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News : Irish Last Updated: Jul 27, 2009 - 9:03:14 AM

Irish Economy: Morgan Stanley scenario analyses on Ireland's fiscal sustainability; Legacy of banking crisis likely to be long-lasting if not permanent increase in net public indebtedness
By Michael Hennigan, Founder and Editor of Finfacts
Jul 24, 2009 - 7:23:44 AM

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From ESRI report Recovery Scenarios for Ireland

Irish Economy: US investment bank Morgan Stanley on Thursday published scenario analyses investigating the sustainability of Ireland's public finances, motivated by the increase in indebtedness arising from the banking crisis and the recession. MS examined three alternative macroeconomic scenarios; special attention is given throughout to the interaction between the macroeconomic situation and the potential recovery on impaired banking sector assets. The MS report says the legacy of the banking crisis is likely to be a long-lasting, if not permanent, increase in net public indebtedness.

In scenario 1 (‘Benign Normalisation'), the macroeconomic backdrop is a relatively positive one, both in the near term (cyclical recovery) and long term (secular growth). The other two scenarios explore the risks for Irish public finances if the economy performs less well. Specifically, scenarios 2 and 3 look at different ways in which the economy might underperform the benign assumptions of the first scenario: in scenario 2 (‘Protracted Adjustment'), Ireland's economic performance is assumed to be moderately inferior to scenario 1 for the entire scenario horizon (ending in 2050). In scenario 3 (‘Competitive Deflation'), on the other hand, the economy performs poorly in the short and medium term, with competitiveness-enhancing deflation and sluggish real growth. In the long run, however, the economy evolves somewhat better than in scenario 1, the benign scenario. The scenarios are constructed in this way in order to contrast short- and long-term risks to the Irish fiscal position. In a sense, therefore, the two scenarios constitute a ‘stress test' of Ireland's public finances.

MS says in the Benign Normalisation scenario, fiscal sustainability is not in peril. Currently planned policies, if maintained indefinitely, are sufficient to maintain a bounded debt/GDP ratio in both the short and long run irrespective of asset recovery. Net indebtedness as a share of GDP peaks at around 107% in 2012 before declining. However, MS says currently planned policies do not allow the government to attain pre-crisis levels of indebtedness by the end of the scenario horizon (2050), even if asset recovery is high.

In the Protracted Adjustment scenario, current fiscal plans fail to stabilise debt/GDP even under the most optimistic assumptions about asset recovery. Achieving debt stabilisation would require drastic fiscal consolidation in this scenario, over and above what is already planned by the Irish government. MS estimates that a budgetary consolidation of 13-15% of GDP over four years would be required. However, the economists say such a fiscal consolidation would be achievable from an economic perspective. This is not least due to the very high level of per capita income that Ireland has attained in recent years. The necessary adjustment, while undoubtedly very painful, would likely still leave living standards at levels familiar to the recent past.

  It is worth pointing out that, even in this most optimistic scenario, the net debt ratio does not actually return to pre-crisis levels (22% in 2008) within the scenario horizon. Put differently, achieving pre-crisis levels of debt given the scenario parameters would require higher primary surpluses and/or higher asset recovery (or, indeed, earlier asset recovery). The legacy of the banking crisis is therefore likely to be a long-lasting, if not permanent, increase in net public indebtedness.

In the Competitive Deflation scenario, economic adjustment is even sharper in the short-to-medium term, followed by solid performance once competitiveness has been regained through deflation. While ultimately fiscal sustainability is ensured by the long-term performance, the risk is that the sharp near-term deterioration of the economy results in very high debt/GDP ratios. Short-term stabilisation of debt/GDP would be very difficult to attain under realistic assessments of the scale of fiscal consolidation possible, and net debt as a share of GDP could exceed 160% in this scenario. Still, such levels of indebtedness are not without precedent for industrialised countries.

MS also investigates the implications of the government receiving dividend income from its equity stakes in the banking sector. In the difficult environment of scenarios 2 and 3 (Protracted Adjustment and Competitive Deflation), such revenue - - while not sufficient to reverse the near-term developments - - - may prove helpful through either lessening the required fiscal consolidation or shaving some percentage points off the debt/GDP ratio.

