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.
40 replies on “Rollover Risk and the Crisis Resolution Mechanism”
@John McHale,
I think you’re moving on too quickly. This deal imposed by the Troika can’t and won’t work. Ireland is being crucified to keep whole bond investors in core EZ countries’ banks and pension funds who failed to price risk properly. At some stage these exposures will have to be recognised – rather than being salted away as they are at the moment (and where Chancellor Merkel and Pres. Sarkozy would like to keep them until after 2013) – and they will impose a contingent liability on the relevant states to support/recap the Euro financial system. Bond investors want to know how this will play out. They simply want to minimise the uncertainty. And they don’t believe that the peripherals can carry the can for their own sins and pay more to keep these stupid Euro area bond investors whole.
The EU is trying to suspend disbelief – and, for some reason the IMF is going along with this. But one thing we know for certain is that the bond markets will very quickly close the gap between fantasy and reality. The continued pressure being exerted is simply evidence of this.
This game has a bit more to run. The question now is whether Ireland should pull the pin – by voting down the budget – or sit tight, let it through, and let the bond market do its job.
@John McHale
“EU Resolution regime”
I agree with Paul Hunt that, at present, muddling through is the order of the day.
But as we have learnt from the 1986 rescue of AIB from the full consequences of its bad judgment on ICI, muddling through is not enough.
In 1997, Patrick Honohan and Jane Kelly (both then in ESRI) in a review of this rescue, pointed out
“….The emerging conventional wisdom on financial crises stresses the need for thorough prudential supervision on a consolidated basis of financial conglomerates. It seeks to ensure that the methods chosen to allocate the cost of failures does not destabilize confidence in the financial system, but is not such as to induce carelessness on the part of management, owners or customers of financial institutions. The ICI affair revealed a lack of administrative preparedness and several mistakes were made….”
They concluded
“Ireland’s worst banking crisis passed off with scarcely any disturbance on the markets and with practically no taxpayer cost. Although the total losses came to well over 1 per cent of GNP, this sum is negligible beside the losses in banking crises of other countries. Our experience has no counterpart to the severe and widespread bank failures which have occurred in France, Spain and the Scandinavian countries, to mention only EU member states that have experienced deep problems. In a way it is the exception that proves the rule of apparent stability and prudence in bank strategic management. Though the authorities’ inability to forestall the event, and their actions in trying to contain it and to allocate the cost, can be criticized, they did muddle through to an overall outcome which has proved reasonably satisfactory.”
The Insurance Corporation Collapse: Resolving Ireland’s Worst Financial Crash. Administration, vol. 45, no. 3
(Autumn 1997), p.67‐77
Perhaps this time, it will be different at least at EU level as the Germans work their way through the implications of the current crisis and set about bringing in measures at €urozone level.
However, I fear that your concluding comment does not augur well for us here.
“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”
Nor will it. These kinds of measures have been rejected, in practice, by the governing class who prefer to be able to govern in whimsical and abitrary ways. The feuding baronies replace quiet competence with grand gestures.
However, you are absolutely right to draw attention to these kinds of mechanisms by which we can limit the scope for excess by the powerful – elected and appointed, public and private.
We also need other measures, as a Swedish journalist pointed out in a BBC Radio 4 talk last June
“…In 1766, when a new young radical government came to power convinced that only transparency could deal with the corruption that was looting the Swedish state and society Freedom of Information Act was passed…”
http://politicalreform.ie/2010/06/21/freedom-of-information-and-corruption/
I would just like to once more make the point that the EU is seeking to impose a Eurozone-wide Sovereign debt resolution mechanism when its first priority should be to impose a Eurozone-wide bank resolution and rescue mechanism.
Is this because the larger members banks are insolvent whereas their sovereigns aren’t?
In 1987, Ireland’s debt to GDP ratio was 125% and the spread on Irish 10 year bonds with the German bund was 700 basis points (bps) or 7%. On joining the European Exchange Rate Mechanism (ERM) the spread began to fall, and was down to 100bps in 1992.
Before joining the euro in Jan 1999, the spread was 10-20bps. There was a similar pattern for other countries and in the third week of July 2007, when the subprime crisis was just placing the world on notice, the yield on the 10-year maturity Irish sovereign bond was lower than the yield on a comparable German bund.
In or out of the euro, this situation is not going to return but who wants a fiscal union?
There would also have been a prospect of a significant risk premium irrespective of the 2013 burden sharing plan which will take up to 8 years before a country as a majority of its debt issued from that date.
