irish economy 2009 solutions question 1a in an open economy with free capital flows, under what...

Irish Economy 2009

Solutions

Question 1a

• In an open economy with free capital flows, under what conditions is it possible for domestic and world interest rates to diverge?

• Basic answer: Uncovered Interest Rate parity. – Interest rates may deviate if the exchange rate is

expected to appreciate or depreciate.

The capital account CP

To understand the flow of cash to buy and sell assets,

consider an investor contemplating buying a one-

year bond:

Should she invest at home or abroad?

Invest at home – at end of year

€1 becomes €(1+i)

Invest abroad -

where is the expected exchange rate at end of year

1 1/ (1 )1/ (1 ) /e

w w e

E

E i E i E E

Uncovered interest parity (UIP)

Requires that the expected return from investing

at home is the same as the expected return

from investing abroad, so1 (1 ) /

aproximately equals

( ) /

that is, domestic interest rates equal world interest rates

± the expected rate of depreciation (apprecation)

w e

w e

i i E E

i i E E E

Question 1b

• Under floating exchange rates the balance of payments will balance in the sense that the sum of the current account and cap account will be zero: Curr +cap=0

• So if there is a current account deficit there must be a cap account surplus (inflow)

• This must be the case because there is a free market in currency so flows. So if curr+cap <0 for an instant there would be excess demand for foreign currency ($) and excess supply of domestic currency (€)

• Basic micro theory tells us that the price of $ must rise in response to the excess demand i.e. the domestic currency depreciates.

• This depreciation will make the country a more attractive investment (cap inflows increase) and boost next exports (current account improvement).

• If the e rate is truly freely floating it will adjust fully and immediately to close the deficit or surplus in this manner. Obviously in the short run most of the adjustment will take place through the capital account.

• If the e rate is not free floating then the whole of the deficit or surplus may not be cleared. In the extreme case of a fixed rate, the deficit will remain. The continuing excess demand for $ will be met by the central bank supplying $ from its reserves

• So for fixed or floating e we can say that the BOP balances in the sense that the following is always true: cap + cur – change reserve = o

• In the case of floating e the change in reserves is identically zero

• Sometimes the change in reserves (or “official financing”) is considered as part of the capital account.

Question 1c

• Comment on how the balance of payments reflected the boom and property market bubble in Ireland during 2002-7.

• Basic answer is that a boom in the domestic property market shifted the AD curve to the right. This lead to an increase in wages and price reducing competitiveness and net exports

P

YY*

LRAS

AD1

AD0

SRAS(Pe=PA)

C

B

A

SRAS(Pe=Pc)

Prices (Competitiveness)

• Real Exchange Rate– Compare price levels of different

countries – Simple example is the Hamburger

index• Do for all goods in a basket and

calculate the ratio– i.e. CPI or GDP or wagesLook at R for Ireland over time– Level doesn’t tell much– Trend does: we get expensive– Trade weighted real e rate rises by

about 30% from 2000, having fallen by 20% the previous decade

Leddin and Walsh Macroeconomy of the Eurozone, 2003

US

IRL

US

IRL

P

P*e

$P

$PR

Competitiveness

0.000

50.000

100.000

150.000

200.000

250.000

NEER

REER

Crowding Out• The consequence of the housing boom was the

misallocation of resources i.e. crowd out other aspects of the economy

• Exports– Boom forces up prices and competitiveness suffers

– Don’t notice during boom (because I is high)

– Notice now!

• A caveat– Balassa-Samuelson theory– Expect richer countries to be more expensive– Nevertheless, Ireland became more expensive

than countries of a similar level of wealth.– See graphs

Cap flows

• Extra credit for this• International Credit conditions fuelled the

bubble in some countries• Ireland

– Huge capital inflows to Ireland– Cap a/c surplus reflects insufficient savings– Banks foreign borrowing

• On the way up this financed the boom

National Savings• Two identities

– Y=C+I+G+NX– Y=C+S+T

• This imply– S+(T-G)+NX=I

• So insufficient domestic savings were supplemented by capital inflows

• Boom financed by cap inflows via banks

Savings

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Personal

Corporate

Gov

Inv

CA

Question 2

• These are short questions so students don’t have time to give the full answer as outlined below

• So be generous!