MS concludes that Ireland's public finances may well be able to withstand serious economic headwinds. However, substantial additional fiscal consolidation would be required if the economy underperforms the optimistic scenario. Finally, under certain adverse, but plausible, macroeconomic conditions, indebtedness may climb sufficiently to test financial markets' confidence about fiscal sustainability.

Budget Terms Glossary

Primary expenditure: All budget expenditure items except interest payments on outstanding debt.

Primary balance: Primary expenditure less total revenue. If primary expenditure exceeds total revenue, the primary balance is in deficit (primary deficit).  If primary expenditure is less than total revenue, the primary balance is in surplus (primary surplus).

Net borrowing (general government deficit):Excess of total expenditure over total revenue. If total expenditure exceeds total revenue, net borrowing is positive and the budget is in deficit.

Net borrowing versus primary deficit:By definition, the primary deficit is the general government deficit (net borrowing) excluding interest payments on the outstanding debt. Put differently, net borrowing is the sum of interest payments and primary deficit:

1. Context

MS economist Spyros Andreopoulos, says Ireland has been one of the great economic performers of the late 20th century. However, since around the turn of the millennium, the path of the economy was unsustainable as large macroeconomic imbalances built up. Consequently, Ireland was vulnerable to a correction. The intensity of the global financial turmoil has hit Ireland - - an economy with a relatively large financial sector and stretched real estate valuations - - particularly hard. The ensuing systemic banking crisis resulted in the government taking on a substantial part of the banking system's assets as well as guaranteeing its liabilities.

Andreopoulos says while this policy response was similar to many other governments, the size of the banking sector relative to the economy was such that it resulted in an increase in measures of government indebtedness so substantial that the very solvency of the Irish sovereign has been called into question by some commentators. The contingent obligations connected with the government's guarantee of banking sector liabilities (both bank debt and deposits) have attracted particular attention due to their size (250% of GDP). The recent easing in global financial stress has taken some of the pressure off Irish assets. However, Ireland faces an economic turmoil on a scale some have compared to the Great Depression.

Given the adjustment ahead, and the marked worsening of the government's balance sheet, the spotlight is now on the sustainability of current and planned fiscal policy. MS therefore concentrated on four questions. (1) Are current (currently planned) policies sustainable? (2) If not, what level of primary surplus is necessary to achieve sustainability? (3) Is further budgetary consolidation necessary to achieve the primary surplus consistent with sustainability? (4) If yes, is this consolidation achievable?

In order to answer these questions, MS conducted a scenario analysis of Ireland's public finances. It investigated three scenarios. The first scenario combines official European Commission (EC) forecasts for 2009-10 and the Irish government's own projections for 2011-13 with an extrapolation of those projections into the future. The other two scenarios assume that the Irish economy underperforms the first scenario in different ways over the medium and long term. In a sense, therefore, these scenarios constitute ‘stress tests' since they investigate the evolution of public finances under macroeconomic conditions worse than projected by the Irish government.

"We emphasise that this piece is an exercise in scenario analysis rather than an attempt at forecasting," MS says.

What Is Fiscal Sustainability?

The key question throughout is whether current or currently planned budgetary policies are sustainable, given the different scenarios. That is, if executed as planned, and maintained indefinitely, would these policies lead to fiscal outcomes consistent with the sovereign being able to meet its obligations? The analysis distinguishes two notions of sustainability.

  • ‘Weak' sustainability is about policies that are consistent with a stable level of government liabilities as a percentage of income (GDP), i.e., a constant debt/GDP ratio;

  • ‘Strong' sustainability is a more stringent requirement and involves the achievement of a target debt/GDP ratio, e.g., the Maastricht requirement of 60%.

The Policy Response to the Banking Crisis

MS says the Irish government's response to the crisis has comprised several elements, encompassing both sides of the banking sector's balance sheet. It is likely that more measures will be announced in the near future.

Bad bank: While not all details have been finalised at the time of writing, the plan is to set up an asset management company (the National Asset Management Agency - NAMA) which will take the problematic assets off the banking sector's balance sheet. At the moment, it is envisaged that NAMA takes on real estate and related assets (land and development loans and associated commercial loans) with a book value of €80-90 billion. The government's aim is for a comprehensive solution. That is, it is intended that all impaired loans are taken off the banks' books. In return for the impaired real estate assets, the banks will receive government bonds issued by the National Treasury Management Agency. (These bonds could then be used as collateral to obtain ECB funding.)

