Saturday 20 April 2019

Seamus Coffey: A huge shift at EU summit, but the devil will be in the detail

ANOTHER EU summit has passed but the reaction on this occasion has been one of gushing achievement from several of the leaders who have spoken in its aftermath. While there does appear to have been some significant shifts in attitude, the detail of what has been agreed is still unknown.



The statement released by the European leaders is incredibly short and contains just four paragraphs. It will take more than 300 words to end the eurozone crisis but what was agreed at four o’clock on Friday morning may be the first step into the conclusion of the crisis. The statement has a strong opening and leads with the “imperative to break the vicious circle between banks and sovereigns”.



The detrimental link between banks and sovereigns forced Ireland into an EU/IMF bailout and for the past few weeks we have witnessed the start of the same process repeating in Spain. This summit promises to break this circle but we must await to see if it can deliver.



The EU leaders have said that the European Stability Mechanism (ESM) can be used to directly recapitalise banks. This is huge shift has repeatedly been advocated by the IMF but there are a number of issues to be resolved as the details are agreed by finance ministers over the coming months.



The ESM as it is currently constituted cannot directly recapitalise banks. The statement says that this will be achieved with a “regular decision” of the European Council. However, it will require a change to the ESM Treaty or a very loose interpretation of the existing treaty to allow the ESM to directly recapitalise banks. The current ESM Treaty only allows for the provision of loans to eurozone countries or the buying of government bonds in the secondary market.



The process of recapitalising banks involves giving rather than lending money. The ESM is designed to issue loans and apply strict conditionality to those loans. If the ESM is going to recapitalise banks it cannot do so via a loan. If the ESM lends money to a bank the net effect on the bank’s balance sheet is zero as the asset (the money received) is exactly offset by a liability (the loan to be repaid) meaning there is no increase in capital.



In Ireland, the recapitalisation process has seen the State take an equity stake in the banks in return for the recapitalisation money provided. The means that the banks don’t owe any money to the State but that the State owns (part of) the banks.



For banks like AIB and PTSB this would allow for some of the money to be repaid when the crisis passes and the equity stake in the banks can be sold on. However, for defunct banks like Anglo and Irish Nationwide the recapitalisation money that is poured into them will never be returned.



Up to last week if official funding was needed to recapitalise banks it could only be obtained if it was added to government debt before being passed on to the banks. The ultimate responsibility for repaying the loans lay with the government rather than the banks. In fact, the Finns were not satisfied with these government guarantees to repay the loans and were looking for collateral to be provided before the loans could be issued. The change agreed last night is a world away from that stance.



There are only two countries mentioned in the statement, Ireland and Spain. The reference to Spain is simply to speed-up the agreement for the loans it currently needs to recapitalise its ailing banks. This will continue in the format agreed two weeks ago and these loans will be applied to the Spanish government debt.



Last night’s agreement means that down the line this will be revisited and the debt will be taken off the government’s balance sheet. It is pretty clear that if this is going to be done for Spain that the Irish government was going to shout loudly to have the banking debt we have assumed treated similarly. It seems this was so loud that the statement could only be released if there was a reference to Ireland.



The achievement cannot be limited to a vague reference in a press statement and must see a reduction in the burden of the banking debt we have assumed. For AIB /EBS and PTSB this could be achieved by transferring to the ESM both the debt created by the recapitalisation of the banks and the equity stake taken in the banks.



This would involve the transfer of an asset and a liability to the ESM but the reduction in the liability created by recapitalising the banks would be far more significant and the Irish government’s balance sheet would look far better and show a lower debt to GDP ratio.



The case for the €35 billion that was provided to Anglo and Irish Nationwide, now combined in the Irish Bank Resolution Corporation (IBRC), is less clear-cut. The problem here is that there is just a liability and no asset as these are defunct banks with no equity. Most of the talk of a deal on bank debt for Ireland has focussed on this money and if there is to be a change in how the IBRC is to be wound down it could be far more valuable than simply making the government’s balance sheet look better.



We have been provided no insight into the exact form that this change might take but with no asset to give to the ESM the best we can probably hope for is that the repayment on the debt created by the Anglo bailout can be delayed for a very long time.



The structure of the funding used to recapitalise Anglo using Promissory Notes means the interest cost is very low. The problem is that with annual repayments of €3.1 billion it is being repaid far too quickly and involves a switch to much more costly debt. If this repayment could be extended over a period of 30 years at continued low interest rates then growth and inflation would significantly reduce the real burden of the Anglo disaster.



What was agreed last night will not be introduced immediately. The creation of a regulatory authority for the eurozone banking system in the ECB will take time and is a pre-condition for any ESM involvement in recapitalising banks. There may also be intermediate steps until a bank resolution process for eurozone banks is finalised. This will allow for the bailing-in of senior bondholders and will reduce the need for bank recapitalisation funds to come from governments.



After most EU summits we get a statement that contains lots of words but very few actions. On this occasion we have got a very short statement but one which suggests that key actions will be taken. On its own this summit will not be a game-changer but it has turned the official response to the crisis in the direction of one of the exits.



The impact for Ireland is best seen in the reaction in Irish government bond yields which for the first time have dropped below the levels seen at the time of the EU/IMF bailout.



Being over six percent, the nine-year yield is still to high to allow a return to borrowing from the markets. However if this a vague statement can see Irish government bonds viewed as a lower risk than when the EU/IMF programme was announced nearly 20 months, and down from more than 15 percent as seen in July, it is clear that the final details could make a return to the markets much more likely.



Significant problems remain and reigning in the budget deficit must remain a priority but it is now even clearer that Ireland can work its way out of this crisis.



Seamus Coffey lectures in economics at UCC







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