Rollover Risk and the Crisis Resolution Mechanism
This post was written by John McHale
Gauged by yesterday’s market reaction, the EU-IMF support package did little to dampen longer-term default worries on Irish debt. The yield on the 10-year bond rose on Monday after an initial rally, even as the yield on 2-year bonds fell. Potential buyers continue to have a number of doubts about Ireland’s creditworthiness: doubts about the political capacity to produce the necessary primary budget surplus; doubts about whether sufficient nominal growth can be generated to stabilise the debt to GDP ratio even with an impressive turnaround in the primary balance; and doubts about how the direct cost of the banking bailout will impact the starting level of debt.
There has been a lot of discussion of an additional source of doubt that is largely outside of our control: the rules of the new EU resolution regime that will be in place for government debt. It is not immediately obvious why the arrangements that will be in place from 2013 should have such a bearing on the cost of borrowing today. However, the new regime will affect the cost and ease of rolling over debts, and so forward-looking investors must look beyond the resolution arrangements that apply to bonds purchased now. It seems likely that today’s potential investors worry that it will be more difficult for countries such as Ireland to roll-over debts under the new rules.
The proposed rules reflect a watering down of the tougher arrangements advocated by Germany. Under the new proposals, a country has to be deemed to have an unsustainable debt to trigger collection action clauses to restructure existing debt as part of any bailout. Even so, there is an expectation that it will be more costly to raise funds in the future.
What are the implications for the policy effort to restore Ireland’s creditworthiness? The nature of the new regime suggests that a country lacking in “fiscal space” could pay a large risk premium in the future. This could explain why even the expectation of successfully stabilising the debt to GDP ratio at a high level still leaves a country vulnerable to perceived roll-over risk. Unfortunately, there is no easy solution, but it does suggest the importance of adopting a national fiscal regime aimed at ensuring fiscal space (e.g., putting in place such measures as an independent fiscal council and appropriate fiscal rules).
I don’t think the report on fiscal governance by the Joint Oireachtas Committee on Finance and the Public Service – and in particular Philip Lane’s excellent background paper for the Committee – received sufficient attention (the report and background paper are available here). Moving to put the necessary institutions in place may not just be essential to improve fiscal policy in the future, but also an essential part of restoring creditworthiness today in a context where perceptions of future fiscal space are so critical.