I have circulated a briefing note on this issue that goes through the technical considerations related to interest rates on the IMF and EU loans. There are many technical issues relating to these loans and it will not be possible to describe them in full in a ten minute presentation. I will give an overview in a short presentation but I will occasionally refer to calculations that are discussed in the briefing paper.
The overall package of funding associated with the EU-IMF package has frequently been described as an €85 billion package but €17.5 billion comes from Irish State funds. The package of external funding is €67.5 billion. That is being offered from four different sources: €22.5 billion comes from the International Monetary Fund, €22.5 billion from the European Financial Stability Mechanism, which is associated with the EU, a further €17.7 billion from the European Financial Stability Facility and €4.8 billion in bilateral loans from Britain, Sweden and Denmark. I will discuss the first three of these. It was requested that I discuss the European loans but it is important to compare the European loans with the IMF loans. There has been a great deal of comparison in the media and that is a useful starting point.
The IMF loan is a variable interest rate loan, and the State will have to pay interest at a rate dependent on short-term money market rates in financial markets. The funds will be loaned to Ireland in the form of SDRs, special drawing rights. That means we will not get the €22.5 billion in euros, we will get it in a mix of euro, dollars, sterling and yen that will translate to €22.5 billion depending on the exchange rates at the time.
This loan is an example of what the IMF refers to as an extended fund facility, a standard IMF programme, and the terms and conditions associated with the programme are standard across all countries. The principal features of the interest rate on the loans are that loans up to 300% of a country's IMF quota carry very low interest rates. Often we read that the IMF lends to countries at extremely low interest rates that help them with their financial difficulties. That is true up to a point but when they borrow larger amounts, surcharges are added on. The surcharge will increase in proportion to the length of time the money is borrowed for. It increases from two percentage points to three percentage points after three years.
Ireland's loan is very large relative to the IMF's standard lending practices, even though it only accounts for a third of the external funding for our loan; it is 23 times our current quota. The quota is calculated based on an economy's GDP and other features of its economy. Most of the money, therefore, that Ireland is borrowing from the IMF will carry these large surcharges. What is the interest rate on the IMF loan to be? We do not know because it depends on variable interest rates. The calculations we have seen tend to be based on current market interest rates. Based on those rates, we can calculate that the average interest rate during the first three years will be 3.1% and after the first three years, almost 4%.
Those figures are based on Ireland's current quota. In fact, there is an extra complication; Ireland's quota is about to be revised upwards by about 50%. That will allow us to borrow some more of the money at a lower interest rate, which drops the average cost by about 20 basis points.
In general, the approach the Government is taking to the funds being borrowed is to pay them back over a relatively long period. A benchmark of seven and a half years has been used for the European and IMF loans. By my calculation, with variable interest rates, if it is paid back over seven and a half years, the loan will cost Ireland 317 basis points, 3.17%, more than the variable interest rates used as the basis for the formula. We should bear that figure in mind when looking at the European loans.
The IMF loans carry two different types of risk. The first risk is the interest rate risk; because the interest rates are variable, they could go up. It is likely the interest rates in the formula for the IMF lending rate will increase. Policy rates from the ECB, the Bank of England and the Federal Reserve are at historically low levels and we expect they will increase in the coming years. The second risk is currency risk. The Irish Government gets its tax revenue in euros, and if the euro depreciates in the coming years, we must still pay the IMF back in SDRs, meaning we must pay back dollars, yen and sterling. If the euro depreciates that would effectively increase the cost of the IMF loan. European loans have neither of these elements to them. They are fixed interest rate loans and they are denominated in euro. To provide a more direct comparison, the NTMA has done calculations that basically indicate what would happen if one swapped the stream of IMF loan payments with variable rates in euro or in SDRs for something that carried a fixed rate and was denominated in euro. They calculate that would be about 5.7%. It should be emphasised that this kind of swap is not actually taking place, the NTMA is not entering into an enormous hedging contract or an interest rate swap contract. This is purely for illustrative purposes but that is what the 5.7% rate is.
Moving on to the European loans, there is the mechanism and the facility. The facility is extremely complicated in structure and I will not be able to do it justice in this short presentation but I can take further questions on it. The mechanism is extremely simple compared with either the facility or the IMF loans. The mechanism is essentially a way that the EU can go into financial markets and borrow based on the financial backing provided by the resources from the EU budget. It was agreed last May that the maximum amount that the EU could do for this was €60 billion, so clearly on its own the mechanism was not going to provide enough funding to solve the EU sovereign debt crisis. It was clear that a larger fund than this would be necessary. Ireland is being offered €22.5 billion from the mechanism so that it is clear the facility must provide a lot more of future funding.
