This paper considers elements of macroeconomic policy central to Ireland’s objective of being among the first countries to enter into European Economic and Monetary Union. The paper analyzes the main determinants of the Irish pound/sterling exchange rate, an issue brought to the fore by the currency turbulence of March 1995, which saw a sterling-inspired decline in the Irish pound against the deutsche mark. It also considers fiscal developments and prospects, highlighting tax reform measures undertaken to accelerate job creation, the growth of spending in recent years, and the medium-term fiscal outlook.

Abstract

This paper considers elements of macroeconomic policy central to Ireland’s objective of being among the first countries to enter into European Economic and Monetary Union. The paper analyzes the main determinants of the Irish pound/sterling exchange rate, an issue brought to the fore by the currency turbulence of March 1995, which saw a sterling-inspired decline in the Irish pound against the deutsche mark. It also considers fiscal developments and prospects, highlighting tax reform measures undertaken to accelerate job creation, the growth of spending in recent years, and the medium-term fiscal outlook.

III. Proposed Changes to the Structure of the Irish Government Bond Market 1/

1. Introduction

A major restructuring of the market for domestic Irish Government Bonds (IGBs) has been proposed by the NTMA, the entity charged with funding Exchequer borrowing requirements and managing the national debt. Under the proposal, the agency-only system of trading IGBs, which has been in place since 1799, would be replaced in October 1995 by a market-making system based on a group of primary brokers committed to quoting firm two-way prices for IGBs.

The changes to the IGB market represent a key element of the Irish authorities’ objective of conforming to international conventions in the regulation and structure of financial markets. Other adaptations include legislation to incorporate the Irish Stock Exchange (which now operates as a division of the International Stock Exchange of the United Kingdom and the Republic of Ireland) in Ireland and enable the Central Bank to supervise the Exchange and its members. Other Exchange rules, including listing and membership requirements, would be established and monitored by the Exchange. In addition, the Investment Intermediaries Bill aims at regulating all investment intermediaries not covered in the Stock Exchange Bill. The enactment of these two pieces of legislation would permit firms authorized by the Central Bank or Department of Enterprise and Employment to provide investment services throughout the EU.

The rationale for the proposed reform of the IGB market is threefold. First, since a system of market making based on primary brokers has become the norm in government bond markets, the NTMA hopes that its adoption in Ireland will increase the attractiveness of the Irish market to investors. Second, the NTMA expects that the introduction of a market-making system would reduce trading costs, increase turnover, tighten spreads, and lower the Exchequer’s borrowing costs. Finally, the move to a primary broker system has been given impetus by the ruling of the Competition Authority in June 1994 that stock exchange regulations mandating agency-only broking and a system of fixed commissions were anticompetitive. Commissions fell sharply subsequently and a hybrid market has developed that is neither strictly based on agency-only broking, nor entails an obligation by brokers to make continuous markets.

Much progress has already been made in improving the efficiency of the IGB market and reducing funding costs. Average daily turnover increased by a factor of 10 during the 1980s, while the spread on IGBs over deutsche mark denominated bonds has fallen sharply as a result of a successful effort to correct earlier macroeconomic imbalances (Chart 5). Although the largest element of the spread between IGBs and those of other governments is the premium for currency and inflation risk demanded by investors (factors little influenced by market structure), a reduction of transaction costs and greater ease in buying and selling IGBs would tend to reduce the liquidity premium on Irish securities. 1/

CHART 5
CHART 5

IRELAND INTEREST RATE DEVELOPMENTS

(In percent)

Citation: IMF Staff Country Reports 1995, 076; 10.5089/9781451818673.002.A003

Sources: Central Bank of Ireland, Quarterly Bulletin; IMF, Data Fund; and data provided by the Irish authorities.1/ Three-month interbank deposit rate.2/ Rate on Irish Government 15-year securities.

The proposed reforms represent a sweeping change in the way IGBs are marketed. The small size of the IGB market, the limited number of likely candidates to become primary dealers, and the additional exposure of dealers to market risk under a market-making system dictate that careful attention be given to the introduction and supervision of the new system.

