Tuesday 21 May 2019

IMF is too polite to say, but this bailout pushes us further into the red zone

The cost of the bank rescue and the onus on taxpayers means we have no chance to service our own debt, writes Colm McCarthy

The team from the International Monetary Fund which conducted the bailout negotiations released their conclusions on Ireland's financial rescue package on Friday. The report is detailed and authoritative. Two conclusions stand out, one clear and unambiguous, the second a little muted.

The clear and unambiguous conclusion is that Ireland's debt burden when the programme concludes -- and assuming all goes reasonably well -- will be at the absolute limits of sustainability. This is not what the IMF team says (they are international diplomats), it is what they mean. I infer from the language they use that they are not convinced that this bailout for Ireland is sure to be the last. On exit from the programme in 2013, the ratio of debt to GDP on the IMF's figures will be so high as to raise questions about Ireland's ability to re-enter the sovereign debt markets at reasonable interest rates. The IMF economists are too polite to say this in so many words, but it is the inescapable implication of their figures.

The second, more muted conclusion from the IMF is that it is the costs of the bank rescue that will push the exit debt ratio into the red zone. Reading between the lines, it seems that the IMF team would have preferred a decisive resolution of the banking mess through allocating a greater share of costs to bank bondholders and a smaller share to Irish taxpayers. Our EU partners have won this argument with the IMF for now. Bank bondholders will be protected at the expense of taxpayers but also at the expense of sovereign bondholders. It is not in the interests of sovereign bondholders to have their security diminished through the State diluting its financial capacity by underwriting non-sovereign debt. The notion that being kind to bank bondholders would somehow add to the attractions of government debt was peddled assiduously around Dublin over the past couple of years. This piece of bad advice has been tested at considerable cost and, unsurprisingly, it has not worked.

In IMF lingo, the Fund's assistance to Ireland is called an 'exceptional access' case. They state: "Ireland's total external and private external debts as ratios of GDP are the highest among recent exceptional access cases." The IMF concludes that: "There are significant risks to the progra-mme that could affect Ireland's capacity to repay the Fund".

The essential problem is the excessive assumption by the Irish State of liability for bank losses which far exceeded the Government's worst fears. The IMF way of saying this is: "Debt dynamics would improve if the recapitalisation requirement remains contained." In simple English, if the State could get itself off the hook with more of the bank bondholders, its ability to service its own debt, including debt to the IMF, would be enhanced. The IMF report goes on to say: "The sovereign's obligations will also be lower if the debt owed by banks is restructured." The policy implication, not surprisingly, is that "where a bank has lost substantial value -- and, indeed, is insolvent -- the debt holders should share in the losses. Further such action is contemplated for banks that have received substantial state assistance, and would help reduce the need for fresh injections of capital by the government."

The international financial press has been reporting the IMF analysis in terms which have heightened fears in the bond markets. Ireland's sovereign debt has again been downgraded and credit default swaps on senior bank debt became even more expensive on Friday. Conflict between the traditional IMF prescription (face the music, devise a programme with a realistic exit strategy) and the more political concerns of the European Central Bank and the EU Commission has been highlighted repeatedly.

The respected Canadian market analysts BCA noted this week: "Ireland's sovereign debt risks would have abated if bondholders had been forced to take a haircut on their positions, because this would have given the government more resources to repay creditors. Apparently the IMF realised this, but failed to persuade EU officials." (BCA mean bank bondholders taking haircuts, and I guess they include the ECB under 'EU' officials). There has been much more along the same lines from other sources.

The position appears to be that the bank guarantee entered into in September 2008 and criticised vehemently by many of our European partners at the time, has now become a plank in European policy, in opposition to the preferences of the IMF. But the issue will not go away just by pretending that it can be ignored in Ireland. The same issue will arise if Spain needs a bailout, since the Spanish sovereign would probably be fine were it not for the banking situation -- Spain had a credit-induced housing bubble too. At some stage, holders of bank senior debt on a Europe-wide basis will have to face haircuts. The alternative is the risk of sovereign default in countries where excess lending to governments did not cause the problem in the first instance.

In the meantime, the Government is proceeding with the programme of budgetary austerity and has succeeded in getting another Budget through. The next Budget will likely be introduced by a new government and expectations will be raised during the election campaign that austerity can be tempered, or even avoided, through some deal on the bank bonds. It cannot: if the costs of the banking mess were contained at the figure already spent, the public finances would of course be more manageable but still pretty daunting. Most of the borrowing is to finance the excess of day-to-day spending over government revenue, and that gap is still enormous and unsustainable. It will take (at least) three tough budgets to get the figures back in line, and that means more spending cuts and more tax increases.

Of course the Government should explore every option in dealing with the cost of the banking system failure and it is reasonable to hope that the IMF view will eventually prevail over the European approach, but the Irish fiscal imbalance is so large that no plausible relief from further bank bailout costs will obviate the need for fiscal austerity.

While the public spending bubble and the bubble in bank credit were the most visible manifestations of policy failure through Mr Ahern's years as Taoiseach, the steady loss of competitiveness by the traded sector of the economy was another casualty and has left another enduring and unwelcome legacy.

Resources were diverted into domestic, non-traded activities such as professional services, banking, the retailing of imported consumer goods and the construction of ghost estates and costly prestige projects. Employment in manufacturing, having risen steadily from 1993 onwards, peaked in 2002 and has been falling ever since.

The twin bubbles, in public spending and in bank credit, squeezed the traded sector badly, and the strong euro exchange rate did the rest. The result has been a serious and widespread loss of competitiveness across the traded sector, including agri-business, manufacturing, tourism and export services. Since it is not possible to cut the exchange rate in a common currency area and not practical to leave the euro by issuing a new currency, competitiveness must be restored through the containment of domestic costs. That means reductions in payroll costs and in all other elements of non-payroll overheads.

There is a lot of ground to be made up and the task will take years. It is to the credit of the current Government that they have made progress in dealing with these problems since mid-2008, not that they can expect any thanks, but the damage is so great that most of the budgetary adjustment and the re-attainment of competitiveness remain to be achieved by their successors.

Political candidates will come calling fairly soon. Any who pretend that budget austerity and cost-cutting can somehow be avoided do not deserve a welcome.

Colm McCarthy lectures in Economics at University College Dublin. He has headed an expert group examining State assets and chaired the Special Group on Public Service Numbers and Expenditure Programmes, aka An Bord Snip Nua

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