ab Global Economics Research Europe Including UK UBS Investment Research London European Economic Focus Ireland’s four-year plan: ticks all the boxes 26 November 2010 but… www.ubs.com/economics Banks, banks, banks The Irish government published an ambitious 4-year fiscal plan yesterday. Stephane Deo Although the plan ticked all the correct boxes, markets remain unimpressed. Hard Economist to know the precise reason for this, but in our view a resolution on the banks is firstname.lastname@example.org necessary for Ireland to benefit from its fiscal efforts. +44-20-7568 8924 Amit Kara Related to this is the status of senior bank debt holders. A decision forcing senior Economist bond holders to suffer a haircut has the potential to hurt the other vulnerable email@example.com economies too. Portugal’s wider funding gap leaves it vulnerable on that front too. +44-20-7568 3522 Reto Huenerwadel We also discuss the sustainability of Irish fiscal position in the context of the new Economist debt and deficit forecasts. Our calculations show that Ireland will have to run a firstname.lastname@example.org persistent primary surplus of at least 1-2% to at just hold the debt ratio at an +41-44-239 6178 elevated level. Cutting the debt ratio will require a much larger primary surplus. Matteo Cominetta Analyst email@example.com +44-20-7567 4652 Jennifer Miller Associate Economist firstname.lastname@example.org +44 20 7568 6585 This report has been prepared by UBS Limited ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 6.
European Economic Focus 26 November 2010Ireland’s four-year plan: ticks allthe boxes but…Ireland’s ‘National Recovery Plan’ (NRP) set out a tough fiscal roadmap torestore confidence in the economy, but in spite of ticking all the right boxes,Irish bond yields sold off along with Spanish and Portuguese bonds. Sure, theplan lacks some detail, but then again, this was not the place for specific tax andspend measures – those will be announced in the Budget on 7 December. Thiswas also not meant to be the occasion for an announcement on the bankingsystem, which no doubt remains Ireland’s Achilles heel.Ireland has now sought external assistance and although market attention hasturned elsewhere, we believe there is still reason to remain focussed on Ireland.We highlight three key issues that are relevant for Ireland, of course, but forother economies in the euro area too.Banking system:Irish investors and depositors lost confidence in Ireland for several reasons. Keyamong these was a revelation in October that the problems in AIB are muchlarger than previously thought. Those issues, as it happens, remain largelyunresolved and no doubt, that is the focus of the IMF and EU.A number of options are available but one the EU-IMF mission appears tosupport, according to press reports, involves a haircut on senior bank debt. Itmust be emphasised that the ruling Fianna Fáil party has rejected anyspeculation on burden sharing by senior bond holders on the grounds thatIreland will suffer a major outflow of funds.Chart 1: Funding gap in Europe 100 % of GDP 80 60 40 20 0 Euro Area France Germany Spain Italy Ireland UK Portugal % of GDP (2003) % of GDP (2007) % of GDP(2008) % of GDP(Q3)Source: UBS, Haver, ONS, EurostatWe could get some clarity of the final EU-IMF package sometime this weekendor next week, and if bond holders are made to suffer a haircut, there is a risk, asthe Economist newspaper suggests this week, of contagion elsewhere. Possiblecandidates include the usual suspects: Greece, Portugal and Spain. The focus onPortugal is., in our view, particularly interesting in light of our now familiarfunding gap chart, which is reproduced above. For those that are not familiar UBS 2