This chapter reviews the current structure of the IGB market, high-lighting the NTMA’s central role in primary issuance and supporting the secondary market; describes the NTMA’s proposal for instituting a primary dealer system, including the obligations and privileges of primary dealers; and considers the issues raised by the proposed change in market structure, focusing on the potential risks of the transition.

2. Current market structure

a. NTMA and primary issuance

Established in 1990, the NTMA is responsible for the borrowing and debt management functions previously performed by the Department of Finance. 2/ The large size of Ireland’s debt, the complexity of debt management, and the need for a flexible management structure and qualified personnel to realize cost savings and limit risk were cited as the main rationale for the NTMA’s establishment. In carrying out its functions, the NTMA seeks to minimize the long-term costs of servicing the national debt, within annual guidelines 3/ on debt management issued by the Department of Finance. The NTMA pursues sustainable cost minimization in three ways: by selling bonds at the lowest possible yield; structuring its portfolio to take advantage of yield curve developments; and reducing transaction costs. The NTMA arranges tap issues 1/ via the Government Broker who acts as the NTMA’s agent on the stock exchange. There are also regular, typically quarterly, auctions of the long bond open to all, but in practice bids are generally made only by brokers.

The NTMA’s performance is measured by two benchmarks: the annual budgetary allocation to debt service payments, and a shadow portfolio 2/ against which the cost of the actual portfolio is assessed. This latter assessment, undertaken by J.P. Morgan, seeks to measure in Irish-pound terms the mark-to-market value of all future principal and interest debt service payments of the NTMA’s obligations. In this way, the full economic costs of portfolio decisions are considered over their lifespan, rather than in one particular year. However, the assumptions underlying the anticipated performance of the benchmark and the NTMA’s portfolio may not apply during times of extreme market turbulence, as these assumptions are typically influenced by historical ranges of average market movements. In 1993, the benchmark was revised to reflect expectations for global interest rates to rise, imparting a tilt in the NTMA’s portfolio toward longer maturity, fixed rate debt.

In addition to minimizing funding costs over the long run, the NTMA is responsible for containing risks. Chief among the risks faced by the NTMA is underperformance relative to its two benchmarks, including in particular the annual budgetary allocation for debt service. 3/ In order to minimize the risk of underperforming its shadow portfolio, the divergence of the NTMA’s actual portfolio from the composition of the benchmark is likely to be limited, 4/ except in the event of large shifts in market expectations. In addition to the risk of underperformance, the NTMA seeks to contain liquidity risk (which would compromise its ability to refinance maturing debt and meet the Exchequer’s new borrowing requirements) by spreading the maturity structure of government debt (Tables A36 and A37). A balanced maturity structure is also pursued to reduce the market impact of NTMA activities. Credit risk is controlled by the imposition of exposure limits on counterparties. Operational risk is managed through the segregation of the NTMA’s dealing, processing, payments, and reporting and control functions.

b. Secondary market

The agency-only broking system which has been in place since 1799 is an order-driven market in which brokers match buyers and sellers; they do not execute trades immediately by temporarily taking the security onto their books or selling bonds from inventory. Trades are executed on the Irish Stock Exchange, which is a self-regulatory organization. 1/ Settlement on the secondary market is typically made the next business day, although deferred settlement is possible. The NTMA quotes terms for deferred settlement of up to 7 days. The Central Bank operates a settlement office, which handles 90 percent of all IGB transactions, to increase efficiency and reduce the risk of default. The transfer of securities is matched against payment guaranteed by settlement banks.

The NTMA is quite active in promoting secondary market liquidity, 2/ although it is not strictly speaking a market maker, a function that would be incompatible with its objective of funding the Exchequer’s borrowing requirements. To provide liquidity and gather market intelligence, the NTMA maintains a daily presence in the secondary market through a trader that manages a small fund. In addition, the NTMA bids continuously at below the market clearing level for lots of at least IRE5 million of all designated benchmark bonds, with the view to supporting the market and establishing a floor in unsettled conditions; the liquidity so provided is less (and less certain) than what would be expected in a market-making system, however. The NTMA has established clearly defined tap and auction procedures to permit planning by market participants. It has also adopted a policy of concentrating issues in benchmark bonds as another means of promoting liquidity and depth. 3/ The NTMA facilitates stock switches from illiquid to benchmark issues. In order to attract international investors, the NTMA has been active in marketing Irish securities abroad, establishing links for international clearance and settlement, and seeking the inclusion of IGBs in international bond indices. 1/

