The Irish Debt Swap: a promising deal?

Posted by ACELG on 14/02/13

Last week we have witnessed an interesting and positive development in the sustainability of Irish public finance. On February 7, 2013 the Irish Bank Resolution Corporation (IBRC) – an Irish Bad Bank that came into being in July 2011 after a merger between the failing Irish Banks Anglo Irish and Irish Nationwide – was liquidated. The promissory notes held by IBRC, a burden on the Irish budget considered too heavy by many, were changed into long term bonds. Since the promissory notes had functioned as collateral for loans provided by the Irish Central Bank, the liquidation of IBRC meant that they came into the hands of the central bank. Because of the debt swap, the central bank ended up with long term government bonds instead of promissory notes, greatly reducing the financial burden on Ireland in the short term. To put it in economic terms, the repayment is no longer front-loaded. The European Central Bank (ECB) unanimously ‘took note of the Irish operation’.

By Thomas Beukers

Ireland and the ECB

The most recent developments represent yet another interesting element in the relationship between Ireland and the ECB. It is no secret that the European Central Bank played an important role in the Irish decision to ask for financial assistance to the EFSF and IMF in November 2010. Its Risk Control Framework constitutes a powerful tool to provide, but also withdraw funding, allowing it according to Irish economist Karl Whelan ‘to control events at a number of key junctures in the euro crisis’. Through the Securities Markets Programme (SMP) the ECB has bought Irish government bonds on the secondary market, reducing the costs of Irish government borrowing.

The promissory notes

The promissory notes were issued by the Irish government to Anglo Irish and Irish Nationwide in 2010 to function as collateral for Emergency Lending Activities (ELA lending) to these banks by the Irish Central Bank. They are basically a promise from the Irish government to pay money on a fixed schedule, first to these banks and after the merger to the IBRC. This however turned out to be a very heavy burden, amounting to €3,1 billion each year, and corresponding to around 2% of Irish GDP, which is why the Irish government has been trying to restructure the promissory notes for a long time

ELA is interesting from a legal perspective. It is conducted by national central banks at their own risk when credit institutions are not able to lend from the ECB because of lack of eligible collateral. However, the European Central Bank closely monitors this risky lending and can make an end to it through the powers given to the ECB in article 14(4) of the European System of Central Banks and ECB Statute, which reads:

National central banks may perform functions other than those specified in this Statute unless the Governing Council finds, by a majority of two thirds of the votes cast, that these interfere with the objectives and tasks of the ESCB. Such functions shall be performed on the responsibility and liability of national central banks and shall not be regarded as being part of the functions of the ESCB. (italics added TB)

This means the ECB has a big say in practice. That is why any deal on a restructuring of the promissory notes, which functioned as collateral for ELA, had to involve the ECB in some way.

Was the ELA in the Irish case legally uncontroversial? No, because of article 123(2) of the Treaty on the Functioning of the European Union (TFEU). This article basically says that the prohibition of monetary financing of article 123(1) TFEU does not apply to publicly owned credit institutions – so nationalised banks like IBRC – but that these institutions have to be treated the same way as private credit institutions. It reads:

Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions. (italics added TB)

In other words, the ECB/national central banks can lend money to publicly owned banks, but must do so on the same conditions as would apply to private banks. Doubts have been raised about whether this rule was actually observed. Loans should not be provided to insolvent credit institutions. Liquidity support programmes should moreover be temporary, whereas ‘IBRC was going to take at least 10 more years to pay off its ELA loans’. Collateral should furthermore be provided through marketable instruments, which the promissory notes are not. 

The debt swap: from promissory notes to government bonds

Together with the overnight liquidation of IBRC in the early morning of February 7, which turned the Irish Central Bank into the economic owner of the promissory notes, Ireland decided to swap the debt, i.e. exchange the promissory notes for government bonds. Instead of paying high immediate yearly amounts of money, the Irish government for now only pays interest over the bonds, where the bonds importantly have maturities from 27 to 40 years. In other words, future generations will have to pay off the debt, and inflation should help them with it.

How to appreciate the debt swap from a legal perspective? Several economic commentators have stated that what we are witnessing is in effect monetary financing. Karl Whelan argues that ‘the current agreements are monetary financing in spirit if not necessarily according to the letter of the law.’ Financial Times columnist Wolfgang Münchau calls it ‘a hidden form of monetary financing’: ‘In legal terms, the agreement is probably watertight. It may be a borderline issue, but who cares? In economic terms, the situation is much clearer. This is monetary financing in all but name’. Both commentators have no problem with it.

The relevant legal framework is now article 123(1) TFEU, which prohibits monetary financing:

Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments. (italics added TB)

This article is, in Eurozone crisis practice, understood to mean that the ECB/national central banks are not allowed to buy government bonds directly, i.e. on the primary market. It should not prevent them from buying bonds on the secondary market, which we know is what happened through the ECB unconventional Securities Markets Programme (SMP) for Greek, Irish, Portuguese, Spanish and Italian bonds.

Is the Irish Central Bank actually buying the €25 billion of Irish government bonds, the same value of the promissory notes, directly from the Irish government? Karl Whelan argues that ‘because the bonds ended up at the CBI (Central Bank of Ireland, TB) indirectly because of the liquidation of IRBC, it can be argued that last week’s exercise was not monetary financing’. Is this convincing? I am not sure. Joseph Cotterill of the Financial Times argues that the ECB by only taking note has signalled that this is not monetary financing and explains it through one of the benefits of the debt swap: the bonds are marketable instruments so can – and in fact will – at a certain point be sold by the Irish Central Bank. Another benefit for the ECB, in the words of President Mario Draghi at the press conference of February 7: ‘there is no more ELA. So that is a positive step’. Does that mean Ireland’s safe? No. Again in the words of Mario Draghi:

We will certainly review the situation in due course. I am not saying that this is the last word on this. I am only saying that, today, the Governing Council unanimously took note of the Irish operation. So I have to say that this is certainly not the last word. We will come back to this.

Dr. Thomas Beukers is a Max Weber Postdoctoral Fellow in Law at the European University Institute, Florence. His personal webpage can be accessed here.

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