2a Discretionary FP

• Changes in the AS/AD curves cause actual real GNP to swing around natural real GNP.

• Keynesians advocate an active fiscal policy (changes in government expenditure and/or taxes) to try to stabilise the business cycle.


The Stance of Fiscal Policy• A recession automatically worsens the budget deficit. Tax

revenues fall and social welfare spending rises. • Diagram shows how the budget balance varies as GNP

changes. • Boom period, the deficit falls. • Positive relationship between Net Taxes and GNP.

• Current spending (G) is assumed to be constant. • Note distinction between automatic and discretionary

changes in the budget balance. Discretionary change occurs when the government deliberately changes G, T or SW.


Government expenditure (G)

GNP1

AB

GNP2

C

Nominal GNP

NT

GNP

€ billions

Full-employment budget

G, NT

Budget surplus

Budget deficit

*

Natural GNP

Balanced budget


Government expenditure (G)

GNP1

AB

GNP2

C

Nominal GNP

NT

GNP

€ billions

Discretionary changes in taxes and expenditure

G, NT

*

Natural GNP

NT

NT

1

2

3


2b: Laffer Curve• Changes in taxes can give unpredictable

results. Refer to the Laffer curve.• Examine relationship between tax rate and tax

revenue. • Optimal tax rate: T*

• Below optimal: normal positive relationship.• Above optimal: an increase in tax rate may lead to

a decrease in tax revenue. High taxes affect the “incentive to work” and drive industry into the black economy, as we saw in Ireland in the mid-1980’s.


Averagetax rate

100%

0 %

T

T

T

1

*

2

R 1 R 2

Revenuemaximizingtax rate

Tax revenue £m

A

B

Laffer Curve

Z


Problem with Laffer Curve

• Not clear where the revenue max tax rate is– Peak of curve

• Is it above or below current rates?• Highly ideological debate• Current government policy implies they think we

are at max as they didn’t raise or reduce taxes in budget

• Is this likely? Do they have any evidence for this?

2c: Growth in Celtic Tiger

Convergence due to

1. Rapid rise in ratio of non-agricultural employment to population

• This in turn due

– Demographic factors• Decline in proportion aged under 15

– Exceptional growth in numbers at work outside agriculture

2. Reasonable growth in productivity • High by some standards

• But no miracle

Demographics

The fall in birth rate after 1980 could be regarded as– Ireland’s belated convergence to the

demographic norm for a developed country• Facilitated by rising female educational levels

and

• Changes in attitudes and laws concerning contraception

• Triggered by rise in unemployment in early 1980s?

Where did the economic growth come from in the 1990s?

38%

62%

Productivity Employment growth

2d: PPP

• PPP: equal value for money for goods and services.– Prices of similar goods expressed in a common

currency should be the same.– Based on arbitrage. Buy cheap, sell expensive

to make profit. – Actions should lead to a convergence of prices


Absolute PPP

• Pirl e = Pw

• Prices, adjusted for the exchange rate, should be the same in different countries.

• Example: Levi Jeans, • Pirl = €10 in Dublin, • Pus = $20 in New York. • If e = $/€ = 2 then PPP holds.• If e 2, PPP does not hold.


Real Exchange Rate• Compare price levels of different countries

– In a common currency (usually US$)

• Related to the concept of purchasing power parity (PPP)– Law of one price

• Simple example is the Hamburger index– What is the US$ price of a Big Mac in various

countries– $PIRL=€ PIRL*e– Is $PIRL >$PUS

• What does this tell you?– “competitiveness”– Are one country’s goods cheaper than

another’s?

• Do for all goods in a basket and calculate the ratio– i.e. CPI or GDP or wages

• Look at R for Ireland over time– Level doesn’t tell much– Trend does

US

IRL

US

IRL

P

P*e

$P

$PR

Relative PPP

• Total differentiation of the absolute PPP equation gives:

Pirl + e = Pw

• Or irl + e = w

• Inflation rates, adjusted for changes in the exchange rate, should be similar across countries.

• Weak form of PPP.– Prices can be initially different, but change at the same

rate over time.


