Saturday 14 December 2019

Colm McCarthy: EU approach to solving state solvency problems is baffling and inconsistent

The Cypriot bailout will be bigger than Greece, Portugal and Ireland's – yet it may be about to get sizable haircuts

Colm McCarthy

Colm McCarthy

Almost half of the bank-related debt incurred by the Exchequer resides in the promissory notes issued to secure euro-system funding for the two most bankrupt of the Irish banks, Anglo Irish and Irish Nationwide. Both of these banks have been closed and their affairs are being run down by a State agency, the Irish Bank Resolution Corporation.

The Irish banks still operating -- AIB, Bank of Ireland, Permanent TSB and Educational (absorbed into AIB) -- also went bust but were bailed out in a different way. They got injections of State cash, some from sales of financial assets owned by the pension reserve fund, the rest from borrowings. The Government is seeking a deal with the European Central Bank, which could see a longer maturity for the promissory notes, lower interest, or both. The book value of the debt might stay the same but the real burden of repayment could be reduced.

The debts arising from the rescues for banks still open, most of which arose in AIB, are in a different category. Here the hope is that some mechanism can be found to secure a sharing of these burdens with the ESM -- the eurozone rescue fund -- perhaps through the ESM paying for share stakes in these banks. At this stage it would appear that the Government's chances of success are better with the promissory notes than is the case with the debts arising from the banks still operating, since the commitment at European level to sever the doom-loop between bust banks and distressed sovereign borrowers has weakened steadily over the past few months.

The eurozone sovereign debt crisis intensified in the first half of 2012 as investors fled the Italian and Spanish government bond markets. A meltdown was avoided on June 29 when a Brussels summit announced measures designed to prevent market exit by these too-big-to-fail countries. An Italian or Spanish exit from bond markets would likely have led to a disorderly break-up of the common currency.

The key sentence in the summit communique was the first. It stated simply: "We affirm that it is imperative to break the vicious circle between banks and sovereigns."

The first steps towards banking union were also announced and the intention stated that bank rescues would be centrally financed, once a new European system of bank supervision was in place. The communique also stated: "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. Similar cases will be treated equally."

This statement was greeted, understandably, by the Government as signalling a willingness to devote resources from the ESM rescue fund to alleviation of the debts arising in the still-functioning banks, separately from any rejigging of the promissory notes.

In September, the ECB announced that it would support troubled member states through direct purchases of government debt in the secondary market. The immediate crisis in Italy and Spain appeared to be over and investors began to purchase eurozone peripheral bonds at lower interest rates. Ireland too was able to sell debt again at lower interest rates.

It is widely accepted that 'banking union', consisting of centralised supervision of European banks, some form of deposit insurance and a coherent system for dealing with bust banks without resort to taxpayers, is essential in order to complete the monetary union. These features should have been designed into the common currency from the beginning. But progress has been fitful. In Europe, it takes a crisis to encourage decisions; the crisis has passed for now and the decision-making has slowed down.

In the past few weeks there have been contradictory developments. The European Commission has released a draft on bank resolution, which seems to represent a step back from what had been agreed last June. Meanwhile, the banking crisis in Cyprus, the fourth country to apply for a bailout, has stimulated a reaction in Germany quite at variance with the commission's position and potentially relevant to Ireland's case for assistance from the ESM.

The Financial Times reported on Tuesday that, ". . . the two-page proposal drafted by the European Commission would force countries that could afford it to inject their own national funds into failing banks to make them viable before the ESM would shell out any of its own cash. In the case of a country that would face insolvency after a bank bailout, the national government would still have to 'indemnify the ESM for any loss', or guarantee the ESM would get all its money back."

Note that the exposure of eurozone states unable to finance themselves under this proposal would extend to future bank busts. It had been the understanding that the June 29 summit opened the possibility that the rescue fund would address these and also the costs of bank rescues that had already occurred. This commission draft goes even further than the pronunciamento delivered in Helsinki by the finance ministers of Germany, the Netherlands and Finland on September 25 last, when the unravelling of the June summit agreement commenced in earnest. They ruled out assistance with legacy debts and said, " ... .direct bank recapitalisation by the ESM should take place based on an approach that adheres to the basic order of first using private capital, then national public capital and only as a last resort the ESM".

According to the commission's latest proposal, not merely would distressed sovereigns receive no assistance with legacy costs, they would be responsible (until borrowing capacity is exhausted) for future bank busts (and in addition to the requirements of the Helsinki Three) they would, having exhausted borrowing capacity, then have to indemnify the ESM. What value might be placed on this indemnity from a bust sovereign is clear only to the commission.

Tuesday's leak to the Financial Times was only a draft: the definitive commission proposals are not due until June. By that time, reality may again intrude, in the form of Cyprus, which has had to apply for an EU/IMF rescue. Cyprus has had an even bigger banking bust than Ireland. Its banks, swollen with, it is alleged, hot money deposits from Russia and elsewhere, had become big holders of Greek government bonds and suffered huge losses in the Greek default last year. They are now bust, as is the Cypriot government. The bailout will have to be, relative to the island's GDP, even bigger than the bailouts for Greece, Ireland and Portugal. The IMF, conscious of the failure to deal properly with Greece in May 2010 when debt restructuring was long-fingered, believe that there is no point leaving Cyprus with an impossible debt burden and are insisting on haircuts all round, including for bank bondholders and even depositors. In this they are being supported by some German politicians, reluctant to be seen bailing out Russian oligarchs who are believed to be major creditors of Cypriot banks.

The negotiations on Cyprus are being conducted by the familiar troika of the European Union, the ECB and the International Monetary Fund. If the IMF gets its way this time, the Cypriot bank creditors will see haircuts upfront, possibly sizeable ones. That would shine the spotlight again on the bank-sovereign doom-loop and would undermine the latest position taken by the European Commission.

There are two drawbacks. The first is that European policymakers are under no obligation to be consistent and could require haircuts for bank creditors in Cyprus having resisted them, against the advice of the IMF, in Ireland. Crack squads of top-notch spin doctors could be engaged to explain that there is no inconsistency.

The alternative problem is that Cyprus is a Seft (Small-Enough-to-Fail) country, and could safely be burdened with unsustainable debt in another extend-and-pretend exercise. The bank rescue cost alone could be as much as 60 per cent of Cypriot GDP. The rescue for Cyprus will have to be concluded before the German federal elections in the autumn and it will be interesting to see if the eurozone can impose an unsustainable bank bailout cost on the Cyprus treasury while rattling on unembarrassed about 'breaking the vicious circle between banks and sovereigns'. The IMF must be seriously disaffected at this unique European approach to state solvency problems.

* Correction: Last week I wrote that the NTMA was the seller of the €1bn debt instrument in Bank of Ireland. Wrong -- the seller was the Department of Finance.

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