Wednesday 11 December 2019

Brussels' Plan A is junk and that's great news for us

Debt relief is clearly on the cards for Greece -- and this will enable Ireland to get a much better deal with the help of the IMF, writes Colm McCarthy

THE slow-motion failure of the European policy response to the banking and sovereign debt crises accelerated during last week. The collapse in Spanish and Italian bond prices on Monday brought both countries close to the point reached by Greece in May of last year, by Ireland in October and by Portugal in recent months. That is the point where the interest rate required by the markets exceeds what can realistically be sustained and the countries can no longer borrow.

They will then be unable to fund the roll-over of maturing debt, never mind ongoing budget deficits, without resort to non-market sources of funds. These are, for EU members, the EU institutions and also the International Monetary Fund, of which most countries in the world are members.

So Greece, Ireland and Portugal have had to withdraw from the markets and rely on these bodies to provide them with multi-year finance. There has also been deposit flight from the banks in all three countries, most notably in Ireland, and disappearing bank liquidity has had to be replaced by the European Central Bank.

As long as the list of 'programme' countries could be confined to just three small eurozone members, the available EU and IMF funds were adequate to prevent their collapse into financial meltdown. But Spain and particularly Italy are too big to save within available resources and the scramble to produce a credible Plan B has commenced.

Plan A has failed to create circumstances in which the three 'rescued' countries can return to the markets, the over-riding objective of any programme of official support. Their traded debt has collapsed in price and all three are rated junk by at least one of the bond-rating agencies. They will not be graduating from the programmes of official support anytime soon and the verdict of the markets, the only verdict that matters, is that Plan A is also junk.

The essence of Europe's Plan A, as first applied to Greece, is to pretend that the problem is less serious than is actually the case, avoid any element of debt relief and insist that budgetary stringency alone will do the trick.

Should the markets demur, the authors of the failing plan simply insist the markets are mistaken, misled by the ratings agencies or just plain wrong. Many readers will recall the periodic exchange-rate crises over the last three decades of the 20th century. These were never the fault of wrong-headed government policies but always the work of speculators.

The current insistence, from people who should know better, that the destruction of the European bond market is caused by ratings agencies rather than by wrong-headed policies, is the eurozone version of blaming speculators back in the days before Europe gifted itself a single currency.

Persistence with Plan A and blaming the markets and ratings agencies is not a viable option should Spain and Italy go under. The game is up. Plan A is being quietly abandoned. In this sense, this has been a good week for Ireland.

The vituperations about ratings agencies from EU Commission leaders during the week should be seen not just as fatuous shoot-the-messenger blame-diversion but also as a convenient smokescreen for the inevitable policy shift. When a failed policy has to be abandoned, it is expedient to pretend that the new and different policy is just a seamless transition from the old.

The press conference given by the 'troika' of EU commission, ECB and IMF officials on Thursday in Dublin furnished additional evidence of the rift that has been obvious since last autumn between the IMF and the Europeans over the viability of the rescue package for Ireland.

The European line has been that sticking to the programme of budgetary adjustment will do the trick, provided all bank bondholders are paid in full. Emergency short-term liquidity support for the banks is enough and a benign outcome, including an early return to the markets, will be the reward.

It is pretty clear that the IMF officials never believed any of this, felt that non-sovereign debt should be haircut if necessary, that the European interest rate was too high and that ECB support for the banks should be placed on some kind of credible medium-term basis. They went further on Thursday in registering their disquiet and perhaps felt vindicated by the unfolding verdict of the markets.

The November 'rescue' deal for Ireland has failed, not because the Irish authorities have strayed from its terms but because it was badly designed, clearly at the insistence of the EU Commission and the ECB and equally clearly against the advice of the IMF.

It is possible that Ireland can still avoid sovereign default, but only if several necessary steps are taken. These are the cessation of payments of either interest or principal to holders of bonds issued by insolvent Irish banks; the reduction of interest charged by the EU rescue fund to a long-term sustainable level; the provision of medium-term liquidity support to the Irish banks; and the elimination, ahead of schedule, of the budget deficit.

The first three measures are more likely to be taken because of the misfortunes of Spain and Italy and when Ajai Chopra, the IMF's point man on the Irish rescue, referred on Thursday to "a European solution to a European problem" this is what he meant.

It is important that the Irish Government and its advisers overcome whatever residual loyalty they may feel towards the European institutions and recognise that Ireland's interests are being better served by the IMF's approach.

The chaos in European bond markets is the predictable outcome of a three-year exercise in what engineers call 'destructive testing'. When they design a new product or component, they place it under a lifetime of stresses in the lab to see how quickly it will fail. A new door handle gets slammed thousands of times in rapid succession, for example. The sovereign bond market, a critical component in the eurozone financial architecture, has been subjected to this type of treatment by the EU leadership and we have learned what it takes to make it fail.

The absence of any European leadership was graphically illustrated during the week when Moody's, one of the three main ratings agencies, decided to downgrade Ireland's sovereign debt below investment grade. Moody's was denounced by Jose Manuel Barroso, the EU Commission president, who accused it of anti-European bias. His colleague, the competition commissioner Michel Barnier, chipped in with the bizarre proposal that it should be banned from issuing ratings for countries already unable to borrow, a list which currently includes Greece, Ireland and Portugal.

Barnier was duly aced by one Irish economic commentator who suggested that they be just banned, period! The ratings agencies are holding up a mirror to the incompetence of policymakers and if they do not like what they see, attacking the mirror is a pathetic response and reinforces the scepticism of markets.

It is clear that some form of debt relief will shortly be offered to Greece and it is time to consider what options there may be in terms of a better deal for Ireland.

It must first be understood that there is no longer any realistic prospect of Irish re-entry to the bond market within the parameters of the current arrangements, even with strict adherence to the fiscal plan. Ministers Leo Varadkar and Pat Rabbitte both pointed this out a few weeks back and got clipped on the ear for their pains. They called it correctly.

Minister Noonan should now be seeking European support for an end to payments to holders of bonds, guaranteed or unguaranteed, in the Irish banks. Every cent paid to them is at the expense of the holders of Ireland's sovereign debt, who have been treated in quite cavalier fashion at the behest of the European Central Bank and apparently in response to threats from this unique organisation.

ECB officials come and go but sovereign states need sovereign credit forever. It would be an unmitigated disaster if Ireland's act of faith in Europe were to result in the first-ever default on the sovereign obligations of the State.

This is not just about the remaining bonds of Anglo and Nationwide. All of the Irish banks have consumed their capital and would be bankrupt and out of business without state support.

If they were US banks, the bondholders would expect, and would receive, either nothing or a few cents on the dollar.

Colm McCarthy lectures in economics at UCD. He headed an expert group examining State assets and chaired the Special Group on Public Service Numbers and Expenditure Programmes, An Bord Snip Nua. He also authored the report into the semi-state sector from the Review Group on State Assets and Liabilities

Sunday Independent

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