Business Irish

Tuesday 17 October 2017

Putting brakes on default bandwagon

The populist urge to blow Ireland Inc's creditors out of the water is a siren call that could land us on the rocks, writes John McHale

Each day seems to bring another respected international economic commentator calling for a pre-emptive Irish default -- with some even throwing in a euro exit for good measure.

As we reel from a painful Budget, it is understandable that these calls fall on receptive ears. But as difficult as things are, we must resist the siren calls that could really pull us to the rocks.

The markets are certainly pricing in a substantial risk of an Irish default, though ECB bond buying caused yields to ease back from their highs last week.

This default pessimism reflects a number of understandable concerns. Potential investors worry that Ireland cannot achieve the Government's projected 2.7pc average growth rate over the next four years in the face of waves of austerity.

There are also doubts about the size of eventual bank losses that will be carried by the State, and doubts that the Irish political system has the capacity to produce the primary budget surplus necessary for state solvency. Unfortunately, the emerging design of the permanent EU rescue mechanism is an additional source of concern.

The German demand that debt restructuring be a part of any permanent bailout mechanism has alarmed investors. Moreover, as economist Daniel Gros points out, proposals to make official creditors senior under that mechanism makes potential buyers of long-term bonds fear large losses will be piled on to them in any restructuring.

Even a relatively small probability of a big loss can lead to a large risk premium on Irish bonds today.



Damage

While the default bandwagon is gaining passengers, it is worthwhile to step back and consider the counterarguments.

The counterarguments are both negative and positive: the negative relate to the damage done to reputation and goodwill if we default; the positive to the chances of the current strategy working if we stay the course.

The first negative argument is the reputational damage that would follow a default. For a country so dependent on international trade and investment, losing a reputation for dependable rules of the game could seriously under- mine Ireland's attractiveness as a place to do business.

Some default advocates call for drawing a bright line between the guaranteed debts of the banks and the debts of the State. Outside of the Government, there are few who would say that the original blanket guarantee of existing bank creditors was anything other than a massive blunder. But that guarantee expired at the end of September.

The guarantee now in place is the Eligible Liabilities Guarantee (ELG) on new funding. This was only introduced at the end of 2009. The new funding was not provided to the banks based on confidence in their balance sheets, but based on a promise by the State to make good on the loans.

Reneging on these state guarantees would be a sovereign default plain and simple, with all the long-term reputational damage that goes with it. There is no bright line there.

The second negative reason is that we risk losing the goodwill of the international community with a go-it-alone default.

There are legitimate complaints that the terms of the EU/IMF bailout were unnecessarily and counterproductively harsh, notably the high average interest rate and the ruling out of any burden sharing with unguaranteed senior bondholders.

It would be a mistake, however, to underestimate the value of that international assistance. Without the ECB's ongoing commitment to go beyond its normal lender-of-last resort function, providing what is effectively long-term funding to banks, the Irish banking system would have collapsed.

Moreover, without the package of budgetary supports, we would soon have burned through our cash reserves and would then have had to close the budget deficit cold turkey. We saw on Tuesday what a €6bn one-year adjustment looks like; most of us would not like to see a €19bn version.

There are also positive arguments to avoid default. The first is that despite the momentum of the default-inevitability view there is a decent chance that Ireland has the economic and political resilience to secure solvency.

On economic growth, it looks like the economy will stop shrinking this year despite a fiscal adjustment that is not much smaller than is planned for 2011 (making allowance for underspending of the capital budget and the €700m revenue-raising measures included in next year's €6bn).

Recent indicators show surprising resilience in the real economy. Of course, this is being led by the capital-intensive export sector. But there are also tentative signs that the pessimism about the domestic economy that took hold after the disappointing second-quarter growth release was overdone.

The economy is certainly facing some nasty headwinds. In addition to the fiscal austerity, growth is being held back by a credit squeeze and efforts to repair balance sheets across the economy.

As any recession progress, however, pent-up demand from postponed purchases provides an increasingly countervailing force.

When combined with Ireland's unusually dynamic export sector and competitiveness gains, there is a good chance this will be enough to achieve the relatively modest growth required for solvency.

On the banking losses, the pessimists have recently been in the ascendancy, with seemingly ever-escalating estimates of the likely losses. Time will tell whether the resilience view of Elderfield/Honohan or the mass impairment view of their critics is correct.

On political capacity, the main parties have responded responsibly to the need for substantial fiscal adjustment to avoid default. This is being closely watched by international investors. With the scope for damaging populism further limited by the conditions of the EU/IMF funding, there is a good chance that the four-year plan will be seen through.



Positives

The second positive argument is that the European-level crisis management/prevention arrangements are still a work in progress.

Given the systemic nature of crisis, we can expect ongoing efforts to correct the deficiencies of current arrangements, although understandable German concerns about moral hazard and footing the bill remain an obstacle.

The recent proposal for collectively guaranteed "E bonds" from the head of the euro group Jean-Claude Juncker and Italian finance minister Giulio Tremonti is an encouraging development. There are likely to be additional innovations as European policy makers grope their way towards more workable solutions.

Even if debt restructuring is eventually required, there will be less damage to reputation and goodwill if it takes place as part of a multi-country rescue plan for the euro rather than as a unilateral default.

With the suffering caused by the recession, it is no surprise that radical solutions receive a sympathetic hearing.

But as bad as things are, a pre-emptive default on ELG guaranteed bank debt or on state bonds could make things much worse if it compounds the "sudden stop" of market funding with a sudden stop of official assistance. The best course for now is to follow through on our commitments, and to work constructively with our partners to put more effective crisis management arrangements in place.

Professor John McHale is Head of Economics at the Cairnes School of Business and Economics, NUI Galway.

Irish Independent

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