While the change of government has brought a welcome fresh start, long-term bond yields – and the implied probability of an Irish default they signal – continue to rise. The 10-year yield is now above levels that forced Ireland to seek the EU-IMF assistance programme in November. It is of course early days. But there is no getting away from the message the bond market is sending.
The hope behind the programme is that it would catalyse private funding. With this in mind, it is interesting to look at the literature on the catalytic effect of official funding, much of it originating from the IMF itself (see here for an example). The basic idea is that official funding can be a complement to private funding.
There are two main catalytic mechanisms. First, in a situation where private investors are unwilling to provide (non-senior) funding because of a debt overhang or liquidity concerns, the existence of official funding can increase confidence that they will get their money back. And second, a combination of IMF conditionality, an IMF “seal of approval”, and direct IMF input into the design of the adjustment programme can increase confidence that the programme will work. Against this is the possibility of official lending will induce “debtor moral hazard” – effectively a weaker adjustment effort. (Unfortunately, the apparent weakening of the adjustment effort in the new Programme for Government, and the rather confusing split between taxation and expenditure responsibility in the newly organised Department of Finance, may have raised these concerns in our case.)
The hoped for catalytic effect has not materialised so far. I know many readers of this blog are confident they know the reason – given the outlooks for growth and bank losses, Ireland will not / cannot make the fiscal adjustments necessary to first stabilise the debt-GDP ratio and then bring it down to a less vulnerable level. And indeed the empirical literature on the catalytic effect does point to it being present for countries with weak but not disastrously weak fundamentals (see here).
But it is worthwhile to also consider another factor: private investors do not want to buy Irish debt because they fear getting caught in any new crisis resolution mechanisms that involve creditor bail-ins. Such mechanisms are now envisioned for new issues after 2013, but investors fear that they will be brought forward if the crisis does not abate. The direct involvement of the EU/euro zone along with the IMF makes the likely evolution of the resolution mechanisms more unpredictable than usual.
Discussions on revamping the resolution mechanisms have focused up to now on how to make the bailout more generous. But potentially just as important is to have more clarity on any eventual bail-ins. Advocates of more orderly bail-ins emphasise the deadweight costs of disorderly defaults, as well as the benefits of fairer burden sharing and avoiding creditor moral hazard. Clarity on whether such mechanisms will be pursued – and on whether they will be toward the more voluntary end of the spectrum – could allow the catalytic effect to finally emerge.