PPP as a Economic Theory: Under Flexible Exchange Rates

• PPP becomes a theory of exchange rates. e = w - irl

• Inflation is the most important determinant of e. Country’s with high inflation rates will experience weak exchange rates and visa versa. – Why?

• Very relevant in the case of large countries: USA, Japan and EMU.


PPP as an Economic Theory: Under Fixed Exchange Rates

• PPP becomes a theory of inflation.irl = w - e• If e is fixed, irl is determined by w.• Ireland is a price taker on international

markets.• One of the main reasons for fixed e

– EMS & EMU.

• Used by small countries world-wide.


Q3: Irish vs US FP

• Basic answer– The US government is applying standard

Keynesian demand management to the current crisis.

– The Irish government is doing the opposite because it believes that the debt is already too high and any further increase will reduce confidence and hence AD

• Figure 1 shows what the US government is doing i.e. applying an increase in aggregate demand to a demand shock.

• Start from LR eqm– Y=Y*

– Pe=P• The fall in AD

– Eqm moves from A to B– Y<Y*

• Recession• We could wait for the economy to adjust automatically

to C• Prolonged recession

• Alternatively we can increase aggregate demand by increasing G and/or decreasing Taxes

– This will shift AD curve to right and economy will move from B to A

– This is US policy

YY*

LRAS

AD0

AD1

SRAS(Pe=PC)

A

B

C

Policy for a AD shock

SRAS(Pe=PA)

Differences between US and Ireland• Or between any large country and a small open

economy• US issues debt in its own currency

– Can use inflation if necessary• Possibility of a dynamically unstable debt in ireland

– Borrowing to pay interest – Burden of €35,000 per worker already

• FP policy likely more effective (see later)• US can depreciate its currency

– Could expand economy by depreciation– Control deficit by cutting G, raising T

• US can reduce interest rates

What is to be done?• For any SOE conflict between two basic issues

– Stabilisation policy– Deficit control– Empirical question

• Stabilization policy– Ideally we would want to increase the deficit in a recession– Shift AD to right and restore full employment– Some of deficit is the automatic stabiliser but could do

more– Blanchflower argued this recently

• Deficit control– Irish deficit this year heading towards €30bn = 13%GDP– 13% not sustainable forever

The Multiplier

• A key detail ails of stabilization policy are key– What is the multiplier?– The effect of any G on Y– Theory suggests low in SOE

• Reason: any increase in G will lead to an increase in imports so that the stimulus will be lost to the Irish economy

• Expansionary Fiscal Contraction– Multiplier negative in times of crisis– Failure to deal with debt causes people to cut back

consumption– AD shift to left– Very controversial idea– Some evidence for it including Ireland in 1987

• Small multiplier argues against traditional stabilization policy– If Neg mult no conflict between the two goals

Negative Multiplier

Deficit Control• If the multiplier is positive cutting deficit now

will make recession worse– If mult is negative there is no conflict

• So why do it now as distinct from postponing to the future?

• Dynamically unstable debt– 13% of GDP is unsustainable– End up borrowing to pay interest– Lenders might refuse loan

• If we decide to control deficit there are two questions– How much how soon?

– By taxes or expenditure?

• Time– Do not have to close all the gap immediately

– Governments plan is to bring within 3% of GDP within 4 years

– That is actually quite quickly

• Automatic stabiliser will close some as the economy improves– So plan should concentrate on the structural deficit

Tax or Expenditure• The Big question today is whether we choose to close

the gap by increasing taxes or cutting expenditure or in what combination

• All these actions have multipliers– Probably all positive (assuming no EFC)– Some bigger than others– Lane suggests inv > wages

• Government seems to favour expenditure cuts. Why?– Philosophy: ideology supplants evidence– Multipliers: unlikely– Laffer Curve

International Evidence• Empirical matter whether tax based or exp

based budget is better• Policy makers remember Ireland’s experience

of 1980s and 1990s– But that is just one observation

• There is a large literature looking at deficit control worldwide– Conclusion is that expenditure based more likely

succeed– Evidence is not overwhelming

Q4 Celtic Tiger

• Note that the student is free to talk about any 5 (or more) of the policies outlined below

• If they don’t show how these policies affect the AS-AD (last slide) then award no more than 60%

Economic Policy in the Tiger• Distinguish between pre-boom factors:• 1. Foreign direct investment (Industrial policy). • 2. External assistance. • 3. Investment in education. • Factors that combined to ignite the boom:• 4. Centralised wage bargaining.• 5. Fiscal policy.• 6. Upturn in World (US) economy.• 7. Achieving EMU entry criteria. • 8. Exchange rate policy.• 9. Small is beautiful.