Bank recapitalisation/nationalisation:The Irish government has already injected €7 billion in equity capital into the banking system (€3.5 billion each into Allied Irish Banks and Bank of Ireland) as well as nationalising one specific lender (Anglo-Irish Bank PLC). The government has also announced a €4 billion injection of equity capital into Anglo Irish. Depending on the scale of the losses, further capital injections into the banking system may become necessary.

Guarantee scheme: On September 28, 2008, the Irish government announced a guarantee scheme. This consists of (1) Deposit guarantee: a guarantee of all deposits (retail, commercial, institutional and interbank). (2) Debt guarantee: a large part (covered bonds, senior debt, dated subordinated debt) of the debt securities issued by Irish banks was guaranteed. The total guarantee is worth around €485 billion and expires at midnight on September 28, 2010.

What Matters?

As discussed, there have been many elements to the Irish government's response to the banking crisis. Not all are immediately relevant from a fiscal sustainability perspective. The guarantee scheme that covers deposits and bank debt is worth around €485 billion. This guarantee amounts to a contingent liability for the government in excess of 2.5 times GDP and has attracted considerable attention in the media and financial markets. However, the government is effectively taking ownership of the banking sector, through equity stakes (prospective or actual) or outright nationalisation. At the same time, the planned ‘bad bank' will divest the banking system of its troubled assets. If done comprehensively, as is the government's intention, the banks should be viable and even reasonably profitable - and likely to be able to service their debt as well as meet their obligations towards depositors.

In short MS says, through the government's intervention on both sides of the banking system's balance sheet, it has become less likely that the contingent liabilities from the guarantee scheme will ever become explicit. Put differently, it is the government's ability or otherwise - - now and in the future - - to service the actual debt that matters. With the sovereign having backstopped the banking system, all other issues have been relegated below this question. The answer, of course, depends to a substantial extent on the performance of the economy.

2. Assumptions Underlying the Scenario Analysis

General Assumptions

MS argued above that the most relevant aspects of recent policy interventions to shore up the banking system are those that have consequences for the actual stock of government debt. First, additional debt will have to be issued to beef up banks' equity capital. How much additional capital is needed will in turn depend on the scale of the losses banks face. Second, the government will need to capitalise NAMA, the asset management company (AMC) that will take the bad loans off banks' balance sheets. Since at the time of writing many of these issues have not yet been definitively resolved, MS made some assumptions which are  common for all MS scenarios.

NAMA: MS assumes that NAMA takes on assets with a book value of €85 billion after applying a 40% discount (haircut). The losses taken by banks would therefore be around €35 billion (or 20% of GDP). NAMA then needs to be capitalised with €50 billion (30% of GDP) - - MS assumes that the government raises the full amount by issuing bonds. The potential cash flows that may accrue to the government from the NAMA assets is ignored.

Recapitalisation: MS assumes that the government recapitalises the banks with €20 billion (12% of GDP), which is added to the stock of debt for 2009. This assumption follows the IMF: "If the losses suffered by banks are about 20 percent of GDP, as estimated by staff, then bank recapitalisation needs could be around 12-15 percent of GDP".

Interest rate on debt. MS assumes that the implicit interest rate on the debt (the product of interest payments and last year's stock of debt) is a constant 5.1% throughout. This assumption extrapolates the implicit interest rate forecast by the European Commission for 2010. Note that this level is probably optimistic in the short run, given the sharp increase in indebtedness. In Appendix A in the full report, MS conducts a sensitivity analysis by setting the implicit interest rate to 5.5%, the average implicit interest rate for Ireland over 1991-2008.

National Pensions Reserve Fund (NPRF) and government cash balances. MS follows Bergin et al. Recovery Scenarios for Ireland (2009) and assume that these amount to €18.3 billion (11% of GDP) each at the end of 2009. MS assumes that the NPRF earns a (nominal) rate of return of 5% annually. MS assumes, arbitrarily, that the government's liquid assets (cash balances) grow at the same rate as nominal GDP.

