Funding Versus Capital

The debate about the banks has gone off the boil.   But, as John Ihle argues in yesterday’s Sunday Tribune, the next six months will be a very active period in the restructuring of the Irish banking system (article here).    

Fixing the credit system and minimising the cost of the rescue to the State have been the focus of the debate.    The first has strangely faded from view.   The second has acquired an ominous twist: tension between the ECB (which bears increasing risk as funder of last resort of the banking system) and the State (which is effectively on the hook for bank losses given limits on creditor loss imposition).  The ECB wants to shrink the balance sheets of Irish banks to minimise its exposure, even at the cost of “fire sales”; the State wants to minimise bank losses to give it a fighting chance of regaining its creditworthiness.    Like the ECB, the Central Bank of Ireland is increasingly on the hook for funding the banks through its Emergency Liquidity Assistance, although things are complicated by the fact that first on hook for losses on this assistance will be the State itself.  

This basic funding versus capital tension is most likely behind the conflict pointed to by John Ihle between the Central Bank/Financial Regulator on one side and the NTMA/Department of Finance on the other.   How this conflict plays out will have a significant impact on how the restructuring unfolds. 

Paying Attention to European Crisis Resolution Developments

Even as we are distracted by political upheavals at home, the debate on how best to reorient the euro zone’s bailout mechanisms continues.   The proposal gaining most traction, with at least a degree of German support, is to allow countries in difficulty to use EFSF funds to buyback their own debt on the secondary market.   The initial focus is on Greece, but any new mechanism should be available in time to Ireland.   (Wolfgang Munchau provides a critical analysis here.)

The attraction of buybacks is that they allow a country to reduce the face value of outstanding debt without a formal default.   A disadvantage is that they can be gamed by bondholders: it makes sense for bondholders to hold out for a higher price if a buyback is really expected to improve creditworthiness.   One partial solution that I mentioned previously is for countries to buy back the debt accumulated by the ECB through its Securities Markets Programme (see here).  

Writing on Friday before the latest developments, Arthur Beesley reminds us of the stakes:

[T]he debate merits serious attention across the political spectrum in Dublin. Political activity for the next . . . weeks will centre on the election, but neither the Government nor the Opposition can afford to lie low on this front.

The debate on Greek debt takes place amid an intensive negotiation of key reforms to the European Financial Stability Facility (EFSF) rescue fund, including lower interest rates. Any inattention here would hamper Ireland’s argument for a rate cut, which is already difficult. But the Irish dimension does not end there, far from it.

.  .  .

[S]etting the election date brings clarity as to when a new government is likely to take office. From the perspective of European talks, the timing is tricky enough. Polling day is March 11th. EU leaders are working to make final decisions on EFSF reforms and a new permanent bailout fund at a summit only 13 days later.

There will be time – just about – to install a new taoiseach. By then, however, the really tough talking may well be done.

Michael Noonan in the Sunday Independent

Michael Noonan puts forward some ideas for amending the bailout deal in an opinion piece for the Sunday Independent.   His focus is on ways to reduce the expected cost/risk to the State of cleaning up the banking mess.  

He suggests four main options: (i) have the EFSF put capital directly into systemically important European banks; (ii) have the EU provide insurance against bank losses beyond some specified level (an idea already suggested by Patrick Honohan); (iii) the fast-tracking of an EU-wide of a bank resolution regime (that presumably would not be limited to future bank creditors); and (iv) an ECB-funded special purpose vehicle for bank assets to avoid the alternative of firesales with losses rebounding on the State.

Bini-Smaghi: ‘Ireland’s meltdown is the outcome of the policies of its elected politicians’

Lorenzo Bini-Smaghi of the ECB is interviewed by Arthur Beesley in today’s Irish Times; it provides a very interesting account of the concerns of the ECB during Summer/Autumn 2009.  You can read it here.

Sargent: Ask Olli Rehn About the Minimum Wage

Anyone left in any doubt as to which of the outside parties was calling the shots in setting the terms of the EU-IMF agreement should consider checking out the clip from last night’s Week in Politics show. About two minutes in, there is a clip of Green Party TD Trevor Sargent discussing the decision to cut the minimum wage with a protestor. Sargent tells the protestor to take it up with Olli Rehn and that it was the EU, and not the IMF, that insisted on the cut in the minimum wage.

