Friday 15 February 2019

There is no safety in these numbers

Default is inevitable and the 'rescue plan' has only succeeded in delaying it, writes Constantin Gurdgiev

Last week's deal between the Irish Government and the ECB/EU/IMF troika -- the details of which continue to trickle down from the stratospheric heights of secretive bureaucracies to the lowly taxpayers -- has been anything but a rescue for our battered economy.

Far from providing a resolution to Ireland's financial and fiscal crises, it made the restructuring of our banks' debt inevitable, no matter what the conditions underlying the deal says.

Instead of resolving the core problem of catastrophic losses within our banking sector and the related problem of the fiscal insolvency of our Exchequer, the ECB/EU/IMF loan created an internationally binding agreement that officially transferred the debts of our private banks onto the shoulders of Irish taxpayers. By doing so, the EU, with the complicity of the Irish Government, has delivered a full-blown contagion across the entire Irish economy.

The levels of our banking sector indebtedness are gargantuan. Carrying the Government and household debts amounting to some 225 per cent of the annual national economic output on the shoulders of ordinary income earners is a problematic proposition for a healthy economy. Doubling it to also cover the debt obligations of our banks is simply equivalent to economic suicide. Worse than that -- it is an act of subjugation of the ordinary taxpayers by their own Government.

Recognising that in addition to the catastrophically increased indebtedness of the real economy achieved by the ECB/EU/IMF deal, we have also experienced an unprecedented collapse of economic activity, which implies that the end game has not been changed by the latest loan agreement.

Default through the restructuring of Ireland's overall debts is inevitable.

The loan has simply delayed it, buying Europe some time before it has to face the ultimate crisis. The problem is, delaying things serves only to exacerbate the future fallout.

Insolvency is a condition that is determined by three factors -- the overall levels of debt, the cost of servicing this debt and the economy's capacity to repay interest and principal on the debt.

Before last week's loan was forced onto the Irish Government, our real economy -- households, non-banking financial intermediaries and non-financial corporations operating here -- were carrying the debts of €340bn. Add to this the Exchequer's outstanding debt and the total level of Irish economy's indebtedness and ex-banks, and the figure stood at €430bn. This was secured against the expected national income of about €130bn in 2010. In other words, the Irish economy has leveraged some 3.3 times its income.

Courtesy of the ECB/EU/IMF loan, our debt levels have risen overnight to €497bn. Factoring in future borrowings that will be required to underwrite the banks' bondholders, this figure can be expected to rise to €560bn in three to four years' time in constant euros. Nominally, the debt pile could reach over €593bn under benign inflation assumptions and before we factor in rolled-up interest.

Getting a new credit card can never solve the problem of an insolvent household. Ditto for an economy.

Assuming the Government projections for increasing the pool of Irish taxpayers materialise -- a tall order assumption in the society where already excessive tax burden is shifting more and more economic activities into cash-only grey markets -- by the end of 2014 total debt of the Exchequer and households will add up to €341,000 per taxpayer.

For a person on average earnings, this adds up to 10 times the current annual pre-tax income.

Let's consider the above numbers from another point of view. Using the 'subsidised' rate of interest attained under the loan deal, the total ex-banks' cost of interest repayments for the Irish economy in 2014 can be expected to be €34.6bn per annum, or more than one-quarter of our entire national income.

Now, imagine the thoughts running across the bond traders' desks when they attempt to calculate our solvency ratios.

In short, debt restructuring -- or in the more direct language of the street, a debt default -- is no longer just an option. Instead, courtesy of the ECB/EU/IMF loan and our own Government's failures to manage the banking and fiscal crises, it is simply unavoidable. Which brings us to the question as to what alternative do we have to minimise the damage to the real economy? At this moment in time we face a painful choice: either we choose a path of orderly restructuring of our banks' debts today, or we face a disorderly collapse of the banking and Exchequer finances two to three years down the road.

The first path requires abandoning the memorandum on the State's bank guarantee, signed with the troika, that commits the Irish State to ensure the continuation of bond repayments to Irish bank bondholders. This step is easy to take.

Within the ECB/EU/IMF team, it was the EU that insisted on underwriting bank bondholders, against the advice of the IMF. Even a simple glance at the numbers above would imply that should the EU continue to adhere to the same position, by 2012-2013 it will have to deal with the worst possible scenario -- an insolvent member state with insolvent banking and household sectors. The fallout from this for the EU would be far worse than some €60-90bn in the debt writedowns required to repair the Irish economy.

The next step -- after shredding the Irish Government commitment to the bank bondholders -- will be to rebuild the banking sector through a structured recapitalisation of the Bank of Ireland and AIB, by a combination of debt-for-equity swap -- setting current bondholders to equity holders in the banks -- the state purchase of shares in the banks at a heavily discounted price, and a restructuring of Irish bank debts to the ECB. Alongside these financial measures, the banks must be cleansed of their top management and reformed in areas of their long-term strategy and operations.

The state guarantee must remain only for the depositors and even this should be limited, after the reforms take place, to deposits under €200,000. A voluntary insurance scheme should be set up for all deposits in excess of that amount. It can be underwritten, in part, by the State in exchange for premium payments out of deposits. Anyone suggesting that a debt-for-equity swap would result in the Irish banking system collapsing altogether should go back to May this year, when the Bank of Ireland carried an €852m conversion of subordinated debt for equity, netting a capital gain of €233m in the process.

Restructuring bank debt today is the only alternative to a disorderly default in a few years' time. The latter outcome would imply -- following Argentina's and other recent scenarios -- a total stop to all functional banking operations in the country and a full restructuring of the sovereign and bank debts, carried out while the markets panic.

Terms and conditions of such a default, from the point of view of Irish households and companies, will be fully determined not by us, but by the international markets running for cover.

The real tragedy of last week's 'rescue' package for Ireland is that by forcing on to our shoulders the entire burden of banking sector debts, the troika has virtually assured the destruction of the very fabric of this economy that represents the only hope for our recovery.

The Irish economy is an economy with great potential for growth. Our entrepreneurs and exporters, our skilled workers and able and creative businesses can be a real engine of robust recovery, if only we can lift the unsustainable debt burden off our shoulders.

Constantin Gurdgiev is adjunct lecturer in Finance with Trinity College, Dublin

Sunday Independent

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