Assumptions on Asset Returns

The report says both the timing and the price at which the assets will be disposed of, matter for fiscal sustainability. This is true for both the real estate assets warehoused in NAMA and the equity stakes the Irish government has with the banks. However, both the timing and the government's ultimate return on those assets are uncertain at the moment. In what follows, MS assumes that all assets are disposed of in 2020. That is, it assumes that NAMA will be dissolved and the proceeds from the sale of NAMA assets will accrue to the government, who will in turn retire an equal amount of debt. The bank also assumes that the government will sell its equity stake in the banking sector in the same year. This assumption about the timing is arbitrary and made for analytical convenience. MS notes however, that this seems a reasonable time span in the light of previous experiences with asset management companies (AMCs) in the context of systemic banking crises. Further, official announcements by the Irish government explicitly indicate that the life span envisaged for NAMA is 10-15 years.

Regarding the sale price of the assets, the report says it is clear that this will depend to an important extent on the performance of the economy. If the recovery is sustained and the Irish economy returns to a robust trend growth rate, then the disposal of assets will likely make a significant contribution towards a structural improvement of the fiscal situation. If, on the other hand, the economy underperforms, then the contribution made by asset sales is likely to be small.

In what follows, MS at first assumes that the government breaks even, in a present value sense, with respect to the equity stakes in the banking sector. That is, the government recovers the exact amount of the initial investment and the accumulated interest cost of financing the capital injection. For the NAMA assets, on the other hand, it simply investigate various recovery assumptions.

Why treat NAMA assets and equity stakes differently? MS says this treatment is sensible assuming all bad assets have been taken off the banking sector's books, as is the expressly stated objective of the government: the performance of banks which start off with a clean balance sheet should be a lot less dependent on the macroeconomic outcome than the resale value of the bad assets. The analytically simplest way to reflect this dichotomy is to assume that the bank equity stakes will be neutral for public indebtedness in the medium term.

However, MS looks at the consequences of relaxing this assumption. This may be important because the government could receive non-negligible cash flows from the assets it owns. This would provide some relief on the budgetary side but may also slow down the accumulation of the debt. In particular, it is possible that the yield the government earns on at least some of the assets actually exceeds the rate of interest it has to pay on the debt issued to acquire them. In other words, the government may end up benefiting from a type of ‘carry trade'.

In this alternative framework, MS assumes:

  • The government receives a fixed dividend of 8% on its equity stakes up to, and including, 2020, when all equity is sold: this increases revenue for the government by €1.6 billion every year. It abstracts from any other cash flows the government may receive in this context.

  • There are no capital gains on the equity stakes, i.e., when sold in 2020 the government earns €20 billion, the exact amount it assumed will be spent in 2009.

Three Long-Term Macroeconomic Scenarios

MS constructs three scenarios for the evolution of the economy over the next 40 years (2011-50). The long horizon of the analysis serves to highlight how the evolution of indebtedness depends on a few key economic factors. For the short term, 2009 and 2010, the bank uses European Commission (EC) forecasts with one modification: the level of interest payments in 2010 is higher than estimated by the EC. This is because the €70 billion jump in the stock of debt in 2009 due to the described measures had not been taken into account in the EC forecasts.

In the first scenario, the economy rebounds out of the recession and grows solidly afterwards. The other two scenarios assume that the loss of competitiveness reflected in the large macroeconomic imbalances of the last few years will have to be reversed.

(1) ‘Benign Normalisation' scenario: MS assumes here a healthy cyclical recovery from the deep slump of 2009-10 as well as long-term outperformance, with trend real GDP growth at 3%.

(2) ‘Protracted Adjustment' scenario: MS assumes that the economy regains competitiveness gradually over a long time span (2011-50). Inflation and real GDP growth are both lower than for Ireland's main trading partners. In this scenario, nominal GDP growth is lower than the assumed interest rate on the stock of debt for the entire horizon of the analysis.

(3) ‘Competitive Deflation' scenario: This scenario differs from the previous one in two main respects. First, MS assumes that competitiveness is restored by 2020, that is, the necessary adjustment is sharper, but faster. This involves outright deflation, as well as very low growth rates for real GDP. Second, the Irish economy outperforms its trading partners after 2020. In this scenario, between 2011 and 2020 nominal GDP growth is zero and thus substantially below the assumed interest rate on debt. From 2021 onwards, nominal GDP growth exceeds the interest rate.

Which Measure of Debt?