We will have to be more innovative with our own savings and the four-plan has acknowledged that.
An additional concern is that the majority of bank deposits are held by overseas residents; we need to ensure that source will continue.
Who on earth is going to buy the bonds of peripheral eurozone countries when it ill be likely impossible to roll them over coming up to or after 2013?
One thing about our situation and Deauville/Merkel’s soverign debt-restructuring plan, is that it brings forward the day when the underlying problems will have to be sorted out through QE or otherwise. The current contagion is dangerous but it may work out better than expected for Ireland.
@zhou_enlai – “Is this because the larger members banks are insolvent whereas their sovereigns aren’t?”
That looks like the case doesn’t it? And having looked at what happened to Ireland vis-a-vis solvent states (I think we were back then anyway) trying to bail out insolvent banks, the larger EU sovereigns probably thought they don’t want to go there.
It aint good out there today folks, it aint good at all. Not freefall or anything, but just complete drying up of liquidity in even some of the core Eurozone sovereigns. The system is starting to freeze up again, and it aint cos of the weather…
@John McHale
I am not sure I understand why a stabilization of the debt to GDP (should be GNP IMO but we’ve had that discussion) is sufficient to demonstrate creditworthiness if the level is too high.
Based on the governments projections it look like debt will stabilize somewhere above 130%. I have seen a report from UBS last week that suggested that it will be closer to 160% of GNP.
At an average 5% interest rate that would imply approximately 8% of GNP on interest payments solely on public debt.
When you add in the interest payments on private debt I think it is becoming clearer why Ireland will not be able to sustain this.
So while it may be sustainable in theory in practice it will be close to impossible.
I believe that the current market spreads are elevated above the fundamentals but the market is correct in pricing in a very high probability of restructuring.
A 20%-25% loss on restructure is almost fully priced into the market and I think the market has it spot on.
@Donal,
You’re right, of course, but this is moving way beyond political and economic governance in Ireland – or the poor quality thereof – to some fundamental problems in the EU.
@Zhou,
Again +1. The major EZ banks would probably not be solvent at current asset to equity ratios if they were to recognise the exposures that have been salted away. Merkel/Sarkozy are hoping they can build equity via retained earnings up to 2014 so that can then deal with these. Otherwise the sovereigns will have to back them up. The peripherals are being screwed to shore this up. But the markets aren’t buying it.
@Eoin,
How long do you think it will take to close the gap between fantasy and reality?
What leaves me despairing is that the powers that be: ECB, EU, IMF have not acknowledged the shocking extent of how the financial system simply broke down.
Rating agencies were giving Irish bank bonds a triple A rating in say 2006. bonds were issued on this basis.
Excerpts from IMF, EU, and OECD assessments of the Irish economy as late as 2007 are given at http://notesonthefront.typepad.com/ and make for shocking reading now. These organisations gave their blessing to the Irish Fiscal and Financial situation right on the brink of utter collapse.
The entire system has failed catastrophically from top to bottom and no serious effort has been made to reshape it.
@ Paul Hunt
ordinarily i would say another year or so, but this morning feels a bit odd. Think a lot of investors are starting to shun EZ altogether, not just PIIGS, this whole thing could be coming to a head sooner than we think. Bunds beta has turned positive in recent days, ie when PIIGS get sold off, so do Bunds, which isn’t the way its supposed to work…Oddly the equity market doesn’t seem to be affected too much….
@Eoin,
Bunds beta positive!? No flight to safety must mean the game is close to being up. If the markets are pricing in the risk that Germany will have to wade in to bail out the whole shooting match driven by a desire to support the Euro as a political project, then we’re on the cusp.
The implication of Philip Lane’s proposals is that we could better manage fiscal policy in the future by changing our regulatory architecture. But the failures of the past were surely cognitive failures rahter than failures of architecture.
Consider the following contemporaneous judgements of policy by professional economists:
IMF / July 2006
“The Irish financial sector has continued to perform well since … 2000. Financial soundness and market indicators are generally very strong. The outlook for the financial system is positive.”
OECD / Nov 2006
“Ireland has continued its exemplary economic performance, attaining some of the highest growth rates in the OECD … Further progress will require strong productivity growth and continued increases in labour supply.”
EU / March 2008
“Despite the weakening in the budgetary position in 2007, the medium-term objective, which is a balanced position in structural terms, was reached by a large margin.”
