Osborne takes default risk

Don and Sue both make the obvious leftist response to Osborne’s proposal to lend to Ireland: how can a government which claims that spending cuts are necessary suddenly find £7bn?
It’s a good, glib debating point, but maybe not much more. In truth, it could be that lending to Ireland will reduce UK government borrowing.
The reason for this is simple. The UK can raise £7bn very cheaply, and earn a high return by lending to Ireland. The terms of the loan are not yet known, but let’s assume for illustration that the interest rate is 7.7%, the current yield on five year Irish gilts. UK yields are now at 2%, so this implies that, over the course of the loan, the UK would earn just over £2.2bn.
We could add to this the taxes the Exchequer would receive from UK exporters, who find their ability to sell to Ireland enhanced. But this is a second-order gain. In 2009, Ireland spent 17% of its GDP (pdf) on UK goods and services. So, if our £7bn loan raises Irish GDP by £7bn, and assuming a tax rate of 40% on exporters‘ income, the Treasury will get another £640m: 0.4 x 0.23 x 7.
The Treasury’s £7bn loan could therefore earn it a total return of just under £3bn. This is almost certainly better than it would get from orthodox loose fiscal policy. To recoup £3bn from £7bn of borrowing to finance domestic spending at a 40% tax rate requires a multiplier of well over three. This is  larger than most plausible estimates.
All of which raises the question. If bailing out Ireland is such a good idea, why not do more of it? Why not lend to Portugal and Greece as well, and to all comers?
Simple - default risk. Lending to  Ireland brings with it the risk that Ireland won’t repay - a risk which Duncan thinks very high.
This changes the maths. If the Treasury gets back only half of its loan, then it’s touch and go whether lending to Ireland is better than ordinary Keynesian borrowing. (The politics, of course, is much worse, as Osborne would get much more flak for a bad overseas loan than he would for lacklustre domestic fiscal policy).
But let’s be clear. The question here is not: how can Osborne find £7bn? He’ll find it from the same place as the other £155bn he’ll borrow this year - from the gilt market. Instead, the issue is: what is the default risk and the interest rate on this loan? It is this, and this alone, that determines whether the loan is a good idea or not.

Comments

[Gary]

It strikes me that after 13 years of every item of spending being labelled 'investment', we don't actually recognise a real investment when we see one...

[Niklas Smith]

Amen to what Gary said. Raising nurses' salaries is not "investment", however deserved it may be.

Chris: A very good post as usual. Sweden's finance minister Anders Borg has apparently surprised international media by offering to lend Ireland 5-10bn SEK (£450-900 million). The next morning the radio news here in Sweden reported that such a loan would be highly profitable for the Swedish exchequer because Sweden's borrowing rates are much lower than the likely rate charged on such an emergency loan. Not a word was said about default risk...

[Adam Bell]

Bagehot has a cracking post on the way in which this liability came about through the EU's funding mechanism. It's very explicitly a liability as consequence of us signing up to the rapid reaction stabilisation fund rather than a UK Gov loan per se:

http://www.economist.com/blogs/bagehot/2010/11/euro_crisis

[Tom Freeman]

"Lending to Ireland brings with it the risk that Ireland won’t repay"

But Osborne doesn't think so: "we are making a loan to another sovereign nation that we fully expect to be paid back... This is a loan that we can afford to make and which we will get back".

Given that Ireland's credit ratings are well below any downgrade the UK has been threatened with, why was he going around saying such a prospect would be apocalyptic for the government's credibility?

[Leftoutside]

"Given that Ireland's credit ratings are well below any downgrade the UK has been threatened with, why was he going around saying such a prospect would be apocalyptic for the government's credibility?"

He's an idiot or a liar. You get to chose.

[pablopatito]

If I naively assume the gilt market is perfect, doesn't 7.7% interest reflect a high degree of risk of default?

Also, Osborne cut government spending by £7bn because he said we couldn't afford to borrow it, and because borrowing would risk our credit status. Borrowing it and giving to Ireland seems like a double-whammy if what he said about the UK's credit status was true. We now have £7bn of dodgy loans on our balance sheet.

I don't really understand how Ireland can service 7.7% on its loans when its broke, has little corporate tax receipts and has no real prospect of growth. Where's the money coming from?

Also, wouldn't the money be better spent lending to UK businesses at say 5%, which will increase UK GDP and likely give a greater take from tax receipts than Ireland will give us.

[Laban]

"The terms of the loan are not yet known, but let’s assume for illustration that the interest rate is 7.7%, the current yield on five year Irish gilts"

Hold on a minute. Isn't that the market price of already-issued (at much lower rates) Irish gilts at the moment? Haven't the Irish stopped gilts issuance until next summer?

I thought that if the Irish could only sell gilts at 7.7% they'd be effectively bust and in a debt spiral where the cost of debt servicing exceeds austerity savings.

Ireland could presumably get around 7.7% in the open market by issuance. Therefore, whatever the rate we're lending at is, it's likely to be much less than 7.7%. At which point the question of default risk arises.

The politics of this are likely to be more beneficial than the economics, but I wouldn't bank on either.

[Iain]

So, Osborne can borrow after all and at a cheap rate. Wonder why the austerity is needed so .

It also seems that we will be lending at a rate lower than existing bond yields which factor in the default risk. And if there is a default, that might be because the Irish banks themselves default on their loans, including those to RBS and Lloyds, so we have doubled up the risk.

It is important that we see the terms of this loan, including interest rate and currency. Luckily it will need to be passed by Parliament so there will be some transparency.