Sharing is Caring
Amidst the staggering news flow of the past few weeks, Ireland’s debt crisis and its status in the Eurozone, has been relatively low on the international agenda, but potentially epoch making for Irish people. Ultimately, Ireland will have to default on some of its obligations – they have grown (and will continue to grow) to the point where they are simply too great to sustain. The new coalition government needs to play their hand with subtle aggression. Burden sharing is a compulsory goal, but it should be sought in the first instance for good behaviour – follow through on public sector reform, austerity and hitting economic growth targets. The nuclear option of non-payment and euro withdrawal should be held in the background.
In an Irish Times article a couple of weeks ago: “How the World Sees Ireland”, citizens of some faraway and some not-so-faraway lands were asked what three things come to mind when they think of Ireland.
Raphaëlle Collomb, a young florist on rue de Bretagne in Paris: “The scenery, the open spaces, the sea, the cold climate. The people have a reputation for being friendly. Everyone knows about St Patrick. And the beer.” In China Li Linzi, 25, plumps for “beautiful dresses, U2 and grasslands”, while Li Ping, 55, says “Ireland is a small country, in some way related to England”. And a personal favourite: Zhang Yuehan, 27, says: “I know of Ireland’s ‘holy marriage’, where when a couple get married they can’t get divorced, they have to keep their promise for 100 years. Is that true? I love it, it’s so romantic.”
Ireland’s rising divorce rates over the past 10 years would suggest otherwise. The only true version of an Irish “holy marriage” is playing out in its relationship with the Eurozone, which is considerably less romantic.
The ECB and the Irish Central bank are collectively rolling over close to €190bn (115% of Irish GDP) worth of funding for Irish banks, which have no independent access to interbank or deposit markets. The expectations of a sovereign level default mean that the potential of attracting deposits in the near term is close to nil.
Secondly, a EU/IMF sponsored loan of over Euros 80bn is in place to cover Irish sovereign funding requirements for bank recapitalisations and planned public sector spending.
The recent results of the Irish bank stress tests clarified little. Irish banks’ loan books held €255.6bn worth of loans at the end of 2010 (loan to deposit ratio of 180%); with €190bn of that funded in the short term money markets via the ECB/ Irish Central bank there is little to be certain about. Under the requirements of the stress tests the banks must sell €72bn of assets by 2013.
According to the Irish Central Bank “Banks should be able to avoid fire sale of assets, but the deleveraging is likely to result in €13.2bn of losses.”
Two points here:
a) that loss projection is probably nonsense: it represents an average write down on assets sold of just over 18%. While there are quality international assets on the Irish banks/ NAMA’s books, even if that write down figure is correct the remaining loans will be an ugly agglomeration of mainly domestic mortgages.
b) €72bn worth of asset sales leaves another €185bn of “other assets” to find funding for. Irish negotiators were hoping to be able to announce with the recapitalisation that this ECB funding had been converted into some kind of medium term facility to allow the banks time to deleverage or find alternative deposits. But there’s been unexplained silence on this front so far.
It’s hard to believe that two years forward this process will leave the Irish state able to fund its banking liabilities independently. Consequently it’s hard to believe that further asset firesales won’t be pushed for, and these assets will be domestic mortgage loans. Who would be a buyer, and at what price?
In exchange for playing in this merry charade, bailout funds will be forthcoming and if Ireland behaves there may be interest payment reductions. In particular, if Ireland agrees to address its low corporate tax rate then there is the potential for a 1% reduction on the interest bill for the IMF/ EU bailout.
Allowing this holy marriage to continue in this way has the potential to lead to a multi-generational loss of competitiveness in the Irish economy, all-the-while not changing the likelihood of a partial or complete default on these obligations to our European friends.
Consider that a 1% drop in the interest burden would reduce the expected debt interest bill by around 600mm Euros. Not chicken feed, but unfortunately not game changing in Ireland’s context: the sizes are just too large: the projected interest bill on the IMF/EU loan is Euros 3.9bn per annum. That’s a big number – but the potential end size of the cost of banking recapitalisations is anybody’s guess, regardless of what the stress tests tell us.