Where were the contemporaneous warnings on fiscal policy in 2005, 2006 and 2007 from the OECD, the IMF, the ESRI or – for that matter – from Professor Philip Lane? And where is the new analytical fiscal framework for the future that would have identified the failures of the past, in a timely manner?
We continue today with cognitive failures. For our problems are principally monetary in nature. Fiscal developments, in Ireland over the last decade, have been merely lagging indicators of monetary developments:
*EMU > interest rate fall > credit boom > construction boom > FISCAL BOOM … followed eventually by …
* property bubble + chronic overindebtedness > debt-deflation > FISCAL BUST.
(This is not to deny that regulatory capture / incompetence severely aggravated matters).
Philip Lane’s suggested body may eventually provide some new jobs and some self-actualization for some graduate economists. And, no doubt, it gives economists a warm, comfortable feeling that they are “doing something constructive”.
But where is the evidence that the analytical models have changed in a manner that they now work? It is much more the analytical tools which economists use to evaluate the fiscal impulse which need to be fixed than the political architecture (a democratically elected government answerable to Dail Eireann) within which policy is made.
And is it not a fact that Ireland’s worst-ever policy failure (the Central Bank’s failure to warn of the bubble and refusal to use regulation to lean heavily against it) was perpetrated by a body granted exactly the same sort of institutional independence and populated by precisely the same sort of graduate, middle-class worthies that would end up dominating the body envisaged by Philip Lane?
We need more (not less) democratic control of economic policy in order to rein in self-aggrandizing bureaucrats who – in this country anyway – seem too often to end up as underperforming rent-seekers.
@ Paul
“Infected – German Bunds”
http://ftalphaville.ft.com/blog/2010/11/30/420511/infected-german-bunds/
They’re getting a bit of flight to quality this morning, but only marginally.
@ Tomaltach
The biggest concern is that there is no obvious growth engine.
It is not like the early 1990s when there was an influx of a large number of big US firms.
As I said before, in that period, EU grants offset the interest burden; now the workforce is 25% bigger and employment in the exporting sector is at a level when there were 400,000 less workers.
German CDS up +9bps on the day to 60bps and now up almost 20bps since Friday morning…in % terms thats rather chunky…
I was just looking at Spanish bond charts over last couple of months.
The words “inexorable rise” come to mind. Then I looked at Belgium.
Then Portugal etc.
Where will that rise end?
Retirement allows for looser lips it seems….”Ireland bounced into bailout by ECB” – Dermot Ahern
http://www.irishtimes.com/newspaper/breaking/2010/1130/breaking24.html
@Eoin,
Many thanks for keeping us up to speed on developments. It would be great if you could keep this going on this thread – or a new one should any of the principal contributors consider this a good idea? – as I sense that something will have to give – and give quite soon.
@ Eoin, Paul H
Perhaps by offering up their Irish flank, the Euro Generals thought that the attrition would stay there and the lines would hold with Irish sacrifice, while attention could be directed to the Portuguese and Spanish lines of defense.
Maybe the whole defense wasn’t well thought out!
But they did expect the Irish to suffer heavy losses
@ Cormac Lucey
There is an interesting dynamic in the mix of perceived self-interest and the herd instinct.
We saw it then and we see it now; where did all the kool-aid kids and boosters disappear to?
On a separate issue, we see it in relation to the ‘smart economy’ strategy.
There is the self-interest in the universities, start-ups, policymakers in need of a strategy; insiders unwilling to speak out and beyond this cocoon, tech journalists afflicted with Stockholm syndrome and members of the Oireachtas out of their depth. Has anyone heard of Fine Gael’s spokesperson on innovation?
To create a sense of success, ‘wins’ are spun and we are told that in two years, the number of IDA Ireland investment ‘wins’ with a research and development ‘component’ has gone from 10% to 49%.
Last year an insurance company established a ‘centre of excellence’ and it got an R&D grant.
Today Minister Batt O’Keeffe said: “The creation of 100 jobs (over 4 years) in Accenture’s new analytics innovation centre demonstrates that the Government’s approach to investing in our research and development capacity is the right one for economic recovery.”
This issue is right on topic because it’s déjà vu all over again!
And to add an additional Gallic touch: Plus ça change, plus c’est la même chose!
@Cormac Lucey
“But the failures of the past were surely cognitive failures rather than failures of architecture….We need more (not less) democratic control of economic policy in order to rein in self-aggrandizing bureaucrats who – in this country anyway – seem too often to end up as underperforming rent-seekers.”