MS uses the ratio of net general government debt to GDP as the measure of financial liabilities (henceforth net debt or net debt ratio). It uses net debt rather than gross debt because this is the proper measure of the country's fiscal position: the difference is made up of liquid assets in the NPRF and cash held by the government. These are liquid funds that are instantly available to the government in the case of a severe fiscal crisis and should therefore be subtracted from gross debt if one is to have a proper assessment of the scale of government liabilities.

The economists says there is one more conceptual issue to be addressed in the present context. A substantial part of the debt run-up is due to the acquisition of assets on behalf of the Irish government - - this is true for both the real estate and related loans warehoused in NAMA, and the equity stakes in the banking system. These assets may well produce cash flows over the period they are held by the government for and/or capital gains when eventually sold off to private investors. In other words, they may be partly or wholly self-financing, and should therefore be ring-fenced, i.e., shown separately.

MS says the practical problem is, of course, that the cash flows and - - even more so -  - the eventual proceeds from the sale of these assets are uncertain. If, for the sake of argument, these assets were to not generate any income at all, the Irish government would still be liable for the corresponding debt. Therefore, an analysis of fiscal sustainability must be based on total debt, that is, the debt arising from the acquisition of banking sector assets should be included. The measure of net debt will therefore be net total debt, i.e., net debt including the liabilities resulting from the acquisition of assets.

3. The Three Scenarios with Alternative Recovery Assumptions

MS illustrates the outcomes across scenarios for the net debt ratio assuming that the currently planned primary surplus of 0.7% to GDP for 2013 (from the Irish government's Euro Stability Pact submission to the European Commission) is maintained until 2050 - - under three different recovery assumptions: €10 billion, €30 billion and €50 billion.

This amounts to 20%, 60% and 100%, respectively, of the assumed 2009 outlays for the capitalisation of NAMA. Of course, if the economy evolves according to the Benign Normalisation scenario (scenario 1), high asset recoveries are more likely. Similarly, if economic performance is poor (scenario 2 and scenario 3 in the short term), low recoveries are to be expected. The report nevertheless compares the scenarios for identical recoveries in order to demonstrate the dynamics implied by the different assumptions.

The report  also illustrates debt outcomes in each scenario for three different levels of the primary surplus with more detailed recovery assumptions. The first line for each recovery level shows the debt ratios at different points in time assuming that the currently planned primary surplus is achieved in 2013 and maintained until the end of the scenario horizon. The second line, wherever relevant, shows the level of the primary deficit that, if maintained from 2014 onwards, stabilises the net debt ratio (at whichever level).  The third line shows the primary deficit that achieves a terminal net debt ratio of 60%.

(1) Benign Normalisation scenario: Sustainability Not an Issue...

In scenario 1 (Benign Normalisation), the macroeconomic outturn ensures sustainability of currently planned policies as the rate of growth of nominal GDP exceeds the interest rate on the debt from 2012 onwards. If the target primary surplus of 0.7% of GDP is achieved by 2013, and maintained for all subsequent years, the debt ratio is not only stable but decreasing after reaching a peak of around 107% in 2012. Even the lowest recovery of €10 billion would have the debt ratio at 67% of GDP in 2050. With a - - more likely - - recovery of 60 cents on the euro in 2020 (€30 billion), a net debt ratio of 60% is achieved towards the end of the scenario horizon. A full recovery (€50 billion) in 2020 would have the net debt ratio below 60% by 2036.

...but the Crisis-Related Increase in Debt May Be Near-Permanent

It is worth pointing out that, even in this most optimistic scenario, the net debt ratio does not actually return to pre-crisis levels (22% in 2008) within the scenario horizon. Put differently, achieving pre-crisis levels of debt given the scenario parameters would require higher primary surpluses and/or higher asset recovery (or, indeed, earlier asset recovery). The legacy of the banking crisis is therefore likely to be a long-lasting, if not permanent, increase in net public indebtedness.

(2) Protracted Adjustment Scenario: Currently Planned Policies Not Sustainable...

