Friday 19 January 2018

Deal or no deal and the reality of financing in a cagey Europe

While hopes of getting full relief for bailing out the banks is naive there are other options Ireland can consider

THE statement made towards the end of September by the finance ministers of Germany, Finland and The Netherlands, together with more recent remarks by the German Chancellor, Angela Merkel, have been seen as a blow to hopes that Europe, through the ESM fund, will alleviate the cost to Irish taxpayers of Irish bank bail-outs, in spite of some reassurances that followed an intense diplomatic exchange with Germany.

While the initial assessment of the likely extent of a 'bank deal' was perhaps a bit optimistic -- effectively hoping for full relief from future disbursements and possibly the reimbursement of the funds already injected in the bailed out banks -- there is the possibility that relief may come through different, more subtle mechanisms.

The Irish Government has injected around €30bn of capital into the Irish 'pillar' banks (AIB, ILP and BoI), but realistically it would now be able to recover only €9-12bn through a transfer to the ESM of the stakes in these banks, as this is the current market price. It has always been very unlikely that the ESM would pay substantially more. Moreover, the financial benefit of cashing in part or all of the €9-12bn recoverable through a transfer of the banks' equity stakes to the ESM fund might not be worth the strategic cost of handing over control of Irish lenders to European authorities, who would most likely accelerate deleveraging and lending contraction (the quickest way to get their money back).

What is left to deal with is the roughly €34bn spent towards capital injections made to IBRC (the 'bad bank' that took over the Anglo and Nationwide legacy assets and liabilities). The injections were made through Nama and the Government's backing of the Anglo and Nationwide promissory notes. These notes represent a loan made to Anglo and Nationwide by the Central Bank of Ireland.

To make this loan, the Central Bank 'created' money on behalf of the ECB. But it is committed to the ECB itself to reverse that money creation, which would be inflationary, by making sure it gets the money back from the IBRC and the Irish Government, for the €30bn guaranteed by the promissory notes. This means that the €42bn liabilities of IBRC are unlikely to be taken up by the ESM, unless they are backed by the promissory notes.

The only place where the Irish Government could get some financial relief to cover the commitment arising from the promissory notes is from the ECB. But, indirectly, it is already getting that through ECB funding of Irish Government-owned banks, ELA, and the various LTROs and the likes.

So what will come of the June 29 summit promise that the "eurogroup will examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme"?

Subject to skilful negotiation with EU partners, this might be a combination of lower interest rates on the funds loaned by the euro-area partners to Ireland as part of the bailout package and, most importantly, the removal of the risk that the Irish State might have to provide further financial support to the domestic banking system.

This might happen if economic recovery does not take hold quickly enough to bring the banks back to profitability. Given that recovery is under way, this is a low probability scenario. But it is playing an important role in limiting access to funding in the open capital market and in keeping its cost stubbornly high, at levels that do not reflect the strength of a rapidly improving domestic economy. A credible EU commitment to use the ESM fund to subscribe any recapitalisation need would lower the cost of servicing financial obligations for the banks and the Government, ultimately resulting in a lower burden on taxpayers.

Hope of anything more generous than this is naive.

What would then be the worst-case scenario if relations with key EU institutions and partners deteriorated over the issue of bank debt? Ireland's status of "golden boy" of Europe would be at risk and it would become more difficult to secure positive developments and stave off unwelcome ones. This could dent Ireland's reputation as a reliably advantageous location for companies wishing to export into the EU common market.

In time, Ireland would have to become less reliant on foreign direct investments, internationally traded services and international (European) capital markets and more on home-grown export-oriented manufacturing and domestic savings. Under this scenario, in the first few years, both GDP and GNP would grow a little less and property prices come down a bit more, to gain additional competitiveness in the fight for international market share in manufacturing, at least until the domestic economy developed the ability to compete in the high end of the market for internationally traded services (we are still more 'back' and 'middle office' than 'front office' and we only do a bit of real R&D and hi-tech). It is a choice worth pondering.

Dr Valerio Poti is head of Economics, Finance and Entrepreneurship and director of the MSc in Finance at DCU Business School and adjunct professor of Applied Econometrics at Cattolica University Piacenza

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