c. NTMA and the Central Bank

The NTMA continuously informs the Central Bank of anticipated transactions in the IGB market to forestall any disruption in the Central Bank’s conduct of monetary policy. 2/ In addition to this information flow, the Central Bank and the NTMA coordinate their activities when necessary. 3/ During the 1992 ERM turmoil, the NTMA curtailed its domestic borrowing, maintained firm bids in benchmark bonds and those maturing within one year to sustain liquidity, and increased its foreign borrowing to replace funds that would have otherwise been raised on the domestic market and to supplement the Central Bank’s external reserves. In addition to policy coordination, the Central Bank is the NTMA’s fiscal agent and banker, and provides a settlement office, which handles IGB transactions in excess of IR£100,000. The Gilts Settlement Office (GSO) provides a secure transfer system for IGBs (and certain other securities) by matching trades with simultaneous payment guaranteed by approved settlement banks. Transactions through the GSO by its members (which include most stock brokers and large domestic institutional investors) are in book-entry form.

d. Shortcomings of the current system

The IGB market is characterized by low liquidity as measured by market depth (the continuity of pricing and trading), speed of execution, turnover 4/, and transaction costs. The NTMA contends that, prior to the June 1994 ruling of the Competition Authority, the market’s limited liquidity had been attributable to the maintenance of a system of agency-only broking.

Under that system, delays arose as dealers attempted to match buyers and sellers, exposing investors to intervening adverse price movements. Following the Competition Authority ruling, a hybrid system has emerged. Some brokers have begun to act as principals in filling orders to buy and sell bonds, while others continue to act only as agents on negotiated commissions. According to the NTMA, the current market structure is not conducive to the development of a pool of market makers. Market depth is consequently limited, with the result that small temporary imbalances can trigger disproportionately large price movements, thereby amplifying volatility and reducing the information content of market prices. Although commissions have declined substantially since the abolition of fixed commissions, the NTMA maintains that trading costs remain high. The lack of depth and immediacy in the cash market, and the limited need for hedging vehicles by brokers not obligated to make markets have also inhibited the development of derivative securities on IGBs, and contributed to higher credit costs in other sectors. 1/

3. Proposed new market structure

The market-making system proposed by the NTMA will entail a marked departure from the current roles of the main participants and regulators of the IGB market, and a new entity—an inter-dealer broker—will be required to facilitate wholesale trades. The new structure will also result in the more intensive use of instruments designed to fund (repos) and hedge (futures) bond positions. At the same time as these changes are in train, the Irish Stock Exchange will be reformed under a new legal and regulatory structure.

a. Market making

A market-making system typically involves the selection of a limited number of primary dealers obligated to take up a significant amount of new government issues and to quote firm, continuous, two-way prices in all or some government securities on the secondary market. In exchange for this obligation, primary dealers are typically accorded privileged access to new issues of government debt, or facilities to fund their positions in such securities. Primary dealers are typically selected on the basis of their ability to place new issues, managerial competence, and capital adequacy. In the secondary market, primary dealers facilitate immediate execution and provide market depth by standing ready to act as a principal in trades and bear the risk of adverse price movements on their bond inventory. Imbalances in the market will typically be reflected by widening spreads. 2/ During periods of relative calm, spreads across market makers can be expected to be fine, but differ to reflect varying perceptions of the market and the composition of primary dealer inventories. Spreads are also a function of the cost to primary dealers of hedging their exposures, financing their inventories, and the amount of capital required to underwrite trading activities. As a result, the existence of a liquid derivatives market, an active repo market, and access to securities lending facilities can reduce broker costs and narrow spreads. Primary dealers generate revenues on the bid-ask spread, their inventory, and through proprietary trading, whose profitability may be enhanced through access to information on order flow.

