Opinion Analysis

Thursday 21 February 2019

John McHale: Investors are starting to like us again but we've got to do more

What a difference a year makes. On July 13, 2011, the eight-year bond yield -- a current key benchmark -- peaked at 15.6pc. This week the yield has hovered around 6pc. Taking advantage of the lower yields, in late July of this year the National Treasury Management Agency (NTMA) made a return to the international bond markets, placing €5.2bn of five- and eight-year bonds at an average yield of 5.95pc, with reported strong interest from influential US-based investors.

Although it is not straightforward to infer perceptions of default risk from observed bond yields, a standard calculation puts the implied probability of default over the rest of the decade at 83pc in July 2011 and 52pc today. (This calculation assumes risk- neutral investors, a total recovery rate of 50pc in the event of a default, and treats observed German yields as providing the "risk-free" rate.)

What explains both the significant improvement over the course of the last year and substantial remaining investor concerns? Three factors stand out: perceptions of the Government's capacity to push through a daunting fiscal adjustment; evaluations of the economy's growth potential; and developments in eurozone crisis-resolution policies.

As of last summer, the capacity of a new centre-right/centre-left coalition government to achieve difficult budgetary adjustments was untested. Following a series of difficult budgets implemented by the previous coalition government, total savings of €3.8bn were planned for Budget 2012. These adjustments were successfully implemented, with the troika confirming programme targets have been met in subsequent reviews. The credibility of Ireland's capacity to make the difficult adjustments required for debt sustainability and the avoidance of default has been reinforced.

Yet the remaining adjustments required for a deficit of below 3pc of GDP by 2015 are daunting. The primary (or non-interest) deficit peaked at 9.5pc of GDP in 2009 (excluding banking-related recapitalisation costs). This deficit is projected to be 4.2pc of GDP this year and must be turned into a primary budget surplus of close to 3pc by 2015. The Government estimates this will require a projected €8.6bn billion of additional adjustments between 2013 and 2015.

Ireland's record suggests this is doable, but the total effort still stands out as extraordinary in an international context. Maintaining public support depends on ensuring that the burden of adjustments are seen to be spread fairly, protecting the most vulnerable and ensuring that more powerful interests -- not least in the public sector -- do not succeed in pushing the heaviest burdens to the less well-organised, including younger generations.

Achievement of the plan's targets also depends on return to a growth rate of around 3pc. Last year finally saw a stabilisation of the real economy, with revised figures showing that inflation-adjusted GDP grew at a rate of 1.4pc. This followed a cumulative decline of 8.2pc between 2007 and 2010.

The return to growth was the result of the strong performance of net exports, which offset continuing declines in domestic demand.

On the broader growth prospects, it is worrying that the long-anticipated return to robust growth has been continuously postponed, with a pattern of downward revisions to year-specific forecasts as the target date approaches. With economists struggling to understand the growth prospects of the post-bubble Irish economy, a notable downside risk is the continuation of prolonged "balance-sheet recession", with households, businesses and banks all struggling to repair their financial positions.

As of July 2011, investors were concerned that any new support programme for the Irish economy would force a restructuring of privately held Irish debt. Concerns were heightened further by the likelihood that official creditors would be protected in such a restructuring, meaning that the size of the default on private investors would have to be even larger in order to restore the sustainability of the remaining debt. Although the threat of such forced restructuring has not completely disappeared, the threat has receded as governments stepped back from the damaging market discipline-based approach adopted in Deauville in late 2010.

Commitments made by eurozone leaders on June 29 last have further reinforced the confidence of investors. Although post-summit speculation of major write-offs in banking-related state debt went overboard, the commitment to "examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme" provided a vote of confidence and signalled a willingness to take steps to reduce the burden of banking-related debt.

But while the stance of eurozone crisis-resolution policies has improved from an Irish perspective, the broader eurozone crisis has worsened since last year. The odds of a Greek exit from the eurozone have increased -- an exit that almost certainly would push the crisis into a new, more virulent phase. With Italian and Spanish bond yields now in unsustainable territory, a formula must be found to credibly lower these yields on a permanent basis.

From an Irish perspective, it is bad luck that the eurozone crisis has escalated just as the domestic effort began to bear fruit. There is little doubt that a big portion of the remaining default risk relates to broader eurozone concerns.

Notwithstanding the uncertainties relating to growth and eurozone crisis-resolution policies, the best domestic course is to push ahead with the difficult fiscal adjustments required for debt sustainability, avoiding a political gridlock that would cast doubt on the capacity to see the adjustment through.

Getting through the crisis without default would cement Ireland's reputation as a stable place to invest and do business. Maintaining access to necessary official support would also ensure that the adjustment can continue to take place in a reasonably phased way, avoiding a sudden funding shock that would further shrink the economy and unravel social supports.

The decline in investor perceptions of Irish default risk over the last year has been dramatic. But, with investors still pricing in a 50-50 chance of an Irish default, there is no room for complacency.

John McHale is professor of economics at the National University of Ireland, Galway and chairman of the Irish Fiscal Advisory Council. He is writing here in a personal capacity.

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