Kevin Daly’s piece is below:
European Views: Ireland – Old News, New News, and Breaking the ‘Vicious Circle’
September 9, 2010
Irish bond spreads have widened significantly in recent weeks, driven by fears over the cost of bailing out the banking system and the nationalised Anglo Irish Bank in particular. Some of this is old news (the government’s estimate of the cost of bailing out Anglo was first announced six months ago) and the Irish government argues – credibly, in our view – that the costs of bailing out the bank are “infuriating but manageable”. However, the rise in Ireland’s borrowing costs has now created a dangerous dynamic of its own, which needs to be addressed with some urgency. Providing an independent estimate of the bailout costs will be an important first step. In addition, the Irish government should (and, we expect, will) accelerate the speed of its fiscal adjustment.
Background: Rise in Irish Bond Spreads on Costs of Anglo Bailout
The spread between Irish and German 10-year government bonds reached more than 360bp yesterday, up from 230bp at the start of August (Chart 1). With German bond yields exceptionally low, the rise in outright rates has been less than this, but the yield on Irish 10-year government bonds is nevertheless close to 6%. Irish spreads have tightened a little today.
The underperformance of Irish government bonds has been driven, first and foremost, by international concern surrounding the cost of bailing out the Anglo Irish Bank, an institution that was fully nationalised by the Irish government in January 2009. In addition, Anglo also has around EUR7bn in government-backed, medium-term debt that is maturing this month (in the context of heavy refinancing needs across Europe).
The government indicated in March that the total cost of re-capitalising Anglo was likely to be around EUR25bn (or 16% of GDP), some of which has already been disbursed, with the remainder spread out over a number of years. Others, including the ratings agency S&P, have suggested that the final cost is likely to be higher (S&P put the estimate at EUR35bn). Further capital injections (likely to total EUR5bn-EUR10bn) will also probably be required for some of Ireland’s other banks.
Meanwhile, Ireland’s ‘underlying’ budget deficit – i.e. stripping out transactions related to the banking sector – is very high but has been tracking broadly in line with the government’s forecast (11 ½% of GDP in 2010, 10.0% in 2011).
Costs of the Anglo Bailout Are High But Have Been Known For Some Time
Irish policymakers and analysts have been taken by surprise by the recent spread-widening as, while the situation with Anglo is serious, there hasn’t been much important new information on the cost of the Anglo bailout for some time:
· The estimated cost of the Anglo bailout has been unchanged since March: On March 30, Ireland’s Finance Minister Brian Lenihan announced a further EUR8½bn capital injection into the bank and suggested that the total up-front cost of bailing out the bank was likely to be around EUR25bn. At that stage, some analysts suggested that the final cost was likely to be higher than the government’s estimate. While it remains the case that some analysts think the final cost will be higher than EUR25bn, neither the government’s estimate nor those of other analysts have changed that much since March.
· Anglo’s H1 results (reported August 31) were poor but this was also widely expected: Anglo reported a EUR8bn loss for H1, the worst loss in Irish corporate history. However, the losses were broadly predictable because, having sold assets to NAMA (Ireland’s bad bank) at a large discount during this period, it had to book these transactions as losses in its H1 accounts. It may be that some of the international ‘surprise’ at this news is because, as a nationalised institution, Anglo is no longer followed by equity analysts.
· An additional concern – which was genuine news – is that the government appeared to be constrained from implementing the least costly re-structuring option by the European Commission (due to competition concerns). The option preferred by the Anglo’s (new) management was to separate the bank into a ‘good bank’ and ‘bad bank’, slowly winding down the ‘bad bank’ but retaining the ‘good bank’ as a going entity (before floating it or selling it when circumstances allowed). However, this appeared to meet with resistance from the European Commission due to concerns that a government-owned ‘good bank’ would distort competition in the market. If the government was forced into an immediate wind-down of Anglo, this would hugely inflate the cost. At the same time, many feared that the intermediate option – an ‘orderly’ wind-down of the institution over a number of years – would be very difficult to implement in practice.
Breaking the ‘Vicious Circle’
Whatever the cause of the increase in Irish spreads, the development in itself presents a clear danger for Ireland, because the rise in borrowing costs and the loss of investor confidence threaten the government’s financial position. This danger is surely not immediate because the funding position of the Irish government is very strong: the NTMA – Ireland’s debt management agency – has a policy of significantly over-funding its borrowing requirements and it is fully funded right up until 2011Q2 if needs be. However, it will need to continue to access the market if it is to maintain this buffer. So what action has the government taken and what can we expect in the future?
· The government announced yesterday that Anglo will be split into two entities, a “funding bank” that will take over Anglo’s deposits and an “asset recovery bank”, which will manage the loans that are not transferred to NAMA. This is closer to the “orderly wind-down” option than the management’s preferred good bank/bad bank option but, in separating the deposit base from the part of the bank that is being wound down, the risk of deposit flight should be much lower. We consider this to be a sensible move.
· In order to provide transparency on the likely cost of the bailout, the government has asked Ireland’s Central Bank to provide an independent estimate of the total cost before the end of this month. The Central Bank is expected to provide a central estimate and a stress estimate. An announcement will also be made on the likely funding required for Ireland’s other banks. This is also a very sensible decision in our view, even if it means that the uncertainty will remain for a few more weeks.
What else could the Irish government do to reassure investors?
Speed the rate of fiscal adjustment: Ireland won a lot of praise for tightening fiscal policy relatively early (and aggressively) in 2009 but, as other peripheral EU states have tightened their fiscal finances, Ireland’s budgetary projections no longer look that impressive. We expect the government to speed up the rate of fiscal adjustment in the next budget. However, the budget isn’t scheduled until December. An early announcement of the intention to speed up the rate of fiscal adjustment would be helpful and the Pre-Budget Outlook – due for release in mid-October – could provide the vehicle to do so.
What is likely now?
While the announcements made by the Irish government yesterday were welcome, we expect the uncertainty to linger until the Central Bank announces its estimate of the total cost of the bailout later this month. We can only speculate as to what the Central Bank is likely to say. The only point we would make is that the Irish government has a good record in being realistic and transparent on likely costs and projections, which would suggest the Central Bank’s assessment will be closer to its estimate than some of the wilder estimates that have been circulating.