It is a day for taking stock after an extraordinary week. On Wednesday, the Government unveiled its four-year plan for stabilising the debt ratio with about as much political acceptance as could be expected. Yet by the end of the week the expected probability of default on sovereign debt implied by bond yields had increased, and that was despite the imminent announcement of the details of an international rescue package. It was also a week in which those advocating sovereign default—on State guaranteed bank debt and State bonds—were advancing, while those arguing that creditworthiness could still be restored were in retreat. I think it is worthwhile to reflect on the two broad views.
The “restorationist” view is that there is a path through the crisis that avoids default. This has to restore the creditworthiness of both the banks and the State.
The banks provide the most immediate challenge given the slow motion run on wholesale deposits. Their creditworthiness was based on a three-legged stool: adequate capital as a buffer against additional bank losses; a credible ELG guarantee on new bank borrowing; and a credible commitment by the ECB to act as lender of last resort. The bank run continued as each leg wobbled. The restoration strategy requires that each leg is shored up. Banks must be “overcapitalised” relative to current regulatory requirements (i.e. adequately capitalised relative market requirements). The State must itself regain creditworthiness to restore the credibility of the ELG. And on the condition the Government is undertaking to do what is necessary to pursue the first two with international support, the ECB must be willing to do its job as lender of last resort.
I have long argued that losses should be imposed on the unguaranteed creditors of insolvent or critically under-capitalised banks in the context of well-designed bank resolution legislation. One of the main failures of policy is that a special resolution regime (SRR) is still not in place.
Press reports suggest that the international negotiators are intent on imposing losses on senior bond holders, presumably those without an ELG guarantee. But this will not be easy to do. The normal series of events would be to first have the SRR in place to determine the rules, then stress test the banks to identify critical undercapitalisation, and finally to impose losses in reverse order of seniority. Of course, losses are first imposed on equity holders. This creates a timing problem. If capital is injected first, then the SRR is less likely to be triggered. And if it is subsequently triggered, the State’s capital will be wiped out. It will be interesting to see how the EU-IMF-ECB will square this circle. (One possibility is that capital adequacy is judged before any State injections took place, but creditors who provided funding the bank on the presumption that the capital buffer was real are protected – essentially the same creditors who provided funding based on the ELG.) However they go about imposing burden sharing, it is important that the measures do not further undermine investor faith in stable “rules of the game”.
For the restoration of State creditworthiness, the strategy is to demonstrate that we have the political capacity to achieve a primary budget surplus that stabilises the debt ratio, and that the strategy is economically feasible in the sense that the assumed growth rate is feasible given the austerity measures. The four-year plan has the debt to GDP ratio stabilising at 108 percent of GDP in 2013 (counting the run down of cash balances as equivalent to an increase in debt). While I do not think the growth projections are unreasonable, it is not hard to imagine a significantly worse outcome given the unpredictability of events. However, even with nominal growth averaging just 2 percent – less than half of what is assumed in the plan, the debt ratio would stabilise peak at 113 percent of GDP in 2013 with an additional one percent of GDP improvement in primary surplus in 2014 (2.9 percent instead of 1.9 percent). Moreover, if we raise the starting ratio by 10 percent of GDP to allow for larger State-financed bank losses, the debt ratio peaks at 124 percent of GDP in 2013. While one came imagine worse outcomes easily enough, my takeaway is that that strategy is robust to some quite bad news.
Of course, none of this will be easy, and despite our best efforts it might not be enough. But the “defaultists” need to make the case that a near-term default on guaranteed bank debt and/or State bonds provides a better path through the crisis. A revealed propensity to renege on obligations when the going gets tough would have a long-lasting impact on creditworthiness and on Ireland’s broader international business reputation. I would expect that it will also make it harder to get the support of our international partners, not least the willingness of the ECB to act as lender of last resort to the banking system. The presumption is that with sufficient defaults on senior bonds the banking system will be well capitalised. This might be enough to get deposits flowing back into the system without an ELG guarantee and with shaky lender of last resort support; I doubt it. Moreover, as a still-rich country despite the crisis, we shouldn’t expect international support to cover our budget deficit if we are unwilling to make reasonable sacrifices to pay our bills. The result would be an even larger forced adjustment that envisioned under the four-year plan. Those advocating default need to spell out more clearly how their strategy is supposed to work.