In the case of scenario 2 (Protracted Adjustment), maintaining the currently envisaged policy, i.e., a primary surplus of 0.7% of GDP by 2013 for the entire horizon, is no longer sufficient to achieve stabilisation of the net debt ratio. This is the case irrespective of asset recovery. Put differently, the net debt ratio rises inexorably even under the most optimistic assumptions about future proceeds from the sale of NAMA assets. A full recovery of €50 billion, for example, would have the net debt ratio dip from a peak of 117% of GDP in 2019 to 82% in 2020, but the debt ratio would resume its upward trajectory from then on since the nominal interest rate exceeds the rate of growth of nominal GDP throughout.

...Making Additional Consolidation Necessary

Clearly, asset recovery at the upper end of the spectrum becomes less likely if the economy underperforms, as in this scenario. And even achieving the primary surplus currently planned for 2013 (0.7% of GDP) would require further fiscal efforts as the economy in this scenario performs worse than assumed in the Irish government's plans (more on this below).

(3) Competitive Deflation scenario: Long-Term Economic Outperformance Ensures Bounded Indebtedness Eventually...

Scenario 3 (Competitive Deflation) has a much sharper adjustment in the short run but the economy outperforms in the long run. This ‘split' trajectory results in a considerable difference between short- and long-term debt dynamics. In the long run, unchanged policies - i.e., primary surpluses equal to the target 0.7% of GDP from 2013 onwards - would stabilise the debt ratio even with very low asset recovery. Indeed, the assumed outperformance of the economy ensures that the debt ratio actually declines steadily after 2020 and reaches a level of 93.6% by 2050, even with a very low recovery of 20 cents on the euro.

...but Beware Short-Term Levels

However, in the short run the debt ratio would reach a very high 167% of GDP in 2019 before declining in 2020 on asset sales. Even with very high recovery, the net debt ratio would still be above 123% of GDP in 2020. The risk in this scenario is obvious: in the short term the debt ratio exhibits unstable behaviour. Even though the resulting debt levels are certainly not unprecedented for a developed economy, financial markets may become increasingly nervous as debt climbs. The reports says the stylised nature of the analysis probably exaggerates both the short-term debt build-up and the subsequent turnaround. However, the main insight is valid: if the economy evolves according to a possible worst-case scenario such as this one, with deflation and near-stagnant growth, debt levels are likely to climb substantially.

4. Debt-Stabilising Primary Balance

Which level is required for the primary surplus in order to achieve debt stabilisation? What primary surplus would achieve a 60% net debt ratio in 2050?

The report says:"We have discussed above that under the conditions of the Benign Normalisation scenario, currently planned policies are sustainable. In scenarios 2 and 3, however, higher primary surpluses are required."

(2) Protracted Adjustment Scenario: Doubling of Planned Primary Surplus Likely Required for Stabilisation...

The economists say depending on asset recovery, a primary surplus of at least 1.3% of GDP from 2014 onwards is required to stabilise the debt ratio. A 60 cents on the euro recovery in 2020 - - possibly an optimistic assumption for this scenario - - would require a primary surplus of 1.4% of GDP from 2014 onwards to stabilise net debt at a level of 85% of GDP. This is double the primary surplus currently planned (for 2013). Under the worst assumptions about recovery, €10 billion in 2020, a primary surplus of 1.5% of GDP from 2014 onwards is required to stabilise the debt ratio at around 93% of GDP. Of course, from a historical perspective these levels for the primary surplus are far from unusual. However, in this scenario (and scenario 3), the economy is in much worse a shape than it was when those historical primary surpluses were achieved.

...While the 60% Debt Target Could Require Three Times the Currently Planned Primary Surplus

Achieving a target of 60% for the debt ratio by 2050 would require primary surpluses of at least 1.7% of GDP from 2014 onwards. A 60 cents on the euro recovery would require a primary surplus of 1.9% of GDP. In the worst case of a €10 billion recovery (20 cents on the euro), the required primary surplus rises to 2.2% of GDP.

(3) Competitive Deflation Scenario: Short-Term Debt Stabilisation Very Difficult

MS says because of the long-term outperformance of the economy, the currently planned primary surpluses (0.7% of GDP in 2013) are sufficient for debt stabilisation if upheld until the end of the scenario horizon. For the same reason, the requirement for the 60% terminal debt ratio is lower in this scenario. For example, with a (low) recovery of 20 cents on the euro, a primary surplus of around 1.8% of GDP is sufficient to reduce the debt ratio to 60% by 2050. However, the report emphasises again the short-term issues: such a primary surplus would still have the peak (2019) level of the debt ratio near or above 160%. Conversely, near-term stabilisation of the debt ratio requires primary surpluses that would be virtually unattainable, given the assumed macroeconomic backdrop: for example, a primary surplus of 7% of GDP from 2014 onwards would still result in a net debt ratio of 124% in 2019.

