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 Munchau’s “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.

The Spirit of Ireland 2.0

The Spirit of Ireland is back. A new glossy was distributed widely by email today. More than one-and-a-half year into the project, there is still no detailed plan, at least not in the public domain.

As before, SoI combines wind power with pumped hydro to create a stable supply of electricity. That would work. Unfortunately, wind power cannot compete without subsidies; and pumped hydro would further add to the costs. SoI is still silent on its cost estimates.

The latest plan is different from what we saw before. SoI aims to export most (all?) of the generated power. The idea is that Great Britain and the Continent are heading for a capacity crunch (likely in Great Britain, less likely elsewhere) and that Irish power would fill the gap. British electricity may well be very expensive around 2020, but it is unlikely that that will last very long. Gas-fired power stations can be built in a matter of years, and shale will keep down the price of gas.

I still fail to understand the business plan of SoI. I would be surprised if this is economically viable, but if others want to invest in it, that’s fine by me as long as they keep the taxpayer out of it. But if this is a commercial venture, then why send a glossy brochure to all and sundry? SoI apparently even visits schools. The glossy lists all sorts of social benefits, but no private ones. This strikes me as a plan to get subsidies.

UPDATE: Graham O’Donnell responds:

Hello Richard,

Thank you for your renewed interest in the project. In fairness to you and to others who have commented, the responsibility now rests with Spirit of Ireland to answer the questions you have raised.

Over the last two years, we have worked through every aspect of the project in great detail. While particular site-specific designs have not yet commenced, we have sufficient detailed costings across a number of locations to complete comprehensive business plans and financial projections. These show a robust technical, commercial and business model.

You were right about several things. Energy independence cannot be achieved in five years. It will take 5 to 6 years to build the first Hydro Storage Reservoir. Based on investor appetite, an additional location could commence approximately every two years thereafter. While be examined very many locations, 4 to 5 appear economically feasible. The smaller scale locations simply do not work.

Secondly, you are correct, it would not make economic sense to damage existing capital investments in thermal power stations. These make a valuable contribution to Ireland’s energy mix, security and exports. We need to optimise their use.

Our initial launch over 18 months ago, was a little flamboyant and in some respects very general, but the principles are sound.

First some basic facts about the project as it now:
1. No state subsidies are assumed to be received
2. Ireland’s energy needs are now being met. Any additional energy produced can be exported provided is done so on competitive terms.
3. Spirit of Ireland is not proposing to build wind farms. This was part of the original plan but there are sufficient number of wind farms in planning that a contracted approach is now the preferred route.
4. the cost of the Hydro Storage Reservoir is approximately 700 million Euro
5. another 700 million is required for substations and bulk power transmission
6. around 200 million is allocated to lower voltage networks
7. the business model is a mix of approximately 50% contracted wind and 50% power purchased from the Irish market at times of excess supply
8. unless required for reasons of security, relatively little power will be fed into the Irish system.
9. a separate capital and purchase envelope is being negotiated, to allow Irish wind farm developers to build additional wind resources. These would be owned by the developers.

About a year ago, following an enormous amount of detailed design, technical and financial analysis, the first draft business plan was produced. It was examined by financial groups in Dublin and London. We iterated this based on expert input, re-costed many aspects and built a succession of additional technical models. The results were very surprising indeed. The interaction between intermittent wind and large scale hydro storage is counterintuitive. Our initial technical models resembled the traditional pumped storage approach. By the time we had finished, a whole new methodology for the operation of storage with wind had evolved. This had very surprising and beneficial commercial results.

One significant mistake that some commentators made was that much energy would be wasted, because we pump all of the wind. This is not the case. In many normal circumstances, the wind simply passes the door. Energy is used only to keep the reservoir at levels sufficient to meet contracted demand.

The hydro storage reservoir produces revenue of between 600 and 800 million Euro per year for the average station. Larger ones produce proportionately more. Take away the costs of the purchased contracted wind power and a more than respectable profit is produced.

The financial assumptions do not include for receipt of the Irish Refit subsidy. Capital costs are kept low by building surface rather than tunneled hydro storage facilities. Framework agreements were negotiated with all the major wind turbine providers, such that significant discounts would apply where many turbines were purchased over a 2 to 3 year period. The keys to success are low capital costs, high wind capacity (33% assumed) and the ability to dispatch power at a time which achieves the highest commercial return.

With respect to ownership, our objective is that these assets are owned to the greatest extent possible by Irish people. The balance of investment can come from external sources. We cannot guarantee at this stage that the project will be funded. However, we can confirm that the level of interest internationally from very large sources of funds is extraordinary. Clearly they will only invest if the numbers and project risk work for them.

The greatest risk to the project is now perceived to be planning rather than technical or financial issues. There are no shortcuts to the planning or environmental processes. These have to be done by the book. It is our responsibility to ensure that we give this project the greatest possible chance of success by conducting a highly professional and consultative environmental and planning process. This has already started with able and generous direction and advice from government officials in Dublin and Brussels.

It is correct to say that wind on its own require subsidies. While wind is a free source of energy, it is not immediately dispatchable and therefore not predictably saleable to large buyers such as the UK power utilities. When combined with low cost storage in a symbiotic operation, wind can participate in any market on a predictable contractible – known price basis.

From a commercial perspective, every major UK power operator wants to buy dispatchable carbon free power. They will buy it from Ireland. They are all required by EU law that a minimum proportion of their generation output comes from renewable resources. The Italians and Germans, all face huge power shortages. The EU Energy Commissioner declared in a report of last month that Europe would need to spend up to EUR1 trillion to secure energy supplies. This Commission report is available on the web.

It is also correct to say that nobody knows the future price of gas. Some think it will follow the price of oil upwards, others that that link with oil will be broken. It is this very commercial uncertainty that means that large UK power buyers do not want to place all of their bets in gas power stations. The lights will not go out in the UK or anywhere else, but there is an extraordinary opportunity available to Ireland to export power to the almost unlimited British and EU market.

Our objectives are:
1. everyone recognise that Ireland has extraordinary wealth in terms of natural energy
2. create a coherent technical, commercial, legal and financial framework, which makes rapid large scale development of these resources possible
3. finalise business and investment plans, acceptable to international investors
4. create a structure which allows all current players to participate – private, semi state and community
5. to the greatest extent possible, ensure that the ownership and resulting profits return to the Irish people – in perpetuity

Some information on our website is out of date. It will be amended shortly.

We are in commercial negotiations with many parties and we cannot discuss all of the details of the project. However, within the constraints of time, we will try to answer any reasonable questions that people may have.

Kindest regards,

Graham O’Donnell

Krugman agrees with O’Rourke

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

Regional Quantitative Easing in the Eurozone

There are obvious difficulties and constraints on monetary policy in the 16-member Eurozone compared to more fully integrated currency zones like the fifty states of the USA, the ten provinces of Canada, etc. But could the lack of integration in the 16-member eurozone be used advantageously for some types of policies?

Continue reading “Regional Quantitative Easing in the Eurozone”

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.