1. Industrial Policy

• Success of IDA in attracting high-tech foreign multinational companies (MNCs): microelectronics, pharmaceuticals, medical instrumentation, computer software, financial services, telemarketing.

• However, the contribution of MNC’s can easily be exaggerated.

• Need to take into account their high level of imports (including payments for patents and royalties) and repatriated profits.

• Contribution to GNP in 1998 was only €4.8 billion. Considerably less than the sales figure.


2. External Assistance

• 1973-2001: • Total net receipts = €33,853.5 million.• Annual average of €1,167.4 million or 3.9 % of GNP.• The peak was 6.6% of GNP in 1991.• Paid under a variety of headings: agriculture, social,

regional and cohesion funds.• Money mostly spent on roads, railways,

telecommunications.• Greatly improved the country’s productive capacity.


3. Investment in Education

• The importance of “human capital formation” in the growth process.

• 2000: Primary €1,068 mSecondary €1,243 mThird level €838 m

• Well educated labour force acts as a magnet to foreign multinationals.

• Much of this investment took place in the 1970s and early 1980s.

• Note: Factors 1 to 3 were in place in the 1980s and do not explain the spurt in growth in the 1990s. Considered to be essential pre-conditions.


4. Wage Bargaining

• Wage moderation following a return to centralised wage bargaining.

• National wage agreements involving the trade unions, employers and government.

• In return for moderate increases in nominal wages, the government promised tax cuts at budget time.

• For a number of years, inflation was greater than the basic wage awards resulting in a fall in real earnings.

• Improved Ireland’s competitive advantage.• Only applies to workforce of 500,000 out of total

employment of 1.7 million.• May or may not have facilitated the IDA’s industrial

policy.


5. Fiscal Policy• Restoring oder to the public finances in late 1980s was a pre-condition

for a resumption of economic growth.

• Improved investor confidence and reduced the outflow of capital.

• Tax rates cut from 35% and 58% in 1988 to 20% and 42% in 2002.

• Difficult to disentangle cause and effect.

• Tax cuts in recent budgets increased the supply of labour and stimulated aggregate demand.

• Government expenditure under the 1994 and 2000 National Development Plans was €28 billion and €51 billion respectively.

• Expenditure went into improving infrastructure (road conjestion), environmental pollution, education and training, and housing.


6. World Economy• Ireland is very open to trade. • Non-EMU countries account for 80.4 % of Irish

trade.• Very dependent on the US economy. Exports of

€1.6 billion in 2001.• Economic performance in USA has been major

factor behind the growth in Ireland.• Current slowdown in Ireland is due in large part

to slowdown in US, terrorist attack 11th September and the foot and mouth disease.

• Tourism increased by 8% per annum throughout the 1990s.


7. EMU Entry Criteria

• To join EMU, Irish inflation had to drop to below 2.7 %.

• Hence, EMU forced the government to adopt an anti-inflationary stance.

• EMU membership also entailed a fall in Irish interest rates down to the low German rates.

• By the late 1990s, negative real interest rates stimulated the demand-side of the economy and fulled house price inflation.


8. Exchange Rate Policy• Over-valued exchange rate combined with high interest

rates can seriously curtail a country’s growth potential.

• Devaluations in August 1986 (8%) and January 1993 (10%) prevented over-valuation.

• Central Bank followed a policy of stabilising the effective exchange rate.

• Involved playing off the strength of sterling against the weakness of the DM. Middle ground.

• From August 1997, the DM rate was allowed to drift down to the EMU entry rate of 2.4834.


9. Small is Beautiful

• Obviously a lot easier to turn around a small country like Ireland than a very large country.

• The same level of foreign direct investment would have much less of an impact on, say, the Spanish economy.

• Factor number 10 was “luck”. Most of the above mentioned factors complemented each other in moving in the right direction at the right time.


