Ciaran O’Hagan is head of rates research at Société Générale in Paris
Risk aversion has picked up in Europe over the past weeks. The debate over the fiscal and banking outlooks in Ireland needs to be placed in this context. While Irish credit is under pressure, it is also against a backdrop that favours risk aversion.
The flavour of Wednesday’s press alone gives a good idea of the headwinds facing any country wanting to grow itself out quickly from public debt.
The ECB’s chief economist, Mr Stark, is warning of a slowdown in growth, Meanwhile the Bundesbank’s Weber is cautioning that the global financial crisis is not yet over and setbacks in financial markets cannot be ruled out. Behind this talk is of course the cautioning of governments that they need to show long-term commitment towards fiscal consolidation, or else brave the consequences.
Unfortunately several governments are non-existent. Belgium’s mediators warn there will be no announcement in relation to a new government this week, and there is no quick progress in the Netherlands either. Italy’s finance minister affirmed that there’s no autumn emergency. In France, the unions are trying to complicate very necessary – if still modest – pension reforms.
Even what should just be simple procedure is becoming problematic. Comments from the ECB, as reported by government sources in Berlin, suggest ongoing frustration with the IMF over how to deal with the challenges posed by Greece. And Eurostat is reported as saying it is frustrated as it can’t get all the Greek documentation on debt that it wants.
Moreover in Brussels, we have the overriding impression of cacophony from the latest Ecofin and Eurogroup meetings. We had the spectacle of head of the Commission, Mr Barroso, calling on the governments to reform. That absence of reform leads to titles in the press Wednesday like “Europe is Acting as Though it Wants to be Left Behind” (the WSJ) and “Realisation has dawned that sovereign credits cannot survive unless banks are recapitalised (the FT).
Even in AAA land, we read titles like “German banks are in reality the Achilles’ heel of the European banking system” (FT). The Bundesbank’s Weber affirmed that higher capital requirements for banks won’t curb economic growth. However even Mr Weber would probably agree that without strong banks, there will be no robust recovery. Unfortunately Europe won’t allow banks fail, and yet at the same time, many governments treat them as taxable cash cows and excuses for a lame recovery.
Last but not least, Mr Lenihan, the Irish finance minister, extended the guarantee for deposits at domestic banks and laid out plans for the dénouement of Anglo. These were necessary actions. However they unfortunately raise the contingent liability for the Irish state still further.
All this is just in a day’s news. It provides an unfortunate backdrop for any country wanting to grow itself out of public debt quickly. Ireland’s growth rate is probably more elastic than most with respect to global prospects. Unfortunately fiscal consolidation elsewhere in Europe over 2011 and beyond faces strong headwinds. That is helping make investors ever more averse to taking on risk, even among sovereigns, traditionally regarded as among the strongest of all credits.
All of these developments are over the past day. And there will be more days like this. Ireland is particularly exposed to moves of risk aversion as it has the largest public budget deficit as a share of national income for three years now, and there is no sign of that changing. Indeed our latest forecasts for 2011 show a widening gap in fiscal performance between Ireland and its neighbours.
Moreover there is a strong gap between perceptions and reality. Many, both inside and outside Ireland, are under the impression that Ireland embarked on a programme of fiscal austerity these past two years. The international press repeated the same good tidings incessantly. That reflected a large well of sympathy towards Ireland’s predicaments. It is still there. But it can only be capitalised upon if the government goes some way towards delivering on promises of fiscal stringency.
The main challenges ahead now are more fiscal, less financial. The present and future governments of Ireland have considerable leeway in how they manage the process of fiscal consolidation. But on the banking side, there is increasingly less room for manoeuvre. The costs to the taxpayer of the domestic banking crisis have been more and more socialised by the policies of the present government. That unfortunately has made what were contingent liabilities certain liabilities for the taxpayer. Even lower grade bonds have been bought back, at prices below their redemption value, but at prices above what might have been considered market value (those higher prices can be justified by the need to attract investors into the buyback).
Now Anglo Irish is seeking approval from government to launch yet another buyback of subordinated debt. Banks that buy back debt at a discount to face value create a capital gain that can used to bolster capital ratios. All Irish banks are then strongly incentivised to buy back debt at a discount while still under guarantee. However the interests of the banks and of the taxpayer are not necessarily identical. All these buy backs help socialise the ultimate liability for the taxpayer. Once a bond is bought back, it cannot be watered down anymore and the new funding is probably under guarantee or somehow securitised.
After the expiry of the CIFS guarantees on the 29 September, there may only be a few billion of domestic banking bonds left in the hands of investors that is not somehow securitised or subject to further guarantees. Maybe even less than that.
For bonds still outstanding at the end of the month, there is quite a range of possibilities, ranging between full and zero redemption for this debt. The easiest option of course for any government is to do nothing and muddle through. However some governments (notably the USA and the Netherlands) have seen their credit worthiness reinforced, not weakened, by allowing holders of bank debt largely bear losses (if admittedly in quite different circumstances).
The “muddle through”, do nothing, option is more attractive if the government has a rosy view of future growth prospects. If however it is fearful that growth will be anaemic over the coming years, with little to no inflation, then there is all the more urgency to take action now in order to safeguard the integrity of the signature of the state.