The operation of the mechanism is pretty simple. The EU goes to financial markets and borrows money at fixed rates at certain maturities and it takes all that money and lends it directly to Ireland. However, in the meantime, the EU adds on 292.5 basis points, it is very precise. In other words it is adding on almost 3% to its cost of borrowing. What will that cost us? The NTMA estimated in December that these loans would have an average interest rate of approximately 5.7%, thereby on a like by like basis, being equivalent to the IMF loans. I looked into this last week. Based on recent developments in market interest rates, and also the fact that the mechanism issued a bond on 5 January - and we know what the terms of that bond were - my assessment is the actual rate that the mechanism will be lending to Ireland is something more like 6.1%.
The facility has a very complicated structure. Rather than go into precisely what the complicated structure is - that may be a good point for questions - I will try to explain the reason for this complicated structure. The mechanism linked directly to the EU budget is clearly not large enough to credibly say that you can stand by and help Ireland, Portugal, Spain with their budgetary problems, so a much larger facility was required. Ideally one wants this facility to be something that was shared across all eurozone countries and that is indeed what the facility is. The problem is that not all eurozone countries are good credits. It was unclear that international investors would want to lend money to something that is essentially a weighted average of eurozone creditors or if they did, the cost of that funding would be quite expensive because of the participation of weaker creditors. These transactions are only taking place when international markets decide that the country applying to the programme is not a good bet for paying back loans. To get a low interest rate in the market, these EU facilities have to convince the market not to worry about the credit quality of the donor country, that is the country that is getting the money. Instead they need to say that European Union countries are standing behind this and the markets know for that reason they will get their money back.
The way the facilities have been constructed is to reassure people that the average financial strength is essentially the same as the AAA rated members of the eurozone. Roughly 80% of the financial backing for this facility comes from AAA rated members and the facilities operate as though one only needs to worry about the credit worthiness of those member states. What that means is that when they borrow €100 million in the market, they do not lend out all of that €100 million, but keep some back for cash to assure investors that there is a pile of cash sitting there already ready to pay interest payments and so on. Furthermore, of the money earmarked for a particular country, much of it is kept back to increase the cash buffer and so much of the interest cost that Ireland will pay takes the form of an immediate deduction of a lot of the money that we are borrowing.
I will show a slide of what a stylised loan from the facility would look like in terms of cash flows and I will come back to it later. These additional features to try to make the facility more attractive to investors add about 35 basis points to the cost of the facility's funds relative to the costs of the mechanism's funds. Therefore, since I calculated that I think the mechanism's interest rate will be approximately 6.1%, I think at this point the cost of the facility would be approximately 6.45%. Again, it will depend on the rate at which the facility is able to raise funds in the market. They have not done so yet, but I understand they are planning to do so this week.
There is a detailed discussion on the content of this slide in the briefing paper. Essentially it is a set of numbers describing that when the EU goes into the market as the EFSF and borrows €100 million, it only earmarks €80 million as being a loan to Ireland and then it immediately deducts a load of that money so that Ireland never sees it. In this example, Ireland only gets €67.5 million. We make interest payments for a number of years but at the end of the day, we still need to pay back the full €80 million. One can then calculate how this arrangement would have worked relative to a regular loan of €67.5 million from the bank and make interest payments back. In this example, when we put it all together, there is a simple average interest rate of 6.05%. This is an illustration of what is meant when people say that the interest rate would be about 6%. As I have said, I have calculated the figures and I think it would be slightly higher.
I will finish up on these two points. Comparing the EU and the IMF loans, it is important to emphasise that although it may appear that the IMF loans carry a lower rate than the corresponding EU loans, once they are compared on a like-by-like basis, it is fair to say that the overall costs of funding over a long period would be likely to be similar. It is true that right now and over the next year or two, the cost of funding from the IMF is lower than the cost of funding from the EU and we have locked in at fixed rates this relatively high cost from the EU. However, the cost to the IMF is more of a process that we expect to increase in the future. That is an important difference. When thinking about what it would cost a country to borrow at variable rates compared with fixed rates, one can think of all three of these programmes as being programmes that tack on a margin of 3% to the corresponding cost of borrowing. The last question but probably the most important question, is whether there is room for getting a lower rate by negotiating on any component of these loans. In relation to the IMF loan, I would say, absolutely not. This is a standard programme and one can go on the IMF's website and find out the terms and conditions and what an extended fund facility looks like.