5. Additional Consolidation Requirements

MS says it has shown above that in scenarios 2 and 3 additional consolidation is necessary to achieve debt-stabilising levels for the primary balance. Here, it provides some answers to question (3) - - what further consolidation is required to achieve sustainability? - - and (4) - - whether these requirements are feasible - - posed at the outset. The economists says they use the requirements posed by the worst asset recovery assumptions; since the debt-stabilising level of primary surplus is highest for those cases, achieving these levels would be automatically sufficient if recovery is higher.

In the Protracted Adjustment scenario above, the report showed that the 0.7% of GDP primary surplus planned for 2013 is not, if maintained indefinitely, sufficient to stabilise the net debt ratio under any assumption about asset recovery. Debt stabilisation under the lowest recovery assumption of €10 billion would require a primary surplus of 1.5% of GDP. Achievement of a target debt ratio of 60% of GDP by 2050 on the other hand would require a primary surplus of 2.2% of GDP under the same recovery assumption. Here, MS recognises that achieving the necessary primary surpluses would require further consolidation since revenue and expenditure are different to the levels underlying the assumptions in the Stability Pact (SP) due to the assumed macroeconomic environment. It concentrates on the Protracted Adjustment scenario as this suffices to illustrate the issues.

The Estimated Consolidation Needed to Achieve the Target Primary Surplus in the Scenarios...

MS' target primary balances for 2011 and 2012 are the levels projected in the Stability Pact (SP) submission by the government (deficits of 3.5% and 1.7% of GDP, respectively). The target primary surplus level of 0.7% of GDP for 2013 is also from the SP submission. Even though insufficient for debt stabilisation in scenario 2 if maintained - as shown above - it constitutes a natural benchmark for the analysis.

...Would Be 13-15% of GDP over Four Years...

Overall, achieving the target primary surplus of 0.7% of GDP requires a cumulative reduction of 13.2% of GDP over 2011-13. As explained above, even this reduction is not sufficient to stabilise the debt ratio. Stabilisation actually necessitates a primary surplus of 1.5% of GDP from 2014 onwards, which requires a cumulative consolidation of 14.0% of GDP over 2011-14.  Finally, achieving a 60% net debt ratio by 2050 requires a primary surplus of 2.2% of GDP from 2014 onwards. In turn, this implies a total consolidation requirement of 14.7% of GDP between 2011 and 2014.

...Which Would Require Drastic Cuts in Public Expenditure or Large Increases in Taxes for Many Years...

Is a primary surplus of 2.2% of GDP and thus an almost 15% of GDP reduction in the deficit feasible? MS calculates that a consolidation of this magnitude would necessitate reducing the share of expenditure to GDP from a peak of about 51.5% in 2010 to about 39.5% in 2014 while simultaneously increasing the ratio of government revenue to GDP from 33.5% in 2010 to 35% in 2014: on the expenditure side, interest payments as a share of GDP increase until 2014, thereby requiring a decrease in the ratio of primary expenditure from around 46% to 33% in 2014. Compensation of employees, i.e., public sector wages, and social transfers, being the largest expenditure items would have to bear the brunt of the cuts. An average annual reduction of 5% in both these items would be required over 2011-14, along with other minor expenditure reductions. As the emphasis here is on expenditure cuts, this plan for the deficit reduction would require an only modest increase in the share of taxes and social security contributions in GDP - from 28.5% in 2010 to 30.5% in 2014.

...Likely a Major Challenge, but Achievable From an Economic Perspective

The report says there is little doubt that a fiscal consolidation on this scale - - whether tilted heavily towards expenditure cuts as in the example or more towards revenue-raising - - would pose nothing less than a major challenge. Whether such a challenge would be met is probably as much a political question as it is an economic one. From an economic perspective, the adjustment, painful as it would be, seems to us to be achievable: given the high pre-crisis per capita income levels, the required cuts would bring living standards down substantially, but probably not below levels familiar from the recent past.