European Economic Focus 26 November 2010with this chart, we have defined the gap as the difference between total credit inthe economy and deposits, as measured by the broad money aggregates. Thelatest data until 2010Q3 shows that Portugal too faces a sizeable and growingmismatch between total M3 credit and holding. In other words, its banks too arerelying more and more on non-deposit funding, which may either emanate fromthe ECB directly or elsewhere. Neither position is comforting in the currentcircumstances where sovereign risk concerns are at elevated levels and the ECBis keen to embark on an exit strategy.PoliticsIreland’s 2011 Budget will be presented on 7 December. The political situationremains fragile with the governing coalition expecting to pass the Budget on7 December only with the narrowest of margins. If exit polls are to be believed,the governing Fianna Fáil party has lost yesterday’s by-election, and, with that,its parliamentary majority will have shrunk to just two. Two independentparliamentarians who in the past have supported the government have morerecently wavered in their support for the budget.1 On top of all this, there arealso backbenchers from the major political parties that could shift allegiance oneway or another. In spite of all this, we believe the budget will be passed with theopposition either abstaining or voting for the budget ‘in the interest of thecountry’. Failure has the potential to affect Ireland and the periphery.The table below shows the current make-up of the parliament withoutconsidering the result of the latest by-election.Table 1: Composition of the current Dáil (Irish parliament) Total no. of seats 166 Vacant Seats (including Donegal) 4 Total 162 Speaker 1 Government 82 Opposition 79 Fianna Fáil 70 Fine Gael 51 Greens 6 Labour 20 Sinn Féin 4 INDEPENDENTS Independents 6 Independents 4Source: UBSEconomicsThe Irish government has retained its real GDP growth forecast of 1.75%, andaround 3% for the subsequent three years. That growth is largely driven by asolid expansion in export volumes with government spending in particularacting as a significant drag to economic growth. We will revisit our forecasts1 Irish Times, ‘Lowry and Healy-Rae doubts could mean key roles for Kirk’ November 23rd page 9 UBS 3
European Economic Focus 26 November 2010once the budget is published on 7 December, but in our view the government’s1.75% forecast for next year seems optimistic, not least because recent eventsreflect a dramatic erosion in confidence, the consequence of which is not onlylikely to be lower consumption and investment demand, but also tighter creditconditions.There is then the crucial issue of debt sustainability. Will Ireland be able torepay its debts eventually, or alternatively, what is the scale of the fiscal squeezerequired for Ireland to stabilise its debt?The government has, very usefully, provided a number of scenarios in the NRPbased on alternative GDP growth and borrowing costs assumptions. Briefly,under baseline assumptions Ireland is able to stabilise its debt-to-GDP ratio in2013 at around 108%. It is only under the pessimistic scenario where nominalgrowth is lower than the borrowing costs that the debt dynamics developperversely for Ireland (see Annex 3 of the doc for more details).We have run a similar exercise, asking the question, what is the primary surplusrequired to stabilise the debt-to-GDP ratio? The table below summarises ourresults.To start with, we take the government’s estimate of the peak debt-to-GDP of108% generated under its baseline scenario as our starting point. Assumingaverage borrowing costs of 4.5% and potential nominal GDP growth of 4.6%,Ireland will need to run a primary budget balance of -0.1% to stabilise its debtratio. By way of comparison, Ireland expects to run a primary deficit around 6%next year. This in itself is not too challenging, in our view.Table 2: Debt sustainability GDP/GNP in Debt in Debt-to- Nominal Nominal Required € bn € bn GDP (%) interest GDP/GNP primary rate (%) growth (%) balance (% of GDP/GNP)Baseline scenario 175,400 189,432 108 4.5 4.6 -0.1Based on GNP 137,600 189,432 138 4.5 4.6 -0.1GNP plus additional € 30bn for banks 137,600 219,432 159 4.5 4.6 -0.2GNP plus additional € 30bn for banksand higher borrowing cost 137,600 219,432 159 5.7 4.6 1.7GNP plus additional € 30bn for banksand higher borrowing cost 137,600 219,432 159 5.7 3.5 3.4Source: UBSIn our view, the more appropriate measure to use for debt calculations forIreland in particular, is GNP rather than GDP. Ireland, as is well known, hosts UBS 4