How Did these Factors Influence Output?

• Examine how factors 1 to 9 impact on the demand-side (AD) and the supply-side (AS) of the economy.

• This analysis is subjective because:1. Some factors impact on both AS and AD.2. The factors interact with each other.3. It is virtually impossible to quantify the effect of each

factor on economic growth, unemployment and inflation.

LRAS• Long-run (natural real GNP) and short-run AS curves are

determined by:– A. The size of the labour force.– B. Physical and human capital.– C. Advances in technology.

• Some of the Policies affect AS1. Foreign direct investment Affects B and C.2. External assistance Affects B.3. Investment in education Affects B and C.4. Centralised wage bargaining Short-run AS curve.5. Fiscal policy Affects A, B and C.6. World economy Affects B and C.

• Result: the long-run and short-run AS curves shift to the right.

AD

• AD curve is determined by: Consumer expenditure (C), Investment (I), Government expenditure (G) and Net exports (NX).

• 5. Fiscal policy affects C, I and G.

• 6. World economy I and NX. • 7. EMU entry criteria C, I and NX.• 8. Exchange rate policy NX. • Result is a shift of the AD curve to the right.

Overall

• Equal movement of the AS and AD curves resulted in very fast real growth rates with little or no effect on inflation.

• 1994 – 2000.

• Average real growth rate = 8%

• Average inflation rate = 2%

• If the shift in AD > shift in AS, inflation would have increased by considerably more.

• Employment increased from 1,118,300 in 1993 to 1,745,000 in 2002.

• Unemployment rate fell from 14.5% to 3.6%.


AS1

1

Graphical Representation

AD1

AS2

AD2

Inflation

Real growth rate

Natural realGNP


Q5

• During the 1993 currency crisis, the Irish government resisted devaluation for some time. Discuss the origins of the crisis. Was the government correct to resist the devaluations? Discuss the economic effects of this resistance and the eventual devaluation. Be sure to illustrate your answer with the appropriate diagrams.

Currency Crises• UIP & Competitiveness help explain how

currency crises arise.• Basic story for any crisis

– Country in a recession with fixed e rate

– Markets expect that gov will devalue to boost AD

– Expectation of devaluation leads to higher interest rates

– Makes recession worse

– Speculators try to sell their holdings of the domestic currency

– Self fulfilling prophecy

– Devaluation usually but not always occurs.

Origins EMS Crisis 1992/3• Objective is to stabilise exchange rates.

• Key point is that for the system to work, there must be similar inflation, interest rates and growth rates.– German unification ensured that there wasn't

• German unification in 1990 lead to huge budget deficit.– Could not be financed by increasing taxes – AD shifts right.

• Bundesbank raises interest rates to combat inflation i (by 3%).– AD shift to left

• Because of fixed exchange rates, the increase in interest rates was transmitted to rest of Europe– The FP was not– Everyone else’s AD shifts left.

• Europe has recession (worse for UK)

YY*

LRAS

AD1

AD0

SRAS(e)

Germany 1992

YY*

LRAS

AD0

AD1

SRAS(e)

UK & Ireland 1992

The Irish Pound and the Crisis of 1992-93

• Example of SOE

• Sterling’s dropped EMS in September and the currency depreciated by 15%

• However, the Ireland was only coming out of a long recession – Unemployment was 12%


• Speculators took view that DM/IR£ e was not sustainable. – Expect that gov will boost AD by devaluation and/or

reduction in interest rates

– Especially true once sterling depreciated as now Ireland lost competitiveness in main export market

– Speculators Try to sell IR£ and buy DM

• Situation becomes self re-enforcing– As speculators fear a devaluation, sell IR£ (supply

increases)

– CB has to use up more reserves

– Anticipation of devaluation pushes up int rates making recession worse, making devaluation more likely

S

D

£/DM

e*

E above market value. CB must buy £ with DM

£ billions


Irish and German interest rates during the currency crisis

05

1015202530354045

%

Implications of the No Devaluation Stance

• If continued lead to recession– e was overvalued– i high in anticipation of devaluation– Both shift AD to left

• The Central Bank’s external reserves fell from £3.05 billion at the end of August to £1.07 billion at the end of September, despite significant foreign borrowing.

