Playing at Home
The often used phrase “sovereign debt-crisis” happily lumps the PIIGS (Portugal, Ireland, Italy, Greece and Spain) into the same collective boat, but each national crisis has its own characteristics that make the likelihood of default different from country to country.
For Greece, fiscal adjustment is the key issue, as the government has been extravagantly fire-hosing the public sector with borrowed money for some time. For Portugal, however, the key problem is the private sector’s continuing external deficit: the government debt to GDP ratio isn’t that high by comparison to other Eurozone countries. The Irish situation is a banking crisis turned into a potentially unsustainable government debt crisis. Ireland can no longer raise funds on the capital markets and has had to accept a bail-out financed jointly by the IMF and the European Financial Stability Facility (EFSF), yet it has huge untapped private sector foreign assets.
Following my own national interest, the Irish situation is of most personal concern. Potential investors in Irish bonds fear that by the time the European support ends as planned in 2012, the country will still not have access to the bond markets, and might then be forced into default. In 2013 a new mechanism will replace the EFSF, called the European Stability Mechanism (ESM).
The critical difference is that under the new ESM, contributing countries bailout 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 (in other words to satisfy the German electorate). 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.
In this context, it’s unlikely that a continuing reliance upon foreign support is going to end well for Ireland. Ireland doesn’t have access to capital markets even now, when the EFSF ranks as an equal creditor to private Irish bondholders. Unless the economic situation changes dramatically between now and the end of next year, it’s hard to believe that foreign bond investors will be jumping to hold Irish bonds, given that they will be subordinated as creditors versus the ESM, under that new regime.
This dependency of Ireland on foreign support is “difficult to understand given that the country has not lived continuously above it’s means in the past”, according to Daniel Gros of the CEPS. Ireland has run a current account deficit (i.e. the country has a shortfall between resources used and produced) for only a few years. In total, according to Gros, the current account balance over the last 25 years shows a foreign debt of only around 30bn Euros; a figure which is only 20% of Irelands annual GDP. Furthermore, Ireland is predicted to run a current account surplus for 2011, and did so in the 4th quarter of 2010.
The talk in Ireland of export led growth is correct, yet instead of the Irish private sector funding the public sector deficit it chooses to hold its assets in foreign equities, bonds and deposits. Currently 10 year Irish government bonds yield around 11% – an exorbitant and unsustainable level of interest – whereas the private sector earns very little on its foreign assets. As Daniel Gros points out, if this is allowed to go on, the “government could indeed still have to default”.
Estimates suggest that Irish pension funds and life insurance companies alone own over 100bn Euros in foreign assets, roughly €25bn of which are invested in non-Irish government debt. A recent report from the Irish public pension fund suggests that the average rate of return achieved during the past 10 years has been 1.7%.
Again picking up Daniel Gros’ point: “A very strong case can thus be made that Irish pension funds and life insurance companies should somehow be ‘induced’ to invest their entire portfolio of gilts in Irish government bonds. The Euros 25bn in financing that this would yield for the government is equivalent to the IMF contribution to the current rescue package. A massive investment in the bonds of the country, would not be just some nationalistic punt, but would be in the interest of current and future retirees, and the State as a whole.
The Irish government’s only recourse to making payment of foreign deficits is taxation. As a member of the Euro, it cannot control interest rates or devalue its liabilities by printing money, unlike the US or UK approach to ’stimulating’ their economies. Whatever interest rates the government pays on its national debt are a direct claim on tax revenues – so if rates on government debt remain high, in the absence of higher economic growth, the only alternative is to raise taxes to compensate, which will have a knock on drag on prospects for growth.
A redirection of pension fund monies would be a start in this process. Irish deposit holders should also be incentivised to ‘look to home’ as well: they are not receiving meaningful returns on deposits held in foreign banks, yet are likely to be taxed heavily in the future by a variety of means if the government cannot reduce it’s interest burden; a proverbial robbing Peter to pay Paul.
The Argentine debt crisis in the late 1990s and later default (2002) holds some lessons for the Irish situation. Argentina’s private sector, similarly, had large foreign assets while the government had an even larger amount of foreign liabilities. The country went bankrupt with only a moderate net foreign debt because wealthy Argentines took their assets to safe havens outside of the country, and thus outside of the reach of the government, while poor Argentines refused to pay the taxes needed to satisfy the claims of foreign creditors.
Ireland is different in many ways to Argentina, and perhaps most significantly there is a greater culture of tax paying than Argentina, where the wealthy elite viewed taxes with a certain degree of ‘optionality’. Also, the private sector growth prospects for Ireland are already showing cause for optimism, in a way that Argentina was not, and to some extent still is not.
The real danger for Ireland is an inability to fund the government foreign deficit at anything like reasonable rates of interest. Having committed to stand behind the large Irish banks, the liabilities are substantial and growing, and the deposit base to support the banking infrastructure is negligible. At present the ECB is rolling over close to Euros 190bn worth of short-term funding to support the domestic banking base. It is this liability that is preventing the Irish government accessing the capital markets more than anything else.
As Daniel Gros points out again: “Given the scale of foreign assets owned by Irish residents there should be no need for the government to depend on the funds of the EFSF and the IMF, which are very expensive in both political and economic terms.” Mobilizing these private assets towards Irish bank deposits and Irish government bonds would not only serve the national interest but is in the economic interest of those making these investment decisions. GDP growth and continued low domestic taxes would be the virtuous circle that would result.
In practical terms, the incentives to ‘look to home’, should be in the form of tax relief on government bond investments or interest subsidies on deposits. The EU might protest that such incentives are akin to capital controls. I don’t know the legalities of the European Union, but certainly given how much German taxpayers have at stake in Ireland, and elsewhere, there will be a common appreciation for the idea that Irish people are taking on their own government’s liabilities.