European Economic Focus 26 November 2010many large foreign-owned companies. These companies tend to repatriate theirprofits, and as such that income is not available to Irish domestic residents. TheGNP measure allows for that repatriation. The wedge between GDP and GNP isa sizeable €40bn or 20-25% of GDP. That 108% debt-to-GDP ratio becomes amuch larger 140% in GNP space.The government’s debt sustainability exercise did not include any potentialrescue for banks. If we allow for an additional €30 bn for the banks, the debt-to-GNP ratio rises to 160%. Ireland will, in this case, need to run a small primarydeficit of 0.2% to stabilise its debt ratio.In the next scenario we assume a higher borrowing cost of 5.7% - the levelassumed by the government under its pessimistic scenario. As it happens, that isprobably the level at which the government will access funds under the EFSFfacility. Holding the nominal GDP at the baseline scenario of 4.6%, the requiredprimary balance jumps to 1.7%. In the final scenario, we assume a lower growthrate of 3.5%. The required surplus is close to 3.5%.These numbers are at best indicative and at face value they don’t seem toochallenging. Countries are frequently able to turn large primary deficits intosurpluses, but key point is that even at these levels, the debt-to-GNP ratio willonly stabilise at 160%. The country will need run bigger surpluses, year afteryear, to reduce the debt ratio and that will be extremely challenging.Summary of the four-year planMain points:- Fiscal deficit falls from 11.7% in 2010 to 2.7% in 2014.- The debt-to-GDP ratio peaks at 102% in 2013.- Real growth of 1.75% in 2011 and around 3% for the following 3 years.- The average interest rate on the stock of General Government debt rises from 3.4% to almost 5% by 2014. The government will announce consolidation measures worth €15bn, of which €10bn will be achieved through spending cuts and €5bn from taxesTax measures: - The 12.5% corporation tax rate is held unchanged. - The tax base will be broadened. Currently, 45% of workers do not pay any income tax. This is expected to raise €1.9bn. - Tax expenditures and pension-related tax changes worth €1.5bn. - VAT will be raised from 21% to 22% in 2013 and to 23% in 2014. - Property tax or site value tax will be introduced to yield around €500m. - Carbon tax will be raised. UBS 5
European Economic Focus 26 November 2010 Spending plans: - Of the total €10bn of spending cuts, current spending will be lowered by €7bn and investment by €3bn. - Public sector job losses of around 27,500. - Public sector pension will be cut to save €800mn. - Water charges. - Student contribution for third-level education.Other measures include: - A reduction in the minimum wage from €8.65/hour to €7.65/hour. - Cuts in social welfare. - The NPRF will be available to fund the exchequer and be deployed to acquire state assets. - Asset sales. - Amend the legal framework to encourage domestic pension funds to invest in Irish government bonds. - The NTMA will issue index-linked bonds and a four-year solidarity bond. Analyst CertificationEach research analyst primarily responsible for the content of this researchreport, in whole or in part, certifies that with respect to each security or issuerthat the analyst covered in this report: (1) all of the views expressed accuratelyreflect his or her personal views about those securities or issuers; and (2) no partof his or her compensation was, is, or will be, directly or indirectly, related tothe specific recommendations or views expressed by that research analyst in theresearch report. UBS 6
European Economic Focus 26 November 2010Required DisclosuresThis report has been prepared by UBS Limited, an affiliate of UBS AG. UBS AG, its subsidiaries, branches and affiliatesare referred to herein as UBS.For information on the ways in which UBS manages conflicts and maintains independence of its research product;historical performance information; and certain additional disclosures concerning UBS research recommendations,please visit www.ubs.com/disclosures. The figures contained in performance charts refer to the past; past performance isnot a reliable indicator of future results. Additional information will be made available upon request.Company Disclosures Issuer Name 2, 4 Republic of IrelandSource: UBS; as of 26 Nov 2010.2. UBS AG, its affiliates or subsidiaries has acted as manager/co-manager in the underwriting or placement of securities of this company/entity or one of its affiliates within the past 12 months.4. Within the past 12 months, UBS AG, its affiliates or subsidiaries has received compensation for investment banking services from this company/entity. UBS 7