• Short-term interest rates were raised to unprecedented heights to defend the currency from speculative attacks. – One-month inter-bank interest rates peaked at 57 per cent on 12 January

1993. – Overnight interest rates on the Euro-Irish pound market rose to 1,000 per

cent. • The combination of an overvalued currency and penal interest rates

was seriously damaging the Irish economy.• Eventually had to devalue


The Alternative to Devaluation• The over-valuation of the sterling/Irish pound exchange

rate results in a loss of competitiveness relative to the UK and this reduces Irish exports and increases imports. – This shifts the aggregate demand (AD) curve down to the left.– Real wages increase because the inflation rate falls while the

nominal wage remains unchanged.

• If workers were to accept a cut wages nominal wages so as to restore the original real wage, the aggregate supply (AS) curve would move down to the right. – The economy would return to the natural real growth rate. – Same argument as with any recessionary shock – Workers are not any worse off because the original real wage has

been restored.

• Devaluation is easier to implement


YY*

LRAS

AD0

AD1

SRAS(e)

Ireland alternative to devaluation 1992

Q6

• SGP vs Golden Rule

The Golden RuleOver the business cycle the government should borrow

only to invest and not to fund current spending

No current deficits over the business cycle, but

automtaic stabliser is allowed. So can have deficit in

recession year as long as paid back in boom

Future generations should contribute to the

costs of infrastructure from which they

benefit

So can borrow for capital projects even in

long run

We adhered roughly to this rule in Ireland

until the late 1970s

The Golden Rule

The threshold between current and capital

spending is not hard-and-fast

Education?

Health? Etc

Until recently government capital formation

account for borrowing equal to about 4.5% of

GDP

The SGP• Attempt to implement something that

looks like the golden rule• Fiscal deficits should average at most 1%

of GDP over the business cycle• Deficits in excess of 3% of GDP will

attract penalties unless they were due to “exceptional” and/or “temporary” Could imply pro-cyclical transfers from countries to the centre.– Fiscal federalism in reverse

SGP

• Countries have to prepare a Stability Programme when presenting their national budgets

• This Programme contains projections of General Government Balance for four years showing that national fiscal policy respects the SGP

SGP• Ireland was reprimanded in 2001

because the Council felt that Budget 2001 was too expansionary

Charlie McCreevy v Pedro Solbes• But the stagnation of the Eurozone economy during 2002 has lessened the

appetite for enforcing the SGPPortugal, Germany, Italy, and France at or

above the 3% ceiling

SGP

The deadline for reaching a balanced

budget postponed from 2004 to 2006

Then France ignored SGP in formulating

its 2003 Budget

What to do about the SGP?Scrap it?

Some argue that it is irrelevant because small

deficits incurred during periods of slow growth are

not a threat to the euro

The initial weakness of the euro was not due to fears

about the level of government borrowing

It may also be argued that Europe needs a growing

stock of government debt

What to do about the SGP?

Modify it?

Move to a “cyclically adjusted” budget

balance, taking account of the automatic

stabilisers that depress revenue and raise

spending during a slowdown

What to do about the SGP?

Stick with it?

Don’t risk the loss of credibility involved

in abandoning the discipline of the SGP

when it faces its very first crisis.

Regard compliance as a test of the

commitment to the euro.

Conclusion There is need for a rule, but a rigid one is undesirable

We have to bear in mind the uncertainty of

projections of GDP, tax revenue, and public

spending

Rules force the present generation to pay for the level

of spending on (current) public services it desires

Q7 Bubbles and Nama

• It turns out that this is a very long question so unlikely student would get all this material down

a) Evidence of bubble• Bubble is sustained price increase substantially

above the “fundamental value”– not just a rapid price increase. This could be

justified– Sustained: not temporary blip

Fundamental Value• Long term value concept

– Determined by rational analysis of other variables: income, interest rates etc

– Notion is that the relationship between variables does not change over time

• The opposite of New Era story

• Income should be a driver of house prices– Price clearly out of line with this

“fundamental” after 1997 in Ireland

500

001

0000

01

5000

02

0000

0

1970 1980 1990 2000 2010 2020year

real inc

• As always there are a “New Era” counter arguments– Growing economy– Immigration– Housing stock– Irish people pre-disposed to ownership– Low interest rates