The EU Commission’s View of Ireland

Despite the constant references to the IMF in the media, on placards and on posters, the truth is that the Irish bailout deal is largely funded by the European Union and most of the reliable reports about the negotiations have suggested that the terms and conditions of the deal largely represent the preferences of the European Union.

Given that, I’ve been surprised at how little attention has been paid to the European Commission’s Autumn forecasts, released on November 29, the day after the EU-IMF deal was agreed. This post examines these forecasts and what they suggest the Europeans think will happen in Ireland.

Growth

The growth assumptions (see page 9 of this document) underlying this year’s budget come from the government’s four-year plan, published on November 24. They assume real GDP growth of 1.7% in 2011 and 3.2% in 2012 and, more importantly for budgetary projections, nominal GDP growth of 2.5% in 2011 and 4.3% in 2012.

The EU Commission forecast published five days later projects real GDP growth of 0.9% in 2011 and 1.9% in 2012. They project growth in the GDP deflator of 0.4% in 2011 and 0.8% in 2012, so their forecasts for nominal GDP growth are 1.3% in 2011 and 2.7% in 2012, putting them 1.2 percentage points behind the government in 2011 and 1.6 points behind them in 2012.

Budget Deficit

Even if the government’s projected budget deficits came about, the lower level of nominal GDP projected by the Commission would produce a higher deficit as a fraction of GDP but this effect is small. Here’s a spreadsheet I’ve put together with various calculations. It’s not too easy to read but it reports that, on its own (i.e. keeping the government’s deficit forecasts), the lower projected level of nominal GDP in the Commission’s forecast would raise the deficit ratio from the government’s projected 9.4% of GDP for 2011 to 9.5% and from 7.3% in 2012 to 7.5%.

The Commission’s actual forecasts for the deficit ratios for the next two years, however, are 10.3% in 2011 and 9.1% in 2012. Based on my calculations of the Commission’s forecasts for nominal GDP, this implies deficit levels of €16.2 billion in 2011 and €14.9 billion in 2012. These figures are €1.3 billion higher than the government’s assumption in 2011 and €2.6 billion higher in 2012.

The discussion of the Irish forecast on pages 85 to 86 makes it clear that the Commission fully expects the implementation of the adjustment packages of €6 billion in 2011 (though €700 million of this is once-off measures) and €3.6 billion in 2012. This means that the Commission’s higher deficit forecasts are due to their estimates that the weaker economy will mean lower tax revenues and higher welfare spending.

The government projects revenue shares of 35.4% in 2010 and 2011 and 35.8% in 2012. The Commission project revenues shares of 35.1% in 2010, falling to 34.9% in 2011 and 34.7% in 2012.

The government projects an expenditure share of 67.3% this year, with 20.3% of this due to banking costs. The government then project expenditure share of 44.8% in 2011 and 43.1% in 2012. The Commission project expenditure shares of 67.5% in 2010, 45.2% in 2011 and 43.8% in 2012.

It seems clear from these calculations that the Commission do not view the 3% deficit target in 2014 as attainable. If a cumulative adjustment of €8.9 billion over 2011-2012 only succeeds in reducing the underlying deficit from 12.0% to 9.1%, it’s hard to credit how a further €6.2 billion in adjustments will succeed in reducing the deficit to below 3% in the following two years, even if economic growth did turn out to be strong. Indeed, a six percentage point reduction in the deficit over the three years after 2012, thus reaching the 3% deficit in 2015, seems ambitious.

Debt and the Cost of the Banks

One would expect the Commission’s projections for Irish public debt levels to be higher than those of the government over the next two years because of their higher deficit forecasts. However, the higher debt levels in the Commission’s forecasts also appear to reflect the EU’s view on the likely costs related to the banking system.

The Commission are forecasting Debt/GDP ratios of 107% in 2011 and 114.3% in 2012. Based on their nominal GDP forecasts, I calculate that this means debt levels that are higher than those projected in the budget documents by €11.6 billion in 2011 and by €15.5 billion in 2012.

The higher deficit projections will have implied an additional €1.3 billion of debt in 2011 and an additional €3.9 billion in 2012. The remaining €10.3 billion in 2011 and €11.6 billion in 2012, likely reflect the cost of the banking bailout.

The EU-IMF program involved the Irish government committing €17.5 billion in resources from the Pension Reserve Fund and cash balances towards the bank plan. These commitments do not add to the gross government debt. If the Commission are adding an additional €10.3 billion to their forecast for gross government debt in 2011, then this suggests that their estimate of the total cost of the banking package is €27.8 billion. This is already pretty close to the total of €35 billion that has been provided for these purposes. And this is prior to any unveiling of new information on loan losses from the upcoming PCAR stress tests.

