Monday 15 July 2019

In keeping with Halloween, here's a scary one

If the Budget fails to convince markets of our financial independence the game is truly up, writes Colm McCarthy

The Irish Government has taken a three-month holiday from borrowing, instead running down reserves of cash borrowed earlier in the year. The four-year plan, due in about two weeks, and the Budget on December 7, are just preludes to the main event -- the re-entry of the Irish Government into the bond market in the New Year.

The €1.5bn not borrowed in October plus the €1.5bn not borrowed in November represent borrowing postponed, not borrowing avoided. The decision to exit the market for a while was taken because the market had turned against Ireland, with interest rates on the benchmark 10-year bond moving above six per cent. But the cash reserves are finite and will run low in the Spring of 2011 unless Ireland re-enters the market with a pretty big issue.

Realistically the Government needs to do this in January, or February at the latest. And the first issue needs to be big -- maybe €4bn or €5bn. The decision to withdraw from the monthly sale of bonds in October was brave, but to work, it requires improving market sentiment as well as convincing budgetary action from the Government.

Market sentiment has gone decidedly the wrong way over the last week or two. The key Irish bond yield reached seven per cent during the week and the penalty over German rates soared. Ireland is now seen, at these rates, as the poorest risk in the Eurozone bar only Greece, which can no longer borrow and is in a bailout programme courtesy of the EU and the International Monetary Fund (IMF). The reasons for the nervousness about Ireland are principally three.

The debt already accumulated is sizeable; fresh borrowing to cover the excess of spending over revenue is making it grow at an unsustainable rate; and there is residual fear that there could be even further costs from the banking rescue.

In the spirit of Halloween, here's a scary scenario. What if the re-entry to the bond market doesn't work? Not working takes two possible forms. The amount required is not offered or the rate of interest demanded is just too high to be affordable. In either case early resort to a bailout would be unavoidable. In the current condition of the markets, and even with decisive action in the four-year plan and 2011 Budget, this bad outcome is a possibility.

These are the nerviest bond markets most of us can remember and there is no sign of a turnaround. At the time of last year's Budget it was reasonable to judge that Ireland's fiscal programme had a good chance of working -- market reaction in the early months of 2010 was positive and the Exchequer figures for 2010 thus far have stayed on track.

But the Greek crisis has had a devastating impact on market perceptions of risk and Ireland has had another piece of bad luck. The emergence of higher and higher bank rescue costs as the year progressed did the rest of the damage.

The only factor the Government can do anything about at this stage is the budget deficit. If they do too little to convince the markets, the game is up and the Irish Government will be unable to finance itself, which means an IMF/European bailout and economic policy dictated from outside the country. How bad would that be?

Both Government and the main opposition parties are committed to avoiding this outcome and there are solid reasons for supporting their stance. Some commentators seem to believe that a bailout would be a soft option. But there is no good reason to expect that this would be the case. The EU and the IMF would agree to lend to Ireland for a period of years, subject to an exit strategy and a timetable. The rate of interest would be expensive; the total amount would not necessarily be generous; and the exit strategy would require that Ireland restore its creditworthiness on a tight timetable.

Bailouts come to an end and the IMF and EU would expect their money back. It is an illusion to expect that the budgetary austerity we face can be avoided through resort to a bailout. Recent discussion in the Dail and elsewhere has created an impression that the binding constraint is the target for 2014 imposed by the EU. This assumes that, were the EU to relax this target, Ireland could borrow a larger amount in the markets. There is no reason whatsoever to believe that this is realistic. In a bailout, a tough target would certainly be imposed.

There is a further complication: the Irish banks are virtually unable to borrow, even with a State guarantee. Almost all of their new funding is coming from the European Central Bank (ECB), from which they borrowed an additional €23bn in September to re-finance maturing debt. At some stage, bailout or no bailout, the Irish State must regain its creditworthiness and so must the commercial banking system.

The other objection to a bailout is the risk of obtrusive intervention in Irish economic policy, including interference with long-established sources of competitive advantage such as our low corporate tax regime. There has already been serious reputational damage, and several years in a bailout programme, with neither the Government nor the Irish banks deemed credit-worthy by the international capital markets, would make matters worse. It could take a very long time to undo the damage and the politicians are right to avoid resort to bailout if they can.

The first mover is the Government and the four-year plan will be critical. But the Budget measures will matter even more.

The priority is to reduce sharply the projected amount of fresh borrowing for 2011 and hope that the bond market re-entry goes well. Those who object to a tough Budget on the grounds that it will weaken an already weak economy are whistling in the wind unless they can identify a less deflationary option. It is not that we are living beyond our means: we are living beyond the willingness of lenders to lend.

If the strategy succeeds and we can borrow successfully in the New Year, attention needs to focus again on the condition of the banking system. The reliance of Irish banks on credit from the ECB is unsustainable and they can derive limited support from guarantees issued by a Government which is itself struggling to borrow. The task of re-capitalising the two main banks -- Allied Irish and Bank of Ireland -- will be completed shortly, at substantial cost to the taxpayer. But that task is not really completed until the banks can finance themselves.

While interest rates charged to Ireland have been rising sharply, many large countries can borrow at very low rates, as little as three per cent. Many economists have been arguing recently that these countries should consider a further fiscal stimulus package. Instead most of them are committed to deficit reduction. This debate is one that we cannot join, unfortunately. These countries have a choice since it appears that they could borrow more if they chose to do so.

We cannot do that, nor can we devalue our exchange rate, since we do not have one. It is perfectly reasonable to ask how we got into this mess, to allocate blame and to demand retribution. But no amount of ranting can expand the limited range of choices available to the Government.

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.

Sunday Independent

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