• A more complicated model can take account of these factors– Same result: price out of line with fundamentals

b) Effect on banks

• The outline of the story is well known.– Banks in several countries may too many

loans to the property market– These loans have now gone bad as the bubble

has burst– The banks are now in financial trouble and

have to be rescued by governments

Bank Balance Sheet

Assets Liabilities

Cash

LoansBanksCompanies Individuals

Deposits from the Public

Equity (Capital)


Bond holders

Role of Equity• Crucial to the way bank operates• The idea is that if banks suffers losses they are

absorbed by the shareholders not the depositors or bond holders

• Therefore equity has to be large enough to absorb expected losses

• This is the money you have to put down in order to own a bank

• Common sense and regulation require a certain level– “reserve ratios”; “Capital requirements”; “Tier 1”

• Banks want the ratio as low as possible as it means can lend out more

• The lower ratio allows bank to take in twice the deposits for the same level of commitment from shareholders

• Profits higher

• Risk higher because cushion lower– Smaller bad debts would bankrupt the bank

Key Issue: Solvency• One of the key issues in the banking crisis was that

the cushion was too low – Banks like small cushion because higher profits

– But higher risk also

• This was a failure of regulator and banks own risk management – Should have realised property lending risky because of

bubble

• Regulator require higher cushion– Reduces profits so lending to property slows down

– Canadian approach

The problem

• Huge reliance on property and on development in particular

• Bubble bursting creates huge potential for losses– Particularly so in development loans– What NAMA is now concentrating on

• banks aware of this potential & try to assuage investors fears– Say LTV is 65%

Solvency

• LTV is important– Indicates how much the bank could get back if

borrower defaults

– One of the key assumptions of NAMA

• As long as they have declined by no more than 35% bank will get its money back

• Bubble graph suggests that prices were twice fundamentals– expect decline of 50%

Bad Loans

• What happens when loans go bad?– Small losses: handle as “bad debts”– Medium losses: Zombie bank– Large Losses: bankrupt

Zombie Bank

• Losses wipe out lots (but not all) of capital• Bank remains solvent but cannot operate effectively• Bank will probably continue in existence

– But limited lending– Remember the role of equity – has to cut back on lending– Zombie bank: not dead but not alive either

• Solution: Get more capital from markets or government– Dilute shareholders wealth– So shareholders may prefer zombie

• Japan during 1990s

Bankrupt• Now suppose even Bigger Losses• This is more than the shareholders funds can absorb• Bank bankrupt: cannot continue in operation• Any other business all creditors take a hit in proportion or

priority• This means that depositors would loose 10% of savings• To avoid this the government usually steps in some way• Rational for NAMA-like arrangements

c) NAMA

• Don’t want banks bankrupted for two reasons– To avoid depositors taking a hit

– Banks central to economy so formal bankruptcy (even temporary) is very disruptive

• So government needs to deal with hole in the banks• Need to decide three related Q

– How big is the hole?

– who pays?

– What is done with the banks afterwards?

Who Pays?

• Someone has to• 4 possibilities

– Depositors: want to avoid at all costs– Shareholders: “rules of capitalism”– Bond holders: rules also

• 4th possibility Tax payers– Make up gap if share and bond holders not enough– It looks like NAMA has taxpayers take on some of the

losses even without share and bond holders funds being exhausted

– We will look at whether this is necessary

What happens to Banks?• After the losses are dealt with banks will need

sufficient capital to work with– Avoid zombification– After NAMA: AIB, BOI <4% (JP Morgan)– 10% now standard internationally

• Certain that they will not have enough on their own– Shareholders will absorb some losses– International practice now requires more capital

• “Recapitalisation” can happen– Via market: rights issue BofA– Via government share holder: RBS 80% owned by UK– Overpayment: NAMA pays €54bn for €47

How Big is the Hole?• How much are the bad debts of the banks?• IMF estimated them at €35bn• Probably a low estimate• Government is more optimistic

– Assume LTV 77%– Assume prices reached bottom and will rise 10%– Lead to a conclusion that NAMA will make a

profit

Three Key Assumptions• LTV=77

– Anecdotal evidence of 100%– Use other property as collateral for the loan– If 100% then the original value of the collateral

was €68bn

• 47% decline– Maybe €21bn in land where decline has been 95%– 34% of loans outside Ireland– So final loss could easily be higher than the

government predicts

• LTEV will be €54bn– Rationale for overpayment– Based on assumption that prices rise by 10% from

current level– 10% reasonable– is the current level the bottom?

