Sunday 24 September 2017

Colm McCarthy: For distressed nations, growth is only way out

Even as the State tries to renegotiate our deal, a larger crisis is making the euro unsustainable, writes Colm McCarthy

THE twists and turns surrounding the Irish Government's efforts to achieve some relief from bank-related debt have dominated media coverage over the past few weeks.

But the broader eurozone crisis rumbles on with no agreement on the critical issue of constructing a proper banking union. Meanwhile, there is little sign of any improvement in the economic outlook in Europe.

The greatest danger to the eurozone's survival is the inability of the distressed members to grow their way out of the crisis. Of the 17 members, seven could now be described as financially distressed. These include Greece, Ireland and Portugal, already in EU/IMF rescue programmes, as well as Cyprus, where a programme is being negotiated. Slovenia is experiencing a banking crisis and may have to seek official lender assistance shortly, while Spain and Italy narrowly avoided going over the edge last summer and may need some form of assistance too.

These countries have debt levels which may not prove sustainable and all seven face difficulties borrowing in the sovereign credit market at affordable interest rates. Their sovereign debt levels, in a nutshell, may not be sustainable, there are risks of default or even of exit from the euro, and hence investors require higher interests rates to compensate for these risks. Holders of Greek government bonds have already kissed goodbye to €100bn, so investor caution and consequent high interest rates for these countries is hardly surprising.

They have something else in common. Real output is falling in every single one.

Real output was sluggish in the eurozone as a whole, but the performance of the distressed members was the weakest. This is important because heavily indebted countries are more likely to meet their debt-service burdens if they can grow. There is simply no sign of any pick-up in the countries of the eurozone which most need it. The position is only slightly better elsewhere in Europe. The German economy is barely growing and recent business confidence indicators have been gloomy. The best-performing of the major developed economies is the US, and even there growth is anaemic.

The countries experiencing financial distress do not have policy options to stimulate demand. They cannot expand their budget deficits temporarily in textbook Keynesian fashion, since they cannot borrow without moving interest rates against themselves or breaching the terms of their rescue programmes. Nor can they devalue, or engage in monetary expansion, since these policy instruments were sacrificed in the cause of currency union.

In these circumstances it would not be surprising if the bond markets lost confidence in the ability of the distressed countries to get out of the debt trap and started selling their sovereign bonds again.

There is one overriding reason why the markets are reluctant to go negative on these countries, Ireland included. The ECB President, Mario Draghi, has promised to purchase sovereign bonds in the secondary markets if interest rates begin to spike again and the markets are afraid to sell with such an impressive buyer lurking.

But there is no certainty that the ECB would purchase unlimited quantities of bonds indefinitely if sentiment turned negative. They could do, but there is no absolute commitment and there is no declared ceiling to be put on the borrowing costs of the distressed countries.

The sovereign bond crisis has thus entered a kind of Phoney War phase, where the fundamentals are not really improving but an intensification of the crisis has been deterred by the threat of Central Bank action. The ECB's willingness to act, however, remains untested and politicians continue to dither over

the redesign of the monetary union. Problems left unresolved have a nasty habit of getting worse, and there are several ways for the eurozone crisis to intensify again.

The key concern is that both Italy and Spain must borrow substantial amounts on the bond market every month, both to fund their ongoing deficits and to refinance maturing debt. The interest rates they face, particularly in the case of Spain, are too high for comfort, even though they are a little lower than the levels reached during the acute crisis last July. With GDP declining, Spain cannot pay 5.6 per cent for 10-year money for any length of time, not can it concentrate borrowing in shorter-term bonds where rates are lower. That just creates a bigger refinancing cliff when the short-dated bonds mature.

For Spain and Italy, as well as for countries due to exit bailout programmes, longer-term funds must be available in the market, in substantial quantities and at longer maturities, at interest rates these countries can afford to pay. With GDP declining or flat, they cannot afford to pay anything like the rates the markets are now quoting. Disaster was avoided at the end of July, when the eurozone was within weeks of a Spanish exit from the bond market.

The next risk of disaster could come from Greece, where the debt write-off of €100bn does not appear to have been enough, or once again from Spain, where the exposure of the state finances to uncertain banking liabilities has not yet been addressed.

The longer-term redesign of the eurozone, creating a durable monetary union from the limited currency union established in 1999, is a work in progress and significant steps are being taken. These include stronger fiscal oversight of errant member states as well as the construction of a proper banking union. But it is also necessary to extricate the distressed countries from the cul-de-sac of high debt and declining economic activity.

If the eurozone had a single authority in charge of macroeconomic policy, it would now be considering a stimulus package. True, the overall eurozone sovereign debt level is high and the zone as a whole is continuing to run a budget deficit. But these numbers are actually somewhat better than the corresponding figures for the US and Britain, both of which have chosen a more expansionary overall policy stance.

Such a stimulus package would see an easing of budgetary policy in those countries, especially Germany, capable of cheaper financing, as well as an accommodating monetary policy from the ECB. The distressed countries unable to undertake stimulus themselves would benefit from the improvement in overall European demand.

Ireland is seeking assistance with its bank-related debt burden from our European partners, hence the meetings in Berlin and Paris last week, and from the ECB. The Taoiseach was right to stress, in Paris on Monday night, the unique circumstances that apply to Ireland alone.

The Irish Government, in October and November 2010, was subjected to improper pressure from the ECB to continue payments to unsecured and unguaranteed bondholders in bust banks. The ECB's motives in all of this appear to have been twofold. The first was to reassure the bank bond market in continental Europe, an objective which was not achieved since most banks lost access to this source of funding in 2011.

The second was to contain the ECB's exposure as lender to what it saw as risky banks in Ireland. This objective was also abandoned -- the ECB has since taken on far greater exposure to banks throughout the eurozone and has accepted increasingly risky collateral for its loans. The policy failed on its own terms, at Ireland's expense.

The circumstances surrounding the events of October and November 2010 have been insufficiently explained. As outlined by Noel Whelan in his Irish Times column yesterday, the late Brian Lenihan, Irish Finance Minister at the time, had planned to write a full account of what happened but sadly did not live to do so. It is past time for those with knowledge of what occurred, including serving and former Irish and ECB officials, to put their recollections in the public domain.

Sunday Independent

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