Ruling out further costs of bank recapitalisations after 2012, if indeed the deficit is still 9.1% in 2012 and the debt ratio ends that year at 114.3%, it will take a very strong combination of GDP growth and fiscal adjustment to see the debt ratio stabilise at less than 120% in the following years.

Arguments for Front-Loading in EU-IMF Plan?

I did a short pre-budget presentation today at UCD. Here are the slides. One point I emphasised is whether the level of front-loading of adjustment in the four-year plan agreed with the EU and IMF makes sense.

Up until the past few weeks, it was reasonable to argue that a significant front-loading was necessary (if not sufficient) to regain access to the sovereign bond market. However, now that our banking problems and the ECB have caught up with us and access to the sovereign bond market is not an issue for the next few years, I’m struggling to understand the logic for the extent of front-loading in the current plan (€6 bilion in adjustments in 2011, €3.6 billion in 2012, €3.1 billion in 2013 and 2014).

The economy is still in poor shape, so I’m not sure what the current argument is for further undermining it with such a front-loaded adjustment. As I speculated in the talk, perhaps the EU wanted to lock in as much adjustment as possible with the current government because comittments beyond the 2011 budget were most likely going to be open to negotiations with the next government.

No Cards?

Writing in the Sunday Independent today, Colm McCarthy characterises the Irish government’s position in the EU-IMF negotiations as follows:

The analogy of a poker game has been invoked, with the Irish negotiators having held, according to economist Antoin Murphy, no more than a pair of twos. In reality they held no cards at all, and could not bluff either. An Irish rejection would have created unwelcome but manageable problems for the eurozone banking system but would have brought immediate financial meltdown in Ireland. The inevitability of the latter is the reason why the bailout providers were in Ireland in the first place.

I’m not sure that I agree with the asymmetry that Colm invokes here: That a meltdown of the Irish banking system would have been a disaster for us but merely an “unwelcome but manageable” problem for the rest of the Eurozone.

An Irish banking system meltdown, complete with senior debt defaults, could have had extremely serious consequences for the rest of the European banking system. If the cavalry had arrived in Ireland but failed to negotiate a deal because of their desire to make the terms too onerous, how could one feel secure about Spanish banks, for instance?

If, as it appears, the Europeans (rather than the IMF) were pushing for faster fiscal adjustment, more intense conditionality, no defaults on senior bonds and a high borrowing rate, rather than have no hand to play at all, the Irish side could still have adopted the Dirty Harry strategy: Go ahead punk, make my day.

Resilience

Many commentators have used the idea of “vicious cycles” or “feedback loops” to understand the virility of the financial and economic crisis.  (A nice example is this influential piece from last year by Larry Summers on the American situation.) 

This schematic attempts to capture some of the feedback loops operating between the Irish banks, public finances and growth.    One way to think about it is to view all three as facing some nasty headwinds.   For the real economy, growth is retarded by an impaired credit system, budgetary austerity and various multiplier/accelerator effects that intensify the recession.   For the public finances, it is harder to stabilise in the face of costly of automatic stabilisers, bank bailout costs and a self-fulfilling loss of creditworthiness as the risk premium on Irish debt rises.   And for the banks, they are strained by falling assets values, lost credibility of government guarantees and a slow motion run on wholesale deposits.    Everything seems to feed negatively on everything else. 

The adverse dynamics became overwhelming in recent months and international assistance has been required to prevent an effective collapse of the Irish economy.   The “bailout” means that the Government has time to implement a phased deficit reduction rather than face a sudden stop of funding, and the banks have access to recapitalisation funds and continued large-scale funding from the ECB.   This helps to ease some of the most virulent sources of negative feedback.  

The question now is whether it will be enough.    While in no way meaning to minimise the challenge, I think it is worth pointing out some potential sources of resilience in the system.   On growth, there are encouraging signs that despite severe headwinds the real economy is holding up surprisingly well (see here).   With capital spending 16 percent below profile, this is happening despite a fiscal adjustment this year that is not that much smaller than the €6 billion adjustment that the economy will have to bear next year.    

On the banks, a key point of contention is the likely future deterioration in loans, and especially mortgages.   Time will tell whether the resilience view of Elderfield/Honohan or the mass impairment view of Kelly/Matthews is correct. 

