Wednesday 17 January 2018

Default and devalue: the only shows in town

DESPITE the Government's announcement a week ago that we would be applying for an EU-IMF bailout, the Irish financial crisis continued to worsen all week. With any bailout likely to do no more than delay dealing with the underlying problems, an Irish debt default followed by our departure from the eurozone is beginning to look like the least bad option.

As financial crises go, this one is an absolute humdinger. Who would have thought that the reckless lending of the Irish banks and the profligate ways of successive Fianna Fail governments would not alone effectively bankrupt Ireland, but bring the entire eurozone to the very brink of collapse?

The Irish economy is now gripped by a series of problems, any of which on their own would be extremely serious. However, it is the combination of these problems and the way they have interacted with one another that has proved so utterly disastrous.

The Government is trapped, no matter which way it turns. The deposit guarantee, Nama and bank recapitalisation have left the national balance sheet in tatters. This, in turn, has forced a series of hairshirt budgets, which have further worsened our plight. Irish economic output, as measured by GNP, has fallen by almost 17 per cent in real terms and by a massive 22 per cent in nominal or cash terms over the past two years.

While further fiscal tightening may be a condition of the EU-IMF bailout, it is likely to result in further economic contraction. This, in turn, will reduce the tax revenue that the Government needs to service the huge increase in the national debt. It is set to rise to at least €200bn as a result of the €85bn bailout.

So what can the Government do to extricate itself from the mess it has led us into? Even if the IMF can strong-arm the senior bank bondholders into accepting a 'haircut', there is only about €33bn of senior bonds that has not already been paid off, so the scope for spreading the pain is relatively limited.

With AIB senior bonds now trading at a 25 per cent discount to face value and Bank of Ireland bonds having shed almost 20 per cent of their value, the market is now indicating that senior bondholders can expect to suffer a 'haircut' of at least 20 per cent.

However, a 20 per cent across-the-board writedown in the senior bonds would yield a saving of just €6.6bn, while a 25 per cent writedown would save €8.25bn. Better than a smack in the gob, but hardly significant in the overall scheme of things.

Unfortunately, by having waited so long, forcing a 'haircut' on the remaining senior bondholders amounts to little more than closing the stable doors after the proverbial horse has bolted.

So how do we begin to crawl out of the hole we have dug for ourselves?

Even if we burn the senior bondholders, the national debt is likely to rise from its current level of just over €100bn to more than €180bn if the bailout is fully drawn down.

Throw in other odds and sods and the national debt is rapidly headed for €200bn or even higher.

How on earth can the Irish economy hope to service such an enormous national debt, particularly if we have to pay the five per cent-plus interest rates that were levied on Greece when it received a bailout last May? The answer is that we can't.

When it published its four-year economic plan on Wednesday, the Government forecast average annual economic growth of 2.75 per cent for the four years to the end of 2014. Even in the unlikely event of this forecast being met, it is still predicting that 2014 tax revenues will be just €42bn. So even if all goes according to plan, the national debt will be five times annual tax revenues by 2014. Merely servicing this debt would devour a quarter of all tax revenues.

However, if, as seems far more likely, the economy does no more than tread water over the next four years, tax revenues will only rise to about €36bn. This would mean that the national debt in 2014 would be almost six times annual tax revenues, of which 30 per cent would be going on debt-service costs.

So while the bailout might well rescue our stricken banks, no matter how you do the numbers, this combination of a much larger national debt and steadily rising interest costs points to an almost inevitable debt default some time in 2013 or 2014. This is what the markets are saying, having pushed Irish bond yields back up over 9 per cent this week, despite our bailout application.

With the markets expecting us to default anyway, why not get the pain out of the way and default now? Until we do, we won't be able to go back to the bond markets.

While a default is necessary, it won't be enough to solve our problems on its own. It should now be crystal clear that the euro is largely responsible for our present plight. Not alone did the abundant credit and low interest rates that resulted from our euro membership fuel the property boom and lead directly to the banking crisis, it also helped stoke the inflation that left Ireland with the highest prices in the eurozone.

If we are to return to growth, we must rapidly restore our competiveness. The grinding deflation envisaged by the four-year plan is not the way to do this. This will condemn Ireland to another decade or more of depression.

Far better, having first written our national debt down to a manageable level, to leave the euro and let the new Irish currency fall to a more appropriate level.

It is only by doing so that we can finally begin to emerge from our economic depression.

Sunday Independent

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