b. Selection criteria for primary dealers

Prior to the introduction of the primary-dealer system envisaged for October 1995, the NTMA hopes to identify 5–7 brokers qualified to make markets in IGBs. The targeted number of primary dealers is an attempt to balance the limited size of the IGB market with the need to avoid market concentration. If the number of primary dealers were to fall below four, the NTMA would reassess the proposed new issuance and debt management procedures. The NTMA will evaluate potential primary dealers on the following criteria: management depth and experience, dealing capability, placement ability (including the capacity to market issues internationally), capital adequacy, and ability to support the NTMA’s funding schedule. The minimum capital requirement is IR£5 million dedicated exclusively to market making in IGBs. 1/ In order to limit market concentration, the maximum capital dedicated to this purpose would be IR£8 million. In addition, to limit the NTMA’s exposure to any single primary dealer, the level of securities lending and repo facilities afforded to primary dealers by the NTMA would be based on a maximum capital of IR£5 million. Designated primary dealers would be separately incorporated members of the Irish Stock Exchange. Separate incorporation would be aimed at segregating the primary dealer’s market-making business from other activities and ensuring adequate capitalization for these activities.

c. Obligations of primary dealers

Primary dealers, who would commit themselves to remain such for at least three years, would be expected to participate in NTMA auctions and taps at reasonable prices and at levels commensurate with their past market share. To facilitate this task, the NTMA would continue to enhance market liquidity by concentrating new issues in existing benchmark bonds. Primary dealers would also be committed to quoting firm two-way prices in eight current and former benchmark issues in a minimum size and maximum spread. The NTMA envisages that normal trading would occur well within the maximum spreads (equivalent to 3 basis points in the case of benchmark bonds and 5 basis points for other designated bonds), which are intended to cover all market conditions. 1/ Primary dealers would be expected to place bonds among a large number of geographically diverse retail clients. Primary dealers would also be obliged to segregate their bond inventory for market making from their proprietary trading book.

d. NTMA support to primary dealers

During the early stages of the primary dealer system, the NTMA would be prepared to support its establishment to ensure that all market participants are confident with the new system. In particular, the NTMA would intervene in the secondary market during times of market turbulence on an exceptional basis and without prejudice to its primary function of Exchequer funding. It would consider requests to unwind the long or short positions of primary dealers. In addition, the NTMA would quote, for the exclusive benefit of primary dealers, continuous bids in minimum lots of IR£3 million for each of the bonds in which primary dealers must make a market. The NTMA may also maintain a secondary trading capability—segregated from its other operations—to trade on the retail market through the Irish Stock Exchange and on the Irish Futures and Options Exchange.

Primary dealers would have sole access to the NTMA’s tap issues. Competitive auctions, 2/ however, would be open to all members of the Irish Stock Exchange and to institutional investors. Immediately after the announcement of auction results, primary dealers would be allowed to make non-competitive bids for the issue at its average dealt price. 3/ In addition, the NTMA would facilitate securities lending for primary dealers and enter, through the inter-dealer broker (IDB), into repos and reverses with primary dealers. The NTMA would limit access to these facilities on the basis of primary dealer capital and expects that reliance on the NTMA facility would decline as the market matures. Primary dealers would also have exclusive access to stock switching facilities provided by the NTMA. Primary dealers would trade among themselves through an IDB (to be established) as a means of increasing liquidity in the wholesale market and affording anonymity to primary dealers loathe to reveal their positions to competitors.

In order to assess the need of primary dealers for the stock switching, repo, and continuous bid facilities offered by the NTMA, primary dealers would be required to provide daily information on their net open positions in the relevant issues, and monthly data on turnover. These data would also be used to assess the primary dealers’ contribution to market liquidity. The NTMA would establish performance criteria—based on share in market turnover—to ensure that primary dealers are meeting their obligations.

4. Main issues

The successful establishment of a primary dealer system would contribute to market efficiency. However, there are a number of potential pitfalls.

