This weekend the troika (the European Central Bank, European Commission and the International Monetary Fund) that is attempting to solve Ireland's financial crisis has some very tough decisions to make, decisions that will not only have considerable ramifications here but which also have the potential to destabilise the international monetary system.
The ECB is believed to be the institution that unleashed the most recent elements of the crisis. Faced with a rising lending commitment of over €165bn to the Irish banking system -- €130bn directly lent to the Irish banks plus €35bn euro lent indirectly to the banks through the Central Bank of Ireland -- the ECB decided to raise a red flag to further Irish bank borrowing.
This action was accompanied by a link-up with the European Commission and the International Monetary Fund so as to share part of the risk of lending to Ireland's Government and banks, and also to provide some solutions to the fiscal crisis (the sizeable budget deficit and its financing) and the banking crisis.
The Programme for National Recovery, released by the Government last week, provided the template to address the first part of the financial crisis -- namely the budget deficit.
It provides a road map for the reduction of the budget deficit to three per cent by the end of 2014 and shows how the tax base may be widened and deepened, and how public expenditure may be reduced in order to attain the fiscal objectives.
The second fiscal solution, namely the funding of new government borrowing and the rolling over of existing debt, is critically linked to finding a solution to the banking crisis. The reason for this is that the government guarantees for a huge part of the banking system's liabilities (deposits and bonds) has now led to a perception by the financial markets that Ireland's sovereign debt consists not only of government debt but also the insured deposits and bonds of the banking system.
Currently, the Irish banks face major liquidity difficulties. Firstly, they have no further access to the ECB's liquidity -- hopefully they will be able to roll over the existing €165bn that they have accessed from the ECB; secondly, they cannot borrow on the interbank market; thirdly, they have been suffering a significant loss of deposits; and fourthly, they have to undergo further stress testing of their loan book despite the fact that both AIB and Bank of Ireland received a clean bill of health some months ago.
In a bid to release the taxpayers from the debts of the banks, some commentators have pushed for the banks to be obliged to default on their bondholders. The populist cry has been to burn the bondholders as they have been perceived to have been imprudent in lending to the Irish banks which, in turn, were imprudent in pushing so many loans in to the property market.
Recently researched statistics published by Dealogic and Royal Bank of Scotland show the full extent of bondholders' lending to Irish financial institutions:
Before the populists start licking their lips about taking €77bn off the shoulders of the Irish taxpayers through a partial or full bond default, they need to realise that these bonds are held in a variety of financial instruments namely:
Unless a total default is contemplated, the covered bonds and government guaranteed bonds cannot be touched. This leaves the subordinated and the senior unsecured bonds. Whilst there may be some scope to buy back some of the heavily discounted subordinated debt -- as has been happening with Anglo -- there are major objections associated with defaulting on the €19bn of senior unsecured bonds. The first problem is that up to a half of the unsecured bonds may be held by Irish institutions. So the application of a 50 per cent haircut to such loans could impose a loss of €5bn on Irish pension funds, insurance companies and even the banks themselves. Does the Irish public wish for such a result that would shift the problem to their pensions invested with the pension funds and insurance companies?
The second objection to burning the unsecured bondholders is that it has the potential to destabilise the international bond markets by creating contagion effects. If Ireland is seen to adopt such a policy the markets will assume that countries such as Spain could follow suit. Spain will need to borrow (or roll over) some €700bn on behalf of the government and banks in the early months of 2011.
A partial default by Ireland on its banks senior unsecured bonds would send a strong message to the international financial markets that governments and banks had become even more untrustworthy. The potential for systemic failure of the banking systems of the peripheral EU countries would become very great. Interest rates would rise significantly and the supposed gains of a partial default would be quickly offset by the very high interest that would be exacted by the markets when the Government and, eventually, our banks tried to access them.
These are very strong arguments against taking the default route and I would be surprised if the troika insisted on such action when it presents its views this evening.
Antoin E Murphy is Associate Professor of Economics, Trinity College Dublin.