• Probably not!

• Even bigger loss

A Comment• Any prediction difficult• Govt seems optimistic but possible• Real issue is not the numbers but how it is structured

and who takes the risk– Why over-pay?

– Why not take shares in the banks?

– Why not have bond-holders pay the price?

• Under NAMA tax payer bears risk of asset values– There is a notion of future levy

Consequences for Banks• See balance sheet

• Loans decline by €77bn

• Banks paid €54bn in bonds that may be exchanged for cash at ECB

• Losses of 77-54 absorbed by shareholders

• Capital ratio below 4%

• Need capital injection of €30bn – Market or government

Mortgage lenders Sept 09 After NAMA

Assets Liabilities

Cash etc 76

Loans 556

Deposits 571

Equity 21


Total 692Total 692

Debt 110Others 60

Consequence for the Taxpayer• Govt already spent €7bn on capital injection to banks

in return for preference shares that pay 8%• Overpayment is a form of recapitalisation

– Without pref shares and overpayment equity would be only €7bn

– No ordinary shares in return• State guarantees all liabilities of banks

– Taxpayers bears all the risks of business– Get very little return

• In the end taxpayer will provide almost all the capital of the bank but will (likely) have less than 100% shares

Alternatives• What are the alternatives?

• Any sensible alternative is going to look at lot like NAMA– Segregate bad assets from good– Some government involvement

• The big differences among the alternatives is who pays what and who bears the risk

Alternative 1: Nationalise the Banks• Wipe out the equity holders• Admit that total losses are likely to be more than the

current shareholders funds• Risk to taxpayer reduced as we now have assets as

well as liabilities• Consequences

– Overpayment no longer matters – Total losses to be absorbed by the state will be less by the

amount of the equity– Taypayer will get the value of the future business of the

bank to offset losses

Arguments Against • Unfair to shareholders

– Maybe if losses actually less than equity– Unlikely– Retrospective compensation possible

• Too expensive because share price is too high– Lenihan made this argument– Clearly nonsense– Price is only above zero because of NAMA

• Nationalised banks become politicised– True

– Re-privatise early

– Very expensive way of avoiding corruption

• Foreigners will not deal with nationalised banks– Maybe true for some but not generally true

– In any case will not deal with any bank without state guarantee so seem unlikely to object to state ownership

• Doesn’t get rid of the losses so is irrelevant– True that losses remain

– But get share (or all) of future profitable business to offset losses

– Eg €7bn overpayment or for shares

• Nationalisation hurts reputation– Banana republic– Other countries have done it UK– Partial possible

• Nationalisation will lead to higher risk premium on corporate and national debt– Anglo cited as evidence – Premium already up because of extent of bad debts– Idea is that nationalisation would increase it

further– No evidence that ever happened before

Alternative 2: Bond-holders

• In addition to wiping out equity holders we could force bond-holders to take some of losses

• Could even force them to take all the losses (after equity)– Mirrors normal bankruptcy– Joseph Stiglitz & Morgan Kelly– “Debt-equity swap”: INM

• Minimises cost and risk to taxpayer

Arguments Against• Bank financing premium in future

– Maybe true– Cost to banks– Pass on to society in short run– In long run foreign Competition will mean no cost

to society

• Pension funds loose out– Mainly foreigners– deal with pension funds directly

• Sovereign Risk– Defaulting on the bank debt will be seen as

equivalent as defaulting on national debt– Big issue: risk premium of national debt will

increase: huge cost– Plain wrong: no evidence of it internationally– Makes no sense: sovereign risk premium rose

when we took on the bank liabilities (guarantee) and bad assets (NAMA)

– Why would the risk increase if we hand-back those liabilities.

irish economy 2009 solutions question 1a in an open economy with free capital flows, under what...

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