The long and short of it is that Ireland will have to share the burden (sovereign states tend not to ‘default’) of these obligations at some point, and that the European Union specialism for “muddling through” won’t change that.
In order for the Irish coalition to understand the hand it is playing with it is important to understand a couple of technical aspects of the financial rescue mechanisms in place.
The current one – the European financial stability facility (EFSF) – will run out in 2013. It grants access to credit to countries in trouble, and may soon buy their bonds on the primary markets. These rank pari passu – on the same terms – with everybody else’s investments. That means if the troubled country defaults, everybody gets hit equally.
If Ireland were to default today, Germany and France would have to make good on their credit guarantees to the EFSF, which would be a political disaster. German conservatives would be apoplectic and haul Angela Merkel to the German constitutional court. As part of the muddling through principal, the creditor nations would therefore not allow a default until 2013.
In 2013, a new mechanism will replace the EFSF. It is called the European stability mechanism (ESM). The critical difference between the two is that its loans will rank senior to those of private investors, i.e. current and future bondholders. The idea is to make default possible, with only a moderate risk to the budget of the creditor nations. By 2013, the European banks should (fingers crossed for this bit) be in a better position than today to absorb big losses, or so one hopes. Happy days – end of crisis.
Unfortunately any half-witted bond trader can look forward. They know that once a country defaults, old and new bonds will be treated alike. In the Irish context, therefore, the access to the EFSF is a devils bargain. Bondholders and potential bondholders know that Ireland’s position is untenable in terms of its current obligations, so the threat of an organized default against them is on the cards in 2013 when the ESM is introduced, with particularly painful write downs.
The reason domestic banks can’t access deposit markets is because potential depositors know this. Consequently it’s hard to see beyond a continuing reliance on ECB overnight funds to cover daily interbank requirements, and they will have no choice but to push for future asset sales to get (some) of their money back.
For leaders in Brussels, this game will continue until the debtor country’s economy collapses under its debt burden, at which point the inevitable default will be very messy. If you are lucky, you are no longer in office by then, and you can blame your successor for the mess.
So what to do instead? For Enda Kenny and Michael Noonan, Ireland’s Taioseach and Minister of Finance respectively, the major task is to understand the hand they are playing with. For me, that means that they have to draw the firm conclusion that the current debt burden is too much and start stating that clearly.
This is a tight-rope walk for the Irish government, which is why “subtle” aggression is what is required. As former IMF deputy-director Donal Donovan points out: “You can hardly burn the bondholders in the morning and then expect in the afternoon the same broad class of lenders to come and give new financing to these banks.”
Donovan predicts that Ireland could get a third of its debt ‘restructured’ but said it had to keep to its side of the bargain, continuing with internal adjustments and driving down public sector pay to bring it into line with the private sector.
“Debt restructuring is a reward and a reward which is held back for quite some time until the person that’s getting it or the country that’s getting has done enough to have earned it,” Donovan said. “It sounds rather calculating and cynical, but honestly this is how much of the world works on these matters.”
The European Central Bank would eventually come around to the idea of writing off some of Ireland’s debt, he said, because by 2013 external agencies like the IMF were “likely” to deem Ireland’s debt to GDP “unsustainable”. Ireland’s debt to GDP ratio is expected to rise to between 115 and 120 per cent in 2013-14. They may well get there quicker – and perhaps Enda Kenny should be pleading more to the IMF than to Sarkozy and Merkel.
“The IMF has no problem with the principle of debt rescheduling – I think the EU has more difficulties with the idea of rescheduling. They are new to the game, they’re worried about the reputational loss to the euro,” he said as well as worried that “other countries could be tempted to follow some more profligate policies if they feel a debt rescheduling exit if they get into trouble”.
“For these reasons – I’m not saying they are good reasons, but they are the reasons – the EU has been much keener to muddle through on this, rather than take definitive steps early. This isn’t very attractive intellectually but we live in a world of political institution constraints, so I think this will continue for some time.”
Clearly there are many moving parts, and Ireland is a provincial outpost in European terms. The only course of action is for the new government to push for public acknowledgement that the debt burden is too big to sustain, and seek restructuring concessions as early as possible. The concessions should come not because of belligerence, but because of a clear commitment to reform and economic growth.