Another Voice for Default

Wolfgang Munchau is the latest in a growing list of influential international commentators to advocate a default on State guaranteed bank debt and/or State bonds (Irish Times article here).

I would advise the following course of action.

First, Ireland should revoke the full guarantee of the banking system, and convert senior and subordinate bondholders into equity holders.

I am aware that this would create second-level problems, in pension funds, in other banks, but it would be less costly, and more equitable, to deal with those specific problems on a case by case basis, than to dump the entire cost on the taxpayer.

The Government should then assess its own solvency position on the basis of an estimate of nominal growth of no more than 1 per cent per year for the rest of the decade. That may well be too pessimistic an assumption, but at this juncture it would be more prudent to err on the side of caution than optimism. Given the scale of the financial crisis, and its direct impact on growth, and everything we know from the history of financial crises, the case for a cautious forecast is overwhelming.

Without the load of the banking sector, such an analysis may well conclude that the Irish State is solvent. The result would depend to a very large extent on the success and extent of any bail-in programme, and the ability to contain any fall-out from such action.

If the analysis concludes that Ireland is insolvent, the Government should waste no time, and restructure the debt. Massive pressure from the EU will be brought on Ireland not to do so. But the right answer to insolvency is default – not liquidity support. Let the German government pay for the German banks, and for the recapitalisation of the European Central Bank, which may need to be refinanced under such a scenario as well.

As the momentum builds, I think it is worthwhile to recap the case for the alternative avoid default strategy. It is true that the markets no longer consider Ireland creditworthy based on fears about the size of banking losses and medium-term nominal growth. However, if Patrick Honohan is even reasonably close to being right about the size of the banking losses, and we get a half decent draw on nominal growth, then the debt to GDP ratio would stabilise under the current fiscal plan the key necessary condition for solvency.

Perhaps even more importantly, the plan secures a large package of funding support for the budget and for recapitalising the banks, and (with less certainty) an commitment from the ECB to provide a large share of the ongoing funding of Irish banks until creditworthiness can be restored. It would be good to see significant burden sharing with unguaranteed senior debt holders in Irish banks as part of the strategy, but it is likely that this would have been a deal breaker for the ECB and possibly the some European governments.

I believe there is a reasonable chance that this strategy will work to restore creditworthiness. In the meantime, we avoid a crippling sudden stop of funding to the banks and the government through international support, and are better positioned to avail of a broader European debt restructuring solution if the crisis spreads to other countries so that more radical containment measures are required. As bad as things are at present, it is important to remember that through bad policy decisions, borne of understandable frustration with soft budget constraints on investors, we could make things much worse.

I fear that Wolfgang Munchaus embrace default strategy runs a large risk of making things very much worse. Indeed, he admits that the immediate effect would be a considerable intensification of the crisis.

A default would cause havoc, no doubt, and would cut Ireland off from the capital markets for a while. But I would suspect that the shock would only be temporary. With a more sustainable level of debt, and the benefit of a real devaluation, Ireland should be able to pull through this. Once the market recognises that solvency is assured, I would bet international investors would once again be willing to lend. Even Argentina was able to gain funding from investors a few years after its default.

Hardly confidence inspiring. On balance, I think the best course is to continue to work within the present cooperative arrangements to avoid defaulting on sovereign obligations.

Krugman agrees with O’Rourke

Paul Krugman has a written a blogpost commenting favourably on Kevin O’Rourke’s recent blogpost on irisheconomy.ie.

EU-IMF Programme Details

The Department of Finance has released the documents setting out the “policy conditions for the provision of financial support to Ireland by EU member states and the International Monetary Fund.” (Statement by the Minister here.) The documents are available here. Both the review process (including “actions for the twelfth review”) and the detailed economic and financial policies appear to be very detailed.

A simple question

What will have to happen before the powers that be decide that the strategy of making Ireland fall on its sword in order to prevent contagion isn’t working?

Rollover Risk and the Crisis Resolution Mechanism

Gauged by yesterdays 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 Irelands 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 todays 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 Irelands 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 rollover 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 dont think the report on fiscal governance by the Joint Oireachtas Committee on Finance and the Public Service and in particular Philip Lanes 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.