Saturday 16 February 2019

Colm McCarthy: This burden of bank debt is simply not sustainable

No other country in the eurozone has been subject to such threats from the ECB, writes Colm McCarthy

Ireland's ratio of debt to GDP is expected to hit about 120 per cent in a few years' time. Roughly one-third of the total will be due to bank-rescue costs.

If these were not a factor, the accumulated budget deficits -- the normal source of debt -- would total about 80 per cent of GDP, a common figure in the EU and a level that should be sustainable. It is the extra 40 per cent deriving from the rescue of bank creditors that has pushed the total into the red zone and destroyed the credit-worthiness of the Irish Exchequer. Even the huge Irish deficits of recent years have not been enough to destroy credit-worthiness on their own because the initial debt level when the crisis struck in 2008 was low.

Indeed, Ireland ran budget surpluses in every year but one since eurozone membership commenced in 1999 and was one of the few eurozone countries that stayed within both the deficit and debt limits of the Stability and Growth Pact in every year up to 2007.

The International Monetary Fund has been expressing publicly the view that Irish debt sustainability is fragile and that re-entry to the bond market next year as planned is not guaranteed. For this reason, and not because they believe -- in public at any rate -- that a portion of the debt has been inappropriately incurred, IMF staff have argued that Ireland's European partners should do a deal which would reduce the burden of bank-rescue debts.

Both of our European partners, the European Commission and the European Central Bank, take a different view. Both have been resisting any deal, through anonymous press briefings in the case of the ECB but with a commendably up-front approach from the Commission.

EU Economics Commissioner Olli Rehn resorted to Latin last Tuesday. "Pacta sunt servanda," he advised, which translates roughly as "contracts (or treaties) must be honoured".

Asked by reporters about the promissory-note controversy, he responded: "I actually wonder why this has to be asked at all because the principle in the European Union and in the long European legal and historical tradition is -- in Latin -- pacta sunt servanda; respect your commitments and obligations."

Last Wednesday, the European Commission followed up with a statement to the effect that the promissory note issued to support financing for bust banks constituted part of Ireland's national debt -- which indeed it does. The commission pronounced: "It is of the utmost importance that Ireland is seen to honour its financial obligations."

States can accumulate debts which simply cannot be met and debt relief becomes inevitable. But states can also accumulate debts improperly.

Commissioner Rehn and his colleagues in the Commission effect not to understand that not all debts are created equal. There are objections to at least a portion of the bank-related debt now carried on the books of the Irish Exchequer that are in the nature of moral or ethical objections, arising from the circumstances in which the debts were created.

The case for a proper negotiation on the bank-related debt, or at least a major portion of it, does not arise solely from Ireland's high debt burden and consequent concerns about debt sustainability. Even if there were no question marks about debt sustainability, there is a portion of the Irish debt which was incurred under duress and inappropriately, under threats from the European Central Bank.

That portion is smaller than the total of bank-related debt which has now been socialised. Many European countries have chosen to shoulder bank bailout costs. Ireland is unique in the Eurozone in two respects. It has absorbed 40 per cent of GDP in this manner, far more than in any other eurozone member, to the point where the State could no longer borrow in the markets. In addition, some of the bank-related debt was incurred involuntarily. It was inflicted on the Irish Exchequer after exit from the markets became the likely consequence, due to arbitrary actions by the ECB.

The Irish Government responded (foolishly) to the emergence of stresses in Ireland's mismanaged and poorly regulated banks in the autumn of 2008 by issuing a blanket guarantee of bank liabilities. The most insolvent banks were subsequently nationalised and placed in resolution, having lost large multiples of their capital.

The ECB, for reasons which it has never explained, then forced the Irish Government, against its declared wishes, to continue paying 100 per cent of face value on maturing senior bonds in these zombie banks. Beneficiaries included bondholders who did not enjoy any kind of guarantee, foolish or otherwise, from the Irish Government. Some of the beneficiaries were hedge funds that had bought these bonds of bust banks at large discounts in the secondary market, betting that the ECB would behave arbitrarily. They won their bets.

The ECB threat was to restrict liquidity provision to the Irish banking system unless the unguaranteed bondholders were paid in full. The result has been the imposition by a central bank, on a sovereign already in an IMF programme, of an obligation to pay unguaranteed bondholders in banks which have already been closed and are in resolution. This has never happened before in the history of central banking.

The losers are not just Irish taxpayers. Traditional holders of Irish sovereign debt have also been disadvantaged, queue-jumped by unguaranteed bondholders in private banks, which have already been closed down.

The IMF's money has been used to pay out on the following bond-market trade: go short Irish sovereign debt and go long the debt of unguaranteed, bust and closed Irish banks.

No other eurozone member has incurred bank-related debt under ECB duress. There are no provisions in the Maastricht Treaty, in the Stability and Growth Pact or in any other pact or international treaty which grant this power to the ECB, nor was any eurozone member state ever asked to accede to such an arrangement. Commissioner Rehn's Latin phrase ("pacta sunt servanda") has no pact to refer to, insofar as these imposed debts are concerned. Ireland never signed a pact or treaty which empowered the ECB to behave in this fashion.

One can only speculate as to the ECB's motives, since it does not deign to explain. European banks have come to rely heavily on unsecured bond financing and the ECB may have felt that no bank bondholder should suffer losses, in order to encourage the survival of this market in bank debt. If this was the motive, the policy is being paid for, not by the ECB, but by Irish taxpayers and sovereign bondholders and financed by European taxpayers and the IMF. There is no pact which confers powers of taxation on the ECB.

All of the Greek debt relieved, to the tune of €100bn in recent weeks, was contracted, without duress, by the lawfully elected Greek government. The write-down was welcomed by Commissioner Rehn, who described himself as "very satisfied by the large positive turnout of the voluntary debt exchange in Greece". The same "exchange" was described by one of the bankers enduring a 74 per cent haircut as "about as voluntary as the Spanish Inquisition". The bondholders agreed only after punitive retrospective clauses had been inserted into bond contracts, with the agreement of the European Commission. Some of them are initiating court actions, presumably in jurisdictions cognisant of the "long European legal and historical tradition" to which Commissioner Rehn refers so approvingly.

The Financial Times, in a leader last Thursday, argued that Ireland should be afforded debt relief in order to ensure debt sustainability. "Pacta sunt mutanda" it intoned, which means treaties should be altered. The portion of the Irish debt in dispute here does not derive from any pact or treaty but was arbitrarily imposed by the ECB. There is no need to alter any treaties and the FT, uncharacteristically, has misunderstood the Irish case.

This whole sorry saga has raised once more the enduring policy dilemma of ensuring that central banks are both independent and accountable.

The European Commission at least communicates without resort to anonymity and is to be commended for accepting this form of accountability.

It is time for the Commission to show independence as well -- in particular, independence from the unaccountable central bank.

Sunday Independent

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