scheme. The vast majority of IBRCs original deposit book had already moved to Allied Irish Bank and Permanent TSB. So, any impact on deposits is likely to be limited. This cost would fall under the Deposit Protection Account maintained by the CBI. Claims under the ELG could cost the Irish State between 0.9bn and 1.1 bn according to government estimates. The government also has to pay shortfalls that may occur in the swap between NAMA and the Central Bank. These one off costs will offset any interest rate savings on the new structure for 2013 and in all likelihood there will be a marginally negative impact on this years budget arithmetic (the Department of Finance estimates this at just 25 million). Any remaining assets after the unwinding of all secured liabilities will be available for the benefit of the pool of unsecured creditors. This will depend on the value ascribed on the assets in the valuation process. It is expected that no assets will be available to repay subordinated liability holders. As was noted by the EU/IMF review, further good repair of the financial sector is underway, which will allow a removal of the costly ELG-Scheme (see table 1). This will also improve domestic banks profitability, as funding costs of banks are still pushed up by the high fees from this ELG-Scheme.

1 2

Central Bank of Ireland, 7 February 2013. The CBI schedule to sell bonds: 0.5 bn to end 2014, 2015-2018: 0.5 bn per year, 2019-2023: 1 bn per year, 2024 and after: 2bn per year.

Table 1: IMF assessment of Irish bank profitability

Consequences for government budget and debt sustainability Under the scheme, the Irish government had to pay back 1/10th of the Promissory Notes each year, including a yearly interest rate of 8% (altogether 3.1 bn, or 2 % of GDP), placing a significant yearly burden on taxpayers. The 25 bn short-term promissory notes (weighted average life of 7 years), are swapped for longer-term Irish government bonds (avg. 34-35 years), and with an estimated yearly interest rate of 3% (floating rate, Irish spread over 6M Euribor). The funding costs for the Irish state are thus significantly lowered. There will be a reduction in the underlying deficit of 1 bn per year in the coming years, reducing the forecast deficit by 0.6% of GDP annually. In the first year, the costs of the ELG-scheme will incur an estimated cost of 0.6%, thus leveling out the gain from the deal in the first year. For technical reasons related to an interest rate holiday on promissory notes in 2011 and 2012, Irish government debt will initially also slightly increase, to an estimated 122.1% of GDP (up from our forecast of 121%) end 2013. Debt will however decrease faster over time, due to the lower interest rate payments in the medium term (compounded interest benefit are assumed at 5%). Government refinancing needs and debt sustainability have significantly improved. Ireland reduces its market financing requirement by approximately 20 bn in the next ten years. As the Irish government notes, there are significant benefits from a market perspective as it ensures the liability to repay is beyond most credit investors time horizon. This deal noted and therefore agreed to if not formally signed off by the European Central Bank is one of several elements in Irelands debt burden that may be eased by agreement with its EU partners. The European Council is to examine proposals currently being prepared that could also decide on a lengthening of the maturity of EFSF/EFSM bonds for Ireland and Portugal, as was done for Greece, in order to further smoothen the path for Ireland to regain full access to the bond market.

Graph 1: Irish bond yields back to normal

14 12 Ireland Germany

Government bond yields, in %

10 8 6 4 2 0

Growth risks tilted to the upside With a longer maturity financing and a somewhat reduced funding costs, Irelands debt sustainability outlook is impacted favourably. In addition, it appears that the 1 bn interest rate savings will be used to ease the scale of Budget adjustment rather than to speed up the attainment of the 3% deficit/GDP target. So, with the scale of near term austerity eased somewhat, Irish economic growth prospects have been improved modestly. With no policy change, the government deficit would drop below 3 % of GDP (2.4% according to the government) in 2015. Instead, it now seems planned budget adjustments will amount to 4.1 bn between now and 2015 rather than the originally planned 5.1 bn (3.1 bn in 2014, 2 bn in 2015). So, the Irish fiscal stance turns slightly more favorable as a result of this deal. Moreover, the deal can be regarded by the Irish citizens as an adherence of the Troika to the promise of the European Council made last year, that the sustainability of Ireland would be improved. This may stir confidence of consumers, producers and investors. In this context, the immediate impact on Irish Government bond yields has been significant. The removal of IBRC from the financial landscape also further indicates the restoration of the Irish financial sector. This may in turn help interbank lending (the disturbed transmission mechanism) to be restored, and thus ease credit constraints towards the Irish real economy. All in all, the deal again confirms our relatively positive outlook for the Irish economy. Other factors have recently also became more favorable. The recent improvement of the international business environment should be supportive for the Irish exports. It should also be noted that a very strong current account surplus also reflects a statistical impact from a redomiciling of international companies into Ireland that means their international profits appear as a factor income inflow. We assume some gradual normalisation of this effect through 2014-2016. The slight decrease of the unemployment rate and the bottoming-out of Irish house prices also indicate that the worst may be over for the domestic economy. Over the next few years, growth may thus positively surprise, and be firmly above 1% this year and between 2.5 and 3% next year.

Updated macroeconomic outlook Ireland 2013-16

2010
Real GDP growth (in%) Unemployment rate (in %) Inflation (in %, HICP) House prices (annual change, in %) Gov. budget balance (% of GDP) Government debt (% of GDP) Current account balance (% of GDP) -0.8 13.6 -1.6 -13.7 -31.2 92.2 0.5

2011
1.4 14.3 1.2 -15.4 -12.7 106.5 1.1

2012
0.9 14.8 1.8 -12.5 -8.1 118.5 4.5

2013
1.3 14.2 1.9 0.0 -7.5 121.0 5.5

2014
2.5 13.2 1.9 1.5 -4.8 119.0 5.0

2015
3.0 12.0 2.0 3.0 -2.7 115.0 4.5

2016
3.0 10.5 2.0 3.0 -2.2 111.5 4.0