6. Dividend Payments

MS also looked at the implications of the government actually receiving cash flows in return for the assets acquired. As discussed above, it assumed a dividend of 8% on the total amount of capital injected into the banking system. At the same time, it assumed no capital gains or losses when the government's shares are sold in 2020.

With 8% Dividend and No Capital Gains or Losses...

An 8% dividend on €20 billion implies revenue of €1.6 billion every year from 2009 to 2020. In terms of budgetary accounting, this dividend income increases current revenue and therefore decreases the primary deficit (increases the primary surplus). The report illustrates the implications for the debt ratio assuming the usual 20%, 60% and 100% recoveries on NAMA assets. Since fiscal sustainability is ensured in scenario 1, it restricts attention to scenarios 2 and 3 for brevity and assumes that the full amount of the dividend income is used to repay outstanding debt; the consolidation requirements discussed above therefore remain unchanged.

In order to maintain comparability with the evidence presented previously, the net debt ratios resulting from the primary deficit levels indicated net of the received dividend income. That is, the actual level of the primary balance (for the years until 2020) is equal to the sum of the number shown in the table and the received dividend income (as a percentage of GDP).

...the Main Conclusions Are Unaffected...

Overall, the broad conclusions of the analysis remain intact even when dividend payments are introduced. In the Protracted Adjustment scenario, it is still the case that under no recovery assumption is the planned primary surplus of 0.7% of GDP sufficient to stabilise the debt ratio. Further, the primary surplus that stabilises net debt to GDP is similar to the main case scenario without dividends, as is the primary surplus that achieves a 60% net debt ratio in 2050.

...Though Peak Debt Ratios Are Lower...

The main difference arises in the level of the net debt ratio in 2019. The annual flow of dividends now results in a debt ratio of 108.3% of GDP if the (long-term unsustainable) primary surplus of 0.7% of GDP is maintained. If the government received no dividend payments, the 2019 level would be 117.4% of GDP as discussed above. Assuming a €10 billion recovery, the debt-stabilising primary surplus of 1.47% of GDP implies a peak debt ratio of 103.6% of GDP in 2019, compared to 112.4% under the stabilising PS of 1.51% in the case of no dividends. And of course, debt is now stabilised at a lower ratio to GDP than in the no dividends case.

...It May Not Be Sufficient to Make a Difference in Competitive Deflation Scenario

Recall that in the Competitive Deflation scenario a primary surplus of 0.7% from 2013 onwards would be sufficient to stabilise debt in the long run, but in the short term, as the economy underperforms, debt rises quickly. With dividend payments, this primary surplus would result in a lower peak debt ratio of 154.2% in 2019, compared to 166.7% without dividend payments. Clearly, 154% is still a very high level. Since it is difficult to speculate which level of the debt ratio would test financial markets' tolerance, it is impossible to say whether dividend payments would make a material difference.

Specific outcomes aside, MS says the analysis has the straightforward but interesting implication that as long as the dividend yield exceeds the interest rate on the debt - -i.e., the carry is positive - - the government would, from a narrow fiscal perspective, be inclined to hold on to its stakes in the banking sector rather than sell them as quickly as possible. The carry implies that the part of the debt arising from the public equity stake in the banking system is shrinking, both in absolute terms and as a percentage of GDP.


The scenario analysis yields the following main results:

In scenario 1 (Benign Normalisation), which is very similar to the Irish government's assumptions:

  • Currently planned policies are sustainable, and no further consolidation is required.

  • High asset recovery would probably provide further help in reducing indebtedness.

  • However, currently planned policies are not generally sufficient to return net indebtedness to pre-crisis levels, even if asset recovery is high.

In scenario 2 (Protracted Adjustment), the economy does only moderately worse than in scenario 1, but on a sustained basis. In this scenario:

  • Currently planned fiscal policies are not sustainable as the net debt ratio is not stabilised under any assumption about asset recovery.

  • The budgetary consolidation required for sustainable policies would pose a major challenge, though MS thinks that it would be economically achievable.

In scenario 3 (Competitive Deflation), the economy stagnates in the medium term but outperforms in the long run once competitiveness is regained.

  •  In the short term, the debt build-up is substantial and would result in levels of public indebtedness at the higher end of industrialised countries' experience; these levels may test market confidence.

  • In the long term, debt ratios are brought under control by an outperforming economy.

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