Thursday 17 January 2019

Colm McCarthy: Events beyond satire conspire to warn us that the State debt hasn't gone away

Economic recovery remains fragile 10 years after bubble burst as many banks wrestle with fears of new debt crisis, writes Colm McCarthy

A re-run of the Eurozone sovereign debt crisis would make things
difficult and last week it looked as if Italy had unhinged the markets yet again. Photo: Copyright 2010 © Alexander Karasev
A re-run of the Eurozone sovereign debt crisis would make things difficult and last week it looked as if Italy had unhinged the markets yet again. Photo: Copyright 2010 © Alexander Karasev
Colm McCarthy

Colm McCarthy

When the Irish Government finances became seriously unbalanced in the late 1980s, it took a decade of cautious budgets and steady economic growth to get things back into shape.

Unfortunately, a combination of profligate banks and careless expenditure control produced a bigger crisis in 2008. Recovery from the subsequent recession has been better than many expected but the job is only half-completed. Budgets need to stay cautious for many years to come: likewise the domestic banks and their supervisors.

A re-run of the Eurozone sovereign debt crisis would make things difficult and last week it looked as if Italy had unhinged the markets yet again.

The ECB's most decisive intervention in stabilising the common currency area, its giant purchase programme in the government bond markets of Eurozone members, commenced three years ago last March and was expected to finish soon. The major beneficiary has been Italy, whose bond yields fell back to affordable levels along with those of other heavily-indebted members including Ireland.

Italy has the largest public debt of any European country and is simultaneously too big to fail and too big to save: if an Italian default threatens, there would be a worldwide financial crisis, and there is inadequate official funding available to finance a bail-out. Italy is too big to be another Greece. The departure, or ejection, of Greece from the common currency was averted but could have been contemplated with equanimity by everybody except the Greeks.

An Italian departure is different but now looks improbable: there is finally a new Italian government, the midweek bond market jitters have subsided and the ECB will defer the wind-down of its bond-buying programme if need be.

However, the episode should serve to remind the Irish authorities that another Eurozone crisis is just one political accident away.

Ten years after the bubble burst, the European banking system has not been decisively restored and there are too many vulnerable banks around, including in Germany where Deutsche Bank suffered another ratings downgrade last Friday. Banks in France and Spain, as well as the domestic lenders, are exposed to the Italian bond market which will weaken again if the new government proceeds to expand government borrowing.

If the Eurozone ever does come apart, the strong favourite to act as the catalyst is Italy, which has suffered from a dismal economic performance since well before the financial crisis of 2008. There has been neither a credit-fuelled property binge nor a recent explosion in the government deficit.

The weakness of the Italian banks is attributable to the prolonged economic stagnation - borrowers have accumulated non-performing loans by attrition rather than through an asset price bubble. The government deficit in recent years has been modest and public debt, dangerously high at around 130pc of GDP, was already at that level five years ago. The Italian problem is neither reckless banks nor profligate government, but rather an economy that stubbornly refuses to grow.

Despite the dramatic downturn in Ireland from 2007 onwards, the recovery has brought economic activity back above the pre-recession peak and per capita living standards are about 40pc ahead of where they were 20 years ago.

In Italy, after an unbroken record of solid economic growth from the 1960s through to the 1990s, there has remarkably been no growth at all for the last 20 years. Real output per head is stuck at the level it had reached in 1998, the year before Italy joined the Euro. It is this 20 years of economic stagnation which has given Italy its dysfunctional politics and the willingness to blame Euro membership for the country's ills.

The new government has agreed a joint programme which aggregated rather than averaged the proposals of the component parties, cumulating their competing plans to raise spending and to cut taxes. The result is a set of promises which would add about 6pc of GDP to the budget deficit: it would have been a manageable 1pc next year on unchanged policies.

Without a climbdown, there will be a row with the EU, trouble in the bond market or both. There is no possibility that Italy will be lent this extra money by the markets or by its European partners, starting from the current monster debt ratio. We have seen this movie before in Greece.

Ireland struck it lucky with the easy bond market conditions engineered by the ECB these last few years. The budget deficit would be four billion per annum higher had interest rates not been driven down across the Eurozone. But the flip side is that an early return to higher bond spreads for the more indebted countries is still a danger, and last week's gyrations affected borrowing costs for Spain and Portugal as the bond traders reassembled the Club Med.

There has as yet been no market tendency to group Ireland with the southern countries and the dreaded p-word (periphery) has yet to re-surface. The National Treasury Management Agency has sold more bonds than it needed to while the going was good and has substituted long for short-term debt. It would take a real meltdown coming from the Italian crisis to create early funding problems for Ireland.

But the state debt has not gone away. In an investor presentation released on Friday, the NTMA gave figures for the ratio of outstanding debt to government revenue for various countries. Greece is off the chart - but the numbers for Ireland, while improved, are still in a bunch with Italy, Spain and Portugal. With the Irish deficit almost eliminated and the economy (and hence government revenue) continuing to expand, Ireland's graduation northwards in the perception of bond markets is justified on the evidence.

There are two domestic developments which could see that perception drift southwards again. The first is a return to careless budget policy, the second a repeat credit splurge and consequent weakening in bank balance sheets. The two together would be an unforgivable squandering of all that has been achieved these last few years.

Fortunately, Finance Minister Paschal Donohoe has been dampening down expectations of budget giveaways while an OECD report during the week stressed again the risks of over-heating. Last Thursday, Central Bank deputy governor Sharon Donnery hinted that the Regulator might increase the capital ratios required of banks as the top of the cycle nears, noting that some other European central banks have already done so.

If domestic common sense prevails, that leaves Brexit, and things are not getting better. David Davis, the Brexit secretary, has come up with an extraordinary wheeze to solve the Irish border problem.

Beyond satire, he has proposed two borders. There would be a 10-mile area in the North coupled with another in the south where special trading rules (or none) would apply, creating a kind of demilitarised zone where chlorinated chickens could roam free, an Irish Free State reincarnate. The lucky inhabitants could call it Saorstat Eireann, with the capital at Crossmaglen.

Bundoran on the Donegal coast would be inside the Saorstat on my calculations, thus separating Donegal completely from the rest of the Republic. This is surely a disproportionate penalty for voting No at the abortion referendum.

Sunday Independent

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