+2 x10^3
Reading these forums it is easy to imagine that the entire fiasco of the EU financial crisis was brought on by poor economic policy making and improper regulation when at the very root of the problem is how markets are understood, and thus allowed, to function (for instance that markets can effectively price risk, a nonsense upon which the whole tottering edifice of classical economics rests).
Of course Ireland took this market failure and brilliantly made it into a government and then a state failure but a substantial part of this is a political unwillingness in Europe to transfer the blame where it belongs and that unwillingness stems in substantial part from a problem of understanding.
Economists, private institutions and public regulatory bodies believe things that just aint so.
@Al,
Completely agree. I’ve previously described Ireland’s Troika deal as the EU’s economic reprise of Verdun in WWI. Ireland’s economic interests are now perfectly aligned with those of the bond market; but its political interests following the Troika deal are diametrically opposed. Since Ireland is now on the EU’s ‘naughty step’, it would probably be wise not to be even naughtier or teacher will get very cross. We should probably let the bond market do its job.
http://www.ft.com/cms/s/0/f478cede-fbe9-11df-b7e9-00144feab49a,dwp_uuid=50df1d0c-9e54-11df-a5a4-00144feab49a.html#ixzz16lnhILeD
earlier actions of the Irish authorities have already demonstrated that being tentative in addressing the banks’ problems backfires – remember the slow timetable for the creation of the Nama bad bank; the restricted definition of assets allowed into it; the level of recapitalisation – all have had to be revisited and radicalised.
The same will be true of the latest bail-out. In fact, even the contingency fund of €25bn – a figure seemingly plucked out of thin air – could well not go far enough. It remains bizarrely unclear, for a start, what this contingency is designed to deal with. The documentation does not say, leaving the markets to guess. All but the most optimistic believe the banks will need to fall back on it for another slug of capital.
That will probably become apparent when the regulator carries out its next round of stress tests of the banks – the so-called prudential capital assessment review – in the spring. So we can expect another four months of uncertainty. It would have been more painful for shareholders if the authorities had insisted on, say, a radical 20 per cent core tier one capital ratio. But at least that might have been the end of it. A year or two hence, there might even have been a bit of surplus capital to return to investors.
Another oddity of the EU/IMF bail-out is its stance on bank liquidity, the short-term financing vital to ensure the banks still do their core job of funding the economy.
Alongside the capital stress tests in the spring, the bail-out document promises a prudential liquidity assessment review – a pretty essential exercise, you might think, given that the commercial funding markets have all but given up on the Irish banks, leaving a record €130bn of financing to be supplied by the emergency folk at the European Central Bank.
Yet the bail-out document seems not to address this core concern. In four short paragraphs about liquidity, the central bank says simply that it will set “bank specific funding targets”. Beyond that, all the “liquidity” measures are focused exclusively on shrinking the banks to such an extent that they won’t need so much of it.
An element of the bail-out should have been specifically targeted at plugging the liquidity gap, if only to signal an acknowledgement of how crucial a role it has played in undermining the global system – in Ireland, just as it did during the big bank failures in the UK (Northern Rock) and the US (Lehman Brothers and Bear Stearns).
http://www.ft.com/cms/s/0/18a7cb92-fc7c-11df-a9c5-00144feab49a.html#ixzz16lnz7DIW
European bank and corporate borrowing costs have risen as the eurozone debt crisis spreads beyond the sovereign debt markets.
Bankers and traders say troubles in the eurozone could force some institutions to delay bond issues amid fears of contagion, which has this week sparked a rise in borrowing costs for Italy and Spain, two of the currency zone’s biggest economies
@ Al
thats the one thing a lot of guys have said over the last week – everything is moving at lightspeed now, the Irish flank collapsed in double quick time. After the Greek bailout we got a few months of relief before things turned ugly again. After the Irish one we got a few hours. After the Portuguese one, i fully expect the IMF to be conducting their press conference from Madrid in the name of efficiency and expediency.
@Cormac Lucey
A nice whack there. Actually, if the proposed body consisted of the likes of Prof. Lane it mightn’t be such a bad idea after all.
But I came across this on page 29 of the link document:
Note the word ‘just’. If the second sentence is to be taken literally, it means that there are some Keynesians out there who believe that THE ONLY effect of downward wages is to reduce demand. And that in a ‘small open economy’ etc etc. of all things.