On the public finances, the key resilience factor is the capacity of the political system to generate the necessary primary budget surplus over the four- to five-year timeframe.    The coming months will be especially revealing on that score. 

Schematic

Subordinated Bond Strategy?

The idea of subordinated bond holders in AIB and\or Bank of Ireland potentially taking haircuts has been discussed on various occasions since the IMF-EU deal was announced on Sunday. This post examines this issue and tries to figure out what the government’s strategy is.

The Minister for Finance’s statement on this matter was as follows:

As I said in my statement on the 30th of September last, there will be significant burden sharing by junior debt holders in Irish Nationwide and Anglo Irish Bank. These two institutions had received very substantial amounts of State assistance and it was only right that this should be done.

My Department has been working with the Office of the Attorney General to draft appropriate legislation to achieve this and this is near finalisation. Parallel to this Anglo Irish Bank has run a buyback operation which will offer these bondholders an exchange of new debt for old but at a discount of at least 80%. This process is still underway and will be concluded shortly.

Obviously this approach will also have to be considered in other situations where an institution receives substantial and significant State assistance in terms of capital provided to maintain their solvency ratios. I hope to be in a position soon to announce this legislation.

The policy conditionality document goes into more detail:

Consistent with EU State Aid rules, burden sharing will be achieved with holders of subordinated debt in relevant credit institutions over the period of the programme. This will be based on the quantum of capital and other financial assistance the State commits to support specific credit institutions and the financial viability of those institutions in the absence of such support. Resolution and restructuring legislation will address the issue of burden sharing by subordinated bondholders will be submitted to the Oireachtas by end-2010. Where it is appropriate, the process of implementing liability management exercises similar to that which is currently being undertaken in relation to holders of subordinated debt in Anglo Irish Bank will be commenced by end-Q1 2011.

Now let’s bring into the mix the Central Bank’s statement from Sunday:

The Central Bank has set a new minimum capital requirement for Allied Irish Bank, Bank of Ireland, ILP and EBS of 10.5% Core Tier 1. In addition, the Central Bank is requiring these banks to raise sufficient capital to achieve a capital ratio of at least 12% core tier 1 by 28 February, 2011 in the case of AIB, BOI and EBS and by 31 May 2011 in the case of ILP.

And after this, we get

Bank of Ireland, Allied Irish Banks, ILP and EBS will be subject, as previously announced, to a stress test in March 2011 under the Central Bank’s PCAR methodology. If, as a result of the PCAR, banks are assessed to be at risk of falling below the 10.5% core tier 1 target then further capital injections will occur.

So, the following appears to be the sequence of events:

December: Resolution legislation is introduced outlining a mechanism whereby subdebt holders lose out if the State has to provide a large amount of capital to maintain solvency.

February: AIB and BoI are recapitalised, presumably mainly or totally with state money, to 12 percent core tier one ratios.

March: PCAR is completed. This will involve writing down of asset values and this will trigger the need for more capital injections if the core tier one ratio fall below 10.5%.

So how exactly might burden sharing with subordinated bondholders happen? Frankly, it’s as clear as mud.

One interpretation is the following: AIB and Bank of Ireland are capitalised to 14% and 12.5% core equity ratios by the end of February. After this occurs, there are stress tests and only if these stress tests uncover losses that wipe out the end-February levels of capital will the subdebt holders be start to lose out.

If that’s the scenario, then it would seem pretty unlikely that subdebt holders will lose out. Stress tests rarely uncover that a bank has lost 14% of its risk weighted assets.

So perhaps all the talk of subdebt holders losing is just waffle. However, the tone of the public comments on this has been to suggest burden sharing is likely.

If that’s the case, the process might have to be something like as follows: AIB and Bank of Ireland are capitalised to 14% and 12.5% core equity ratios by the end of February. Then more money is put in after the PCAR. At this point, if the combined amount of state funding that has been put in during these two stages (the “quantum of capital”) is the difference between solvency and insolvency, then the legislation triggers a mechanism through which subdebt holders lose out.

I’m no lawyer but this latter mechanism seems legally dubious. It seems to propose that the state can put €9.8 billion in equity into AIB in February and then turn around in March after some additional losses have been diagnosed and somehow ask bondholders, who are senior to equity in the liability pecking order, to take a hit even though the bank is not insolvent at that point.