First, there is the risk that the small size of the market and its limited daily turnover may not be sufficient to sustain an adequately large number of market makers to avoid market concentration. This outcome is considered unlikely by the NTMA, which expects market turnover to double as a result of its proposed reforms. In any case, the NTMA would always have the option of seeking additional primary dealers. Failing that, the NTMA has left open the possibility of marketing bonds itself through the Irish Stock Exchange to a wider range of investors. In this event, other dealer prerogatives would also be curtailed to reflect changes to their exclusive market-making role.

Second, a market-making system requires primary dealers to accept a degree of market risk on their inventory of bonds carried to fill client orders. The likely increase in proprietary trading undertaken to replace (much reduced) commission income would further expose primary dealers to adverse price movements. The available vehicles to hedge this risk are currently illiquid, although the NTMA expects that turnover on the Irish Futures and Options Exchange (IFOX) will increase with the hedging requirements of primary dealers. The parties undertaking, hedging, and monitoring these additional risks would, at least initially, be untried. Any untoward developments in the IGB market could spill over into other markets, particularly as some of the likely market makers to emerge under the new system are the brokerage arms of large banks. Attentive market supervision, adequate capitalization, and sound internal risk management will be critical to contain the additional risks of the market-making system.

Third, although the adoption of a primary dealer system is likely to enhance liquidity, the gains from the new market structure should not be exaggerated. The IGB will remain a small government bond market, and funding costs will continue to be influenced in the main by global interest rate movements and the risk premia needed to entice investors to hold Irish securities. The pursuit of sound macroeconomic policies that promote price and exchange rate stability are likely to make a far greater contribution to reduced funding costs than improved market efficiency, although the latter can also reduce costs by diminishing the liquidity risk premium demanded by investors. Liquidity in the IGB market may also be prejudiced by factors unrelated to its structure. For example, the ease with which foreign investors can establish, liquidate, and hedge positions in IGBs will be constrained by the liquidity of Ireland’s currency markets.

Fourth, the development of the futures market and the use of repos by primary dealers are necessary to reduce the costs faced by market makers, thereby narrowing spreads. As both these instruments also afford leverage, their abuse needs to be avoided by careful market supervision. In this regard, the adequacy of the minimum capital required to be earmarked by primary brokers to support their market-making activities needs to be monitored carefully and eventually linked explicitly to the risk (rather than the size) of the inventories and proprietary trading of market makers.

Fifth, the NTMA has indicated a readiness to promote the development of the proposed primary dealer system through facilities for repos, stock switching, and securities lending, the maintenance of continuous bids for designated bonds, and the activities of its own secondary market trader. While the NTMA’s credit facilities for primary dealers and its market support will be limited, these facilities expose the NTMA to risk. It will be necessary to balance the objective of supporting the development of a market-making system with the need to limit the exposure of the NTMA.

Finally, individual investors appear to lose a degree of access under the proposed reforms. Efforts to make government bonds attractive to individuals have been successfully pursued elsewhere, and might usefully be adopted for the IGB market.

References

  • Central Bank of Ireland, Annual Report, various issues.

  • National Treasury Management Agency, “Proposals for Development of a Market-Making System in Government Bonds”, June 1994.

  • National Treasury Management Agency, Statement by the National Treasury Management Agency: Market Making Issuance Procedures and Related Debt Management Arrangements, May 8, 1995.

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  • National Treasury Management Agency, Annual Report, various issues.

1/

Prepared by David J. Ordoobadi.

1/

Although the NTMA has not attempted to quantify the reduction in funding costs that would arise from the successful adoption of a market-making system, it expects a doubling of turnover to result. Assuming that this increase in liquidity resulted in a 10 basis point decline in the liquidity premium on IGBs, funding costs would, over time, decline by IR£14 million annually.

2/

Its constituent legislation states in relevant part that the NTMA’s objective is “to borrow moneys for the Exchequer and to manage the National Debt on behalf of and subject to the control and general superintendence of the Minister for Finance.”

3/

These guidelines, which leave a large degree of latitude to the NTMA in its debt management operations, typically indicate financing requirements over the year and preferences of the Department of Finance on the sources of funding, including, for example, the balance between fixed versus floating and domestic versus foreign debt.

