Saturday 23 February 2019

Time for a whole new strategy on negotiations

We can fool ourselves and even Europe but we won't fool the ones that count -- the markets, writes Colm McCarthy

Colm McCarthy

Colm McCarthy

THE Government's negotiating strategy with our European partners consists of two conflicting components: regular expressions of confidence that all of Ireland's public debt will be repaid, accompanied by requests for debt relief.

The necessity for debt relief is denied by the aforementioned expressions of confidence. It is undermined further by assertions that Ireland expects to re-enter the bond market next year. If you are confident that you can pay all your debts, so confident that you expect to be back in the markets pretty soon, what is the case for debt relief? This never looked like a coherent strategy and it emerged last Friday that the European Central Bank is not sympathetic to the case put to them.

This is the same ECB whose actions have imposed excessive bank rescue costs on Ireland, through its insistence that bank creditors outrank sovereign lenders and are the exclusive responsibility of host governments. The reported ECB attitude on Irish debt relief should come as no surprise to anyone. Taking one for the team will not go unpunished in the new European order.

Here's an alternative negotiating strategy. The key premise is that debt relief cannot be confined to Greece, a centrepiece of the most recent deal in Brussels. This is, of course, a matter of judgement, but it is the judgement of the bond market, the one that matters in the end. The debt relief currently contemplated for Greece is inadequate, so there will be more. Debt relief will be required also for Portugal. If Ireland is to repay its core sovereign debt, there needs to be a deal on sharing the bank-rescue costs. Otherwise, Ireland will either join Greece and Portugal in sovereign default or will be reliant on official lenders indefinitely.

It follows that the number of European sovereign defaults can, with luck, be confined to two, but only with a deal on sharing some of the Irish bank-rescue costs with those who insisted that they be incurred.

Perhaps the European leadership would place a low value on containing the number of sovereign defaulters to just one more, in addition to Greece. But the question will arise anyway when the current official lending programmes run out, if not sooner, as happened with Greece. Accordingly, the alternative negotiating strategy is to say that we do not feel confident that we will be able to meet all the debt that has been accumulated, and that accordingly we have no intention of trying to sell bonds next year.

A complement to this alternative negotiating position would be a ban on ministers or officials expressing upbeat opinions about Irish economic prospects. There is no obvious downside to telling the market what it already knows. We are out of the bond market anyway for the next two years, and the market is not expecting us back unless there is a deal on bank rescue costs.

If you think that the limited haircut on Greek debt already agreed will prove adequate, you can buy Greek bonds that yield extraordinary returns, even with the haircut. In other words, the markets do not believe that the current haircut will be the last. The recent IMF report on Greece, which projects the debt forward taking the haircut into account, is a scary document. There is no chance that Greece will stabilise its debt on plausible assumptions and the contrary conclusion of the IMF team is surprising.

If you share the confidence of the Brussels summiteers in Portugal, where no haircut is to be countenanced, you can earn 17 per cent per annum on a bond maturing in September 2013. French and German bonds of the same vintage yield less than 1 per cent. Portugal has not had a serious banking bust and its public debt is almost all truly sovereign. Those who bought Portuguese government bonds got it wrong and the appropriate remedy is a haircut.

The prospective debt situation in Ireland is not as dismal, and Ireland's bond yields are lower than in Portugal, but far higher than they would be if investors saw no risk of default. The market to which Ireland must return does not believe that this will happen on current policies. The difference between Ireland and the two southern European countries is that over €60bn of the Irish debt mountain, 40 per cent of GDP, arises from bank-

rescue costs, including costs inflicted by the ECB. If this cost burden could be shared, there is a decent chance that Ireland could avoid default on the truly sovereign portion of its public debt.

Those who bought Irish government bonds down the years have suffered undeserved losses, through the promotion of queue-jumping bank bondholders, who made far worse investment decisions and have been paid in full, due to Irish policy mistakes but also at the behest of the ECB.

The confident assertions of the summiteers that Greece is the last sovereign haircut are not believed, because previous assertions from the same source have proved so costly for believers. Greece, Ireland and Portugal are recipients of emergency finance from the EU and IMF because the markets will not lend to them.

There are plausible grounds for believing that Spain and Italy, the too-big-to-save eurozone members, can avoid sovereign default if adequate policy measures are taken to cut their deficits. The ECB will eventually backstop their bond markets, either directly or through lending the needed euro to an intermediary. The alternative is a world financial crisis on an epic scale, probable euro break-up, and the end of the ECB.

The destruction of confidence in the European sovereign debt markets could have been avoided if the banking crisis had been acknowledged and addressed honestly. The extend-and-pretend policy has not saved the banks, but the attempt to save them through sacrificing sovereign investors has wrought enormous damage.

Policymakers have undermined the credibility of governments through exposing their balance sheets to undercapitalised and insolvent banks. To have done otherwise would have required an early acknowledgement that the European banking system was a mess, that national supervisors had failed and that the ECB had presided over a banking bubble as bad as those in the United States and in Britain. Governments would have had to stump up for bank recapitalisation and politicians would have suffered at the polls.

After three years of evasions and blame-shifting, we now have a sovereign debt crisis in addition to the banking mess. It is too late to undo much of the damage, but future costs can be contained. One important component in

building a durable currency union would be restoration of confidence in sovereign debt, with losses imposed only on those who deserve it.

In Ireland, bond investors in Anglo are still being repaid in full, under threats from the ECB, despite the fact that they bought bonds in a bank which has lost eight times its capital and has been closed down. It is insufficiently appreciated that traditional sovereign bond investors have been treated abysmally by the policies pursued in Europe, most obviously in Ireland.

The day the Anglo investors bought their bonds, they could have bought Irish government bonds instead, on a somewhat lower yield but with lower risk as they would have seen it. Had they done so, they would have got screwed, courtesy of the ECB. Is it any wonder that traditional sovereign bond buyers have fled? Policymakers have deemed that sovereign bonds are risky, but bonds issued by bust and closed banks that are under criminal investigation are to be paid in full, in the Irish case by a Government hunted from the markets and unable to borrow itself.

Irish taxpayers are quite right to be fed up about this. If it is any consolation, so are many bond traders, who cannot understand why the ECB instructed the Irish Government to pay $1bn which it had not guaranteed to bondholders in a bust bank already in the closure process.

The Government plans to take its case to the EU Commission, having admitted the lack of progress with the ECB. This is not a good idea. It is the ECB that is in a position to find a funding formula that relieves a portion of the bank-rescue costs.

The EU Commission also happens to have no money, and tends to defer to the ECB on monetary and banking matters. It is surely time to release all communications with the ECB over their conduct towards Ireland, which can only be more embarrassing to the former.

Sunday Independent

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