It is now over two weeks since we have had a change of government here and in the meantime a special meeting of eurozone leaders has taken place to discuss a modified Competitiveness Pact to support the euro. This report will reflect an Irish view of the problems.
There are two sets of discussions taking place and neither side is listening to the other. One is the financial market which worries about sovereign default; the other the eurozone leaders dealing with the question of saving the euro. Both problems are interrelated.
Wall Street financiers ask the question when will Ireland default on sovereign debt, not will it default. When Wall Street traders see the figures they see the high debts of the banks and the amount that has to be paid by the taxpayers of the state, they all agree the way to go forward is to default and that If Ireland stops paying the bank debt then the economy will recover very quickly and the country can start again. The words of the European Commission and the European Central Bank are simply not believed by the market.
George Magnus from UBS has said that EU leaders seem unable to see that the festering EU debt crisis cannot be resolved without going to the root cause and recapitalise the banks. Louis Gargou from LNG Capital has stated that the EU will do too little too late and the markets will dictate the solution.
Financial markets have concluded that the Irish banks cannot be restructured within the financial parameters of the EU / IMF deal. There appears to be a growing consensus amongst European economists that the Irish debt situation is unsustainable despite the ECB / IMF arrangements. Borrowing more money to repay bondholders and even more money to recapitalise the banks after the latest bank stress tests are revealed will mean that the limit to what the taxpayer can bear is near and that default is inevitable. Default or debt restructuring is not only unavoidable but necessary before there is any further destruction of the Irish economy. One possible solution proposed by Irish economist Karl Whelan is a debt for equity swap for the banks. He proposes that the €150 billion bank funding from the ECB and the Irish Central Bank be converted into equity. These banks will immediately be solvent beyond the most pessimistic doubts of the financial markets and they could then be sold into private ownership. This could be organised through the new stability fund which would allow repayments to the ECB and would help restore the credibility of the ECB; it would also restore the Irish banks to stability without seeing defaults on senior bondholders and reduce the possibility of a state sovereign default.
The argument within the eurozone is the need to restore stability. The proposed new bank stress tests suggest that there is still no stability yet in the eurozone. The periphery countries face continuing financial instability as their bond yields indicate that the market believe that there is a high risk of sovereign default. European leaders believe that there is no banking crisis or that whatever crisis there is can be dealt with by the ECB which financiers know lacks the key financial instruments and perhaps the will to act.
The proposed Pact for the Euro assumes that the euro crisis is a problem of sovereign indebtedness which can be solved by a stringent programme of fiscal retrenchment and stronger rules against overspending. The rate of interest on the rescue fund for Ireland has been deliberately increased by 3 per cent as a penal rate to punish what Europe sees as a profligate spending spree by Ireland.
As Willem Buiter of Citibank stated, the current interest rate is an invitation to sovereign default. It makes no sense as part of a package that is meant to prevent sovereign default. European leaders appear to believe that the indebted countries can avoid default through domestic action alone. However, in Ireland the problems do not arise from state indebtedness but from a weak and overleveraged banking system which is bigger than the state can support. The proposed German solution will not repair it. The current position looks like a policy mistake imposing an unacceptable burden on peripheral states to resolve common European problems.
According to the latest data from the Bank for International Settlements, German banks are owed €99 billion by Irish banks and French banks are owed €30.9 billion. One of the arguments against Irish debt restructuring is that German and French banks don’t have balance sheets strong enough to withstand this kind of loss.
The vast majority of Ireland’s creditors lent their money to private Irish banks, not to the government, yet the government is expected to repay these loans due to the bank guarantee. In doing so it has protected the financial systems in other countries by preventing a financial contagion in EU financial markets on a Lehman Brothers scale. Many of the bondholders include major banks and insurance companies, which explains the unwillingness of the ECB to allow a haircut of bondholders. Yet eurozone leaders seem prepared to allow debt restructuring under the new permanent stability fund after 2013 but not before. No one knows why this date cannot be changed and brought forward.
It is clear that the IMF / EU plan to deleverage and recapitalise the banking system cannot be financed within Irish resources. It is argued that lenders should be forced to accept some financial responsibilities. What Ireland needs is liquidity not a bailout. It is not fully understand how totally interdependent European banks now are.
The two challenges facing European leaders are the avoidance of disorderly default by the periphery countries on sovereign debt and the resolution of a European-wide banking crisis. At the recent eurozone meeting Ireland was offered a 1 per cent reduction in the bailout interest rate in return for an increase in the country’s corporate tax rate. This offer was rejected. It was noted that the French corporation tax rate was 8.2 per cent when hidden incentives are included, which is lower than the Irish rate. Germany’s rate is 15.8 per cent. A recent study by the Chartered Accountants of Ireland showed that corporation tax rate yield in Ireland is the equivalent of 2.9 per cent of GDP while in Germany it is 1.1 per cent and in France 2.8 per cent. The report also states that Ireland’s corporation tax take constitutes 9.8 per cent of its overall tax rate compared with 2.8 per cent in Germany and 6.5 per cent in France.
It appears to Ireland that the ECB is willing to see the cost of the bailout fall on the shoulders of the Irish taxpayer. It was the ECB that ruled out any prospect of senior bondholders sharing some of the cost of the bailout, for fear it would destabilise the eurozone. In European terms it appears that Ireland should continue to pay off European banks who lent recklessly to Irish banks and to stop talking about interest rate decreases and defaults.
The new Irish finance minister Michael Noonan will propose that the new EU bailout mechanism be used as an insurance on lending by bond markets to Ireland. This, it is believed, would encourage the private sector to take over funding of Irish banks from the ECB. He will also ask for a longer time frame to sell off bank assets rather than having a firesale which would increase bank losses. He would also like to see more medium term liquidity available to Irish banks. This is at odds with the ECB exit strategy which would like to wean what it sees as addicted banks from emergency support operations.
A banking crisis will not go away although it can be postponed by piling costs on peripheral states. The German Social Democrat leader Frank-Walter Steinmeier is reported as supporting cautious moves to creating a eurobond system which would collectivise the risk at EU level. It looks as if the choice facing the eurozone is sovereign defaults or a move to some form of a transfer union or else plunge everyone into a deeper crisis. If the new stability pact allows the ECB to buy up to €77 billion of sovereign bonds, Dr Ulrike Guerot, Berlin head of European Council on Foreign Relations, notes on her blog that the bailout figure under discussion represents about 1 per cent of eurozone GDP. The financial markets’ reaction to the proposed new Pact for the Euro, while initially favourable, now suggests that the day of reckoning has only been delayed.
As Jean Monnet said, Europe will be forged in crisis and will be the sum of the solutions adopted for these crises.
This article was written by Patrick Mc Nally, member of the Federal Union committee. The opinions expressed are those of the author and not necessarily those of Federal Union (nor of Enda Kenny). 18 March 2011.