Now, just imagine the state of chassis that would occur if loose cannons like that were to be represented on the envisioned body!
Ora pro nobis.
@Michael H
“The biggest concern is that there is no obvious growth engine.”
And there are competitor challenges. The UK apparently is reducing corporation tax on profits earned overseas.
The Irish industrial development quiver is almost empty. The most expensive arrows have been fired, almost all missing their targets and now too expensive to restock.
Only a few months ago the government, in what must have been a bout of collective hoarseness, announced the ‘creation’ of 300,000 jobs over ten years. Last year various state oracles proclaimed that over 100K jobs would be created in the same period. And the year before that, the brainy twins TCD and UCD announced that their ‘innovation alliance’ would create 30K jobs within ten years. This was a modest step up on the original promise of the previous week to create 10k jobs.
The smart economy policy always struck me as a less imaginative version of Blade Runner. In the latter, one and two persons workshops knock out synthetic skins, genetically engineer eyes and so forth. Mass production is replaced by boutique minute production. A good movie (and great book ‘Do Androids Dream of Electric Sheep?’) but still a work of fantasy like government policy.
@Zhou
re: Who on earth is going to buy the bonds of peripheral eurozone countries when it ill be likely impossible to roll them over coming up to or after 2013?
Nobody in their right minds.
There is a solution to all of this. The ECB should do its job.
1. Replace interbank funding with ECB funding. This can easily be done at a nice profit right now.
2. If banks are insolvent then the ECB should take them into custodianship and wind them down.
3. The final losses to be borne by its profits from buying banks bonds at less than par.
4. The above would break the link between bank and State that is severely compounding the current problem.
5. An ECB mechanism for State bailouts that is not punitive as in the case of Ireland but is dependent on structural reforms, particularly on higher levels of pay.
Merkels 2013 remarks were like a starting gun in a race to sell all bank bonds and all but the most secure State bonds. In fact there will be no such thing as a secure State bond unless Merkel’s 2013 is publicly withdrawn.
@John McHale
If I buy an Irish sov today and the country takes the view in the future that it is not in a position to pay, it might take unilateral action and restructure the bond under its own law.
How would this new proposed regime assist me in explaining the capital loss to the trustees?
New KOR thread, looks like we’re all done for …
@Eoin
As Roger Waters said
“Forward he cried from the rear/and the front rank died’
I’m hearing the penny might have dropped in certain circles and that a rethink is in process. Rather than offering us and other PIIGS as canon fodder there may have to be a regrouping. If there is too much debt there is too much debt; so there has to be less debt IN THE SYSTEM. Forced debt/equity swaps coming to a town near you…
@Michael Hennigan:
“The biggest concern is that there is no obvious growth engine.”
Michael Taft has some interesting thoughts on growth rates: http://notesonthefront.typepad.com/politicaleconomy/2010/11/does-anyone-else-get-this.html
bjg
It is nice to see the likes of Michael Burke and Michael Taft getting a hearing. Austerity alone isn’t working. Neither are 450,000 Irish people. 10 consecutive quarters of no growth.
@Al – “Maybe the whole defense wasn’t well thought out!”
As Hitler found out, fighting a war on many fronts isn’t the best approach.
Now if they just turned Europe into one big single happy country there would only be one front….
Rollover Risk and the Crisis Resolution Mechanism would be a great name for a band .
@ Joseph
What was the quote from Longshanks in Braveheart
“Send in the Irish”!!!!!!!!!!
@Al – I recall the film well. And I remember what happened next…..
Oddly enough, I think it’s on Film4 tonight.
@ Brian J Goggin
Michael Taft is right and I assume this is why an extra year was added on to the 3% target date last weekend.
Austerity won’t create jobs; neither will costs from a fairytale bubble period help us to develop new markets in Europe which we should be focusing on.
Tribunal lawyers are still on €2.5k per day and the litany could go on and on.
The central bank was effectively – in attitude – an arm of the civil service. Like the ESRI and the IMF it did issue clear warnings (but not strongly enough). However, it took no action and failed even to ensure that loan documentation standards were maintained. Providing the fiscal council is substantially elected by economists and is explicitly given the responsibility of warning against bubbles and debt crises, it would be very valuable. Among other measures to emphasise their duty, I would propose that a large neon sign saying, “YOU ARE RESPONSIBLE FOR TELLING IT LIKE IT IS, AND SAYING IT LOUDLY,” should be placed in their meeting room.