1/

Taps are so named because they allow issuers to respond to market demand by opening the tap to permit new amounts of existing bonds to flow into the market. The tap is not opened in falling markets. By periodically reopening existing bonds, the liquidity and depth of benchmark issues can be increased. Bonds not fully subscribed in auctions may also be sold through subsequent taps.

2/

The composition of the shadow portfolio, which is confidential, is determined by the Department of Finance, the NTMA, and J.P. Morgan.

3/

Since the budget is on a cash basis, this benchmark is in practice relatively easy to outperform given the NTMA’s latitude in determining the maturity and coupon profile of new debt issuance. In exercising this latitude, however, the NTMA needs to balance both short- and long-term considerations, a discipline imposed by the shadow portfolio. In practice, the NTMA’s actual annual debt service payments have been kept well below the budgeted target and these “savings” have been accumulated and applied as a source of funds in subsequent budgets.

4/

Benchmarks thus embody both an expectation for debt management cost and acceptable risk.

1/

The pending Stock Exchange Bill will, in accordance with the EU Investment Services Directive, name the Central Bank as the competent authority to supervise the exchange and its members. Under this legislation, the stock exchange (and any other subsequent exchanges) would be incorporated in Ireland with a broadly based board that represented its members’, users’, and the public’s interests.

2/

An efficient secondary market serves many purposes: it provides a basis for pricing of new issues; underpins the NTMA’s continued access to funds; and limits the market impact of the NTMA’s activities.

3/

A deep cash market promoted by concentrating issuance to a limited number of benchmark bonds should also facilitate the development of derivative instruments on these bonds. Thus far, however, the Irish Futures and Options Exchange, which was established in 1990, has been quiescent. Five contracts are traded on the IFOX: short, medium, and long gilt contracts; a DIBOR contract; and a stock index contract on the Irish Stock Exchange.

1/

IGBs are included in the global government bond indices of Salomon Brothers, Lehman Brothers, Bloomberg/EFFAS, UBS Phillips & Drew, Merrill Lynch, and J.P. Morgan.

2/

There are two main instruments of monetary policy in Ireland. The short-term facility (STF) rate at which overnight funds are lent to banks is used to influence money market rates. Repurchase and reverse repurchase agreements are used to make short-term and self-reversing adjustments to domestic liquidity. The Central Bank does not undertake outright purchases and sales of securities in open-market operations.

3/

Because of the potential conflicts between debt management and monetary policy implementation and the close contacts between the central bank and market participants, debt management is undertaken in many countries by a department of the Central Bank.

4/

The IGB market turnover ratio (total turnover divided by market capitalization), which measured 2.6 in 1993, compared unfavorably with Australia (11.4), Belgium (5.3), Finland (3.1), Germany (3.0), New Zealand (3.3), Norway (7.7), Sweden (11.0), and the United Kingdom (5.4), but was at least as high as Austria (1.3), the Netherlands (2.6), and Portugal (0.9).

1/

For example, spreads on 5-year interest rate swaps in Ireland, which are used to price fixed rate mortgages, are high.

2/

In times of extreme market volatility, liquidity may dry up completely (or spreads widen to levels designed to discourage business) as primary dealers temporarily renege on their obligation to make markets.

1/

The NTMA’s estimate of required capital is based on expectations for market turnover and EU capital adequacy requirements for market makers. On the basis of turnover in 1993, the NTMA estimated that the aggregate capital required to support the IGB market would be Ia£11 million (or about IR£2 million for each of five primary dealers). Since the NTMA believes that a significant increase of turnover is both desirable and the likely outcome of its proposed restructuring, of the IGS market, the aggregate capital requirement is estimated at IR£25 million or an average of IR£5 million for each primary dealer.

1/

The NTMA’s proposal envisages adjustments to these spreads as new benchmark bonds are introduced, the duration of existing designated bonds declines, and market conditions evolve.

2/

The NTMA plans to continue its quarterly auction of the long bond and may increase its reliance on auctions over time.

3/

The degree of privileged access to taps and non-competitive bidding at auctions accorded primary brokers would be determined by the success of the market-making system. If the primary broker system fails to develop into an efficient means for placing government debt, the NTMA would limit the access of primary brokers to a proportion of new issues with the balance offered directly to the market.