There is no denying that such action is hard to undertake, and involves risk. Moreover some action that was available to foreign governments is not as easy to implement in Ireland. The Irish Constitution provides an unusually strong defence of property rights. I have no doubt however that a government would have the necessary leeway if the public understands that its purpose is to allow wider sharing of losses at banks.
There is, however, no escaping repayment on the vast bulk of the bank debt clocked up on behalf of the Irish taxpayer without impinging on the sovereign signature. That puts an ever greater onus on the government to limit the growth of public debt ex-banks, if risk premia on sovereign are to be contained. Our initial projections for 2011 see several eurozone governments with general government budget deficits in the 6-8% area as a percent of GDP. Ireland, more than ever, is standing out from the pack.
Measures of Ireland’s sovereign credit worthiness have been strong up until now, both in terms of “ability to pay” and “willingness to pay”. “Ability to pay” criteria are mainly based on some notions of wealth, income and national debt as well as contingent liabilities (those are mainly pensions and banking risks). “Willingness to pay” benefits from a history of stable and responsible government, and a strong respect for procedure and the rule of law.
Access to ready cash is also elevated for Ireland. The NTMA could go well into 2011 without raising a single cent on international markets, and government wouldn’t run out of cash. That is unusual among sovereigns. However this is also very much a double edged sword. It buys the country time to get its affairs in order. But it also gives governments the opportunity to just dig a deeper hole for itself. Indeed it is unfortunate that the discipline of market did not prevent a build-up in public debt over the past two years, in part because the government was so cash rich.
In this context, we can safely exclude any repeat of the Greek crisis for Ireland. Pasok, as soon as it came to power, started begging for solidarity from the EU, in the belief that would ease repayments. It eventually did, but in an extraordinarily disruptive way that took the Greek authorities by surprise. I can’t imagine the present or future Irish governments ever doing likewise, having seen the fate that befell Greece.
Somewhat for the same reasons, I can’t see Ireland wanting to seek help from the EFSF (the European Financial Stability Facility). Like for Greece, it would mean the death of the local bond market, along with the nosey oversight of the “Troika” (EU, ECB, IMF). The loss of reputation would be severe, and getting back to normality after a few years could prove very costly indeed.
Irish government credit, despite all the challenges ahead of it, is still not attractive to sell. There will be no Greek-like crisis in Ireland, given that Ireland is not going to run out of cash anytime soon. Any investor that wants to “short” Irish government bonds (i.e. sell a bond in the expectation that its price will go down) will probably have to hold that position for quite a while indeed. But that would prove very expensive, as the differential between yields on Irish bonds and AAA bonds or swaps is already quite wide.
Little surprise then that few investors have short positions on Irish government bonds, in all probability. It is no secret that hedge funds have not been actively trading sovereign debt in Europe for some time. Trading volumes generally have dropped off, and prices for sovereign debt have become unfortunately very sticky. There are sizeable holders of Irish debt, with the ESCB (Eurosystem) now probably the largest (from IMF reports on Greek debt holdings, I’d guess the ESCB now holds some EUR15bn+ of Irish government debt – compare to a total outstanding of some EUR90bn).
In these conditions, the yield Ireland pays over AAA governments is a function of global risk appetite (outside the control of Ireland), along with any news that substantially impacts the creditworthiness of Ireland. That consists mainly of the expected path of the growth of public debt in the years to come. Other factors, like the prospects for growth, play a role, but they are very much second fiddle, as slow moving.
If the present or future governments want to get the cost of borrowing down, it has to control the growth of public debt. The easiest way of doing so very quickly would be to find measures with a sizeable long term impact, but little upfront cost, and hopefully, a weak burden in terms of disincentives. The mere announcement of such measures – if perceived as credible and likely to be retained by the next government – would almost certainly help narrow yield spreads. Measures might include:
– the introduction of property taxes and local government charges, on a par with the rest of Europe;
– legislated future increases in retirement ages;
– the taxation of pensions and pensioner benefits (already extraordinarily generous in some respects compared to the rest of Europe);
– the introduction of fiscal oversight or rules (Germany now has a constitutional balanced budget rule, and the UK is setting up the Office for Budget Responsibility);
– smoother budget processes and transparency (Ireland is among the last of the eurozone countries to present the upcoming year’s budget, with an unusual focus on “budget day”);
– legislative developments, such as bank resolution legislation and clarifications around property rights.
As for more orthodox belt tightening, it is difficult to ascertain what impact a billion more or less on the 2011 budget deficit would have on investor sentiment. Probably a reduction of several billion in the deficit is needed, just to prevent Ireland from sticking out among eurozone members in 2011 as having the largest current budget deficit. Yet the focus of investors as a whole (along with the ECB, the IMF and the rating agencies) is very much on the likely path for public debt over the coming years. So long term measures like those above could prove very valuable indeed in helping restore confidence in the ability of the State to meet its obligations. And certainly the government would get more kudos from voluntarily engaging in such measures right now, rather than being obliged to in extremis at a certain point. All easier written than done, of course!