There seems to be a cake-and-eating-it problem here. On the one hand, the government wants to reassure everyone owed money by the Irish banks that their money is safe. Thus, it wants to keep the banks adequately capitalised and avoid ever having to declare a bank temporarily insolvent. On the other hand, since there are strong suspicions that the banks really are insolvent, it wants a mechanism to allow it to apply ex post haircuts to subordinated bondholders after a stress test shows that the banks have been insolvent.

Or maybe I’ve got it all wrong. I’m happy to hear from others who perhaps have a better idea than me as to what’s going on.

EU-IMF Bailout Borrowing Rates

The NTMA have released a note explaining the interest rate associated with the bailout package. The average interest rate is 5.82% and the average maturity of the borrowings is 7.5 years.

The 5.82% is presented as being comprised of an average rate of 5.7% from the IMF and EFSM and 6.05% from the EFSF.

The statement leaves a few questions unanswered about the IMF and EU rates.

Regarding the IMF rate, the IMF’s statement on Sunday night said

At the current SDR interest rate, the average lending interest rate at the peak level of access under the arrangement (2,320 percent of quota) would be 3.12 percent during the first three years, and just under 4 percent after three years.

How do we get from a weighted average of 3.12% and 4% to the government’s figure of 5.7%? The answer appears to be related to the fact that the IMF lends in SDRs at a floating rate. From the NTMA statement:

The SDR comprises a basket of four currencies, Euro, Sterling, the US Dollar and Japanese Yen. The IMF’s SDR lending rate is based on the three month floating interest rates for the currencies in the basket. In the presentation of the financial support programme the interest cost on the IMF’s floating rate SDR lending is expressed as the equivalent rate when the funds are fully swapped into fixed rate Euro of 7.5 years duration.

Since both IMF and NTMA statements must be true, this suggests that the cost of swapping a floating rate SDR loan into a fixed rate Euro loan is somewhere between 170 and 258 basis points. That seems very high to me.

Regards the EFSM rate, the NTMA tell us that it “will be at a rate similar to the IMF funds, i.e. 5.7 per cent per annum.” But presumably the EFSM is lending in euros and so there was no need to undertake a very expensive swap exercise, so this deal factors in a profit margin for the EFSF that does not apply to the IMF loan.

Finally, the mystery that is the EFSF rate is revealed. 6.05%. Less than the 6.7% that was doing the rounds last week but more than the 5.7% that I had guessed a few weeks ago and still a pretty hefty rate.

I have to confess to having no idea how this 6.05% was arrived at. The EFSF FAQ states

fixed-rate loans are based upon the rates corresponding to swap rates for the relevant maturities. In addition there is a charge of 300 basis points for maturities up to three years and an extra 100 basis points per year for loans longer than three years. A one time service fee of 50 basis points is charged to cover operational costs.

So let’s plug in the numbers consistent with a seven year maturity. The seven year swap rate is 2.85%. Add 400 basis points for the profit margin and you’re at 6.85%. And this ignores the 50 basis point service fee which, if annualised over the term, would bring the rate up to 6.92%. Finally, this also ignores the following aspect of EFSF lending. From the framework agreement:

The Service Fee and the net present value of the anticipated Margin, together with such other amounts as EFSF decides to retain as an additional cash buffer, will be deducted from the cash amount remitted to Borrower in respect of each Loan (such that on the disbursement date (the “Disbursement Date”) the Borrower receives the net amount (the “Net Disbursement Amount”)) but shall not reduce the principal amount of such Loan that the Borrower is liable to repay and on which interest accrues under the relevant Loan.

This seems to mean that we are paying the service fee and margin up front. In addition, we are going to pay interest on a cash buffer, which is money kept by EFSF that we’ll never see.

So, two thoughts here. First, it seems likely that the government negotiated in the final days to get the “profit margin” aspect of the EFSF money down. Second, I wouldn’t be surprised if the true effective cost of this loan is understated by the 6.05% figure, for instance because it doesn’t include the up-front service fee or the role played by the cash buffer.

A full detailed explanation of the EFSF rate from either the Irish government or the EFSF would be very welcome.

The Red C opinion poll

We are into political economy territory bigtime now, and I don’t think economists can ignore the constraints that this may impose going forward.

So it would be wrong not to have a thread on the latest opinion poll, which shows Sinn Féin leap-frogging Fianna Fáil into third place. Pretty predictable really. Presumably the boffins from Brussels and Frankfurt have factored this sort of thing into their calculations?

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.

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.

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.