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IMF wins key battle with Europe on debt

It has been a good week from Ireland's perspective but it would be unwise to exaggerate. Last Thursday's deal to fix the eurozone banking and debt crises has done more than the markets expected but less than will ultimately be required. The deal has succeeded in avoiding, for now, a disorderly Greek default.

But even with a measure of debt relief and an interest rate cut, Greece remains well removed from any realistic prospect of being able to borrow in the markets. The other two countries in intensive care, Ireland and Portugal, will also benefit from the interest rate reduction but there has been no debt relief for them. Indeed the summit communique contained an emphatic statement that Greece is a special case and that there will be no haircuts for creditors of the other two.

All three 'programme' countries will welcome some other features of the deal, including extensions to debt maturities. But Ireland's prospects of early re-entry to the bond market have improved only a little. On Friday the interest rate on Ireland's 10-year bonds fell back to 12 per cent, having been above 14 per cent some days earlier. This is still entirely inconsistent with market re-entry and signals a high perceived probability of default.

Financial rescue programmes for states unable to finance themselves are successful only when those countries can borrow freely again in the markets. The second rescue for Greece is thus a success only in the sense that additional lending has been promised and liquidity restored. But solvency, in the sense of a restoration of credit-worthiness, would have required a far greater element of debt relief than has been furnished and the private sector creditors of Greece have been asked to make a smaller contribution than would have been warranted.

When Ireland's deal with the EU/IMF was negotiated back in October 2010, the interest rate on the official support from Europe was pitched at a level too high for debt sustainability. The likely rate of growth in national income, including inflation, sets an upper bound to what can be afforded, since this will constrain tax revenues.

Loosely, if inflation can be no more than two per cent (the official eurozone target) and if economic growth beyond a further one per cent or two per cent is unlikely, then the interest rate needs to be below about four per cent or the sums will not add up. This has finally been recognised and it looks as if the IMF has won an important battle with the Europeans on this issue. Two plus two equals four, not six.

The overall deal, however, should be seen as the latest in what will be a long series of interim arrangements. Greece will be deemed in at least partial default by the ratings agencies and both Ireland and Portugal are likely to be stuck with a junk credit rating, or close to it, for years to come. The deal does not address the solvency issue for these countries and persists in the expectation that something will happen to restore their borrowing ability. These PIGs will not be flying back to market anytime soon.

The real threat to stability is contagion to Italy and Spain, whose bond yields in the market were heading into unaffordable territory prior to Thursday's deal. They have fallen back, but only a little. These countries borrow continuously and they could be excluded from the markets at any time. The EU leaders have, in the cases of Greece, Ireland and Portugal, acknowledged that distressed eurozone sovereigns cannot be expected to pay much beyond four per cent. On Friday, 10-year bonds for Italy and Spain were trading at 5.4 per cent and 5.8 per cent, which means that markets remain nervous about debt sustainability in these 'too-big-to-save' countries.

A feature of the programme intended to deal with the contagion threat is a provision that loans could be extended from the European Financial stability facility (EFSF) to countries not yet in a formal rescue programme, for which read Italy and Spain. But the conditions for such assistance are unclear and the EFSF has been allocated additional tasks but no additional financing. This inspired economist Willem Buiter to liken it to a soldier instructed to shoot some additional targets but furnished with no additional bullets.

European decision-makers will be heading for the beaches shortly but the bond market will not. If Spain or Italy get into trouble over the next few months (an upward creep in rates and a cancelled bond auction), there is no clarity about the policy response. This is the crucial weakness in Thursday's deal. While the EFSF can now buy bonds in the secondary market, they will not have funds to do so. The European Central Bank has felt constrained from the creation of extra liquidity to do this job itself. A normal central bank, such as the US Federal Reserve or the Bank of England, would respond this way to a financial crisis and indeed both have already done so. The Brussels decisions will work for now provided Italy and Spain get lucky. If not, there will be more crisis summits in due course.

Several other detailed features of the deal have come in for criticism. The banks and other financial institutions stuck with large Greek debt portfolios have negotiated a favourable deal, which will see limited debt relief for Greece but a payback to the creditors in excess of current market value.

There is also a provision that Europe could fund debt buybacks in the secondary market. This sounds like a clever wheeze but there are drawbacks. If you owe €100 and look like you are unable to pay, that debt will trade in the secondary market for maybe €50. If you can borrow €50 and buy it in, hey presto you now owe only €50, the creditor has taken the haircut voluntarily and you are solvent again! The snag is that the debt holder would be nuts to sell all the debt back at today's distressed price. Suppose €99 has been bought in at half-price and you are the guy holding the last €1. The borrower is now (almost) solvent, so why should you sell for anything less than full price? Debt buybacks are not as advantageous to the distressed borrower it appears and are inferior to straight haircuts. It looks like the IMF lost the argument on this one.

There are two further features of the deal that have attracted attention in Ireland. The first is the commitment extracted from Ireland to engage with our European partners on the EU draft directive concerning the base of calculation for corporation tax, a sop to Nicolas Sarkozy. The current French administration has behaved with shameless opportunism on this issue. The same Sarkozy visited Dublin to reassure Irish politicians on this very issue prior to the second Lisbon referendum. The appropriate diplomatic response is the cultivation of a long memory.

The government has drawn attention to the commitment to continue the provision of funds to Ireland in the eventuality that market re-entry has to be deferred, which is of course reassuring. But it is going a bit further to say that this means no second bailout. If the current rescue does not work, in the sense of securing market re-entry within the funding currently available, continuing support is a further rescue, whatever one wants to call it.

Debt sustainability is enhanced by the interest rate cut and would also benefit if economic expansion resumes. But these things are largely outside of government control. The policy focus needs to narrow to those aspects the government can influence directly. The first is the budget deficit, which needs to be eliminated rapidly. The second is the exposure of the Exchequer to liabilities arising from the banking collapse.

The Brussels deal offers a chink of light in the proposal that European funds would be available to governments to assist with bank re-capitalisation. It is reasonable for the government to stress whenever possible that the Irish have been taking one for the team on this issue. Unilateral default options are treacherous and have rightly been ruled out, but Europe, which has insisted on these obligations being extended, can reasonably be asked to share the burden.

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 Progra-mmes, 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